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Do you want to convert your Dream into Success? Possess the above five characters in you.

Hand Book On

Finance, Financial Market & Institutions, Monetary Policy, Banking and so on

By REJOAN

BBA (F&B) 12 batch

UNIVERSITY OF RAJSHAHI

BASIC OF FINANCE
This book is written only for myself, but after my B.B.A final exam I thought it should be published for the students who are new to the F&B department. Those students as well as others may be benefited by thisREJOAN

By REJOAN

Dedicated
TO

My beloved Parents
(Those hearts who are always trying to make a happy world)

A
REJOAN

Contents
Chapter No. Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Bibliography Chapter Name Introduction to Finance Time Value of Money Cost of Capital Risk and Return Some Basic Bond and Stock Valuation Leverage Capital Budgeting Dividend Policy Banking Monetary Policy Financial market and Institutions Lease Financing Bibliography Page Numbers 1 to 7 8 to 10 11 to 18 19 to 32 33 to 33 34 to 34 35 to 39 40 to 48 49 to 50 51 to 53 54 to 56 57 to 66 67 to 69 71 to 71

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Chapter one

Introduction

Finance is the arts and science of managing money

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Chapter one

Introduction

INTRODUCTION TO FINANCE Finance is a discipline provides ability to convert financial liabilities into real assets. It is the combination of different activities like rising of funds, investment of funds, and proper management of those funds to accomplish the objectives of an individual or of a firm. In a ward, Finance is the process of converting accumulated wealth into productive uses. A simple example will clear you the functions of Finance. Suppose we plan to plant trees on courtyard of our house. In this case, we have to perform step by step the following tasks. (1) Planning of tree plantation. (2) Search the sources of the good plants. (3) Collect plants. (4) Plant the collected plants. (5) Maintain of trees. (6) Consume and distribute the fruits. Now, with these very popular works of tree plantation, we compare the functions of Finance. TREE PLANTATION (1) Planning of tree plantation (2) Searching the sources of good plants (3) Collecting the plants (4) Planting the collected plants (5) Maintenance of the trees (6) Consuming and distributing the fruits FINANCE (1) Planning to invest (2) Searching the sources of capital with minimum cost (3) Collecting / raising of capital (4) Investing capital in the business (5) Maintenance of capital (6) Retention and distribution of profit

Financial manager refers to the man responsible for a significant financial decisions (i,e; investment, financing, dividend decision). Business finance is that business activity which is concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objective of business enterprise. Nature of Finance Nature of finance is as follows: (1) Predicting inflow and outflow of funds (2) Identification of probable sources of funds (3) Protection of capital (4) Distribution of profit. 1
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Chapter one

Introduction

Main Goal of a Business or Profit Maximization Vs Wealth Maximization Profit is a test of economic efficiency. Profit maximization is the maximizing the taka (monetary value) or income of firms. Arguments in favor of profit maximization (1) Profit maximization is the indicator of economic efficiency (2) Through best use of resources, profit is maximum (3) Through profit maximization created own fund of business (4) Profit maximization ensures social welfare.

Increase amount of govt. taxes and revenues Business expansions (i,e; create opportunities of staffing) Increase earning of shareholders

Profit maximization

Social welfare maximization

Direct contribution in protecting environment and social welfare tasks

Nevertheless above arguments, profit maximization is not considered as firms objectives in current business environment. Because it does not consider time value of money, ignores risk and uncertainty and concept of cash flow. But wealth maximization consider all mentioned above. And most of the financial decisions are tradeoff between risk and return, wealth maximization also considers it. Wealth maximization emphases on the net present value of the firm. There are clear concept of objectives ( i,e; maximize the wealth of owners ). Moreover it provides an unambiguous measure of what financial management should seek to maximize in making investment and financing decision. The ultimate goal of wealth maximization is to confirm social and economic welfare of owners removing all the faults and weakness of profit maximization. So, the wealth maximization objective is a guide for efficient allocation of the societys economic resources. From above discussion, we can say the ultimate goal of a business should be wealth maximization. 2
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Chapter one

Introduction

Relationship Between Finance and Accounting Accountant identifies records and communicates the economic events of an organization to the interested users. On the other hand, financial managers evaluate the accounting statements, develop additional data and make decisions on the basis of their assessment of the associated return and risks.

Supply arranged and Trustworthy information

Accounting
Demand for information

Business Finance

(1) Investment Decision (2) Financing Decision (3) Dividend Decision

RELTIONSHIP BETWEEN FINANCE AND ECONOMICS The field of finance is closely related to economics. Financial managers must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy. They must also be able to use economic theories as guidelines for efficient business operation. Examples include supply and demand analysis, profit maximizing strategies, and price theory. The primary economic principle used in marginal finance is marginal cost benefit analysis, the principle that financial decisions should be made and actions taken only when the added benefits exceed the added costs. Nearly all financial decisions ultimately come down to an assessment of their marginal benefits and marginal costs.

SPECIALISED FIELD OF FINANCE

Field of finance

Financial management

Institutional finance

International finance

Public finance

Security and investment analysis

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Chapter one

Introduction

FINANCIAL ASSETS
Financial assets

Money

Debenture

Stock

Common stock

Preferred stock

MAJOR DECISIONS OF FINANCE

Capital Budgeting Investment Decision Working Capital

Capital Structure Decisions of Finance Finance Decision Leverage

Dividend Decision

Retention & Distribution of Profits

Financial institution is an intermediary that channels the savings of individuals, businesses, and governments into loans or investments. For financial institutions, the key suppliers of funds and the key demands of funds are individuals, businesses, and governments. Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. The two key financial markets are the money market and capital market. 4
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Chapter one

Introduction

Money Market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is created by a financial relationship between suppliers and demanders of short-term funds. The market where marketable securities~ short term debt instruments, such as treasury bills, commercial paper, and negotiable certificates of deposit etc. are exchanged between government, business, and financial institutions called money market. Bank, insurance, and financial institutions are the examples of money markets. Capital Market is the market where the long-term securities (i,e; shares and bonds or debentures) issued by the firms and governments are traded ( bought and sold ) between investors. The secondary markets are also called Capital markets. Dhaka stock exchange is the example of capital market. Primary market is the financial market in which NEW securities are sold. This is the only market where the issuer is directly involved in the transaction. The initial public offering (IPO) market is a subset of primary market. AGENCY ISSUE We have seen that the goal of the financial manager should be to maximize the wealth of the firms owners. Thus managers can be viewed as agents of the owners who have hired them and given them decision-making authority to manage the firm. But actually they are appointed for protecting the interest of shareholders or owners. The relation existing between managers and shareholders or owners called agency relationship. In theory, most financial managers would agree with the goal of owners wealth maximization. In practice, however, managers are also concerned with their personal wealth, job security, and fringe benefits. Such concern may make managers reluctant or unwilling to take more than moderate risk. This results a less return than maximum and a potential loss of wealth for the owners. Although managers are appointed just for protecting the interest of owners but they place personal goals ahead of corporate goals. This is the problem called agency problems. The cost borne by the stockholders to minimize agency problems and contribute to the maximization of owners wealth is known as agency costs. Agency cost includes the opportunity costs, monitoring costs, incentive and performance plans, dishonesty prevention costs etc. Two factors market forces and agency costsserve to prevent or minimize agency problems. Liquidity (marketability) is the ability of an asset to be converted into cash quickly and without any price discount. Liquidity varies inversely with the costs incurred 5
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Introduction

when buying or selling. The liquidity of a market or the liquidity of an asset usually increases as the volume of trading in it increases. Three qualities that liquid markets possess are depth (orders exist both above and below the market price), breadth (buy or sell orders exist in volume), and resiliency. Profitability is the ability of a firm to generate net income on a consistent basis. It is often measured by price to earnings ratio.

FACTORS INFLUENCING THE FUNCTIONS OF BUSINESS FINANCE

Factors influencing the financial decisions

Internal factors Size of firm Nature of firm Equity structure Possible income and risk

External factors Economic condition Business cycle Capital and money market

Marginal efficiency Structure of business assets Regulatory and adequacy of income Life of business Favorable contracts Liquidity of business Management approach Restrictions of credit terms

Taxation policy Govt. regulation

Managerial training

DIFFERENCE BETWEEN BUSINESS AND PUBLIC FINANCE Business finance is that business activity which is concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objective of business enterprise. Business finance concerned with the earning and expenditure of a firm. Its ultimate goal / main purpose is to earn profits or to increase wealth. Sources of financing are retained earnings, money and capital 6
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Introduction

market, bank, leasing company etc. On the other hand, public finance is the field of economics that analyzes the government taxes and expenditure policies. To make development structure, increase social welfare and ensure securities of the people etc. are the main purposes of public finance. Taxes are the main source of public financing.

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Chapter two

Time Value of Money

Time Value of Money

The time value of money is the concept concerned with changing the real value of money with changing time. This means that the value of a sum of money received today is more than its value received after some time. Why todays money is preferred to future money? Because of uncertainty of future. For consuming early. To avoid risk. Investment opportunity. Because of inflation. Present value of money with example The current value of a future amount(the amount of money that would have to be invested today at a given interest rate over a specified period to equal the future amount). Present value depends largely on the investment opportunities and the point in time at which the amount is to be received. Present value of money is calculated by the following formula: PV=
FV (1 i) n

Where, PV= present value FV= future value i= rate of interest n= no. of years Example: Mr. REJOAN wants to get a amount of Tk. 12155.06 after 4 years. What amounts he has to deposit now, if bank pays 5% annual interests. PV=
FV (1 i) n 12155.06 = (1 .05) 4 12155.06 = 1.054

= Tk. 10,000

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Chapter two

Time Value of Money

Future value of money with example: Future value is the value at a given future date of a present amount placed on deposit today and earning interest at a specified rate. It depends on the rate of interest earned and the length of time a given amount is left on deposit. Future value is calculated by the following formula: FV=PV(1+i) n Where, PV= present value FV= future value i= rate of interest n= no. of years Example: You are interested to deposit a amount of tk. 7,000 for 5 years into the bank. If bank pays 10% annual interest, what will be the amount after years? FV= PV(1+i) n = 7,000(1+.10) 5 = 7,000(1.61051) = Tk. 11273.57 Interest is the fee paid to use anothers money or may be said thus: - its the compensation paid by the borrower of funds to the lender; from the borrowers point of view, the cost of borrowing funds. Compound interest is the interest that is earned on a given deposit and has become part of the principal at the end of a specified period. Interest paid on interestreinvested is called compound interest. Principal amount is the amount of money on which interest is paid. Simple interest is the interest that is paid once at the end of the year and it is not converted into the principal amount next year. This calculated by the following formula: simple interest= P.n.i A time line is a graphical representation used to show the timing of cash flows. It is a horizontal line on which time zero appears at the leftmost end and future periods are marked from left to right; can be used to depict investment cash flows.

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Chapter two
Tk.-10,000 0 Tk 3000 Tk 5000 1 2 Tk 4000 3

Time Value of Money

Tk 3000 4 Tk 2000 5 End of Year

An annuity is a series of payments of a fixed amount for a specified numbers of periods. A series of payments of a fixed amount starting at the beginning of each period for a specified numbers of periods is called an annuity due. A series of payments of a fixed amount starting at the end of each period for a specified numbers of periods is called an ordinary annuity. Perpetuity is an annuity whose payments begins on a certain date and continues indefinitely (forever). Discounting is the process of determining present value of a future payment (or receipt) or a series of future payments (or receipts). Compounding is the process of determining the future value of a present payment (or receipt) or a series of present payments (or receipts). Continuous compounding is the compounding of interest an infinite number of times per year at intervals of microseconds. The nominal rate of interest Interest may be compounded for any period of time, annually, semi-annually, quarterly, monthly, daily etc. when rate of compound interest is given it is usually specified as an annual rate, called the nominal rate of interest. Hence if the interest is to be compounded semi-annually, this must be divided by 2, if the interest is to be compounded quarterly must be divided by 4 and so on. The effective rate of interest The effective rate of interest is defined to be the rate, when compound annually, give this same amount of interest as a nominal rate compounded several times each year. It is the true annual rate of interest that is actually paid or earned. It also reflects the effects of compounding frequency. Eventually effective rate is the inflation adjusted rate of interest.

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Chapter Three

Cost of Capital

Cost of Capital
Basic Concept from the Desk of the Financial Manager
From what sources we will collect funds or capital? We have to give dividends when we collect funds from issuing common stocks, give dividends at fixed rate as we collect capital by issuing preferred stocks, pay interests at fixed rate in case of debentures. We also pay interests for using bank loans, and in case of retained earnings have an opportunity cost. That means, from whatever sources we collect funds or capital it incurs costs in every case, it is cost of capital. Profit would be increased as we decrease the cost of capital. The cost of capital represents the minimum rate of return that must be earned from capital budgeting projects to ensure that the value of the firm does not decrease. In other words, the cost of capital is the firms required rate of return, r. It represents the overall cost of financing to the firm. For example, if investors provide funds to a firm for an average cost of 15 percent, wealth will decrease if the funds are used to generate returns less than 15 percent, wealth will not change if exactly 15 percent is earned, and wealth will increase if the firm generates returns greater than 15 percent. Weighted Average Cost of Capital, (WACC) is the expected average future cost of financing from different sources to the firm over the long run. Capital component is the element used by firms to raise money. There are four sources or elements to raise capital: long term debt, preferred stock, common stock, and retained earnings. Business Risk is the risk that a company will not have adequate cash flow to meet its operating expenses (administrative expenses, depreciation expenses, advertising expenses, property taxes). Financial Risk is the risk that a company will not have adequate cash flow to meet financial obligations. It is the additional risk a shareholder bears when a company uses debt in addition to equity financing. Opportunity Cost is a cash flow that a firm must forgo to accept a project. For example, if the project requires the use of a building that could otherwise be sold, the market value of the building is an opportunity cost of the project. Flotation Costs are the total costs of issuing and selling a new security including documentation costs and underwriters commission. These include two components: 11
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Cost of Capital

(i) undertaking costscompensation earned by investment bankers for selling the security, and (ii) administrative costsissuer expenses such as legal, accounting, printing, and other expenses. Weighted Marginal Cost of Capital, (WMCC) is the firms weighted average cost of total new (or incremental) financing. Capital Asset Pricing Model, (CAPM) is a model which determines the equilibrium of risk and return of the risky securities in the securities market. The CAPM equation is r i = r RF +b i (r M -r RF ) Investment Opportunities Schedule, (IOS) is a ranking of investment possibilities from best (highest return) to worst (lowest return); the graph that plots project IRRs in descending order against the total investment. Some Key Assumptions To isolate the basic structure of the cost of capital, we make some key assumptions relative to risk and taxes: 1. Business riskis the risk that a company will not have adequate cash flow to meet its operating expenses (administrative expenses, depreciation expenses, advertising expenses, property taxes etc.). Business risk results from the variability of EBIT. 2. Financial riskis the risk that a company will not have adequate cash flow to meet financial obligations (interest, lease payments, preferred stock dividends). Financial risk arises from the variability of EPS. It is the additional risk a shareholder bears when a company uses debt in addition to equity financing. 3. After-tax costs are considered relevant. In other words, the cost of capital is measured on an after-tax basis. This assumption is consistent with the framework used to make capital budgeting decisions. Specific Sources of Capital Capital component is the element used by firms to raise money. There are four sources or elements to raise capital: long term debt, preferred stock, common stock, and retained earnings.

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Cost of Capital

Review Questions & Answers Q: What is the cost of capital? What role does it play in long-term investment decisions? Ans: The cost of capital is the rate of return a firm must earn on its investment in order to maintain the market value of its stock. The cost of capital provides a benchmark against which the potential rate of return on an investment is compared.. Q: Why do we assume that business risk and financial risk are unchanged when evaluating the cost of capital? Discuss the implications of these assumptions on the acceptance and financing of new projects. Ans: Holding business risk constant assumes that the acceptance of a given project leaves the firm's ability to meet its operating expenses unchanged. Holding financial risk constant assumes that the acceptance of a given project leaves the firm's ability to meet its required financing expenses unchanged. By doing this it is possible to more easily calculate the firm's cost of capital, which is a factor taken into consideration in evaluating new projects. Q: Why is the cost of capital measured on an after-tax basis? Why is use of a weighted average cost of capital rather than the cost of the specific source of funds recommended? Ans: The cost of capital is measured on an after-tax basis in order to be consistent with the capital budgeting framework. The only component of the cost of capital that actually requires a tax adjustment is the cost of debt, since interest on debt is treated as a tax-deductible expenditure. Measuring the cost of debt on an after-tax basis reduces the cost. The use of the weighted average cost of capital is recommended over the cost of the source of funds to be used for the project. The interrelatedness of financing decisions assuming the presence of a target capital structure is reflected in the weighted average cost of capital. Q: You have just been told, Because we are going to finance this project with debt, its required rate of return must exceed the cost of debt. Do you agree or disagree? Explain. Ans: In order to make any such financing decision, the overall cost of capital must be considered. This results from the interrelatedness of financing activities. For example, a firm raising funds with debt today may need to use equity the next time, and the cost of equity will be related to the overall capital structure, including debt, of the firm at the time.

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Cost of Capital

Cost of Long-Term Debt The cost of long-term debt, ki, is the after-tax cost today of raising long-term funds through borrowing. For convenience, we typically assume that the funds are raised through the sale of bonds. Review Questions & Answers Q: What are the net proceeds from the sale of a bond? What are flotation costs and how do they affect a bonds net proceeds? Ans: The net proceeds from the sale of a bond are the funds received from its sale after all underwriting and brokerage fees have been paid. A bond sells at a discount when the rate of interest currently paid on similar-risk bonds is above the bond's coupon rate. Bonds sell at a premium when their coupon rate is above the prevailing market rate of interest on similar-risk bonds. Flotation costs are fees charged by investment banking firms for their services in assisting in selling the bonds in the primary market. Flotation costs include two components: (i) undertaking costscompensation earned by investment bankers for selling the security, and (ii) administrative costsissuer expenses such as legal, accounting, printing, and other expenses. These costs reduce the total proceeds received by the firm since the fees are paid from the bond funds. Q: What three methods can be used to find the before-tax cost of debt? Ans: The three approaches to finding the before-tax cost of debt are: 1. The quotation approach which uses the current market value of a bond to determine the yield-to-maturity on the bond. If the market price of the bond is equal to its par value the yield-to-maturity is the same as the coupon rate. 2. The calculation approach finds the before-tax cost of debt by calculating the internal rate of return (IRR) on the bond cash flows. 3. The approximation approach uses the following formula to approximate the before-tax cost of the debt.
kd I [($1,000 Nd )] n ( Nd $1,000) 2

where:

I = the annual interest payment in dollars Nd = the net proceeds from the sale of a bond N = the term of the bond in years The first part of the numerator of the equation represents the annual interest, and the second part represents the amortization of any discount or premium; the denominator represents the average amount borrowed.

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Cost of Capital

Q: How is the before-tax cost of debt converted into the after-tax cost? Ans: The before-tax cost is converted to an after-tax debt cost (ki) by using the following equation: ki = kd (1 - T), where T is the firm's tax rate. Cost of Preferred Stock Preferred stock represents a special type of ownership interest in the firm. It gives preferred stockholders the right to receive their stated dividends before any earnings can be distributed to common stockholders. Because preferred stock is a form of ownership, the proceeds from its sale are expected to be held for an infinite period of time. The cost of preferred stock, kp, is the ratio of the preferred stock dividend to the firms net proceeds from the sale of the preferred stock. The net proceeds represent the amount of money to be received minus any flotation costs. Following equation gives the cost of preferred stock, kp, in terms of the annual dollar dividend, Dp, and the net proceeds from the sale of the stock, Np: Because preferred stock dividends are paid out of the firms after-tax cash flows, a tax adjustment is not required. Cost of Common Stock The cost of common stock is the return required on the stock by investors in the marketplace. There are two forms of common stock financing: (1) retained earnings and (2) new issues of common stock. As a first step in finding each of these costs, we must estimate the cost of common stock equity. The cost of common stock equity, ks is the rate at which investors discount the expected dividends of the firm to determine its share value. Two techniques are used to measure the cost of common stock equity. One relies on the constant growth valuation model, the other on the capital asset pricing model (CAPM).
,

Using the Constant-Growth Valuation (Gordon) Model We found the value of a share of stock to be equal to the present value of all future dividends, which in one model were assumed to grow at a constant annual rate over an infinite time horizon. This is the constant-growth valuation model, also known as the Gordon model. The key expression derived for this model is as following equation: Where, P0 = value of common stock 15
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Cost of Capital D1 = per-share dividend expected at the end of year 1 Ks = required return on common stock g = constant rate of growth in dividends

Using the Capital Asset Pricing Model (CAPM) The capital asset pricing model (CAPM) describes the relationship between the required return, ks, and the non-diversifiable risk of the firm as measured by the beta coefficient, . The basic CAPM is: ( ) Using CAPM indicates that the cost of common stock equity is the return required by investors as compensation for the firms non-diversifiable risk, measured by beta. Cost of Retained Earnings As you know, dividends are paid out of a firms earnings. Their payment, made in cash to common stockholders, reduces the firms retained earnings. Lets say a firm needs common stock equity financing of a certain amount; it has two choices relative to retained earnings: It can issue additional common stock in that amount and still pay dividends to stockholders out of retained earnings. Or it can increase common stock equity by retaining the earnings (not paying the cash dividends) in the needed amount. In a strict accounting sense, the retention of earnings increases common stock equity in the same way that the sale of additional shares of common stock does. Thus the cost of retained earnings, kr, to the firm is the same as the cost of an equivalent fully subscribed issue of additional common stock. Stockholders find the firms retention of earnings acceptable only if they expect that it will earn at least their required return on the reinvested funds. Viewing retained earnings as a fully subscribed issue of additional common stock, we can set the firms cost of retained earnings, kr, equal to the cost of common stock equity as given by Equations: It is not necessary to adjust the cost of retained earnings for flotation costs, because by retaining earnings, the firm raises equity capital without incurring these costs. Cost of New Issues of Common Stock Our purpose in finding the firms overall cost of capital is to determine the after -tax cost of new funds required for financing projects. The cost of a new issue of common stock, kn, is determined by calculating the cost of common stock, net of under-pricing and associated flotation costs. Normally, for a new issue to sell, it has to be underpricedsold at a price below its current market price, P0. Firms under-price new issues for a variety of reasons. First, when the market is in equilibrium (that is, the demand for shares equals the supply of shares), additional demand for shares can be achieved only at a lower price. Second, when additional shares are issued, each shares percent of ownership in the firm is diluted, thereby 16
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justifying a lower share value. Finally, many investors view the issuance of additional shares as a signal that management is using common stock equity financing because it believes that the shares are currently overpriced. Recognizing this information, they will buy shares only at a price below the current market price. Clearly, these and other factors necessitate under-pricing of new offerings of common stock. Flotation costs paid for issuing and selling the new issue will further reduce proceeds. We can use the constant-growth valuation model expression for the cost of existing common stock, ks, as a starting point. If we let Nn, represent the net proceeds from the sale of new common stock after subtracting under-pricing and flotation costs, the cost of the new issue, kn, can be expressed as follows: The net proceeds from sale of new common stock, Nn, will be less than the current market price,P0. Therefore, the cost of new issues, kn, will always be greater than the cost of existing issues, ks, which is equal to the cost of retained earnings, kr. The cost of new common stock is normally greater than any other long-term financing cost. Because common stock dividends are paid from after-tax cash flows, no tax adjustment is required. Review Question & Answer Q: Why is the cost of financing a project with retained earnings less than the cost of financing it with a new issue of common stock? Ans: The cost of retained earnings is technically less than the cost of new common stock, since by using retained earnings (cash) the firm avoids underwriting costs, as well as possible under-pricing costs.

Weighted Average Cost of Capital (WACC)

Now that we have calculated the cost of specific sources of financing, we can determine the overall cost of capital. As noted earlier, the weighted average cost of capital (WACC), ka, reflects the expected average future cost of funds over the long run. It is found by weighting the cost of each specific type of capital by its proportion in the firms capital structure. Calculating the Weighted Average Cost of Capital (WACC) Calculating the weighted average cost of capital (WACC) is straightforward: Multiply the specific cost of each form of financing by its proportion in the firms capital structure and sum the weighted values. As an equation, the weighted average cost of capital, ka, can be specified as follows:

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Review Question & Answer Q: What is the weighted average cost of capital (WACC), and how is it calculated? Ans: See above.

Basic Concept from the Desk of the Financial Manager

Investment decision is very important for a company. But how will this decision be taken properly? It is such type of decision, where there is no way to comeback without incurring loss, if we take wrong decision. In what project shall we invest? How much would be earnings? Have any chance of financial loss? How will we select best profitable investment projects? How do we compare selected project to others? We will get answers of such type of many questions learning this chapter.

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Chapter Four

Risk and Return

Risk and Return

The Return from holding an investment over some period of time is simply any cash payments received due to ownership, plus the change in market price usually expressed as a percent of the beginning market price of the investment. Return comes to owners mainly from two sources income or dividend plus any price appreciation (capital gain or loss). (ending value - initial value) + cash distribution Return = initial value Return of everything is the time in future; future is always a term of uncertainty, when uncertainty is measurable by probability is called risk. Risk is the variability of expected return. That means i.e; profit will be earned or not. Diversification means investing in at least two assets that differ. Diversification can reduce risk but cannot eliminate risk. Total Risk = Systematic Risk + Unsystematic Risk
(Non diversifiable or unavoidable) (Diversifiable or avoidable)

Systematic Risk is due to risk factors that affect the overall market such as changes in the nations economy, tax reform by the Govt. these are risks that affect securities overall and cannot be avoided and diversified away. Unsystematic Risk is risk unique to a particular company or industry; it is independent of economic, political and other factors that affect all securities. This risk can be reduced or eliminated by the well diversification. The total risk of an asset is measured by the variance or more commonly, the standard deviation of its return. Total Security Risk/Portfolio Risk: composed of two components-systematic risk and unsystematic risk. Beta measures how closely a securitys returns vary with the return of all securities in the market. Indicated by the symbol i ( i is the Risk Adjustment Factor) 19
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Risk and Return

Security Market Line, (SML) indicates the going rate of return in the market for given amount of risk i,e; the SML shows the current risk-return tradeoff in the market. Risk Premium is the extra return that an investor requires to hold risky stock instead of a risk free asset. (r M -r RF ) = Risk Premium Slope = tan =
perpendicu lar Rise = = Tangent of Angle. base Run

Efficient market characteristics: many small investors, all having the same information and expectations with respect to securities; no restrictions on investment, no taxes, and no transaction costs; and rational investors, who view securities similarly and are risk averse, preferring higher returns and lower risk. Risk Averse: The attitude toward risk in which investors would require an increased return as compensation for an increase in risk. Financial Market Efficiency/efficient market hypothesis (EMH): States (1) that stocks are always in equilibrium and (2) that it is impossible for an investor to consistently bear the market. Financial markets are said to be efficient when security prices fully reflect all available information. In such a market, security prices adjust very rapidly to new information. Portfolio: A combination of two or more securities or assets. Portfolio Return: The expected return of a portfolio is simply a weighted average of the expected returns of the securities constituting that portfolio. Efficient Frontier: is a set of efficient portfolios out of the full set of potential portfolios. On a graph, the efficient frontier constitutes the boundary line of the set of potential portfolios. Efficient Portfolio: The efficient portfolio is one that provides the lowest degree of risk for any expected return. It also provides the highest expected return for any degree of risk. Covariance is a statistical measure of the degree to which two variables (e.g., securities returns) move together. Positive covariance shows that, on average, the two variables move together. Negative covariance shows that, on average, the two 20
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Risk and Return

variables move in opposite directions. Zero covariance means that the two variables show no tendency to vary together in either a positive or negative linear fashion. Standard Deviation (SD): A statistical measure of the variability of a distribution around its mean. It is the square root of the variance. =

Coefficient Of Variance (CV): The ratio of the standard deviation of a distribution to the mean of that distribution to the mean of that distribution. It is a measure of relative risk. CV = Thus, the CV is a measure of relative dispersion (risk) a measure of risk per unit of expected return. Correlation Coefficient: A standardized statistical measure of the linear relationship between two variables. Its range is from -1.0 (perfect negative correlation), through 0 (no correlation), to +1.0 (perfect positive correlation). Risk Assessment: Assessment the general level of risk embodied in a given asset. Sensitivity analysis and probability distributions are the two tools for risk assessment. Review Questions Q: What is an efficient portfolio? How can the return and standard deviation of a portfolio be determined? Ans: An efficient portfolio is one that maximizes return for a given risk level or minimizes risk for a given level of return. Return of a portfolio is the weighted average of returns on the individual component assets:

p j k wj k
j 1

j = expected Where n = number of assets, wj = weight of individual assets, and k returns.

The standard deviation of a portfolio is not the weighted average of component standard deviations; the risk of the portfolio as measured by the standard deviation will be smaller. It is calculated by applying the standard deviation formula to the portfolio assets:

(ki k ) 2 kp n i 1
n

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Q: Why is the correlation between asset returns important? How does diversification allow risky assets to be combined so that the risk of the portfolio is less than the risk of the individual assets in it? Ans: The correlation between asset returns is important when evaluating the effect of a new asset on the portfolio's overall risk. Returns on different assets moving in the same direction are positively correlated, while those moving in opposite directions are negatively correlated. Assets with high positive correlation increase the variability of portfolio returns; assets with high negative correlation reduce the variability of portfolio returns. When negatively correlated assets are brought together through diversification, the variability of the expected return from the resulting combination can be less than the variability or risk of the individual assets. When one asset has high returns, the other's returns are low and vice versa. Therefore, the result of diversification is to reduce risk by providing a pattern of stable returns. Diversification of risk in the asset selection process allows the investor to reduce overall risk by combining negatively correlated assets so that the risk of the portfolio is less than the risk of the individual assets in it. Even if assets are not negatively correlated, the lower the positive correlation between them, the lower the resulting risks. Q: How are total risk, non-diversifiable risk, and diversifiable risk related? Why is non-diversifiable risk the only relevant risk? Ans: The total risk of a security is the combination of non-diversifiable risk and diversifiable risk. Diversifiable risk refers to the portion of an asset's risk attributable to firm-specific, random events (strikes, litigation, loss of key contracts, etc.) that can be eliminated by diversification. Non-diversifiable risk is attributable to market factors affecting all firms (war, inflation, political events, etc.). Some argue that non-diversifiable risk is the only relevant risk because diversifiable risk can be eliminated by creating a portfolio of assets which are not perfectly positively correlated. Q: What risk does beta measure? How can you find the beta of a portfolio? Ans: Beta measures non-diversifiable risk. It is an index of the degree of movement of an asset's return in response to a change in the market return. The beta coefficient for an asset can be found by plotting the asset's historical returns relative to the returns for the market. By using statistical techniques, the "characteristic line" is fit to the data points. The slope of this line is beta. The beta of a portfolio is

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calculated by finding the weighted average of the betas of the individual component assets. Beta calculated by the following formula:

Q: Explain the meaning of each variable in the capital asset pricing model (CAPM) equation. What is the security market line (SML)? Ans: The equation for the Capital Asset Pricing Model is: kj = RF + [bj (km - RF)], where: kj = the required (or expected) return on asset j. RF = the rate of return required on a risk-free security (a U.S. Treasury bill) bj = the beta coefficient or index of non-diversifiable (relevant) risk for asset j km = the required return on the market portfolio of assets (the market return) The security market line (SML) is a graphical presentation of the relationship between the amount of systematic risk associated with an asset and the required return. Systematic risk is measured by beta and is on the horizontal axis while the required return is on the vertical axis. Q: What impact would the following changes have on the security market line and therefore on the required return for a given level of risk? (a) An increase in inflationary expectations. (b) Investors become less risk-averse. Ans: a. If there is an increase in inflationary expectations, the security market line will show a parallel shift upward in an amount equal to the expected increase in inflation. The required return for a given level of risk will also rise. b. The slope of the SML (the beta coefficient) will be less steep if investors become less risk-averse, and a lower level of return will be required for each level of risk. Q: Why do financial managers have some difficulty applying CAPM in financial decision making? Generally, what benefit does CAPM provide them? Ans: The CAPM provides financial managers with a link between risk and return. Because it was developed to explain the behavior of securities prices in efficient markets and uses historical data to estimate required returns, it may not reflect future variability of returns. While studies have supported the CAPM when applied in active securities markets, it has not been found to be generally applicable to real corporate assets. However, the CAPM can be used as a conceptual framework to evaluate the relationship between risk and return. Q: What are the formulas for the expected return, variance, and standard deviation of a portfolio of two assets? E{Rp } = Wi Ri + Wj Rj 23
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Varp = Wi2 [Ri - E(Ri)]2 + Wj2 [Rj - E(Rj)2] + 2Wi Wj [Ri E(Ri)] [Rj - E(Rj)] SDp = Q: How do you calculate the expected return and the variance of an individual security? Ans: Expected return is the weighted average of possible returns that an individual expects a stock to earn over the next period. We calculate expected return of an individual security by the following formula: Expected return, E Where, = probability = return on stock Variance, a measure of the squared deviations of a securitys return from its expected return, assesses the volatility of a securitys return. It is calculated by the following formula: Standard deviation is the root over of the value of variance, SD = = Q: How do you calculate the covariance and the correlation between the two securities? Ans: Returns on individual securities are related to one another. Covariance and correlation are statistical tools, measures the interrelationship between two securities returns. Covariance is calculated by the following formula: Cov (RA,RB) = Expected value of [RA E(RA)] [RB E(RB)] And correlation is calculated by the following formula: Corr (RA,RB) = Q: What is the diversification effect? Ans: As long as the correlation coefficient between two securities is less than one, the standard deviation of a portfolio of two securities is less than the weighted average of the standard deviations of the individual securities. Q: What are the highest and lowest possible values for the correlation coefficient? Ans: The highest and lowest possible values for the correlation coefficient are +1 and -1 respectively. This is due to the standardizing procedure of dividing by the two standard deviations. 24
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Q: What is portfolio expected returns? And how to calculate? Ans: The expected return on a portfolio is simply a weighted average of the expected returns on the individual securities. The equilibrium price of risks of two securities is expected portfolio returns. Calculated by the following equation: The expected return on the portfolio equals: E(RP) = (WF)[E(RF)] + (WG)[E(RG)] Where, E(RP) = the expected return on the portfolio E(RF) = the expected return on Security F E(RG) = the expected return on Security G WF = the weight of Security F in the portfolio WG = the weight of Security G in the portfolio Q: What is the relationship between the shape of the efficient set for two assets and the correlation between the two assets? Ans: The less correlation there is between two assets the more the efficient set bends in toward the y-axis. This indicates that the diversification effect raises as P (correlation of two securities) declines. The backward bending always occurs if P 0. The greater bend occurs in the case where P = -1. This is shown in the figure given below.

Q: What is the formula for the variance of a portfolio for many assets?
NN Varp = [XiXj(Ri Ri)(Rj Rj)]
I=1 j=1

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Q: What are the two components of the total risk of a security? Ans: Total risk = Portfolio risk and diversifiable risk Total risk is the risk that one bears by holding onto one security only. Portfolio risk is the risk that one still bears after achieving full diversification. Portfolio risk is often called systematic or market risk as well. Diversifiable, unique, or unsystematic risk is that risk that can be diversified away in a large portfolio. Q: What is the formula for the standard deviation of a portfolio composed of one riskless and one risky asset? SDP =(WA2VarA)1/2 = WASDA where A is the risky asset and W is weight. Q: What is the formula for beta? Bi =

Q: How can the formula be expressed in terms of a box or matrix? Ans: The terms on the diagonal of the matrix represent the variances of each term and the off-diagonal elements represent the covariances.

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Q: Why doesn't diversification eliminate all risk? Or, Systematic risk cannot be reduced whereas unsystematic risk can be reduced and often be eliminated. Why? Explain. Or, Why is some risk diversifiable? Why are some risks non? Or, Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk. Ans: Total risk = Systematic risk + Unsystematic risk Systematic risk is due to risk factors that affect the overall marketsuch as changes in the nations economy, tax reform by the Govt.these are risks that affect securities overall and cannot be avoided and diversified away. Unsystematic risk is risk unique to a particular company or industry; it is independent of economic, political and other factors that affect all securities. This risk can be reduced or eliminated by the well diversification. Risk can be reduced through diversification only when the assets are not perfectly positively correlated [that means, Corr( ) = < +1]. Total risk can be eliminated, if two securities are perfectly negatively correlated (P = -1). But this is in theoretically. In the real world, it is not possible to eliminate all the risk, since there are no pair of securities that shows perfectly negatively correlation. Overall, it is obviously impossible to eliminate all risk by diversification because the variance of the portfolio asymptotically approaches the portfolio risk. This risk is the covariance of each pair of securities, which always remains. Q: How does one determine the optimal portfolio among the efficient set of risky assets? Ans:

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The optimal portfolio investment among the efficient set of risky assets After estimating (a) the expected returns and variances of individual securities, and (b) the covariance between pairs of securities, the investor calculates the efficient set of risky assets, represented by curve XAY in above figure. One investor then determines point A, the tangency point between capital market line (line II) and the efficient set of risky assets (curve XAY) and this is the optimal portfolio of risky asset that the investor will hold. Q: If all investors have homogeneous expectations, what portfolio of risky assets do they hold? Ans: The market portfolio.

If all investors had homogeneous expectations, above figure would be the same for all individuals. That is, all investors would sketch out the same efficient set of risky assets because they would be working with the same inputs. This efficient set of risky assets is represented by the curve XAY. Because the same risk-free rate would apply to everyone, all investors would view point A as the portfolio of risky assets to be held.

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Q: Why is the beta the appropriate measure of risk for a single security in a large portfolio? Ans: The contribution of a security to the risk of a diversified portfolio is measured by the securitys beta. The higher of a securitys beta, the more the security raises the risk of the diversified portfolio. A securitys beta indicates how closely the securitys return move with the returns from a diversified portfolio. Since the returns from diversified portfolio move with the market as a whole, beta also measures how closely the securitys returns move with the market. If an investors holds a diversified portfolio, he still views the variance (or SD) of his portfolios return as the proper measure of the risk of his portfolio. However, he is no longer interested in the variance of each individual securitys return. Rather, he is interested in the contribution of an individual security to the variance of the portfolio. Under the assumption of homogeneous expectations, all investors hold the market portfolio. Thus, we measure risk as the contribution of an individual security to the variance of the market portfolio. This contribution, when standardized properly, is the beta of the security. While very few investors hold the market portfolio exactly, many hold reasonably diversified portfolios. These portfolios are close enough to the market portfolio so that the beta of a security is likely to be the appropriate measure of risk for a single security in a large portfolio. Q: Why is the SML a straight line? Or, why must all assets plot directly on in a well-functioning market? Ans: The SML expresses the relationship between the expected rate of return required by the investors and the risk of the security. It relates expected return to beta. The relationship between expected return to beta corresponds to a straight line. Securities lying above the SML are underpriced. Their prices must rise until their expected returns lie on the line. If securities lying below the SML are overpriced. Their prices must decrease until their expected returns lie on the line. If the SML is itself curved, many stocks would be mispriced. In equilibrium, all securities would be held only when prices changed so that the SML become straight. In short, the SML is straight because investors could form homemade portfolios that dominate portfolios that don't lie on a straight line. Buying and selling of these portfolios would then drive any outliers back to the line.

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Q: What is the Capital-Asset-Pricing model? Ans: The CAPM is a model which determines the equilibrium of risk and return of the risky securities in the securities markets that relates the expected return on an asset to its systematic risk (beta). Q: What are the differences between the capital market line and the security market line? Ans: The capital market line (CML) is a straight line from risk free rate, tangent to the efficient set of risky assets; it provides the investor with the best possible opportunities. The security market line (SML), is the graphical depiction of the capital asset pricing model (CAPM), indicates the going rate of return in the market for given amount of risk. The SML relates expected return to beta, while the CML relates expected return to the standard deviation. The SML holds both for all individual securities and for all possible portfolios, whereas the CML holds only for efficient portfolios. Q: What is the expected return on market? Ans: The expected return on the market is the sum of the risk free rate plus some compensation for the risk inherent in the market portfolio. It is calculated by the following equation: E( Q: What is the portfolio weight? Ans: The portfolio weights are the proportion of total funds invested in each security (the weights must sum to 100 percent). Q: What is the difference between feasible set and efficient set? Or, what is opportunity set and efficient frontier? Ans: An opportunity set or feasible set represents different appropriate mix of two assets for making a portfolio. An efficient portfolio is a portfolio that has the highest expected return for a given risk level or the lowest risks level for a given level of expected return. The set of all efficient portfolios form the efficient set or efficient frontier. Q: What does the CAPM tell us about the required return on a risky investment? Ans: The CAPM tells that properly priced securities should provide an expected rate of return (required return) to investors equal to the rate of interest on risk less securities plus a premium for bearing risk. 30
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Q: What are the assumptions of the CAPM? Ans: There are some assumptions of the CAPM: i) All investors of the market adopted a portfolio theory approach to investment. ii) All investors have the same expectation about means, variance and covariance of assets return. iii) All investors have a common time horizon (a single period) for investment decision making. iv) All assets are sold in complete and perfect markets (with zero transaction cost). v) There exists a risk free asset with single rate that investors can borrow and lend at.

Q: Describe the basic procedures involved in using risk-adjusted discount rates

(RADRs). How is this approach related to the capital asset pricing model (CAPM)? Ans: Risk-adjusted discount rates reflect the return that must be earned on a given project in order to adequately compensate the firm's owners. The relationship between RADRs and the CAPM is a purely theoretical concept. The expression used to value the expected rate of return of a security ki (ki = RF + [i (km - RF)]) is rewritten substituting an asset for a security. Because real corporate assets are not traded in efficient markets and estimation of a market return, km, for a portfolio of such assets would be difficult, the CAPM is not used for real assets. Q: Explain how the range is used in sensitivity analysis. Ans: Sensitivity analysis evaluates asset risk by using more than one possible set of returns to obtain a sense of the variability of outcomes. The range is found by subtracting the pessimistic outcome from the optimistic outcome. The larger the range, the more variability of risk associated with the asset. Q: What relationship exists between the size of the standard deviation and the degree of asset risk? Ans: The standard deviation of a distribution of asset returns is an absolute measure of dispersion of risk about the mean or expected value. A higher standard deviation indicates a greater project risk. With a larger standard deviation, the distribution is more dispersed and the outcomes have a higher variability, resulting in higher risk.

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Q: What does a plot of the probability distribution of outcomes show a decision maker about an assets risk? Ans: The decision maker can get an estimate of project risk by viewing a plot of the probability distribution, which relates probabilities to expected returns and shows the degree of dispersion of returns. The more spread out the distribution, the greater the variability or risk associated with the return stream. Q: When is the coefficient of variation preferred over the standard deviation for comparing asset risk? Ans: The coefficient of variation is another indicator of asset risk, measuring relative dispersion. It is calculated by dividing the standard deviation by the expected value. The coefficient of variation may be a better basis than the standard deviation for comparing risk of assets with differing expected returns. Q: Describe how each of the following behavioral approaches can be used to deal with project risk: (a) sensitivity analysis, (b) scenario analysis, and (c) simulation. Ans: a. Sensitivity analysis uses a number of possible inputs (cash inflows) to assess their impact on the firm's return (NPV). In capital budgeting, the NPVs are estimated for the pessimistic, most likely, and optimistic cash flow estimates. By subtracting the pessimistic outcome NPV from the optimistic outcome NPV, a range of NPVs can be determined. b. Scenario analysis is used to evaluate the impact on return of simultaneous changes in a number of variables, such as cash inflows, cash outflows, and the cost of capital, resulting from differing assumptions relative to economic and competitive conditions. These return estimates can be used to roughly assess the risk involved with respect to the level of inflation. c. Simulation is a statistically based approach using random numbers to simulate various cash flows associated with the project, calculating the NPV or IRR on the basis of these cash flows, and then developing a probability distribution of each project's rate of returns based on NPV or IRR criterion.

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Chapter Five

Some Basic

Some basic
The Slope Of A Line is the ratio of the vertical distance covered to the horizontal distance covered as we move along the line. Price Ceiling is a legal maximum on the price at which a good can be sold. Price Floor is a legal minimum on the price at which a good can be sold Consumer Surplus is a buyers willingness to pay minus the amount the buyer actually pays producer surplus the amount a seller is paid for a good minus the sellers cost Deadweight Loss is the fall in total surplus that results from a market distortion, such as a tax Tariff is a tax on goods produced abroad and sold domestically Import Quota is a limit on the quantity of a good that can be produced abroad and sold domestically The Marginal Propensity To Consume (MPC) is the ratio of the change in consumption relative to the change in disposable income that produces the change in consumption. On a graph, it appears as the slope of the consumption function. Gross Domestic Product (GDP) is the sum of the money values of all final goods and services produced during a specified period of time, usually one year. National Income is the sum of the incomes that all individuals in the country earn in the forms of wages, interest, rents, and profits. It includes indirect business taxes but excludes transfer payments and makes no deduction for income taxes. By necessity, it must be approximately equal to domestic product. The Inflationary Gap is the amount by which equilibrium real GDP exceeds the full employment level of GDP

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Chapter Six

Bond and Stock Valuation

Bond and Stock Valuation

Valuation is the process that links risk and return to determine the worth of an asset (security). Bond is a long term debt instrument issued by a company or government to raise large sums of money, generally from a diverse group of lenders. Bonds are classified into four main types: treasury, corporate, municipal, and foreign. Yield to Maturity, (YTM) is the expected rate of return on a bond if bought at its current market price and held to maturity. Par Value is the stated face value of the bonds. Required Return is the cost of funds obtained by selling an ownership interest and it reflects the funds suppliers level of expected return. Yield Curve is a graph of the relationship between the debts remaining time to maturity (x axis) and its yield to maturity (y axis). Coupon Interest Rate is the percentage of a bonds par value that will be paid annually, typically in two equal semiannual payments, as interest. Call Premium is the amount by which a bonds call price exceeds its par value. Current Yield is a measure of a bonds cash return for the year; calculated by dividing the bonds annual interest payment by its current price. Yield to Call, (YTC) is the rate of interest earned on a bond if it is called. If current interest rates are well below an outstanding callable bonds coupon rate, the YTC may be a more relevant estimate of expected return than the YTM, since the bond is likely to be called. Discount is the amount by which a bond sells at a value that is less than its par value. Premium is the amount by which a bond sells at a value that is greater than its par value. 34
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Chapter Seven

Leverage

Leverage
Leverage means the potential use of fixed cost assets or funds (i,e; administrative expenses, depreciation expenses, advertising expenses, property taxes, interest on debt, preferred stock dividend etc.) in the business firm to magnify the rate of earning of shareholders. It magnifies the variability of EBIT or EPS and thus it affects a firms overall risk and returns. It arises from the use of fixed cost assets or funds in the firms capital structure to magnify returns to the firms owners.

Operating Leverage
Operating leverage means the potential use of fixed operating cost (i,e; administrative expenses, depreciation expenses, advertising expenses, property taxes) to magnify the amount of EBIT through changing of sales.

Degree of Operating Leverage

Operating leverage magnifies the sensitivity of the firms operating income or (loss) to the level of sales (or volume of activity). A quantitative measure of this sensitivity of a firms operating profits to a change in the firms sales is called DOL. It can be measured using the following equations:
DOL= Percentage change in EBIT Percentage change in sales This can be shown to equal DOL=
X (P V ) X ( P V ) Fo

DOL=

EBIT Fo EBIT

DOL=

CONTRIBUTION EBIT

KEY TERMS: EBIT = X (P-V)-Fo Where, x = the output level P= sales price per unit V= variable cost per unit Fo= operating fixed cost 35
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DOL means, in change of Fo, how much the additional changes in EBIT than sales. DOL 3 times DOL 3 times, that means if sales changes 1% then EBIT changes 3%

Financial Leverage
Financial leverage means the potential use of fixed financial cost (i,e; interest on debt, preferred stock dividend ) in order to magnify the earning of shareholders. Financial leverage arises only when a company borrows funds. It results from the presence of fixed financial cost in the firms cost structure.

Degree of Financial Leverage

DFL is a quantitative measure of the sensitivity of a firms EPS (i,e; earning per share) to a change in the firms operating profits. It can be measured using the following equation.
DFL=
Percentage change in EPS Percentage change in EBIT

This can be shown to equal DFL=

X ( P V ) Fo X (P V ) F EBIT EBIT Ff

DFL=

DFL=

EBIT EBT

Key Terms: F= Ff + Fo Where, F = total fixed cost assets or funds Ff = fixed financial costs Fo = fixed operating costs DFL means, in using of Ff, how much the additional changes in EPS than EBIT.

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DFL 2.5 times If DFL is 2.5 times, that means if EBIT increases 1% then EPS increases 2.5%.

Combined Leverage
Combined leverage is the measure of the total leverage due to both operating and financial fixed cost. It is easily computed using the DOL and DFL formulas.

Degree of Combined Leverage

The degree of total or combined leverage is the numerical measure of the firms total leverage. The degree of combined leverage equals:
DCL =

Percentage change in EPS Percentage change in sales

This can be shown to equal DCL =
X (P V ) X (P V ) F EBIT Fo DCL = EBIT Ff

Or simply, DCL = DOL DFL DCL is a measure of the overall risk or uncertainty associated with stockholders earning that arises because of operating and financial leverage. DTL 2 times DTL 2 times means that if a sales increase 1%, then EPS increases 2%.

Relationship Between Operating Leverage And Business Risk

Operating leverage is often incorrectly used as a synonym for Business Risk. Business risk refers to the uncertainty or variability of the firms EBIT. A high DOL indicates a high business risk. But risk also depends on two other factors: (1) The variability of the firms sales. (2) The variability of the companys cost and price structure. EBIT can vary not only because of sales fluctuate but also because of changes in the companys output, price and costs. If price and costs are uncertain, DOL is 37
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uncertain, since DOL is defined in terms of P, Fo, and V. In this case, the use of DOL in evaluating business risk is somewhat limited. So, DOL should be viewed as a measure of potential risk which becomes active only in the presence of sales and production cost variability. Q. why does DOL not measure the total business risk? Or Does DOL measure the total business risk? Relationship Between Financial Leverage And Financial Risk Financial risk means added variability of EPS arising from the use of financial fixed cost. Financial leverage also arises from the use of financial fixed cost. But financial risk encompasses / includes both the risk of insolvency and the added variability in EPS that is induced by the use of financial leverage. As a firm increases the proportion of fixed cost financing in its capital structure, fixed cash outflow increases. As a result, the probability of cash insolvency increases.
KEY TERMS:

Because of two reasons financial risk arises which are probability of cash insolvency and added variability of EPS. Financial leverage arises because of just one reason which is use of fixed financial cost.

Relationship of Operating, Financial and Total Leverage

Total leverage reflects the combined impact of operating and financial leverage on the firm. High operating leverage and high financial leverage will cause total leverage to be high. The opposite will also be true. The relationship between operating leverage and financial leverage is multiplicative rather than additive. The relationship between DTL and DOL and DFL is given by equation:DTL == DOL DFL

LEVERAGE MULTIPLIER

DFL can be expressed more generally as a multiplier of the percentage change in EBIT, that is Percentage change in EPS = leverage multiplier percentage change in EBIT The leverage multiplier can be calculated from the leverage ratio as follows:Leverage ratio ==
Interest EBIT

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1 (1 leverage ratio)

Leverage

If, for example, leverage multiplier is 1.2 then a 10% increase in EBIT will increase EPS by 12%
INCOME STATEMENT FORMAT

Sales Less: variable cost Contribution Less: fixed cost EBIT Less: interest EBT Less: taxes EAT

xxxx (-) xxxx (-) xxxx (-) xxxx (-) xxxx

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Chapter Eight

Capital Budgeting

Capital Budgeting
Capital is the long-term fund of a firm. Capital Budgeting is the process of evaluating and selecting long-term investments that are consistent with the firms goal of maximizing owner wealth. Capital Budgeting Process consists of five distinct but interrelated steps: proposal generation, review and analysis, decision making, implementation, and follow up. The Basic Motives for capital expenditures are to expand operations, replace or renew fixed assets, or to obtain some other, less tangible benefit over a long period. Capital Expenditure is an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year. Operating Expenditure is an outlay resulting in benefits received within 1 year. Independent Projects are those projects whose cash flows are unrelated or independent of one another and the acceptance of one does not eliminate the others from further consideration. Mutually Exclusive Projects are projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function. Capital Rationing is the financial situation in which a firm has only a fixed amount of money available for capital expenditures, and numerous projects compete for these amount. Initial Investment is the relevant cash outflow for a proposed project at time zero. Sunk Cost is a cost that has already occurred and is not affected by the capital project decision. Sunk costs are not relevant to capital budgeting decisions. Book Value/Face Value is the strict accounting value of an asset, calculated by subtracting its accumulated depreciation from its installed cost. Simulation is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes. 40
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Capital Budgeting

Risk-Adjusted Discounted Rate, (RADR) is the rate of return that must be earned on a given project to compensate the firms owners adequatelythat is, to maintain or improve the firms share price. A Scenario Analysis is a risk analysis technique in which bad and good sets of financial circumstances are compared with a most likely situation. Portfolio means a collection, or group of assets held in combination. Conflicting Ranking are conflicts in the ranking given a project by NPV and IRR, resulting from differences in the magnitude and timing of cash flows. Pay Back Period, (PBP) is the amount of time required for a firm to recover its initial investment in a project. Internal Rate of Return, (IRR) is the discounted rate that equates the present value of the expected future cash inflows and outflows. IRR measures the rate of return on a project, but it assumes that all cash flows can be reinvested at the IRR rate. Modified Internal Rate Of Return (MIRR): This assumes that cash flows from all projects are reinvested at the cost of capital as opposed to the projects own IRR. This is a better indicator of a projects true profitability. Net Present Value, (NPV) is a sophisticated capital budgeting technique that shows the present value of the projects expected future cash flows, discounted at the appropriate cost of capital. Profitability Index, (PI) is a sophisticated capital budgeting technique which considers time value of money. Capital Gain (Loss) is the profit (loss) from the sale of a capital asset for more (less) than its purchase price. Debt Capital includes all long-term borrowing incurred by a firm, including bonds. Equity Capital includes the long-term funds provided by the firms owners, the stockholders. N:B: capital budgeting details will be discussed later 41
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Capital Budgeting

Recaptured depreciation: The portion of an assets sale price that is above its book value and below its initial purchase price. Cash flow Vs Net profit: The amount of money received by the firm is represented by the cash flow figure, not the net profit figure. Only cash flows are relevant for the purposes of setting a value on a project. Cash flow can be reinvested, not profit. Income statement may be manipulated by window dressing technique but cash flow statement cannot.

Capital Budgeting Techniques

NPV

Discounted CFs

IRR

Evaluating Tools

PI
PBP
Conventional

ARR
Conventional or unsophisticated technique does not give explicit consideration to the time value of money. On the other hand, sophisticated technique gives explicit consideration to the time value of money. Generally when required rate of return/cost of capital is known, we use discounted CFs techniques.

Payback Period (PBP)

PBP tells investors how much time (number of years) an investment will take to recover its initial investment. Although this measure provides a rough guide to the 42
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Capital Budgeting

liquidity of a project, it is a poor gauge of profitability. Generally firm uses this, in case of minor investment decisions. PBP may provide useful insights, but it is best employed as a supplement to discounted cash flow methods. Why we use this? Because PBP .. i) Considers cash flows rather than net profit (accounting profit) ii) Gives implicit consideration to the timing of cash flows: higher the PBP, higher the risk and the greater the possibility of a calamity (a great misfortune). Thus, it can be viewed as a measure of risk exposure. iii) Is a good measure of liquidity. iv) Is so simple to calculate. Weakness: i) PB rule takes into account only CFs before PBP, not after PBP. Consequently, it cannot be regarded as a measure of profitability. ii) The method ignores the time value of money. PB rule simply adds cash flows without regard to the timing of these flows. iii) Since payback rule is not based on discounting cash flows, it is not compatible with firms wealth maximization goal. iv) The maximum acceptable payback period, which serves as the cutoff standard, is a purely subjective choice. That means PB rule requires an arbitrary cutoff point. Decision criteria: If PBP is equal or less than maximum acceptable PBP, Accept otherwise not. Formula for calculating PBP: In case of annuity, PBP = In case of mixed stream, PBP = Year before full recovery +

Q. Payback period is a good measure of liquidity and a poor gauge of profitability Explain

Net Present Value (NPV)

NPV of an investment is the difference between its market value and its cost. NPV is frequently estimated by calculating the PV of the future cash flows (to estimate 43
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market value) and then subtracting the cost. NPV has no serious flows. It is the preferred decision criterion. NPV = PV of all CFs Initial Investment Decision criterion: If NPV is greater than O (zero), accept the project. Q. NPV = O, what will be your decision? If there is no other alternative, the firm can marginally accept the project. Because since there is no alternative and it meets firms minimum required rate of return that keep firms value unchanged. NPV profile: It is a graph which shows the relationship between NPV and discount rate. The relationship between NPV and discount rate is negative. NPV = (CIF, COF, DR, N)

Limitation: NPV may give conflicting ranking when projects have unequal lives. ANPV: Annualized NPV is an approach which converts the NPV of unequal lived, mutually exclusive projects into an equivalent annual amount that can be used to select the best project.

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Q. Why is ANPV preferred over NPV when ranking projects with unequal lives? Comparing projects of unequal lives gives an advantage to those projects that generate cash flows over the longer period. ANPV adjusts for the differences in the length of the projects and allows selection of the optimal project.

Internal Rate of Return (IRR)

IRR is the rate at which PV of all cash inflows equal to initial investment. That means, the rate at which NPV will be zero (O), called IRR.

Decision Rules: If IRR Cost of Capital ----------------- accept If IRR< Cost of Capital ----------------- Reject Limitations of IRR: i) The IRR cant be used to rank mutually exclusive projects. ii) When project cash flows are not conventional, there may be no IRR or there may be more than one.

Profitability Index, (PI)

PI, or benefit cost ratio, of a project is the ratio of the present value of future net cash flows to the initial cash outflow. PI is calculated by the following equation:

PI is a relative measure which generates return per dollar. Decision Rule: PI1------------------------------- Accept PI<1------------------------------ Reject PI vs NPV PI is only ratio not an absolute term. On the other hand, only NPV gives information about absolute dollar return. PI is quiet similar to NPV; but like IRR, PI cant be used to rank mutually exclusive projects. However, PI is sometimes used to rank 45
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projects when a firm has more positive NPV investments than is can currently finance.

Comparison among IRR, NPV, and PI

When the project will be conventional and independent, all discounting cash flow techniques (i.e. NPV, IRR, and PI) always lead to the same accept/reject decisions. Because if the projects NPV is positive, its IRR will exceed the cost of capital and PI will be greater than one, and vice versa. If NPV is greater than zero, IRR will be greater than cost of capital and PI will be greater than 1. But when two or more investment proposals are mutually exclusive, so that we can select only one, ranking proposals on the basis of the IRR, NPV, and PI methods may give contradictory results. If projects are ranked differently using these methods, the conflict in rankings will be due to one or a combination of the following three project differences: 46
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Chapter Eight i) ii) iii)

Capital Budgeting

Scale of investment: Costs of projects differ. Cash flow pattern: Timing of cash flows differ. For example, the cash flows of one project increase over time whereas those of another decrease. Project life: Projects have unequal useful lives.

Multiple IRR
Multiple IRR means the situation where a project has 2 or more than two IRR. When a projects cash flow changes its sign more than one then multiple IRR can be occurred. Two necessary conditions of it are: i) non cash pattern ii) large magnitude of cash flow. N:B: Normally we know that PV is inversely related with discount rate. But in case of multiple IRR, PV increases when DR increases, and vice versa.

Capital Rationing
Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of capital expenditure during a particular period of time. The main purpose of capital rationing is to select the combination of those projects which will provide highest total positive NPV to increase the firm value subject to not exceeding the budget ceiling. Types of rationing:

Capital Rationing

Soft rationing

Hard rationing

Soft rationing: In this case, actually there is no budget constraint but firm constraints their policy to invest a limited amount of money. Hard rationing: Sometimes firms are involuntarily forced to ration capital. When the market is not perfect, in this case the market forces the firms to take decision of capital rationing. 47
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The reasons of both rationing are pointed below: Soft rationing Hard rationing i) To deal with overstated Market imperfections CFs ii) Viewpoint of controlling Information asymmetric capacity iii) Financing policy Legal restrictions iv) Rapid growth vs Management control & comfort While firms facing budget constraints, PI is the best technique to select best projects which maximize profits. But PI fails to give this best result when one of the following two is not fulfilled: i) Total budget must be exhausted ii) Budget constraint prevails only for one year

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Chapter Nine

Dividend Policy

Dividend Policy
Dividend is a payment made out of a firms earnings to its owners in the form of either cash or stock. Dividend Policy is the firms plan of action to be followed whenever a dividend decision is made. Declaration Date is the date at when Board of Directors declares amount of dividend to be distributed among shareholders and date of payments. Record Date: the Board of Directors fixes a date when declares dividend within that day all shareholders of the company are to be enlisted into share register. The final day of name enlisted into the share register of the company is called record date. Ex-Dividend Date: on the two working days or two days before the record date, the right to the dividend no longer goes with the shares. The last date when the right to the dividend doesnt leave the stock is called the ex-dividend date. Payment Date is the date at when the pre-declared dividend actually is distributed among shareholders. Stock Dividend is a dividend paid in the form of additional shares or stock rather than in cash. Stock Split is a method commonly used to lower the market price of firms stock by increasing numbers of shares belonging to each shareholder. Stock Repurchase is a transaction in which a firm buys back shares of its own stock. Clientele Effect means the tendency of a firm to attract the type of investors who likes its dividend policy. Stable Taka Dividends: The Taka level of dividends is relatively stable from year to year or follows a steady upward or downward trend over time. Dividend Payout Ratio, (DPR) is the percentage of EPS that distributed to the shareholders as dividends. Dividend Payout Ratio = 100 49
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Chapter Nine i) ii) Dividend Per Share, (DPS) = EPS DPR Retention Ratio = 1 DPR

Dividend Policy

Reverse Stock Split is a stock in which the number of shares outstanding is decreased. MM Irrelevance Theory Marton Miller and Franco Modigiliani (1961) argued that the value of the firm is determined only by its basic earnings power and its business risk not on how its income is split between dividends and retained earnings. In MMs view, most investors plan to reinvest their dividends in the stock of the same or similar firms anyway, and, in any event. The riskiness of the firms cash flows to investors in the long run is determined only by the riskiness of its operating cash flows and not by its dividend payout policy. Bird-In-Hand Theory Myron Gordon and John Linter argued that cost of equity increase as the dividend payout is decreased because investors are less certain of receiving the capital gains or future dividends than they are receiving dividends payments. If dividends are not paid in current time it relates risk or uncertain to the future payments. They also argued that a dividend in the hand is less risky than possible capital gains in the bush. So investors require a larger total return if that return has a larger capital gains component than dividend yield.

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Chapter Ten

Banking

BANKING
Merchant banking: Merchant banking refers to specialization in financing and
promotion of projects, investment management and advisory services. A bank that deals mostly in (but is not limited to) international finance, long-term loans for companies and underwriting. Merchant banks do not provide regular banking services to the general public. IDLC Investment Ltd. Eunoos Trade Centre, LankaBangla Finance Limited, Prime Finance & Investment Ltd are examples of merchant banking. Investment bank: A financial intermediary that performs a variety of services. This includes underwriting, acting as an intermediary between an issuer of securities and the investing public, facilitating mergers and other corporate reorganizations, and also acting as a broker for institutional clients. Investment banker advises IPO clients, handle administrative tasks, underwrite the issue, and distribute the securities.

Deposit mobilization: It implies tapping of potential savings and putting them

into banking sector for productive uses.

Lien: A lien is the right of person or a bank to retain the goods or securities in his
possession until the debt due to him is settled. Pledge: Pledge is a special kind of bailment (the delivery of goods by one person to another) of movable property to secure the payment of debt or the performance of a promise. Money cannot be pledged. Mortgage: Mortgage refers to the transfer of interests/rights (not ownership) in specific immovable property for the purpose of securing the repayment of a debt. The instrument or deed by which the transfer is made is called the mortgage deed. Hypothecation: Hypothecation is a pledge neither transferring the ownership nor possession of moveable goods/property.

Demand deposits: Deposits which can be withdrawn by the depositor at any time
by means of cheques are known as demand deposits. This basically means current accounts. Credit creation: The power of commercial banks to expand deposits through loans, advances and investments is known as credit creation. 51
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Treasury bill: A treasury bill is a kind of financial bill or promissory note issued
by the Government to raise short-term funds.

Certificate of Deposit: It is a money market instrument with a view to further

widens the range of money market instruments and to give investors flexibility in the development of their short-term funds.

Endorsement: Endorsement means writing of a persons name on the back of the

instrument or on any paper attached to it for the purpose of negotiation.

Crossing: The act of drawing two transverse parallel lines on the face of a cheque
is called crossing of the cheque.

Margin: Margin means the excess of market value of the security over the advance
granted against it.

Garnishee order: Garnishee order is a judicial order served on a bank to suspend

its dealings with a customer. Title: Title is legal term (document but not written) which serves as evidence of ownership. That means you have the ability to prove that you are the original owner of the assets. To be a good title, 3 features are important: i.e; Possession, Right of Possession, and Right of the Property. Deed: Deed is written document/instrument used to convey title from one person (grantor/seller) to another person (grantee/buyer). Conditions to be a good/valid/marketable deed: sufficient documentation, free from reasonable doubt, free from litigation, but deed can be readily sold or mortgaged. Golden Handshake/Parachute: A stipulation (condition) in an employment agreement which states that the employer will provide a significant severance package if the employee loses their job. A golden handshake is usually provided to top executives for loss of employment through layoffs, acquisition, merger, firing or even retirement. Payment can be made several ways, such as cash, or stock options. Share Certificate: A share certificate is a written document signed on behalf of a corporation, and serves as legal proof of ownership of the number of shares indicated.

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Right share: A security giving stockholders entitlement to purchase new shares issued by the corporation at a predetermined price (normally less than the current market price) in proportion to the number of shares already owned. Rights are issued only for a short period of time, after which they expire. Mutual fund: Mutual fund is a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. Mutual funds allow the small investor to obtain the benefits of lower transaction costs in purchasing securities and to take advantage of the reduction of risk by diversifying the portfolio of securities held. Many mutual funds are run by brokerage firms, but others are run by banks or independent investment advisers. Fixed deposits: A Fixed Deposit is an agreement between a customer and bank wherein the customer agrees to deposit a fixed sum of money for a specific duration of time. The bank in return accepts the deposit and issues a separate receipt for every FD because each deposit is treated as a distinct contract. This receipt is known as the Fixed Deposit Receipt (FDR), which has to be surrendered to the bank at the time of renewal or encashment. Deposit Pension Scheme: DPS is an installment based savings deposit (on monthly basis) for individual customer. In this account a customer deposit a certain amount of money for a certain period. And on maturity an agreed amount will be paid to the customer. NBFCs are doing functions similar to banks. What is difference between banks &NBFCs? NBFCs are doing functions akin to that of banks; however there are a few differences: (i) an NBFC cannot accept demand deposits; (ii) an NBFC is not a part of the payment and settlement system and as such an NBFC cannot issue cheques drawn on itself; and (iii) deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available for NBFC depositors unlike in case of banks. Bank Guarantee: A bank guarantee is an assurance given by a domestic bank in favor of a client (importer or investor) oversees and requires that the client has a certain percentage of the total amount of the guarantee in a bank account.

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Chapter Eleven

Monetary Policy

Monetary Policy
Monetary policy is the management of money supply and interest rates by central banks to influence prices and employment. It works through expansion or contraction of investment and consumption expenditure. The Bangladesh Bank Order of 1972 outlines the main objectives of monetary policy in Bangladesh, which comprises To achieve the price stability (control of inflation) To regulate currency and reserves (exchange rate stability) To promote and maintain a high level of production, employment and real income, and economic growth, since independence BB operated under a variety of pegged exchange rate systems amid capital controls To manage the monetary and credit system To maintain the par value of domestic currency To promote growth and development of the country's productive resources in the best national interest. (economic growth) Although the long term focus of monetary policy in Bangladesh is on growth with stability, the short-term objectives are determined after a careful and realistic appraisal of the current economic situation of the country. INSTRUMENTS OF MONETARY POLICY: Major instruments of monetary control available with Bangladesh Bank are the bank rate, open market operations, rediscount policy, and statutory reserve requirement. The methods of credit control can be classified as follows: a) Quantitative/ General credit control measures include:

Bank rate policy Open market policy Variation of reserve ratio

b) Qualitative/selective credit control measures include:

Prescription of margin requirements Consumer credit regulation Moral suasion Direct action Credit rationing

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a) Quantitative/ General Methods: The methods by which Central Bank controls the total amount of credit in the economy are termed as quantitative methods of credit control. Bank rate policy: The rate at which the central bank advances loans to the commercial banks. Bank rate is also called as the discount rate. To contract money supply, bank rate is increased and vice versa. Open market operation: The sale or purchase of securities by the central bank to withdraw liquid funds from the banking system (commercial banks) or inject the same into that system. To increase the money supply, the Central bank buys securities from commercial banks and public and vice versa. Varying reserve requirements: There are two ratios (CRR & SLR) by changing those central bank control money supply. All the commercial banks have to maintain a certain percentage of their deposits as cash reserves with the central bank is called cash reserve ratio (CRR). Statutory Liquidity Ratio (SLR) refers to the amount that the commercial banks require to maintain in the form of cash, or gold or govt. approved securities before providing credit to the customers. To increase money supply, central bank reduces CRR & SLR ratios and vice-versa. b) Qualitative/selective credit control measures include: Prescription of margin requirements: Generally, commercial banks give loan against stocks or securities. While giving loans against stocks or securities they keep margin. Margin is the difference between the market value of a security and its maximum loan value. Let us assume, a commercial bank grants a loan of Rs. 8000 against a security worth Rs. 10,000. Here, margin is Rs. 2000 or 20%. To reduce money supply, margin requirements are increased and vice versa. Consumer credit regulation: Now-a-days, most of the consumer durables like T.V., Refrigerator, Motorcar, etc. are available on installment basis financed through bank credit. Such credit made available by commercial banks for the purchase of consumer durables is known as consumer credit. If there is excess demand for certain consumer durables leading to their high prices, central bank can reduce consumer credit by (a) increasing down payment, and (b) reducing the number of installments of repayment of such credit and vice versa. Moral suasion: Moral suasion means persuasion and request. To arrest inflationary situation central bank persuades and request the commercial banks to refrain from giving loans for speculative and non-essential purposes. On the other hand, to 55
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counteract deflation central bank persuades the commercial banks to extend credit for different purposes. Direct Action: This method is accepted when a commercial bank does not cooperate the central bank in achieving its desirable objectives. Direct action may take any of the following forms: Central banks may charge a penal (punishing) rate of interest over and above the bank rate upon the defaulting banks; may refuse to rediscount the bills of those banks; may refuse to grant further accommodation. Credit rationing: Refers to the situation where Central Bank (lender) limit the supply of additional credit to Commercial Banks (borrowers) who demand funds, even if the latter are willing to pay higher interest rates. A repo or repurchase agreement: is an instrument of money market. Repo is a collateralized lending i.e. the commercial banks which borrow money from central bank by selling securities to meet short term needs with an agreement to repurchase the same at a predetermined rate and date. The central bank charges some interest rate on the cash borrowed by banks, but this rate (called repo rate) will be less than the interest rate on bonds. Reverse repo: In a reverse repo central bank borrows money from commercial banks by lending securities. The interest paid by central bank in this case is called reverse repo rate. The Money Measures announced by central bank were as follows1) M 1 : Cash + Net Demand Deposits + Other Deposits with central bank 2) M 2 : M 1 + Post Office Saving Deposits 3) M 3 : M 2 + Net Time Deposits With Banks

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Monetary Policy Operating Procedures

Policy Instruments: CRR & SLR, Open market operations withdrawing or injecting liquidity, Changing bank rate, repo, reverse repo etc.

Targets: (i) Operating Targets > Reserve Money (ii) Intermediate Targets > Broad Money

Goals: (i) Price stability (ii) Economic growth (iii) Financial stability

Policy Decision:
Based on market information and value judgment of the policy makers

> > > > >

Information Variables: Foreign reserves Short-term interest rates Liquidity situation Domestic credit Information and exchange rates

Common Concepts on Financial Market & Institutions

Securitization: Securitization is the process of pooling and repackaging mortgage loans into securities that are then sold to investors. Credit-rating agency: The rating agency estimates the default risk of the portfolio relative to that of an investment-grade (low-risk) security and decides how much default protection the lender must provide to investors to make the asset-backed security investment grade. Eventually, it certifies the quality of the loan portfolio. Market: Market is a mechanism by which price of products and services are fixed on the basis of demand and supply. Economic system: Economic system combines inputs-land and other natural resources, labor and managerial skills, and capital equipment to produce output, 57
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goods and services needed by society. The basic function of it is to allocate scarce resources to their mostly valued use and to produce goods and services according to the forces of demand and supply. Es ensures timely supply and exact amount needed and determines what to produce, how to produce, and for whom to produce. Financial system: Financial system is an institutional arrangement which mediates between surplus economic unit (SEUs) and deficit economic unit (DEUs). Its primary task is to move scarce loan-able funds from those who save to those who borrow to buy goods and services and to make investments in new equipment and facilities so that the economy can grow and increase the standard of living enjoyed by its citizens. Financial market is the heart of financial system. Financial asset & its creation: It is a claim against the income or wealth of a business firm, household, or unit of government, represented usually by a certificate, receipt, computer record file, or other legal document, and usually created by lending of money. Characteristics of FAs are (i) not provide a continuing stream of services to their owners as a home, an automobile would do, (ii) serve as store of value (purchasing power), (iii) promise of future return, (iv) cannot be depreciated, (v) fully transferable (vi) physical condition not relevant in determining market value. Debt security prices and interest rates are inversely related because with increasing interest rates, investors would rather go for newer securities than stay with the older ones at lower rates. Interest rates and corporate stock (equity) prices frequently move in opposite directions as well. If interest rates rise, bonds and other debt instruments now offering higher yields become more attractive relative to stocks, resulting in increased stock sales and declining equity prices. Conversely, a period of falling interest rates often leads investors to dump their lower-yielding bonds and switch to equities, driving stock prices upward. Then, too, lower market interest rates tend to lower the overall cost of capital for businesses issuing stock, resulting in a rise in stock prices. Market orders: An investor instructs the broker to buy or sell specified securities at the best possible price as soon as the order reaches the trading floor of the exchange. Market orders are usually executed immediately. Broker: An individual or firm that charges a fee or commission for executing buy and sell orders submitted by an investor. Broker is commission salespeople who 58
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need not invest their own funds in the securities they sell. Most brokers are employed by dealers. Dealer: An individual or a firm that puts its own capital at risk by investing in a security in order to carry an inventory and make a market in that security. They purchase shares and securities from ultimate borrowers (issuers) for resale to investors. Wash Sale: An illegal transaction an investor makes by simultaneously (at the same time) buying and selling a security through two different brokers, thereby creating the illusion of activity. Investors do this to try and recognize a tax loss without actually changing their position. Matched Order: An order is placed with a broker to buy a specified stock at a price above the market price with the intention of immediately selling the stock through another broker at the same price. It is designed to give the appearance of active trading in the stock. Due diligence violation: Failure of dealers-brokers, managing directors, or partners to learn every essential fact about every underwriting that falls within their responsibility, and/or inadequate disclosure to investors of material information with respect to the purchase of securities. Insider Trading: The buying or selling of a security by someone who has access to material, nonpublic information about the security. Insider trading can be illegal or legal depending on when the insider makes the trade: it is illegal when the material information is still nonpublic. Illegal insider trading therefore includes tipping others when you have any sort of nonpublic information. Insider trading is legal once the material information has been made public, at which time the insider has no direct advantage over other investors. The SEC, however, still requires all insiders to report all their transactions. So, as insiders have an insight into the workings of their company, it may be wise for an investor to look at these reports to see how insiders are legally trading their stock. Insiders: Insiders are corporate directors, owners of 10 percent or more of the equity shares, and brokers-dealers, executives who have access to material and nonpublic information about corporation. Inside information is material and nonpublic information about corporation. Bull market: A bull market is a period of time during which there are usually more buyers than sellers. As a result, the prices of most assets traded in the market are 59
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rising. Bull markets may last for as long as several years. For most investors, bull markets are a better time to buy than to sell. Bear market: A bear market is a period of time during which there are usually more sellers than buyers. The prices of most assets during that time falls. Bear markets are usually much shorter than bull markets. Some investors endeavor to buy at the beginning of a bull market and sell before the peak, which marks the start of a new bear market. Margin trading: Practice of buying stock with money borrowed from the broker. Margin trading includes both margin buying and margin short selling. In this arrangement, the investor makes a cash down payment (called the margin) with the broker and can purchase stocks worth about twice the cash amount. The broker charges interest on this loan (in addition to the commission on each buy/sell trade) and the investor has to keep the entire stockholding with the broker as collateral. Also, the investor has to put up additional cash in case the value of the stockholding falls below a certain amount. Margin requirement: Margin requirement is the percentage of a security's value that may be used as a collateral for a loan to finance its purchase. In other word, the amount that an investor must deposit in a margin account before buying on margin or selling short. Short selling: Borrowing a security from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker. Short selling (or "selling short") is a technique used by investors who try to profit from the falling price of a stock. The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock. Maintenance Margin: The minimum amount of equity that must be maintained in a margin account. In other word, A sum, usually smaller than but part of the original margin, that must be maintained on deposit at all times. If a customer's equity in any futures position drops to or below, the maintenance margin level, the broker must issue a margin call for the amount at money required to restore the customer's equity in the account to the original margin level. Also referred to as "minimum maintenance" or "maintenance requirement". Margin Call: A broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum 60
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maintenance margin. Margin calls occur when your account value depresses to a value calculated by the broker's particular formula. This is sometimes called a "fed call" or "maintenance call".

Margin percentage = Where, AMV = aggregate market value of all securities in the account TD = total debt E = equity One period margined return: Where,

Problem: On Monday, July 3, you ask your broker to buy 200 share of IBM at market, using the 50% allowed initial margin. The broker charges a commission of 61
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2% and the brokerage firm has a 30% maintenance margin. The later calls you and says that the trade was extended at $70 per share. i) How much must you pay the brokerage firm? ii) Since the stock was bought on margin, below what stock price will a margin call be required? iii) If the stock falls to $40 and you intend to deposit more cash into the account to bring it back to the maintenance margin by repaying part of the loan, how much cash must you deposit? iv) If the stock falls to $40 and you intend to sell stock to repay some of the debt to bring it back to the maintenance margin, how many shares must you sell? Solution: i) The value of securities bought (200 70) = 14000 Plus 2% commission (14000 .002) = 280 Minus margin 50% (14000 .50) = 7000 Net = 7280 I have to pay for purchasing the stocks $7280 ii) We know that maintenance margin = Now, security value = price no. of outstanding shares So, MM = Or, 0.30 = Or, price 60 = 200 price 7000 Or, price = 50 Since the stock was bought on margin, below $50 stock price a margin call will be required. iii) MM = Or, 0.30 = Or, 2400 = 8000 7000 + cash Or, cash = 1400 So, I have to deposit $1400 into the account for maintenance margin. iv) Again, MM = 62
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Financial Market and Institutions

Or, 12(200 N) = 8000 40N 7000 + 40N Or, N = N = 117 117 shares must have to sell for maintenance margin. Prospectus: After the receipt of certificate of incorporation, if the promoters of a public limited company wishes to issue shares to the public, he will issue a document called prospectus. It is an invitation to the public to subscribe to the share capital of the company. Formal written document to sell securities that describes the plan for a proposed business enterprise, or the facts concerning an existing one, that an investor needs to make an informed decision. The prospectus is not an offer in the contractual sense but only an invitation to offer. Market Index: An aggregate value produced by combining several stocks or other investment vehicles together and expressing their total values against a base value from a specific date. Market indexes are intended to represent an entire stock market and thus track the market's changes over time. Index values are useful for investors to track changes in market values over long periods of time. For example, the widely used Standard and Poor's 500 Index is computed by combining 500 large-cap U.S. stocks together into one index value. Investors can track changes in the index's value over time and use it as a benchmark against which to compare their own portfolio returns. Use of market index: as quick indicator, for historical analysis, to make predictions, to detect repetitive patterns, to form the basis for investment strategies. Characteristics of a good index: sample size with significant fraction, heterogeneous elements so that it can be representative, weights that correspond to actual investment opportunities, stated in convenient units that are easy to understand, availability. Market Average: A measure of the overall price level of a given market, as defined by a specified group of stocks or other securities. A market average equals the sum of all current values of stocks in the group divided by the total number of shares in the group. A market average measurement is a simple way to evaluate the price level of a group of stocks. For example, the Dow Jones Industrial Average, which is a price-weighted 63
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average, covers 30 blue chip stocks listed on the NYSE and is widely used to track overall U.S. stock market performance. Market Capitalization: The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share. The investment community uses this figure to determining a company's size, as opposed to sales or total asset figures. Frequently referred to as "market cap". If a company has 35 million shares outstanding, each with a market value of $100, the company's market capitalization is $3.5 billion (35,000,000 x $100 per share). Call Money Rate: The interest rate on a type of short-term loan that banks give to brokers who in turn lend the money to investors to fund margin accounts. For both brokers and investors, this type of loan does not have a set repayment schedule and must be repaid on demand. Market turnover: The turnover index measures the variability of average money value exchanged per script in the current period in relation to the average money amount during the base period. Disintermediation: Disintermediation means the withdrawal of funds from a financial intermediary by ultimate lenders (SBUs) and the lending of those funds directly to ultimate borrowers (DBUs). In other words, disintermediation involves the shifting of funds from indirect finance to direct and semi direct finance. We engage in disintermediation when we remove funds from a savings account at the local bank and purchase common stock or other financial assets through a broker.

Dhaka Stock Exchange (DSE)

DSE, the biggest capital market in the country, performs many functions. The major functions are: Listing of Companies, Providing the screen based automated trading of listed Securities, Settlement of trading, Gifting of share / granting approval to the transaction/transfer of share outside the trading system of the exchange, Market Administration & Control, Market Surveillance (observation), Publication of Monthly Review, Monitoring the activities of listed companies, Investors grievance (compliant) Cell, Investors Protection Fund, Announcement of Price sensitive or other information about listed companies. DSE listing requirements: As per Dhaka Stock Exchange (Direct Listing) Regulations, 2006. The concerned company i) shall have minimum paid up capital of Tk. 100 (one hundred) million; ii) shall have no accumulated loss; iii) shall be in 64
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commercial operation for at least immediate last five years; iv) shall have profit in three years out of the immediate last five completed accounting/financial years with steady growth pattern; v) is regular in holding annual general meeting (AGM).

DSE governing body (board of directors) structure

Board of Directors (12) Senior Vice President (1)

President (1)

Vice President
(1)

Directors (9)

Investment Corporation of Bangladesh (ICB)

ICB caters (provide) to the need of institutional support to meet the equity gap of the companies. Objectives are as follows: To encourage and broaden the base of investment, to develop the capital market, to provide for matters ancillary (additional/subsidiary) thereto, to mobilize savings, to promote and establish subsidiaries for business development. Functions of ICB: Underwriting of initial public offering of shares and debentures, Underwriting of right issue of shares, Direct purchase of shares and debentures including Pre-IPO placement and equity participation, Providing lease finance to industrial machinery and other equipment singly or by forming syndicate, Managing investors' Accounts, Managing Open End and Closed End Mutual Funds, Operating on the Stock Exchanges, Providing investment counsel to issuers and investors, Participating in Government divestment Program, Participating in and financing of, joint-venture projects, Dealing in other matters related to capital market operations, Trusty, Custodian, Bank Guarantee, Consumer Credit.

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Chapter twelve The structure of ICB:

Financial Market and Institutions

Chairman (1)

MD (1)

Directors (8)

Secretary (1)

Securities and Exchange Commission (SEC)

SEC is the regulator of the capital market of Bangladesh comprising DSE and CSE. Its a govt. commission to regulate the securities market and protect investors. In addition to regulation and protection, it also monitors the corporate takeover in the Bangladesh. Missions or objectives of the SEC are to: Protect the interests of securities investors, Develop and maintain fair, transparent and efficient securities markets, Ensure proper issuance of securities and compliance with securities laws. The commission of SEC consists of one chairman and four members.

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Chapter Thirteen

Leasing

Lease Financing
A lease is a contract by which the owner of property gives someone else the right to use that property for a specified time period in exchange for specified payments. Lease payments are tax deductible. It is a financial fixed cost. The types of lease are discussed below: Operating lease: A cancelable contractual agreement whereby the lessee agrees to make periodic payments to the lessor, often for five or fewer years, to obtain an assets services; generally the total payments over the term of the lease are less than the lessors initial cost of the leased asset. For example, the computer manufacturer is not only delivering you products but also giving the assurance of continued serviceability. Financial lease or capital lease: A longer term lease agreement than an operating lease that is non-cancelable and obligates the lessee to make payments for the use of an asset over a predefined period of time; the total payments over the term of the lease are greater than the lessors initial cost of the leased asset. In financial lease arrangement the lessee selects the asset and negotiates the price. The lessee also negotiates independently with a bank commercial finance company, or leasing company that will serve as lessor. The lessor buys the asset and simultaneously lease the asset to the lessee. Leveraged lease: A leveraged lease is a lease in which the lessor uses borrowed money to acquire the asset to be leased. The lessor may be a bank, leasing company, wealthy individual, or limited partnership. The lender may be a life insurance company, charitable trust, or other investor in a low tax bracket. The leveraged lease allows assignment of cash flows and tax benefits among parties according to their particular tax situations, and therefore, reduces the cost of the lese. Sale and leaseback: With a sale and leaseback arrangement, the owner of an asset contracts to sell the asset and to lease it from the buyer, typically under a financial lease arrangement. The sale and leaseback is a way to raise money based on an asset while continuing to use the asset.

Reasons for leasing:

i) Increased availability of financing: In the event of default, a lessor can often reclaim the leased asset faster and easier than would be the case for a secured lender. Therefore, lessors are often willing to provide assets 67

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Chapter Thirteen

Leasing

through a lease when the companys credit rating would not be strong enough to induce a creditor to make money available. The creditor compensates for risk by financing only part of the asset, while leases often provide close to 100 percent financing. Because of the increased protection of the lessor, an organization that needs an asset can often arrange a lease faster than a loan and with divulgence of less information. Leasing is also used when restrictive covenants limiting additional borrowing have been accepted as part of past financings. Since a lease is not technically a loan, a lease can sometimes be used when additional borrowing is not allowed. ii) Shift of ownership risk: The purchaser of an asset faces uncertainty with regard to serviceability, obsolescence, and residual value of the asset at the end of its use life. Leases can be a tool for decreasing or shifting those risks. Flexibility: Flexibility is another advantage of leasing particularly with a cancellation provision, the lessee can respond quickly to changing market conditions. Tax advantage: A lease transfers depreciation tax benefits to the lessor. If the lessor is in a better position to use these benefits, the lease may be less expensive than the purchase. Accounting benefits: When assets and debt are placed on the companys books, the debt to equity ratio increases, and ratios measuring the efficiency of asset usage decline. In addition, the combined interest and depreciation expenses cause income to decline. A financial lease to be treated on the accounting statements as if the asset were purchased. An operating lease, on the other hand, results in no change to the balance sheet and may result in lower reported expenses than would occur if the asset were purchased. vi) Circumvent decision process: The purchase of an asset often requires a lengthy capital expenditure approval process. In some cases, though, acquisition of an asset through a lease is not subjected to the same decision 68
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iii)

iv)

v)

Chapter Thirteen

Leasing

process. Thus, a manager may be able to acquire an asset quickly through a lease when a request to purchase would be time consuming. vii) Reimbursement: Some organizations, such as hospitals, are reimbursed based on expenses incurred. When assets are leased, the lease payments are allowed as expenses. When assets are purchased, depreciation is allowed as an expense.

viii) Lower cost: Other things aside, a lease will be attractive if the present value of the net cash outflows to lease is less than the present value of the net cash outflows to buy.

Disadvantage of leasing:
i) ii) iii) iv) v) vi) No ownership Deprived from terminal value Does not reflect the true and fair condition of business Risk to cancellation of contract Changing problem Inflation problem

Lease vs Purchase decision

The long term asset acquisition can be done by the followings: i) Lease the assets ii) Borrow fund to purchase the asset iii) Purchase the asset by using available fund Among the three alternatives we will compare the one. Because they are considered as an alternatives of one another. To determine whether the leasing or buying an asset is better, the net present value of the assets cash flows, the lessee under the lease agreement must be compared with the net present value of the asset, if purchased. A lease can be compared to a purchase based on the present value of the cash flows to lease and the PV of the cash flows to own. The net advantage of leasing is the difference between the present value of cash flows to own and cash flows to lease.

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If something someone else has created is useful to you, it has value, and you should assume the creator wants compensation for this work. Albeit compensation not only means monetary value, But also other a lot of thingsREJOAN

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Bibliography
SL 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. Writer Name Gitman. L. J. Khan, Ghosal, Jahangir Van Horne, J. C. and Wachowicz. J. M. Schall, L. D. and Haley. C. W. RossWesterfieldJaffe Ross, Westerfield, and Jordan Besley & Brigham Brealey, Myers Marcus Peter S Rose K. K. Dewett F. Mishkin Rosen Pandey. I. M. N. T. Somashekar
SL 1. 2. 3. 4. 5. 6.

Book Name Principles of Managerial Finance Fundamental of Finance Fundamental of Financial Management Introduction to Financial Management Corporate finance Fundamentals of Corporate Finance Essentials of Managerial Finance Principles of Corporate Finance Capital & Money market Modern Economic Theory The economics of Money Banking and Financial Markets Public Finance Financial Management Banking
Website www.Investopedia.com www.encyclopedia.com www.wikipedia.com Official website of ICB Official website of SEC Official website of DSE

Other Sources (the most valuable)

1. 2. 3. Lecture & Lecture sheet of Monimul Haque Sir Lecture of Jahid Hasan Milky Sir Lecture of Rashed Kabir Likhon Sir

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