SCR

An ultimate book of
FINANCE
AND
ACCOUNTING
ACCOUNTING – FINANCE - SECURITIES

CHANDRA SEKHAR
M.Com., M.B.A
S.V.U. College of C.M.I.S

Copyright © Chandra Sekhar, 2020

Preface
It gives me a great pleasure and satisfaction to present this book “FINANCE
AND ACCOUNTING”. The main characteristics of the book are simple
understanding and key concepts. The following important highlights in this
book will make the users to read this book.

i. I have illustrated Accounting cycle steps by creating 42 transactions, given

the journal entries for these 42 transactions, prepared all the various ledger
accounts from these journal entries, preparation of Trial balance has done
with these ledger account balances and finally, prepared the final accounts
(Trading, Profit and loss account and Balance sheet) based on the Trial
balance. Hence, I conclude that the end-to-end process of Accounting cycle
with data interpretation has done in this book which will help the readers to
understand that “where can we get the amounts which are appear in trial
balance).

ii. I have evaluated 45 ratios based on latest financial statements of a leading

manufacturing company for the financial year ended December 2019.

iii. Clear presentation of financial statements analysis have done in this book.

iv. Bank Reconciliation statement have prepared based on real time scenario.

v. Capital budgeting methods have explained in clear and transparent manner.

vi. Readers can easily understand about Derivatives.

vii. The computation of Sensex from live indices will help the readers to
understand how the Sensex figures arrive.

And also, I have given an important 150 terms under ‘GLOSSARY’ at the
end of the book which can be used as a quick reference to learn an important
terminology of Finance and Accounts. Chapter wise hyperlink will help the
readers to go quickly to the desired chapter. This book is useful to everyone
in Finance and Accounting field like students, Accounts executives, Financial
analysts, etc. I have added two important chapters ‘Monetary policy Rrates’
and ‘GDP and Inflation’ in this book. I hope that the book will help the
readers to study in a focused manner. Any criticism and constructive
suggestion in the direction of making the book a better teaching and studying
manual will be gratefully acknowledged by the author. Suggestions will be
incorporated in the subsequent editions.
All the best …

Chandra Sekhar
Sri Venkateswara University
[email protected]

Acknowledgement
This book drawn from the works of a large number of researches in the field of Cost accounting. My
writing in this book has also been influenced by a number of standard and popular text books,
magazines, and websites in the field. I express my gratitude to all of them. I have tried to give credit to
all sources from where I have drawn material in this book. Still there may have remained unintended
errors. I shall feel obliged if they are brought to my notice.
Chandra Sekhar

About the Author

Chandra Sekhar holds an M.Com., and MBA in Finance during 2007-09 from Sri venkateswara
university college of Commerce, Management and Information Sciences, Sri venkateswara university.
He has also got certifications in Finance field from National Stock Exchange and Bombay Stock
Exchange. He has been working with Conduent, Bangalore in Finance and Accounts field. He worked
in Capgeminini, and Shahi exports private limited. He also served in external audit field for large
companies like MRF, Aventis pharma limited, and Zydus Cadila health care limited, etc. Chandra
Sekhar’s general area of expertise lies in writing books and articles in Financial accounting, Cost and
Management accounting. His specific research interest is in Cost Accounting, Financial decision-
making process mainly through Ratio analysis, Capital budgeting decisions, Capital markets and
financial services. He is the author of more than 35 books and management cases.
Chandra Sekhar

Dedicated
---- to ----
My father

CONTENTS
Chapter
Name of the chapter
No.
1 ACCOUNTING FOR BEGINNERS
 2 JOINT STOCK COMPANIES
3 BANK RECONCILIATION STATEMENT
DEPRECIATION AND REVALUATION OF
4
FIXED ASSETS
5 BREAK-EVEN ANALYSIS
6 CAPITAL BUDGETING
7 WORKING CAPITAL MANAGEMENT
8 FINANCIAL STATEMENTS ANALYSIS
9 FINANCIAL RATIO ANALYSIS
10 LEVERAGES
11 TIME VALUE OF MONEY
12 VALUATION OF BONDS AND SHARES
13 COST OF CAPITAL
14 PORTFOLIO MANAGEMENT
15 SENSEX
16 FINANCIAL DERIVATIVES
INTERNATIONAL FINANCIAL
17
MANAGEMENT
18 MONETARY POLICY RATES
19 GDP AND INFLATION

CHAPTER – 1
ACCOUNTING FOR BEGINNERS
I. INTRODUCTION TO ACCOUNTING
1. Accountancy
2. Accounting
3. Branches of Accounting
4. Methods of Accounting
5. Generally Accepted Accounting Principles (GAAP)
6. Accounting Principles
Concepts
i. Business Entity
ii. Money measurement
iii. Cost concept
iv. Going concern
v. Realization
vi. Dual aspect
vii. Accounting period
 viii. Accrual
ix. Matching
Conventions
i. Consistency
ii. Disclosure
iii. Materiality
iv. Conservatism
v. Relevance
vi. Feasibility
vii. Objectivity
7. Account
8. Classification of Accounting
9. Capital type accounts vs Revenue type accounts
10. Permanent accounts vs Temporary accounts
11. Debit balance vs Credit Balance
12. Accounting Cycle
II. DOUBLE ENTRY SYSTEM
1. Book keeping
2. Single entry system
3. Double entry system
4. Journal
5. Ledger
6. Classification of ledger

III. SUBSIDIARY BOOKS

1. Cash book and its subsidiaries
2. Purchase book
3. Sales book
4. Purchase Returns book
5. Sales Returns book
6. Bills Receivable book
7. Bills Payable book
8. Journal proper
IV. TRIAL BALANCE
1. Suspense account
V. FINAL ACCOUNTS
1. Trading account
2. Profit and loss account
3. Balance sheet
VI. ACCOUNTING CYCLE (end to end interpretation)
a. 42 Transactions selection
b. Journal entries for 42 transactions
c. Preparation of Ledger accounts and balanced for those transactions
d. Preparation of Trial balance with those ledger balances
 e. Preparation of Trading and Profit & Loss account based on the Trial balance
f. Preparation of Balance sheet based on the Trial balance

CHAPTER – 2
JOINT STOCK COMPANIES
I. COMPANIES
A. Meaning of company
B. Meaning of corporation
C. Difference between company and corporation
D. Difference between Inc. and Ltd
E. Characteristics of a company
F. Statutory books
G. Types of companies
i. Chartered companies
ii. Statutory companies
iii. Registered companies
iv. Limited liability companies
v. Companies limited by shares
vi. Companies limited by guarantee
vii. Un limited companies
viii. Public ltd
ix. Private ltd
x. Difference between public ltd and Pvt. ltd
xi. Holding company
xii. Subsidiary company
xiii. Govt. company
ix. Non-Govt. companies
i. Foreign company
ii. One-person company
II. SHARES
A. Introduction
B. Types of Shares
1a. Equity Shares
i. Characteristics
ii. Advantages
iii. Disadvantages
1b. Other type of equity shares
i. Blue chip shares
ii. Income shares
iii. Growth Shares
iv. Cyclical shares
v. Defensive shares
vi. Speculative shares
2. Preference shares
i. Cumulative & Non-cumulative preference shares
ii. Participated & Non-participated preference shares
 iii. Redeemable & irredeemable preference shares
iv. Convertible & Non-convertible preference shares
v. Deferred shares
C. Types of Share capital
i. Authorized capital
ii. Issued capital
iii. Subscribed capital
iv. Called up capital
v. Paid up capital
vi. Reserve capital
D. Order of issuing shares
i. Prospectus
ii. Application for shares
iii. Allotment of shares
iv. Calls on shares
E. Issue of shares at premium
F. Issue of shares at discount
G. Forfeiture of shares
H. Accounting – Issue of shares
I. Rights issue
i Reasons to right issue
ii. Advantages of Right issue
J. Buy-back of shares
i. Introduction
ii. What is buy back
iii. How is buy back
iv. Conditions to buy back
v. Notes to not buy back
vi. Maintenance of registers
vii. Sources of buy back
viii. Modes of buy back
ix. Advantages of buy back
x. Determination of quantum for buy back
xi. Accounting treatment – buy back
K. Redeemable preference shares
i. Introduction
ii. Conditions for issue and redemption redeemable pre. shares
iii. Capital Redemption Reserve
iv. Accounting-Redemption of shares & issue on bonus shares
III. DEBENTURES
A. Introduction
B. Debentures vs Bonds
C. Bonds and its kinds
D. Debentures and its types
i. Registered debentures
ii. Bearer debentures
iii. Mortgage debentures
iv. Naked debentures
v. Redeemable debentures
vi. Irredeemable debentures
 vii. Convertible debentures
viii. Non-convertible debentures
ix. First debentures
x. Second debentures
E. Key differences between bonds and debentures
F. Loan vs Debt
G. Advantages of Debentures
H. Requirements of Debentures
I. Shares vs Debentures
J. Issue of debentures
i. Important provisions to issue of debentures
ii. Issue of consideration for cash
iii. Issue of consideration for other than cash
iv. Issue of consideration for collateral security
v. Accounting treatment – issue of debentures
K. Redemption of debentures
i. Introduction
ii. SEBI on creation of DRR
iii. Creation of provision for DRR
iv. Sinking fund method – Accounting treatment
v. Insurance policy method – accounting treatment
L. Methods – Redemption of debentures
i. Conversion
ii. Rollover
M. Sources of Redemption
i. Redemption out of capital
ii. Redemption out of profits
N. Conversion or Rollover and Accounting treatment
O. When to be redeemed
i. By Annual drawings
ii. Purchase and cancellation of own debentures
iii. Accounting treatment

CHAPTER – 3
BANK RECONCILIATION STATEMENT
INTRODUCTION TO BRS
IMPORTANCE OR NEED TO PREPARE BRS
TERMS USED IN THIS CHAPTER
REASONS FOR DIFFERENCES IN CASH BOOK OR PASSBOOK
1. Cheques issued but not presented for payment
2. Interest on investments collected by bank and recorded in pass book only
3. Bank interest credited in passbook only
4. Customers deposited the funds directly in to the bank
5. Cheques collected by bank and recorded in bank pass book only
6. Interest on debentures / bonds collected by bank and recorded in pass book only
7. Dividends collected by bank and recorded in pass book credit only
8. Wrong (excess) credit in pass book or cash book
9. Cheques deposited (paid) in to bank, but, not credited (cleared) in to pass book
10. Bank charges debited in pass book only
11. Cheque deposited in to bank, but, it was dishonored
12. Commission charged by bank in pass book debit only
13. LIC premium debited in pass book only
14. Promissory note amount paid by bank but not recorded in cash book
15. Interest on overdraft debited in pass book only
16. Received cheque from customer is recorded in cash book and forgot to send the same to bank
(Omitted to be banked)
17. Rent paid by bank, but, not recorded in cash book
18. Wrong (excess) debit in pass book or cash book
CASE STUDY AND SOLUTION
CONCLUSION

CHAPTER – 4
DEPRECIATION AND REVALUATION OF FIXED
ASSETS
A. MEANING OF DEPRECIATION
B. ACCUMULATED DEPRECIATION
C. DEPRECIATION ACCOUNTING – AS 6
1. DEFINITIONS
(i) Depreciation
(ii) Depreciable assets
(iii) Useful life
(iv) Depreciable amount
2. DISCLOSURE
D. DIFFERENCE – DEPRECIATION, AMORTIZATION, DEPLETION AND DILAPIDATION
E. CAUSES OF DEPRECIATION
F. NEED FOR PROVIDING DEPRECIATION
G. ACCOUNTING FOR DEPRECIATION – JOURNAL ENTRIES
1. When Accumulated depreciation/Provision for depreciation is not maintained
2. When Accumulated depreciation/Provision for depreciation is not maintained
H. METHODS OF DEPRECIATION
1. Straight line method with example
2. Written Down Value method with example
3. Annuity method with example
4. Depreciation Fund (Sinking fund) method with example
5. Double declining balance method with example
6. Units of production method with example
7. Machine hour rate method with example
8. Sum of years’ digits method with example
I. Definition of Revaluation of Fixed Assets
II. Reasons for Revaluation of fixed As./ sets
III. Classification of Valuation of Fixed Assets
A. Cost Model
B. Revalued Model
(1) Indexation Method
(2) Current Market Value Method
(3) Selective Method
(4) Appraisal Method
Upward Revalued amount
Downward Revalued amount
Reversal of Revaluation
IV. Case Study

CHAPTER – 5
BREAK-EVEN ANALYSIS
I. INTRODUCTION
II. BREAK-EVEN POINT
III. DETERMINANTS OF BEP
1. BEP in terms of physical units
Example and Solution
2. BEP in terms of sales value
Example-1 and Solution
Example-2 and Solution
3. BEP as a percentage of full capacity
Example and Solution
IV. BREAK-EVEN CHART
1. Meaning of BEC
2. Example of BEC
3. Construction of BEC
4. Angle of incidence
5. Margin of safety
V. NOTES OF BREAK-EVEN ANALYSIS
VI. ASSUMPTIONS OF BREAK-EVEN ANALYSIS
VII. ADVANTAGES OF BREAK-EVEN ANALYSIS
VIII. LIMITATIONS OF BREAK-EVEN ANALYSIS
IX. PROBLEMS AND SOLUTIONS
1. Case-1 and solution
2. Case-2 and solution
3. Case-3 and solution
4. Case-4 and solution
 5. Case-5 and solution

CHAPTER – 6
CAPITAL BUDGETING
I. INTRODUCTION
II. CAPITAL BUDGETING METHODS
1. Payback period
2. Discounted payback period
3. Average rate of return
4. Net present value
5. Profitability index
6. Internal rate of return
7. Modified internal rate of return
III. CONCLUSION

CHAPTER – 7
WORKING CAPITAL MANAGEMENT
1. Introduction
2. Concepts of working capital
a. Gross working capital
b. Net working capital
3. Current assets management
4. Liquidity management
a. Measures of liquidity
i. Current ratio
ii. Liquid ratio
iii. Net working capital ratio
5. Operating cycle
A. Gross operating cycle
a. Inventory conversion period
i. Raw material conversion period
ii. Work-in-progress conversion period
iii. Finished goods conversion period
iv. Debtors conversion period
B. Net operating cycle
i. Creditors deferral period
6. Statement of Cost of sales
7. Permanent and variable working capital
8. Balanced working capital maintain
a. Excessive working capital
b. Inadequate working capital
9. Policies for financing current assets
 a. Short-term financing
b. Long-term financing
c. Spontaneous financing
10. Estimating working capital requirement
A. Methods of estimating WC requirement
a. Current assets holding period
b. Ratio of sales
c. Ratio of fixed investment
11. Factors influencing working capital
12. Advantages of working capital
13. Problems and Solutions
i. Case 1 and solution
ii. Case 2 and solution
iii. Case 3 and solution
iv. Case 4 and solution
v. Case 5 and solution

CHAPTER – 8
FINANCIAL STATEMENTS ANALYSIS
I FINANCIAL STATEMENTS
A. BALANCE SHEET
1. ASSETS
a. Non-Current assets
Tangible Fixed assets
Intangible fixed assets
b. Current assets
2. LIABILITIES
a. Long-term liabilities
b. Current liabilities
3. OWNER’S EQUITY
Pro forma of Balance sheet
B. PROFIT AND LOSS ACCOUNT
i. Operating Income
ii. Operating Expenses
iii. Non-operating Income
iv. Non-operating Expenses
v. Gross profit
vi. Net Profit
vii. EBITDA
viii. EBIT
ix. EBT
x. EAT
xi. NOPAT
Pro forma of Profit and loss account
C. STATEMENT OF CHANGES IN FINANCIAL POSITION
1. FUNDS FLOW STATEMENT
 i. Forms of funds flow statement
ii. Sources & uses of working capital
iii. Schedule of changes in working capital
iv. Sources of working capital
v. Funds from operations
vi. Uses of working capital
vii. Exercise with working notes (case study)
2. CASH FLOW STATEMENT
a. Sources of cash
b. Uses of cash
c. Categories of cash flow statement
i. Operating activities
ii. Investing activities
iii. Financing activities
Pro forma of Cash flow statement
D. STATEMENT OF CHANGES IN EQUITY
Pro forma of Retained earnings statement
II. FINANCIAL STATEMENTS ANALYSIS
1. Comparative analysis
2. Common size analysis
3. Trend analysis
4. Inter-firm analysis
III. F A Q s
1. What is the Annual report?
2. What is Annual General Meeting?
3. What are 4 basic financial statements?
4. What is the order of financial statements?
5. How do we prepare the financial statements?
6. What are the users of financial statements?
7. What are the elements of financial statements?

CHAPTER – 9
FINANCIAL RATIO ANALYSIS
A. INTRODUCTION TO FINANCIAL ANALYSIS
B. RATIO ANALYSIS
1. MEANING OF RATIO
2. ADVANTAGES OF RATIOS
3. DISADVANTAGES OF RATIOS
C. CLASSIFICATION OF RATIOS
I. BALANCE SHEET RATIOS
1. CURRENT RATIO
2. QUICK (LIQUID) RATIO
3. CASH (ABSOLUTE LIQUID) RATIO
4. INTERVAL MEASURE RATIO
5. NETWORKING CAPITAL RATIO
 6. DEBT RATIO
7. DEBT EQUITY RATIO
8. CAPITAL EMPLOYED TO NET WORTH RATIO
9. PROPRIETARY RATIO
10. ASSETS TO NET WORTH RATIO
11. CAPITAL GEARING RATIO
II. PROFIT AND LOSS ACCOUNT RATIOS
1. INTEREST COVERAGE RATIO
2. DEBT SERVICE COVERAGE RATIO
3. GROSS PROFIT RATIO
4. NET PROFIT RATIO
5. OPERATING COST RATIO
6. EXPENSE RATIO
7. OPERATING PROFIT RATIO
8. MATERIAL CONSUMED RATIO
9. MANUFACTURING EXPENSES RATIO
10. FINANCIAL LEVERAGE RATIO
11. OPERATING LEVERAGE RATIO
12. PREFERENCE DIVIDEND COVERAGE RATIO
13. EQUITY DIVIDEND COVERAGE RATIO
III. MIXED OR COMBINED RATIOS
1. INVENTORY TURNOVER RATIO
2. DEBTORS TURNOVER RATIO
3. CREDITORS TURNOVER RATIO
4. NET ASSETS TURNOVER RATIO
5. TOTAL ASSETS TURNOVER RATIO
6. FIXED ASSETS TURNOVER RATIO
7. CURRENT ASSETS TURNOVER RATIO
8. WORKING CAPITAL TURNOVER RATIO
9. RETURN ON CAPITAL EMPLOYED (ROCE)
10. RETURN ON INVESTMENT (ROI)
11. RETURN ON EQUITY (ROE)
12. RETURN ON PROPRIETOR’S FUND
13. RETURN ON TOTAL ASSETS
14. EPS & DILUTED EPS
15. DPS (DIVIDEND PER SHARE)
16.PAYOUT RATIO
17. DIVIDEND YIELD (MARKET YIELD) RATIO
18. EARNINGS YIELD RATIO
19. PRICE-EARNINGS RATIO
20. MARKET VALUE TO BOOK BALUE RATIO
21. CAPITAL TURNOVER RATIO
D.ANNEXURE

CHAPTER – 10
LEVERAGES
I. Definition of Leverage
II. Capital structure
III. Types of Leverages
1. Operating leverage
Degree of operating leverage
2. Financial Leverage
Degree of financial leverage
A. Measures of Financial leverage
i. Debt ratio
ii. Debt-equity ratio
iii. Interest coverage ratio
B. Financial leverage & Shareholder’s return
i. Calculation of EPS
ii. Calculation of ROE
iii. Effect of leverage on EPS & ROE
C. Financial leverage and shareholder’s risk
3. Combined leverage
Degree of combined leverage
IV. Problems and solutions
i. Case 1 and solution
ii. Case 2 and solution
iii. Case 3 and solution
iv. Case 4 and solution
v. Case 5 and solution
vi. Case 6 and solution
vii. Case 7 and solution

CHAPTER – 11
TIME VALUE OF MONEY
I. Meaning of Time value of money
II. Types of Time value of money
1. Future value of single cash flow
i. Discrete method with example
ii. Compound method with example
2. Future value of an annuity
i. Discrete method with example
ii. Compound method with example
3. Present value of a single cash flow
i. Discrete method with example
ii. Compound method with example
4. Present value of an annuity
i. Discrete method with example
ii. Compound method with example
 CHAPTER – 12
VALUATION OF BONDS AND SHARES
I. DEFINITIONS
A. Value
B. Tangible asset
C. Intangible asset
D. Financial asset
E. Concepts of the value
a. Book value
b. Replacement value
c. Liquidation value
d. Market value
F. Bond/Debenture
a. Features of a bond
i. Face value
ii. Interest rate
iii. Maturity
iv. Redemption value
v. Market value
II. VALUATION OF BONDS AND DEBENTURES
A. Bond/debenture with maturity
B. Yield to maturity
C. Current yield
D. Yield to call
E. Bond value and amortization
i. Annual interest payments
ii. Semi-annual interest payments
F. Pure discount bonds
G. Perpetual bonds
H. Bond duration – Interest rate sensitivity
I. Yield curve
III. VALUATION OF PREFERENCE SHARES
A. Types of preference shares
i. Redeemable & Irredeemable
ii. Cumulative & Non-cumulative
iii. Transferable & Non-transferable
B. Share value with maturity
C. Irredeemable preference shares
D. Yield on preference shares
IV. VALUATION OF ORDINARY SHARES
A. Single-period valuation
B. Multi-period valuation
C. Growth in dividends
i. Constant growth
 ii. Super-normal growth
iii. Normal growth
iv. Perpetual growth
v. Zero growth
D. Earnings model
E. Equity capitalization ratio
V. BETA ESTIMATION AND COST OF EQUITY
A. Beta
B. Case with calculation of:-
i. Average return on market
ii. Average return on firm
iii. Deviations on market returns
iv. Deviations on firm’s returns
v. Variance of firm
vi. Co-variance of market returns
vii. Beta
viii. Alpha
ix. Characteristic line of a firm
x. Correlation between market return and firm
C. Cost of Equity
VI. COST OF CAPITAL
A. Cost of capital
B. Debt issued at par
C. Debt issued at Discount
D. Sold at discount and redeem at par
E. Cost of preference capital
F. Cost of Equity share capital
G. Cost of Irredeemable preference shares
H. Dividend growth rate
i. Constant growth
ii. Normal growth
iii. Zero growth
I. Weighted average cost of capital (WACC)
VII. ANNUITY FACTOR TABLES
A. Future value of a lump sum
B. Present value of a lump sum
C. Future value of an annuity
D. Present value of an annuity

CHAPTER – 13
COST OF CAPITAL
I. DEFINITION OF COST OF CAPITAL
II. IMPORTANCE OF COST OF CAPITAL
III. COMPONENTS OF COST OF CAPITAL
IV. CLASSIFICATION OF COST OF CAPITAL
V. COMPUTATION OF COST OF CAPITAL
A. Computation of specific costs
1. Cost of Debt
(a) Cost of irredeemable debt
(b) Cost of redeemable debt
(c) Cost of existing debt
2. Cost of preference shares
(a) Cost of irredeemable preference share capital
(b) Cost of redeemable preference share capital
3. Cost of Equity shares
(a) Dividend model (No growth)
(b) Dividend plus growth (Dividend discount) model
(c) Earnings model
(d) Capital Asset Pricing model (CAPM)
4. Cost of Retained Earnings
B. Cost of Composite capital or Weighted Average Cost of Capital

CHAPTER – 14
PORTFOLIO MANAGEMENT
1. MEANING OF PORTFOLIO
2. MEANING OF DIVERSIFICATION
3. PROCESS OF PORTFOLIO MANAGEMENT
A. MEANING OF PORTFOLIO MANAGEMENT
B. STEPS IN PORTFOLIO MANAGEMENT
i. Identification of objectives and constraints
ii. Selection of Asset mix
iii. Formulation of portfolio management
iv. Security analysis
v. Portfolio execution
vi. Portfolio revision
vii. Portfolio evaluation
4. PORTFOLIO RETURN AND RISK
A. PORTFOLIO RETURN
B. PORTFOLIO RISK
i. Variance
ii. Standard deviation
iii. Difference between variance and standard deviation
C. EXAMPLE WITH SOLUTION
5. MEASUREMENTS IN CO-MOVEMENTS IN SECURITY RETURNS
A. COVARIANCE
B. COEFFICIENT OF CORRELATION
C. NOTES TO MEASUREMENTS
6. PROBLEMS WITH SOLUTIONS
i. Problem 1 with solution
ii. Problem 2 with solution
 iii. Problem 3 with solution

CHAPTER – 15
SENSEX
I. BASIC CONCEPTS OF STOCK MARKET
1. Stock
2. Stock price
3. Why companies issue stock
4. Capital
5. Equity vs Debt
6. Bull and Bear markets
7. Hedging
8. Initial Public offering
9. Short selling
10. Rolling settlement
11. Market regulation
12. Blue-chip company
13. Advances and Declines
14. Market capitalization vs Turnover

II. ROLES OF STOCK MARKET

1. Introduction
2. Index
3. Types of indices
A. Foreign stock indices
B. Indian stock indices
(i) BSE stock indices
(ii) NSE stock indices

III. INTRODUCTION TO SENSEX

1. Meaning
2. Standard & Poor’s (S&P)
3. Objectives of Sensex
4. Scrips in Sensex
5. Sectors in Sensex
6. Selection and review of scrip for the Sensex
7. security groups in BSE

IV. COMPUTATION METHODOLOGY OF SENSEX

1. Introduction
2. Process of calculation of Sensex
3. Free-float
4. determine free-float factors of companies
5. Free-float bands
6. Determining Sensex using FF factor with example
 7. Advantages of free-float methodology
8. Adjustment of Base market capitalization
9. Example of Base market capitalization
10. Trading session timings
11. NOTES
A. Closing index value
B. Why don’t stocks begin trading at previous day’s closing price

V. CALCULATION OF SENSEX
1. Problem
2. Solution
3. NOTES
1. Open
2. Low
3. High
4. LTP
5. Number of shares traded
6. Number of trades
7. Total turnover

CHAPTER – 16
FINANCIAL DERIVATIVES
I. INTRODUCTION TO FINANCIAL DERIVATIVES
II. OVER-THE-COUNTER DERIVATIVES
III. HISTORY OF DERIVATIVES MARKET
IV. USES OF DERIVATIVES
V. INVESTING VS TRADING
VI. TYPES OF DERIVATIVES
1. FORWARDS
Introduction
Features of Forward contract
Limitations of Forward contract
2. FUTURES
Introduction
Features of Future contract
Limitations of Future contract
Types of settlement in Futures
(i) Cash based settlement
(ii) Delivery based settlement
When to buy or sell Futures
Vanilla vs. Exotic Derivatives
Short Selling
Open interest
Basis
3. OPTIONS
 a. Introduction
b. Call option
c. Put option
d. Strike Price
e. Spot price
f. Expiration date
g. American option and European Option
h. Option premium
i. In-the-money, At-the-money & Out-of-the-money
j. Intrinsic value
k. Extrinsic Value
l. Factors affecting Option value
m. Profit profile of Option buyer or seller
n. Speculative view – Option market participants
o. Option classes and series
p. Option Greeks
(i) Delta
(ii) Gamma
(iii) Vega
(iv) Theta
(v) Rho
q. Relationship – Option Delta & type of Option
r. Standard deviation
s. Volatility
t. Alpha
u. Beta
Option spread Strategies:-
(i) Bull call spread
(ii) Bull put spread
(iii) Bear call spread
(iv) Bear put spread
(v) Long Butterfly spread
(vi) Short Butterfly spread
(vii) Long Straddle
(viii) Short Straddle
(ix) Long Strangle
(x) Short strangle
4. WARRANTS
5. SWAPS
a. Introduction
b. Types of Swaps
(i) Interest rate swaps
(ii) Currency swaps
(iii) Commodity swaps
(iv) Equity swaps
(v) Asset swaps
(vi) Liability swaps
(vii) Total return swaps
VII. PARTICIPANTS IN DERIVATIVES MARKET
1. Hedgers
 i. Perfect hedge
ii. Imperfect hedge
iii. Cross hedge
iv. Short hedge
v. Long hedge
2. Speculators
3. Arbitrageurs
i. Hedging with Swaps
ii. Hedging with Options

CHAPTER – 17
INTERNATIONAL FINANCIAL MANAGEMENT
1. INTRODUCTION TO INTERNATIONAL FINANCIAL MANAGEMENT
2. FOREIGN EXCHANGE MARKET
a. Introduction to Foreign Exchange market
b. Structure of Foreign exchange market
c. Types of transactions and settlement dates
d. Participants in Foreign exchange market
e. Functions of Foreign exchange market
f. Segments of Foreign exchange market
3. FOREIGN EXCHANGE RATES
a. Foreign Exchange rate Quotations
i. Direct Quote
ii. Indirect Quote
b. Spot Exchange rates
c. Cross rates
d. Bid-Ask Spread
i. Bid Price
ii. Ask Price
iii. Factors influencing Spread
iv. Forward Exchange rates
4. INTERNATIONAL PARITY RELATIONSHIPS
a. Interest rate parity
b. Purchasing Power parity
c. Forward rates and expected future spot rate parity
d. International Fisher effect
5. FOREIGN EXCHANGE RISK
a. Transaction exposure
b. Economic exposure
c. Translation exposure
6. HEDGING FOREIGN EXCHANGE RISK
a. Instruments for hedging currency risk
i. Forward contract
ii. Currency futures
iii. Currency ETFs
iv. Currency options
 v. Money market operations
7. RISK MANAGEMENT
a. Definition
b. Steps in Risk management process
c. Types of Risk
8. GLOBAL INVESTMENT MANAGEMENT
a. Risks in Global investment
b. Benefits of Global investing
c. Why Global Investment
d. Where to invest
e. Factors influencing global investment decisions
9. INTERNATIONAL MONETARY SYSTEM
a. Introduction
b. Features of International monetary system
c. Stages of International monetary system
d. International Monetary Fund (IMF)
e. The World bank and its group
10. EXCHANGE RATE REGIME
a. Types of Exchange rate Regimes
b. Trends in Exchange rate regime
c. Who determine the exchange rates?
d. Determinants (factors) of exchange rates
11. BALANCE OF PAYMENTS (BOP)
a. Definition
b. Importance of Balance of Payments
c. Components of BOP
d. Deficit
e. Surplus
f. Imbalances of balance of Payments
g. Causes of BOP imbalances
h. Statement of BOP
12. FOREIGN DIRECT INVESTMENT (FDI)
a. Introduction
b. Types of FDI
c. Methods of FDI
d. Forms of FDI incentives
e. Advantages of FDI
f. Disadvantages of FDI
g. FDI in India
h. Difference between FDI and FII
13. INTERNATIONAL FINANCIAL MARKETS
A. Definition of Financial markets
B. Types of Financial markets
i. Capital markets
ii. Money markets
C. Sources of International finance/fund
a. Commercial banks
b. International Agencies
c. International capital markets
i. GDRs
 ii. ADRs
iii. FCCBs
iv. IDRs
v. ICDs

CHAPTER – 18
MONETARY POLICY RATES
I. OVERVIEW OF MONETARY POLICY
II. PROCESS OF MONETARY POLICY
III. GOALS OF MONETARY POLICY
IV. INSTRUMENTS / TOOLS OF MONETARY POLICY
A. Policy Rate
1. Bank Rate
2. Repo Rate
3. Reverse Repo Rate
4. MSF Rate
B. Reserve Ratios
1. CRR
2. SLR
C. Lending Rates
1. Base rate
2. Savings Bank Rate
3. Term Deposit Rate
4. MCLR
V. KINDS OF MONETARY POLICY
1. Expansionary
2. Contractionary
VI. OTHER TERMINOLOGY
1. Prime Lending Rate
2. London bank offered rate
3. Open Market Operations
4. Market Stabilization Scheme
5. Liquidity Adjustment Facility
6. Corridor
7. bps
8. Inflation
9. Deflation
10. Unencumbered securities

CHAPTER – 19
GDP AND INFLATION
GROSS DOMESTIC PRODUCT
I. Meaning of GDP
II. Calculation methods of GDP
1. GDP based on Production
2. GDP based on Income
3. GDP based on Expenditure
III. Formula to obtain GDP
1. Consumption
2. Investments
3. Government Expenditure
4. Net exports
IV. Other components
1. Net National product
2. National income
3. Private Income
4. Personal income
5. Disposable income
V. Difference between GDP and GNP
VI. Difference between Normal GDP and Real GDP
VII. Limitations of GDP
VIII. Case
INFLATION
I. What is Inflation
II. Calculation of inflation rate
i. Example 1
ii. Example 2
III. Classification of Inflation
1. demand-Pull effect
2. Cost-push effect
3. Built in inflation
IV. Inflation Indices
1. Wholesale Price Index
2. Consumer Price Index
V. Price Index
Problem & solution
VI. Inflation is a good or bad
VII. Controlling Inflation
VIII. Other terms
1. Deflation
2. Stagflation

GLOSSARY
GLOSSARY

------------ End of the CONTENTS ----------

 CHAPTER – 1
ACCOUNTING FOR BEGINNERS
Learning objectives
After studying this chapter, you can be able to :-
1. Understand Accounting concepts and
conventions,
3. Know golden rules of Accounting,
4. Learn Double entry system,
5. Know the Accounting cycle,
6. Understand and preparation of ledgers,
7. Preparation of subsidiary books, and
8. Preparation of Trial balance and Final accounts,
etc.

1. INTRODUCTION TO ACCOUNTING

Accountancy
Accountancy is the language of business efficiently communicated by well-
organized and the honest professionals are called as accountants.
Accountancy is one of the subjects like Mathematics, Science, Economics,
Politics, etc. which deals accounting and in this accountancy, we can learn
how accounting is done in a business.

Accounting
The process of recording, classifying, summarizing and reporting the
business transactions of a firm is called as Accounting.

The definition of accounting is given by the American Accounting

Association (AAA) as “The process of identifying, measuring and
communicating economic information to permit informed judgments and
decisions by users of the information”.

Advantages of Accounting :-
a. The financial performance (net profit or net loss) and financial position
(health) of a business firm in a financial year can be arrived through
accounting.

b. We can know approximate cost of production of the goods manufactured.

c. It is useful to submitting the statutory returns (Income tax, sales tax,

Commercial tax etc. to the government online.

Branches of Accounting

There are 3 branches of accounting. They are as under.

a. Financial Accounting
It is also known as historical accounting. It deals with recording, classifying,
summarizing and reporting the business transactions of a firm.

b. Cost accounting
the cost accounting is to find out the cost of goods produced and services
rendered by a business concern. It helps at estimating costs in future.

c. Management Accounting
it is concerned with internal reporting of information to management for
Planning & controlling operations, decision making and formulating long
term plans of a firm.

Accounting methods
There are 3 methods of accounting. They are as under.

a. Cash system
The business entries of a firm are made only when cash is received or paid by
the firm in cash system of accounting.

b. Accrual (mercantile) system

In the Accrual system of accounting, Income as well as expenses are
considered on the basis of their occurrences in an accounting period and not
on the basis of their actual receipts and payments. For example, Outstanding
expenses and accrued income etc.

Hybrid (mixed) System

It is a combination of cash and accrual systems. Incomes are recorded on
cash basis and expenses are recorded on an accrual basis.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

The primary objective of the Financial Accounting is to communicate
and provide information to the investors and creditors on the economic
activities of the enterprise that will help them in their investment decisions.
The financial statements of different entities must be prepared on a uniform
basis, and an enterprise must maintain consistency in preparing the financial
statements. Therefore, the language of accounting needs to adhere to a
framework of principles, known as Generally Accepted Accounting
Principles (GAAP).
The term GAAP is used to describe rules developed for preparation and
presentation of financial statements and is also known as concepts,
conventions, principles, modifying principles etc. They are the basic
foundation of accounting structure. Accounting principles are the basis of
preparation of financial statements in every country. Since they are accepted
by all countries, they are referred to ‘Generally Accepted Accounting
Principles’ or simply as ‘GAAP’.
Accounting Standard Board in India(ASB), American Institute of Certified
Public Accountants (AICPA), International Accounting Standard Board
(IASB) etc. are some professional bodies which have been set up to issue
accounting standard and guidelines.
Due to presence of various agencies, there is need for harmonization of
accounting practices and systems. This role of binding factor responsible for
harmonization of accounting practices and systems is performed by Generally
Accepted Accounting Principles. Public auditors are required to ensure such
compliance and report to the users in case of non-compliance. If GAAPs are
observed while preparing financial statements, it ensures use of a standard
language of accounting by all users across nations.
However, the observance of GAAPs does not mean absolute rigidity. There
is scope for the accountants to select alternate policies. For example, in the
matter of inventory valuation the accountant may follow FIFO, LIFO, or
Weighted Average Method.
Statement No. 4 of the Accounting Principles Board (US) on 'Basic concepts
and Accounting principles Underlying Financial Statements of Business
Enterprises' describes accounting principles as follows :-
"Generally Accepted Accounting Principles incorporate the consensus at a
particular time as to which economic resources and obligations should be
recorded as assets and liabilities by financial accounting, which changes in
assets and liabilities should be recorded, when these changes are to be
recorded, how the assets and liabilities and changes in them should be
measured, what information should be disclosed and which financial
statements should be prepared."
The GAAP depends upon how well these principles meet or satisfy three
attributes namely relevance, objectivity and feasibility. A principle is said to
have relevance if it results in more meaningful and useful information about
the enterprise to the users. It is said to be objective to the extent that
accounting information is free from personal bias of judgments of those who
provide it. A principle is said to be feasible if it can be used without much
complexity or cost. It applies to time, labor and cost of providing accounting
information and its accuracy is relation to probable use and resulting benefits.
ACCOUNTING PRICIPLES

Accounting principles are the basis of preparation of financial statements in

every country. Accounting principles are divided in to 2 categories. They are
:-
a. Accounting concepts
b. Accounting conventions

A. CONCEPTS

1. Business entity concept :-

According to this concept, the business of the firm and the owners
(proprietors) are separate entities while recording the business transactions in
the books of accounts and record only the business transactions which are
relating to the firm. The business transactions of the firm and the personal
transactions of the owners should not be mixed in the books of accounts of
the firm. The final accounts are prepared to reflect the profit or loss and
assets or liability of the business of the firm.

For example, The LIC premium of the owner of the firm should not consider
as business transaction of the firm. Hence, it should be treated as owner’s
expenditure and should be shown under “drawings” which is exclude from
“capital” in the books of accounts of the firm.

2. Money measurement concept :-

According to this concept, all the business transactions are should be
expressed in terms of money only in the books of accounts of the firm. For
example, the employee services, depreciation or amortization on fixed assets
etc… should be recorded in terms of money only but not in any other terms.

The limitation of this concept is a transaction is recorded at its money value

on the date of occurrence and the subsequent changes in the money value are
ignored.

3. Cost Concept :-
All the business transactions are should be recorded “at cost”” in the books of
accounts of the firm. For example, If a firm purchased a machinery for
$20,000, it should be recorded as $20,000 only and should not be recorded at
escalated value i.e. more than $20,000 even though the machine plays a very
important role in production activity of the firm. This gives the true and
accurate financial position of the firm.

This concept applies only to Fixed assets. The fixed assets of the business are
recorded on the basis of their original cost (cost price or purchase price) in
the first year of accounting. Then Subsequently, these assets are recorded at
original cost excludes depreciation. So, we can conclude that no rise or fall in
market price taken in to account.

Hence, there is a limitation to this concept is When the asset is recorded “at
cost”, the change in real worth of the asset with passage of time is not
recorded in the books of accounts of the firm. For example, if a land
purchased for $50,000 and then the market value of that land at the time of
preparation of financial statements is $65,000 should not be considered in the
books of accounts of the firm. Thus, this concept does not indicate “what is
the real worth of the asset” or “what is the price of the asset could sell for” at
the time of preparation of financial statements.
Even though, the limitation of the cost concept as above, we should prefer
this concept for the below reasons :-

a. More subject lies in the concept of “market value” or “real worth of an

asset”.
b. Fixed assets are purchased for used in production and not held for to re-
sale.

4. Going concern concept :-

All the business transactions are recorded assuming that the business will
expected to continue for a longer period and carry out its commitments and
obligations. The firm presumes that will stay in the business for a longer
period while selling the goods to outsiders and buying the goods from
outsiders. This concept is useful to determine the value of the fixed assets.
For example, in the case of taking a factory building on lease basis for 5
years, the firm has to presume that the firm will continue their operations for
longer period.

This assumption implies that “Assets will be valued on the basis of going
concern assumption” and “Assets are depreciated on the basis of expected life
rather than market value”. So, it supports that “depreciation is a process of
allocation and not of valuation”. Hence, this concept is basic to the valuation
of assets and provision of depreciation there on.

5. Realization concept :-
According to this concept, imaginary profits should not be recorded at all in
the books of accounts of the firm. This mean revenue is recognized only on
the date when it is earned (realized). But, un earned (un realized) revenue is
treated as earned on some specific transactions. For example,

a. When goods are sold to customers (debtors), they are legally liable to pay.
Then, it is treated as earned because of as soon as the property of goods
passes from the seller to buyer.

b. If a firm received the sales order or service order from a customer, it is not
treated as revenue is earned.
c. An advance paid to customer is not considered as revenue (profit) until the
goods or services will have been delivered to the buyer.

d. The title or ownership of the goods is not transferred from the seller to the
buyer until the last instalment is paid.

e. the down payment and instalment received or due should be treated as

actual sale and it is treated as revenue realized (earned).

6. Dual aspect concept :-

According to this concept, every business transaction should have 2 aspects
i.e. one is receiving aspect and another one is giving aspect. The receiving
aspect is called as ‘Debit’ and the giving aspect is called as ‘Credit’. So, for
every debit, there is an equal corresponding credit. The recognition of 2
aspects of every business transaction is known as Dual aspect analysis.

For example, assume that a firm is purchasing a vehicle for $40,000 by

giving a cheque of $40,000. In this case, the receiving aspect i.e. vehicle
account is an increasing by $40,000 as debit and similarly, the giving aspect
i.e. bank (cheque) is decreasing by $40,000 as credit in the books of accounts
of the firm. So that the receiving aspect of the transaction and the giving
aspect of the transaction are always equal.

7. Accounting period concept :-

According to this concept, Since the life of business is assumed to be very
long (indefinite) as per going concern concept, the measurement of income or
expenses are not possible for that very long (indefinite) period. The owner of
the firm cannot wait for such a longer period as he has to know that “how
things are going” in a business of the firm for frequent intervals. Therefore,
the accountants chose some shorter and convenient time for the measurement
of income or expense of the business of the firm. So, for this purpose, the 12-
month period is normally adopted to know the financial performance of the
firm. Hence, the accounts are to be prepared for the 12-month period under
the companies act in India and Banking regulation act in India. This 12-
month time interval is called as Accounting period.

8. Accrual concept :-
According to this concept, all business transactions even though not yet
settled in to cash must be taken in to accounts to ascertain the correct profit or
loss for an accounting period and to show the true financial position of the
business of the firm at the end of an accounting period.

The revenue recognition is depending on its realization (earned) and not

actual receipt. Similarly, the costs are recognized when they are incurred and
not when paid. In the case of revenue, the accounts should exclude the
amounts relating to subsequent period (income received in advance) and add
the revenue recognized but not received in cash (accrued income). Similarly,
in the case of cost (expense), add costs incurred but not paid (outstanding
expenses) and exclude the cost paid for subsequent period (prepaid
expenses).

NOTE :-
As per cash system of accounting, revenue recognition does not take place
until the cash is received and cost is recorded only after they are paid.

9. Matching concept :-
According to this concept, for every entry of revenue recorded in a given
accounting period, an equal expense entry has to be recorded for correctly
calculating the profit or loss in a given accounting period. For the matching
purpose, the prepaid expenses are excluded from the total cost and
outstanding expenses are added to the total cost for ascertain the cost related
to the accounting period.
But, this concept creates the below problems

a. The advertisement expenses, Preliminary expenses, Expenses in

connection with the issue of shares and debentures, etc. are cannot be easily
identified and match against revenue of a particular period.

b. Accurate matching is not possible in the case of how much of the capital
expenditure should be written off by way of depreciation for a particular
period against revenue in the particular period.

CONVENTIONS
An accounting convention consists of the guidelines that arise from the
practical application of accounting not a legally binding practice; rather, it is
a generally accepted convention based on customs and designed to
help accountants overcome practical problems that arise out of the
preparation of financial statements. If an oversight organization, such as
the Securities and Exchange Commission (SEC) or the Financial Accounting
Standards Board (FASB) sets forth a guideline that addresses the same topic
as the accounting convention, the accounting convention is longer applicable.

Accounting conventions provide a standardized methodology that creates a

reliable means of comparing financial results from industry to industry and
from year to year.

There are four widely recognized accounting conventions that guide

accountants:
1. Consistency
2. Disclosure
3. Materiality
4. Conservatism

1 . Consistency :-
As per this convention, the accounting practices and methods should be
unchanged from one accounting period to another accounting period to find
out the conclusions regarding the business of the firm by managers of the
firm over a number of years. The comparison of accounting data of the firm
one accounting period with that in the past is possible only when consistency
in the periods.

According to AS (Accounting Standards)-1, Consistency is a fundamental

assumption and it is assumed that accounting policies are consistent from the
period to another. Where this assumption is not followed, the reason should
be disclosed.

For example, for depreciating the any fixed asset, if written down value
method is considered for one accounting period, then, the same method we
can use to calculate the depreciation for the particular fixed asset over the
expected life of that fixed asset. We should not change the depreciation
method of written down value method (WDM) to another depreciation
method.

Similarly, the firms should follow uniform accounts for all the years. For
example, If the accounting year is followed from 01st January to 31st
December for one accounting year, that should not be changed to from 01st
April to 31st March for another accounting year without clearly defining the
objective to changed.

However, there is no inconsistency in the below cases if it looks like

inconsistency :-

a. The stock is valued “at cost” or “market value”, whichever is lower.

b. The investments are valued “at cost” or “market value”, whichever is

lower.

In the above cases, there is no inconsistency because the shift from the cost to
market is only the application of principle.

2. Disclosure :-
According to this convention, the accounts must be honestly prepared and all
information must be disclosed from time to time to the shareholders of the
firm, creditors of the business, employees and government. Here, the term
“disclosure” does not mean all the information included in accounting
statements, but, “disclosure” mean the sufficient disclosure of information
which is material (important) interest to owners, creditors and investors.

The content of Balance sheet and Profit & Loss account are prescribed by
law. These are designed to make disclosure of all material facts compulsory.
The “notes” relating to various facts or items which are not shown in
financial statements are must disclose as under ‘foot note” like Contingent
liabilities, Market value of investments, et,

The concept of “disclosure” also applies to events occurring after the balance
sheet date and the date on which the financial statements are authorized for
issue. Such events include bad debts, destruction of plant & equipment due to
natural calamities, major acquisition of another firm etc. Such events are
likely to have a substantial influence on the earnings and financial position of
the firm. Their non-disclosure would affect the ability of the users of such
statements to make proper evaluations and decisions.

3. Materiality :-
According to this convention, All the information which can be expected to
affect the decisions of the users of financial statements is called as materiality
and all such materiality (important) information should be disclosed in
financial statements to take economic decisions by the users of financial
statements regarding to that information and immateriality (un important)
information can be either left out or merged with relevant or shown as foot
note.

For example, assume that there is a waste basket which costs of $10 and has a
useful life of 5 years. In this case, the Matching concept tells us to record the
waste basket as an asset for an amount of $10 in the year purchased and
depreciate its cost as expense of $2 every year for useful life of 5 years. But,
the Materiality concept tells us to expense the waste basket for entire $10 in
the year it is purchased instead of recording depreciation expense of $2 per
year for 5 years because there is no investor, creditor or any other interested
party would be misled by not depreciating the waste basket over a 5 year
period.

4. Conservatism :-
This convention is treated as the policy of “playing safe”. It takes all the
prospective losses in to consideration and leaves all the prospective profits. In
other words, when 2 values of business transaction are available, the lower
value of the transaction has to be considered. By this convention, profit
should never be overestimated and there should be a provision for losses. For
example,

a. valuation of stock is at cost price or market price, whichever is lower.

b. Provision for doubtful debts and discount on debtors, but, not provide the
discount on creditors.

c. provision has to be made for fluctuation in the investment price.

d. Use written down method (WDM) instead of using Straight line method
(SLM) to calculation of depreciation because the WDM is more conservative
than SLM.

NOTE :- The conservatism can applied if there is an uncertainty in the activity.

5. Relevance :-
The convention of relevance emphasizes the fact that only such information
should be made available by accounting as is relevant and useful for
achieving its objectives. For example, business is interested in knowing as to
what has been total labour cost? It is not interested in knowing how much
employees spend and what they save.

6. Feasibility :-
The convention of feasibility emphasizes that the time, labour and cost of
analysing accounting information should be compared vis-à-vis benefit
arising out of it.
For example, the cost of 'oiling and greasing' the machinery is so small that
its break-up per unit produced will be meaningless and will amount to
wastage of labour and time of the accounting staff.

7. Objectivity :-
The convention of objectivity emphasizes that accounting information should
be measured and expressed by the standards which are commonly acceptable.
For example, stock of goods lying unsold at the end of the year should be
valued as its cost price not at a higher price even if it is likely to be sold at
higher price in future. Reason is that no one can be sure about the price which
will prevail in future.

Account
An account is a summarized statement of debit (receiving aspect) and credit
(giving aspect) of the business transactions of a firm. It is the shape of ‘T’.
The benefits received on left (debit) side and the benefits given (credit) on
right side. The particulars of debit side are start with ‘To’ and particulars of
credit side are start with ‘By’. The pro forma of account is as under :-
 Dr. Cr.
Capital Account
Amount
Date Particulars L.F (Debit) Date Particulars L.F Amount(Credit)

Classification of Accounts (or) Golden rules of Accounts

The debit and credit of the personal and impersonal accounts are called as
classification of accounts or golden rules of accounts. The accounts are
classified as under :-

A. Personal Accounts :-
The firm has to deal with many individuals and other organizations in the
process of business operations. Therefore, it has to open the accounts in the
names of those individuals and organizations. The accounts deal the business
transactions with regard to persons or organization are called as Personal
accounts. These personal accounts are classified in to 3 types. They are :-

a. Natural persons :-
Natural persons like John, David, Sastri & shah etc.

b. Artificial persons :-
Artificial persons like MRF Limited, Reliance Industries limited, HDFC bank
limited etc...

c. Representative persons :-
Representative persons like Outstanding expenses, Accrued income, Income
received in advance etc. because these are relating to persons.

Golden rule of Personal Account :-

Debit the receiver
Credit the giver
B. Impersonal Accounts :-
The impersonal accounts are sub grouped in to 2. They are :-

a. Real Accounts :-
All the accounts which records the transactions related to assets are known as
Real accounts. A separate account will be opened for every asset in a firm.
For example, Machinery A/c, Goodwill A/c, Patents A/c, Cash A/c,
Trademarks A/c, Sales A/c, Purchases A/c, etc.

Golden rule of Real Account :-

Debit what comes in
Credit what goes out

b. Nominal Accounts :-
Account which gives the information relating to income and expenditure of
the firm is known as Nominal account. For example, Salaries A/c, Rent A/c,
Discount allowed A/c, Interest received A/c, Bad debts A/c, Depreciation
A/c, Workmen compensation A/c etc.

Golden rule of Nominal Account :-

Debit all the expenses and losses
Credit all the incomes and gains

Capital type of accounts vs Revenue type of Accounts

Capital type of accounts are those accounts whose effect is not limited to a
particular accounting year but carries over the effect to subsequent (future)
accounting years also. For example, Machinery A/c, Furniture A/c, Capital
A/c, Loan A/c etc.. . Thus, Personal accounts and Real accounts are come
under this category.

Revenue type of accounts are those accounts whose effect is limited to a

particular accounting year but not carries over the effect to subsequent
(future) accounting years are called as revenue type of accounts. For
example, Discount received A/c, Interest A/c, Salaries A/c, Rent A/c etc.. .
Thus, all the income and expense accounts are come under this category.

Permanent accounts vs Temporary accounts

All those accounts which are carry forward their balances to future
(subsequent) accounting years are known as Permanent accounts. Thus, all
the assets and liabilities accounts of a balance sheet of the firm are comes
under this category.

All those accounts which are not carry forward their balances to future
(subsequent) accounting years are known as Temporary accounts. Thus, all
the income and expenses accounts of a Trading and Profit & loss account of
the firm are coming under this category.
NOTE :-
Nominal accounts have not been balanced.

Debit balance vs Credit balance :-

The total value of the debit side of an account is more than the total value of
the credit side of the account is called as debit balance.

The total value of the credit side of an account is more than the total value of
the debit side of the account is called as debit balance.

In Personal accounts, debit balance indicates that the person has to pay
money to the firm. Similarly, the credit balance indicates that the firm has to
pay money to the person.

In Real accounts, debit balance indicates that assets. Generally, all the assets
showing debit balance but, an asset shows a credit balance only when asset is
sold for profit which has to be transferred to profit and loss account.

In Nominal accounts, debit balance indicates that expense or loss to the firm
while the credit balance indicates the income or gain to the firm.

Accounting cycle
It is the flow of accounting information during the accounting period. The
accounting transactions are pass through a cyclical process of the below steps
is called as accounting cycle.

Steps :-
1. Writing business transactions when they took place.
2. Writing journal entries for all the transactions.
3. All journal entries are posted to ledger and balances are taken from each
ledger account.
4. Extract the Trial balance with all ledger account balances.
5. Preparation of Trading and Profit & Loss account based on trial balance to
know the profit or loss.
6. Preparation of Balance sheet at the end of the period based on trial balance
and Trading and Profit & loss account to know the financial position.

2. DOUBLE ENTRY SYSTEM

Book Keeping
The art of keeping accounts of separate set of books in a regular and
systematic manner of day-to-day business transactions of a firm is called as
Book keeping. Book keeping is universally accepted accounting system to
have a permanent record for future purpose, to analyses & compare business
data, and to submit information to government authorities etc. The
preparation of final accounts is made easy with book keeping.

Single entry system

The system which is only one side aspect of the business transaction (either
debit or the credit) is to be recorded instead of two aspects of the business
transaction (both the debit and credit) is called as single entry system. This
system is also known as “incomplete double entry system” as the accountant
maintains only personal accounts and cash book but, leaves the nominal
accounts. For example, when a machine is sold for $20,000 to john, then,
only John is recorded as a debtor. The sale transaction of machine aspect will
not be recorded.

The disadvantage of the single entry system is that since every debit does not
have a corresponding credit, a trial balance cannot be extracted to test the
arithmetical accuracy of the entries. Therefore, it is not possible to prepare
final accounts at the end of the accounting year to know accurate financial
performance and financial position of the firm.

Double entry system

Every business transaction should have 2 aspects i.e. one is receiving aspect
and another one is giving aspect. The receiving aspect is called as ‘Debit’ and
the giving aspect is called as ‘Credit’. Hence, for every debit, there is an
equal corresponding of credit. The recording of 2 aspects i.e. debit and credit
of every business transaction in the books of accounts of a firm is known as
Double entry system of accounting.

Advantages of Double entry system :-

a. The firm will get accurate, comprehensive, and reliable record of all the
business transactions of a firm.

b. All the information relating to assets and liabilities of the balance sheet of
a firm as well as incomes and expenses of the Trading and Profit & loss
account of the firm will be made available.

c. it gives facility to the firm to know the actual profit or loss from Trading
and profit & loss account as well as true financial position from the balance
sheet of a firm for an accounting period.

d. It prevents the errors and frauds.

Journal
‘Journal’ is derived from Latin word ‘journ’ which means a ‘day’. Journal is
a preliminary record of day-to-day business transactions of a firm which is to
give effect to two different accounts involved in business transactions. All the
business transactions are should be first recorded in the journal. So that, the
journal is also called as “Day book” or “Prime book” or “Book of first entry”
or “Book of original entry”. Journal is the first step of accounting.

Combined journal entry :-

If there is more than one debit or one credit in a business transaction of a
firm, then, it is called as combined journal entry.

Advantages of journal entries :-

a. As the business transactions are recorded in a chronological (day wise)
order in the journal, if any information pertaining to those transactions is
required, then, an accountant can easily find out the information as quick.
b. While posting the business transactions, if any difference arises with
regard to the transactions, the accountant can satisfy by explaining the dates
and circumstances of the differences.

c. it will be help in the preparation of the final accounts at the end of an

accounting year by giving all the ledger account balances to prepare trial
balance. The ledger account balances will come based on the transactions
recorded in the journal only.

Ledger
A set of accounts or the book containing classified information is called as
“Ledger”. Ledger is the second step of accounting. It is a permanent record of
all the business transactions of a firm in a summarized and classified form.
Hence, the ledger is also called as “Principal book” or “Main book” or “Final
book”. It is a shape of ‘T’ form. Left side is debit and the right side is credit.
The pro forma of a ledger is as under.

Dr. Cr.
Capital Account
Amount Amount
Date Particulars L.F (Debit) Date Particulars L.F (Credit)

Ledger posting :-
The process of transferring the debit and credit items (balances) from journal
to classified accounts in the ledger is called as “ledger posting”.

Advantages of ledger :-
a. All the business transactions of a firm relating to each account are recorded
at one place.
b. Overall picture of each account will be available at any time.

Classification of ledgers :-
The ledger is classified in to four types of ledgers. They are :-

a. Debtors ledger :-
When customers are purchased goods on credit basis from the business
concern (firm), they become the debtors of the firm. When all their accounts
are recorded in one book is called as debtors ledger. All the accounts in the
debtor’s ledger show only debit balances. The total balance of these accounts
indicate the total amount to be received from the customers (debtors).

b. Creditors ledger :-
When the firm purchased goods on credit basis from the suppliers, the
suppliers become creditors to the firm. When all the accounts of creditors are
recorded in one book is called as creditors ledger. All the accounts in this
book show only credit balances. The total balance of these accounts indicate
the total amount to be paid by the firm to the suppliers (vendors or creditors).

c. General ledger :-
When the firm records all the accounts relating to the assets, incomes,
expenses are called as General ledger. In General ledger, assets accounts and
expenses accounts are shown debit balances while the income accounts will
show credit balances.

d. Self-ledger :-
When all the accounts which are indicated the relationship between proprietor
and the business firm are recorded in one book is called as Self ledger. For
example, capital account, Drawings account etc. This is also called as private
ledger. This self-ledger is highly confidential.

3. SUBSIDIARY BOOKS
If the size of the firm is small, and transactions are limited, then, it is not
difficult to record all business transactions are in one book. If the size of the
firm is large, and transactions are more, it will be difficult to record all the
transactions in one book and post them in to various ledger accounts. Thus, to
overcome such problems, the different transactions are classified in to various
groups and relevant transactions are record in a separate journal are called
Subsidiary journals or Book of original entry or Subsidiary books. In other
words, the sub division of journal in to various books are called as
Subsidiary books. The subsidiary books are not a part of double entry system
of book keeping. The subsidiary books are as under :-

1. Cash book :-
The cash receipt and cash payment transactions are recorded in the separate
book is called cash book. The person who maintains the cash book is called
cashier.

Characteristics of cash book :-

a. only cash transactions are should be record.
b. It always shows the debit balance.
c. The balance of cash can be known at any point of time.

Types of cash book :-

Generally, the cash book is divided in to following types. All types of cash
books have to balance every day. They are :-

A. Simple cash book ;-

Generally, the simple cash book is maintained by newly started firms whose
business transactions are limited. All cash receipt transactions should be
record in debit side and all the cash payment transactions should be recorded
in credit side. The format of simple cash book is as below :-

Dr. Cr.
Simple cash book
Amount Amount
Date Particulars L.F (Debit) Date Particulars L.F (Credit)

B. Double column cash book :-

The transactions relating to cash or bank and their discounts are recorded in
double column cash book. The discounts are mainly 2 types. They are Trade
discount and Cash discount.
Trade discount :-
The discount offered by the seller to the buyer on the gross price of the goods
sold is called as trade discount. This discount is shown in the invoice itself
and the account is preparing with the Net amount. This discount does not
appear either in the cash book or any other book. The seller gives the trade
discount to increase their sales volume and this discount is calculated on
gross price of the goods before calculation of taxes.

Cash discount :-
If the debtor clears his debt before or date specified by the seller (creditor),
the debtor may receive some rebate in the form of cash from the creditor
which is called as Cash discount. This discount will appear in the books as
discount allowed in debit side and discount received in credit side. The seller
gives the cash discount to the buyer to collect the debt from debtor quickly
and this cash discount will be calculated on the net amount of the goods price
which is after the taxes paid.

Similarly, the rebate given by the creditor is treated by him as discount

allowed. Unlike the other accounts, the amount of the discount columns
should not be balanced. They should be shown as discount allowed in debit
side and discount received in credit side.

The double column cash is 2 types. They are:-

B(a). Cash book with cash and discount column :-

The transactions relating to cash and cash discounts are recorded in this book.
The format of this book is below :-

Dr. Cr.
2 column cash book with cash and cash discount
Discount Cash Discount Cash
Date Particulars L.F Date Particulars L.F
allowed (Debit) received (Credit)
B(b). Cash book with Bank and discount column :-
The transactions relating to bank and bank discounts are recorded in this
book. Now a day, for safety reasons, the business transactions of the firm are
usually carried out through banks by giving cheques or receiving cheques.
The cash and cheque deposited in the bank are recorded on the debit side of
this book and cash or cheques drawn are shown in credit side of this book.
Discount obtained (received from creditor) is shown in debit side and
discount allowed (given to debtor by firm) is shown in credit side. In general,
the bank and cash columns are shown as debit balance. If these are show the
credit balance, then it is called as overdraft. This means the payments are
more than the receipts. The format of this book as below :-

Dr. Cr.
2 column cash book with bank and discount columns
Discount Bank Discount Bank
Date Particulars L.F Date Particulars L.F
allowed (Debit) received (Credit)

C. Three column cash book :-

This book also a type of cash book which contains bank column along with
the cash and discount columns. The discount columns are totalled but not
balanced. The format of this book as below :-

Dr.
3 column cash book with cash, bank & discount columns
Discount Discount
Bank Cash Bank
Date Particulars L.F allowed Date Particulars L.F received
(Debit) (Debit) (Credit)
(Debit) (Credit)
Contra Entry :-
If a transaction of cash and bank requires an entries on both the debit and/or
credit sides simultaneously is called as contra entry. Generally, the contra
entries will appear in the following situations :-
i. When a bank account is opened
ii. Cash deposited in the bank
iii. Cash is withdrawn from bank
Contra entries don’t have L.F (Ledger folio) numbers. The alphabet ‘C’ will
be mentioned in L.F column on both the debit and credit sides to indicate that
it is a contra entry. Here, ‘C’

D. Petty cash book :-

The very small amount of expenses like stationary, postage, transportation
etc. are called as petty expenses. The firm cannot payment made through
cheques for this type of expenses. Similarly, the small amount of incomes
like employee’s travel expenses return to the firm, income received against
new employee ID cards issued if they lost, etc. are called as petty incomes.
The firm cannot get payment through cheques (bank) from employees for this
type of incomes. Hence, the firm withdrawn some cash from bank and kept
with cashier in the firm for petty expenses. All the petty expenses are paid
through this amount and recorded in a separate cash book is called petty cash
book. The person who maintained this petty cash book is called petty cashier
or cashier. All receipts are recorded on debit side and all payments are
recorded on credit side.

Advantages of petty cash book :-

1. Time save for chief (head) cashier
2. Provides control over small payments
3. Convenience in preparing the ledger accounts
4. Helps to know the expenses spent on each head.

2. Purchases book :-
Only the credit purchase of goods is recorded in this book. Cash purchases
and asset purchases (either cash or credit) are not recorded in this book. This
book is also called as Invoice book.

3. Sales book :-
Only the credit sale of goods is recorded in this book. Cash sales and asset
sales (either cash or credit) are not recorded in this book. This book is also
called as sales day book.

4. Purchase returns book :-

The transactions of goods returned to supplier (outward returns) are recorded
in this book. The goods can be returned in the following situations :-

1. When supplier don’t send the goods or material on time.

2. The material supplied by the supplier is not meet the firm’s agreed quality
or quantity.
3. When, there is a difference in price.
4. When the goods are damaged
This book is also known as “Returns outward” book.

Debit note :-
Debit note means purchase return. Debit note is issued when goods are
returned to supplier due to the above reasons. Debit note is prepared by the
purchaser. The amount is debited to the supplier and debit note must be sent
to supplier.

5. Sales returns book :-

The transactions of goods returned from customer (inward returns) to the firm
are recorded in this book. This book is also known as “Returns inward” book.
The goods can be returned in the following situations :-

1. When the firm don’t send the goods or material on time to customer
(debtor).

2. The material received by the customer is not meet their agreed quality or
quantity.

3. When, there is a difference in price.

4. When the goods are damaged

Credit note :-
Credit note means sales return. Credit note is issued when goods are returned
from customer due to the above reasons. Credit note is prepared by the
customer. The amount is credited to the customer (debtor) and credit note
must be sent to the firm by the customer. Then, immediately the amount
mentioned in credit note is reduced from customer account.

6. Bills Receivables book :-

The bills on which the amount is yet to be received and promissory notes
drawn by the seller or creditor are recorded in this book. The bills drawn by
the trader and duly accepted by his debtor is called Bills receivable.

7. Bills Payable book :-

All bills and promissory notes accepted by the buyer or debtor are recorded in
this book. Bills drawn by the creditor and accepted by the in settlement of
accounts is called Bills payable.

8. Journal proper :-
This book is used for recording the transactions which cannot be recorded in
any other subsidiary books like Opening Entries, Rectification Entries,
Transfer entries, Adjustment entries, Closing entries and Other entries etc.

4. TRIAL BALANCE
A trial balance is prepared on a particular date with all the ledger account
balances to know the arithmetical accuracy of books of accounts of the firm
and to find out the errors and mistakes in passing journal entries and their
postings. It is the third step of accounting process. It is not a part of double
entry system of book keeping. Preparation of final accounts will become easy
with preparation of trial balance. In trial balance, all assets and expenses are
shown in debit side and all the incomes and liabilities are shown in credit
side. If the debit and credit totals are equal, we can say that the books of
accounts are correctly written. Preparation of trial balance is two types :-

a. total balances method :-

Under this method, total of debit side and total of credit side of each
individual account is taken in trial balance.

b. Net balances method :-

Under this method, balance in each ledger account is taken in trial balance.
This method is very popular.

Suspense Account :-
When a trial balance is prepared, sometimes the totals of debit and credits
may not disagree (not equal). The
causes for such a disagreement is not apparent at once. The accountant is
forced to make the trial balance to agree by transferring the balance to an
artificial account is called as” Suspense account”.

5. FINAL ACCOUNTS
The package of accounts and statements that are used to ascertain the Gross
profit, Net profit and financial position are called as Final accounts. The trial
balance is the base from which the final accounts are prepared. The stages in
the preparation of final accounts are as below :-
a. preparation of Trading account,
b. Preparation of Profit and loss account and
c. preparation of balance sheet.

Objectives of preparation of final accounts :-

a. To assess the profit earned or loss incurred by the business in a specific
period.
b. To find out the financial position of the firm and to know the total assets
and liabilities and net capital of a business firm on the particular date.

(a) Trading account :-

The Trading account is prepared for a particular period to know the gross
profit or loss with help of all the expenses and incomes which are directly
relating to trade. All the trade expenses are shown in the debit side and all the
trade incomes are shown in credit side. The pro forma of Trading account as
under :-

Dr. Cr.
Trading account of ABC limited for FYE 2019
Amount Amount
Particulars Amount Particulars Amount
(Debit) (Credit)
 To Opening stock xxxxx By Sales xxxxx
Less : Sales
To Purchases xxxxx returns xxxxx xxxxxx
Less : Purchase
returns xxxx xxxxx By Closing stock xxxxx
To Carriage inward xxxxx
To Wages xxxxx
To Freight/cartage xxxxx
To Octroi xxxxx
To Coal, fuel & power xxxxx
To Factory expenses xxxxx
To Manufacturing
expenses xxxxx

To Gross profit xxxxx By Gross loss

(Transferred to P/L (Transferred to P/L
A/c) A/c)

xxxxxx xxxxxx

(b) Profit and Loss account :-

The Profit and loss account is prepared for a particular period with all indirect
expenses / losses and incomes to know the net profit / loss. If total amount of
credit is more than the total amount of debit is calls as net profit and vice
versa.

Items which are not shown in Profit and loss account :-

a . Income tax
Income tax is tax levied on income of the proprietor (owner) but not on the
firm. Income tax should be reduced from the capital in the liabilities side of
the balance sheet.

b. Domestic Expenses :-
Household expenses like taking material to home, paying club subscriptions
from the business etc. are other forms of drawings. Hence, they should be
added to the drawings and then drawings are deducting from the capital in the
liabilities side of balance sheet.

c. Capital Expenses :-
Capital expenses which are incurred to purchase an asset i.e. installation
charges, wages paid for installation charges of plant etc. These expenses will
increase the value of the asset. Hence, they should not be debited to the profit
and loss account. They have to add to the relevant asset in assets side of the
balance sheet.

d. Life Insurance premium (LIC) :-

It is an individual expense of proprietor but not of firm. So, it should not be
debited to Profit and loss account. It should be treated as drawings and added
to the drawings and then drawings are deducting from the capital in the
liabilities side of balance sheet.

The pro forma of the Profit and loss account as under :-

Dr. Cr.
Profit and Loss account of ABC limited for FYE 2019
Amount Amount
Particulars Amount Particulars Amount
(Debit) (Credit)
To Gross loss xxxxxx By Gross profit xxxxxx
General, Administrative
Expenses By discount received xxxxxx
To salaries xxxxxx By Interest received xxxxxx
To Rent xxxxxx By Commission received xxxxxx
By Reserve for bad debts
To Postage xxxxxx (decreased) xxxxxx
To Printing &
stationary xxxxxx By Interest on drawings xxxxxx
By reserve for discount
To Legal charges xxxxxx on creditors xxxxxx
To Audit fee xxxxxx By Dividends received xxxxxx
To Telephone charges xxxxxx By Apprentice premium xxxxxx
To Electricity charges xxxxxx By Profit on sale of assets xxxxxx
To Insurance xxxxxx

Selling & Distribution

Expenses
 to Salaries to sales staff xxxxxx
To Travelling expenses xxxxxx
To Advertisements xxxxxx
To Commission &
brokerage xxxxxx
To Carriage outward xxxxxx
To commission on sales xxxxxx
To packing charges xxxxxx
To Wharehouse charges xxxxxx
To free samples xxxxxx
To Van expense xxxxxx
To Trade expense xxxxxx

Financial Charges
To Interest on Capital xxxxxx
To Interest allowed xxxxxx
To Discount allowed xxxxxx
To Commission allowed xxxxxx
To Repairs xxxxxx
To Loss on sale of assets xxxxxx
To depreciation on
assets xxxxxx

Others
Bad debts xxxxxx
reserve for bad debts xxxxxx
Discount on Debtors xxxxxx

To Net profit xxxxxx By Net loss xxxxxx

(transferred to Capital (transferred to Capital
account) account)

xxxxxx xxxxxx

(c) Balance sheet :-

The balance sheet is a statement prepared on a particular date with
all assets and liabilities of the firm to know the financial position of
the firm. It shows what the business owns and what it owes. The
pro forma of balance sheet as under :-
 Balance sheet of ABC limited as on 31st December 2019
Amount Amount
Liabilities Amount Assets Amount
(Debit) (Credit)
Share capital xxxxxx Fixed assets
a. Tangible assets
Add : Additional capital xxxx :-
Add : Interest on Capital xxxx Land & buildings xxxxxx
Add : Net profit xxxx Plant xxxxxx
xxxxxxx Machinery xxxxxx
Less:
Drawings Furniture &
xxxx fittings xxxxxx
Less: Interest on Lease hold
Drawings xxxx property xxxxxx
Les : Net
loss xxxx Loose tools xxxxxx xxxxxx
Less : Income
tax xxxx
Less :
LIC b. Intangible
xxxx xxxx xxxxxx assets :-
Goodwill xxxxxx
Loans Copyrights xxxxxx
Long term loans xxxxx patents xxxxxx
Short term loans xxxxx Trademarks xxxxxx xxxxxx
Secured loans xxxxx
Un secured loans xxxxx Financial assets
Investments xxxxx
Current Liabilities
Creditors xxxxx
Bills (Accounts) payable xxxxx Current Assets :-
Bank overdraft xxxxx Debtors xxxxx
Outstanding expenses xxxxx Bills receivables xxxxx
Income received in advance xxxxx Closing stock xxxxx
Cash at bank xxxxx
Cash in hand xxxxx
Prepaid expenses xxxxx
Accrued income xxxxx xxxxxx

By Net profit By Net loss xxxxxx

 (transferred to Capital (transferred to
account) Capital account)

xxxxxx xxxxxx

6. ACCOUNTING CYCLE (END TO END INTERPRETATION)

It is the flow of accounting information during the accounting period. The
accounting transactions are pass through a cyclical process of the below steps
is called as accounting cycle.

Steps :-

1. Writing business transactions when they took place.

2. Writing journal entries for all the transactions.
3. All journal entries are posted to ledger and balances are taken from each
ledger account.
4. Extract the Trial balance with all ledger account balances.
5. Preparation of Trading and Profit & Loss account based on trial balance to
know the profit or loss.
6. Preparation of Balance sheet at the end of the period based on trial balance
and Trading and Profit and loss account to know the financial position.

Now, we can do the below exercise with end to end process of the above 6
steps of accounting cycle :-

1. WRITING BUSINESS TRANSACTIONS WHEN THEY TOOK PLACE :-

TRANSACTIONS
The ABC Limited has started the business for the Financial year 2019. The
transactions of the firm as following :-
1. ABC Limited issued 100,000 equity shares @ $10 each. So that the firm
has started the business with paid up equity share capital of $1,000,000
(100,000@10) received as cash.
2. Cash deposited in to Citi bank of $1,000,000.
3. 1,000 debentures issued @$10 each with 2% discount.
4. Received long term loan from HSBC for $50,000 .
5. Provision for product warranty expenses of $800.
6. Received long term loan from Standard Chartered Bank for $20,000.
7. Purchased goods (Raw materials) from sundry creditors on credit for
$17,000 (inclusive of Excise duty $1,000, GST $800 and packing charges
$200) with trade discount of 1% excluding taxes.
8. Provision made for Employee benefit expenses for $1,000.
9. Acquisition of buildings for $200,000.
10. Acquisition of Machinery for $150,000.
11. Acquisition of Furniture with fittings for $90,000.
12. Acquisition of vehicles for $180,000.
13. Software purchased of $50,000.
14. Goodwill of $7,000.
15. Patents & copyrights for $7,000.
16. Trademarks of $5000.
17. Cost of construction materials for $6,000.
18. Project development expenditure of $4,000.
19. Investments in Mutual funds of $25,000.
20. Investments in cumulative shares of $20,000.
21. Closing stock of Raw material for $500.
22. Closing stock of Finished goods for $200.
23. Closing stock of work in progress for $300.
24. Closing stock of spare parts for $100.
25. Purchased treasury bills for $250.
26. Sale of goods (raw materials) to sundry debtors on credit for $92000
(inclusive of Excise duty $4,000 and GST $3,000).
27. Advances given to sundry creditors for $600.
28. Interest received for amount deposited with Citi bank of $500.
29. Fuel and Octroi for manufacturing purpose of $100.
30. Electric power charges for manufacturing purpose of $200.
31. Labor processing charges for manufacturing purpose of $400.
32. Repairs and Maintenance of machinery for manufacturing purpose of
$80.
33. Salaries and wages of $17,000.
34. Factory building rent for $6,000.
35. Selling & Distribution expenses of $300.
36. Audit fee for $200.
37. Withdrawn cash of $500 from Citi bank for petty cash expenses.
38. Stationary purchased for $100.
39. Depreciation on buildings @10% i.e. $20,000 (200,000@10%).
40. Depreciation on Machinery @20% i.e. 30,000 (150,000@20%).
41. Depreciation on Furniture and fittings @10% i.e. $9,000 (90,000@10%).
42. Depreciation on Vehicles @20% i.e. $36,000 (180,000@20%).
NOTE :-
Assume that there is no opening stock because it is a newly started firm.
Here, opening stock means current accounting year’s closing stock will treat
as opening stock of next accounting year or previous accounting year’s
closing stock is treat as opening stock of current accounting year.

2. WRITING JOURNAL ENTRIES FOR ALL THE TRANSACTIONS :-

JOURNAL ENTRIES

Index for the below Journal entries :-

L.F No. = Transaction number
Dr = Debit
Cr = Credit

JOURNAL ENTRIES OF ABC LIMITED FOR THE FINANCIAL YEAR

2019
 L.F Credit
Date Dr/Cr Particulars Debit ($)
No. ($)
Dr Cash 1,000,000
Cr Equity Share Capital 1,000,000
1
(Being business started with
capital)

Dr Citi Bank 1,000,000

Cr Cash 1,000,000
2
(Being cash deposited with Citi
bank)

Dr Cash 9,800
Dr Discount on Debentures issued 200
Cr Debentures payable 3 10,000
(Being debentures issued with
discount)

Dr Citi Bank 50,000

Cr Loan Payable to HSBC 50,000
4
(Being long term loan taken from
HSBC)

Dr Product warranty Expenses 800

Cr Product warranty payable 800
5
(Being provision made for
warranty expenses)

Dr Citi Bank 20,000

Loan Payable to Standard
Cr 6
Chartered bank 20,000
(Being long term loan taken)

Dr Purchases 14,000
Dr Excise Duty 1,000
Dr GST 800
Dr Packing Charges 7 200
Cr Discount received 140
Cr Sundry Creditors 15,860
(Being Purchases made)

Dr Employee benefit expenses 1,000

Cr Employee benefits payable 1,000
8
(Being provision made for
 warranty expenses)

Dr Buildings 200,000
Cr Citi Bank 9 200,000
(Being Buildings purchased)

Dr Machinery 150,000
Cr City Bank 10 150,000
(Being Machinery purchased)

Dr Furniture & Fittings 90,000

Cr Citi Bank 11 90,000
(Being furniture purchased)

Dr Vehicles 180,000
Cr Citi Bank 12 180,000
(Being Vehicles purchased)

Dr Software 50,000
Cr Citi Bank 13 50,000
(Being software purchased)

Dr Goodwill 7,000
Cr Citi Bank 14 7,000
(Being Goodwill purchased)

Dr Patents & Copy rights 7,000

Cr Citi Bank 15 7,000
(Being Copy rights purchased)

Dr Trade marks 5,000

Cr Citi Bank 16 5,000
(Being Trademarks purchased)

Dr Construction material 6,000

Cr Citi Bank 6,000
17
(Being Construction material
purchased)

Dr Project development expenditure 4,000

Cr Citi bank 4,000
18
(Being Project development
charges)
Dr Investments (Mutual funds) 25,000
Cr Citi Bank 19 25,000
(Being invested in Mutual funds)

Dr Investments (Cumulative Shares) 20,000

Cr Citi Bank 20,000
20
(Being invested in Cumulative
Shares)

Dr Closing stock (Raw material) 500

Cr Purchases 500
(Being un sold stock of raw 21
material at godown at the time of
accounts closed)

Dr Closing stock (Finished goods) 200

Cr Purchases 200
(Being un sold stock of finished 22
goods at godown at the time of
accounts closed)

Closing stock (Work-in-

Dr
progress) 23 300
Cr Purchases 300
(Being un sold stock of WIP at
godown at the time of accounts
closed)

Dr Closing stock (Spare parts) 100

Cr Purchases 100
(Being un sold stock of Spare 24
parts at godown at the time of
accounts closed)

Dr Treasury bills 250

Cr Citi Bank 25 250
(Being Treasury bills purchased)

Dr Sundry Debtors 92,000

Cr Sale of goods 85,000
Cr Excise Duty 26 4,000
Cr GST 3,000
(Being Sales made)
Dr Advances 600
Cr Citi Bank 600
27
(Being advances given to sundry
creditors)

Dr Citi Bank 500

Cr Interest received 28 500
(Being interest received)

Dr Fuel & Octroi 100

Cr Citi Bank 100
29
(Being Expenses incurred for
Fuel & Octroi)

Dr Electrical Power 200

Cr Citi Bank 200
30
(Being Expenses incurred for
Electrical power)

Dr Labor processing charges 400

Cr Citi Bank 400
31
(Being Expenses incurred for
Labor processing)

Dr Repairs & Maintenance 80

Cr Citi Bank 80
32
(Being Expenses incurred for R
& M of machinery)

Dr Salaries & Wages 17,000

Cr Citi Bank 33 17,000
(Being Salaries & Wages given)

Dr Rent 6,000
Cr Citi Bank 34 6,000
(Being building rent given)

Dr Selling & Distribution 300

Cr Citi Bank 300
35
(being expenses incurred for
selling & distribution)

Dr Audit fee 200

 Cr Citi bank 36 200
(Being audit fee paid)

Dr Cash 500
Cr Citi bank 37 500
(Being cash withdrawn)

Dr Stationary 100
Cr Cash 38 100
(Being Stationary purchased)

Dr Depreciation 20,000
Cr Buildings 20,000
39
(Being depreciation provided for
buildings)

Dr Depreciation 30,000
Cr Machinery 30,000
40
(Being depreciation provided for
machinery)

Dr Depreciation 9,000
Cr Furniture & Fittings 9,000
41
(Being depreciation provided for
Furniture)

Dr Depreciation 36,000
Cr Vehicles 36,000
42
(Being depreciation provided for
vehicles)

3. ALL JOURNAL ENTRIES ARE POSTED TO LEDGER AND BALANCES ARE TAKEN
FROM EACH LEDGER ACCOUNT.

Index for the below Ledgers :-

L.F = Transaction number or Journal entry number

LEDGERS AND BALANCES OF ABC LIMITED FOR THE FINANCIAL YEAR 2019

EQUITY SHARE CAPITAL

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By Cash 1 1,000,000
1
 31.12.2019 To Balance 1,000,000
c/d
1,000,000 1,000,000
31.12.2019 By Balance b/d 1,000,000

DEBENTURES
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By Cash 3 9,800
2 By Discount 3 200
To Balance
31.12.2019 10,000
c/d
10,000 10,000
31.12.2019 By Balance b/d 10,000

HSBC LOAN
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By Citi bank 4 50,000
3
To Balance
31.12.2019 50,000
c/d
50,000 50,000
31.12.2019 By Balance b/d 50,000

WARRANTY PAYABLE
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By Warranty
5 800
4 Exp.
To Balance
31.12.2019 800
c/d
800 800
31.12.2019 By Balance b/d 800

STANDARD CHARTERED BANK LOAN

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By Citi bank 6 20,000
5
To Balance
31.12.2019 20,000
c/d
20,000 20,000
31.12.2019 By Balance b/d 20,000
 SUNDRY CREDITORS
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Discount 7 140 By Purchases 7 14,000
By Excise duty 7 1,000
6
By GST 7 800
By Packing
7 200
charges
To Balance
31.12.2019 15,860
c/d
16,000 16,000
31.12.2019 By Balance b/d 15,860

EXCISE DUTY
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Discount 7 140 By Purchases 7 14,000
To Sundry
By GST 7 800
Creditors 7 15,860
To Sale of By Packing
26 85,000 7 200
7 goods Charges
By Sundry
To GST 26 3,000 26 92,000
Debtors

To Balance
31.12.2019 3,000
c/d
107,000 107,000
31.12.2019 By Balance b/d 3,000

GST
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Discount 7 140 By Purchases 7 14,000
To Sundry
By Excise duty 7 1,000
Creditors 7 15,860
To Sale of By Packing
26 85,000 7 200
8 goods Charges
To Excise By Sundry
26 4,000 26 92,000
duty Debtors

To Balance
31.12.2019 2,200
c/d
107,200 107,200
31.12.2019 By Balance b/d 2,200
 EMPLOYEE BENEFITS PAYABLE
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By Emp.
8 1,000
9 Benefit exp.
To Balance
31.12.2019 1,000
c/d
1,000 1,000
31.12.2019 By Balance b/d 1,000

CASH
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Equity
1 1,000,000 BY Citi bank 2 1,000,000
Share Capital
To By Disc. On
3 200
Debentures 3 10,000 debentures
10
To Citi bank 37 500 By Stationary 38 100

31.12.2019 By Balance c/d 10,200

1,010,500 1,010,500
To Balance
31.12.2019 10,200
b/d

CITI BANK
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Cash 2 1,000,000 BY Buildings 9 200,000
To HSBC
4 50,000 By Machinery 10 150,000
loan
To SC bank By Furniture &
6 20,000 11 90,000
loan Fittings
To Interest
28 500 By Vehicles 12 180,000
received
By Software 13 50,000
By Goodwill 14 7,000
By Patents &
15 7,000
Copyrights
By Trade marks 16 5,000
By construction
17 6,000
material
By Project
18 4,000
development
 By Investments 19 25,000
in MF
By Investments
20 20,000
in Shares
11 By Treasury
25 250
bills
By Advances 27 600
By Fuel &
29 100
Octroi
By Electric
30 200
Power
By Labor
31 400
processing
By R&M -
32 80
Machinery
By Salaries &
33 17,000
Wages
By Rent 34 6,000
By Selling &
35 300
Distribution
By Audit fee 36 200
By Cash 37 500

31.12.2019 By Balance c/d 300,870

1,070,500 1,070,500
To Balance
31.12.2019 300,870
b/d

BUILDING
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By
To Citi bank 9 200,000 39 200,000
Depreciation
12
31.12.2019 By Balance c/d 180,000
2,000,000 200,000
To Balance
31.12.2019 180,000
b/d

MACHINERY
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By
To Citi bank 10 150,000 40 30,000
Depreciation
13
 31.12.2019 By Balance c/d 120,000
150,000 150,000
To Balance
31.12.2019 120,000
b/d

FURNITURE
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By
To Citi bank 11 90,000 41 9,000
Depreciation
14
31.12.2019 By Balance c/d 81,000
90,000 90,000
To Balance
31.12.2019 81,000
b/d

VEHICLES
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By
To Citi bank 12 180,000 42 36,000
Depreciation
15
31.12.2019 By Balance c/d 144,000
180,000 180,000
To Balance
31.12.2019 144,000
b/d

SOFTWARE
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 13 50,000
16
31.12.2019 By Balance c/d 50,000
50,000 50,000
To Balance
31.12.2019 50,000
b/d

GOODWILL
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 14 7,000
17
31.12.2019 By Balance c/d 7,000
7,000 7,000
 To Balance
31.12.2019 7,000
b/d

PATENTS AND COPYRIGHTS

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 15 7,000
18
31.12.2019 By Balance c/d 7,000
7,000 7,000
To Balance
31.12.2019 7,000
b/d

TRADE MARKS
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 16 5,000
19
31.12.2019 By Balance c/d 5,000
5,000 5,000
To Balance
31.12.2019 5,000
b/d

20 CONSTRUCTION MATERIAL
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 17 6,000

31.12.2019 By Balance c/d 6,000

6,000 6,000
To Balance
31.12.2019 6,000
b/d

PROJECT DEVELOPMENT
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 18 4,000
21
31.12.2019 By Balance c/d 4,000
4,000 4,000
To Balance
31.12.2019 4,000
b/d
 INVESTMENTS (IN MUTUAL FUNDS)
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 19 25,000
22
31.12.2019 By Balance c/d 25,000
25,000 25,000
To Balance
31.12.2019 25,000
b/d

INVESTMENTS (IN CUMULATIVE SHARES)

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 20 20,000
23
31.12.2019 By Balance c/d 20,000
20,000 20,000
To Balance
31.12.2019 20,000
b/d

CLOSING STOCK (RAW MATERIAL)

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Purchases 21 500
24
31.12.2019 By Balance c/d 500
500 500
To Balance
31.12.2019 500
b/d

CLOSING STOCK (FINISHED GOODS)

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Purchases 22 200
25
31.12.2019 By Balance c/d 200
200 200
To Balance
31.12.2019 200
b/d

CLOSING STOCK (WORK-IN-PROGRESS)

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
 To Purchases 23 300
26
31.12.2019 By Balance c/d 300
300 300
To Balance
31.12.2019 300
b/d

CLOSING STOCK (SPARE PARTS)

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Purchases 24 100
27
31.12.2019 By Balance c/d 100
100 100
To Balance
31.12.2019 100
b/d

TREASURY BILLS
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 25 250
28
31.12.2019 By Balance c/d 250
250 250
To Balance
31.12.2019 250
b/d

SUNDRY DEBTORS
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Sale of
26 85,000
goods
To Excise
26 4,000
29 duty
To GST 26 3,000
31.12.2019 By Balance c/d 92,000
92,000 92,000
To Balance
31.12.2019 92,000
b/d

ADVANCES
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 27 600
30
31.12.2019 By Balance c/d 600
600 600
To Balance
31.12.2019 600
b/d

DISCOUNT (RECEIVED)
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Sundry
7 15,860 By Purchases 7 14,000
Creditors
By Excise duty 7 1,000
31 By GST 7 800
By Packing
7 200
charges
By Balance
31.12.2019
c/d 140
16,000 16,000
31.12.2019 To Balance b/d 140

SALE OF GOODS
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Excise By Sundry
26 4,000 26 92,000
duty Debtors
32 To GST 26 3,000

By Balance
31.12.2019
c/d 85,000
92,000 92,000
31.12.2019 To Balance b/d 85,000

INTEREST (RECEIVED)
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
By Citi bank 28 500
33
By Balance
31.12.2019
c/d 500
500 500
31.12.2019 To Balance b/d 500

DISCOUNT (ALLOWED)
 Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To
Debentures 3 10,000 By Cash 3 9,800
34 issued

31.12.2019 By Balance c/d 200

10,000 10,000
To Balance
31.12.2019 200
b/d

PRODUCT WARRANTY EXPENSES

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Prod.
Warranty 5 800
payable
35

31.12.2019 By Balance c/d 800

800 800
To Balance
31.12.2019 800
b/d

PACKING CHARGES
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Discount
7 140 By Purchases 7 14,000
received
To Sundry
By Excise duty 7 1,000
creditors 7 15,860
36
By GST 7 800

31.12.2019 By Balance c/d 200

16,000 16,000
To Balance
31.12.2019 200
b/d

PURCHASES
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Discount
7 140 By Excise duty 7 1,000
received
To Sundry
By GST 7 800
creditors 7 15,860
By Packing
7 200
charges
 By Raw
21 500
material
37
By Finished
22 200
goods
By Work-in-
23 300
progress
By Spare parts 24 100

31.12.2019 By Balance c/d 12,900

16,000 16,000
To Balance
31.12.2019 12,900
b/d

EMPLOYEE BENEFIT EXPENSES

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Emp.
benefit 8 1,000
38 payable
31.12.2019 By Balance c/d 1,000
1,000 1,000
To Balance
31.12.2019 1,000
b/d

DEPRECIATION
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Buildings 39 20,000
To Machinery 40 30,000
To Furniture
41 9,000
39 & Fittings
To Vehicles 42 36,000
31.12.2019 By Balance c/d 95,000
95,000 95,000
To Balance
31.12.2019 95,000
b/d

FUEL & OCTROI

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 29 100
40 31.12.2019 By Balance c/d 100
100 100
To Balance
 31.12.2019 b/d 100

ELECTRICAL POWER CHARGES

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 30 200
41 31.12.2019 By Balance c/d 200
200 200
To Balance
31.12.2019 200
b/d

LABOUR PROCESSING CHARGES

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 31 400
42 31.12.2019 By Balance c/d 400
400 400
To Balance
31.12.2019 400
b/d

REPAIRS & MAINTENANCE - MACHINERY

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 32 80
43 31.12.2019 By Balance c/d 80
80 80
To Balance
31.12.2019 80
b/d

SALARIES AND WAGES

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 33 17,000
44 31.12.2019 By Balance c/d 17,000
17,000 17,000
To Balance
31.12.2019 17,000
b/d

RENT - FACTORY
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 34 6,000
45 31.12.2019 By Balance c/d 6,000
 6,000 6,000
To Balance
31.12.2019 6,000
b/d

SELLING & DISTRIBUTION

Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 35 300
46 31.12.2019 By Balance c/d 300
300 300
To Balance
31.12.2019 300
b/d

AUDIT FEE
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Citi bank 36 200
47 31.12.2019 By Balance c/d 200
200 200
To Balance
31.12.2019 200
b/d

STATIONARY
Date Particulars L.F Debit ($) Date Particulars L.F Credit ($)
To Cash 38 100
48 31.12.2019 By Balance c/d 100
100 100
To Balance
31.12.2019 100
b/d

4. EXTRACT THE TRIAL BALANCE WITH ALL LEDGER ACCOUNT BALANCES.

Index for the below Trial balance :-

A/c No = Ledger Account number
Particulars = Name of the Ledger account

TRIAL BALANCE OF ABC LIMITED AS ON 31st DECEMBER

2019
A/c
Particulars Debit ($) Credit ($)
No.
1 Equity Share Capital 1,000,000.00
2 Debentures 10,000.00
3 Loan (HSBC) 50,000.00
Loan (Standard
4 Chartered) 20,000.00
5 Warranty Payables 800.00
6 Sundry Creditors 15,860.00
7 Excise Duty 3,000.00
8 GST 2,200.00
Employee benefits
9 payable 1,000.00
10 Cash in hand 10,200.00
11 Cash at bank (Citi bank) 300,870.00
12 Buildings 180,000.00
13 Machinery 120,000.00
14 Furniture 81,000.00
15 Vehicles 144,000.00
16 Software 50,000.00
17 Goodwill 7,000.00
18 Patents & Copyrights 7,000.00
19 Trade marks 5,000.00
20 Capital work-in-progress 6,000.00
21 Project development 4,000.00
Investments in Mutual
22 funds 25,000.00
investments in
23 Cumulative shares 20,000.00
Closing stock (Raw
24 material) 500.00
Closing stock (Finished
25 goods) 200.00
Closing stock (work-in-
26 progress) 300.00
Closing stock (Spare
27 parts) 100.00
28 Treasury bills 250.00
29 Sundry Debtors 92,000.00
30 Advances 600.00
31 Discount (received) 140.00
32 Sale of goods (Sales) 85,000.00
33 Interest (received) 500.00
34 Discount (allowed) 200.00
Product warranty
35 Expenses 800.00
36 Packing charges 200.00
 37 Purchases 12,900.00
Employee benefit
38 expenses 1,000.00
39 Depreciation 95,000.00
40 Fuel and Octroi 100.00
41 Electrical power charges 200.00
42 Labor processing charges 400.00
Repairs & Maintenance -
43 Machinery 80.00
44 Salaries & Wages 17,000.00
45 Rent - factory building 6,000.00
Selling & Distribution
46 expenses 300.00
47 Audit fee 200.00
48 Stationary 100.00
TOTAL 1,188,500.00 1,188,500.00

5. PREPARATION OF TRADING AND PROFIT & LOSS ACCOUNT BASED ON TRIAL

BALANCE TO KNOW THE PROFIT OR LOSS.

Index for the below Trading and Profit & Loss Account :-
A/c = Ledger Account number

TRADING AND PROFIT & LOSS ACCOUNT OF ABC LIMITED FOR FY 2019
Particulars A/c Debit ($) Particulars A/c Credit ($)
To Opening stock 0.00 By Sales 32 85,000.00
To Purchases 37 12,900.00
To Product warranty
35 800.00
expenses
To Packing Charges 36 200.00
To Fuel & Octroi 40 100.00
To Electrical power
41 200.00
charges
To Labor processing
42 400.00
charges
To Repairs &
43 80.00
Maintenance (M/C)

To Gross profit
(Transferred to P/L 70,320.00
A/c)
85,000.00 85,000.00
To Discount (allowed) 34 By Gross Profit
 200.00 70,320.00
To Employee benefit By Discount
38 1,000.00 31 140.00
expenses (received)
By Interest
To Depreciation 39 95,000.00 33 500.00
(received)
To salaries and wages 44 17,000.00
To Rent (Factory
45 6,000.00
building)
To Selling &
46 300.00
Distribution expenses
To Audit fee 47 200.00
To Stationary 48 100.00
Net Loss
(transferred to 48,840.00
Capital A/c)
119,800.00 119,800.00

NOTE :-
Net loss for the company. Company is not having any net profit due to it is a
newly started firm. If net profit made by company, then, it will come debit
side of Profit & Loss account.

6. PREPARATION OF BALANCE SHEET AT THE END OF THE PERIOD BASED ON TRIAL

BALANCE AND TRADING AND PROFIT
& LOSS ACCOUNT TO KNOW THE FINANCIAL POSITION.

Index for the below Balance sheet :-

A/c = Ledger Account number

BALANCE SHEET OF ABC LIMITED AS ON 31st DECEMBER

2019
Particulars A/c Amount ($) Amount ($)
LIABILITIES
Equity Share Capital 1 1,000,000.00
Add : Net profit (transferred from
-48,840.00 951,160.00
P/L A/c)

Debentures 2 10,000.00

Reserves & Surplus 0.00

Non-Current Liabilities
Loan (HSBC) 3 50,000.00
Loan (Standard Chartered) 4 20,000.00 70,000.00

Current Assets
Warranty Payables 5 800.00
Sundry Creditors 6 15,860.00
Excise duty payable 7 3,000.00
GST Payable 8 2,200.00
Employee benefits payable 9 1,000.00 22,860.00

TOTAL LIABILITIES 1054020

ASSETS
Non-Current Assets
1. Fixed asses
A. Tangible Assets
Buildings 12 180,000.00
Machinery 13 120,000.00
Furniture & Fittings 14 81,000.00
Vehicles 15 144,000.00 525,000.00

B. Intangible Assets
Software 16 50,000.00
Goodwill 17 7,000.00
Patents & Copyrights 18 7,000.00
Trade marks 19 5,000.00 69,000.00

C. Capital work-in-progress
Cost of construction material 20 6,000.00
Project development 21 4,000.00 10,000.00

2. Financial Assets
Investments in Mutual funds 22 25,000.00
Investments in Cumulative shares 23 20,000.00 45,000.00

Current Assets
A. Inventory
Raw material (Closing stock) 24 500.00
Finished Goods (Closing stock) 25 200.00
Work-in-progress (Closing stock) 26 300.00
Spare parts (Closing stock) 27 100.00 1,100.00
 B. Cash & Cash Equivalents
Cash in hand 10 10,200.00
Cash at bank (Citi bank) 11 300870 311070

B. Financial Assets
Treasury Bills 28 250

C. Trade Receivables
Sundry Debtors 29 92000

D. Loans and Advances

Advances to debtors 30 600

TOTAL ASSETS 1,054,020.00

NOTE :-
There is no Income tax paid by ABC Limited due to Net loss for the
company.

------------ End of the CHAPTER – 1 ----------

CHAPTER – 2
JOINT STOCK COMPANIES

Learning objectives
After studying this chapter, you can be able to :-
1. Understand about shares and bonds,
2. Understanding the meaning of issue of shares at
par/discount/premium,
3. Understand the meaning of Rights issue, buy-back of
shares,
4. Understand the meaning of debentures – issue and
redemption,
5. Understand the meaning of redemption of preference
shares, and
 6. Learn types of companies, etc.

I. COMPANIES
Meaning of Company
A Company is considered as voluntary association (artificial person) of 2 or
more persons recognized by law and having a distinctive name and common
seal, formed to carry on business for profit, with capital divisible into shares,
limited liability, a corporate body and perpetual succession to achieve a
common objective. Law creates it and law only can dissolve it. Its existence
is of the life of its members.

Meaning of Corporation
A corporation is a business organization which is incorporated inside or
outside the nation which is having a separate legal entity i.e. its identity is
distinct from its owners. It is formed by the notification in the official gazette
by the central govt.

Difference between Company and Corporation

Basis for Company Corporation

Comparison
Meaning A company which is An entity which is
created and registered formed and registered
under the Indian in or out side India
companies Act
Incorporated India India and outside India
Minimum authorized As per the rules Rs. 5 crore
capital
Scope Comparatively less wide
Defined in Sec Sec 2(20) of Indian Sec 2(11) of Indian
Companies Act, 2013 Companies Act, 2013

Difference between Incorporation and Limited

When a company would like to begin its operations it is decided to select the
correct business model whether Inc. or Limited. These 2 business models
should not use interchangeably. The business model is mandatory to ensure
the positive growth of an entity. The business organization has to adopt the
business model whether Inc. or Ltd and this model should be used for all the
company’s letter heads, correspondence, domain names and business cards.

Inc.
Inc. refers to a company that is able to do business in legal manner and there
are specific stipulations for this business model that protect the owners, CEO
and board members. The shareholders, directors and officers are not
questionable for the debts and other obligations which are hold by the
company in the concern of Inc. companies. These companies are not separate
legal entities.

Ltd
Ltd (Limited) means limited liability and it is commonly used for small
companies that have a limited number of owners and it can be similarly
associated with a limited liability company (LLC) or a corporation.
Companies with limited have a limited liability and therefore, the members of
the company have restrictions for their shares. some limited companies have
been established on the basis of public funds that are in the form of equity
and preference shares.

Unlike limited companies, Inc. refers to a company that has no restrictions

for members as far as their shares are concerned. The Inc. Designation is best
for large business organizations whereas the limited is better for smaller
businesses. Inc. may have more business owners than the limited companies
that ltd have limited number of business owners. The shareholders, directors
and officers are not questionable for the debts and other obligations of the
company. Limited companies don’t have these same rules.

Characteristics (features) of a company

The most important characteristics of a company are as follows :-

1. Voluntary Association
A company is a voluntary association of two or more persons to earn profits.
A single person cannot constitute a company. At least two persons must join
their hands to form a private company while a minimum of seven persons are
required to form a public company. The maximum membership of a private
company is restricted to 50 whereas no upper limit for members in public
companies.

2. Artificial Person created by law

In the eyes of law, there are two types of persons :-
a. Natural persons i.e. human beings and
b. Artificial persons such as companies, firms, institutions etc.
A company is a creation of law, and is called an artificial person. It does not
take birth like natural person but comes into existence through law. But a
company enjoys all the rights of a natural person. It has right to enter into
contracts and own property. It can sue (legal proceedings against) other and
can be sued. But it is an artificial person.

3. Incorporation
A company comes into existence the day it is incorporated/registered. A
company cannot come into being unless it is incorporated and recognized by
law. This feature differentiates a company from partnership which is also a
voluntary association of persons but in whose registration is optional.

4. Separate Entity
Being separate legal entity, it bears its own name and acts under a corporate
name. A company has got an identity of its own which is quite different from
its members. This indicates that a company cannot be held liable for the
actions of its members and vice versa. A shareholder cannot be held liable for
the acts of the company even if he holds almost the entire share capital. The
shareholders are not agents of the company and so they cannot stick with
company by their acts.

5. Perpetual Succession
A company has a perpetual succession. Here, perpetual succession means the
Retirement, death, insolvency and insanity of its members do not affect the
continuity of the company i.e. the members of the company may keep on
changing from time to time but, this is not affect the continuity of the
company. A company enjoys a continuous existence. The shares of the
company may change in number of hands, but the life of the company
remains unaffected. If all the members of a company died in an accident, but,
the company can continue its operations. It can be say as “members may
come and go but, company go on forever”.

6. Common Seal
A company being an artificial person cannot sign for itself. A seal with the
name of the company embossed on it acts as a substitute for the company’s
signatures. The company gives its assent to any contract or document by the
common seal. A document which does not bear the common seal of the
company is not authentic and has no legal importance.

7. Transferability of Shares
The capital of the company is contributed by its members. The shareholders
can transfer their shares to any person without permission of other members
in public limited company where as the private companies impose some
restrictions on the transfer of shares by their members (shareholders).

8. Limited Liability
If the assets of the company fall less than of its liabilities, the members
cannot be asked to contribute anything more than the unpaid amount on the
shares held by them. Unlike the partnership firms, the private property of the
members cannot be utilized to satisfy the claims of company’s creditors.

9. Separation of Ownership from Management

This is also known as Representative Management. Though all the
shareholders are owners of the company, it is not possible for all the
shareholders to take part in the day-to-day management. A company is
managed by the elected representatives of its members (shareholders). The
elected representatives are individually known as directors or the Board of
Directors

10. Limitation of Work

The company’s field work is fixed by its charter i.e. the Memorandum of
Association. A company cannot do anything beyond the powers defined in it.
This mean its action is limited. In order to do the work beyond the
memorandum of association, there is a need for its alteration.

11. Termination of Existence

A company is created by law, carries on its affairs according to law and
ultimately is affected by law. However, if the owners of the company decided
to stop doing business under that entity, a company may terminate its
existence for any number of reasons. Occasionally, the duration period stated
in the formation documents expires or an event of termination stated in the
formation documents occurs. The termination may be required by law or by a
court.

Statutory books
Statutory Books
A limited company under statutory obligation is to maintain the below
statutory books at its registered office. The main statutory books are :-
(i) Register of Investments held and their names
(ii) Register of charges
(iii) Register of Members
(iv) Register of debenture holders
(v) Annual returns
(vi) Minutes books
(vii) Register of contracts
(viii) Register of Directors and their shareholdings
(ix) Register of loans to companies under the same management
(x) Register of Investment in the shares of other companies.

Types of Companies
Companies may be classified into various types on the following basis :-
1. On the basis of incorporation
2. On the basis of liability
3. On the basis of number of members
4. On the basis of control
5. On the basis of ownership.

1. On the Basis of Incorporation

According to this, the companies may be classified into the following three
categories :-

(a) Chartered Companies :-

A chartered company is a type of corporation and created by the charter or
special sanction granted by the supreme ruler of the State giving certain
exclusive privileges, rights and powers to a distinct body of persons for
undertaking commercial activities in specified geographical areas. These
rights and privileges are to be enjoyed and the powers are to be used within
the terms of the charter.
For example, The British East India Company and Dutch East India
Company to trade with India and the Bank of England. Since the country
attained the independence, these types of companies do not exist in India.

(b) Statutory Company :-

A statutory company is brought into existence under the Act passed by the
legislature of the country or state. Powers, responsibilities, liabilities, objects,
scope etc. of such a company are clearly defined under the provisions of the
Act which brings it into existence. These type of companies are established to
run the enterprises of social or national importance. For example, Reserve
Bank of India (RBI), State Bank of India (SBI), Industrial Finance
Corporation of India (IFC), the Life Insurance Corporation of India (LIC) in
India.

(c) Registered Companies :-

These companies are also known as Joint stock companies. A registered
company is a company which is registered with the Registrar of Companies
under the provisions of Companies Act. The formation, working and
continuity of such a company are governed by relevant provisions of the
Companies Act. Most of the companies in the field of industry are the
registered companies. In India such companies are registered under the Indian
Companies Act, 1956 or similar earlier acts.

2. On the Basis of Liability

According to this, the companies may be classified into below :-

a. Limited Liability Companies :-

A limited liability company (LLC) is a corporate structure whereby the
members of the company cannot be held personally liable for the company's
debts or liabilities. In other words, the liability of the members of a company
is limited to the extent of the nominal value of shares held by them, such
companies are known as Limited liability companies.
b. Companies Limited by Shares :-
These are the most popular companies in India at present. The Shareholders
enjoy limited liability. The liability of the members of a company is limited
by the Memorandum of Association to the amount unpaid on the shares is
called company limited by shares. In other words, If the business becomes
insolvent, they are only legally required to pay for their shares. The company
itself is liable for all debts beyond this amount. Shareholders receive a share
of business profits. The amount they receive depends on the ownership
percentage represented by their shareholdings. Profits are issued as
‘dividends’. Members appoint directors to manage day-to-day activities. In
the case of winding up (closure) of the company, the members cannot be
asked to pay more than the amount unpaid on the shares held by them. A
company limited by shares may be a public company or a private company.

c. Companies Limited by Guarantee :-

A company that is viewed as a legal person and is responsible for its own
debts. There are no shares or shareholders. This type of company is owned by
‘guarantors’. They are also referred to as members. To become a guarantor,
we must guarantee a fixed sum of money to the company. This is the extent
of a guarantor’s personal liability to the business and it must be paid if the
company becomes insolvent or winding up (closure of the company).
Guarantors appoint directors to manage day-to-day activities. The liability of
the members of a company is limited by the Memorandum of Association to
such an amount as the members undertake to contribute to the assets of the
company in the event of its winding up (closure of the company). Such type
of companies is not formed for the purpose of profit but are formed for the
promotion of art, science, sports, commerce and for cultural activities. Such
companies may or may not have share capital. If it has a share capital, it may
be a public company or a private company.

d. Unlimited Liability Companies :-

Where the liability of members is not limited, such companies are known as
unlimited liability companies. Every member of such a company is liable for
company’s debts in proportion to his interest in the company. Such a
company can be converted into a limited liability company after passing a
special resolution for conversion and applying to the Registrar of Companies
for enrolling it as a limited company.
3. On the Basis of number of Members
According to this, the company may be as below :-
a. Public Company, and
b. Private Company

a. Public Limited Company (PLC) :-

A Public Limited Company (PLC) is a joint stock company formed and
registered under the Indian Companies Act, 2013 or any other previous act
that has permission to issue registered securities to the general public through
Initial Public Offerings (IPO) and it should be trade on at least one stock
exchange. A Public Limited Company can raise the capital from public by
issuing shares through stock markets. The PLC can issue the bonds or
debentures that are unsecured debt issued to public on the basis of financial
performance and integrity of the company. A public limited company is not
authorized to begin its business operations if it obtains the grant of the
‘Certificate of Incorporation’. In addition to this, it should be obtaining
another document i.e. a ‘trading certificate’ also to run the business
operations. The liability of a public limited company is limited. No
shareholder is individually liable for the payment. The Public limited
company is managed by the Board of Directors and the board of directors are
elected by the shareholders in Annual general meeting (AGM). The elected
directors are act as representatives of the shareholders in managing the
company and taking the decisions. The public limited companies are
regulated by law to publish their financial statements quarterly or annually to
ensure the financial performance, position and owner’s equity to its
shareholders and investors. The shares of a PLC can freely have transferred
among the members (shareholders) who are trading on stock markets. There
is no restriction on the maximum number of the members in the company. It
invites the general public to purchase the shares and debentures of the
company.

Dis advantages of a PLC :-

Going public is an expensive and time consuming process. It is very difficult
to prepare the reports and disclosures which are to be match with the SEBI
(Securities and Exchange Board of India) regulations concerning the Initial
Public Offerings (IPO). Going public is selling a part of the company’s
ownership to strangers. Each bit of the ownership that the owner sells comes
out of their current equity position. The company owners should hold at least
51% of the ownership in their control. The owner of the company can no
longer make decisions independently. Even as the majority shareholder is
accountable to minority shareholders about how the company is managed.
The enhanced reporting requirements are essential for public limited
companies.

b. Private Limited Company :-

A Private Limited Company is a joint stock company formed and registered
under the Indian Companies Act, 2013 or any other previous act. It is an
association of persons formed voluntarily having the minimum paid up
capital of Rs.1,00,000. It is a business entity that held by private owners. The
liability of each member (shareholder) is limited to their ownership stock.
This means if the company having a loss, the company’s shareholders are
liable to sell their company’s shares to clear the liability (debt) there by their
personal assets of the shareholders are not at risk. It restricts the shareholders
from public traded shares. This is having the ‘perpetual succession’. Here, the
‘perpetual succession’ means the company continues its existence even
though any shareholder (owner or member) dies, goes for bankruptcy, exits
from the business and transfer his shares to another person. The private
companies need not to issue a prospectus because the public is not invited to
subscribe the shares of the company. Here, the prospectus means detailed
statement containing about the company details. A private company is easy to
form than a public company. Only 2 members are sufficient to form a private
company. 1 director out of 2 directors must have stayed in India for the total
period of not less than 182 days in the previous calendar year. The directors
and the shareholders are can be the same people. It can start its business
immediately after incorporation. Certificate to commence the business is not
required to be obtained, which is compulsory for a public company. It may
give loan to directors without obtaining consent or approval of the Central
Government. There is a greater flexibility in regard to the management and
conduct of the business than in the public company. The control and
management is generally in the hands of capital owners, which is not the case
with public company. The maximum number of members is 200 excluding
the current employees and the ex-employees who were the members during
their employment or continues to be the member after the termination of
employment in the company.

Disadvantages of Private company :-

The shares of a private limited company cannot be sold or transferred to any
one unless other shareholders agree on the same. No option to invite the
public to subscribe the capital through shares.

Difference between Public Limited Company and Private Company

Limited Company

Feature Public Limited Private Limited

Company Company
Minimum members 7 2
(Shareholders)
Maximum members Un limited 200
(increased from 50 to
200 as per companies
act, 2013)
Minimum directors 3 2
Maximum directors 15 15
(If may appoint more
than 15 directors by
passing special
resolution)
Minimum paid-up Rs.5,00,000 Rs.1,00,000
capital
Invitation to public Yes No
Public subscription Yes Not allowed
Transferable of shares Freely transferable Completely restricted
(No restriction)
Managerial No restriction Cannot exceed more
remuneration than 11% of net profit
Quorum at AGM 5 members 2 members
Statutory meeting Yes (Compulsory) Optional
Certificate of Yes (Compulsory) No
 commencement of
business (mandatory)
Start of business After receiving After receiving
certificate of certificate of
incorporation and incorporation
certificate of
commencement of
business
Suffix (Term used after “Ltd” “Pvt. Ltd”
the company name)

(i). A company is called as private limited when all its shares are in private
hands while the shares in a Public Limited company are open to everyone.

(ii). Pvt. Ltd Company is owned by a group of promoters. On the other hand,
a Public Limited company is not in the hands of a few promoters but it is the
public that owns it.

(iii). The shares of a Limited company are listed in the stock exchange
whereas it is not in the case of Private Limited Company.

4. On the Basis of Control

According to this, the companies may be classified into two categories :-
a. Holding company
b. Subsidiary company
a. Holding Company :-
A holding company is a parent company that owns enough voting stock in
another company to control that company's management and operations. A
holding company exists for the sole purpose of controlling another company
which might also be a corporation, limited partnership or limited liability
company, rather than for the purpose of producing its own goods or services.
If a business is 100% owned by a holding company, it is called a wholly
owned subsidiary.

b. Subsidiary Company :-
A company is said to be a subsidiary of another if:
(i) The other company controls the composition of its Board of Directors.
(ii) The other company holds more than half in nominal value of its equity
share capital.
(iii) It is a subsidiary of such a company which is itself subsidiary of any
other company.
For example, if company B is the subsidiary of company A and company C is
the subsidiary of company B then company C also becomes the subsidiary of
company A. If company D is the subsidiary of company C, it also becomes
subsidiary of Company B and A and so on.

5. On the Basis of Ownership

According to this, company may be a
a. Government Company :-
According to section 617 of the Companies Act. 1956, Government company
means, “any company in which not less than 51% of the paid-up share capital
is held by the Central Government or by any State Government and includes
a company which is a subsidiary of a Government Company.” It may be a
public company or a private company.

b. Non-Government Companies :-
Non-Government company means a company which is not government
company. The majority of companies in India are belong to this category.

Foreign Company :-
Foreign company means any company incorporated outside India but has
established business in India.
These companies may be of the following two types :-
(i) Companies incorporated outside India which established a place of
business in India after the commencement of Indian Companies Act, 1956;
and
(ii) Companies incorporated outside India which established a place of
business in India before the commencement of this Act and continued to have
such a place of business in India at the time of commencement of this Act.

After the establishment of business in India the following documents must be

filed with the Registrar of Companies within 30 days from the date of
establishment.
a. A certified copy of Memorandum and Articles of the company translated
into English.
b. The complete address of the Registered Office of the company.
c. A list of directors and secretary of the company.
d. The complete address of the place at which the company has constituted as
its main office in India.

One-Person Company :-
One-Person company is that company where one person holds practically the
whole of the share capital of the company and in order to meet the statutory
requirement of minimum number of members, some dummy names are
added. The dummy names which are added are mostly the relatives or friends
of principal shareholder.

2. SHARES

Introduction
Capital is needed by the companies, so that the companies go for Initial
Public Offering (IPO) to raise the capital for increase their productivity or
market reach. If they had already gone for IPO, then, they go for Follow-on
Public Offer (FPO). In FPO or IPO, they generally sell their shares and
debentures to the investors or shareholders. Most companies use ordinary
shares, however, it is possible to issue more than one kind of shares as a way
to vary shareholder voting, dividend and capital rights. The public shares are
issued by the public companies. Each issued share goes to the public. They
are traded in everyday stock market and the value of the company is decided
by the value of the shares at the end of the day. Each share is entitled to one
vote in any circumstances. Each share has equal rights to dividends. Each
share is entitled to participate in a distribution arising from a winding up
(closure) of the company. If the company is dissolved, any assets left after the
company’s debts are paid can be distributed to shareholders. However,
different share classes may have different rights to capital distribution.

Types of Shares

Share :-
Sec 2(84) of the Companies Act, 2013 defines ‘Share’ as “a share in the share
capital of a company and includes stock”. Sec 43 of Companies Act 2013, the
share capital of a company limited by shares shall be of 2 kinds :-
1. Equity Share Capital
2. Preference Share Capital.

1. Equity (Ordinary) Shares :-

These are the most common type of shares also known as ‘common stock’ or
‘standard shares’. Ordinary shares carry voting rights, but not usually any
special rights and restrictions beyond that. Even though the ordinary
shareholders are entitled to voting rights, they are the last to be paid if the
company is winding up (closure of the company). Ordinary shareholders have
the right to a corporation's residual profits. In other words, they are entitled to
receive dividends if any are available after the dividends on preferred shares
are paid. They are generally issued and traded in everyday stock market.
Their returns are not fixed.

Non-Voting (ordinary) Shares

These shares are carry the same conditions as ordinary shares except with
regards to voting rights. Shareholders may have voting rights under certain
circumstances or they may have no voting rights at all. These shares are like
ordinary shares except that they carry no voting rights. This type of share is
usually issued to employees so that part of their compensation can be paid in
the form of dividends. This arrangement usually provides tax benefits for the
company and the employees.

Characteristics (Features of Equity Shares) :-

1. They are permanent in nature.
2. Equity shareholders are the actual owners of the company and they bear
the highest risk.
3. Equity shares are transferable, i.e. ownership of equity shares can be
transferred with or without consideration to other person.
4. Dividend payable to equity shareholders is an appropriation of profit.
5. Equity shareholders do not get fixed rate of dividend.
6. Equity shareholders have the right to control the affairs of the company.
7. The liability of equity shareholders is limited to the extent of their
investment.
Advantages of Equity Shares :-
i. Advantages from the Shareholders’ Point of View
(a) Equity shares are very liquid and can be easily sold in the capital market.
(b) In case of high profit, they get dividend at higher rate.
(c) Equity shareholders have the right to control the management of the
company.
(d) The equity shareholders get benefit in two ways, yearly dividend and
appreciation in the value of their investment.
ii. Advantages from the Company’s Point of View
(a) They are a permanent source of capital and do not involve any repayment
liability.
(b) They do not have any obligation regarding payment of dividend.
(c) Larger equity capital base increases the creditworthiness of the company
among the creditors and investors.

Disadvantages of Equity Shares :-

i. Disadvantages from the Shareholders’ Point of View
(a) Equity shareholders get dividend only if there remains any profit after
paying debenture interest, tax and preference dividend. Thus, getting
dividend on equity shares is uncertain every year.
(b) Equity shareholders are scattered and unorganized, and hence they are
unable to exercise any effective control over the affairs of the company.
(c) Equity shareholders bear the highest risk of the company.
(d) Market price of equity shares fluctuate very widely which, in most
occasions, erode the value of investment.
(e) Issue of fresh shares reduces the earnings of existing shareholders.
ii. Disadvantage from the Company’s Point of View
(a) Cost of equity is the highest among all the sources of finance.
(b) Payment of dividend on equity shares is not tax deductible expenditure.
(c) As compared to other sources of finance, issue of equity shares involves
higher floatation expenses of brokerage, underwriting commission, etc.

Other types of Equity Shares :-

a. Blue Chip Shares :-

A blue-chip share (stock) is the stock which is issued by a large well-
established and financially sound company that has operated for many years.
A blue-chip stock typically has a market capitalization in the billions, is
generally the market leader or among the top three companies in a specific
sector.

b. Income Shares :-
An income share is a class of shares offered by a dual purpose fund.
a share that is entitled to a portion of a firm's ordinary income. Dual purpose
funds issue two types of shares i.e. income shares and capital shares which
are entitled to appreciation on the firm's investments. This share class pays
out distributions and dividends to its investors. It may also be known as
preferred shares. The funds offered a limited number of shares to the public
in an initial public offering (IPO). Post-IPO, the funds traded on exchanges
with a market price and an accounting net asset value (NAV) calculated each
day. Dual purposes funds were also structured with specific durations.
Therefore these funds had a specified maturity date in which they returned
principal to their investors.

c. Growth Shares :- A growth share (stock) is a share in a company whose

earnings are expected to grow at an above-average rate relative to the market.
A growth share usually does not pay a dividend as the company would prefer
to reinvest retained earnings in capital projects. Growth investors choose
stocks based on the potential for capital gains.
d. Cyclical Shares :- A cyclical stock is an equity share whose price is
affected by the ups and downs in the overall economy. Cyclical stocks are
relating to companies that sell discretionary items. Consumers can afford to
buy more of in a booming economy and cut back on during a recession.
e. Defensive Shares :- These shares also known as non-cyclical stocks.
These shares are belonging to companies whose business performance and
sales are not highly correlated with the larger economic cycle. These
companies are seen as good investments when the economy sours. companies
in the utilities sector are called as defensive stocks.

f. Speculative Shares :- A speculative stock is a stock with a high degree of

risk. A speculative stock may offer the possibility of substantial returns to
compensate for its higher risk profile. Speculative stocks are favored by
speculators and investors because of their high-reward, high-risk
characteristics.
2. Preference Shares :-
Preference shareholders have the right to be paid dividends prior to dividends
being paid for other share types like ordinary (equity) shares. Shares in this
category receive a fixed dividend, which means that a shareholder would not
benefit from an increase in the business' profits. However, usually the
preference shares have lead rights than equity shares to their dividend if the
business is in trouble. Preference shares do not typically carry the voting
rights. So that this is a slightly less preferred share type. This means that part
of the share capital of the company which carries (or would carry) the
preferential right with respect to :-
Dividend :-
Payment of dividend, either a fixed amount or an amount calculated at a fixed
rate, which may either be free of or subject to Income tax, and

Repayment :-
In case of winding-up of a company or repayment of capital, repayment of
the amount of share capital paid-up or deemed to have been paid-up, whether
or not, there is a preferential right to the payment of any fixed premium or
premium on any fixed scale specified in the memorandum of articles of the
company.

Preference shares are shares of a company's stock issued to

preferential shareholders. Preference shares represent ownership in a
company like common stock or equity shares.

a. Cumulative and Non-Cumulative Preference Shares

The right of any scheduled dividends that cannot be paid when due are
carried forward and must be paid before the company can pay out ordinary
share dividends. The preference shares which are having this right are called
as “Cumulative preference shares” and which shares are not having this right
are called as “Non-Cumulative Shares”. If a dividend cannot be paid one
year, it will be carried forward to successive years. Dividends on cumulative
preference shares must be paid despite (without being affect) the earning
levels of the business. For example, a company was not doing well for past 4
years but, suddenly it started performing well in the 5th year. Then, the
preference shareholders having cumulative shares will get the interest of past
5 years but, the preference shareholders having non-cumulative shares will
get only the interest of the 5th year.
b. Participating and Non-participating preference shares
In the case of winding up (closure) of the company, the debenture holders
were paid up first, then the preference shareholders and then the equity
shareholders were paid up. After this, if any surplus amount is left, it is
distributed equally to equity shareholders and participating shareholders.
Then, the preference shares which are having the participating right
(preference) to get the distributed profits in surplus amount after paid
dividends are called as “Participating preference shares” and those shares
which are not having this right are called as “Non-participating preference
shares” investors have participating preference.

c. Redeemable and Non-redeemable preference share :-

Generally, the capital received through equity shares or preference shares will
not be re-distribute to the shareholders in life time of the company except
closes down the company. But, some shares can be redeemed i.e. bought
back by the company at a future date either at fixed date or after a certain
time period or on a given date by the company or at the choice of the
business. These preference shares could be matured during the lifetime of the
company or before the company closes down. On the maturity date of these
preference shares, the company buy back the shares. Those preference shares
which are having the right of Redeemable are called as “Redeemable
preference shares” and those preference shares which are not having the right
of redeemable are called as “Non-redeemable preference shares” and these
non-redeemable shares are matured only after closing down (winding-up) of
the company.

d. Convertible and Non-convertible preference shares :-

The preference Shares which are having the right of converting in to equity
shares or debentures on maturity date are called as “convertible preference
shares” and which are not having the right to convert in to equity shares or
debentures on maturity date are called as “non-convertible preference shares.
These shares also known as Transferable or Non- transferable preference
shares.
e. Deferred Shares
A deferred share is a share that does not have any right to the assets of a
company undergoing bankruptcy until all common (equity) and preferred
shareholders are paid. These shares are issued to establishers of the company
and the public companies should not issue these type shares as per present act

Types of share capital

(i) Nominal or Registered or Authorized Capital :-
The amount of capital with which the company intends to be registered is
called as registered capital. It is the maximum amount which the company is
authorized to raise by way of public subscription. There is no legal limit on
the extent of the amount of authorized capital. It can be increased from time
to time. Some fee is required to be paid to legal bodies accompanied with
some formalities.

(ii) Issued Capital :-

That part of the authorized capital which is offered to the public for
subscription is called as issued capital.

(iii) Subscribed Capital :-

That part of the issued capital for which applications are received from the
public or accepted and agreed by the investors is called as subscribed capital.

(iv) Called up Capital :-

The amount on the shares which is actually demanded by the company to be
paid is known as called up capital.

(v) Paid up Capital :-

The part of the called up capital which is offered and is actually paid by the
members or investors is known as paid up capital. Normally, all companies
accept complete money in one shot and therefore issued, subscribed and paid
capital becomes one and the same. Conceptually, paid up capital is the
amount of money which is actually invested in the business. The sum which
is still to be paid is known as calls in arrears.

(vi) Reserve Capital :-

Reserve Capital is defined as a part of subscribed uncalled capital which will
not be called up until and unless the company goes into liquidation. In other
words, it is the portion of share capital that is reserved by the company and
which will be utilized only on the happening of the said event. It should not
be disclosed at all. Special Resolution must be passed by the company at
Annual General Meeting (AGM) for determining that the specified portion of
the company’s share capital will not be called up except when the company is
about to wind up. It is not compulsory for the companies to create reserve
capital. Such type of share capital is known as reserve capital.

Order of issuing shares

When company decided to issue the shares to the public, the company must
follow the below order :-

1. Prospectus :-
A Prospectus is a formal legal document that is required by and filed with
the Securities and Exchange Commission (SEC) that provides details about
an investment offering for sale to the public. After the Company files the
registration statement with the SEC for review, a cooling-off period begins.
During this 20-day period, share (stock) brokers can discuss with clients
about the new IPO and details of the company’s business. Only this
information is available in the preliminary prospectus. The preliminary
prospectus is the first offering document provided by a security issuer (i.e.
company). When the registration statement becomes effective, the company
will amend the preliminary prospectus to add such important information as
the exact number of shares issued and the precise offering price to become
the final prospectus. This final prospectus must contain the finalized
background information including the below :-
i . History of the business
ii. Description of management
iii. Number of shares
iv. Price of the share
v. Date
vi. Selling discounts
vii. Use of proceeds
viii. Description of the underwriting
ix. Financial information
x. Risks to buyers
xi. Legal opinion regarding the formation of the company
xii. SEC disclaimer
When the final prospectus is released, stock brokers can take orders from
those clients who indicated an interest during the cooling-off period. A copy
of the final prospectus must precede or accompany all the
sales confirmations.

The role of the prospectus is the make investors aware of the risks of
an investment. This disclosure also protects the company from claims.

2. Application for Shares

When the shares are to be issued by the company, an advertisement is given
for the information of the public. Those who are interested to purchase the
shares on the basis of that information may have the prospectus for detailed
information of the company and application form. If a person is satisfied with
the profitability and other things mentioned in the prospectus of the company,
he is required to fill up the application form and has to deposit the application
along with the requisite amount (i.e. application money) with the prescribed
bank. The application money should at least be 5% of the face value of the
share. The scheduled bank will send this application money along with a list
of applicants to the company. The company will ultimately record these
details in the book of “Application and Allotment”.

3. Allotment of Shares
After receiving the applications from the applicants (public), the directors
take steps to allot the shares. Allotment of shares mean acceptance of the
offer of the applicant for the purchase of shares. Directors have discretionary
power either to reject or to accept partially the applications. There are no
restrictions
on the rights of a private company to allot its shares. But the public company
cannot allot its shares unless :-

a. The minimum subscription stated in the prospectus has been subscribed by

the public.
b. A prospectus or a statement in lieu of prospectus has been filed with the
Registrar before
making the first allotment.
c. The amount of application, i.e., at least 5% of the face value has been
received.
The applicants to whom shares are allotted will be sent the allotment letters
to the applicants of shares. After the allotment, they become the shareholders
of the company. Those to whom shares could not be allotted will be sent a
‘letter of regret’ along with refund of their application money. The
shareholders
will be required to pay the allotment money on allotment of shares. This will
also be recorded in the “Application and Allotment” book.

4. Calls on Shares
Out of the face value of the shares, 5% is payable with application, some
money will be paid on allotment and rest of the money will be paid as and
when calls are made by the company. Generally, the prospectus gives the
dates of different calls along with the amount of the calls by the shareholders.
In case the details are not given in the prospectus, the directors have the
discretion to call it through one call or more than one call. For this a
resolution of the Board of Directors must be passed and a notice is sent to the
shareholders with a request to pay the amount of the call. As soon as a call
notice is sent, its particulars are entered in a separate book known as “Share
Calls” book.

When Both Preference and Equity Shares are Issued

When a company issues both preference and equity shares, then the entries
for application money, allotment money and share calls money should be
separately passed for each type (equity and preference) of share capital. The
word Equity or Preference must use in all the circumstances.

Issue of Shares for Purchase of Assets

If the shares have been allotted to any person or firm from whom the
company has purchased any asset, the below entry will be passed :-
Dr Asset Account
Cr Share Capital Account
(Being shares allotted in consideration of purchase of an asset
for the company)
This information should also be disclosed in the Balance Sheet while
showing the issued, subscribed
and paid up capital.

Issue of Shares at Premium

A company may issue the shares at a premium i.e. at a value higher than its
face value of the share. The power to issue shares at a premium need not be
given in the Articles of Association. If company received such premium, the
same shall be credited to a separate account called Share (securities)
Premium account. The company may issue the shares at premium for the
below purpose :-
(i) For the issue of fully paid bonus shares to the shareholders of the
company,
(ii) For writing off preliminary expenses of the company,
(iii) For writing off the expenses of the commission paid or discount allowed
on any issue of
shares or debentures of the company,

Issue of Shares at a Discount

A company may issue shares at a discount i.e. at a value less than the face
value of the share subject to the following conditions :-

(i) The issue of shares at a discount is authorized by a resolution passed by

the company in Annual
general meeting and sanctioned by the Central Government.

(ii) The resolution must specify the maximum rate of discount which should
not exceed 10% of the face value of shares or such higher percentage
approved by the Central government.

(iii) One year must have been completed since the date at which the company
was allowed to commence business to issue the shares at discount.

(iv) Shares Issue at discount must take place within 2 months after the date
sanction by the court or
within extended time if allowed by the court.

(v) Every prospectus relating to the issue of shares and every balance sheet
after the issue of shares must contain the particulars of the discount allowed
and discount has not been written off.

If company received such discount, the same shall be debited to a separate

account called Discount on issue of shares account.

Adjustment of Excess Money towards the Amount due on the Allotment

and Calls
A Company may not allot all the shares for which applications have been
received because of over subscription from the applicants. Allotment can be
done by either made of less number of shares or on pro-rata basis. For
example, if the company offered 1,00,000 shares, but, the company received
application money for 2,00,000 shares. Then, the directors sent letter of
regret to the applicants of 60,000 shares and applicants of 1,40,000 shares
were allotted to the 1,00,000 shares on pro-rata basis. In such a case,
application money of 40,000 shares will be adjusted either on allotment
or/and on calls. If there is still surplus money after adjusting the allotment
and call money due from shareholders, it will be refunded in cash to the
applicants.

Forfeiture of Shares
Generally, If a shareholder fails to pay the allotment money or a call, a notice
has to be served by the company to that shareholder to pay the unpaid amount
together with interest accrued by a certain date. If a shareholder fails to pay
the allotment money or a call or a part thereof by the last date fixed for
payment, the Board of Directors proceed to forfeit the shares on which
allotment money or call(s) has become in arrears. The Articles of
Association lay down the procedure. After forfeiture of shares, the original
shareholder ceases to be a member and his name must be removed from the
register of members.

Surrender of Shares :-
After the allotment of shares, sometimes, a shareholder is not able to pay the
further calls and returns his shares to the company for cancellation. Such
voluntary return of shares to the company by the shareholder himself is called
surrender of shares. Surrender of shares has no separate accounting treatment
but it will be treated as forfeiture of shares. The same entries (i.e. are passed
in the case of forfeiture of shares) will be passed in the case of surrender of
shares also.

Re-issue of Forfeited Shares :-

Forfeited shares may be reissued by the company board of directors for any
amount, but, if such shares are issued at a discount, then, the amount of
discount should not exceed the actual amount received on forfeited shares.
The purchaser of forfeited re-issued shares is liable for payment of all future
calls duly made by the Company.

When all Forfeited Shares are not Issued :-

When all the forfeited shares are not re-issued i.e. only a part of such shares
are re-issued, it is desirable to spread the amount of total shares forfeited
minus shares which has been re-issued. discount on re-issue of forfeited
shares should be deducted from such spread amount and the balance should
be transferred to “capital reserve account” as capital profit. The amount
relating to the part of forfeited shares (i.e. which has not been re-issued)
should be shown on the liabilities side of Balance Sheet as “Shares Forfeited
Account”.

Accounting – Issue of shares

Journal Entries for Issue of Shares

(1) For Application Money received :-
Dr Bank A/c
Cr Share Application A/c
(2) For excess share application money refunded to applicant
:-
Dr Share Application A/c
Cr Bank A/c
(3) For Share application money transferred to share capital
:-
Dr Share Application A/c
Cr Share Capital A/c
Share Premium A/c (if application money includes
Cr
premium)
(4) For Share allotment Money due :-
Dr Share Allotment A/c
Discount on Issue of shares A/c (if shares issued at a
Dr
discount)
Cr Share Capital A/c
Cr Share Premium (if shares issued at a premium)
(5) For Share allotment money received :-
Dr Bank A/c
Dr Calls-in-Arrears A/c (if allotment money not received)
Cr Share Allotment A/c
Calls-in-Advance A/c (if call money received in advance
Cr
along with allotment)
(6) For Share Call money due :-
Dr Share Call A/c
Cr Share Capital A/c
(7) For Share Call money received :-
Dr Bank A/c
Dr Call-in-Arrear A/c (if call money not received)
Calls-in-Advance A/c (adjustment of share call money
Dr
received earlier)
Cr Share Call A/c
(8) For forfeiture of shares :-
Share Capital A/c (No. of shares forfeited × Called up
Dr
value per share)
Share Premium A/c (if issued at a premium and premium
Dr
not received)
Calls-in-Arrear A/c (amount not received on forfeited
Cr
shares)
Cr Shares Forfeited A/c (amount received on forfeited shares)
Cr Discount on Issue of Shares A/c (if issued at a discount)
(9) For re-issue of forfeited shares :-
Dr Bank A/c (No. of Shares Reissued × Reissue Price/Share)
Discount on Issue of Shares A/c (No.of shares Reissued ×
Dr
Discount per share)
 Dr Shares Forfeited A/c Dr. (No. of shares × Further discount
on reissue)
Share Capital A/c (No. of shares Reissued × Paid up value
Cr
per share)
Cr Securities Premium A/c (if reissued at a premium)
(10) For transferring profit on reissue of forfeited shares :-
Shares Forfeited A/c (Profit on Forfeiture - discount on
Dr
reissue of forfeited share)
Cr Capital Reserve

Note :-
If part of the forfeited shares are reissued, then Profit on Reissue of Forfeited
Shares should be calculated proportionately as below :-

(Total Profit on forfeiture of shares / No. of shares forfeited) ×

No.of Shares re-issued XXXXX
Less : Discount on re-issue xxx
Transfer to Capital Reserve XXXX

Rights Issue
Issue of an additional shares by an existing company to its existing equity
shareholders is called as rights
issue. The company may issue these additional shares where at any time after
the expiry of two years from the formation of a company or the expiry of one
year from the first allotment of shares in the company, whichever is earlier.
If the Board of Directors are decided to increase the subscribed capital of the
company or to convert the debentures or/and loans into shares in the
company, the further (additional) shares can be allotted to existing equity
shareholders with following conditions :-

(a) Such additional shares shall be offered to the existing equity shareholders
of the company proportionately to their equity holdings on that date.
(b) The offer shall be made by a notice that specifying the number of shares
offered and limiting
a time not being less than 15 days from the date of the offer. If not accepted,
it will be deemed to have been declined.
Reasons for Rights Issue
a. At the time of inflation, the replacement costs of assets will be high, unless
the company can retain cash from substantial profits, the only alternative is to
raise cash from a fresh issue of shares.

b. A company can make rights issue for funding to expansion of projects.

c. If a company has a proportion of interest bearing loan capital, the company

can suffer from a squeeze on profits. At this time, the company can improve
the capital structure position by obtaining extra share capital.

d. In the case of the share prices were relatively high, companies found it
easy to persuade their shareholders to subscribe cash for new issues with a
view to expansion by takeover.

Advantages of Rights Issue

1. Control of the company by retained in the hands of the existing equity
shareholders i.e.
enables them to retain their existing share of voting rights
2. The expenses of public issue can be saved through right issue because it is
cheaper than a public share issue.
3. The existing shareholders do not suffer on account of dilution in the value
of their holdings if fresh shares are offered to them because value of the
shares is likely to fail with fresh issue. This decrease in the value of the
shares will be compensated by getting new shares at a price lower than the
market price. They are likely to suffer on account of the dilution in the value
of their holdings if fresh shares are offered to the general public.
4. There is more certainty of getting capital when fresh issue of shares is
made to the existing shareholders instead of to the general public.

5. Directors cannot misuse the opportunity of issuing new shares to their

friends and relatives at lower prices and at the same time retaining more
control in their hands when right shares are issued because in rights issue, the
shares are offered proportionately to the existing shareholders according to
their existing holdings.
Buy-back of Shares
Introduction
By virtue of section 77(1) of the Companies Act 1956, a “company limited
by shares” could not buy its own shares as the same as it is illegal reduction
of capital. This section specifically laid down that no “company limited by
shares” and no “company limited by guarantee” and having a share capital,
shall have power to buy its own shares unless the consequent reduction of
capital is affected. But, in response to the persistent demand from the
corporate sector for buyback of shares, the Central government promulgated
the Companies (Amendment) Ordinance 1998 to permitting companies to
buy-back their own shares subject to fulfillment of the conditions laid down
therein. In addition to that, SEBI has also issued its own guidelines seeking to
regulate buy-back of securities.

What is buy-back
Buy-back of shares is just the opposite of issue of shares. Buy-back of
securities is nothing but, the company can purchase its own shares or
debentures for cancellation or redemption of shares. In the case of buy-back,
the company which has issued shares to the public can re-purchases its own
shares.

How the buy-back

The companies may re-purchase (buy-back) its own shares from public for
the price of the share at par or at a premium or at a discount. This can be
cause for resorted in order to increase the company’s share value by
enhancing the earning per share.

Conditions of buy-back
A special resolution should be passed in the general meeting to authorizing
the buy-back subject to the following conditions :-

a. The buy-back should be less than 25% of the total paid-up capital and free
reserves of the company.

b. The buy-back of equity shares in any financial year should not exceed 25%
of its total paid-up equity capital.
c. The buy-back does not exceed 10% of the total paid-up equity capital and
free reserves of the company. But, there cannot be more than one such buy-
back in a period of 365 days.

d. Debt-equity ratio shall not be exceeding 2:1 after such buy-back. However,
the Central government may prescribe a higher ratio for a class or classes of
companies.

e. All the shares or other specified securities are fully paid up.

f. The buy-back of the shares or other securities listed on any recognized

stock exchange is in accordance with the regulations made by the Securities
and Exchange Board of India (SEBI).

g. The notice of the meeting at which the special resolution on buy-back is

proposed to be
Passed with disclosure of all material facts regarding the below :-
i. The necessity for the buy-back
ii. The class of security intended to be purchased under the buy-back;
iii. The amount to be invested under the buy-back;
iv. The time limit for completion of buy-back;
v. The price at which buy-back of shares is to be made;
vi. If the promoters intend to offer their shares, then, the quantum of shares
proposed to be tendered and the details of their transactions and their
holdings for the last six months prior to
the passing is to be disclose in notice of the meeting.

h. Every buy-back should be completed within 12 months from the date of

passing the special resolution.

In addition to above conditions, the important another condition is to be

complied by the company is that after buy-back, physically destroy the
securities within seven days of the last date of completion of buy-back. The
securities bought back should be destroyed in the presence of a Registrar or
Merchant Banker and the statutory auditor. A certificate to this effect shall be
furnished to the SEBI duly signed by 2 whole time directors including the
managing director and verified by the Registrar or Merchant Banker
and statutory auditor.

Note to not buy-back

No company shall directly or indirectly purchase its own shares or other
specified securities such as :-
a. through any subsidiary company including its own subsidiary companies,
b. through any investment company or group of investment companies.

No further issue within six months.

After completing buy back of shares or other securities, a Company cannot
make further issue of the same kind of shares including by way of rights or
other specified securities within a period of 6 months.
However, this rule is not applicable in case of bonus issue or in the discharge
of subsisting obligations such as conversion of warrants, stock option
schemes, sweat equity or conversion of preference shares or debentures into
equity shares.

Maintenance of Register
The Company should maintain a register of the securities (shares) under this
buy-back scheme with details of the consideration paid for Buy Back, the
date of cancellation of securities, the date of extinguishing and physically
destroying the securities and such other particulars as may be prescribed.
This register should be file with the Registrar and the Securities and
Exchange Board of India (SEBI) within 30 days from completion of such
buy-back. No such return need to be filed with the SEBI if the company
which is buying back is an unlisted company.

Prohibition of loan or Financial Assistance

A public company cannot give loan or should not provide the financial
assistance to any person to enable him to purchase company’s own shares or
shares of its holding company. However, this provision is not applicable if
lending the money by a banking company in the ordinary course of its
business.

Sources of Buy-Back
A company can buy its own shares or other specified securities from the
below sources :-
a. Company’s free reserves
b. Share (securities) premium account
c. The proceeds of any shares or other specified securities.

However, no buy-back shall be made out of the proceeds of an earlier issue of

the same kind of shares or same kind of other specified securities. The word
‘specified securities’ includes the employee’s stock option or other securities
as may be notified by the Central government from time to time. The word
‘Free reserves’ means those reserves which are as per the latest audited
balance sheet of the company are free for distribution as dividend and shall
include balance to the credit of securities premium account but shall not
include share application money.

Modes of buy-back
Buy-back is permissible in the below cases :-
a. from the existing security holders on a proportionate basis through the
tender offer.
b. from the open market through “book-building process” or through “stock
exchange”.
c. from odd lots i.e. where the lot of securities of a public company whose
shares are listed on a recognized stock exchange is smaller than such
marketable lot as may be specified by the stock exchange.
d. by purchasing the securities issued to employees of the company pursuant
to a scheme of stock option or sweat equity.

However, A company cannot buy-back its shares from any of the below
person :-
a. through negotiated deals whether on or off the stock exchange.
b. through spot transactions
c. through any private arrangements

Advantages of Buy-back

i. A company with capital which cannot be profitably employed may get rid
of it by resorting to buy-back and re-structure its capital.
ii. Free reserves which are utilized for buy-back instead of payment of
dividend shall enhance the value of the company’s shares and improve the
earnings per share.

iii. Surplus cash can be utilized by the company for buy-back and avoid the
payment of dividend tax.

iv. Buy-back may be used as a weapon to frustrate any hostile take-over of

the company by undesirable persons.

Determination of quantum for buy-back

The maximum number of shares to be bought back is determined as the least
number of shares arrived by performing the following tests :-
1. Share outstanding test
2. Resource test
3. Debt-Equity Ratio test

1. Share Outstanding test :-

a. Ascertain the number of shares
b. 25% of the number of shares is eligible for buy back with the approval of
shareholders.

(2) Resource test :-

a. Ascertain the shareholder’s fund (Capital + Free Reserves). Here, Free
Reserve includes Share (Securities) Premium, General Reserve, Revenue
Reserves, Profit and Loss account (Cr. Balance) and excludes Revaluation
Reserve, any other specific reserves.
b. No. of shares held for buy-back = Shareholder’s fund / Buy back price

3. Debt-Equity Ratio test

We can learn about this in separate chapter i.e. “Ratio analysis”.

Accounting for Buy-back

Journal Entries - Buy-back of shares

(i) Shares held for buy-back
Dr Equity Share Capital A/c
 Dr Premium on Buyback A/c
Equity Shareholders A/c (or) Shares
Cr
bought back A/c
(ii) Adjustment of premium on buyback
Dr Share (Securities) Premium A/c
Dr General Reserve A/c
Cr Premium on Buyback A/c
(iii) Transfering reserves to the extent of
capital redeemed
Dr Reserves A/c
Dr Profit Loss A/c
Cr Capital Redemption Reserve A/c
(iv) On buy-back of shares
Equity Shareholders A/c (or) Shares
Dr
bought back A/c
Cr Bank A/c

REDEEMABLE PREFERENCE SHARES

Introduction :-
The preference shares which can be redeemed by the company in accordance
with the terms of issue are called Redeemable Preference shares. However,
this provision should be stated in the Articles of the company. Generally, the
preference shares can be redeeming at par or at premium. But should not
redeem the irredeemable preference shares except in the event of the
company being wound up (closure of the company). There is not much
difference between the equity shares and irredeemable preference shares
except in terms of return, the equity shareholders can enjoy a better return
than the irredeemable preference shareholders.

Conditions for Issue and Redemption of “Redeemable Preference

Shares”
1. A company limited by shares can issue redeemable preference shares
subject to the provisions
of Sec. 80 of the Companies Act and such an issue should be authorized by
the Articles of the company.

2. A company cannot issue irredeemable preference shares or shares which

can be redeemed beyond a period of 20 years.

3. A company is permitted to carry out redemption from only two sources.

They are :-
(a) Profits of the company which would otherwise be available for dividend.
(b) Proceeds of fresh issue of shares made for the purpose of redemption.
But, should not redemption from any other source like issue of debentures,
borrowing from banks
and other financial institutions for carrying out redemption.

4. Where shares are redeemed from out of profits otherwise available for
dividend, a sum equal to the nominal value of the shares redeemed must be
transferred to ‘Capital Redemption Reserve Account’.

5. Only fully paid preference shares are to be redeemed. If partly paid shares
are to be redeemed, call must be made first and then redemption must be
carried out.

6. Redemption may be at par or at premium according to the terms of issue. If

redemption is at premium, such premium should be met out of profits or the
balance in ‘security premium account’.

7. Capital Redemption Reserve Account is available only for the purpose of

issue of bonus shares. This reserve must be kept intact unless otherwise
sanctioned by the court.

8. Redemption of redeemable preference shares does not result in the

reduction of authorized capital of the company. To the extent reduction has
taken place, the company can issue further shares, as if those shares had
never been issued.

9. If new shares are issued for the purpose of redemption, it will not amount
to increase in capital.
However, redemption must be carried out in accordance with the terms
provided in the Articles of the company.

Capital Redemption Reserve :-

A. Transfer to capital redemption reserve account is allowed from the
below profits :-
(i.e. the Profits available for dividend )
I. General reserve
2. Reserve fund
3. Dividend equalization fund
4. Insurance fund
5. Workmen compensation fund
6. Workmen accident fund
7. Voluntary debenture redemption account
8. Voluntary debenture sinking fund
9. Profit and loss account

B. Transfer to capital redemption reserve account is not allowed from the

below profits :-
(i.e. Profits not available for dividend )
1. Securities premium account
2. Forfeited shares account
3. Profit prior to incorporation
4. Capital reserve
5. Development rebate reserve

Accounting – Redemption of Shares and bonus shares

Journal Entries - Redemption and issue of Bonus Shares

1. Due from Redemption at a premium
Dr Regd. Preference Share Capital A/c
Dr Premium on Redemption A/c
Cr Regd. Preference shareholders A/c
2. Due from Redemption at par
Dr Regd. Preference Share Capital A/c
Cr Regd. Preference shareholders a/c
3. Sale of investment if any for fund and Profit or loss on sale
transferred to P/L A/c
Dr Bank A/c
Cr Investments
Cr Profit and Loss A/c
4. Fresh issue for fund if any at par
Dr Bank A/c
Cr Equity Share Capital A/c
5. Fresh issue for fund if any at premium
Dr Bank A/c
Cr Equity Share Capital A/c
Cr Share (Securities) premium A/c
6. Fresh issue for fund if any at discount
Dr Bank A/c
Dr Discount on issue of shares
Cr Equity Share Capital A/c
7. Transfer of premium on redemption
Dr Share (Securities) premium A/c
Dr Profit and Loss A/c
Cr Premium on redemption A/c
8. Payment to Shareholders
Dr Regd. Preference Shareholders A/c
Cr Bank A/c
9. Nominal value of shares redeemed, not by fresh issue of
shares
Dr General Reserve A/c
Dr Profit and Loss A/c
Cr Capital Redemption Reserve
10. Issue of bonus shares at a premium
Dr Capital Redemption Reserve A/c
Dr Share (Securities) premium A/c
Cr Bonus shares to shareholders
11. Issue of bonus shares at par
 Dr Capital Redemption Reserve A/c
Cr Bonus shares to shareholders
12. Conversion of bonus shares in to equity shares
Dr Bonus shares to shareholders
Cr Equity Share Capital A/c
13. Conversion of preference shares in to other shares
Dr Regd. Preference Share Capital A/c
Cr Preference/Equity share capital A/c

3. DEBENTURES
Introduction
A debenture is a medium to long-term debt instrument to borrow money.
They may or may not secured by physical assets and collateral. Debentures
are typically loans that are repayable on a fixed date, but some debentures are
irredeemable securities (i.e. are sometimes called perpetual
bonds/debentures) which means that they do not have a fixed date of
expected return of the funds. Most debentures also pay a fixed rate of interest.
Debenture holders (investors) do not have any rights to vote in the company's
general meetings of shareholders, but they are allowed separate meetings or
votes like on changes to the rights attached to the debentures. The interest
paid to debenture holders is calculated as a charge against profit in the
company's financial statements.

Here, “Collateral” means an asset is pledged as security that if the company

fails to pay the sum within stipulated time, the holders can discharge their
debts by seizing and selling the asset secured.

Debentures vs Bonds
Financing is the basic requirement of every organization (company). Funds
can be raised by issuing debt or equity instruments. When it is about debt
instruments, the 2 major sources of raising external finance are used by the
companies are Bonds and Debentures. Bonds and debentures are two
financial assets which are issued by the borrowing company for a price which
is equal to or less than or more than its face value, but they are not one and
the same. There are many differences between bonds and debentures :-
Bonds :-
A financial instrument which shows the obligation of the borrower to the
lender is called as Bond. They are created to raise funds for the company or
government. It is a certificate signifying a contract of indebtedness of the
issuing company for the amount lent by the bondholders. Generally, bonds
are secured by collateral i.e. an asset is pledged as security that if the
company fails to pay the sum within stipulated time, the holders can
discharge their debts by seizing and selling the asset secured. Bonds are
issued for a fixed period which carries interest known as ‘coupon.’ The
interest needs to be paid at regular intervals or it will accrue over time. Bonds
are issued by public sector undertaking, government firms, large
corporations, etc. The issue of government bonds is done in auctions where
members bid for the bonds. The principal amount of the bonds is to be paid at
a future specified date known as maturity date. Some common types of bonds
are as below :-
i. Zero coupon bonds
ii. Double option bonds
iii. Option bonds
iv. Inflation bonds
v. Floating rate bonds
vi. Euro bonds
vii. Foreign bonds
viii. Fully Hedged bonds
ix. Euro convertible zero bonds
x. Euro bonds with equity warrants.

Debenture
A debenture is a debt instrument used for supplementing capital for the
company. Debentures are may or may not secured by physical assets and
collateral. It is an agreement between the debenture holder and issuing
company. The capital raised is the borrowed capital so that the status of
debenture holders is like creditors of the company. Debentures carry interest
which is to be paid at periodic intervals. The amount borrowed is to be re-
paid at the end of the stipulated term as per the terms of redemption. The
issue of debentures publicly requires credit ratings. Debentures are issued by
issued by the companies whether it is public or private.
Debentures are classified in the following categories :-

1. On the basis of record :-

a. Registered debentures :-
These debentures are registered with the company and the amount is payable
only to those debentures holders whose names are registered with the
company.

b. Bearer debentures :-
These debentures are not registered with the company, these are transferable
merely by delivery and the debenture holder will get the interest.

2. On the basis of security :-

a. Secured (or mortgaged) debentures :-
Debentures, which are secured either on a particular asset (i.e. called as fixed
charge) or on the general assets of the company (i.e. called as floating charge)
is known as Mortgage debentures. These are secured by a charge on the
assets of a company. The principle amount and the unpaid interest could be
recovered by the holder out of the assets mortgaged by the company.

b. Unsecured (or Naked) debentures :-

Those debentures which are not secured is called as naked debentures.
Companies having very good standing are able to issue debentures of this
type. They are not very common. They do not get any security in reference to
principal amount or unpaid interest. They are simple debentures.

3. On the basis of Redemption (permanence) :-

a. Redeemable Debentures :-
Debentures which are redeemed or the re-payment made on maturity date are
called as Redeemable Debentures. These debentures can be redeemable :-
i. At the expiry of a specified period (maturity date) either at par or at
premium
ii. By purchasing in the open market at any time at the price prevailing in the
market
iii. By annual drawings.
b. Irredeemable debentures :-
When the issuing company does not fix any date by which they should be
redeemed and the
holders of such debentures cannot demand payment from the company so
long as it is a going
concern. Usually such debentures are repayable after a long period of time or
on winding up of
the company. This type of debentures is called as irredeemable debentures.

4. On the basis of convertibility :-

a. Convertible debentures :-
Those debentures which are having the option to convert the debentures fully
or partly into equity shares after a predefined specified time (i.e. on maturity
date) are called as Convertible debentures. If the debentures are fully
converted, then it is called as ‘Fully Convertible Debentures’. Those which
are partly convertible are called as ‘Partly Convertible Debentures’. The non-
convertible portion of the debenture is also called ‘Khoka’ in market circles.
Conversion may be at par or premium. Convertible debentures are more
attractive to investors since the debentures have the ability to convert. These
are more attractive to companies since they typically have lower interest
rates than non-convertible debentures.

b. Non –Convertible debentures :-

Those debentures which cannot be converted into equity shares of the
company is called as “Non-convertible debentures”. Since they are not able to
convert, they usually carry higher interest rate than convertible debentures.

5. On the basis of priority :-

a. First debentures :-
Those debentures which are repaid before the payment of other debentures
are called as First debentures.

b. Second debentures :-
Those debentures which are paid after the payment to the first debenture are
called as Second debentures.

Key differences between Bonds and debentures :-

1. A financial instrument issued by the government agencies, for raising
capital is known as Bonds. A financial instrument issued by the companies
whether it is public or private for raising capital is known as Debentures.
2. Bonds are backed by assets. Conversely, the Debentures may or may not
be supported by assets.
3. The interest rate on debentures is higher as compared to bonds.
4. The holder of bonds is known as bondholder whereas the holder of
debentures is known debenture holder.
5. The payment of interest on debentures is done periodically whether the
company has made a profit or not while accrued interest can be paid on the
bonds.
6. The risk factor in bonds is low which is just opposite in the case of
debentures.
7. Bondholders are paid in priority to debenture holders at the time of
liquidation.

Basis for comparison Bonds Debentures

Meaning A bond is a Debenture is a
financial/debt financial/debt
instrument showing the instrument used to raise
indebtedness of the long term finance
issuing company
towards its bond
holders.
Collateral Bonds are secured by Debentures may or may
collateral. not be secured by
collateral
Interest rate Low High
Issued by Government Agencies, Companies whether
financial institutions, private or public
large corporations
Payment Accrued Periodical
Risk factor Low High
Priority in repayment at First Second
the time of liquidation
Loan vs Debt
Basically, there is no major difference between loan and debt. both are
liabilities that need to be paid off. Loan represents an amount borrowed by an
individual to meet his/her requirements, whereas Debt represents an
accumulative amount a person can be borrowing from a lender.

Advantages of debentures :-
The main advantage of debentures to companies is that they have a lower
interest rate than overdrafts and also they are usually repayable at a date far
off in the future. For an investor, they are often easy to sell in stock
exchanges and they contain less risk than other options such as equities.

Requirement
The long-term capital can be raised by any company primarily through issue
of shares and debentures. While the shareholders are essentially the owners
of the enterprise, those who bought the debentures are treated as creditors for
long-term funds of the company but, they do not enjoy the voting rights. In
brief all securities other than shares issued by a company will come under the
term debentures.

Shares vs Debentures

Basis of comparison Shares Debentures

Definition An instrument to An instrument to
acknowledge the acknowledge the
ownership of the creditors of the
company company
Status A shareholder is the A debenture holder is
owner and a not a member but, a
member of the company creditor.
Return A shareholder may A debenture holder has
receive a right to
dividend only when a get interest even if the
company company does not make
makes a profit. profit.
 Rate of Return Dividend rate can be Debenture carries a
vary depending on the fixed rate of
profit position. interest.
Accounting treatment Dividend is given out of Debenture interest is
appropriable profit and chargeable to Profit and
not Loss account.
chargeable to Profit and
Loss
account.
Redemption A company can buy Debentures are
back the shares as per normally redeemable
the Companies Act although a company can
issue perpetual
debentures
Voting rights A shareholder has A debenture holder
voting rights cannot have
voting rights
Status at the At the time of winding At the time of winding
time of winding up up, share up , debenture holders
(closes the company) holders have the least have a priority over the
priority shareholders regarding
regarding the return of the return of amount
amount due to them. due to them

ACCOUNTING FOR DEBENTURES

There are 3 stages of accounting for debentures :-
(i) When debentures are issued
(ii) When provision for its redemption is made
(iii) When ultimately debentures are redeemed.

A detailed study of each stage is made in the following :-

ISSUE OF DEBENTURES
Important Provisions in the Companies Act on Issue of Debentures.
1. A company cannot issue any debentures carrying voting rights at any
meeting of the company.

2. Whenever debentures are issued to the public for subscription, it is

mandatory to appoint one or more debenture trustees for such debentures.

3. When a company issues debentures, it must create a ‘Debenture

Redemption Reserve’ (DRR) for the redemption of such debentures. Such a
reserve is created by crediting adequate amounts from out of the profits until
such debentures are redeemed. The company has to pay interest in
accordance with the terms and conditions of their issue.

4. Perpetual debenture means debentures that cannot be redeemed. If

perpetual secured debentures are issued, the implication is that the borrower
can never repay the loan and free the property from the charge.

5. The company has a right to re-issue debentures except when there is a

contrary provision in the Articles or a specific resolution has been passed.

6. The power to issue debentures is to be exercised by the board at a meeting.

7. Technically a company can issue unsecured debentures. However, such

debentures will be prepaid as public deposits and all the provisions relating to
acceptance of public deposits will apply.

Accounting Aspects to Issue of Debentures :-

Accounting aspects of issue of debenture may be studied from the below 3
different sides :-

1. What would be the consideration ?

a. Issued for cash
b. Issued for consideration other than cash
c. Issued as collateral security
2. What would be the issue price ?
a. Issued at par
b. Issued at premium
c. Issued at discount
3. How the redemption be made.
a. Redeemed at par
b. Redeemed at premium
c. Redeemed at discount

Combining of (2) and (3), the following are the options of issue.
1. Issued at par and redeemable at par
2. Issued at discount and redeemable at par
3. Issued at premium and redeemable at par
4. Issued at premium and redeemable at premium
5. Issued at par and redeemable at premium
6. Issued at discount and redeemable at premium

The accounting entries for the above 6 combinations are given below :-

The Accounting treatment for the issue of Debentures :-

1. Issued at par and redeemable at par

Dr Bank A/c
Cr debentures A/c
2. Issued at discount and redeemable at par
Dr Bank A/c
Dr Discount on issue of debentures
Cr Debentures A/c
3. issued at premium and redeemable at par
Dr Bank A/c
Cr debentures A/c
Cr Share (security) premium A/c
4. issued at premium and redeemable at premium
Dr Bank A/c
Dr Loss on issue of debentures A/c
Cr debentures A/c
Cr Share (security) premium A/c
Cr Premium on redemption of debentures
 5. Issued at par and redeemable at premium
Dr Bank A/c
Dr Loss on issue of debentures A/c
Cr debentures A/c
Cr Premium on redemption of debentures
6. Issued at discount and redeemable at premium
Dr Bank A/c
Dr Loss on issue of debentures A/c (See Note)
Cr debentures A/c
Cr Premium on redemption of debentures

NoTe :- Loss on issue of debentures includes discount on issue and

premium on redemption

Issue for Consideration other than Cash :-

In this case, debentures are issued for consideration other than cash. For
example, allotment of
debentures for assets purchased or technical services received, etc. There is
no receipt of cash in
these transactions for the allotment of debentures.

Debentures issued as Collateral Security :-

(a) This is the third type of consideration for which company issues
debentures. Issue of
debentures as a collateral security means issue of debentures as a subsidiary
or secondary
security, that is, a security in addition to the prime security. Secondary
security is to be
realized only when the prime security fails to pay the amount of loan.
Debentures issued
as a collateral security can be dealt with in two ways in the books :-

a. First Method :-
No entry is made in the books. On the liability side of the balance sheet,
below t h e
item of loan, a note that “it has been secured by the issue of debentures is to
be given”.

b. Second method :-
Sometimes, the issue of debentures as collateral security is recorded by
making a journal
entry as below :-
Dr. Debenture suspense account (Assets side of the balance sheet)
Cr. Debenture account (Liabilities side of the balance sheet))

Note :- When the loan is paid, the above entry is cancelled by means of a
reverse entry.

Discount on issue of Debenture

When debentures are issued at discount, it is prudent to write off the loss
during the life of debentures.

REDEMPTION OF DEBENTURES

Meaning
Redemption of debentures is the process of discharging the liability on
account of debentures. Discharge of debenture liability is usually by paying
cash to the debenture holders. But, this can be take other forms i.e.
conversion or ‘rollover’. “Conversion” refers to the debentures are
converted into preference shares or equity shares. “Rollover” refers to the
issue of new debentures in exchange for the old ones. Both conversion and
rollover are subject to detailed SEBI guidelines. When a company issues
debentures, it must also plan the resources required for such redemption. This
can be done commonly through the below two ways :-

i. By setting aside profits every year and investing them wisely in

investments outside. So that there will be no liquidity problem at the time of
redemption.

ii. The company can take an insurance policy by paying regular premium. So
that the policy matures coinciding with the time of redemption. With the
amount received on the maturity of policy, the company faces no problem in
carrying out the redemption.

The above 2 ways in which a company can make provisioning for redemption
of debentures.

SEBI on Creation of Debenture Redemption Reserve (DRR)

1. A company has to create DRR in case of issue of debentures with maturity

of more than 18
months.

2. DRR must be created for the non-convertible portion of debenture issues

on the same lines as applicable for fully non-convertible debenture issue.

3. In respect of convertible issues by new companies, the creation of DRR

must commence from the year the company earns profits for the remaining
life of debentures.

4. DRR shall be treated as part of general reserve for consideration of bonus

issue proposals and for price fixation related to post-tax return.

5. Company must create DRR equivalent to 50% of the amount of debenture

issue before debenture redemption commences. Only after the company has
actually redeemed 10% of the debenture liability, withdrawal from DRR is
permissible.

Note :-
The requirement of creation of DRR is not applicable to issue of debt
instruments by infrastructure companies.

Restrictions on Dividends
Dividends may be distributed out of profits of particular year only after
transfer of requisite amount in DRR. If residual profits are inadequate to
distribute reasonable dividends, company may distribute dividend out of
general reserve.

Creation of provision for Debenture Redemption Reserve (DRR)

It is always difficult for a company to save money (lump sum amount) for
redeeming debentures on the due date to re-pay the debt. But, this can be
done by adopting any of the below two methods to create the DRR :-
1 Sinking fund method
2. Insurance Policy method

1. Sinking fund method

Under this method, the amount is invested in first class securities with
secured and fixed return.
Accumulation of interest becomes compounded resulting to produce the
amount required to redeem the debentures on the due date (i.e. maturity date).
This method of providing for funds is also called “debenture redemption fund
method”. The sinking fund method for redeeming a loan is different from
sinking fund method for replacing an asset in the following ways :-

a. Sinking fund created for replacing an asset is in the nature of accumulated

depreciation while sinking fund created for repaying loan is in the nature of
accumulated profits. It is for this reason that sinking fund’s balance (after the
redemption of loan) is transferred to general reserve while that for an asset is
transferred to asset account.

b. Annual installment set aside for the replacement of an asset is a charge and
is debited to profit and loss account while that for the redemption of a loan is
an appropriation and is debited to profit and loss appropriation account.

Accounting entries for making the provision for the redemption of debentures
as per sinking fund are as follows :-

Journal Entries - Provision for the redemption of

debentures
First year
Dr Profit and loss appropriation account
Cr Sinking fund account
1
(Setting aside the required amount based on sinking
fund table)
Dr Sinking fund investment account
2 Cr Bank account
(Investment of amount set aside )

Second and subsequent years

Dr Bank Account
1 Cr Sinking fund interest account
(Interest on sinking fund investment received.)
Dr Sinking fund interest account
2 Cr Sinking fund account
(Transfer of interest account to sinking fund.)
Dr Profit and loss appropriation account
Cr Sinking fund account
3
(Setting aside the required amount based on sinking
fund table)
Dr Sinking fund investment account
Cr Bank account
4
(Investment of amount set aside and the amount of
interest received)

Last year
Dr Bank Account Dr
1 Cr Sinking fund interest account
(Interest on sinking fund investment received.)
Dr Sinking fund interest account
2 Cr Sinking fund account
(Transfer of interest account to sinking fund.)
Dr Profit and loss appropriation account
Cr Sinking fund account
3
(Setting aside the required amount based on sinking
fund table)

At the time of sale of investments and redemption

Dr Bank Account
 1 Cr Sinking fund investment account
(Amount received from sale of investment)
Dr Sinking fund account
2 Cr Sinking fund investment account
(Loss on sale)
Dr Sinking fund investment account
3 Cr Sinking fund account
(Profit on sale)
Dr Sinking fund account
4 Cr General reserve
(Transfer of balance of sinking fund account)
Dr Debentures account
5 Cr Bank A/c
(Redemption of debentures)

Note :-
In the final year, the amount appropriated from the profits of the company
and the amount received as interest on sinking fund investment are not
invested as the amount would be needed on the following day for the
redemption of debenture.

Non-cumulative sinking fund :-

A non-cumulative sinking fund differs from the cumulative type of sinking
fund only in one respect i.e. in non-cumulative sinking fund, interest received
on sinking fund investment is not re-invested, nor it is transferred to sinking
fund. Interest on sinking fund investment is treated as a simple profit and is
kept in the business without earmarking its use and the amount is transferred
to profit and loss account. Nevertheless, a careful study of the two types of
funds will reveal that there is no difference between the two methods. In a
non-cumulative type of fund, the appropriation from the profits is more but,
the excess burden on the profits is corrected by the transfer of interest on the
investment to profit and loss account. In the case of a cumulative type of
sinking fund method, the appropriation from the profit is less but, that
amount is made up by crediting to sinking fund as the amount of interest
earned on investment.
2. Insurance policy method
Under this method, an insurance policy for the required amount is to be taken
for the redemption of debentures at the end of a fixed period. Under this
system, the premium is paid regularly in installments and the insurance
company in its turn, returns the total accumulated money at the expiry of the
period. Money so received is used for redeeming debentures. This method
differs from the sinking fund method only in respect of interest on
investment. Unlike sinking fund method, the insurance company does not
give any interest on the installments received.

The Journal entries in respect of insurance policy method are as below :-

Each year
Dr Profit and loss appropriation A/c
Cr Debenture redemption fund A/c
(Appropriation of the amount of premium of the policy)
Dr Debenture redemption policy account A/c
Cr Bank account A/c
(Payment of premium on the policy)
Premium in the policy is always paid in advance. so, it must be
paid even in the last year.
At the time of realization of policy and redemption
Dr Bank A/c(amount of policy taken)
Debenture redemption policy A/c (Amount at which policy
Cr account stands)
Debenture redemption fund A/c (Difference in the two
Cr amounts)
Dr Debenture redemption fund account
Cr General Reserve A/c
(Transfer of Balance)

Different methods of redemption of debentures :-

However, following are the other methods by which the liability on
debentures may be extinguished.
Conversion
The conversion of debentures means the debentures are converted into
preference shares or
equity shares. For the purpose of conversion debentures are to be classified as
fully convertible debentures (FCDs), partly convertible debentures (PCDs),
and non-convertible debentures (NCDs). A company cannot issue FCDs
having a conversion period of more than 36 months unless the conversion
is made optional with a put and call option. If conversion takes place 18
months after the date of allotment but before 36 months, any conversion in
part or whole of the debenture is optional in the hands of the debenture
holder. If he does not exercise the option, it will effectively become an NCD.
FCDs with conversion period less than 12 months are treated as quasi-equity
and are treated at par with equity.

FCDs are fully convertible into equity shares either at par or premium. The
premium to be charged at conversion must be predetermined and announced
in the prospectus. In the case of PCDs, it comprises two parts namely the
convertible portion and the non-convertible portion. It is only the convertible
portion that would be converted into shares. In the case of NCDs, the liability
will be discharged by payment of cash or rollover. A company can also
convert NCDs at a later date into equity shares but it should be at the option
of debenture holder.

Rollover
Rollover means the issue of new debentures in the place of old ones. Rollover
must be with the
written consent of the debenture holder. If he does not give written consent,
his claim must be settled in cash. Also, whenever the debenture liability is
rolled over, company must obtain fresh credit rating. Fresh trust must be
executed at the time of rollover. Also, fresh security must be created in
respect of rolled over debentures subject to the conditions listed. Rollover can
be done without change in the interest rate if the non-convertible portion of
PCDs/NCDs of a listed company exceeds Rs.50 lakhs.

Sources of redemption
From the point of view of sources, redemption may be carried out with the
help of any of the following sources:-
1. Out of capital
2. Out of profits
3. Conversion or rollover
4. Out of provision in the nature of sinking fund

1. Redemption out of capital

SEBI guidelines require the setting up of a ‘Debenture Redemption Reserve’
when profits are available and the debentures are issued for a period beyond
18 months. If the debentures are for a period less than 18 months or profits
are not available for capital redemption, debentures may be redeemed from
out of capital. When redemption is carried from out of capital, only entries
are made for redemption and no entry will be made to transfer profits to
‘Debenture Redemption Reserve’.

2. Redemption from out of Profits

Now it is mandatory to set up ‘Debenture Redemption Reserve’. After
carrying out the entire redemption, the amount to the credit of ‘debenture
redemption Reserve’ will be transferred to general reserve account.

3. Conversion or rollover
In the case of conversion, debentures are converted into equity or preference
shares. In the case of rollover, old debentures or replaced by the issue of new
debentures. The new shares may be issued at par or at premium.

Additional accounting entries for conversion or rollover are as below :-

1. Conversion in to shares at par

Debenture redemption or Debenture
Dr holders A/c
Cr Equity / Preference share capital A/c
2. Conversion in to shares at premium
Debenture redemption or Debenture
Dr holders A/c
Cr Share capital A/c
Cr Share premium A/c
 3. Rollover at par
Debenture redemption or Debenture
Dr holders A/c
Cr New Debentures A/c
4. Rollover at premium
Debenture redemption or Debenture
Dr holders A/c
Cr New Debentures A/c
Cr Share premium A/c

When to be redeemed?
Time of redemption can be classified in the following three ways :-
1. Redemption by annual drawings even before the maturity of debentures,
2. Purchases of debentures from the open market and canceling them
immediately or later,
3. Redemption only on maturity.

Redemption by Annual Drawings

SEBI guidelines state that the issuing company shall redeem the debentures
as per the offer document. A company at the time of issue, may provide for
staggered redemption. This can be done in two ways. The redemption may be
certain amount of each debenture with a schedule so that redemption may be
completed over a time frame. The other way is to select certain number of
debentures every year and redeem them fully. The debentures to be redeemed
are selected by drawing a lot annually. This method is known as ‘Redemption
by Annual Drawings’. Again whether the redemption is at par, premium or
discount, depend on the terms of offer. Nowadays it is also common for
companies to have a call option which gives them the right to redeem the
debentures at a pre-determined price. This gives them the right to cancel but
not the obligation to cancel.

Purchase and Cancellation of Own Debentures

Debentures may also be cancelled before the expiry of the period by
purchasing them from the open market at market price, which may be at
premium or discount to the book value. It is certainly advantageous to buy
when they are selling in the market at a discount. Cancellation of debentures
may be done immediately or later. In some cases, such debentures may also
be reissued. This method of redemption is known as ‘purchase and
cancellation of own debentures’. For purchase and cancellation of own
debentures, the company have to consider the following Parameters :-

a. The company may cancel such debentures immediately or carry them as an

investment and cancel at a later date.

b. Where they are immediately cancelled, a debenture liability is extinguished

to the extent of par value of the debentures cancelled. From the date of
cancellation, interest is not payable on cancelled debentures. Since the
debenture liability cancelled is more than the amount paid for such
debentures, profit on cancellation of debentures should be recorded. If there
is a Sinking Fund, such profit is transferred to the Sinking Fund.

c. When debentures are carried as an investment, debenture liability is shown

as before and at the same time, ‘Investment in own Debentures’ or simply
‘Own Debentures’ appears on the assets side of the balance sheet till they are
cancelled.

d. In the case of own debentures, interest on own debentures must be

reckoned as income or set-off against the gross interest payable on the whole
of debentures.

e. If debentures are purchased between two interest dates, and not

immediately after payment of interest, then the price paid for debentures
depends on the quotation.

Accounting Entries

Accounting Entries
1. Purchase of own debentures
Dr Own debentures A/c
Cr Bank A/c
2. Cancellation of own debentures
Dr Debentures A/c
 Cr Own debentures A/c
3. Profit on cancellation
Dr Debentures A/c
Profit on cancellation of debentures A/c or
Cr Sinking fund A/c
4. Loss on cancellation
Loss on cancellation of debentures A/c or
Dr Sinking fund A/c
Cr Own debentures A/c
5. Re-issue (or sale) of own debentures
Dr Bank A/c
Cr Own debentures A/c
6. Profit on Re-issue
Dr Own debentures A/c
Cr Profit and loss A/c
7. Loss on Re-issue
Dr Profit and loss A/c
Cr Own debentures A/c
8. Interest on own debentures
Dr Profit and loss A/c
Cr Sinking fund A/c

------------ End of the CHAPTER – 2 ----------

CHAPTER – 3
BANK RECONCILIATION STATEMENT

Learning objectives
After studying this chapter, you can be able to :-
1. Know the meaning of reconciliation,
 2. Understand the need of Bank Reconciliation
Statement,
3. Know the reasons for differences in cash book
and passbook, and
4. know the preparation of Bank Reconciliation
Statement.

INTRODUCTION TO BRS
Here, reconciliation means finding reasons for differences between 2 books
i.e. cash book or bank register maintained by a person or firm and pass book
or bank statement of the account holder.

“Bank Reconciliation Statement” (BRS) is a statement which contains a

complete and satisfactory explanation of the differences in balances as
per the cash book and pass book.

A BRS is to be prepared whenever a bank statement received or all the

transactions are updated in pass book and the BRS prepared by the customer
(bank account holder) of the bank.

A BRS can be prepared based on balance as per cash book or balance as per
pass book or overdraft balance as per cash book or overdraft balance as per
pass book.

Bank Reconciliation Statement (BRS) is prepared on a stated day and the

preparation of BRS is not a part of the double entry system of book keeping.

BRS is neither part of pass book nor part of cash book.

When a bank column of cash book shows a credit balance, it means overdraft.
Simultaneously, when a pass book shows a credit balance, it means amount
due from the bank to the account holder.

BRS is prepared to examine the mistakes committed in the pass book.

BRS is prepared to find out the exact bank balance.

Generally, the cash book or bank register maintained by a person or firm
shows debit balance. Simultaneously, the pass book (Bank statement) of a
person or firm shows credit balance. But, in the case of overdraft account
with bank, vice versa i.e. the cash book or bank register maintained by a
person or firm shows credit balance. Simultaneously, the pass book (Bank
statement) of a person or firm shows debit balance.

IMPORTANCE OR NEED TO PREPARE BRS :-

1. To ascertain the total amount of cheques issued but not presented the same
in to the bank for payments.
2. It reflects the actual bank balances position
3. It helps to detect any mistakes in the cash book and/or pass book of the
bank.
4. It prevents frauds in recording the banking transactions.
5. It explains any delay in the collection of cheques.

TERMS USED IN THIS CHAPTER

OVERDRFT
A deficit in bank account caused by drawing more money than the account
holds is called overdraft. An overdraft allows us to access extra funds through
our transaction account up to an approved overdraft limit by the banker.

The bank sanctions us a specific limit and our account will be in negative
balance to that limit. We have to pay only interest amount on the amount
taken as loan. In the case of overdraft, passbook has a debit balance and the
cash book has a credit balance.

Any debit in pass book without a corresponding credit in cash book, makes
pass book overdraft is to be more than cash book overdraft. Similarly, any
credit in pass book without a corresponding debit in cash book, makes pass
book overdraft is to be lower than cash book overdraft.

Any debit in cash book without a corresponding credit in pass book, makes
cash book overdraft is to be lower than pass book overdraft. Similarly, any
credit in cash book without a corresponding debit in pass book, makes cash
book overdraft is to be more than pass book overdraft.

CHEQUE :-
"Cheque is an instrument in writing containing an unconditional order,
addressed to a banker, signed by the person who deposited money with the
banker, requiring him to pay on demand a certain sum of money only to or to
the order of certain person or to the bearer of instrument."

E-CHEQUE :-
Electronic cheque (e-cheque) is the image of a normal paper cheque
generated, written and signed in a secure system using the minimum safety
standards with the use of digital signature (with or without
biometrics signature) and asymmetric crypto system. Simply said an
electronic cheque is nothing more than an ordinary cheque produced on a
computer system and instead of signing it in ink, it is signed using the digital
equivalent of ink and legal recognition has been accorded to e-cheques and
they have been brought at par with the normal cheques. Now, a ‘cheque’
includes an e-cheque.

Dishonor of cheque :-
A situation when the accepter of the bill refuse to pay the amount unable to
do so is called dishonor of cheque due to in the following reasons :-
a. Insufficient funds in drawee’s bank account
b. Drawyee’s bank account closed
c. Stop payment instructions given by drawee to banker etc…

Presentation of cheque :-
Depositing the cheque in to bank for receiving the payment

Clearing of cheque :-
Collection of the amount of cheque by the bank

MOST REASONS FOR DIFFERENCES IN CASH BOOK OR PASSBOOK :-

1. Cheques issued, but not presented for payment :-

For example, The ABC limited issued Citi bank’s cheque to DEF limited
(vendor to ABC limited) for $ 10,000 . then, the ABC limited has passed the
journal entry in their cash book as below :
 Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit DEF Limited 10,000.00
Credit Citi Bank 10,000.00
(being payment made to DEF Limited)

But, DEF Limited is not presenting the cheque in to bank till the ABC
Limited has received the bank statement of Citi bank to prepare the BRS.

So, at the time of preparing BRS by ABC limited, the pass book shows less
debit balance while the cash book of ABC limited shows more credit balance
as already passed the journal entry in their books.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category \of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
1 Add this transaction to balance as per cash book
Less this transaction from balance as per bank
2 pass book
Less this transaction from overdraft balance as per
3 cash book
Add this transaction to overdraft balance as per
4 bank pass book

NOTE :-
If the cheque will not be presented in to bank for 3 months from cheque
issued date, it is called as stale cheque. Then, the journal entry which was
recorded is need to be reverse as below :-

Journal Entry
Dr / Description of Amount
 Cr Account ($)
Debit Citi Bank 10,000.00
Credit DEF Limited 10,000.00
(being payment made to DEF Limited)

2. Interest on investments collected by bank and recorded in pass book

only :-
For example, The Citi bank has collected the interest on investments for $
500 on behalf of ABC limited and credited the ABC limited.

So, at the time of preparing BRS by ABC limited, the pass book shows more
credit balance of ABC limited while the cash book of ABC limited shows
less debit balance due to not recorded the journal entry for this transaction so
far in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
1 Add this transaction to balance as per cash book
Less this transaction from balance as per bank
2 pass book
Less this transaction from overdraft balance as
3 per cash book
Add this transaction to overdraft balance as per
4 bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :

Journal Entry
Dr / Description of Amount
Cr Account ($)
 Debit Citi Bank 500.00
Interest on
Credit investments 500.00
(being interest on investments
received)

3. Bank interest credited in passbook only :-

For example, when ABC limited is keeping the balances with Citi bank
account, the bank will give some amount as interest of $ 200 by credited the
party.

So, at the time of preparing BRS by ABC limited, the pass book shows more
credit balance of ABC limited while the cash book of ABC limited shows
less debit balance due to not recorded the journal entry for this transaction so
far in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
1 Add this transaction to balance as per cash book
Less this transaction from balance as per bank
2 pass book
Less this transaction from overdraft balance as per
3 cash book
Add this transaction to overdraft balance as per
4 bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :-

Journal Entry
Dr / Description of Amount
Cr Account ($)
 Debit Citi Bank 200.00
Credit Interest 200.00
(being interest received)

4. Customers deposited the funds directly in to the bank :-

For example, the customer PQR limited directly deposited $ 7000 in the
account of ABC limited with Citi bank. This is not informed to ABC limited.

So, at the time of preparing BRS by ABC limited, the pass book shows more
credit balance of ABC limited while the cash book of ABC limited shows
less debit balance due to not recorded the journal entry for this transaction so
far in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
1 Add this transaction to balance as per cash book
Less this transaction from balance as per bank
2 pass book
Less this transaction from overdraft balance as
3 per cash book
Add this transaction to overdraft balance as per
4 bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 7,000.00
Credit PQR Limited 7,000.00
 (being amount received from PQR
limited)

5. Cheques collected by bank and recorded in bank pass book only :-

The Citi bank collected the cheque for $ 3000 from XYZ limited who is
customer of ABC limited and credit the same to ABC limited.

So, at the time of preparing BRS by ABC limited, the pass book shows more
credit balance of ABC limited while the cash book of ABC limited shows
less debit balance due to not recorded the journal entry for this transaction so
far in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
1 Add this transaction to balance as per cash book
Less this transaction from balance as per bank
2 pass book
Less this transaction from overdraft balance as
3 per cash book
Add this transaction to overdraft balance as per
4 bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 3,000.00
Credit XYZ Limited 3,000.00
(being amount received from XYZ
 limited)

6. Interest on debentures / bonds collected by bank and recorded in pass

book only :-
For example, The Citi bank has collected the interest on debentures for $ 400
on behalf of ABC limited and credited the ABC limited.

So, at the time of preparing BRS by ABC limited, the pass book shows more
credit balance of ABC limited while the cash book of ABC limited shows
less debit balance due to not recorded the journal entry for this transaction so
far in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
1 Add this transaction to balance as per cash book
Less this transaction from balance as per bank
2 pass book
Less this transaction from overdraft balance as
3 per cash book
Add this transaction to overdraft balance as per
4 bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 400.00
Interest on
Credit debentures 400.00
 (being interest on debentures received)

7. Dividends collected by bank and recorded in pass book credit only :-

For example, The Citi bank has collected the dividend for $ 150 on behalf of
ABC limited and credited the ABC limited.

So, at the time of preparing BRS by ABC limited, the pass book shows more
credit balance of ABC limited while the cash book of ABC limited shows
less debit balance due to not recorded the journal entry for this transaction so
far in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
1 Add this transaction to balance as per cash book
Less this transaction from balance as per bank
2 pass book
Less this transaction from overdraft balance as
3 per cash book
Add this transaction to overdraft balance as per
4 bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 150.00
Credit Dividend 150.00
(being dividend received)
8. Wrong (excess) credit in pass book or cash book :-
8 (a). Cheque received amount is excess recorded in pass book credit :-
For example, the ABC limited received the cheque from XYZ limited for $
340 and recorded the below journal entry in their cash book and presented the
same cheque in to Citi bank.

Journal Entry - 1
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 340.00
Credit XYZ liLimited 340.00
(being cheque received from XYZ
limited)

While crediting the ABC limited by Citi bank, wrongly considered the
amount as $ 430 instead of $ 340 by mistake.

So, the cash book of ABC limited is showing less debit balance while the
pass book is showing more credit balance.

Hence, The ABC limited has to do 1 of the following 4 activities (for

difference of $ 90 i.e. 430 – 340) based on category of balances (either
normal or overdraft) maintained by ABC limited with City bank to reconcile
the balance in Bank Reconciliation Statement :-

S.No Activity
1 Add this transaction to balance as per cash book
Less this transaction from balance as per bank
2 pass book
Less this transaction from overdraft balance as
3 per cash book
Add this transaction to overdraft balance as per
4 bank pass book
After observe this transaction by ‘ABC limited’ in pass book or bank
statement, the ABC limited has to pass the below journal entry for difference
of $ 90 (430 – 340) in their cash book to match the balance in both the cash
book and pass book.

Journal Entry - 2
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 90.00
Credit XYZ Limited 90.00
(being adjustment entry passed to match
the balance)

Then, the ABC limited need to inform the Citi bank to debit the difference
amount of $ 90. Once the bank will debit the ABC limited, then, the ‘ABC
limited’ has to reverse the above Journal entry – 2 in their cash book.

8 b. Excess recorded in cash book credit :-

The ABC limited issued cheque to ‘DEF limited’ for $ 570 and passed the
journal entry wrong for $ 750 instead of 570 as below :

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit DEF Limited 750.00
Credit Citi Bank 750.00
(being payment made to DEF limited))

Then, the same cheque presented in bank by DEF limited. So, Citi bank
debited the ABC limited for actual cheque amount of $ 570.

So, here, the cash book of ‘ABC limited’ is showing more credit balance
whereas the pass book of ABC limited is showing less debit balance.

Hence, The ABC limited has to do 1 of the following four activities (for
difference of $ 180 i.e. 750 – 570) based on category of balances (either
normal or overdraft) maintained by ABC limited with City bank to reconcile
the balance in Bank Reconciliation Statement :-

S.No Activity
1 Add this transaction to balance as per cash book
Less this transaction from balance as per bank
2 pass book
Less this transaction from overdraft balance as per
3 cash book
Add this transaction to overdraft balance as per
4 bank pass book

After reconciliation, the ABC limited has to reverse the above journal entry
which passed as wrong for $ 750 in their cash book and has to record the
below journal entry for actual payment made for the amount of $ 570 .

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit DEF Limited 570.00
Credit Citi Bank 570.00
(being payment made to DEF limited))

9. Cheques deposited (paid) in to bank, but, not credited (cleared) in to

pass book :-
For example, The ABC limited received an account payee cheque from the
customer XYZ limited for $ 2000 against services rendered and recorded the
below journal entry in their cash book and then, deposited the same cheque in
to Citi bank.

Journal Entry
Dr / Description of Amount
Cr Account ($)
 Debit Citi Bank 2000.00
Credit XYZ Limited 2000.00
(being payment received from XYZ
limited)

But, the cheque has not been cleared or credited the ABC limited by Citi
bank so far i.e. as on date.

So, the cash book of ABC limited is showing more debit balance whereas the
Citi bank pass book is showing for less credit balance of ABC limited.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book

10. Bank charges debited in pass book only :-

For example, the Citi bank charged $ 6.00 as debit the ABC limited for
banking services rendered to their customer. The bank can charged the bank
charges due to the following reasons :-

a. transaction charges
b. Minimum balance not maintained by the customers
c. Charges for Cheque book issued
d. Charges for cheque bounced etc…
So, at the time of preparing BRS by ABC limited, the pass book shows more
debit balance of ABC limited while the cash book of ABC limited shows less
credit balance due to not recorded the journal entry for this transaction so far
in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :-

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Bank Charges 6.00
Credit Citi Bank 6.00
(being bank charges charged by the
bank)

11. Cheque deposited in to bank, but, it was dishonored :-

The cheque can be dishonored by the bank due to the following reasons :-
a. Insufficient funds in drawyee’s bank account
b. Drawyee’s bank account closed
c. Stop payment instructions given by drawee to banker etc…

For example, the ABC limited has received the cheque for $ 9000 from
customer XYZ limited and recorded the entry in their cash book as below and
the same cheque has presented in to bank.

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 9000.00
Credit XYZ Limited 9000.00
(being payment received from XYZ
limited)

But, the cheque has not been cleared or credited the ABC limited by Citi
bank so far i.e. as on date due to the cheque has bounced (dishonoured due to
insufficient balance maintained by XYZ limited).

So, the cash book of ABC limited is showing more debit balance due to the
cheque has not been credited in pass book whereas the Citi bank pass book is
showing for less credit balance of ABC limited.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book
12. Commission charged by bank in pass book debit only :-

For example, the Citi bank charged the commission of $ 8.00 as debit the
ABC limited in pass book only.

So, at the time of preparing BRS by ABC limited, the pass book shows more
debit balance of ABC limited while the cash book of ABC limited shows less
credit balance due to not recorded the journal entry for this transaction so far
in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No. Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Bank Commission 8.00
Credit Citi Bank 8.00
(being bank charges the bank
commission)
13. LIC premium debited in pass book only :-
This can be happening when party (LIC agent) received the post-dated
cheques from ABC limited and presented the same in the bank and date is
scheduled for payment. For example, the Citi bank debited the ABC limited
for the amount of $ 100 on an account of life insurance cheque received to
clear.

So, at the time of preparing BRS by ABC limited, the pass book shows more
debit balance of ABC limited while the cash book of ABC limited shows less
credit balance due to not recorded the journal entry for this transaction so far
in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :

Journal Entry
Dr / Description of Amount
Cr Account ($)
Life Insurance
Debit Corporation 100.00
Credit Citi Bank 100.00
 (being LIC premium paid)

14. Promissory note amount paid by bank but not recorded in cash book
:-
The ABC limited borrowed the amount of $ 5000 from PQR limited by
pledging the promissory note through the guarantee of Citi bank. Now, the
PQR limited claimed this amount of $ 5000 with Citi bank. Then, Citi bank
has paid this amount to PQR limited and the same has been debited the ABC
limited in pass book without giving any information to ABC limited.

So, at the time of preparing BRS by ABC limited, the pass book shows more
debit balance of ABC limited while the cash book of ABC limited shows less
credit balance due to not recorded the journal entry for this transaction so far
in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit PQR Limited 5,000.00
 Credit Citi Bank 5,000.00
(being promissory note amount paid to
PQR Limited)

15. Interest on overdraft debited in pass book only :-

For example, when the ABC limited is maintaining the overdraft account
with Citi bank and taken the amount of $ 1200 as overdraft, the Citi bank
debited the ABC limited by charging the interest on overdraft @ 1% i.e. $ 12
(1200 x 1%)

So, at the time of preparing BRS by ABC limited, the pass book shows more
debit balance of ABC limited while the cash book of ABC limited shows less
credit balance due to not recorded the journal entry for this transaction so far
in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :-

Journal Entry
Dr / Description of Amount
Cr Account ($)
Interest on
 Debit overdraft 12.00
Credit Citi Bank 12.00
(being interest in overdraft is paid)

16. Received cheque from customer is recorded in cash book and forgot
to send the same to bank (Omitted to be banked) :-
For example, the ABC limited has received the cheque for $8,000 from
customer XYZ limited and recorded the entry in their cash book as below and
forgot (omitted) to send this cheque to Citi bank.

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 8000.00
Credit XYZ Limited 8000.00
(being payment received from XYZ
limited)

So, the cash book of ABC limited is showing more debit balance due to the
cheque has not been credited in pass book whereas the Citi bank pass book is
showing for less credit balance of ABC limited.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book
After reconciliation, the ABC limited must send this cheque to Citi bank to
clear.

17. Rent paid by bank, but, not recorded in cash book :-

This can be happening when party (owner of the property given for rent)
received the post-dated cheques from ABC limited and presented the same in
the bank and date is scheduled for payment. For example, the Citi bank
debited the ABC limited for the amount of $ 600 on an account of Rent
cheque received to clear.

So, at the time of preparing BRS by ABC limited, the pass book shows more
debit balance of ABC limited while the cash book of ABC limited shows less
credit balance due to not recorded the journal entry for this transaction so far
in their cash book.

Hence, The ABC limited has to do 1 of the following 4 activities based on

category of balances (either normal or overdraft) maintained by ABC limited
with City bank to reconcile the balance in Bank Reconciliation Statement :-

S.No Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book

After reconciliation done, the below entry need to pass by ABC limited in
their cash book :

Journal Entry
Dr / Description of Amount
 Cr Account ($)
Debit Rent 600.00
Credit Citi Bank 600.00
(being Rent paid)

18. Wrong (excess) debit in pass book or cash book :-

18 (a). Cheque issued amount is excess recorded in pass book

debit :-
For example, the ABC limited issued the cheque to DEF limited for $ 360
and recorded the below journal entry in their cash book and presented the
same cheque in to Citi bank by DEF limited.

Journal Entry - 1
Dr / Description of Amount
Cr Account ($)
Debit DEF Limited 360.00
Credit Citi Bank 360.00
(being payment made to DEF Limited)

While debiting the ABC limited by Citi bank, wrongly considered the amount
as $ 630 instead of $ 360 by mistake.

So, the pass book of ABC limited is showing more debit balance while the
cash book is showing less debit balance.

Then, ABC limited has to

Hence, The ABC limited has to do 1 of the following 4 activities (for
difference of amount $ 270 i.e. 630 – 360) based on category of balances
(either normal or overdraft) maintained by ABC limited with City bank to
reconcile the balance in Bank Reconciliation Statement

S.No. Activity
Less this transaction from balance as per cash
1 book
 Add this transaction to balance as per bank pass
2
book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book

And the ABC limited has to pass the below journal entry for difference of $
270 (630 – 360) in their cash book to match the balance in both the cash book
and pass book.

Journal Entry - 2
Dr / Description of Amount
Cr Account ($)
Debit DEF Limited 270.00
Credit Citi Bank 270.00
(being adjustment entry passed to match
the balance)

Then, the ABC limited need to inform the Citi bank to credit the difference
amount of $ 270. Once the bank will credit the ABC limited, then, the ABC
limited has to reverse the above Journal entry – 2 in their cash book.

18 (b). Excess recorded in cash book debit :-

The ABC limited received cheque from XYZ limited for $ 170 and passed
the journal entry as wrong for $ 710 instead of 170 as below :-

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 710.00
Credit XYZ Limited 710.00
(being payment received from XYZ
limited))
Then, the same cheque presented in bank by ABC limited. So, Citi bank
credited the ‘ABC limited’ for actual cheque amount of $170 .

So, here, the cash book of ‘ABC limited’ is showing more debit balance
whereas the pass book of ABC limited is showing less credit balance.

Hence, The ABC limited has to do 1 of the following 4 activities (for

difference of $ 540 i.e. 710 – 170) based on category of balances (either
normal or overdraft) maintained by ABC limited with City bank to reconcile
the balance in Bank Reconciliation Statement :-

S.No Activity
Less this transaction from balance as per cash
1 book
Add this transaction to balance as per bank pass
2 book
Add this transaction to overdraft balance as per
3 cash book
Less this transaction from overdraft balance as
4 per bank pass book

After reconciliation, the ABC limited has to reverse the above journal entry
which passed as wrong for $ 710 in their cash book and has to record the
below journal entry for actual payment made for the amount of $ 170 .

Journal Entry
Dr / Description of Amount
Cr Account ($)
Debit Citi Bank 170.00
Credit XYZ Limited 170.00
(being payment received from XYZ
limited))

CASE :-
The ABC limited maintained current account with Citi bank. Now, the ABC
limited decided to prepare the ‘Bank Reconciliation Statement’ of ‘Citi Bank’
as on 31st December 2019 to know whether all the items in both the cash
book maintained by ‘ABC limited’ and pass book with ‘Citi bank’ are
matched or not. So, the ABC limited get the bank statement (or pass book)
from Citi bank as on 31st December 2019 and find out the below unmatched
transactions between cash book and pass book. The un-matched transactions
are :-

1. Cheque issued to ‘DEF limited’ but not presented for payment of $ 10,000.
2. Interest on investment collected by bank for $ 500 and recorded in pass
book only.
3. Bank interest credited in passbook only for $ 200.
4. Customer PQR limited deposited the funds directly in to the bank for the
amount of $ 7000.
5. Cheque collected by bank from XYZ limited and recorded in bank pass
book only for $3000.
6. Interest on debentures collected by bank and recorded in pass book for $
400.
7. Dividend collected by bank and recorded in pass book for $ 150.
8. Cheque received amount from XYZ limited is excess recorded in pass
book credit for $ 90.
9. Cheque received from DEF limited is excess recorded in cash book for $
180.
10. Cheques deposited in to bank, but, not credited yet for $ 2000.
11. Bank charges debited in pass book for $ 6.
12. Cheque from XYZ Limited was deposited in to bank, but, it has bounced
for $9000.
13. Commission charged by bank in pass book debit only for $ 8.
14. LIC premium debited in pass book only for $ 100.
15. Promissory note amount to PQR was paid by bank but not recorded in
cash book for $5000.
16. Interest on overdraft debited in pass book only for $ 12.
17. Received cheque from customer XYZ limited is recorded in cash book
and forgot to send the same to bank for $ 8000.
18. Rent paid by bank, but, not recorded in cash book for $ 600.
19. Cheque issued to DEF limited amount is excess recorded in pass book
debit for $270.
20. Cheque received from XYZ limited which is excess recorded in cash
book debit for $ 540.
The closing balance of cash book of ‘ABC limited’ is showing debit as $
37,000, and the closing balance of Citi bank statement for ‘ABC limited’ is
showing credit as $ 32,984.

Assume that the overdraft balances also same values as above and Prepare
the Citi Bank Reconciliation statement for the above un matched transactions,
based on the following :-

A. Balance as per Cash book,

B. Balance as per pass book (bank statement),
C. Overdraft balance as per cash book, and
D. Overdraft balance as per pass book (bank statement).

Solution :-

A. BRS, based on balance as per Cash book :-

BANK RECONCILIATION STATEMENT AS ON 31st DECEMBER 2019

Particulars $ Amount ($)
Balance as per Cash book (closing balance) 37000.00
ADD :-
Cheque issued to DEF limited but not presented for payment 10000.00
Interest on investment collected by bank and recorded in pass
book 500.00
Bank interest credited in passbook 200.00
 PQR limited deposited the funds directly in to the bank 7000.00
Cheque collected by bank and recorded in bank pass book 3000.00
Interest on debentures collected by bank 400.00
Dividend collected by bank and recorded 150.00
Excess recorded by bank which collected from XYZ limited 90.00
Excess recorded in cash book which collected from DEF limited 180.00
Sub total 21520.00
Grand Total 58520.00
LESS :-
Cheques deposited in bank, but not cleared yet 2000.00
Bank charges debited in pass book 6.00
Cheque from XYZ Limited was bounced 9000.00
Commission charged by bank 8.00
LIC premium debited in pass book 100.00
Promissory note amount to PQR debited by bank 5000.00
Interest on overdraft debited in pass book 12.00
Omitted to send to bank which cheque collected from XYZ
limited 8000.00
Rent paid by bank 600.00
Excess recorded in pass book which cheque given to DEF limited 270.00
Excess recorded in cash book which collected from XYZ limited 540.00
25536.00
Balance as per Pass book (closing balance) 32984.00

B. BRS, based on balance as per pass book (bank statement) :-

BANK RECONCILIATION STATEMENT AS ON 31st DECEMBER 2019

Particulars $ Amount ($)
Balance as per pass book (closing balance) 32984.00
ADD :-
Cheques deposited in bank, but not cleared yet 2000.00
Bank charges debited in pass book 6.00
Cheque from XYZ Limited was bounced 9000.00
Commission charged by bank 8.00
LIC premium debited in pass book 100.00
Promissory note amount to PQR debited by bank 5000.00
Interest on overdraft debited in pass book 12.00
Omitted to send to bank which cheque collected from XYZ
limited 8000.00
Rent paid by bank 600.00
 Excess recorded in pass book which cheque given to DEF
limited 270.00
Excess recorded in cash book which collected from XYZ limited 540.00
Sub total 25536.00
Grand Total 58520.00
LESS :-
Cheque issued to DEF limited but not presented for payment 10000.00
Interest on investment collected by bank and recorded in pass
book 500.00
Bank interest credited in passbook 200.00
PQR limited deposited the funds directly in to the bank 7000.00
Cheque collected by bank and recorded in bank pass book 3000.00
Interest on debentures collected by bank 400.00
Dividend collected by bank and recorded 150.00
Excess recorded by bank which collected from XYZ limited 90.00
Excess recorded in cash book which collected from DEF limited 180.00
21520.00
Balance as per cash book (closing balance) 37000.00

C. BRS, based on overdraft balance as per cash book :-

BANK RECONCILIATION STATEMENT AS ON 31st DECEMBER 2019

Particulars $ Amount ($)
Overdraft balance as per cash book (closing balance) -37000.00
ADD :-
Cheques deposited in bank, but not cleared yet 2000.00
Bank charges debited in pass book 6.00
Cheque from XYZ Limited was bounced 9000.00
Commission charged by bank 8.00
LIC premium debited in pass book 100.00
Promissory note amount to PQR debited by bank 5000.00
Interest on overdraft debited in pass book 12.00
Omitted to send to bank which cheque collected from XYZ
limited 8000.00
Rent paid by bank 600.00
Excess recorded in pass book which cheque given to DEF
limited 270.00
Excess recorded in cash book which collected from XYZ
limited 540.00
Sub total 25536.00
 Grand Total -11464.00
LESS :-
Cheque issued to DEF limited but not presented for
payment 10000.00
Interest on investment collected by bank and recorded in
pass book 500.00
Bank interest credited in passbook 200.00
PQR limited deposited the funds directly in to the bank 7000.00
Cheque collected by bank and recorded in bank pass book 3000.00
Interest on debentures collected by bank 400.00
Dividend collected by bank and recorded 150.00
Excess recorded by bank which collected from XYZ
limited 90.00
Excess recorded in cash book which collected from DEF
limited 180.00
21520.00
Overdraft Balance as per pass book (closing balance) -32984.00

D. BRS, based on overdraft balance as per pass book (bank statement) :-

BANK RECONCILIATION STATEMENT AS ON 31st DECEMBER 2019

Particulars $ Amount ($)
Overdraft Balance as per pass book (closing balance) -32984.00
ADD :-
Cheque issued to DEF limited but not presented for
payment 10000.00
Interest on investment collected by bank and recorded in
pass book 500.00
Bank interest credited in passbook 200.00
PQR limited deposited the funds directly in to the bank 7000.00
Cheque collected by bank and recorded in bank pass book 3000.00
Interest on debentures collected by bank 400.00
Dividend collected by bank and recorded 150.00
Excess recorded by bank which collected from XYZ
limited 90.00
Excess recorded in cash book which collected from DEF
limited 180.00
Sub total 21520.00
Grand Total -11464.00
LESS :-
 Cheques deposited in bank, but not cleared yet 2000.00
Bank charges debited in pass book 6.00
Cheque from XYZ Limited was bounced 9000.00
Commission charged by bank 8.00
LIC premium debited in pass book 100.00
Promissory note amount to PQR debited by bank 5000.00
Interest on overdraft debited in pass book 12.00
Omitted to send to bank which cheque collected from
XYZ limited 8000.00
Rent paid by bank 600.00
Excess recorded in pass book which cheque given to DEF
limited 270.00
Excess recorded in cash book which collected from XYZ
limited 540.00
25536.00
Overdraft balance as per cash book (closing balance) -37000.00

CONCLUSION :-
A. Balance as per Cash book

BANK RECONCILIATION STATEMENT AS ON DD-MM-YYYY

Particulars $ Amount ($)
Balance as per Cash book (closing balance) XXXXXX
ADD :-
All un matched items credited in Pass book (bank
statement) XXXX
All un matched items credited in cash book XXXX
Sub total XXXXX
Grand Total XXXXXX
LESS :-
All un matched items debited in Pass book (bank
statement) XXXX
All un matched items debited in cash book XXXX
XXXXX
Balance as per Pass book (closing balance) XXXXXX

B. Balance as per pass book (bank statement)

 BANK RECONCILIATION STATEMENT AS ON DD-MM-YYYY
Particulars $ Amount ($)
Balance as per Pass book (closing balance) XXXXXX
ADD :-
All un matched items debited in Pass book (bank
statement) XXXX
All un matched items debited in cash book XXXX
Sub total XXXXX
Grand Total XXXXXX
LESS :-
All un matched items credited in Pass book (bank
statement) XXXX
All un matched items credited in cash book XXXX
XXXXX
Balance as per cash book (closing balance) XXXXXX

C. Overdraft balance as per cash book

BANK RECONCILIATION STATEMENT AS ON DD-MM-YYYY

Particulars $ Amount ($)
Overdraft balance as per cash book (closing
balance) XXXXXX
ADD :-
All un matched items debited in Pass book (bank
statement) XXXX
All un matched items debited in cash book XXXX
Sub total XXXXX
Grand Total XXXXXX
LESS :-
All un matched items credited in Pass book (bank
statement) XXXX
All un matched items credited in cash book XXXX
XXXXX
Overdraft balance as per Pass book (closing
balance) XXXXXX
D. Overdraft balance as per pass book (bank statement)
BANK RECONCILIATION STATEMENT AS ON DD-MM-
YYYY
Particulars $ Amount ($)
Overdraft balance as per pass book
(closing balance) XXXXXX
ADD :-
All un matched items credited in Pass book
(bank statement) XXXX
All un matched items credited in cash book XXXX
Sub total XXXXX
Grand Total XXXXXX
LESS :-
All un matched items debited in Pass book
(bank statement) XXXX
All un matched items debited in cash book XXXX
XXXXX
Overdraft balance as per cash book
(closing balance) XXXXXX

------------ End of the CHAPTER – 3 ----------

CHAPTER – 4
DEPRECIATION AND REVALUATION OF FIXED
ASSETS

Learning objectives
After studying this chapter, you can be able to
:-
 1. Understand the meaning of
Depreciation,
2. Know the reasons for
depreciation,
3. Understand the need for
depreciation, and
4. learn concept of Revaluation of
fixed assets.

A. Meaning of Depreciation:-
A company to write-off the planned, continuing and gradual value of a
tangible fixed (long-term) asset over its useful life due to continuous use of
an asset, time lapse, wear and tear, new technology and unfavourable market
conditions is called as “Depreciation”. Depreciation is charged on book value
of the asset (Original cost i.e. purchase price minus scrap/salvage/residual
value) rather than market value. Here, book value means cost price of an
asset minus accumulated depreciation. Depreciation is a non-cash expense
transaction because the depreciation expense is un-related to cash flows of a
fixed asset. Only cash flows related to a tangible fixed asset are when the
asset is acquired and when the asset is eventually sold. If a tangible fixed
(long-term) asset is expected to produce a benefit in future periods, some of
these costs should be treated as deferred expense instead of a current expense.
The company then records the depreciation expense in its financial reporting
as the current period's allocation of such costs by debit in Income statement
(Profit and Loss Account). This is usually done in a reasonable and
systematic manner. Depreciation expense generally begins to deduct from
when the asset is used to service (i.e. put to used date). Company depreciates
the long-term tangible fixed assets for both the accounting and tax purposes.
For example, in India, for tax purposes, the company can deduct depreciation
from the cost of tangible fixed assets which it is purchased as business
expenses as per Income Tax Act rules and for accounting purpose, company
can deduct depreciation from the cost of tangible fixed assets as per
Companies Act in India. The methods of computing depreciation and the
periods over which assets are depreciated are may vary between asset types
within the same company and may vary for tax purposes. These may be
specified by law or accounting standards which may vary by country.
We can calculate the depreciation amount as per given percentage on
respective asset price. If not provided any certain percentage, we can
calculate the depreciation as per given formula below:-

Depreciation = [(Cost price of the asset – Scrap value) / Estimated life of

the asset]

Here, Cost price is also termed as original price or purchase price of the
asset, scrap value is also termed as residual value or salvage value of the
asset and Estimated life of the asset is also termed as useful life of the asset.

Note:-
Salvage value (scrap/residual) may be ignored in some countries or for some
purposes. The rules of some countries specify lives and methods to be used
for particular types of assets. However, in most countries, the life is based on
business experience and the method may be chosen from one of several
acceptable methods.

B. Accumulated depreciation:-
While the depreciation expense is recorded as debit on the income statement
(Profit and Loss Account) of a company, its impact is generally recorded in a
separate account and disclosed in the balance sheet as accumulated
depreciation under fixed assets as per accounting principles. Accumulated
depreciation is a contra asset account (i.e. off-setting account or clearing
account) because it separately shows a negative amount which is directly
associated with fixed assets account in the balance sheet.

C. Depreciation Accounting - Accounting Standard (AS) 6 as per The

Institute of Chartered Accountants in India:-

Accounting Standard (AS) 6 in India deals with depreciation accounting and

applies to all depreciable assets except the following items to which special
considerations apply:-
(i) Forests, plantations and similar regenerative natural resources,
(ii) Wasting assets including expenditure on the exploration for and
extraction of minerals, oils, natural gas and similar non-regenerative
resources,
(iii) Expenditure on research and development,
(iv) Goodwill and other intangible assets,
(v) live stock.
This standard also does not apply to land unless it has a limited useful life for
the enterprise.

Definitions 3 (AS 6):-

The following terms are used in this Accounting Standard 6 with the
meanings specified below:-

Depreciation (AS 6 3.1):-

Depreciation is a measure of the wearing out, consumption or other loss of
value of a depreciable asset arising from use, effluxion of time or
obsolescence through technology and market changes. Depreciation is
allocated so as to charge a fair proportion of the depreciable amount in each
accounting period during the expected useful life of the asset. Depreciation
includes amortisation of assets whose useful life is predetermined.

Depreciable assets (AS 6 3.2):-

Depreciable assets are assets which are mentioned below:-
(i) Assets which are expected to be used during more than one accounting
period,
(ii) Assets which are have a limited useful life,
(iii) Assets which are held by an enterprise for use in the production or
supply of goods and services, for rental to others, or for administrative
purposes and not for the purpose of sale in the ordinary course of business.

Useful life (AS 6 3.3):-

Useful life is either
(i) the period over which a depreciable asset is expected to be used by the
enterprise, or
(ii) the number of production or similar units expected to be obtained from
the use of the asset by the enterprise.

Depreciable amount (AS 6 3.4):-

The amount of a depreciable asset is its historical cost or other amount
substituted for historical cost1 in the financial statements, less the estimated
residual value.

Disclosure (AS 6 17):-

The depreciation methods used, the total depreciation for the period for each
class of assets, the gross amount of each class of depreciable assets and the
related accumulated depreciation are disclosed in the financial statements
along with the disclosure of other accounting policies. The depreciation rates
or the useful lives of the assets are disclosed only if they are different from
the principal rates specified in the statute governing the enterprise.

D. Difference among Depreciation, Amortization, Depletion and

Dilapidation:-
Depreciation is differentiate from amortization, Depletion and Dilapidation as
below:-

Depreciation:-
It is used for discounting the process of writing down the fixed (long-term)
tangible assets.

Amortization:-
It is used for discounting the process of writing down the investments in fixed
(long-term) intangible assets such as Goodwill, Patents, Copyrights and
trademarks etc.

Depletion:-
This is applied to the process of measuring and recording the exhaustion of
natural resources or calamities. It is relating to wasting the assets such as
quarries, oil-wells, etc. It implies a reduction in the service capacity of an
asset.

Dilapidation:-
It is related to the value in reducing the fixed assets like building or other
property due to damage during tenancy. In this case, the landlord is entitled to
demand that the property should be returned to them in good condition as it
was then lease out after expiry of the lease period. For this purpose,
leaseholders often set aside some amount each year to provide for any
dilapidation that need to put right when the property is returned. The
expected amount of dilapidations is added to the cost of leased property.

E. Causes of Depreciation:-
The most common causes of depreciation charged are as below:-

1. Wear and Tear:-

Wear and tear. If we continuously use the fixed assets for a certain usage
period, their parts are gradually wear out due to movement, strain, friction,
erosion etc. and need to be replaced. Eventually, the asset can no longer
be repaired and should be disposed of. This cause is most common for
production equipment which typically has a manufacturer's recommended
life span that is based on a certain number of units produced. For
example, Plant, Machinery, Furniture, Vehicles, etc. Other assets like
buildings which can be repaired and upgraded for longer period of time.

2. Lapse of Time:-
There are certain fixed assets such as patents, copy-rights, trade marks and
leasehold property, etc. are acquired for a certain period. After the expiry of
that period, they are rendered useless i.e. their value will cease to exist. Thus,
their cost is written off over their legal life.

3. Obsolescence:-
If we replaced the new and improved (latest technology) machines in the
place of existing machines, this will result in discarding of old machines.
Thus, new inventions, change in trend, Government policies, market
conditions, etc. are the causes to discard the value of the existing fixed assets.
Therefore, the existing machine may become out of date or outmoded or
obsolete.

4. Non-Use:-
The fixed assets such as machines which are slowly dishonest become less
useful due to passage of time. This type of machines exposed to weather
conditions and may have more depreciation from not using it than from its
use.

5. Inadequacy:-
If a company expansion its business or production, there will be inadequacy
in using the quantity of fixed assets in its business. In this case, company may
discard the assets by depreciate.

6. Exhaustion:-
The assets such as quarries, oil-wells, mines, etc. are of wasting in nature.
This is reduction in the value of natural deposits as resources have been
extracted year after year. These assets are called as wasting assets. The
coalmine or oil-well gets physically exhausted by removal of its contents.

7. Market Trend:-
The market price may increase or decrease in the case of certain assets. for
example, investments in gilt-edged stocks. When the prices go down, the
respective asset may depreciate its value. In some cases, accident causes
depreciation in the value of fixed assets.

8. Maintenance:-
Generally, a good maintenance of machine will increase its useful life. When
there is no maintenance, there is more depreciated value. When there is good
maintenance, there is longer life to the machines. The long life of machine
depends upon good and skilled maintenance.

F. Need for providing Depreciation:-

Depreciation is necessary for the fixed assets to achieve the following
results:-

1. To ascertain true profits:-

The company may spend huge amounts for acquisition of assets which are
worn out in the process of earning income. Assets are important tools in
earning revenues. The assets get depreciated in their value over its useful life
due to many reasons (causes) explained above. When the value of assets
decreases, this loss must be brought into account, otherwise, a true profit
cannot be known. Depreciation is an operating expense of a physical asset
and the same should be considered in arriving the true profit earned during
each accounting year. If depreciation is ignored, the loss that is occurring in
respect of fixed assets will also be ignored and then, the income statement of
the business will show as more profits which leads to distribute among
shareholders as dividend. The Companies Act, 1956 in India now makes it
compulsory to write off depreciation on fixed assets before declaring
dividend. Hence, depreciation must be debited to Income statement (Profit
and Loss Account) before the profit is ascertained.

2. To ascertain true financial position:-

Financial position can be arrived from the Balance Sheet of the business and
for the preparation of the Balance Sheet, the fixed assets are required to be
shown at their true value. If depreciation is not charged, assets are shown at
its original cost (acquisition price) i.e. overstated for every accounting year
and will not reflect the true financial position of the business. Therefore, the
depreciation must be deducted from the respective fixed assets and then at
such reduced value (i.e. after deducting the depreciation) will be shown in the
Balance Sheet for the purpose of reflecting the true financial position of the
company.

3. To create (make) provision for replacement of fixed assets:-

When an asset is continuously used, the machineries often becomes obsolete
(i.e. outdated) or wear out (i.e. useless) and a time will come when the asset
is to be given up and hence its replacement is essential. It is a permanent loss
in value of the fixed asset. If depreciation is not charged in each accounting
period against the profit, it will be very difficult to find cash to replace the
asset during the life time of that asset. Hence, it is necessary to make
provision and create funds to replace such fixed assets in proper time.

4. To reduce tax liability:-

Depreciation is tax deductible expense and it is permitted by the taxation laws
to be deducted from profit. If depreciation is not charged, profits will show
more and the company will pay the tax accordingly. Therefore, the owner of
the business may avail the benefit by charging depreciation to the profit and
reducing the tax liability.

G. Accounting for depreciation:-

There are 2 methods of recording or accounting the depreciation in the books
of accounts.

1. When Accumulated depreciation / provision for depreciation account

is not mentioned:-
Under this method, the asset A/c appears in the Balance sheet at a written
down value (i.e. the value remaining after deducting the depreciation) till the
asset will be sold or discard. When asset is sold, it is desirable to calculate its
book value after charging even the current period’s depreciation and this
value is to be compared with the realisable value in order to calculate the
profit or loss on the sale of asset. The depreciation account is a nominal
account.
the journal entries will be as following :-

S.No. Dr/Cr Particulars

Dr. Asset A/c
1 Cr. Bank / Cash A/c
(Being acquisition of asset)
Dr. Depreciation A/c
2 Cr. Asset A/c
(Being depreciation charged)
Dr. Profit and Loss A/c
Cr. Depreciation A/c
3
(Being depreciation charged to Profit
and loss account)
Dr. Bank / Cash A/c
4 Cr. Asset A/c
(Being asset sold)
Dr. Asset A/c
5 Cr. Profit and Loss A/c
(Being profit on sale of asset)
Dr. Profit and Loss A/c
6 Cr. Asset A/c
(Being loss on sale of asset)

2. When Accumulated depreciation / provision for depreciation account

is mentioned:-
Under this method, the depreciation is credited to provision for depreciation /
Accumulated depreciation account instead of asset A/c. So that the asset A/c
always appears in the ledger at its original cost instead of its book value. The
balance of the credit side for depreciation A/c shows the total amount of
depreciation accumulated till date. However, when the asset is sold or
discard, the total accumulated depreciation for that asset is transferred to the
credit side of asset a/c. Accumulated depreciation A/c is a contra asset
account to the respective depreciating asset account. Provision for
depreciation A/c is a contra liability account which appears on the liabilities
side. Contra accounts have the opposite balance of their counterpart accounts.
The purpose of the contra account is to put aside a sum that is required to net
off the counterpart without touching the balance of the counterpart account.
so that we can still see the original cost of the asset. In the balance sheet, the
asset appears at its original cost. As the year passes, the balance of the
accumulated depreciation goes on increasing since constant credit is given to
this account in each accounting year. After the expiry of useful life, these two
accounts are closed by debiting Accumulated Depreciation A/c and crediting
Asset A/c and balance in asset account is transferred to Profit & Loss A/c.
The journal entries are passed as following :-

S.No. Dr/Cr Particulars

Dr. Asset A/c
1 Cr. Bank / Cash A/c
(Being acquisition of asset)
Dr. Depreciation A/c
Accumulated depreciation /
Cr.
2 Provision for depreciation A/c
(Being depreciation charged to
Accumulated depreciation)
Dr. Profit and Loss A/c
Cr. Depreciation A/c
3
(Being depreciation charged to Profit
and loss account)
Accumulated depreciation /
Dr.
Provision for depreciation A/c
4 Cr. Asset A/c
(Being Accumulated depreciation
 transferred to asset)
Dr. Bank / Cash A/c
5 Cr. Asset A/c
(Being asset sold)
Dr. Asset A/c
6 Cr. Profit and Loss A/c
(Being profit on sale of asset)
Dr. Profit and Loss A/c
7 Cr. Asset A/c
(Being loss on sale of asset)

Example:-
On 01st January 2017, ‘XYZ’ company purchased the machinery cost of
$10,000 through cheque payment and the machinery also be used from the
purchased date itself. The company needs to deduct depreciation at 20% per
annum. The useful life of the machinery is 3 years. The company sold the
machinery for $4,500 through cheque payment on 31st December 2019. You
are required to post the necessary journal entries in the books of accounts of
‘XYZ’ limited.

Solution:-

Debit Credit
S.No. Date Dr/Cr Journal Entry Amount Amount
($) ($)
Dr. Machinery A/c 10,000
01-
Cr. Bank A/c 10,000
1 Jan-
17 (Being Machinery
purchased)
Dr. Depreciation A/c 2,000
Accumulated
Cr. 2,000
31- depreciation A/c
2 Dec- (Being Depreciation
17 charged to
 Accumulated
depreciation A/c)
Dr. Profit and loss A/c 2,000
31- Cr. Depreciation A/c 2,000
3 Dec- (Being depreciation
17 is transferred to
Profit and loss A/c)
Dr. Depreciation A/c 2,000
Accumulated
Cr. 2,000
31- depreciation A/c
4 Dec- (Being Depreciation
18 charged to
Accumulated
depreciation A/c)
Dr. Profit and loss A/c 2,000
31- Cr. Depreciation A/c 2,000
5 Dec- (Being depreciation
18 is transferred to
Profit and loss A/c)
Dr. Depreciation A/c 2,000
Accumulated
Cr. 2,000
31- depreciation A/c
6 Dec- (Being Depreciation
19 charged to
Accumulated
depreciation A/c)
Dr. Profit and loss A/c 2,000
31- Cr. Depreciation A/c 2,000
7 Dec- (Being depreciation
19 is transferred to
Profit and loss A/c)
Accumulated
Dr. 6,000
Depreciation A/c
31-
Cr. Machinery A/c 6,000
 8 Dec- (Being Accumulated
19 depreciation is
transferred to
Machinery A/c)
Dr. Bank A/c 4,500
31-
Cr. Machinery A/c 4,500
9 Dec-
19 (Being Machinery
sold)
Dr. Machinery A/c 500
31- Cr. Profit and loss A/c 500
10 Dec- (Being profit
19 generated on sale of
machinery)

NOTE:-
After the completion of asset’s useful life and all depreciation is charged
throughout the years, the asset approaches it as scrap or residual value if the
asset is not sold. In this case, If the machinery is dissolved after the end of its
useful life of the period, then, the following journal entry will come instead
of the journal entry for machinery sold.

Dr. Scrap A/c 4,000

31-
Cr. Machinery A/c 4,000
Dec-
19 (Being Machinery is
discarded/dissolved)

H. Methods of Depreciation:-
The main methods of providing depreciation are as following:-

1. Straight line or Fixed instalment method:-

Under this method, depreciation is written off at a fixed percentage on cost
price (original price) of the asset every year so as to reduce the asset account
to zero or to its scrap value at the end of the useful (or estimated) life of the
asset. Otherwise, the depreciation is calculated as below:-
Depreciation = (Cost price of the asset – scrap value) / Estimated life of
the asset

The amount of depreciation charged during each period of the life of the asset
is constant (i.e. fixed or not changed). The charge of depreciation is plotted
periodically (i.e. yearly) on a graph and the points joined together, then, the
graph reveals a straight line. Thus, it is called as Straight line method.

Example:-
On 01st April 2017, XYZ limited purchased second hand machinery for
$50,000 and re-conditioned the machine by spending $4,000. On 01st October
2017, a new machine was purchased for $32,000. On 31st March 2019, the
machine (which purchased on 01st October 2017) was sold for $24,500 and
another machine was purchased at a cost of $28,000. The company writes off
depreciation at 10% every year end i.e. 31st December on original cost of the
machine. You are required to show the Machinery Account for the period
from 01st January 2017 to 31st December 2019.

Solution:-

Machinery A/c from 01-Jan-2017 to 31-Dec-2019 of XYZ Limited

Dr. Cr.
Amount Amount
Date Particulars Date Particulars
($) ($)
01- To Bank 31-
By Depreciation
Apr- (50,000 + 54,000 Dec- 4050
[(54,000x10%x(9/12)]
17 4,000) 17
01- 31-
By Depreciation
Oct- To Bank 32,000 Dec- 800
[(32,000x10%x(3/12)]
17 17

31-
Dec- By Balance c/d 81,150
17
86,000 86,000
01- 31-
 Jan- To Balance 81,150 Dec- By Depreciation 5,400
18 b/d 18 [(54,000x10%]
31-
By Depreciation
Dec- 3,200
[(32,000x10%]
18

31-
Dec- By Balance c/d 72,550
18
81,150 81,150
01- 31-
To Balance
Jan- 72,550 Mar- By Bank 24,500
b/d
19 19
31- 31-
By P/L A/c (See
Mar- To Bank 28000 Mar- 2,700
Note)
19 19
31-
By Depreciation
Dec- 5,400
[(54,000x10%]
19
31-
By Depreciation
Dec- 800
[(32,000x10%x(3/12)]
19
31-
By Depreciation
Dec- 2,100
[(28,000x10%x(9/12)]
19

31-
Dec- By Balance c/d 65,050
19
1,00,550 1,00,550
01-
To Balance
Jan- 65,050
b/d
20

Working Notes:-
 Calculation of loss on sale of
machine:-
Amount Amount
Particulars ($) ($)
Cost of Machinery on 01-
Oct-2015 32,000
Less:-
Depreciation
[(32,000x10%x(3/12)] 800
Depreciation [(32,000x10%] 3,200
Depreciation
[(32,000x10%x(3/12)] 800 4800
Book value of asset 27,200
Less : Amount realized from
sale of Machine 24,500
Loss on Sale of Machinery
(P/L A/c) 2,700

Advantages:-
(i) This method is simple to understand. Calculation of depreciation under
this method is also very simple. So that this method is the most suitable
method for small firms.
(ii) Assets can be written off to zero at the end of their useful lives.
(iii) This method is suitable for assets those operate uniformly and
consistently over the life of their periods.
(iv) Under this method, each year the same amount of money is taken as a
depreciation on the company's tax returns.

Disadvantages:-
( i) This method seems as illogical to charge depreciation on the original cost
of the asset every year because of the balance of the asset is decreasing year
after year.
(ii) Cost of the repairs usually increase over time, but, the depreciation
calculated under this method does not account for the loss of efficiency or the
increase in repairs expense over the years.
(iii) This method is not considering the interest on capital invested in fixed
assets.
(iv) It does not provide the funds for replacement of assets.
(v) Under this method, the depreciation charge remains the same from year to
year irrespective of use of the asset. Therefore, this method does not consider
the effective utilization of the assets.

2. Written Down Value (Diminishing balance or Reducing instalment)

method:-
Under this method, depreciation is calculated at a given percentage for every
accounting year on the balance of the asset price which is brought forward
from the previous accounting year. Thus, the amount of depreciation charged
in each period is not fixed, but, it will decrease gradually because the
depreciation charged in initial periods are higher than the depreciation
charged in the later periods. Both the depreciation charged amount and
repairs and maintenance amount together remains same throughout the life of
the asset. Generally, this method is adopted for Plant and Machinery. The
cost and expense of purchasing and installing assets is treated as capital cost
and expenditure and it is added to asset value to calculate depreciation.

Example:-
On 01st February 2017, ‘ABC’ company purchased second hand machinery
for $40,000. On 29th March 2017, the company incurred a cost of $6,000 for
the installation of machinery and spent $2,000 for repairs and maintenance of
the machinery. Then, the machine is used from 01st April 2017. The company
provides the depreciation on the machinery at 20% per annum on Written
Down value method from the date is put to used. The company will close the
books by 31st December of every year. On 31st Sep 2019. the company sold
the machinery for $15,000 and amount of $500 was paid as dismantling
charges of the machinery.

You are required to prepare the machinery account of ‘ABC’ limited for the
period from 01st Jan 2017 to 31st Dec 2019.

Solution:-

Machinery A/c from 01-Jan-2017 to 31-Dec-2019 of ABC Limited

Dr. Cr.
 Amount Amount
Particulars Particulars
Date Date
($) ($)
01- 31-
By Depreciation
Feb- To Bank 40,000 Dec- 7,200
[(48,000x20%x(9/12)]
17 17
29-
Mar- To Bank 6,000
17
29-
Mar- To Bank 2,000
17
31-
Dec- By Balance c/d 40,800
17
48,000 48,000
01- 31-
To Balance By Depreciation
Jan- 40,800 Dec- 8,160
b/d [(40,800x20%]
18 18

31-
Dec- By Balance c/d 32,640
18
40,800 40,800
01- 31-
To Balance By Depreciation
Jan- 32,640 09- 4,896
b/d [(32,640x20%x9/12)]
19 2019
31- 31-
To Cash
09- 500 09- By Bank 15,000
(Dismantling)
2019 2019
31-
09- 13,244
2019 By P/L Account
33,140 33,140
Advantages:-
(i) This method gives a fair depreciation against the asset’s value each period
because of higher depreciation is charged in earlier periods when the asset’s
utility as more as compared to later periods when it becomes less useful.
(ii) This method is accepted by the Income tax authority in India.
(iii) This method is suitable for Plant and Machinery, Buildings, etc. which
lasts for long and which require increased repairs and maintenance expense
with passage of time.

Disadvantages:-
(i) As compared to the Straight line method, this WDM method is difficult to
determine the suitable rate of depreciation.
(ii) The value of asset will never be zero under this method even if asset is of
no use to company.
(iii) It provides higher bandwidth.

3. Annuity method:-
Under annuity method of depreciation, the cost of asset is regarded as
investment and interest amount at fixed rate is calculated thereon. If the
proprietor invested outside the business and that amount is equal to cost of
the asset, the proprietor would have earned some interest. So that a result of
purchasing the asset, the proprietor loses not only the cost of asset by using it,
but also the interest. Thus, depreciation is calculated in such a way as will
cover both the losses above mentioned. The annuity method requires the
determination of the internal rate of return (IRR) on the cash inflows and
outflows of the asset. The IRR is then multiplied by the initial book value of
the asset, and the result is deducted from the cash flow for the period in order
to find the actual amount of depreciation to be taken.

The amount of annual depreciation is determined from the below annuity

table:-

Annuity Table
Amount required to write off $1 by the annuity
method.
 Years 3% 3.50% 4% 4.50% 5%
3 0.353530 0.359634 0.360349 0.363773 0.367209
4 0.269027 0.272251 0.275490 0.278744 0.282012
5 0.218355 0.221418 0.224627 0.227792 0.230975
6 0.184598 0.187668 0.190762 0.193878 0.197017
7 0.160506 0.163544 0.166610 0.169701 0.172820
8 0.142456 0.145477 0.148528 0.151610 0.154722

As the cash flow of the asset being depreciated is constant over the life of the
asset, this method is called as annuity method. The annuity method is also
known as the compound interest method of depreciation. Annuity method is
particularly applicable to those assets whose cost is heavy and useful life is
long and fixed. For example, leasehold property, land and buildings, etc.
However, the annuity method is not accepted by Generally Accepted
Accounting Principles (GAAP).

Steps Annuity method of depreciation:-

This method focuses for a constant rate of return on any asset by following
the below steps:-
(i) Estimate the future cash flows that are associated with an asset.
(ii) Determine what is the internal rate of return (IRR) will be on those cash
flows.
(iii) Multiply that IRR by the asset's initial book value.
(iv) Subtract the above result from the cash flow for the current period.
(v) The result of step 4 will be the depreciation to charge for expense in the
current period.

Example:-
On 01st January 2015, ‘PQR’ limited purchases a 5-year’s lease for $50,000.
It decides to write off depreciation as per Annuity method presuming the rate
of interest to be 5% per annum. You are required to show the lease account
for 5 years i.e. from 01st January 2015 to 31st December 2019. Calculations
are to be made to the nearest dollar.

Solution:-

Depreciation = Investment (Asset’s initial book value) x IRR factor on

investment
 = 50,000 x 0.230975
= $11,549

Lease A/c from 01-Jan-2015 to 31-Dec-2019 of PQR

Limited
Dr. Cr.
Amount Amount
Date Particulars Date Particulars
($) ($)
By
01- 31-
Depreciation
Jan- To Bank 50,000 Dec- 11,549
(50,000 x
15 15
0.230975)
31- To Interest
Dec- (50,000 x 2,500
15 5%)
31-
By Balance
Dec- 40,951
c/d
15
52,500 52,500
By
01- 31-
To Balance Depreciation
Jan- 40,951 Dec- 11,549
b/d (50,000 x
16 16
0.230975)
31- To Interest
Dec- (40,951 x 2,048
16 5%)
31-
By Balance
Dec- 31,450
c/d
16
42,999 42,999
By
01- 31-
To Balance Depreciation
Jan- 31,450 Dec- 11,549
b/d (50,000 x
17 17
0.230975)
31- To Interest
 Dec- (31,450 x 1,573
17 5%)
31-
By Balance
Dec- 21,474
c/d
17
33,023 33,023
By
01- 31-
To Balance Depreciation
Jan- 21,474 Dec- 11,549
b/d (50,000 x
18 18
0.230975)
31- To Interest
Dec- (21,474 x 1,074
18 5%)
31-
By Balance
Dec- 10,999
c/d
18
22,548 22,548
By
01- 31-
To Balance Depreciation
Jan- 10,999 Dec- 11,549
b/d (50,000 x
19 19
0.230975)
31- To Interest
Dec- (10,999 x 550
19 5%)
31-
By Balance
Dec- 0
c/d
19
11,549 11,549

4. Sinking fund (Depreciation fund) method:-

Under this method, a certain fund is created with the amount of periodic
depreciation. The amount equal to periodic depreciation is invested each
period in government securities or in some other gilt-edged securities outside
the business of the firm. The income earned from the investment is deposited
into the fund and immediately reinvested. This process is carried out
throughout the useful life of the asset and at the end of its life, a sum equal to
cost of the asset is accumulated in the fund. Then the whole investment is
sold and a new asset is purchased with the sale proceeds. The sum required to
purchase the new asset is available from depreciation fund or sinking fund.
As a result, the working capital of business is preserved. Sinking fund or
Depreciation fund method is especially applicable to costly machines in large
firms.

The sinking fund method of higher depreciation provides for funds to

purchase a new asset when the old asset has been fully
depreciated. The sinking fund method is sometimes not desirable
when interest rates cannot reasonably be predicted. Even though the sinking
fund method is not common in the broad market, it is used regularly by some
specific Large-scale industries with their long-term assets.

The amount of periodic sinking fund depreciation will be ascertained from

the below sinking fund table:-

Sinking Fund Table

Periodic deposit which will amount $1
[Investment / (1 + investment)n-1
Period 3% 4% 5% 6%
1 1.000000 1.000000 1.000000 1.000000
2 0.492611 0.490196 0.487805 0.485437
3 0.323530 0.320348 0.317209 0.314110
4 0.239027 0.235490 0.232012 0.228591
5 0.188355 0.184627 0.180975 0.117396
6 0.154597 0.150762 0.147017 0.143363
7 0.130506 0.126610 0.122820 0.119135
8 0.112456 0.108528 0.104772 0.101036
9 0.098434 0.094493 0.090690 0.087022
10 0.087231 0.083291 0.079505 0.075868

Journal entries:-
The entries will be as follows:-

First year:-
S.No. Dr/Cr Particulars
Dr. Depreciation A/c
1 Cr. Depreciation Fund A/c
(Being providing periodic depreciation)
Dr. Depreciation Fund investment A/c
2 Cr. Bank A/c
(Being investing the amount of depreciation)
Dr. Profit and Loss A/c
Cr. Depreciation A/c
3
(Being transferred the depreciation to Profit
and loss account)

Subsequent year:-
Dr. Bank A/c
Cr. Depreciation Fund investment A/c
1
(Being interest received on investment out of
depreciation fund)
Dr. Depreciation A/c
2 Cr. Depreciation Fund A/c
(Being periodic instalment of depreciation)
Dr. Depreciation Fund investment A/c
Cr. Bank A/c
3
(Being depreciation and interest earned are
invested in securities)
Dr. Profit and Loss A/c
Cr. Depreciation A/c
4
(Being transferred the depreciation to Profit
and loss account)

Last year:-
Dr. Bank A/c
 1 Cr. Depreciation Fund investment A/c
(Being interest received on investment out of
depreciation fund)
Dr. Depreciation A/c
2 Cr. Depreciation Fund A/c
(Being periodic instalment of depreciation)
Dr. Profit and Loss A/c
Cr. Depreciation A/c
3
(Being transferred the depreciation to Profit
and loss account)
Dr. Bank A/c
4 Cr. Depreciation Fund investment A/c
(Being sale of investment)
Dr. Depreciation Fund investment A/c
5 Cr. Depreciation Fund A/c
(Being profit on sale of securities)

NOTE :- if loss, reverse entry will be pass as below:-

Dr. Depreciation Fund A/c
6 Cr. Asset A/c
(Being writing off the old asset)
Dr. Depreciation Fund A/c
Cr. Profit and Loss A/c
7
(Being transferred the balance of Depreciation
fund A/c if credit balance to P/L A/c)

NOTE :- if debit balance, reverse entry will be pass as

below:-
Dr. New Asset A/c
8 Cr. Bank A/c
(Being acquisition of new asset)
In the balance sheet, Depreciation fund account will be shown on the liabilities side and both the
Depreciation account and Depreciation fund investment account will be shown on the asset side. The
Asset account for which this depreciation fund is being created will appear at its original cost in assets
side of the balance sheet.
Example:-
On 01st January 2016, ‘XYZ’ limited purchased a lease for $20,150. It was
decided to provide for the replacement of the lease at the end of 4 years by
setting up a Depreciation fund (Sinking fund). It is expected that investments
will fetch interest at 4%. On 31st December 2019, the investments were sold
for $14,830. On 01st January 2020, the same lease was renewed for a further
period of 4 years by payment of $22,000. You are required to prepare the
below:-
(i) Lease Account
(ii) Depreciation Fund Account
(iii) Depreciation Fund Investment Account
(iv) Lease Account (New)
Investments are made to the nearest rupee.

Solution:-

Depreciation = Investment (Asset’s initial book value) x Interest factor as per

sinking fund table
= 20,150 x 0.235490
= $4,745

(i) Lease Account:-

Lease A/c from 01-Jan-2016 to 31-Dec-2019 of XYZ Limited

Dr. Cr.
Amount Amount
Date Particulars Date Particulars
($) ($)
01-
To Bank 20,150
Jan-16
31-
Dec- By Balance c/d 20,150
16
20,150 20,150
01- To Balance
20,150
Jan-17 b/d
 31- By Balance c/d 20,150
Dec-
17
20,150 20,150
01- To Balance
20,150
Jan-18 b/d
31-
Dec- By Balance c/d 20,150
18
20,150 20,150
01- To Balance
20,150
Jan-19 b/d
31-
By Depreciation
Dec- 20,150
Fund A/c
19
20,150 20,150

(ii) Depreciation Fund Account:-

Depreciation Fund A/c from 01-Jan-2016 to 31-Dec-2019 of

XYZ Limited
Dr. Cr.
Amount Amount
Date Particulars Date Particulars
($) ($)
By
31-
Depreciation
Dec- 4,745
20,150 x
16
0.235490)
31-
By Balance
Dec- 4,745
c/d
16
4,745 4,745
01-
To Balance
Jan- 4,745
 17 b/d
31-
By Bank
Dec- 190
(Interest)
17
31- 31- By
By Balance
Dec- 9,680 Dec- Depreciation 4,745
c/d
17 17 A/c
9,680 9,680
01-
To Balance
Jan- 9,680
b/d
18
31-
By Bank
Dec- 387
(Interest)
18
31- 31- By
By Balance
Dec- 14,812 Dec- Depreciation 4,745
c/d
18 18 A/c
14,812 14,812
31- 01-
To Lease To Balance
Dec- 20,150 Jan- 14,812
A/c b/d
19 19
31- 31-
By Bank
Dec- To P/L A/c 18 Dec- 592
(Interest)
19 19
31- By
Dec- Depreciation 4,745
19 A/c
By
31- Depreciation
Dec- Fund 18
19 Investment
A/c(Profit)
20,168 20,168
(iii) Depreciation Fund investment Account:-

Depreciation Fund Investment A/c from 01-Jan-2016 to 31-Dec-

2019 of XYZ Limited
Dr. Cr.
Amount Amount
Date Particulars Date Particulars
($) ($)
31-
To Bank A/c 4,745
Dec-16
31- By Balance
4,745
Dec-16 c/d
4,745 4,745
01-Jan-
To Balance b/d 4,745
17
31- To Bank A/c
4,935
Dec-17 (Bank + interest)
31- By Balance
9,680
Dec-17 c/d
9,680 9,680
01-Jan-
To Balance b/d 9,680
18
To Bank A/c
31-
(Bank + 2 years 5,132
Dec-18
interest)
31- By Balance
14,812
Dec-18 c/d
14,812 14,812
01-Jan- 31- By Bank
To Balance b/d 14,812 14,830
19 Dec-19 A/c
31- To Depreciation
18
Dec-19 Fund A/c
14,830 14,830
(iv) Lease (new) Account:-

Lease account (New) of XYZ Limited

Dr. Cr.
Amount Amount
Date Particulars Date Particulars
($) ($)
01-Jan-
To Bank A/c 22,000
20

Difference between Annuity method and Sinking fund method:-

S.No. Point of Annuity method Sinking fund method

difference
1 Investment Depreciation charged Depreciation charged
is invested in outside is not invested in
securities. outside securities.
2 Interest amount Interest is earned from First interest is earned
the first day of the first in second year and first
year. Thus, entry is entry for investment of
made at the end of first interest is made at the
year. end of second year.
3 Interest No interest is received, Actual interest amount
received but, adjustment entries is received.
are made.
4 Calculation of Depreciation is Depreciation is
depreciation calculated with help of calculated with help of
Annuity table. Sinking fund table.
5 Charge to P/L Depreciation can be Depreciation can be
A/c charged as Cost price charged as Cost price
plus interest. minus interest.
6 Change in The amount of interest The amount of interest
interest decreases year after increases year after
 year year

5. Double-Declining balance method:-

The Double-Declining-Balance method is simply doubles the straight-line
depreciation amount which is taken in the first year and then that same
percentage is applied to the un-depreciated amount in subsequent years. The
double-declining-balance method produces a very aggressive depreciation
schedule and the asset cannot be depreciated beyond its salvage (scrap or
residual) value. Depreciation under this method is calculated as below:-

Depreciation % = [(Original cost of asset – Accumulated depreciation) x

(2 / n)]
Here, n = number of periods

Example:-
The asset of equipment that costs $25,000 with an estimated useful life of 8
years and scrap value of $2,500. Calculate the double declining balance of
depreciation and show the schedule for 8 years.

Solution:-
Depreciation % = [(Opening book value of asset – Accumulated
depreciation) x (2 / n)]
Here, n = number of periods

The schedule of depreciation is mentioned below:-

Year 1 2 3 4 5 6 7 8
Opening
Book Value 25000 18750 14063 10547 7910 5933 4449 3337
($)
Less :
Depreciation 6250 4688 3516 2637 1978 1483 1112 834
($)
Ending
Book Value 18750 14063 10547 7910 5933 4449 3337 2503
($)

6. Unit of Production method:-

Under this method, depreciation is fixed at the rate per unit of production.
Under this method, first determine the cost per one production unit and then
multiply that cost per unit with the total number of units the company
produced within an accounting period to determine its depreciation expense.

Depreciation Expense= (Total Acquisition Cost - Salvage Value) /

Estimated total units
Where, Estimated total units = the total units the machine can produce over
its lifetime
Depreciation expense = Number of units produced in an accounting period x
depreciation per unit

Example:-
‘XYZ’ limited purchased a machine for $5,00,000 that can produce 1,00,000
products over its useful life of 5 years. The company estimates that the
machine has a salvage (scrap or residual) value of $50,000. The total units
produced in each year as below:-

Year 1 2 3 4 5 Total
Units
10,000 15,000 20,000 25,000 30,000 1,00,000
produced

You are required to calculate the depreciation expense and depreciation

schedule.

Solution:-

Depreciation and Depreciation schedule of XYZ limited

Ending
Opening
Units Book
Year book Depreciation expense ($)
produced value
value($)
($)
5 = (2 -
1 2 3 4
 4)
45,000 =
1 5,00,000 10,000 [(10000/100000)x(500000- 4,55,000
50000)]
67,500 =
2 4,55,000 15,000 [(15000/100000)x(500000- 3,87,500
50000)]
90,000 =
3 3,87,500 20,000 [(20000/100000)x(500000- 2,97,500
50000)]
1,12,500 =
4 2,97,500 25,000 [(25000/100000)x(500000- 1,85,000
50000)]
1,35,000 =
5 1,85,000 30,000 [(30000/100000)x(500000- 50,000
50000)]
TOTAL 1,00,000 4,50,000

At the end of the asset’s useful life, the asset's accumulated depreciation is
equal to its total cost minus its scrap value and its accumulated production
units equal to the total estimated production capacity in life time of the asset.
The drawback of this method is that if the units of products decrease due to
slow demand for the product, the depreciation expense also will decrease.
This result will show as more profits in the Income statement and more value
of the asset (i.e. ending book value) in respective assets section of the balance
sheet of the company.

7. Machine hour rate method:-

This is the same concept as unit of production depreciation except that the
depreciation expense is calculated as the total hours of service used during an
accounting period.

8. Sum of the years (periods) digits Method:-

In this depreciation method, the remaining life of an asset is divided by the
sum of the periods (years) and then multiplied by the original cost minus
scrap value to determine the depreciation expense.

Depreciation Expense = (Remaining life of the asset / Sum of the year’s

digits) x (Cost – Scrap value)

Example:-
Company ‘XYZ limited purchased a machine for $4,00,000 that will have an
estimated useful life of 5 years. The company also estimates that the
company will be able to sell it for $40,000 for scrap parts in 5 years. You are
require to prepare a depreciation and depreciation schedule.

Solution:-

Depreciation and Depreciation schedule of XYZ limited

Sum
of Opening
Remaining Depreciation Cost - Depreciation
Year the book
life (years) base Scrap expense ($)
years value($)
digits
1 2 3 4 = (2/3) 5 6 7 = (4 x 5)
1 5 15 0.3333 360000 4,00,000 120000
2 4 15 0.2667 360000 2,80,000 96000
3 3 15 0.2000 360000 1,84,000 72000
4 2 15 0.1333 360000 1,12,000 48000
5 1 15 0.0667 360000 64,000 24000
15 360000

REVALUATION OF FIXED ASSETS

I. DEFINITION OF REVALUATION OF FIXED ASSETS :-
The process of increase or decrease carrying value of the fixed asset, in case
of major change(s) in fair market value of that fixed asset is known as
Revaluation of a fixed asset. It is a technique that accurately define true value
of the fixed assets (or capital goods) of an organization’s business. The
purpose of Revaluation of fixed assets is to bring fair market value of the
asset into books of accounts of an organization.

Fixed asset :-
An asset held by an organization for the purpose of producing goods or
rendering services, but not held for resale purpose is known as Fixed asset.
For example, Buildings, Machineries, Patents, etc.

Carrying value :-
Nothing, but book value of an asset. The value is based on the original cost of
an asset less Depreciation Amortised / impairment costs made against that
asset.

Fair market value :-

The price at which a seller can sell their goods or services to a buyer is
known as Fair Market Value (FMV). In simple words, FMV is nothing, but
Current Market Price (CMP). The fair market value is calculated based on the
growth rate, profit margins, and potential risk of a company.

Impairment :-
A permanent reduction in the value of fixed asset or an intangible asset which
occur as the result of an unusual (un common / rare) cases due to changes in
legal or an economic condition, customer demands, and damage of assets,
etc.

II. REASONS FOR REVALUATION OF FIXED ASSETS :-

(a) to conserve adequate funds in the business for replacement of fixed assets
at the end of their useful lives.

(b) Provision for depreciation, based on historical cost, will show increased
profit, and lead to payment of excessive dividend.

(c) when a company wants to take a loan from banks or financial institutions
by mortgaging its fixed assets, the Revaluation of fixed assets would enable
the company to get a higher amount of loan.
(d) To show the true rate of return on capital employed,

(e) To negotiate fair price for the assets of the company before merger or
acquisition by another company.

(f) To get fair market value of assets, in case of sale and or lease
back transactions.

(g) To decrease the leverage ratio i.e. debt to equity.

III. CLASSIFICATION OF VALUATION OF FIXED ASSETS :-

The valuation of fixed assets can be done by any method of below explained
:-

A. COST MODEL :-
Fixed assets are carried at their cost (book value) i.e. [historical cost i.e.
original cost of an asset - (Accumulated Depreciation + impairment losses)].

B, REVALUED MODEL :-
Fixed asset is initially recorded at cost, but subsequently it’s carrying amount
is increased to the fixed asset for any appreciation in value of that fixed asset.
The difference between cost model and Revalued model is that Revalued
model allows both upward and downward adjustment in value of fixed asset,
whereas cost model allows that only downward adjustment due to an
impairment loss of the fixed asset.

The Revaluation of fixed assets can be measured by suitable method from the
below :-

1. Indexation method :-
Under this method, indices are applied to the cost value of the fixed assets to
arrive the current cost of the fixed assets. The Indices are used by Statistical
Bureau departments of the country, or Economic Surveys for the revaluation
of fixed assets.

2. Current Market price method :-

Under this method, Land, Buildings, Plant & machineries are using the
current market price as mentioned below for their revaluation.

(a) Land :-
The price estimated by using recent prices for similar plots of land sold in the
area after certain adjustments will have to be made by the company. This can
be done with the assistance of real estate brokers and agencies.

(b) Buildings :-
The price estimated by using latest price for similar buildings purchased /
sold in that area. This can be also done with the assistance of real estate
brokers.

(c) Pant & Machinery :-

The price estimated by using current market price obtained from suppliers of
those fixed assets. If those brands are not available in the market due to
closure of the companies who manufacturing them, then it is compared to
value of similar asset’s prices.

3. Selective Method :-
Under this method, the price estimated by using only a specific asset in a
class of assets of a specific location.

4. Appraisal model :-
Appraisal method is also known as Evaluation method or Assessment
Method or Pricing method.
Under this method, the technical experts required to carry out a detailed
examination of the fixed assets to determining their fair market value. For
example, a complete estimation (evaluation) is required when the
organization is taking out an insurance policy for protection of its fixed
assets. We ensure that the fixed assets are not over / under insured under this
method. The below factors affecting in determining the revaluation of fixed
assets :-
(a) Date of purchase of fixed assets (for calculating the age of those assets),
(b) Usage of an assets i.e. 8 hours, 16 hours and 24 hours (Generally 1 Shift =
8 Hours),
(c) Purpose of an assets (General purpose or special purpose),
(d) Repairs & Maintenance policy of the organization,
(e) Availability of Spare Parts in the future especially in the case of imported
machineries,
(f) Future demand for the product(s) manufactured by an asset.

Upward Revaluation :-
The increased value of the fixed asset over that asset’s carrying value (book
value) is called as upward amount of Revaluation of that fixed asset. Upward
revaluation can be used mainly for fixed assets such as land, and real estate
whose value will be raised year to year. The upward value of fixed asset has
to be credited to Revaluation Surplus / reserve (which is capital reserve), and
it should not be used for dividend distribution. The increased value of
depreciation arising out of revaluation of fixed asset is debited to revaluation
surplus (reserve), and the normal depreciation amount to profit and loss
account.

Downward Revaluation :-
The decreased value of the fixed asset over that asset’s carrying value (book
value) is called as downward amount of Revaluation of that fixed asset. The
downward value of fixed asset has to be debited to Revaluation Surplus /
reserve (which is capital reserve). The downward revision value, first, need to
adjust with Revaluation surplus if available, still it is there, then transfer to
profit and loss as “impairment loss".

Reversal of Revaluation :-
Revalued amount is subsequently valued down due to an impairment. The
loss is first write off against any balance available in the Revaluation surplus,
and if the loss exceeds that of Revaluation surplus, then the balance of same
asset is charged to profit & loss account as impairment loss. We should not
consider the upward adjustment of Revaluation amount as normal gain, and
the same should not show in profit and loss account.

IV. CASE :-
XYZ company purchased a machinery on 01st January 2017 for $100,000 and
its useful life is 10 years. Assume that Straight line method is using for
calculation of Depreciation.
Then, Depreciation per year = Original cost of an asset / number of years of
useful life i.e.
= $100,000 / 10 years = $10,000

The journal entry for purchase of an asset (machinery) is :-

Machinery
Dr $100,000
A/c
01-
Bank A/c Cr $100,000
Jan-
17 (Being
Asset
purchased)

On 01st January 2019, Revalued, and fair market value of the machinery
have fixed on that date is $85,000 . The journal entries, and necessary ledgers
are showing the balances as below on 01st January 2019 :-

Depreciation A/c Dr $10,000

Machinery A/c Cr $10,000
31-12-
2017 (Being
Depreciation
provided)

Depreciation A/c Dr $10,000

Machinery A/c Cr $10,000
31-12-
2018 (Being
Depreciation
provided)

Dr. Machinery A/c Cr.

Date Description Amount Date Description Amount
01- 31-
By
Jan- To Bank $100,000 Dec- $10,000
Depreciation
17 17
 31- By $10,000
Dec- Depreciation
18

31-
By Balance
Dec- $80,000
c/d
18
$100,000 $100,000
01-
To Balance
Jan- $80,000
b/d
2019

Dr. Depreciation A/c Cr.

Date Description Amount Date Description Amount
31-
To
Dec- $10,000
Machinery
17
31-
To
Dec- $10,000
Machinery
18

31-
By Balance
Dec- $20,000
c/d
18
$20,000 $20,000
01-
To Balance
Jan- $20,000
b/d
19
Dr. Bank A/c Cr.
Date Description Amount Date Description Amount
01-
By
Jan- $100,000
Machinery
17

31-
To Balance
Dec- $100,000
c/d
17
$20,000 $100,000
01-
To Balance
Jan- $100,000
b/d
18

As said above, the Revalued amount of the machinery on 01st January 2019 is
$85,000, but actual carrying amount of that machinery on 01st January 2019
is only $80,000 . The difference i.e. the excess amount over carrying cost of
the machinery (85,000 – 80,000) is $5,000 which would have been
transferring to Revaluation surplus A/c by passing below journal entry.

Machinery A/c Dr $5,000

01- Revaluation Surplus
Cr $5,000
Jan- A/c
19 (Being difference
amount transferred)

On 01st January 2020, again Revalued, and fair market value of the
machinery have fixed on that date is $70,000 .

Now, it should be note that the depreciation needs to calculate on the

Revalued amount, and should not calculate on original cost of the asset in
Revaluation model. Thus, the depreciation for the year 2019 will be calculate
as per below :-
Depreciation = Revalued amount of the fixed asset / Number of remaining
periods of useful life i.e. 85,000 / 8 years = $10,625

The necessary ledgers are showing the balances as below on 01st January
2020 :-

Dr. Machinery A/c Cr.

Date Description Amount Date Description Amount
31-
01- By
To Bank $100,000 Dec- $10,000
Jan-17 Depreciation
17
To 31-
01- By
Revaluation $5,000 Dec- $10,000
Jan-19 Depreciation
surplus 18
31-
By
Dec- $10,625
Depreciation
19

31-
By Balance
Dec- $74,375
c/d
18
$105,000 $105,000
01- To Balance
$74,375
Jan-20 b/d

Dr. Depreciation A/c Cr.

Date Description Amount Date Description Amount
31-
Dec- To Machinery $10,000
17
31-
Dec- To Machinery $10,000
18
 31-
Dec- To Machinery $10,625
19

31-
By Balance
Dec- $30,625
c/d
19
$30,625 $30,625
01- To Balance
$30,625
Jan-20 b/d

Dr. Revaluation Surplus A/c Cr.

Date Description Amount Date Description Amount
01-
By
Jan- $5,000
Machinery
19

31-
To Balance
Dec- $5,000
c/d
19
$5,000 $5,000
01-
By Balance
Jan- $5,000
b/d
20

As said above, the Revalued amount of the machinery on 01st January 2020 is
$70,000, but actual carrying amount of that machinery on 01st January 2020
is only $74,375. The difference i.e. the less amount over carrying cost of the
machinery (70,000 – 74,375) is $4,375 which would have been transferring
to ‘Revaluation Surplus A/c’ by passing below journal entry.
 Revaluation Surplus A/c Dr $4,375
01- Machinery A/c Cr $4,375
Jan-20 (Being difference
amount transferred)

Note :-
If the Revalued amount is less than the actual carrying cost of the asset, first,
we need to adjust that loss amount against any Revaluation surplus amount of
that same asset, still any balance after the adjustment also, then that amount
need to transfer to profit and loss account as “Impairment loss”.

Suppose, in the above case, the Revalued amount is fixed $69,000 instead of
$70,000. Then, the difference i.e. the less amount over carrying cost of the
machinery (69,000 – 74,375) is $5,375 which would have been transferring
to ‘Revaluation Surplus A/c’. But, in this case, the revaluation $5,375 against
Revaluation surplus, the remaining balance after adjustment i.e. (5,375 –
5,000) $375 need to transfer to Impairment loss. The journal entry for this
transaction will come as mentioned below :-

Revaluation Surplus A/c Dr $5000

Impairment loss A/c Dr $375
Machinery A/c Cr $5000
01-
Jan-20 Accumulated Impairment Cr
losses A/c $375
(Being loss of Revalued
amount adjusted)

------------ End of the CHAPTER – 4 ----------

CHAPTER – 5
 BREAK-EVEN ANALYSIS
Learning objectives
After studying this chapter, you can be able to :-
1. Understand the concept of Break-even and
Margin of safety,
2. know break-even point and break-even chart,
3. Recognize the assumptions and advantages of
break-even, and
4. Illustrate Break-even analysis.

Introduction:-
Break-even analysis is a tool of profit planning and forecasting. The primary
objective of profit maximizing firm is to cover the all costs, then to reach
break-even point (BEP) and make net profit thereafter.

Break-even point(BEP) :-
The point (i.e. level) of sales at which the total revenue is equal to total cost
and the net income is equal to zero is called as break-even point (BEP). The
BEP is also known as No Profit No loss point.

Determinants of Break-even point:-

The break-even point can be determined either in terms of physical units or in
monetary terms i.e. sales value.

A. Break-even point in terms of physical units:-

The break-even volume is the number of units of the product which must be
hold to earn profit to cover the all variable and fixed cost. The selling price
per unit covers the variable cost and contribution margin through fixed cost
i.e. the costs remaining fixed irrespective of the volume of units. The BEP is
reached when the sufficient number of units have been sold. Hence, the total
contribution margin of units sold is equal to the fixed cost.

Break-even point (BEP) = Fixed cost / contribution margin per unit

Here, contribution margin per unit = Selling price per unit (S) – Variable cost
per unit (V)
This method is convenient for the single-product firm.

Example:-
The fixed cost of the factory is $ 20,000 per year, the variable cost per unit is
$5 and selling price per unit is $8. Then, you are required to calculate the
BEP.

Solution:-
BEP = Fixed cost / contribution margin per unit
Here, contribution margin per unit = Selling price per unit (S) – Variable cost
per unit (V)
BEP = 20,000 / (8 – 5)
= 20,000 / 3
= 6,666.67

In other words, the company would not make any profit or loss at a sales
volume of 6,666.67 units as shown below:-

Amount
Particulars
($)
Sales (6,666.67 x $8) 53333.33
Less : Variable cost
33333.33
(6666.67 x $5)
Contribution 20000.00
Less : Fixed cost 20000.00
Net operating profit or
0.00
loss

So, at the level of 6,666.67 units, there is No gain or No loss. Therefore, the
BEP is 6,666.67 units of the product in this method.

B. Break-even point in terms of sales value (in terms of money):-

It is not possible for multi-product firms to determine the BEP in terms of
physical units because the BEP can change product to product. Hence, in the
case of multi-product firms, the BEP can be determined in terms of sales
value in respective currency at which the contribution margin (i.e. selling
price – variable cost) would be equal to their fixed cost. The contribution
margin is expressed as a ratio to sales.

Break-even point (BEP) = Fixed cost / contribution margin ratio

Here, contribution margin ratio = [(Sales – Variable cost) / sales] or [(S – V)
/ S]

This method is convenient for the single-product firm.

Example 1:-
The fixed cost of the factory’s multi-products is $ 50,000 per year, the selling
price per unit is $60 and the variable cost per unit is $45. Then, you are
required to calculate the BEP.

Solution:-
As per mentioned above formula, the BEP can be calculated as below:-
BEP in units = 50,000 / [(60-45)/60]
= 50,000/(15/60)
= $50,000/0.25
= $ 2,00,000

In other words, the company would not make any profit or loss at a sales
revenue (value) of $ 2,00,000 as shown below:-

Amount
Particulars
($)
Sales revenue (value) 200000.00
Less : Variable cost [sales value x (variable cost/selling
150000.00
price)] [200000 x (45/60)]
Contribution 50000.00
Less : Fixed cost 50000.00
Net operating loss 0.00

So, at the $2,00,000 of sales revenue, there is No gain or No loss. Therefore,

the BEP in this method is $2,00,000 of the multi-products of the firm.
Example 2:-
Sales were $1500 generates a profit of $40 in a month. In the next month, the
sales increased to $1900 which generate a profit of $120. You are required to
calculate BEP.

Solution:-
Increase in sales (1900 – 1500) = $400
Increase in profit (120 – 40) = @80
Increase in variable cost (400 – 80) = $320

The variable cost over the sales of $400 is $320

The variable cost per dollar of sale is 320 / 400 i.e. $0.80

Amount
Particulars
($)
Fixed cost for the sales over $1500
1200.00
(1500 x 0.80)
Add : Profit 40.00
Variable cost + profit 1240.00
Less: Sales value 1500.00
Fixed cost [Sales value - (Variable
260.00
cost + profit)]

Contribution margin ratio = [(Sales – Variable cost) / sales] or [(S – V) / S]

= (1500 – 1200) / 1500
= 300 / 1500
= 0.20

Break-even point (BEP) = Fixed cost / contribution margin ratio

= 260 / 0.20
= $1300

Break-even point as a percentage (%) of full capacity:-

In this case, BEP is usually expressed as a percentage (%) of full capacity.
For example, assume that the full capacity of the firm is 1000 units, then the
BEP at 6000 units can be expressed as 60% of full capacity.

Example:-
A manufacturer is produced and sells 3 varieties of products with the
following data:-
Selling Variable
Percentage of
price cost
Product dollar -
per unit per unit
Sales volume ($)
($) ($)
1 4.00 3.00 20.00
2 5.00 4.00 30.00
3 7.00 5.00 50.00

Capacity of the firm = $15,000 of total sales value.

Fixed cost per annum is $2,000

You are required to calculate the below:-

(i) Break-even point
(ii) Profit if firm works at 80% of capacity

Solution:-
The necessary calculations may be done in the following tabular form:-

Selling
Variable Percentage
price Percentage
cost of dollar - Contribution
Product per of sales
per unit Sales percentage
unit amount ($)
($) volume ($)
($)
5 = [(2 - 3) / 6 = (4 x
1 2 3 4
2] 5)
1 4.00 3.00 20.00 0.2500 5.00
2 5.00 4.00 30.00 0.2000 6.00
3 7.00 5.00 50.00 0.2857 14.29
25.29
Thus, the contribution per dollar of overall sales is 0.2529 or 25.29%

(i) Break-even point:-

Break-even point = Fixed cost / Contribution margin ratio

= 2000 / 0.2529
= $7,908.26

(ii) Profit at 80% of capacity:-

Profit = Total revenue – Total cost i.e. Fixed cost + Variable cost
= (15000 x 80%) – (2000 + 75% of 12000)
= 12000 – (2000 + 9000)
= 12000 – 11000
= $1,000

Break-even chart:-
Meaning of Break-Even Chart:-
The chart or device which is a graphical presentation between cost, volume
and profit is called as Break-even chart. Thus, the break-even chart is also
termed as CVP (Cost, Volume and Profit) graph. The break-even chart will
show the break-even point and will indicate the estimated cost and estimated
profit or loss at different volumes of production activity. Break-even chart
represents the following information:-
Cost i.e. fixed, variable and total,
Sales value and Profit or Loss,
Break-even point,
Margin of Safety,
Angle of incidence.

Example of Break-even chart:-

From the below information of XYZ limited, we can draw the break-even
chart.

Amount
Particulars
($)
Sale price per
14
Unit
 VC per Unit 4
FC 20000

Fixed Variable Total Sales

Units
cost ($) cost ($) cost ($) ($)
0 20000 0 20000 0
1000 20000 4000 24000 14000
2000 20000 8000 28000 28000
3000 20000 12000 32000 42000
4000 20000 16000 36000 56000
5000 20000 20000 40000 70000
6000 20000 24000 44000 84000

Construction of Break-even chart:-

On the X-axis of the break-even chart, the number of units produced is
arranged. On the Y-axis of the break-even chart, the sales revenue and costs
are arranged. The fixed cost line is drawn parallel to the X-axis. The fixed
cost line indicates that the fixed cost will remain un-changed irrespective of
volume of production. The variable costs for different levels of output are
plotted (arranged) over the fixed cost line. The variable cost line is joined to
the fixed cost line at zero volume of production. This line can also be
regarded as the total cost line because it starts from the point where the fixed
cost has been incurred and variable cost is zero. Sales revenue at various
levels of output are plotted and the resultant line is called as the sales line.
The sales line will cut the total cost line at the point where total costs are
equal to total revenues and this point of intersection ‘OX’ of two lines is
called as breakeven point i.e. the point of no gain no loss. The number of
units to be produced at the break-even point is determined by drawing a
perpendicular line to the X-axis from the point of intersection and measuring
the horizontal distance from the zero point to the point at which the
perpendicular line is drawn. The sales value at breakeven point is determined
by drawing a perpendicular line to the Y-axis from the point of intersection
and measuring the vertical distance from the zero point to the point at which
the perpendicular line is drawn. Profit and loss have been showing in the
chart (graph) which show that if the production is less than the break-even
point, the business will be running at a loss and if the production is more than
the break-even point, the business will be running at a profit.

NOTE:-
In the break-even chart, we see that the total cost line and the sales line as
straight lines. This is possible only with number of assumptions. But, in real
time, the total cost line and the sales line are not as straight lines because the
assumptions do not hold good. Therefore, there might be several break-even
points at different levels of production activity.

Angle of Incidence:-
The angle which is formed at the break-even point at which the sales line cuts
the total cost line is called as Angle of incidence. This angle indicates the rate
at which profits are being made. The large angle of incidence is an indication
to that the profits are being made at a high rate. Conversely, a small angle of
incidence is an indication to that the profits are being made at a low rate. A
large angle of incidence with a high margin of safety is an indication of that
the most favourable position of the business even though the existence of
monopoly conditions.

Margin of safety:-
the amount of sales that are above the break-even point. In other words,
the margin of safety indicates the amount by which a company's sales could
decrease before the company will become unprofitable.

Margin of safety (MOS) = [(sales – BEP) / sales] x 100

or
Margin of safety (MOS) = Actual sales – Break-even point

Notes of Break-even analysis:-

(a) Increase in fixed cost or variable cost will cause to increase the break-
even point.
(b) Increase in selling price will cause to reduce the break-even point and
vice versa.
(c) Levy of any taxes will cause to increase the break-even point.
(d) Subsidy of grants if any will cause to reduce the break-even point and
vice versa.

Assumptions of Break-even chart/analysis:-

(i) All costs can be separated into fixed and variable costs.
(ii) Semi-Variable Cost can be bifurcated into variable and fixed components.
(iii) Fixed cost will remain constant during the relevant period and will not
change whenever the changes in the level of output.
(iv) Variable cost per unit also will remain constant during the relevant
period.
(v) Selling price also will remain constant during the relevant period
irrespective of the quantity sold.
(vi) The number of units produced and sold will be the same. Then, there is
no opening stock or closing stock.
(vii) Operating efficiency also will not be change.
(viii) Product mix will remain constant (unchangeable) either in the case of
one product or in the case of many products.
(ix) Specifications of the product and methods of manufacturing and selling
will remain constant i.e. volume of production and sales are equal.

Advantages of Break-Even Chart/analysis:-

(i) A Break-Even Chart gives very clear-cut information which helps to
managerial decisions regarding cost, profit and volume of production.
(ii) The break-even chart/analysis helps to the management to determine
profit earning capacity after analysing both the Angle of incidence and
Margin of Safety.
(iii) The break-even chart/analysis is used to show the profit position at
different price levels under assumed conditions of costs and demand.
(iv) Break-even analysis will help the manufacturer to take decision of make
or buy the product. The make or buy decision may account for the
consideration of Quality of the product, guarantee of product supply, defence
from monopoly, etc.
(v) A break-even chart is used as a device for cost control because it shows
the relative importance of the fixed costs and the variable costs of the
business.
(vi) A break-even chart can ascertain the Profits at different levels of
production activity.
(vii) Break-even analysis would make the manufacturer to take decision
regarding the question of how the additional fixed costs would influence the
break-even point.
(viii) The break-even chart helps in the determination of sale price which
would give desired profits and also It is very helpful in knowing the effect of
increase or decrease in selling price.
(ix) The profit capabilities can be judged from a study of the break-even point
position and the angle of incidence in the break-even chart. Low break-even
point and large angle of incidence in the break-even chart indicate that the
fixed costs are low and margin of safety is high which is the sign of financial
stability and vice versa. High break-even point and large angle of incidence
show that fixed costs are high and margin of safety is low.

Limitations of Break-Even Chart/analysis:-

(i) Selling price remains constant irrespective of the sales volume and
variable cost also should remain the same.
(ii) A break-even chart is based on number of assumptions (discussed earlier)
which may not hold good. Fixed costs vary beyond a certain level of output.
Variable costs do not vary proportionately if the law of diminishing or
increasing returns is applicable in the business.
(iii) Production and sales should be equal without considering the value of
stock.
(iv) Break-even analysis ignores the capital employed which is very
significant for calculating the rate of profitability or earnings
(v) Sales revenues do not vary proportionately with changes in volume of
sales due to reduction in selling price will result in increased production or in
competition.
(vi) If different products are produced, then separate break-even chart should
be drawn up which creates a problem of allocation of fixed overheads.
(vii) The effect of different Product mix on profits cannot be studied from a
single break-even chart.
(viii) Break-even analysis is not an effective tool for long-term use and its use
is restricted to the short-term only.

PROBLEMS AND SOLUTIONS

Case 1:-
XYZ company sells boxes in Newyork, USA. Boxes are imported from
Australia and are sold to customers in Newyork for profit. Sales persons paid
basic salary plus commission of $10 on each sale made by them. Selling price
and expense data is mentioned below:-

Amount
Particulars
($)
Selling price per box 50.00

Variable expenses
per box:-
Invoice cost 20.00
Sales commission 10.00
Total variable
30.00
expenses

Fixed cost per

annum:-
Marketing expenses 200000.00
Rent 80000.00
Salaries 120000.00
Total Fixed cost 400000.00
You are required to prepare the below:-
(i) Calculate the break-even point in units and in sales revenue (in dollars)
using the information given above.

(ii) Prepare a break-even chart (CVP graph) and show the break-even point
on the chart.

(iii) What would be net operating income or loss if company sells 17,000
boxes in a year?

(iv) If the manager is paid a commission of $5 per box in addition to the

salesperson’s commission, what will be the effect on company’s break-even
point?

(v) As an alternative to (3) above, company is thinking to pay $5 commission

to manager on each box sold on excess of break-even point. What will be the
effect of these changes on the net operating income or loss of the XYZ
company if 22,000 boxes are sold in a year?

(vi What will be the break-even point of the company if entire commission is
eliminated and salaries are increased by $1,90,000?

Solution:-
(i) Calculate the break-even point:-
Break-even point (BEP) = Fixed cost / contribution margin ratio
Here, contribution margin ratio = [(Sales – Variable cost) / sales] or [(S – V) /
S]

BEP in units = 4,00,000 / [(50-30)/50]

= $4,00,000/(20/50)
= $4,00,000/0.40
= $ 10,00,000

or

Break-even point (BEP) = Fixed cost / contribution margin per unit

Here, contribution margin per unit = Selling price per unit (S) – Variable cost
per unit (V)

BEP in units = 4,00,000 / (50-30)

= 4,00,000 / 20
= 20,000 units of boxes

or

BEP = Selling price Q = Variable cost Q+ Fixed cost

50 Q = 30 Q + 4,00,000
50 Q – 30 Q = 4,00,000
20 Q = 4,00,000
Q = 4,00,000 / 20
Q = 20,000 units of boxes

BEP in sales revenue = BEP in unit’s x selling price per unit

= 20,000 boxes × $50.00 sale price per blouse
= $10,00,000 of sales revenue

(ii) Break-even chart (CVP graph):-

The break-even chart prepared based on the below information.
Fixed Revenue Total Sales
Units
cost ($) ($) cost ($) ($)
0 400000 0 400000 0
10000 400000 500000 700000 500000
20000 400000 1000000 1000000 1000000
30000 400000 1500000 1300000 1500000
40000 400000 2000000 1600000 2000000
50000 400000 2500000 1900000 2500000
60000 400000 3000000 2200000 3000000

NOTE:-_
Revenue ($) = Number of units x selling price per unit
Total cost – [(Number of unit’s x variable cost per unit) + Fixed cost]
Break-even chart:-

(iii) Net operating income or loss if 17,000 boxes are sold in a year:-

Amount
Particulars
($)
Sales (17,000 x $50) 850000
Less : Variable cost
510000
(17,000 x $30)
Contribution 340000
Less : Fixed cost 400000
Net operating loss -60000

or

Net operating profit or loss = (Actual sales – Break-even sales) x contribution

margin per unit
Here, contribution margin per unit = Selling price per unit (S) – Variable cost
per unit (V)

Net operating profit or loss = (17,000 – 20,000) x $20

= $ -3000 x 20
= $ - 6,000
Since it is showing negative balance, the Net operating loss = $6,000

(iv) Break-even point if manager also paid a commission of $5 per box

sold and net effect on BEP:-
The payment of a commission of $5 to manager will increase variable cost
and decrease the contribution margin. Now the variable expenses will be $35
(30 + 5) per unit and contribution margin will be $15 ($50 – $35) per unit.
Break-even point (BEP) = Fixed cost / contribution margin per unit
Here, contribution margin per unit = Selling price per unit (S) – Variable cost
per unit (V)

BEP in units = 4,00,000 / (50-35)

= 4,00,000 / 15
= 26,666.67 or 26,667 units of boxes

BEP in sales revenue = BEP in unit’s x selling price per unit

= 26,666.67 boxes × $50.00 sale price per blouse
= $ 13,33,333.33 of sales revenue

Therefore, the net effect on company’s break-even point is an increase of

6,666.67 (26,666.67 – 20,000) units of boxes and an increase of the sales
revenue $ 3,33,333.33 (13,33,333.33 – 10,00,000).

(v) Effect on net operating income or loss if manager is paid a

commission of $5 on each box sold after the break-even point:-

Amount
Particulars
($)
Sales (22,000 x $50) 1100000
Less : Variable cost [(20,000 x $30) +
670000
(2000 x 35)]
Contribution 430000
Less : Fixed cost 400000
Net operating income 30000

Therefore, the effect if manager is paid a commission of $5 on each box sold

after the break-even point is the net operating income of $30,000

(vi) Break-even point after elimination of commission and increase in

salaries:-
The new variable cost is $20 (invoice cost, no commission) and new fixed
cost is $5,90,000 ($400,000 + $1,90,000).
Break-even point (BEP) = Fixed cost / contribution margin per unit
Here, contribution margin per unit = Selling price per unit (S) – Variable cost
per unit (V)

BEP in units = 5,90,000 / (50-20)

= 5,90,000/ 30
= 19,666.67 units of boxes

BEP in sales revenue = BEP in unit’s x selling price per unit

= 19,666.67 boxes × $50.00 sale price per blouse
= $9,83,333.33 of sales revenue

Case 2:-
A manufacturer sells his product at $6 per each. Variable cost is $4 per unit
and fixed cost is $50,000. You are required to calculate:-
(i) Break-even point
(ii) What would be the profit if the firm sells 35,000 units?
(iii) What would be the BEP if firm spends $2,000 on advertising?
(iv) How much should the manufacturer sell to make a profit of $20,000 after
spending $2,000 for advertisement?

Solution:-

(i) Break-even point:-

Break-even point (BEP) = Fixed cost / contribution margin per unit
Here, contribution margin per unit = Selling price per unit (S) – Variable cost
per unit (V)

BEP in units = 50,000 / (6-4)

 = 50,000 / 2
= 25,000 units

BEP in sales revenue = BEP in unit’s x selling price per unit

= 25,000 units × $6 sale price per unit
= $1,50,000 of sales revenue

(ii) Profit:-
Profit = Total revenue – Total cost (i.e. Fixed cost + variable cost)
= [(35,000 x 6) – {50,000 +(35,000 x 4)}]
= 2,10,000 – (50,000 + 1,40,000)
= 2,10,000 – 2,10,000
= $0.00

(iii) BEP when increase in fixed cost:-

If the firm spends $2,000 on advertisements, then the fixed cost will raise the
$2,000 i.e. from $50,000 to $52,000. Thus, the BEP would be as follow:-

Break-even point (BEP) = Fixed cost / contribution margin per unit

Here, contribution margin per unit = Selling price per unit (S) – Variable cost
per unit (V)

BEP in units = 52,000 / (6-4)

= 52,000 / 2
= 26,000 units

BEP in sales revenue = BEP in unit’s x selling price per unit

= 26,000 units × $6 sale price per unit
= $1,56,000 of sales revenue

(iv) Calculation of number of units sell to make a profit of $30,000:-

Target sales volume = [(Fixed cost + target profit) / contribution margin]
Here, contribution margin per unit = Selling price per unit (S) – Variable cost
per unit (V)

Target sales volume = [(52,000 + 20,000) / (6 – 4)]

= 72,000 / 2
 = 36,000 units

Case 3:-

The ABC company sells 3 products. They are ‘Product A’, ‘Product B’ and
‘Product C’. The budgeted contribution margin income statement of the
company for the coming month is mentioned below:-

Products
Particulars Total
Product - A Product - B Product - C
Percentage
of total sales 48% 20% 32% 100%
Sales 48000 100% 20000 100% 32000 100% 100000 100%
Less :
Variable
cost 14400 30% 16000 80% 17600 55% 48000 48%
Contribution 33600 70% 4000 20% 14400 45% 52000 52%
Less : Fixed
cost 44720
Net
operating
income 7280

Budgeted break-even point = Fixed cost / contribution margin ratio

Here, contribution margin ratio = [(Sales – Variable cost) / sales] or [(S – V) /
S]

BEP = 44,720 / [(100-48)/100]

= 44,720/(52/100)
= 44,720/0.52
= $86,000

The actual data of sales of the month is below:-

Amount
 Product ($)
Product -
A 32000
Product -
B 40000
Product -
C 28000
Total 100000

You are required to calculate the break-even point of ABC company based on
the actual sales. Explain the reason of difference if any between the break-
even point calculated on the basis of budgeted sales and the break-even point
calculated on the basis of actual sales data.

Solution:-

Income statement based on the actual sales:-

Products
Particulars Total
Product - A Product - B Product - C
Percentage
of total sales 32% 40% 28% 100%
Sales 32000 100% 40000 100% 28000 100% 100000 100%
Less :
Variable
cost 9600 30% 32000 80% 15400 55% 57000 57%
Contribution 22400 70% 8000 20% 12600 45% 43000 43%
Less : Fixed
cost 44720
Net
operating
income -1720

Actual break-even point = Fixed cost / contribution margin ratio

Here, contribution margin ratio = [(Sales – Variable cost) / sales] or [(S – V) /
S]

BEP = 44,720 / [(100-57)/100]

= 44,720/(43/100)
= 44,720/0.43
= $1,04,000
The difference in break-even point is because of shift in sales mix. A shift in
sales mix from the products generating high contribution margin to the
products generating low contribution margin decreased the
overall contribution margin ratio of the company from 52% to 43% and
increased the dollar sales required to break-even from $860,000 to
$1,040,000.

Case 4:-
PQR company manufactures two products i.e. product X and product Y.
Product X sells for $80 and product Y for $120. Company sells its products
through its own stores and outlets owned by various merchandising
companies. Total fixed cost of a company is $13,200 per month. Variable
cost and monthly sales data are given below:
Variable cost per unit is:-
Product X : $48
Product Y : $24

Monthly sales in units are:-

Product X : 20 Units
Product Y : 8 Units

You are required to:-

(i) Prepare the contribution margin income statement showing dollars and
percent columns for the product X and product Y and for the company as a
whole.
(ii) Calculate the break-even point in dollars and margin of safety using the
above information.
(iii) PQR company is considering the manufacture of another product i.e.
product Z which does not have fixed cost. The variable cost to manufacture
and sell a unit of product Z will be $120. If the selling price of the new
product is set at $160 per unit, the company expect to sell 4 units per month.
(a) Prepare a new contribution margin income statement that includes the
product Z.
(b) Calculate the new break-even point and margin of safety.
(iv) The chairman is unable to understand the increase in break-even sales
because the new product has increased the sales revenue and contribution
margin without any increase in fixed costs. Explain to the chairman the
reason of increase in break-even sales.
Solution:-

(i) Contribution margin format income statement:-

Products
Total
Particulars Product -X Product - Y
$ % $ % $ %
Sales 16000 100% 9600 100% 25600 100%
Less : Variable
cost 9600 60% 1920 20% 11520 45%
Contribution 6400 40% 7680 80% 14080 55%
Less : Fixed
cost 13200
Net operating
income 880

(ii) Break-even point and margin of safety:-

Break-even point = Fixed cost / contribution margin ratio
Here, contribution margin ratio = [(Sales – Variable cost) / sales] or [(S – V) /
S]

BEP = 13,200 / [(100-45)/100]

= 13,200/(55/100)
= 13,200/0.55
= $24,000

Margin of safety (in dollars) = Actual sales – Break-even sales

 = 25600 – 24000
= $1600

Margin of safety (in %) = (Margin of safety / Actual sales) x 100

= ($1600/$25600) x 100
= 0.0625 x 100
= 6.25%

(iii) Addition of Product Z:-

(a) New contribution margin income statement:-
Products
Total
Particulars Product - A Product - B Product - C
$ % $ % $ % $ %
Sales 16000 100% 9600 100% 6400 100% 32000 100%
Less :
Variable
cost 9600 60% 1920 20% 4800 75% 16320 51%
Contribution 6400 40% 7680 80% 1600 25% 15680 49%
Less : Fixed
cost 13200
Net
operating
income 2480

(b) New break-even point and margin of safety:-

Break-even point = Fixed cost / contribution margin ratio
Here, contribution margin ratio = [(Sales – Variable cost) / sales] or [(S – V) /
S]

BEP = 13,200 / [(100-51)/100]

= 13,200/(49/100)
= 13,200/0.49
= $26938.78

Margin of safety (in dollars) = Actual sales – Break-even sales

= 32000 – 26938.78
 = $5061.22

Margin of safety (in %) = (Margin of safety / Actual sales) x 100

= ($5061.22/$32000) x 100
= 0.1582 x 100
= 15.82%

(iv) Explanation to the chairman:-

The break-even point has increased from $24,000 to $26,938.78 because the
new product Z has decreased the overall or average contribution margin
ratio of the company. Product Z has a contribution margin ratio of only 25%
which has caused a drop in overall or average contribution margin ratio from
55% to 49%. Even though the break-even point is higher, the addition of new
product has increased the margin of safety from $1600 to $5061.22 or from
6.25% to 15.82% which indicates that the company has shifted much further
from its break-even point.

Case 5:-
The present cost and output data of manufacturer of a company as below:-
Variable
Price cost
Product ($) per unit % of
($) sales
(S) (V)
Baskets 50 30 40
Tables 80 45 20
Racks 180 110 40

Total fixed cost per annum is $40,000

The sales in last year are $1,50,000

Then, the manufacturer is dropped the line of tables and replace it with Bays.
If this drop and add decision is taken, the cost and output data will be as
following:-
 Product Price Variable % of
($) cost per unit sales
($)
Baskets 50 30 60
Bays 100 25 10
Racks 180 110 30

Total fixed cost per annum is $55,000

The sales in last year are $2,00,000

Is the change worth undertaking?

Solution:-

(i) The profit on the present product line is calculated in the following
manner:-
Variable
Profit on
Price cost Contribution
Contribution
($) per unit % of ratio
Product ratio
($) sales
[(S - V) / S] x
(S) (V) (S - V) / S
% of sales
Baskets 50 30 40 0.40 0.16
Tables 80 45 20 0.44 0.09
Racks 180 110 40 0.39 0.16
0.40

Then, the total contribution = 1,50,000 x 0.40

= $60,000

Profit = Contribution – Fixed cost

= 60,000 – 40,000
= $20,000

(ii) Profit on the proposed product line will be as below:-

 Variable Profit on
Price cost Contribution
Contribution
($) per unit % of ratio
Product ratio
($) sales
[(S - V) / S] x
(S) (V) (S - V) / S
% of sales
Baskets 50 30 60 0.40 0.24
Bays 100 25 10 0.75 0.08
Racks 180 110 30 0.39 0.12
0.43

Then, the total contribution = 2,00,000 x 0.43

= $86,000

Profit = Contribution – Fixed cost

= 86,00000 – 55,000
= $31,000

Conclusion:-
Therefore, the proposed change is worth undertaking.

------------ End of the CHAPTER – 5 ----------

CHAPTER – 6
CAPITAL BUDGETING

Learning objectives
After studying this chapter, you can be able to :-
1. Understand the nature and need of
investment decisions,
2. show the implications of NPV and IRR,
 3. Evaluating the Discounted cash flow
criteria, and
4. Illustrate the calculation of PBP, ARR, NPI,
PI, and IRR.

Introduction :-
Efficient allocation of capital is one of the most important functions of
financial management. This function involves the firm’s decision to commit
the funds in long term assets and other profitable activities. Capital budgeting
is also known as Investment appraisal.
Meaning of ‘Capital Budgeting’ :-
The process of decision making with regard to investment of money or
current funds efficiently in the long term projects.
The investment decisions of the firm are commonly known as Capital
budgeting or Capital expenditure decisions.
The investment criteria or Capital Budgeting techniques or methods are as
under :-
1. Pay Back Period (PBP)
2. Discounted Pay Back Period (DPBP)
3. Average Rate of Return (ARR)
4. Net Present Value (NPV)
5. Profitability Index (PI)
6. Internal Rate of Return (IRR)
7. Modified Internal Rate of Return (MIRR)

How to decide to take acceptable project from the below :

Case :-
The estimated revenue (cash inflow) before depreciation and tax of Project
‘A’ and Project ‘B’ for 6 years as below :-

Year 1 2 3 4 5 6
Project 50000 70000 90000 100000 95000 105000
A ($)
Project 61000 66000 57000 70000 78000 88000
B ($)
(i) Investment of ‘Project A’ is $250000
(ii) Investment of ‘Project B’ is $210000
(iii) Both the projects will be depreciated at 10%
(iv) Cost of capital (k) for both projects is 10%
(v) Tax rate for both the projects is 30%
(vi) Scrap value for both the projects is $10000

Based on the above details of the projects, which project can we accept by
analysis of the below capital budgeting techniques?

1. Pay Back Period (PBP)

2. Discounted Pay Back Period (DPBP)
3. Average Rate of Return (ARR)
4. Net Present Value (NPV)
5. Profitability Index (PI)
6. Internal rate of Return (IRR)
7. Modified Internal rate of Return (MIRR)

Solution or Decision making process :-

After we will have analyzed the profitability of the below two projects
(Project A & Project B) through the below various capital budgeting
methods, we should be able to take a decision for acceptable project.

1. Payback period (PBP) :-

The length of time required to recover the cost of an investment is called Pay
Back Period. It is calculated as :-

PBP = Cost of an investment of project / Annual Cash flows

It is used as a first screening method for an investment back. The shorter

payback period is better investment back of the project. In other words, Less
Pay Back period is more favorable to accept a project. We may have a
target Pay Back Period. With any project, taking longer PBP than the target
PBP is being rejected.

Disadvantages of PBP :-
(a) Cash flows after the PBP are ignored. Therefore, the effect of the whole
cash flows of the project are not considered. It does not consider the Time
Value of Money.

(b) Time Value of Money :-

The money now is more valuable than the same amount of money in future.

Because of these disadvantages of PBP, other methods of Capital budgeting

like NPV, PI and IRR are generally preferred.

PBP for ‘Project A’ :-

Calculation of Profitability Statement of ‘Project A’ :-

Year Year Year

Particulars 1 2 3 Year 4 Year 5 Year 6
EBDT ($) 50000 70000 90000 100000 95000 105000
Less : Dep@10%
($) 5000 7000 9000 10000 9500 10500
EBT ($) 45000 63000 81000 90000 85500 94500
Less : Tax@30%
($) 13500 18900 24300 27000 25650 28350
EAT ($) 31500 44100 56700 63000 59850 66150
Add : Dep 5000 7000 9000 10000 9500 10500
NCF ($) 36500 51100 65700 73000 69350 76650

Here :-
EBDT : Earnings before Depreciation and Tax
Dep : Depreciation
EBT : Earnings before Tax
EAT : Earnings after Tax (or) Net Profit (or) Profit after Tax(PAT)
NCF : Net Cash Inflows
EBDT – Dep = EBT – Tax = EAT + Dep = NCF

The cash flows for 4 years comes to (36500 + 51100 + 65700 + 73000) =
226300

We require only 23700 (250000 – 226300) to reach investment of $250000 in

5th year out of 69350
So, 23700 / 69350 = 0.34 year or 0.34 x 12 = 4.10 months.

Thus, the PBP for project A is 4.34 years (or) 4 years and 4.10 months.

This means the cash inflows of ‘project A’ is reaching their investment at

4.34 years.

PBP for ‘Project B’ :-

Calculation of Profitability Statement of ‘Project B’ :-

Year Year Year Year Year Year

Particulars 1 2 3 4 5 6
EBDT ($) 61000 66000 57000 70000 78000 88000
Less : Dep@10%
($) 6100 6600 5700 7000 7800 8800
EBT ($) 54900 59400 51300 63000 70200 79200
Less : Tax@30%
($) 16470 17820 15390 18900 21060 23760
EAT ($) 38430 41580 35910 44100 49140 55440
Add : Dep 6100 6600 5700 7000 7800 8800
NCF ($) 44530 48180 41610 51100 56940 64240

Here :-
EBDT : Earnings before Depreciation and Tax
Dep : Depreciation
EBT : Earnings before Tax
EAT : Earnings after Tax (or) Net Profit (or) Profit after Tax(PAT)
NCF : Net Cash Inflows
EBDT – Dep = EBT – Tax = EAT + Dep = NCF

The cash flows for 4 years comes to (44530 + 48180 + 41610 + 51100) =
185420

We require only 24580 (210000 - 185420) to reach investment of $210000 in

5th year out of 56940

So, 24580 / 56940 = 0.432 year or 0.432 x 12 = 5.18 months.

Thus, the PBP for project B is 4.43 years (or) 4 years and 5.18 months.
This means the cash inflows of ‘project B’ is reaching their investment at
4.43 years.

2. Discounted payback period (DPBP) :-

DPBP also calculated as :-
DPBP = Cost of an investment of project / Annual Cash flows
DPBP method is more reliable than PBP since it accounts for Time value of
money by discounting each cash flow before the cumulative cash flow is
calculated.

Less DPBP is more preferable to accept a project.

Disadvantage :-
It ignores the cash flows from project after the payback period.

DPBP for Project A :-

Year NCF ($) D.Fact@10% DCF ($) Cuml.CF ($)

0 -250000.00 0.00 -250000.00
1 36500.00 0.909090909 33181.82 -216818.18
2 51100.00 0.826446281 42231.40 -174586.78
3 65700.00 0.751314801 49361.38 -125225.40
4 73000.00 0.683013455 49859.98 -75365.42
5 69350.00 0.620921323 43060.89 -32304.53
6 76650.00 0.564473930 43266.93 10962.40
260962.40

Here :-
NCF : Net Cash inflow
D.Fact : Discounting Factor
DCF : Discounted Cash inflow
Cuml.CF : Cumulative Cash inflow

D.Fact = 1/(1+k)1 for ‘year 1’, 1/(1+k)2 for ‘year 2’ ……..

K = Cost of Capital (COC) i.e. 10% or 0.1
DCF = NCF x D.Fact
Cuml.CF = Cuml.CF of previous year – DCF of present year

So, we break even some time in the 6th year. When?

(Break even = At which the revenue is equal to investment)

The cash inflows for 5 years come to (33181.82 + 42231.40 + 49361.38 +

49859.98 + 43060.89) = 217695.48

Then, we require only 32304.52 (250000 – 217695.48) in 6th year out of

43266.93

So, 3234.52 / 43266.93 = 0.75 year or 0.75 x 12 = 8.96 months.

Thus, the DPBP for project A is 5.75 years (or) 5 years and 8.96 months.

This means the cash inflows of ‘project A’ is reaching their investment at

5.75 years.

DPBP for Project B :-

Year NCF ($) D.Fact@10% DCF ($) Cuml.CF

($)
0 -210000.00 0.00 -210000.00
1 44530.00 0.909090909 40481.82 -169518.18
2 48180.00 0.826446281 39818.18 -129700.00
3 41610.00 0.751314801 31262.21 -98437.79
4 51100.00 0.683013455 34901.99 -63535.80
5 56940.00 0.620921323 35355.26 -28180.54
6 64240.00 0.564473930 36261.81 8081.26
218081.26

Here :-
NCF : Net Cash inflow
D.Fact : Discounting Factor
DCF : Discounted Cash inflow
Cuml.CF : Cumulative Cash inflow
D.Fact = 1/(1+k)1 for ‘year 1’, 1/(1+k)2 for ‘year 2’ ……
K = Cost of Capital (COC) i.e. 10% or 0.1
DCF = NCF x D.Fact
Cuml.CF = Cuml.CF of previous year – DCF of present year

So, we break even some time in the 6th year. When?

(Break even = At which the revenue is equal to investment)

The cash inflows for 5 years comes to (40481.82 + 39818.18 + 31262.21 +

34901.99 + 35355.26) = 181819.46

Then, we require only 28180.54 (250000 – 181819.46) in 6th year out of

36261.81

So, 28180.54 / 36261.81 = 0.777 year or 0.75 x 12 = 9.33 months.

Thus, the DPBP for project B is 5.78 years (or) 5 years and 9.33 months.

This means the cash inflows of ‘project B’ is reaching their investment at

5.78 years.

3. Average rate of return (ARR) :-

It is also known as Accounting Rate of Return. ARR is calculated as :-

ARR = (Average Income / Average Investment) X 100

Here :-
Average Income = Total income(profit) from all years / No.of years

Average Investment = (Cost of an investment + Scrap Value) / 2

ARR provides a quick estimate of a project’s worth over its useful life.

ARR measures the overall profitability of the investment.

Disadvantages :-
(a) It uses profits rather than cash flows.
(b) It does not account for the Time value of money.

More ARR is desirable to accept the project of a company.

ARR for Project A :-

ARR = (Average Income / Average Investment) X 100

Average Income = (31500 + 44100 + 56700 + 63000 + 59850 + 66150) / 6 =

53550

Average Investment = (250000 + 10000) / 2 = 130000

Thus, ARR = (53550 / 130000) x 100 = 41.19%

ARR for Project B :-

ARR = (Average Income / Average Investment) X 100

Average Income = (38430 + 41580 + 35910 + 44100 + 49140 + 55440) / 6 =

44100

Average Investment = (210000 + 10000) / 2 = 110000

Thus, ARR = (44100 / 110000) x 100 = 40.10%

4. Net present value (NPV) : -

NPV is calculated as :-
NPV = PV of Cash inflows – PV of cash outflows

Here : -
PV = Present Value
Cash outflows nothing but investment. Otherwise, We can calculate NPV as
under also :

NPV = CF1/(1+K)1 + CF2/(1+K)2 + CF3/(1+K)3 + CF4/(1+K)4 …..

CFn/(1+K)n – C0
Here :-
CF = Cash inflow every year.
K = Cost of capital or Discounting rate or WACC (Weighted average cost of
capital) or Rate of Return.
C0 = Cost of an investment or Cash Outflow.

NPV is the difference between the present value of cash inflows and present
value of cash outflows (cost of an investment of a project). This means the
NPV is subtract our investment of a project from our cash inflows.

NPV is used to know the profitability of an investment of a project.

NPV compares the value of rupee today to value of that same rupee in future.

More NPV of a project is acceptable.

If NPV is negative, the project should be reject because the net cash flows
also be negative.

NPV for ‘Project A’ :-

Year NCF ($) D.Fact@10% DCF ($) Cuml.CF

($)
0 -250000.00 0.00 -250000.00
1 36500.00 0.909090909 33181.82 -216818.18
2 51100.00 0.826446281 42231.40 -174586.78
3 65700.00 0.751314801 49361.38 -125225.40
4 73000.00 0.683013455 49859.98 -75365.42
5 69350.00 0.620921323 43060.89 -32304.53
6 76650.00 0.564473930 43266.93 10962.40
260962.40

NPV = PV of Cash inflows – PV of cash outflows(investment)

Thus, NPV = 260962.40 – 250000

= 10962.40

NPV for Project B :-

 Year NCF ($) D.Fact@10% DCF ($) Cuml.CF
($)
0 -210000.00 0.00 -210000.00
1 44530.00 0.909090909 40481.82 -169518.18
2 48180.00 0.826446281 39818.18 -129700.00
3 41610.00 0.751314801 31262.21 -98437.79
4 51100.00 0.683013455 34901.99 -63535.80
5 56940.00 0.620921323 35355.26 -28180.54
6 64240.00 0.564473930 36261.81 8081.26
218081.26

NPV = PV of Cash inflows – PV of cash outflows (investment)

Thus, NPV = 218081.26 – 210000

= 8081.26

5. Profitability Index (PI) :-

PI is calculated as :-

PI = PV of cash inflows / Investment

Or

PI = 1 + (NPV / Investment)

PI is the ratio of the pv of cash inflows at required rate of return (k) i.e. NPV
to the initial cash outflow (investment).

PI is used to know that for every 1 dollar of invested, how much we are
getting.

More PI is more favorable to accept a project.

PI for ‘Project A’ :-
PI = 1 + (10962.40 / 250000)
= 1 + 0.0438
= 1.044
This means for every $1.00 dollar of investment in ‘project A’, we can get
$1.044

PI for Project B :-
PI = 1 + (8081.26 / 210000)
= 1 + 0.038
= 1.038

This means for every $1.00 dollar of investment in project A, we can get
$1.038

6. Internal rate of return (IRR) :-

IRR is also known as ERR (Economic Rate of Return). IRR is the
discounting rate which equates the NPV is equal to zero. IRR is calculated as
:-

IRR = R1 + [{NPV 1 x (R2 – R1)} / (NPV 1 – NPV 2)]

Here :-
R1 : Lower discount (coc) rate
R2 : Higher discount (coc) rate
NPV 1 : Higher NPV (from R1 coc)
NPV 2 : Lower NPV (from R2 coc)

IRR is used to know the efficiency of the investment of a project.

The more IRR is acceptable to undertake the project.

IRR for ‘Project A’ :-

We got NPV of $10962.40 at COC (k) of 10%. At which COC %, we can get
the NPV is equal to Zero?

So, Assume that the COC i.e. k is 7% and NPV will be at 7% are as below :-

Year NCF ($) D.Fact@7% DCF ($) Cuml.CF ($)

0 -250000.00 0.00 -250000.00
1 36500.00 0.934579439 34112.15 -215887.85
 2 51100.00 0.873438728 44632.72 -171255.13
3 65700.00 0.816297877 53630.77 -117624.36
4 73000.00 0.762895212 55691.35 -61933.01
5 69350.00 0.712986179 49445.59 -12487.42
6 76650.00 0.666342224 51075.13 38587.71
288587.71

NPV = PV of Cash inflows – PV of cash outflows(investment)

Thus, NPV = 288587.71 – 250000

= 38587.71

So, NPV will be at 7% is $38587.71

Thus, IRR = 7 + [ {38587.71 x (10 – 7)} / (288587.71 – 260962.40)]

= 7 + 4.1905
= 11.19%

Thus, The NPV will be zero at COC i.e. k of 11.19%

IRR for ‘Project B’ :-

We got NPV of $8081.26 at COC (k) of 10%. At which COC %, we can get
the NPV is equal to Zero?

So, Assume that the COC i.e. k is 7% and NPV will be at 7% are as below :-

Year NCF ($) D.Fact@7% DCF ($) Cuml.CF

($)
0 -210000.00 0.00 -210000.00
1 44530.00 0.934579439 41616.82 -168383.18
2 48180.00 0.873438728 42082.28 -126300.90
3 41610.00 0.816297877 33966.15 -92334.74
4 51100.00 0.762895212 38983.95 -53350.80
5 56940.00 0.712986179 40597.43 -12753.37
6 64240.00 0.666342224 42805.82 30052.46
240052.46

NPV = PV of Cash inflows – PV of cash outflows (investment)

Thus, NPV = 240052.46 – 210000
= 30052.46

So, NPV is at 7% is $30052.46

Thus, IRR = 7 + [ {30052.46 x (10 – 7)} / (240052.46 - 218081.26)]

= 7 + 4.1034
= 11.10%

Thus, The NPV will be zero at COC i.e. k of 11.10%

7. Modified Internal rate of return (MIRR) :-

MIRR is Basically same as IRR except it assumes that the Future value of net
cash inflows (Fvcf) are reinvested in the project at the rate of coc (k) or a
specified reinvestment rate over the investment period.

MIRR = –1
Here :-
n : No. of years
FVCF : Sum of Future value of Net Cash inflows

MIRR usually to be lower than IRR. The project should be accepted if

MIRR is more than the COC (Cost of Capital i.e. k). However, it is
preferable to select a project with the highest NPV rather than highest MIRR
because NPV analysis is the better measure of the impact of an investment.
IRR and MIRR should be more than the cost of capital (k) for accept the
project of a company.

MIRR for ‘Project A’ :-

If we reinvested the cash inflows @ 12%, then, the MIRR would be as under
:-

Year NCF ($)

Reinvest @ DCF ($) Cuml.CF ($)
12%
0 -250000.00 0.00 -250000.00
 1 36500.00 0.567426856 20711.08 -229288.92
2 51100.00 0.635518078 32474.97 -196813.95
3 65700.00 0.711780248 46763.96 -150049.98
4 73000.00 0.797193878 58195.15 -91854.83
5 69350.00 0.892857143 61919.64 -29935.19
6 76650.00 1.00 76650.00 46714.81
296714.81
Here :
Reinvest @ 12% for year 1 = NCF x 1 / (1 + k)6-1 i.e. reinvested @ 12% for 5
years.
Reinvest @ 12% for year 2 = NCF x 1 / (1 + k)6-2 i.e. reinvested @ 12% for 4
years.
Reinvest @ 12% for year 3 = NCF x 1 / (1 + k)6-3 i.e. reinvested @ 12% for 3
years.
Reinvest @ 12% for year 4 = NCF x 1 / (1 + k)6-4 i.e. reinvested @ 12% for 2
years.
Reinvest @ 12% for year 5 = NCF x 1 / (1 + k)6-5 i.e. reinvested @ 12% for 1
year.
Reinvest @ 12% for year 6 = NCF x 1 / (1 + k)6-6 i.e. reinvested @ 12% for 0
year.

MIRR = –1

MIRR = –1

MIRR = –1

MIRR = 1.18686^1/6 – 1

MIRR = (1.18686 ^ 0.16667) - 1

MIRR = 1.02896 - 1
MIRR = 0.02896 i.e. 2.896%

MIRR for ‘Project B’ :-

If we reinvested the cash inflows @ 12%, then, the MIRR would be as under
:-

Year NCF
Reinvest DCF Cuml.CF
@ 12%
0 -210000.00 0.00 -210000.00
1 44530.00 0.567426856 25267.52 -184732.48
2 48180.00 0.635518078 30619.26 -154113.22
3 41610.00 0.711780248 29617.18 -124496.04
4 51100.00 0.797193878 40736.61 -83759.44
5 56940.00 0.892857143 50839.29 -32920.15
6 64240.00 1.00 64240.00 31319.85
241319.85

Here :

Reinvest @ 12% for year 1 = NCF x 1 / (1 + k)6-1 i.e. reinvested @ 12% for 5
years.
Reinvest @ 12% for year 2 = NCF x 1 / (1 + k)6-2 i.e. reinvested @ 12% for 4
years.
Reinvest @ 12% for year 3 = NCF x 1 / (1 + k)6-3 i.e. reinvested @ 12% for 3
years.
Reinvest @ 12% for year 4 = NCF x 1 / (1 + k)6-4 i.e. reinvested @ 12% for 2
years.
Reinvest @ 12% for year 5 = NCF x 1 / (1 + k)6-5 i.e. reinvested @ 12% for 1
year.
Reinvest @ 12% for year 6 = NCF x 1 / (1 + k)6-6 i.e. reinvested @ 12% for 0
year.

MIRR = –1
MIRR = –1

MIRR = –1

MIRR = 1.1491421^1/6 - 1

MIRR = (1.1491421 ^ 1.6667) – 1

MIRR = 1.0234398 - 1

MIRR = 0.0234398 i.e. 2.344%

Conclusion :-
Project A is acceptable(favorable) as the below capital budgeting methods
of ‘Project A’ values are showing higher than the values of ‘Project B’.

NOTE :-
Both the projects ‘A’ and ‘B’ would be reject in the case of MIRR because
the MIRR for both projects is less than COC (cost of capital).

METHOD PROJECT A PROJECT B

VALUE RANK VALUE RANK
PBP 4.340 1 4.430 2
DPBP 5.750 1 5.780 2
ARR 41.190 1 40.100 2
NPV 10962.40 1 8081.26 2
PI 1.044 1 1.038 2
IRR 11.190 1 11.100 2
MIRR 2.896 1 2.344 2

------------ End of the CHAPTER – 6 ----------

 CHAPTER – 7
WORKING CAPITAL MANAGEMENT

Learning objectives
After studying this chapter, you can be able to :-
1. Understand the necessity of managing Current assets and
Current liabilities,
2. know the operating cycle,
3. Learn the statement of cost of sales,
4. Know the factors influencing working capital, and
5. Focus on the advantages of working capital.

Introduction:-
Working capital management explains the management of current assets and
current liabilities. A company can analyse their effects on its return and risk
in current assets management. The firm’s liquidity position will be high by
holding the more current assets especially cash. By holding the more current
assets, a firm can reduce its risk. At the same time, it will also be reducing its
overall profitability by holding more current assets. The firm has more
flexibility in current assets management by adjusting current assets with sales
fluctuations in a short run.

Concepts of Working capital (GWC):-

The amount of funds necessary to cover the cost of a company is called as
Working capital. The two common concepts of working capital are:-

(a) Gross working capital:-

Gross working capital means the total current assets of a firm and does not
account for current liabilities. In other hand, the Gross working capital means
the investment of a company in its current assets. Thus, we can say that the
total current assets is called as Gross working capital.
(b) Net working capital (NWC):-
The difference between current assets and current liabilities is known as Net
working capital.
Here:-
Current assets mean those assets which can be convertible in to cash within
the short period or an accounting year i.e. one year. Example of current assets
are mentioned below:-
(i) Cash-in-hand
(ii) Cash-at-bank
(iii) Sundry debtors
(iv) Closing stock
(v) Bills receivables
(vi) Pre-paid expenses
(vii) Advances given
(viii) Marketable securities, etc.

Current liabilities mean those liabilities which are re-payable within the short
period or an accounting year i.e. one year. Example of current liabilities
(obligations) are mentioned below:-
(i) Sundry creditors
(ii) Bills payable
(iii) Outstanding expenses
(iv) Bank over draft (short-term)
(v) Income tax liability
(vi) Proposed dividend
(vii) Long-term liability matured in current year, etc.

Net working capital may be either positive or negative. It is said to be

positive net working capital when current assets are more than current
liabilities. On contrary, it is said to be negative working capital if current
assets are less than the current liabilities.

Current assets management:-

The concept of Gross working capital involved in two aspects of current
assets management.
a. How to optimize the investment in current assets?
b. How should current assets be financed?
The consideration of investment level in current assets will be avoid two
points such as excessive investment or inadequate investment in current
assets. Excessive investment in current assets will reduce the profitability of a
company. Inadequate amount of working capital will be threat to solvency of
the company because of inability to meet its current liabilities. Thus, it is to
manage the current assets and current liabilities in such a way that is an
acceptable level of Net working capital is maintain by the financial manager.

Liquidity management:-
The liquidity management of working capital indicates the liquidity position
of the firm. A weak liquidity position can reduce the solvency of the firm and
it is un-safe to the firm. A negative liquidity means negative working capital
which is harmful to reputation of the firm. On other hand, excessive liquidity
which will arise due to mismanagement of current assets will also be not
good to the firm. So that the firm should follow the conventional rule to
maintain the current assets twice to the level of current liabilities for efficient
management of working capital. There is no exact way to determine the exact
amount of Gross working capital for a firm. The required amount of gross or
net working capital may be determined by financial data and problems of the
respective firm. The firms differ in their requirements of the working capital.
In summary, the task of a financial manager in managing working capital
efficiency is to ensure sufficient liquidity in operations of the respective firm.

Measures of liquidity:-
The three basic measures of overall liquidity are mentioned below:-

1. Current ratio:-
It is a quick measure of the firm’s short-term liquidity.
Current Ratio = Current Assets / Current Liabilities
This ratio indicates the ability of current assets in rupees for everyone rupee
of current liabilities.
Standard norm of this ratio is 2 : 1 means for every 1 dollar of current
liabilities, current assets should be 2 dollars. A higher the ratio is
favourable which indicates a good liquidity and satisfactory debt repayment
capacity of the firm. A lower this ratio than standard indicates a bad liquidity,
over trading, less working capital and un satisfactory debt repayment capacity
of the firm. The investment of a creditors in a firm having a low current ratio
may not be too safe. It should be noted that in case of recession, the firm may have large unsold
stock and long outstanding debtors. This would increase current assets and result in a high current ratio.
But, in this case, the trend indicated by the high current ratio may not stand favourable for the firm.

2. Liquid ratio or Quick ratio:-

It is used to measure short term liquidity of the firm.
Quick Ratio = Quick Assets / Quick Liabilities
Here :-
Quick Assets = Current assets – (Closing Stock + Prepaid Expenses)
Quick Liabilities = Current liabilities – Bank Over Draft (Short term and not payable on demand)
It indicates an immediate ability to pay off its current liabilities.
Standard norm of this ratio is 1 : 1 means for every 1 dollar of Quick
liabilities, Quick assets should be 1 dollar. A Quick ratio is considered as a
better test of liquidity than Current ratio. But, Quick ratio itself may not be
taken as a conclusive test of liquidity. A high Quick ratio along with a
higher Current ratio is favourable which indicates a good short-term
liquidity and debt repayment capacity of the firm. Even if the Current ratio is
high, a low Quick ratio does not indicate a good debt repayment capacity of
the firm. A company with a high value of Quick ratio can suffer from the
shortage of funds if it has slow paying, doubtful and long duration
outstanding debtors.

3. Net working capital (NWC) ratio:-

The difference between current assets and current liabilities excluding short
term bank borrowings is called NWC or NCA (Net Current Assets) ratio. It is
used to measure the short-term liquidity of the firm.
NWC ratio = NWC / CE or NA
Here :-
NWC = Current assets(CA) – Current Liabilities(CL)
NA (Net Assets) = NFA (Net Fixed Assets) + NWC (or) Total Assets – Current Liabilities(CL)
NFA = Total Fixed Assets (FA) – Depreciation (Dep.)
CE (Capital Employed) = Total Debt (TD) + Net worth
TD = Short term Debt + long term Debt + Secured Loans + Un secured loans + Bonds + Debentures
Net worth = Equity Share Capital + Preference Share Capital + Reserves + Surplus - Fictitious assets
Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,
Preliminary expenses, Samples, Loss on issue of shares, etc…
Standard norm of this ratio is absent i.e. depend on the norm followed by
the firm or industry. The higher the ratio is favourable.
Operating cycle:-
Operating cycle means the continuous flow from cash to suppliers, to
inventory, to debtors and back in to cash. The main aim of the firm is to
maximize the shareholder’s wealth (return). In order to increase the
shareholder’s return, the firm should earn required return from its operations
of business. The firm has to invest sufficient (required) funds in current assets
for generate sales. Earning the frequent amount of profit requires the length
of the time required to complete the following events of the cycle.
a. Conversion of cash in to resources or inventory
b. Conversion of resources or inventory in to receivables
c. Conversion of receivables in to cash

The same is
presented in the below picture of operating cycle.
In the above flow chart of operating cycle:-
(2) Suppliers mean Payment of amount to suppliers for acquisition of
resources i.e. raw material, power, labour, etc.
(3) Inventory means Manufacture of the product i.e. conversion of raw
material in to work-in-progress and in to Finished goods.
(4) Accounts receivables mean Sale of Products either on credit or cash to
sundry debtors.

Types of operating cycle:-

The operating cycle is 2 types as below:-
1. Gross operating cycle
2. Net operating cycle

1. Gross Operating cycle (GOC):-

Gross Operating cycle (GOC) = ICP + DCP
Where:-
A. Inventory conversion period (ICP):-
Inventory conversion period (ICP) = RMCP + WIPCP + FGCP

Here:-
(i) Raw material conversion period (RMCP):-
RMCP is the average time (period) taken to convert raw material in to work-
in-progress. It depends on Raw material conversion per day (RMC) and Raw
material inventory (RMI).
RMCP = [RMI / (RMC/360)] or [(RMI/RMC)x360]

(ii) Work-in-progress conversion period (WIPCP):-

WIPCP is the average time (period) taken to complete the work-in-progress
or Semi-finished goods. WIPCP = [WIPI / (COP/360)] or
[(WIPI/COP)x360]
WIPI = Work-in-progress inventory
COP = Cost of production

(ii) Finished goods conversion period (FGCP):-

FGCP is the average time (period) taken to sell the finished goods to debtors.
FGCP = [FGII / (CGS/360)] or [(FGI/CGS)x360]
FGI = Finished goods inventory
CGS = Cost of goods sold

B. Debtors (receivables) conversion period (DCP):-

DCP is the average time taken to convert debtors in to cash. DCP is also
known as Average collection period (ACP).
DCP = [Debtors / (Credit sales/360)] or [(Debtors / Credit sales) x 360]

2. Net Operating cycle (NOC):-

NOC is the difference between Gross operating cycle (GOC) and Creditors
deferral period (CDP).
NOC = GOC – CDP
Where:-
A. Creditors Deferral Period (CDP):-
It is the average time taken by the firm to pay to its creditors (suppliers).
CDP = [Creditors / (Credit purchases/360)] or [(Creditors / Credit
purchases) x 360]

Net operating cycle is also known as Cash conversion cycle (CCC). It should
be noted that the firm has to primarily recover total costs and make profits
instead of deducting the depreciation. Thus, the calculation of operating cycle
should include depreciation.

Statement of Cost of Sales:-

The below statement of Cost of Sales of ‘K’ limited is for our reference:-

Statement of Cost of Sales

Amount Amount
 Particulars ($) ($)
Opening Raw material inventory 420.00
Add: Purchase of Raw material 4500.00
4920.00
Less: Closing Raw material inventory 840.00
Raw material consumption 4080.00
Add:
Direct labour 350.00
Depreciation 75.00
Other manufacture expenses 495.00 920.00
Total Cost 5000.00
Add: Opening Work-in-Progress
170.00
inventory
5170.00
Less: Closing Work-in-Progress
290.00
inventory
Cost of Production (COP) 4880.00
Add: Opening Finished Goods
295.00
inventory
5175.00
Less: Closing Finished Goods
475.00
inventory
4700.00
Add: Selling, Administrative and
350.00
General expenses
Cost of Sales (COS) or Cost of
5050.00
Goods Sold (CGS)

Permanent and variable working capital:-

The firm has to maintain a minimum required level of current assets are
called as Permanent or Fixed working capital. But, sometimes, the working
capital which is over and above the permanent working capital may be
fluctuate. This type of working capital which may fluctuate depend on the
changes in production or sales is known as Variable or Fluctuating or
Temporary working capital. For example, an additional inventory of finished
goods will have to be maintained to support of increasing the sales in peak
period and investment in debtors may also be increase during such periods.
On the contrary, the investment in raw material, work-in-progress and
Finished goods will fall in case of inefficient market. Therefore, the
permanent working capital is stable over time whereas temporary working
capital is fluctuating i.e. sometimes increasing and sometimes decreasing.

Balanced working capital maintain:-

The maintenance of both the excessive and inadequate working capital are
not good to the firm and the firm will face the below draw backs:-_

a. Excessive working capital disadvantages:-

Excessive working capital means holding the costs and idle funds which
earns no profit for the firm. The below are disadvantages of excessive
working capital.
(i) Excessive working capital leads to payment of less dividends to its
shareholders because the firm invests in acquisition of inventories.
(ii) Un necessary additional inventories to waste, mishandling, increase the
loss and sometimes leads to theft.
(iii) It tells the company that inefficient credit policy and poor collection
period.
(iv) Excessive working capital is indication of high debtors which leads to
bad debts and thereby it effects the profits of the firm.

b. Inadequate working capital disadvantages:-

(i) It cannot meet day-to-day commitments of operations of the business of a
firm.
(ii) It makes the firm unable to get credit opportunities from Banks or
Financial institutions.
(iii) It may result in slow moving growth
(iv) It may not achieve the set profit target of the firm.

Therefore, the firm should maintain the right amount of balanced working
capital on continuous basis. The firm should consider the required quantum
of working capital at different time periods based on the financial and
statistical data of the firm.

Policies for financing current assets:-

A firm can use three different types of financing policies to finance the
current assets as below:-

A. Short-term financing:-
The short-term financing policy is used for the period less than a year. These
are including Advances from banks, Commercial papers, Public deposits, etc.

B. Long-term financing:-
The long-term financing policy is used for the period more than a year. These
are including Equity share capital, Preference share capital, Bonds,
Debentures, Long-term borrowings from banks and financial institutions
(FIs), Reserves and surplus, etc.

B. Spontaneous financing:-
Spontaneous financing includes Suppliers credit (Trade credit), Outstanding
expenses, etc.

Estimating working capital requirements (needs):-

Even though “operating cycle” is the most suitable method of calculating the
working capital requirements of a firm, there is an another method also be
used to determine the working capital needs. The methods are:-

(i) The Current assets holding period:-

This method is used to estimate the working capital needs based on the
average holding period of current assets and relating costs based on previous
years. This method is primarily based on the operating cycle concept. The
limitation of this method is that it cannot estimate the working capital
requirement if markets are seasonal.

(ii) Ratio of sales:-

This method is used to estimate the working capital needs based on the
assumption that current assets may change with sales over time.

(iii) Ratio of fixed investment:-

This method is used to estimate the working capital need as a percentage of
fixed investment.

Example:-
The one year data of ‘XYZ limited’ as below:-

Amount Amount Amount

Particulars
($) ($) ($)
Annual Sales 40500.00
I. Material Cost:-
Raw material consumed 10000.00
less: By product 2000.00
Net material cost 8000.00
Add:-
II. Manufacturing cost:-
Labour 3000.00
Maintenance 2000.00
Power and Fuel 500.00
Factory overheads 700.00
Depreciation (10% on
7000.00
investments)
Total manufacturing cost 13200.00
Total Product cost 21200.00
Earnings before interest
19300.00
and tax (EBIT)
Add: Depreciation 7000.00
EBIDT 26300.00

ROI [{EBIT/(Investment -
30.63
Dep)}x100] %

Investments 70000

Period 1 year
 Plant life 10 years

Based on the above information, you are required to calculate the below:-

Method 1:-
A. Current assets holding period:-
a. Inventory:-
(i) 1 month supply of raw material
(ii) 1 month supply of semi-finished goods
(iii) 1 month supply of Finished goods

b. Debtors:-
(i) 1 month sales

c. Operating cash:-
(i) 1 month of total cost

Method 2:-
B. Ratio of sales:-
(i) 25 to 35% of annual sales

Method 3:-
C. Ratio of fixed investment:-
(i) 15 to 25% of fixed capital investment

And also calculate the Rate of return.

Solution:-

Method 1:-
A. Current assets holding period:-
a. Inventory:-
(i) 1 month supply of raw material
= 10000 / 12
= $833.33
(ii) 1 month supply of semi-finished goods
= 833.33 + [{(3000 + 2000 + 500)/2} / 12]
= 833.33 + [(5500 / 2) / 12]
= 833.33 + (2750 / 12)
= 833.33 + 229.17
= $1062.50

(iii) 1 month supply of Finished goods

= 21200 / 12
= $1766.67

Thus, the total inventory needs is (833.33 + 1062.50 + 1766.67) = $3662.50

b. Debtors:-
(i) 1 month sales
= 40500 / 12
= $3375.00

c. Operating cash:-
(i) 1 month of total cost
= 21200 / 12
= $1766.67

Therefore, the total working capital need under method 1 is (3662.50 +

3375.00 + 1766.67) = $8804.17

Method 2:-
B. Ratio of sales:-
(i) 25 to 35% of annual sales
= 40500 x [(25+35)/2)]%
= 40500 x 30%
= $12150

Method 3:-
C. Ratio of fixed investment:-
(i) 15 to 25% of fixed capital investment
= 70000 x [(15+25)/2]%
 = 70000 x 20%
= $14000

Calculation of Rate of return:-

[EBIT / (Net fixed investment + working capital)] x 100
Here, Net fixed investment = Total investment – Depreciation
= [19300 / {(70000 – 7000) + 8804.17}] x 100
= [19300 / (63000 + 8804.17)] x 100
= (19300 / 71804.17) x 100
= 0.26879 x 100
= 26.88%

Factors influencing working capital:-

In order to determine total investment in working capital, the below factors
(determinants) influence the working capital requirements (needs) of a firm.
(i) General nature of business
(ii) Production (Manufacture) cycle i.e. inventory conversion cycle i.e.
purchase of raw material, use of raw material and production of finished
goods. Longer the manufacture cycle, longer will be the firm’s working
capital requirements.
(iii) Market and demand conditions for sales of the firm
(iv) Production policy of the firm
(v) Credit policy to debtors of the firm
(vi) Credit availability from suppliers
(vii) Vagaries in availability of raw material
(viii) Profit level of the firm
(ix) Growth and expansion
(x) Level of taxes
(xi) Dividend policy
(xii) depreciation policy
(xiii) Changes in price level (Pricing policy of the firm
(xiv) Operating efficiency of the business of a firm
(xv) Technology and manufacturing policy

Advantages of working capital:-

The advantages of working capital are mentioned below:-
(i) The working capital of the firm used to make prompt payments and helps
in creating and maintaining goodwill.
(ii) the enough working capital is used to regular supply of raw material,
continuous production, paying regular dividends to investors and maintaining
the favourable market conditions.
(iii) the firm which is having an adequate working capital can get loans from
banks and financial institutions freely.
(iv) the firm can maintain solvency of the business with having an adequate
working capital.

PROBLEMS AND SOLUTIONS

Case 1:-
From the below proforma cost sheet and additional information of ‘XYZ
limited’, you are required to prepare a statement showing the working capital
required to finance a level of activity of 65000 units of output. Assume that
production is carried throughout the year and wages and overheads accrue
similarly.

Pro forma cost sheet:-

Amount
Particulars $
($)
Costs per
unit:-
Raw materials 4.50
Direct labour 2.10
Overheads 3.80
Total cost per
10.40
unit
Profit per unit 2.00
Selling price
12.40
per unit

Additional information: -
Particulars requirement
Average raw material in
1 month
stock
Average materials in
Half a month
process
Credit allowed by suppliers 1 month
Credit allowed to debtors 2 months
Time lag in payment of
1 and a half weeks
wages
Overheads 1 month
One-fourth of total
Sales on cash basis
sales
Three-fourth of total
Sales on credit basis
sales
Cash balance are expected
12500.00
to be ($)

Solution:-

STATEMENT OF WORKING CAPITAL NEEDED OF ‘XYZ

LIMITED’
Amount Amount
Particulars
($) ($)
A. Investment in inventory
1. Raw material inventory (30 days) (See
24375.00
Note 1)
2. Work-in-process inventory (15 days)
28166.67
(See Note 2)
3. Finished goods inventory (30 days)
56333.33
(See Note 3)
Total Investment in Inventory 108875.00
B. Investment in Debtors (60 days) (See Note
84500.00
4)
C. Cash balance 12500.00
D. Investment in Current assets (A+B+C) 205875.00
E. Current liabilities (Deferred payment)
 1. Creditors (30 days) (See Note 5) 24375.00
2. Deferred wages (10 days i.e. 1 and half
3791.67
weeks) (See Note 6)
3. Deferred overheads (30 days) (See Note
20583.33
7)
Total Deferred payment (spontaneous
48750.00
sources of working capital)
Net working capital (D - E) 157125.00

Working notes:-
Note 1:-
Raw material inventory (30 days):-
= (Raw material consumption / 360) x 30
= {(65000 x 4.50) / 360} x 30
= (292500/360) x 30
= 812.50 x 30
= $24375.00

Note 2:-
Work-in-process inventory (15 days):-
= (Cost of production / 360) x 30
= {(65000 x 10.40) / 360} x 15
= (676000/360) x 15
= 1877.778 x 15
= $28166.67

Note 3:-
Finished goods inventory (30 days):-
= (Cost of Sales (CGS) / 360) x 30
= {(65000 x 10.40) / 360} x 30
= (676000/360) x 30
= 1877.778 x 30
= $56333.33

Note 4:-
Investment in Debtors (60 days):-
= (Credit Sales / 360) x 60
= {(65000x3/4 x 10.40) / 360} x 60
= (48750x10.40/360) x 60
= (507000/360) x 60
= 1408.33 x 60
= $84500.00
Here, we considered the debtors based on total cost price ($10.40) because
there is not mentioned in problem to consider based on selling price ($12.40).
If particularly said in problem to consider the debtors on selling price, then
only should consider accordingly. Otherwise, we should consider the debtors
on cost price only. But, in the case of creditors, we always should consider
the creditors based on material price only instead of cost price or selling
price.

Note 5:-
Creditors (30 days):-
= (Purchase of Raw material / 360) x 30
= {(65000 x 4.50) / 360} x 30
= (292500/360) x 30
= 812.50 x 30
= $24375.00
Here, we always should consider the creditors only on material price ($4.50)
instead of cost price ($10.40) or selling price ($12.40).

Note 6:-
Deferred wages (10 days):-
= (Direct labour(wages) / 360) x 10
= {(65000 x 2.10) / 360} x 10
= (136500/360) x 10
= 379.167 x 10
= $3791.67

Note 7:-
Deferred overheads (30 days):-
= (Overheads / 360) x 30
= {(65000 x 3.80) / 360} x 30
= (247000/360) x 30
= 686.11 x 30
= $20583.00

Case 2:-
From the below information, you are required to advice the working capital
required to ABC limited to purchase the business. It should be noted to add
10% to your computed figure to allow for contingencies.

Amount per
Particulars
year ($)
Average amount backed up for stocks:-
stock of finished product 5000.00
stock of stores and materials 8000.00

Average credit given:-

Inland sales of 6 weeks credit 312000.00
Export sales of one and half weeks credit 78000.00

Average time lag in payment of wages and

other outgoings:-
Wages of one and half weeks credit 260000.00
Stores and materials of one and half a month 48000.00
Rent and Royalties of 6 months 10000.00
Clerical staff of half a month 62400.00
Manager salary for half a month 4800.00
Miscellaneous expenses for one and half a
48000.00
month

Payment in advance:-
Sundry expenses (paid quarterly) 8000.00
Average un-drawn profits (throughout the
11000.00
year)
Solution:-

STATEMENT OF WORKING CAPITAL

REQUIRED FOR ABC LIMITED
Amount Amount
Particulars
($) ($)
Current Assets:-
Stock of finished product 5000.00
Stores and materials 8000.00
Inland sales (312000 x 6/52) 36000.00
Export sales (78000 x 1.5/52) 2250.00
Payment in advance (8000 x
1/4) 2000.00
A. Total Current assets 53250.00
Current Liabilities:-
Wages (260000 x 1.5/52) 7500.00
Stores and materials (48000 x
1.5/12) 6000.00
Rent and Royalties (10000 x
6/12) 5000.00
clerical staff salaries (62400 x
0.5/12) 2600.00
Manager salary (4800 x
0.5/12) 200.00
Miscellaneous expenses
(48000 x 1.5/12) 6000.00
B. Total Current liabilities 27300.00
Working capital (A - B) 25950.00
Add : Contingency (25950 x
10%) 2595.00
Net working capital required 28545.00
Case 3:-
The ‘A limited has investigated the profitability of its assets and the cost of
its funds (liabilities). The results indicate as below:-
(i) Current assets earn is 1%
(ii) Profit on fixed assets is 13%
(iii) Cost of current liabilities is 3%
(iv) Average cost of long-term funds is 10%

The balance sheet of ‘A limited as follows:-

Balance Sheet of 'A' limited
Amount Amount
Liabilities ($) Assets ($)
Current Current
liabilities 5000.00 assets 10000.00
Long-term Fixed
funds 35000.00 assets 30000.00
40000.00 40000.00

A. What is the Net profitability?

B. The company is contemplating the lowering its Net working capital to
$3500 by
(i) either shifting $1500 of current assets in to fixed assets, or
(ii) shifting $1500 of its long-term funds in to current liabilities.

Workout the profitability for each of the above 2 alternatives. Then, which
one do you prefer and what is the Net profitability if both alternatives
implemented.

Solution:-

Amount
Particulars
($)
Calculation of profit on assets:-
Profit on current assets (10000 x 1%) 100.00
Profit on fixed assets (30000 x 13%) 3900.00
4000.00
1. Total profit

Calculation of cost on liabilities:-

Cost of current liabilities (5000 x 3%) 150.00
Cost of long-term funds (35000 x 10%) 3500.00
2. Total cost 3650.00

A. Net profitability (1 - 2) 350.00

Shifting $1500 of current assets to fixed

assets:-
Profit on current assets (10000 - 1500) x 1% 85.00
Profit on fixed assets (30000 + 1500) x 13% 4095.00
3. Total profit 4180.00

B. Net profitability (3 - 2) 530.00

Shifting $1500 of long-term funds in to

current liabilities:-
Cost of current liabilities (5000 + 1500) x 3% 195.00
Cost of long-term funds (35000 - 1500) x 10% 3350.00
4. Total cost 3545.00

C. Net profitability (1 - 4) 455.00

D. Net profitability when both alternatives

implemented (3 - 4) 635.00

Conclusion:-
The shifting of $1500 of current assets in to fixed assets is more beneficial
than shifting of liabilities for working capital lowering to $3500.
Case 4:-
The PQR limited approached their bankers for their working capital
requirements to have agreed to sanctioned by retaining the margins as under:-
(i) Raw materials 20%
(ii) Work-in-progress 25%
(iii) Finished goods 20%
(iv) Debtors (Net) 10%

From the following projections for next year, work out the below:-
A. The working capital require for the company,
B. The working capital limits likely to be approved by bankers
C. estimations for the next year as follows:-
(i) Annual sales of $1440000
(ii) Cost of production is $1200000
(iii) Raw materials purchased $705000
(iv) Monthly expenses $25000
(v) Estimated opening stock of raw material $140000
(vi) Estimated closing stock of raw material $125000

Inventory norms as below:-

(i) Raw materials 2 months
(ii) Work-in-progress 15 days
(iii) Finished goods 1 month

The firm enjoys a credit of 15 days on its purchases and allows 1-month
credit on its customers. The company has received an advance of $15000 on
sales orders.

Solution:-

Calculation of material consumed:-

Opening Raw material 140000.00
Add: Raw materials purchased 705000.00
845000.00
Less: Closing Raw material 125000.00
Material consumed 720000.00

Amount
Particulars
($)
I. Calculation of working capital require for the
company
Calculation of Current assets:-
Materials (720000 x 2/12) 120000.00
Work-in-progress (1200000 x 0.5/12) 50000.00
Finished goods (1200000 x 1/12) 100000.00
Debtors (1200000 x 1/12) 100000.00
Monthly expenses 25000.00
Total Current assets 395000.00

Calculation of Current liabilities:-

Creditors (1200000 x 0.5/12) 50000.00
advance received from debtors 15000.00
Total Current liabilities 65000.00
I. Working capital (A - B) 330000.00

II. Calculation of working capital likely to be

approved by Bankers:-
Current assets:-
Raw materials (120000 - 120000x20%) 96000.00
Work-in-progress (50000 - 50000x25%) 37500.00
Finished goods (100000 - 100000x20%) 80000.00
Debtors (100000 - 100000x10%) 90000.00
Monthly expenses 25000.00
C. Total Current assets 328500.00

Calculation of Current liabilities:-

Creditors (1200000 x 0.5/12) 50000.00
advance received from debtors 15000.00
D. Total Current liabilities 65000.00
II. Working capital (C - D) 263500.00

Case 5:-
From the following information belongs to ‘XYZ limited’, you are required
to calculate the below :-
(i) Raw materials storage period
(ii) Work-in-progress period
(iii) Finished goods storage period
(iv) Debtors collection period
(iv) Creditors payment period
(v) Operating cycle

Amount
Particulars
($)
Opening balances:-
Raw materials 4400.00
Work-in-progress 2200.00
Finished goods 4800.00
Book debts (debtors) 6800.00
Trade creditors 5600.00

Closing balances:-
Raw materials 4600.00
Work-in-progress 1300.00
Finished goods 5300.00
Book debts 7200.00
Trade creditors 6000.00

Purchase of Raw
15600.00
material
consumption of Raw
15400.00
material
Manufacturing expenses 7600.00
Depreciation 1800.00
Excise duty 4200.00
Selling and distribution
4900.00
expenses
Sales 42500.00

Solution:-

Trade Profit and Loss Account of XYZ limited

Amount Amount
Particulars Particulars
($) ($)
By Closing
To Opening stock:-
stock:-
Raw
Raw materials 4400.00 4600.00
materials
Work-in-
Work-in-progress 2200.00 1300.00
progress
Finished
Finished goods 4800.00 5300.00
goods
To purchases 15600.00 By Sales 42500.00
To manufacturing
7600.00
expenses
To Excise duty 4200.00

To Gross Profit 14900.00

53700.00 53700.00

To Depreciation 1800.00 By Gross profit 14900.00

To Selling and distribution
4900.00
expenses

To Net Profit 8200.00

 14900.00 14900.00

(i) Raw materials storage period:-

Raw materials storage period = Cost of Goods Sold / Average stock of Raw
material
Here:-
Cost of Goods Sold (COGS) = sales – Gross profit
= 42500 – 14900
= 27600

Average Raw materials = (Opening Raw material + Closing raw material) / 2

= (4400 + 4600) / 2
= 4500

Raw materials velocity = 27600 / 4500

= 6.133 times

(ii) Work-in-progress (WIP) period:-

Work-in-progress period = COGS / Average stock of WIP
Here:-
Cost of Goods Sold (COGS) = sales – Gross profit
= 42500 – 14900
= 27600

Average stock of WIP = (Opening stock of WIP + Closing stock of WIP) / 2

= (2200 + 1300) / 2
= 1750

Work-in-progress velocity (period) = 27600 / 1750

= 15.77 times

(iii) Finished goods storage period:-

Finished goods storage period = COGS / Average stock of Finished goods
Here:-
Cost of Goods Sold (COGS) = sales – Gross profit
= 42500 – 14900
= 27600

Average stock of Finished goods (FG) = (Opening stock of FG + Closing

stock of FG) / 2
= (4800 + 5300) / 2
= 5050

Finished goods velocity (period) = 27600 / 5050

= 5.465 times

(iv) Debtors collection period:-

Debtors collection period = (Average debtors / credit sales) x 360
Here:-
Average debtors = (Opening debtors + Closing debtors) / 2
= (6800 + 7200) / 2
= 7000

Credit sales = 42500

Debtors collection period = (7000 / 42500) x 360

= 0.1647 x 360
= 59.292 days

(v) Creditors payment period:-

Creditors payment period = (Average Creditors / credit Purchases) x 360
Here:-
Average debtors = (Opening Creditors + Closing Creditors) / 2
= (5600 + 6000) / 2
= 5800

Credit purchases = 15600

Debtors collection period = (5800 / 15600) x 360

 = 0.3718 x 360
= 133.85 days

(vi) Operating cycle ratio (OCR):-

Operating cycle ratio = {(COGS + Operating expenses) / Sales} x 100
Here:-
Cost of Goods Sold (COGS) = sales – Gross profit
= 42500 – 14900
= 27600

Operating expenses = Depreciation + Selling and Distribution expenses

= 1800 +4900
= 6700

Sales = 42500
Sales means Net sales i.e. (Cash sales + credit sales - Sales discount – Sales
returns)
Operating cycle ratio = {(27600 + 6700) / 42500} x 100
= (34300 /42500) x 100
= 0.807059 x 100
= 80.71%

------------ End of the CHAPTER – 7 ----------

CHAPTER – 8
FINANCIAL STATEMENTS ANALYSIS
 Learning objectives
After studying this chapter, you can be able to :-
1. Analyze the company’s financial statements through
various devices,
2. Understand and carry out Comparative, Common size, and
Trend analysis,
3. Describe how financial statements analysis is used for
different purposes, and
4. Preparation of financial statements based on the business
transactions.

The Statements which has to be prepare to know the firm’s financial position,
financial performance, changes in equity, inflow and outflow of cash are
called as Financial statements. They are :-
a. Income Statement
b. Statement of Changes in Equity
c. Balance sheet
d. Cash flow statement
e. Notes to the items in above financial statements.

BALANCE SHEET
The balance sheet is a most important financial statement of an entity. It
indicates the financial position of a firm at a particular moment of time. The
statement prepared on a particular date with all assets and liabilities of the
firm to know the financial position of the firm is called as Balance sheet. It
contains all assets (resources), liabilities (obligations) and owner’s equity of
the firm in monetary terms.

I. Assets (resources) :-
Assets represent cash and cash equivalents, sundry debtors, stock, land,
buildings, plant and machinery, Stock of raw material, stock of finished
goods, Goodwill, patents, copyrights etc. Assets are mainly classified as Non-
current (fixed) assets and Current assets as under :-

A. Non-current (fixed) assets :-

The assets which are gives more than one year (i.e. long term in nature) of
services to the firm are called as fixed assets. These assets are sub grouped in
to two categories :-

a. Tangible fixed assets :-

The assets which are having their physical existence in the firm and used in
the business operations to generate profits of the firm. For example, Land,
buildings, plant, machinery, furniture, equipment, vehicles, etc. These assets
are generally recorded at their cost price instead of their current market price.
These cost prices of tangible fixed assets (except land) are allocated over the
expected useful life of their assets after reduced the depreciation every year
due to continuous use of an asset & time lapse. But, in the case of land,
generally, there is an appreciation (increase of cost price) instead of
depreciation.

b. Intangible fixed assets :-

The assets which are not having their physical existence in the firm, but, the
have value to the firm. For example, goodwill, patents, copyrights,
trademarks, franchises etc. These assets are the firm’s rights. These assets
also recorded at their cost price. These cost prices are amortized (like
depreciate) over their useful lives.

The original cost of the fixed asset (Gross block) minus accumulated
depreciation is called the Net block. Here, accumulated depreciation means
the sum of total depreciation amount which is reduced for all years of the
fixed asset.

B. Current assets :-
Current assets are resources of an enterprise those which are held in the form
of cash or converted in to cash within the accounting period i.e. one year. The
accounting period is also known as operating cycle which is the time taken to
convert the raw material in to finished goods. Generally, the operating cycle
is equal to or less than the accounting period. Sometimes, the current assets
also known as liquid assets. The current assets include cash-in-hand, cash-at
bank, sundry debtors, closing stock, accounts receivable, prepaid expenses,
advances given, marketable securities, etc.

2. LIABILITIES :-
Liabilities represent the amount (debt) repayable by the firm to lenders,
creditors, etc. The liabilities can be classified as below :-

A. Long-term (fixed) liabilities :-

Long-term liabilities are those which are repayable within the period of more
than one accounting year.
These are include secured and/or un secured loans from banks or FIs, bonds,
debentures, etc. for more than one accounting period.

B. Current liabilities :-
Current liabilities are those which debts are repayable by the firm within an
accounting period of one year. These liabilities include sundry creditors, bills
payable, outstanding expenses, Bank overdraft, income tax liability, proposed
dividend, long-term liability maturing in the current accounting year.

3. OWNER’S (PROPRIETORS) EQUITY :-

The financial interests of the owners of a firm is called as owner’s equity.
Owner’s equity represents the total assets minus total liabilities. Equity is the
owner’s claim whereas liabilities are the outside parties’ claims. So that, the
earnings or losses of the firm cannot affect the creditors’ (outside party)
claims, but, effect the owner’s equity. For example, if the firm makes net
profit, we will add the same to capital or reserves & surplus which is owner’s
equity. Similarly, if the firm makes net loss, we can reduce this from capital
or reserves & surplus which is owner’s equity in balance sheet of the firm.
Owner’s equity can increase when the firm makes earnings (net profit) and
retains that earnings whole or a part. In the case of joint stock companies,
owners are called as shareholders or stockholders and owner’s equity called
as shareholder’s (stockholders/proprietors) equity or fund. The shareholder’s
equity is 2 types as below :-

a. Paid up share capital :-

It is the amount of the funds directly contributed by the shareholders through
purchase of shares.

b. Reserves and surplus :-

It is also known as retained earnings which represents un distributed profits
or book profits. The paid up share capital and Reserves and surplus together
is called as Net worth.
The below pro forma of balance sheet is for reference :-

BALANCE SHEET of ABC COMPANY LTD AS AT 31st DEC, 2019

Particulars
Non-current assets
Plant and Machinery (after depreciation)
Capital Work-in-Progress
Intangible assets (after amortization)
Financial Assets (Non-Current)
Investments in bonds & debentures
Loans
Total Non-Current assets
Current assets
Inventories (Closing Stock)
Financial Assets (Current)
Investments
Trade receivables (Debtors)
Cash and cash equivalents Cash in hand & cash at Banks
Other Loans
Total Current assets
Total
Assets
EQUITY AND LIABILITIES
EQUITY
Equity Share capital (Paid-up) (Shares of 325127810 @ $10 each)
Total Equity share capital
Other Equity
A. Reserves and Surplus
1. Capital Reserve
2. General Reserve
Add : Transferred from Retained earnings
3. Retained earnings
Add : Net profit (transferred from P/L A/c)
Less : Dividend Paid
Less : Transferred to General reserve
4. Debenture Redemption Reserve
5. Securities premium reserve
B. Other comprehensive income
Total other Equity
Total Equity
 LIABILITIES
Non-current liabilities
Secured loans (long term)
Un Secured loans (long term)
Deferred tax liabilities (Net)
Total non-current liabilities
Current liabilities
Loans and Advances
Trade payables (Creditors)
Financial Liabilities
Other Current liabilities
Provisions
Total current liabilities
Total Liabilities
Total Equity and
Liabilities

2. PROFIT & LOSS ACCOUNT (INCOME STATEMENT) :-

The Profit and loss account is prepared for the particular period with all
revenues and expenses of a firm to know the net profit or net loss. The
earning capacity of a firm is reflected by its income statement. It considers as
a measure of the firm.

The cost of the resources which are used to generate revenue during the
period of an accounting year i.e. one year is called an expenses. Expenses
may be in the form of cash payments (i.e. salaries, wages, rent, etc..) or an
amount taken out of earnings (i.e. bad debts) or an expired portion of an asset
(i.e. depreciation/amortization). Expenses are summarized and charged in the
profit and loss account as deductions from the gross profit.

Revenue is the amount of money that a firm received during the period of
time against the sale of goods and services rendered to outsiders (customers,
etc..). the discount received and deductions for returned merchandise by the
firm are also known as revenue.

Thus, the accounting system matches the expenses incurred during the time
of an accounting period against revenues generated during the same period.
This matching of expenses with revenue is called as matching concept.

Revenues and Expenses are sometimes categorized as operating and non-

operating.

Operating income (revenue) :-

The amount of profit arising from core operations (business) of a firm in an
accounting period is called as operating income. It is also known as Earnings
(profit) before interest and tax (EBIT). It can be arrived from the below
formula :-

EBIT = Revenue from sales – (cost of Goods Sold (COGS) + operating

expenses).

The operating income include gross proceeds from the sale of products
manufactured by a firm.

Operating expenses :-
The expenses which are incurred for core operating (business) activities of a
firm in an accounting period are called as operating expenses. These include
Cost of Goods Sold (COGS), wages, heat & electricity, general &
administrative expenses, selling & distribution expenses, depreciation and
amortization, etc.

Note :-
Depreciation/amortization is considered as an operating expense because it is
a periodic and scheduled conversion of a fixed asset in to an expense. Since
the fixed asset is a part of business operations, depreciation/amortization is
considered as operating expense.

Non-operating income :-
The amount of profit arising from sources which are not relating to the core
operations of a firm in an accounting period are called as non-operating
income. It includes the gains from investments, gains from sale of asset or
property, gains from foreign currency exchanged, interest received, dividend
received, etc.
Non-operating expenses :-
The amount of expense which are incurred by a firm that is un related to its
core operations in an accounting period are called as non-operating expenses.
These include interest paid, Income tax paid, and other non-operating costs,
etc.

Concept of profits :-
The different types of profits are given below :-

a. Gross profit :-
It is the difference between sale of goods and Cost of Goods Sold (COGS).
Here, Cost of goods sold means all the manufacturing cost of the goods sold.
But, unsold goods (stock) are called as assets (closing stock).

b. EBITDA :-
It is equal to the revenue minus all operating expenses except interest, taxes
and depreciation /amortization. EBITDA stands for Earnings (profit) before
interest, tax, depreciation and amortization.

c. Operating profit (EBIT) :-

it is the difference between gross profit and operating expenses. It measures
the performance of the firm’s operations without regard to the sources of
financing (i.e. debt or equity) and may include other income. EBIT stands for
Earnings (profit) before interest and tax.

d. Earnings (profit) before tax (EBT) :-

It is the difference between EBIT and interest charges. EBT may also include
the non-operating profit. Here, non-operating profit means non-operating
revenue minus non-operating expenses.

e. Earnings after tax (EAT):-

it is the difference between EBT and taxes. It is also known as Net profit. It
arrives by earnings before tax minus taxes.

f. Net operating profit after tax (NOPAT):-

It is arising by EBIT minus tax on EBIT. It can be say in formula as [EBIT (1
– tax rate)]. Alternately, it is equal to EAT + after tax interest.
The below profit & loss account or Income statement of ABC limited is for
reference :-

INCOME STATEMENT ( PROFIT & LOSS

ACCOUNT) of
ABC COMPANY LTD FOR FINANCIAL YEAR
ENDING DECEMBER, 2019
Amount
Particulars $ ($)
INCOME
Revenue from operations
Sale of Products (including Credit Sales of $ 180155) 265041
Other Income (Non-operating) 8709
Total Income 273750
LESS : EXPENSES
Cost of Material Consumed 164250
Purchase of Stock-in-Trade 5161
Changes in Inventories -4839
Manufacturing Expenses 18255
Excise duty of purchases 23016
Employee Benefits Expense 4434
Finance Costs (Interest, Bank charges etc…) 2723
Interest, Depreciation / Amortization Expense (Non- 8465
operating)
Office & Administration Expenses 1100
General Expenses 920
Selling & Distribution Expenses 8436
Charity & Donations / Corporate Social Responsibility 1052
(CSR)
Total Expenses 232973
Profit Before Tax 40777
Less :Tax Expenses 9352
Current Tax 8333
Deferred Tax 1019
Profit for the Year 31425
Earnings per equity share (EPS)
Basic (in $) ( 31425 / 324316853) 96.90
a. Weighted average number of equity shares is 324316853
avail
Diluted (in $) [ 31425 / (324316853+559307)] 96.73
a. Weighted average number of equity shares is 324316853
 avail
b. Weighted average potential equity shares of 559307

STATEMENT OF CHANGES IN FINANCIAL POSITION

The balance sheet gives a summary of assets (resources) and obligations
(owner’s equity and liabilities) on a particular date to know the financial
position of a firm. The income statement gives summary of income and
expenses for the specific period to know the results of the firm. But, both the
balance sheet and profit and loss account (income statement) are not gives
any information about the changes in assets, liabilities and owner’s equity
between two balance sheet dates. The balance sheet of a firm gives only a
static view of the assets (resources) and uses of finances, but, it does not
indicate the causes of changes in resources or movement of finances between
two balance sheet dates. The change in owner’s equity may be reflected
through income statement. For example, the owner’s equity may increase or
decrease due to investments of profits or withdrawn of profits.

Hence, in addition to the balance sheet and income statement, one more
additional statement is required to show the changes in assets (resources) and
obligations (owner’s equity and liabilities) between two balance sheet dates is
called as Statement of changes in financial position.

The statement of changes in financial position is prepared to know the below

:-

a. changes in assets, liabilities and owner’s equity resulting from financial

and investment transactions between two balance sheet dates.

b. the way in which the firm used its financial resources between two balance
sheet dates.

The state of changes in financial position is having two forms. They are :-
1. Funds flow statement
2. Cash flow statement

Now a day, the cash flow statement is an important statement of financial

reporting by firm. It is mandatory for a listed company to include the cash
flow statement in their annual reports.

1. FUNDS FLOW STATEMENT

Funds mean working capital which effect the current assets and current
liabilities. Flow means movement. The movement of working capital which
effect the current assets and current liabilities is called funds flow. The
statement which determine the information relating to the sources
(inflows)and uses (outflows or applications) of funds between the two
balance sheet dates is known as Funds flow statement. Here, working
capital means the difference between current assets and current liabilities i.e.
net working capital. Working capital determines the liquidity position of the
firm.

The working capital flow (or fund) arises when the net effect of a transaction
is increase or decrease the amount of working capital. Some transactions of
the firm may change net working capital (NWC) where as some transactions
are not. The transactions which are change the net working capital are items
of the profit and loss account. On the other hand, the transactions which are
not change the net working capital are both the current and non-current assets
and/or liabilities in the balance sheet.

For example :-
a. if the firm paid salaries to employees, then the journal entry for the
transaction is Salaries debit and Cash/bank (current asset) is credit. So, this
transaction is effecting of decreasing the net working capital as the cash/bank
(current asset) is out flow from the firm.

b. when the firm provide the depreciation for machinery, then, the
depreciation (expense) is debit and machinery (non-current asset) is credit.
Hence, this transaction would not affect the net working capital because both
the depreciation and machinery are not relating to the current assets or current
liabilities.
Note :-
Depreciation reduces the non-current (fixed) asset but, it does not increase or
decrease the working capital. Thus, the depreciation should be added to net
profit to determine the net flow of working capital from operations.

c. If payment made by the firm to its creditor of $500, then, creditor (current
liability) id debit for $500 and cash/bank (current asset) is credit for $500.
Hence, there is no effect in net working capital because both the creditor
(decreasing in current liabilities) and cash/bank (decreasing in current asset)
are decreased for $500.

d. if the firm received interest from bank, then, cash (current asset) is debit
and interest received (income) is credit. Hence, this transaction would effect
of increasing the net working capital because the current asset (cash) is
increasing in this transaction.

Forms of Funds flow statement :-

The statement of funds flow or the statement of changes in working capital is
the summary of the sources (inflow) and uses/applications (outflow)of
working capital. The funds flow statement is presented in the below two
forms ;-
a. Sources and uses of working capital which statement explains the causes
of changes in the amount of working capital between two balance sheet dates.
b. schedule of changes in working capital which statement shows the items
of changes in the working capital between two balance sheet dates.

Sources (inflow) of working capital :-

1. Funds from operations (Net profit)
2. Sale of Non-current assets :-
a. Sale of tangible fixed assets (Buildings, machinery etc.)
b. Sale of intangible fixed assets (Goodwill, copyrights etc.)
c. Sale of investments (Shares, bonds, debentures etc.)
3. Long-term financing :-
a. Long-term borrowings (Loans, bonds, debentures etc.)
b. issue of shares (equity and preference shares, etc.)
4. Short-term financing (loans from banks, FIs etc.)

Funds from operations :-

The main inflow (source) of working capital of a firm from operations is net
profit. All the expenses and losses which are not effecting the working capital
(either current asset or current liability) should be add to the net profit.
Similarly, the gain or loss from the sale of non-current asset should be
adjusted (add or less) with net profit.

As with Net profit, All the expenses including depreciation/amortization and

losses which are not effecting the working capital should be adjusted (add or
less) with net loss. Similarly, the gain or loss from the sale of non-current
asset should be adjusted (add or less) with net loss.

For example, in the case of depreciation/amortization, the

depreciation/amortization is not affect the working capital (either current
asset or current liability) because the journal entry for depreciation is
Depreciation/amortization (expense account) is debit and fixed asset (Non-
current asset account) is credit. So, it is not effecting the working capital due
to it is not a source of fund. Hence, the depreciation / amortization (expense)
should be add to net profit. If it is not added to net profit, then, the net
working capital is understated. Similarly, in the case of Gain (profit) from
sale of non-current (fixed) asset, it should be less from net profit because the
sale of non-current asset (Cash/bank account is debit and non-current asset
account is credit) which is effected the working capital is already recorded
separately as a source of working capital. The total inflow of cash/bank on
the sale of non-current assets are shown as a source of working capital. If it
should be not less from net profit, it will be recorded as twice as cash
realization from the sale of non-current asset includes gain. In the case of loss
from sale of non-current asset, the amount of loss should be added to the net
profit.

Uses (outflows or applications) of working capital :-

1. Funds from operations (Net loss)
2. Purchase of Non-current assets :-
a. Purchase of tangible fixed assets (Plant, machinery etc.)
b. Purchase of intangible fixed assets (Goodwill, patents etc.)
c. Purchase of long-term investments (Shares, bonds, etc.)
3. Redemption of redeemable preference shares
4. Repayment of long-term debt
5. Repayment of short-term debt
6. Dividend paid
Case :-
From the below balance sheet for the dates 31st Dec 2017 and 31st Dec 2016
and Profit & loss account for the accounting / financial year ending
December 2019 of ABC limited, prepare the funds flow statement.
Comparative Balance sheet of ABC limited
for the year ended 31st Dec 2019 & 31st Dec
2018
Change
Particulars 2019 ($) 2018 ($)
($)
Non-Current
Liabilities
Institutional loan 20,000.00 12,000.00 8,000.00
Debentures 100,000.00 110,000.00 -10,000.00
Total Non-Current
Liabilities 120,000.00 122,000.00 -2,000.00
Current Liabilities
Sundry Creditors 30,000.00 24,000.00 6,000.00
Salaries Payable 40,000.00 32,000.00 8,000.00
Provision for tax 25,000.00 22,000.00 3,000.00
Provision for dividend 35,000.00 31,000.00 4,000.00
Total Current Liabilities 130,000.00 109,000.00 21,000.00
Owner's Equity
Share Capital 200,000.00 100,000.00 100,000.00
Share premium 15,000.00 9,000.00 6,000.00
Reserves and Surplus 75,000.00 60,000.00 15,000.00
Total Equity 290,000.00 169,000.00 121,000.00
Total Funds (or
Liabilities) 540,000.00 400,000.00 140,000.00
Non-Current Assets
Land & Buildings 180,000.00 130,000.00 50,000.00
Plant & Machinery 190,000.00 170,000.00 20,000.00
Less : Accumulated
Depreciation -40,000.00 -35,000.00 -5,000.00
Total Non-Current
Assets 330,000.00 265,000.00 65,000.00
Current assets
Cash 50,000.00 40,000.00 10,000.00
Sundry Debtors 60,000.00 15,000.00 45,000.00
Closing stock 100,000.00 80,000.00 20,000.00
Total Current assets 210,000.00 135,000.00 75,000.00
Total Assets 540,000.00 400,000.00 140,000.00
 Profit and Loss account of ABC
limited
for the year ended 31st Dec 2019
Amount
Particulars
$ ($)
Sales 434,500.00
Less :- Cost of Goods Sold
(COGS) 150,000.00
284,500.00
Less :- Operating Expenses
General & Administrative
Expenses 40,000.00
Selling & Distribution
Expenses 20,000.00
Depreciation 15,000.00
Wages 25,000.00 100,000.00
Operating Profit (EBIT) 184,500.00
Add :- Gain on sale of plant 5,000.00
Earnings before Tax (EBT) 189,500.00
Less :- Income Tax 50,000.00
Earnings after Tax (EAT
or PAT) 139,500.00

Additional information :-

A. The plant cot of $40,000 (accumulated depreciation of $8,000) was sold

during the year.
b. The debentures of $20,000 were converted to share capital at par.
c. The firm declared a cash dividend of $25,000 and bonus shares of $15,000
during the year.
d. The firm issued additional shares of 3500 at par value of $10 per share and
at premium of $1 per share during the year.

Solution :-
Based on the above comparative balance sheet, we can prepare the below
balance sheet in order of working capital :-

Comparative Balance sheet of ABC limited

for the year ended 31st Dec 2019 & 31st Dec
 2018
Change
Particulars 2019 ($) 2018 ($)
($)
Current assets
Cash 50,000.00 40,000.00 10,000.00
Sundry Debtors 60,000.00 15,000.00 45,000.00
Closing stock 100,000.00 80,000.00 20,000.00
Total Current assets
(A) 210,000.00 135,000.00 75,000.00
Current Liabilities
Sundry Creditors 30,000.00 24,000.00 6,000.00
Salaries Payable 40,000.00 32,000.00 8,000.00
Provision for tax 25,000.00 22,000.00 3,000.00
Provision for dividend 35,000.00 31,000.00 4,000.00
Total Current
Liabilities (B) 130,000.00 109,000.00 21,000.00
Net Working Capital (
C) A-B 80,000.00 26,000.00 54,000.00
Fixed Assets
Land & Buildings 180,000.00 130,000.00 50,000.00
Plant & Machinery 190,000.00 170,000.00 20,000.00
Less : Accumulated
Depreciation -40,000.00 -35,000.00 -5,000.00
Net Fixed Assets (D) 330,000.00 265,000.00 65,000.00
Net Assets (E) C +
D 410,000.00 291,000.00 119,000.00
Owner's
(Shareholder's)
Equity
Share Capital 200,000.00 100,000.00 100,000.00
Share premium 15,000.00 9,000.00 6,000.00
Reserves and Surplus 75,000.00 60,000.00 15,000.00
Net worth (F) 290,000.00 169,000.00 121,000.00
Long-term Liabilities
Institutional loan 20,000.00 12,000.00 8,000.00
Debentures 100,000.00 110,000.00 -10,000.00
Total Non-Current
Liabilities (G) 120,000.00 122,000.00 -2,000.00
Capital Employed
(H) F + G 410,000.00 291,000.00 119,000.00

From the above balance sheet, we can prepare the below Funds flow
statement :-
 FUNDS FLOW STATEMENT OF ABC LIMITED
FOR THE YEAR ENDED 31st DECEMBER 2019
(A) Sources and uses of working capital
Amount
Particulars $ ($)
Sources (Inflow) of Funds :-
Working Capital from operations (see
Note 1) 147,500.00
Sale of Plant (see Note 2) 37,000.00
Institutional loan 8,000.00
Issuance of Ordinary Shares (See Note
3) 38,500.00
Total sources of Funds provided 231,000.00
Less :- Uses (outflow/application) of
Funds :-
Purchase of Land & Building (See
Note 4) 50,000.00
Purchase of Plant & machinery (See
Note 5) 60,000.00
Payment of Cash dividend (See Note
7) 25,000.00
Total uses of funds applied 135,000.00
Increasing in Working Capital 96,000.00

(B) Schedule of Changes in working capital

31-Dec-19 31-Dec-18 Changes ($)
Particulars
($) ($) Increase Decrease
Current Assets :-
Cash 50,000.00 40,000.00 10,000.00
Debtors 60,000.00 15,000.00 45,000.00
Closing stock 100,000.00 80,000.00 20,000.00
Total Current Assets (A) 210,000.00 135,000.00 75,000.00
Current Liabilities :-
Creditors 30,000.00 24,000.00 6,000.00
Salaries Payable 40,000.00 32,000.00 8,000.00
Provision for Tax 25,000.00 22,000.00 3,000.00
Provision for Dividend 35,000.00 31,000.00 4,000.00
total Current Liabilities (B) 130,000.00 109,000.00 21,000.00
Working Capital (A - B) 80,000.00 26,000.00
Increasing in working capital (as per
above statement) 96,000.00
96,000.00 96,000.00
Working Notes :-

Note 1 :-
Working Capital from operations:-
Amount
Particulars
($)
Net Profit 139,500
Add : Depreciation (5,000 in balance sheet + 8,000 in
adjustments) 13,000
152,500
Less : Gain on sale of plant 5,000
147,500

Note 2 :-
Sale of Plant :-
Amount
Particulars
($)
Plant sold for 40,000
Less : Accumulated
depreciation 8,000
32,000
Add : Gain on sale of plant 5,000
37,000

Note 3 :-
Shares issue :-
The shareholder’s equity has increased by $103,500 (100,000 + 3,500)
between two balance sheet dates. This increase inclusive of $ 15,000 of
retained earnings (increase in Reserves & Surplus), which has already taken
to calculation of “working capital of operations” (via adjusted in net income).
out of the remaining increase of $155,000 (Net profit), $20, represents the
debentures and $15,000 of bonus shares to shareholders. Both these items do
not affect the working capital. Therefore, the net increase in working capital
of $38,500 due to the following :-

Amount
Particulars
($)
Issuance of shares of 3,500 @ $10
each 35,000
Add : Share premium of 3,500
 shares of @ $1 3,500
38,500

Note 4 :-
Purchase of Land and buildings :-
In the absence of any information about depreciation and sale of Land and
buildings, the amount of $50,000 which is increased between two balance
sheet dates represents the net purchase.

Note 5 :-
Purchase of Plant & Machinery :-
If we consider the sale of plant of $40,000, the Plant & machinery should
have been reduced to $130,000 ($170,000 - $40,000) on 31st Dec 2019. But,
it has increased to $190,000. This implies that the firm must have acquired
additional plant and machinery of $60,000 ($190,000 - $130,000).

Note 6 :-
Conversion of debentures :-
The firm converted debentures of $20,000 in to equity shares. Where both the
accounts involved are non-current assets. Therefore, No working capital is
involved.

Note 7 :-
Payment of dividend :-
The company paid a cash dividend of $25,000. This is use of working capital.
However, the issuance of bonus shares of $20,000 did not reduce working
capital. Bonus shares represent the conversion of a portion of net profit in to
share capital. It is a book entry and does not involve use of the funds.

2. CASH FLOW STATEMENT

A statement summarizes where a company’s money (cash) came from
(inflow/cash receipts) and where it went (out flow or payments) is called as
Cash flow statement or statement of cash flow. It is also known as Statement
of changes in cash position. It is a standard financial statement along with the
Balance sheet and Profit & Loss account (Income statement). It is used for
short-run planning. It indicates the sources (inflow) and uses (out flow or
applications) of cash. It analyzes the changes in non-current accounts as well
as current accounts. Here, the term current accounts indicate current assets
and/or current liabilities. The cash flow statement indicates the changes in
cash position is to only record the inflow and outflow of cash and find out the
net change during the period. The amount received minus the amount paid
during the period is the cash balance at the end of given period.

Sources (inflows) of Cash :-

a. Profit from operations
b. Increasing in liabilities including debentures and bonds
c. Decreasing in assets except cash
d. Sale of shares

Uses (outflows or applications) of Cash :-

a. Loss from operations
b. Increase in assets except cash
c. Decrease in liabilities including redemption of debentures
d. Payment of Cash dividend

Change in Current assets :-

Increase in current assets is reduce the cash flow from operations whereas
decreasing in current assets is increase the cash flow.

Change in Current liabilities :-

Increase in current liabilities is increase the cash flow from operations
whereas decreasing in current assets is decrease the cash flow.

The cash flow statement can break the cash flows into three categories or
activities. They are :-

Operating activities :-
These activities include the day-to-day business operations like selling
products, purchasing inventory (goods), paying wages and operating
expenses etc. This section of statement is associated with the current assets
and current liabilities section of the balance sheet as well as the revenues and
expenses section of the income statement of the firm

Investing activities :-
These activities include buying and selling the assets like property and
equipment, lending money to others, collecting the principal and buying and
selling the investment and securities. This section of the balance sheet is
associated with long-term assets section of the balance sheet of the firm.

Financing activities :-
These activities include borrowing from creditors, repaying the loans, issuing
& purchasing stock, collecting money from owners & investors and payment
of cash dividend. This section of the statement is associated with long-term
liabilities section of the balance sheet of the firm.

The pro forma of Cash flow statement is as below :-

CASH FLOW STATEMENT OF ABC LIMITED

AS ON 31st DEC 2019
Amount
Particulars $ $ ($)
Cash flow from beginning of the year
(A) XXXXX
Cash flow from operating activities :-
Sources (inflow) of cash :-
Earnings before tax (EBT) XXXXX
Cash receipts from customers XXXXX
Interest received XXXXX
Trade & other receivables XXXXX XXXXX
Less :- Uses (outflow) of cash :-
Purchase of inventory XXXXX
General expenses XXXXX
Office & Administrative expenses XXXXX
Interest paid XXXXX
Income tax paid XXXXX XXXXX
Net cash flow from operating
activities (B) XXXXX

Cash flow from investing activities :-

Sources (inflow) of cash :-
Sale of tangible fixed assets (plant,
machinery etc.) XXXXX
Sale of intangible fixed assets (Goodwill,
patents etc.) XXXXX
Sale of equipment XXXXX
 Collection of principals and loans XXXXX
sale of investments and securities XXXXX
Dividend received XXXXX XXXXX
Less :- Uses (outflow) of cash :-
Purchase of tangible fixed assets (plant,
machinery etc.) XXXXX
Purchase of intangible fixed assets
(Goodwill, patents etc.) XXXXX
Purchase of equipment XXXXX XXXXX
Net cash flow from investing
activities ( C ) XXXXX

Cash flow from financing activities :-

Sources (inflow) of cash :-
Receipt from insurance of stock XXXXX
Borrowing from outsiders XXXXX
Long-term borrowings from banks and
FIs XXXXX XXXXX
Less :- Uses (outflow) of cash :-
Repurchase of stock XXXXX
repayment of long-term loans XXXXX
payment of dividends XXXXX XXXXX
Net cash flow from financing
activities (D) XXXXX
Net cash flow from operations (A + B
+ C + D) XXXXXX

STATEMENT OF CHANGES IN EQUITY (Retained earnings

statement) ;-
The amount of total profits left in the firm after dividends paid to its
shareholders (stockholders or stakeholders) are called as retained earnings.
Retained earnings are also known as Accumulated earnings (profits). These
earnings (profits) has been kept by the firm for internal use. These earnings
will be re-invested in the firm for various activities to promote growth and
development of business operations, and used to make payment against the
firm’s debt obligations, etc.

A statement of Retained earnings has to be appear as a separate statement or

as an inclusive of either a balance sheet or a profit & loss account (Income
statement) for a time period of an accounting year. The Retained earnings
statement is also known as “Statement of Changes in equity” or “statement of
owner’s (shareholders or stakeholders) equity”. This statement is prepared
with an accordance with Generally Accepted Accounting Principles (GAAP).
The purpose to prepare the Retained earnings statement is to improve the
market and investor confidence in the firm and used to analyze the firm’s
financial health for the specific period. The general calculation structure of
the retained earnings statement is s below :-

Opening balance of Retained earnings + net profit during the year –

Dividend paid during the year = Closing balance of retained earnings

The example of retained earnings statement of ABC limited as below :-

Retained earnings statement of ABC limited for the year ended 31st Dec 2019
Common Additional Retained Total
Particulars stock Paid-up earnings Shareholder's
@ $10 capital ($) ($) Equity ($)
Retained earnings at 31st Dec 2018 20,000 35,000 80,000 135,000
Add :- Net profit for the year ended
31st Dec 2019 25,000 25000
20,000 35,000 105,000 160,000
Less :- Dividend paid to its
shareholders for the year 2019 15,000 15000
Retained earnings at 31st Dec 2019 20,000 35,000 90,000 145,000

FINANCIAL STATEMENT ANALYSIS

Financial statement analysis (Financial analysis) is the process of identifying
the financial strengths and weaknesses of the firm by properly establishing
relationship in the items of financial statements (mainly from Balance sheet
and Income statement). The financial analysis is required to compare the
data with the help of items in financial statements to take effective economic
decisions by the management of the firm with regarding the financial position
and financial performance to become more useful to investors, shareholders,
managers and other outside interested parties. The main devices of financial
analysis are as below :-

1. Comparative analysis
2. Common size analysis
3. Trend analysis
4. Inter-firm analysis
5. Ratio analysis

1. Comparative (Horizontal) analysis :-

Comparison of two or more years’ financial data of a firm is known as
comparative statement analysis. This analysis is also known as Horizontal
analysis. This analysis is facilitated by showing changes between years in
both the currency value and in percentages form. This analysis indicates
change in amount as well as change in percentage. Comparison of data can be
done for balance sheet and income statement. The limitation of this analysis
is If the value in the first year (base year) is zero, then, change in percentage
cannot be indicated. It is the most popular analysis by the financial analysts.

The below comparative balance sheet and income statement of ABC limited
is for reference.

Comparative Balance sheet of ABC Limited

2019 2018 Increase/Decrease
Particulars
($) ($) $ %
Non-Current
Liabilities
Un secured loans from
Banks 3526.00 4256.00 -730.00 -17.15
Bonds 2156.00 1909.00 247.00 12.94
Debentures 2389.00 1897.00 492.00 25.94
Secured loans from
Banks 1562.00 2365.00 -803.00 -33.95
Total Non-Current
Liabilities 9633.00 10427.00 -794.00 -7.61
Current Liabilities
Sundry Creditors 1023.00 236.00 787.00 333.47
Short tern Bank
borrowings 597.00 459.00 138.00 30.07
Provisions 367.00 523.00 -156.00 -29.83
Total Current
Liabilities 1987.00 1218.00 769.00 63.14
Owner's Equity
Share Capital 4256.00 4125.00 131.00 3.18
Reserves and Surplus 1254.00 1259.00 -5.00 -0.40
Total Equity 5510.00 5384.00 126.00 2.34
 Total Funds (or
Liabilities) 17130.00 17029.00 101.00 0.59

Non-Current Assets
Tangible Fixed assets 5005.00 4589.00 416.00 9.07
Less : Accumulated
Depreciation -923.00 -859.00 -64.00 7.45
Intangible Fixed assets 4658.00 4256.00 402.00 9.45
Investments 2136.00 3254.00 -1118.00 -34.36
Total Non-Current
Assets 10876.00 11240.00 -364.00 -3.24
Current assets
Sundry Debtors 2389.00 3265.00 -876.00 -26.83
Closing stock 2897.00 368.00 2529.00 687.23
Short term loans &
Advances 968.00 2156.00 -1188.00 -55.10
Total Current assets 6254.00 5789.00 465.00 8.03
Total Assets 17130.00 17029.00 101.00 0.59

Comparative Profit & Loss account of ABC Limited

Increase /
2017 2016 Decrease
Particulars
($) ($)
$ %
Net Sales 11000.00 10500.00 500.00 4.76
Less : Cost of goods Sold 8250.00 8220.00 30.00 0.36
Gross Profit 2750.00 2280.00 470.00 20.61
Less : Admin & General
Expenses 1020.00 930.00 90.00 9.68
Operating Income 1730.00 1350.00 380.00 28.15
Add : Other Income 70.00 90.00 -20.00 -22.22
EBIT 1800.00 1440.00 360.00 25.00
Less : Interest 260.00 440.00 -180.00 -40.91
EBT (PBT) 1540.00 1000.00 540.00 54.00
Less : Taxes 180.00 110.00 70.00 63.64
EAT or PAT or Net profit 1360.00 890.00 470.00 52.81

Conclusion :-

a. Un secured loans from banks in the year 2019 are decreased by $730 from
$4256 in 2018 to $3526 which is net effect by 17.5%.

b. The closing stock of $2697 in 2019 from $ 368 in 2018 which is huge
increased by $2529 with 687.23%. this means the firm has made more
production in generating the stock of finished goods for the year 2019.

c. the net sales in 2019 was increased by $500 or 4.76% from the year 2018.

d. The gross profit in 2019 is increased by $470 or 20.6% from 2018.

e. the net profit in 2019 is increased by $470 or 52.81% from the previous
year of 2018.

2. Common size (vertical) analysis :-

The financial statements are prepared on common base percentages is known
as common size analysis or vertical analysis. This analysis indicates the
relation of each component to the whole.

Common size ratio = (Item of interest / reference item) x 100

The firm also can be compare to its industry to the whole. To compare to the
industry, the ratios are calculated for each firm in the industry and an average
for the industry is considered. The result is a quick overview of where the
firm stands in the industry with respect to key items in the financial
statements. The below common size balance sheet analysis and income
statement analysis are for reference :-
Common size Balance sheet of ABC Limited
Common size
2019 2018 %
Particulars
($) ($)
2019 2018
Non-Current
Liabilities
Un secured loans
from Banks 3,526.00 4,256.00 20.58 24.99
Bonds 2,156.00 1,909.00 12.59 11.21
Debentures 2,389.00 1,897.00 13.95 11.14
Secured loans
from Banks 1,562.00 2,365.00 9.12 13.89
Total Non-
Current
Liabilities 9,633.00 10,427.00 56.23 61.23
Current
Liabilities
Sundry Creditors 1,023.00 236.00 5.97 1.39
Short tern Bank
borrowings 597.00 459.00 3.49 2.70
Provisions 367.00 523.00 2.14 3.07
Total Current
Liabilities 1,987.00 1,218.00 11.60 7.15
Owner's Equity
Share Capital 4,256.00 4,125.00 24.85 24.22
Reserves and
Surplus 1,254.00 1,259.00 7.32 7.39
Total Equity 5,510.00 5,384.00 32.17 31.62
Total Funds (or
Liabilities) 17,130.00 17,029.00 100.00 100.00

Non-Current
Assets
Tangible Fixed
assets 5,005.00 4,589.00 29.22 26.95
Less :
Accumulated
Depreciation -923.00 -859.00 -5.39 -5.04
Intangible Fixed
assets 4,658.00 4,256.00 27.19 24.99
Investments 2,136.00 3,254.00 12.47 19.11
Total Non-
Current Assets 10,876.00 11,240.00 63.49 66.01
Current assets
Sundry Debtors 2,389.00 3,265.00 13.95 19.17
Closing stock 2,897.00 368.00 16.91 2.16
Short term loans
& Advances 968.00 2,156.00 5.65 12.66
Total Current
assets 6,254.00 5,789.00 36.51 33.99
Total Assets 17,130.00 17,029.00 100.00 100.00

Common size Profit & Loss account of ABC Limited

Common size
2019 2018 %
Particulars
($) ($)
2019 2018
Net Sales 11,000.00 10,500.00 100.00 100.00
Less : Cost of
goods Sold 8,250.00 8,220.00 75.00 78.29
 Gross Profit 2,750.00 2,280.00 25.00 21.71
Less : Admin &
General Expenses 1,020.00 930.00 9.27 8.86
Operating Income 1,730.00 1,350.00 15.73 12.86
Add : Other
Income 70.00 90.00 0.64 0.86
EBIT 1,800.00 1,440.00 16.36 13.71
Less : Interest 260.00 440.00 2.36 4.19
EBT (PBT) 1,540.00 1,000.00 14.00 9.52
Less : Taxes 180.00 110.00 1.64 1.05
EAT or PAT or
Net profit 1,360.00 890.00 12.36 8.48

Conclusion :-

a. The investments proportion has decreased from 19.11% to 12.47%.

b. The debtors were in 2018 are $3265, then, these are decreased to $2389.
This means the firm received more money from its customers.

c. the proportion of General and Administrative expenses are increased from

8.86% to 9.27% from the year 2018 to 2019. Hence, the management would
take the decision to control the payments against their expenses.

3. Trend Analysis :-
Trend analysis calculates the percentage change for one item (account) over a
period of time of two or more years of financial data. In this analysis, the
procedure followed is to assign the number 100 to items of the base year and
to calculate percentage (%) changes in each items of other years in relation to
the base year. This procedure is called as Trend analysis or Time series
analysis. This analysis indicates the direction of change between the items in
financial reports. The below Trend analysis (Time series analysis) of balance
sheet and income statement are for reference :-

Trend analysis Balance sheet of ABC Limited

2016 2017 2018 2019
Particulars
$ % $ % $ % $ %
Non-
Current
Liabilities
Un secured
loans from
Banks 3,526.00 100.00 4,256.00 120.70 4,400.00 124.79 2,256.00 63.98
Bonds 2,156.00 100.00 1,909.00 88.54 2,000.00 92.76 1,708.00 79.22
Debentures 2,389.00 100.00 1,897.00 79.41 1,899.00 79.49 1,698.00 71.08
Secured
loans from
Banks 1,562.00 100.00 2,365.00 151.41 2,456.00 157.23 2,145.00 137.32
Total Non-
Current
Liabilities 9,633.00 100.00 10,427.00 108.24 10,755.00 111.65 7,807.00 81.04
Current
Liabilities
Sundry
Creditors 1,023.00 100.00 236.00 23.07 255.00 24.93 256.00 25.02
Short tern
Bank
borrowings 597.00 100.00 459.00 76.88 489.00 81.91 458.00 76.72
Provisions 367.00 100.00 523.00 142.51 594.00 161.85 657.00 179.02
Total
Current
Liabilities 1,987.00 100.00 1,218.00 61.30 1,338.00 67.34 1,371.00 69.00
Owner's
Equity
Share
Capital 4,256.00 100.00 4,125.00 96.92 5,698.00 133.88 3,210.00 75.42
Reserves and
Surplus 1,254.00 100.00 1,259.00 100.40 2,654.00 211.64 2,393.00 190.83
Total Equity 5,510.00 100.00 5,384.00 97.71 8,352.00 151.58 5,603.00 101.69
Total Funds
(or
Liabilities) 17,130.00 100.00 17,029.00 99.41 20,445.00 119.35 14,781.00 86.29

Non-
Current
Assets
Tangible
Fixed assets 5,005.00 100.00 4,589.00 91.69 5,589.00 111.67 3,874.00 77.40
Less :
Accumulated
Depreciation -923.00 100.00 -859.00 93.07 -1,365.00 147.89 -700.00 75.84
Intangible
Fixed assets 4,658.00 100.00 4,256.00 91.37 4,896.00 105.11 4,256.00 91.37
Investments 2,136.00 100.00 3,254.00 152.34 3,874.00 181.37 1,879.00 87.97
Total Non-
Current
Assets 10,876.00 100.00 11,240.00 103.35 12,994.00 119.47 9,309.00 85.59
Current
assets
Sundry
Debtors 2,389.00 100.00 3,265.00 136.67 4,593.00 192.26 2,564.00 107.33
Closing
stock 2,897.00 100.00 368.00 12.70 590.00 20.37 458.00 15.81
Short term
loans &
Advances 968.00 100.00 2,156.00 222.73 2,268.00 234.30 2,871.00 296.59
Total
Current
assets 6,254.00 100.00 5,789.00 92.56 7,451.00 119.14 5,472.00 87.50
Total Assets 17,130.00 100.00 17,029.00 99.41 20,445.00 119.35 14,781.00 86.29

Index :-
Base year
Increase/decrease the % based on base year

Trend analysis Profit & Loss account of ABC Limited

2016 2017 2018 2019
Particulars
$ % $ % $ % $ %
Net Sales 11,000.00 100.00 10,750.00 97.73 12,000.00 109.09 11,400.00 103.64
Less : Cost
of goods
Sold 8,250.00 100.00 8,220.00 99.64 8,500.00 103.03 8,220.00 99.64
Gross Profit 2,750.00 100.00 2,530.00 92.00 3,500.00 127.27 3,180.00 115.64
Less :
Admin &
General
Expenses 1,020.00 100.00 900.00 88.24 920.00 90.20 930.00 91.18
Operating
Income 1,730.00 100.00 1,630.00 94.22 2,580.00 149.13 2,250.00 130.06
Add : Other
Income 70.00 100.00 80.00 114.29 105.00 150.00 101.00 144.29
EBIT 1,800.00 100.00 1,710.00 95.00 2,685.00 149.17 2,351.00 130.61
Less :
Interest 260.00 100.00 420.00 161.54 580.00 223.08 126.00 48.46
EBT (PBT) 1,540.00 100.00 1,290.00 83.77 2,105.00 136.69 2,225.00 144.48
Less :
Taxes 180.00 100.00 98.00 54.44 180.00 100.00 135.00 75.00
EAT or
PAT or Net
profit 1,360.00 100.00 1,192.00 87.65 1,925.00 141.54 2,090.00 153.68
 Index :-
Base year
Increase/decrease the % based on base year

Conclusion :-

a. The Reserves and surplus of the firm are huge increased from 2017
(100.40%) to 2018 (211.64%). Similarly, the tangible fixed assets also
increased from 2018 to 2019 are from $4589 to $5589.

b. the bonds were decreased from base year 2016 to 2017 from $2156 to
$1909. This implies the firm made payment against bonds.

c. The General & Administration expenses are increased every year based on
the base year of 2016.

d. the net profit was decreased from 2016 to 2017 was 87.65%, but, later, this
was increased to 141.54% and 153.68% for the years 2018 and 2019
respectively.

4. Inter-firm Analysis :-
The firm would like to know its financial standing among its major
competitors and the industry group. The analysis of the financial performance
of all firms in an industry and then comparison at a given point of time is
called as Inter-firm analysis. This analysis is known as cross section analysis.
To ascertain relative financial standing of a firm, its financial ratios are
compared either with its immediate competitors or with the industry average.
The below Inter-firm analysis (cross section analysis) is for reference :-

FINANCIAL DATA FOR MANUFACTURING COMPANIES

Company Amount in $
Name CE NW NS EBIT EBT EAT DIV
ABC 102,521.00 50,000.00 48,526.00 19,410.00 17,663.10 12,070.96 1,810.64
DEF 88,523.00 42,000.00 65,324.00 25,010.00 22,759.10 15,553.57 2,333.04
GHI 75,486.00 51,000.00 62,354.00 24,901.00 22,659.91 15,485.78 2,322.87
JKL 91,200.00 42,000.00 75,265.00 28,524.00 25,956.84 17,738.90 2,660.84
MNO 90,265.00 62,000.00 89,425.00 41,000.00 37,310.00 25,497.65 3,824.65
PQR 88,000.00 35,000.00 65,324.00 45,000.00 40,950.00 27,985.23 4,197.78
STU 78,698.00 47,000.00 57,869.00 23,085.00 21,007.35 14,356.42 2,153.46
 VW 74,128.00 32,000.00 52,691.00 21,008.00 19,117.28 13,064.75 1,959.71
XYZ 87,211.00 41,000.00 78,005.00 30,256.00 27,532.96 18,816.02 2,822.40

Index :-
CE Capital Employed
NW Net worth
NS Net Sales
EBIT Earnings before Interest and Tax
EBT Earnings before Tax
EAT Earnings after tax or Net Profit
DIV Dividend paid

FINANCIAL RATIOS FOR

MANUFACTURING COMPANIES
RATIOS
Company
Name NP CE TO EBIT /
ROE
Margin NW NS
ABC 24.88 0.39 2.05 40.00
DEF 23.81 0.60 2.11 38.29
GHI 24.84 0.49 1.48 39.93
JKL 23.57 0.68 2.17 37.90
MNO 28.51 0.66 1.46 45.85
PQR 42.84 1.29 2.51 68.89
STU 24.81 0.49 1.67 39.89
VW 24.80 0.66 2.32 39.87
XYZ 24.12 0.74 2.13 38.79

Index :-
NP Net Profit
Margin margin
Return on
ROE Equity
CE to
NW Capital employed to Net worth ratio
EBIT/NS Operating profit Ratio

Conclusion :-

a. the capital employed of ABC limited is showing $102,581 which is highest

CE among all its competitors.
b. the VW limited CE is lowest comparing to all companies in the
manufacturing industry.

c. The MNO limited having the more net profit (EAT) of $25497.65 whereas
the ABC limited having very less net profit of $12090.76 comparing to all
firms in industry.

d. the PQR limited has paid more dividend of $4197.78 to its shareholders.

e. The operating profit ratio of 68.89% showing for the PQR limited which is
the top in industry.

f. The GHI limited and STU limited has recorded lowest Return on Equity
(ROE) of 0.49 .

g. The PQR limited has been traded the net profit margin of 42.84% as
highest in the industry comparing to all competitors.

Hence, based on the above inter-firm analysis, we conclude that the PQR
limited is financially good health to its shareholders to invest in the firm.

FAQs

1. What is the Annual Report :-

The report made by the directors/chairman or manager of a firm to its
shareholders at the end of each accounting year is called annual report which
contains the main reports such as :-
a. Director’s report (chairman’s report) which is outlining a review of the
firm’s operations during an accounting year, a summary of its financial
results and future projections if any.
b. Auditor’s report given by registered auditors of the firm
c. Balance sheet to know the financial position of the firm
d. Income statement to know the financial performance of the firm.
e. Cash flow statement to know the inflow and outflow of cash of the firm
f. Other supporting documents if any, and notes to the statements providing
details for various items.
All the public companies must be preparing the annual report to give detailed
financial and operational information of the firm to its shareholders. The
annual report has to contain a brief description of the firm's business in recent
year, current market price of the firm's stock and dividends paid, etc. The
auditor's has to confirm the accuracy of the firm's financial statements. In the
auditor's report, the auditor will include a statement i.e. the firm's financial
statements are fair and accurate. That statement is called an "unqualified
opinion”. If the auditor does not give an "unqualified opinion", the readers of
the annual report should regard the statements with suspicion.

2. What is Annual general meeting (AGM) :-

The gathering of the directors and shareholders (stock holders) of every
incorporated firm, required by law to be held each accounting year is called
as Annual general meeting (AGM). Generally, not more than 15 months are
allowed to elapse between two AGMs. The firm has to give a written notice
to its shareholders 21 days prior to the AGM. The main purpose of an AGM
is to comply with legal requirements such as :-
a. Presentation and approval of the audited accounts
b. Selection of directors of the firm.
c. Appointment of auditors for the new accounting year

other items that may also be discussed include :-

a. Compensation of officers
b. Confirmation of proposed dividend
c. issues raised by the stockholders, etc.
d. Proposed amendments to the constitution if any, etc.

3. What are the four basic financial statements?

The financial statements are containing of four basic reports. They are :-
i. Income statement
ii. Balance sheet
iii. Statement of cash flows
iv. Statement of retained earnings

4. What is the order of financial statements?

Financial statements have to be prepared in the below order because, the
information in one statement is needed for the next statement. The
preparation of order of financial statements is :-
1. Income statement,
2. Statement of retained earnings,
3. Balance sheet,
4. Cash flow statement, and
5. Notes to the items in financial statements.

5. How do we prepare the financial statements?

The following below steps to prepare the financial statements :-
a. Close the revenue accounts. Prepare one journal entry that debits all the
revenue accounts. ...
b. Close the expense accounts. Prepare one journal entry that credits all the
expense accounts. ...
c. Transfer the income summary balance to a capital account. ...
d. Close the drawing account.

6. What are the users of financial statements?

i. The most common users of financial statements are :-
ii. Management of the firm
iii. Employees
iv. Creditors
v. Debtors
vi. Competitors
vii. Investors
viii. Lenders
ix. Investment analysts
x. Government

7. What are the elements of financial statements?

i. Assets
ii. Liabilities
iii. Equity
iv. Income
v. Expense
------------ End of the CHAPTER – 8 ----------

CHAPTER – 9
FINANCIAL RATIO ANALYSIS

Learning objectives
After studying this chapter, you can be able to :-
1. Use a company’s financial statements to calculate financial
ratios,
2. Describe the use of financial ratios to get useful information
from financial statements,
3. Know the advantages and disadvantages of Ratio analysis, and
4. Evaluate a firm’s financial position through Ratio analysis.

A. FINANCIAL ANALYSIS
Financial analysis is the process of identifying the strengths and weaknesses
of the firm by properly establishing relationship between the items of balance
sheet and items of income statement. In other words, Financial analysis is a
process which involves reclassification and summarization of information
through the establishment of ratios and trends.
The financial analysis can be done through the following devices :-
(i) Comparative statement (analysis),
(ii) Common size statement (analysis),
(iii) Trend analysis,
(iv) Intra-firm analysis,
(v) Funds flow statement,
(vi) Cash flow statement, and
(vii) Ratio Analysis.
B. RATIO ANALYSIS
One of the techniques of analysis of financial statements is calculate Ratios.

Meaning of Ratio :-
A ratio is the simple numerical or arithmetical relationship between two
numbers. Ratio analysis is a powerful tool of financial analysis. In financial
analysis, Ratio is used as a benchmark for evaluating the financial position
and financial performance of a company.

The ratios computed in the process of financial analysis, and it may be

expressed in any of the following four types :-

(a) In multiples :-
In this case, the result of ratio can be expressed in terms of ‘times’. For
example, we can express the P/E ratio in ‘times’.

(b) In time element :-

In this case, the result of ratio can be expressed in terms of ‘months’ or
‘days’. For example, we can express the Debtors turnover in months or days.

(c) In proportion :-
Ratios can also be expressed in the form of ‘proportion’ between the two
figures. For example, Current ratio expressed in the form of 2 : 1

(d) In percentage :-
In this case, the result of ratio can be expressed in terms of ‘percentage’. For
example, we can express the gross profit margin in percentage.

Advantages of Ratio Analysis :-

The most uses of ratios are as below :-
(i) Comparison of past data,
(ii) Comparison of one firm with another,
(iii) Comparison of one firm with industry,
(iv) Comparison of an achieved performance with pre-determined standards,
(v) Comparison of one department of a concern with another department,
(vi) Detailed information of financial analysis can be expressed in simple
way,
(vii) Financial position and performance of a firm can be judged through the
Ratio analysis,
(viii) Efficiency of management can be explained through ratios,
(ix) Help in planning and forecasting, and
(x) Help in controlling the expenses and liabilities.

Disadvantages of Ratio analysis :-

The disadvantages of Ratio analysis are as below :-
(i) Standards for comparison,
(ii) Change of Price levels,
(iii) Change in situations,
(iv) Historical data,
(v) Dependence on financial statements,
(vi) Only quantitative analysis, and
(vii) Linkage among different contradictory figures.

C. CLASSIFICATION OF FINANCIAL RATIOS :-

Accounting Ratios are classified as under :-
A. On the basis of importance,
B. On the basis of users,
C. On the basis of Sources or financial statements,
D. On the basis of functions or purposes,

The ratios based on the basis of Sources or financial statements are grouped
in to 3 categories. They are :-

I. Balance sheet Ratios

II. Income Statement Ratios
III. Mixed or Combined Ratios

Case :-
Observe the below financial statements (Balance sheet and Income
statement), and Reference Notes available in annual reports of ABC company
limited for the financial year ended December 2019.

(A) Balance sheet :-

 BALANCE SHEET of ABC COMPANY LTD AS AT 31st DECEMBER 2019
₹ Amount
Particulars Note (in (₹ in
millions) millions)
I EQUITY AND LIABILITIES
(1) Shareholder's funds 36737.40
(a) Share capital (equity) (Shares of 96420000 @ ₹10 each) 964.20
(b) Other equity 1 35773.20
(c) Money received against share warrants -
(2) Share application money pending allotment -
(3) Non-Current liabilities 25593.90
(a) Financial liabilities
(i) Secured loans (12% per annum, repayable in 10 equal
204.20
annual instalments)
(ii) Un secured loans (Interest free, repayable after 8 years
147.20
from the year of deferment)
(b) Borrowings (long service awards, ceremonial gifts, pension &
24649.20
Gratuity, of employees, etc.)
(c) Deferred tax liabilities (net) [Provision] 2 588.20
(d) Other Non-current liabilities (Deferred Government grants) 5.10
(4) Current liabilities 18549.50
(a) Financial liabilities
(i) Trade payables
Outstanding dues of Banks and Financial institutions 107.70
Outstanding dues of Creditors 12296.00
(ii) Other financial liabilities
Payables for capital expenditure 469.80
Customer credit balances and payables 1082.00
Employees cost and Reimbursement 1379.60
Bank over draft 0.90
Un paid Dividend 112.90
Security deposits 60.60
Derivative liabilities - Forward contracts 56.00
(b) Provisions (Pension, incentives and welfare benefits of
1572.60
employees)
(c) Other current liabilities
(i) Statutory liabilities 519.10
(ii) Advance from customers 407.90
(iii) Others 484.40
TOTAL EQUITY AND LIABILITIES 80880.80

II ASSETS
(1) NON CURRENT ASSETS
(a) Fixed assets 25058.20
 (i) Property, plant and equipment (Net Fixed assets i.e. after
3 24006.20
depreciation)
(ii) Capital work-in-progress 1052.00
(iii) Intangible assets -
(iv) Intangible assets under development -
(b) Financial investments 7735.00
(i) Investments (Tax free bonds, Fair value through other
7333.60
comprehensive income, etc.)
(ii) Loans - long term
Secured loans to Employees 1.10
Un secured loans 72.80
Security deposits 327.50
(c ) Deferred tax asset (net) -
(d) Other non-current assets 718.10
(i) Capital advances 28.60
(ii) Payments under protest with government authorities 689.50
Total Non-current assets 33511.30
(2) CURRENT ASSETS
(a) Financial assets 37301.60
(i) Investments
Treasury bills - Government securities 11668.20
Certificate of deposits with banks 1341.50
Commercial papers 1495.80
Short term bonds 846.20
Mutual funds - Debt 3899.60
(ii) Trade receivables 1245.90
(iii) Cash and cash equivalents
Balances with banks (Current accounts) 188.30
Balances with banks (Deposit accounts) 15691.20
Cheques, drafts on hand including remittances in transit 108.20
(iv) Unpaid dividend accounts 112.90
(v) Loans and advances
Secured loans to Employees 1.20
Un secured loans 29.30
Security deposits 148.40
(vi) Other financial assets
Recoverable from related parties 77.50
Derivative assets - forward contracts 46.80
Interest accrued on bank deposits / tax free long term
391.30
bonds, etc.
Others 9.30
(b) Inventories (At cost, or Net realisable value, whichever is
9655.50
less)
 (i) Raw material 3235.60
(ii) Packing material 378.70
(iii) Work-in-progress 1132.60
(iv) Finished goods 3873.80
(v) Stock-in-trade (Goods purchased for resale) 364.00
(vi) Stores and spares 670.80
(c) Current tax assets 188.50
(d) Other current assets 223.90
Advances given to Suppliers, Employees, etc. 116.10
Balances with government authorities 31.00
Prepaid expenses 76.80
Total Current assets 47369.50
TOTAL ASSETS 80880.80

(B) Income Statement (P/L A/c) :-

INCOME STATEMENT of
ABC COMPANY LTD FOR THE FINANCIAL YEAR ENDED 31st DECEMBER 2019

₹ Amount
S.No Particulars Note (in (₹ in
millions) millions)
I Revenue from operations 112922.70
(a) Sale of Products (inclusive of Credit sales of ₹ 34750.00
4
millions)
(i) Domestic sales 105075.40
(ii) Export sales 7086.90
Total Sales 112162.30
(b) Other operating revenue (Export incentives and Scrap
760.40
sales, etc.)
II Other income 2589.20
(a) Interest (on Bank deposits, Investments and Employee
1929.20
loans, etc.)
(b) Interest on tax free long term bonds 474.60
(c) Dividend on Mutual funds 183.80
(d) Net gain on financial assets at fair value through profit &
1.60
loss
III Total Income (I + II) 115511.90
IV Expenses 91222.40
(a) Cost of material consumed
(i) Raw material 35986.60
 (ii) Packing material 7670.20
(b) Purchase of stock-in-trade 2305.60
(c) Changes in inventories of finished goods, work-in-progress
5 -60.10
and stock-in-trade
(d) Employee benefits expenses
(i) Salaries, Wages, Bonus, Pension, Performance
9654.00
incentives, etc.
(ii) Contribution to provident fund and other funds 857.90
(iii) Share based payments 117.00
(iv) Staff welfare expenses 612.60
(e) Interest cost (Interest and instalments on loan)
(i) Interest cost on Employee benefit plans 1079.00
(ii) Interest on Bank overdraft and others 40.50
(f) Depreciation and Amortization 3 3356.70
(g) Impairment loss on property, plant and equipment 3 110.80
(h) Manufacturing expenses -
(i) Excise duty -
(j) Other expenses 6 28181.10
(k) Net provision for contingencies
Operations 621.70
Others 415.10
(l) Corporate social responsibility (Charity & Trust, etc.) 273.70
Profit / loss before exceptional and extraordinary items and tax
V 24289.50
(III - IV)
VI Less : Exceptional items
VII Profit / loss before extraordinary items and tax (V - VI) 24289.50
VIII Less : Extraordinary items
IX Profit / loss before tax (VII - VIII) 24289.50
X Less : Tax expense 8220.20
(a) Current Tax
(i) Current year tax (Profit before tax of ₹ 24,289.50 @
8464.90
34.85%)
(ii) Additional allowances Net 422.50
Less : Exempted tax -38.70
8848.70
(b) Deferred Tax 2 -628.50
Profit / loss after tax for the period from continuing
XI 16069.30
operations (IX - X)
XII Other comprehensive income -404.10
(a) (i) Items that will not be reclassified to profit or loss
Re-measurement of retiral defined benefit plans -464.00
Changes in fair value of equity instruments -100.00
(ii) Income taxes relating to items that will not be
162.00
reclassified to P/L
 -402.00
(a) (i) Items that will be reclassified to profit or loss
Changes in fair value of cash flow hedges -3.20
(ii) Income taxes relating to items that will be reclassified
1.10
to P/L
-2.10
XIII Total Comprehensive Income (XI + XII) 15665.20
XIV Weighted average number of equity shares outstanding (No.s) 96420000
Weighted average number of potential equity shares
XV 550000
outstanding (No.s)
XVI Earnings per equity share
(a) Basic (XI / XIV) 166.66
(b) Diluted [XI / (XIV + XV)] 165.71

Additional information :-
(i) Manufacturing cost of ₹ 52800 million.
(ii) Variable cost of ₹ 1.6 million.
(iii) Current market price of ABC company is traded at stock exchange as ₹ 103.86

C. Reference Notes :-

1. OTHER EQUITY :-

Reserves and Surplus OCI

(₹ in millions) (₹ in millions)
Effective Total
S.No. Particulars Equity portion (₹ in
Capital General Retained Instrument of millions)
Reserve Reserve earnings through cash
OCI flow
hedges
Balance as at 31st
I 4000.00 4374.30 25054.50 -200.00 12.90 33241.70
December 2018
II Profit after tax 16069.30 16069.30
Less : Other
III -302.00 -100.00 -2.10 -404.10
comprehensive income
Total Comprehensive
IV 15767.30 15665.20
Income (II - III)

Dividend :
V (i) Interim Dividend 8677.40 8677.40
VI (ii) Final Dividend 2217.60 2217.60
Total Dividend (V +
VII 10895.00 10895.00
VI)
 Dividend distribution
VIII 2238.70 2238.70
tax
Total appropriation
IX 13133.70 13133.70
(VII + VIII)
Balance as at 31st
X December 2019 (I + 4000.00 4374.30 27688.10 -300.00 10.80 35773.20
IV - IX)
OCI : Other Comprehensive Income

2. MOVEMENT IN DEFERRED TAXES:-

Amount (₹ in millions)
Recognised
S. in the Recognised
Particulars Opening Statement in Other Closing
No.
Balance of Comprehensive Balance
Profit and Income
loss
Deferred tax Liabilities
(i) Property, Plant and Equipment 2533.50 -154.40 0.00 2379.10
(ii) Inventories 208.70 -208.70 0.00
(iii) Financial instruments 12.40 -3.10 -1.10
I Total Deferred tax Liabilities 2754.60 -366.20 -1.10 2387.30

Deferred tax Assets

(i) Contingencies 1143.80 232.70 0.00 1376.50
(ii) Employee benefits (Compensated
331.90 25.90 1.80 359.60
absences and Gratuity)
(iii) Allowances for credit impaired assets
20.60 0.50 0.00 21.10
and Trade receivables
(iv) Other items deductible on payment 38.70 3.20 0.00 41.90
II Total Deferred tax Assets 1535.00 262.30 1.80 1799.10

III Deferred Tax Liabilities (Net) (I - II) 1219.60 -628.50 -2.90 588.20

3. PROPERTY, PLANT AND EQUIPMENT :-

4. SALE OF PRODUCTS
Amount
Quantity
Particulars (₹ in
(MT)
millions)
Milk products and Nutrition (includes dairy whitener, Condensed milk, Yoghurt,
137066 51876.30
health care nutrition, etc.)
Prepared dishes and Cooking aids (includes noodles, sauces, Pasta, Cereals, etc.) 240879 31052.50
Powdered and Liquid beverages (includes instant coffee, instant tea, ready to
27013 15226.10
drink beverages)
Confectionery (includes bar count lines, tablets and sugar confectionary) 42197 14007.40
Total Sales (Domestic and Exports) 447155 112162.30

5. CHANGES IN INVENTORIES OF FINISHED GOODS, WORK-IN-PRODRESS AND STOCK-

IN-TRADE :-
Amount
S.
Particulars (₹ in
No.
millions)
Opening stock
(i) Finished goods 3881.70
(ii) Work-in-progress 1148.10
(iii) Finished goods 280.50
I Total Opening stock 5310.30

Closing stock
(i) Finished goods 3873.80
(ii) Work-in-progress 1132.60
(iii) Finished goods 364.00
II Total Closing stock 5370.40
 Net increase / Decrease in Opening stock and
III -60.10
Closing stock (I - II)

6. OTHER EXPENSE :-
Amount
Particulars (₹ in
millions)
Finished goods handling, transportation and
5256.00
Distribution
Advertising and Sales promotion (Selling and
7294.40
Distribution expense
General expense 500.00
Administration expense 450.00
Finance cost (Bank charges, etc.) 50.00
Power and Fuel 3441.80
General licence fee (net of taxes) 4926.50
Information technology and Management Information
840.60
Systems
Repairs and maintenance 925.30
Rates and Taxes 75.00
Travelling 799.30
Rent 560.30
Contract manufacturing charges 364.30
Consumption of Stores and spare parts 538.80
Training 490.20
Withholding tax on General licence fee 492.60
Laboratory (Quality testing) 214.20
Market Research 301.80
Milk collection and District development 156.40
Security charges 133.90
Exchange difference (Net) 134.70
Deficit / Surplus on fixed assets sold / scrapped /
-10.30
written off (Net)
Insurance 53.80
Miscellaneous 191.50
Total Other expenses 28181.10

Based on the above financial statements and important Reference notes

forming part of the financial statements, you are required to evaluate each
ratio and give necessary comment or advice to the company.
Solution :-
The below profitability statement based on above financial statements will
help to evaluate some ratios.

Profitability statement :-

PROFFITABILITY STATEMENT OF ABC COMPANY LTD AS AT

31st DECEMBER 2019
₹ Amount
Particulars (in (₹ in
millions) millions)
Sale of Products (including Credit Sales of ₹ 37377
112922.70
million )
Less : Cost of Goods Sold (COGS) :- 45902.30
Cost of Material Consumed 43656.80
Purchase of Stock-in-Trade 2305.60
Changes in Inventories -60.10
Manufacturing Expenses 0.00
Excise duty of purchases 0.00
Gross Profit 67020.40
Add : Non-operating income (other income) 2589.20
69609.60
Less : Operating expenses (Indirect) :- 40843.90
Employee Benefits Expense 11241.50
Impairment loss on property, plant and
110.80
equipment
Other expenses 28181.10
Net provision for contingencies
(i) Operations 621.70
(ii) Others 415.10
Corporate social responsibility (Charity &
273.70
Trust, etc.)
Operating profit (EBIDT) 28765.70
Less : Interest (Non-operating expense) 1119.50
EBDT (Earnings before Depreciation and Taxes) 27646.20
Less : Depreciation and Amortisation Expense
3356.70
(Non-operating expense)
Profit before Tax (EBT) 24289.50
Less : Taxes 8220.20
(a) Current Tax 8848.70
(b) Deferred Tax -628.50
Net Profit or Profit after Tax (EAT) 16069.30
Analyze the below ratios based on above reports :-

I . BALANCE SHEET RATIOS :-

If both the components of a ratio can be taken from items of Balance sheet, it
is considered as Balance sheet ratios. The following Balance Sheet Ratios are
commonly used for financial statement analysis :-

1. CURRENT RATIO :-

It is a quick measure of the firm’s short term liquidity.

Current Ratio = Current Assets / Current Liabilities

Here :-
Current Assets mean the assets which are converted in to cash within a short period of one year i.e.
Cash-in-hand, Cash-at-bank, Closing Stock, Sundry Debtors, Bills Receivable, Prepaid Expenses,
Advances given and Marketable Securities (Trade investment).

Current Liabilities mean the liabilities which are repayable within a short period of one year i.e.
Sundry Creditors, Bills Payable, Outstanding Expenses, Income tax liability, Proposed Dividend, Bank
Over Draft and Long term debt maturing in the current year.

This ratio indicates the ability of current assets in rupees for every one rupee
of current liabilities.

Standard norm :- 2 : 1 (For every one rupee of current liabilities,

current assets should be two rupees)

A higher the ratio is favorable which indicates a good liquidity and

satisfactory debt repayment capacity of the firm.

A lower this ratio than standard indicates a bad liquidity, over trading, less
working capital and un satisfactory debt repayment capacity of the firm.

The investment of a creditors in a firm having a low current ratio may not be
too safe.
NOTE :
In case of recession, the firm may have large unsold stock and long outstanding debtors. This would
increase current assets and result in a high current ratio. But, in this case, the trend indicated by the high
current ratio may not stand favorable for the firm.

Interpretation :-
Current Assets (See Balance
sheet) :-
₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial assets 37301.60
(i) Investments 19251.30
(ii) Trade receivables 1245.90
(iii) Cash and cash
15987.70
equivalents
(iv) Unpaid dividend
112.90
accounts
(v) Loans and advances 178.90
(vi) Other financial assets 524.90
(b) Inventories (Closing stock) 9655.50
(c) Current tax assets 188.50
(d) Other current assets 223.90
Total Current assets 47369.50

Current Liabilities (See Balance sheet, Income statement) :-

₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial liabilities 15565.50
(i) Trade payables 12403.70
(ii) Other financial liabilities (including Bank Over draft
3161.80
and un-paid Dividend)
(b) Provisions 1572.60
(c) Other current liabilities 1411.40
(d) Income tax 8220.20
Total Current Liabilities 26769.70

Current Ratio = 47369.50 / 26769.70 = 1.7695 times

Conclusion : The ABC company is having low current ratio. It is having ₹

1.77 of current assets for every one rupee of current liabilities. It is near to the
ideal norm.

2. LIQUID / QUICK / ACID TEST RATIO :-

It is used to measure short term liquidity of the firm.

Just as gold is tested through acid solution, the trend indicated by the current
ratio is verified by the Quick ratio. For this reason, Quick / Liquid ratio is
also called as Acid Test Ratio.

Quick Ratio = Quick Assets / Quick Liabilities

Here :-
Quick Assets = Current assets – (Closing Stock + Prepaid Expenses)

Quick Liabilities = Current liabilities – Bank Over Draft (Short term and not payable on demand)

It indicates an immediate ability to pay off its current liabilities.

Stand norm :- 1 : 1 (For every 1 rupee of Quick liabilities, Quick assets

should be 1 rupee)

A Quick ratio is considered to be a better test of liquidity than Current ratio.

But, Quick ratio itself may not be taken as a conclusive test of liquidity.

A high Quick ratio along with a higher Current ratio is favorable which
indicates a good short term liquidity and debt repayment capacity of the firm.

Even if the Current ratio is high, a low Quick ratio does not indicate a good
debt repayment capacity of the firm.

A company with a high value of Quick ratio can suffer from the shortage of
funds if it has slow paying, doubtful and long duration outstanding debtors.

Interpretation :-

Current Assets (See Balance

sheet) :-
 ₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial assets 37301.60
(i) Investments 19251.30
(ii) Trade receivables 1245.90
(iii) Cash and cash
15987.70
equivalents
(iv) Unpaid dividend
112.90
accounts
(v) Loans and advances 178.90
(vi) Other financial assets 524.90
(b) Inventories (Closing stock) 9655.50
(c) Current tax assets 188.50
(d) Other current assets 223.90
Total Current assets 47369.50

Current Liabilities (See Balance sheet, Income statement) :-

₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial liabilities 15565.50
(i) Trade payables 12403.70
(ii) Other financial liabilities (including Bank Over draft
3161.80
and un-paid Dividend)
(b) Provisions 1572.60
(c) Other current liabilities 1411.40
(d) Income tax 8220.20
Total Current Liabilities 26769.70

Quick Ratio = [47369.50 – (9655.50 + 76.80)] / (26769.70 – 0.90)

= [47369.50 – 9732.30) / (26769.70 – 0.90)
= 37637.20 / 26768.80
= 1.406 times

Conclusion : The ABC company is having good Quick ratio. It is having ₹

1.41 of Quick assets for every one rupee of Quick liabilities. It is meeting the
ideal norm also.
3. CASH / CASH POSITION / ABSOLUTE LIQUID RATIO :-

It is used to measure the Cash or capital position of the firm.

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

or

Cash Ratio = (Quick Assets - Debtors) / Quick liabilities

It is only a supporting ratio used with Current ratio and Quick ratio. It is
never used as a single test.

Standard norm :- 0.5 : 1 (For 0.50 rupee of cash, Quick liabilities of 1

rupee)

A high Cash ratio along with Current ratio and Quick ratio than
standard is favorable to indicate good short term liquidity of the firm.

Even if the Current ratio and quick ratio are having a higher than standard, A
low Cash ratio indicates the debt repayment capacity of the firm is not sound.

A Cash ratio very higher than standard indicates the holding of un necessary
cash or other assets which are equivalent to cash. In other words, a very
higher cash ratio is an indicator of holding un productive assets.

Interpretation :-

Current Assets (See Balance

sheet) :-
₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial assets 37301.60
(i) Investments 19251.30
(ii) Trade receivables 1245.90
(iii) Cash and cash
15987.70
equivalents
(iv) Unpaid dividend
112.90
 accounts
(v) Loans and advances 178.90
(vi) Other financial assets 524.90
(b) Inventories (Closing stock) 9655.50
(c) Current tax assets 188.50
(d) Other current assets 223.90
Total Current assets 47369.50

Current Liabilities (See Balance sheet, Income statement) :-

₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial liabilities 15565.50
(i) Trade payables 12403.70
(ii) Other financial liabilities (including Bank Over draft
3161.80
and un-paid Dividend)
(b) Provisions 1572.60
(c) Other current liabilities 1411.40
(d) Income tax 8220.20
Total Current Liabilities 26769.70

Quick Ratio = [47369.50 – (9655.50 + 76.80) – 1245.90] / (26769.70 – 0.90)

= [47369.50 – 9732.30 – 1245.90) / (26769.70 – 0.90)
= 36391.30 / 26768.80
= 1.359 times

Conclusion : The ABC company is having sound Cash ratio. It is having

₹1.36 which is more than the standard norm.

4. DEFENSIVE INTERVAL / INTERVAL MEASURE RATIO :-

It is used to measure the firm’s capacity to meet its daily cash expenses.

Interval measure ratio = Total Defensive or Quick Assets / Average Daily

operating Expenses or Projected Daily cash requirements

Here :-
Quick Assets = Current assets – (Closing Stock + Prepaid Expenses)

Average Daily operating expenses = (Cost of Goods Sold (COGS) + Selling & Administrative expenses
+ General Expenses – Depreciation) / 360

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

This ratio is not a measure of short term debt repayment capacity of the firm,
rather, it measures the firm’s capacity to pay off its immediate cash needs
without resorting to sales realized.

A higher the ratio is favorable to meet its day-to-day cash expenses.

Interpretation :-

Amount
Particulars (₹ in
millions)
Cost of Material Consumed 43656.80
Purchase of Stock-in-Trade 2305.60
Changes in Inventories -60.10
Manufacturing Expenses 0.00
Excise duty of purchases 0.00
Cost of Goods Sold (COGS)
45902.30
:-

Quick assets = 47369.50 – (9655.50 + 76.80)

= 37637.20

Average daily operating expenses = (45902.30 + 7294.40 – 500.00) / 360

 = 52696.70
= 146.3797

Defensive Interval = 37637.20 / 146.3797

= 257.120 times

Conclusion : It is favorable to meet the daily cash expenses.

5. NET WORKING CAPITAL (NWC) RATIO :-

The difference between current assets and current liabilities excluding short
term bank borrowings is called NWC or NCA (Net Current Assets) ratio.

It is used to measure the short term liquidity of the firm.

NWC or NCA ratio = NWC / CE or NA

Here :-
NWC = Current assets(CA) – Current Liabilities(CL)

Current Assets mean the assets which are converted in to cash within a short period of one year i.e.
Cash-in-hand, Cash-at-bank, Closing Stock, Sundry Debtors, Bills Receivable, Prepaid Expenses,
Advances given and Marketable Securities (Trade investment).

Current Liabilities mean the liabilities which are repayable within a short period of one year i.e.
Sundry Creditors, Bills Payable, Outstanding Expenses, Income tax liability, Proposed Dividend, Bank
Over Draft and Long term debt maturing in the current year.

NA (Net Assets) = NFA (Net Fixed Assets) + NWC

or

NA (Net Assets) = Total Assets – Current Liabilities(CL)

NFA = Total Fixed Assets (FA) – Depreciation (Dep.)

CE (Capital Employed) = Total Debt (TD) + Net worth

TD = Short term Debt + long term Debt + Secured Loans + Un secured loans + Bonds + Debentures

Net worth = Equity Share Capital + Preference Share Capital + Reserves + Surplus - Fictitious assets
Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,
Preliminary expenses, Samples, Loss on issue of shares, etc…

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

The higher the ratio is favorable.

Difference between ‘Short term debt’ and ‘Current liabilities’ :-

Current liabilities include both interest-bearing instruments and non-
interest-bearing instruments, whereas Short-term debt is an interest-
bearing liability. ‘Debt’ is usually seen as a duty to financial institutions
like banks or third-party capital providers. Accounts payable, taxes
payable, and other kind of payables are commonly not duties to financial
institutions, so we can separate these from “debt”. Current liabilities are
commonly higher than short-term debt. We should not use them as
interchangeable definitions. Accounts payable to suppliers treated as
current liability as it commonly does not bear any interest cost within
expiration time.

Interpretation :-

Current Assets (See Balance

sheet) :-
₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial assets 37301.60
(i) Investments 19251.30
(ii) Trade receivables 1245.90
(iii) Cash and cash
15987.70
equivalents
(iv) Unpaid dividend
112.90
accounts
(v) Loans and advances 178.90
(vi) Other financial assets 524.90
(b) Inventories (Closing stock) 9655.50
(c) Current tax assets 188.50
(d) Other current assets 223.90
Total Current assets 47369.50

Current Liabilities (See Balance sheet, Income statement) :-

₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial liabilities 15565.50
(i) Trade payables 12403.70
(ii) Other financial liabilities (including Bank Over draft
3161.80
and un-paid Dividend)
(b) Provisions 1572.60
(c) Other current liabilities 1411.40
(d) Income tax 8220.20
Total Current Liabilities 26769.70

Long term Debt (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
(i) Secured loans (12% per annum, repayable in 10 equal annual instalments) 204.20
(ii) Un secured loans (Interest free, repayable after 8 years from the year of
147.20
deferment)
Total Long term debt 351.40

Short term Debt (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
Outstanding dues of Banks and Financial
107.70
institutions
Bank overdraft 0.90
Total Short term debt 108.60

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
 Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

NWC Ratio = (47369.50 – 26769.70) / (351.40 + 108.60 + 37026.60)

= 20599.80 / 37486.60
= 0.5495 times

Conclusion : Being the Net current assets is lower than equity and debt, it is
not satisfactory.

6. DEBT RATIO :-

Debt ratio is also referred to as Debt-to-Assets ratio.

It is the ratio of total debt to total assets that are financed by debt. The total
debt is not equal to total liabilities because it excludes non-debt liabilities
such as accounts payable, etc…

Debt Ratio = Total Debt (TD) / CE or Total Assets

Here :-
CE (Capital Employed) = Total Debt (TD) + Net worth

TD = Short term Debt + long term Debt + Secured Loans + Un secured loans + Bonds + Debentures

Net worth = Equity Share Capital + Preference Share Capital + Reserves + Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…

Total assets = NFA + Current Assets (CA)

or
Total assets = Total liabilities + Shareholder’s equity

Current Assets mean the assets which are converted in to cash within a short period of one year i.e.
Cash-in-hand, Cash-at-bank, Closing Stock, Sundry Debtors, Bills Receivable, Prepaid Expenses,
Advances given and Marketable Securities (Trade investment).

The Debt ratio can help investors to determine a company’s risk level.
Standard norm :- Absent ( depend on the norm followed by the firm or
industry)

Companies with higher levels of debt compared with assets are considered as
highly leveraged and more risk for lenders.

A lower the ratio is more favorable because creditors are always looking
about being repaid. When companies borrow more money from creditors or
lenders, their debt ratio will be increase and there by the companies unable to
get loans from creditors or Financial Institutions.

A debt ratio of 0.50 is often considered to be less risky.

Interpretation :

Long term Debt (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
(i) Secured loans (12% per annum, repayable in 10 equal annual instalments) 204.20
(ii) Un secured loans (Interest free, repayable after 8 years from the year of
147.20
deferment)
Total Long term debt 351.40

Short term Debt (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
Outstanding dues of Banks and Financial
107.70
institutions
Bank overdraft 0.90
Total Short term debt 108.60

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
 (iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

Debt ratio = (351.40 + 108.60) / 351.40 + 108.60 +37026.60

= 460 / 37486.60
= 0.01227 times

Conclusion : Hence, it is more considered to be less risky.

7. DEBT EQUITY RATIO :-

The relationship describing the lender’s contribution for each rupee of

owner’s contribution is called Debt-Equity ratio.

This ratio is used for long term solvency, capital structure & risk, financial
stability and managerial efficiency of the firm.

Debt Equity ratio = Total Debt (TD) / Net worth

Here :-
TD = Short term Debt + long term Debt + Secured Loans + Un secured loans + Bonds + Debentures

Net worth = Equity Share Capital + Preference Share Capital + Reserves + Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…

Standard norm :- 1 :1 (per 1 rupee of debt, same amount of equity)

NOTE :- If long term debt is taken as numerator, then standard norm is 2 : 1

A too higher this ratio indicates that more investment of loan capital than
equity capital which is high risk because of a higher claim of outsiders to the
firm.

A lower this ratio than standard is favorable which indicates that more use
of equity capital than debt capital which is low financial risk.
A very lower the ratio indicates a sound long term solvency, low risk,
conservative capital structure, low profitability and inefficient managerial
efficiency.

Interpretation :

Long term Debt (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
(i) Secured loans (12% per annum, repayable in 10 equal annual instalments) 204.20
(ii) Un secured loans (Interest free, repayable after 8 years from the year of
147.20
deferment)
Total Long term debt 351.40

Short term Debt (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
Outstanding dues of Banks and Financial
107.70
institutions
Bank overdraft 0.90
Total Short term debt 108.60

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

Debt equity ratio = (351.40 + 108.60) / 37026.60

 = 460 / 37026.60
= 0.01242 times

Conclusion : It is satisfactory because the more use of equity capital than

debt capital.

8. CAPITAL EMPLOYED TO NET WORTH RATIO :-

It is the another alternative way of expressing the relationship between debt

and equity or in other words, this ratio is simply 1 + Debt Equity ratio.

CE to Net worth ratio = CE or NA / Net worth

Capital employed is also known as Funds employed is the total amount of

capital used for the acquisition of profits. It is the value of all the assets
employed in a business and can be calculated by adding fixed assets to
working capital or by subtracting current liabilities from total assets.

Net worth of a business gives an idea of what the company is actually worth
after liabilities are taken out.

Here :-
CE (Capital Employed) = Total Debt (TD) + Net worth

TD = Short term Debt + long term Debt + Secured Loans + Un secured loans + Bonds + Debentures

Net worth = Equity Share Capital + Preference Share Capital + Reserves + Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…

NA (Net Assets) = NFA (Net Fixed Assets) + NWC

or

NA (Net Assets) = Total Assets – Current Liabilities (CL)

NFA = Total Fixed Assets (FA) – Depreciation (Dep.)

NWC = Current assets (CA) – Current Liabilities (CL)

Current Assets mean the assets which are converted in to cash within a short period of one year i.e.
Cash-in-hand, Cash-at-bank, Closing Stock, Sundry Debtors, Bills Receivable, Prepaid Expenses,
Advances given and Marketable Securities (Trade investment).

Current Liabilities mean the liabilities which are repayable within a short period of one year i.e.
Sundry Creditors, Bills Payable, Outstanding Expenses, Income tax liability, Proposed Dividend, Bank
Over Draft and Long term debt maturing in the current year.

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

In general, a lower the ratio is better i.e. the business has lots of assets
relative to the amount of debt it holds.

Interpretation :

Long term Debt (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
(i) Secured loans (12% per annum, repayable in 10 equal annual instalments) 204.20
(ii) Un secured loans (Interest free, repayable after 8 years from the year of
147.20
deferment)
Total Long term debt 351.40

Short term Debt (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
Outstanding dues of Banks and Financial
107.70
institutions
Bank overdraft 0.90
Total Short term debt 108.60

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
 (v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

CE to Net worth ratio = (351.40 + 108.60 + 37026.60 / 37026.60

= 37486.60 / 37026.60
= 0.9877 times

Conclusion : It is indicates the business has more assets relative to the

amount of debt the company holds.

9. PROPRIETARY OR NET WORTH RATIO :-

It is useful to analyze the long term solvency and financial stability of the
firm.

Proprietary ratio = Proprietor(Shareholder)’s Fund or Net worth / Total

assets – Fictitious assets

Here :-
Net Capital Employed (Net worth) = Equity Share Capital + Preference Share Capital + Reserves +
Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…
or
Fixed Assets + NWC
or
Total assets – Current liabilities

Standard Norm :- 1 : 3 (33.33% of total assets collected through

proprietary capital)

A higher this ratio is favorable which indicates more use of proprietor’s

fund in acquiring the firm’s assets there by useful to long term creditors and
investors.
A lower this ratio indicates less use of proprietary funds and more use of debt
funds. This situation speaks of the high risk, poor solvency and unstable
financial position of the firm.

A too high of this ratio indicates un willingness of the firm and more debt
capital.

Interpretation :

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

Proprietary ratio = 37026.60 / (80880.80 – 0)

= 0.45779 times

Conclusion : It is more than the standard norm which indicates more using
the proprietary funds in acquiring the company’s assets.

10. ASSETS TO NET WORTH RATIO :-

It is useful to analyze the long term solvency and financial stability of the
firm.

Assets to Net worth ratio = (Total assets – Fictitious assets) / Net worth

Here :-
Net Capital Employed (Net worth) = Equity Share Capital + Preference Share Capital + Reserves +
Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…
or
Fixed Assets + NWC
or
Total assets – Current liabilities

Standard Norm :- 2 : 3 (2/3rd of net worth collected through assets)

It analyzes the proprietary capital in acquisition of total assets.

A higher this ratio is favorable which indicates using more equity capital
than debt capital in financing the asses and also an indication of good
financial capable of repaying the debts.

A lower this ratio indicates the firm is depending mostly on debt capital in
financing the assets. Hence, it is not good(safety) of investor’s fund.

Interpretation :

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
 37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

Assets to Net worth ratio = (80880.80 – 0) / 37026.60

= 2.184397 times

Conclusion : It is an indication of the company using more equity capital

than debt capital in financing the assets.

11. CAPITAL GEARING RATIO (CGR) :-

It is used to measure the Capital structure policy and financial stability of the
company

Capital Gearing Ratio (CGR) = (Debentures + Preference share capital +

other long term loans) / (Equity share capital + Free reserves – Losses)

or

Capital Gearing ratio (CGR) = Interest bearing funds / Non-Interest

bearing funds

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

The term gear is used to measure the financial risk involved in capital
structure of a company.
A lower the ratio is favorable because a highly geared company runs with
more risk and lowly geared company runs with less risk.

In inflationary situation, high gearing is effective because, the increased

income helps to bear the fixed interest burden.

In deflationary market situation, low gearing is more effective because, the

low income earned during deflationary period is not sufficient to bear huge
interest burden.

Interpretation :-

Long term Debt (See Balance sheet) :-

Amount
Particulars
(₹ in millions)
(i) Secured loans (12% per annum, repayable in 10 equal annual instalments) 204.20
(ii) Un secured loans (Interest free, repayable after 8 years from the year of
147.20
deferment)
Total Long term debt 351.40

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

CGR = (0 + 0 + 351.40) / (964.20 + 4000 + 4374.30 + 27688.10)

 = 351.40 / 37026.60
= 0.00949 times

Conclusion : It is treated as less risky because the ratio is very low.

II . INCOME STATEMENT (P/L A/c ) RATIOS :-

If both the components of a ratio can be taken from items of Revenue

statement (P/L Account) is considered as Revenue statement ratios. The
important Profit and Loss Account or Revenue Statement Ratios are stated
below :-

1. INTEREST COVERAGE RATIO :-

This ratio is used to test debt servicing capacity of the firm and measures the
long term solvency of the firm.

Interest coverage ratio = EBIT / Fixed interest charges

or

Interest coverage ratio = EBITDA / Interest

Here :-
EBITDA = Earnings before Interest, Tax, Depreciation and Amortization

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A higher this ratio is favorable which indicates better debt servicing

capacity of the firm.

Interest coverage is calculated in relation to before tax earnings. Depreciation

is non cash item. Therefore, funds equal to depreciation are also available to
pay interest charges. Thus, calculate this ratio as EBITDA divided by
Interest.
The limitation of this ratio is it does not consider repayment of loan.

Interpretation :

Interest Coverage ratio = 28765.70 / 1119.50

= 25.695 times

Conclusion : The company have more debt servicing capacity.

2. DEBT SEVICE COVERAGE RATIO :-

This ratio is used to measure the safety of the lender’s money invested in the
firm and return on the same. It explains the firm’s ability to serve the debt
timely.

Interest coverage ratio = EBITDA / Interest and installments of loans

due

Here :-
EBITDA = Earnings before Interest, Tax, Depreciation and Amortization

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A higher this ratio is favorable both the firm and lenders. It indicates the
sound capacity to repay interest and installments due on time. It is less risk in
repaying the interest and principal to lenders.

A lower the ratio indicates the company is not in a satisfactory position to

repay the interest and principal to lenders. It goes against the firm’s goodwill
and will not get further loan from banks or financial institutions.

A lower the ratio is also not a welcoming feature to the lenders because it
indicates more risk in getting interest and principal on time.

Interpretation :

Debt Service coverage ratio = 28765.70 / 1119.50

= 25.695 times

There is No separation amounts for Interest and Installments. The total

amount given under Interest and Installments. So, the same result came for
Interest coverage and Debt service coverage.

Conclusion : A higher this ratio is indicating the sound capacity to repaying

the interest and loans.

3. GROSS PROFIT RATIO :-

It is used to measure the overall profitability and managerial efficiency of the

firm.

Gross Profit margin = ( Gross Profit / Net Sales ) x 100

Here :-
Gross Profit = Net sales – COGS (Cost of Goods Sold)

COGS (In case of trading concern) = Opening stock + Purchases – Closing Stock + All Direct
expenses relating to purchases
COGS (In case of manufacturing concern) = Sum of the cost of Raw materials + wages + Direct
expenses + All manufacturing expenses

Note :-
Generally, the expenses charged to P/L account or operating expenses are excluded from the calculation
of Cost of Goods Sold(COGS).

Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]

It reflects efficiency with a firm produces products.

Standard Norm :- Absent (generally a gross profit margin in the range of

25% to 30% is taken as acceptable norm)
A higher the ratio is favorable which indicates more profitability and better
managerial efficiency.
A lower the ratio indicates weak profitability and poor managerial efficiency.
A negative the ratio indicates that direct costs are more than the
sales(turnover) and the firm is not in a position to meet any indirect cost.
Interpretation :

Gross profit Ratio = 67020.40 / 112922.70

= 0.5935 i.e. 59.35%

Conclusion : It is more than standard norm of 25% . The company

maintained sound Gross profit margin.
4. NET PROFIT RATIO :-

It is used to measure the overall profitability and managerial efficiency in

generating additional revenue over and above the total operating costs of the
firm.
Net Profit margin = ( Net Profit (PAT) / Net Sales ) x 100

Here :-
Net profit is referred as Profit After Tax (PAT) or Earnings After Tax (EAT)

Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]

This ratio shows the net contributions made by sales of one rupee to the
owner’s fund.

Standard Norm :- Absent (depend on the norm followed by firm /

industry)
The higher the ratio is favorable which indicates better overall profitability
and managerial efficiency of the firm.

Interpretation :
Net profit = 16069.30 / 112922.70
0.1423 or 14.23%

Conclusion : Company needs to increase the sales volume to increase the net
profit.

5. OPERATING RATIO :-

This ratio is also known as Operating Expenses ratio. It is used to measure

the overall profitability and managerial efficiency of the firm.

Operating ratio = (Operating Cost / Net Sales) x 100

Here :-
Operating Cost = COGS + Operating Expenses
COGS (In case of trading concern) = Opening stock + Purchases – Closing Stock + All Direct
expenses relating to purchases

COGS (In case of manufacturing concern) = Sum of the cost of Raw materials + wages + Direct
expenses + All manufacturing expenses

Note :-
Generally, the expenses charged to P/L account or operating expenses are excluded from the calculation
of Cost of Goods Sold(COGS).

Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]

Operating Expenses = Administrative & Office Expenses + selling & Distribution Expenses + General
Expenses – Financial Charges (i.e. Interest, Provision for Tax etc…)

It explains the proportion of operating expenses in sales of one rupee.

Standard Norm :- Absent (generally a range of 70% to 80% is taken as

acceptable norm)

A lower this ratio indicates the firm has more surplus in its hand after
meeting the operating costs. This surplus is used for payment of tax, payment
of dividend, transfer to reserve etc…

A lower the ratio is favorable which indicates the high profitability and
good managerial efficiency of the firm and vice versa.

Interpretation :-
 Amount
Particulars (₹ in
millions)
Cost of Material Consumed 43656.80
Purchase of Stock-in-Trade 2305.60
Changes in Inventories -60.10
Manufacturing Expenses 0.00
Excise duty of purchases 0.00
Cost of Goods Sold (COGS)
45902.30
:-

Operating cost ratio = (45902.30 + 40843.90) / 112922.70

= 86746.20 / 112922.70
= 0.76819 or 76.82%

Conclusion : Company has incurred the more operating cost during financial
year 2019 .

6. EXPENSE or SPECIFIC EXPENSE RATIO :-

The relationship between any particular expense and net sales is expressed by
Expense Ratio.
Expense ratio = Particular expense / Net Sales x 100

For Example :-
A . Factory expenses ratio = Factory expenses / Net Sales x 100

B . Administrative expenses ratio = Administrative expenses / Net Sales x

100

C . Selling expenses ratio = Selling expenses / Net Sales x 100

D . Finance expenses ratio = Finance expenses / Net Sales x 100

It is used to measure the higher profitability and better managerial efficiency

of the firm.

Standard Norm :- Absent (depend on the norm followed by firm /

industry)

A lower the ratio is favorable which indicates the high profitability and
good managerial efficiency of the firm and vice versa.

7. OPERATING PROFIT RATIO :-

It is used to measure the overall profitability and managerial efficiency of the

firm.

Operating Profit Ratio = Operating Profit (EBIT) / Net sales x 100

Here :-
EBIT = Earnings before Interest and taxes
EBIT = Net Sales – (COGS + Operating expenses)
Operating Expenses = Administrative & Office Expenses + selling & Distribution Expenses + General
Expenses – Financial Charges (i.e. Interest, Provision for Tax etc…)

or

EBIT = Net Profit + Non-operating expenses – Non operating revenue

or
EBIT = Gross profit – Operating Expenses excluding COGS

Standard Norm :- Absent (depend on the norm followed by firm /

industry)

A higher the ratio is favorable which indicates of good profitability and

managerial efficiency of the firm.

Interpretation :

Operating profit ratio = 28765.70 / 112922.70

= 0.2547 or 25.47%

Conclusion : Company having optimum profitability.

8. MATERIAL CONSUMED RATIO :-

It is used to analyze the managerial skill in carrying out production and

increasing the profitability of the firm. It explains the proportion of material
cost to the total cost of production.
Material consumed ratio = ( Cost of materials consumed / Cost of
production ) x 100

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

A lower the ratio is favorable because higher this ratio indicates a greater
portion of total cost is spent for material. It is the indicator of managerial
inefficiency and a possible lower profitability.

Interpretation :

Amount
Particulars (₹ in
millions)
Cost of Material Consumed 43656.80
Purchase of Stock-in-Trade 2305.60
Changes in Inventories -60.10
Manufacturing Expenses 0.00
Excise duty of purchases 0.00
Cost of Goods Sold (COGS)
45902.30
:-

Material Consumed ratio = 43656.80 / 45902.30

= 0.95108 or 95.11%

Conclusion : It is very poor in maintain the cost of production by the ABC

company.

9. MANUFATURING EXPENSES RATIO OR CONVERSION COST

RATIO :-

It explains the relationship between the cost of converting raw material in to

finished goods and net sales.

Manufacturing expenses ratio = [(Manufacturing cost – Cost of material

consumed) / Net Sales x 100

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

A lower the ratio is favorable which indicates comparatively lower cost of

conversion of raw materials is higher profitability and better managerial
expertise.

Interpretation :

Additional information :-
(i) Manufacturing cost of ₹ 52800 million.
(ii) Variable cost of ₹ 1.6 million.
(iii) Current market price of ABC company is traded at stock exchange as ₹ 17,735.70

Manufacturing expenses ratio = (52800.00 – 43856.80) / 112922.70

= 8943.20 /
112922.70
= 0.0791975 or 7.92%

Conclusion : The company having satisfactory managerial expertise.

10. FINANCIAL LEVERAGE RATIO :-

Financial Leverage ratio = EBIT / EBT

Here ;-
EBIT = Earnings before Interest and tax (Operating profit)

EBT = Earnings before tax after interest

It is used to analyze the Capital structure and financial risk of the company.
It explains how does the fixed interest bearing loan capital affect the
operating profit of the firm.

It tells about the extent of change in EBT as a result of a change in EBIT.

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

If EBIT is more than EBT, this ratio becomes more than 1 .

A slightly higher the ratio is favorable i.e. If this ratio is marginally more
than 1, that is nearer to 1, it indicates moderate use of debt capital, low
financial risk and good financial judgement .

Interpretation :

Financial leverage ratio = 28765.70 / 24289.50

= 1.184285 times

Conclusion : the company maintain more than 1 . So, it is indication of low

financial risk and good financial judgement.

If this ratio is far more than 1, it indicates high debt burden, too much risk
and aggressive financial policy.

11. OPERATING LEVERAGE RATIO :-

It is used to analyze the effect of fixed cost on the operating profit (EBIT) of
the firm.

Operating Leverage ratio = Contribution / EBIT

Here :-
EBIT = Earnings before Interest and tax (Operating profit)

Contribution = sales – Variable Cost

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

If in the total operating cost of the firm, fixed cost is more than the variable
cost, then, this ratio becomes high.

A higher the ratio is favorable which indicates a higher rate of increasing in

profit as a result of an increase in sales.

If the ratio is too low i.e. variable cost is far more than the fixed cost, change
in sales does not have so sensitive and wide impact on the profit of the firm.
It indicates the lower operating risk of the firm.

A moderate operating leverage ratio is favorable which indicates balanced

risk position to the firm both from the viewpoints of profitability and risk.

Interpretation :

Additional information :-
(i) Manufacturing cost of ₹ 52800 million.
(ii) Variable cost of ₹ 1.6 million.
(iii) Current market price of ABC company is traded at stock exchange as ₹ 17,735.70
Operating leverage ratio = (112922.70 – 1.6) / 28765.70
= 112921.10 / 28765.70
= 3.9255 times

Conclusion : It is more favorable as more sales and less variable cost

incurred..

12. PREFERENCE DIVIDEND COVERAGE RATIO :-

It explains how many times the preference dividend liability of the firm is
covered by the EAT.

It is used to analyze the long term financial stability of the firm.

Preference dividend coverage ratio = EAT / Preference dividend

Here ;-
EAT (PAT) = Net profit after taxes

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

The higher this ratio is more scope of higher dividend for the equity
shareholders because equity dividend is paid from the surplus profit
remaining after paying preference dividend.

A lower the ratio indicates a low return for equity shareholders too as well as
preference dividend holders.

Interpretation :
As the company is not having the preference dividend, we cannot calculate
this ratio.

13. EQUITY DIVIDEND COVERAGE RATIO :-

It is used to measure the profitability of paying equity dividend.

Equity dividend coverage ratio = (EAT – Preference dividend) / Equity
dividend

or

Equity dividend coverage ratio = Earnings available to equity

shareholders / Equity dividend

Here ;-
EAT (PAT) = Net profit after taxes

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

A higher the ratio is favorable which indicates good financial stability of

the firm because the firm is in a position to pay equity dividend after meeting
all fixed burdens and tax liability.

A lower the ratio reduces the security of getting equity dividend by the equity
shareholders.

Interpretation :
Equity dividend coverage ratio = (16069.30 – 0) / 10895
= 1.47492 times

Conclusion : The company maintaining optimum financial stability.

III . MIXED or COMBINED RATIOS :-

If one variable of ratio taken from Balance sheet and other variable of ratio
taken from P/L account is considered as mixed or composite ratio. The
commonly used Mixed or Composite Ratios are stated below :-

1. INVENTORY OR STOCK TURNOVER RATIO :-

It indicates the efficiency of the firm in producing and selling it’s product.

Inventory Turnover ratio = COGS or Net Sales / Average Inventory (if

expressed in times)

or
Inventory Turnover ratio = (Average Inventory x 12) / COGS or Net
Sales (if expressed in months)

or

Inventory Turnover ratio = (Average Inventory x 360) / COGS or Net

Sales (if expressed in no. of days)

Here :-
COGS (In case of trading concern) = Opening stock + Purchases – Closing Stock + All Direct
expenses relating to purchases

COGS (In case of manufacturing concern) = Sum of the cost of Raw materials + wages + Direct
expenses + All manufacturing expenses

Note :- Generally, the expenses charged to P/L account or operating expenses are excluded from the
calculation of Cost of Goods Sold(COGS).

Average stock = (Opening stock + Closing stock) / 2

Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]
NOTE :- If it is not possible to ascertain the COGS, then, Net sales is used for the computation of this
ratio.

It shows the rapidity with which the inventory transforms into receivables
through sales.

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A higher this ratio is better which indicates low inventory level and quick
conversion of stock in to sales. It is the sign of efficient inventory
management.

A low inventory turnover indicates maintenance of a high level inventory and

slow rotation of inventory in operating cycle process. It is the sign of poor
inventory management.

A too higher (much higher than the industry standard) the ratio indicates
holding a very low level of inventory. This bears the risk of frequent shortage
of stock which affect the production process.

A too low (much lower than the industry standard) this ratio indicates holding
of excessive inventory which indicates unproductive blocking of funds which
increases cost and reduces profit.

It is always desirable for a firm to maintain a balanced level of inventory.

Hence, a firm must fix up an optimum inventory turnover level and try to
maintain that.

Interpretation :

Opening stock (See Reference Note 5) :-

Amount
Particulars (₹ in
millions)
Opening stock :-
(i) Finished goods 3881.70
(ii) Work-in-progress 1148.10
(iii) Finished goods 280.50
Total Opening stock 5310.30

Closing stock (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
Closing stock :-
(i) Raw material 3235.60
(ii) Packing material 378.70
(iii) Work-in-progress 1132.60
(iv) Finished goods 3873.80
(v) Stock-in-trade (Goods purchased for
364.00
resale)
(vi) Stores and spares 670.80
Total Closing stock 9655.50

Inventory turnover = 112922.70 / [(5310.30 + 9655.50)/2]

= 112922.70 / 7482.90
 = 15.09 times

Conclusion : A higher this ratio is better which indicates low inventory level
and quick conversion of stock in to sales. It is the sign of efficient inventory
management.

Days of Inventory holding (DIH) :-

An inventory turnover ratio may be used to find out the no. of Days of
Inventory Holding (DIH) as :-

DIH = 360 / Inventory Turnover ratio

or
DIH = Average Inventory / COGS

Interpretation :

Days of inventory holding = 360 / 15.09

= 23.857 days

2. DEBTORS OR RECEIVABLES TURNOVER RATIO (DTR) :-

It is used to measure the short term solvency and overall activity of the firm.

DTR = Credit sales / Average Debtors or receivables (if expressed in

times)

or

DTR = (Average Debtors x 12) / Credit sales (if expressed in months)

or

DTR = (Average Debtors x 360) / Credit sales (if expressed in no. of days)

Here :-
Average Debtors = (Opening Debtors + Closing Debtors) / 2
Accounts Receivables = Sundry Debtors + Bills receivables

The liquidity position of the firm depends on quality of debtors. It measures

the debt collection period and reveals whether the debtors are slow paying or
quick paying.

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A higher the ratio than standard is favorable which indicates quick

collection from debtors i.e. short credit period, quick recycling of working
capital and efficient debt management.

A lower the ratio than standard is indicates slow collection from debtors i.e.
long credit period, slow recycling of working capital and inefficient debt
management.

A very high this ratio or too short collection period does not indicate efficient
receivables management. It is indicating of restricted debt collection policy of
the management. Such a policy may be helpful to reduce the changes of bad
debt hut. It also reduces the sales and profitability.

Interpretation :

Debtors turnover = 37377 / [(0 + 1245.90)/2]

= 37377 / 622.95
= 60 times
Conclusion : A higher this ratio than standard is favorable which cates quick
collection from debtors i.e. short credit period, quick recycling of working
capital and efficient debt management.

Average Collection Period (ACP) :-

If the Debtors turnover is expressed in months or days, it reveals the Average

Collection Period (ACP).

ACP = 360 / Debtors turnover (DTR)

If the collection period is long, the quality of debtors is poor and require more
working capital.

If the collection period is short or near to the standard, debtors are good
paying and requirement of working capital seems to be reasonable.

Interpretation :

ACP = 360 / 60
= 6 days

3. CREDITORS (PAYABLES)s TURNOVER RATIO (CTR) :-

It compares creditors with the total credit purchases.

CTR = Credit Purchases / Average creditors or payables (if expressed in

times)

or

CTR = (Average Creditors x 12) / Credit Purchases (if expressed in

months)

or
CTR = (Average Creditors x 360) / Credit Purchases (if expressed in no.
of days)

Here :-
Average Creditors = (Opening Creditors + Closing Creditors) / 2

Accounts Payables = Sundry Creditors + Bills Payables

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A high Creditors Turnover Ratio or lower credit period is favorable

which indicates the creditors are being paid promptly. This situation enhances
the credit worthiness of the firm.

Interpretation :

Creditors turnover = 2305.60 / [(0 + 12296)/2]

= 2305.60 / 6148
= 0.375 times
Conclusion : As this ratio is low, the creditors are not being paid promptly.

Average Payment Period (APP) :-

APP = Sundry Creditors / Average daily Credit purchases

Here :-
Average daily Credit purchases = Credit purchases / 360

or

Average daily Credit purchases = (Sundry Creditors x 360) / Credit purchases

The APP indicates the Average credit period given to company by creditors
and represents the no. of days by the firm to pay its creditors.

Interpretation :

APP = (12296 / 2305.60) x 360

= 5.3331 x 360
= 1919.92

ASSETS TURNOVER RATIOS :-

Assets are used to generate sales. Hence, a firm should manage its assets
efficiently to maximize the sales. The relationship between sales and assets is
called assets turnover. The below are the Assets turnover ratios.

4. NET ASSETS TURNOVER RATIO :-

It is also referred as Capital Employed turnover ratio.

Net Assets Turnover = COGS or Net Sales / Net Assets

Here :-
COGS (In case of trading concern) = Opening stock + Purchases – Closing Stock + All Direct
expenses relating to purchases

COGS (In case of manufacturing concern) = Sum of the cost of Raw materials + wages + Direct
expenses + All manufacturing expenses

Note :-
Generally, the expenses charged to P/L account or operating expenses are excluded from the calculation
of Cost of Goods Sold(COGS).
Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]

NOTE :-
If it is not possible to ascertain the COGS, then, Net sales is used for the computation of this ratio.

NA (Net Assets) = NFA (Net Fixed Assets) + NWC

or

NA (Net Assets) = Total Assets – Current Liabilities(CL)

NFA = Total Fixed Assets(FA) – Depreciation(Dep.)

NWC = Current assets(CA) – Current Liabilities(CL)

Current Assets mean the assets which are converted in to cash within a short period of one year i.e.
Cash-in-hand, Cash-at-bank, Closing Stock, Sundry Debtors, Bills Receivable, Prepaid Expenses,
Advances given and Marketable Securities (Trade investment).

Current Liabilities mean the liabilities which are repayable within a short period of one year i.e.
Sundry Creditors, Bills Payable, Outstanding Expenses, Income tax liability, Proposed Dividend, Bank
Over Draft and Long term debt maturing in the current year.

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A higher the ratio is favorable

Interpretation :

Current Liabilities (See Balance sheet, Income statement) :-

₹ Amount
 Particulars (in (₹ in
millions) millions)
(a) Financial liabilities 15565.50
(i) Trade payables 12403.70
(ii) Other financial liabilities (including Bank Over draft and un-
3161.80
paid Dividend)
(b) Provisions 1572.60
(c) Other current liabilities 1411.40
(d) Income tax 8220.20
Total Current Liabilities 26769.70

Net Assets turnover = 112922.70 / (80880.80 – 26769.70)

= 112922.70 / 54111.10
= 2.08687 times

Conclusion : The company used efficient utilization of Net assets to generate

the sales.

5. TOTAL ASSETS TURNOVER RATIO :-

This ratio shows the firm’s ability in generating sales from all financial
resources committed to total assets.

Total assets turnover = COGS or Net Sales / Total assets

Here :-
COGS (In case of trading concern) = Opening stock + Purchases – Closing Stock + All Direct
expenses relating to purchases

COGS (In case of manufacturing concern) = Sum of the cost of Raw materials + wages + Direct
expenses + All manufacturing expenses

Note :- Generally, the expenses charged to P/L account or operating expenses are excluded from the
calculation of Cost of Goods Sold(COGS).

Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]

NOTE :- If it is not possible to ascertain the COGS, then, Net sales is used for the computation of this
ratio.

Total assets = NFA + Current Assets

or
Total assets = Total liabilities + Shareholder’s equity

NFA = Total Fixed assets – Depreciation

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A higher the ratio is favorable

Interpretation :

Total Assets turnover = 112922.70 / 80880.80

= 1.39616 times

Conclusion : The company used efficient utilization of Total assets to

generate the sales.

6. FIXED ASSETS TURNOVER RATIO :-

It shows the relationship between Sales and Fixed assets.

Fixed Assets turnover = COGS or Net Sales / Net Fixed Assets (NFA)

Here :-
COGS (In case of trading concern) = Opening stock + Purchases – Closing Stock + All Direct
expenses relating to purchases
COGS (In case of manufacturing concern) = Sum of the cost of Raw materials + wages + Direct
expenses + All manufacturing expenses

Note :-
Generally, the expenses charged to P/L account or operating expenses are excluded from the calculation
of Cost of Goods Sold(COGS).

Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]
NOTE :- If it is not possible to ascertain the COGS, then, Net sales is used for the computation of this
ratio.

NFA = Total Fixed assets – Depreciation

It indicates the generation of sales for each rupee invested in fixed assets.

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A higher this ratio is better of efficient utilization of fixed assets in

generating the sales.

Interpretation :

Fixed Assets turnover = 112922.70 / 24006.20

= 4.703897 times

Conclusion : The company used efficient utilization of fixed assets to

generate the sales.

7. CURRENT ASSETS TURNOVER RATIO :-

It shows the relationship between Sales and Current assets.

Current Assets turnover = COGS or Net Sales / Current Assets

Here :-
COGS (In case of trading concern) = Opening stock + Purchases – Closing Stock + All Direct
expenses relating to purchases

COGS (In case of manufacturing concern) = Sum of the cost of Raw materials + wages + Direct
expenses + All manufacturing expenses

Note :- Generally, the expenses charged to P/L account or operating expenses are excluded from the
calculation of Cost of Goods Sold(COGS).

Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]
NOTE :- If it is not possible to ascertain the COGS, then, Net sales is used for the computation of this
ratio.

Current Assets mean the assets which are converted in to cash within a short period of one year i.e.
Cash-in-hand, Cash-at-bank, Closing Stock, Sundry Debtors, Bills Receivable, Prepaid Expenses,
Advances given and Marketable Securities(Trade investment).

It indicates the generation of sales for each rupee invested in current assets.

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A higher this ratio is favorable indicates of efficient utilization of Current

assets in generating the sales.

A lower this ratio indicates an inefficiency in working capital management.

Interpretation :

Current Assets (See Balance sheet) :-

₹ Amount
Particulars (in (₹ in
 millions) millions)
(a) Financial assets 37301.60
(i) Investments 19251.30
(ii) Trade receivables 1245.90
(iii) Cash and cash equivalents 15987.70
(iv) Unpaid dividend accounts 112.90
(v) Loans and advances 178.90
(vi) Other financial assets 524.90
(b) Inventories (Closing stock) 9655.50
(c) Current tax assets 188.50
(d) Other current assets 223.90
Total Current assets 47369.50

Current assets turnover = 112922.70 / 47369.50

= 2.383869 times

Conclusion : It is indicate of efficient utilization of Current assets in

generating the sales.

8. WORKING CAPITAL TURNOVER RATIO :-

It relates Net Current Assets (NCA) or Net Working Capital (NWC) to sales.

NWC or NCA turnover = COGS or Net sales / Net Current Assets (NCA)

Here :-
COGS (In case of trading concern) = Opening stock + Purchases – Closing Stock + All Direct
expenses relating to purchases

COGS (In case of manufacturing concern) = Sum of the cost of Raw materials + wages + Direct
expenses + All manufacturing expenses

Note :-
Generally, the expenses charged to P/L account or operating expenses are excluded from the calculation
of Cost of Goods Sold(COGS).

Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]

NOTE :- If it is not possible to ascertain the COGS, then, Net sales is used for the computation of this
ratio.

NWC = Current assets(CA) – Current Liabilities(CL)

Current Assets mean the assets which are converted in to cash within a short period of one year i.e.
Cash-in-hand, Cash-at-bank, Closing Stock, Sundry Debtors, Bills Receivable, Prepaid Expenses,
Advances given and Marketable Securities (Trade investment).

Current Liabilities mean the liabilities which are repayable within a short period of one year i.e.
Sundry Creditors, Bills Payable, Outstanding Expenses, Income tax liability, Proposed Dividend, Bank
Over Draft and Long term debt maturing in the current year.

Standard norm :- Absent ( depend on the norm followed by the firm or

industry)

A higher this ratio is favorable which indicates of efficient utilization of

working capital in generating the sales.

Interpretation :

Current Assets (See Balance sheet) :-

₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial assets 37301.60
(i) Investments 19251.30
(ii) Trade receivables 1245.90
(iii) Cash and cash equivalents 15987.70
(iv) Unpaid dividend accounts 112.90
(v) Loans and advances 178.90
(vi) Other financial assets 524.90
(b) Inventories (Closing stock) 9655.50
(c) Current tax assets 188.50
(d) Other current assets 223.90
Total Current assets 47369.50

Current Liabilities (See Balance sheet, Income statement) :-

₹ Amount
Particulars (in (₹ in
millions) millions)
 (a) Financial liabilities 15565.50
(i) Trade payables 12403.70
(ii) Other financial liabilities (including Bank Over draft and un-
3161.80
paid Dividend)
(b) Provisions 1572.60
(c) Other current liabilities 1411.40
(d) Income tax 8220.20
Total Current Liabilities 26769.70

Working capital turnover = 112922.70 / (47369.50 – 26769.70)

= 112922.70 / 20599.80
= -5.48174 times

Conclusion : It indicates of efficient utilization of working capital in

generating the sales.

9. RETURN ON CAPITAL EMPLOYED (ROCE) :-

ROCE compares the earnings with capital invested in the company.

This ratio explains the relationship between the Operating Profit (EBIT) i.e.
Net profit after tax but before interest and the Net Capital Employed or Gross
Capital Employed.

9 (a) Return on Gross Capital Employed = EBIT / Gross capital

employed

Here :-
Gross Capital Employed = Equity Share Capital + Preference Share Capital + Reserves + Surplus +
Long term loan + Current liabilities - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…

Interpretation :
Current Liabilities (See Balance sheet, Income statement) :-
₹ Amount
Particulars (in (₹ in
millions) millions)
(a) Financial liabilities 15565.50
(i) Trade payables 12403.70
(ii) Other financial liabilities (including Bank Over draft and un-
3161.80
paid Dividend)
(b) Provisions 1572.60
(c) Other current liabilities 1411.40
(d) Income tax 8220.20
Total Current Liabilities 26769.70

Long term Debt (See Balance sheet) :-

Amount
Particulars (₹ in
millions)
(i) Secured loans (12% per annum, repayable in 10 equal annual instalments) 204.20
(ii) Un secured loans (Interest free, repayable after 8 years from the year of
147.20
deferment)
Total Long term debt 351.40

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
 Total Long term debt 37026.60

ROCE = 28765.70 / (351.40 + 37026.60 + 26769.70)

= 28765.70 / 64147.70
= 0.448429 or 44.84%

Conclusion : It is moderate earnings with capital invested in the company.

.9 (b) Return on Net Capital Employed = EBIT / Net capital employed

Here :-
Net Capital Employed (Net worth) = Equity Share Capital + Preference Share Capital + Reserves +
Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…
or
Fixed Assets + NWC
or
Total assets – Current liabilities

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

This ratio is the real test of the profitability and managerial efficiency of the
firm.

A higher the ratio is always favorable in the view point of Shareholders

and the management

A low ROCE indicates the firm has not been able to earn a reasonable profit.

If the cost of long term borrowing is lower than the ROCE, then,
shareholder’s returns would increase.

A high ROCE achieved for a few consecutive years indicates that the firm
has a stable financial position and has good future prospect.

Interpretation :
 Net worth (See Balance sheet and Reference
Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

ROCE = 28765.70 / 37026.60

= 0.77689 or 77.69%

Conclusion : ROCE on Net capital employed is better than Gross capital

employed.

10. RETURN ON INVESTMENT (ROI) :-

ROI and ROCE are almost same. ROCE calculated on Gross capital
employed and Net capital employed whereas ROI calculated Gross long term
capital excluding Current assets or Net worth.

10 (a) ROI (before tax) = EBIT / Gross long term capital or Net worth

10 (b) ROI (after tax) = EBIT(1-t) / Gross long term capital or Net worth

Here :-
t = Tax rate
Gross Long-term capital = Equity Capital + Net Preference Capital + Reserves + Debentures + Other
long term debt.

Net Capital Employed (Net worth) = Equity Share Capital + Preference Share Capital + Reserves +
Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

This ratio is the real test of the profitability and managerial efficiency of the
firm.

A higher the ratio is always favorable in the view point of Shareholders

and the management

A low ROI indicates the firm has not been able to earn a reasonable profit.

If the cost of long term borrowing is lower than the ROI, then, shareholder’s
returns would increase.

A high ROI achieved for a few consecutive years indicates that the firm has a
stable financial position and has good future prospect.

ROI before Tax :

Interpretation :

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
 Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

ROCE = 28765.70 / 37026.60

= 0.77689 or 77.69%

Conclusion : ROI before tax is sound..

ROI after Tax :

Interpretation :

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60
ROI = 28765.70 (1-0.3485) / 37026.60
= 28765.70 (0.6515) / 37026.60
= 18740.85 / 37026.60
= 0.5061456

Conclusion : ROI after tax is Sound.

11. RETURN ON EQUITY or EQUITY SHAREHOLDER’S FUND

(ROE):-

ROE, ROI and ROCE are almost same. ROE is used to measure the
profitability from equity shareholder’s view and the management efficiency
in the utilization of equity capital employed in the business.

ROE = EAT or PAT / Net worth

Here :-
EAT (Earnings after Tax) = Profit after tax (PAT) i.e. Net profit after interest and tax

Net Capital Employed (Net worth) = Equity Share Capital + Preference Share Capital + Reserves +
Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…

This ratio explains the return available to the equity shareholders as a

percentage of their claim to the firm.

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

This ratio is the real test of the profitability and managerial efficiency of the
firm.

A higher the ratio is always favorable in the view point of Shareholders

and the management
A low ROE indicates the firm has not been able to earn a reasonable profit.

A high ROE achieved for a few consecutive years indicates that the firm has
a stable financial position and has good future prospect.

Interpretation :

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

ROI = 16069.30 / 37026.60

= 0.43399 or 43.40%

Conclusion : ROE on Equity shareholder’s fund is more.

12. RETURN ON PROPRIETOR’S FUND (EQUITY) :-

It is nothing but, Return on Net Capital Employed.

Return on Proprietor’s fund = EBIT / Net capital employed

Here :-
Net Capital Employed (Net worth) = Equity Share Capital + Preference Share Capital + Reserves +
Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…
or
Fixed Assets + NWC
or
Total assets – Current liabilities

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

This ratio is the real test of the profitability and managerial efficiency of the
firm.

A higher the ratio is always favorable in the view point of proprietor’s.

A lower this ratio indicates the firm has not been able to earn a reasonable
profit.

A higher this ratio achieved for a few consecutive years indicates that the
firm has a stable financial position and has good future prospect.

Interpretation :

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
 (iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

ROI = 28765.70 / 37026.60

= 0.77689 or 77.69%

Conclusion : ROE on Proprietor’s fund is sound..

13. RETURN ON TOTAL ASSETS RATIO :-

It is used to measure the profitability of the firm in terms of assets employed

in the firm.

Return on Total assets ratio = (EBIT / Total assets) x 100

It is also calculated by taking EAT as the numerator.

Here :-
EBIT = Earnings before interest and tax (Operating profit)

EAT (Earnings after Tax) = Profit after tax (PAT) i.e. Net profit after interest and tax

Total assets = Total Fixed assets + Current assets

It measures the managerial efficiency in relation to the utilization of assets.

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

A high return on total assets is favorable which is an indicator of high

profitability and good overall efficiency.

If the total assets of the firm increase without any corresponding increase in
its operating profit, the return on total assets will come down. It reveals that
the increase in investment has not resulted in the welfare of the owners.

Interpretation :

Return on total assets = (28765.70 / 80880.80) x 100

= 0.355655 or 35.57%

Conclusion : The company’s Return on total assets is moderate

14. EARNINGS PER SHARE (EPS) :-

EPS = Earnings available to equity shareholders / Weighted average no.
of outstanding equity shares

or

EPS = Net profit – (Dividends on Preferred stock) / Weighted average

no. of outstanding equity shares

NOTE :-
In the calculation of EPS, it is more accurate to use a weighted average no. of outstanding shares over
the reporting term because the no. of outstanding shares can change over time.

EPS shows earnings available to equity shareholders on a per share basis.

EPS shows what shareholders earned by way of profit for a period.

EPS indicates an estimation of company’s income in future.

EPS is the portion of a company’s profit allocated to each outstanding share

of common stock.

We can measure the profitability of the shareholder’s investment by

calculating the EPS.

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

A higher the EPS is favorable.

Diluted EPS :-
Diluted EPS (reduced) is usually a more accurate measure of the company’s
real earning power than EPS because we can add the Preference shares,
Conversion of convertible bonds, Stock options and warrants also to no. of
outstanding shares while calculating the EPS.

Interpretation :
Conclusion : The company’s EPS is ₹ 166.66 which is good for
shareholders.
The company’s Diluted EPS is ₹ 165.71 which is good for
shareholders

15. DIVIDEND PER SHARE (DPS) :-

Dividend :- The amount that a stock holder will receive for each share of
stock held.

DPS = Total Dividend (Earnings paid to Shareholders) / No. of

outstanding equity shares

The Net profit after taxes belongs to shareholders. But, the income which
they really receive is the amount of distributed as cash dividends. Therefore,
a large number of investors may be interested in DPS. Typically, blue chip
companies pay high dividends per share while start-ups pay small amount of
dividends.
Standard Norm :- Absent (depend on the norm followed by the firm /
industry)

A higher the ratio is favorable.

Dividend indicates the company’s income in current situation.

DPS shows how much the shareholders where actually paid by way of
dividends.

Interpretation :

DPS = 10895,000,000 / 96420000

= ₹ 113

Conclusion : It is good for shareholders to receive a dividend for financial

year 2019.
16. DIVIDEND PAYOUT (PAYOUT) RATIO :-

Payout ratio = Dividend per equity share (DPS) / EPS

or

Payout ratio = Cash dividend paid / Profits available to shareholders

Here :-
DPS = Total Dividend (Earnings paid to Shareholders) / No. of outstanding equity shares

EPS = Earnings available to equity shareholders / Weighted average no. of outstanding equity shares

or

EPS = Net profit – (Dividends on Preferred stock) / Weighted average no. of outstanding equity shares

NOTE :-
In the calculation of EPS, it is more accurate to use a weighted average no. of outstanding shares over
the reporting term because the no. of outstanding shares can change over time.

A complementary of this Payout ratio is Retained Earnings ratio.

Retained Earnings (Retention) Ratio = Retained earnings per equity

share / EPS

or

Retained Earnings (Retention) Ratio = 1 – Payout ratio

Retained Earnings :- Earnings not distributed to shareholders are retained in

the business. Thus, Retention ratio is equal to 1 – Payout ratio.

If the figure is multiplied by the ROE (Return on Shareholders fund), we can

know the growth in the owner’s equity as a result of retention policy.

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)
Dividend payout ratio is calculated to find which EPS have been used for
paying dividend and to know what portion of earnings have been retained in
the business.

It is an important ratio because ploughing back of profits enables a company

to grow and pay more dividends in future.

A higher this ratio is favorable to equity shareholders which indicates that

the greater portion of profits available to the equity shareholders has been
distributed while a smaller portion has been retained. The shareholders like to
get more cash dividend.

A high payout ratio is never desirable from the view point of financial health
of the company because in such a case, retention of profit becomes less.

A low payout ratio indicates less distribution of dividend and more retention
is helpful for sustained growth of the company.

Interpretation :

DPS = ₹ 113
EPS = ₹ 166.66

Payout Ratio = (113 / 166.66)x100

= 0.6780 times

Conclusion : A higher this ratio is favorable to equity shareholders which

indicates that the greater portion of profits available to the equity
shareholders has been distributed

17. DIVIDEND YIELD RATIO :-

It is used to measure the profitability and assess the extent of protection of

equity shareholders interest.

As per market experts, we should calculate dividend on cost price and not
calculate on face value.
Dividend yield ratio = DPS / MPS

Here :-
DPS = Total Dividend (Earnings paid to Shareholders) / No. of outstanding equity shares

MPS = Market value per share

NOTE :-
The information on the market value per share (MPS) is generally not available from the financial
statements but, available from external sources like stock exchanges or financial newspapers etc…

It indicates the income (dividend) on cost price we get every year.

The dividend yield is the dividend paid in the last accounting year divided by
the current market value of the share.

It makes an analysis on the return on equity shares not on the basis of the face
value but on their market value. So, it reflects on the true rate of return
available to equity shareholders.

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

A higher the ratio is favorable which gives more returns for equity
shareholders. It indicates the high rate of profit earned by the company.

A market value per equity share is too high, the dividend yield ratio may be
low. In such a case, the equity shareholder’s return may not be too low. So, a
lower the ratio in a situation of very high MPS is not against the interest of
the equity shareholders.

Interpretation :

Additional information :-
(i) Manufacturing cost of ₹ 52800 million.
(ii) Variable cost of ₹ 1.6 million.
(iii) Current market price of ABC company is traded at stock exchange as ₹ 17,735.70
DPS = ₹113

Dividend yield = 113 / 103.86

= 1.08800 or 108.80%

Conclusion : A higher the ratio indicates the high rate of profit earned by the
company.

18. EARNINGS YIELD RATIO (E/P) RATIO :-

This is also known as Earnings multiple.

The EPS for the most recent 12 month period divided by the current market
price per share.

Earnings Yield ratio = ( EPS / MPS ) x 100 = %

Here :-
EPS = Net profit – (Dividends on Preferred stock) / Weighted average no. of outstanding equity shares

NOTE :-
In the calculation of EPS, it is more accurate to use a weighted average no. of outstanding shares over
the reporting term because the no. of outstanding shares can change over time.

MPS = Market value per share

NOTE :-
The information on the market value per share (MPS) is generally not available from the financial
statements but, available from external sources like stock exchanges or financial newspapers etc…

The earnings yield (which is inverse of P/E ratio) shows the percentage of
each rupee invested in the stock that was earned by the company.

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

A higher the ratio is favorable.

The earnings yield is used by money investment managers to determine

optimal asset allocations.
Interpretation :

Earnings yield = EPS / MPS

= 166.66 / 103.86
= 1.60466 or 160.47%

Conclusion : A higher this ratio is favorable to shareholders or investors.

19. PRICE EARNINGS (P/E) RATIO :-

This is also known as Price multiple.

The Current market price per share is divided by the EPS for the most recent
12-month period is called Price multiple.

Price Earnings ratio = ( MPS / EPS ) = (expressed in times)

or

Price Earnings ratio = Market capitalization / Total Annual Earnings

Here :-
EPS = Net profit – (Dividends on Preferred stock) / Weighted average no. of outstanding equity shares

or

EPS = Earnings available to equity shareholders / Weighted average no. of outstanding equity shares

NOTE :-
In the calculation of EPS, it is more accurate to use a weighted average no. of outstanding shares over
the reporting term because the no. of outstanding shares can change over time.

Market Capitalization = No. of outstanding shares in a company x share price

MPS = Current Market value per share

NOTE :-
The information on the market value per share (MPS) is generally not available from the financial
statements but, available from external sources like stock exchanges or financial newspapers etc…

The P/E ratio (which is inverse of E/P ratio) used to ascertain the true value
of each equity share.

This ratio is measure of the price paid for a share relative to the profit earned
by the firm per share.

This ratio is units of years which can be interpreted as no. of years of

earnings to pay back purchase price, ignoring the time value of money.

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

The P/E ratio indicates that the length of time (no. of years) required to get
back shareholder’s investment

The lower the ratio is more beneficial to shareholders at normal situation.

But, we should note that if some companies are in recession, but, as per
market boom, they are in very good position. At this situation, even their P/E
showing as high, being these companies turnaround, we can buy their shares.
In this case, we should not estimate that these companies P/E is high.
A higher this ratio indicates the investors are paying more for each unit of
income.

A higher the ratio indicates either a fall in EPS or increase in MPS. Increase
in MPS is beneficial to the shareholders. It indicates managerial efficiency
and high profitability.

A lower this ratio indicates reduced MPS. It also reveals a low level of
managerial efficiency and profitability.

If lower the ratio caused by an increased EPS, it does not indicate an un

favorable situation for the shareholders.

A higher the ratio indicates that investors are paying more for each unit of
Net income. So, the stock is more expensive compared to lower P/E ratio.

Interpretation :

Earnings yield = MPS / EPS

= 103.86 / 166.66
= 0.62318 times
Conclusion : A higher this ratio indicates the investors are paying more for
each unit of income..

20. MARKET VALUE TO BOOK VALUE (MV to BV) RATIO :-

MV to BV ratio = MVPS / BVPS

or
MV to BV ratio = Market capitalization / BVPS

Here :-
Market Capitalization = No. of outstanding shares in a company x share price

MVPS (MPS) = Current market value per share

BVPS (Book value per share) = Net worth / No. of outstanding shares in a company

or

BVPS (Book value per share) = Book value / No. of outstanding shares in a company

Book Value = Cost of an asset – Accumulated depreciation

or

Book value = (Capital + Reserves) / No. of shares in a company

(It indicates Shareholders can get total amount per share of a company)

or

Book value = Net Asset Value (NAV) i.e. Total Assets – Intangible Assets (Patents, Goodwill etc…) –
Liabilities

Net Capital Employed (Net worth) = Equity Share Capital + Preference Share Capital + Reserves +
Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…
or
Fixed Assets + NWC
or
Total assets – Current liabilities

It compares the Market capitalization with capital invested in the company.

Standard Norm :- Absent (depend on the norm followed by the firm /
industry)

A higher the ratio is favorable

The book value is used to know the value of the funds of the company.

If book value is less than the face value indicates that company is in loss. But,
newly established companies book value might be equal to face value
because no reserves so far.

Interpretation :

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

MV to BV ratio = MVPS / BVPS

Here : BVPS = (Capital +Reserves & Surplus) / no. of available shares in a
company
MV to BV = 103.86 / (37026600000 / 96420000)
= 103.86 / 384.01369
= 0.270459 times

Conclusion : The higher ratio is favorable to company or shareholders.

21. CAPITAL TURNOVER RATIO :-

It explains the sales achieved for one rupee of net capital employed (net
worth).

It is used to analyze the efficiency in use of capital and overall managerial

efficiency.

Capital turnover ratio = COGS or Net sales / Net capital employed

Here :-
COGS (In case of trading concern) = Opening stock + Purchases – Closing Stock + All Direct
expenses relating to purchases

COGS (In case of manufacturing concern) = Sum of the cost of Raw materials + wages + Direct
expenses + All manufacturing expenses

Note :-
Generally, the expenses charged to P/L account or operating expenses are excluded from the calculation
of Cost of Goods Sold(COGS).

Net Sales = [(Cash sales + Credit sales) – (Sales returns + Discount sales + Asset sales)]

NOTE :- If it is not possible to ascertain the COGS, then, Net sales is used for the computation of this
ratio.

Net Capital Employed (Net worth) = Equity Share Capital + Preference Share Capital + Reserves +
Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…

Standard Norm :- Absent (depend on the norm followed by the firm /

industry)

The higher this ratio is favorable which indicates an efficient management

of the capital employed in the firm. It reveals that lower employment of
capital has resulted in higher achievement of sales. This situation is helpful
for increased profitability.

The lower the ratio indicates inefficient management of the capital employed.
In such situation, more use of capital results in a comparatively lower
generation of sales. A continuously falling this ratio is an indicator of
deteriorating business growth.

Interpretation:

Net worth (See Balance sheet and Reference

Note 1) :-
Amount
Particulars (₹ in
millions)
(i) Equity share capital (Shares of 96420000 @
964.20
$10 each)
(ii) Preference share capital 0.00
(iii) Capital Reserve (See Reference Note 1) 4000.00
(iv) General Reserve (See Reference Note 1) 4374.30
(v) Surplus (Retained earnings) (See Reference
27688.10
Note 1)
37026.60
Less : Fictitious assets 0.00
Total Long term debt 37026.60

Capital turnover = 112922.70 / 37026.60

= 3.04977 times

Conclusion : The higher this ratio is favorable which indicates an efficient

management of the capital employed in the firm.

ANNEXURE :-

S.No Name of the Ratio Unit of Standard

Expression Norm (in
Indian
perspective)
1 Current ratio Times 1:1
2 Quick ratio Times 2:1
3 Cash ratio Times 0.5 : 1
4 Interval measure ratio Times Depend on firm
5 NWC ratio Times Depend on firm
6 Debt ratio Times Depend on firm
7 Debt equity ratio Times Depend on firm
8 CE to Net worth ratio Times Depend on firm
9 Proprietary ratio Times 1:3
10 Assets to net worth Times 2:3
ratio
11 Capital gearing ratio Times Depend on firm
12 Interest coverage ratio Times Depend on firm
13 Debt Service Coverage Times Depend on firm
ratio
14 Gross profit ratio Percentage 25
15 Net profit ratio Percentage Depend on firm
16 Operating cost ratio Percentage 75
17 Expense ratio Percentage Depend on firm
18 Operating profit ratio Percentage Depend on firm
19 Material consumed Percentage Depend on firm
ratio
20 Manufacturing Percentage Depend on firm
expenses ratio
21 Financial leverage ratio Times Depend on firm
22 Operating leverage Times Depend on firm
 ratio
23 Preference Dividend Times Depend on firm
coverage ratio
24 Equity Dividend Times Depend on firm
coverage ratio
25 Inventory turnover Times Depend on firm
ratio
26 Debtors turnover ratio Times Depend on firm
27 Creditors turnover ratio Times Depend on firm
28 Net assets turnover Times Depend on firm
ratio
29 Total assets turnover Times Depend on firm
ratio
30 Fixed assets turnover Times Depend on firm
ratio
31 Current assets turnover Times Depend on firm
ratio
32 Working capital Times Depend on firm
turnover ratio
33 Return on capital Percentage Depend on firm
employed (ROCE)
34 Return on investment Percentage Depend on firm
(ROI)
35 Return on equity Percentage Depend on firm
(ROE)
36 Return on proprietor’s Percentage Depend on firm
fund
37 Return on total assets Percentage Depend on firm
38 Earnings per share Rupees Depend on firm
(EPS)
39 Dividend per share Rupees Depend on firm
(DPS)
40 Payout ratio Times Depend on firm
41 Dividend yield ratio Percentage Depend on firm
 42 Earnings yield ratio Percentage Depend on firm
43 Price earnings ratio Times Depend on firm
(P/E)
44 Market value to book Times Depend on firm
value ratio
45 Capital turnover ratio Times Depend on firm

------------ End of the CHAPTER – 9 ----------

CHAPTER – 10
LEVERAGES

Learning objectives
After studying this chapter, you can be able to :-
1. Understand the concept of Financial leverage, Operating
leverage,
2. Evaluate the risk and return implications of Financial leverage
and operating leverage,
3. Analyze the combined effect of financial and operating leverage.

Definition of Leverage :-
Leverage is a business term which refers to borrowing funds or other
financial instruments i.e. debt to finance the firm’s assets (purchase of
inventory, equipment and other company’s assets) and thereby to increase the
potential return of an investment. A firm with significantly more debt
(leverage) than equity is considered a highly leveraged and vice versa. A
company using a more debt is increases the risk of bankruptcy, but it also
increases the company’s returns especially the Return on equity (ROE). The
owner’s equity will not be diluted if using the debt financing rather than
equity financing. The interest payments on debt capital are tax deductible.
Investors prefer the business to use debt financing but only up to a point.

Capital structure:-
The financing or capital structure decision is an important significant
managerial decision. The company’s assets can be financed either by increase
the creditor’s claims (i.e. debt) or owner’s claims (equity). The debt can be
increase when the firm borrowing the debt from creditors. The owner’s
claims can be increase when the firm raise the funds by issuing shares or
retaining the existing earnings. The equity plus liabilities of the firm are
referred to as financial structure of the firm. The long-term claims can be
form capital structure of the enterprise. The proportionate relationship
between debt and equity is referred to as capital structure of the firm. Here,
equity means paid-up capital, share premium and reserves & surplus i.e.
retained earnings. The capital structure decision can be affect the
shareholder’s return and risk and also it affects the market value of the share.
The capital structure decision may be involved when the firm has to be raised
the funds to finance its investments.

Types of Leverages:-
There are three types of leverages.

1. OPERATING LEVERAGE:-
The leverage which measures a firm’s fixed costs as a percentage of its total
costs is called as Operating leverage. Operating leverage is a measure of the
combination of fixed costs and variable costs in a company’s cost structure.
A company with high fixed costs and low variable costs has high
operating leverage whereas a company with low fixed costs and high variable
costs has low operating leverage. A company with high operating leverage
depends more on sales volume for profitability. The company must generate
high sales volume to cover the high fixed costs. In other words,
the company becomes more profitable when sales increased. In a company
that has low operating leverage, increasing sales volume will not dramatically
improve profitability since variable costs increase proportionately with sales
volume.
Operating leverage ratio = Contribution / EBIT

Operating leverage ratio is used to analyse the effect of fixed cost on the
operating profit (EBIT) of the firm. A higher the ratio is favourable which
indicates a higher rate of increasing in profit as a result of increase in sales. If
the ratio is too low i.e. variable cost is far more than the fixed cost.

Degree of Operating leverage:-

The percentage change in EBIT relative to given percentage in sales is called
as Degree of Operating leverage (DOL).

DOL = % change in EBIT / % change in sales

= (∆EBIT/EBIT) / ((∆Sales/Sales)
or
Operating leverage ratio = 1 + (Fixed cost / EBIT)
or
Operating leverage ratio = {Q(S-V)} / {Q(S-V) – F}

Here:-
Contribution = (Sales – Variable cost) or (EBIT + Fixed cost)
EBIT : Earning (profit) before Interest and Tax
Q : Units of output
S : Unit selling price
V : Unit variable cost
F : Fixed cost

2. FINANCIAL LEVERAGE:-
The process of using borrowed capital (debt) to increase the shareholder’s
return on their investments or equity in capital structure is called as Financial
leverage or Trading on equity. The financial leverage analysed by the firm is
intended to earn more return on the fixed charge funds rather than their costs.
The surplus will increase the return on owner’s equity whereas the deficit will
decrease the return on owner’s equity. Financial leverage affects the EPS
(Earnings per share). When the EBIT increases, then EPS increases.
For example, If the firm borrows a debt from creditors for $1000 at 7%
interest per annum i.e. $70and invests this debt to earn 12% return on this i.e.
$120 per annum. Then the difference of surplus i.e. $50 which is after interest
payment done to the creditors of the firm will belongs to the shareholders or
owners of the firm and it is referred to as profit from financial leverage.
Conversely, if the firm would earn 5% return, then the firm has loss of $20
(i.e. $70 - $50) to the shareholders.
The rate of interest on debt is fixed and it is legal binding to pay the interest
by the firm to its creditors. The rate of preference dividend is also fixed to
pay to shareholders of the firm by the company. Highly leveraged companies
may be at risk of bankruptcy if they are unable to make payment on their
debt, but it can increase shareholder’s return on their investment and there are
tax advantages associated with leverage.
Financial leverage ratio = EBIT / EBT

Financial leverage ratio is used to analyse the Capital structure and financial
risk of the company. It explains how does the fixed interest-bearing loan
capital affect the operating profit of the firm. If EBIT is more than EBT, this
ratio becomes more than 1. A slightly higher the ratio is favourable i.e. if this
ratio is marginally more than 1, that is nearer to 1, it indicates moderate use
of debt capital, low financial risk and good financial judgement.

Degree of Financial leverage:-

The percentage change in EPS due to a given percentage change in EBIT is
called as Degree of Financial leverage (DFL).

DFL = % change in EPS / % change in EBIT

= (∆EPS/EPS) / ((∆EBIT/EBIT)
or
Financial leverage ratio = [EBIT / (EBIT – Interest)]
or
Financial leverage ratio = 1 + (Interest / EBT)
or
Financial leverage ratio = {Q(S-V) - F} / [{Q(S-V) – F} – Interest]

Here:-
EBIT : Earning (profit) before Interest and Tax
EBT : Earning (profit) before tax
Q : Units of output
S : Unit selling price
V : Unit variable cost
F : Fixed cost

Measures of Financial leverage:-

The most common measures of Financial leverage are as under:-

(i) Debt ratio :-

Debt ratio is also referred to as Debt-to-Assets ratio. It is the ratio of total
debt to total assets that are financed by debt. The Debt ratio is also known as
Ratio of Debt to total capital.

Debt Ratio = Total Debt (TD) / CE or Total Assets

Here :-
CE (Capital Employed) = Total Debt (TD) + Net worth (equity)

TD = Short term Debt + long term Debt + Secured Loans + Un secured loans + Bonds + Debentures

Net worth = Equity Share Capital + Preference Share Capital + Reserves + Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…

Total assets = NFA + Current Assets (CA)

or
Total assets = Total liabilities + Shareholder’s equity

Current Assets mean the assets which are converted in to cash within a short period of one year i.e.
Cash-in-hand, Cash-at-bank, Closing Stock, Sundry Debtors, Bills Receivable, Prepaid Expenses,
Advances given and Marketable Securities (Trade investment).

The Debt ratio can help investors to determine a company’s risk level.
Companies with higher levels of debt compared with assets are considered as
highly leveraged and riskier for lenders. A lower the ratio is more favourable
because creditors are always looking about being repaid. When companies
borrow more money from creditors or lenders, their debt ratio will be
increase and there by the companies unable to get loans from creditors or
Financial Institutions.

(ii) Debt equity ratio :-

The relationship describing the lender’s contribution for each rupee of
owner’s contribution is called Debt-Equity ratio. This ratio is used for long
term solvency, capital structure & risk, financial stability and managerial
efficiency of the firm.

Debt Equity ratio = Total Debt (TD) / Net worth (equity)

Here :-
TD = Short term Debt + long term Debt + Secured Loans + Un secured loans + Bonds + Debentures

Net worth = Equity Share Capital + Preference Share Capital + Reserves + Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc…

A too higher this ratio indicates that more investment of loan capital than
equity capital which is high risk because of a higher claim of outsiders to the
firm. A lower this ratio than standard is favourable which indicates that more
use of equity capital than debt capital which is low financial risk. A very
lower the ratio is indicating a sound long term solvency, low risk,
conservative capital structure, low profitability and inefficient managerial
efficiency.

(iii) Interest coverage ratio:-

This ratio is used to test debt servicing capacity of the firm and measures the
long term solvency of the firm.

Interest coverage ratio = EBIT / Fixed interest charges

or
Interest coverage ratio = EBITDA / Interest

Here :-
EBITDA = Earnings before Interest, Tax, Depreciation and Amortization.

Interest coverage is calculated in relation to before tax earnings. Depreciation

is non-cash item. Therefore, funds equal to depreciation are also available to
pay interest charges. Thus, calculate this ratio as EBITDA divided by
Interest. The limitation of this ratio is it does not consider repayment of loan.
Financial leverage and Shareholder’s return:-
The role of a firm in using financial leverage is to maximize the shareholder’s
return based on fixed- charges funds i.e. debentures or debt (loans)from
banks and financial institutions. This debt can be obtained at a cost lower
than the firm’s rate of return on Net assets (RONA) or Return on Investment
(ROI). Hence, EPS and ROE (Return on equity) will be increase, but if the
firm obtains fixed-charges funds at a cost higher than the RONA or ROI, the
EPS and ROE will decrease. Therefore, we can say that the EPS, ROI and
ROE are playing a vital role in analysing the impact of financial leverage.

Calculation of EPS and ROE:-

EPS (Earnings per share):-
EPS = Earnings available to equity shareholders or EAT / Number of shares
If a firm uses the preference dividend, then EPS can be calculated as:-
EPS = [{(EBIT – Interest) (1 – t)} – preference dividend] / Number of shares
of the firm
EPS shows earnings available to equity shareholders on a per share basis.
EPS shows what shareholders earned by way of profit for the period. EPS
indicates an estimation of company’s income in future. We can measure the
profitability of the shareholder’s investment by calculating the EPS. A higher
the EPS is favourable.

ROE (Return on Equity):-

ROE, ROI and ROCE (Return on capital employed) are almost same. ROE is
used to measure the profitability from equity shareholder’s view and the
management efficiency in the utilization of equity capital employed in the
business.

ROE = EAT or PAT / Net worth (equity)

or
ROE = {(EBIT – Interest) (1 – t)} / Equity
or
ROE = [r + (r – i) D/E] (1 – t)

Here :-
EAT (Earnings after Tax) = Profit after tax (PAT) i.e. Net profit after interest and tax
Net Capital Employed (Net worth) = Equity Share Capital + Preference Share Capital + Reserves +
Surplus - Fictitious assets

Fictitious Assets = Unabsorbed portion of Deferred revenue expenditure i.e. Advertisements,

Preliminary expenses, Samples, Loss on issue of shares, etc.

r : before tax return on investment / assets

i : interest rate on debt
D : debt
E : equity
t : tax rate

Note :-
For 100% equity structured firm, D/E will be zero. Therefore, ROE for such firm is simply the after tax
return on assets i.e. ROE = r(1 – t)

ROE explains the return available to the equity shareholders as a percentage

of their claim to the firm. This ratio is the real test of the profitability and
managerial efficiency of the firm. A higher the ratio is always favourable in
the view point of Shareholders and the management. A low ROE indicates
the firm has not been able to earn a reasonable profit. A high ROE achieved
for a few consecutive years indicates that the firm has a stable financial
position and has good future prospect.

Interest tax shield (ITS) = Tax rate x Interest

Effect of leverage on EPS and ROE:-

Favourable if Return on investment (ROI) is greater than interest rate
Un-favourable if Return on investment (ROI) is less than interest rate
Neutral if Return on investment (ROI) is equal to interest rate

Financial leverage and Shareholder’s risk:-

As the financial leverage maximizes the shareholder’s earnings, the EBIT
causes to fluctuate the EPS within the range of debt in capital structure. With
more debt, the rise and fall in EPS is faster than the rise and fall in EBIT.
Hence, we can conclude that financial leverage not only maximizes EPS, but
also increases its variance. The most common risks in financial leverage are
as below:-

(i) Operating risk:-

Operating risk in financial leverage can be effect the variance of EBIT (or
Return on assets). The internal and external environment in a firm can
determine the variance of EBIT. Thus, the operating risk is an un-avoidable
risk. The variance of EBIT has two components such as:-
a. Variance of Sales
b. Variance of fixed or variable expenses

(ii) financial risk:-

The variance of EPS can be caused in use of financial leverage is called as
financial risk. A 100% equity financed firm will have no financial risk, but
the firm adds financial risk when the firm used the debt. Therefore, the
financial risk is avoidable risk when the firm decides that not to use any debt
in its capital structure.

3. COMBINED (COMPOSITE) LEVERAGE:-

The combination of operating leverage and financial leverage is called as
combined leverage or composite leverage. The degree of composite leverage
can be calculated as follows:-

Combined leverage = Operating leverage x Financial leverage

Degree of Combined leverage (DCL):-

DCL = (% change in EBIT / %Change in Sales) x (% change in EPS / %
change in EBIT)
= % change in EPS / % change in Sales
or
DCL = (∆EPS/EPS) / (∆Sales/Sales)
DCL = [{Q(S-V)/Q(S-V)-F} X {Q(S-V)-F / Q(S-V)-F-Interest}]
= Q(S-V) / {Q(S-V)-F-Interest}
or
DCL = Contribution / EBT
= (EBIT + Fixed cost) / EBT
= {EBT + Interest + Fixed cost / EBT}
= (1 + (Interest + Fixed cost) / EBT]

Here:-
Contribution = (Sales – Variable cost) or (EBIT + Fixed cost)
EBIT : Earning (profit) before Interest and Tax
EBT : Earnings (Profit) before tax
Q : Units of output
S : Unit selling price
V : Unit variable cost
F : Fixed cost

PROBLEMS AND SOLUTIONS

Case 1 :-
From the below information of ‘ABC limited’, Calculate the degree of
operating leverage.

Alternate 1 Alternate 2
Amount Amount
Particulars Units ($) Units ($)
Sales 50000 51500
Selling price
per unit 6.00 6.00
Variable cost
per unit 4.00 3.00
Fixed cost 60000.00 70000.00

Solution:-

Profitability Statement of ABC limited

Alternate 1
$ per Amount
Particulars Units
unit ($)
Sales 50000 6.00 300000.00
Less : Variable
50000 4.00 200000.00
cost
Contribution 100000.00
Less : Fixed
60000.00
Cost
EBIT 40000.00

DOL = % change in EBIT / % change in sales

= (∆EBIT/EBIT) / ((∆Sales/Sales)
or
Operating leverage ratio = 1 + (Fixed cost / EBIT)
or
Operating leverage ratio = {Q(S-V)} / {Q(S-V) – F}

Here:-
Contribution = (Sales – Variable cost) or (EBIT + Fixed cost)
EBIT : Earning (profit) before Interest and Tax
Q : Units of output
S : Unit selling price
V : Unit variable cost
F : Fixed cost

DOL = 1 + (Fixed cost / EBIT)

= 1 + (60000 / 40000)
= 1 + 1.50
= 2.50

or

DOL = [50000 (6-4) / 50000(6-4) – 60000]

= 100000 / 100000 – 60000
= 100000 / 40000
= 2.50

Conclusion :-
DOL of 2.50 implies that for a given change in sales of ABC limited, the
EBIT will change by 2.50 times.

Profitability Statement of ABC limited

Alternate 2
$ per Amount
Particulars Units
 unit ($)
Sales 51500 6.00 309000.00
Less : Variable
51500 3.00 154500.00
cost
Contribution 154500.00
Less : Fixed
70000.00
Cost
EBIT 84500.00

DOL = % change in EBIT / % change in sales

= (∆EBIT/EBIT) / ((∆Sales/Sales)
or
Operating leverage ratio = 1 + (Fixed cost / EBIT)
or
Operating leverage ratio = {Q(S-V)} / {Q(S-V) – F}

Here:-
Contribution = (Sales – Variable cost) or (EBIT + Fixed cost)
EBIT : Earning (profit) before Interest and Tax
Q : Units of output
S : Unit selling price
V : Unit variable cost
F : Fixed cost

DOL = 1 + (Fixed cost / EBIT)

= 1 + (70000 / 84500)
= 1 + 0.8284
= 1.8284

Conclusion :-
DOL of 1.8284 implies that for a given change in sales of ABC limited, the
EBIT will change by 1.83 times.

Case 2 :-
The EBIT of ABC limited increases from $60000 to $80000. Similarly, the
EPS also increased from $0.825 to $1.225. ABC limited paid interest charges
of $18750 to its creditors. With this information, find out the Degree of
Operating leverage.
Solution:-
DFL = % change in EPS / % change in EBIT
= (∆EPS/EPS) / ((∆EBIT/EBIT)
or
Financial leverage ratio = [EBIT / (EBIT – Interest)]
or
Financial leverage ratio = 1 + (Interest / EBT)
or
Financial leverage ratio = {Q(S-V) - F} / [{Q(S-V) – F} – Interest]

Here:-
EBIT : Earning (profit) before Interest and Tax
EBT : Earning (profit) before tax
Q : Units of output
S : Unit selling price
V : Unit variable cost
F : Fixed cost
DFL = {(1.225 – 0.825)/0.825} / {(80000-60000)/60000}
= (0.4/0.825) / (20000/60000)
= 0.4848 / 0.3333
= 1.4545

or

DFL = 1 + (Interest / EBT)

= 1 + (18750/41250)
= 1 + 0.4545
= 1.4545

Conclusion :-
This implies that for a given change in EBIT, EPS will change by 1.4545
times.
Case 3 :-
From the below information belongs to PQR limited, calculate the degree of
combined leverage.

Amount
Particulars Units ($)
Sales 40000
Selling price
per unit 7.00
Variable cost
per unit 4.00
Fixed cost 75000.00
Interest 8000.00

Solution:-
DCL = (% change in EBIT / %Change in Sales) x (% change in EPS / %
change in EBIT)
= % change in EPS / % change in Sales
or
DCL = (∆EPS/EPS) / (∆Sales/Sales)
DCL = [{Q(S-V)/Q(S-V)-F} X {Q(S-V)-F / Q(S-V)-F-Interest}]
= Q(S-V) / {Q(S-V)-F-Interest}
or
DCL = Contribution / EBT
= (EBIT + Fixed cost) / EBT
= {EBT + Interest + Fixed cost / EBT}
= (1 + (Interest + Fixed cost) / EBT]

Here:-
Contribution = (Sales – Variable cost) or (EBIT + Fixed cost)
EBIT : Earning (profit) before Interest and Tax
EBT : Earnings (Profit) before tax
Q : Units of output
S : Unit selling price
V : Unit variable cost
F : Fixed cost

DCL = Q(S-V) / {Q(S-V)-F-Interest}

DCL = [40000(7-4) / {40000(7-4) – 75000 – 8000)}]
= 120000 / (120000- 75000 – 8000)
= 1200000 / 37000
= 3.243

Conclusion :-
Combined effect of leverage is to increase EPS by 3.243 times for the unit
increase in sales.

Case 4 :-
The financial data of XYZ limited as below:-

Alternate 1 Alternate 2
Amount Amount
Particulars Units ($) Units ($)
Sales 55000 75000
Selling
price per
unit 10.00 10.00
Variable
cost per
unit 4.00 4.00
Fixed cost 160000.00 190000.00
Interest 60000.00 65000.00
Tax rate 0.35 0.35
Number of
Shares 15000.00 18000.00
Preference
Dividend 500.00 4000.00
Equity
investment 16000 70000
 1 - Tax rate 0.65 0.65

From the above information, calculate the below:-

(i) Operating Leverage
(ii) Financial Leverage
(iii) Combined leverage
(iv) EPS
(v) ROE
(vi) % changes in sales between 2 alternative projects.
(vii) % changes in EPS between 2 alternative projects.

Solution:-

Profitability Statement of ABC limited

Alternate 1
$ per Amount
Particulars Units
unit ($)
Sales 55000 10.00 550000.00
Less : Variable cost 55000 4.00 220000.00
Contribution 330000.00
Less : Fixed Cost 160000.00
EBIT 170000.00
Less : Interest 60000.00
EBT 110000.00

Less : Taxes 0.35 38500

EAT 71500.00
Less : Preference dividend 500.00
Earnings available to
Equity Shareholders 71000.00
Number of Shares 15000.00
EPS 4.7333333
ROE 4.46875
Working notes:-

(i) Operating Leverage:-

Operating Leverage = Contribution / EBIT
= 330000 / 170000
= 1.94

(ii) Financial Leverage:-

Financial Leverage = EBIT / EBT
= 170000 / 110000
= 1.545

(iii) Combined leverage:-

Combined leverage = operating leverage x financial leverage
= 1.94 x 1.545
= 2.997

(iv) EPS:-
EPS = Earnings available to equity shareholders / No. of shares
= 71000 / 15000
= $4.733

(v) ROE:-
ROE = EBT(1-t) / equity
= {110000 (1-0.35)} / 16000
= 71500 / 16000
= 4.468

Profitability Statement of ABC limited

Alternate 2
$ per Amount
Particulars Units
unit ($)
Sales 75000 10.00 750000.00
Less : Variable cost 75000 4.00 300000.00
Contribution 450000.00
Less : Fixed Cost 190000.00
EBIT 260000.00
Less : Interest 65000.00
EBT 195000.00

Less : Taxes 0.35 68250

EAT 126750.00
Less : Preference dividend 4000.00
Earnings available to
Equity Shareholders 122750.00
Number of Shares 18000.00
EPS 6.8194444
ROE 1.8107143

Working notes:-

(i) Operating Leverage:-

Operating Leverage = Contribution / EBIT
= 450000 / 260000
= 1.731

(ii) Financial Leverage:-

Financial Leverage = EBIT / EBT
= 260000 / 195000
= 1.333

(iii) Combined leverage:-

Combined leverage = operating leverage x financial leverage
= 1.731 x 1.333
= 2.308

(iv) EPS:-
EPS = Earnings available to equity shareholders / No. of shares
= 122750 / 18000
 = $6.819

(v) ROE:-
ROE = EBT(1-t) / equity
= {195000 (1-0.35)} / 70000
= 126750 / 70000
= 1.811

(vi) % change in sales:-

= (Sales in Alternate 2 – sales in alternate 1) / sales in alternate 1
= (750000 – 550000) / 550000
= 0.3636 or 36.36%

(Vii) % change in EPS:-

= (EPS in Alternate 2 – EPS in Alternate 1) / EPS in Alternate 1
= (6.819 – 4.733) / 4.733
= 2.086 / 4.733
= 0.4407 or 44.07%

Case 5 :-
‘D’ company is considering 3 financial plans as below:-
(i) All equity
(ii) 60% equity and 40% debt
(iii) 40% equity and 60% debt
Total funds need $30000. EBIT is expected to $4500 and shares can be sold
at $2 per share.
Funds can be borrowed as following:-
(i) up to $6000 at 8%
(ii) from $6001 to $15000 @ 12%
(iii) Above $15000 at 18%
Assume the tax rate is 50% and calculate the EPS for each plan.

Solution:-

Calculation of Interest on debt:-

Financial plan 1 :-
Interest on debt = 0.00 because there is No debt in plan 1.

Financial Plan 2 (Total Funds $30000 x 40%

debt = $12000):-
interest on Debt Up to 6000 @ 8% $480
interest on debt from 6001 to 12000 i.e.
(6000 x 12%) $720
Total interest on debt $1200

Financial Plan 3 (Total Funds $30000 x 60%

debt = $18000):-
interest on Debt Up to 6000 @ 8% $480
interest on debt from 6001 to 15000 i.e.
(9000 x 12%) $1080
interest on debt above 15000 i.e. (3000 x
18%) $540
Total interest on debt $2100

Calculation of number of shares:-

Financial Plan 1:-
Equity share capital (30000 x 100%) $30000
Share value $2
number of shares (30000 / 20) 1500

Financial Plan 2:-

Equity share capital (30000 x 60%) $18000
Share value $2
number of shares (18000 / 20) 900

Financial Plan 3:-

Equity share capital (30000 x 40%) $12000
Share value $2
number of shares (12000 / 20) 600
 Profitability statement of 'D' limited
Alternative Alternative Alternative
Particulars
1 2 3
EBIT 4500.00 4500.00 4500.00
Less :
0.00 1200.00 2100.00
Interest
EBT 4500.00 3300.00 2400.00
Less :Tax 2250.00 1650.00 1200.00
EAT or net
2250.00 1650.00 1200.00
Earnings
No. of
1500.00 900.00 600.00
shares
EPS 1.50 1.83 2.00

NOTE :-
EPS = EAT or Net earnings / No. of shares

Case 6 :-
The capital structure of a company ‘P’ consists of an ordinary share capital of
$20000 (shares of $10each) and $20000 of 10% debentures. The sales of the
company increased by 20% from 2000 units in the year 2018 to 2400 units in
the year 2019. The selling price is $10 per unit. Variable cost is $6 per unit.
The fixed cost is $2000. Tax rate is 35%. Calculate the below:-
(i) EPS
(ii) operating leverage
(iii) Financial leverage

Solution:-

Profitability statement of 'P' limited

Year Year
Particulars
2018 2019
Sales (2000x10) (2400x10) 20000.00 24000.00
 Less : Variable cost(2000x6) 12000.00 14400.00
(2400x6)
Contribution 8000.00 9600.00
Less : Fixed cost 2000.00 2000.00
EBIT 6000.00 7600.00
Less : Interest (20000x10%) 2000.00 2000.00
EBT 4000.00 5600.00
Less :Tax @35% 1400.00 1960.00
EAT or net Earnings 2600.00 3640.00
No. of shares 2000.00 2000.00
EPS (EAT or Net earnings / No. of
1.30 1.82
shares)
Operating leverage (Contribution /
EBIT) 1.33 1.26
Financial leverage (EBIT / EBT) 1.50 1.36

Case 7 :-
‘C’ limited is considering an expansion programme which requires $150000
additional finance. The financing options under consideration include a 50%
of debenture issued for 20 years at 13% interest and an issue of equity stock
at $50 per share i.e. $ 10 less than the current market price. The company has
an equity structure with 15000 equity shares outstanding. The company
projects its EBIT after expansion at $210000 and the tax rate is 35%. Analyse
the effect of Financial leverage.

Solution:-

Profitability statement of 'D' limited

Amount
Particulars
($)
EBIT 210000.00
Less : Interest (150000x50%x13%) 9750.00
EBT 200250.00
Less :Tax @35% 70087.50
 EAT or net Earnings 130162.50
No. of shares 15000.00
EPS (EAT or Net earnings / No. of
8.68
shares)
Financial leverage (EBIT / EBT) 1.05

Financial leverage = $1.05 lakhs

------------ End of the CHAPTER – 10 ----------

CHAPTER – 11
TIME VALUE OF MONEY

Learning objectives
After studying this chapter, you can be able to :-
1. Understand that what the money gives time
value, and
2. Calculate the present value and future value
of cash flows.

Meaning:-
The relationship between the monetary value of today and the same monetary
value in future is called as “Time value of money”.

Types of Time value of money:-

The time value of money can be calculated in the following circumstances: -
1. Future value of single cash flow
2. Future value of an annuity
3. Present value of a single cash flow
4. Present value of an annuity
1. Future value of single cash flow:-
In this type, we can make payment by investing or depositing the single lump
sum amount today and we will get the single lump sum amount inclusive
interest in future against we invested today. Fixed deposit is one of the
examples of this type.

(a) Discrete method:-

Example 1:-
Mr ‘X’ is deposited $50,000 today with interest rate of 10% per annum.
Then, how much amount Mr ‘X’ will earn after 5 years.

Solution:-
We can calculate the future value of a single cash flow by given formula
below:-
FV = PV (1+r)t
Here:-
FV : Future value
PV : Present value i.e. 50,000
r : interest rate i.e. 0.10 or 10%
t : tenure i.e. 5 years (periods)

We can get the values as below by substitute in above formula

FV = 50,000 (1 + 0.10)5
FV = 50,000 (1.1)5
FV = 50,000 x 1.61051
FV = 80.525.50

Conclusion:-
Mr ’X’ will get the future value of single cash flow inclusive interest after 5
years is $80525.50

(b) Compounding method:-

Example 2:-
In the case of above problem, how much Mr ‘X’ will get the future value of
single cash flow inclusive interest after 5 years by continuous compound
method?

Solution:-
We can calculate the future value of a single cash flow by given formula
below:-
FV = PV (ert)
Here:-
FV : Future value
PV : Present value i.e. 50,000
e : 2.7183 i.e. exponential which is taken from natural logarithm (i.e. log to
the base of 2.7183)
r : interest rate i.e. 0.10 or 10%
t : tenure i.e. 5 years (periods)

We can get the values as below by substitute in above formula

FV = 50,000 (e0.10 x 5)
FV = 50,000 (e0.5)
FV = 50,000 x 1.64872678
FV = 82436.34

Conclusion:-
Mr ’X’ will get the future value of single cash flow inclusive interest after 5
years is $82436.34

2. Future value of an annuity:-

In this case, we can make a deposit or investment of equated amounts in
continuous periods and we will get single lump sum amount inclusive interest
in future.

(a) Discrete method:-

(i) To know the future value of single lump sum amount by investing
equated amount for continuous number of periods:-

Example 1 :-
Mr ‘A’ deposited $4,000 annually in a bank for 5 years and the deposits earn
an interest rate of 10%. Then, what will be the value of this service of
deposits at the end of 5 years i.e. calculate the future value of an annuity after
5 years.

Solution:-
We can calculate the future value of an annuity by given formula below:-
FV = PV(1+r)t-1 + PV(1+r)t-2 + PV(1+r)t-3 + PV(1+r)t-4 + PV(1+r)t-5 +
……..
Here:-
FV : Future value
PV : Present value i.e. 4,000
r : interest rate i.e. 0.10 or 10%
t : tenure i.e. 5 years (periods)

We can get the values as below by substitute in above formula

FV = 4000(1+0.10)5-1 + 4000(1+0.10)5-2 + P4000(1+0.10)5-3 + 4000(1+0.10)5-4

+ 5000(1+0.10)5-5
FV = 4000(1.1)4 + 4000(1.1)3 + 4000(1.1)2 + 4000(1.1)1 + 5000(1.1)0
FV = 4000(1.4641) + 4000(1.331) + 4000(1.21) + 4000(1.1) + 5000(1)
FV = 5856.40 + 5324.00 + 4840.00 + 4400.00 + 4000
FV = 24,420.40

Conclusion:-
The future value of an annuity after 5 years is $24,420.40 i.e. Mr ‘A’ will get
single lump sum amount inclusive interest after 5 years is $24,420.40 by
investing $4,000 every year for 5 years.

(ii) To know the cash flow i.e. equated amount of investment:-

Example 2:-
Inverse of the above problem i.e. Mr ‘A’ wants to buy a car after 5 years
when it is expected to cost of $24,420.40 . Then, how much Mr ‘A’ should
invest (save) annually if the savings earn an interest rate of 10% per annum.

Solution:-
We can calculate the cash flow i.e. equated investment amount for 5 years by
given formula below:-
FVA = CF x FVIFA
FVIFA = [{(1+r)t – 1} / r]
CF = FVA / FVIFA
or
CF = FVA / [{(1+r)t – 1} / r]
Here:-
FVA : Future value of an annuity i.e. 24,420.40
PV of CF : Present value or cash flow
r : interest rate i.e. 0.10 or 10%
t : tenure i.e. 5 years (periods)

We can get the values as below by substitute in above formula

CF = 24420.40 / [{(1+0.10)5 – 1} / 0.10]

CF = 24420.40 / [{(1.1)5 – 1} / 0.10]
CF = 24420.40 / [{(1.61051 – 1} / 0.10]
CF = 24420.40 / (0.61051 / 0.10)
CF = 24420.40 / 6.1051
CF = $4,000

Conclusion:-
Mr ‘A can invest $4000 annually as equated investment to get the single
lump sum amount of $24,420.40 (inclusive interest) to buy a car after 5 years.

(b) Compounding method:-

Example 3:-
In the case of above problem, how much amount should invest annually by
Mr ‘A’ for 5 years to get single lump sum amount (inclusive interest) of
$24,420.40 after 5 years by continuous compounding method.

Solution:-
We can calculate the future value of an annuity by given formula below:-
FVA = CF x FVIFA
FVIFA = [(ert-1) / r]
CF = FVA / FVIFA
or
CF = FVA / [(ert-1) / r]
Here:-
FVA : Future value of an annuity i.e. 24,420.40
PV of CF : Present value or cash flow
e : 2.7183 i.e. exponential which is taken from natural logarithm (i.e. log to
the base of 2.7183)
r : interest rate i.e. 0.10 or 10%
t : tenure i.e. 5 years (periods)

We can get the values as below by substitute in above formula

CF = 24,420.40 / [(2.71830.10 x 5-1) / 0.10]

CF = 24,420.40 / [(2.71830.50-1) / 0.10]
CF = 24,420.40 / [(2.7183-0.5) / 0.10]
CF = 24,420.40 / (0.606528632 / 0.10)
CF = 24,420.40 / 6.065286324
CF = 4,026.26

Conclusion:-
Mr ‘A should invest $4026.26 annually as equated investment to get the
single lump sum amount of $24,420.40 (inclusive interest) to buy a car after 5
years.

3. Present value of single cash flow:-

In this type (method), we receive a single lump sum amount today and we
have to pay single lump sum amount inclusive interest after some periods in
future.

(a) Discrete method:-

Example 1:-
Mr ‘P’ has to pay a single lump sum amount to the bank (inclusive interest
rate of 12% per annum) of $6,000 after 5 years. Then, how much amount Mr
‘P’ received (i.e. present value) today from the bank?

Solution:-
We can calculate the present value of a single cash flow by given formula
below:-
PV = FV / (1+r)t
Here:-
FV : Future value i.e. 6000
PV : Present value
r : interest rate i.e. 0.12 or 12%
t : tenure i.e. 5 years (periods)

We can get the values as below by substitute in above formula

PV = 6000 / (1+0.12)5
PV = 6000 / (1.12)5
PV = 6000 / 1.76234
PV = 3,404.56

Conclusion:-
Mr ‘P’ received today of $3,404.56 as single lump sum amount and he has to
pay $6000 inclusive interest rate of 12% as single lump sum amount after 5
years.

(b) Compounding method:-

Example 2:-
In the case of above problem, how much Mr ‘P’ is receiving today to pay the
single lump sum amount (inclusive continuous discounting interest rate of
12% per annum) of $6000 after 5 years.

Solution:-
We can calculate the present value of a single cash flow by given formula
below:-
PV = FV / ert
Here:-
FV : Future value i.e. 6000
PV : Present value
e : 2.7183 i.e. exponential which is taken from natural logarithm (i.e. log to
the base of 2.7183)
r : interest rate i.e. 0.12 or 12%
t : tenure i.e. 5 years (periods)
We can get the values as below by substitute in above formula

PV = 6000 / ert
PV = 6000 / 2.71830.12x5
PV = 6000 / 2.71830.60
PV = 6000 / 1.822126
PV = 3296.86

Conclusion:-
Mr ‘P’ has received today as single lump sum amount of $3292.86 in
continuous discounting method.

4. Present value of an annuity:-

(i) Under this method, we have to pay single lump sum amount today to
party. Then, we will receive the equated instalments for number of years
(periods) inclusive interest from the party.

Example 1:-
Mr ‘C received equated instalment amount (inclusive of interest rate 12% per
annum) of $1000 for 5 years. Then, how much Mr ‘C’ should invest single
lump sum amount today.

Solution:-
We can calculate the present value of an annuity by given formula below:-
PVA = FV(1/1+r)1 + FV(1/1+r)2 + FV(1/1+r)3 + FV(1/1+r)4 + ………
FV(1+r)t
Here:-
FV : Future value
PVA : Present value of an annuity i.e. 1,000
r : interest rate i.e. 0.12 or 12%
t : tenure i.e. 5 years (periods)

We can get the values as below by substitute in above formula.

PVA = 1000(1/1+0.12)1 + 1000(1/1+0.12)2 + 1000(1/1+0.12)3 +

1000(1/1+0.12)4 + 1000(1+0.12)5
PVA = 1000(1.12)1 + 1000(1.12)2 + 1000(1.12)3 + 1000(1.12)4 + 1000(1.12)5
PVA = 1000(0.8928) + 1000(0.7971) + 1000(0.7116) + 1000(0.6354+
1000(0.5673)
PVA = 892.80 + 797.10 + 711.60 + 635.40 + 567.25
PFA = 3604.15

Conclusion:-
Mr ‘C’ should invest as single lump sum amount of $3604.15 today to
receive the annual equated instalment amount of 1,000 (inclusive interest) for
5 years .

(ii) Under this method, we can receive single lump sum amount today from
party. Then, we have to pay as equated instalments for number of periods
inclusive interest. Loan taken from bank is the best example for this type.

(a) Discrete method:-

Example 2:-
Mr ‘C’ taken a home loan from bank for $50,000 at interest rate of 12% per
annum. Then, what should Mr ‘C’ has to pay equal annual instalment for re-
payment period of 5 years.

Solution:-
We can calculate the present value of an annuity in discrete discounting
method by given formula below:-
CF = PVA x PVIFA
PVIFA = [{(1+r)t – 1} / {r(1+r)t}]
PVA = CF / PVIFA
or
PVA = CF / [{(1+r)t – 1} / {r(1+r)t}]
Here:-
PVA = Present value of an annuity
CF : Cash inflow i.e. 50,000
PVIFA : Present value interest factor for an annuity
r : rate of interest i.e. 0.12 or 12%
t : Tenure i.e. 5 years

We can get the values as below by substitute in above formula.

PVA = 50000 / [{(1+0.12)5 – 1} / {0.12(1+0.12)5}]
PVA = 50000 / [{(1.12)5 – 1} / {0.12(1.12)5}]
PVA = 50000 / [1.76234 – 1} / 0.12{1.76234}]
PVA = 50000 / (0.76234 / 0.211481)
PVA = 50000 / 3.604768
PVA = 13,870.52

If Mr ‘C’ wants to pay Equated monthly instalments, then,

r : 0.12 / 12 i.e. 0.01
t : 5 x 20 i.e. 60 months (periods)

PVA = 50000 / [{(1+0.01)60 – 1} / {0.01(1+0.01)60}]

PVA = 50000 / [{(1.01)60 – 1} / {0.01(1.01)60}]
PVA = 50000 / [(1.816697 – 1) / 0.01(1.816697}]
PVA = 50000 / (0.816697 / 0.018167)
PVA = 50000 / 44.95497
PVA = 1,112.22

Conclusion:-
Mr ‘C’ should pay equated instalment of $13,870.52 per year for 5 years or
$1,112.22 per month for 5 years in discrete discounting method.

(b) Compounding method:-

Example 3:-
In the case of above problem, how much equated instalment per year has to
pay by Mr ‘C’ in continuous discounting method.

Solution:-
We can calculate the present value of an annuity in continuous discounting
method by given formula below:-

CF = PVA x PVIFA
PVIFA = [(1 – e-rt) /r]
PVA = CF / PVIFA
or
PVA = CF / [(1 – e-rt) /r]
Here:-
PVA = Present value of an annuity
CF : Cash inflow i.e. 50,000
e : 2.7183 i.e. exponential which is taken from natural logarithm (i.e. log to
the base of 2.7183)
PVIFA : Present value interest factor for an annuity
r : rate of interest i.e. 0.12 or 12%
t : Tenure i.e. 5 years

We can get the values as below by substitute in above formula.

PVA = 50000 / [(1 – 2.7183-0.12x5) / 0.12]

PVA = 50000 / [(1 – 2.7183-0.60) / 0.12]
PVA = 50000 / [(1 – 0.54881) / 0.12]
PVA = 50000 / (0.45119 / 0.12)
PVA = 50000 / 3.75992
PVA = 13,298.16

If Mr ‘C’ wants to pay Equated monthly instalments, then,

r : 0.12 / 12 i.e. 0.01
t : 5 x 20 i.e. 60 months (periods)

PVA = 50000 / [(1 – 2.7183-0.01x60) / 0.01]

PVA = 50000 / [(1 – 2.7183-0.60) / 0.01]
PVA = 50000 / [(1 – 0.54881) / 0.01]
PVA = 50000 / (0.45119 / 0.01)
PVA = 50000 / 45.119
PVA = 1,108.18

Conclusion:-
Mr ‘C’ should pay equated instalment of $13,298.16 per year for 5 years or
$1,108.18 per month for 5 years in continuous discounting method.

------------ End of the CHAPTER – 11 ----------

 CHAPTER – 12
VALUATION OF BONDS AND SHARES

Learning objectives
After studying this chapter, you can be able to :-
1. Know the features of a bond,
2. Valuation of bonds and debentures,
3. Valuation of preference shares,
4. Explain the process of return generating and equilibrium risk-return
relationship,
5. Explain the relationship between market return and stock’s return
using Beta calculation.
6. Calculate the Beta of a security.

I. DEFINITIONS
Value:-
The value is what an asset is worth today in terms of its potential benefits.

Tangible Asset:-
The asset which is having physical form is called Tangible asset or Real
asset.
For example:- Plant, Machinery, Furniture, etc.

Intangible asset:-
The assets those are not having physical form are called as intangible assets.
For example:- Copyrights, Trademarks, Patents, goodwill etc.

Financial asset:-
The asset which is not having physical existence and is derived from
contractual claim is called financial asset. For example, Bank deposits,
bonds, shares, etc. Assets are recorded at historical cost and they are
depreciated over years.

Concepts of the Value:-

Book value:-
The book value is difference between total assets minus intangible assets and
liabilities of the firm. The book value of share is derived as Share capital plus
reserves divided by number of shares of a company. In other words, the book
value of debt is stated at the outstanding amount.

Replacement value:-
The amount that a company would be required to spend if it were to replace
its existing assets or things in current condition is called as Replacement
value.

Liquidation value:-
The amount that a company could realize if sold its assets or things after
having terminated its business. But, it should not include the value of
intangible assets as the operations of the company are assumed to cease.
Generally, the liquidation value is minimum value if a company may accept
if it sold. Going concern value is higher than the liquidation value.

Market value:-
The current price at which the asset (or security) is being bought or sold in
the market is called as the market value of the asset. In ideal situation, the
market value should be equal to present value of a security where the capital
markets are efficient and equilibrium. Here, present value means intrinsic
value.

Bond/Debenture:-
A bond or debenture is a long-term debt instrument. It is an example for a
financial asset. Bonds are issued by the government and thereby the bonds
have no risk by default. The bonds issued by Public sector undertakings
(PSUs) are secured, but we cannot say these are risk less. The private
companies issued the bonds are called as debentures. Generally, the interest
rate is fixed in case of both the bonds and debentures.
Features of a bond/debenture:-
The most common features of a bond or debenture are as mentioned below:-

Face value:-
The value of the face of the bond (or debenture or security) is called as face
value. The interest will be calculated on the face value of the bond/debenture.
The face value is also known as par value.

Interest rate:-
Interest rate on a bond or debenture is fixed to pay to bond holder or
debenture holder. This interest amount received on a bond/debenture is tax
deductible. The interest rate is also known as coupon rate.

Maturity:-
The bond/debenture generally issued for the specific period is called as
maturity period. The bond/debenture’s amount will be re-paid on the maturity
date or expiration date of the bond/debenture.

Redemption value:-
The value i.e. the bond holder or debenture holder will get on maturity date is
called as maturity value or redemption value or terminal value. A
bond/debenture can be redeemed at par (face value) or premium or at
discount. Here, premium means the value is more than the face value and
discount means the value less than the face value of the bond/debenture.

Market value:-
The value of the bond or debenture at which it is traded on the stock
exchange is called the market value of the bond/debenture/security.
Otherwise, the price at which it is currently sold or bought in market is
known as market value. The market value is different from face/par value or
redemption value of the bond/debenture.

II. VALUATION OF BONDS OR DEBENTURES

Bond/Debenture with maturity:-
The companies issue the bonds/debentures with specify the interest rate and
maturity period. The present value of the bond/debenture is the discounted
value of bond/debenture’s cash flows i.e. the annual interest payments plus
the maturity value of the bond/debenture. The discount rate is the interest rate
i.e. the investors could earn on bonds/debentures with similar characteristics.
We can determine that whether the bond or debenture is overvalued or
undervalued by comparing the present value of a bond/debenture with its
current market value of the bond/debenture.

Case 1
An investor is considering the purchase of a 5-year $100 face value bond
bearing a nominal rate of interest of 9% per annum. The required rate of
return of the investor is 8%. What should the investor be willing to pay now
to purchase the bond if it matures at par (face) value.

Solution:-
Bond value (B0)= [Int1/(1+Kd)] + [(Int2/(1+Kd)2] + [(Int3/(1+Kd)3] + ………..
[(Int n/(1+Kd)n]

Here:-
B0 : Present value of a bond/debenture
Int1 : The amount of interest in period 1
Int2 : The amount of interest in period 2
Int3 : The amount of interest in period 3
Intn : The amount of interest in period n
Kd : Required rate of return on the bond/debenture or Market interest rate
n : Number of years (periods) to maturity

Interest = 100 x 6% i.e. $6.00

Bn = $100
Kd = 8% i.e. 0.08
n = 5 years

we can substitute the above values in the formula as below:-

Bond value (B0)= [6/(1.08)] + [6/(1.08)2] + [6/(1.08)3] + [6/(1.08)4] +

[6/(1.08)5] + [100/(1.08)5]
Bond value (B0)= (6/1.08) + (6/1.1664) + (6/1.2597) + (6/1.3605) +
(6/1.4693) + (100/1.4693)
Bond value (B0)= 5.5555 + 5.1440 + 4.7630 + 4.4102 + 4.0835 + 68.0583
Bond value (B0)= $92.0145

Conclusion:-
Hence, this implies that $100 bond is worth of $92.0145 today if the required
rate of return is 8%. The investor would not be willing to pay more than
$92.02 for the bond today.

Yield to maturity (YTM):-

YTM is a maturity of a bond/debenture’s rate of return i.e. interest income
and capital gain/loss if any. We can calculate the rate of return or yield of the
bond/debenture when its cash flows and current price known. YTM is also
known as internal Rate of Return (IRR) of the bond/debenture.

Case 2
The rate of interest on $100 face value perpetual bond is 7% and its price is
$82 . Find the YTM.

Solution:-
The YTM of the bond/debenture = (Interest income / price of the bond) x 100
The YTM of the bond/debenture =(7% on $100 / 82)x100
The YTM of the bond/debenture = (7 / 82) x 100
The YTM of the bond/debenture = 8.537%

Conclusion:-
The YTM of the bond is 8.54%

Case 3
The market price of a bond is $85 and face value of the bond is $100. The
bond will pay 6% annually for After 5 years, it will be redeemed at par. What
is the bond’s YTM i.e. the rate of return.

Solution:-
Interest amount is 100 x 6% i.e. $6.00
85 = [6/(1+YTM)] + [6/(1+YTM)2] + [6/(1+YTM)3] + [6/(1+YTM)4] +
[6/(1+YTM)5] + [100/(1+YTM)5]

So, we can calculate the YTM by Trial and Error method. We can assume the
YTM is 8% and substitute in below:-
85 = [6/(1.08)] + [6/(1.08)2] + [6/(1.08)3] + [6/(1.08)4] + [6/(1.08)5] +
[100/(1.08)5]
85 = (6/1.08) + (6/1.1664) + (6/1.2597) + (6/1.3605) + (6/1.4693) +
(100/1.4693)
85 = 5.5555 + 5.1440 + 4.7630 + 4.4102 + 4.0835 + 68.0583
85 = $92.0145
The market price of the bond is not equal if we substitute the YTM as 8%.
Hence, let us assume the YTM is 10% and substitute the 10% in above
formula as below:-
85 = [6/(1.10)] + [6/(1.10)2] + [6/(1.10)3] + [6/(1.10)4] + [6/(1.10)5] +
[100/(1.10)5]
85 = [6/(1.10)] + (6/1.21) + (6/1.331) + (6/1.4641) + (1.61051) +
(100/1.61051)
85 = 5.4545 + 4.9587 + 4.5079 + 4.0981 + 3.7255 + 62.0921
85 = $84.8368
Now, the market price of the bond is equal if we substitute the YTM as 10%

Conclusion:-
Hence, we can say the YTM is 10% by using Trial and error method.

Current yield:-
Current yield is annual interest divided by current value of the
bond/debenture. If the bond/debenture’s current price is less than its maturity
value or redemption value, then the bond/debenture’s overall rate of return
would be less than the current yield. The current yield is not same as the
YTM.

Case 4
The annual interest amount is $6 and the current investment is $85. Find the
current yield.
Solution:-
Current yield = Annual interest / market value (current value) of the bond
Current yield = (6 / 85) x 100
Current yield = 7.0588%

Conclusion:-
Current yield in this case is 7.06%. But, current yield considers only annual
interest and it does not account for the capital gain/loss. If the bond price will
increase to $100 on maturity, then there would be a capital gain of $15 (100 –
85). Hence, the bond’s overall rate of return over the period would be higher
than the current yield. The bond’s overall rate of return would be less than the
current yield if the current price of the bond were less than its maturity value.

Yield to call (YTC):-

Sometimes, most of the companies issued the bond/debenture with buy back
(or call provision). This means the companies can be redeemed the
bond/debenture when call back by the company before its maturity date of
the bond/debenture. The YTC is the rate of return of the bond/debenture may
be redeemed before the maturity. Thus, the call period may be different from
maturity period and there by the call value (or terminal/redemption value)
could be different from the maturity value. The procedure for calculating the
YTC is same as the procedure to calculate the YTM.

Case 5
XYZ limited is issuing the bond as the 10% and 10-year $100 bond is
redeemable (callable) in 5 years at a call price of $105. The bond is currently
selling at $92. What is the bond’s yield to call (YTC).

Solution:-
Interest amount is 100 x 10% i.e. $10.00
Bond value (B0)= [Int1/(1+YTC)] + [(Int2/(1+YTC)2] + [(Int3/(1+YTC)3] +
……….. [(Int n/(1+YTC)n]

92 = [10/(1+YTC)] + [10/(1+YTC)2] + [10/(1+YTC)3] + [10/(1+YTC)4] +

[10/(1+YTC)5] + [105/(1+YTC)5]

So, we can calculate the YTC by Trial and Error method. We can assume the
YTC is 12% and substitute in below:-
92 = [10/(1.12)] + [10/(1.12)2] + [10/(1.12)3] + [10/(1.12)4] + [10/(1.12)5] +
[105/(1.12)5]
92 = (10/1.12) + (10/1.2544) + (10/1.4049) + (10/1.5735) + (10/1.7623) +
(105/1.7623)
92 = 8.9286 + 7.9719 + 7.1178 + 6.3552 + 5.6743 + 59.5798
92 = $95.6276
The currently selling price of the bond is not equal if we substitute the YTC
as 12%. Hence, let us assume the YTC is 13% and substitute the 13% in
above formula as below:-
92 = [10/(1.13)] + [10/(1.13)2] + [10/(1.13)3] + [10/(1.13)4] + [10/(1.13)5] +
[105/(1.13)5]
92 = (10/1.13) + (10/1.2769) + (10/1.4429) + (10/1.6305) + (10/1.8424) +
(105/1.8424)
92 = 8.8496 + 7.8315 + 6.9305 + + 6.1332 + 5.4276 + 56.9898
92 = $92.1622
Now, redeemable value of the bond is equal if we substitute the YTC as 13%

Conclusion:-
Hence, we can say the YTC is 13% by using Trial and error method.

Bond value and amortization of principal:-

A bond/debenture may be amortized (i.e. re-payment of principal) every year
rather than at maturity. In this case, the principal will decrease with annual
payments and interest will be calculated on the outstanding amount.

(i) Annual Interest Payments:-

Case 6
The ABC limited is proposing to sell a 5-year bond of $100 at 8% rate of
interest per annum. The bond amount will be amortized (re-paid) equally over
its life. If an investor has a minimum required rate of return of 6%, then what
is the present value of the bond for the investor.

Solution:-
Equal amortized amount for 5 years = $100/5 i.e. $20
The interest rate per annum = 8% i.e. 0.08
PV of Bond (B0)= [CF1/(1+Kd)] + [(CF 2/(1+Kd)2] + [(CF 3/(1+Kd)3] +
………..

The necessary computations may be done in the following tabular form to

calculate Cash flow (CF):-

Total PV
Principal
Re- Principal of the
at the Interest
Year payment at the bond or
beginning ($)
($) end Cash
($)
Flow ($)
2 (1 x 5 (3 +
1 3 4 (1 - 3)
8%) 2)
1 100.00 8.00 20.00 80.00 28.00
2 80.00 6.40 20.00 60.00 26.40
3 60.00 4.80 20.00 40.00 24.80
4 40.00 3.20 20.00 20.00 23.20
5 20.00 1.60 20.00 0.00 21.60
24.00 100.00 124.00

PV of Bond (B0)= [CF1/(1+Kd)] + [(CF 2/(1+Kd)2] + [(CF 3/(1+Kd)3] +

………..

Here:-
CF (Cash flow) = Re-paid amount + interest amount
Kd = 6% i.e. 0.06

B0 = [28.00/(1.06)] + [26.40/(1.06)2] + [24.80/(1.06)3] + [23.20/(1.06)4] +

[21.60/(1.06)5]
B0 = [28.00/(1.06)] + [26.40/(1.1236)2] + [24.80/(1.1910)3] +
[23.20/(1.2625)4] + [21.60/(1.3382)5]
B0 = 26.4151 + 23.4959 + 20.8226 + 18.3766 + 16.1408
B0 = $105.2510
Conclusion:-
Hence, Present value of the bond for the investor is $105.25.

(ii) Semi-annual interest payments:-

Case 7
A 10-year debenture of $100 has an annual rate of interest is 13%, but
interest paid half-yearly. What is the value of the bond if required rate of
return is 16% per annum?

Solution:-
B0 = [[½{(Intt)/{1+(Kd/2)}t] + [(Bn/{1+(Kd/2)}2xn]
Here:-
Interest amount (Int) = $100 x 13% i.e. $13
Bn = $100
Kd = 16% i.e. 0.16
Bn = [[½{(13)/(1+0.08)20] + [(Bn/(1+0.08)2x10]
Bn = [6.50/(1.08)20] + [(Bn/{(1.08)2x10]
Bn = [6.50/(1.08)20] + [(Bn/{(1.08)2x10]
Bn = [6.50 x Annuity factor (8%, 20)] + [100 x PV factor (8%, 20)]
Bn = [6.50 x 9.8181] + [100 x 0.2145]
Bn = 63.8176 + 21.45
Bn = 85.2676

Conclusion:-
Hence, Present value of the bond for the investor is $85.27 at 16% interest
rate annually.

Pure Discount bonds:-

The pure discount bond/debenture does not have any interest rate. It proves
for the payment of a lump sum amount at a future date in exchange for the
current price of the bond/debenture. The difference between face/par value of
the bond/debenture and its purchase price gives the return or YTM to the
investor. The pure discount bond/debenture is also known as zero interest
bond (or coupon/deep discount bond). It is simple to find out the value of
Pure discount bond/debenture because it involves onetime payment i.e.
face/par value of the bond/debenture at maturity. The value of the pure
discount bond is equal to the present value of the amount on maturity.

Case 8
The government issued a pure discount bond for $60 which is having face
value for that is $100. This bond issued for a period of 5 years. This means
that while maturity, the government will pay the investor the face value of
$100. What is the interest rate?

Solution:-
60 = 100 / (1+YTM)5
(1+YTM)5 = 100/60
(1+YTM)5 = 1.6667
Interest (i) = 1.66671/5 - 1
Interest (i) = 1.66670.2 - 1
Interest (i) = 1.1076 - 1
Interest (i) = 0.1076 i.e. 10.76%

Conclusion:-
Hence, Interest rate is 10.76%.

Case 9
XYZ limited issued a debenture with a face value of $25000 with a maturity
of 10 years. The current market yield on the similar debenture is 10%. What
is the value of the pure discount debenture of XYZ limited.

Solution:-
B0 = [Mn/(1+Kd)n

Here:-
M = Maturity value i.e. $25000
Kd = Market yield% i.e. 10%
n = No. of periods i.e. 10 years

B0 = [25000/(1+0.10)10
B0 = [25000/(1.10)10
B0 = 25000/2.5937
B0 = 9638.74

Conclusion:-
Hence, value of the pure discount debenture of XYZ limited is $9638.24.

Perpetual bond:-
The bond/debenture which has an indefinite life i.e. no maturity value is
called as Perpetual bond or debenture. In the case of perpetual bond, the
value of the bond/debenture would simply be the discounted value of the
infinite stream of interest flows because no terminal value or redemption
value or maturity value. The perpetual bond is also known as “consol”.

Case 10
A 10%, $100 debenture with annual interest payment of $10 is perpetuity.
What would be the debenture’s value if the market yield (interest rate) is 16%

Solution:-
B0 = Int/Kd
B0 = 10/0.16

Conclusion:-
Hence, value of the perpetual debenture is $ 62.50 at 16% interest rate. So
that we can remember that the value of bond/debenture will decrease as the
interest rate increased. Conversely, the value of bond/debenture will increase
as the interest rate decreased.

Bond duration and interest rate sensitivity:-

The bond/debenture’s maturity and coupon rate provide an idea of its price
sensitivity to interest rate changes. The sensitivity of the bond/debenture can
be more accurately estimated by its duration. The bond prices are sensitive to
changes in interest rate and they are inversely related to the interest rates. The
intensity of the price sensitivity depends on a bond’s maturity and the coupon
rate. The longer the maturity of a bond/debenture is higher the sensitivity to
the interest rate changes. Similarly, the price of a bond with low interest rate
will be more sensitive to the interest rate changes.

Case 11
There is a 2 bonds with maturity of 5 years.
(i) The 8% rate bond of $100 face value has a current market value of $95
and YTM is 10%.
(ii) The 12% rate bond of $100 face value has a current market value of $104
and YTM is 11%.

Calculate the duration for both the bonds. Each cash flow is discounted at
YTM to calculate the present value (PV).

Find out the proportion of present value of each cash flow to the value of the
bond. Duration of the bond is calculated as the proportion of the present
value of cash flows.

Solution:-
The necessary computations of 2 types of bonds are may be done in the
following tabular forms:-

1st Category:-
Cash Discount Proportion
flow factor@10% PV @ Weights of of bond price x
Year
@ 8% on 1/(1+k)n, 10% PV @10 Time
100 k=10% (Duration)
4 (2 x
1
2 3 3) 5 6 (5 x 1)
1 8 0.9091 7.2727 0.0787 0.0787
2 8 0.8264 6.6116 0.0715 0.1431
3 8 0.7513 6.0105 0.0650 0.1951
4 8 0.6830 5.4641 0.0591 0.2365
5 108 0.6209 67.0595 0.7256 3.6280
92.4184 1.0000 4.2814

2nd Category:-

Discount Proportion
Cash Weights
factor@11% PV @ of bond price x
 Year flow 1/(1+k)n, 11% of PV @ Time
@ 12% k=11% 11% (Duration)
1 2 3 4 (2 x 3) 5 6 (5 x 1)
1 12 0.9001 10.8011 0.1045 0.1045
2 12 0.8102 9.7219 0.0941 0.1882
3 12 0.7292 8.7506 0.0847 0.2541
4 12 0.6564 7.8764 0.0762 0.3049
5 112 0.5908 66.1680 0.6404 3.2022
103.3180 1.0000 4.0539

We noticed from above tables that 72.56% (0.7256) of present value of the
cash flows of 8% bond i.e. 1st category and 64.04% (0.6404) of present value
of the cash flows of 12% bond i.e. 2nd category were occurred in the last year.

The duration of 8% bond is (lower coupon bon) greater i.e. 4.2814 than the
duration of 12% bond (higher interest/coupon bond).

Volatility or Interest sensitivity:-

Volatility of bond = Duration / (1+YTM)

(i) The volatility of 8% bond = 4.2814 / (1+0.10)

= 4.2814 / 1.10
= 3.892

(ii) The volatility of 8% bond = 4.0539 / (1+0.12)

= 4.0539 / 1.12
= 3.6195

Conclusion:-
Hence, the 8% bond has higher volatility (3.892) than 12% bond (3.6195).
It implies that if YTM is increased by 1%, this will result in 3.892% decrease
in the price of the 8%bond and 3.6195% decrease in the price of the 12%
bond.
Yield Curve:-
The curve which shows the relationship between the YTM and their maturity
is called as yield curve or “Term structure of interest rate”. Generally, the
yield curve showing upward slope which indicates that the long-term yields
are higher than the short-term yields. Conversely, the high inflation periods
have the downward slope yield curve which indicates the short-term yields
are higher than the long-term yields. The down slope yield curve is also
termed as “inverted yield curve”.

III. VALUATION OF PREFERENCE SHARES

Types of Shares:-
The owners of the shares are called as shareholders. The capital contributed
by the shareholders is called as share capital.

Preference shares:-
Preference shares are those which are having the preference comparing to
ordinary shares in terms of dividend payment and re-payment of capital when
the company is closing (or windup).

The company may issue below types of shares:-

Redeemable and Irredeemable preference shares:-

The companies may be issued the preference shares with or without maturity
period. The shares which are having maturity period is called as redeemable
preference shares and those shares which are issuing without maturity period
are called as irredeemable preference shares.

Cumulative and Non-cumulative preference shares:-

The preference shareholders get dividends paid at a fixed rate. The preference
share’s dividends which are un-paid and the same will accumulate and
payable in the future are called as Cumulative preference shares. The
preference share’s dividends which are in arrears and do not accumulate and
not paid in future to the preference shareholders by the companies, those
preference shares are called as Non-cumulative preference shares.

Transferable and Non-transferable preference shares:-

The preference shares which are having the right to convert from preference
shares to equity (ordinary) shares after a stated period are called as
Transferable or Convertible preference shares and those shares which are not
having the right to convert the preference shares in to equity shares are
known as Non-transferable or Non-convertible preference shares.

The main features of the preference or equity shares are dividend, redemption
and conversion. The dividend paid on preference shares and ordinary shares
are not tax deductible in India.

Share value with maturity:-

Case 1
The investor is considering the purchase of a 8-year 10% $100 face value
preference share. The redemption value of the preference share on maturity is
$125. The required rate of return of the investor is 11%. What should investor
be willing to pay for the share now.

Solution:-
The investor would expect to receive the Preference dividend of $10 every
year for 12 years and $110 on maturity i.e.at the end of 12 years.

Value of preference share = present value of dividends + present value of

maturity value.
P0 = [PDIV1/(1+Kp)] + [PDIV2/(1+Kp)2] + [(PDIV3/(1+ Kp)3] + ……
[(PDIVn/(1+ Kp)n]
or
P0 = PDIV x [(1/Kp) - 1/{Kp(1+Kp)n}] + [Pn/(1+Kp)n]

Here:-
PDIV = Preference dividend per share in period t i.e. $10
Kp = Required rate of return of preference share i.e. 11% or 0.11
Pn = Value of the preference share on maturity

P0 = PDIV x [(1/Kp) - 1/{Kp(1+Kp)n}] + [Pn/(1+Kp)n]

P0 = 10 x [(1/0.11) - 1/{0.11(1+0.11)8}] + [125/(1+0.11)8]
P0 = 10 x [(1/0.11) - 1/{0.11(2.3045}] + [125/(2.3045]
P0 = 10 x [(9.091) – 1/0.2535] + [125/(2.3045]
P0 = 10 x [9.091 – 3.9448] + [125/2.3045]
P0 = [10 x 5.1461] + [54.2417]
P0 = 51.461 + 54.2417
P0 = 105.7027

Conclusion:-
The present value of $105.7027 is a composite of the present value of
dividends $51.461 and present value of redemption value $54.2417. The
$100 preference share is worth of $105.70 today at 11% required rate of
return. So that the investor would be better by purchase the share for $100
today.

Irredeemable preference share

Case 2:-
ABC limited issued $100 irredeemable preference share on which it pays a
dividend of $8.00. Assume that the preference share is currently yielding a
dividend of 12%. Find the value of preference share.

Solution:-
The preference dividend of $8 is perpetuity. Thus, the present value of the
preference share is :-
P0 = PDIV / Kp
P0 = 8 / 0.12
P0 = 66.67

Conclusion:-
The present value of the preference share is $66.67

Yield on preference share:-

Case 3:-
If the price of preference share is $70 and preference dividend of $8, then,
what return do investors require.

Solution:-
Rate of return = PDIV / PV
Rate of return = 8/70
Rate of return = 0.1143 or 11.43%

Conclusion:-
The required rate of return is 11.43%

IV. VALUATION OF ORDINARY (EQUITY) SHARES

The valuation of ordinary shares is relatively more difficult because of the
below 2 factors:-
(i) The rate of dividend on equity shares are not shown.
(ii) The payment of equity dividend is optional i.e. not mandatory.
Thus, the estimation of amount and timing of the cash flows expected by
equity shareholders are more un-certain.

Single-period valuation:-
Case 3:-
An investor expects the share of to pay a dividend of $4.00 next year and
would sell the share at an expected price of $35 at the end of the year. If the
investor’s opportunity cost of capital i.e. the required rate of return is 13%.
How much should investor pay for the share today.

Solution:-
P0 = (DIV1 + P1) / 1+Ke
P0 = (4 + 35) / 1+0.13
P0 = 39 / 1+0.13
P0 = 39/ 1.13
P0 = 34.5133

Conclusion:-
The investor should pay for the share today is $34.51
Case 4:-
According to the above case, if the investor would have expected the share
price to grow at 4%, what is the value of share today.

Solution:-
P0 = D / (Ke – g)
P0 = 4 / (0.13 – 0.04)
P0 = 4 / (0.09)
P0 = 4 / (0.09)
P0 = 44.4444
Conclusion:-
The value of the share today is $44.44

Multi-period valuation:-
Present value of equity share = Present value of future dividends
P0 = [D1/(1+R)] + [(D2/(1+R)2] + [(D3/(1+R)3] + [(D4/(1+R)4] + ………..
[(Dn/(1+R)n]
Here:-
P0 : Price of the equity share
D1: Expected dividend in first year from now
D2 : Expected dividend in second year from now
D3 : Expected dividend in third year from now
D4 : Expected dividend in fourth year from now
Dn : Expected dividend in n number of year from now
R : Expected rate of return or cost of equity

Example:-
An investor with a 5-year horizon wants to calculate the fair value of the
stock. Given the expected dividend stream for next 5 years and expected
price after 5 years.
D1 = $2.00
D2 = $3.00
D3 = $4.00
D4 = $5.00
D5 = $6.00
Expected stock price after 5 years is $120.00
Cost of equity is 10%.

Case 5:-
An investor with a 5-year horizon wants to calculate the fair value of the
stock. Given the expected dividend stream for next 5 years and expected
price after 5 years.
D1 = $2.00
D2 = $3.00
D3 = $4.00
D4 = $5.00
D5 = $6.00
Expected stock price after 5 years is $120.00
Cost of equity is 10%.

Solution:-
The fair value of the stock is as below:-
P0 = [D1/(1+R)] + [(D2/(1+R)2] + [(D3/(1+R)3] + [(D4/(1+R)4] + ………..
[(Dn/(1+R)n]
P0 = [2/(1+0.1)] + [(3/(1+0.1)2] + [(4/(1+0.1)3] + [(5/(1+0.1)4] + [(6/(1+0.1)5]
……….. [(120/(1+0.1)5]
P0 = (2/1.1)+(3/1.21)+(4/1.331)+(5/1.4641)+(6/1.6105)+(120/1.6105)
P0 =1.82 + 2.48 + 3.00 + 3.42 + 3.72 + 74.51
P0 = 88.95
Hence, the fair value of the stock is $88.95

Conclusion:-
The fair value of the stock is $88.95.

Growth in dividends:-
Earnings and dividends of most of the companies grow over time because
one of the reasons is their retention policies. So that dividends do not remain
constant. They can change in annually. Generally, most of the companies
have been retaining their earnings approximately 50% for re-investing in
business. This will increase the ordinary shareholder’s equity as well as
future earnings of the firm. This leads to increase the EPS if the number of
shares does not change. Moreover, it causes to increase the Dividend per
share (DPS).

Value of share under constant growth

Case 5:-
The price of the share today is $20 and It is expected to increase at an annual
rate of 4%,
The expected dividend after a year is $2,
It is expected to grow at a rate of 4% per annum.
The opportunity cost of capital is 13%
What would be the price of share if were held for 5 years.

Solution:-
P0 = [D1/(1+Ke)] + [(D2/(1+ Ke)2] + [(D3/(1+ Ke)3] + [(D4/(1+ Ke)4] +
……….. [(Dn/(1+ Ke)n]
Here:-
P0 : Price of the equity share
D1: Expected dividend in first year from now i.e. $2
D2 : Expected dividend in second year from now i.e. 2+(2x4%) or 2.08
D3 : Expected dividend in third year from now i.e. 2.08+(2.08x4%) or 2.1632
D4 : Expected dividend in fourth year from now i.e. 2.1632+(2.1632x4%) or
2.250
D5 : Expected dividend in fifth year from now i.e. 2.25+(2.25x4%) or 2.34
Ke : Expected rate of return or cost of equity i.e. 13% or 0.13

Dn : Expected dividend in n number of year from now i.e.

Dn : [Dividend at the end of the last year / (Ke-g)] or [D/(k-g)]
Dn : [2.34/(0.13-0.04)]
Dn : 2.34/0.09
Dn : 26.00

P0: Expected PV at beginning of the year i.e. $20

P1 : Expected PV in second year from now i.e. 20(1.04) or 20.80
P2 : Expected PV in third year from now i.e. 20.08(1.04) or 21.632
P3 : Expected PV in fourth year from now i.e. 21.632(1.04) or 22.50
P4 : Expected PV in fifth year from now i.e. 22.5(1.04) or 23.4
P5 : Expected PV in fifth year from now i.e. 23.4(1.04) or 24.33

P0 = [2/(1+0.13)] + [(2.08/(1+ 0.13)2] + [(2.1632/(1+ 0.13)3] + [(2.25/(1+

0.08)4] + [(2.34/(1+ 0.08)5] + [(24.33/(1+ 0.08)5]

P0 = [2/(1.13)] + [(2.08/(1.13)2] + [(2.1632/(1.13)3] + [(2.25/(1.13)4] +

[(2.34/(1.13)5] + [(24.33/(1.13)5]
P0 = [2/(1.13)] + [(2.08/1.2769] + [(2.1632/1.4429] + [(2.25/1.6305] +
[(2.34/1.8424] + [(24.33/1.8424]
P0 = [1.7700 + 1.6289 + 1.4992 + 1.3800 + 1.2700] + 13.2053
P0 = 7.5481 + 13.2053
P0 = 20.7534

Conclusion:-
The present value (PV) of the stream of dividends is 7.5481 and the share
price at the end of 5 years is 13.2053. Then, the total present value (PV) of
the share is $20.75

Super-normal growth:-
The dividends of a company may not be grow at same rate of constant. It will
face a situation of two stage growth as below:-
(i) the first stage is that the dividends may grow at a super-normal growth
rate when the products of the company having a high demand and collect the
premium from its customers.
(ii) The second stage is that the demand for that company’s products may
come to normal and there by the earnings and dividends may grow at a
normal growth rate.
The share value in the first stage, we can find the present value of constantly
growing dividend annuity for a definite super normal growth period. The
share value in second stage, we can calculate the present value of constantly
growing dividend in perpetuity (indefinite) after the super-normal growth
period.
Case 6:-
A par value of share is $100
Dividend at the end of the 1st year is 12%
It grows at 20% for next 2 years and 10% grows for another 2 years. After
that it grows at 5%
The discount rate is 15%
Find out the present value of the share.

Solution:-
P0 = [D1/(1+Ke)] + [(D2/(1+ Ke)2] + [(D3/(1+ Ke)3] + [(D4/(1+ Ke)4] +
……….. [(Dn/(1+ Ke)n]
Here:-
P0 : Price of the equity share
D1: Expected dividend in first year from now i.e. $100x12% or $12
D2 : Expected dividend in second year from now i.e. 12+(12x20%) or 14.40
D3 : Expected dividend in third year from now i.e. 14.40+(14.4x20%) or
17.28
D4 : Expected dividend in fourth year from now i.e. 17.28+(17.28x10%) or
19.008
D5 : Expected dividend in fifth year from now i.e. 19.008+(19.008x10%) or
20.9088
D6 : Expected dividend in sixth year from now i.e. 20.9088+(20.9088x5%) or
21.95

Ke : Expected rate of return or cost of equity i.e. 15% or 0.15

Dn : Expected dividend in n number of year from now i.e.

Dn : [Dividend at the end of the last year / (Ke-g)] or [D/(k-g)]
Dn : [21.95/(0.15-0.05)]
Dn : 21.95/0.10
Dn : 219.50

P0 = [12/(1+0.15)] + [(14.40/(1+ 0.15)2] + [(17.28/(1+ 0.15)3] + [(19.008/(1+

0.15)4] + [(20.9088/(1+ 0.15)5] + [(219.50/(1+ 0.15)5]
P0 = [12/(1.15)] + [(14.40/1.3225] + [(17.28/1.5209] + [(19.008/1.7490] +
[(20.9088/2.0114] + [(219.50/2.0114]
P0 = [10.4348 + 10.8885 + 11.3619 + 10.8679 + 10.3953] + 109.1303
P0 = 53.9484 + 109.1303
P0 = 163.0787

Conclusion:-
The present value (PV) of the stream of dividends is 53.984 and the share
price at the end of 5 years is 109.1303 Then, the total present value (PV) of
the share is $163.0787

Normal growth:-
If a firm (totally equity financed) retains constant proportion of its annual
earnings and re-invest the same at its IRR which is its ROE, then it will show
that the dividends will grow at a constant rate equal to the product of
retention ratio and Return on Equity (ROE). Hence, Growth = Constant
proportion of annual earnings x ROE.

Case 7:-
The book value of the XYZ firm’s equity per share today is $100 and its ROE
(Return on Equity) is 15%. The firm’s retention ratio is 60% (or payout ratio
is 40%). It is expected that the firm will also earn 15% on its retained
earnings. Assume that the firm has no debt. What is the EPS of the XYZ
firm?

Solution:-
EPS = $100 x 15% i.e $6.667

The firm is retaining 6% and remaining 4% is distributing as dividends.

The book value of equity per share in the beginning of 2nd year is $100+6.667
i.e. $106.667
The firm’s EPS in 2nd year will be (EPS 2) = 106.67x15% i.e. $16.00
Again, it will retain 60% of the earnings = 16x60% i.e. $9.60
And distribute 40% of earnings as dividends – 16x40% i.e. 6.40

Growth = Retention ratIo (b) x ROE

= (60/100) x 15/100)
 = 0.60 x 0.15
= 0.09

Growth in dividends =( Div2 – Div1) / Div1

= (9.60 - 6.667) / 6.667
= 2.933 / 6.667
= 0.4399

Conclusion:-
The EPS is $6.67 and growth rate is 0.09 or 9% and growth in dividends is
0.4399

Perpetual growth model:-

It is based on the below assumptions:-
(i) The capitalization rate or the opportunity cost of capital must be higher
than the growth rate. Otherwise, ridiculous (un-reasonable) results will be
generated.
(ii) The initial dividend per share in end of the year one must be greater than
zero.
(iii) The relationship between capitalization rate and growth is assumed to
remain constant and perpetual.

Case 8:-
A company paid a dividend of $4.50 in the previous year. The dividends in
future are expected to grow perpetually at a rate of 7%. Find out the share
price today if the market capitalizes the dividend at 10%.

Solution:-
P0 = [D0(1+g)/(Ke-g)]
P0 = D1/(Ke-g)
P0 = 4.50/(0.10-0.07)
P0 = 4.50/(0.03)
P0 = 150

Conclusion:-
The share price of the company is $150.00
Case 9:-
XYZ company has a book value per share of $150. The firm’s ROE is 12%.
The firm maintaining 60%of retained earnings. If the cost of capital is 15%,
What would be price of share today.

Solution:-
The firm’s EPS after a year (EPS1) = b x ROE
= $150 x 12%
= $18.00

The firm’s dividend per share after a year (DIV1) = (1 – Retention) x EPS
after the year
= (1-0.60) x $18
= 0.40 x 18
= $7.20

The growth in dividends (g) = Retaining x ROE

= 0.60 x 0.12
= 0.072 or 7.20%

Dividends would grow perpetually.

Price of the share today (P0) = EPS1 / (Ke – g)

= 7.20 / (0.15 – 0.072)
= 7.20/0.078
= $92.3077

Conclusion:-
The share price of the firm today is $92.31

Zero growth:-
Case 9:-
A firm paid $5.00 per share as dividend in the previous year. The
capitalization rate is 15%. What would be the price of the share today if
(i) Growth in dividends is zero
(ii) Growth in dividends is 6% per annum forever.

Solution:-
(i) Ig g = 0, then, P0 = D0(1+g)/(Ke – g)
= 5((1+0)/(0.15 – 0)
=5/0.15
= 33.3333

(ii) If g 0.06, then, P0 = D0(1+g)/(Ke – g)

= 5((1+0.06)/(0.15 – 0.06)
=5.30/0.09
= 58.8889

Conclusion:-
The share price of the firm when growth in dividends is zero is $33.33 and
the share price of the firm when growth in dividends is 6% PA is $58.89

Earnings model:-
Case 10:-
Find out the price of a share if EPS is $4.00 , b=0.30, Ke=0.10, ROE=0.25.
What shall be the price if r=Ke=0.10

Solution:-
P0 = EPS1(1-b)/(Ke – rb)
= 4((1-0.30)/(0.10– 0.25x0.30)
=4(0.70)/0.10-0.075
= 2.80/0.025
= $31.11

Where r=0.10, the price will be (P0) =

= 4((1-0.30)/(0.10– 0.10x0.30)
=4(0.70)/0.10-0.030
= 2.80/0.07
 = $40.00
or Simply EPS1/Ke
= (4/0.10) i.e. $40.00

Conclusion:-
The share price of the firm is $40.00

Equity Capitalization Ratio:-

Case 11:-
A firm’s share is currently selling for $45 per share. It is expected a dividend
of $4 per share after 1 year will grow at 7% indefinitely. Find out the Equity
capitalization rate.

Solution:-
The equity capitalization rate (Ke) = (D/P0)+g
= (4/45)+0.07
=0.08888+0.07
= $0.15888 or 15.89%
Conclusion:-
The Equity capitalization rate is 15.89%

Case 12:-
A firm estimates its EPS1 is $6.50. The firm would pay a dividend of $4.00
per share in the first year and re-invest the retained earnings at a rate of return
of 25%. What is the firm’s
(i) Payout ratio
(ii) Retention ratio
(iii) Growth rate

Solution:-
(i) Payout ratio = D/EPS1
= 4/6.50
= 0.6154 or 61.54%
(ii) Retention ratio = 1 – Payout ratio
= 1 – 0.6154
= 0.3846 or 38.46%

(iii) Growth rate = Retention ratio x ROE

= 0.3846 x 0.25
= 0.09615 or 9.615%
Conclusion:-
The Payout ratio is 61.54%, Retention ratio is 38.46%, Growth rate is
9.615% for the firm.

Case 13:-
A company has a P/E multiplier of 12.50 and the company expects its EPS to
be $10.15 next year. What is the expected share value?

Solution:-
The expected share value will be = EPS x P/E multiplier
= 10.15 x 12.50
= 126.875

Conclusion:-
The expected share value of the firm is $126.875.

V. BETA ESTIMATION AND COST OF THE EQUITY

Beta (β):-
Beta (β) is the measure of systematic risk and it is the ratio of co-variance
between market return and the security’s return to the market return variance.

Case 1:-
The percentage returns on the market based on BSE’s SENSEX (sensitivity
index) and the share of the “Chandu InfoTech Limited” for recent 5 years are
as below:-

Market Chandu
Year Return InfoTech
 rm (%) rc (%)
1 17.50 24.51
2 -15.50 -32.27
3 58.90 48.95
4 -16.23 -9.52
5 -16.85 -11.68

Based on the above data, calculate the below:-

(i) The average return on market (SENSEX) and Chandu’s share
(ii) Deviations on returns on market from the average return
(iii) Deviations of returns on Chandu InfoTech from the average return,
(iv) Variance of Chandu InfoTech’s returns
(v) Co-variance of market returns
(vi) Beta
(vii) Intercept term (Aipha)
(viii) Characteristic line of Chandu InfoTech
(ix) Correlation between market return and Chandu InfoTech share
(x) Co-efficient of determination

Solution:-
The necessary computations may be done in the following tabular form:-

Beta calculation for Chandu InfoTech limited:-

Chandu
Market
Infotech rm - rc - (rm - rm ̅) (rc -
Year Return rc (rm - rm̅̅)2
rm (%) rm ̅ rc ̅ r c)
̅
(%)
1 17.50 24.51 11.94 20.51 244.831232 142.468096
2 -15.50 -32.27 -21.06 -36.27 763.949152 443.692096
3 58.90 48.95 53.34 44.95 2397.559872 2844.728896
4 -16.23 -9.52 -21.79 -13.52 294.611292 474.978436
5 -16.85 -11.68 -22.41 -15.68 351.406692 502.387396
5.564 3.998 4052.35824 4408.254920
(i) a. The average return on market (SENSEX) (rm ̅ ):-
= {17.50 + (-15.50) + 58.90 + (-16.23) + (-16.85)} / 5
= 27.82 / 5
= 5.564

(i) b. The average return on Chandu InfoTech’s share (rc ̅ ):-

= {24.51 + (-32.27) + 48.95 + (-9.52) + (-11.68)} / 5
= 19.99 / 5
= 3.998

(ii) Deviations on returns on market from the average return (rc ̅ ):-
See column number 4 in above table (rm - rm ̅) i.e. 11.94, -21.06, 53.34,
-21.79, -22.41

(iii) Deviations of returns on Chandu InfoTech from the average return:-

See column number 5 in above table (rc - rc ̅) i.e. 20.51, -36.27, 44.95,
-13.52, -15.68

(iv) Variance of Chandu InfoTech’s returns:-

Covmc = {Σ (rm - rm ̅) (rc - rc ̅)} / No. of years
Covmc = 4052.35824/5
Covmc = 810.47

(v) Co-variance of market returns (σ2):-

σm2 = 4408.254920/5
σm2 = 881.65

(vi) Beta (β) (Slope):-

βc = Covcm / σm2
βc = 810.47 / 881.65
βc = 0.919265

(vii) Intercept term (Aipha) (α):-

αC = rc̅ - [βc x rm̅]
αC = 3.998 - [0.9193 x 5.564]
αC = 3.998 - [5.1150]
αC = - 1.117

(viii) Characteristic line of Chandu InfoTech (rC):-

rC = Intercept term (α) + Beta (β)
rC = (-1.117) + 0.9193
rC = -0.1977

(ix) Correlation between market return and Chandu InfoTech share

(Co-efficient of correlation):-

rm
Year rc(Y) X2 y2 XY
(X)
1 17.50 24.51 306.25 600.7401 428.925
2 -15.50 -32.27 240.25 1041.3529 500.185
3 58.90 48.95 3469.21 2396.1025 2883.155
4 -16.23 -9.52 263.41 90.6304 154.5096
5 -16.85 -11.68 283.92 136.4224 196.808
27.82 19.99 4563.05 4265.2483 4163.58

X̅ = ΣX/n
= 27.82/5
= 5.564

Y̅ = ΣY/n
= 19.99/5
= 3.998

βc = [{nΣXY – (ΣX) (ΣY)} / {nΣX2 – (ΣX)2}]

βc = [{5(4163.58) – (27.82) (19.99)} / {5(4563.05) – (27.82)2}]
βc = [{20817.90 – 556.1218} / {22815.25 – 773.95}]
βc = [ 20261.7782 / 22041.30]
βc = 0.91926

Alpha (αC) = Y̅ - βX ̅
Alpha (αC) = 3.998 – 0.91926(5.564)
Alpha (αC) = 3.998 – 5.1148
Alpha (αC) = 1.1168

Co-efficient of correlation (Corcm) = [{nΣXY – (ΣX) (ΣY)}] / [{(nΣY2) -

(ΣY)2} {(nΣX2) - (ΣX)2}1/2]
Corcm = [{5(4163.58) – (27.82) (19.99)} / [{5(4265.2483)} – {(19.99)2}
{5(4563.05) – (27.82)2}1/2]
Corcm = [{20817.90 – 556.1218} / [21326.2415 – 399.6001} {22815.25 –
773.95}1/2]
Corcm = [ 20261.7782 / {(20926.6414) (22041.30)}1/2]
Corcm = [ 20261.7782 / {(461250381.10)1/2}]
Corcm = [ 20261.7782 / 21476.7405]
Corcm = 0.9434

(x) Co-efficient of determination:-

Co-efficient of determination (r2) = (Corcm)2
(r2) = (Corcm)2 (Corcm)2 =
(r2) = 0.94342
(r2) = 0.8900 or 89%

Conclusion:-
(i) The positive correlation indicates that when the market returns go up,
Chandu InfoTech returns also goes up.
(ii) Co-efficient of determination (89%)indicate the percentage of the
variance of Chandu InfoTech returns explained by changes in the market
returns. Therefore, the market explains 89% of Chandu InfoTech risk
(variance of returns) and the remaining 11% un-explained variance is the firm
specific variance.

NOTES:-
(i) Total risk (security variance) = Systematic risk + Un-systematic risk
(ii) Systematic risk = (Cor2) x (security variance)
(iii) Un-systematic risk = (1- Cor2) x (security variance)
(iv) Chandu InfoTech’s Beta (β)= [Covmc / Varm]
Here:-
Cov = Co-variance,
Var = Variance,
m= market returns,
c = Chandu InfoTech returns

Cost of Equity using CAPM:-

Cost of Equity or Expected rate of return using CAPM:-
Case 1:-
XYZ limited is an all equity firm without having any debt. It has a Beta of
1.14. The current risk-free rate is 9% and historical market premium is 10%.
XYZ limited is considering a project that is expected to generate a return of
18%. Assume that the project has the same risk as the firm. What is cost of
equity (Ke)?

Solution:-
Expected rate of return(r) or cost of equity(Ke) = Rf + (Rm – Rf) β
Here:-
Rf = Risk-free rate
Rm = Market returns or market premium
Β = Beta
Ke = Cost of equity

(Ke) = Rf + (Rm – Rf) β

= 9 + [(10)1.14]
= 9 + 11.40
r = 20.40

Conclusion:-
The Expected rate of return(r) or cost of equity(Ke) is 20.40
Case 2:-
ABC limited has a Beta of 1.45. The current risk-free rate is 4% and
historical market return is 11%. What is cost of equity (Ke)?

Solution:-
Cost of Equity (Ke ) = Risk Free Rate + {(Market Rate of Return − Risk Free
Rate) x Beta Coefficient}
Expected rate of return(r) or cost of equity(Ke) = Rf + {(Rm – Rf) β}
Here:-
Rf = Risk-free rate
Rm = Market returns or market premium
β = Beta
Ke = Cost of equity

(Ke) = Rf + (Rm – Rf) β

= 4 + [(11 - 4)1.45]
= 4 + (7 x 1.45)
= 4 + 10.15
r = 14.15

Conclusion:-
The Expected rate of return(r) or cost of equity(Ke) is 14.15

VI. COST OF CAPITAL

In the view point of investors, the average rate of return required by the
investors who provide the long-term funds to the companies is called the cost
of capital. In the view point of companies, the cost of capital is that the
minimum rate of return which a firm must earn on its investment (or both the
debt and equity). So that the market value of company’s equity shareholders
does not fall. The cost of capital is used to evaluate new projects of a
company. In other terms, the discounting rate of the project to discounting its
cash flows is called as opportunity cost or simply called as the Cost of
Capital. The minimum required rate of return on funds committed to the
project which depends on the riskiness of its cash flow is called as the
project’s cost of capital of the firm. Since the investment project of a firm
may difference in risk, each one of them having their own cost of capital. The
cost of capital of a firm’s project is defined by its risk rather than by its
characteristics of the firm’s project. The firm represents the aggregate of
firm’s investment projects. Thus, the cost of capital of the firm will be overall
or average rate of return on aggregate of investment projects. Therefore, the
firm’s cost of capital is not the same as the project’s cost of capital.

The required rate of return of the investment project of the firm may be equal
to the firm’s cost of capital plus or minus a risk-adjustment factor depending
on that whether the risk of the project is higher or lower than the firm’s risk.
The objective method of computing the risk-adjusted cost of capital for
projects is to use the capital asset Pricing Model (CAPM).

The cost of capital of the firm is useful as a standard for the below:-
(i) Evaluating the investment decisions,
(ii) Designing the debt policy of the firm.
(iii) Appraising the financial performance of the management.
In NPV method, the project of investment is accepted if it has a positive
NPV. In the IRR method, the investment project is accepted if the IRR is
greater than the cost of capital. Hence, we can say that the cost of capital is
the minimum required rate of return on an investment project. It is also
termed as “hurdle rate” or “cut-off” rate.

The general formula for the cost of capital is as below:-

I0 = [C1/(1+K)] + [(C2/(1+K)2] + [(C3/(1+K)3] + [(C4/(1+K)4] + ………..

[(Cn/(1+K)n]
Here:-
I0 : Capital supplied by investors in period 0 (i.e. Net cash flow to the firm)
Ct : Expected returns by investors (cash out flows from the firm)
k : Required rate of return or cost of capital

Debt issued at par:-

The before tax cost of debt is rate of return required by lenders. It is easy to
calculate the before-tax cost of debt issued and to be redeemed at par. It is
just equal to the contractual of interest i.e. coupon rate or interest rate.

Case 1:-
A company decides to sell a new issue of 6-year 12% bonds of $100 each at
par. If the company realizes the full face value of $100 bond and will pay
$100 principal to bond holders at maturity, what is the before-tax cost of
debt?

Solution:-
Before-tax cost of debt (Kd) = i = Int / B0
Here
i = Coupon rate
B0 = Issue price of the bond (debt)
Kd = 12/100
= 0.12 or 12%

Conclusion:-
Before-tax cost of debt is 12%

Debt issued at discount:-

Case 2:-
A company issued 5-year 12% bonds of $100 each at par. Each bond is sold
below face value for $95. What is the cost of debt (coc or Kd)?

Solution:-
coc or Kd = [{Int + 1/n(f - B0)}/{1/2(f + B0)}]
Here:-
Int = Coupon rate i.e. 12% or 0.12
f = Face value of the bond
B0 = Issue price of the bond (debt)
N = No. of periods
Kd = [{12+1/5(100-95)}/{1/2(100+95)}]
= [{12+1/5(5)}/{1/2(195)}]
= [{12+1}/{97.5}]
= [{12+1}/{97.5}]
= 0.1333 or 13.33%
Conclusion:-
Cost of debt is 13.33%

Cost of the bond sold at discount and redeem at the par:-

Case 3:-
A 5-year $100 debenture of a firm can be sold for a net price of $95.90. The
interest rate is 12% per year and debenture will be redeemed at 5% premium
on maturity .The firm’s tax rate is 35%. Calculate after-tax cost of debenture.
Solution:-
The annual interest = face value of debenture x interest rate
= 100 x 0.12
= $12

Maturity price = face value x (1 + % of premium)

= 100 x (1 + 0.05)
= 100 x 1.05
= $105

B0 = [Int1/(1+Kd)] + [(Int2/(1+Kd)2] + [(Int3/(1+Kd)3] + ……….. [(Int

n
n/(1+Kd) ]

Here:-
Int1 : The amount of interest in period 1
Int2 : The amount of interest in period 2
Int3 : The amount of interest in period 3
Intn : The amount of interest in period n
Kd : Cost of debt
n : Number of years (periods) to maturity
We can calculate cost of debt by trial and error method. So, assume that the
Kd is 15% i.e. 0.15

95.90 = [12/(1.15)] + [12/(1.15)2] + [12/(1.15)3] + [12/(1.15)4] + [12/(1.15)5]

+ [112/(1.15)5]
95.90 = (12/1.15) + (12/1.3225) + (12/1.5209) + (12/1.7490) + (12/2.0113) +
(112/2.0113)
95.90 = 10.4348 + 9.0737 + 7.8902 + 6.8610 + 5.9661 + 55.6838
95.90 = $95.9096

Thus, the cost of debt (Kd) is 15%

The after-tax cost of debenture = Kd(1-t)
= 0.15(1-0.35)
= 0.15(0.65)
= 0.0975 or 9.75%
Conclusion:-
The after-tax cost of debenture is 9.75%

Cost of Preference capital:-

The companies never issued the preference share capital with an intention of
not to pay dividends. Even though it is not legally compulsory to pay the
preference dividend to the shareholders, the companies generally paid the
dividend when the companies earn profits. Although the failure of payment
of dividend is not cause to bankruptcy, it is a serious matter from the
shareholder’s point of view. The non-payment of dividend on preference
share capital may result in voting rights and control to the preference
shareholders and also the credit standing of the firm may be damaged.
Moreover, market value of equity shares can be adversely affected if
company not paying the dividend to shareholders. The cost of preference
share is not adjusted for taxes because preferential dividend is paid after the
corporate taxes were paid.

Cost of Equity Capital:-

The companies may raise equity capital internally by retained earnings is
called as internal cost of equity whereas the companies may distribute entire
earnings to equity shareholders and raise equity share capital externally by
issuing new shares is called as external cost of equity. The required rate of
the return of the equity shareholders would be the same whether they supply
the funds by purchasing new shares or by foregoing dividends which could
have been distributed to them. The cost of external equity is more to firm
than the cost of internal equity because of the firm may have to issue new
shares at a price lower than the current market price. It can be say that the
equity capital is free of cost as it is not compulsorily required to pay
dividends to the equity shareholders. It is difficult to measure the cost of
equity because of the below two factors:-
(i) Difficult to estimate the expected dividends,
(ii) The future earnings and dividends are expected to grow over time.
Due to the above difficulties, the methods of computing the cost of internal
and external equity are as mentioned below:-
(i) The dividend growth model,
(ii) Constant growth model,
(iii) Zero-growth model

Cost of irredeemable preference share:-

Case 4:-
A company issues 10% irredeemable preference shares. the face value per
share is $100, but the issue price is $96. What is the cost of preference share.

Solution:-
Cost of preference share (Kp) = PDIV/P0

Here:-
PDIV : Expected preference dividend i.e. 100x10% i.e. $10
P0 : Issue price of preference share

Kp = PDIV/P0
= 10/96
= 0.1042 or 10.42%

Conclusion:-
The cost of preference share is 10.42%

Dividend growth model

(i) Constant growth:-
Case 5:-
XYZ Limited’s current market price of a share is $96 and expected dividend
per share in next year is $5.00. If the dividends are expected to grow at a
constant rate of 7%, what is the shareholder’s required rate of return.

Solution:-
The required rate of return (Ke) = (DIV1/ P0)+g
Here:-
DIV1 : Expected dividend in 1st year i.e. $5.00
P0 : Current market price of a share i.e. $96
g : growth rate i.e. 7% or 0.07

Ke = (DIV1/ P0)+g
 = (5/96)+0.07
= 0.0521 + 0.07
= 0.1221 or 12.21%

Conclusion:-
The shareholder’s required rate of return is 12.21%

(ii) Normal growth:-

The Cost of equity (Ke) = (DIV1/ P0)+g
Here:-
DIV1 : DIV0 (1+g)
g : growth rate

P0 = DIV1 / (Ke – g)

Dividend yield = DIV1 / P0

Growth = ROE x b
Here, b means retention ratio

(iii) Zero growth:-

Case 6:-
The share of a company is currently selling at $100. The company wants to
finance its capital expenditure of $80 million either by retaining earnings or
selling new shares. If the company sells new shares, the issue price will be
$96. The dividend per share next year (DIV1) is $5.00 and it is expected to
grow at 7%. Calculate (i) Cost of Internal equity (retained earnings) and Cost
of external equity (new issue of shares).

Solution:-
(i) Cost of internal equity (Ke) = (DIV1 / P0) + g
= (5/100) + 0.07
= 0.05 + 0.07
= 0.12 or 12%

(ii) Cost of external equity (Ke) = (DIV1 / P0) + g

 = (5/96) + 0.07
= 0.0521 + 0.07
= 0.1221 or 12.21%
Conclusion:-
The Cost of internal equity is 12.00% and Cost of external equity is 12.21%.

Weighted Average Cost of Capital (WACC):-

The rate that a company is expected to pay on average to all its shareholders
to finance its assets. It is commonly referred to as the firm’s cost of capital. It
should be noted that it is dictated by the external market and not by the
management. The steps involved for calculating the firm’s WACC are
mentioned below:-
(i) The component costs of debt and equity are calculated.
(ii) Weights to each component of cost of capital are assigned according to
the target capital structure.
(iii) The product of component costs and weights are summed-up to
determine the WACC.
The Weighted average cost of new capital is the Weighted Marginal Cost of
Capital (WMCC). WACC can be calculate using the below formula:-

WACC(K0) = Ke(E/E+D)+Kd(1-T)(D/E+D)
Here:-
Ke : Cost of equity
Kd : Cost of debt
E : Equity
D : Debt
T : Tax rate

Case 7:-
From the following particulars of XYZ Limited calculate the Weighted
average cost of capital.

After tax
Source of Amount Proportion
component
Finance (S) (%)
cost (%)
Share capital
 (Equity 2500 36.76471 15
Reserves and
Surplus 1100 16.17647 16
Share capital
(Preference) 1000 14.70588 12
Debt 2200 32.35294 8
6800

Solution:-
The necessary computations may be done in the following tabular form to
calculate weighted average cost of capital (WACC).

After tax
Source of Amount Proportion WACC
component
Finance ($) (%) (%)
cost (%)
5 = [(3 x
1 2 3 4
4)/100]
Share capital
(Equity) 2500 36.76470588 15 5.51
Reserves and
Surplus 1100 16.17647059 16 2.59
Share capital
(Preference) 1000 14.70588235 12 1.76
Debt 2200 32.35294118 8 2.59
6800 100 12.46

Suppose, XYZ Limited having 250 outstanding equity shares and the current
market price per share is $20. Assume that the market value and book values
of debt and preference share capital are the same. If the component costs
were the same as before, what is the market value WACC?

Computation of WACC (market value):-

After tax
Source of Amount Proportion WACC
 Finance ($) (%) component (%)
cost (%)
5 = [(3 x
1 2 3 4
4)/100]
Share capital
(Equity) 5000 60.97560976 15 9.15
Share capital
(Preference) 1000 12.19512195 12 1.46
Debt 2200 26.82926829 8 2.15
8200 100 12.76

Conclusion:-
The WACC is 12.46% and market value WACC is 12.76%

NOTE:-
The equity capital for XYZ Limited is total market value of the equity shares
(ordinary) which include retained earnings (reserves) . it is compulsorily that
the market value WACC (12.76) is higher than the book value of WACC
(12.46%) because, the market value of share capital ($5000) is higher than
the book value i.e. Equity share capital + Reserves (i.e. 2500 + 1100).

VII. ANNUITY FACTOR TABLES

1. Future value of a lump sum:-

Future value interest factor of $1 per period at i% for n periods, FVIF (i,n).

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853
 12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.835
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449

Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.110 1.120 1.130 1.140 1.150 1.160 1.170 1.180 1.190 1.200
2 1.232 1.254 1.277 1.300 1.323 1.346 1.369 1.392 1.416 1.440
3 1.368 1.405 1.443 1.482 1.521 1.561 1.602 1.643 1.685 1.728
4 1.518 1.574 1.630 1.689 1.749 1.811 1.874 1.939 2.005 2.074
5 1.685 1.762 1.842 1.925 2.011 2.100 2.192 2.288 2.386 2.488
6 1.870 1.974 2.082 2.195 2.313 2.436 2.565 2.700 2.840 2.986
7 2.076 2.211 2.353 2.502 2.660 2.826 3.001 3.185 3.379 3.583
8 2.305 2.476 2.658 2.853 3.059 3.278 3.511 3.759 4.021 4.300
9 2.558 2.773 3.004 3.252 3.518 3.803 4.108 4.435 4.785 5.160
10 2.839 3.106 3.395 3.707 4.046 4.411 4.807 5.234 5.695 6.192
11 3.152 3.479 3.836 4.226 4.652 5.117 5.624 6.176 6.777 7.430
12 3.498 3.896 4.335 4.818 5.350 5.936 6.580 7.288 8.064 8.916
13 3.883 4.363 4.898 5.492 6.153 6.886 7.699 8.599 9.596 10.699
14 4.310 4.887 5.535 6.261 7.076 7.988 9.007 10.147 11.420 12.839
15 4.785 5.474 6.254 7.138 8.137 9.266 10.539 11.974 13.590 15.407
16 5.311 6.130 7.067 8.137 9.358 10.748 12.330 14.129 16.172 18.488
17 5.895 6.866 7.986 9.276 10.761 12.468 14.426 16.672 19.244 22.186
18 6.544 7.690 9.024 10.575 12.375 14.463 16.879 19.673 22.901 26.623
19 7.263 8.613 10.197 12.056 14.232 16.777 19.748 23.214 27.252 31.948
20 8.062 9.646 11.523 13.743 16.367 19.461 23.106 27.393 32.429 38.338
25 13.585 17.000 21.231 26.462 32.919 40.874 50.658 62.669 77.388 95.396
30 22.892 29.960 39.116 50.950 66.212 85.850 111.065 143.371 184.675 237.376

2. Present value of a lump sum:-

Present value interest factor of $1 per period at i% for n periods, PVIF (i,n).

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057
35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 0.036
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009

Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
 20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
25 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010
30 0.044 0.033 0.026 0.020 0.015 0.012 0.009 0.007 0.005 0.004
35 0.026 0.019 0.014 0.010 0.008 0.006 0.004 0.003 0.002 0.002
40 0.015 0.011 0.008 0.005 0.004 0.003 0.002 0.001 0.001 0.001
50 0.005 0.003 0.002 0.001 0.001 0.001 0.000 0.000 0.000 0.000

3. Future value of an annuity:-

Future value interest factor of an ordinary annuity of $1 per period at i% for n
periods, FVIFA (i,n).

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347
30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.28 136.31 164.49
35 41.660 49.994 60.462 73.652 90.320 111.43 138.24 172.32 215.71 271.02
40 48.886 60.402 75.401 95.026 120.80 154.76 199.64 259.06 337.88 442.59
50 64.463 84.579 112.80 152.67 209.35 290.34 406.53 573.77 815.08 1,163.9

Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.110 2.120 2.130 2.140 2.150 2.160 2.170 2.180 2.190 2.200
 3 3.342 3.374 3.407 3.440 3.473 3.506 3.539 3.572 3.606 3.640
4 4.710 4.779 4.850 4.921 4.993 5.066 5.141 5.215 5.291 5.368
5 6.228 6.353 6.480 6.610 6.742 6.877 7.014 7.154 7.297 7.442
6 7.913 8.115 8.323 8.536 8.754 8.977 9.207 9.442 9.683 9.930
7 9.783 10.089 10.405 10.730 11.067 11.414 11.772 12.142 12.523 12.916
8 11.859 12.300 12.757 13.233 13.727 14.240 14.773 15.327 15.902 16.499
9 14.164 14.776 15.416 16.085 16.786 17.519 18.285 19.086 19.923 20.799
10 16.722 17.549 18.420 19.337 20.304 21.321 22.393 23.521 24.709 25.959
11 19.561 20.655 21.814 23.045 24.349 25.733 27.200 28.755 30.404 32.150
12 22.713 24.133 25.650 27.271 29.002 30.850 32.824 34.931 37.180 39.581
13 26.212 28.029 29.985 32.089 34.352 36.786 39.404 42.219 45.244 48.497
14 30.095 32.393 34.883 37.581 40.505 43.672 47.103 50.818 54.841 59.196
15 34.405 37.280 40.417 43.842 47.580 51.660 56.110 60.965 66.261 72.035
16 39.190 42.753 46.672 50.980 55.717 60.925 66.649 72.939 79.850 87.442
17 44.501 48.884 53.739 59.118 65.075 71.673 78.979 87.068 96.022 105.93
18 50.396 55.750 61.725 68.394 75.836 84.141 93.406 103.74 115.27 128.12
19 56.939 63.440 70.749 78.969 88.212 98.603 110.28 123.41 138.17 154.74
20 64.203 72.052 80.947 91.025 102.44 115.38 130.03 146.63 165.42 186.69
25 114.41 133.33 155.62 181.87 212.79 249.21 292.10 342.60 402.04 471.98
30 199.02 241.33 293.20 356.79 434.75 530.31 647.44 790.95 966.71 1,181.9
35 341.59 431.66 546.68 693.57 881.17 1,120.7 1,426.5 1,816.7 2,314.2 2,948.3
40 581.83 767.09 1,013.7 1,342.0 1,779.1 2,360.8 3,134.5 4,163.2 5,529.8 7,343.9
50 1,668.8 2,400.0 3,459.5 4,994.5 7,217.7 10,436 15,090 21,813 31,515 45,497

4. Present value of an annuity:-

Present value interest factor of an (ordinary) annuity of $1 per period at i%
for n periods, PVIFA (i,n).

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.644
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779
50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.233 10.962 9.915

Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
25 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948
30 8.694 8.055 7.496 7.003 6.566 6.177 5.829 5.517 5.235 4.979
35 8.855 8.176 7.586 7.070 6.617 6.215 5.858 5.539 5.251 4.992
40 8.951 8.244 7.634 7.105 6.642 6.233 5.871 5.548 5.258 4.997
50 9.042 8.304 7.675 7.133 6.661 6.246 5.880 5.554 5.262 4.999
------------ End of the CHAPTER – 12 ----------

CHAPTER – 13
COST OF CAPITAL

Learning objectives
After studying this chapter, you can be able to :-
1. Understand the concept of cost of capital,
2. Recognize the need for calculating cost of capital,
3. Distinguish the various types of Debt,
4. Develop the inputs required for applying Capital Asset
Pricing Model (CAPM). and
5. Computation of Weighted Average Cost of Capital
(WACC).

I. DEFINITION OF COST OF CAPITAL :-

The rate of return which the firm requires from investment in order to
increase value of the firm in the market is termed as Cost of Capital. From the
view of investors, the average rate of return required by the investors who
provide the long-term funds to the companies is called the cost of capital. In
the view of companies, the cost of capital is that the minimum rate of return
which a firm must earn on its investment (both the debt and equity). The
sources of capital of a firm may be in the form of preference shares, equity
shares, debt, and retained earnings. In simple cost of capital of a firm is the
weighted average cost of their different sources of financing.

The cost of capital of the firm is useful as a standard for the below:-
(i) Evaluating the investment decisions,
(ii) Designing the debt policy of the firm.
(iii) Estimating the financial performance of the company / project.
The general formula for the cost of capital is as below:-
I0 = [C1/(1+K)] + [(C2/(1+K)2] + [(C3/(1+K)3] + [(C4/(1+K)4] + ………
[(Cn/(1+K)n]
Here:-
I0 : Capital supplied by investors in period 0 (i.e. Net cash flow to the firm)
Ct : Expected returns by investors (cash out flows from the firm)
k : Required rate of return or cost of capital

II. IMPORTANCE OF COST OF CAPITAL :-

(a) It helps in evaluating the investment options, by converting the future
cash flows of the investment pathways into present value by discounting it.
(b) It is useful in construct the optimum credit policy at the time of deciding
credit period to be allowed to the debtors of the firm, and it should be
compared with the cost of allowing credit period.
(c) It plays a key role in mapping the optimal capital structure of the firm,
wherein the firm’s value is maximum, and the cost of capital is minimum.
(d) It can be used to evaluate the performance of specific projects by
comparing the performance against the cost of capital of the firm.
(e) It is helpful in taking capital budgeting decisions regarding the sources of
finance which is used by the firm.

III. COMPONENTS OF COST OF CAPITAL :-

A firm’s cost of capital includes 3 components. They are :-

(a) Return at zero risk level :-

It is relating to the expected rate of return when a project involves no
financial risk or business risk.

(b) Business risk premium :-

It is determined by the capital budgeting decisions for investment proposals.
If the firm selects a project which has higher than the normal risk, the
suppliers of the funds for the project will generally expect a higher rate of
return than that of normal rate. Hence, the cost of capital increases.

(c) Financial risk premium :-

It is relating to the pattern of capital structure of a company. A company
which has higher debt content in its capital structure should have more risk
than a company which has comparatively low debt content.
The above 3 components of cost of capital will be written in the form of
below equation :-
k = r0 + b + f
Here, k = cost of capital,
r0 = return at zero risk level
b = business risk premium
f = financial risk premium

IV. CLASSIFICATION OF COST OF CAPITAL :-

1. Historical cost and Future cost :-

Historical cost is the cost which incurred for procurement of the funds, based
on the existing capital structure of the company. It is nothing, but a book cost.
Future cost is the cost which relates to estimation for the future. Simply, it is
the cost to be incurred for raising new funds.

2. Specific cost and Composite cost :-

Specific cost refers to the cost which is associated with the particular source
of capital such as cost of equity, cost of debt, cost of preference shares, cost
of retained earnings, etc. Composite cost is the combined cost of different
sources of capital taken together i.e. weighted average cost of capital.

3. Average cost and Marginal cost :-

Average cost is combined cost of various sources of capital such as equity
shares, debentures, preference shares, etc. Marginal cost is the cost of raising
one extra dollar of capital. It is also termed as incremental (or differential)
cost of capital. It refers to the change in overall cost of capital resulting from
the raising of one more dollar of fund. Simply, Marginal cost is the relevant
cost of new funds required to be raised by the firm.

4. Explicit cost and Implicit cost :-

Explicit cost of capital is the cost of capital in which company’s cash outflow
is adapt towards utilisation of capital which is an evident i.e. payment of
dividend to the shareholders, interest to the debenture holders, etc. Implicit
cost of capital doesn’t involve any cash outflow, but it denotes the
opportunity foregone while opting for another alternative opportunity. If a
firm retains its earnings, implicit cost will be the income, the shareholders
could have earned if such earnings would have been distributed and invested
by them elsewhere.

V. COMPUTATION OF COST OF CAPITAL :-

Computation of cost of capital may be done from the below types.
A. Computation of specific costs,
B. Cost of Composite capital or Weighted Average Cost of Capital (WACC).

A. Computation of specific costs :-

1. Cost of Debt :-
It is the rate of return which is expected by lenders. Debt may be perpetual
(or irredeemable), and redeemable (or repayable).

(a) Cost of irredeemable debt :-

(i) before tax :-
Cost of Debt (kd) = I / NP
Here, kd = cost of debt
I = Interest
NP = Net proceeds (or issue price of the bond)
(i) when debt issued at par : NP = face value - issue expenses
(ii) when debt issued at premium : NP = (face value + premium) - issue
expenses
(iii) when debt issued at discount : NP = (face value – discount) – issue
expenses

Example :-
A company decides to sell a new issue of 6-year 12% bonds of $100 each at
par. If the company realizes the full face value of $100 bond and will pay
$100 principal to bond holders at maturity, what is the before-tax cost of
debt?

Solution:-
Before-tax cost of debt (Kd) = I / NP
Here
Kd = 12/100
= 0.12 or 12%

(ii) after tax :-

Cost of Debt (kd) = [(I / NP) (1 - t)]
Here, kd = cost of debt
I = Interest
NP = Net proceeds
t = tax rate

(b) Cost of redeemable debt :-

Redeemable debt refers to the debt which is to be redeemed (or repayable)
after the expiry of a fixed period of the time.
(i) before tax :-
Kd = [{I + (p – NP)}/n / (p + NP)/2]
Here, I = Annual interest payment
P = par value of debentures
NP = net proceeds of debentures
n = number of years to maturity

(ii) after tax :-

Kd = [kd (before tax) x (1 – t)]
Here, t = tax rate

(c) Cost of existing debt :-

Cost of existing debt (before tax) = Annual cost before tax / Average value of
Debt
Here, Average value of Debt (AV) = [(NP + RV) / 2]
Here, AV = Average value
NP = Net proceeds
RV = Redemption value

2. Cost of preference shares :-

Even though it is not legally compulsory to pay the preference dividend to the
shareholders, the companies generally paid the dividend when the companies
earn profits. The cost of preference shares is not adjusted for taxes because
preferential dividend is paid after the corporate taxes were paid. The cost of
preference shares can be calculate in below two types :-
(a) Cost of irredeemable preference share capital :-
Cost of irredeemable preference share capital (kp) = D / NP
Here,
D = fixed preference dividend
NP = Net proceeds of preference shares

Example :-
A company raises preference share capital of $100,000 by issuing 10%
preference shares of $100 each. Compute the cost of preference capital when
they are issued at
(i) at 10% premium, and
(ii) at 10% discount

Solution :-
(i) when preference shares are issued at a premium of 10%,
Kp = DP / NP
Where D = fixed preference dividend
= $100,000 x 10% i.e. $10,000
NP = face value + premium - issue expenses
= 100,000 + (10% 0f 100,000) – 0
= $110,000
Therefore kp = 10,000 / 110,000
= 0.09090 or 9.09%

(ii) when preference shares are issued at a discount of 10%,

Kp = D / NP
Where D = fixed preference dividend
= $100,000 x 10% i.e. $10,000
NP = face value - discount - issue expenses
= 100,000 - (10% 0f 100,000) – 0
= $90,000
Therefore kp = 10,000 / 90,000
= 0.11111 or 11.11%

(b) Cost of redeemable preference share capital :-

Cost of redeemable preference share capital (kp) = [d + {(p – NP)/n} /
(d + NP)/2]
Here, d = annual dividend
P = par value of preference shares
NP = Net proceeds of preference shares
n = number of years to maturity

Example :-
A company issues 10% redeemable preference shares for $100,000
redeemable at the end of the 10th year from the year of their issue. The
underwriting cost is 5%. Calculate the effective cost of preference share
capital.

Solution :-
(kp) = [d + {(p – NP)/n} / (d + NP)/2]
Here, d = $100,000x10% i.e. $10,000
P = $100,000
NP = [$100,000 – ($100,000x5%)] i.e. $95,000
n = 10

Therefore, = [10,000 + {(100,000 – 95,000)/10} / (100,000 + 95,000)/2]

= [{10,000 + (5000/10} / (100,000 + 95,000)/2]
= (10,000 + 500) / (195,000/2)
= 10,500 / 97500
= 0.10769 or 10.77%

3. Cost of Equity shares :-

Cost of equity (Ke) is the minimum rate of return which an organization must
earn to convince their investors to invest in the company's common stock
(equity shares) at its current market price. Cost of equity also termed as cost
of common stock or required return on equity. It can be say that the equity
capital is free of cost as it is not compulsorily required to pay dividends to the
equity shareholders. It is difficult to measure the cost of equity because of the
below two factors:-
(i) Difficult to estimate the expected dividends,
(ii) The future earnings and dividends are expected to grow over time.
The below 4 methods commonly used to calculate cost of equity.

(a) Dividend model (No growth) :-

This model is used for estimation of cost of equity when the stock is paying a
dividend. Growth rate is nothing, but the product of retention.
Cost of equity capital (ke) = d / NP
Here, d = expected dividend per share
NP = Net proceeds per equity share

Example :-
A company issues dividend at 10% irredeemable preference shares. the face
value per share is $100, but the issue price is $96. What is the cost of
preference share.

Solution:-
Cost of preference share (Ke) = d / NP
Ke = 10 / 96
= 10/96
= 0.1042 or 10.42%

(b) Dividend plus growth (Dividend discount) model :-

In this method, cost of equity capital calculated based on the dividend yield
and the growth rate in dividend.
Cost of equity capital (ke) = (d / NP) + g
Here, d = expected dividend per share
NP = Net proceeds per equity share (or current market price of the
stock)
g = growth rate of the dividend

Example :-
XYZ Inc’s current market price of a share is $96 and expected dividend per
share in next year is $5.00. If the dividends are expected to grow at a constant
rate of 7%, what is the shareholder’s required rate of return.

Solution:-
The required rate of return (Ke) = (d / NP) + g
Here:-
D : Expected dividend in 1st year i.e. $5.00
NP : Current market price of a share i.e. $96
g : growth rate i.e. 7% or 0.07

Ke = (d / NP) + g
= (5/96)+0.07
= 0.0521 + 0.07
= 0.1221 or 12.21%

(c) Earnings model :-

Cost of equity capital (ke) = EPS / NP
Here, EPS = Earnings per equity share
NP = Net proceedings

(d) Capital Asset Pricing model (CAPM) :-

We can use CAPM model, or any other advanced model for many stocks
which are not paying the dividend. CAPM is a model which used to
determine a theoretically appropriate required rate of return of an asset to
make decisions about adding assets to a well-diversified portfolio. Beta co-
efficient is a statistic that measures the systematic risk of a company's
common stock. The market rate of return is the rate of return on the market.
Return on a relevant benchmark index such as SENSEX or NIFTY is a good
estimate for market rate of return.
Cost of Equity Ke CAPM = Risk free rate + Market risk premium (or equity
risk premium)
Here, Market risk premium = [ Beta co-efficient x (market return – risk free
return) ]
We can simplify, Ke CAPM = [ Rt + {β + ( Rm - Rt )} ]
Here, Rt = Risk free rate of return
Β = Beta co-efficient
Rm = Return on market portfolio

Example :-
Assume that the yield on 6-year treasury bonds as at 31st March 2020 is
0.75%. we find that “XYZ Inc” share price as at 31st March 2020 is $87.45
per share while it has a beta coefficient of 1.78. Trailing 12 months return on
S&P CNX NIFTY is 10.67%. Estimate the cost of equity.
Solution :-
Ke CAPM = [ Rt + {β + ( Rm - Rt )} ]
= 0.75% + {1.78 × (10.67% − 0.75%)}
= 0.75 + (1.78 x 9.92)
= 0.75 + 17.6576
= 18.4076%

4. Cost of Retained Earnings :-

The portion of the profit retained by the company for future development,
and expansion of the business is known as Retained earnings. Simply, un-
distributed profits are called as Retained earnings. We should not consider
the floatation cost while calculating retained earnings. Some people feel that
retained earnings carry no cost as no dividend is required to be paid on
retained earnings. But this approach is not appropriate. Retained earnings
have the opportunity cost of dividends from alternative investment. Hence,
shareholders can expect return on retained earnings at least equity.
Thus, Cost of retained earnings is equal to cost of equity. If any tax, and
brokerage is there, then,
Cost of retained earnings (kr) =[ ke (1 – t) (1-b) ]
Here, t = tax rate
b = brokerage rate (%)

Cost of Rights Issue :-

The shares are offered to the existing shareholders in proportion to the
existing shareholding is known as Rights issue. Hence, the existing
shareholders will have the right to subscribe first. If any balance shares, after
allotted to existing shareholders, will be offered to public for subscription, or
private placement, etc.
When he sells ex-rights i.e. after exercising the option :-
P = [ (MN + SR) / (N + R) ]
Here,
P = Theoretical market price of the share when he sells ex-rights
M = market price of the share when it is sold cum – rights
N = Number of existing shares
S = Subscription price per share
R = Number of right shares
Note :-
Value of right = Cum-right share price – Ex- right share price

Cum-rights :-
A company offers right to its shareholders to purchase new shares at a
discount in order to maintain their proportionate ownership (i.e., no dilution),
is known as cum right. The shares which are still have rights available to
shareholders are referred to as cum rights.

Ex-rights :-
Shares trading ex-rights have passed the expiration of the rights offering
period, or they have been transferred to another party (thus making the rights
no longer possible to trade), or the original holder may have already
exercised the rights. Ex-rights shares are worth less.

B. Cost of Composite capital or Weighted Average Cost of Capital

(WACC):-
The rate that a company is expected to pay on average to all its shareholders
to finance its assets is known as weighted average cost of capital (WACC). It
is commonly referred to as the firm’s cost of capital. It should be noted that it
is dictated by the external market and not by the management. It refers to the
weighted average cost of different sources of finance. It is very important in
financial decision making. Steps involved in computation of WACC :-
(i) Calculate the cost of each of the sources of finance is ascertained,
(ii) Assigned weights to the specific costs,
(iii) Multiplying the cost of each source by their appropriate weights,
(iv) Dividing the total weighted cost by the total weights.
Weighted average cost of capital (kw) = ∑XW / ∑W
Here, X = cost of specific source of finance
W = weights i.e. portion of specific source of finance

Example :-
The cost of capital (after tax), and its capital structure of an organization are
as mentioned below :-
Cost of debt 5.00%
Cost of preference
share capital 12.00%
Cost of equity share
capital 15.00%
Cost of Retained
earnings 14.00%

Book value
Source ($)
Debt 200000
Preference share
capital 300000
Equity share
capital 500000
Retained earnings 200000
Total 1200000

Calculate the weighted average cost of capital (WACC).

Solution :-
The necessary computations may be done from the following tabular form :-

Amount After tax Weighted

Source Weights
($) cost cost
E=(Cx
A B C D
D)
200000 0.167 5.00% 0.00833
Debt (200000 /
1200000)

Preference share 300000 0.250 12.00% 0.03000

(300000 /
capital 1200000)

Equity share 500000 0.417 15.00% 0.06250

capital (500000 /
1200000)
200000 0.167 14.00% 0.02333
Retained earnings (200000 /
1200000)
Total 1200000 1.000 0.12417

Therefore, the weighted average cost of capital (WACC) is 0.12417 or

12.417% .

Alternative approach :-
We can calculate the WACC from the below method also :-

Amount Total
Source ($) Cost cost
D=(B
A B C x C)
Debt 200000 5.00% 10000
Preference
share capital 300000 12.00% 36000
Equity share
capital 500000 15.00% 75000
Retained
earnings 200000 14.00% 28000
Total 1200000 149000

Therefore, the WACC = Total cost / Total capital structure

= 149,000 / 1,200,000
=0.124167 or 12.417% .

Suppose, the market value of various sources of funds are mentioned below
in addition to the information in above example, calculate WACC.

Market
Source
value ($)
Debt 300000
Preference shares 400000
Equity and Retained
900000
earnings
Total 1600000

We can calculate the market value share of Equity share capital and Retained
earnings are as below :-

Book Market Market

Source Percentage
value ($) value ($) value ($)
A B C D E=CxD
Equity 0.7142857 642857.14
500000 (500000 /
Shares 700000)
900000
Retained 0.2857143 257142.86
200000 (200000 /
earnings 700000)
Total 700000 1.00 900000.00

Then, we can calculate WACC from the below tabular form :-

Market value Total Cost

Source Cost (%)
($) ($)
A B C D=BxC
Debt 300000.00 5.00% 15000.00
Preference share
400000.00 12.00% 48000.00
capital
Equity share
642857.14 15.00% 96428.57
capital
Retained earnings 257142.86 14.00% 36000.00
Total 1600000.00 195428.57

Therefore, WACC = Total cost / Total market value

= 195,428.57 / 1,600,000
 =0.1221428 or 12.214% .

Flow chart of Classification of cost of capital :-

------------ End of the CHAPTER – 13 ----------

CHAPTER – 14
PORTFOLIO MANAGEMENT

Learning objectives
After studying this chapter, you can be able to :-
1. Measure the risk and return of a portfolio,
2. Know the steps involved in portfolio management,
3. Explain the risk tolerance,
4. Select an appropriate asset allocation mix based on time
horizon and risk tolerance,
 5. Calculate the various measures of portfolio performance, and
6. Learn the measures in co-movements in security returns.

Meaning of portfolio:-
A portfolio is any combination or a group of financial assets such as stocks,
bonds, commodities, gold, currencies and cash equivalents as well as their
fund counterparts including mutual, exchange-traded and closed funds. A
portfolio can also consist of non-publicly tradable securities like real estate
and private investments. Portfolios of investments are held directly by
investors and/or managed by financial professionals and money managers
like portfolio managers, financial advisors (analysts), mutual fund managers,
wealth management advisors, banks and other financial institutions. Investors
should construct an investment portfolio in accordance with their risk
tolerance and their investing objectives. The monetary value of each asset
may influence the risk/reward ratio of the portfolio. The main aim of the
proper asset allocation (portfolio) is minimizing the risk and maximizing the
expected return. There are several methods for calculating the portfolio
returns and their performance. One traditional method is using periodic
(monthly or quarterly) money-weighted returns. However, the true time-
weighted method is also a method preferred by many investors in financial
markets.

Generally, the process of investment exists of 2 jobs as mentioned below:-

1. Security analysis:-
The analysis which focuses on evaluating the risk and return characteristics
of the available alternatives of investment.

2. Portfolio selection:-
The selection which is involved in choosing the best possible portfolio from
the set of reasonable portfolios.

Investors can build the practicable portfolio with help of the efficient
diversification.

Meaning of diversification:-
Diversification is a method of portfolio management or an asset allocation
plan whereby an investor reduces the investment risk of their portfolio by
holding a wide variety of investments in different types of assets that have
low correlations with each other. It is a risk management technique. Investors
accept a certain level of risk and also need to have an exit strategy if their
investment does not generate the expected return in their portfolio. Hence, by
constructing a well-diversified portfolio, the investors will protect their
investments. The proper asset allocation allows investors to leverage the
investment risk and portfolio volatility as each asset is expected to react
differently to various market conditions. Diversification reduces risk if
returns are not perfectly positively correlated.

Process of portfolio management:-

Meaning of portfolio management:-
Portfolio means a combination of financial assets and physical assets. The
financial assets include shares, bonds, debentures and other securities while
physical assets are gold, silver, real estates, etc. The essence of portfolio is
that assets are held for investment purposes and not for consumption
purposes.

Steps (Phases) in Portfolio management:-

The below essential Steps (phases) involved in Portfolio management
process:-

1. Identification of objectives and constraints

2. Selection of asset mix
3. Formulation of portfolio strategy
4. Security analysis
5. Portfolio execution
6. Portfolio revision
7. Portfolio evaluation.

1. Identification of objectives and constraints:-

The primary step in the portfolio management process is to identify the
objectives and limitations. The portfolio management has to focus on the
below objectives and constraints of an investor in first place.

A. Objectives:-
The objective of an Investor is income with minimum amount of risk, capital
appreciation, etc. The goals or objectives of portfolio investment are as
under:-
(i) Income:-
Income means which the investor can receive regular dividend, interest
amount, etc. of the investment.
(ii) Growth:-
Growth also very important to the investor to increase the principal of an
investment.
(iii) Stability of growth or income:-
After growth in the principal of investment, the investor requires the stability
in growth or income.
(iv) Risk assessment:-
The risk assessment (tolerance) questionnaires by portfolio managers i.e.
mutual fund managers, fund advisors, brokerage firms, etc. will help the
investors to get an idea of risk tolerance of investment in securities.

B. Limitations (constraints):-
The limitations of portfolio management are as below:-
(i) Liquidity:-
If the investors sell their assets, they may have to give some significant
discount to the buyers against its fair market price. So that the investors have
to maintain the minimum level of cash in their investment portfolio.
(ii) Investment horizon:-
Investment horizon means the time till the investment or a part of the
investment is planned to be liquidated to meet a specific requirement. If the
investment involves a higher investment horizon, the investor should wait
more time to liquidate the money. So, the investment horizon is an important
constraint on the choice of assets or securities.
(iii) Taxes:-
If the taxes are having higher percentage on the investments, the investment
will be less liquidity (or income) from such a higher rate of taxes levied. So,
investors should carefully select the asset or stock which is not having higher
rate of taxes.
(iv) Regulations:-
Even though individual investors are generally not limited much by law, the
institutional investors may bind to various regulations of the nation. For
example, mutual funds in India should not hold more than 10% of the equity
shares of a public company.

2. Selection of asset mix:-

The investors have to specify their asset allocation (mix) based on their
objectives and limitations to decide how much of the portfolio have to be
invested in each of the following asset categories or sectors in portfolio
investment.
i. Preference shares,
ii. Equity shares,
iii. Cash,
iv. Stocks,
v. Bonds or debentures,
vi. Precious metals,
vii. Real estate,
viii. Banking, etc.
The percentage of the asset mix depends on the risk tolerance and investment
limit of the investor. Generally, the stocks are riskier than bonds or
debentures and hence the stocks can earn more returns than bonds or
debentures. The below various types of stocks or bonds with order wise risk
and return levels are for our reference.
i. Bank deposits (less risk and less returns)
ii. Public sector bonds (less risk and less returns)
iii. Private sector bonds (moderate risk and moderate returns)
iv. Defensive stocks (moderate risk and moderate returns)
v. Blue-chip stocks (moderate risk and moderate returns)
vi. Growth stocks (high risk and higher returns)
vii. Speculative shares (high risk and higher returns)
viii. As per Benjamin Graham who is the investment guru, the investors
should invest between 25% and 75% of their funds in common stocks.

3. Formulation of portfolio strategy:-

After certain asset mix is chosen, the next step in the portfolio management
process is formulation of an appropriate portfolio strategy. There are 2
choices for the formulation of portfolio strategy as below:-

(A) Active portfolio strategy:-

An active portfolio strategy attempts to earn a superior risk adjusted return by
adopting the market timing, sector rotation (i.e. switching from one sector to
another sector) according to market condition, security selection or a
combination of all of these. These strategies respond much more to changing
expectations. They aim to benefit from the differences between the beliefs of
a portfolio manager concerning the valuations and those of the marketplace.
Making investments according to a particular style of investment and
generating alpha are examples of such active investments.

(i) Market timing:-

The market timing is depend based on an explicit or implicit forecast of
general market movements. A clear study on market timing tells that an
investment manager must forecast the market correctly. After the costs of
errors and costs of transactions are taken in to accounts, 75% of the time just
to break-even.

(ii) Sector rotation:-

This can be applied for stocks and bonds. The investors can invest their
investments with respect to the stock component of the portfolio where
shifting the weights in the growing stocks. For example, the investors believe
that the banking sector will raise in near future. Then the investors will rotate
their investments in banking sector. Similarly, the investors can rotate their
investments in bonds whose bonds are having attractive interest rates and
benefits to investors.

(iii) selection of security:-

The investors must select the stock or bonds or any other securities which are
actively trading, giving higher returns with lesser risk to invest their
investments. The investors should select the stocks which are having good
performance through fundamental as well as technical analysis. The below
stocks are successfully used or selected by the investment professionals to
invest the funds.
i. Growth stocks
ii. Value stocks
iii. Cyclical stocks
In the passive strategy, the capital market is characterised by inefficiencies
which are used by resorting to their aims.
(B) Passive portfolio strategy:-
A passive portfolio strategy has a pre-determined level of risk tolerance. The
portfolio is broadly diversified and maintained strictly. These strategies
comprise of portfolios that do not respond to any changes in expectations.
Buy and hold and indexing are examples of such passive strategies. In the
passive portfolio strategy, the capital market is efficient with respect to the
available information. The passive strategy sticks to the following 2 guide
lines:-
(i) Creation of a well- diversified portfolio at a pre-determined level of risk.
(ii) Investors hold the portfolio which is relatively un-changed over time
unless it becomes inadequately diversified or inconsistent with the
preferences of investors risk-return.

By analysing the above 2 strategies, we can conclude that the active strategy
takes a lot of time and consumes a great deal of energy whereas the passive
strategy takes little time or effort. Hence, if the investors have more time to
spare, highly competitive and linking a complicated challenge, then active
strategy is the best to implement. If the investors feel rushed, simplicity and
don’t like to think about money, then passive approach is the best to
investors.

4. Security analysis:-
Security analysis involves both micro analysis and macro analysis. For
example, analysing one stock (script) is micro analysis. Analysis of market of
securities is macro analysis. Fundamental analysis and technical analysis
helps to identify the securities that can be included in portfolio of an investor.
There are many types of securities available in the market including equity
shares, preference shares, debentures and bonds. Apart from it, there are
many new securities that are issued by companies like zero coupon bonds,
convertible debentures, floating rate bonds, flexi bonds, Deep Discount
bonds, global depository receipts (GDRs), etc. The basic approach for
investing in securities is to sell the overpriced securities and purchase under-
priced securities. The security analysis comprises of Fundamental Analysis
and technical Analysis.

During this step (stage or phase), an investor involves in selecting the

securities. The selection of securities is basically two types:-

(A) Selection of equity shares:-

The portfolio investors should carefully evaluate the following approaches
(strategies or analysis) to select the bet security:-

(i) Fundamental analysis:-

This analysis focuses on fundamental factors i.e. Earnings per share,
Dividend per share, Book value of the stock, Price/earnings, etc. So, the
investors have to choose the stocks which are satisfy these fundamental
factors. The recommendation to buy, hold or sell the security is based on the
comparison of the intrinsic value and prevailing the market price.

(ii) Technical analysis:-

This analysis looks at the volume data and price behaviour i.e. price
fluctuation to determine whether stock price is move-up or move-down or
remain un-changed to decide that the investor has to buy or sell or hold the
stock.

(iii) Random selection:-

This analysis tells the investor that whether the market is efficient and the
securities at=re properly priced or not based on the assumptions.

(B) selection of bonds or debentures:-

Investors should carefully evaluate the following factors in selecting the
bonds or debentures which are fixed income instruments:-

(i) Yield to maturity (YTM):-

It indicates the rate of return earned by the investor if he invests and hold the
bond till maturity. High YTM bonds or debentures are favourable to invest.

(ii) Default risk:-

Investors chose bonds or debentures to invest which are having high credit
rating. If credit rating is not available, the investors can examine the financial
ratios such as Debt-equity ratio, Interest coverage ratio, Earnings per share
etc. to define the default risk.
(iii) Taxes:-
Investors can choose the fixed income securities to invest which are having
less taxes and more tax benefits of the bonds or debentures.

(iv) Liquidity:-
Investors may choose the bonds to invest which are going to convert in to
cash in a short period because of these bonds or debentures have a liquidity
of a higher order.

5. Portfolio execution:-
Portfolio execution is related to buying and selling of specified securities in
given amounts. The investors must understand the below concerns for
effectively handling the portfolio execution.

(A) Trading game:-

The investor must aware of the buyer and/or seller. For example, if we want
to buy a security from XYZ limited, we must know about the XYZ limited.
When both the buyer and seller gain from a business transaction, the security
transaction tends to be a zero sum game. In this case, value of security is the
same to the buyer and seller. In some cases, the security transactions would
attract the one party either seller or buyer and not attract another party. Thus,
the investor should aware about the trading game.

(B) Key transactions:-

Investors must aware of the following three types of transactions because the
securities market appears to be crowded by the below 3 types of transactions.
i. Value based transactions
ii. Information based transactions
iii. Liquidity based transactions
A dealer intermediates between the buyers and sellers to transact.

(C) Winners and losers of the market:-

The investors should know that who wins and who loses the trading game to
efficiently invest their funds in winning securities.

(D) Guide lines:-

The investors should follow the below guide lines which must be keep in
mind while executing the market transactions.
(i) Discuss with the broker about sensitivity of the stock to buy or sell the
volume of the stock, etc.
(ii) Place an order which is having the best interest to the investors
(iii) Avoid the trading errors

6. Portfolio revision:-
After execution of the portfolio, investors should monitor and revise their
portfolio periodically. This usually requires 2 things such as:-

(A) Portfolio re-balancing:-

Portfolio re-balancing involves reviewing and revising the portfolio of stock
and bond mix. There are three basic policies regarding to portfolio re-
balancing.

(i) Buy and hold policy:-

Buy and hold policy means the initial portfolio is left un-distributed. For
example, if initial portfolio has a stock-bond mix of 50:50 today and after 3
months, the stock-bond mix happens to be 70:30 because of the stock
component increased whereas bond component has decreased, the portfolio
mix is having no changes effected. Then, investor may stick with buy and
hold policy.

(ii) Constant mix policy:-

During this policy, maintaining the proportion of stocks and bonds in line
with their target value.

(iii) Portfolio insurance policy:-

This policy calls for increasing the exposure to stocks when the portfolio
increases value and decreasing the exposure to stocks when the portfolio
decreases in value. The basic idea is to ensure that the portfolio value does
not fall below a floor level. Thus, the portfolio re-balancing involves shifting
from stocks to bonds or bonds to stocks.

(B) Portfolio upgrading:-

The portfolio upgrading calls for re-assessing the risk-return characteristics of
various stocks and bonds, selling over-priced securities, buying under-prised
securities. Under this concept, the investor may consider the necessity to
enhance the performance of the portfolio. The investor may delay to revise
the portfolio and may hold the over-prised investments.

A portfolio manager has to constantly monitor and review scripts (stocks)

according to the market conditions. Revision of portfolio includes adding or
removing scripts, shifting from one stock to another or from stocks to bonds
and vice versa. After selecting the optimal portfolio, investor is required to
monitor it constantly to ensure that the portfolio remains optimal with
passage of time. Due to dynamic changes in the economy and financial
markets, the attractive securities may cease to provide profitable returns.
These market changes result in new securities that promises high returns at
low risks. In such conditions, investor needs to do portfolio revision by
buying new securities and selling the existing securities.

7. Portfolio evaluation:-
This phase involves the regular analysis and assessment of portfolio
performances in terms of risk and returns over the period of time. Portfolio
manager has to assess the performance of portfolio over a selected period of
time. Performance evaluation includes assessing the relative merits and
demerits of portfolio, risk and return criteria, adherence of the portfolio
management to publicly stated investment objectives or some combination of
the factors. The two key measurements of performance evaluation of the
portfolio are mentioned below:-

(A) Rate of return:-

The rate of return of a portfolio is measured as below:-
Rate of return = [(Dividend +Terminal value + Initial value) / Initial value] x
100

(B) Risk:-
The two most commonly used measures of risk are as below:-
(i) Variance:-
The variance ( s 2) is calculated below:-
s 2 = [Proportion of the stock x {(return of the stock – Average return of the
stock)2}]
or
s 2 = [Proportion of the stock x {(Deviations)2}]
(ii) Beta:-
A beta measures the volatility or systematic risk of a particular stock (or
portfolio of stock)'s returns with respect to a relevant bench mark index (i.e.
SENSEX, NIFTY, etc..) based on the price levels. Beta is the ratio of co-
variance between market return and the security’s return to the market return
variance. Beta is used in the Capital Asset Pricing model (CAPM) which
calculates the expected return of an asset (stock) based on the expected
market returns. Beta is also known as the beta coefficient. High beta stocks
are called as aggressive stocks while low beta stocks are called as defensive
stocks.
Performance evaluation gives a useful feedback to improve the quality of the
portfolio management process on a continuing basis.

Portfolio return and risk:-

(A) Portfolio return:-

The expected return on portfolio is nothing but, the weighted average of the
expected returns on the individual securities in the portfolio. We can calculate
the expected portfolio’s return as proportion (weights) of investment in stock
‘n’ multiplied by the return of the stock ‘n’. In simplified terms, this is
expressed as below formula.
Expected portfolio return E(Rn) = Wi Ri
Where E(Rn) : expected portfolio’s return of stock ‘n’
Wi : Weights or probability or proportion of investment in stock ‘n’
Ri : Return on investment in stock ‘n’

(B) Portfolio risk:-

Risk means simply the variance. The risk of an individual security or a
portfolio is measured by variance and/or standard deviation of its returns. So,
the portfolio risk which is measured by variance and/or standard deviation is
not the weighted average of the risks of individual stocks (securities or
assets) in the portfolio except when the returns from the securities are un-
correlated. Hence, the portfolio risk is measured by the below 2 factors
namely Variance and Standard deviation.
Variance and Standard deviation:-
The variance ( s 2) and standard deviation (square root of variance) are the
most commonly used as risk measures of spread (i.e. variability or volatility).

(i) Variance ( s 2):-

Variance measures how far a data set is spread out. In other words, variance
is used to measure the variability i.e. volatility. The variance is calculated by
taking the differences between each number and the average in given data set
and squaring the differences to make them positive. A value of zero means
that there is no variability i.e. all the numbers in the given data set are the
same or identical. A large variance indicates that the numbers in the given
data set are far from the average and each other whereas a small variance
indicates that the numbers in the given data set are close to the average and
each other. The advantage of variance is that it treats all the deviations from
the average the same regardless of direction. As a result, the squared
deviations cannot sum to zero and give the appearance of no variability at all
in the given data set. A disadvantage of variance is that it gives added weight
to numbers far from the average because of squaring these numbers can
misrepresent the interpretations of the given data set.

The variance of stock ‘n’ is calculated as below:-

Variance ( s 2n) = Proportion of investment x Deviations square
Here, Deviation = return of the security ‘n’ minus Average return of the
security ‘n’
In simplified terms, this is expressed as below formula.
Variance( s 2n) = ∑P(r - r¯)2
Where P : Proportion or weights or probability of investment in stock ‘n’
r : return of stock ‘n’
r ¯ : Average return of the stock ‘n’
Here, Average return of the stock ‘n’ = Total returns of stock ‘n’ / Number of
state of natures in stock ‘n’

(ii) Standard deviation (√ s 2):-

Standard deviation is the square root of the variance by determining the
variation (i.e. deviation) between each data point relative to the average. It
applies to the rate of return of an investment in the security. The higher the
standard deviation of a security is the higher the variance between each price
and the mean which indicates a higher price range i.e. higher risk. Likewise,
the lower the standard deviation of a security is the lower the variance
between each price and the mean which indicates a lower price range i.e.
lower risk. The standard deviation is used as a fundamental risk measure of
an investment in portfolio of stocks by portfolio managers, financial advisors,
mutual fund managers and wealth management advisors, etc. Standard
deviation is useful tool in trading and investing strategies and it measures the
stock and market volatility (or variability).

The standard deviation of stock ‘n’ is calculated as below:-

Standard deviation (√ s 2n) = √Variance

or
Standard deviation (√ s 2n) = √∑P(r - r¯)2
Where P : Proportion or weights or probability of investment in stock ‘n’
r : return of stock ‘n’
r¯ : Average return of the stock ‘n’
Here, Average return of the stock ‘n’ = Total returns of stock ‘n’ / Number of
state of natures in stock ‘n’

Difference between Variance and Standard deviation:-

The variance determines the deviations of given data against the average
value. Higher variance indicates more deviation in data values i.e. more
difference between one data value and another. If the data values are all close
together, the variance will be smaller. Then, this is difficult to hold than the
standard deviation. Since the variance represents a squared result, the
variance may not be meaningfully expressed the given data set. Standard
deviation is usually easier to apply comparing to variance. The standard
deviation is expressed the same unit of measurement of the given data instead
of squared result.

Example:-
The investor ‘ABC’ have $10,000 to invest. He wants to invest this $10,000
equally in 2 stocks i.e. ‘stock X’ and ‘stock Y’. The returns on these 2 stocks
depend on the state of the nature. The probability distributions, individual
returns and portfolio returns of 2 stocks are as following:-
 State of Proportion Returns Returns Returns
the of on on on
nature value stock X stock Y portfolio
invested
1 0.15 10% -5% 10%
2 0.20 15% 10% 10%
3 0.25 -5% 15% 5%
4 0.30 20% 25% 15%
5 0.10 10% 15% 10%

Based on the above portfolio information, you are require to calculate the
below:-
(A) Expected returns of stock X, stock Y and portfolio of stock ‘X’ and ‘Y’
(B) Risk through standard deviation of stock X, stock Y and portfolio of
stock X and Y

Solution:-
(A) Expected returns:-
(i) Expected return of stock ‘X’:-
Expected return of stock ‘X’ = proportion (weights) of investment in stock
‘X’ x returns of the stock ‘x’
Expected portfolio return E(Rx) = Wi Ri
Where E(Rx) : expected portfolio’s return of stock ‘x’
Wi : Weights or probability or proportion of investment in stock ‘x’
Ri : Return on investment in stock ‘x’

E(Rx) = 0.15(0.10) + 0.20(0.15) + 0.25(-0.05) + 0.30(0.20) + 0.10(0.10)

= 0.015 + 0.03 + (-0.0125) + 0.06 + 0.01
= 0.1025 or 10.25%

(ii) Expected return of stock ‘Y’:-

Expected return of stock ‘Y’ = proportion (weights) of investment in stock
‘Y’ x return of the stock ‘Y’
Expected portfolio return E(Ry) = Wi Ri
Where E(Ry) : expected portfolio’s return of stock ‘y’
 Wi : Weights or probability or proportion of investment in stock ‘y’
Ri : Return on investment in stock ‘y’

E(Rx) = 0.15(-0.05) + 0.20(0.10) + 0.25(0.15) + 0.30(0.25) + 0.10(0.15)

= (0.0075) + 0.020 + 0.0375 + 0.075 + 0.015
= 0.1400 or 14%

(iii) Expected return on portfolio ‘X and Y’:-

Expected return on portfolio = proportion (weights) of investment in stock
‘XY’ x return of the stock ‘XY’
Expected portfolio return E(Rxy) = Wi Ri
Where E(Rxy) : expected portfolio’s return of stock ‘n’
Wi : Weights or probability or proportion of investment in stock ‘n’
Ri : Return on investment in stock ‘n’

E(Rxy) = 0.15(0.10) + 0.20(0.10) + 0.25(0.05) + 0.30(0.15) + 0.10(0.10)

= 0.015 + 0.02 + 0.0125 + 0.045 + 0.01
= 0.1025 or 10.25%

(B) Risk through standard deviation:-

(i) Standard deviation of stock ‘X’ :-
The standard deviation of stock ‘X’ is calculated as below:-
Standard deviation (√ s 2x) = √∑P(x - x¯)2
Where P : Proportion or weights or probability of investment in stock ‘x’
x : return of stock ‘x’
x ¯ : Average return of the stock ‘X’
Here, Average return of the stock ‘x’ = Total returns of stock ‘x’ / Number of
state of natures in stock ‘x’
Average return of stock X (x ¯) = Total returns of stock ‘X’ / Number of
state of natures in stock ‘X’
= [10 + 15 + (-5) + 20 +10] / 5
= 50 / 5
= 10

Standard deviation (√ s 2x) = √∑P(x - x¯)2

= √0.15(10-10)2 + 0.20(15-10)2 + 0.25(-5-10)2 + 0.30(20-10)2 +
0.10(10-10)2
= √0.15(0)2 + 0.20(5)2 + 0.25(-20)2 + 0.30(10)2 + 0.10(0)2
= √0.15(0) + 0.20(25) + 0.25(400) + 0.30(100) + 0.10(0)
= √0 + 5 + 100 + 30 + 0
= √135 or 1351/2
= √135 or 1350.50
= 11.61895 or 11.62%

(ii) Standard deviation of stock ‘Y’ :-

The standard deviation of stock ‘Y’ is calculated as below:-
Standard deviation (√ s 2y) = √∑P(y - y¯)2
Where P : Proportion or weights or probability of investment in stock ‘n’
y : return of stock ‘y’
y ¯ : Average return of the stock ‘y’
Here, Average return of the stock ‘y’ = Total returns of stock ‘y’ / Number of
state of natures in stock ‘y’
Average return of stock ‘Y’ (y ¯) = Total returns of stock ‘Y’ / Number of
state of natures in stock ‘Y’
= [(-5) + 10 +15 + 25 + 15] / 5
= 12

Standard deviation (√ s 2y) = √∑P(y - y¯)2

= √0.15(-5-12)2 + 0.20(10-12)2 + 0.25(15-12)2 + 0.30(25-12)2 +
0.10(15-12)2
= √0.15(-17)2 + 0.20(-2)2 + 0.25(3)2 + 0.30(13)2 + 0.10(3)2
= √0.15(289) + 0.20(4) + 0.25(9) + 0.30(169) + 0.10(9)
= √43.35 + 0.80 + 2.25 + 50.70 + 0.90
= √98 or 981/2
= √98 or 980.50
= 9.899 or 9.90%

(iii) Standard deviation of portfolio of stock ‘XY’ :-

The standard deviation of portfolio of stock ‘Xy’ is calculated as below:-
Standard deviation (√ s 2xy) = √∑P(xy - xy¯)2
Where P : Proportion or weights or probability of investment in stock ‘n’
xy : return of stock ‘xy’
xy ¯ : Average return of the stock ‘Xy’
Here, Average return of the stock ‘xy’ = Total returns of stock ‘xy’ / No. of
state of natures in stock ‘xy’
Average return of stock XY (xy ¯) = Total returns of stock ‘XY’ / Number
of state of natures in stock ‘XY’
= [10 + 10 + 5 + 15 + 10] / 5
= 10

Standard deviation (√ s 2xy) = √∑P(xy - xy¯)2

= √0.15(10-10)2 + 0.20(10-10)2 + 0.25(5-10)2 + 0.30(15-10)2 +
0.10(10-10)2
= √0.15(0)2 + 0.20(0)2 + 0.25(-5)2 + 0.30(5)2 + 0.10(0)2
= √0.15(0) + 0.20(0) + 0.25(25) + 0.30(25) + 0.10(0)
= √0 + 0 + 6.25 + 7.50 + 0
= √13.75 or 13.751/2
= √13.75 or 13.750.50
= 3.71%

Conclusion:-
If we invest only in stock X, the expected return is 10.25% and standard
deviation is 11.62%. If we invest only in stock Y, the expected return is 14%
and standard deviation is 9.90%. Likewise, if we invest in portfolio
consisting of stocks X and Y, the expected return is 10.25% which is almost
same or near to the investment in stock X (10.25%) or stock Y (14%) but
standard deviation of portfolio consisting of stocks X and is 3.71% which is
very far to the investment in stock X (11.62%) or stock Y (9.90%). This
analysis indicates us that the investment in portfolio consisting of stocks X
and Y is less risky (3.71%) than investment in individual stocks X (11.62%)
and Y (9.90). Hence, technically, we can conclude that the diversification of
an investment reduces risk if returns are not perfectly correlated. In other
words, the portfolio risk decreases when more and more securities added to
the portfolio. Because of this reason, generally, the investors hold a portfolio
of securities, but, it has a limit to certain number of securities (or assets) i.e.
of 10 as per empirical studies. Thereafter the limit, gain from the
diversification turns to be negligible.

Measurements of co-movements in security returns:-

Co-movements between the returns of an individual securities is measured by
the below 2 factors:-

(A) Covariance:-
The covariance is an absolute measure of co-movements between the returns
of an individual securities. The covariance reflects the degree to which the
returns of the 2 securities change together. Covariance may be positive or
negative. A positive covariance indicates that the returns of the 2 securities
move in the same direction. Conversely, the negative covariance indicates
that the returns of the 2 securities move in the opposite direction. Covariance
is calculated to help the diversify of security holdings.

The covariance between 2 securities is calculated as below:-

Covariance of stock X and stock Y [Cov(X,Y)] = ∑P[(rx - rx¯) (ry - ry¯)]
Where, P : Proportion or weights or probability of investment
rx : Security ‘X’
ry : Security ‘Y’
rx¯ : Average returns of security ‘X’
ry¯ : Average returns of security ‘Y

(B) Coefficient of correlation:-

The correlation coefficient is a relative measure of co-movements between
the measures of 2 securities. Correlation coefficient also reflects the degree to
which returns of the 2 securities change together. In other words, the
correlation coefficient is used to measure how strong a relationship between 2
securities. Here, correlation means the linear relationship between 2
variables.

The correlation coefficient between 2 securities is calculated as below:-

Correlation coefficient of stock X,Y = Covariance of X,Y / Product of
standard deviations of X,Y
or
Correlation coefficient of stock X and stock Y [Cor(X,Y)] = [∑P{(rx -
rx¯) (ry - ry¯)}] / s X s Y
Where, P : Proportion or weights or probability of investment
rx : Security ‘X’
ry : Security ‘Y’
rx¯ : Average returns of security ‘X’
 ry¯ : Average returns of security ‘Y
s X : Standard deviation of stock ‘X’
s Y : Standard deviation of stock ‘Y’

The correlation coefficient is varying between +1 and -1. A value of exactly 1

(i.e. +1) means perfect positive correlation or perfect co-movement in the
same direction i.e. if a positive increase in one stock, there is also a positive
increase in the second stock. A value of exactly -1 means perfect negative
correlation or perfect co-movement in the opposite direction i.e. if a positive
increase in one stock, there is a decrease in another stock. A value of zero (0)
means, there is no correlation or co-movement between the 2 securities.
Thus, we can say that the strength of relationship between the 2 securities
varies in the degree based on the value of correlation coefficient. For
example, the value of correlation coefficient is 0.3 indicates that there is a
positive relationship between the 2 securities, but, it is weak and likely
insignificant.

NOTES:-
(i) It should be noted that the covariance measures the directional relationship
between the 2 securities, but, it does not show the strength of the relationship
between the 2 securities. The correlation coefficient is more appropriate
indicator of this strength.

(ii) If a number of securities included in a portfolio is increased, then, the

importance of the risk of each individual security decreases, but, importance
of the covariance relationship is increased.

PROBLEMS AND SOLUTIONS

Problem 1 :-
The returns of 2 securities ‘X and ‘Y’ under 5 possible states of nature are
given below:-

Proportion of
State of Return Return
investment i.e.
the on Stock on Stock
 nature (Probability or 'rx' (%) 'ry' (%)
weights) (P)
1 0.12 5.00 4.00
2 0.25 10.00 8.00
3 0.35 15.00 18.00
4 0.13 20.00 22.00
5 0.15 10.00 18.00

You are required to prepare the below:-

(i) Expected returns of 2 stocks X and Y
(ii) Variance of 2 stocks X and Y
(iii) Standard deviation of 2 stocks X and Y
(iv) Covariance of X,Y
(v) Correlation coefficient of stock X,Y

Solution:-

(i) Expected returns of 2 stocks X and Y:-

The necessary calculation has been done from the below tabular form:-

Proportion
of Return Expected Expected
Return
State of investment on return return
on
the i.e. Stock on Stock on Stock
Stock
nature (Probability 'ry' 'X' 'Y'
'rx' (%)
or weights) (%) E(rx) E(ry)
(P)
5 = [2 x 6 = [2 x
1 2 3 4
(3/100)] (4/100)]
1 0.12 5.00 4.00 0.0060 0.0048
2 0.25 10.00 8.00 0.0250 0.0200
3 0.35 15.00 18.00 0.0525 0.0630
4 0.13 20.00 22.00 0.0260 0.0286
5 0.15 10.00 18.00 0.0150 0.03
TOTAL 1.00 60.00 70.00 0.1245 0.1434
 Deviation Deviation Deviation Deviation
of X of y square of x square of y
rx - rx ̅ ry - ry ̅ (rx - rx̅̅ )2 (ry - ry̅ )2
7 = (3 - 8 = (4 -
9 = (72) 10 = (82)
rx̅̅ ) ry̅ )
-7.00 -10.00 49.00 100.00
-2.00 -6.00 4.00 36.00
3.00 4.00 9.00 16.00
8.00 8.00 64.00 64.00
-2.00 4.00 4.00 16.00
0.00 0.00 130.00 232.00

Variance Variance
Variance
( s )2 of x = ( s )2 of Xy =
( s )2 of y = (rX - rX̅) (ry -
P(rx - rx̅ )2 P[(rX - rX̅ )
P(ry - ry̅ )2 ry̅)
(ry - ry̅̅ )]
11 = (2 x 9) 12 = (2 x 10) 13 = (7 x 8) 14 = (2 x 13)
5.88 12.00 70.00 8.40
1.00 9.00 12.00 3.00
3.15 5.60 12.00 4.20
8.32 8.32 64.00 8.32
0.60 2.40 -8.00 -1.20
18.95 37.32 150.00 22.72

Expected return of stock ‘X’:-

Expected return of stock ‘X’ = proportion (weights) of investment in stock
‘X’ x return of the stock ‘x’
Expected portfolio return E(Rx) = Wi Ri
Where E(Rx) : expected portfolio’s return of stock ‘x’
Wi : Weights or probability or proportion of investment in stock ‘x’
Ri : Return on investment in stock ‘x’
Thus, the expected return of stock ‘X’ from the above table is 0.1245 or
12.45%

Expected return of stock ‘Y’:-

Expected return of stock ‘Y’ = proportion (weights) of investment in stock
‘Y’ x return of the stock ‘Y’
Expected portfolio return E(Ry) = Wi Ri
Where E(Ry) : expected portfolio’s return of stock ‘y’
Wi : Weights or probability or proportion of investment in stock ‘y’
Ri : Return on investment in stock ‘y’
Thus, the expected return of stock ‘Y’ from the above table is 0.1434 or
14.34%

(ii) Variance of stocks X and Y:-

Variance of stock ‘X’:-

Variance ( s 2X) = Proportion of investment x Deviations square
Here, Deviation = return of the security ‘rx’ minus Average return of the
security ‘rx’
In simplified terms, this is expressed as below formula.
Variance( s 2X) = ∑P(rx - rx¯)2
Where P : Proportion or weights or probability of investment in stock ‘X’
r : return of stock ‘X’
r ¯ : Average return of the stock ‘X’
Here, Average return of the stock ‘X’ = Total returns of stock ‘X’ / Number
of state of natures in stock ‘X’
= 5 + 10 + 15 + 20 +10 / 5
= 60 / 5
= 12

Variance( s 2X) = ∑P(rx - rx¯)2

= 18.95 (as per 11th column of above table)

Variance of stock ‘Y’:-

Variance ( s 2Y) = Proportion of investment x Deviations square
Here, Deviation = return of the security ‘ry’ minus Average return of the
security ‘ry’
In simplified terms, this is expressed as below formula.
Variance( s 2Y) = ∑P(ry - ry¯)2
Where P : Proportion or weights or probability of investment in stock ‘Y’
r : return of stock ‘Y’
r ¯ : Average return of the stock ‘Y’
Here, Average return of the stock ‘X’ = Total returns of stock ‘X’ / Number
of state of natures in stock ‘X’
= 4 + 8 + 18 + 22 +18 / 5
= 70 / 5
= 14

Variance( s 2X) = ∑P(rx - rx¯)2

= 37.32 (as per 12th column of above table)

(iii) Standard deviation of 2 stocks X and Y:-

(i) Standard deviation of stock ‘X’ :-

Standard deviation (√ s 2x) = √∑P(x - x¯)2
Where P : Proportion or weights or probability of investment in stock ‘x’
x : return of stock ‘x’
x ¯ : Average return of the stock ‘X’
Standard deviation (√ s 2x) = √Variance
= √∑P(x - x¯)2
= √18.95 or 18.951/2
= √18.95 or 18.950.50
= 4.353 or 4.353%

(ii) Standard deviation of stock ‘Y’ :-

Standard deviation (√ s 2y) = √∑P(y - y¯)2
Where P : Proportion or weights or probability of investment in stock ‘n’
y : return of stock ‘y’
y ¯ : Average return of the stock ‘y’

Standard deviation (√ s 2y) = √Variance

= √∑P(y - y¯)2
 = √37.32 or 37.321/2
= √37.32 or 37.320.50
= 6.109 or 6.109%

(iv) Covariance of X,Y:-

Covariance of stock X,Y [Cov(X,Y)] =∑P[(rx - rx¯) (ry - ry¯)]
Where, P : Proportion or weights or probability of investment
rx : Security ‘X’
ry : Security ‘Y’
rx¯ : Average returns of security ‘X’
ry¯ : Average returns of security ‘Y

Cov(X,Y) =∑P[(rx - rx¯) (ry - ry¯)]

= 22.72 (asper the 14th column of above table)

(v) Correlation coefficient of stock X,Y:-

Correlation coefficient of stock X,Y = Covariance of X,Y / Product of
standard deviations of X,Y
or
Correlation coefficient of stock X and stock Y [Cor(X,Y)] = [∑P{(rx - rx¯)
(ry - ry¯)}] / s X s Y
Where, P : Proportion or weights or probability of investment
rx : Security ‘X’
ry : Security ‘Y’
rx¯ : Average returns of security ‘X’
ry¯ : Average returns of security ‘Y
s X : Standard deviation of stock ‘X’
s Y : Standard deviation of stock ‘Y’

Cor(X,Y)] = [∑P{(rx - rx¯) (ry - ry¯)}] / s X s Y

= 22.72 / (4.353)(6.109)
= 22.72 / 26.592
= 0.854
So, the value of correlation coefficient is 0.85 indicates that there is a positive
relationship between the securities x and Y, but, it is weak and likely
insignificant.
Problem 2 :-
The weights and standard deviations of 3 stocks A, B and C given below:-

Stock Stock Stock

Particulars
A B C
Weights (W) 0.20 0.40 0.30
Standard deviations of %
5 8 9
returns ( s )

The correlation coefficient among 3 security returns are as following:-

PAB : 0.50
PAC : 0.70
PBC : 0.80
You are required to calculate the Standard deviation of portfolio return of
3stocks A, B and C.

Solution:-
The standard deviation of portfolio of stock A, B and C is calculated as
below:-
s P = √W2A s 2A + W2B s 2B + W2C s 2C + 2WAWBPAB s A s B +
2WAWCPAC s A s C + 2WBWCPBC s B s C
Where,
W : Weights
P : Portfolio
s : Standard deviation
A : Stock ‘A’
B : Stock ‘B’

s P=√(0.2)2(5)2 + (0.4)2(8)2 + (0.3)2(9)2 + 2(0.2)(0.4)(0.5)(5)(8) + 2(0.2)(0.3)

(0.7)(5)(9) + 2(0.4)(0.3)(0.8)(8)(9)
s P = √(0.04 x 25) + (0.16 x 64) + (0.09 x 81) + 3.2 + 3.78 + 13.824
s P = √1.00 + 10.24 + 7.29 + 3.20 + 3.78 + 13.824
s P = √39.334
s P = 6.272%
Conclusion:-
The standard deviation of portfolio of 3 stocks A, B and C is 6.272%

Problem 3 :-
The investment details of stock ‘A’ and ‘B’ is mentioned below:-

Stock Stock
Particulars
A B
Weights or Proportion (W) 0.60 0.40
Expected return (%) 14 10
Standard deviations of %
5 8
returns ( s )
Correlation coefficient 0.70

You are required to calculate the below:-

(i) What is the expected returns of portfolio consisting of stock ‘A’ and ‘B’
(ii) What is the risk of portfolio consisting of stock ‘A’ and ‘B’
(iii) What is the covariance between portfolio consisting of stock ‘A and ‘B’

Solution:-
(i) Expected returns of portfolio of stock ‘A’ and ‘B’ :-
Expected returns of portfolio = Weights x Returns
ER(A,B) = WX Rx + WY RY
= (0.60 x 14) + 0.40 x 10)
= 8.40 + 4.0
= 12.40%

(ii) What is the risk of portfolio of stock ‘A’ and ‘B’ :-

Risk (standard deviation) of portfolio stocks of ‘A’ and ‘B’ ( s AB) =
√variance
( s AB) = √W2A s 2A + W2B s 2B + 2WAWBPAB s A s B
or
( s AB) = √W2A s 2A + W2B s 2B + 2WAWBCovariance(A,B)
( s AB) = √(0.60)2(12)2 + (0.4)2(8)2 + 2(0.60)(0.40)(0.70)(12)(8)
( s AB) = √0.36(144) + 0.16(64) + 32.256
( s AB) = √51.84 + 10.24 + 32.256
( s AB) = √94.336 or 94.3361/2
( s AB) = √94.336 or 94.3360.50
( s AB) = 9.713%

(iii) What is the covariance between stock ‘A and ‘B’ :-

CovAB = Correlation coefficient of portfolio stock x Portfolio of standard
deviation
CovAB = PAB s A s B
= 0.70 x 12 x 8
= 67.20

Conclusion:-
(i) Expected returns of portfolio consisting of stock ‘A’ and ‘B’ is 12.40%
(ii) Risk of portfolio consisting of stock ‘A’ and ‘B’ is 9.713%
(iii) Covariance between portfolio consisting of stock ‘A and ‘B’ is 67.20

------------ End of the CHAPTER – 14 ----------

CHAPTER – 15
SENSEX

Learning objectives
After studying this chapter, you can be able to :-
1. Understand the basic concepts in Indian stock markets,
2. Understand about Short selling, Rolling settlement, and
Market regulation,
 3. Explain the concept of Full and Free float market
capitalization,
4. Describe the concept of Sensex,
5. Illustrate the computation methodology of Sensex, and
6. Calculate the Sensex.

I. BASIC CONCEPTS OF STOCK MARKET

1. Stock:-
Stock is ownership in a company and each share of stock representing a tiny
piece of ownership. The more shares we own, the more of the company we
own. The more shares we own; the more dividends we earn when the
company makes a profit. In the financial world, ownership is called an equity.
Investors may purchase stock in the primary or secondary market. A
company sells its stock to the public on the primary market through its initial
public offering. Investors may sell their shares through brokers to other
investors in the secondary market. Stock prices can be found (quotes) in
newspapers, on television and through the Internet.

2. Stock price:-
The price of a share of stock is that of any other financial asset and equals the
present value of the expected stream of future cash payments to the owner.
Stock exchanges are the physical locations where stocks are bought and sold.
The OTC (over-the-counter) refers to a market in which securities
transactions are conducted through a telephone and computer network
connecting dealers in stocks and bonds, rather than on the floor of an
exchange. Together, these two markets form the secondary market. Both the
primary and secondary markets together make up the stock market.

3. Why companies issue stock:-

Businesses issue stock to raise money. They use this money to finance the
business expansions, pay for equipment and fund projects, etc. Corporations
issue stock when they may need additional capital to operate successfully.
The term for issuing stock to raise money is equity financing. The money
received from investors who buy stocks is called equity capital. In the world
of securities, the word ‘equity’ usually refers to stocks. The other method of
raising money is debt financing which involves selling bonds. When
companies make profits, they may reward their stockholders with pieces of
their profits, known as dividends. Dividends are an incentive for investors to
hold stocks.
Companies issue stock to raise capital.

Advantages of issuing stock are mentioned below:-

1. A Company can raise more capital than it could borrow.
2. A Company does not have to make periodic interest payments to creditors.
3. A Company does not have to make principal payments.

Advantages for stock holders:-

As part owner of a corporation, the shareholders may be entitled to share in
the profits of the company. There is also a chance that the company will grow
and the price of the stock may rise.

4. Capital:-
All the money that we invest to start our business is known as capital.
Essentially, the capital of a business consists of all of its assets (or items to
assist in the creation of financial wealth).

5. Equity vs Debt:-
To start a new business (or fund a new project), a company can raise money
in two ways such as:-
(i) By selling shares of equity, or
(ii) By incurring debt.
If the owner of the business invested all their own savings to buy the
materials necessary to start the business, they made an equity investment in
the company. Equity is simply ownership of a corporation. Typically,
ownership units in a corporation are referred to as stock. However, if our
owner did not have necessary funds to start their own business they could
finance their operation in one of the below 2 ways:-
(i) Issue stock (or certificates of partial ownership in his company) to people
who may be interested in helping their venture out in return for a proportional
share of the profits that the company might generate.
(ii) Borrow money that will need to be paid back with interest.

6. Bull & Bear Markets:-

The Bull markets are movements in the stock market in which prices are
rising and the consensus is that prices will continue moving upward. During
this time, economic production is strong, jobs are plentiful and inflation is
low. Bear markets are the opposite that the stock prices are falling, and the
view is that they will continue to falling. The economy will slow down,
coupled with a rise in un-employment and inflation. In either scenario, the
people invest as though the trend will continue. Investors who think and act
as though the market will continue to rise are bullish, while those who think it
will keep falling are bearish.

7. Hedging:-
If we are un-sure of how the price of a security is going to move, we can
hedge. In hedging, we take a position that protects us from an adverse price
movement. Hence, the process of minimize the risk is known as hedging, but,
the maximize the profits is not called as hedging.

8. Initial Public Offering:-

The very first sale of corporation (company)’s stocks to the outside investors
or public is known as initial public offering (IPO) and it occurs on the
primary market. This does not necessarily mean that a company is a new
business. It simply means that the company is offering shares of ownership to
investors outside the corporate family for the first time. Most businesses are
privately owned. They don’t have outside investors. A few people who may
be management or employees and members of their respective families are
own all the outstanding stock and such corporations are referred to as
"closely held corporations”. Compared to the costs of borrowing large sums
of money for ten years or more, the costs of an initial public offering are
small.

9. Short selling:-
In short selling, the trader borrows stock (usually from his brokerage which
holds its clients' shares or its own shares on account to lend to short sellers)
then sells it on the market, betting that the price will fall. The trader
eventually buys back the stock, making money if the price felt in the
meantime and losing money if it rise. Exiting a short position by buying back
the stock is known as "covering”. Hence, the most markets either prevent
short selling or place restrictions on when and how a short sale can occur.
10. Rolling Settlement:-
Settlement is a mechanism of settling trades done on a stock exchange on ‘T’
(i.e. trading day) plus ‘X’ trading days, where ‘X’ could be 1,2,3,4 or 5 days,
etc. In other words, in ‘T+2’ environment, a trade done on ‘T’ day and it is
settled on the 2nd working day excluding the ‘T’ day. SEBI (Securities &
Exchange Board of India), as a step towards easy flow of funds and
securities, introduced ‘T+2’ rolling settlement in Indian equity market from
1st April 2003.

11. Market Regulation:-

The overall responsibility of development, regulation and supervision of the
stock market rests with the Securities & Exchange Board of India (SEBI)
which was formed in 1992 as an independent authority. Since then, SEBI has
consistently tried to lay down market rules in line with the best market
practices. It enjoys huge/enormous powers of imposing penalties on market
participants in case of a violation.

12. 'Blue-chip' company:-

The name "blue chip" is derived from the game of poker in which the blue
chips have the highest value. The company which is a nationally recognized,
well-established, actively traded on a stock exchange and financially sound is
called as Blue-chip company. Blue chip companies generally sell with high-
quality, widely accepted products and services. The Blue-chip companies are
operating profitably in the case of down turns and adverse economic
conditions, which helps to contribute to their long record of stable and
reliable growth.

13. Advances And Declines:-

Advances and declines refers to the number of stocks that closed at a higher
and lower price than the previous day respectively. Technical analysts look at
advances and declines to analyse stock market behaviour, differential
volatility and predict that whether a price trend is likely to continue or
reverse. Generally, a market will be more bullish if more stocks advance than
decline and vice versa. The Advances and Declines (A/D) is generally
expressed as a ratio which indicates the general direction of the market.

14. Market capitalization vs Turnover:-

Market capitalization is the total value of the company's shares - i.e. the
current share price multiplied by the number of shares that have been issued.
It represents what the market currently considers the company to be
worth. Turnover (revenue) is simply the amount of money flowing into a
company as a result of the sale of shares or stocks or goods and services.

2. ROLE OF STOCK MARKETS

1. Introduction:-
The stock markets are playing a vital role in the consolidation of a national
economy in general and in the development of the specified industrial sector.
Stock exchange is the most dynamic and organised component of capital
market. Especially, in developing countries like India, the stock exchanges
play a cardinal role in promoting the level of capital formation through
effective mobilisation of savings and ensuring investment safety. The
economic relevance and purpose of the institution of stock exchange lie in its
effectiveness in performing successfully the below 2 basic functions:-
(i) To facilitate resource raising from the community for financing corporate
sector and
Government for various activities, and
(ii) To provide an organised market place for the investors to freely buy and
sell the securities.

The functioning of the stock exchange has therefore to be such as to create a

climate conducive to an active primary market (new issues market) and to
ensure fair and efficient trading in securities in the secondary market (stock
exchange) and to establish a balanced relationship between the two.
the stock market is often considered the primary indicator of a country's
economic strength and development. Thus, some of the below key functions
include:-

(i) Liquidity of investment,

(ii) Financial resources for public and private sectors,
(iii) Indicator of Industrial Development,
(iv) Pricing of Securities and Wide Marketability to Securities,
(v) Promoting Capital formation and better allocation of Capital, and
(vi) Barometer of National economy.
2. Index (or stock index):-
An index is an indicator or statistical measure of change i.e. stock movement
in a securities market. In the case of financial markets, stock and bond
market indices consist of a hypothetical portfolio of securities representing a
specified market or a segment of it. We cannot invest directly in an index.
The S&P BSE SENSEX is a common benchmark for Bombay stock
exchange. Each index related to the stock and bond markets has its own
calculation methodology. In Stock Market context, an Index represents the
price behaviour of equity market. Further the movement of a stock Index is
influenced by various factors. Generally, there are 3 types of news which
affect the stock market:-
a. Company Specific news which affects the valuation of only that company
b. Industry Related news which affects all the companies in that industry.
c. Economy Related news affects all companies

3. Types of Indices:-
A. Foreign stock Indices:-
i. Dow Jones (USA)
ii. GSTI (Goldman Sachs) Semiconductor Index (USA)
iii. Shanghai Composite (China)
iv. NASDAQ (USA)
v. Nikkei 225 Index (Japan)
vi. FTSE (Financial Times)100 Index (UK)
vii. CAC 40 Index (France)
viii. Kospi (South Korea)
ix. S & P ASX 200 (Australia)
x. FTSE Italia Mid Cap Index (Italy)
xi. S&P TSX 60 Index (Canada)

B. Indian Stock indices:-

A Stock Exchange Index is a quick shorthand to measure & compare the
performance of various markets. The SENSEX (BSE) and Nifty (NSE) are
two stock market indexes in India. The SENSEX Index is comprised of 31 of
the largest and most actively-traded stocks on the BSE.

(i) BSE stock indices:-

i. S&P BSE SENSEX,
ii. S&P BSE SENSEX 50,
iii. S&P BSE SENSEX Next 50,
iv. S&P BSE 100,
v. S&P BSE Bharat 22 Index,
vi. S&P BSE Mid Cap,
vii. S&P BSE Small Cap,
viii. S&P BSE 200,
ix. S&P BSE 150 Mid Cap Index,
x. S&P BSE 250 Small Cap Index,
xi. S&P BSE 250 Large Mid Cap
Index,
xii. S&P BSE 400 Mid Small Cap
Index,
xiii. S&P BSE 500,
xiv. S&P BSE All Cap,
xv. S&P BSE Large Cap,
xvi. S&P BSE Small Cap Select
Index,
xvii. S&P BSE Mid Cap Select
Index,

(ii) NSE stock indices:-

i. Nifty 50
ii. CND Nifty
iii. NIFTY Mid Cap
iv. INDIA VIX

3. INTRODUCTION TO SENSEX
1. Meaning:-
The full Form of Sensex is Sensitive Index. The SENSEX is a free-float
stock market weighted index of 31 well-established, financially sound and
well performance companies listed on Bombay Stock Exchange. The 31
component companies which are some of the largest and most actively traded
stocks are representative of various industrial sectors of the Indian economy.
The SENSEX Published since 1st January 1986 and due to the wide
acceptance amongst the investors, the SENSEX is regarded as the pulse of
the domestic stock markets in India. The base value of the SENSEX is taken
as 100 on 1st April 1979 and its base year as 1978–79. Sensex is the large cap
stock market index indicator for the BSE. It is also sometimes referred to as
S&P BSE SENSEX. The tag S&P (Standard & Poor's) was added after the
BSE and the S&P Dow Jones announced a strategic partnership during 2013.

The below qualities which make SENSEX a successful and prominent

indicator are:-
(i) A portfolio of quality Blue Chip companies
(ii) The only broad based Free-Float weighted index in India
(iii) A good proxy for overall market movements
(iv) Reliable benchmark for Fund Performance
(v) A Good Hedging Tool
(v) It is not easy to manipulate

2. Standard & Poor's (S&P):-

Standard & Poor's (S&P) is the world's leading index provider and the
foremost source of independent credit ratings. Standard & Poor's has been
providing the financial market intelligence to decision makers for more than
150 years. S&P Global divisions include S&P global ratings, S&P Global
market intelligence, S&P Dow Jones Indices and S&P Global plats. Standard
& Poor’s is well-known to investors around the world for its wide variety of
investable and benchmark indices and it issues the large number of credit
ratings. Standard & Poor’s is a market leader in its categories and it is located
in 26 countries so far.

3. Objectives of SENSEX:-
The S&P BSE SENSEX is the benchmark index with wide acceptance among
individual investors, institutional investors, foreign investors and fund
managers. The objectives of the SENSEX are as below:-

i. To measure the market movements,

ii. Benchmark for Funds Performance, and
iii. For Index Based Derivatives Products.

Institutional investors, money managers and small investors, etc. are refer to
the S&P BSE SENSEX for their specific purposes

4. Scrips in SENSEX:-
The 30 constitutes of S&P BSE SENSEX as on 04th June, 2020 as mentioned
below.

Exchange
S.No. Name of the company Sector
ticker
1 500820 Asia Paints & Varnishes
2 532215 Axis Bank Banking
3 532977 Bajaj Auto Automotive
4 500034 Bajaj Finance Finance
5 532454 Bharti Airtel Telecommunications
HCL Technologies
6 532281 Software
Ltd
7 500180 HDFC Bank Banking
8 500182 Hero MotoCorp Automotive
9 500696 Hindustan Unilever Personal Care
Housing Development
10 500010 Finance
Finance Corporation
11 532174 ICICI Bank Banking
12 532187 IndusInd Bank Banking
13 500209 Infosys Software
14 500875 ITC Cigarettes & FMCG
15 500247 Kotak Mahindra Bank Banking
16 500510 Larsen & Toubro Infrastructure
17 500520 Mahindra & Mahindra Automotive
18 532500 Maruti Suzuki Automotive
19 500790 Nestle India Ltd -
20 532555 NTPC Power
Oil and Natural Gas
21 500312 Oil & Gas
Corporation
Power Grid
22 532898 Power
Corporation of India
 23 500325 Reliance Industries Conglomerate
24 500112 State Bank of India Banking
25 524715 Sun Pharmaceutical Pharmaceutical
Tata Consultancy
26 532540 Software
Services
27 500470 Tata Steel Steel
28 532755 Tech Mahindra Ltd Software
29 500114 Titan Co Ltd -
Ultra Tech Cement
30 532538 -
Ltd

5. Sectors in SENSEX:-
The major sectors in SENSEX are mentioned below:-

S.
Sector name
No
1 Finance
2
Information
Technology
3 Oil & Gas
4 Transport equipment
5 FMCG
6 Capital Goods
7
Metal, Metal Products
& Mining
8 Power
9 Healthcare
10
Chemical &
Petrochemical
11 Telecom
12 Transport Services

6. Selection and review of scrips (companies) for SENSEX:-

The scrip selection and review policy for S&P BSE SENSEX is based on the
objective of:-
(i) Transparency
(ii) Simplicity

A. Index Review Frequency:-

The Index Committee meets every quarter to review all the BSE indices
including S&P BSE SENSEX. However, every review meeting need not
necessarily result in a change in the index constituents (scrips). In case of a
revision in the Index constituents, the announcement of the incoming and
outgoing Securities is made six weeks in advance of the actual
implementation of the replacements in the Index in accordance with SEBI
requirements.

B. Qualification Criteria:-
The general guidelines for selection of scrip in S&P BSE SENSEX are as
follows:-

a. Quantitative Criteria :-
(i) Market capitalization:-
The Security should figure in the Top 100 companies listed by full market
capitalization. The weight of each S&P BSE SENSEX Security based on
free-float should be at least 0.5% of the Index. (Market Capitalization would
be averaged for last six months)

(ii) Trading frequency:-

The Security should have been traded on each and every trading day for the
last one year. Exception can be made for extreme reasons like Security
suspension etc.

(iii) Average daily trades:-

The Security should be among the Top 150 companies listed by average
number of trades per day for the last one year.

(iv) Average daily turnover:-

The Security should be among the Top 150 companies listed by average
value of shares traded per day for the last one year.
(v) Number of trades:-
The scrip should be among the top 150 companies listed by average number
of trades per day for the last one year.

b. Qualitative Criteria:-
(i) Track Record :-
In the opinion of the Committee, the company should have an acceptable
track record.
(ii) Industry representation:-
The companies should be leaders in their industry group.
(iii) Listed history:-
The companies should have a listing history of at least one year on BSE.
7. Securities groups in BSE:-
The scrips traded on BSE have been classified into below various groups:-
BSE has for the guidance and benefit of the investors and it classified the
scrips in the equity segment into 'A', ‘B’,'T', ‘S', ‘TS' and 'Z' groups on certain
qualitative and quantitative parameters. The classification has done based on
several factors such as market capitalization, trading volumes and numbers,
track records, profits, dividends, shareholding patterns, and some qualitative
aspects. Group A is the most tracked segment consisting of about 200 scrips,
while Group B consists of more than 3,000 stocks.

Group A:-
It is the most tracked class of scripts consisting of about 200 scripts. Market
capitalization is one key factor in deciding which scrip should be classified in
Group A.

Group S:-
“The Exchange has introduced a new segment named “BSE Indonext” w.e.f.
January 7, 2005. The “S” Group represents scripts forming part of the “BSE-
Indonext” segment. “S” group consists of scripts from “B1” & “B2” group on
BSE and companies exclusively listed on regional stock exchanges having
capital of 3 crores to 30 crores. All trades in this segment are done through
BOLT system under ‘S’ group.”

Group Z:-
The ‘Z’ group was introduced by the Exchange in July 1999 and includes the
companies which have failed to comply with the listing requirements of the
Exchange and/or have failed to resolve investor complaints or have not made
the required arrangements with both the Depositories, viz., Central
Depository Services (I) Ltd. (CDSL) and National Securities Depository Ltd.
(NSDL) for dematerialization of their securities.

Group B1 & B2:-

All companies not included in group ‘A’, ‘S’ or ‘Z’ are clubbed under this
category. B1 is ranked higher than B2. B1 and B2 groups will be merged as a
single Group B effective from March 2008.

Group T:-
It consists of scripts which are traded on trade to trade basis.

Group TS:=
The “TS” Group consists of scripts in the ‘BSE-Indonext’ segments which
are settled on a trade to trade basis as a surveillance measure.

Besides these equity groups, there are two other groups i.e. Fixed Income
Securities (Group F) and Government Securities (Group G). In 2014, BSE
introduced two new segments, 'D' and 'DT', for listed companies to provide
guidance to the investors. "The companies which would apply for listing on
the exchange through direct listing norms would be placed in the Group 'D'
for trading in normal segment and in Group 'DT' for trade to trade segment,"
the BSE said in a circular.
8. Trading frequency of SENSEX:-
During trading hours, value of the indices is calculated and circulated on real
time basis. This is done automatically based on the prices at which trades in
index constituents are executed.
During market hours, prices of the index Securities, at which trades are
executed, are automatically used by the trading computer to calculate the
SENSEX every second and continuously updated on all trading workstations
connected to the BSE trading computer in real time. A day's opening, high
and low prices are also given by the computer. But the closing prices are
calculated using spreadsheet to ensure theoretical consistency.
9. Maintenance of the BSE indices:-
One of the important aspects of maintaining continuity with the past is to
update the base year average. The base year value adjustment ensures that
replacement of stocks in Index, additional issue of capital and other corporate
announcements like bonus etc. do not destroy the historical value of the
index. The beauty of maintenance lies in the fact that adjustments for
corporate actions in the Index should not per se affect the index values. The
Index Cell of the exchange does the day-to-day maintenance of the index
within the broad index policy framework set by the Index Committee. The
Index Cell ensures that S&P BSE SENSEX® and all the other BSE indices
maintain their benchmark properties by striking a delicate balance between
frequent replacements in index and maintaining its historical continuity. The
Index Committee of the Exchange comprises of experts on capital markets
from all major market segments. They include Academicians, Fund-managers
from leading Mutual Funds, Finance-Journalists, Market Participants,
Independent Governing Board members, and Exchange administration. All
BSE Indices are reviewed periodically by the BSE Index Committee. This
Committee which comprises eminent independent finance professionals
frames the broad policy guidelines for the development and maintenance of
all BSE indices. The BSE Index Cell carries out the day-to-day maintenance
of all indices and conducts research on development of new indices. Here,
Index committee means the members comprise of Academicians, Fund
managers, Journalists, and Brokers.

4. COMPUTATION METHODOLOGY OF SENSEX

1. Introduction:-
The SENSEX index was initially calculated based on the "Full Market
Capitalization" methodology from 01st January 1986 and was shifted to the
"Free-float Market Capitalization" methodology w.e.f 01st September 2003.
Hence, the S&P BSE SENSEX has been calculating by using the "Free-float
Market Capitalization" methodology at present. As per this methodology, the
level of index at any point of time reflects the Free-float market value of 31
component companies relative to a base period. The market capitalization of
a company is determined by multiplying the price of its stock by the number
of shares issued by the company. This market capitalization is further
multiplied by the free-float factor to determine the free-float market
capitalization. The base period of SENSEX is 1978-79 and the base value is
100 index points. This indicates by the record 1978-79=100. The calculation
of SENSEX involves dividing the Free-float market capitalization of 31
companies in the Index by a number called the Index Divisor. The Index
devisor means the Base index value divided by Base market capitalization.
The Divisor is the only link to the original base period value of the SENSEX.
It keeps the Index comparable over time and is the adjustment point for all
Index adjustments arising out of corporate actions, replacement of Securities
etc. During market hours, prices of the index Securities at which latest trades
are executed are used by the trading system to calculate SENSEX every
second and circulated in real time.

SENSEX = (Free float market capitalization of 31 index scrips / Base

Market capitalization) x Base Index Value
Here, the base index value or base value is 100

2. Process of calculation of Sensex:-

The market capitalization of a company is determined by multiplying the
price of its stock by the number of shares issued by the company. This market
capitalization is further multiplied by the free-float factor to determine the
free-float market capitalization. Then, this free-float market capitalization be
divided by Base market capitalization and the result be further multiplied by
index base value to get SENSEX. Sensex is a stock market index used to
determine the value and strength of the stock market.

3. Free float:-
The total number of shares available for the public to trade in the market.
Free-float market capitalization takes into consideration only those shares
issued by the company that are readily available for public to trading in the
market. It generally excludes the shares from total number of shares of a
respective company. The following categories of holding the shares are
generally excluded from the definition of Free-float:-

(i) Shares held by founders/directors/acquirers which has control element

(ii) Shares held by persons/ bodies with "Controlling Interest"
(iii) Shares held by Government as promoter/acquirer
(iv) Holdings through the FDI Route
(v) Strategic stakes by private corporate bodies/ individuals
(vi) Equity held by associate/group companies (cross-holdings)
(vii) Equity held by Employee Welfare Trusts
(viii) Locked-in shares and shares which would not be sold in the open
market in normal course.
Holding of equity shares by the remaining shareholders fall under the free
float category. All BSE indices exception of BSE PSU index have adopted
the free-float methodology.
4. Determine Free-float Factors of Companies:-
BSE has designed a Free-float format which is filled and submitted by all
index companies on a quarterly basis. BSE determines the Free-float factor
for each company based on the detailed information submitted by the
companies in the prescribed format. Free-float factor is a multiple with which
the total market capitalization of a company is adjusted to arrive at the Free-
float market capitalization. Once the Free-float of a company is determined, it
is rounded-off to the higher multiple of 5 and each company is categorized
into one of the 20 bands given below. For example, a Free-float factor of 0.85
means that only 85% of the market capitalization of the company will be
considered for index (SENSEX) calculation. A simple way to understand the
“free-float market cap” would be the total cost of buying all the shares in the
open market.

5. Free-float Bands:-
Adjusted
Band % Free-
Free-Float
# Float
Factor
1 0 – 5% 0.05
2 5 – 10% 0.10
3 10 – 15% 0.15
4 15 – 20% 0.20
5 20 – 25% 0.25
6 25 – 30% 0.30
7 30 – 35% 0.35
 8 35 – 40% 0.40
9 40 – 45% 0.45
10 45 – 50% 0.50
11 50 – 55% 0.55
12 55 – 60% 0.60
13 60 – 65% 0.65
14 65 – 70% 0.70
15 70 – 75% 0.75
16 75 – 80% 0.80
17 80 – 85% 0.85
18 85 – 90% 0.90
19 90 – 95% 0.95
95 –
20 1.00
100%

For example, look in to the below table containing the shares details of
company ‘X’.
No. of
Description %
Shares
Total Equity Shares of
10000 100
company "X"
Less :-
Promoter and Promoter's
200 2.00
Group
Promoter Depository
180 1.80
Receipts
Holdings through the FDI
150 1.50
route
Shares held by directors 250 2.50
Shares held by the
100 1.00
Government
Public Shareholders
120 1.20
Locked in
 Strategic holding 150 1.50
Total shares % belongs to
11.50
Promoters

Then, Free Float Factor in the above case is (100-11.50) = 88.50 and the
adjusted free float factor is 0.90 which is fall under band # 18 .
6. Determining the SENSEX using free float factor with example:-
SENSEX which was first organized in 1986 but its base year is 1978-79. The
base value of SENSEX has been chosen to be 100 points for the purpose of
ease of calculation and to logically represent the change in terms of
percentage. For example, if the market capitalization moves up by 10% in
next day, the index also moves up by 10% to 110. It is comprised of a basket
of 31 stocks which represents large, liquid companies that represents overall
market movement. The year 1978-79 is considered the base year of the index
with a value set to 100. This means that suppose at that time the market
capitalisation of the stocks that comprised the index was 6000 (remember at
that time there may have been some other stocks in the index, may not be
present companies, but that does not matter), then we assume that an index
market cap of 6000 is equal to an index-value of 100. Thus, the value of the
index (SENSEX) today based on above is (if closing price of the share is
Rs.120, total shares are 10,000 and free-float factor is 88.50%) as below:-
= (10,000x120x0.8850) x 100/6,000
= 10,62,000 x (100 / 6,000)
= 17,700
Thus, the index (SENSEX) value today is 17,700
This is how the Sensex is calculated.
It should be noted that the factor 100/6000 is called as index divisor.

7. Advantages of Free-float methodology:-

(i) A Free-float index reflects the market trends more logically as it takes into
consideration only those shares that are readily available for public trading in
the market.
(ii) A Free-float index assists both active and passive investing styles. It
supports the active managers by enabling them to benchmark their fund
returns regarding an investible index.
(iii) Facilitating better evaluation of performance of active managers.
8. Adjustment of Base market capitalization:-
The base market capitalization may be changed in the below cases:-
When adjustment for Bonus issue, Rights issue and Newly issued
capital:-
Index (Sensex) calculation needs to be adjusted for issue of Bonus and Rights
issue. If no adjustments were made, a discontinuity would arise between the
current value of the index and its previous value despite the non-occurrence
of any economic activity of substance. At the BSE Indices Department, the
Base value is adjusted which is used to alter market capitalization of the
component scrips to arrive at the index value. The BSE Indices Department
(Index cell) keeps a close watch on the events that might affect the index on a
regular basis and carries out daily maintenance of all BSE Indices.

(i) Adjustments for Rights Issues:-

When a company is included in the compilation of the index, issues right
shares, the free-float market capitalization of that company is increased by
the number of additional shares issued based on the theoretical (ex-right)
price. An offsetting or proportionate adjustment is then made to the Base
Market capitalization.

(ii) Adjustments for Bonus Issue:-

When a company is included in the compilation of the index, issues bonus
shares, the market capitalization of that company does not undergo any
change. Therefore, there is no change in the Base market capitalization, only
the number of shares in the formula is updated.

(iii) Other Issues:-

Base Market capitalization Adjustment is required when new shares are
issued by way of conversion of debentures, mergers, spin-offs etc. or when
equity is reduced by way of buy-back of shares, corporate restructuring etc.

9. Example of Adjustment of Base market capitalization:-

The formula for adjusting the Base Market capitalization is as follows:-
New Base Market capitalization = [Old Base Market capitalization X
(New Market capitalization / Old Market capitalization)]
For example, assume that a company issues additional shares which increases
the market capitalization of the shares of that company by Rs.50 crores. The
existing Base Market capitalization (Old Base Market capitalization) is
Rs.2000 crore and the aggregate market capitalization of all the shares
included in the index before this issue is made is, say Rs.4500 crore. The
"New Base Market capitalization" will then be:-
= 2000 x [(4500+50) / 4500]
= Rs.2022.22 crore.
This figure of Rs.2022.22 crore will be used as the Base Market
capitalization for calculating the index number from then onwards till the
next base change becomes necessary.

10. Trading session Timings:-

There are 4 trading sessions in a trading day. They are:-

1. Pre-open (call auction) session:-

The trading day starts from 09:00 am. The pre-open session for 15 minutes
i.e. from 9:00 am to 9:15 am. The pre-open session is divided in to 2 sessions
such as:-

A. Order Entry Period:-

The order entry period for 8 minutes. During this time, the order entry,
modification and cancellation shall be allowed. It should be noted that the 8
minutes are set up by the system driven random stoppage between 7th and
8th minute. Both Limit and market order will be allowed in this period.
During in this period, Dissemination of indicative equilibrium price,
indicative match-able quantity & indicative index values are done.

B. Order Matching Period:-

Order matching period will start immediately after completion of order entry
period. No Order Addition/Modification/Cancellation shall be allowed in this
period. Opening price determination, and trade confirmation are done in this
period.

After order matching period there are buffer period to facilitate transition
between pre-open and continuous session.

2. Continuous Trading session:-

This session will start from 9:15am to 3:30pm. Trading occur continuously as
orders match at time / price priority. The continuous trading session will
commence only after the pre-open session ends. Both the continuous and pre-
open sessions will not run concurrently. The block deal trading session (35
minutes) will start with the commencement of the continuous session.

3. Closing session:-
Closing session is for 10 minutes i.e. starts from 03:30pm to 03:40pm.
During this period, volume weighted average price (VWAP) will be
calculated.

4. Post close session:-

The execution of trades at the closing price is determined during this period.

11. NOTES:-
A. Closing index value:-
The closing index value on any trading day is computed taking the weighted
average of all the trades of index constituents in the last 30 minutes of trading
session. If an index constituent has not traded in the last 30 minutes, the last
traded price is taken for computation of the index closure. If an index
constituent has not traded at all in a day, then, its last day's closing price is
taken for computation of index closure. The use of index closure algorithm
prevents any intentional manipulation of the closing index value.

B. Why don't stocks begin trading at the previous day's closing price:-
Most of the stock exchanges work according to the forces of
demand and supply which determine the prices at which stocks are bought
and sold. This means that no trade can occur until one participant is willing to
sell the stock at a price at which another is willing to buy it, or until
an equilibrium is reached. If there are more buyers than sellers, the stock's
price will rise due to increased demand. Conversely, if more people are
selling a stock, then, its price will decrease. During a regular trading day, the
balance between demand and supply fluctuates as the attractiveness of the
stock's price increases and decreases. In the hours between the closing bell
and the following trading day's opening bell, a number of factors can affect
the attractiveness of a particular stock. For example, the good news such as a
positive earnings announcement may be issued, increasing a stock's demand
and raising the price from the previous day's close. On the other hand, bad
news can negatively affect the price with less demand for the shares. Along
with good and bad news, the development of After-hours trading (AHT) has
had a major effect on the price of the stock between the closing and opening
bells. AHT used to be restricted to Institutional investors and high-net-worth
individuals. However, AHT is now available to average investors with the
development of Electronic Communication Networks (ECNs). AHT creates
greater volatility in a stock's price.

5. CALCULATION OF SENSEX (ARRIVAL OF SENSEX)

Problem:-
From the below stock market data of the SENSEX scripts, you are required to
calculate the BSE SENSEX under free-float methodology by using the
provided actual free-float factors of the companies. Assume that the total
Base market capitalization of the below provided 31 scrips is ₹9,886.70
crores. (The below figures are taken from last week of June, 2018)

No. of Total No.of shares

No. of FF
S.No Security Name Open High Low LTP Shares Turnover
Trades Factor
Traded (in lakhs)
1 ADANIPORTS 374.00 376.45 359.15 372.00 28711602 10680715944.00 5444 0.34
2 ASIANPAINT 1264.85 1270.95 1252.05 1264.10 30034 37965979.40 3360 0.47
3 AXISBANK 506.35 514.30 499.05 510.40 260477 132947460.80 3181 0.65
4 BAJAJ-AUTO 2735.00 2827.75 2726.05 2811.15 29326 82439784.90 1948 0.47
5 BHARTIARTL 373.00 382.65 373.00 381.00 79742 30381702.00 1639 0.33
6 COALINDIA 260.00 265.50 260.00 264.40 97253 25713693.20 1323 0.21
7 HDFC 1892.45 1911.50 1875.10 1907.35 33357 63623473.95 1115 1.00
8 HDFCBANK 2127.90 2138.95 2105.05 2108.05 43690 92100704.50 1770 0.74
9 HEROMOTOCO 3528.60 3531.00 3460.00 3472.05 11002 38199494.10 1365 0.65
10 HINDUNILVR 1604.00 1645.15 1604.00 1641.85 250390 411102821.50 2781 0.33
11 ICICIBANK 272.00 276.00 269.70 275.50 1165082 320980091.00 5349 1.00
12 INDUSINDBK 1969.00 1979.70 1934.00 1939.30 34093 66116554.90 1673 0.83
13 INFY 1295.20 1313.45 1284.00 1306.75 118623 155010605.25 5715 0.87
14 ITC 262.50 266.75 260.30 266.05 673996 179316635.80 5435 0.75 12204294911
15 KOTAKBANK 1345.00 1359.50 1336.00 1341.80 81798 109756556.40 2198 0.70
16 LT 1238.00 1274.80 1235.00 1271.30 129485 164614280.50 4589 0.87
17 M&M 907.30 914.35 894.50 896.80 89760 80496768.00 2293 0.78
18 MARUTI 8799.00 8892.00 8775.00 8821.20 23857 210447368.40 2734 0.44
19 NTPC 155.90 160.60 153.75 159.45 113034 18023271.30 1232 0.38
20 ONGC 154.50 159.00 154.40 158.20 226177 35781201.40 1737 0.32 12833235180
21 POWERGRID 185.35 190.25 184.30 186.65 170082 31745805.30 853 0.43
22 RELIANCE 952.00 977.75 949.70 972.95 325103 316308963.85 8350 0.53
23 SBIN 257.60 263.30 257.60 259.30 569762 147739286.60 5265 0.43
24 SUNPHARMA 569.25 572.05 560.35 560.55 1381646 774481665.30 3949 0.46
25 TATAMOTORS 265.00 270.50 263.00 269.30 1674053 450822472.90 8555 0.64
 26 TATAMTRDVR 159.00 159.95 157.10 158.70 174966 27767104.20 2021 1.00
27 TATASTEEL 552.00 569.85 551.70 567.85 689752 391675673.20 8713 0.69
28 TCS 1846.00 1868.00 1843.00 1847.20 229631 424174383.20 12213 0.26
29 VEDL 228.10 237.50 228.10 235.75 719554 169634855.50 4472 0.50
30 WIPRO 259.40 262.35 255.25 261.40 460996 120504354.40 1280 0.26
31 YESBANK 330.05 341.50 329.65 339.60 418383 142082866.80 4026 0.80

Solution:-
The necessary computations may be done in the following tabular form:-

Full Free-float
No.of shares Market Market
FF
S.No Security Name LTP issued / Cap cap
Factor
subscribed (in Crore (in Crore
rupees) rupees)
1 2 3 4 5 = (4 x 3) 6 7 = (5 x 6)
1 ADANIPORTS 372.00 2070951761 77039.41 0.34 26193.54
2 ASIANPAINT 1264.10 959197790 121252.19 0.47 56988.62
3 AXISBANK 510.40 2567940686 131067.69 0.65 85194.27
4 BAJAJ-AUTO 2811.15 289367020 81345.41 0.47 38232.53
5 BHARTIARTL 381.00 3997400107 152300.94 0.33 50259.62
6 COALINDIA 264.40 6207409177 164123.90 0.21 34466.21
7 HDFC 1907.35 1681984048 320813.23 1.00 320813.45
8 HDFCBANK 2108.05 2604157867 548969.50 0.74 406237.81
9 HEROMOTOCO 3472.05 199711455 69340.82 0.65 45072.06
10 HINDUNILVR 1641.85 2164633806 355400.40 0.33 117282.26
11 ICICIBANK 275.50 6431703522 177193.43 1.00 177193.87
12 INDUSINDBK 1939.30 600437982 116442.94 0.83 96648.42
13 INFY 1306.75 2184127091 285410.81 0.87 248308.11
14 ITC 266.05 12204294911 324695.27 0.75 243521.65
15 KOTAKBANK 1341.80 1906140487 255765.93 0.70 179036.24
16 LT 1271.30 1401727601 178201.63 0.87 155035.97
17 M&M 896.80 1243210516 111491.12 0.78 86963.47
18 MARUTI 8821.20 302080060 266470.86 0.44 117247.56
19 NTPC 159.45 8245464400 131473.93 0.38 49960.44
20 ONGC 158.20 12833235180 203021.78 0.32 64967.22
21 POWERGRID 186.65 5231589648 97647.62 0.43 41988.75
22 RELIANCE 972.95 6336398949 616499.94 0.53 326745.47
23 SBIN 259.30 8924587534 231414.55 0.43 99508.50
24 SUNPHARMA 560.55 2399324494 134494.13 0.46 61867.67
25 TATAMOTORS 269.30 2887348428 77756.29 0.64 49764.22
26 TATAMTRDVR 158.70 508502291 8069.93 1.00 8070.86
27 TATASTEEL 567.85 1204119440 68375.92 0.69 47179.71
 28 TCS 1847.20 3828575182 707214.41 0.26 183875.86
29 VEDL 235.75 3717194239 87632.85 0.50 43816.89
30 WIPRO 261.40 4524013999 118257.73 0.26 30747.25
31 YESBANK 339.60 2305713095 78302.02 0.80 62641.62
TOTAL 6297486.58 3555830.11

Based on the above information in the table, the SENSEX is calculated by

using the below formula:-

SENSEX = [(Current free-float market capitalization / Base market

capitalization) x Base value]
= (3555830.11 / 9886.70) x 100
= 359.657936 x 100
= 35965.79

NOTES:-
(i) Open :-
The price of the stock when trading day begins.

(ii) Low:-
The lowest price of the stock traded on the day.

(iii) High:-
The highest price of the stock traded on the day.

(iv) LTP:-
The Last Traded Price of the stock on the day i.e. closing price of the trading
day.

(v) Number of shares traded:-

The total number of shares traded on a day.

(vi) Number of Trades:-

The total volume of the shared traded on the day.

(vii) Total Turnover:-

The total turnover (revenue) arrives by multiply the total number of the
shares traded by the closing price of the day.
------------ End of the CHAPTER – 15 ----------

CHAPTER – 16
FINANCIAL DERIVATIVES

Learning objectives
After studying this chapter, you can be able to :-
1. know how options work,
2. know the factors influencing option’s
valuation,
3. Understanding about Forwards and Futures,
4. Understand relationship between Call and put
prices,
5. know the factors influencing call option,
6. Calculate the profit function of various option
strategies, and
7. Understand about Warrants and Swaps.

Introduction to Financial ‘Derivatives’:-

Simply, the term ‘derivative’ is referred as ‘price guarantee’. Every
Derivative specifies a future price of which some product is must be sold.
This item is called an “underlier”. An “Underlier” can be a physical thing like
wheat or oil etc. or it can be an abstract thing like “price index” traded on
stock exchange. Derivative is a contract between 2 parties. The buyer agrees
to purchase an underlying asset from the seller on a specific date at a specific
price. A “derivative” is a financial contract between two or more parties
that derives its price (value) upon an underlying instruments or financial
assets such as stocks, bonds, commodities (gold, silver, oil, gas, agricultural
products, etc..), currencies, interest rates (such as the yield on the 5-year
Treasury bills), market indices (reference rates). Here, the financial asset
means a tangible liquid asset which is an asset that can be converted into cash
quickly. For example, stocks, bonds, bank deposits etc. The foreign exchange
(FOREX) market is referred to as most liquid market in the world because it
hosts the exchange of trillions of dollars each day and making it impossible
for any one individual to influence the exchange rate. The most common
derivatives are Forwards, Futures, Options, Warrants and Swaps.
“Derivatives” can either be traded Over-the-Counter (OTC) or through
an exchange counter (National Stock Exchange or Bombay Stock Exchange,
etc. in India). The derivatives traded through exchanges are considered as
standardized whereas the derivatives traded Over-the-Counter (OTC) are
considered as greater risk for the counterparty. Derivatives are considered as
a form of insurance. Derivatives hold a variety of functions and applications
based on type of derivative. Certain kinds of derivatives can be used for
hedging or insuring against risk of an asset. Derivatives can derive the profit
from changes in interest rates and equity markets around the world.
Derivatives can be used for speculation in betting on the future price of an
asset or find a way to escape in exchange rate issues. “Derivatives” are
securities and hence the trading of derivatives is governed by the regulatory
frame work under the Securities Contracts (Regulation) Act, 1956 in India.

Example of Derivative:-
(i) The farmers may wish to sell their products in a future date at today’s pre-
agreed price to avoid the risk of a change in prices by that date.

(ii) Assume that we are the trader of rice and we expect to buy the rice in the
next month. But, we are afraid of the prices of rice could go up within the
next one month. Then, we can buy the rice today itself at today’s pre-agreed
price and for delivery and settlement in the next month. Thus, we are
protecting ourselves against the price increases in rice.

(iii) Assume that we are a jeweler and we will be selling some jewelry in next
month. But, we are afraid of the prices of gold could fall within the next one
month. Then, we can sell the gold today itself at today’s pre-agreed price and
for delivery and settlement will take place in the next month. Thus, if the
price of the gold will fall, then, actually we will make a profit on Gold in this
case of Derivatives.

(iv) Suppose, we are an importer and we need a dollar to pay for our import
purchases in the next month. But, we are afraid of that the dollar will be
increase before we will make a payment to exporters. Then, we should buy
the derivatives on dollars today itself at today’s dollar price. Thus, even if the
dollar will increase, we will still be able to get the dollars in future at prices
decided today.

(v) Suppose, we are an exporter and we are expecting that the import
payments will be receiving in dollars in next month. But, we are afraid of that
the dollar price will be decrease before we will receive a payment from
importers. Thus, even if the dollar will decrease, we will still be able to get
the dollars in future at prices decided today.

(vi) An agreement to buy a car in the future at a today’s pre-agreed price is a

forward contract.
(vii) An agreement to buy a sports ticket in future at today’s pre-agreed price
is a forward contract.
(viii) An agreement to buy a television today at the posted price is not a
forward contract.
(ix) An agreement to subscribe a newspaper in future at today’s pre-agreed
price is a forward contract.

The common underlying assets for derivatives are as below :-

i. Equity shares
ii. Equity indices
iii. Interest rates
iv. Debt market securities
v. Foreign exchange
vi. Commodities, etc.

Over the Counter (OTC) derivative contracts:-

The derivatives those which are trading on an exchange(s) are called as
‘exchange traded derivatives’ whereas privately negotiated derivative
contracts are called as ‘OTC contracts’. OTC Derivatives are unlisted
derivatives structured by parties based on their own convenience. These are
generally popular in the developed markets where leading brokers and
institutions create their own kind of special derivatives and sell to interested
investors. OTC Derivatives generally do not require any margin payments.
They are tailor made and are subject to counter party risk. The OTC
derivative contracts consisting of the following features compared to
exchange-traded derivatives.
(i) The counter-party (credit) risk is decentralized within individuals or individual institutions,
(ii) The OTC contracts are generally not regulated by a regulatory authority.
(iii) No formal rules for risk and burden sharing between individuals.
(iv) No formal rules for safeguarding the collective interests of market participants
(v) No formal centralized limits on individual positions, leverages, margins, etc.
(vi) No formal rules or mechanisms for ensuring market stability and integrity.
However, they are affected indirectly by national legal systems, banking
supervision and market surveillance.

Market makers:-
Market Makers are the players who offer the continuous bid and ask quotes
for particular securities or series. The market makers are also called as
Jobbers.

History of Derivative Markets:-

Financial derivatives have emerged as one of the biggest markets of the
world during the past two decades. Globalization of financial markets has
forced several countries to change laws and introduce innovative financial
contracts which have made it easier for the participants to undertake
derivative transactions. The first exchange-traded financial derivatives
emerged in 1970’s due to the collapse of fixed exchange rate system and
adoption of floating exchange rate systems. As the system broke down
currency volatility became a crucial problem for most countries. To help
participants in foreign exchange markets, hedge their risks under the new
floating exchange rate system, foreign currency futures were introduced in
1972 at the Chicago Mercantile Exchange. In 1973, the Chicago Board of
Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to
facilitate the trade of options on selected stocks. The first stock index futures
contract was traded at Kansas City Board of Trade. Currently the most
popular stock index futures contract in the world is based on S&P 500 index,
traded on Chicago Mercantile Exchange. During the mid1980’s, financial
futures became the most active derivative instruments generating volumes
many times more than the commodity futures. Index futures, futures on T-
bills and Euro-dollar futures are the three most popular futures contracts
traded today. Other popular international exchanges that trade derivatives are
LIFFE in England, DTB in Germany, SGX in
Singapore, TIFFE in Japan, MATIF in France, Eurex etc. Futures contracts
on interest-bearing government securities were introduced in mid-1970s. The
option contracts on equity indices were introduced in the USA in early
1980’s to help fund managers to hedge their risks in equity markets.
Afterwards, a large number of innovative products have been introduced in
both exchange traded format and the Over the Counter (OTC) format. The
OTC derivatives have grown faster than the exchange-traded contracts in the
recent years.

Uses of Derivatives:-
Today, the derivatives are traded based upon a wide variety of transactions
and have many more uses.
(i) Derivatives make future cash flows can be more predictable.
(ii) Derivatives can eliminate the financial risk
(iii) To ensure balanced exchange rates for goods traded internationally.
(iv) Derivatives allow the companies to forecast their earnings more
accurately.
(v) To Price discovery.
(vi) To improve the market efficiency for the underlying an asset.
(vii) To less risk management.
(viii) To reduce the market transaction costs.

INVESTING VS TRADING:-
Investing and trading are two different methods of attempting to generate
profit in the financial markets. The 3 key differences between investing and
trading are as under:-

(i) Period:-
Investing:-
The goal of investing is to build wealth over an extended period of time
through the principle of ‘Buying and holding’ of a portfolio of stocks, baskets
of stocks, Mutual funds, bonds and other instruments of financial investment.
Investors invest their money for some years, decades or for even longer
period. Short term market fluctuations are insignificant in the long running
investing approach.

Trading:-
Trading is a method of holding stocks for a short period of time. It could be
for a week or more often a day. Trader holds stocks till the short term high
performance. In other words, trading involves the more frequent buying and
selling of stock, commodities, currency pairs or other instruments with the
goal of generating returns that outperform buy-and-hold investing.

(ii) Capital Growth:-

Investing:-
Investing is an art of creating wealth by compounding interest and dividend
over the years by holding quality stocks in the market. Investors may be
content with a 10 to 15% annual return.

Trading:-
Traders look at the price movement of stocks in the market. If the price goes
higher, traders may sell the stocks. If the price falls down, traders may buy
the stocks. Traders might seek a 10% return each month. Trading profits are
generated through buying at a lower price and selling at a higher price within
a relatively short period of time (i.e. short selling) and vice versa also may
happen.

(iii) Risk:-
Investing:-
Investing involves comparatively lower risk and lower returns in a short run,
but, might deliver higher returns by compounding interests and dividends if
held for a longer period of time. Daily market cycles do not affect much on
quality stock investments for a longer time.

Trading:-
Trading comparatively involves higher risk and higher potential returns as the
price might go high or low in a short period.

Investors are typically more concerned with market fundamentals such

as EPS, Dividend, DPS, P/E and management forecasts to make informed
investment decisions. Stock investors usually focus on the below concerns:-
i. Value of company’s shares
ii. Future success

Traders generally fall into one of the below 4 categories:-

i. Position Trader:-
Positions are held from months to years.

ii. Swing Trader:-

Positions are held from days to weeks.

iii. Day Trader:-

Positions are held throughout the day only with no overnight positions.

iv. Scalp Trader:-

Positions are held for seconds to minutes with no overnight positions.

Stock traders usually focus on the below concerns (factors affecting the stock
trader):-
i. Price patterns
ii. Supply and demand
iii. Market emotion
iv. Trader support
v. Account size
vi. Amount of time that can be dedicated to trading,
vii. Level of trading experience,
viii. Personality and risk tolerance.

Types of Derivatives:-
The most common types of derivatives are as under:-

1. FORWARDS
Introduction:-
Assume that a farmer grows a ton of apples a year. If the farmer wants to sell
those apples to a merchant but are not sure what the price will be when the
season comes. Thus, the farmer can agree with a merchant to sell all his
apples for a fixed price of $1500. This is a forward contract where in the
farmer is the seller of apples forward and the merchant is the buyer. The price
is agreed today in advance and the delivery will be take place sometime in the
future. So, the forward contract is a customized contract between two
parties where in the settlement takes place in future at today’s pre-agreed
price, quantity and quality of an underlying asset(s). In the above example,
the underlying asset is an apple. Forward contracts have been using since
centuries especially in commodity trades. Forwards are also widely used in
the foreign exchange (FOREX) market.

Features of a “forward contract”:-

(i) Contract between two parties without any legal party (exchange) between
them.
(ii) Price decided today.
(iii) Quantity decided today (can be based on convenience of the parties).
(iv) Quality decided today (can be based on convenience of the parties).
(v) Settlement will take place sometime in future (can be based on
convenience of the parties).
(vi) No margins are generally payable by any of the parties to the other.

Limitations of a “forward contract”:-

(i) Counter-party risk:-
In the above example, if the merchant does not buy the apples for $1500
when the season comes, what can be the farmer (seller) will do? He can only
file a case in the court, but, that is a difficult process. The counter-party risk
is also known as “credit risk” or “default risk”.

(ii) Price cannot be transparent:-

The price of $1500 was negotiated between the farmer and the merchant. If
somebody else wants to buy these apples from the farmer, there is no
mechanism of knowing what the right price is.

2. FUTURES
Introduction:-
Future contracts are similar to forward contracts except the futures are
supported by a stock exchange.
Future contracts were first traded in the Chicago in USA. The “future
contract” is an agreement between two parties through an exchange (legal
counter-party) to buy or sell an underlying asset at a certain time in future
at a today’s pre-agreed price, quantity and quality. Futures are quoted on a
stock exchange. Prices are available to all buyers and sellers those who want
to buy or sell their underlying asset(s) because the trading takes place on a
transparent computer system.

Features of a “future contract”:-

(i) Contract between two parties through an exchange. Exchange is the legal
counter party to both parties.
(ii) Price decided today.
(iii) Quantity decided today (quantities have to be in standard denominations
specified by the exchange).
(iv) Quality decided today (quality should be as per the specifications decided
by the exchange)
(v) ‘Tick size’ is decided by the exchange. Here, ‘Tick size’ means the
minimum amount by which the price quoted can change.
(vi) Delivery will be take place sometime in future (expiry/maturity date is
specified by the exchange).
(vii) Margins are payable by both the parties to the exchange.
(viii) In some cases, the price limits (or circuit filters) can be decided by the
exchange.

NOTE:-
(i) In the case of underlying asset of stock-index, the futures contract cannot
be used as a means of acquiring the underlying assets.
(ii) Futures contracts can be reversed with any member of the derivatives
segment of the exchange.

As an exchange or its clearing corporation becomes the legal counter-party in

the case of future contracts, the futures can overcome the forward contract’s
limitations such as Counter-party risk and Price cannot be being
transparent. If we buy any futures contract on an exchange, the exchange or
its clearing corporation becomes the seller instead of the real seller and the
exchange will guarantee us the delivery of the product (underlying asset).
Further, the prices of all Futures quoted on the exchange are known to all the
players. Transparency in prices is a big advantage comparing to the forward
contracts.

In the case of futures, the exchange is supposed to carry out an on-line

surveillance of the derivatives segment. The exchange surveys the market
movements, volumes. The process of positions, prices, trades entered into by
brokers on a continuous basis to identify any unusual trades is called as an
on-line surveillance. Futures are allowed on 2 indices i.e. Sensex and Nifty at
present in India. The price of an underlying asset is determined based on
forces of demand and supply of an underlying asset and are discovered
during the trading or market hours.

In India, the futures contracts will be expired on a certain pre-specified date

i.e. the last Thursday of every month. For example, a June Futures contract
will expire on the last Thursday of June. In this case, June is referred to as the
Contract month. If the last Thursday is a holiday, the Futures contracts will
be expired on the previous working day. On expiry, all the contracts will be
compulsorily settled. Settlement can be effected in cash or through delivery.

The profit on the Futures contract at the point of entering into the transaction
is zero. The Profit or loss will develop only after passage of time. If prices of
Futures are move up, the buyer will make a profit and the seller will have a
loss whereas prices of Futures are move down, the buyer will have a loss and
the seller will make a profit.

Limitations of a “future contract”:-

Lack of flexibility in quantity:-
Suppose, If we want to buy 73 shares of ‘Reliance Industries Limited’ for a
future delivery date of 14th June, we cannot buy this quantity because the
exchange (legal authority) will have standardized specifications for each
contract. Thus, we can buy the ‘Reliance Industries Limited’ futures in lots of
100 only. Thus, the specifications of futures contracts are standardized by the
exchange.

Types of Settlement in Futures:-

All the contracts must be settled on expiry of the contract through the
following 2 types of settlement :-
1. Cash based Settlement:-
The settlement of payment by cash or receipt in cash is the difference
between the contracted price and the closing price of the underlying asset on
the expiry day of the contract. For example, if ‘A’ bought
SENSEX futures for Rs5000 (referred as contract price) and the closing price
of an exchange on the last Thursday of the contract month was Rs5040, then,
‘A’ will be paid profit of Rs40 (closing price minus contract price) by the
exchange. The exchange will collect the Rs40 from the ‘B’ who sold the
Futures because the ‘B’ would have made a loss of Rs40. In the system of
cash settlement, we can buy and/or sell futures on stocks without holding the
stocks at any time. For example, to buy and sell the futures of Reliance, we
don’t have to hold of Reliance shares.

2. Delivery based Settlement:-

In the Delivery based settlement, the seller of futures will deliver their
underlying asset of futures to the buyer on the expiry day through the
exchange. For example, if ‘A’ bought 1000 futures of Reliance at Rs400
each, then, ‘A’ will get the same i.e. 1000 futures of Reliance at Rs400 each
on the expiry day of the contract even though the closing share price of the
Reliance was traded as Rs425 on expiry day. In this case, ‘A’ would still get
the futures of Reliance at Rs400 which effectively generating a profit of Rs25
each of 1000 shares for ’A’. Hence, the ‘A’ will get total value of profit is the
price per futures unit (share) multiplied by the lot size (contract multiplier)
i.e. Rs25000 [1000 x (425-400)].

When to buy or sell the futures:-

The futures can be bought or sold in various circumstances. But the simplest
of these circumstances could be:-
i. Buy the futures when bullish.
ii. Sell the futures when bearish.
Here, bullish means that expect the market to rise and bearish means that
expect the market to fall.

‘Vanilla’ vs ‘exotic’ derivatives:-

The standardized derivatives which are specified by the exchanges and have
simple standard features are known as “vanilla derivatives” or “plain vanilla
derivatives”. The derivatives which are having non-standard features and
which might appeal to special classes of investors are called as “exotic
derivatives”. These are generally not exchange traded and are structured
between parties on their own.

Short Selling:-
In the context of the stock market, Short-selling is that a trader sells the
shares (that he does not own at the time of selling them) to the buyer at
market price in the hope that the price of those shares will decline in future
and he will profit by buying back those shares at a lower price. A short seller
can try to sell the stock at high price and buy at low price. After all this, the
trader will get money the difference if the share price has fallen, but the
trader will have lost money if the price will increase. In India, there is no
prohibition on short-selling by retail investors. Banks and insurance
companies are prohibited from short-selling and are compulsorily required to
settle on the basis of delivery of securities owned and held by them. Short-
selling is considered an essential feature of the securities market not just for
providing liquidity, but also for helping price corrections in overvalued
stocks.
Open Interest:-
The number of transactions open at the end of the day is referred to as Open
Interest. For example, if 40000 contracts have been executed on day one of
the derivatives market and none of them squared up so far, the open Interest
will be 40,000 contracts. If on day two, the 6,000 contracts are squared up
and 10,000 new contracts are executed, then, the open Interest will become
44,000 contracts [(40,000 – 6,000) + 10000]. The level of Open Interest
indicates the depth of the market.

Basis:-
The ‘basis’ is the difference between spot price (i.e. current market price) and
futures price. Generally, in financial markets, future’s prices should be higher
than spot prices. But, in practice, the reverse also happens. The ‘basis’ would
decrease with passage of time and it would reduce to zero on the day of
expiry. On that expiry day, both the futures price and spot price would
become equal. The regular situation where future’s prices are higher than spot
prices are referred to as “contango” whereas the unusual situation where
futures prices are lower than spot prices are referred to as “backwardation”.

3. OPTIONS
Introduction:-
The parties to an option contract are the option buyer (or holder) and the
option seller (or writer). Here, Option means the offer price (or
strike/exercise price) given to an option buyer to buy or sell an underlying
asset or security. Option is given the buyer the right but not the obligation of
buying or selling an underlying asset or a security at a certain price (i.e. strike
price or an exercise price) before a certain date (i.e. the expiration date).
Market traders can purchase the call options which give them the right to buy
(but not obligation to buy) when they expect the market price of the security
or an underlying asset to increase. Market traders can purchase the put
options which are enable them to sell (but not obligation to sell) when they
expect the value of the security or an underlying asset to decrease. Options
have an intrinsic value when underlying asset or a security’s strike price is
lower than the spot price in the case of a call option or higher than spot price
in the case of the put option. In options market, the buyers are called
as holders whereas the sellers of options are called as writers. The
buyer can exercise the call or put and profit on the difference. Options are
two types:-
A. ’Call’ option
B. ‘Put’ option

A. ’Call’ option:-
‘Call’ option gives the buyer the right to buy (but not obligation to buy) a
specified quantity of an underlying asset at a given price (or call’s strike
price) on or before a given future date. For example, the Reliance 380 June
‘call’ option gives the buyer the right to buy Reliance at a price of Rs380 per
share on or before the last Thursday of June (i.e. expiry date of the option
contract). The price of 380 in the above example is called as strike price or
the exercise price. In the Indian markets, the ‘call’ options are also known as
‘Teji’. In the case of call option, the ‘call’ option sellers are under obligation
to deliver the underlying asset(s) whenever the call option buyer exercises his
right.
B. ’Put’ option:-
‘Put’ option gives the buyer the right to sell (but not obligation to sell) a
specified quantity of an underlying asset at a given price (or call’s strike
price) on or before a given future date. For example, the Reliance 380 June
‘put’ option gives the buyer the right to sell Reliance at a price of Rs380 per
share on or before the last Thursday of June (i.e. expiry date of the option
contract). The price of 380 in the above example is called as strike price or
the exercise price. In the Indian markets, the ‘put’ options are also known as
‘Mandi’. In the case of put option, the ‘put’ option sellers are under
obligation to buy the underlying assets whenever the put option buyer
exercises his right.

The options can be created on the various underlying assets such as:-
i. Equity shares
ii. Equity indices
iii. Foreign exchange
iv. Commodities
v. Swaps, etc.
An option over a Swap is called a ‘Swaption’.

We need not invest the entire contract value when buy the futures or options
whereas we need to invest the whole amount in the cash market. We invest an
Initial margin amount in the case of futures whereas we will invest the
amount of option premium as a buyer or provide a certain margin as a seller
in the case of options. Strike Prices are decided by the exchange under SEBI
guidelines in India. Margins are paid only by the sellers in the options
market. Buyers pay Premium and hence no Margins are applicable to buyers.
Thus, we can take a larger exposure with a lower investment requirement in
derivatives. This practice increases our risks and returns substantially. For
example, if we buy Reliance shares and these are go up by 20%, then, we can
earn 20% on our investment in normal situation. But, in the case of futures, if
we buy Reliance futures which are go up by 20%, we will earn much more.
For example, if we paid a margin of only 10%, we will earn 20% even
though10% margin invested.

On exercise, the option buyer is paid by the exchange for the amount of
difference between the spot price (current market price) and the strike
(exercise) price. The exchange can get this amount (which has to pay to
option buyer) from option seller to make this difference payment.

NOTE:-
In the case of index options, delivery of an index is not possible. These
options are cash settled. The seller of options is under obligation to pay the
difference between the market value of the index and strike price of the
option to the option buyer.

Strike price (Exercise price):-

In the call option, the price specified in the option contract at which the
option buyer can purchase an underlying asset from the option seller is called
as strike price or exercise price. Similarly, in the put option, the price
specified in the option contract at which the option seller can sell an
underlying asset to the option buyer is called as strike price or exercise price.
It should be noted that this price is not the option price or option premium.
But, it is the rate of exchange for the underlying asset which applies to the
transaction if option buyer or option seller decides to exercise the option.

Spot price:-
Spot price is nothing but the price at which is trading on the exchange at
present. Spot price is also known as current market price of the underlying
asset.

Expiration date (Maturity date):-

The date on which the option contract is expire. The exchange traded options
have standardized maturity dates.

American option and European option:-

American option:-
An option either a call option or put option which can be exercised by the
option buyer or option seller on any business day from initiation of the
contract to the expiry day of the contract.

European option:-
An option either a call option or put option which can be exercised by the
option buyer or option seller only on expiration day of the contract.
American options are more flexible. The minimum value of American
options will be the intrinsic value at all times. In India, both the American
options and European options are available. Index Options are European style
whereas the individual stock options are an American style in India.

Option premium (or Option value/Price):-

An option premium is the income received by an investor who sells (i.e.
"writes") an option contract to another party called buyer. Option premium is
paid by the buyer of the option to the seller of that option through the
exchange. Option premium usually pay ‘upfront’ i.e. at the time of initiation
of the contract and it is non-refundable whether the option is exercised or not.
The Option premium paid is the maximum loss to a buyer and maximum
profit to the seller. Option premium can be made up of intrinsic & extrinsic
value. These values change based on three inputs such as strike price in
relation to the stock price, implied volatility and time until expiration. In
summary, Options are like insurance contracts.
Factors affecting the option Value:-

Option Values depend on the following factors:-

i. Spot (market) price of underlying asset/stock
ii. Strike (exercise) price underlying asset/stock
iii. Time to expiry
iv. Interest rates
v. Dividends
vi. Volatility

‘In-the-money’, ‘At-the-money’, and ‘Out-of-the money’ options:-

Options are classified in 3 ways depending on the relationship of the strike
price to the underlying asset or security's current market price (i.e. spot
price). The amount of the premium paid for an option depends on whether the
option is In-the-money, At-the-money or Out-of-the money.

In-the-money (ITM):-
In the money means that a strike price of call option is below the spot price of
an underlying asset or the strike price of a put option is higher than the
spot price of an underlying asset. In-the-money does not mean that will get
profit, but, it just means the option is worth exercising. In-the-money means
that the stock option is worth money if an option holder can turn around
and sell or exercise it. For example, if Smith buys a call option on XYZ
stock with a strike price of Rs120, and the spot price of the stock is at Rs150,
the option is considered to be in-the-money. This is because the option gives
Smith the right to buy the stock for Rs120 but Smith could immediately sell
the stock for Rs150, then, a gain of Rs30 (150-120). If Smith paid Rs32 for
the call, then, he wouldn't actually profit from the total trade, but it is still
considered in the money. Similarly, the strike price of Reliance 380 June call
option will be In-the-money when spot price of Reliance share price is above
Rs380. If the spot price of Reliance share is Rs390, the Option will generate
Rs10 (390-380) on exercise. The Strike price of TCS 450 June Put option
will be In-the-money when the spot price of TCS share is trading below
Rs450. If the share price is Rs385, the Option will generate Rs15 on exercise.

At-the-money (ATM):-
At-the-money means the underlying asset or a security’s strike price and spot
price is the same. Both call and put options are simultaneously At-the-money.
For example, if ABC stock is trading at Rs260, then the ABC 260 call
option is At-the-money and it is also called as the ABC 260 put option. At-
the-money option has no intrinsic value, but, it may still have time value. The
options trading activity tends to be high when options are At-the-money.

Near-the money options are those whose strike prices are very near to the
market Prices i.e. within 50 cents of being At-the-money. For example,
Suppose, an investor purchases a call option with a strike price of Rs250.50
and an underlying stock price is trading at Rs250. In this case, the call option
is said to be as Near-the-money.

Out-of-the-money (OTM):-
Out-of-the-money is used to describe a call option with a strike price is
higher than the spot price of the underlying asset or a security or a put option
with a strike price is lower than the spot price of the underlying asset or a
security. Out-of-the-money options have zero intrinsic value. They only carry
the time value (i.e. an extrinsic value). Out-of-the-money options are those
which will not generate the negative return if exercised. So that the Out-of-
the-money options are usually never exercised. For example, strike price of
Reliance 380 June call option will be out-of-the-money when spot price of
Reliance share price is Rs352. Similarly, the strike price of TCS 2500 June
put option will be out-of-the- money when spot price of Infosys share is
Rs2750.

In summary, both the ITM and OTM options have extrinsic value, but OTM
options are purely made up of extrinsic value. At the money (ATM) options
are closest to the stock price and have the most extrinsic value. Extrinsic
value is very similar to a standard bell curve if there is no volatility skew.
Extrinsic value is highest in ATM options and trails off as the traders go
further OTM and further ITM.

Therefore, simply, In-the-money, At-the-money and Out-of-the-money in a

call option and put option are as under:-
In-the-money (ITM):-
Call Option: S>X (or S – X)
Put Option: X>S (or X – S)
ITM option is worth if exercises.

At-the-money:-
Call option: X=S
Put option: S=X

Out-of-the-money:-
Call Option: X>S (or X – S)
Put Option: S>X (or S – X)
OTM have zero intrinsic value. They only carry the ‘time value’ (i.e.
extrinsic value). OTM options are never exercised.

Intrinsic value and Extrinsic value:-

Options can be made up of intrinsic value and/or extrinsic value. The intrinsic
value and extrinsic value add together to form the option's total value.
The total value of an option can be say in below two ways:-

Total option value = Intrinsic value + Extrinsic value

Total option value = Current value + Time and Volatility value
Intrinsic Value:-
The intrinsic value is how much an option would be worth full (not includes
additional fee) if it is expiring right now. If we are not making money at
expiration, the option would have no intrinsic value. If we make money, the
amount which we make is the intrinsic value of the option contract. An
option is worth less if there is no intrinsic value. If an option was ever being
sold for less than its intrinsic value, the experienced traders would buy the
option and exercise it immediately for the intrinsic value. The profit they
would make would be equal to the difference between how much they paid
for the option and the amount they get for exercising it (less commission if
any). Options have intrinsic value if they are in the money i.e. ‘In the money’
is said to be the option has intrinsic value.

For Put options:-

A put option gives the right (but not obligation) to the option buyer to sell the
underlying asset at the put’s strike price. Put options are in-the-money (i.e.
have intrinsic value) if their strike price is higher than the spot price of
underlying asset (or security/index/currency etc..). If the strike price is higher
than the spot price of the underlying asset, then, the option buyer able to sell
the stock for more than it is currently worth. Thus, the total profit at
expiration is the intrinsic value (or Strike Price – spot Price). If the option
has no intrinsic value (i.e. out of the money) at expiration, the option will
expire as worthless.

For Example,
XYZ’s stock is trading (i.e. spot price) at $100 and he sell the put at a strike
price of $107, then, the

Intrinsic Value = Strike Price (X) – spot price (S)

= 107 – 100
= $7.00
Therefore, the intrinsic value of XYZ’s stock at expiration is $7.00

For Call options:-

A Call option gives the right (but not obligation) to the option buyer to buy
the underlying asset at the call’s strike price. Call options are in-the-money
(i.e. intrinsic value) if the spot price of underlying stock is higher than the
strike price. If the spot price is higher than the strike price, then, the option
buyer be able to buy the stock for less than it is currently worth. Thus, the
total profit at expiration is the intrinsic value (or spot price – Strike Price). If
a call option has no intrinsic value (i.e. out-of-the money) at expiration, the
option will expire as worthless.

For Example,
XYZ’s stock is trading (i.e. spot price) at $120 and he buys the call at a strike
price of $115, then, the

Intrinsic Value = Spot Price (S) – Strike price (X)

= 120 – 115
= $5.00
Therefore, the intrinsic value of XYZ’s stock at expiration is $5.00

NOTE:-
In-the-money options have intrinsic value whereas Out-of-the-money options
do not have intrinsic value (i.e. Out-of-the money options are all extrinsic
value).

Extrinsic Value:-
If we know the Option’s total value or price i.e. which is the premium it is
being bought or sold for, we can calculate the ‘extrinsic value’ as below:-

Extrinsic Value = Total Option Premium – Intrinsic Value.

For example,
XYZ’s stock is trading (i.e. spot price) at $120 and he buys the call at a strike
price of $115 with an option premium of $7.50, then, the

Extrinsic value = Option premium (option value / price) – Intrinsic value.

= 7.50 – (120 – 115)
= $2.50
Therefore, the extrinsic value of XYZ’s stock is $2.50

Both intrinsic and extrinsic values are determined by the fill price and the bid
or ask spread. Some investors may buy the stocks at price higher than
Option’s current strike price because there is a value in the ability to hold a
contract over time. The amount of time left until expiration and the volatility
of the underlying asset directly impact the price of an option which is
impacting the ‘extrinsic value’. Investors buy the options hoping the option’s
value will increase during the option’s lifetime or sell options hoping that the
option value will decrease. Options cost significantly less money than buying
stock outright because options have expiration dates whereas the stocks do
not have an expiry date. Because of the options have expiry dates, the
extrinsic value is defined as the additional time and volatility value traders
pay for. Traders are hoping that the options price will change in their favor.
Essentially, the market is aware the price may change so added premium
(extrinsic value) is included to compensate for the changes in time value and
volatility.

Aspects of Extrinsic value:-

Even though multiple factors that affect the extrinsic value, the main factors
(or aspects) are the below can affect the extrinsic value.

Time Value (Days to expiration):-

The option which is having more time until expiration is considered as
become a more valuable because it is having the more time underlying
stock’s price has to change.

Volatility:-
Implied volatility is simply speculation of where the underlying stock could
go over the period of time. Implied volatility effectively measures how much
the stock price may swing over a specific timeframe. Adding volatility to the
time value gives the extrinsic value of the option. As time expires, the
option’s extrinsic value will move to $0.00 and leaving only intrinsic
value. If volatility of underlying asset decreases, the extrinsic value of the
option also will decrease. If an option has a longer contract or higher implied
volatility, the extrinsic value of the option will increase.

Factors affect an option Values:-

A. For Call Options:-
Higher market price, Higher option value.
Higher strike price, Lower option value.
Higher volatility, Higher option value.
Longer time to expiry, Higher option value.
Higher interest rates, Higher option value.
Higher dividends, Lower option value.

B. For ‘Put’ Options :-

Higher market price, Lower option value.
Higher strike price, Higher option value.
Higher volatility, Higher option value.
Longer time to expiry, Higher option value.
Higher interest rates, Lower option value.
Higher dividends, Higher option value.

Profit profile of Option buyer or seller:-

Buyers of options enjoy the potential of unlimited profits, but, suffer limited
losses. Sellers of options face the potential of unlimited losses, but, make
limited profits. This profit profile is called asymmetric. In contrast, Futures
payoffs are symmetric. Both the parties i.e. buyers and sellers can make
unlimited profits and losses in Futures.

Speculative views of option market participants:-

Call option Buyer - Bullish
Call option Seller - Bearish or Neutral
Put option Buyer - Bearish
Put option Seller - Bullish or Neutral

Option classes and series:-

All options on the same underlying, same expiry and the same type of calls or
puts are called as one Option class. For example, Reliance June calls or
Reliance June Puts. Within one option class, there is a several series for each
strike price. For example, the Reliance June 380 calls.

OPTION GREEKS
The Option Greeks are major risk measures used by option traders. The
below are the Option Greeks:-

1. Delta
2. Gamma
3. Theta
4. Vega
5. Rho

1. Delta (or Hedge Ratio):-

Delta is the rate of change of option’s price with respect to its underlying
asset price. The Delta is an important concept for option sellers. Delta reflects
the increase or decrease in the option’s price with respect to one point of
movement of the underlying stock price. The Delta value of an option is from
1 to -1 i.e. either positive or negative depending on the type of the option.
The Delta value of an option is from 0 to 1 i.e. positive for call options (i.e.
Strike price or option price is less than the underlying stock price for In-the-
money call options i.e. profitable or Strike price or option price is greater
than the underlying stock price for Out-of-the-money call options i.e. not
profitable). Conversely, The Delta value of an option is from 0 to -1 i.e.
negative for put options (i.e. Strike price or option price is greater than the
underlying stock price for In-the-money put options or Strike price or option
price is less than the underlying stock price for Out-of-the-money put
options). Simply, a Delta of call option will always be 0 to 1 because if the
underlying stock increases in price (spot price), call options will increase in
price. Similarly, a Delta of put option will always be -1 to 0 because if the
underlying stock increases, the value of put option will decrease. For
example, if Delta of a call option is 0.20 when the spot price of underlying
asset increases by $1, the price of the call option will increase by $0.20.
Generally, At-the-money options usually has a delta at approximately 0.5 or
-0.5 because of both the strike price (i.e. option price) and spot price of the
underlying asset are same in ITM and OTM call or put options.

Example of Delta:-
Assume that the Delta of call option on XYZ shares is 0.25. This implies that
if $1 changes in spot price of XYZ’s stock, it generates a $0.25 increase in
the price of XYZ call option. Therefore, if XYZ’s shares trade at $35 and the
call option trades at $3, then, a change in the spot price of XYZ’s shares are
increased from $35 to 36 means the call option will increase to a price of
$3.25 (i.e. $3.00 + $0.25). Conversely, assume that the Delta of put option on
XYZ shares is -$.20. This implies that if $1 changes in spot price of XYZ’s
stock, it generates a $0.20 decrease in the price of XYZ put option.
Therefore, if XYZ’s shares trade at $30 and the put option trades at $4, then,
a change in the spot price of XYZ’s shares are increased from $30 to
$31means the put option will decrease to a price of $3.80 (i.e. $4.00 - $0.20).

The Delta sign of common option strategies are as below:-

Option Sign of the

Strategy Gamma
Long Call Positive
Short Call Negative
Long Put Negative
Short Put Positive

2. Gamma:-
Gamma of an option measures the rate (percentage) of change of the option’s
delta with respect to one-point movement of the underlying stock price (i.e.
spot price). Generally, the Gamma is at peak value when the spot price of
underlying security is near the strike price of the option. Delta increases or
decreases along with the underlying asset price, whereas Gamma is a
constant that measures the rate of change of Delta. The higher Gamma of an
option is considered as a higher risk since an unfavorable move in the
underlying stock i.e. an oversized impact. This is a bad situation for most
traders looking for predictable opportunities. Gamma is the measure of the
stability of probability of an option over time whereas Delta represents the
probability of In-the-money at expiration.
Example of Gamma:-
Assume that spot price of XYZ’s stock is at $47, a JUN 50 call option selling
for $2, it has a delta of 0.4 and a gamma of 0.1 (i.e. 10%). If the spot price of
XYZ’s underlying stock moves up by $1 i.e. from $47 to $48, the delta will
be adjusted upwards by 10 percent i.e. from 0.4 to 0.5. Conversely, the spot
price of XYZ’s stock downwards by $1 i.e. from $47 to $46, then the delta
will decrease by 10 percent i.e. from 0.4 to 0.3.

The Gamma sign of common option strategies are as below:-

 Option Strategy Sign of the
Gamma
Long Call Positive
Short Call Negative
Long Put Positive
Short Put Negative
Long Straddle Positive
Short Straddle Negative
Long Strangle Positive
Short Strangle Negative
Calendar
Positive
Spread
Covered Call
Positive
Write
Covered Put
Positive
Write

3. Theta:-
A Theta of an option is the rate of change of value of the portfolio with
respect to the passage of time with all else remaining the same. Theta is
referred to as the time decay of the portfolio. Generally, Theta is expressed as
a negative number. The theta of an option reflects the amount by which the
option's value will decrease every day. Theta values of an option are always
negative for long options and will have a zero-time value at expiration since
time only moves in one direction and time runs out when an option expires.
Theta is higher for shorter term options especially for At-the-money options
because such options have the highest time value, so have more premium to
lose each day. Generally, the options of high volatility stocks have
higher theta because the time value of premium on these options are higher
and so they have more to lose per day. To obtain the theta for a calendar day,
the formula for theta must be divided by 365. To obtain the theta per trading
day, it must be divided by 250.

Example of Theta :-
A call option with a spot price of $3 and a theta of -0.10 indicates a decrease
in price of $0.10 per day. Hence, the price of the option should fall to $2.80
(i.e. $3.00 – 0.20) in two days.

The Theta sign of common option strategies are as below:-

Sign of the
Option Strategy
Gamma
Long Call Negative
Short Call Positive
Long Put Negative
Short Put Positive
Long Straddle Negative
Short Straddle Positive
Long Strangle Negative
Short Strangle Positive
Calendar
Positive
Spread
Covered Call
Positive
Write
Covered Put
Positive
Write

4. Vega:-
Vega is the rate of change in option premium (price) for one unit is respect to
the change in the volatility of the underlying asset or security. If Vega is
high, the portfolio of an option is become expensive. If Vega is low, the
volatility changes have relatively little impact on the value of the stock’s
portfolio. If volatility increases, the price of the option will increase and if
volatility decreases, the price of the option will also decrease. Thus, when
calculating the new option price due to volatility changes, we add the Vega
when volatility increases and vice versa.

Example of Vega:-
The spot price of XYZ’s stock is $35 in May and a JUN 50 call is selling for
$3. Assume that the Vega of the option is 0.10 and that the underlying
volatility is 25%.
If the volatility is increased by 1% i.e. from 35% to 36%, then the price of the
option should increase to $3.10 (i.e. $3 + $0.10). Conversely, if the volatility
decreased by 2% i.e. from 35% to 33%, then the option price should decrease
to $2.80 [i.e. $3 - (2 x 0.10)].
The Vega sign of common option strategies are as below:-
Option Sign of the
Strategy Gamma
Long Call Positive
Short Call Negative
Long Put Positive
Short Put Negative
Long Straddle Positive
Short Straddle Negative
Long Strangle Positive
Short Strangle Negative
Calendar
Positive
Spread
Covered Call
Negative
Write
Covered Put
Negative
Write

5. Rho:-
The Rho of a portfolio of an option is the rate of change in the value of the
portfolio of an option with respect to the 1% change in risk-free interest rate
(simply called interest rate) of underlying security. Here, the risk-free interest
rate is the minimum return we can expect to receive while keeping our risk at
zero. Generally, the prices of call options will increase as the interest rates
are increased and the prices of put options will decrease as the interest rates
are increased (not decreased). Thus, call options have positive rho while put
options have negative rho.

Example of Rho:-
Assume that the price of the call option is at $2.50, Rho is 0.05 and risk-free
rate is 2%. If the risk-free rate (interest rate) increases 3% i.e. from 2% to
5%, then the value of the call option will be $2.65 [i.e. 2.50 + (0.05x3)].
Conversely, assume that the price of the put option is at $4.00, Rho is 0.06
and risk-free rate is 4%. If the risk-free rate (interest rate) increases 2% i.e.
from 4% to 6%, then the value of the Put option will be $3.88 [i.e. 4.00 -
(0.06x2)].

Relationships between option delta and type of options:-

(i) Call options have positive deltas for buyers and negative deltas for sellers
i.e. implying call option values will increase when the price of the underlying
asset value is increases.
(ii) Put options have negative deltas for buyers and positive deltas for sellers
i.e. implying put option values will decrease when the price of the underlying
asset value is increases.
(iii) Out-of-the-money options have very low Deltas.
(iv) In-the-money options have high Deltas.
(v) At-the-money call options have deltas nearly equal to 0.5 for the buyer
and -0.5 for the seller.
(vi) At-the-money put options have deltas nearly equal to -0.5 for the buyer
and 0.5 for the seller.
(vii) Far Out-of-the-money options have deltas nearly equal to zero.
(viii) Far In-the-money options have deltas nearly equal to 1 for buyer and -1
for seller.
(ix) As the option moves into the money, the delta will increase in value.
(x) As the option moves out of the money, the delta will decrease in value.

NOTE:-
If Delta is 0.7 and the underlying asset or share price moves up by Rs30, the
option price is expected to move up by Rs21 (i.e. 30 x 0.7).

Standard Deviation:-
Standard deviation measures the dispersion (variation or spread out) of a set
of data from its average (mean). Standard deviation is a measurement to
calculate the annual rate of return of the historical volatility of that
investment. It is calculated as the square root of variance by determining the
variation between each data point relative to the average. The greater the
standard deviation of a security, the higher the variance between each price
and the mean (average) which indicates a larger price range. Similarly, the
lower the standard deviation of a security, the lower the variance between
each price and the mean (average) which indicates a smaller price range.
Standard deviation is a simple way to measure an investment or portfolio's
volatility. It is calculated based on the average.

Volatility:-
Volatility is the rate at which the price of an underlying asset (or security or
commodity or foreign exchange etc..) fluctuates i.e. increase or decrease for a
given set of returns for a given period of time. Volatility is a statistical
measure of the dispersion of the underlying stock’s price or returns for a
given period of time. Volatility indicates the expected ‘one standard
deviation’ range for the stock based on the option price. One standard
deviation means that there is approximately a 68% probability of a stock
settling within the expected range as determined by option prices. Options are
like insurance contracts, when the future of an asset becomes more uncertain,
there is more demand for insurance on that asset. When applied to stocks, this
means that a stock’s options will become more expensive as market
participants become more uncertain about the performance of stock’s in the
future. Volatility measures the risk or uncertainty of a security. The level of
Volatility indicates the level of Margins. Higher volatility will result in higher
margins and lower volatility will result in lower margins. Volatility helps the
traders to understand whether an option is cheap or expensive. There are two
types of volatility. They are Historical Volatility and Implied Volatility.

Past Present Future

Historical Theoretical Implied
Volatility price volatility

Historical Volatility indicates to the option traders that how the price
movements have been over a given period of time. Historical Volatility tells
that how volatile the asset has been in the past. The most common method of
calculating historical volatility is the Standard deviation. Standard deviation
measures the dispersion (variation or spread out or deviation) of a set of data
values from its average. The more disperse the data indicates the higher the
deviation. This deviation is referred as volatility by the traders. Assets whose
price movements are high frequency are said to be as volatile or high
volatility and assets whose price fluctuations are low frequency and
predictable are said to be as low volatile assets. To determine an option's
implied volatility, the trader must use a pricing model.

Implied Volatility is the markets view on how volatile the asset will be in the
future. We can tell that how the high or low implied volatility is by
comparing the spot price of an underlying asset of an option to the option’s
theoretical fair value. This can be done through an option pricing model to
determine the fair value of an option and to know the market price for the
option is over or under valued.

Factors of Volatility:-
The factors that could affect the volatility as under:-
(i) Major impact of supply or demand on the underlying stock/asset
(ii) Central bank’s decisions
(iii) Announcements or speeches by policy-makers
(iv) Changes of interest rates
(v) Changes in taxation policies
(vi) Major political events
(vii) Extreme weather conditions
(viii) Natural disasters
(ix) A merger or an acquisition, etc…

Calculation of Volatility:-
Based on the underlying prices given below, calculate the volatility.

Calculation of Volatility or Standard deviation of XYZ

Average
Underlying Deviation Average of
S. (mean) of Deviation
Date asset price (or) "Deviation
No "Underlying Squared
($) Variation Squared"
price"

1-
1 Jun-
18 100.00000 100.31600 -0.31600 0.09986 0.81862
2-
 2 Jun-
18 100.91000 100.31600 0.59400 0.35284 0.81862
3-
3 Jun-
18 101.35000 100.31600 1.03400 1.06916 0.81862
4-
4 Jun-
18 100.59000 100.31600 0.27400 0.07508 0.81862
5-
5 Jun-
18 101.56000 100.31600 1.24400 1.54754 0.81862
6-
6 Jun-
18 100.82000 100.31600 0.50400 0.25402 0.81862
7-
7 Jun-
18 99.88000 100.31600 -0.43600 0.19010 0.81862
8-
8 Jun-
18 98.45000 100.31600 -1.86600 3.48196 0.81862
9-
9 Jun-
18 99.26000 100.31600 -1.05600 1.11514 0.81862
10-
10 Jun-
18 100.34000 100.31600 0.02400 0.00058 0.81862
1003.16000 8.18624

NOTE:-
The prices of underlying asset in above data are the closing prices of the
stock at the end of chosen periods.

Steps to calculate Volatility:-

(i) Calculate the average price for the number of periods or observations.
(ii) Determine the deviation of each period by subtracting the average from
respective period’s spot price (i.e. closing price) of underlying asset.
(iii) Square each period's deviation (i.e. disperse or variation)
(iv) Sum the squared deviations.
(v) Calculate the average of “sum of squared deviations”.
(vi) Square root of that average. This is the volatility.

Hence, from the above steps, the volatility of the given data is 0.90478

This means the daily volatility of XYZ’s stock is 0.90478

The monthly volatility of the stock is :-

= 0.90478 x square root of 21 (the average number of trading days in a
month.is 21)
= 0.90478 x 4.5826
= 4.146%
This mean the monthly volatility of XYZ’s stock is 4.146%

The monthly volatility of the stock is :-

= 0.90478 x square root of 252 (the average number of trading days in a
year.is 252)
= 0.90478 x 15.8745
= 14.363%
This mean the annual volatility of XYZ’s stock is 14.363%.

Alpha :-
‘Alpha’ measures a portfolio's risk-adjusted returns. A positive number of
Alpha suggests the portfolio should get a positive return in exchange for the
risk level taken. The alpha of 0 or less indicates that a portfolio taking an
excessive risk and not getting a sufficient return. Alpha is a tool for investors
looking to measure the success of a portfolio. A portfolio manager with a
positive alpha indicates a better return with either the same or less risk than
the market index.

Beta:-
A beta measures the volatility or systematic risk of a particular stock (or
portfolio of stock)'s returns with respect to a relevant bench mark index (i.e.
SENSEX, NIFTY, etc..) based on the price levels. Beta is used in the Capital
Asset Pricing model (CAPM) which calculates the expected return of an asset
(stock) based on the expected market returns. Beta is also known as the beta
coefficient. High beta stocks are called as aggressive stocks while low beta
stocks are called as defensive stocks.

For example :-
If TCS limited has a beta of 1.12 with respect to the bench mark of Sensex, it
implies that the TCS limited fluctuations will be 1.12 times the fluctuations in
the Sensex. If the Sensex moves up by 10%, TCS will move up by 11.2%. If
we have TCS shares worth $10000 and we want to hedge our portfolio using
Sensex Futures, we will typically sell $11200 (increase 11.2% from $10000)
of Sensex Futures. Then, If Sensex moves down by 10%, TCS will move
down by 11.2%. Thus, we will gain $1120 (10% of $11200) on the Sensex
Futures whereas we will loss $1120 (11.5% of $10000) on TCS.

The beta measures the dispersion (variation) of a security's returns relative to

a particular bench mark or market index. If the dispersion is higher than that
of the benchmark, then the stock is considered to be riskier than the
benchmark. Conversely, the dispersion is less than that of the benchmark, the
stock is considered to be less risky than the benchmark. Both the beta and
standard deviation are common measurements used to determine the
dispersion of a portfolio but often work independently of each other.

Calculation of Beta:-
Beta is calculated using regression analysis. A security’s ‘beta’ represents the
tendency of a security's returns in relation to swings in the market index
based on price levels. A security's beta is calculated by dividing covariance of
the returns of the security and market index by the variance of the market
index returns over a specified period. A security's beta should only be used
when a security has a high R- squared value in relation to the benchmark (or
market index). The R-squared measures the percentage of a security's
historical price movements of the market index.

Steps to calculating Beta:-

(i) Take the closing prices of stock and market index (benchmark).
(ii) Convert the closing prices of both the stock and bench mark index into
return percentages by calculating as “Closing price of today minus closing
price of yesterday divided by closing price of yesterday”. The result is
percentage change in results.

Formula of Beta (β):-

Where, ‘ rs’ represents the returns of the stock, and ‘ rm’ represents the
returns of the market index.

Interpreting ‘Beta’:-
A beta of 1 indicates that the security's price moves with the market (i.e.
market index). A beta of less than 1 indicates that the security is theoretically
less volatile than the market index. A beta of greater than 1 indicates that the
security's price is theoretically more volatile than the bench mark. For
example, if a stock's beta is 1.3, it is theoretically 30% more volatile than the
market. If a stock's beta is 0.8, it's theoretically 20% less volatile than the
market. Therefore, the fund's excess return is expected to underperform the
benchmark by 20% during up markets and outperform by 20% during down
markets. The interpretation of Beta is simply as under:-

Beta(β) Interpretation
value
Stock movement is uncorrelated to the market index i.e.
β=0
fixed yield stock
Stock movement is in the opposite direction of the market
β<0
index
Stock moves in the same direction of lesser amount to the
0<β<1
market index
Stock moves in the same direction and in the same amount
β =1
of the market index
Stock moves in the same direction of greater amount to the
β>1
market index

Limitations of Beta:-
(i) As Beta is calculated from historical data, it does not capture the future
changes in the market and it depends on only the chosen time period.
(ii) Beta does not differentiate between upward and downward volatility.

Example of Beta calculation in Excel:-

From the above data, the percentage of returns calculated as “Present closing
price minus previous closing price divided by previous closing price”. Then,
we calculated the Beta of XYZ’s stock in excel using the below any of the
one formula:-

Method 1:-
Formula = COVARIANCE.P(D4:D17,E4:E17)/VAR.P(E4:E17)
By using this formula in excel, we can get the Beta of XYZ’s stock is
1.230980335

Method 2:-
Formula = SLOPE(D4:D17,E4:E17)
By using this formula in excel, we can get the Beta of XYZ’s stock is
1.230980335

Conclusion:-
As Beta is more than 1 i.e. 1.23, This mean the Stock moves in the same
direction of greater amount to the market index i.e. the XYZ’s stock is
theoretically 23% more volatile than the market.

OPTION STRATEGIES
The most common strategies of an option are as under :-

1. BULL CALL SPREAD (BUY ITM CALL OPTION AND SELL OTM
CALL OPTION):-

Strategy :-
Buy a call option with a lower strike price(X) than spot price(S) i.e. In-the-
money (ITM) and sell a call option with a higher strike price than spot price
i.e. Out-of-the money (OTM) on the same underlying asset and expiry date.

When to use :-
When the investor in moderately bullish i.e. raising the spot price of
underlying asset.

Loss:-
Minimum loss is the option premium paid on initiation of contract.
Maximum loss occurs when the spot price of underlying asset falls below the
strike price.
Net loss is option premium paid on buy (at lower strike price) minus option
premium received on sell.

Profit:-
Minimum profit is “(selling strike price - buying strike price) - Net premium
paid”.
Maximum profit occurs when spot price of underlying asset increases above
the strike price.

Break-even point (BEP):-

Lower strike price at call buy + Net option premium (i.e. initial investment).

Example:-
‘XYZ’ buys a call option of an underlying asset with a Strike price of $100 at
an option premium paid of $3.00 and XYZ sells a call option of an
underlying asset with a strike price of $108 at an option premium received of
$1.20.

Spot price of
Amount
underlying Particulars
($)
asset
Today's market
101.50
price
Buy ITM Call
Strike price (S) 100.00
option
Option Premium
XYZ Pays 3.00
(S)
Sell OTM Call
Strike price (S) 107.00
option
Mr. XYZ Option Premium
1.20
receives (S)
Net premium
1.80
paid ($)
Break-even
101.80
point ($)

The payoff schedule:-

Profit or Profit or
Spot price of Net
Loss Loss
underlying profit
on Long on Short
stock or Loss
(Call) (Put))
96.00 -3.00 1.20 -1.80
97.00 -3.00 1.20 -1.80
98.00 -3.00 1.20 -1.80
99.00 -3.00 1.20 -1.80
100.00 -3.00 1.20 -1.80
101.00 -2.00 1.20 -0.80
101.80 -1.20 1.20 0.00
102.00 -1.00 1.20 0.20
 103.00 0.00 1.20 1.20
104.00 1.00 1.20 2.20
105.00 2.00 1.20 3.20
106.00 3.00 1.20 4.20
107.00 4.00 1.20 5.20
108.00 5.00 0.20 5.20
109.00 6.00 -0.80 5.20
110.00 7.00 -1.80 5.20
111.00 8.00 -2.80 5.20
112.00 9.00 -3.80 5.20

In the above example, the loss, profit and Break-even points are as follows :-

Loss:-
Minimum loss is $3.00 i.e. the option premium paid on initiation of contract.
Maximum net loss $1.80 occurs when the spot price of underlying asset falls
to lowest level.
Net loss is $1.80 i.e. option premium paid ($3.00) - option premium received
($1.20).

Profit:-
Minimum profit is $5.20 i.e. “[selling strike price ($107) - buying strike price
($100)] - Net premium paid ($1.80)”.
Maximum net profit is $5.20 occurs when spot price of underlying asset
increases to higher level.

Break-even point (BEP):-

BEP is $101.80 i.e. Lower strike price at call buy ($100) + Net option
premium ($1.80). So, at this point of $101.80, the net profit is $0.00.

2. BULL PUT SPREAD (SELL ITM PUT OPTION AND BUY OTM
PUT OPTION) :-

Strategy :-
Sell a Put option with a higher strike price than spot price i.e. In-the-money
(ITM) and Buy a Put option with a lower strike price(X) than spot price(S)
i.e. Out-of-the-money (OTM) on the same underlying asset and expiry date.
If spot price of underlying asset is above the strike price on expiration date,
then, both the options are expire as worthless. So, at this stage, this strategy
earns the maximum profit which is the option premium received at the time
of initiation of the contract.

When to use:-
When the investor in moderately bullish i.e. raising the spot price of
underlying asset.

Loss:-
Maximum loss the difference between strike prices of 2 puts minus net
premium received. Maximum loss occurs when the spot price of underlying
asset falls to lowest level to the strike price.

Profit:-
Minimum profit is Net option premium received (i.e. Net premium credit).
Maximum profit occurs when spot price of underlying asset increases above
the strike price.

Break-even point (BEP):-

Strike price of short put (i.e. ITM sell put) – Net option premium received
(i.e. Net premium credit).
Example:-
XYZ sells an underlying asset with a strike price of $120 at a premium
received of $8.00 and buys a OTM Put option with a strike price $110 at a
premium of $2.00 when the current spot rate of the underlying asset is at
$123 with both options expiring on last Thursday of June.

Spot price of
Amount
underlying Particulars
($)
asset
Today's market
123.00
price
Sell ITM Put
Strike price (S) 120.00
option
Option Premium
XYZ receives 8.00
(S)
Buy OTM Put
Strike price (S) 110.00
option
Option Premium
XYZ Pays -2.00
(S)
Net premium
6.00
received ($)
Break-even point
114.00
($)

The payoff schedule:-

Spot Price of Net profit from Net profit
Net profit
underlying OTM from ITM
(S)
asset ($) put buy ($) put Sold ($)
107.00 1.00 -5.00 -4.00
108.00 0.00 -4.00 -4.00
109.00 -1.00 -3.00 -4.00
110.00 -2.00 -2.00 -4.00
111.00 -2.00 -1.00 -3.00
112.00 -2.00 0.00 -2.00
113.00 -2.00 1.00 -1.00
 114.00 -2.00 2.00 0.00
115.00 -2.00 3.00 1.00
116.00 -2.00 4.00 2.00
117.00 -2.00 5.00 3.00
118.00 -2.00 6.00 4.00
119.00 -2.00 7.00 5.00
120.00 -2.00 8.00 6.00
121.00 -2.00 8.00 6.00
122.00 -2.00 8.00 6.00
123.00 -2.00 8.00 6.00
124.00 -2.00 8.00 6.00
125.00 -2.00 8.00 6.00
126.00 -2.00 8.00 6.00

In the above example, the loss, profit and Break-even points are as follows:-
Loss:-
Maximum net loss $4.00 i.e. “[strike price of buy OTM put ($110) - strike
price of sell ITM put ($120)] –Net premium received of $6. This happens
when the spot price of underlying asset falls to the lowest level of strike
prices.

Profit:-
Minimum profit is $6.00 i.e. Net premium credit (i.e. received). This occurs
when spot price of underlying asset increases to higher level.
Break-even point (BEP):-
BEP is $114 i.e. Strike price of ITM sell put ($120) – Net option premium
received ($8.00 - $2.00).

3. BEAR CALL SPREAD (SELL ITM CALL AND BUY OTM CALL):-

Strategy :-
Sell ITM Call with a lower strike price and buy a OTM Call with a higher
strike price.

When to use:-
When the option trader thinks that the market is moderately in bearish i.e.
falling the spot price of underlying asset in near term (i.e. market down).

Loss:-
Maximum loss the difference between strike prices of 2 calls minus net
premium received. Maximum loss occurs when the spot price of underlying
asset raises from the strike price of long call on expiry date.

Profit:-
Maximum profit is Net premium received i.e. premium received for the short call
minus the premium paid for the long call. Maximum profit occurs when spot price of
underlying asset falls from the strike price of short call on expiry date.

Break-even point (BEP):-

Strike price of short call + Net premium received.

The bear call spread option strategy is also known as the bear call credit
spread as a credit is received when entering in to the contract or trade.

Example:-
XYZ sells an ITM call option with a strike price of $50 at a premium of
$6.00 and buys an OTM call option with a strike price of $57 at a premium of
$2.00
 Spot price of Amount
Particulars
underlying ($)
asset
Today's market
52.70
price (S)
Sell ITM Call
Strike price (S) 50.00
option
Option Premium
XYZ receives 6.00
(S)
Buy OTM call
Strike price (S) 57.00
option
Option Premium
XYZ Pays -2.00
(S)
Net premium
4.00
received ($)
Break-even point
54.00
($)

The payoff schedule:-

Net profit
Spot Price of Net profit
from Net profit
underlying from OTM
ITM call (S)
asset ($) call buy ($)
sell ($)
48.00 6.00 -2.00 4.00
49.00 6.00 -2.00 4.00
50.00 6.00 -2.00 4.00
51.00 5.00 -2.00 3.00
52.00 4.00 -2.00 2.00
53.00 3.00 -2.00 1.00
54.00 2.00 -2.00 0.00
55.00 1.00 -2.00 -1.00
56.00 0.00 -2.00 -2.00
57.00 -1.00 -2.00 -3.00
58.00 -2.00 -1.00 -3.00
 59.00 -3.00 0.00 -3.00
60.00 -4.00 1.00 -3.00
61.00 -5.00 2.00 -3.00

In the above example, the loss, profit and Break-even points are as follows:-
Loss:-
Maximum loss is $3.00 i.e. the difference between strike prices of 2 calls
($50 - $57) minus net premium credit ($4.00). This occurs when the spot
price of underlying asset raises to the peak.

Profit:-
Maximum profit is $4.00 i.e. the Net premium received ($6.00 - $2.00) . This
occurs when spot price of underlying asset falls to the lowest from the strike
price on expiration date.

Break-even point (BEP):-

The BEP is $54 i.e. Strike price of short call ($50) + Net premium received
($6.00 - $2.00).

4. BEAR PUT SPREAD (SELL OTM PUT and BUY ITM PUT):-

Strategy :-
Buy an ITM PUT with a higher strike price and sell an OTM PUT with a
lower strike price.

When to use:-
When the option trader thinks that the market is in moderately bearish i.e.
spot price of underlying asset will go down moderately.

Loss:-
Minimum loss is Net option premium paid (or Premium paid for long put
minus premium received for short put). Maximum loss occurs when spot
Price of underlying asset is greater than or equal to Strike Price of long put on
expiry date.

Profit:-
Maximum profit is the difference between 2 strike prices minus net premium
debit (paid). Maximum profit occurs when spot price of underlying asset is
less than or equal to the strike price of short put (OTM) on expiry date.

Break-even point (BEP):-

Strike price of long put minus Net option premium paid (debit).

Example:-
XYZ buys an underlying asset of an ITM Put with a strike price of $67 at a
premium of $8.00 and sells an OTM Put with a strike price of $59 at a
premium $3.00.

Spot price of
Amount
underlying Particulars
($)
asset
Today's market
60.80
price (S)
Buy ITM put
Strike price (S) 67.00
option
XYZ pays Option Premium (S) -8.00
Sell OTM put
Strike price (S) 59.00
option
 XYZ receives Option Premium (S) 3.00
Net premium Paid
-5.00
($)
Break-even point
62.00
($)

The payoff schedule:-

Spot Price of Net profit Net profit
Net profit
underlying from ITM from OTM
(S)
asset ($) Put buy ($) put sold ($)
57.00 6.00 -3.00 3.00
54.00 5.00 -2.00 3.00
55.00 4.00 -1.00 3.00
56.00 3.00 0.00 3.00
57.00 2.00 1.00 3.00
58.00 1.00 2.00 3.00
59.00 0.00 3.00 3.00
60.00 -1.00 3.00 2.00
61.00 -2.00 3.00 1.00
62.00 -3.00 3.00 0.00
63.00 -4.00 3.00 -1.00
64.00 -5.00 3.00 -2.00
65.00 -6.00 3.00 -3.00
66.00 -7.00 3.00 -4.00
67.00 -8.00 3.00 -5.00
68.00 -8.00 3.00 -5.00
69.00 -8.00 3.00 -5.00
In the above example, the loss, profit and Break-even points are as follows:-
Loss:-
Maximum loss is $5.00 i.e. Net option premium paid ($8 - $3)). Maximum
loss occurs when spot Price of underlying asset is greater than or equal to
Strike Price of long put on expiry date.

Profit:-
Maximum profit is $3.00 i.e. [($59.00 - $67.00) – $5.00]. Maximum profit
occurs when spot price of underlying asset is lower.

Break-even point (BEP):-

The BEP is $62.00 i.e. Strike price of long put minus Net option premium
paid ($67 - $5).

5. LONG CALL BUTTERFLY SPREAD (BUY 1 ITM CALL, SELL 2

ATM CALLS AND BUY 1 OTM CALL):-
The long call butterfly spread is a neutral strategy that is a combination of
a bull spread and a bear spread. There are 3 striking prices involved in a long
butterfly spread and it can be construct by using call option or put option.
Long butterfly spreads are involved when the investor thinks that spot price
of underlying asset will not raise or fall (market movement) much by
expiration date. The long butterfly strategy can be constructed by buying one
lower strike price of an ITM call, sell 2 ATM calls and buying another
underlying asset with higher strike price of OTM call. Maximum profit for
this strategy comes when the spot price of underlying asset remains
unchanged at expiration. At this price, only the lower strike price of call
option expires In-the-money.

Strategy :-
Buy 1 ITM call, Sell 2 ATM calls and buy 1 OTM call options.

When to use:-
the investor thinks that the spot price of underlying asset will not rise or fall
much by expiration date.

Loss:-
Max loss is Net premium paid + commissions (brokerages etc..) paid if any.
The maximum loss occurs when spot price of the underlying asset is less than
the lower strike price of long call option or spot price of the underlying asset
is higher than the higher strike price of long Call.

Profit:-
Max profit is (Strike price of short call - Strike price of lower long call - Net
premium paid – Brokerage (or commissions) paid if any. Maximum profit
can achieve when spot Price of underlying asset is equal to the strike price of
short calls.

Break-even point (BEP):-

Upper Break-even point = Strike price of higher Strike long call - Net
premium paid (debit).
Lower Break-even point = Strike Price of lower strike long call + Net
premium paid (debit).

Example:-
XYZ expects that very small movement of market fluctuation. Then, XYZ
sells 2 ATM call options with a strike price of $120 at a premium received of
$18 per each call, buys 1 ITM call option with a strike price of 110 at a
premium paid of $16 and buys 1 OTM call Option with a strike price of $130
at a premium paid of $7.
 Spot price of
Amount
underlying Particulars
($)
asset
Today's market
120.00
price
sell 2 ATM
Strike price (S) 120.00
calls
XYZ Option Premium
18.00
receives (S)
Buy 1 ITM
Strike price (S) 110.00
call
Option Premium
XYZ pays 16.00
(S)
Buy 1 OTM
Strike price (S) 130.00
call
Option Premium
XYZ pays 7.00
(S)
Net premium
-5.00
debit ($)
BEP higher ($) 125
BEP lower ($) 115

The Payoff (Net profit) schedule:-

Spot Price Net profit
Net profit from Net profit from Net
of from buy
sell 2 ATM buy 1 ITM call profit
underlying 1 OTM call
calls ($) ($) (S)
asset ($) ($)
100.00 18.00 -16.00 -7.00 -5.00
102.00 18.00 -16.00 -7.00 -5.00
104.00 18.00 -16.00 -7.00 -5.00
106.00 18.00 -16.00 -7.00 -5.00
108.00 18.00 -16.00 -7.00 -5.00
110.00 18.00 -16.00 -7.00 -5.00
112.00 18.00 -14.00 -7.00 -3.00
 114.00 18.00 -12.00 -7.00 -1.00
115.00 18.00 -11.00 -7.00 0.00
116.00 18.00 -10.00 -7.00 1.00
118.00 18.00 -8.00 -7.00 3.00
120.00 18.00 -6.00 -7.00 5.00
(See note)
122.00 -4.00 -7.00 3.00
14.00
124.00 10.00 -2.00 -7.00 1.00
125.00 8.00 -1.00 -7.00 0.00
126.00 6.00 0.00 -7.00 -1.00
128.00 2.00 2.00 -7.00 -3.00
130.00 -2.00 4.00 -7.00 -5.00
132.00 -6.00 6.00 -5.00 -5.00
134.00 -10.00 8.00 -3.00 -5.00
136.00 -14.00 10.00 -1.00 -5.00
138.00 -18.00 12.00 1.00 -5.00
140.00 -22.00 14.00 3.00 -5.00

Working Note:-
In the above table, in the column of “Net profit from sell 2 ATM calls”, from
the spot price of 122, we calculated as double because of 2 sell call options.
For example, for spot price of 122, we calculated 14 as [(120-122) x 2] + 18
= 14.
In the above example, the loss, profit and Break-even points are as follows:-
Loss:-
Max loss is $5.00 i.e. Net premium paid. This maximum loss occurs when
spot price ($100) of the underlying asset is less than the lower strike price
($110) of long call option or spot price ($140) of the underlying asset is
higher than the higher strike price ($130) of long Call.

Profit:-
Max profit is $5.00 i.e. [Strike price of short call ($120) - Strike price of
lower long call ($110)] – [Net premium paid ($5.00) + Brokerage paid
($0.00) if any]. This maximum profit can achieved when spot Price ($120) of
underlying asset is equal to the strike price of short (sell) calls ($120).

Break-even point (BEP):-

Upper Break-even point is $125 i.e. Long call of higher strike ($130) - Net
premium paid ($5.00).
Lower Break-even point is $115 i.e. Long call of lower strike ($110) + Net
premium paid ($5.00).

6. SHORT CALL BUTTERFLY SPREAD (BUY 2 ATM CALLS, SELL

1 ITM CALL AND SELL 1 OTM CALL OPTIONS):-
The short call butterfly spread is a neutral strategy that is a combination of
a bull spread and a bear spread. There are also 3 striking prices involved in a
short call butterfly spread and it can be construct by using call option or put
option. Short butterfly spreads are involved when the investor thinks that spot
price of underlying asset will not rise or fall (moment of market) much by
expiration date. The short butterfly strategy can be constructed by selling one
lower strike price of an ITM call, buying 2 ATM calls and selling another
underlying asset with higher strike price of OTM call.

Strategy:-
Sell 1 ITM call, Buy 2 ATM calls and sell 1 OTM call options.

When to use:-
The investor thinks that the spot price of underlying asset will not raise or fall
much by expiration date.

Loss:-
Max loss is [(Strike price of long (buy) calls - strike price of lower short (sell)
call) – (Net premium received – commissions paid if any)]. The maximum
loss occurs when spot price of the underlying asset is equal to strike price of
long (buy) calls.

Profit:-
Max profit is Net premium received (credit) minus Brokerage (or
commissions) paid if any. Maximum profit can achieve when spot Price of
underlying asset is less than or equal to strike price of lower short (sell) call
or spot Price of underlying asset is greater than or equal to strike price of
higher shot (sell) call.

Break-even point (BEP):-

Upper Break-even point = Strike price of higher short (sell) call - Net
premium received (credit)
Lower Break-even point = Strike Price of lower short (sell) call + Net
premium received (credit)

Example:-
XYZ buys 2 ATM call options with a strike price of $120 at a premium paid
of $18 per each call, sell 1 ITM call option with a strike price of 110 at a
premium received of $16 and sell another1 OTM call Option with a strike
price of $130 at a premium received of $7.

Spot price of
Amount
underlying Particulars
($)
asset
Today's market
120.00
price
Buy 2 ATM
Strike price (S) 120.00
calls
Option Premium
XYZ pays -18.00
(S)
Sell 1 ITM
Strike price (S) 110.00
call
Option Premium
XYZ receives 16.00
(S)
Sell 1 OTM
Strike price (S) 130.00
call
Option Premium
XYZ receives 7.00
(S)
Net premium
5.00
credit ($)
BEP higher ($) 125
BEP lower ($) 115

The pay-off schedule:-

Spot Price Net profit Net profit Net profit
of from buy 2 from sell 1 from sell 1 Net profit
underlying ATM calls ITM call OTM call (S)
asset ($) ($) ($) ($)
100.00 -18.00 16.00 7.00 5.00
102.00 -18.00 16.00 7.00 5.00
104.00 -18.00 16.00 7.00 5.00
106.00 -18.00 16.00 7.00 5.00
108.00 -18.00 16.00 7.00 5.00
110.00 -18.00 16.00 7.00 5.00
112.00 -18.00 14.00 7.00 3.00
114.00 -18.00 12.00 7.00 1.00
115.00 -18.00 11.00 7.00 0.00
116.00 -18.00 10.00 7.00 -1.00
118.00 -18.00 8.00 7.00 -3.00
120.00 -18.00 6.00 7.00 -5.00
122.00 -14.00 4.00 7.00 -3.00
124.00 -10.00 2.00 7.00 -1.00
125.00 -8.00 1.00 7.00 0.00
126.00 -6.00 0.00 7.00 1.00
128.00 -2.00 -2.00 7.00 3.00
130.00 2.00 -4.00 7.00 5.00
132.00 6.00 -6.00 5.00 5.00
134.00 10.00 -8.00 3.00 5.00
136.00 14.00 -10.00 1.00 5.00
138.00 18.00 -12.00 -1.00 5.00
140.00 22.00 -14.00 -3.00 5.00
In the above example, the loss, profit and Break-even points are as follows:-
Loss:-
Max loss is $5.00 i.e. [(Strike price of long calls ($120) - strike price of lower
short call ($110)) – (Net premium received ($5.00) – commissions paid if any
($0.00))]. The maximum loss occurs when spot price of the underlying asset
is equal to strike price of long (buy) calls.

Profit:-
Max profit is $5.00 i.e. Net premium received ($5.00) minus Brokerage
($0.00) paid if any. Maximum profit can achieve when spot Price of
underlying asset ($100) is less than or equal to strike price of lower short call
($110)or spot Price of underlying asset is greater than or equal to strike price
($140) of higher shot call ($130).

Break-even point (BEP):-

Upper Break-even point is $125 i.e. Strike price of higher short call ($130) -
Net premium received ($5).
Lower Break-even point is $115 i.e. Strike Price of lower short ($110) call +
Net premium received ($5).

7. LONG STRADDLE (BUY 1 ATM CALL AND BUY 1 ATM PUT):-

The long straddle is a neutral strategy that involves the simultaneously
buying 1 ATM call and buy 1 ATM put of the same underlying
stock, striking price and expiry date. This strategy can be used when the spot
price of underlying asset is expected to show large movements in a market
trade. If the spot price of the underlying asset or stock increases, the call is
exercised while the put expires worthless. Similarly, If the spot price of
underlying asset decreases, the put is exercised while call expires worthless.
In this strategy, the investor’s direction is neutral, but, the investor is looking
out for the spot price of an underlying asset to increase more in either
direction. The long straddle is also called as ‘Straddle’ or ‘Buy straddle’.

Strategy:-
Buy 1 ATM call and buy 1 ATM put of the same underlying stock, striking
price and expiry date.
When to use:-
When spot price of the underlying asset is expect to show large movements in
a market trade.

Loss:-
Maximum loss is the option premium paid on initiation of contract +
brokerage / commission paid.
Maximum profit occurs when spot price of underlying asset is equal to strike
price of long call or put.

Profit:-
Maximum profit is unlimited when [Spot price of underlying asset – (Strike
price of long call - Net premium paid)] or [(Strike price of long put – Spot
price of underlying asset) - Net premium paid]. Maximum profit occurs when
spot price of underlying asset is higher than strike price of long call + Net
premium paid or spot price of underlying asset is lower than strike Price of
long Put - Net Premium Paid.

Break-even point (BEP):-

Upper Break-even point = Strike price of long call + Net premium paid.
Lower Break-even point = Strike price of long put - Net premium paid.

Example:-
Spot price of underlying asset is $120. XYZ buy 1 ATM put for a strike price
of $ 135 with premium paid of $15 and buy 1 ATM call option for a strike
price of $135 with premium paid of $25.

Spot price of Amount

Particulars
underlying asset ($)
Today's market
120.00
price
Buy 1 ATM Put Strike price (S) 135.00
Option
XYZ pays -15.00
Premium (S)
Buy 1 ATM call Strike price (S) 135.00
Option
XYZ pays
 Premium (S) -25.00
Net Premium
paid -40.00
BEP higher ($) 175.00
BEP lower ($) 95.00

The pay-off schedule:-

Spot Price of Net profit Net profit from
Net profit
underlying from buy 1 buy 1 ATM
(S)
asset ($) ATM put ($) call ($)
70.00 50.00 -25.00 25.00
80.00 40.00 -25.00 15.00
90.00 30.00 -25.00 5.00
95.00 25.00 -25.00 0.00
100.00 20.00 -25.00 -5.00
110.00 10.00 -25.00 -15.00
120.00 0.00 -25.00 -25.00
130.00 -10.00 -25.00 -35.00
135.00 -15.00 -25.00 -40.00
140.00 -15.00 -20.00 -35.00
150.00 -15.00 -10.00 -25.00
160.00 -15.00 0.00 -15.00
170.00 -15.00 10.00 -5.00
175.00 -15.00 15.00 0.00
180.00 -15.00 20 5
190.00 -15.00 30 15
200.00 -15.00 40 25
In the above example, the loss, profit and Break-even points are as follows:-
Loss:-
Maximum loss is $40.00 i.e. the premium paid on initiation of contract +
brokerage/commission paid.
Maximum profit occurs when spot price of underlying asset is equal to strike
price of long call or put i.e. at $135.

Profit:-
Maximum profit is $25.00 i.e. when [Spot price of underlying asset – (Strike
price of long call - Net premium paid)] or [(Strike price of long put – Spot
price of underlying asset) - Net premium paid]. Maximum profit occurs when
spot price of underlying asset is higher than strike price of long call + Net
premium paid or spot price of underlying asset is lower than strike Price of
long Put - Net Premium Paid.

Break-even point (BEP):-

Upper Break-even point is $175 i.e. Strike price of long call + Net premium
paid.
Lower Break-even point is $95 i.e. Strike price of long put - Net premium
paid.

8. SHORT STRADDLE (SELL 1 ATM CALL AND SELL 1 ATM

PUT):-
The short straddle is a neutral strategy that involves the simultaneously sell
1 ATM call and sell 1 ATM put of the same underlying stock, striking
price and expiry date. This strategy is opposite to Long straddle i.e. this
strategy can be used when the spot price of underlying asset is expected to
not show large movements in a market trade or expected that the spot price of
underlying asset will experience little volatility in the near term. If the spot
price of underlying asset (or security/index/currency) does not move much in
the view of investor’s direction, the investor retains the Premium as the call
or the Put will be exercised. However, if the spot price of underlying asset
moves in either direction, up or down significantly, the investor’s losses can
be significant. So this is a risky strategy. If the spot price of underlying asset
stays close to the strike price on expiry of the contract, investor gets
maximum gain which is the Premium received is made. The short straddle is
also called as ‘Sell Straddle’ or ‘Naked straddle’. Short straddles have limited
profit and unlimited risk (loss). Short straddles are limited profit and
unlimited risk.

Strategy :-
Sell 1 ATM call and sell 1 ATM put of the same underlying stock, striking
price and expiry date.

When to use:-
When the investor think that the spot price of underlying asset will
experience very little volatility in the near term.

Loss:-
Maximum loss is unlimited when spot price of underlying asset is higher than
strike price of short call + Net premium received or Spot price of underlying
asset is less than the strike price of short put - Net premium received. The
maximum loss is Spot price of underlying asset - Strike price of short call -
Net premium received or Strike price of short put – Spot price of underlying
asset - Net premium received + commissions paid if any.

Profit:-
Maximum profit is Net premium received – commissions or brokerage paid if
any. Maximum profit occurs when spot price of underlying asset is equal to
strike price of short call or put. At this price, both options expire worthless
and the trader gets entire premium received as profit.

Break-even point (BEP):-

Upper Break-even point = Strike price of short call + Net premium received
Lower Break-even Point = Strike price of short put - Net premium received

Example:-
Spot price of underlying asset is $120. XYZ sells 1 ATM put for a strike
price of $ 135 with premium received of $15 and sells 1 ATM call option for
a strike price of $135 with premium received of $25.

Spot price of
Amount
underlying Particulars
($)
asset
Today's market
120.00
price
Sell 1 ATM
Strike price (S) 135.00
Put
XYZ Option
15.00
receives Premium (S)
Sell 1 ATM
Strike price (S)
call 135.00
XYZ Option
receives Premium (S) 25.00
Net Premium
paid 40.00
BEP higher ($) 175.00
BEP lower ($) 95.00

The pay-off schedule:-

Spot Price of Net profit Net profit from
Net profit
underlying from sell 1 sell 1 ATM call
(S)
asset ($) ATM put ($) ($)
70.00 -50.00 25.00 -25.00
 80.00 -40.00 25.00 -15.00
90.00 -30.00 25.00 -5.00
95.00 -25.00 25.00 0.00
100.00 -20.00 25.00 5.00
110.00 -10.00 25.00 15.00
120.00 0.00 25.00 25.00
130.00 10.00 25.00 35.00
135.00 15.00 25.00 40.00
140.00 15.00 20.00 35.00
150.00 15.00 10.00 25.00
160.00 15.00 0.00 15.00
170.00 15.00 -10.00 5.00
175.00 15.00 -15.00 0.00
180.00 15.00 -20 -5
190.00 15.00 -30 -15
200.00 15.00 -40 -25
210.00 15.00 -50.00 -35.00

In the above example, the loss, profit and Break-even points are as follows:-

Loss:-
Maximum loss is $35 when [spot price of underlying asset ($210) – (strike
price of short call ($135)+ Net premium received ($40))].

Profit:-
Maximum profit is $40 (i.e. Net premium received – commissions or
brokerage paid if any). Maximum profit occurs when spot price of underlying
asset ($135) is equal to strike price of short call or put. At this price, both
options expire worthless and the trader gets entire premium received as profit
($40).

Break-even point (BEP):-

Upper Break-even point is $175 i.e. Strike price of short call ($135) + Net
premium received ($40).
Lower Break-even Point is $95 i.e. Strike price of short put ($135) - Net
premium received ($40).

9. LONG STRANGLE (BUY 1 OTM CALL AND BUY 1 OTM PUT):-

This strategy involves the simultaneous buying of a slightly OTM put and a
Slightly OTM call of the same underlying asset (or stock/index/currency) and
expiry date. In this strategy, the investor is directional neutral but is looking
for an increased volatility in the underlying asset and the prices moving
significantly in 2 way (either) direction. In this strategy, the risk (loss) is
limited and profit is unlimited. Since the premium (initial cost) of a Strangle
is cheaper than a Straddle, the returns could potentially be higher. The long
strangle is also called as ‘"strangle" or “buy strangle”.

Strategy :-
Buy 1 OTM call and buy 1 OTM put of the same underlying stock, striking
price and expiry date.

When to use:-
When the investor think that the spot price of underlying asset will
experience very high levels of volatility in the near term.

Loss:-
Maximum loss is premium paid (debit spread + commission/brokerage paid if
any. Maximum loss occurs when spot price of underlying asset is in between
strike Price of long call and strike price of long put.

Profit:-
Maximum profit is unlimited that can be occur when spot price of underlying
asset is higher than the strike price of long call + Net premium paid or Spot
price of underlying asset is lower than strike price of long put - Net premium
paid. Maximum profit is the spot price of underlying asset - strike price of
long call - Net premium paid or Strike price of long put – Spot price of
underlying asset - Net premium paid.

Break-even point (BEP):-

Upper Break-even point = Strike price of long call + Net premium debit.
Lower Break-even Point = Strike price of long put - Net premium debit.

Example:-
XYZ buys I OTM put for $200 with a premium paid of $20 and buy 1 OTM
call for $400 with a premium paid of $30.

Spot price of
Amount
underlying Particulars
($)
asset
Today's market
300.00
price
Buy 1 OTM
Strike price (S) 400.00
call
Option
XYZ paid -30.00
Premium (S)
Buy 1 OTM
Strike price (S)
put 200.00
Option
XYZ paid
Premium (S) -20.00
Net Premium
paid -50.00
BEP higher ($) 450.00
 BEP lower ($) 150.00

The Pay-off schedule:-

Spot Price of Net profit from Net profit from
Net profit
underlying buy 1 OTM put buy 1 OTM
(S)
asset ($) ($) call ($)
50.00 130.00 -30.00 100.00
100.00 80.00 -30.00 50.00
150.00 30.00 -30.00 0.00
200.00 -20.00 -30.00 -50.00
250.00 -20.00 -30.00 -50.00
300.00 -20.00 -30.00 -50.00
350.00 -20.00 -30.00 -50.00
400.00 -20.00 -30.00 -50.00
450.00 -20.00 20.00 0.00
500.00 -20.00 70.00 50.00
550.00 -20.00 120.00 100.00
600.00 -20.00 170.00 150.00
In the above example, the loss, profit and Break-even points are as follows:-

Loss:-
Maximum loss is $50 i.e. premium paid (debit spread).

Profit:-
Maximum profit is $150 that can be occurs when [spot price ($600) of
underlying asset – (strike price of long call ($400) + Net premium paid
($50)].

Break-even point (BEP):-

Upper Break-even point is $450 i.e. Strike price of long call ($400) + Net
premium debit ($50)
Lower Break-even Point is $150 i.e. Strike price of long put ($200) - Net
premium debit ($50)

10. SSHORT STRANGLE (SELL 1 OTM CALL AND SELL I OTM

PUT):-
This strategy involves the simultaneous selling of a slightly OTM put and a
Slightly OTM call of the same underlying asset and expiry date. In this
strategy, the investor is directional neutral but is looking for an little volatility
in the underlying asset. In this strategy, the net credit received by the seller is
less because OTM call and put are sold. In this strategy, the risk (loss) is
unlimited and profit is limited. The short strangle is also called as ‘"Sell
strangle".

Strategy :-
Sell 1 OTM call and sell 1 OTM put of the same underlying stock, striking
price and expiry date.

When to use:-
When the investor think that the spot price of underlying asset will
experience little volatility in the near term.

Loss:-
Maximum loss is unlimited when spot price of underlying asset is higher than
strike price of short call + Net premium received or Spot price of underlying
asset is less than the strike price of short put - Net premium received. The
maximum loss is (Spot price of underlying asset - Strike price of short call -
Net premium received) or (Strike price of short put – Spot price of underlying
asset - Net premium received + commissions paid if any).

Profit:-
Maximum profit is Net premium received – commissions or brokerage paid if
any. Maximum profit occurs when spot price of underlying asset is between
the strike price of the short call and strike price of the Short put.

Break-even point (BEP):-

Upper Break-even point = Strike price of short call + Net premium received.
Lower Break-even Point = Strike price of short put - Net premium received.

Example:-
Mr. XYZ executes a Short Strangle by selling a $200 Put for a premium of
$20 and a $400 Call for $30. The net credit is $50 which is also his maximum
possible gain.

Spot price of
Amount
underlying Particulars
($)
asset
Today's market
300.00
price
Sell 1 OTM
Strike price (S) 400.00
call
XYZ Option Premium
30.00
receives (S)
Sell 1 OTM
Strike price (S)
put 200.00
XYZ Option Premium
receives (S) 20.00
Net Premium
 paid 50.00
BEP higher ($) 450.00
BEP lower ($) 150.00

The pay-off schedule:-

Net profit Net profit
Spot Price of
from from Net profit
underlying
Sell 1 OTM sell 1 OTM (S)
asset ($)
put ($) call ($)
50.00 -130.00 30.00 -100.00
100.00 -80.00 30.00 -50.00
150.00 -30.00 30.00 0.00
200.00 20.00 30.00 50.00
250.00 20.00 30.00 50.00
300.00 20.00 30.00 50.00
350.00 20.00 30.00 50.00
400.00 20.00 30.00 50.00
450.00 20.00 -20.00 0.00
500.00 20.00 -70.00 -50.00
550.00 20.00 -120.00 -100.00
600.00 20.00 -170.00 -150.00
In the above example, the loss, profit and Break-even points are as follows:-
Loss:-
Maximum loss is $150 when Spot price of underlying asset ($600) - Strike
price of short call ($400) - Net premium received ($50).

Profit:-
Maximum profit is $50 Maximum profit occurs when spot price of
underlying asset is between the strike price of the short call and strike price of
short put.

Break-even point (BEP):-

Upper Break-even point is $450 i.e. Strike price of short call ($400) + Net
premium credit ($50).
Lower Break-even Point is $150 i.e. Strike price of short put ($200) - Net
premium credit ($50).

4. WARRANTS
Options are generally having their lives up to one year. A majority of options
traded on an exchanges having a maximum maturity of 9 months. The longer-
dated options are called as warrants i.e. the longest term for an option is two
to three years whereas a stock warrant can last for up to 15 years. Thus, in
many cases, a stock warrant can prove to be a better investment than a stock
option if mid to long-term investments. The warrants are generally traded
over-the-counter. A warrant is a derivative which gives the right, but not the
obligation to buy or sell a security at a certain price before expiration. The
price at which the underlying security can be bought or sold is referred to as
the strike price (or an exercise price). The warrants that gives the right to buy
a security are called as call warrants and warrants which gives the right to sell
are called as put warrants. Warrants are in similar to options in many ways,
but a few key differences distinguish them. Warrants are generally issued by
the company itself, not by a third party such as an exchange counter, and they
are more traded over-the-counter. Warrants tend to have much longer periods
between issue and expiration (rather than options) of years rather than
months. An American warrant can be exercised at any time on or before the
expiration (or maturity) date whereas the European warrants can only be
exercised on the expiration (or maturity) date. Warrants are no longer very
common in the U.S., but are heavily traded in Hong Kong, Germany and
other countries.

The existing stock is delivered to the option holder on exercise in the case of
a standard call option. But, in the case of a warrant, the company issues new
stock that will be delivered to the warrant holder on exercise. Companies
offer warrants for direct sale or give them to employees as incentive. The
issuance of new stock increases the number of shares outstanding (dilutive)
which, in turn, decreases the value of each share. Companies issue stock
warrants to raise money. A warrant usually is offered at a price lower than
that of a stock option. Warrants do not pay any dividends and not having the
voting rights. The investors are attracted to warrants as a means of
leveraging their positions in a security, hedging against exploiting the
arbitrage opportunities.

5. SWAPS
Introduction:-
A “swap” (simply called an exchange) is a derivative contract between two
parties to exchange their financial instruments. These instruments can be
almost anything but most swaps involve in cash flows that both parties
agreed to. Swaps do not trade on exchanges. Swaps are customized contracts
that are traded over-the-counter (OTC) between private parties. The retail
investors do not generally involve in swaps market. Mostly, the firms,
financial institutions and few individuals are involving in swaps market
because counter-party risk is involved in swaps. The most common type of
swaps as under:-
(i) Interest rate swaps
(ii) Currency swaps
(iii) Commodity swaps
(iv) Debt-equity swaps
(v) Asset swaps
(vi) Liability swaps
(vii) Total return swaps

1. Interest rate swaps:-

An interest rate swap is a contractual agreement between two parties to
exchange their cash flows of future interest payments (based on notional
principal amount that both parties agreed to) in order to hedge interest rate
risk or to speculate. Usually, the principal does not change in hands. Each
cash flow comprises one leg of the swap. One cash flow is generally fixed
and the other is variable based on a bench mark interest rate, floating
currency exchange rate, index price (i.e. an equity or commodity) and foreign
exchange rate. The most common type of swap is that ‘Interest rate swap’.
Generally, in Interest rate swaps, a counter-party can swap floating
rate payments with another counter party's fixed-rate interest payment. In
this swap, the party ‘A’ agrees to pay Party ‘B’ at a predetermined fixed rate
of interest on a notional principal on specific dates for a specified period of
time, whereas the party ‘B’ pays party ‘A’ that an amount equal to one-year
bench mark reference rate i.e. LIBOR or Treasury bill + n% per annum on a
notional principal amount. For example, let us see the below case:-

Example of Interest rate swaps:-

(i) ‘A’ pays to ‘B’ at 8% fixed per annum,
(ii) ‘B’ pays to ‘A’ the rate (bench mark reference rate) on a 6-month
Treasury bill + 2%,
(iii) The tenor is for 3 years with payment dues for every 6 months,
(iv) Both companies have a notional principal amount of Rs10,00,000.

Solution :-
 T-
Period bill B' pays (Rs) A' pays (Rs)
rate
0 4% - -
30000 40000
1 3%
[10,00,000x(4+2)%x6/12] [10,00,000x8%x6/12]
25000 40000
2 4%
[10,00,000x(3+2)%x6/12] [10,00,000x8%x6/12]
30000 40000
3 5%
[10,00,000x(4+2)%x6/12] [10,00,000x8%x6/12]
35000 40000
4 7%
[10,00,000x(5+2)%x6/12] [10,00,000x8%x6/12]
45000 40000
5 8%
[10,00,000x(7+2)%x6/12] [10,00,000x8%x6/12]
50000 40000
6 -
[10,00,000x(8+2)%x6/12] [10,00,000x8%x6/12]

2. Currency swaps:-
A ‘currency swap’ is also known as a cross-currency swap. In the ‘currency
swaps’, the parties can exchange their two streams of cash flows i.e. the
interest and notional principal amounts on their debt denominated in different
currencies. Unlike in the interest rate swaps, the principal amount is not a
notional and it is also can exchanged along with interest obligations in order
to gain an exposure to a desired currency. The principal amounts are usually
exchanged at the origination and maturity dates. Currency swaps are widely
used by an institutional investor, banks and MNCs as a mandatory financial
instrument. Currency swaps were designed in the 1980s to find a way the
capital controls imposed by governments and to make borrowing more
efficient in global markets. Currency Swaps are not a method of borrowing
money, but rather a means of managing debt and funding requirements. The
main functions of currency swaps are can reduce the overall cost of
borrowing (liability swap), improve income from investments (asset swap)
and hedge long-term currency exposures and reduce an organization’s
financial risk.
Example of currency swaps:-
U.S MNC company ‘A’ may wish to expand its operations in India.
Simultaneously, an Indian ‘company B’ is seeking entrance into the U.S.
market. The ‘company A’ is facing problem that an Indian bank is
unwillingness to give loans to international corporations (i.e. MNCs).
Therefore, in order to take a loan in India, company A might be subject to a
high interest rate of 10%. Similarly, the company B will not be able to take a
loan with a favorable interest rate in the U.S.A. The Indian company B may
only be able to obtain the credit at 9%.

Due to the international market is having high rate of borrowing cost, both of
the companies have a competitive advantage for taking out loans from their
domestic banks and exchange their loans. Company A taken out a loan from
an American bank at 4% and Company B has borrowed from its local
institutions at 5%. The loans are then swapped. Assuming that the exchange
rate between India (INR) and the U.S (USD) is 66.00 INR/1.00 USD and
both the companies require the same equivalent amount of funding i.e. the
Indian company B receives $100 million from company A in exchange for
6600 million INR is received the ‘company A’ from ‘company B’ and these
notional amounts are swapped.

‘Company A’ now holds the funds it required in INR while Company B is

having in USD. However, both the companies have to pay interest on the
loans to their respective domestic banks in the original borrowed currency.
This means that although the ‘company B’ is swapped its INR for USD,
‘company B’ must pay its obligation to the Indian bank only in INR.
Similarly, ‘company A’ must pay its obligation to the American bank only in
USD even though it is swapped its USD to INR with ‘company B’. As a
result, both the companies will incur the interest payments equivalent to the
other party's cost of borrowing. This is the advantage of currency swap
because rather than borrowing at INR 10%, ‘company A’ satisfies the interest
rate at 5% of payments incurred by ‘company B’ under its agreement with the
Indian bank. Similarly, ‘company B’ satisfies the interest rate at 4% (rather
than 9%) of payments incurred by ‘company A’ under its agreement with the
U.S bank. Under this scenario, ‘company B’ actually managed to reduce
its interest amount (cost of debt) by more than half. Instead of borrowing
from international banks, both companies borrow domestically and lend to
each other at the lower rate of interest.

The below diagram show the general characteristics of the currency swap.

In the case of above example, excludes the role of a swap dealer who serves
as the intermediary for the currency swap transaction. With the presence of
the dealer, the realized interest rate might be increased slightly as a form of
commission to the intermediary. If it happens, the spreads on currency swaps
are fairly low i.e. around 10 basis points depending on the notional
principals and type of clients. Therefore, the actual borrowing rate for
Companies A and B are 5.1% and 4.1% respectively.
Finally, currency based instruments include an immediate and terminal
exchange of notional principal. In the above example, the $100 million and
INR 6600 million are exchanged at initiation of the contract. At termination,
the notional principals are returned to the respective party. Company A
would have to return the notional principal in INR back to Company B,
Similarly, company B would have to return the notional principal in USD
back to Company A. The terminal exchange exposes both the companies
to foreign exchange risk as the exchange rate will likely not remain stable at
original 66.00INR/1.00USD level. Currency moves are unpredictable and
can have an adverse effect on portfolio returns.

3. Commodity swaps:-
The two parties can exchange their two streams of cash flows based on the
floating price (or market price) of an underlying commodity such as oil,
natural gas, precious metals, industrial metals, livestock and grains which are
trading for a fixed price over a specified period. A commodity swap is similar
to a Fixed-Floating Interest rate swap. The commodity swaps are most
commonly involved in crude oil. In the commodity swaps, one party pays a
fixed price on an underlying quantity of the commodity and the other party
pays a floating price usually based on the commodity’s average price over a
period of time.

Generally, the cash flow of floating rate component of the swap is held by the
consumer of the commodity and the cash flow of fixed price component of
the swap is held by the producer of the commodity who agrees to pay a cash
flow of floating rate (which is determined by the spot market price of the
underlying commodity) component of swap. Finally, the consumer of the
commodity gets a guaranteed price over a specified period of time and the
producer is in a hedged position which means protecting them from a
decrease in the commodity's price over the same period of time. Typically,
the commodity swaps are cash-settled though physical delivery can be
stipulated in the contract.

Example of commodity swaps:-

Suppose, the company XYZ needs to purchase 250,000 barrels of oil each
year for the next two years. The forward prices for delivery on oil in first year
and second years are $50 and $51 per barrel respectively. The first year and
second year zero-coupon bond yields are 2% and 2.5% respectively. Then, in
this case, two scenarios can happen i.e. (i) paying the entire cost upfront, (ii)
paying each year upon delivery.

(i) Paying the entire cost upfront:-

To calculate the upfront cost per barrel we have to divide the forward prices
by their respective zero-coupon rates as below:-

Barrel cost = [$50 / (1 + 2%)^1] + [$51 / (1 + 2.5%)^2]

= $49.02 + $48.54
= $97.56.

Therefore, the cost per barrel would be $97.56. By paying $24,390,536

(250,000 x $97.56) today, the consumer is guaranteed 250,000 barrels of oil
per year for two years.
(ii) Paying each year upon delivery:-
In the above first case, there is counterparty’s risk that is if the oil may not be
delivered to consumer by producer, the consumer XYZ will have loss. Hence,
in this second case of payment on delivery, the consumer may opt to pay two
payments i.e. one each year as the barrels are being delivered by the
producer. Here, we have to find out the cost of barrel to equate the total cost
to the above example as :-

Barrel cost (X) = [X / (1 + 2%)^1] + [X / (1 + 2.5%) ^2] = $97.56

X = $50.49
Therefore, the consumer must pay $50.49 per barrel each year upon delivery
by the oil producer.

4. Equity (Debt-equity) swaps:-

A debt-equity swap involves the exchange of debt for equity and it is a way
for the companies to re-finance their debt. In the equity swaps, one party pays
the return on a stock index whereas the other party pays at a benchmark rate
of interest. The cash flows can be in the same currency or different
currencies. The equity swap is generally to help a company for the following
reasons:-
(i) The company which is struggling and wish to continue to operate,
(ii) Manager would like to convert some debt based cash flows into equity
based receipts,
(iii) The bankruptcy company cannot pay its debts or has to improve its
equity standing,
(iv) a company may wish to take an advantage of favorable market
conditions.
Moreover, the company can invite debt holders to swap their debts for equity
to maintain certain debt-equity ratios. Hence, these debt-equity ratios can
finance the requirements imposed by lenders.
Thus, it can be say that the equity swaps can be used as a part of the
company’s bankruptcy restructuring.

5. Asset swaps:-
Asset swaps are used to transform the cash flows of the underlying asset in
order to hedge currency risk, credit (default) risk and interest rate risk. The
asset swaps are most commonly used by the banks to convert their long-term
fixed rate assets to floating rate in order to match their short-term liabilities
such as depositor accounts. The investor pays cash flow of fixed rate of a
swap and receives the cash flow of floating rate of a swap in return. The
buyer of a swap can purchase a bond (i.e. an underlying asset) from the seller
of swap by paying the fixed price of coupon i.e. full price of the bond’s face
value and in return, the swap buyer receives cash flow of floating rate
payments based on bench mark reference rate i.e. LIBOR plus (or minus) an
agreed fixed spread. The maturity of this swap is the same as the maturity of
the asset.

6. Liability swaps:-
The liability swaps are used by the large corporations to exchange of debt
related interest rates between the two parties. In liability swaps, the nominal
(identical) value of cash flows exchanged. Usually a floating rate is
exchanged for a fixed rate of income. For example, the company A may swap
a 5-month LIBOR interest rate for the company B's 5-month fixed rate of 5%
on a notional principal of $7 million. Due to the split, the company ‘A’ will
pay a fixed interest payment of 5% instead of the floating rate and a swap
will have an initial value of zero because the initial cash flows are the same.
However, in future, this will be change because the interest rates may change
and the swap will have either a positive or negative value for each contract
holder.

7. Total return swaps:-

The swap agreement between two parties which one party makes the payment
based on a set fixed rate or floating rate while the other party makes the
payment based on the return of an underlying asset which includes both the
income it generates and any capital gains. In total return swaps, the
underlying asset is referred to as the reference asset i.e. an equity index, loans
or bonds. The asset is owned by the party receiving the set rate payment. The
two parties involved in a total return swap are known as the total return payer
and the total return receiver. In a total return swap, the party receiver can
receive any income and benefits generated by the asset if the price of the
asset increases over the life of the swap period. In return, the total return
receiver must pay the set rate to asset owner over the life of the swap. If price
of an asset falls over the life of the swap, the total return receiver will be
required to pay the amount by which the asset has fallen in price to the asset
owner.

Example of total return swap:-

Assume that two parties entered into a total return swap of one-year, in which
one party receives the LIBOR plus fixed margin of 2%. The other party
receives the total return of the SENSEX Index on a principal amount of $1
million. After one year, if LIBOR is 3.5% and the SENSEX increases by
15%, the first party pays the second party 15% and receives 5.5% (3.5 + 2).
The payment is netted at the end of the swap with the second party receiving
a payment of $95,000 i.e. [$1 million x (15% - 5.5%)]. Assume the SENSEX
falls by 15% instead of increasing by 15%. Then, the first party would
receive 15% + LIBOR + the fixed margin of 2%. Therefore, the payment
netted to the first party would be $205,000 i.e. [$1 million x (15% + 3.5% +
2%)].

PARTICIPANTS IN DERIVATIVES MARKET

The most common participants in Derivatives market or foreign exchange
market are :-
i. Hedgers
ii. Speculators
iii. Arbitrageurs
iv. Traders

1. HEDGERS:-
Hedging is a strategy to minimizing the losses, but not maximizing the
profits. Hedging helps us to create a more certain outcome, but not a better
outcome. Thus, Hedging will not help us to make more profits. Hedgers are
the people who are attempting to minimize their risk. For example, If we hold
shares and we don’t know that the price of these shares might fall in near
future, so that we can protect ourselves by selling these Futures. If the market
actually will fall in a short run, we will make a loss on the shares, but will
make a profit on the Futures. Hence, we will be able to set off our losses with
profits. Hedging is a strategy to protect our position if an adverse move in a
currency pair.
Perfect hedge:-
A hedger can create a hedge to fully protect his existing position from an un
expected movement of the price of underlying security or currency in the
market trade by holding both a short position and a long position
simultaneously on the same underlying security or currency is known as
“perfect hedge” because it eliminates all of the risk associated with that
underlying when the hedge is active.

Imperfect hedge:-
A hedger can create a hedge to partially protect his existing position from an
un expected movement in the price of underlying security or currency pair
using options by holding a short position or a long position is known as
“perfect hedge” because the strategy only eliminates some of the risk
associated with the same underlying.

Cross-hedge:-
A hedger can create a hedge by investing in two positive mutual relationships
of (i.e. one thing depends on another) underlying securities that have similar
price movements. The investor takes opposite positions in each investment to
reduce the risk by holding just one of the securities. Hence, they have enough
mutual relationship (i.e. correlate) to create a hedged position providing the
price movement in the same direction even though the two underlying
securities are not identical. This type of hedge is called as “Cross hedge”.
When using a cross hedge, the expiry of the two securities must be equal i.e.
cannot hedge a long-term security with a short-term security.

Short hedge:-
The hedge that involves a short position in future’s contract is called as
‘Short hedge’. A Short hedge can appropriate when the hedger already owns
the security and expects to sell it at some time in the future. A Short hedge
can be used when the security is not owned right now but will be owned at
some time in the future.

Long hedge:-
The hedge that involves a long position in future’s contract is called as ‘Long
hedge’. A long hedge can appropriate when the hedger knows that will have
to purchase a certain security in the future and wants to lock the price of that
now. Long hedge used to manage an existing short position of the security.

2. SPECULATORS:-
A speculator is a person or an entity that trades securities (or commodities,
bonds, derivatives, etc..) essentially as bet on future price movements of the
security and typically has an above average risk tolerance. Speculators can
increase the potential gains or potential losses in a speculative market.
Speculators take large risks in order to make quick and large gains. If a
speculator believes that a particular security or commodity is going to
increase in price, the speculator may choose that security to buy as much as
possible. This activity can increase demand the security to go up the price
which may cause to others also can purchase of that security. Finally, the
result will be the price of the security above its true value. Conversely, if a
speculator believes that a particular security or commodity is going to
decrease in price, the speculator may choose that security to sell as much as
possible. This activity can decrease demand the security and thereby the
prices of the security will go down which may cause to others also can sell
that security. Finally, the result will be the price of the security below its true
value.

3. ARBITRAGEURS:-
Arbitrage means the buying and selling of securities, commodities, futures,
options or any combination of such products in different markets (i.e.
different bench marks such as SENSEX, NIFTY, FTSE, etc..) at the same
time to take advantage of any price difference opportunities in such markets.
For example, an arbitrageur would seek out the price differences between
stocks listed on more than one exchange (bench mark) by buying the
undervalued shares on one exchange while short selling the same number
of overvalued shares on another exchange. Therefore, an arbitrageur can get
the risk-free profits as the prices on the two exchanges tend to meet at a
point. Arbitrageurs are typically very experienced investors.

Briefly, Speculators provide liquidity and volume to the market while

hedgers provide the depth. Arbitrageurs assist in proper price discovery and
correct price abnormalities. Hedger avoids the risk while speculator takes the
risk.
Hedging with swaps:-
Swap is an agreement between 2 parties to exchange two streams of cash
flows over a period of time. The use of Swap is that it allows a company to
borrow capital at fixed rate (or floating rate) and later, exchange its interest
payments at floating rate or fixed rate if the company desires. This type of
swap is called as “interest rate swap”. The interest rate may be fixed or
floating. For example, a company taken a loan from other party and have to
pay an interest (also called as ‘Cost of debt’) based on floating interest rate.
The floating rate is determined as reference rate of LIBOR (London
Interbank offered rate) in US dollars. At the time of borrowing, the interest
rates were low and expected to be more or less at same level for entire period
of loan. But, if after some time, the interest rates are showing greater
volatility, and the company finds itself at a risky position, the company wants
to convert its floating rate loan to fixed rate loan. In this case, the company
can switch from floating rate to a fixed rate by converting the existing loan,
but, this option may be costly because it involves transaction costs. So,
another possible alternative way is there to the company that the company
can enters into a swap arrangement (i.e. an agreement) to convert its floating
rate loan into fixed rate loan. Thus, the company can hedge its interest rate
risk effectively. This is called as “Interest rate swap”. In Interest rate swaps,
only the interest amount is to be exchanged as principal amount was not
changing. In this case of loan, all the things such as principal, fixed interest or
floating interest are denominated in the same currency. But, in ‘cross
currency (i.e. currency swaps) loan’, the principal amount changes because of
exchange rate of currency change.

Hedging with Option:-

Options give a right but not the obligation (compulsory) to buy or sell an
underlying asset or a security at a future date. Thus, one may or may not use
the option agreement. Assume that we have got a coupon to purchase 1Kg of
Rice at Rs50 which are selling at around Rs56 per Kg. Then, the coupon is
worth to utilize. But, there is 1kg wheat can be purchased for Rs46/- in
market, then, we can simply purchase it from the market itself at current spot
price and throw away the coupon. This is because one is not under any
obligation to use the coupon. An option is also a price guarantee, but, it may
or may not be result in a future sale. There are 2 parties to an option are
option buyer (or long party or holder) and an option seller (or Long party or
writer). Since the option buyer having the right only to buy and not an
obligation (compulsory) to buy is required to compensate to seller for his
advantage by paying him an option premium. Options are 2 types i.e. call
option and Put option. Call option gives a right to its holder to buy the
underlying asset at contract (or fixed) price and Put option gives the holder
the right to sell at a contract (fixed) price. Then, the price at which the option
holder (buyer) may buy or sell that underlying asset is known as strike price
or an exercise price. For example, we buy an American call option for a
stock of ABC ltd with a strike price of Rs350 which will expire after 6
months. This means that we are having a right to buy (but not obligation to
buy) the stock at Rs350. Assume that after 2 months, the said stock is trading
at Rs380, then, we can buy the stock at Rs350 whereas the others must pay
Rs380 to purchase. So, we are at a gain of Rs30 (380-350). But, if it is a
European option, then, we (option buyer) don’t have a right to buy the stock
till expiration day i.e. we have a right to buy the stock on expiration date
itself because a European option can be exercised only at the end of the
expiration day of the contract i.e. 6 months in above example. But, an
American option can be exercised at any time during the validity of the
option period. Thus, American options are considered to be more valuable.

------------ End of the CHAPTER – 16 ----------

CHAPTER – 17
INTERNATIONAL FINANCIAL MANAGEMENT

Learning objectives
After studying this chapter, you can be able to :-
1. learn exchange rate regime,
2. know about Direct quote, Indirect quote, and Cross rates,
3. Describe that how Foreign Exchange Market (FOREX) operates,
 4. Illustrate the foreign exchange risk,
5. Explain the International Monetary system,
6. Focus on Balance of payments,
7. Understand the concept of Foreign Direct Investment,
8. Explain the benefits and risks of global investing,
9. Explain the formula for measuring the return and risk of foreign
investments, and
10. Understand the methods of financing international operations.

1. INTRODUCTION TO INTERNATIONAL FINANCIAL

MANAGEMENT
The objective of financial management in international firms is same as in
domestic firms, but the goal in multinational companies is to maximize the
shareholder’s value on a global basis. The international (multinational) firms
operate their operations in more than one country. Multinational company’s
operations involved in multiple foreign currencies and their operations are
influenced by politics and laws of the respective countries where they
operate. Hence, the international companies face high risk as compared to
domestic firms. Thus, the main objective of multinational firms is to analyze
the implications of the changes in inflation rates, interest rates and exchange
rates on their decisions and minimize the foreign exchange risk.

2. FOREIGN EXCHANGE (FOREX) MARKET

Introduction:-
The place or market where the currency of one country is exchanged for the
currency of another country in order to buy, sell, exchange and speculate on
currencies is called as foreign exchange (FOREX) market. For example,
WIPRO in India purchased (imported) a machine from Australia for INR
1crore. Then, WIPRO (an importer) has to make the payment to Australian
company (exporter) in Australian dollars. So, WIPRO needs Australian
dollars (AUD) to make payment obligation through a commercial bank
dealing in the FOREX market to purchase machinery by exchanging INR.
Similarly, assume that the Japanese company imported goods from Indian
company Reliance Industries Limited (RIL). Then, the Japanese company
will make payment to RIL in its currency of JPY. So, RIL will convert the
JPY in to INR in the FOREX market.
Most of the currency transactions are channeled through worldwide interbank
market. Interbank market is the wholesale market in which major banks trade
with each other. FOREX market is the worldwide market of financial
network among the FOREX market Participants i.e. central banks, FOREX
brokers, Investors of Arbitrageurs and Speculators. The FOREX market is
considered the largest financial market in the world and the FOREX market
operates 24 hours daily FOR 5 days a week. The USD is most traded
currency in FOREX market which is making up near to 85% of all trades.
Second is the EURO which is part of 39% of all currency trades and third is
the Japanese YEN of 19%. (Note:- these figures do not total 100% because
there are two sides to every FX transaction). According to the 2015 Euro
money survey, Citigroup and Deutsche Bank were the two biggest banks in
the FOREX market combining for more than 30% of the global market
share.

Structure of FOREX Market:-

The FOREX market structure may be diagrammatically represented as
below:-
The top guns are the major banks and some smaller or medium-sized banks
which make up the interbank market, the two tiers at the apex of the
pyramid.

The largest banks, such as the Royal Bank of Scotland, Deutsche Bank, BNP
Paribas, Barclays Bank, HSBC, UBS, and Citigroup, among others, really
determine the FX rates through their operations. They are the ultimate
frontier for global FX transactions and have the true overall picture of the
changing demand and supply scenario of any currency. Through the size of
their operations they effectively lay down the bid-ask spread that trickles
down to the lower tiers. Banks are able to view rates and deal if required.

The next tier is made up of the non-bank entities such as retail market-
makers, brokers, ECNs, hedge funds, pension and mutual funds, corporations
etc. They access the FX market through banks, also known as liquidity
providers. They pay higher spreads for executing the transactions. Of this
class, the corporations are a very significant player, because they are
constantly buying or selling FX for their cross-border purchases or sales of
raw materials or finished products. Their activities in the Mergers and
Acquisitions arena also create significant demand or supply of currencies.

Sometimes, governments and central banks also intervene in the FX markets

if they see a need to re-align market rates. For example, if the U.S. monetary
authorities elect to intervene in the FOREX market, the intervention is
conducted by the Federal Reserve Bank of New York. When a decision is
made to support the dollars' price against another currency, the foreign
exchange trading desk of the New York Fed buys dollars and sells the foreign
currency; conversely, to reduce the value of the dollar, it sells dollars and
buys the foreign currency.

The speculators and retail traders make up the last tier, and they pay the
largest spreads, because their trades effectively get executed through two
layers. The sole intentions of these players are to make money trading the
fluctuations in the currency prices. With the advent of the internet and
technology that lets the small guy participate in this huge market, it is now
possible for anyone to trade FOREX.
Types of Transactions and Settlement dates:-
Settlement of transaction takes place by transfer of deposits between the two
parties. The day on which these transfers are carried out is called the
settlement date or the value date. Obviously, to implement the transfers,
banks in the countries of two currencies involved must be open for business.
The relevant countries are called settlement locations. The locations of two
banks involved in the trade are dealing locations which need not be the same
as settlement locations. For example, assume that a London bank can sell
Swiss Francs against US dollar to a Paris bank. In this case, the settlement
locations may be New york and Geneva while dealing locations are London
and Paris. The transaction can be settled only on a day on which both US and
Swiss banks are open. The Foreign exchange transaction involves the
conversion of a currency of one country into the currency of another country
for the settlement of payments.

(i) Spot Transaction:-

The spot transaction is when the buyer and seller of different currencies
settle their payments within the two days of the deal. It is the fastest way to
exchange the currencies. Here, the currencies are exchanged over a 2-day
period which means no contract is signed between the countries. The
exchange rate at which the currencies are exchanged is called the Spot
Exchange Rate. This rate is often the prevailing exchange rate. The market in
which the spot sale and purchase of currencies is facilitated is called as a Spot
Market.

(ii) Forward Transaction:-

A forward transaction is a future transaction where the buyer and seller enter
into an agreement of sale and purchase of currency after 90 days of the
deal at a fixed exchange rate on a definite date in the future. The rate at which
the currency is exchanged is called a Forward Exchange Rate. The market in
which the deals for the sale and purchase of currency at some future date
made is called a Forward Market.

(iii) Future Transaction:-

The future transactions are also the forward transactions and deals with the
contracts in the same manner as that of normal forward transactions.
However, the transactions are made in the future contract differs from the
transaction made in the forward contract on the following grounds:-
(a) The forward contracts can be customized on the client’s request, while the
future contracts are standardized such as the features, date, and the size of the
contracts is standardized.
(b) The future contracts can only be traded on the organized exchanges, while
the forward contracts can be traded anywhere depending on the client’s
convenience.
(c) No margin is required in case of the forward contracts, while the margins
are required of all the participants and an initial margin is kept as collateral so
as to establish the future position.

(iv) Swap Transactions:-

The Swap Transactions involve a simultaneous borrowing and lending of two
different currencies between two investors. Here one investor borrows the
currency and lends another currency to the second investor. The obligation to
repay the currencies is used as collateral, and the amount is repaid at
a forward rate. The swap contracts allow the investors to utilize the funds in
the currency held by him/her to pay off the obligations denominated in a
different currency without suffering a foreign exchange risk.

(v) Option Transactions:-

The foreign exchange option gives an investor the right, but not the
obligation to exchange the currency in one denomination to another at an
agreed exchange rate on a pre-defined date. An option to buy the currency is
called as a Call Option, while the option to sell the currency is called as a Put
Option.

Participants (Players) in FOREX Market:-

1. FOREX Dealers:-
FOREX dealers are amongst the biggest participants in the FOREX market.
They are also known as broker dealers. Most FOREX dealers in the world are
banks. So, the market in which dealers interact with one another is also
known as the interbank market. However, there are some notable non-bank
financial institutions also that deal in foreign exchange. These dealers
participate in the FOREX markets by providing bid-ask quotes for currency
pairs at all times. All brokers do not participate in all currency pairs. Rather,
they may specialize in a specific currency pair. Alternatively, a lot of dealers
also use their own capital to conduct proprietary trading operations. When
both these operations are combined, FOREX dealers have a significant
participation in the FOREX market.

2. Brokers:-
The FOREX market is largely devoid of brokers. This is because a person
need not deal with brokers necessarily. If they have sufficient knowledge,
they can directly call the dealer and obtain a favorable rate. However, there
are brokers in the FOREX market. These brokers exist because they add
value to their clients by helping them obtain the best quote. For instance, they
may help their clients obtain the lowest buying price or the highest selling
price by making available quotes from several dealers. Another major reason
for using brokers is creating anonymity while trading. Many big investors
and even FOREX dealers use the services of brokers who act as henchmen
for the trading operations of these big players.

3. Hedgers:-
There are many businesses which end up creating an asset or a liability priced
in foreign currency in the regular course of their business. For instance,
importers and exporters engaged in foreign trade may have open positions in
several foreign currencies. They may therefore be impacted if there is a
fluctuation in the value of foreign currency. As a result, to protect themselves
against these losses, hedgers take opposite positions in the market. Therefore
if there is an unfavorable movement in their original position, it is offset by
an opposite movement in their hedged positions. Their profits and losses and
therefore nullified and they get stability in the operations of their business.

4. Speculators:-
Speculators are a class of traders that have no genuine requirement for
foreign currency. They only buy and sell these currencies with the hope of
making a profit from it. The number of speculators increases a lot when the
market sentiment is high and everyone seems to be making money in the
FOREX markets. Speculators usually do not maintain open positions in any
currency for a very long time. Their positions are transient and are only
meant to make a short term profit.

5. Arbitrageurs:-
Arbitrageurs are traders that take advantage of the price discrepancy in
different markets to make a profit. Arbitrageurs serve an important function
in the foreign exchange market. It is their operations that ensure that a market
as large, as decentralized and as diffused as the FOREX market functions
efficiently and provides uniform price quotations all over the world.
Whenever arbitrageurs find a price discrepancy in the market, they start
buying in one place and selling in another till the discrepancy disappears.

6. Commercial Banks:-
The major participants in the foreign exchange market are the large
Commercial banks who provide the core of market. As many as 100 to 200
banks across the globe actively “make the market” in the foreign exchange.
These banks serve their retail clients, the bank customers, in conducting
foreign commerce or making international investment in financial assets that
require foreign exchange. These banks operate in the foreign exchange
market at two levels. At the retail level, they deal with their customers -
corporations, exporters and so forth. At the wholesale level, banks maintain
an inert bank market in foreign exchange either directly or through
specialized foreign exchange brokers. The bulk of activity in the foreign
exchange market is conducted in an inter-bank wholesale market-a network
of large international banks and brokers. Whenever a bank buys a currency in
the foreign currency market, it is simultaneously selling another currency. A
bank that has committed itself to buy a certain particular currency is said to
have long position in that currency. A short-term position occurs when the
bank is committed to selling amounts of that currency exceeding its
commitments to purchase it.

7. Central Banks:-
Central Banks of all countries participate in the FOREX market to some
extent. Most of the times, this participation is official. Although many times
Central Banks do participate in the market by covert means. This is because
every Central Bank has a target range within which they would like to see
their currency fluctuate. If the currency falls out of the given range, Central
Banks conduct open market operations to bring it back in range. Also,
whenever the currency of a given nation is under speculative attack, Central
Banks participate extensively in the market to defend their currency.
8. Retail Market Participants:-
Retail market participants include tourists, students and even patients who are
travelling abroad. Then there are also a variety of small businesses that
indulge in foreign trade. Most of the retail participants participate in the spot
market whereas people with long term interests operate in the futures market.
This is because these participants only buy/sell currency when they have a
personal/professional requirement and dealing with foreign currencies is not a
part of their regular business.

9. MNCs:-
MNCs are the major non-bank participants in the forward market as they
exchange cash flows associated with their multinational operations. MNCs
often contract to either pay or receive fixed amounts in foreign currencies at
future dates, so they are exposed to foreign currency risk. This is why they
often hedge these future cash flows through the inter-bank forward exchange
market.

10. Individuals and Small Businesses:-

Individuals and small businesses also use foreign exchange market to
facilitate execution of commercial or investment transactions. The foreign
needs of these players are usually small and account for only a fraction of all
foreign exchange transactions. Even then they are very important participants
in the market. Some of these participants use the market to hedge foreign
exchange risk.

Functions of Foreign Exchange Market:-

Foreign exchange market plays a very significant role in business
development of a country because of the fact that it performs several useful
functions as below:-
1. Foreign exchange market transfers purchasing power across different
countries which results in enhancing the feasibility of international trade and
overseas investment.
2. It acts as a central focus whereby prices are set for different currencies.
3. With the help of foreign exchange market, investors can hedge (or
minimize the risk of loss) due to adverse exchange rate changes.
4. Foreign exchange market allows traders to identify risk free opportunities
and arbitrage these away.
5. It facilitates investment function of banks and corporate traders who are
willing to expose their firms to currency risks.

Segments of Foreign Exchange Market:-

There are two segments of foreign exchange market. They are Spot Market
and Forward Market.

1. Spot Market:-
In spot market currencies are exchanged immediately on the spot. This
market is used when a firm wants to change one currency for another on the
spot. The procedure is very simple. A banker can either handle the
transaction for the firm or may have it handled another bank. Within minutes
the firm knows exactly how many units of one currency are to be received or
paid for a certain number of units of another currency.

For instance, a US firm wants to buy 4000 books from a British Publisher.
The Publisher wants 4000 British Pounds for the books. so that the American
firm needs to change some of its dollars into pounds to pay for the books. If
the British Pound is being exchanged for US $ 1.70, then £ 4,000 equals $
6800. The US firm simply pays $ 6800 to its bank and the bank exchanges
the dollars for 4000 £ to pay the British Publisher.

In the Spot market, the risks are always involved in any particular currency.
Regardless of what currency a firm holds or expects to hold, the exchange
rate may change and the firm may end up with a currency that declines in
values if it is unlucky or not careful. There are also risks that what the firm
owes or will owe may be stated in a currency that becomes more valuable
and, as such possibly harder to obtain and use to pay the obligation.

2. Forward Market:-
Forward market has come into existence to avoid uncertainties. In Forward
market, a forward contract about which currencies are to be traded, when the
exchange is to occur, how much of each currency is involved, and which side
of the contract each party is entered into between the firms. With this
contract, a firm eliminates one uncertainty, the exchange rate risk of not
knowing what it will receive or pay in future. However, it may be noted that
any possible gains in exchange rate changes are also estimated and the
contract may cost more than it turns out to be worth.

For example, suppose that the 90-day forward price of the British pound is
2.000 (US$ 2.00 per £) or quoted £ 0.5000 per US $, and that the current spot
price is US $ 1.650. If a firm enters into a forward contract at the forward
exchange rate, it indicates a preference for this forward rate to the unknown
rate that will be quoted ninety days from now in the spot market.

However, if the spot price of the pound increases by 100 per cent during the
next 90 days, the pound would be US $ 3.3000 and the £ 5,00,000 could be
converted into US $ 1,650,000 The forward market, therefore, can remove
the uncertainty of not knowing how much the firm will receive or pay. But it
creates one uncertainty-whether the firm might have been better off by
waiting.

3. FOREIGN EXCHANGE RATE (QUOTATION)

The price of one currency quoted in terms of another currency is called as
Foreign exchange rate or Exchange rate. For example, an exchange rate of
USD ($) 0.015095 per INR means that the price of 1 INR is $0.015095. An
exchange rate between currencies A and B is simply the price of one in terms
of the other. It can be stated either as number of units of B per unit of A or
number of units of A per unit of B. The International Standards Organization
(ISO) has developed 3- letter codes for all the currencies which abbreviate the
name of the country as well as the currency. These codes are used by the
SWIFT (Society for worldwide Inter-bank Financial Telecommunications)
network which carries out inter-bank fund transfer. The below codes of
currencies which will be frequently used:-
USD: U.S. dollar
GBP: British Pound
EUR: Euro
JPY: Japanese Yen
CAD: Canadian dollar
INR: Indian Rupee
CHF: Swiss Frank
AUD: Australian Dollar, etc.

Direct quote:-
The exchange rate which is quoted as unit of the domestic (home) currency
per unit of a foreign currency is called as direct quote. Therefore, the INR and
USD exchange rate would be written as INR 66.246984/USD is a direct
quote in India or direct quote for rupee. This means, per I US dollar, the
Indian should pay INR 66.246984. This Direct quotation is also known as
European quotation or Quotation in European terms.

Indirect quote:-
The exchange rate which is quoted as number of units of foreign currency per
unit of the domestic (home) currency is called as indirect quote. Therefore,
the INR and USD exchange rate would be written as USD 0.015095/INR is
an indirect quote in India or indirect quote for rupee. This indirect quotation
is also known as American quotation or Quotation i
n American (U.S) terms.

So, the exchange rate between USD and INR can be expressed in either INR
per USD (INR/USD) or USD per INR (USD/INR).

Spot exchange rates:-

The rate at which a currency can be bought or sold for an immediate delivery
which is within two business days after the trading day is called as Spot
exchange rate. The foreign exchange rates are given in the below table. For
example, if we want to buy US dollar (USD), a bank will sell one USD for
INR 66.246984. These exchange rates are whole sale rates for trades among
the FOREX brokers in the Interbank market.

Exchange rates
per 1
Currency 1 USD per
USD
US Dollar
1.000000 1.000000
(USD)
Euro (EUR) 0.813687 1.228974
British Pound
0.714233 1.400103
(GBP)
Indian Rupee
66.246984 0.015095
(INR)
 Australian 1.303711 0.767041
Dollar (AUD)
Canadian Dollar
1.276773 0.783224
(CAD)
Singapore
1.315284 0.760292
Dollar (SGD)
Swiss Franc
0.974593 1.026069
(CHF)
Malaysian
3.897500 0.256575
Ringgit (MYR)
Japanese Yen
107.666623 0.009288
(JPY)
South Korean
1071.090000 0.000940
Won (KRW)
Chinese Yuan
6.295026 0.158856
(CNY)

Exchange rates as of April 21, 2018 02:38 UTC

Source: https://www.x-rates.com/table/?from=USD&amount=1

In the above exchange rates, USD/INR = 66.246984 (i.e. 1 USD = 66.4684

INR). Similarly, INR/USD = 0.014095 (i.e. 1 INR = 0.014095 USD).

Cross rates:-
An exchange rate between the currencies of two countries that are not quoted
against each other, but are quoted against one common currency is called as
“Cross rate”. In other words, the cross rate is the exchange rate between
currency A and currency C derived from actual exchange rate between
currency A and currency B and between currency B and currency C.
Sometimes, the cross rate is referred to an exchange rate between two
currencies not involving the US dollar (USD). The reason for not involving
the USD is the currencies of many countries are not freely traded in foreign
exchange market, but currencies of most countries quoted against the US
dollar. The cross rates of currencies that are not quoted against each other can
be quoted in terms of USD.
Formula for calculation of Cross rate:-
A/C = [(A/B) x (B/C)]
Here,
A/C = unit of currency A per unit of currency C
A/B = unit of currency A per unit of currency B
B/C = unit of currency B per unit of currency C

Calculation of Cross rates:-

Suppose USD/INR = 66.246984 and USD/KRW = 1071.090000, If we want
to know the cross rate of KRW/INR and INR/KRW based on USD currency,
then we can calculate the cross rates as following:-

(i) KRW/INR = [(USD/INR) / (USD/KRW)]

= 66.246984 / 1071.090000
= 0.061850
(ii) INR/KRW = [(USD/KRW) / (USD/INR)]
= 1071.090000 / 66.246984
= 16.168132

Major cross rates and Minor cross rates:-

The exchange rates that any two currencies can be quoted against each other,
but the most actively traded pairs are called as “Major cross rates”. For
example, the currency pairs of EURCHF (i.e. Euro versus the Swiss franc),
EURGBP (i.e. Euro versus the British pound), EURJPY, the Euro versus the
Japanese yen) are major cross rates. The Euro is the base currency for the
quote in this example. These currencies are actively traded in the Interbank
spot FOREX. Conversely, the exchange rates that any two currencies can be
quoted against each other in interbank foreign exchange market, but are far
less active are called as Minor cross rates. For example, the currency pair of
CHFJPY and GBPCHF are minor cross rates.

Bid – Ask spread:-

Foreign currency dealers (brokers) will quote both the Bid and Ask for a
particular currency and always ready to buy or sell foreign currencies. The
average of the bid and ask calculated as [(Ask + Bid)/2].

Bid Price (Buying price):-

The price at a buyer is willing to pay for a security is called Bid price.

Ask Price (Selling or Offer price):-

The price at a seller is willing to sell a security is called as Ask price.

The difference between the buying (bid) and selling (ask or offer) currency
rate is called as FOREX operator’s (i.e. bank or FOREX dealer) Bid-Ask
Spread or simply called as Spread. The bid-ask spread is usually given as a
percentage and it is computed as below:-

Bid-Ask Spread % = [(Ask price – Bid price) / Ask price] x 100

For example, assume that an Ask (offer) price of the stock is $10.00 while
Bid-price for that stock is $9.95. The bid price is $9.95 and the offer price is
$10. Then, the Bid-Ask spread in this case is $0.05 or 5% i.e. [(10.00 –
9.95)/10.00]

Factors Influencing Spread:-

Factors that affect the spread are include:-

(i) Trading Volume:- If the volume of the trading is high or more active a
market, then, the Bid-Ask spread will be lower.

(ii) Currency Rate Volatility:- If the stock prices traded with high volatility,
then, the currency dealers are exposed to higher risk. So, in this case, spread
will increase with higher volatility.

(iii) Political or Economic Risks:- The risks such as political instability,

higher inflation and changing economic conditions will affect the spread
associated with a particular currency. The higher the uncertainty is greater the
expected spread.

Forward exchange rates:-

The exchange rate at which a bank agree today to exchange one currency for
another at a future date when it enters into a forward contract with an investor
is called as Forward exchange rate. The forward exchange rate is also known
as Forward price or Forward rate. In the forward market, currencies are
traded for future delivery. The spot exchange market is much larger than the
forward market in terms of volume of currency transactions. The types of
Forward rates include 30-day, 90-day and 180-day etc. Most of the banks
quote currency forward rates to the traders. The forward rate may be at a
premium or discount.

Forward Premium:-
The price in which the forward (or expected future) price for a domestic
currency is higher than the spot price is called Forward premium. It indicates
the market that the current domestic exchange rate is going to increase
against the other currency. Here, increasing exchange rate means the currency
is depreciating in value.

Forward discount:-
The price in which the forward (or expected future) price of a domestic
currency is lower than the spot price trading is called Forward discount. It
indicates the market that the current domestic exchange rate is going to
decrease against the other currency. Here, decreasing exchange rate means
the currency is increasing in value. The negative premium is also known as
discount.

Forward premium/discount for direct quote:-

The Annualized Forward premium or discount for a direct quote is as under:-
Forward premium or discount = [(Spot rate - Forward rate) / Spot rate] x
360/days x 100

Example for direct quote:-

The USD-INR spot exchange rate is 0.015095 and the bank has quoted a 3-
month forward rate of USD-INR is 0.014021. Then, the Annualized Forward
discount for direct quote is calculated as
= [(0.015095 – 0.014021) / 0.015095] x (360/90) x 100
= (0.001074 / 0.015095) x 4 x 100
= -0.012947 x 4 x 100
= -0.05176 x 100
= -5.176%
Since it is a negative value, the Forward discount for direct quote is 0.05176
or 5.176% i.e. the forward rupee is selling at a discount of 5.176% relative to
the dollar.

Forward premium/discount for indirect quote:-

The Annualized Forward premium or discount for an indirect quote is as
under:-
Forward premium or discount = [(Forward rate – Spot rate) / Spot rate] x
360/days x 100

Example for indirect quote:-

The spot exchange rate is INR 66.246984/USD and the bank has quoted a 6-
month forward rate of INR-USD is 67.265125 Then, the Annualized Forward
discount for indirect quote is calculated as
= [(67.265125 – 66.246984) / 66.246984] x (360 / 180) x 100
= (1.018141 / 66.246984) x 2 x 100
= 0.0153689 x 2 x 100
= 0.030738 x 100
= 3.074%
Since it is a positive value, the Forward premium for indirect quote is
0.030738 or 3.074% i.e. the dollar is strong relative to the INR since the
dollar's forward value exceeds the spot value by a premium of 1.018 INR per
US dollar. The INR would trade at a discount because its forward value
regarding dollar is less than its spot rate.

4. INTERNATIONAL PARITY RELATIONSHIPS

Both the Spot and future exchange rates are should be affected significantly
by the current expectation of future events in a highly competitive foreign
exchange market. Spot and future rates should change in expectation of a
change in interest rates. The change in interest differential will get reflected
quickly in both forward and spot exchange rates in an efficient market.
Interest rates are influenced by inflation rates. Interest rates and inflation rates
will have equal relationships. The below 4 are the international parity
relationships.

(I) Interest rate parity (IRP):-

Interest rate parity is an interest rate differential between two countries is
equal to the differential between the forward exchange rate and the spot
exchange rate. It states that the exchange rate of two countries will be
affected by their interest rate differential. In other words, the currency of a
high interest rate country will be at a forward discount relative to the
currency of a low interest rate country. Similarly, the currency of a low
interest rate country will be at a forward premium relative to the currency of a
high interest rate country. This implies that the exchange rate differential of
spot and forward will be equal to the interest rate differential between the two
currencies.

Interest rate differential = Differential of exchange rate between forward and

spot
(1+rF) / (1+rD) = ƒF/D / SF/D

Here,
rF = Interest rate of country F i.e. the foreign country.
rD = Interest rate of country D i.e. the domestic country.
ƒF/D = Forward exchange rate between countries F and D.
SF/D = Spot exchange rate between countries F and D.

The country that offers the higher risk-free rate of return will be exchanged at
a more expensive future price than the current spot price. In other words, the
interest rate parity presents an idea that there is no arbitrage in the foreign
exchange markets.

Interest rate parity can be used to predict the movement of exchange rates
between two currencies when the risk-free interest rates of the two currencies
are known. But, since the exchange rates are determined by several other
factors and not just the interest rate differences, the interest rate parity cannot
predict or explain all movements in exchange rates, but it does serve as a
useful guide. Interest rate parity states that the high interest rate on a currency
is offset by the forward discount and the low interest rate is offset by forward
premium. Arbitrage will ensure that this happens.

Example 1:-
Suppose USD/CAD spot exchange rate is 1.2500 CAD and one year forward
rate is 1.2380 CAD. The risk-free interest rate is 4% for USD and 3% for
CAD. Check whether interest rate parity exist between USD and CAD?
Solution:-
Ratio of Forward to Spot=1.2380 / 1.2500 = 0.9904
Ratio of Returns = [(1+3%) / (1+4%)] = 0.9904
Since the two values are approximately equal, therefore interest rate parity
exists.

Example 2:-
The interest rate on 1-year bond in India is 14% while on a similar bond in
USA is 9% interest. The spot rate of USD is 0.015095/INR and 1-year
forward rate is 0.014426/INR.

Solution:-
We can notice that the INR is trading at a forward discount while USD is
trading at a forward premium. Assume that we have 1000 USDs.

If we invest this $1000 in USA, At the end of 1 year, we will receive as

$1090.00 ($1000x1.09).

Alternately, we can exchange the $1000 in to INR at the spot rate, we will
receive INR 66247.1017 ($1000/0.015095). If we can invest this @ 14% in
India for one year, at maturity, we can receive INR75521.6959
(66247.1017x1.14). If we sell this INR forward immediately, we can receive
$1089.48 (INR75521.6959x0.014426).

So, both the investments are equal value i.e. $1090. This is called as Interest
parity. Thus,
(1.09/1.14) = (0.014426/0.015095)
0.9561 = 0.956

Suppose, 1-year forward exchange rate is 0.014925 instead of 0.014426, then

on selling the INR forward, we will get USD 1127.1613 (75521.6959 x
0.014925. So, it is profitable of $37.68 (1127.1613 – 1089.48). This $37.68 is
called as Arbitrage profit.

The Arbitrage activity should result in the following effects in the above
case:-
(i) The USD rate will increase as Arbitrageurs borrow USDs.
(ii) The spot rate of INR against USD will appreciate as Arbitrageurs demand
rupees against USDs.
(iii) The interest rate in India will tend to fall as Arbitrageurs invest rupees.
(iv) The forward rate of rupees against USD will depreciate as Arbitrageurs
sell rupees against USDs.

Covered vs. Uncovered Interest Rate Parity:-

The interest rate parity is said to be covered when the no-arbitrage condition
could be satisfied through the use of forward contracts in an attempt to hedge
against foreign exchange risk. Conversely, the interest rate parity is said to be
uncovered when the no-arbitrage condition could be satisfied without the use
of forward contracts to hedge against foreign exchange risk.

Implications of Interest rate parity:-

(i) When domestic interest rate is below foreign interest rates, the foreign
currency must trade at a forward discount. This is applicable for prevention
of foreign currency arbitrage.
(ii) If a foreign currency does not have a forward discount or when the
forward discount is not large enough to offset the interest rate advantage,
arbitrage opportunity is available for the domestic investors. So, domestic
investors can sometimes benefit from foreign investment.
(iii) When domestic rates exceed foreign interest rates, the foreign currency
must trade at a forward premium. This is again to offset prevention of
domestic country arbitrage.
(iv) When the foreign currency does not have a forward premium or when the
forward premium is not large enough to nullify the domestic country
advantage, an arbitrage opportunity will be available for the foreign investors.
So, the foreign investors can gain profit by investing in the domestic market.

(ii) Purchasing Power parity (PPP):-

PPP is the rate of currency conversion that equalize the purchasing power of
different currencies by eliminating the differences in price levels between
countries. PPPs is simply price relatives that show the ratio of the prices in
national currencies of the same goods or services in different countries. PPP
is the expenditure on a similar commodity must be same in both currencies
when accounted for exchange rate. Purchasing power parity is used
worldwide to compare the income levels in different countries. The market
exchange rate doesn’t reflect the purchasing power of a currency.

Example of PPP:-
One liter of Coca-Cola costs 2.3 euros in France and $2.00 in the United
States. The PPP for Coca-Cola between France and the USA is 2.3/2.00 or
1.15. This means that for every dollar spent on a liter of Coca-Cola in the
USA, 1.15 euros would have to be spent in France to obtain the same
quantity and quality or in other words, the same volume of Coca-Cola.

If the price of the shoes in USA is $75, and price of the same shoes in India is
INR5000, then, the current spot exchange rate between USD and INR should
be USD/INR 0.015 (i.e. 75 / 5000). It is referred to as ‘PPP’. Suppose,
inflation rate in USA and India are 5% and 7% respectively. Then, the price
of the shoes in USA should be $78.75 (i.e. 75x1.05) and in India should be
INR5400 (i.e. 5000x1.08). The exchange rate will have to adjust for the shoes
equivalent price in USA to be same in India. The INR relative to the USD
will have to depreciated by 0.02857 or 2.857% i.e. [(1.08/1.05)-1]. Then, the
expected exchange rate will be USD/INR = 0.0145 i.e. [0.015095 x (1 -
0.02857)]. Thus, USD = 78.65 (i.e. 5400 x 0.0145). This is referred to as
‘PPP’.

Inflation rate differential = differential of Current spot and expected spot rate.

[(1+iF)/ (1+iD) = E(SF/D)/ SF/D]

Here,
iF = Rate of inflation in country F
iD = Rate of inflation in country D
E(SF/D) = Expected exchange rate between country F and D
SF/D = Spot exchange rate between country F and D

Suppose, Thailand and South Korea are running annual inflation rates of 5%
and 7% respectively. The current spot exchange rate of KRW is 34.24/THB.
What should be the value of the Thai Baht in 1 year? Then, the expected spot
rate after 1 year will be :-
= [(1.07/1.05) = E(SF/D)/34.24
E(SF/D) = [34.24 x (1.07/1.05)]
= 34.24 x 0.019
= 34.892

(iii) Forward rates and Expected Future spot rates parity:-

Assume that we are an exporter who will receive the payments in foreign
currency in future for goods sold to our customers (importers). Then, we have
two options to receive the payment. We can wait till we receive the dollars
and then convert in to INR. In this case we may face risk of drop in price in
the value of dollar in future. The second alternative is we fix the price of
dollar today and sell the USDs forward. By implementing this, we can avoid
the risk of drop in prices in future. On other hand, assume that we are
importers who will make a payment in foreign currency of dollars in future.
We may face risk of appreciation in prices while we will make the payment
in dollars in future. Then, we will buy the USDs forward to avoid the risk of
a possible appreciation in the value of dollars in future. The forward rate of
USD relative to the INR will be very close to the expected future spot rate if
both the importers and exporters are in large numbers. This theory is known
as Expectation theory of Exchange rates.

The expected future spot rate depends on the expectations of the FOREX
market participants. When the forward rate is lower than the expected future
spot rate, the market participants will buy the foreign currency forward. On
other hand, When the forward rate is higher than the expected future spot
rate, the market participants will sell the foreign currency forward. The
forward rate will raise until it reaches the expected future spot rate. The
expectation theory of forward exchange rates states that the forward rate
provides the best and unbiased forecast of the expected future spot rate. This
means that the forward rate and the current rate differential must be equal to
the expected spot rate and the current spot rate differential.

Thus, forward and current spot rates differential = Expected and current spot
rate differential.

ƒF/D / SF/D = EF/D / SF/D

Here,
rF = Interest rate of country F i.e. the foreign country.
rD = Interest rate of country D i.e. the domestic country.
ƒF/D = Forward rate.
EF/D = Expected future exchange rate (unit of foreign currency per unit of
domestic currency.

The forward rate must be equal to the expected future spot price i.e. ƒF/D = EF/D

(iv) International Fisher effect (IFE):-

IFE tells that an estimated change in the current exchange rate between any
two currencies is directly proportional to the difference between the two
countries nominal interest rates at a particular time. In other words, the
nominal interest rate comprises of a real interest rate and an expected rate of
inflation. The nominal rate of return adjusts when the inflation rate is
expected to change. The nominal interest rate will be higher when a higher
inflation rate is expected and the nominal interest rate will be lower when a
lower inflation rate is expected. This is referred to as the Fisher effect which
is expressed as below:-

(1 + nominal interest rate) = (1 + real interest rate) x (1 + inflation rate)

(1 + rn) = (1 + rr)(1 + i)
rn = rr + I + rri

For example, if the real rate of return is 3.5% and expected inflation is 5.4%,
then the approximate nominal rate of return is as under:-

rn = [0.035 + 0.054 + (0.035 x 0.054)]

= 0.089 + 0.00189
= 0.09089 or 9.1%.

If the expected real rate of return is higher in one country than another
country, then, capital would flow from the second to the first country and
investors will have opportunities to make riskless arbitrage profit. The
arbitrage activity will persist until equilibrium is established in the expected
real returns in the two countries. If the real rates of return are the same in two
countries, then, the nominal rates of interest in the two countries will adjust
exactly for the change in the inflation rates as per Fisher effect.

The International Fisher effect tells that the nominal interest rate differential
must equal to the expected inflation rate differential in two countries.

Thus, Nominal interest rate differential = Expected inflation rate differential

= [(1+rF)/ (1+rD) = E(1+iF)/E(1+iD)]

The International Fisher theory is calculated by the following formula:-

E = [(i1-i2)/(1+i2)] ≈ (i1-i2)

Here;-
E represents the percentage change in exchange rate.
i1 represents the interest rate of ‘country A’.
i2 represents the interest rate of ‘country B’.

For example, if the interest rate of country A is 10% and that of country B is
5%, then the currency of ‘country B’ should appreciate roughly 5% compared
to the currency of ‘country A’.

The International Fisher Theory observation holds that a country with higher
interest rate will also be inclined to have a higher inflation rate. The
International Fisher Theory also estimates the future exchange rates based on
the nominal interest rate relationships. The estimate of the spot exchange rate
12 months from now is calculated by multiplying the current spot exchange
rate by the nominal annual U.S. interest rate and then dividing it by the
nominal annual British interest rate.

5. FOREIGN EXCHANGE RISK

A multinational firm deals in foreign currency and it expects to make or
receive a payment in the foreign currency. The exchange rate between
domestic currency and foreign currency may raise or fall when the firm
receives or pays the cash flows in foreign currency. This exposes the firm to
the foreign exchange risk. Foreign exchange risk is the risk that the domestic
currency value of cash flows denominated in foreign currency may change
because of the variation in the foreign exchange rate. The major three types
of exchange exposures are as blow:-

A. Transaction Exposure:-
Transaction exposure is the risk incurred due to the fluctuations in exchange
rates before the contract is settled. The foreign exchange rate that changes in
cross-currency transactions can affect the involved parties. Once a cross-
currency contract has been commenced and a specific amount of money and
quantity of goods is fixed, exchange rate fluctuations can change the value of
the contract. However, a company that has agreed to a contract but not yet
settled it, faces the transaction exposure risk. The greater the time between
agreement and settlement of contracts, the higher the risky for involved with
exchange rate fluctuations.

Example :-
The XYZ firm of India enters in to an agreement with ABC firm of USA to
import machinery. The machinery price is fixed in USD. XYZ firm received
the machinery immediately but will make payment of $5000 after 3 months.
The current spot exchange rate is INR 66.247/USD. At the current exchange
rate, the value of the contract is INR331235. Suppose, the exchange rate will
be 67.50/USD at the time of making payment after 3 months, then, the XYZ
firm has to pay $337500. So, XYZ will have to pay more INR 6265 (337500
– 331235). Of course, the XYZ will gain and pay less than the expected value
at the time of the contract if the INR appreciates against the USD. But, the
XYZ cannot predict what the exchange rate would be after 3 months. They
cannot sure about the rupee whether it will appreciate or depreciate. So, in
this case, XYZ is exposed to Transaction risk. Thus, Transaction exposure
involves the possible exchange loss or gain on existing foreign currency
denominated transactions.

B. Economic Exposure:-
Economic exposure refers to the change in the value of the firm caused by the
unexpected changes in the exchange rate. The Economic exposure is also
being referred as Operating exposure or Long-term cash flow exposure. The
expected cash flows can change due to various factors such as prices of the
goods, input costs and pricing policy etc.
For example, An Indian firm imported the goods from UK company at an
exchange rate of INR 100.55 / GBP. The goods cost is GBP 7250. So, cost to
Indian company is INR 728987.50 (i.e. 7250 x 100.55). If the INR suddenly
depreciates and exchange rate shifts to 100.95, then, cost to the Indian
importer would be INR 731887.50 (7250 x 100.95). Being the cost increases
due to INR depreciates, the Indian importer might increase the price of the
goods sold to the domestic buyers to cover the highest costs. If he does not
increase the price, his profit margins would fall. But, he might lose the
market share because of the price increased. This would also have effect on
the exporter’s future sales as the demand from the importer falls. Then, the
exporter may reduce the price to keep the cost of goods import same by
reducing the price which would be GBP 7221.27 (728987.50 / 100.95)
instead of 7250. But, this would cause exporter’s revenue to fall which cause
to less profit. Thus, a change in the exchange rate could also affect the price,
volume, market share and firm’s competitiveness.

Hence, Transaction exposure involves the possible exchange loss or gain on

existing foreign currency denominated transactions whereas the Economic
exposure involves the impact of both the exchange rate and inflation rate
changes.

C. Translation Exposure:-
The Transaction exposure refers to exchanging gain or loss occurring from
the differences in the exchange rates at the beginning and at the end of the
accounting period.

For example, The Indian Infosys MNC has subsidiaries in USA, UK,
Australia & Switzerland and in other countries as well. The financial
statements of these subsidiaries will be stated in the local currencies. When
Infosys wants to consolidates financial statements of its subsidiaries with its
financial statement, it has to translate local currencies in to the home currency
i.e. INR. The exchange rate at the end of the accounting period may differ
from the rate in the beginning of the accounting period.

Translation gain or loss should be treated as accounting gain or loss and

should not be treated as economic gain or loss. The firm is exposed to
translation loss if it uses current exchange rate to translate its assets and
liabilities. There are four methods used in translating assets and liabilities.

(i) Current / Non-current method:-

Under this method, current assets and current liabilities are translated at the
current exchange rate and the Non-current assets and Non-current liabilities
are translated at historical exchange rate. Profit and loss statement items are
translated at the average exchange rate of the period. However, revenues and
expenses related to non-current assets and non-current liabilities are
translated at historic cost.

(ii) Monetary / Non-monetary method:-

Under this method, monetary balance sheet accounts such as cash, Accounts
receivables, Accounts payables and long-term debt are translated at the
current exchange rate and the Non-monetary accounts such as Fixed assets,
Inventory and long-term investments are translated at historic exchange rate.
Profit and loss statement items are translated at the average exchange rate
during the period. However, revenues and expenses related to non-monetary
balance sheet accounts are translated at historic cost.

(iii) Temporal method:-

This method is similar to the Monetary / Non-monetary method with only
difference that the inventory may be translated at the current rate when it is
shown at the market value.

(iv) Current rate method:-

Under this method, all the balance sheet and Profit and loss account items are
translated at the current exchange rate.

6. HEDGING FOREIGN EXCHANGE RISK

Hedging is an important risk management strategy in any market, but it is not
the only strategy available to traders. Money management using stop loss and
take profit orders is a great way to control the risk. Exchange rate risk (i.e.
foreign exchange risk) is an unavoidable risk of foreign investing, but we can
reduce the risk considerably through the use of hedging techniques. In order
to totally eliminate the foreign exchange risk, the compulsory choice is to
avoid investing in overseas assets altogether. But, this may not be the best
alternative from the viewpoint of portfolio diversification, since numerous
studies have shown that foreign investing improves portfolio return while
reducing the risk. The rule-of-thumb is to leave exchange rate risk with
regard to our foreign investments un hedged when our local currency is
depreciating against the foreign-investment currency, but hedge this risk
when our local currency is appreciating against the foreign-investment
currency.

Invest in hedged assets:-

It is a method of reducing risk. The easiest solution is to invest in hedged
overseas assets, such as hedged exchange-traded funds (ETFs). ETFs are
available for a very wide range of underlying assets traded in most of the
major markets. Many ETF providers offer hedged and un hedged versions of
their funds that track popular investment benchmarks or indexes. Although
the hedged fund will generally have a slightly higher expense ratio than its un
hedged counterpart due to the cost of hedging, large ETFs can
hedge currency risk at a fraction of the hedging cost incurred by an individual
investor.

Instruments for Hedging Currency Risk:-

We can hedge the currency risk using the one or more of the following
instruments:-

(i) Forward contract:-

Forwards can be effectively used to hedge currency risk. For example,
assume a U.S. investor has a GBP-denominated bond maturing in one year's
time and is concerned about the risk of the GBP declining against the U.S.
dollar in that time frame. So that U.S. investor can enter into a forward
contract to sell GBP (in an amount equal to the maturity value of the bond)
and buy U.S. dollars at the one-year forward rate. While the advantage of
forward contracts is that they can be customized to specific amounts and
maturities. But, a major drawback is that they are not readily accessible to
individual investors. An alternative way to hedge currency risk is to construct
a synthetic forward contract using the money market hedge.

(ii) Currency futures:-

Currency futures are also widely used to hedge exchange rate risk because
they trade on an exchange and need only a small amount of upfront margin.
The disadvantages are that they cannot be customized and are only available
for fixed dates.

(iii) Currency ETFs:-

Currency ETFs can be used to hedge exchange rate risk. This is probably not
the most effective way to hedge exchange risk for larger amounts. But for
individual investors, their ability to be used for small amounts plus the fact
that they are margin-eligible and can be traded on the long or short side, are
major benefits.

(iv) Currency Options:-

Currency options offer another feasible alternative to hedge exchange rate
risk. Currency options give an investor or trader the right to buy or sell a
specific currency in a specified amount on or before the expiration date at
the strike price. For example, currency options traded on the NASDAQ are
available in the denominations of EUR 10,000, GBP 10,000, CAD 10,000 or
JPY 1,000,000, making them well-suited for the individual investor.

(v) Money Market operations:-

A money market hedge is a technique for hedging foreign exchange risk. In
the money market, highly liquid and short-term instruments like Treasury
bills, bankers’ acceptances and commercial papers are traded. The money
market hedge may not be the most cost-effective or convenient way for large
corporations and institutions to hedge such risk. However, the money market
is useful for retail investors or small businesses who looking to
hedge currency risk. The money market hedge is one way to protect against
currency fluctuations without using the futures market or entering into
a forward contract.

7. RISK MANAGEMENT
Definition:-
Risk is about uncertainty. If we put a framework around the uncertainty, then
we effectively de-risk our risk. The process whereby the company (or a
broker, institution, stock exchange, etc..) laid down of how its risk should be
managed is called as Risk management. In other words, the process of
identifying, analyzing and acceptance of uncertainty in investment decisions
is known as Risk management. For example, Risk management occurs when
an investor buys low-risk government bonds over more risky of corporate
bonds. An individuals or an entity may use risk assumption, risk avoidance,
risk retention, risk transfer, or any other strategy or combination of strategies
in process of Risk management of future events. A derivative exchange faces
the legal risk, operational risk and liquidity risk.

Steps in Risk management process:-

The process of risk management will include in the below steps:-
(i) Identifying the risk
(ii) Understand and analyze the nature of risk.
(iii) Evaluate the risk whether the risk is acceptable or not and rank the risk
(iv) Deciding how much risk is acceptable (i.e. deciding how much credit
should be given to each client).
(v) Treat the risk or response the risk planning
(vi) Controlling risk on continuous basis (i.e. frequency of collection of
margins)
(vii) Monitor and review the risk

Types of Risks:-
The most common types of risk are as under:-

Legal risk:-
Legal risk arises out of legal constraints (i.e. lawsuits). A situation that a
company needs to face financial losses out of legal proceedings is known as
Legal risk.

Business risk:-
Business risk will take by the business enterprises in order to maximize the
shareholder value and profits. For example, Companies undertake high cost
of risks in marketing to launch new product in order to gain high volume of
sales.

Non-Business risk:-
Non-business risk is not under the control of firms. The risk that arise out of
political and economic imbalances is known as Non-business risk.

Financial risk:-
Financial risk is the risk that involves financial loss to the firms. Generally,
the financial risk arises due to instability and losses in the financial market
caused by movements (i.e. fluctuations) in stock prices, currencies, interest
rates and commodities etc. The Financial risk is sub divided in to the below
risks:-

(i) Market risk (Systematic risk):-

Market risk is also known as systematic risk. Market risk arises due to
movement (i.e. fluctuations) in prices of financial instrument (i.e. shares or
bonds. etc..). Market risk can be classified as Directional Risk and Non-
directional Risk. Directional risk is caused due to movement in stock price,
interest rates and more. Non-directional risk is can be volatility risk.

(ii) Credit risk:-

Credit risk arises when one fails to fulfill their credit (or obligation) to their
counter party. Credit risk can be classified into Sovereign risk and Settlement
risk. Sovereign risk usually arises due to difficulties in foreign exchange
policies. Settlement risk arises when one party makes the payment while the
other party fails to fulfill their payment or obligation.

(iii) Liquidity risk:-

Liquidity risk can be caused by sale of large number of shares which reduce
the level or strength of the risk in price significantly. Liquidity risk arises out
of inability to execute the transactions. Liquidity risk can be classified
into Asset Liquidity risk and Funding Liquidity risk. Asset Liquidity risk
arises either due to insufficient buyers or insufficient sellers against sell
orders or purchase orders respectively.

(iv) Operational risk:-

Operational risks include losses due to inadequate contingency planning.
Operational risk arises out of operational failures i.e. mismanagement or
technical failures. Operational risk can be classified into Fraud
risk and Model risk. Fraud risk arises due to lack of controls and Model risk
arises due to incorrect model application.
The below image show the various types of risks in summary.

8. GLOBAL INVESTMENT MANAGEMENT

Global Investment management is the professional asset management of
various securities such as shares, bonds, other securities and other assets in
order to meet specified investment goals for the benefit of the global
investors. Here, investors may be institutions such as insurance companies,
pension funds, corporations, charities, educational establishments etc. or
private investors.

RISKS IN INTERNATIONAL (GLOBAL) INVESTING:-

The risks which become more pronounced in international investing are as
below:-

(i) Currency risk:-

The international investors have to face currency risk because of the
exchange rates can change over time. For example, An Indian investor who
invests in the U.S equities will have to bear the risk of U.S dollar declining
against the Indian rupee.

(ii) Liquidity risk:-

Liquidity risk can be caused by sale of large number of shares which reduce
the level or strength of the risk in price significantly. Liquidity risk arises out
of inability to execute the transactions. Liquidity risk is the risk of not being
able to sell our stock quickly enough once a sale order is entered. Typically,
there is no way for the average investor to protect themselves from liquidity
risk. Therefore, investors should pay particular attention to foreign
investments which are become illiquid when they want to close their position.

(iii) Higher Transaction Costs:-

The biggest barrier to investing in foreign markets is the transaction costs.
The transaction costs can vary depending on which foreign country (market)
we are investing in. The brokerage commissions are always higher in
international markets than domestic markets. Moreover, there are additional
charges i.e. Stamp duty, Trading fee, Transaction levy, exchange fee etc. are
levied on brokerage commission based on the respective country.

(iv) Market volatility:-

Generally, the emerging markets are more volatile than developed markets.
So that the foreign investors who have exposure to emerging markets are
have to bear higher market volatility.

(v) Political risk:-

Many national markets especially emerging markets are unsafe (unprotected)
to the political risk because that may arise from seizure of power, political
execution, social unrest, etc. This can lead to an unexpected change in the
government policies toward foreign investors. In the maximum cases, it may
result in dispossessing of the assets owned by the foreign investors.

(vi) Custody risk:-

In most of the countries, the domestic investors enjoy a certain degree of
protection against frauds, bankruptcies and broker misdeeds. This protection
may not be available to global investors. When we invest in foreign markets,
we may be exposed to such type of risks. So, we must understand the
investment protection rules and regulations in respective country where we
propose to invest to ascertain the custodial risk involved.

(vii) Market risk:-

Geopolitical and socio-economic factors in each country or region can
influence the investor’s fund performance.
(Viii) Currency risk:-
Even though Indian investor’s investment is in Indian rupees, the underlying
exposure is in foreign currency assets. Fluctuations in exchange rate can
boost or hurt the fund returns of the investors.

BENEFITS OF GLOBAL INVESTING:-

(i) Portfolio diversification of Funds:-
The benefit of ‘Diversification of funds’ will give the opportunity to foreign
investors from economic fluctuations. For example, if our money is spread
out among various nations, then an economic crash occurs in one country,
will not affect other investment(s). The benefit of Portfolio diversification of
Funds gives the foreign investors an opportunity to engage in international
portfolio diversification of assets which helps to achieve a higher risk-
adjusted return. The most popular forms of global investments are Mutual
funds, exchange traded funds (ETFs) and American depository receipts
(ADRs).

(ii) Reduction in Taxes:-

Most of the countries in the world offer attractive tax incentives to foreign
investors for strengthen other country’s investing environment and to attract
the outside wealth.

(iii) Exchange rate fluctuation:-

International currency exchange rates are keeping change. Sometimes, the
currency of the investor's home country may be increase and sometimes it
may be decrease. When the currency exchange rate of home country has
increased against foreign currency, then the investor has a portfolio
diversification may benefit to the investor.

Why Global investment:-

As investors are investing in different countries, the investors are insulated
against intermittent dips and shocks in the domestic market and also the
investors benefit from some of the fastest-growing markets in the world.

Where to invest:-
Global investing can be a tricky endeavor from language barriers and
currency conversions to foreign exchanges and regulations. But at the same
time, most financial advisors recommend that holding at least some foreign
stocks in a diversified portfolio. Fortunately, there are several easy ways to
invest in foreign markets without picking up a new language or exchanging
dollars for euros or other currencies.

(i) Currency (Exchange rate) rate volatility:-

When the investors invest in an international fund, the currency of investment
is in a respective foreign country’s currency. Hence, how the fund performs
depends not only on the stocks in its portfolio but also on how the investor
home country’s currency fares against that foreign currency. If the home
country’s currency depreciates, the foreign investment of fund will do well,
but it will lose out if the home country’s currency appreciates against foreign
currency.

(ii) Geographic Diversification:-

Geographic diversification is a good idea and investing in international funds
should be a strategic call irrespective of whether those markets are doing well
at a particular point. While a lot of factors that influence a country's economy
are beyond the investors' control, what the investors can control are their
investment goals and portfolio allocation globally. Equity fund portfolios
should be diversified across geographies, like they are across market
capitalization and sectors.

(iii) ETFs and Mutual Funds:-

The easiest and most common way to invest in foreign markets is by
purchasing ETFs or Mutual funds (MFs) that hold a basket of international
stocks and bonds. With foreign holdings across multiple industries and
countries, these ETFs and MFs provide investors with a quick and highly-
diversified foreign component to their portfolio in just one easy transaction.
Investors can also choose between many different types of mutual funds or
ETFs including:-
International Funds invest broadly across many countries outside of the
U.S.
Regional Funds invest in specific regions, like Europe, Asia or the Middle
East.
Country Funds invest in specific countries, like Spain or Russia or Japan,
etc.
Sector Funds invest in particular sectors across multiple countries, like gold
or energy.
Close-ended Mutual funds are selling at a significant discount.

(iv) Foreign Stocks Hassle-Free with ADRs:-

A convenient way of investing in major multinational companies is the
investors can easily purchase many individual foreign stocks using American
Depository Receipts (ADRs) which are U.S.-traded securities that represent
ownership in the shares of foreign companies. Since they are denominated in
dollars and traded on the NYSE, NASDAQ or AMEX. The ADRs do not
require any complex currency conversion or foreign exchange transactions.

Limitation of ADRs:-
Unfortunately, there are many foreign stocks that are not available as ADRs
and must be purchased on foreign exchanges such as the Toronto Stock
Exchange (TSE) in Canada or the London Stock Exchange (LSE) in Europe,
but some international brokerages offer a cheap way to purchase these stocks.
It should be noted that while buying and selling of ADRs occurs in U.S.
dollars, any dividends issued will be denominated in the foreign currency and
then converted into U.S. dollars upon distribution. As a result, there may be
some currency exchange rate risk involved in those situations.

(v) Non-Preferential Taxation:-

Despite being domestic equity-oriented mutual funds, international funds are
treated as debt funds for tax purposes. Long-term gains on investments held
for more than a year are not tax-free for domestic countries like India. For
international funds, long-term is defined as three years or more. While short-
term gains will be added to investor’s income, long-term gains will be taxed
at 10% without indexation or 20% with indexation. Hence, Indian investors
should ideally invest in international funds with a three-year view.

Factors influencing Global Investment decisions:-

Investors tend to a number of factors relating to how they will be able to
operate in a foreign country:-
(i)Rules and regulations pertaining to the entry and operations of foreign
investors,
(ii) Standards of treatment of foreign affiliates, compared to “nationals” of
the host country,
(iii) Functioning and efficiency of local markets,
(iv) Trade policy and Privatization policy,
(v) Business facilitation measures such as investment promotion, incentives,
improvements in amenities and other measures to reduce the cost of doing
business. For example, some countries set up special export processing zones
which may be free of customs or duties or offer special tax breaks for new
investors,
(vi) Restrictions if any, on bringing home (i.e. Re-Patriating) earnings or
profits in the form of dividends, royalties, interest or other payments,
(vii) National economic growth rates,
(viii) Exchange rate stability,
(ix) General macroeconomic stability,
(x) Levels of foreign exchange reserves held by the central bank,
(xi) General health of the foreign banking system,
(xii) Liquidity of the stock and bond market,
(xiii) Interest rates,
(xiv) The ease of repatriating dividends and capital,
(xv) Taxes on capital gains,
(xvi) Regulation of the stock and bond markets,
(xvii) Speed and reliability of dispute settlement systems,
(xviii) Degree of protection of investor’s rights,
(xix) The Volatility, Yield, Quality, Size and value of the global stock.

Taxation:-
All international funds are treated as non-equity funds under taxation rules.
Gains from international funds are taxed at the marginal rate if sold within 3
years from data of purchase. Gains realized from sale after 3 years are
eligible for indexation benefits in the year of sale (20% with indexation and
10% without indexation).

9. INTERNATIONAL MONETARY SYSTEM (IMS)

Introduction:-
A monetary system is the set of institutions by which a government provides
the money in a country's economy. Modern monetary systems usually consist
of the national treasury, the mint, the central banks and the commercial
banks. International monetary system is a set of internationally agreed rules,
conventions and supporting institutions that facilitate International trade,
Cross border investment and Reallocation of capital between nations.
International monetary system refers to the system prevailing in foreign
exchange market through which international trade and capital movements
are financed and exchange rates are determined. The International Monetary
System is a part of the institutional framework that binds national economies
such as a system permits producers to specialize in those goods for which
they have a comparative advantage and serves to seek profitable investment
opportunities on a global basis.

Global trade depends on the smooth exchange of currencies between

countries. Businesses rely on a predictable and stable mechanism.

Features of IMS:-
(i) Stability in foreign exchange.
(ii) Promoting Balance of Payments adjustments to prevent disruptions
associated with temporary or
chronic imbalance.
(iii) Providing countries with sufficient liquidity to finance temporary balance
of payments deficits.

Stages in International Monetary System:-

Classic Gold Standard (1816 – 1914)
Interwar Period (1918 – 1939)
Bretton Woods System (1945 – 1971)
Present International Monetary System (Since 1971)

The “Gold Standard” theory (1816 – 1914):-

Introduction:-
On 22nd June 1816, Great Britain declared the gold currency as official
national currency as per Lord Liverpool’s Act. On 1st May 1821, the
convertibility of Pound Sterling into gold was legally guaranteed. Other
countries pegged their currencies to the British Pound which made it a
reserve currency. This happened when the British more dominated
international finance and the trade relations. At the end of the 19th century,
the Pound was used for two third of world trade and most foreign exchange
reserves were held in this currency. Between 1810 and 1833 the United States
had de facto the silver standard. As per Coinage Act of 1834, the government
set the gold-silver exchange rate to 16:1 which implemented a de facto gold
standard. In 1879, the United States set the gold price to USD 20.67 and
returned to the gold standard. With the “Gold Standard Act” of 1900, gold
became an official instrument of payment. From the 1870s to the outbreak of
World War I in 1914, the world benefited from well integrated financial
order, sometimes known as the First age of Globalization. Money unions
were operating which effectively allowed members to accept each other
currency as legal tender including the Latin Monetary Union and
Scandinavian monetary union• In the absence of shared membership of a
union, transactions were facilitated by widespread participation in the gold
standard, by both independent nations and their colonies

Rules of Gold standard system:-

(i) Each country defined the value of its currency in terms of gold.
(ii) Exchange rate between any two currencies was calculated as X currency
per ounce of gold/ Y currency per ounce of gold.
(iii) These exchange rates were set by arbitrage depending on the
transportation costs of gold.
(iv) Central banks are restricted in not being able to issue more currency than
gold reserves.

The Advantages of the Gold Standard:-

(i) The gold standard dramatically reduced the risk in exchange rates because
it established fixed exchange rates between currencies. Any fluctuations were
relatively small. This made it easier for global companies to manage costs
and pricing. International trade grew throughout the world, although
economists are not always in agreement as to whether the gold standard was
an essential part of that trend.

(ii) The countries were forced to observe strict monetary policies. They could
not just print money to combat economic downturns. One of the key features
of the gold standard was that a currency had to actually have in reserve
enough gold to convert all of its currency being held by anyone into gold.
Therefore, the volume of paper currency could not exceed the gold reserves.
(iii) The gold standard would help a country correct its trade imbalance. For
example, if a country was importing more than it is exporting, (called a trade
deficit), then under the gold standard the country had to pay for the imports
with gold. The government of the country would have to reduce the amount
of paper currency, because there could not be more currency in circulation
than its gold reserves. With less money floating around, people would have
less money to spend (thus causing a decrease in demand) and prices would
also eventually decrease. As a result, with cheaper goods and services to
offer, companies from the country could export more, changing the
international trade balance gradually back to being in balance.

For these three primary reasons and as a result of the 2008 global financial
crises, some modern economists are calling for the return of the gold standard
or a similar system.

Arguments against Gold Standard:-

(i) The growth of output and the growth of gold supplies needs to be closely
linked. For example, if the supply of gold increased faster than the supply of
goods did, there would be inflationary pressure. Conversely, if output
increased faster than supplies of gold did, there would be deflationary
pressure.

(ii) Volatility in the supply of gold could cause adverse shocks to the
economy. The rapid changes in the supply of gold would cause rapid changes
in the supply of money and cause wild fluctuations in prices that could prove
quite disruptive.
(iii) Price Stability which means by tying the money supply to the supply of
gold, central banks are unable to expand the money supply.

(iv) Facilitate the Balance of Payments adjustment automatically i.e. basic

idea is that a country that runs a current account deficit needs to export
money (gold) to the countries that run a surplus. The surplus of gold reduces
the deficit country’s money supply and increases the surplus country’s money
supply.

The “Bretton woods” theory (1945-1971):-

Introduction:-
Bretton Woods is a little town in New Hampshire which is most famous for
good skiing. British and American policy makers began to plan the post war
international monetary system in the early 1940s with objective to create an
order that combined benefits of an integrated and relatively liberal
international system with freedom for governments to pursue domestic
policies which aimed at promoting full employment and social wellbeing. In
July 1944, the International Monetary and Financial Conference organized by
the U.N attempted to put together an international financial system that
eliminated the chaos of the inter-war years. The terms of the agreement were
negotiated by 44 nations led by the U.S and Britain. The main hope of
creating a new financial system was to stabilize exchange rates, provide
capital for reconstruction from the war and foment international cooperation.

The Bretton Woods system established a new monetary system based on the
US dollar. This system incorporated some of the disciplinary advantages of
the gold system while giving countries the flexibility they needed to manage
temporary economic setbacks, which had led to the fall of the gold standard.

Features of Bretton Woods System:-

The features of the Bretton Woods system can be described as a “gold-
exchange” standard rather than a “gold-standard”. The key difference was
that the dollar was the only currency that was backed by and convertible into
gold. The rate initially was $35 per an ounce of gold. Other countries would
have an “adjustable peg” basically they were exchangeable at a fixed rate
against the dollar, although the rate could be readjusted at certain times under
certain conditions. Each country was allowed to have a 1% band around
which their currency was allowed to fluctuate around the fixed rate. Except
on the rare occasions when the par value was allowed to be readjusted,
countries would have to intervene to ensure that the currency stayed in the
required band.

Creation of International Monetary Fund (IMF) and the World Bank:-

Both the IMF and the World Bank have survived the collapse of the Bretton
Woods Agreement. In essence, the IMF’s initial primary purpose was to help
manage the fixed rate exchange system. It eventually evolved to help
governments correct temporary trade imbalances (typically deficits) with
loans. The World Bank’s purpose was to help with post–World War II
European reconstruction. Both institutions continue to serve these roles but
have evolved into broader institutions that serve essential global purposes,
even though the system that created them is long gone. The IMF was created
with the specific goal of being the multilateral body that monitored the
implementation of the Bretton Woods agreement. Its role was to hold gold
reserves and currency reserves that were contributed by the member countries
and then lend this money out to other nations that had difficulty meeting their
obligations under the agreement.

Currencies had to be convertible:-

Central banks had to exchange domestic currency for dollars upon request.
Although the adjustable exchange rate system meant the countries that could
no longer sustain the fixed exchange rate vis-a-vis the dollar would be
allowed to devalue their currencies, they could only do so with the consent of
the other countries and the auspices of the IMF.

In a world with N currencies there are only N-1 exchange rates against the
reserve currency. If all the countries in the world are fixing their currencies
against the reserve currency and acting to keep the rate fixed, then the reserve
country has no need to intervene. Reserve currency country can use monetary
policy for its own domestic policy purposes while other countries are unable
to use monetary policy for domestic policy purposes. Therefore, a decrease in
the reserve country’s money supply would cause an appreciation of the
reserve currency and force the other central banks to lose external reserves.
So the reserve country can affect both the output in its country as well as
output in other countries through changes in its monetary policy.

While no new formal system has replaced Bretton Woods, some of its key
elements have endured, including a modified managed float of foreign
exchange, the International Monetary Fund (IMF), and the World Bank—
although each has evolved to meet changing world conditions.

International Monetary Fund (IMF):-

History of IMF:-
The architects of the Bretton Woods Agreement, John Maynard Keynes and
Harry Dexter White, envisioned an institution that would oversee the
international monetary system, exchange rates, and international payments to
enable countries and their citizens to buy goods and services from each other.
They expected that this new global entity would ensure exchange rate
stability and encourage its member countries to eliminate the exchange
restrictions that hindered trade. Officially, the IMF came into existence in
December 1945 with twenty-nine member countries. In 1947, the institution’s
first formal year of operations, the French became the first nation to borrow
from the IMF. Over the next thirty years, more countries joined the IMF,
including some African countries in the 1960s. The Soviet bloc nations
remained the exception and were not part of the IMF until the fall of the
Berlin Wall in 1989. The IMF experienced another large increase in members
in the 1990s with the addition of Russia. Russia was also placed on the IMF’s
executive committee. Today, 187 countries are members of the IMF and 24
of those countries or groups of countries are represented on the executive
board.

Purpose of the IMF:-

(i) To promote international monetary cooperation through a permanent
institution which provide the machinery for consultation and collaboration on
international monetary problems.

(ii) To facilitate the expansion and balanced growth of international trade and
to contribute thereby to the promotion and maintenance of high levels of
employment and real income and to the development of the productive
resources of all members as primary objectives of economic policy.

(iii) To promote exchange stability to maintain orderly exchange

arrangements among members and to avoid competitive exchange
depreciation.

(iv) To assist in the establishment of a multilateral system of payments in

respect of current transactions between members and in the elimination of
foreign exchange restrictions which hamper the growth of World trade.

(v) To give confidence to the members by making the general resources of

the Fund temporarily available to them under adequate safeguards, thus
providing them with opportunity to correct maladjustments in their balance of
payments without resorting to measures destructive of national or
international prosperity.

(vi) To shorten the duration and lessen the degree of disequilibrium in the
international Balance of Payments of members.

Special Drawing Rights (SDRs):-

A Special Drawing Right (SDR) is basically an international monetary
reserve asset. SDRs were created in 1969 by the IMF in response to the
‘Triffin Paradox’. The Triffin Paradox stated that the more US dollars were
used as a base reserve currency, the less faith that countries had in the ability
of the US government to convert those dollars to gold. The world was still
using the Bretton Woods system and the initial expectation was that SDRs
would replace the US dollar as the global monetary reserve currency and thus
solving the Triffin Paradox. Bretton Woods collapsed a few years later, but
the concept of an SDR solidified. Today the value of an SDR consists of the
value of 4 of the IMF’s biggest members’ currencies i.e. the US Dollar, the
euro, the Japanese yen and the British pound as below:-

Currency Weightage
US
44%
Dollar
Euro 34%
Japanese
11%
yen
British
11%
pound

The above currencies do not hold equal weight. SDRs are quoted in terms of
US dollars. The basket or group of currencies reviewed every 5 years by the
IMF executive board based on the currency’s role in international trade and
finance. The SDR is not a currency, but some refer to it as a form of IMF
currency. It does not constitute a claim on the IMF which only serves to
provide a mechanism for buying, selling and exchanging SDRs. Countries are
allocated SDRs which are included in the member country’s reserves. SDRs
can be exchanged between countries along with currencies. The SDR serves
as the unit of account of the IMF and some other international organizations,
and countries borrow from the IMF in SDRs in times of economic need.

Roles of the IMF:-

(i) To promote international monetary co-operation.
(ii) To facilitate the expansion and balanced growth of international trade.
(iii) To promote exchange stability.
(iv) To assist in the establishment of a multilateral system of payments.
(v) To give confidence to members by making the IMF’s general resources
temporarily available to them under adequate safeguards.
(vi) To shorten the duration and lessen the degree of disequilibrium in the
international balances of payments of members.

Criticism and Challenging Areas for the IMF:-

The IMF supports many developing nations by helping them to overcome
monetary challenges and to maintain a stable international financial system.
Despite this clearly defined purpose, the execution of its work can be very
complicated and can have wide repercussions for the recipient nations. As a
result, the IMF has both its critics and its supporters. The IMF has been
subject to a range of criticisms that are generally focused on the conditions of
its loans, its lack of accountability, and its willingness to lend to countries
with bad human rights records. These criticisms include the following:-

1. Conditions for loans:-

The IMF makes the loan given to countries on conditional based on the
implementation of certain economic policies which typically include:-
(i) Reducing government borrowing (higher taxes and lower spending,
(ii) Higher interest rates to stabilize the currency,
(iii) Allowing failing firms to go bankruptcy,
(iv) Structural adjustment (privatization, deregulation, reducing corruption
and bureaucracy).

2. Exchange rate reforms:-

When the IMF intervened in Kenya in the 1990s, they made the Central bank
to remove controls over flows of capital. The consensus was that this decision
made it easier for corrupt politicians to transfer money out of the economy
which is known as the Goldman scandal. Critics argue that this is another
example of how the IMF failed to understand the dynamics of the country
that they were dealing with - insisting on blanket reforms.

3. Devaluations:-
In the initial stages, the IMF has been criticized for allowing inflationary
devaluations.

4. Free-market criticisms of the IMF:-

Believers in free markets argue that it is better to let capital markets operate
without attempts at intervention. They argue that attempts to influence
exchange rates only make things worse. It is better to allow currencies to
reach of their market level. They also assert that bailing out countries with
large debts is morally hazardous. Countries know that there is always a
bailout provision will borrow and spend more recklessly.

5. Lack of transparency and involvement:-

The IMF has been criticized for imposing policy with little or no consultation
with affected countries.

6. Supporting military dictatorships:-

The IMF has been criticized over the decades for supporting military
dictatorships.

Opportunities and Strengths of the IMF:-

The strengths and opportunities of IMF include the following:-

1. Flexibility and speed:-

In March 2009, the IMF created the Flexible Credit Line (FCL) which is a
fast-disbursing loan facility with low conditionality aimed at re-assuring
investors by injecting liquidity. Traditionally, IMF loan programs require the
imposition of austerity measures such as raising interest rates that can reduce
foreign investment. In the case of the FCL, countries qualify for it not on the
basis of their promises, but on the basis of their history. Just as individual
borrowers with good credit histories are eligible for loans at lower interest
rates than their risky counterparts, similarly, countries with sound macro-
economic fundamentals are eligible for drawings under the FCL. A similar
program has been proposed for low-income countries known as the Rapid
Credit Facility. It is front-loaded (allowing for a single up-front payout as
with the FCL) and is also intended to have low conditionality.

2. Cheerleading:-
The Fund is positioning itself to be less of an adversary and more of a
cheerleader to member countries. For some countries that need loans more for
re-assurance than reform. These changes to the Fund tool kit are welcome.

3. Adaptability:-
Instead of providing the same medicine to all countries regardless of their
particular problems, the new loan facilities are intended to aid reform-minded
governments by providing short-term resources to re-assure the investors. In
this manner, they help politicians in developing countries to manage the
downside costs of integration.

4. Transparency:-
The IMF has made efforts to improve its own transparency and continues to
encourage its member countries to do so. Supporters note that this creates a
barrier to any one or more countries that have more geo-political influence in
the organization. In reality, the major economies continue to exert influence
on policy and implementation.

The World Bank and its group:-

Introduction:-
The World Bank consists of two main bodies. They are IBRD and the
International Development Association (IDA). The World Bank Group
includes the following inter-related institutions :-

(i) The International Bank for Reconstruction and Development (IBRD)

which provides loans to the countries with purpose of building economies
and reduce poverty. IDA which typically provides interest-free loans to
countries with sovereign guarantees

(ii) International Finance Corporation (IFC) which provides loans, equity,

risk-management tools and structured finance with the goal of facilitating
sustainable development by improving investments in the private sector

(iii) Multilateral Investment Guarantee Agency (MIGA) which focuses on

improving the foreign direct investment of the developing countries

(iv) International Centre for Settlement of Investment Disputes (ICSID)

which provides a means for dispute resolution between governments and
private investors with the end goal of enhancing the flow of capital.

The World Bank provides low-interest loans, interest-free credits, and grants
to developing countries. There is always a government (or “sovereign”)
guarantee of repayment subject to general conditions. The World Bank is
directed to make loans for projects but never to fund a trade deficit. These
loans must have a reasonable likelihood of being re-paid. The IDA was
created to offer an alternative loan option. IDA loans are free of interest and
offered for several decades with a 10-year grace period before the country
receiving the loan needs to begin the repayment. These loans are often
called soft loans.

Focus of the World Bank:-

The current primary focus of the World Bank centers on the below 6 strategic
themes:-
1. The poorest countries i.e. poverty reduction and sustainable growth in the
poorest countries, especially in Africa.

2. Post conflict and fragile states i.e. solutions to the special challenges of
post conflict countries and fragile states.

3. Middle-income countries i.e. development solutions with customized

services as well as financing for middle-income countries.

4. Global public goods i.e. addressing regional and global issues that cross
national borders such as climate change, infectious diseases and trade.

5. The Arab world i.e. greater development and opportunity in the Arab
world.

6. Knowledge and learning i.e. leveraging the best global knowledge to

support development.
Criticism of World bank:-
The World Bank is criticized primarily for the following reasons:-

(i) Administrative incompetence:-

The World Bank and its lending practices are increasingly scrutinized with
critics asserting that the World Bank has shifted from being a ‘lender of last
resort’ to an international welfare organization resulting in an institution that
is bloated, incompetent and even corrupt and also incriminating is that the
bank’s lax lending standards have led to a rapidly deteriorating loan portfolio.

(ii) Rewarding or supporting inefficient or corrupt countries:-

The bank’s lending policies often reward macro-economic inefficiency in the
underdeveloped world. It is allowing inefficient nations to avoid the types of
fundamental reforms that would in the long run end poverty in their
countries.

Opportunities and Future Outlook for the World Bank:-

The World Bank is praised by many for engaging in development projects in
remote locations around the globe to improve living standards and reduce
poverty. The World Bank is focused on the following 4 key issues:-
(i) Increased transparency among developing countries,
(ii) Expanding social issues in the fight on poverty,
(iii) Improvements in country’s competitiveness and increasing the exports,
(iv) Improving efficiencies in diverse industries and leveraging the private
sector.

The World Bank continues to play an integral role in helping countries by

reduce poverty and improve the well-being of their citizens. World Bank
funding provides a resource to countries to utilize the services of global
companies to accomplish their objectives.

10. EXCHANGE RATE MECHANISM (REGIME)

Exchange rate can be understood as the price of one currency in terms of
another currency. Regime means authority or reign or system of government.
An exchange rate regime is the system that a country's monetary authority i.e.
generally the central bank of the nation. The central bank adopts the system
to manage its currency in relation to other currencies and the FOREX market.
It is closely related to monetary policy.

Types of Exchange rate Regimes:-

1. Fixed Exchange rate:-

A fixed exchange rate denotes a nominal exchange rate that is set firmly by
the monetary authority with respect to a foreign currency or a basket of
foreign currencies. Typically, a government wants to maintain a fixed
exchange rate does so by either buying or selling its own currency on the
open market. This is the reason for governments maintain reserves of foreign
currencies. a fixed exchange rate which ties the currency to another currency,
mostly reserve currencies such as the USD or the EURO or a basket of
currencies.

2. Floating Exchange rate:-

A floating (flexible) exchange rate is determined in foreign exchange markets
depending on demand and supply and it generally fluctuates constantly. The
economy dictates the movements in the exchange rate. In the modern world,
most of the currencies are floating and such currencies include the
most widely traded currencies i.e. the USD, INR, EURO, GBP, AUD and
YEN etc. A central bank keeps the rate from deviating too far from a target
band or value.

3. Pegged Float:-
Here, Pegged means a fixed price (or rate or amount) at a particular level.
Pegged floating currencies are pegged to some band or value either fixed or
periodically adjusted. For example, During the1960’s, the United States
pegged the dollar to gold ($35.00 was equal to one ounce of gold) and most
other countries had pegged their currencies to the dollar i.e. the German Mark
was fixed at 4 marks equal to one dollar for much during this time. Then the
U.S. government would buy or sell gold at $35.00 per ounce to foreign
governments on demand. In this case, the German government would buy
and sell dollars at a price of 4 marks per dollar.

4. Currency board:-
A currency board is an exchange rate regime based on the full convertibility
of a local currency into a reserve one by a fixed exchange rate and 100%
coverage of the monetary supply backed up with foreign currency reserves.
Therefore, in the currency board system, there can be no fiduciary issuing of
money. As defined by the IMF, a currency board agreement is “a monetary
regime based on an explicit legislative commitment to exchange domestic
currency for a specific foreign currency at a fixed exchange rate. The
advantages of using a currency board include low inflation economic
credibility, and lower interest rates. Examples include the Bulgarian LEV
against the Euro or the Hong Kong dollar against the U.S. dollar.

5. Crawling peg:-
A crawling peg is an exchange rate system mainly defined by two
characteristics i.e. a fixed par value of the currency which is frequently
revised and adjusted due to market factors such as inflation, and a band of
rates within which it is allowed to fluctuate. As defined by the IMF, in
crawling pegs, “the currency is adjusted periodically in small amounts at a
fixed rate or in response to changes in selective quantitative indicators such
as past inflation differentials vis-à-vis major trading partners, differentials
between inflation target and expected inflation in major trading partners”.
The crawling rate can be set in a backward-looking manner (adjusting
depending on inflation or other indicators) or in a forward-looking manner
(adjusting depending on preannounced fixed rate and/or the projected
inflation). It must be noted that maintaining a crawling peg limits monitory
policy making to a similar degree than for target zone arrangements. These
characteristics allow for progressive devaluation of the currency which has a
less traumatic effect in the country’s economy. Furthermore, this technique
helps prevent, or at least soften, speculation over the currency. For these
reasons, this type of exchange rate system is most commonly used with
“weak” currencies. Latin American countries are known for being prone to
use the crawling peg exchange system against the United States dollar, where
in some cases devaluation can be seen occurring on a daily basis.

6. Target zone arrangement:-

A target zone arrangement is an agreed exchange rate system in which certain
countries pledge to maintain their currency exchange rate within a specific
fluctuation margin or band. This margins can be set vis-à-vis another
currency, a cooperative arrangement (such as the ERMII) or a basket of
currencies. The spread of this margin can however vary, giving way to the
below 2 different versions :-

Strong version:-
This is also known as conventional fixed peg arrangements. The exchange
rate fluctuates within margins of ± 1% or less and is revised quite
infrequently. The monetary authority can maintain the exchange rate within
margins through direct intervention (for instance, purchasing and selling
domestic and foreign currency in the market) or through indirect intervention
(for instance influencing on interest rates). The flexibility of monetary
policy is larger than for exchange arrangements with no separate legal
tender.

Weak version:-
This is also known as pegged exchange rates within horizontal bands. In this
case, the exchange rate fluctuates more than ±1% around the fixed central
rate. Here, there is a limited degree of monetary policy discretion. Target
zone arrangements can be seen as being half way between fixed and flexible
exchange rates. This kind of exchange rate system therefore allows for
relatively stable trading conditions to prevail between countries and at the
same time allows some fluctuation in foreign exchange rates depending on
relative economic conditions and trade flows.

7. Managed (dirty) float:-

A managed or dirty float is a flexible exchange rate system in which the
government or the country’s central bank may occasionally intervene in order
to direct the country’s currency value into a certain direction. This is
generally done in order to act as a buffer against economic shocks and hence
soften its effect in the economy.

A managed float is halfway between a fixed exchange rate and a flexible one
as a country can obtain the benefits of a free floating system but still has the
option to intervene and minimize the risks associated with a free floating
currency. For example, if a currency’s value increases or decreases too
rapidly, the central bank may decide to intervene in order to minimize any
harmful effects that might result from the otherwise radical fluctuation. This
is especially the case when international trade might be affected. The central
banks might act to counter a large appreciation of their currency in order to
maintain net exports. For instance, in 1994, the American government
decided to buy large amounts of Mexican pesos with the objective of
stopping the rapid loss in value of the PESO, so to keep the trade status quo.
Even though most developed countries use a flexible exchange rate regime,
in truth, they all use it to a limit. In fact, since most countries intervene in
foreign exchange markets to some extent from time to time, these can be
considered managed floating systems. The International Monetary System
which oversees the correct functioning of the international monetary system
and monitors its member’s financial and economic policies “allows” for
exchange rate intervention when there are clear signs of risk to any of its
member’s economy.

8. Free (clean) float:-

A free float exchange rate sometimes referred to as clean or pure float which
is a flexible exchange rate system solely determined by market forces
of demand and supply of foreign and domestic currency, and
where government intervention is totally inexistent. Clean floats are a result
of laissez-faire or free market economics.

Clean float is theoretically the best way to go. It allows countries to retain
their monetary independence which basically means they can focus on the
internal aspects of their economy and control inflation and
unemployment without worrying about external aspects. However, we must
take into consideration external shocks such as oil price rises or capital flights
which can make it impossible to maintain a purely clean floating exchange
rate system.

In reality, almost none of the currencies of developed countries have a clean

float, as they all have some degree of support from their corresponding
central bank, and so have a managed float.

Trends in exchange rate regimes:-

1973-1985 - Many abandoned fixed exchange rates.
1986-1994 - Exchange rate based stabilization programs.
1990-2000 - Corners Hypothesis i.e. countries move to either hard peg or free
float.
Since 2001 - The rise of the “managed float” category.
Who determine the exchange rate:-
If a currency is floating system, its exchange rate is allowed to vary against
that of other currencies and is determined by the market forces of demand
and supply. Exchange rates for such currencies are likely to change
constantly as quoted on financial markets mainly by banks around the world.
In contrast with the floating system, the fixed exchange rate system is
artificially maintained fixed by the government. The way they do it is
pegging the local currency to a foreign currency (i.e. USD) and compensate
the demand and supply in order to keep the exchange rate fixed. For example,
the Chinese Yuan (CHY), when the local demand of USD increased the
government had to release US Dollar into the market in order to mitigate the
fluctuation.

Who determine the Exchange rates

Type of system Determined by
Fixed Exchange rate
Domestic Government
system
Floating Exchange rate Demand and supply of
system market forces

Determination of Exchange rates or Factors influencing currency

fluctuations:-
Overview:-
The exchange rate is defined as the rate at which one country's currency may
be converted into another. It may fluctuate daily with the changing market
forces demand and supply of currencies from one country to another. Most of
the world's currencies are bought and sold based on floating exchange rates
i.e. their prices fluctuate based on the demand and supply in the foreign
exchange market. A high demand for a currency or a shortage in its supply
will cause an increase in price. For example, higher interest rates attract
foreign capital and cause the exchange rate to rise. The impact of higher
interest rates is mitigated. However, if inflation in the country is much higher
than in others or if additional factors serve to drive the currency down. A
weaker domestic currency stimulates exports and makes imports more
expensive. Conversely, a strong domestic currency hampers exports and
makes imports cheaper. A strong currency makes a country's exports more
expensive i.e. hurting the country's trade competitiveness. Conversely,
a weak currency makes imports more expensive which causes to boosting
domestic inflation.

The key factors or determinants that influencing foreign exchange rates as

under:-

1. Interest Rates differential:-

Changes in interest rate affect currency value and dollar exchange rate.
FOREX rates, interest rates and inflation are all correlated. Increases in
interest rates cause a country's currency to appreciate because higher interest
rates provide higher rates to lenders thereby attracting more foreign capital
which causes a rise in exchange rates.

2. Inflation Rates differential:-

Changes in market inflation cause changes in currency exchange rates. A
country with a lower inflation rate than another country will see an
appreciation in the value of its currency. The prices of goods and services
increase at a slower rate where the inflation is low. A country with a
consistently lower inflation rate exhibits a rising currency value while a
country with higher inflation typically sees depreciation in its currency and is
usually accompanied by higher interest rates.

3. Speculation:-
If a country's currency value is expected to rise, investors will demand more
of that currency in order to make a profit in the near future. As a result, the
value of the currency will rise due to the increase in demand. With this
increase in currency value, a rise in the exchange rate as well.

4. Current Account Deficits:-

A country’s current account or Balance of Payments reflects the balance of
trade and earnings on foreign investment. It consists of total number of
transactions including its exports, imports, debt, etc. A deficit in current
account due to spending more of its currency on importing products than it is
earning through sale of exports causes depreciation in currency. Balance of
payments fluctuates exchange rate of its domestic currency.
5. Political Stability and Economic Performance:-
A country's political and economic performance can affect its currency
strength. A country with less risk for political turmoil is more attractive to
foreign investors. As a result, drawing investment away from other countries
is more political and economic stability. Increase in foreign capital, in turn,
leads to an appreciation in the value of its domestic currency. A country with
sound financial and trade policy does not give any room for uncertainty in
value of its currency. But, a country prone to political confusions may see the
depreciation in exchange rates.

6. Public Debt:-
Government debt is public debt or national debt owned by the central
government. A country with government debt is less likely to acquire foreign
capital is leading to inflation. Foreign investors will sell their bonds in the
open market if the market predicts government debt within a certain country.
As a result, a decrease in the value of its exchange rate will follow.

7. Recession:-
When a country experiences a recession, its interest rates are likely to fall,
decreasing its chances to acquire foreign capital. As a result, its currency
weakens in comparison to that of other countries. Therefore, lower the
exchange rate.

8. Terms of Trade:-
The terms of trade are the ratio of export prices to import prices in relation to
current accounts or Balance of payments. A country's terms of trade improve
if its exports prices rise at a greater rate than its imports prices. This results in
higher revenue which causes a higher demand for the country's currency and
an increase in its currency's value. This results in an appreciation of exchange
rate.

11. BALANCE OF PAYMENTS (BOP)

Definition:-
The balance of payments is the record of all international (foreign) financial
transactions made by a country's residents for the particular period i.e. may
be a quarter, half-year or a year. These transactions are made by individuals,
firms and government bodies. A country's balance of payments tells that
whether it saves enough to pay for its imports or not. It also reveals whether
the country produces enough economic output to pay for its growth or not.

Importance of Balance of Payments:-

The balance of payments divides the transactions in two accounts. They are
the current account and the capital account. Sometimes, the capital account is
called as the financial account. The current account includes transactions in
goods, services, investment income and current transfers. The capital
account includes transactions in financial instruments and central
bank reserves. The current account is included in calculation of national
output while the capital account is not included in calculation of national
output. The sum of all transactions recorded in the balance of payments must
be zero. The reason is that every credit appearing in the current account has a
corresponding debit in the capital account and vice-versa. For example, If a
country exports an item i.e. a current account credit, it effectively imports
foreign capital when that item is paid for i.e. a capital account debit. If a
country cannot fund its imports through exports of capital, it must do so by
running down its reserves. This situation is often referred to as a balance of
payments deficit which simply the meaning is that Capital Account
excludes the central bank reserves. In reality, the broadly defined balance of
payments must add up to zero, but in practice, statistical discrepancies arise
due to the difficulty of accurately counting every transaction between an
economy and the rest of the world.

Components of BOP:-
The balance of payments has 3 components. They are the financial account,
the capital account and the current account. The financial account describes
the change in international ownership of assets. The capital account includes
any financial transactions that don't affect economic output. The current
account measures international trade, the net income on investments and
direct payments.

1. Financial Account:-
The financial account measures the changes in domestic ownership of foreign
assets and foreign ownership of domestic assets. If foreign ownership
increases more than domestic ownership does, it creates a deficit in the
financial account. This means the country is selling off its assets like gold,
commodities and corporate stocks faster than it is acquiring foreign assets.

2. Capital Account:-
The capital account measures financial transactions that don't affect a
country's income, production or savings. For example, it records international
transfers of drilling rights, trademarks and copyrights. Many capital account
transactions happen infrequently such as cross-border insurance payments.
The capital account is the smallest component of the balance of payments.

3. Current account:-
The current account measures a country's trade balance plus the effects of net
income and direct payments. When the activities of a country's people
provide enough income and savings to fund all their purchases, business
activity and government infrastructure spending, then the current account is
in balance.

Trade: Buying and selling of goods and services

Exports: A Credit entry
Imports: A Debit entry

The current account is made up of the following payments:-

(i) Trade in goods:-

These items include the import and export of finished goods such as cars and
computers, semi-finished goods such as parts and components for assembly
and commodities such as oil, tea, coffee, etc.

(ii) Trade in services:-

Trade services include financial services, tourism, and consultancy, etc.

(iii) Income from investment and employment:-

Investment income refers to any income made from investing abroad and
includes profits such as those from business activities of subsidiaries located
abroad, interest received from financial investments and loans abroad and
dividends from owning shares in overseas firms. Payments to individuals
who are residents of a country and are employed in another are also included
in the current account. Investment and employment income are also known as
'primary income'.

(iv)Transfers:-
The final section of the current account includes transfer payments (transfers)
arising from gifts between residents of different countries, donations to
charities abroad and overseas aid. Transfers are also known as 'secondary'
income.

Deficit:-
A balance of payments deficit means the country imports more goods,
services and capital than its exports. It must borrow from other countries to
pay for its imports. In the short-term, that decreases the country's economic
growth. In the long-term, the country becomes a net consumer and not
a producer of the world's economic output. It will have to go into debt to pay
for consumption instead of investing in future growth. If the deficit continues
long enough, the country may have to sell off its assets to pay its creditors.
These assets include natural resources, land and commodities.

A deficit can be a problem if:-

It is persistent.
It forms a large share of GDP.
There are no compensating inflows of investment income or inward
capital account flows.
The Central Bank has low reserves.
The economy has a poor record of repaying debt.

Current Account - Deficit:-

A current account deficit is when a country's residents spend more on imports
than they save. To fund the deficit, other countries lend to, or invest in, the
deficit country's businesses. The lender country is usually willing to pay for
the deficit because its businesses profit from exports to the deficit country. In
the short run, the current account deficit is a win/win for both nations.

Surplus:-
A balance of payments surplus means the country exports more than it
imports. Its government and residents are savers. They provide enough
capital to pay for all domestic production. They might even lend outside the
country. A surplus boosts economic growth in the short term. That is because
its lending money to countries is that buy its products. That boosts its
factories and allowing them to hire more people. In the long-term, the
country becomes too dependent on export-driven growth. It must encourage
its residents to spend more. A larger domestic market will protect the country
from exchange rate fluctuations. It also allows its companies to develop
goods and services by using its own people as a test market.

Imbalances of BOP:-
While the BOP has to balance overall, surpluses or deficits on its individual
elements can lead to imbalances between countries. In general, there is
concern over deficits in the current account. Countries with deficits in their
current accounts will build up increasing debt or see increased foreign
ownership of their assets. The types of deficits that typically raise concern
are:-

(i) A visible trade deficit where a nation is importing more physical goods
than it exports even if this is balanced by the other components of the current
account.
(ii) An overall current account deficit.
(iii) A basic deficit which is the current account plus foreign direct
investment, but excluding other elements of the capital account like short
terms loans and the reserve account.

Causes of BOP imbalances:-

There are conflicting views as to the primary cause of BOP imbalances that
much attention on the US which currently has by far the biggest deficit. The
conventional view is that current account factors are the primary cause. These
include:-
(i) The exchange rate,
(ii) The government's fiscal deficit,
(iii) Business competitiveness, and
(iv) Private behavior.

Statement of Balance of Payments:-

The Balance of Payments identity can be written as below:-
Current account + Financial account + Capital account + Balancing item
=0.
The IMF uses the term current account with the same meaning as that used
by other organizations although it has its own names for its 3 leading sub
divisions as below:-
(i) The goods and services account (the overall trade balance),
(ii) The primary income account (factor income such as from loans and
investments),
(iii) The secondary income account (transfer payments),
Balance of payments also known as "Balance of international trade".

For simple understanding purpose, consider the below statement of Balance

of Payments.

BALANCE OF PAYMENTS FOR FY 2017

Amount
Particulars
(S)
Credits
Exports of goods and
services
Exports of goods 287584.00
Exports of services 229862.00
Total exports of goods
517446.00
and services
Primary income
Compensation of
1295.00
employees
Investment income 130470.00
Other primary income 1961.00
Total primary income 133726.00

Secondary income
General government 5472.00
Other sectors 14417.00
 Total secondary income 19889.00
Total 671061.00

Debits
Imports of goods and
services
Imports of goods 407304.00
Imports of services 139930.00
Total imports of goods
547234.00
and services

Primary income
Compensation of
1384.00
employees
Investment income 155005.00
Other primary income 3087.00
Total primary income 159472.00

Secondary income
General government 25884.00
Other sectors 18704.00
Total secondary income 44588.00
Total 751294.00

Balances
Trade in goods and
services
Trade in goods -119720.00
Trade in services 89932.00
Total trade in goods
-29788.00
and services

Primary income
 Compensation of -89.00
employees
Investment income -24531.00
Other primary income -1126.00
Total primary income -25746.00

Secondary income
General government -20410.00
Other sectors -4287.00
Total secondary income -24699.00
Total (Current balance) -80233.00

12. FOREIGN DIRECT INVESTMENT (FDI)

Introduction:-
Foreign direct investment (FDI) is an investment made by a firm or
individual in one country into business interests located in another
country. The Organization of Economic Cooperation and Development
(OECD) define control as owning 10% or more of the business. Businesses
that make foreign direct investments are often called multinational
corporations (MNCs) or Multinational enterprises (MNEs). An MNE may
make a direct investment by creating a new foreign enterprise which is called
a Greenfield investment or by the acquisition of a foreign firm, either called
an acquisition or brownfield investment. Foreign direct investment includes
"mergers and acquisitions, building new facilities, reinvesting profits earned
from overseas operations, and intra company loans". FDI is the sum
of equity capital, long-term capital, and short-term capital as shown in
the balance of payments. FDI usually involves participation in
management, joint-venture, transfer of technology and expertise. Since 1991,
the regulatory environment for foreign investment has consistently been
eased to make it investor-friendly.

Types of Foreign Direct Investment:-

Foreign direct investments are commonly categorized as being horizontal,
vertical or conglomerate.
(i) Horizontal FDI:-
A horizontal direct investment refers to the investor establishing the same
type of business operation in a foreign country as it operates in its home
country. For example, a cell phone provider based in the United States
opening up stores in China.
(ii) Vertical FDI:-
A vertical investment is one in which different but related business activities
from the investor's main business are established or acquired in a foreign
country, such as when a manufacturing company acquires an interest in a
foreign company that supplies parts or raw materials required for the
manufacturing company to make its products.
(iii) Conglomerate FDI:-
A conglomerate foreign direct investment is one where a company or
individual makes a foreign investment in a business that is unrelated to its
existing business in its home country. Since this type of investment involves
entering an industry the investor has no previous experience in, it often takes
the form of a joint venture with a foreign company already operating in the
industry.

Methods of FDI:-
The foreign direct investor may acquire voting power of an enterprise in an
economy through any of the following methods:
i. By incorporating a wholly owned subsidiary or company anywhere.
ii. By acquiring shares in an associated enterprise.
iii. Through a merger or an acquisition of an unrelated enterprise.
iv. Participating in an equity Joint venture with another investor or enterprise.

Forms of FDI incentives:-

Foreign direct investment incentives may be in the following forms:-
(i) Tax holidays:-
A tax holiday is a temporary reduction or abatement or elimination of a tax.
Tax holidays have been granted by governments at national, sub-national,
local levels and have included income, property, sales, VAT, and other taxes.
Some tax holidays are extra-statutory concessions where governing bodies
grant a reduction in tax that is not necessarily authorized within the law.
In developing countries, governments sometimes reduce or
eliminate corporate taxes for the purpose of attracting foreign direct
investment or stimulating growth in selected industries.

(ii) Special economic zones (SEZs):-

A special economic zone (SEZ) is an area in which business and trade laws
are different from the rest of the country. SEZs are located within a country's
national borders, and their aims are increased trade, increased investment, job
creation and effective administration. To encourage businesses to set up in
the SEZ, financial policies are introduced. These policies typically regard
investing, taxation, trading, quotas, customs and labor regulations. Moreover,
companies may be offered tax holidays where upon establishing in a zone
they are granted a period of lower taxation.

(iii) Maquiladoras:-
In Mexico, a maquiladora is a manufacturing operation
where factories import certain material and equipment on a duty-
free and tariff-free basis for assembly, processing or manufacturing and then
export the assembled, processed and/or manufactured product, sometimes
back to the raw materials' country of origin. They are an example of special
economic zones as seen in many countries.

(iv) EPZ – Export Processing Zones:-

The EPZ is also known as FTZ. A free-trade zone (FTZ) is a specific class
of special economic zone. It is a geographic area where goods may be landed,
stored, handled, manufactured, or reconfigured and re-exported under
specific customs regulation and generally not subject to customs duty. Free
trade zones are generally organized around major seaports, international
airports and national frontiers areas with many geographic advantages for
trade.

(v) Bonded warehouses:-

A bonded warehouse is a building or other secured area in which dutiable
goods may be stored, manipulated or undergo manufacturing operations
without payment of duty. It may be managed by the state or by private
enterprise. In the latter case a customs bond must be posted with the
government. This system exists in all developed countries of the world. Upon
entry of goods into the warehouse, the importer and warehouse proprietor
incur liability under a bond. This liability is generally cancelled when the
goods are:-

i. exported or deemed exported,

ii. withdrawn for supplies to a vessel or aircraft in international traffic,
iii. destroyed under Customs supervision,
iv. Withdraw for consumption domestically after payment of duty.

While the goods are in the bonded warehouse, they may under supervision by
the customs authority be manipulated by cleaning, sorting, repacking, or
otherwise changing their condition by processes that do not amount to
manufacturing. After manipulation and within the warehousing period, the
goods may be exported without the payment of duty, or they may be
withdrawn for consumption upon payment of duty at the rate applicable to
the goods in their manipulated condition at the time of withdrawal. In the
United States, goods may remain in the bonded warehouse up to 5 years from
the date of importation. Bonded warehouses provide specialized storage
services such as deep freeze or bulk liquid storage, commodity processing,
and coordination with transportation.

(vi) Low corporate tax and individual income tax rates

(vii) Other types of tax concessions
(viii) Preferential tariffs
(ix) Investment financial subsidies
(x) Free land or land subsidies
(xi) Relocation & expatriation
(xii) Infrastructure subsidies
(xiii) R&D support
(iv) Energy
(xv) Derogation from regulations (usually for very large projects)

FDI Reporting Requirements in India:-

(i) Within 30 days of receipt of money from the foreign investor, the Indian
company will report to the Regional Office of Reserve Bank of India (RBI)
under whose jurisdiction its registered office is located.

(ii) Within 30 days from the date of issue of shares a report in Form FC-GPR
together with the following documents should be filed with the Regional
Office of RBI.

(iii) Certificate from the Company Secretary of the company accepting

investment from person resident outside.

(iv) Certificate from Statutory Auditors or Chartered Accountant indicating

the manner of arriving at the price of the shares issued to the persons resident
outside India.

Advantages of FDI:-
An FDI may provide some great advantages for the MNE but not for the
foreign country where the investment is made. The advantages for
multinational enterprises (MNEs) are as under:-

(i) Access to markets:-

FDI can be an effective way for investors to enter into a foreign market.
Some countries may extremely limit foreign company access to their
domestic markets. Acquiring or starting a business in the market is a means
for you to gain access.

(ii) Access to resources:-

FDI is also an effective way for investors to acquire important natural
resources such as precious metals and fossil fuels. For example, oil
companies often make tremendous FDIs to develop oil fields.

(iii) Reduces cost of production:-

FDI means for investors to reduce your cost of production if the labor market
is cheaper and the regulations are less restrictive in the target foreign market.
For example, it is a well-known fact that the shoe and clothing industries
have been able to drastically reduce their costs of production by moving
operations to developing countries.

(iv) Economic Development Stimulation:-

Foreign direct investment can stimulate the target country’s economic
development, creating a more conducive environment for you as the investor
and benefits for the local industry.
(v) Easy International Trade:-
Commonly, a country has its own import tariff, and this is one of the reasons
why trading with it is quite difficult. Also, there are industries that usually
require their presence in the international markets to ensure their sales and
goals will be completely met. With FDI, all these will be made easier.

(vi) Employment and Economic Boost:-

Foreign direct investment creates new jobs, as investors build new companies
in the target country, create new opportunities. This leads to an increase in
income and more buying power to the people, which in turn leads to an
economic boost.

(vii) Development of Human Capital Resources:-

One big advantage brought about by FDI is the development of human
capital resources, which is also often understated as it is not immediately
apparent. Human capital is the competence and knowledge of those able to
perform labor, more known to us as the workforce. The attributes gained by
training and sharing experience would increase the education and overall
human capital of a country. Its resource is not a tangible asset that is owned
by companies, but instead something that is on loan. With this in mind, a
country with FDI can benefit greatly by developing its human resources
while maintaining ownership.

(viii) Tax Incentives:-

Parent enterprises would also provide foreign direct investment to get
additional expertise, technology and products. As the foreign investor, you
can receive tax incentives that will be highly useful in your selected field of
business.

(ix) Reduced Disparity between Revenues and Costs:-

Foreign direct investment can reduce the disparity between revenues and
costs. With such, countries will be able to make sure that production costs
will be the same and can be sold easily.

(x) Increased Productivity:-

The facilities and equipment provided by foreign investors can increase a
workforce’s productivity in the target country.
(xi) Increment in Income:-
Another big advantage of foreign direct investment is the increase of the
target country’s income. With more jobs and higher wages, the national
income normally increases. As a result, economic growth is spurred. Take
note that larger corporations would usually offer higher salary levels than
what you would normally find in the target country, which can lead to
increment in income.

Disadvantages of FDI:-
(i) Disappearance of cottage and small scale industries:-
Some of the products produced in cottage and village industries and also
under small scale industries had to disappear from the market due to the
onslaught of the products coming from FDIs. For example, Multinational soft
drinks.

(ii) Higher Costs:-

If you invest in some foreign countries, you might notice that it is more
expensive than when you export goods. So, it is very imperative to prepare
sufficient money to set up your operations.

(iii) Exchange rate crisis:-

Foreign direct investments can occasionally affect exchange rates to the
advantage of one country and the detriment of another. Foreign Direct
Investments are one of the reason for exchange crisis at times. During the
year 2000, the Southeast Asian countries experienced currency crisis because
of the presence of FDls. With inflation contributed by them, exports have
dwindled resulting in heavy fall in the value of domestic currency. As a result
of this, the FDIs started withdrawing their capital leading to an exchange
crisis. Thus, too much dependence on FDls will create exchange crisis.

(iv) Convertibility of Currency:-

FDIs are insisting on total convertibility of currencies in under-developed
countries as a prerequisite for investment. This may not be possible in many
countries as there may not be sufficient foreign currency reserve to
accommodate convertibility. In the absence of such a facility, it is dangerous
to allow the FDIs as they may withdraw their investments the moment they
find their investments unprofitable.

(v) Negative Impact on the Country’s Investment.

The rules that govern foreign exchange rates and direct investments might
negatively have an impact on the investing country. Investment may be
banned in some foreign markets which means that it is impossible to pursue
an inviting opportunity.

(vi) Political corruption:-

In order to capture the foreign market, the FDIs have gone to the extent of
even corrupting the high officials or the political bosses in various countries.
Lockheed scandal of Japan is an example. In certain countries, the FDIs
influence the political setup for achieving their personal gains. Most of the
Latin American countries have experienced such a problem. For example,
Drug trafficking, laundering of money, etc. In addition to this, Because of
political issues in other countries can instantly change, foreign direct
investment is very risky. Moreover, most of the risk factors that investors are
going to experience are extremely high.

(vii) Inflation in the Economy:-

The presence of FDIs has also contributed to the inflation in the country.
They spend lot of money on advertisement and on consumer promotion. This
is done at the cost of the consumers and the price is increased. They also
form cartels to control the market and exploit the consumer. The biggest
world cartel, OPEC is an example of FDI exploiting the consumers.

(viii) Trade Deficit:-

The introduction of TRIPs (Trade Related Intellectual Property Rights) and
TRIMs (Trade Related Investment Measures) has restricted the production of
certain products in other countries. For example, India cannot manufacture
certain medicines without paying royalties to the country which has
originally invented the medicine. The same thing applies to seeds which are
used in agriculture. Thus, the developing countries are made to either import
the products or produce them through FDIs at a higher cost.

(iX) Modern-Day Economic Colonialism.

Many third-world countries, or at least those with history of colonialism,
worry that foreign direct investment would result in some kind of modern day
economic colonialism which exposes host countries and leave them
vulnerable to foreign companies’ exploitations.

FDI in India:-

Introduction:-
Foreign direct investment (FDI) is a major source of non-debt financial
resource for the economic development of India. Foreign companies invest in
India to take advantage of relatively lower wages, special investment
privileges such as tax exemptions, etc. For a country where foreign
investments are being made, it also means achieving technical know-how and
generating employment. The Indian government’s favorable policy regime
and robust the business environment have ensured that foreign capital keeps
flowing into the country. The government has taken many initiatives in recent
years such as relaxing FDI norms across sectors such as Defense, PSU oil
refineries, telecom, power exchanges and stock exchanges, etc.

Market size:-
According to Department of Industrial Policy and Promotion (DIPP), the total
FDI investments in India during April-December 2017 stood at $ 35.94
billion, indicating that government's effort to improve ease of doing business
and relaxation in FDI norms is yielding results. Data for April-December
2017 indicates that the telecommunications sector attracted the highest FDI
equity inflow of $ 6.14 billion, followed by computer software and hardware
of $ 5.16 billion and services of $ 4.62 billion. Most recently, the total FDI
equity inflows for the month of December 2017 touched US$ 4.82 billion.
During April-December 2017, India received the maximum FDI equity
inflows from Mauritius for $ 13.35 billion, followed by Singapore for $ 9.21
billion, Netherlands for $ 2.38 billion, USA for $ 1.74 billion and Japan for $
1.26 billion. Indian impact investments may grow 25% annually to $ 40
billion from $ 4 billion by 2025, as per ‘Mr. Anil Sinha’, Global Impact
Investing Network's (GIIN’s) advisor for South Asia.

Investments or developments:-
India has become the fastest growing investment region for foreign investors
in 2016 led by an increase in investments in real estate and infrastructure
sectors from Canada according to a report by KPMG.
Some of the recent significant FDI announcements are as follows:-
(i) In February 2018, Ikea announced its plans to invest up to Rs.4,000
crores ($ 612 million) in the state of Maharashtra to set up multi-format
stores and experience centers.
(ii) In November 2017, 39 MoUs were signed for investment of Rs.4,000-
5,000 crore ($ 612-765 million) in the state of North-East region of
India.
(iii) In December 2017, the ‘Department of Industrial Policy and Promotion’
(DIPP) approved FDI proposals of ‘Damro Furniture’ and ‘Supr
Infotech Solutions’ in retail sector, while ‘Department of Economic
Affairs’, ‘Ministry of Finance’ approved two FDI proposals worth
Rs532 crore ($ 81.4 million).
(iv) The Department of Economic Affairs, Government of India, closed
three foreign direct investment (FDI) proposals leading to a total
foreign investment worth Rs.24.56 crore ($ 3.80 million) in October
2017.
(v) Singapore's ‘Temasek’ will acquire a 16 per cent stake worth Rs1,000
crore ($156.16 million) in Bengaluru based private healthcare network
‘Manipal Hospitals’ which runs a hospital chain of around 5,000 beds.
(vi) France-based energy firm, ‘Engie SA’ and Dubai-based private equity
(PE) firm ‘Abraaj Group’ have entered into a partnership for setting up
a wind power platform in India.
(vii) US-based footwear company, ‘Skechers’, is planning to add
400-500 more exclusive outlets in India over the next five years and
also to launch its apparel and accessories collection in India.
(viii) The government has approved five Foreign Direct Investment
(FDI) proposals from ‘Oppo Mobiles India’, ‘Louis Vuitton Malletier’,
‘Chumbak Design’, ‘Daniel Wellington AB’ and ‘Actoserba Active
Wholesale Pvt. Ltd’, according to ‘Department of Industrial Policy and
Promotion’ (DIPP).
(ix) Cumulative equity ‘foreign direct investment’ (FDI) inflows in India
increased 40% to reach $ 114.4 billion between FY 2015-16 and FY
2016-17, as against $ 81.8 billion between FY 2011-12 and FY 2013-
14.
(x) ‘Walmart India Pvt. Ltd’, the Indian arm of the largest global retailer, is
planning to set up 30 new stores in India over the coming two years.
 (xi) US-based ecommerce giant, ‘Amazon’, has invested about $ 1 billion in
its Indian arm so far in 2017, taking its total investment in its business
in India to $ 2.7 billion.
(xii) Kathmandu based conglomerate, CG Group is looking to invest
Rs1,000 crores ($ 155.97 million) in India by 2020 in its food and
beverage business, stated ‘Mr. Varun Chaudhary’, Executive Director,
CG Corp Global.
(xiii) ‘International Finance Corporation’ (IFC), the investment arm
of the ‘World Bank’ Group, is planning to invest about $ 6 billion
through the year 2022 in several sustainable and renewable energy
programs in India.
(xiv) ‘SAIC Motor Corporation’ is planning to enter India’s
automobile market and begin operations in 2019 by setting up a fully-
owned car manufacturing facility in India.
(xv) ‘Soft Bank’ is planning to invest its new $ 100 billion
technology fund in market leaders in each market segment in India as it
is seeking to begin its third round of investments.

Government initiatives :-
(i) In September 2017, the Government of India asked the states to focus on
strengthening single window clearance system for fast-tracking approval
processes in order to increase Japanese investments in India.
(ii) The ‘Ministry of Commerce and Industry’, Government of India has
eased the approval mechanism for foreign direct investment (FDI) proposals
by doing away with the approval of ‘Department of Revenue and mandating
clearance of all proposals’ requiring approval within 10 weeks after the
receipt of application.
(iii) India and Japan have joined hands for infrastructure development in
India's north-eastern states and are also setting up an India-Japan
Coordination Forum for development of North East to undertake strategic
infrastructure projects in the northeast.
(iv) The Government of India is in talks with stakeholders to further ease
foreign direct investment (FDI) in defense under the automatic route to 51%
from the current 49% in order to give a boost to the make in India initiative
and to generate employment. In January 2018, 100% FDI was allowed in
single brand retail through automatic route along with relaxations in rules in
other areas.
(v) ‘The Central Board of Direct Taxes’ (CBDT) has exempted employee
stock options (ESOPs), foreign direct investment (FDI) and court-approved
transactions from the long term capital gains (LTCG) tax, under the Finance
Act 2017.
(vi) The Government of India is likely to allow 100 per cent foreign direct
investment (FDI) in cash and ATM management companies, since they are
not required to comply with the Private Securities Agencies Regulations Act
(PSARA).

Difference between FDI and FII (Foreign Institutional Investor):-

Foreign Direct Investment (FDI):-

When any foreign organization or institution of one nation makes an
investment in an organization or institution of another country, then it is
called as Foreign Direct Investment (FDI). This investment can be in various
sectors like electricity, drinking water, road, factory, healthcare, properties,
insurance etc. It is called direct investment because the Investors get a
substantial amount of administrative control over the foreign company. Those
poor countries where the availability of finance or, funds for their
development and growth is quite low can avail the required financial support
from the developed countries having good financial condition.

Foreign Institutional Investment/Investors (FII):-

The companies of a country that invest in the financial market i.e. the Stock
market of a foreign country are known as Foreign Institutional Investment.
The companies who invests through FII in another country needs to be
registered with the Securities and Exchange Board of that country.

Difference between FDI and FII:-

Foreign Direct Investment Foreign Institutional

S.No.
(FDI) Investment/Investor (FII)
When any organization of any
When any organization of one
country
nation
makes an investment in the Stock
1 makes an investment in any
market
organization of another country,
of another country, it is known as
 it is known as FDI. FII.
FII brings long term capital as
2 FDI brings long term capital. well as short
term capital.
Entry and exit is difficult in
3 Entry and exit is very easy in FII.
case of FDI.
In FDI transfer of funds,
technology,
In FII only funds are transferred
resources, strategies, new
4 from
concept are
one country to another.
done from the developed
countries to the developing one.
FDI helps in developing
infrastructure,
increasing job opportunities and FII does not play any role in the
5 also economic
plays a key role in the development of the country.
economic
development of the country.
Through FDI, there is Through FII, there is no any
6 administrative control in the
control in the company. company.
FDI includes complex
procedures and also Through stock markets investors
7 don’t gives an easy way in can make
making money money quickly under FII.
quickly.
Results in increase in capital of
8 Results in increase in GDP.
the country.

In addition to above differences, the below also the differences between FDI
and FII:-

(i) FDI is long term related i.e. may be 30 years whereas FII is for shorter
term i.e. only wants to make profit in short duration of time.
(ii) FDI examples are AMAZON, Walmart, etc. FII examples are Morgan
Stanley, Goldman Sachs, etc.
(iii) FDI company can buy shares of more than 10% of any listed public
company in India. FII company can buy shares of less than 10% of any listed
public company.
(iv) Both FDI & FII can have any amount of investment in any unlisted
company.
(v) FDI can buy 49% shares of insurance companies and 74% shares in
private banks i.e. sectoral caps are made by govt. FII can’t purchase more
than 10%.
(vi) FDI has only one category for everyone. FII has different categories for
SEBI it’s called FPI, for RBI it’s called Re-FPI.
(vii) Both FDI & FII don’t count NRI investment.
(viii) FDI applies to Equity finance only. FII can invest in both equity and
debt.
(ix) FDI company has to take permission by govt. for purchasing fully
convertible debentures. FII cannot purchase fully convertible debentures.
(x) FDI does not have to take permission while investing in Govt. security
and treasury bill as these are debt instruments (since FDI applies equity only).
FII cannot but Treasury bills and can have only 30 billion investments in G-
sec, for corporate can have $51 billion.
(xi) FDI is directed by RBI (by FEMA act), FIPB (by govt.) and companies
in which investment is done. FII is directed by SEBI, RBI & companies.

Conclusion:-
Keeping above points in mind we can say that both FDI and FII are two
completely different forms of investment. Both have their pros and cons.
However, FDI is given preference than FII because it helps in the economic
growth of the country and also FDI is not only brings capital but also brings
the latest technology, better infrastructure, better management and job
opportunities.

13. INTERNATIONAL FINANCIAL MARKETS

Definition of Financial market:-
The financial market is a marketplace where trading of securities
including equities, bonds, currencies and derivatives occurs. A financial
market brings buyers and sellers together to trade in financial assets such as
stocks, bonds, commodities, derivatives and currencies. The purpose of a
financial market is to set prices for global trade, raise capital, and transfer
liquidity and risk.

Types of Financial markets:-

Although there are many components to a financial market, the most
commonly used in financial markets are Capital markets and Money markets.

A. Capital Market:-
Capital markets are the most widely followed markets. The markets which
are used to raise finance for the long term finance are called Capital markets.
Thus, this type of market is composed of both the primary and secondary
markets. Any government or corporation requires capital (funds) to finance
its operations and to engage in its own long-term investments. To do this, a
company raises money through the sale of securities i.e. stocks and bonds in
the company's name. These are bought and sold in the capital markets. The
capital markets may also be divided into primary markets and secondary
markets. Newly formed (issued) securities are bought or sold in primary
markets such as during Initial Public Offerings. Secondary markets allow
investors to buy and sell existing securities. The transactions in primary
markets exist between issuers and investors whereas the secondary market
transactions exist among investors. Liquidity is a crucial aspect of securities
that are traded in secondary markets.

Capital markets which consist of the following:-

(i) Stock markets which are provide financing through the issuance of shares
or common stock and enable the subsequent trading thereof.

(ii) Bond markets which provide financing through the issuance of bonds and
enable the subsequent trading thereof.

(iii) Commodity markets, which facilitate the trading of commodities.

(v) Derivatives markets, which provide instruments for the management

of financial risk.
(vi) Futures markets, which provide standardized forward contracts for
trading products at some future date.

(vii) Forwards market, which provides contract between 2 parties for the
products at some future date.

(vii) Foreign exchange markets, which facilitate the trading of foreign

exchange.

(viii) Spot market , which also referred to as cash market is a public financial
market in which financial instruments or commodities are traded
for immediate delivery.

(ix) Interbank lending market, which is a market in which banks extend loans
to one another for a specified term. Most interbank loans are for maturities of
one week or less. The majority being overnight and such loans are made at
the interbank rate.

B. Money market:-
The markets which are used to raise finance for the short- term period are
called Money markets. These types of securities comprise the bulk of money
market funds because of their safety, liquidity and short duration.

The money market consists of the below Money market instruments:-

(i) Treasury bills (T-bills):-

The T-bill rate is a key barometer of short-term interest rates. Treasury bills
or T-bills are short-term debt instruments issued by the U.S Treasury. T-bills
are issued for a term of one year of less. T-bills are considered the world’s
safest debt as they are backed by the full faith and credit of the United States
government. Treasury bills are sold with maturities of four, thirteen, twenty-
six and fifty-two weeks. They do not pay interest, but rather are sold a
discount to their face value. The full-face value is paid at maturity, and the
difference between the discounted purchase price and the full-face value
equates to the interest rate.

(ii) Commercial paper:-

Commercial paper is an unsecured promissory note or short-term debt
instrument issued by a corporation, typically for the financing of accounts
receivable, inventories and meeting short-term liabilities. Maturities on
commercial paper rarely range any longer than 270 days. Commercial paper
is usually issued at a discount from face value and reflects prevailing market
interest rates.

(iii) Banker’s acceptances:-

A banker's acceptance (BA) is a short-term debt instrument issued by a
company that is guaranteed by a commercial bank. Banker's acceptances are
issued as part of a commercial transaction. These instruments are similar to
T-Bills, are frequently used in money market funds and are traded at a
discount from face value on the secondary market, which can be an
advantage because the banker's acceptance does not need to be held until it
matures.

(iv) Re-purchase agreement:-

A repurchase agreement (repo) is a form of short-term borrowing for dealers
in government securities. The dealer sells the government securities to
investors, usually on an overnight basis, and buys them back the following
day. For the party selling the security and agreeing to repurchase it in the
future, it is a repo; for the party on the other end of the transaction, buying
the security and agreeing to sell in the future, it is a Reverse-Repurchase
agreement. Repos are typically used to raise short-term capital.

(v) Certificate of deposit (CDs):-

A certificate of deposit (CD) is a savings certificate with a fixed maturity
date, specified fixed interest rate and can be issued in any denomination aside
from minimum investment requirements. A CD restricts access to the funds
until the maturity date of the investment. CDs are generally issued by
commercial banks and are insured by the FDIC up to $250,000 per
individual.

The following table illustrates where financial markets fit in the relationship
between lenders and borrowers:-

Relationship between lenders and borrowers

 Lenders Financial Financial Borrowers
intermediaries Markets
Individuals Banks Interbank Individuals
Companies Insurance Companies Stock Exchange Companies
Central
Pension Funds Money Market
Government
Mutual Funds Bond Market Municipalities
Public
Foreign Exchange
Corporations

Sources of International Finance or Fund:-

The most common sources of International finance (fund) are as below:-

1. Commercial Banks:-
They are an important source of financing non-trade international operations.
The types of loans and services provided by banks vary from country to
country.

2. International Agencies and Development Banks:-

A number of international agencies and development banks have been set up
over the years to finance international trade and business by providing long
and medium term loans and grants to promote the development of
economically backward areas in the world. The main among them include
International Finance Corporation (IFC), EXIM Bank and Asian
Development Bank.

3. International Capital Markets:-

Prominent international financial instruments used by various companies
are:-
(i) Global Depository Receipts (GDRs):-
When the local currency shares of a company are delivered to the depository
bank, that bank issues depository receipt to the depositor against shares, these
receipts expressed in US dollars are caller GDRs. Many Indian companies
such as Infosys, Reliance, Wipro and ICICI have raised money through issue
of GDRs.

Features of GDRs:-
1. GDR can be listed and traded on a stock exchange of any foreign country
other than America.
2. It is negotiable instrument.
3. A holder of GDR can convert it into the shares.
4. Holder gets dividends.
5. Holder does not have voting rights.

(ii) American Depository Receipts (ADRs):-

The depository receipt issued by a company in USA is known as ADR.
Feature of ADRs:-
1. It can be issued only to American Citizens.
2. It can be listed and traded is American stock exchange.
3. Indian companies such as Infosys, Reliance issued ADR.

(iii) Foreign currency convertible bonds (FCCBS):-

Foreign currency convertible bonds are equity linked debt securities that are
to be converted into equity or depository receipts or retained as bonds, after a
specific period. The FCCBs are issued in a foreign currency and carry a fixed
interest rate. These are listed and traded in foreign stock exchange and similar
to the debenture.

(iv) Indian Depository Receipts (IDRS):-

IDRs are like GDR or ADR except that the issuer is a foreign company
raising funds from Indian Market. IDRs are rupee dominated. They can be
listed on any Indian stock Exchange.

Issue Procedure of IDRs:-

1. Firstly, a Foreign Co. hands over the shares to OCB (it requires approval
from Finance Ministry to act as a custodian).
2. The OCB request ID to issue shares in the form of IDR.
3. The ID converts the issue which is in foreign currency into IDR and into
Indian rupee.
4. Lastly, the ID issues them to intending investors.

Features of IDRs:-
1. IDRs are issued by any foreign company.
2. The IDRs can be listed on any Indian stock exchange.
3. A single IDR can represent more than one share, such as one IDR = 10
shares.
4. The holders of IDR have no right to vote in the company.
5. The IDRs are in rupee denomination.

Advantages of IDRs:-
1. It provides an investment opportunity to Indian Investors.
2. It fulfills the capital need of foreign companies.
3. It provides listing facility to foreign companies to list on Indian Capital
Market.

(v) Inter-corporate Deposits (ICDs):-

Inter-Corporate Deposits are unsecured short term deposits made by one
company with another company. These deposits involve brokers. The rate of
interest on these deposits is higher than that of banks and other markets. The
biggest advantage of ICDs is that the transaction is free from legal issues.

Type of ICDs:-

(a) 3-months Deposits:-

The most popular type of ICDs, are generally considered by borrowers to
solve problems of short term capital adequacy. The rate of interest for these
deposits is around 12% p.a.

(b) 6-months Deposits:-

The rate of interest for these deposits is around 15% p.a.
(c) Call deposits:-
This deposit can be withdrawn by the lender on a day’s notice. The rate of
interest on call deposits is around 10% p.a.

Features of ICDs:-
1. These transactions take place between two companies.
2. These are short term deposits.
3. These are unsecured deposits.
4. These transactions are generally completed through brokers.
5. These deposits have no organized market.
6. These deposits have no legal formalities.
7. These are risky deposits from the point of view of lenders.

------------ End of the CHAPTER – 17 ----------

CHAPTER – 18
MONETARY POLICY RATES
Learning objectives
After studying this chapter, you can be able to :-
1. Learn overview, process, goals of Monetary policy in India, and
2. Understand the concept of Monetary policy rates / instruments.

The government policy of India is divided into two policies, such as

1. Fiscal policy which relates to Taxes and Government spending, and
2. Monetary policy which relates to Interest rates and Money supply.

I. OVERVIEW OF MONETARY POLICY

The Monetary policy of India refers to the policy of the central bank with
regard to the use of monetary instruments under its control to achieve the
goals specified in the Reserve Bank of India Act, 1934. The Reserve Bank of
India (RBI) is vested with the responsibility of conducting monetary policy.
This responsibility is clearly required under the Reserve Bank of India Act,
1934. Monetary policy is how central bank manage liquidity to create
economic growth. Here, liquidity means money supply like credit, cash,
cheques, and money market mutual funds, etc.

II. PROCESS OF MONETARY POLICY

The Monetary Policy Committee (MPC) which is having 6 members
including Governor and Deputy Governor of RBI, established by the Central
Government of India under Section 45ZB which determines the policy
interest rate required to achieve the inflation target for set period. The
Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in
develop / map the monetary policy. The views of key stakeholders in the
economy, and analytical work of the Reserve Bank contribute to the process
for arriving at the decision on the policy repo rate. The Financial Markets
Operations Department (FMOD) operationalises the monetary policy, mainly
through day-to-day liquidity management operations. The Financial Market
Committee (FMC) meets daily to review the liquidity conditions so as to
ensure that the operating target of monetary policy (weighted average lending
rate or weighted average call money rate) is kept close to the policy’s repo
rate. Before the constitution of the MPC, a Technical Advisory Committee
(TAC) on monetary policy with experts from monetary economics, central
banking, financial markets and public finance advised the Reserve Bank on
the stance of monetary policy. However, its role was only advisory in nature.
With the formation of MPC, the TAC on Monetary Policy ceased to exist.

III. PRIMARY GOALS / OBJECTIVES OF MONETARY POLICY

1. Maintain price stability while keeping in mind the objective of growth.
Price stability is a necessary precondition to sustainable growth.
2. Reduce un-employment, but only after they have controlled inflation,
3. Control the inflation, and liquidity in economy of the country.

The Consumer Price Index (CPI) inflation is 4% as the target for the period
from 05th August 2016 to 31st March 2021 with the upper tolerance limit of
6% and the lower tolerance limit of 2%.

The following factors of failure to achieve the inflation target are :-

(a) the average inflation is more than the upper tolerance level of the inflation
target for any 3 consecutive quarters, or
(b) the average inflation is less than the lower tolerance level for any 3
consecutive quarters.
IV. INSTRUMENTS / TOOLS OF MONETARY POLICY
The present rates of the following Monetary policy instruments / tools of
India as below. These rates taken as on 27th March, 2020.

A. Policy Rates
1. Bank Rate (4.65% as on 27th March, 2020)
The Bank rate is also known as Discount rate is the rate of interest which
central bank (RBI in India) charges on the loans and advances i.e. finance
lends to commercial banks and Financial Institutions / Intermediaries,
without pledging any securities. The central bank uses the Bank rate for
short-term purposes and can rise this rate in order to control liquidity (money
supply) and vice versa. That means, upward revision in Bank rate is an
indication that banks also should increase their deposit rates and benchmark
PLR (Prime Lending Rate). Therefore, interest rates on customer deposits in
to banks also will go up. It can also indicate an increase in customer’s EMIs.
Simply, if the Bank rate goes up, long-term interest rates also tend to move
up, and vice versa. It should be note that Bank rate is not the same as Deposit
rate which is offered by commercial banks on FDs (Fixed Deposits) and RDs
(Recurring Deposits). It concludes that Bank rate is only the rate which helps
the economy in controlling inflation and Deflation. Bank rate serves as a
basic parameter to the commercial banks to fix interest rate on long term
loans to their individuals and corporates. The Bank Rate is published u/s 49
of the Reserve Bank of India Act, 1934.

2. Repo Rate (4.40% as on 27th March, 2020)

Repo(Re-purchase) rate is the rate at which the central bank (RBI in India)
lends short-term money to commercial banks against Government securities
and other approved securities under Liquidity Adjustment Facility (LAF) for
a Re-purchase agreement in the case of any short fall of funds. In the case of
inflation, the central bank increases Repo rate as it acts as a hurdle for
commercial banks to borrow funds from Central bank. This situation
ultimately reduces the liquidity in country’s economy and therefore it helps in
control inflation. A reduction in Repo rate will help commercial banks to
borrow funds from central bank at a lesser rate. The simple diagram of Repo
i.e. injection (take out) of liquidity is mentioned below :-
Here, securities means Treasury bills, Government bonds, corporate
debentures, Mutual funds, stocks, etc.

3. Reverse Repo Rate (4.00% as on 27th March, 2020)

Reverse Repo rate is a rate at which commercial banks keep their excess
liquidity with the Central bank. The banks will keep the excess money with
central bank when the banks feel that they are stuck with excess funds and
are not able to invest or lends anywhere for their expected / reasonable
returns. An increase in Reverse Repo rate would attract commercial banks to
keep more surplus money with central bank, thereby decreasing the supply of
money (liquidity) in the market i.e. enough funds will not be available to lend
to individuals and corporates. A rise in Reverse Repo rate means that the
central bank of a country is ready to borrow money from the commercial
banks at a higher rate of interest. Reverse Repo rate is used to control
liquidity in economy of the country. Therefore, It concludes that Repo rate
indicates the rate at which liquidity is take-out (injected) in the banking
system by the central bank of a country where as Reverse Repo rate indicates
that the rate at which the central bank take-in (absorbs) liquidity from the
commercial banks. The simple diagram of Reverse Repo i.e. Absorption (take
in) of liquidity is mentioned below :-

Here, securities means Treasury bills, Government bonds, corporate

debentures, Mutual funds, stocks, etc.

Impact on increase of Repo and Reverse Repo rate :-

If commercial banks get more money from RBI, and will lend more money to
people or corporations with higher interest rates, then, it causes more demand
in economy. Thus, prices will be increased, and vice versa.
4. MSF Rate (4.65% as on 27th March, 2020)
MSF(Marginal Standing Facility) rate is the rate at which the commercial
banks can borrow additional short-term funds from central bank by pledging
Government securities at a rate higher than Repo rate under “Liquidity
Adjustment Facility – Repo scheme” (LAF – Repo) in an emergency
situation when interbank liquidity completely dries-up. Under MSF,
commercial banks can borrow funds from central bank up to 1% of their net
demand and time liabilities (NDTL). The difference between MSF and Repo
is that in MSF, the banks can keep the securities under SLR (Statutory
Liquidity Ratio) to get loans from central bank.

B. Reserve Ratios :-
1. CRR (4.00% as on 27th March, 2020)
CRR(Cash / Credit Reserve Ratio) is a specified minimum fraction or the
average daily balance of the total deposits of customers, which scheduled
commercial banks need to hold as reserves either in cash or as deposits with
their specified current account maintained with central bank of a nation as a
share of such % of its Net demand and time liabilities (NDTL) that the central
bank may notify from time to time in the Gazette of India. These deposits are
also termed as risk-free deposits. For example, when a commercial bank’s
deposits increased by $10,000 and if CRR is 6%, then, the commercial banks
need to hold $600 with central bank and the bank will be able to use only
$9,400 for investments or lending / credit purpose. CRR ensures that banks
do not run out of cash to meet the payment demand of their depositors
(individuals and corporates, etc.) and it is used to control money supply in an
economy of a country. The central bank uses CRR either to drain excess
liquidity or to release funds needed for growth of the economy from time to
time. In other terms, CRR is used to secure the monetary stability in a
country. Finally, It is conclude that CRR is used to control liquidity in the
banking system.
2. SLR (18.25% as on 27th March, 2020)
The SLR (Statutory Liquidity Ratio) is a minimum required percentage /
portion at which the commercial banks need to hold of their Net demand and
Time liabilities (NDTL) as safe and liquid assets in the form of Cash (at book
value), Gold (at current market price), and unencumbered approved
government securities before providing credit to their customers. Here,
approved securities means Bonds / Debentures and Shares of different
companies. Treasury bills, Dated securities issued under Market Borrowing
Programme, and Market Stabilization scheme, etc. also be a form part of the
SLR. The ratio of liquid assets to Net demand & Time liabilities is known as
SLR. It can be say as SLR = [Liquid assets / (Net demand + Time
liabilities)]x100.

Time liabilities :-
The liabilities which the commercial banks are liable to pay to the customers
after a certain period mutually agreed upon. For example, fixed deposits for 6
years, which is not payable by bank, but bank need to re-pay it after the time
period i.e. 6 years.

Demand liabilities :-
The liabilities which are re-payable on demand, such as deposits of Savings
account and Current account of the customers by giving a with drawl form or
cheque or digital transfer.
The central bank can increase the SLR to stuck liquidity in market and to
safeguard the customers money. In India, Commercial / scheduled banks
need to report to the central bank every alternate Friday about their SLR
maintenance and would attract penalties for failure to maintain SLR as
mandated. If any commercial bank fails to maintain the required level of
SLR, the bank liable to pay penalty to central bank, an interest at 3% per
annum above the Bank rate on the short fall amount for that particular day. If
the defaulter bank continues to default on next working day, the rate of
interest will be increased to 5% per annum above the Bank rate. This
restriction is imposed by central bank of India on its commercial banks to
make funds available to customers on demand as soon as possible. Gold and
Government securities (Gilts) are included along with cash because they are
highly liquid and safe assets.

Impact on increase of CRR and SLR :-

If commercial banks need to keep more liquid funds, so as to less loans to
individuals and corporations, which leads to low demand for goods and
services. Thus, prices will decrease for the goods and services, and vice
versa.

Difference between CRR and SLR :-

Both CRR and SLR ate monetary instruments in the hands of central bank to
regulate money supply in the hands of banks that they can supply in economy
of a country.

The SLR restricts the bank’s leverage in supplying more liquidity into a
country’s economy. CRR is a portion of deposits that the banks need to
maintain with the central bank to reduce liquidity in an economy. Therefore,
CRR controls liquidity in economy, while SLR regulates credit growth in the
country.

To meet SLR, banks can use cash, gold, and approved securities where as
with CRR, it considers only cash. CRR is maintained in cash form with
central bank where as SLR is money deposited in Government securities.
CRR is used to control inflation.

C. Lending / Deposit Rates

1. Base rate (8.15% - 9.40% as on 27th March, 2020)
Base rate is the minimum rate prescribed by the Central bank to scheduled
commercial banks which are not allowed to lend funds to their customers
below the base rate. The base rate is also referred to as base interest rate.
Banks those have low base rate can offer loans to their customers at lower
interest rates. Base rate tends to influence all the other interest rates, such as
mortgage, loans, savings bank rates, and rates for businesses, etc. This rate is
usually taken as the standard interest rate by all the banks functioning in that
country.

2. Savings Bank Rate (3.00% - 3.50% as on 27th March, 2020)

A savings account is an interest-bearing deposit account held at a bank or
financial institution / intermediary. The rate of interest providing by
commercial banks to their customers on the savings bank account is called as
Savings bank rate.

3. Term Deposit Rate (> 1 year) (5.90% - 6.40% as on 27th March, 2020)
The rate at which commercial banks will provide the interest rate to their
customers whose money is invested for an agreed rate of interest over
a fixed amount of time, or term.

4. MCLR (7.40% - 7.90% as on 27th March, 2020)

The MCLR method was introduced in the Monetary policy system by the
Central bank of India (Reserve Bank of India) w.e.f. 01st April 2016. MCLR
(Marginal Cost of Funds Based Lending Rate) is a minimum rate at which the
commercial banks should not lend funds (loans) to their customers below the
MCLR. the bank cannot lend at a rate lower than MCLR of a particular
maturity for all loans linked to that benchmark. MCLR is a tenor-linked
internal benchmark, which means the rate is determined internally by the
bank depending on the period left for the repayment of a loan. MCLR is
closely linked to the actual deposit rates and is calculated based on the
following four components :-

(a) Cost of Funds and Marginal Cost of Funds

A Retail Bank holds deposits made by its customers. The Bank pays interest
rates for all deposits which have different tenure and rate of interest. All that
deposits minus CRR is equal to available funds for lending out by the bank.
The cost of fund is the interest rate being paid on the entire deposit money.
Now, the interest being paid on the deposits today may not be the same
tomorrow, because of tomorrow new deposits have come into the bank at
different cost as they have different tenures and rates. Thus, the cost of the
fresh fund is the marginal cost of fund.

(b) Negative Carry on account of CRR

The Negative Carry on account of CRR is the amount of earning opportunity
lost due to the fact that the commercial bank has to deposit CRR with the
Central Bank. Another case of lost opportunity is the SLR that is held in cash,
gold or other approved securities. This loss of earnings to be built into the
MCLR. A higher CRR thus increases the MCLR.

(c) Operating Costs.

Every Bank has an overhead of operation. While the bank tries to cover its
operational costs through service charges, there are many costs such as
insurance that cannot be covered by any other means.

(d) Tenor Premium

This is nothing but the cost of risk of default by the creditor. The longer the
tenor the higher the risk.
This method of arriving at the lending rate for commercial banks is safer for
the commercial bank as well as more compliant with the controls of the
Central Banks that manage the Monetary Policy.
Under the MCLR regime, banks are free to offer all categories of loans on
fixed or floating interest rates. The actual lending rates for loans of different
categories and tenors are determined by adding the components of spread to
MCLR. Therefore, the bank cannot lend at a rate lower than MCLR of a
particular maturity, for all loans linked to that benchmark.

V. KINDS OF MONETARY POLICY

1. Expansionary
It Central bank uses this to increase inflation by decrease interest rates,
increasing money supply (liquidity), purchase securities through open market
operations, and increasing an aggregate demand. But, it leads to decrease of
un-employment. Simply, Expansionary policy helps in encouraging / increase
economic growth.

2. Contractionary
Central bank uses this to reduce inflation by raising interest rates, decreasing
money supply, and selling securities through open market operations. But, it
will cause to increasing of un-employment. Simply, contractionary policy
helps to decrease economic growth.

VI. OTHER TERMINOLOGY

1. Prime Lending Rate (PLR)

The rate of interest at which the banks charged to their largest, most secure,
and credit worthy customers on short-term loans. The prime rate is a
benchmark for interest rates on business and customer loans. This rate is used
as a guide for computing interest rates for other borrowers. The PLR is also
termed as BPLR (Benchmark Prime Lending Rate).

2. LIBOR
LIBOR stands for London Inter-bank Offered Rate is a daily reference rate
based on the interest rates at which banks borrow un-secured funds from
other banks in the London wholesale money market (or inter-bank market).

3. Open Market Operations (OMOs)

Open market operations is the sale and purchase of government securities and
treasury bills by central bank of the country in its currency for injection (take
out) and absorption (take in) of durable liquidity to (or from) a commercial /
retail bank or a group of banks. The objective of OMO is to regulate the
money supply in the economy. When the RBI wants to increase the money
supply in the economy, it purchases the government securities from the
market, and it sells government securities to suck out liquidity from the
system. In other terms, an open market operation (OMO) is an activity by a
central bank to give (or take) liquidity in its currency to (or from) a bank or a
group of banks. Simply, the buying and selling of government securities in
the open market in order to expand or contract the amount of money in the
banking system. A central bank uses OMO as the primary means of
implementing monetary policy. The usual aim of open market operations is—
aside from supplying commercial banks with liquidity and sometimes taking
surplus liquidity from commercial banks—to manipulate the short-term
interest rate and the supply of base money in an economy, and thus indirectly
control the total money supply, in effect expanding money or contracting the
money supply. This involves meeting the demand of base money at the target
interest rate by buying and selling government securities, or other financial
instruments. Monetary targets, such as inflation, interest rates, or exchange
rates, are used to guide this implementation.

Impact of buying securities :-

More money in economy, which leads to more demand. Thus, increase in
economic growth.

Impact of selling securities :-

Less money in economy, which leads to less demand. Thus, decrease in
economic growth.

4. Market Stabilisation Scheme (MSS)

This instrument for monetary management was introduced in 2004. Surplus
liquidity of a more sustain in nature arising from large capital inflows is
absorbed (take in) through sale of short-dated government securities and
treasury bills. The cash so mobilised is held in a separate government account
with the Central bank.

5. Liquidity Adjustment Facility (LAF)

Liquidity adjustment facility is a mechanism by RBI, used in monetary
policy, that allows banks to borrow money through repurchase agreements
(Repo) or banks to lend to the RBI using reverse repo contracts. This
arrangement manages liquidity pressures and ensures basic financial-market
stability. LAF is used to service commercial banks in resolving any short-
term cash shortages during the periods of economic instability. It is done
through repo rate and reverse repo rate. LAF is used to aid banks in adjusting
the day to day mismatches in liquidity. LAF helps banks to quickly borrow
money in case of any emergency or for adjusting in their SLR /
CRR requirements. In LAF, money transaction is done via RTGS.

6. Corridor
The MSF rate and reverse repo rate determine the corridor for the daily
movement in the weighted average call money rate.

7. bps
The bps is referred to as basis points or decimal places. One bps is one-
hundredth of a percentage point.

8. Inflation
Inflation is the rate at which the general level of prices for goods and services
is rising within an economy. In inflation, the purchasing power of the
consumer will decrease. The measure of inflation over time is referred to as
the inflation rate. In common terminology, many people may refer to
inflation as "the cost of living." Inflation is leading to higher prices for basic
needs such as food, and it can be a negative impact on society. Inflation can
occur when prices rise due to increases in production costs, such as raw
materials and wages. A surge (rise) in demand for products and services can
cause inflation as consumers are willing to pay more for the product. Some
companies reap the rewards of inflation if they can charge more for their
products as a result of high demand for their goods and services.

9. Deflation
Deflation is a general decline in prices for goods and services, typically
associated with a contraction (decrease / reduce) in the supply of money and
credit in the economy, and also prices can also fall due to increased
productivity and technological advancements. During deflation, the
purchasing power of currency rises over time.

10. Unencumbered securities

Unencumbered refers to an asset or property that is free and clear of any
encumbrances, such as creditor claims or liens (temporary rights).
Examples of typical unencumbered assets are :-
(a) A house without an associated mortgage or other lien, or
(b) A car on which the automobile loan has been paid off, or
(c) Stocks purchased in a cash account.
In simply, unencumbered Security is a security issued by Central or State
Government held by us and not pledged / hypothecated for any debt / loan.
For example, encumbered (over burden) means that the securities are pledged
as collateral for a loan / debt. Thus, if we open a margin account, deposit
$1,000 and then buy $1,600 worth of shares, the shares are encumbered (by
the margin loan). If we open a regular account deposit $1,000 and buy $1,000
worth of shares (minus commissions, fees, etc.), the shares would be
unencumbered.

------------ End of the CHAPTER – 18 ----------

CHAPTER – 19
GDP AND INFLATION

Learning objectives
After studying this chapter, you can be able to :-
1. Understand the concept of GDP and Inflation,
2. Know the formula for obtaining GDP,
3. Illustrate the components of GDP,
4. Understand the concept of Price index and Inflation indices, and
5. Computation of GDP and Inflation of a nation.

GDP
I. Meaning of GDP :-
The total market value of all the finished goods and services produced within
a nation (or country) in a specific period of time i.e. monthly, quarterly or
annually is called as Gross Domestic Product (GDP). It indicates the nation’s
economic health.

If GDP is rising, the economy is in rigid form, and the country is in moving
forward. Similarly, if GDP is falling, the economy might be in trouble, and
the country is in losing form. If a country shows negative GDP for
consecutively two periods, it indicates that the country is in economic
recession. GDP enables investors, policymakers and central banks, etc. to
judge whether the economy is falling or growing, and to take strategic
decision making.
II. Calculation methods of GDP :-
GDP can be calculate through the following three methods :-
1. GDP based on Production :-
Under this method, GDP calculates based on the total value of all the firms’
finished goods (products) and services, and not consider intermediate goods
which are used to produce finished products.

2. GDP based on Income :-

Under this method, GDP calculates based on the total value of income earned
by all the factors of production i.e. those which are the inputs needed for the
creation of goods or services in an economy such as wages paid to workers,
rent received, interest on capital, profit of the firm, etc.

3. GDP based on Expenditure / Spending :-

Under this method, GDP calculates based on the total value of expenditure on
goods and services produced. In other terms, total amount spent on
consumption and investments of goods and services of the country in a
specific period of time.

III. Formula to obtain GDP :-

GDP = C + I + G + (X – M)
Where,

Consumption (C) :-
Here, consumption means personal consumption expenditure i.e. total money
spent on finished products and services by private individuals and households
for personal use. In other words, private purchasing on durable goods (or
consumer goods which are tend to last for at least three years i.e. Vehicles,
home, office furnishing, clothing, electronics etc.), non-durable goods ( i.e.
food, condiments, cosmetics, office supplies, fuel, medications, etc.) and
services (i.e. transportation services, information services, etc.).

Investments (I) :-
Here, investments mean the total money spent for capital expenditure i.e.
residential fixed (i.e. new homes, additions and alternations) and non-
residential fixed (i.e. factories, office buildings, plant and machinery, etc.). In
other words, investment means the amount spent to purchase fixed assets or
inventories, or for replacing fixed assets that have depreciated.

Government Expenditure (G) :-

This includes the total money spent by government of the country to purchase
of goods and services of equipment, infrastructure, pay roll, etc. of their
departments such as Education, Defence, Police, etc.

Net exports (X – M) :-
Here, Net exports = total exports (X) – total imports (M).
The goods and services sent by domestic country to overseas / abroad is
called as Exports, whereas the goods and services received by domestic
nation from abroad is called as Imports. If more exports than imports, it is
called as surplus and it boosts a country’s GDP. Similarly, if less exports than
imports, it is called as deficit and it drags / pull the country’s GDP.
Exports = Amount paid and/or payable inclusive of dividend and interest, if
any to domestic country by foreign countries.
Imports = Amount paid and/or payable inclusive of dividend and interest, if
any by domestic country to foreign countries.

Note :-
It should be noted that the below 3 points while calculating GDP :-
(a) Exclude intermediate products,
(b) Exclude non-market output such as house wife’s services, and
(c) Include imputed value of goods also. For example, formers produce and
kept for self-consumption, rent of self-occupied house, etc.

IV. Other components :-

1. Net National product (NNP) :-

The total amount of goods and services of consumers inclusive of services of
government employees and net investment at prices actually paid for them. It
derives by reducing depreciation from GDP. The NNP is also termed as net
national income (NNI) at market prices.
NNP = GDP – depreciation or capital consumption
2. National income (NI) :-
NNP at factor cost is National Income. It measures the income accruing to the
factors of production for their contribution towards producing current output.
It is obtained by deducting indirect taxes and business transfer payments from
and adding subsidies to NNP at market prices. Thus, we can say that
NI = [NNP + subsidies – (Indirect taxes + Business Transfer
Payments i.e. BTP)]
Where,
Business Transfer Payments include :-
(a) Corporate Gifts to non-profit institutions,
(b) Allowances for consumer bad debts, un-covered funds, etc.

Subsidies include :-
Govt. compensation to business for selling its goods and services below
market prices

3. Private Income :-
Income obtained by private individuals from any source, retained earnings of
companies, etc.
Private Income = [NI + Govt. Transfer Payments i.e. GTP + BTP –
(supplements to labour income + profits of Govt. enterprises and
Govt. property)]
Where,
Government Transfer Payments include :-
(a) Retirement pensions,
(b) Social security benefits,
(c) Interest on National debt,
(d) Other transfer payments, etc.

Supplement to labour income :-

Employer’s contributions to social security, pension funds, and to employee
welfare institutions.

4. Personal income (PI) :-

The amount of income which is spendable is available to individuals before
personal taxes are deducted. It defers from private income in that it excludes
undistributed profits of companies, co-operatives, and similar organizations.
PI = Private income – Retained earnings i.e. corporate savings
before taxes.

5. Disposable income (DI) :-

The income which individual have at their disposable after the payment of
personal taxes from personal income. In other words, sum of personal
consumption and personal savings. It measures the purchasing power of the
consumers.
DI = PI – (Employee contributions to social security, pension funds
+ Direct personal taxes)

Or

DI = Consumer expenditure + Net savings of individuals

Where,
Direct personal taxes include Taxes on personal income and inheritance
taxes.

V. Difference between GDP and GNP :-

GDP (Gross domestic Product) :-
Whatever is produced by within the domestic territory of a country (no matter
even if the foreign companies might have contributed) is called as GDP.

GNP (Gross National product) :-

Whatever is produced by domestic nationals whether inside the country or
outside the country, will form the GNP of domestic nation. Also, part of the
product produced in domestic nation by non-domestic nationals (foreigners)
will have to be excluded in case of GNP.

In this case, in brief,

GDP = GNP – NFIA

GNP = GDP + NFIA
Here,
NFIA = Net Factor Income from Abroad

Positive NFIA = Income earned by domestic nationals abroad – Income

earned by foreign nationals in domestic nation.

Negative NFIA = Income earned by foreign nationals in domestic nation -

Income earned by domestic nationals abroad

Thus,
If NFIA value is positive, it will be added to GDP, then GNP > GDP

If NFIA value is negative, it will be deduct from GDP, then GNP < GDP

VI. Difference between Normal GDP and Real GDP :-

Normal GDP :-
The total market value of all the finished goods and services produced within
a nation (or country) in a specific period of time, un-adjusted for inflation is
called as Nominal GDP or Normal GDP.

If prices change from one period to the next and the output does not change,
the nominal GDP would change even though the output remained constant.
Rising prices will tend to increase GDP, whereas falling prices will make
GDP decrease. Therefore, just by looking at an economy’s un-adjusted GDP,
it is difficult to say whether the GDP increased as a result of production
expanding in the economy or because of prices raised. In order to overcome
this and to get correct GDP growth, we have to follow the below Real GDP.

Real GDP :-
The total market value of all the finished goods and services produced within
a nation (or country) in a specific period of time, adjusted for inflation is
called as Real GDP. By adjusting the output in any given period for the price
levels that prevailed in a reference (or base) period, economists adjust for
inflation's impact. So that, it is possible to compare a country’s GDP from
one period to another period and see if there is any real growth in the
economy. It is calculated by using the GDP price deflator which is a price
index that measures inflation or deflation in an economy by calculating a
ratio of nominal GDP to real GDP, and it is the difference in prices between
the current period and the base period. For example, if prices raised by 4%
since the base period, the deflator would be 1.04.
GDP deflator = [(Nominal GDP / Real GDP) x 100]
Nominal GDP is usually higher than real GDP because inflation is typically a
positive number. Nominal GDP is higher than Real GDP in the case of
inflation, whereas Real GDP is higher than Nominal GDP in case of
Deflation. Nominal GDP is used when comparing different quarters of output
within the same year. When comparing the GDP of two or more years, real
GDP is used because, by removing the effects of inflation, the comparison of
the different years focuses solely on volume.
For example, a country’s GDP at current prices and price indices are as
following :-
GDP Price
year
(billion $) Index
2005 90 125
2012 110 170
2020 135 235
If prices have been raising over this time, part or entire increase in GDP may
have been increasing due to these prices raise. we can use this information to
work out the value of GDP in real time. We deflate 2020 GDP by measuring
it in 2012 prices as under :-
$135 x (170 / 235) = $97.66 billion

2005 GDP at 2012 prices as under :-

$90 x (170/125) = $122.40 billion

By what percentage has real output risen between 2005 and 2020 :-
$97.659 billion x (170 / 122.40) = 135.6383 or 35.64%
VII. Limitations of GDP :-
(a) It does not account for several unofficial income sources such as
amounts which are not paid for taxes, volunteer work, and household
production, Black money, etc.
(b) GDP considers only final goods production and new capital investment
and intentionally left out the amounts spent on intermediate goods.
VIII. Case :-
The information provided in below table will give you a brief understand
about calculation procedure of GDP components :-
Amount
Description $ (billion
$)
Expenditure on personal consumption 910
Domestic investment 302
Net exports (Exports - Imports) 11
Purchases by Government 145
Gross National Product (GNP) 1368
Less : depreciation or Capital
consumption 127
Net national Product (NNP) 1241
Less : Indirect business taxes 188
Less : Business Transfer Payments 11
Add : Subsidies less surplus of Govt.
enterprises 7 192
National income (NI) 1049
Add : Govt. Transfer payments to
persons 145
Add : Government interest payments 26
Add : Business transfer Payments 32
add : Inventory valuation adjustment 18
221
Less : supplements to labour income 75
Less : Social security contributions by
Govt. 135
210 11
Private Income 1060
Less : Corporate tax 88
Less : Retained earnings or corporate
savings 75 163
Personal income (PI) 886
 Less : Personal taxes 76
Less : Employee contribution to
pension fund 19 95
Disposable Income (DI) 791
less : Consumption 700
Less : Interest paid by consumers 27
Less : Personal transfer abroad 3 730
Personal Savings 61

INFLATION
I. What is Inflation :-
Inflation is an increase in the general price level and thereby increase in cost
of living which leads to decrease in purchasing power of consumers,
wholesalers, etc. (Here, cost of living means an average cost of buying a
basket (or selected) of goods and services.) In other words, the rate at which
the average price level is increasing for selected goods and services in an
economy, and simultaneously, the purchasing power of currency is
decreasing in a specific period of time is called as Inflation. The inflation rate
is the percentage (%) increase or decrease in prices during a specified period,
usually a month or a year. Inflation may be positive or negative, in the view
point of individuals. increase prices in assets like house, gold, or stocks are
called as Asset inflation.

As prices increase, a single unit of currency loses its value as it buys only few
goods and services. This loss of purchasing power impacts the general cost of
living for the common public which eventually leads to a slowdown in
economic growth of the country. In order to curb this, the central bank (or
monetary authority) of the country takes the necessary steps to keep inflation
within acceptable limits, and keep the economy of the country running
steadily.

II. Calculation of inflation rate :-

The inflation rate is the percentage (%) change in the price of a basket
(selected) of goods and services consumed by households from one period to
another period. The inflation indices i.e. CPI or WPI can be used to calculate
the value / rate of inflation between two particular periods, say months, or
years.

Example 1 :-
The CPI index of year 2019 is 262.53, and 2018 was 254.55. Find the
inflation rate changes %.
The inflation rate = [(current period value – Base period value) / Base period
value] x 100
= [(262.53 – 254.55) / 254.55] x 100
= (7.98 / 254.55) x 100
= 0.031349 or 3.135%
In case pf prices or price index value is decreasing as compared to base /
reference periods, then it is treated as Deflation.

Example 2 :-
If we want to know how the purchasing power of $15,000 changed between
October 1980 and March 2020. Assume that the CPI of October 1980 is
55.80 and March 2020 is 288.45. Thus,
Change in inflation = (Current period’s CPI value / Base period’s CPI value)
x 100
change in inflation (Raise in inflation) = (288.45 / 55.80) x 100
= 5.16935 x 100
= 516.94 %

If we want to know how much $15,000 of October 1980 would be in March

2020, we have to multiply the increased in inflation factor with the amount to
get the changed dollar value as below :-
Change in dollar value = $15,000 x 5.16935
= $77,540

If we want to get the final dollar value of the end period, add original dollar
amount ($15,000) to the change in dollar value as below :-
Final Dollar value = $15,000 + $77,540.25
= $92,540.25

This means that $15,000 in September 1980 will be worth $92,540.25. We

can understand that if we purchased a basket of goods and services (as per
CPI index) worth $15,000 in September 1980, the same basket would cost us
$92540.25 in March 2020.

III. Classification of Inflation :-

1. Demand-Pull effect :-
It occurs when the overall demand for goods and services in an economy
increases speedy than the economy's production capacity in a country. It
creates the situation where higher demand and lower supply exists which
leads to higher prices. For example, a tyres manufacturing company decides
to cut down on production of tyres, the supply decreases, though higher
demand which leads to increase prices of tyres, and finally it results to
inflation. Moreover, an increase in money supply in an economy also leads to
inflation, why because, if more money available to individuals, then
consumers can do higher spending on purchasing of goods and services,
which increases demand and leads to increase in prices. Money supply can be
increased by the central bank either by reducing the respective monetary
policy rates i.e. CRR, SLR, etc. (available more money to the individuals), or
by devalue (reducing the value of) the currency, or printing more currency,
etc. Therefore, demand will increase in all such cases, and simultaneously the
money loses its purchasing power.

2. Cost-push effect :-
This type of inflation occurs when increase in the prices of production
process inputs. For example, an increase in labour costs to manufacture a
product, increase in the cost of raw material, etc. This type of situations lead
to higher cost for the finished goods and services and result to inflation.

3. Built in inflation :-
This type of inflation occurs when suitable expectations by employees /
workers. This means as the prices of goods and services are increased,
workers / employees expect and demands more salaries / wages to maintain
their cost of living. So, their increased wages result in higher cost of goods
and services.

IV. Inflation Indices :-

Inflation can be measured in several ways. The inflation indices were
developed to understand the inflation levels for different types of population
like consumers / retailers, wholesalers, producers, etc. the inflation indices for
these type of population are known as consumer price index, Wholesale price
index, Producer price index, etc. In India, the Consumer price index and
Wholesale price index are two major indices for measuring inflation, whereas
in USA, the Consumer price index and Producer price index are taking in to
measure of inflation. As the prices of some goods and services are more
volatile than others such as food and fuel, it may give dispute signals to
monetary authority (or central bank i.e. RBI in India) as the overall inflation
could change because of a selected goods and services. Thus, separate indices
can be developed and separating the volatile items from the main index.

1. Wholesale Price Index (WPI) :-

It measures and tracks the changes in the price of goods and services in the
stages before the retail level. Since WPI items are different from one country
to other country, they mostly include items at the wholesale or producer
level. For example, cotton prices for raw cotton, cotton yarn, and cotton
clothing, etc. The WPI was main index for measurement of inflation in India
till April 2014. After that, reserve bank of India (RBI) adopted new consumer
price index i.e. CPI (which is combination of CPI for rural and CPI for urban)
as the key measure of inflation.

(i) WPI is to have inflationary trend in the economy as a whole,

(ii) WPI is considering based on wholesale prices for primary articles,
Administered prices for fuel items, ex-factory prices for manufactured items,
(iii) WPI prices can collect based on voluntary,
(iv) WPI covers all goods and services inclusive of intermediate goods
transactions in economy,
(v) WPI weights based on the data of national accounts and enterprise survey,
(vi) the item groups / categories of WPI broadly classified as following :-

weights weights
Type of goods
(approx.) (approx.)
Primary Articles 20%
Food articles 14%
Non-food items and
6%
 Minerals

Manufactured
65%
goods
food items 10%
Non-food items 55%
Fuel and Power 15%

(vii) WPI taking in to consideration of around 700 items and 5500 price
quotations to calculate inflation index (or price index).
(viii) WPI price data provided / released by wholesalers in India as
voluntarily to office of the economic advisor,
(ix) WPI computed by “Office of the Economic Advisor” in “Ministry of
Commerce and Industry”,
(x) The base year of WPI is FY 2012,
(xi) WPI inflation rate released on monthly basis.

Note :-
(a) Relating to point (vi) above, among manufactured products, the highest
weightage is of chemicals and chemical products,
(b) WPI does not take into consideration the retail prices or prices of services.

2. Consumer Price Index (CPI) :-

CPI is percentage change in the retail prices of a basket of goods and services
consumed / purchased by households / individuals. The CPI is a measure that
examines the weighted average of prices of a selected goods and services
which are belongs to primary consumer needs such as transportation, food,
and medical care, etc. CPI is calculated by taking price changes for each item
in the predetermined basket of goods and averaging them based on their
relative weight in the whole basket.

(i) CPI use to adjusting income and expenditure flows for changes in the cost
of living,
(ii) CPI is considering based on retail prices inclusive of taxes and
distribution cost,
(iii) CPI prices can collect based on visiting the markets by investigators,
(iv) CPI covers all goods and services which are relating to only consumers,
(v) CPI weights obtained from the data of survey on consumer expenditure,
(vi) the item groups / categories of CPI broadly classified as following :-

weights
Type of goods
(approx)
Food and beverages 54%
Narcotic substances 3%
Clothing &
footwear 8%
Fuel and light 8%
Others 27%
100%

(vii) CPI taking in to consideration of around 450 items in rural category, and
460 items in urban category to calculate inflation index (or price index).
(viii) CPI price data can be released by the following authorities :-
(a) The price data of industrial workers, agricultural labours, and rural
labours are compiled and released by the “labour bureau” in the
“ministry of labour and employment”, and,
(b) The price data of combination of rural and urban consumers / retailers
is released by “Central Statistics Office (CSO)” in the “Ministry of
Statistics and Programme Implementation”,
(ix) CPI is computed and released by central bank of India i.e. “Reserve Bank
of India (RBI) in India”,
(x) The base year of CPI is FY 2012,
(xi) CPI inflation rate released on monthly basis.

V. Price Index :-
The weighted average of prices of a basket of goods and services at a current
selected period relative to their prices in base period is called ‘price index’.
The formula for obtaining the price index for current period is as following :-

The price index of current period = [ (the total weighted average price of
selected goods and services of current period / the total weighted average
price of same goods and services of in base period) x 100 ]
Problem :-
Calculate price index from the following hypothetical price data of current
FY 2019 and base year of 2012 .

FY 2012 (base
FY 2019
year)
Product
Rate Rate
Qty Qty
(INR) (INR)
Water
50 20 30 16
bottle
Biscuit
40 15 50 12
packet
Footwear 20 100 20 70
T-shirt 30 200 20 250

Solution :-

We need to calculate weighted average prices for above data as below ;-

FY 2019
Amount
Product Rate
Qty (INR)
(INR)
Water
50 20
bottle 1000
Biscuit
40 15
packet 600
Footwear 20 100 2000
T-shirt 30 200 6000
9600

FY 2012
(base year) Amount
Product
Rate (INR)
Qty
(INR)
Water
 bottle 30 16 480
Biscuit
50 12
packet 600
Footwear 20 70 1400
T-shirt 20 250 5000
7480

The weighted average price of selected goods and services in FY 2019 is INR
9600

The weighted average price of selected goods and services in base FY 2012 is
INR 7480

Thus, the price index of 2019 is :-

= (9600 / 7480) x 100
= 1.283422 x 100
= 128.34

the price index of base year 2012 is :-

= (7480 / 7480) x 100
= 1 x 100
= 100

Note :-
Therefore, the price index for base period will always be 100 .

VI. Is Inflation good or bad :-

We can understand inflation as either a good or a bad thing,
The individuals who holds tangible assets, like property, may like to see
some inflation as that increases the value of their assets which they can sell at
a higher rate. On contrary, the buyers of such assets may not be happy with
inflation, as they will be required to distribute more money. If wages increase
with inflation, and if the borrower already owed money before the inflation
occurred, the inflation benefits the borrower, because of the borrower still
owes the same value of money, but now they more money in their pay check
to pay off the debt. This results in less interest for the lender if the borrower
uses the extra money to pay off their debt early.
Inflation can help lenders, especially when it comes to expanding new
financing. First, higher prices mean that more people want credit to buy big-
ticket items, especially if their wages have not increased. This equates to new
customers for the lenders. Moreover, the higher prices of those items earn the
lender more interest. For example, if the price of a refrigerator increased from
$2,000 to $2,200 due to inflation, the lender makes more money because 10%
interest on $2,200 is more than 10% interest on $2,000. In addition, the extra
$200 and all the extra interest might take more time to pay off, meaning even
more profit for the lender.
Second, if prices increase, so cost of living also increases. If people are
spending more money to live, they have less money to satisfy their
obligations (assuming their earnings have not increased). This benefits to
lenders because people need more time to pay off their previous debts,
allowing the lender to collect interest for a longer period. However, the
situation could backfire if it results in higher default rates. People holding
cash may also not like inflation, as it weakens the value of their cash
holdings. Inflation promotes investments, both by businesses in projects and
by individuals in stocks of companies, as they expect better returns than
inflation.
However, an optimum level of inflation is required to promote spending to a
certain range instead of saving. If the purchasing power of money remains the
same over the periods, say years, there may be no difference in saving and
spending. It may limit spending, which may negatively impact the overall
economy as decreased money circulation will slow overall economic
activities in a country. A balanced approach is required to keep the inflation
value in an optimum and desirable range.
High, negative or uncertain value of inflation negatively impacts an
economy. It leads to uncertainties in the market, prevents businesses from
making big investment decisions, may lead to unemployment, promotes
hoarding as people flock to stock necessary goods at the earliest amid fears of
price rise and the practice leads to more price increase, may result in
imbalance in international trade as prices remain uncertain, and also impacts
foreign exchange rates.
VII. Controlling Inflation :-
A country’s financial regulator taking the important responsibility of
monitoring the inflation. It can be done by implementing measures through
monetary policy, which refers to the actions of a central bank or other
committees that determine the size and rate of growth of the money supply.in
an economy.

VIII. Other Terms :-

1. Deflation :-
The general decline in prices for goods and services, generally associated
with a decrease in the supply of money and credit in the economy is called as
Deflation. During deflation, the purchasing power of currency increases over
time. When the change in prices in one period is lower than in the previous
period, the CPI index has declined, this indicates the economy is
experiencing deflation. Deflation, generally occurs in and after periods of
economic crisis. As more money is saved, less money is spent, further
decreasing aggregate demand. Deflation may set in causing an even deeper
and more severe crisis. As prices fall, production slows and inventories are
liquidated. Demand drops and unemployment increases. Thus, Deflation is
typically bad for economy.

2. Stagflation :-
It is defined as a period of inflation combined with a decline in GDP /
economic output. During stagflation, unemployment remains steadily high. It
presents a confusion for economic policy. Stagflation is term that describes a
"perfect storm" of economic bad news, such as high unemployment,
slow economic growth and high inflation.

------------ End of the CHAPTER – 19 ----------

GLOSSARY

1. Accountancy
Accountancy is the language of business efficiently communicated by well-
organized and the honest professionals are called as accountants.
Accountancy is one of the subjects like Mathematics, Science, Economics,
Politics, etc… which deals accounting and in this accountancy, we can learn
how accounting is done in a business.

2. Accounting
The process of recording, classifying, summarizing and reporting the
business transactions of a firm is called as an Accounting.

3. Personal Account
The firm has to deal with many individuals and other organizations in the
process of business operations. Therefore, it has to open the accounts in the
names of those individuals and organizations. The accounts deal the business
transactions with regard to persons or organization are called as Personal
accounts.

4. Real Account
All the accounts which records the transactions related to assets are known as
Real accounts. A separate account will be opened for every asset in a firm.
For example, Machinery A/c, Goodwill A/c, Patents A/c, Cash A/c,
Trademarks A/c, Sales A/c, Purchases A/c, etc.

5. Nominal Account
Account which gives the information relating to income and expenditure of
the firm is known as Nominal account. For example, Salaries A/c, Rent A/c,
Discount allowed A/c, Interest received A/c, Bad debts A/c, Depreciation
A/c, workmen compensation A/c etc.

6. Book Keeping
The art of keeping accounts of separate set of books in a regular and
systematic manner of day-to-day business transactions of a firm is called as
Book keeping. Book keeping is universally accepted accounting system to
have a permanent record for future purpose, to analyses & compare business
data, and to submit information to government authorities etc. The
preparation of final accounts is made easy with book keeping.
7. Double entry system
Every business transaction should have 2 aspects i.e. one is receiving aspect
and another one is giving aspect. The receiving aspect is called as ‘Debit’ and
the giving aspect is called as ‘Credit’. Hence, for every debit, there is an
equal corresponding of credit. The recording of 2 aspects i.e. debit and credit
of every business transaction in the books of accounts of a firm is known as
Double entry system of accounting.

8. Journal
‘Journal’ is derived from Latin word ‘journ’ which means a ‘day’. Journal is
a preliminary record of day-to-day business transactions of a firm which is to
give effect to two different accounts involved in business transactions. All the
business transactions are should be first recorded in the journal. So that, the
journal is also called as “Day book” or “Prime book” or “Book of first entry”
or “Book of original entry”. Journal is the first step of accounting.

9. Ledger
A set of accounts or the book containing classified information is called as
“Ledger”. Ledger is the second step of accounting. It is a permanent record of
all the business transactions of a firm in a summarized and classified form.
Hence, the ledger is also called as “Principal book” or “Main book” or “Final
book”. It is a shape of ‘T’ form. Left side is debit and the right side is credit.
The pro forma of a ledger is as under.

10 Subsidiary books
If the size of the firm is small, and transactions are limited, then, it is not
difficult to record all business transactions are in one book. If the size of the
firm is large, and transactions are more, it will be difficult to record all the
transactions in one book and post them in to various ledger accounts. Thus, to
overcome such problems, the different transactions are classified in to various
groups and relevant transactions are record in a separate journal are called
Subsidiary journals or Book of original entry or Subsidiary books. In other
words, the sub division of journal in to various books are called as Subsidiary
books. The subsidiary books are not a part of double entry system of book
keeping. The subsidiary books are Cash book, Purchase book, Purchase
return book, Sales book, Sales return book, Bills receivable book, Bills
payable book, and Journal proper.
11. Trial balance
A trial balance is prepared on a particular date with all the ledger account
balances to know the arithmetical accuracy of books of accounts of the firm
and to find out the errors and mistakes in passing journal entries and their
postings. It is the third step of accounting process. It is not a part of double
entry system of book keeping. Preparation of final accounts will become easy
with preparation of trial balance. In trial balance, all assets and expenses are
shown in debit side and all the incomes and liabilities are shown in credit
side. If the debit and credit totals are equal, we can say that the books of
accounts are correctly written. Preparation of trial balance is two types :-
a. total balances method :-
Under this method, total of debit side and total of credit side of each
individual account is taken in trial balance.
b. Net balances method :-
Under this method, balance in each ledger account is taken in trial balance.
This method is very popular.

12. Suspense Account

When a trial balance is prepared, sometimes the totals of debit and credits
may not disagree (not equal). The causes for such a disagreement is not
apparent at once. The accountant is forced to make the trial balance to agree
by transferring the balance to an artificial account is called as” Suspense
account”.

13. Profit and Loss account

The Profit and loss account is prepared for the particular period with all
revenues and expenses of a firm to know the net profit or net loss. The
earning capacity of a firm is reflected by its income statement. It considers as
a measure of the firm. The cost of the resources which are used to generate
revenue during the period of an accounting year i.e. one year is called an
expenses. Expenses may be in the form of cash payments (i.e. salaries,
wages, rent, etc..) or an amount taken out of earnings (i.e. bad debts) or an
expired portion of an asset (i.e. depreciation/amortization). Expenses are
summarized and charged in the profit and loss account as deductions from the
gross profit. Revenue is the amount of money that a firm received during the
period of time against the sale of goods and services rendered to outsiders
(customers, etc.). the discount received and deductions for returned
merchandise by the firm are also known as revenue.

14. Capital Expenses

Capital expenses which are incurred to purchase an asset i.e. installation
charges, wages paid for installation charges of plant etc. These expenses will
increase the value of the asset. Hence, they should not be debited to the profit
and loss account. They have to add to the relevant asset in assets side of the
balance sheet.

15. Balance sheet

The balance sheet is a most important financial statement of an entity. It
indicates the financial position of a firm at a particular moment of time. The
statement prepared on a particular date with all assets and liabilities of the
firm to know the financial position of the firm is called as Balance sheet. It
contains all assets (resources), liabilities (obligations) and owner’s equity of
the firm in monetary terms. It shows what the business owns and what it
owes.

16. Tangible fixed assets

The assets which are having their physical existence in the firm and used in
the business operations to generate profits of the firm. For example, Land,
buildings, plant, machinery, furniture, equipment, vehicles, etc. These assets
are generally recorded at their cost price instead of their current market price.
These cost prices of tangible fixed assets (except land) are allocated over the
expected useful life of their assets after reduced the depreciation every year
due to continuous use of an asset & time lapse. But, in the case of land,
generally, there is an appreciation (increase of cost price) instead of
depreciation.

17. Intangible fixed assets

The assets which are not having their physical existence in the firm, but, the
have value to the firm. For example, goodwill, patents, copyrights,
trademarks, franchises etc. These assets are the firm’s rights. These assets
also recorded at their cost price. These cost prices are amortized (like
depreciate) over their useful lives. The original cost of the fixed asset (Gross
block) minus accumulated depreciation is called the Net block. Here,
accumulated depreciation means the sum of total depreciation amount which
is reduced for all years of the fixed asset.

18. Accounting cycle

It is the flow of accounting information during the accounting period. The
accounting transactions are pass through a cyclical process of the below steps
is called as an accounting cycle.
1. Writing business transactions when they took place.
2. Writing journal entries for all the transactions.
3. All journal entries are posted to ledger and balances are taken from each
ledger account.
4. Extract the Trial balance with all ledger account balances.
5. Preparation of Trading and Profit & Loss account based on trial balance to
know the profit or loss.
6. Preparation of Balance sheet at the end of the period based on trial balance
and Trading and Profit and loss account to know the financial position.

19. Company
A Company is considered as voluntary association (artificial person) of 2 or
more persons recognized by law and having a distinctive name and common
seal, formed to carry on business for profit, with capital divisible into shares,
limited liability, a corporate body and perpetual succession to achieve a
common objective. Law creates it and law only can dissolve it. Its existence
is of the life of its members.

20. Corporation
A corporation is a business organization which is incorporated inside or
outside the nation which is having a separate legal entity i.e. its identity is
distinct from its owners. It is formed by the notification in the official gazette
by the central govt.

21. Inc.
Inc. refers to a company that is able to do business in legal manner and there
are specific stipulations for this business model that protect the owners, CEO
and board members. The shareholders, directors and officers are not
questionable for the debts and other obligations which are hold by the
company in the concern of Inc. companies. These companies are not separate
legal entities.

22. Ltd
Ltd (Limited) means limited liability and it is commonly used for small
companies that have a limited number of owners and it can be similarly
associated with a limited liability company (LLC) or a corporation.
Companies with limited have a limited liability and therefore, the members of
the company have restrictions for their shares. some limited companies have
been established on the basis of public funds that are in the form of equity
and preference shares.

23. Public Limited Company (PLC)

A Public Limited Company (PLC) is a joint stock company formed and
registered under the Indian Companies Act, 2013 or any other previous act
that has permission to issue registered securities to the general public through
Initial Public Offerings (IPO) and it should be trade on at least one stock
exchange. A Public Limited Company can raise the capital from public by
issuing shares through stock markets. The PLC can issue the bonds or
debentures that are unsecured debt issued to public on the basis of financial
performance and integrity of the company. A public limited company is not
authorized to begin its business operations if it obtains the grant of the
‘Certificate of Incorporation’.

24. Private Limited Company

A Private Limited Company is a joint stock company formed and registered
under the Indian Companies Act, 2013 or any other previous act. It is an
association of persons formed voluntarily having the minimum paid up
capital of Rs.1,00,000. It is a business entity that held by private owners. The
liability of each member (shareholder) is limited to their ownership stock.
This means if the company having a loss, the company’s shareholders are
liable to sell their company’s shares to clear the liability (debt) there by their
personal assets of the shareholders are not at risk. It restricts the shareholders
from public traded shares. This is having the ‘perpetual succession’.

25. Holding Company

A holding company is a parent company that owns enough voting stock in
another company to control that company's management and operations. A
holding company exists for the sole purpose of controlling another company
which might also be a corporation, limited partnership or limited liability
company, rather than for the purpose of producing its own goods or services.
If a business is 100% owned by a holding company, it is called a wholly
owned subsidiary.

26. Subsidiary Company

A company is said to be a subsidiary of another if:
(i) The other company controls the composition of its Board of Directors.
(ii) The other company holds more than half in nominal value of its equity
share capital.
(iii) It is a subsidiary of such a company which is itself subsidiary of any
other company.

27. Foreign Company

Foreign company means any company incorporated outside India but has
established business in India.
These companies may be of the following two types :-
(i) Companies incorporated outside India which established a place of
business in India after the commencement of Indian Companies Act, 1956;
and
(ii) Companies incorporated outside India which established a place of
business in India before the commencement of this Act and continued to have
such a place of business in India at the time of commencement of this Act.

28. One-Person Company

One-Person company is that company where one person holds practically the
whole of the share capital of the company and in order to meet the statutory
requirement of minimum number of members, some dummy names are
added. The dummy names which are added are mostly the relatives or friends
of principal shareholder.

29. Equity (Ordinary) Shares

These are the most common type of shares also known as ‘common stock’ or
‘standard shares’. Ordinary shares carry voting rights, but not usually any
special rights and restrictions beyond that. Even though the ordinary
shareholders are entitled to voting rights, they are the last to be paid if the
company is winding up (closure of the company). Ordinary shareholders have
the right to a corporation's residual profits. In other words, they are entitled to
receive dividends if any are available after the dividends on preferred shares
are paid. They are generally issued and traded in everyday stock market.
Their returns are not fixed.

30. Preference Shares

Preference shareholders have the right to be paid dividends prior to dividends
being paid for other share types like ordinary (equity) shares. Shares in this
category receive a fixed dividend, which means that a shareholder would not
benefit from an increase in the business' profits. However, usually the
preference shares have lead rights than equity shares to their dividend if the
business is in trouble. Preference shares do not typically carry the voting
rights. So that this is a slightly less preferred share type. This means that part
of the share capital of the company which carries (or would carry) the
preferential right with respect to :-
Dividend:-
Payment of dividend, either a fixed amount or an amount calculated at a fixed
rate, which may either be free of or subject to Income tax, and

Repayment:-
In case of winding-up of a company or repayment of capital, repayment of
the amount of share capital paid-up or deemed to have been paid-up, whether
or not, there is a preferential right to the payment of any fixed premium or
premium on any fixed scale specified in the memorandum of articles of the
company.
Preference shares are shares of a company's stock issued to
preferential shareholders. Preference shares represent ownership in a
company like common stock or equity shares.

31. Rights Issue

Issue of an additional shares by an existing company to its existing equity
shareholders is called as rights issue. The company may issue these
additional shares where at any time after the expiry of two years from the
formation of a company or the expiry of one year from the first allotment of
shares in the company, whichever is earlier. If the Board of Directors are
decided to increase the subscribed capital of the company or to convert the
debentures or/and loans into shares in the company, the further (additional)
shares can be allotted to existing equity shareholders with following
conditions :-
(a) Such additional shares shall be offered to the existing equity shareholders
of the company proportionately to their equity holdings on that date.
(b) The offer shall be made by a notice that specifying the number of shares
offered and limiting a time not being less than 15 days from the date of the
offer. If not accepted, it will be deemed to have been declined.

32. Buy-back of shares

Buy-back of shares is just the opposite of issue of shares. Buy-back of
securities is nothing but, the company can purchase its own shares or
debentures for cancellation or redemption of shares. In the case of buy-back,
the company which has issued shares to the public can re-purchases its own
shares.
33. Bond
A financial instrument which shows the obligation of the borrower to the
lender is called as Bond. They are created to raise funds for the company or
government. It is a certificate signifying a contract of indebtedness of the
issuing company for the amount lent by the bondholders. Generally, bonds
are secured by collateral i.e. an asset is pledged as security that if the
company fails to pay the sum within stipulated time, the holders can
discharge their debts by seizing and selling the asset secured. Bonds are
issued for a fixed period which carries interest known as ‘coupon.’ The
interest needs to be paid at regular intervals or it will accrue over time. Bonds
are issued by public sector undertaking, government firms, large
corporations, etc.

34. Debenture
A debenture is a debt instrument used for supplementing capital for the
company. Debentures are may or may not secured by physical assets and
collateral. It is an agreement between the debenture holder and issuing
company. The capital raised is the borrowed capital so that the status of
debenture holders is like creditors of the company. Debentures carry interest
which is to be paid at periodic intervals. The amount borrowed is to be re-
paid at the end of the stipulated term as per the terms of redemption. The
issue of debentures publicly requires credit ratings. Debentures are issued by
issued by the companies whether it is public or private.

35. Bank reconciliation statement

Reconciliation means finding reasons for differences between two books i.e.
cash book or bank register maintained by a person or firm and pass book or
bank statement of the account holder.

“Bank Reconciliation Statement” (BRS) is a statement which contains a

complete and satisfactory explanation of the differences in balances as per the
cash book and pass book. A BRS is to be prepared whenever a bank
statement received or all the transactions are updated in pass book and the
BRS prepared by the customer (bank account holder) of the bank. A BRS can
be prepared based on balance as per cash book or balance as per pass book or
overdraft balance as per cash book or overdraft balance as per pass book.
Bank Reconciliation Statement (BRS) is prepared on a stated day and the
preparation of BRS is not a part of the double entry system of book keeping.
BRS is neither part of pass book nor part of cash book.

36. Overdraft
A deficit in bank account caused by drawing more money than the account
holds is called overdraft. An overdraft allows us to access extra funds through
our transaction account up to an approved overdraft limit by the banker.

37. Dishonour of cheque

A situation when the accepter of the bill refuse to pay the amount unable to
do so is called dishonour of cheque due to in the following reasons :-
a. Insufficient funds in drawee’s bank account
b. Drawee’s bank account closed
c. Stop payment instructions given by drawee to banker etc.

38. Depreciation
A company to write-off the planned, continuing and gradual value of a
tangible fixed (long-term) asset over its useful life due to continuous use of
an asset, time lapse, wear and tear, new technology and unfavourable market
conditions is called as “Depreciation”. Depreciation is charged on book value
of the asset (Original cost i.e. purchase price minus scrap/salvage/residual
value) rather than market value. Here, book value means cost price of an
asset minus accumulated depreciation.

39. Accumulated depreciation

While the depreciation expense is recorded as debit on the income statement
(Profit and Loss Account) of a company, its impact is generally recorded in a
separate account and disclosed in the balance sheet as accumulated
depreciation under fixed assets as per accounting principles. Accumulated
depreciation is a contra asset account (i.e. off-setting account or clearing
account) because it separately shows a negative amount which is directly
associated with fixed assets account in the balance sheet.

40. Revaluation of fixed assets

The process of increase or decrease carrying value of the fixed asset, in case
of major change(s) in fair market value of that fixed asset is known as
Revaluation of a fixed asset. It is a technique that accurately define true value
of the fixed assets (or capital goods) of an organization’s business. The
purpose of Revaluation of fixed assets is to bring fair market value of the
asset into books of accounts of an organization.

41. Carrying value

Nothing, but book value of an asset. The value is based on the original cost of
an asset less Depreciation Amortised / impairment costs made against that
asset.

42. Fair market value

The price at which a seller can sell their goods or services to a buyer is
known as Fair Market Value (FMV). In simple words, FMV is nothing, but
Current Market Price (CMP). The fair market value is calculated based on the
growth rate, profit margins, and potential risk of a company.

43. Impairment
A permanent reduction in the value of fixed asset or an intangible asset which
occur as the result of an unusual (un common / rare) cases due to changes in
legal or an economic condition, customer demands, and damage of assets,
etc.
44. Break-even point
The point (i.e. level) of sales at which the total revenue is equal to total cost
and the net income is equal to zero is called as break-even point (BEP). The
BEP is also known as No Profit No loss point.

45. Margin of safety:-

the amount of sales that are above the break-even point. In other words,
the margin of safety indicates the amount by which a company's sales could
decrease before the company will become unprofitable.
Margin of safety (MOS) = [(sales – BEP) / sales] x 100
or
Margin of safety (MOS) = Actual sales – Break-even point

46. Capital budgeting

The process of decision making with regard to investment of money or
current funds efficiently in the long term projects. The investment decisions
of the firm are commonly known as Capital budgeting or Capital expenditure
decisions.

47. Payback period

The length of time required to recover the cost of an investment is called Pay
Back Period. It is calculated as :-
PBP = Cost of an investment of project / Annual Cash flows
It is used as a first screening method for an investment back. The shorter
payback period is better investment back of the project. In other words, Less
Pay Back period is more favourable to accept a project. We may have a target
Pay Back Period. With any project, taking longer PBP than the target PBP is
being rejected.

48. Net present value

NPV is the difference between the present value of cash inflows and present
value of cash outflows (cost of an investment of a project). This means the
NPV is subtract our investment of a project from our cash inflows. NPV is
used to know the profitability of an investment of a project. NPV compares
the value of rupee today to value of that same rupee in future.
49. Profitability index
PI is the ratio of the present value of cash inflows at required rate of return
(k) i.e. NPV to the initial cash outflow (investment). PI is used to know that
for every 1 dollar of invested, how much we are getting.

50. Internal rate of return

IRR is also known as ERR (Economic Rate of Return). IRR is used to know
the efficiency of the investment of a project. IRR is the discounting rate
which equates the NPV is equal to zero. IRR is calculated as :-
IRR = R1 + [{NPV 1 x (R2 – R1)} / (NPV 1 – NPV 2)]

51. Modified Internal rate of return

MIRR is Basically same as IRR except it assumes that the Future value of net
cash inflows are reinvested in the project at the rate of cost of capital) or a
specified reinvestment rate over the investment period. MIRR usually to be
lower than IRR. The project should be accepted if MIRR is more than the
COC (Cost of Capital i.e. k).

52. Gross working capital

Gross working capital means the total current assets of a firm and does not
account for current liabilities. In other hand, the Gross working capital means
the investment of a company in its current assets. Thus, we can say that the
total current assets are called as Gross working capital.

53. Net working capital

The difference between current assets and current liabilities is known as Net
working capital. Net working capital may be either positive or negative. It is
said to be positive net working capital when current assets are more than
current liabilities. On contrary, it is said to be negative working capital if
current assets are less than the current liabilities.

54. Current assets

Assets those which can be convertible in to cash within the short period or an
accounting year i.e. one year. Example of current assets are mentioned
below:-
(i) Cash-in-hand
(ii) Cash-at-bank
(iii) Sundry debtors
(iv) Closing stock
(v) Bills receivables
(vi) Pre-paid expenses
(vii) Advances given
(viii) Marketable securities, etc.

55. Current liabilities

Liabilities those which are re-payable within the short period or an
accounting year i.e. one year. Example of current liabilities (obligations) are
mentioned below:-
(i) Sundry creditors
(ii) Bills payable
(iii) Outstanding expenses
(iv) Bank over draft (short-term)
(v) Income tax liability
(vi) Proposed dividend
(vii) Long-term liability matured in current year, etc.

56. Operating cycle

Operating cycle means the continuous flow from cash to suppliers, to
inventory, to debtors and back in to cash. The main aim of the firm is to
maximize the shareholder’s wealth (return). In order to increase the
shareholder’s return, the firm should earn required return from its operations
of business. The firm has to invest sufficient (required) funds in current assets
for generate sales. Earning the frequent amount of profit requires the length
of the time required to complete the following events of the cycle.
a. Conversion of cash in to resources or inventory
b. Conversion of resources or inventory in to receivables
c. Conversion of receivables in to cash

57. Owner’s equity

The financial interests of the owners of a firm is called as owner’s equity.
Owner’s equity represents the total assets minus total liabilities. Equity is the
owner’s claim whereas liabilities are the outside parties’ claims. So that, the
earnings or losses of the firm cannot affect the creditors’ (outside party)
claims, but, effect the owner’s equity. For example, if the firm makes net
profit, we will add the same to capital or reserves & surplus which is owner’s
equity. Similarly, if the firm makes net loss, we can reduce this from capital
or reserves & surplus which is owner’s equity in balance sheet of the firm.
Owner’s equity can increase when the firm makes earnings (net profit) and
retains that earnings whole or a part. In the case of joint stock companies,
owners are called as shareholders or stockholders and owner’s equity called
as shareholder’s (stockholders/proprietors) equity or fund.

58. Operating income (revenue) :-

The amount of profit arising from core operations (business) of a firm in an
accounting period is called as operating income. It is also known as Earnings
(profit) before interest and tax (EBIT). It can be arrived from the below
formula :-
EBIT = Revenue from sales – (cost of Goods Sold (COGS) + operating
expenses).
The operating income include gross proceeds from the sale of products
manufactured by a firm.

59. Operating expenses :-

The expenses which are incurred for core operating (business) activities of a
firm in an accounting period are called as operating expenses. These include
Cost of Goods Sold (COGS), wages, heat & electricity, general &
administrative expenses, selling & distribution expenses, depreciation and
amortization, etc.

60. Non-operating income :-

The amount of profit arising from sources which are not relating to the core
operations of a firm in an accounting period are called as non-operating
income. It includes the gains from investments, gains from sale of asset or
property, gains from foreign currency exchanged, interest received, dividend
received, etc.

61. Non-operating expenses :-

The amount of expense which are incurred by a firm that is un related to its
core operations in an accounting period are called as non-operating expenses.
These include interest paid, Income tax paid, and other non-operating costs,
etc.
62. Funds flow statement
Funds mean working capital which effect the current assets and current
liabilities. Flow means movement. The movement of working capital which
effect the current assets and current liabilities is called funds flow. The
statement which determine the information relating to the sources
(inflows)and uses (outflows or applications) of funds between the two
balance sheet dates is known as Funds flow statement. Here, working capital
means the difference between current assets and current liabilities i.e. net
working capital. Working capital determines the liquidity position of the
firm.

63. Cash flow statement

A statement summarizes where a company’s money (cash) came from
(inflow/cash receipts) and where it went (out flow or payments) is called as
Cash flow statement or statement of cash flow. It is also known as Statement
of changes in cash position. It is a standard financial statement along with the
Balance sheet and Profit & Loss account (Income statement). It is used for
short-run planning. It indicates the sources (inflow) and uses (out flow or
applications) of cash. It analyses the changes in non-current accounts as well
as current accounts. Here, the term current accounts indicate current assets
and/or current liabilities. The cash flow statement indicates the changes in
cash position is to only record the inflow and outflow of cash and find out the
net change during the period. The amount received minus the amount paid
during the period is the cash balance at the end of given period.

64. Retained earnings statement

The amount of total profits left in the firm after dividends paid to its
shareholders (stockholders or stakeholders) are called as retained earnings.
Retained earnings are also known as Accumulated earnings (profits). These
earnings (profits) has been kept by the firm for internal use. These earnings
will be re-invested in the firm for various activities to promote growth and
development of business operations, and used to make payment against the
firm’s debt obligations, etc. A statement of Retained earnings has to be
appear as a separate statement or as an inclusive of either a balance sheet or a
profit & loss account (Income statement) for a time period of an accounting
year. The Retained earnings statement is also known as “Statement of
Changes in equity” or “statement of owner’s (shareholders or stakeholders)
equity”. This statement is prepared with an accordance with Generally
Accepted Accounting Principles (GAAP). The purpose to prepare the
Retained earnings statement is to improve the market and investor confidence
in the firm and used to analyse the firm’s financial health for the specific
period. The general calculation structure of the retained earnings statement is
as below :-
Opening balance of Retained earnings + net profit during the year – Dividend
paid during the year = Closing balance of retained earnings

65. Financial analysis

Financial analysis is the process of identifying the strengths and weaknesses
of the firm by properly establishing relationship between the items of balance
sheet and items of income statement. In other words, Financial analysis is a
process which involves reclassification and summarization of information
through the establishment of ratios and trends. The financial analysis can be
done through the following devices :-
(i) Comparative statement (analysis),
(ii) Common size statement (analysis),
(iii) Trend analysis,
(iv) Intra-firm analysis,
(v) Funds flow statement,
(vi) Cash flow statement, and
(vii) Ratio Analysis.

66. Definition of Leverage

Leverage is a business term which refers to borrowing funds or other
financial instruments i.e. debt to finance the firm’s assets (purchase of
inventory, equipment and other company’s assets) and thereby to increase the
potential return of an investment. A firm with significantly more debt
(leverage) than equity is considered a highly leveraged and vice versa. A
company using a more debt is increases the risk of bankruptcy, but it also
increases the company’s returns especially the Return on equity (ROE). The
owner’s equity will not be diluted if using the debt financing rather than
equity financing. The interest payments on debt capital are tax deductible.
Investors prefer the business to use debt financing but only up to a point.
67. Capital structure
The financing or capital structure decision is an important significant
managerial decision. The company’s assets can be financed either by increase
the creditor’s claims (i.e. debt) or owner’s claims (equity). The debt can be
increase when the firm borrowing the debt from creditors. The owner’s
claims can be increase when the firm raise the funds by issuing shares or
retaining the existing earnings. The equity plus liabilities of the firm are
referred to as financial structure of the firm. The long-term claims can be
form capital structure of the enterprise. The proportionate relationship
between debt and equity is referred to as capital structure of the firm. Here,
equity means paid-up capital, share premium and reserves & surplus i.e.
retained earnings. The capital structure decision can be affect the
shareholder’s return and risk and also it affects the market value of the share.
The capital structure decision may be involved when the firm has to be raised
the funds to finance its investments.

68. Operating leverage

The leverage which measures a firm’s fixed costs as a percentage of its total
costs is called as Operating leverage. Operating leverage is a measure of the
combination of fixed costs and variable costs in a company’s cost structure.
A company with high fixed costs and low variable costs has high
operating leverage whereas a company with low fixed costs and high variable
costs has low operating leverage. A company with high operating leverage
depends more on sales volume for profitability. The company must generate
high sales volume to cover the high fixed costs. In other words,
the company becomes more profitable when sales increased. In a company
that has low operating leverage, increasing sales volume will not dramatically
improve profitability since variable costs increase proportionately with sales
volume.
Operating leverage ratio = Contribution / EBIT
Operating leverage ratio is used to analyse the effect of fixed cost on the
operating profit (EBIT) of the firm. A higher the ratio is favourable which
indicates a higher rate of increasing in profit as a result of increase in sales. If
the ratio is too low i.e. variable cost is far more than the fixed cost.

69. Financial leverage

The process of using borrowed capital (debt) to increase the shareholder’s
return on their investments or equity in capital structure is called as Financial
leverage or Trading on equity. The financial leverage analysed by the firm is
intended to earn more return on the fixed charge funds rather than their costs.
The surplus will increase the return on owner’s equity whereas the deficit will
decrease the return on owner’s equity. Financial leverage affects the EPS
(Earnings per share). When the EBIT increases, then EPS increases. The rate
of interest on debt is fixed and it is legal binding to pay the interest by the
firm to its creditors. The rate of preference dividend is also fixed to pay to
shareholders of the firm by the company. Highly leveraged companies may
be at risk of bankruptcy if they are unable to make payment on their debt, but
it can increase shareholder’s return on their investment and there are tax
advantages associated with leverage. Financial leverage ratio is used to
analyse the Capital structure and financial risk of the company. It explains
how does the fixed interest-bearing loan capital affect the operating profit of
the firm. If EBIT is more than EBT, this ratio becomes more than 1. A
slightly higher the ratio is favourable i.e. if this ratio is marginally more than
1, that is nearer to 1, it indicates moderate use of debt capital, low financial
risk and good financial judgement.
Financial leverage ratio = EBIT / EBT

70. Combined leverage

The combination of operating leverage and financial leverage is called as
combined leverage or composite leverage. The degree of composite leverage
can be calculated as follows:-
Combined leverage = Operating leverage x Financial leverage

71. Time value of money

The relationship between the monetary value of today and the same monetary
value in future is called as “Time value of money”.

72. Book value

The book value is difference between total assets minus intangible assets and
liabilities of the firm. The book value of share is derived as Share capital plus
reserves divided by number of shares of a company. In other words, the book
value of debt is stated at the outstanding amount.

73. Replacement value

The amount that a company would be required to spend if it were to replace
its existing assets or things in current condition is called as Replacement
value.

74. Liquidation value

The amount that a company could realize if sold its assets or things after
having terminated its business. But, it should not include the value of
intangible assets as the operations of the company are assumed to cease.
Generally, the liquidation value is minimum value if a company may accept
if it sold. Going concern value is higher than the liquidation value.

75. Market value

The current price at which the asset (or security) is being bought or sold in
the market is called as the market value of the asset. In ideal situation, the
market value should be equal to present value of a security where the capital
markets are efficient and equilibrium. Here, present value means intrinsic
value.

76. Face value

The value of the face of the bond (or debenture or security) is called as face
value. The interest will be calculated on the face value of the bond/debenture.
The face value is also known as par value.

77. Interest rate

Interest rate on a bond or debenture is fixed to pay to bond holder or
debenture holder. This interest amount received on a bond/debenture is tax
deductible. The interest rate is also known as coupon rate.

78. Maturity
The bond/debenture generally issued for the specific period is called as
maturity period. The bond/debenture’s amount will be re-paid on the maturity
date or expiration date of the bond/debenture.

79. Redemption value

The value i.e. the bond holder or debenture holder will get on maturity date is
called as maturity value or redemption value or terminal value. A
bond/debenture can be redeemed at par (face value) or premium or at
discount. Here, premium means the value is more than the face value and
discount means the value less than the face value of the bond/debenture.

80. Yield Curve

The curve which shows the relationship between the YTM and their maturity
is called as yield curve or “Term structure of interest rate”. Generally, the
yield curve showing upward slope which indicates that the long-term yields
are higher than the short-term yields. Conversely, the high inflation periods
have the downward slope yield curve which indicates the short-term yields
are higher than the long-term yields. The down slope yield curve is also
termed as “inverted yield curve”.

81. Redeemable and Irredeemable preference shares

The companies may be issued the preference shares with or without maturity
period. The shares which are having maturity period is called as redeemable
preference shares and those shares which are issuing without maturity period
are called as irredeemable preference shares.

82. Cumulative and Non-cumulative preference shares

The preference shareholders get dividends paid at a fixed rate. The preference
share’s dividends which are un-paid and the same will accumulate and
payable in the future are called as Cumulative preference shares. The
preference share’s dividends which are in arrears and do not accumulate and
not paid in future to the preference shareholders by the companies, those
preference shares are called as Non-cumulative preference shares.

83. Transferable and Non-transferable preference shares

The preference shares which are having the right to convert from preference
shares to equity (ordinary) shares after a stated period are called as
Transferable or Convertible preference shares and those shares which are not
having the right to convert the preference shares in to equity shares are
known as Non-transferable or Non-convertible preference shares.

84. Cost of capital

The rate of return which the firm requires from investment in order to
increase value of the firm in the market is termed as Cost of Capital. From the
view of investors, the average rate of return required by the investors who
provide the long-term funds to the companies is called the cost of capital. In
the view of companies, the cost of capital is that the minimum rate of return
which a firm must earn on its investment (both the debt and equity). The
sources of capital of a firm may be in the form of preference shares, equity
shares, debt, and retained earnings. In simple cost of capital of a firm is the
weighted average cost of their different sources of financing.
The cost of capital of the firm is useful as a standard for the below:-
(i) Evaluating the investment decisions,
(ii) Designing the debt policy of the firm.
(iii) Estimating the financial performance of the company / project.

85. Weighted average cost of capital

The rate that a company is expected to pay on average to all its shareholders
to finance its assets is known as weighted average cost of capital (WACC). It
is commonly referred to as the firm’s cost of capital. It should be noted that it
is dictated by the external market and not by the management. It refers to the
weighted average cost of different sources of finance. It is very important in
financial decision making. Steps involved in computation of WACC :-
(i) Calculate the cost of each of the sources of finance is ascertained,
(ii) Assigned weights to the specific costs,
(iii) Multiplying the cost of each source by their appropriate weights,
(iv) Dividing the total weighted cost by the total weights.
Weighted average cost of capital (kw) = ∑XW / ∑W
Here, X = cost of specific source of finance
W = weights i.e. portion of specific source of finance

86. Cost of Debt

It is the rate of return which is expected by lenders. Debt may be perpetual
(or irredeemable), and redeemable (or repayable).

87. Capital Asset Pricing model

We can use CAPM model, or any other advanced model for many stocks
which are not paying the dividend. CAPM is a model which used to
determine a theoretically appropriate required rate of return of an asset to
make decisions about adding assets to a well-diversified portfolio. Beta co-
efficient is a statistic that measures the systematic risk of a company's
common stock. The market rate of return is the rate of return on the market.
Return on a relevant benchmark index such as SENSEX or NIFTY is a good
estimate for market rate of return.
Cost of Equity Ke CAPM = Risk free rate + Market risk premium (or equity
risk premium)
Here, Market risk premium = [ Beta co-efficient x (market return – risk free
return) ]
We can simplify, Ke CAPM = [ Rt + {β + ( Rm - Rt )} ]
Here, Rt = Risk free rate of return
Β = Beta co-efficient
Rm = Return on market portfolio

88. Portfolio
A portfolio is any combination or a group of financial assets such as stocks,
bonds, commodities, gold, currencies and cash equivalents as well as their
fund counterparts including mutual, exchange-traded and closed funds. A
portfolio can also consist of non-publicly tradable securities like real estate
and private investments. Portfolios of investments are held directly by
investors and/or managed by financial professionals and money managers
like portfolio managers, financial advisors (analysts), mutual fund managers,
wealth management advisors, banks and other financial institutions. Investors
should construct an investment portfolio in accordance with their risk
tolerance and their investing objectives. The monetary value of each asset
may influence the risk/reward ratio of the portfolio. The main aim of the
proper asset allocation (portfolio) is minimizing the risk and maximizing the
expected return. There are several methods for calculating the portfolio
returns and their performance. One traditional method is using periodic
(monthly or quarterly) money-weighted returns. However, the true time-
weighted method is also a method preferred by many investors in financial
markets.

89. Diversification
Diversification is a method of portfolio management or an asset allocation
plan whereby an investor reduces the investment risk of their portfolio by
holding a wide variety of investments in different types of assets that have
low correlations with each other. It is a risk management technique. Investors
accept a certain level of risk and also need to have an exit strategy if their
investment does not generate the expected return in their portfolio. Hence, by
constructing a well-diversified portfolio, the investors will protect their
investments. The proper asset allocation allows investors to leverage the
investment risk and portfolio volatility as each asset is expected to react
differently to various market conditions. Diversification reduces risk if
returns are not perfectly positively correlated.

90. Portfolio return

The expected return on portfolio is nothing but, the weighted average of the
expected returns on the individual securities in the portfolio. We can calculate
the expected portfolio’s return as proportion (weights) of investment in stock
‘n’ multiplied by the return of the stock ‘n’. In simplified terms, this is
expressed as below formula.
Expected portfolio return E(Rn) = Wi Ri
Where E(Rn) : expected portfolio’s return of stock ‘n’
Wi : Weights or probability or proportion of investment in stock ‘n’
Ri : Return on investment in stock ‘n’

91. Portfolio risk

Risk means simply the variance. The risk of an individual security or a
portfolio is measured by variance and/or standard deviation of its returns. So,
the portfolio risk which is measured by variance and/or standard deviation is
not the weighted average of the risks of individual stocks (securities or
assets) in the portfolio except when the returns from the securities are un-
correlated. Hence, the portfolio risk is measured by the below 2 factors
namely Variance and Standard deviation.

92. Variance ( s 2)
Variance measures how far a data set is spread out. In other words, variance
is used to measure the variability i.e. volatility. The variance is calculated by
taking the differences between each number and the average in given data set
and squaring the differences to make them positive. A value of zero means
that there is no variability i.e. all the numbers in the given data set are the
same or identical. A large variance indicates that the numbers in the given
data set are far from the average and each other whereas a small variance
indicates that the numbers in the given data set are close to the average and
each other. The advantage of variance is that it treats all the deviations from
the average the same regardless of direction. As a result, the squared
deviations cannot sum to zero and give the appearance of no variability at all
in the given data set. A disadvantage of variance is that it gives added weight
to numbers far from the average because of squaring these numbers can
misrepresent the interpretations of the given data set.
The variance of stock ‘n’ is calculated as below:-
Variance ( s 2n) = Proportion of investment x Deviations square
Here, Deviation = return of the security ‘n’ minus Average return of the
security ‘n’
In simplified terms, this is expressed as below formula.
Variance ( s 2n) = ∑P(r - r¯)2
Where P : Proportion or weights or probability of investment in stock ‘n’
r : return of stock ‘n’
r¯ : Average return of the stock ‘n’
Here, Average return of the stock ‘n’ = Total returns of stock ‘n’ / Number of
state of natures in stock ‘n’

93. Standard Deviation

Standard deviation measures the dispersion (variation or spread out) of a set
of data from its average (mean). Standard deviation is a measurement to
calculate the annual rate of return of the historical volatility of that
investment. It is calculated as the square root of variance by determining the
variation between each data point relative to the average. The greater the
standard deviation of a security, the higher the variance between each price
and the mean (average) which indicates a larger price range. Similarly, the
lower the standard deviation of a security, the lower the variance between
each price and the mean (average) which indicates a smaller price range.
Standard deviation is a simple way to measure an investment or portfolio's
volatility. It is calculated based on the average.

94. Volatility
Volatility is the rate at which the price of an underlying asset (or security or
commodity or foreign exchange etc..) fluctuates i.e. increase or decrease for a
given set of returns for a given period of time. Volatility is a statistical
measure of the dispersion of the underlying stock’s price or returns for a
given period of time. Volatility indicates the expected ‘one standard
deviation’ range for the stock based on the option price. One standard
deviation means that there is approximately a 68% probability of a stock
settling within the expected range as determined by option prices.

95. Covariance
The covariance is an absolute measure of co-movements between the returns
of an individual securities. The covariance reflects the degree to which the
returns of the 2 securities change together. Covariance may be positive or
negative. A positive covariance indicates that the returns of the 2 securities
move in the same direction. Conversely, the negative covariance indicates
that the returns of the 2 securities move in the opposite direction. Covariance
is calculated to help the diversify of security holdings.
The covariance between 2 securities is calculated as below:-
Covariance of stock X and stock Y [Cov(X,Y)] = ∑P[(rx - rx¯) (ry - ry¯)]
Where, P : Proportion or weights or probability of investment
rx : Security ‘X’
ry : Security ‘Y’
rx¯ : Average returns of security ‘X’
ry¯ : Average returns of security ‘Y

96. Coefficient of correlation

The correlation coefficient is a relative measure of co-movements between
the measures of 2 securities. Correlation coefficient also reflects the degree to
which returns of the 2 securities change together. In other words, the
correlation coefficient is used to measure how strong a relationship between 2
securities. Here, correlation means the linear relationship between two
variables.
The correlation coefficient between 2 securities is calculated as below:-
Correlation coefficient of stock X,Y = Covariance of X,Y / Product of
standard deviations of X,Y
or
Correlation coefficient of stock X and stock Y [Cor(X,Y)] = [∑P{(rx - rx¯)
(ry - ry¯)}] / s X s Y
Where, P : Proportion or weights or probability of investment
rx : Security ‘X’
ry : Security ‘Y’
rx¯ : Average returns of security ‘X’
ry¯ : Average returns of security ‘Y
 s X : Standard deviation of stock ‘X’
s Y : Standard deviation of stock ‘Y’
The correlation coefficient is varying between +1 and -1. A value of exactly 1
(i.e. +1) means perfect positive correlation or perfect co-movement in the
same direction i.e. if a positive increase in one stock, there is also a positive
increase in the second stock. A value of exactly -1 means perfect negative
correlation or perfect co-movement in the opposite direction i.e. if a positive
increase in one stock, there is a decrease in another stock. A value of zero (0)
means, there is no correlation or co-movement between the 2 securities.
Thus, we can say that the strength of relationship between the 2 securities
varies in the degree based on the value of correlation coefficient. For
example, the value of correlation coefficient is 0.3 indicates that there is a
positive relationship between the 2 securities, but, it is weak and likely
insignificant.

97. Delta (or Hedge Ratio)

Delta is the rate of change of option’s price with respect to its underlying
asset price. The Delta is an important concept for option sellers. Delta reflects
the increase or decrease in the option’s price with respect to one point of
movement of the underlying stock price. The Delta value of an option is from
1 to -1 i.e. either positive or negative depending on the type of the option.
The Delta value of an option is from 0 to 1 i.e. positive for call options (i.e.
Strike price or option price is less than the underlying stock price for In-the-
money call options i.e. profitable or Strike price or option price is greater
than the underlying stock price for Out-of-the-money call options i.e. not
profitable). Conversely, The Delta value of an option is from 0 to -1 i.e.
negative for put options (i.e. Strike price or option price is greater than the
underlying stock price for In-the-money put options or Strike price or option
price is less than the underlying stock price for Out-of-the-money put
options). Simply, a Delta of call option will always be 0 to 1 because if the
underlying stock increases in price (spot price), call options will increase in
price. Similarly, a Delta of put option will always be -1 to 0 because if the
underlying stock increases, the value of put option will decrease. For
example, if Delta of a call option is 0.20 when the spot price of underlying
asset increases by $1, the price of the call option will increase by $0.20.
Generally, At-the-money options usually has a delta at approximately 0.5 or
-0.5 because of both the strike price (i.e. option price) and spot price of the
underlying asset are same in ITM and OTM call or put options.

98. Gamma
Gamma of an option measures the rate (percentage) of change of the option’s
delta with respect to one-point movement of the underlying stock price (i.e.
spot price). Generally, the Gamma is at peak value when the spot price of
underlying security is near the strike price of the option. Delta increases or
decreases along with the underlying asset price, whereas Gamma is a
constant that measures the rate of change of Delta. The higher Gamma of an
option is considered as a higher risk since an un-favourable move in the
underlying stock i.e. an oversized impact. This is a bad situation for most
traders looking for predictable opportunities. Gamma is the measure of the
stability of probability of an option over time whereas Delta represents the
probability of In-the-money at expiration.

99. Theta
A Theta of an option is the rate of change of value of the portfolio with
respect to the passage of time with all else remaining the same. Theta is
referred to as the time decay of the portfolio. Generally, Theta is expressed as
a negative number. The theta of an option reflects the amount by which the
option's value will decrease every day. Theta values of an option are always
negative for long options and will have a zero-time value at expiration since
time only moves in one direction and time runs out when an option expires.
Theta is higher for shorter term options especially for At-the-money options
because such options have the highest time value, so have more premium to
lose each day. Generally, the options of high volatility stocks have
higher theta because the time value of premium on these options are higher
and so they have more to lose per day. To obtain the theta for a calendar day,
the formula for theta must be divided by 365. To obtain the theta per trading
day, it must be divided by 250.

100. Vega
Vega is the rate of change in option premium (price) for one unit is respect to
the change in the volatility of the underlying asset or security. If Vega is
high, the portfolio of an option is become expensive. If Vega is low, the
volatility changes have relatively little impact on the value of the stock’s
portfolio. If volatility increases, the price of the option will increase and if
volatility decreases, the price of the option will also decrease. Thus, when
calculating the new option price due to volatility changes, we add the Vega
when volatility increases and vice versa.

101. Rho
The Rho of a portfolio of an option is the rate of change in the value of the
portfolio of an option with respect to the 1% change in risk-free interest rate
(simply called interest rate) of underlying security. Here, the risk-free interest
rate is the minimum return we can expect to receive while keeping our risk at
zero. Generally, the prices of call options will increase as the interest rates
are increased and the prices of put options will decrease as the interest rates
are increased (not decreased). Thus, call options have positive rho while put
options have negative rho.

102. Beta (β)

A beta measures the volatility or systematic risk of a particular stock (or
portfolio of stock)'s returns with respect to a relevant bench mark index (i.e.
SENSEX, NIFTY, etc..) based on the price levels. Beta is used in the Capital
Asset Pricing model (CAPM) which calculates the expected return of an asset
(stock) based on the expected market returns. Beta is also known as the beta
coefficient. High beta stocks are called as aggressive stocks while low beta
stocks are called as defensive stocks.

103. Alpha
‘Alpha’ measures a portfolio's risk-adjusted returns. A positive number of
Alpha suggests the portfolio should get a positive return in exchange for the
risk level taken. The alpha of 0 or less indicates that a portfolio taking an
excessive risk and not getting a sufficient return. Alpha is a tool for investors
looking to measure the success of a portfolio. A portfolio manager with a
positive alpha indicates a better return with either the same or less risk than
the market index.

104. Stock
Stock is ownership in a company and each share of stock representing a tiny
piece of ownership. The more shares we own, the more of the company we
own. The more shares we own; the more dividends we earn when the
company makes a profit. In the financial world, ownership is called an equity.
Investors may purchase stock in the primary or secondary market. A
company sells its stock to the public on the primary market through its initial
public offering. Investors may sell their shares through brokers to other
investors in the secondary market. Stock prices can be found (quotes) in
newspapers, on television and through the Internet.

105. Capital
All the money that we invest to start our business is known as capital.
Essentially, the capital of a business consists of all of its assets (or items to
assist in the creation of financial wealth).

106. Equity vs Debt

To start a new business (or fund a new project), a company can raise money
in two ways such as:-
(i) By selling shares of equity, or
(ii) By incurring debt.
If the owner of the business invested all their own savings to buy the
materials necessary to start the business, they made an equity investment in
the company. Equity is simply ownership of a corporation. Typically,
ownership units in a corporation are referred to as stock. However, if our
owner did not have necessary funds to start their own business they could
finance their operation in one of the below 2 ways:-
(i) Issue stock (or certificates of partial ownership in his company) to people
who may be interested in helping their venture out in return for a proportional
share of the profits that the company might generate.
(ii) Borrow money that will need to be paid back with interest.

107. Bull & Bear Markets

The Bull markets are movements in the stock market in which prices are
rising and the consensus is that prices will continue moving upward. During
this time, economic production is strong, jobs are plentiful and inflation is
low. Bear markets are the opposite that the stock prices are falling, and the
view is that they will continue to falling. The economy will slow down,
coupled with a rise in un-employment and inflation. In either scenario, the
people invest as though the trend will continue. Investors who think and act
as though the market will continue to rise are bullish, while those who think it
will keep falling are bearish.
108. Hedging
If we are un-sure of how the price of a security is going to move, we can
hedge. In hedging, we take a position that protects us from an adverse price
movement. Hence, the process of minimize the risk is known as hedging, but,
the maximize the profits is not called as hedging.

109. Initial Public Offering

The very first sale of corporation (company)’s stocks to the outside investors
or public is known as initial public offering (IPO) and it occurs on the
primary market. This does not necessarily mean that a company is a new
business. It simply means that the company is offering shares of ownership to
investors outside the corporate family for the first time. Most businesses are
privately owned. They don’t have outside investors. A few people who may
be management or employees and members of their respective families are
own all the outstanding stock and such corporations are referred to as
"closely held corporations”. Compared to the costs of borrowing large sums
of money for ten years or more, the costs of an initial public offering are
small.

110. Short selling

In short selling, the trader borrows stock (usually from his brokerage which
holds its clients' shares or its own shares on account to lend to short sellers)
then sells it on the market, betting that the price will fall. The trader
eventually buys back the stock, making money if the price felt in the
meantime and losing money if it rises. Exiting a short position by buying
back the stock is known as "covering”. Hence, the most markets either
prevent short selling or place restrictions on when and how a short sale can
occur.

111. Rolling Settlement

Settlement is a mechanism of settling trades done on a stock exchange on ‘T’
(i.e. trading day) plus ‘X’ trading days, where ‘X’ could be 1,2,3,4 or 5 days,
etc. In other words, in ‘T+2’ environment, a trade done on ‘T’ day and it is
settled on the 2nd working day excluding the ‘T’ day. SEBI (Securities &
Exchange Board of India), as a step towards easy flow of funds and
securities, introduced ‘T+2’ rolling settlement in Indian equity market from
1st April 2003.

112. Market Regulation

The overall responsibility of development, regulation and supervision of the
stock market rests with the Securities & Exchange Board of India (SEBI)
which was formed in 1992 as an independent authority. Since then, SEBI has
consistently tried to lay down market rules in line with the best market
practices. It enjoys huge/enormous powers of imposing penalties on market
participants in case of a violation.

113. 'Blue-chip' company

The name "blue chip" is derived from the game of poker in which the blue
chips have the highest value. The company which is a nationally recognized,
well-established, actively traded on a stock exchange and financially sound is
called as Blue-chip company. Blue chip companies generally sell with high-
quality, widely accepted products and services. The Blue-chip companies are
operating profitably in the case of down turns and adverse economic
conditions, which helps to contribute to their long record of stable and
reliable growth.

114. Advances and Declines

Advances and declines refers to the number of stocks that closed at a higher
and lower price than the previous day respectively. Technical analysts look at
advances and declines to analyse stock market behaviour, differential
volatility and predict that whether a price trend is likely to continue or
reverse. Generally, a market will be more bullish if more stocks advance than
decline and vice versa. The Advances and Declines (A/D) is generally
expressed as a ratio which indicates the general direction of the market.

115. Market capitalization vs Turnover

Market capitalization is the total value of the company's shares - i.e. the
current share price multiplied by the number of shares that have been issued.
It represents what the market currently considers the company to be
worth. Turnover (revenue) is simply the amount of money flowing into a
company as a result of the sale of shares or stocks or goods and services.

116. Index (or stock index)

An index is an indicator or statistical measure of change i.e. stock movement
in a securities market. In the case of financial markets, stock and bond
market indices consist of a hypothetical portfolio of securities representing a
specified market or a segment of it. We cannot invest directly in an index.
The S&P BSE SENSEX is a common benchmark for Bombay stock
exchange. Each index related to the stock and bond markets has its own
calculation methodology. In Stock Market context, an Index represents the
price behaviour of equity market. Further the movement of a stock Index is
influenced by various factors. Generally, there are 3 types of news which
affect the stock market:-
a. Company Specific news which affects the valuation of only that company
b. Industry Related news which affects all the companies in that industry.
c. Economy Related news affects all companies.

117. Market capitalization

The Security should figure in the Top 100 companies listed by full market
capitalization. The weight of each S&P BSE SENSEX Security based on
free-float should be at least 0.5% of the Index. (Market Capitalization would
be averaged for last six months).

118. Free float

The total number of shares available for the public to trade in the market.
Free-float market capitalization takes into consideration only those shares
issued by the company that are readily available for public to trading in the
market. It generally excludes the shares from total number of shares of a
respective company. The following categories of holding the shares are
generally excluded from the definition of Free-float:-
(i) Shares held by founders/directors/acquirers which has control element
(ii) Shares held by persons/ bodies with "Controlling Interest"
(iii) Shares held by Government as promoter/acquirer
(iv) Holdings through the FDI Route
(v) Strategic stakes by private corporate bodies/ individuals
(vi) Equity held by associate/group companies (cross-holdings)
(vii) Equity held by Employee Welfare Trusts
(viii) Locked-in shares and shares which would not be sold in the open
market in normal course. Holding of equity shares by the remaining
shareholders fall under the free float category. All BSE indices exception of
BSE PSU index have adopted the free-float methodology.
119. Derivative
Simply, the term ‘derivative’ is referred as ‘price guarantee’. Every
Derivative specifies a future price of which some product is must be sold.
This item is called an “underlier”. An “Underlier” can be a physical thing like
wheat or oil etc. or it can be an abstract thing like “price index” traded on
stock exchange. Derivative is a contract between 2 parties. The buyer agrees
to purchase an underlying asset from the seller on a specific date at a specific
price. A “derivative” is a financial contract between two or more parties that
derives its price (value) upon an underlying instruments or financial assets
such as stocks, bonds, commodities (gold, silver, oil, gas, agricultural
products, etc..), currencies, interest rates (such as the yield on the 5-year
Treasury bills), market indices (reference rates). Here, the financial asset
means a tangible liquid asset which is an asset that can be converted into cash
quickly.

120. Over the Counter (OTC) derivative contracts

The derivatives those which are trading on an exchange(s) are called as
‘exchange traded derivatives’ whereas privately negotiated derivative
contracts are called as ‘OTC contracts’. OTC Derivatives are unlisted
derivatives structured by parties based on their own convenience. These are
generally popular in the developed markets where leading brokers and
institutions create their own kind of special derivatives and sell to interested
investors. OTC Derivatives generally do not require any margin payments.
They are tailor made and are subject to counter party risk. The OTC
derivative contracts consisting of the following features compared to
exchange-traded derivatives.
(i) The counter-party (credit) risk is decentralized within individuals or
individual institutions,
(ii) The OTC contracts are generally not regulated by a regulatory authority.
(iii) No formal rules for risk and burden sharing between individuals.
(iv) No formal rules for safeguarding the collective interests of market
participants
(v) No formal centralized limits on individual positions, leverages, margins,
etc.
(vi) No formal rules or mechanisms for ensuring market stability and
integrity.
However, they are affected indirectly by national legal systems, banking
supervision and market surveillance.

121. Market makers

Market Makers are the players who offer the continuous bid and ask quotes
for particular securities or series. The market makers are also called as
Jobbers.

122. Investing
The goal of investing is to build wealth over an extended period of time
through the principle of ‘Buying and holding’ of a portfolio of stocks, baskets
of stocks, Mutual funds, bonds and other instruments of financial investment.
Investors invest their money for some years, decades or for even longer
period. Short term market fluctuations are insignificant in the long running
investing approach.

123. Trading
Trading is a method of holding stocks for a short period of time. It could be
for a week or more often a day. Trader holds stocks till the short term high
performance. In other words, trading involves the more frequent buying and
selling of stock, commodities, currency pairs or other instruments with the
goal of generating returns that outperform buy-and-hold investing.

124. Forward contract

forward contract is a customized contract between two parties where in the
settlement takes place in future at today’s pre-agreed price, quantity and
quality of an underlying asset(s).
Features of a “forward contract”:-
(i) Contract between two parties without any legal party (exchange) between
them.
(ii) Price decided today.
(iii) Quantity decided today (can be based on convenience of the parties).
(iv) Quality decided today (can be based on convenience of the parties).
(v) Settlement will take place sometime in future (can be based on
convenience of the parties).
(vi) No margins are generally payable by any of the parties to the other.
125. Futures contract
Future contracts are similar to forward contracts except the futures are
supported by a stock exchange. Future contracts were first traded in the
Chicago in USA. The “future contract” is an agreement between two parties
through an exchange (legal counter-party) to buy or sell an underlying asset
at a certain time in future at a today’s pre-agreed price, quantity and quality.
Futures are quoted on a stock exchange. Prices are available to all buyers and
sellers those who want to buy or sell their underlying asset(s) because the
trading takes place on a transparent computer system.

Features of a “future contract”:-

(i) Contract between two parties through an exchange. Exchange is the legal
counter party to both parties.
(ii) Price decided today.
(iii) Quantity decided today (quantities have to be in standard denominations
specified by the exchange).
(iv) Quality decided today (quality should be as per the specifications decided
by the exchange)
(v) ‘Tick size’ is decided by the exchange. Here, ‘Tick size’ means the
minimum amount by which the price quoted can change.
(vi) Delivery will be take place sometime in future (expiry/maturity date is
specified by the exchange).
(vii) Margins are payable by both the parties to the exchange.
(viii) In some cases, the price limits (or circuit filters) can be decided by the
exchange.

126. Open Interest

The number of transactions open at the end of the day is referred to as Open
Interest. For example, if 40000 contracts have been executed on day one of
the derivatives market and none of them squared up so far, the open Interest
will be 40,000 contracts. If on day two, the 6,000 contracts are squared up
and 10,000 new contracts are executed, then, the open Interest will become
44,000 contracts [(40,000 – 6,000) + 10000]. The level of Open Interest
indicates the depth of the market.

127. Option
Option means the offer price (or strike/exercise price) given to an option
buyer to buy or sell an underlying asset or security. Option is given the buyer
the right but not the obligation of buying or selling an underlying asset or a
security at a certain price (i.e. strike price or an exercise price) before a
certain date (i.e. the expiration date).

128. ’Call’ option

‘Call’ option gives the buyer the right to buy (but not obligation to buy) a
specified quantity of an underlying asset at a given price (or call’s strike
price) on or before a given future date. For example, the Reliance 380 June
‘call’ option gives the buyer the right to buy Reliance at a price of Rs380 per
share on or before the last Thursday of June (i.e. expiry date of the option
contract). The price of 380 in the above example is called as strike price or
the exercise price. In the Indian markets, the ‘call’ options are also known as
‘Teji’. In the case of call option, the ‘call’ option sellers are under obligation
to deliver the underlying asset(s) whenever the call option buyer exercises his
right.

129. ’Put’ option

‘Put’ option gives the buyer the right to sell (but not obligation to sell) a
specified quantity of an underlying asset at a given price (or call’s strike
price) on or before a given future date. For example, the Reliance 380 June
‘put’ option gives the buyer the right to sell Reliance at a price of Rs380 per
share on or before the last Thursday of June (i.e. expiry date of the option
contract). The price of 380 in the above example is called as strike price or
the exercise price. In the Indian markets, the ‘put’ options are also known as
‘Mandi’. In the case of put option, the ‘put’ option sellers are under
obligation to buy the underlying assets whenever the put option buyer
exercises his right.

130. Warrants
Options are generally having their lives up to one year. A majority of options
traded on an exchanges having a maximum maturity of 9 months. The longer-
dated options are called as warrants i.e. the longest term for an option is two
to three years whereas a stock warrant can last for up to 15 years. Thus, in
many cases, a stock warrant can prove to be a better investment than a stock
option if mid to long-term investments. The warrants are generally traded
over-the-counter. A warrant is a derivative which gives the right, but not the
obligation to buy or sell a security at a certain price before expiration.

131. Swaps
A “swap” (simply called an exchange) is a derivative contract between two
parties to exchange their financial instruments. These instruments can be
almost anything but most swaps involve in cash flows that both parties
agreed to. Swaps do not trade on exchanges. Swaps are customized contracts
that are traded over-the-counter (OTC) between private parties. The retail
investors do not generally involve in swaps market. Mostly, the firms,
financial institutions and few individuals are involving in swaps market
because counter-party risk is involved in swaps.

132. Foreign exchange market (FOREX)

The place or market where the currency of one country is exchanged for the
currency of another country in order to buy, sell, exchange and speculate on
currencies is called as foreign exchange (FOREX) market. For example,
WIPRO in India purchased (imported) a machine from Australia for INR
1crore. Then, WIPRO (an importer) has to make the payment to Australian
company (exporter) in Australian dollars. So, WIPRO needs Australian
dollars (AUD) to make payment obligation through a commercial bank
dealing in the FOREX market to purchase machinery by exchanging INR.
Similarly, assume that the Japanese company imported goods from Indian
company Reliance Industries Limited (RIL). Then, the Japanese company
will make payment to RIL in its currency of JPY. So, RIL will convert the
JPY in to INR in the FOREX market.

133. Direct quote

The exchange rate which is quoted as unit of the domestic (home) currency
per unit of a foreign currency is called as direct quote. Therefore, the INR and
USD exchange rate would be written as INR 66.246984/USD is a direct
quote in India or direct quote for rupee. This means, per I US dollar, the
Indian should pay INR 66.246984. This Direct quotation is also known as
European quotation or Quotation in European terms.

134. Indirect quote

The exchange rate which is quoted as number of units of foreign currency per
unit of the domestic (home) currency is called as indirect quote. Therefore,
the INR and USD exchange rate would be written as USD 0.015095/INR is
an indirect quote in India or indirect quote for rupee. This indirect quotation
is also known as American quotation or Quotation in American (U.S) terms.
So, the exchange rate between USD and INR can be expressed in either INR
per USD (INR/USD) or USD per INR (USD/INR).

135. Cross rates

An exchange rate between the currencies of two countries that are not quoted
against each other, but are quoted against one common currency is called as
“Cross rate”. In other words, the cross rate is the exchange rate between
currency A and currency C derived from actual exchange rate between
currency A and currency B and between currency B and currency C.
Sometimes, the cross rate is referred to an exchange rate between two
currencies not involving the US dollar (USD). The reason for not involving
the USD is the currencies of many countries are not freely traded in foreign
exchange market, but currencies of most countries quoted against the US
dollar. The cross rates of currencies that are not quoted against each other can
be quoted in terms of USD.

136. Bid-Ask spread

Foreign currency dealers (brokers) will quote both the Bid and Ask for a
particular currency and always ready to buy or sell foreign currencies. The
average of the bid and ask calculated as [(Ask + Bid)/2].
Bid Price (Buying price):-
The price at a buyer is willing to pay for a security is called Bid price.
Ask Price (Selling or Offer price):-
The price at a seller is willing to sell a security is called as Ask price.
The difference between the buying (bid) and selling (ask or offer) currency
rate is called as FOREX operator’s (i.e. bank or FOREX dealer) Bid-Ask
Spread or simply called as Spread. The bid-ask spread is usually given as a
percentage and it is computed as below:-
Bid-Ask Spread % = [(Ask price – Bid price) / Ask price] x 100

137. Forward exchange rates

The exchange rate at which a bank agree today to exchange one currency for
another at a future date when it enters into a forward contract with an investor
is called as Forward exchange rate. The forward exchange rate is also known
as Forward price or Forward rate. In the forward market, currencies are
traded for future delivery. The spot exchange market is much larger than the
forward market in terms of volume of currency transactions. The types of
Forward rates include 30-day, 90-day and 180-day etc. Most of the banks
quote currency forward rates to the traders. The forward rate may be at a
premium or discount.

138. Forward Premium

The price in which the forward (or expected future) price for a domestic
currency is higher than the spot price is called Forward premium. It indicates
the market that the current domestic exchange rate is going to increase
against the other currency. Here, increasing exchange rate means the currency
is depreciating in value.

139. Forward discount

The price in which the forward (or expected future) price of a domestic
currency is lower than the spot price trading is called Forward discount. It
indicates the market that the current domestic exchange rate is going to
decrease against the other currency. Here, decreasing exchange rate means
the currency is increasing in value. The negative premium is also known as
discount.

140. Interest rate parity (IRP)

Interest rate parity is an interest rate differential between two countries is
equal to the differential between the forward exchange rate and the spot
exchange rate. It states that the exchange rate of two countries will be
affected by their interest rate differential. In other words, the currency of a
high interest rate country will be at a forward discount relative to the
currency of a low interest rate country. Similarly, the currency of a low
interest rate country will be at a forward premium relative to the currency of a
high interest rate country. This implies that the exchange rate differential of
spot and forward will be equal to the interest rate differential between the two
currencies.

141. Purchasing Power parity (PPP)

PPP is the rate of currency conversion that equalize the purchasing power of
different currencies by eliminating the differences in price levels between
countries. PPPs is simply price relatives that show the ratio of the prices in
national currencies of the same goods or services in different countries. PPP
is the expenditure on a similar commodity must be same in both currencies
when accounted for exchange rate. Purchasing power parity is used
worldwide to compare the income levels in different countries. The market
exchange rate doesn’t reflect the purchasing power of a currency.

142. Bank Rate

The Bank rate is also known as Discount rate is the rate of interest which
central bank (RBI in India) charges on the loans and advances i.e. finance
lends to commercial banks and Financial Institutions / Intermediaries,
without pledging any securities. The central bank uses the Bank rate for
short-term purposes and can rise this rate in order to control liquidity (money
supply) and vice versa.

143. Repo Rate

Repo(Re-purchase) rate is the rate at which the central bank (RBI in India)
lends short-term money to commercial banks against Government securities
and other approved securities under Liquidity Adjustment Facility (LAF) for
a Re-purchase agreement in the case of any short fall of funds.

144. Reverse Repo Rate

Reverse Repo rate is a rate at which commercial banks keep their excess
liquidity with the Central bank.

145. MSF Rate

MSF(Marginal Standing Facility) rate is the rate at which the commercial
banks can borrow additional short-term funds from central bank by pledging
Government securities at a rate higher than Repo rate under “Liquidity
Adjustment Facility – Repo scheme” (LAF – Repo) in an emergency
situation when interbank liquidity completely dries-up. Under MSF,
commercial banks can borrow funds from central bank up to 1% of their net
demand and time liabilities (NDTL). The difference between MSF and Repo
is that in MSF, the banks can keep the securities under SLR (Statutory
Liquidity Ratio) to get loans from central bank.

146. CRR
CRR(Cash / Credit Reserve Ratio) is a specified minimum fraction or the
average daily balance of the total deposits of customers, which scheduled
commercial banks need to hold as reserves either in cash or as deposits with
their specified current account maintained with central bank of a nation as a
share of such % of its Net demand and time liabilities (NDTL) that the central
bank may notify from time to time in the Gazette of India.

147. SLR
The SLR (Statutory Liquidity Ratio) is a minimum required percentage /
portion at which the commercial banks need to hold of their Net demand and
Time liabilities (NDTL) as safe and liquid assets in the form of Cash (at book
value), Gold (at current market price), and unencumbered approved
government securities before providing credit to their customers. Here,
approved securities means Bonds / Debentures and Shares of different
companies. Treasury bills, Dated securities issued under Market Borrowing
Programme, and Market Stabilization scheme, etc. also be a form part of the
SLR.

148. GDP
The total market value of all the finished goods and services produced within
a nation (or country) in a specific period of time i.e. monthly, quarterly or
annually is called as Gross Domestic Product (GDP). It indicates the nation’s
economic health.
GDP = C + I + G + (X – M)
Here,
C : Consumption
I : Investments
G : Government Expenditure
X : Exports
M : Imports

149. National income

NNP at factor cost is National Income. It measures the income accruing to the
factors of production for their contribution towards producing current output.
It is obtained by deducting indirect taxes and business transfer payments from
and adding subsidies to NNP at market prices. Thus, we can say that
NI = [NNP + subsidies – (Indirect taxes + Business Transfer
Payments i.e. BTP)]
Where,
Business Transfer Payments include :-
(a) Corporate Gifts to non-profit institutions,
(b) Allowances for consumer bad debts, un-covered funds, etc.

150. Inflation
Inflation is an increase in the general price level and thereby increase in cost
of living which leads to decrease in purchasing power of consumers,
wholesalers, etc. (Here, cost of living means an average cost of buying a
basket (or selected) of goods and services.) In other words, the rate at which
the average price level is increasing for selected goods and services in an
economy, and simultaneously, the purchasing power of currency is
decreasing in a specific period of time is called as Inflation. The inflation rate
is the percentage (%) increase or decrease in prices during a specified period,
usually a month or a year. Inflation may be positive or negative, in the view
point of individuals. increase prices in assets like house, gold, or stocks are
called as Asset inflation.

------------ End of the GLOSSARY ----------

…………...The End ……………

Best wishes ….

Thank you,
Chandra Sekhar,
[email protected]