10MBAPF204 Semester II

FINANCIAL MANAGEMENT
UNIT – I

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

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

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

OBJECTIVES OF FINANCE

The management of finance is to achieve financial objectives. The following are the main
objectives of finance
 To create wealth for business
 To generate cash
 To provide adequate return of investment (bearing in mind the risk of business and
the resources invested)
 To ensure that sufficient fund is provided at right time to meet the needs of the
business

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

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

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

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

Long-term financial decisions:

 Long-term asset-mix or investment decision
 Capital-mix or financing decision
 Profit allocation or dividend decision

Short-term financial decisions:

 Short-term asset-mix or liquidity decision

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

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

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

 Investment Decisions: A firm’s investment decisions involve capital expenditures.

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

 Financing Decisions: A financing decision is the second important function to be

performed by the financial manager. He or she must decide when, where from and
how to acquire funds to meet the firm’s investment needs. The mix of debt and
equity is known as the firm’s capital structure. The financial manager must strive
to obtain the best financing mix or the optimum capital structure for his or her firm.
  Dividend Decisions: A dividend decision is the third major financial decision. The
financial manager must decide whether the firm should distribute all profits or
retain them or distribute a portion and retain the balance. The proportion of profits
distributed as divided is called the dividend-payout ratio and the retained portion of
profits is known as the retention ratio.

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

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

RISK RETURN RELATIONSHIP

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

Risk-return relationship

Risk
 An overview of financial management

Financial Management

Maximization of Share Value

Financial Decision

Investment Liquidity Financing Dividend

Decisions Management Decisions Decisions

Trade-off
Return Risk

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

Return= Risk-free rate + Risk premium

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

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

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

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

The risk of a portfolio of securities is measured by its variance and standard deviation. The
variance of a portfolio is the sum of
 The variances of individual securities and (the square of) their respective
weights,
 The covariance (that is, the correlation coefficient between securities times
their standard deviations) of securities and twice the product of their
respective weights.

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

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

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

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

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

σ2 σm x σm σm

Estimation of Beta:
The following table shows the percentage returns on the market, represented by the BSE
Sensex (Sentivity Index) and the share of the Jaya Infotech Limited for recent five years:
Returns on Sensex and Jaya Infotech
Year Market Return Jaya Infotech
Rm (%) Rj (%)
1 18.60 23.46
2 −16.50 −36.13
3 63.83 52.64
4 −20.65 −7.29
5 −17.87 −12.95
The Beta can be calculated by the following steps:
1. Calculate the average return on market (Sensex) and Jaya’s share (column 2 and 3).
2. Calculate deviations of returns on market from the average return (column 4)
3. Calculate deviations of returns on Jaya’s share from the average return (column 5)
4. Multiply deviations of market returns and deviations of Jaya’s return (column 6).
Take the sum and divide by 5 (number of observations) to get covariance.

Covm,j = 4666.30 = 933.26

5

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

σm = 5288.23 = 1057.65
5
6. Divide the covariance of market and Jaya by the market variance to get beta.

βj = Covj,m = 933.26 = 0.88

2
σm 1057.65

7. The intercept term is given by the following formula:

αj = rj−βj x rm rj represents average return on investment j
rm represents average market return.

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

Beta Calculation for Jaya Infotech Limited

-------------------------------------------------------------------------------------------------------------
(rm− rm)
x
Year rm rj (rm− rm) (rj− rj) (rj− rJ) (rm− rm)2
-------------------------------------------------------------------------------------------------------------
1 18.60 23.46 13.11 19.51 255.91 171.98
2 −16.50 −36.13 −21.98 −40.08 880.83 483.08
3 63.83 52.64 58.35 48.69 2841.35 3404.85
4 −20.65 −7.29 −26.13 −11.24 293.64 682.96
5 −17.87 −12.95 −23.35 −16.90 394.57 545.35
rm rj Sum = Sum =
= 5.48 = 3.95 4666.30 5288.23
THE MARKET MODEL:
Yet another procedure for calculating beta is the use of the market or index model. In the market,
we regress returns on a security against returns of the market index. The market model is given
by the following equations

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

Rm is the expected market return,
α is intercept, βj is slope of the regression
ej is the error term (with zero mean and
constant standard deviation)

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

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

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

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

Estimates for Regression Equation

-------------------------------------------------------------------------------------------------------------
Year rm (X) rj(Y) XY X2 Y2
 -------------------------------------------------------------------------------------------------------------
1 18.60 23.46 436.30 345.88 550.37
2 −16.50 −36.13 595.99 272.10 1305.38
3 63.83 52.64 3360.26 4074.86 2770.97
4 −20.65 −7.29 150.54 426.42 53.14
5 −17.87 −12.95 231.41 319.31 167.70
2
Sum SX = SY = SXY = SX = SY2 =
27.42 19.73 4774.49 5438.58 4847.56

Average X= Y=
5.48 3.95

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

β = NΣXY − (ΣX) (ΣY)

NΣX2 − (ΣX)2

βj = (5) (4774.49) − (27.42) (19.73)

(5) (5438.58) − (27.42)2

= 23872.45 − 541.00 = 23331.45 = 0.88

27192.90 − 751.86 26441.04

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

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

…….. P.No.118-119

Coefficient of correlation = NΣXY − (ΣX) (ΣY)

[{(NΣY2) − (ΣY)2} {(NΣX2) − (ΣX)2}]½

Corj,m = ________(5) (4774.49) − (27.42) (19.73)

[{(5)(4847.56) − (19.73)2} {((5)(5438.58) − (27.42)2}]½

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

= 23331.45 / 25111.35 = 0.93

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

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

The R-square indicates the extent to which the market model explains a security’s returns. In
the above example, the market is able to explain 86 percent of Jaya Infotech’s share return.
Beta Estimation in Practice
In practice, the market portfolio is approximated by a well diversified share price index. We
have several price indices available in India. For example, these indices are:
(a) Bombay Stock Exchange’s Sensitivity Index (Sensex)
(b) Bombay Stock Exchange’s National Index
(c) National Stock Exchange’s Nifty
(d) Economic Times Share Price Index
(e) Financial Express Share Price Index

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

In computing beta by regression, we need data on returns on market index and the security for
which beta is estimated over a period of time. There is no theoretically determined time period
and time intervals may vary. The returns may be measured on a daily, weekly or monthly basis.
One should have sufficient number of observations over a reasonable length of time. A number
of agencies providing the beta values, in developed countries like the USA and the UK, use
monthly returns for five-year periods for estimating beta.
The return on a share and market index may be calculated as total return; that is, dividend yield
plus capital gain:
Current Dividend + Share price in the beginning – Share price at the end
Rate of return = Share price in the beginning

= Dividend yield + Capital gain/loss

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

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

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

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

Summaries of Regression Parameters for HUL Vs Market Returns

Alpha (intercept) −0.8770

Standard error of alpha 1.0801
Beta 0.6621
Standard error of beta 0.1455
Correlation 0.5130
Coefficient of determination 0.2631
F-statistic 20.713
Significance 0.0000
Market HUL
Average monthly return 2.9957 1.1055
Variance of returns 46.9270 78.1804
Covariance 30.5534

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

……………P.No.120

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

 Beta (slope) HUL has a beta of 0.66 based on the monthly returns during April 2003 to
March 2008. A beta of less than 1 means that HUL’s returns are less volatile than the
market (Sensex) returns.
  Alpha (intercept) The intercept is −0.887. HUL has negative 0.9% return (Rh) when the
market return is zero. HUL’s beta (Bh) is 0.66 If the monthly market return (Rm) is
expected to be 1 percent, HUL’s expected monthly return is −0.23 percent:

Rh = α + βRm = −0.887 + 0.66 * 1 = −0.227

 Coefficient of correlation (Cor) The coefficient of correlation is 0.51. The positive
correlation indicates that when the market return goes up, HUL’s return also goes up.
 Coefficient of determination (Cor2) The squared coefficient of correlation or the
coefficient of determination (Cor2) is 0.26 (or26%). It indicates the percentage of the
variance of HUL’s returns, explained by the changes in the market returns. Thus, the
market explains 26 percent of HUL’s risk (variance of returns). The 74 percent
unexplained variance is the firm-specific variance. The HUL’s systematic and non-
systematic risks are as follows:

Total risk = Security variance

= Systematic risk + Unsystematic risk

Systematic risk = Cor2 * security variance

= 0.26 * 78.1804 = 20.33

Unsystematic risk = (1−Cor2) * security variance

= (1−0.26) * 78.1804 = 57.85

 Variance and covariance: Variance of the security is a measure of total risk. The
variance of HUL’s returns is 78.1804 and the market return is 46.9270. The covariance of
the HUL returns and the market returns is 30.5534. HUL’s beta can also be calculated as
follows:
 Standard error of beta: Standard error of beta coefficient is 0.1455. It indicates the
extent of error in the estimation of beta. The confidence level of the estimated value is
measured plus or minus two standard errors. Thus HUL’s beta has a confidence range
between 0.37 [i.e.0.66 − (2 * 0.1455)] and 0.95 [i.e.0.66 + (2 * 0.1455)] and there is 95
percent probability that it would range within these intervals.

Betas for the Sensex Companies

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

Name of Company Beta Values R2

1. A.C.C. 0.79 0.30
2. Jaiprakash Associates 2.28 0.14
3. Bharati Televentures 0.79 0.34
4. BHEL 1.12 0.52
5. CIPLA Limited 0.46 0.18
6. DLF Ltd 1.58 0.54
7. Grasim Ind. 0.77 0.46
8. Gujarat Ambuja Cement 0.37 0.16
9. HDFC 1.02 0.46
 10. HDFC Bank 0.99 0.51
11. HINDALCO 1.23 0.49
12. Hindustan Lever 0.54 0.22
13. ICICI Bank 1.26 0.64
14. Infosys Technologies 0.71 0.32
15. ITC Ltd 0.66 0.31
16. Larsen & Toubro 1.11 0.55
17. Mahindra & Mahindra 0.73 0.34
18. Maruti Udyog Ltd 0.65 0.29
19. National Thermal Power 1.18 0.55
20. ONGC 1.06 0.58
21. Ranbaxy Lab. 0.63 0.30
22. Reliance 1.17 0.76
23. Reliance Comm. 1.19 0.60
24. Reliance Energy 1.66 0.50
25. Satyam Computer 0.68 0.25
26. State Bank of India 1.03 0.54
27. Tata Consultancy 0.70 0.34
28. Tata Motors 0.77 0.45
29. Tata Steel 1.13 0.48
30. Wipro Ltd 0.76 0.35

Does Beta Remain Stable Over Time?

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

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

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

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

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

Asset Beta and Equity Beta

Assets of a levered firm are financed by debt and equity. Therefore, the asset beta should be the
weighted average of the equity beta and the debt beta:
 Asset beta = Equity beta * Weight of equity * Debt beta * Weight of debt

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

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

βA = βE * Equity / Equity + Debt

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

ΒE = βA [ 1+ Debt / Equity (1−T]

______________________________________

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

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

We need the following information to estimate a firm’s cost of equity:

 The risk-free rate
 The market premium
 The beta of the firm’s share
_______________________________________
 TIME VALUE OF MONEY

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

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

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

Time Preference for Money

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

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

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

 Risk
 Preference for consumption
 Investment opportunities

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

Required Rate of Return

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

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

Thus, the individual is indifferent between Rs.100 and Rs.105 a year from now as he considers
these two amount equivalent in value. In reality, an investor will be exposed to some degree of
risk. Therefore, he would require a rate of return, called risk premium from the investment,
which compensates him for both time and risk. The required rate of return will be calculated as:

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

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

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

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

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

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

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

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

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

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

Once the investor has determined his interest rate, say, 10 percent, he would like to receive
at least Rs.1.10 after one year or 110 percent of the original investment of Re 1 today. A
 two year period is two successive one-year periods. When the investor invested Re1 for
one year, he must have received Rs.1.10 back at the end of that year in exchange for the
original Re1. If the total amount so receive (Rs.1.10) were reinvested, the investor would
expect 1.10 percent of that amount, or rs.1.21 = Re1 * 1.10 * 1.10 at the end pf the second
year.

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

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

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

Future Value of a Single Cash Flow

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

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

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

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

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

Future Value of an Annuity

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

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

For example, a constant sum of Re1 is deposited in a savings account at the end of each year for
four years at 6 percent interest. This implies that Re1 deposited at the end of the first year grow
for 3 years, Re1 at the end of second year for 2 years, Re1 at the end of the third year for 1 year
and Re1 at the end of the fourth year will not yield any interest.
Using the concept of the compound value of a lump sum, we can compute the value of annuity.
The compound value of
Re1 deposited in the first year will be: 1*1.063 = 1.191
2
Re1 deposited in the second year will be: 1*1.06 = 1.124
Re1 deposited in the third year will be: 1*1.061 = 1.060
Re1 deposited at the end of fourth year will be: 1 = 1.000
Total = 4.375

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

In the above equation A is the annuity. We can extend the same for n periods and rewrite it as
follows:
Fn = A [(1+i)n – 1 / i]

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

Consider an example:

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

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

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

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

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

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

Fn = A*CVFAni

A= Fn*1/CVFAni

A= Fn*1/SFF

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

Sinking fund (annuity) = Future Value

Compound value factor of an annuity of Re1

A= Fn[i/(1+i)n − 1]

From the above equation we obtain the following result:

A = 21875* 1/4.375 = 21875*0.2286 = Rs.5000

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

PRESENT VALUE
We have so far studied how compounding technique can be used for adjusting for the time value
of money. It increases an investor’s analytical power to compare cash flows that are separated by
more than one period, given the interest rate per period. With the compound technique, the
amount of present cash can be converted into an amount of cash equivalent value in future.
However, it is a common practice to translate future cash flows into their present values. Present
value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent
value to the decision maker. Discounting is the process of determining present values of a series
of future cash flows. The compound interest rate used for discounting cash flows is also called
the discount rate.

Present Value of a Single Cash Flow

As we have seen earlier that an investor with an interest rate i, of say, 10 percent per year, would
remain indifferent between Re1 now and Re1*1.101 = Rs1.10 one year from now and Re1*1.102
= Rs1.21 after two years and Re1*1.103 = Rs1.33 after 3 years.

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

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

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

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

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

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

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

P = Fn / (1+i)n = Fn [(1+i)−n]

P = Fn / (1+i)n

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

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

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

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

Present Value of Annuity

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

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

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

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

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

P = A[1/i − 1/i (1+i)n]

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

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

P = A[1/i − 1/i (1+i)n]

P = 5000 [1/0.10 − 1/0.10 (1.10)4]

= 5000 * (10 − 6.830) = 5000 * 3.170 = Rs.15,850

It can be realized that the present value calculations of an annuity for a long period would be
extremely cumbersome without a scientific calculator. We can use the table of pre-calculated
present values of an annuity of given present value of annuity of Rs.1 for numerous
combinations of time periods and rates of interest.
We can also calculate the present value factor of an annuity of Rs.1 for n periods at i rate of
interest, by the formula and using the table (factor) value as shown below:

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

Capital Recovery and Loan Amortization

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

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

P = A * PVFAn,i

A = P [1/ PVFAn,i]

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

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

A = P * CRFn,i

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

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

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

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

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

1
--------------------------
A = 10000 1 1
------- − -------------
 0.10 0.10(1.10)4

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

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

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

Loan Amortization: Problem

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

Solution: The annual installment will be as follows:

P = A * PVFAn,i

10000 = A * PVFAn,i

10000 = A * 2.531

A = 10000 / 2.531 = Rs.3,951

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

Loan Amortization Schedule

End of Year Payment Interest Principal Outstanding
Repayment Balance
0 - - - 10000
1 3951 900 3051 6949
2 3951 625 3326 3623
3 3951 326 3625* 0
______________________________________________________________________________
* Rounding off error.

Present Value of Perpetuity

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

Present value of perpetuity = Perpetuity / Interest rate

 P =A/i

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

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

Present Value of an Uneven Cash Flow

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

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

Solution: The present value is calculated as follows:

Present value = 1000 + 1500 + 800 + 1100 + 400

(1.08) (1.08)2 (1.08)3 (1.08)4 (1.08)5

The complication of solving this equation can be resolved by using the calculated table. We can
find out the appropriate present value factors (PVFs) either from the calculated table or by using
calculator land multiplying them by respective amount. The present value calculation will be as
follows:

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

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

= Rs.3,927.60
_________________________________

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

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

n
= ∑ At / (1+i)t
t=1

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

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

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

End of year Amount of Salary (Rs.)

1 1000 = 1000 * 1.100 1000
2 1000*1.10 = 1000 * 1.101 1100
3 1100*1.10 = 1000 * 1.102 1210
4 1210*1.10 = 1000 * 1.103 1331
5 1331*1.10 = 1000 * 1.104 1464

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

Table of Present Value of a Growing Annuity

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

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

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

There is a short cut to solve the problem. You can use Equation to find the present value of the
series of dividends as follows:
n
P = A 1+g
------ 1− 1+i
i–g

= 66
15
----------- 1 − 1.10
0.21-0.10 1.21
 = 600 * (1-0.90915) = 600 * 0.7606 = Rs.456.36
________________________________
Yet another alternative is to use Equation as shown below:

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

i + g 1.10

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

P = 66 + 66(1.10) + 66(1.10)2 + …… + 66(1.10)n–1

1.21 (1.21)2 (1.21)3 (1.21)n

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

P = A / i–g

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

VALUE OF AN ANNUITY DUE

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

 Lease is a contract to pay lease rentals (payments) for the use of an asset.
 Hire purchase contract involves regular payments (installments) for acquiring (owning)
an asset.
 Annuity due is a series of fixed receipts or payments starting at the beginning of each
period for a specified number of periods.

Future Value of an Annuity Due

How can we compute the compound value of an annuity due? Suppose you deposit Rs.1in a
savings account at the beginning of each year for 4 years to earn 6 percent interest, how much
will be compound value at the end of 4 years? You may recall that when deposit of Rs.1 made at
the end of each year, the compound value at the end of 4 years will be Rs.4.375 as seen earlier.
However, Rs.1 deposited in the beginning of each year 1 through year 4 will earn interest
respectively for 4 years, 3 years, 2 years and 1 year.

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

= 1.262 + 1.191 + 1.124 + 1.06

= Rs.4.637

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

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

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

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

= A [(1+i)n −1] (1+i)

1
Thus the compound value of Rs.1 deposited at the beginning of each year for 4 year is:

1 * 4.375 * 1.06 = Rs.4.637

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

Present Value of an Annuity Due

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

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

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

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

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

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

 P = A [(1 / i) – (1 / i(1+i)n] (1+i)

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

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

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

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

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

Interest = Rs.100 * 10% *½ = Rs.5

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

Interest = Rs.105 * 10% *½ = Rs.5.25

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

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

EIR = 5 + 5.25 / 100 = 10.25%

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

EIR in the above example can also be found out using the following equation:
 EIR = [1+i/m]nm – 1

= [1+i/2]1*2 – 1 = [1+0.10/2]2 – 1

= 1.1025 – 1 = 0.1025 or 10.25%

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

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

EIR = [1+i/m]nm – 1 where ‘i’ is the annual nominal rate of interest,

‘n’ the number of years and
‘m’ the number of compounding per year.

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

compounding m = 52.

Effective Interest Rate (EIR)

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

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

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

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

______________________________________

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

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

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

Fn = P[1+i/m]n*m
Fn is the future value, P the cash flow today, ‘i’ the annual rate of interest, ‘n’ is the number of
years and ‘m’ is the number of compounding per year. The compound value of an annuity in
case of the multi period compounding is given as below:

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

Problem: (Multi-period Compounding)

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

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

Half-yearly compounding

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

Quarterly compounding

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

Monthly compounding

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

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

Fn = P*eim = P*ex

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

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

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

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

P = Fn/ein = Fn*e−i*n
Thus, if Rs.1271.30 is due in 2 years, discount rate being 12 percent, then the present value of
this future sum is:

P = 12713.30 / 1.2713 = Rs.1000

NET PRESENT VALUE

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

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

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

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

PV = A*PVFAn,I

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

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

The general formula for calculating NPV can be written as:

NPV = C1 + C2 + . . . . . + Cn − C0
(1+k) (1+k)2 (1+k)n

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

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

Present Value and Rate of Return

You may be frequently reading advertisement in newspapers: deposit say Rs.1000 today and get
twice the amount in 7 years; or pay us Rs.100 a year for 10 years and we will pay you Rs.100 a
year thereafter in perpetuity.
A company or financial institution may offer you bond or debenture for a current price lower
than its face value and repayable in the future at the face value, but without and interest (coupon).
A bond that pays some specified amount in future (without periodic interest) in exchange for the
current price today is called a zero-interest bond or zero-coupon bond. In such situations, you
would be interested to know what rate of interest the advertiser is offering. You can use the
concept of present value to find out the rate of return or yield of these offers.

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

100*(1+i) = 112

100 = 112 / (1+i)

(1+i) = 112 / 100

i = 112 / 100 – 1 = 0.12 or 12%

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

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

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

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

1000 = 1762 / (1+i)5

(1+i)5 = 1762/1000

i = (1762/1000)1/5 – 1

= 1.7621/5 – 1

i = 1.12 – 1 = 0.12 or 12%

Let us take an example of an annuity. Assume you borrow Rs.70000 from the Housing
Development Finance Corporation (HDFC) to buy a flat in Ahmedabad. You are required to
mortgage the flat and pay Rs.11,396.93 annually for a period of 15 years. What interest rate
would you be paying? You may note that Rs.70,000 is the present value of a fifteen-year annuity
of Rs.11,396.93. That is,
 70000 = 11396.93*PVAF15,i

PVAF15,I = 70000 / 11396.93 = 6.142

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

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

Problem: (Calculating Rate of Return)

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

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

Cash Flow PV of Cash Flow

Year (Rs.) PVF at 8% (Rs.)
1 700 0.926 648.20
2 600 0.857 514.20
3 500 0.794 397.00
1559.40

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

Year Cash Flow PVF PV of Cash Flow

(Rs.) at 6% (Rs.)
1 700 0.943 660.00
2 600 0.890 534.00
3 500 0.840 420.00
1614.00

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

= 6% +(7% − 6%) * (1614 – 1600)

(1614 – 1586)

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

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

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

= (700*0.939)+ (600*0.883)+ (500*0.828)

= Rs.1600

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

RESERVE BANK OF INDIA

(Central Banking)

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

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

Open Market Operations

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

Bank Rate or Discount Rate

Bank rate has been defined in Section 49 of the Reserve Bank of India Act, 1934 as the standard
rate at which the bank is prepared to buy or rediscount bills of exchange or other commercial
papers eligible to purchase under the Act. It is the rate at which the central bank lends funds as a
‘lender of last resort’ to banks against approved securities, purchases, discounts eligible bills of
exchange. Its effectiveness depends on the dependence of commercial banks on the central bank
for a additional resources.

Selective Credit Controls

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

RESERVE BANK OF INDIA

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

Main Functions of the Bank

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

Money Supply Measures

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

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

Issue of Currency
The Reserve Bank is the sole authority for the issue of currency in India. Rupee coins/notes and
subsidiary coins are issued by the Government of India but they are put into circulation only
through the Reserve Bank. Currency notes are legal tender in payment or on account, without
limit. One rupee notes and coins are legal tender for unlimited amounts, fifty paise coins for a
sum not exceeding ten rupees and smaller coins for any sum not exceeding one rupee.
The Act permits the issue of notes in the denominations of rupees two, five, ten, twenty, fifty,
hundred, five hundred, one thousand, five thousand and ten thousand. At present denominations
up to Rs.1000 are being used.

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

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

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

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

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

Ways and Means Advances

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

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

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

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

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

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

Banking Department
Liabilities 1999-2000 Assets 1999-2000
Capital paid-up 5 Notes 15
Reserve fund 6500 Rupee coins -
National industrial credit Small coins -
(long-term operations fund) 4,633 Bills purchased
National housing credit & discounted
(long-term operations fund) 883 a) Internal -
b) External -
c) Govt. treasury bills -
Deposits
a) Government Balances held abroad 32,372
i) Central Govt. 100 Investments 79,728
ii) State Govt. 41 Loans & Advances to
i) Central Govt. 5,298
ii) State Govt. 2,386
b) Banks Loans & Advances to
i) Scheduled commercial i) Scheduled commercial
banks 60,854 banks 8,712
ii) Scheduled state ii) Scheduled
cooperative banks 845 cooperative banks 215
iii) Other scheduled iii) NABARD 5,104
cooperative banks 1,625 iv) Others 5,187
iv) Non-scheduled state
cooperative banks 52 Loans & Advances to
v) Other banks 658 i) Industrial Development
Bank of India 1,740
c) Others 16,470 ii) Export Import Bank
 Bills payable 744 of India 697
Other liabilities 65,069 iii) Industrial Reconstn.
Bank of India 170
iv) Others 2,005
Loans & Advances and
Investment from National
Housing Credit (Long-term
Operations fund) -
Loans & Advances to
National Housing bank 875
Other assets 13,972
------------- -------------
1,58,481 1,58,481
------------ -------------

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

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

Secondary Debt Market

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

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

REPOs
REPO and reverse REPO operated by RBI in dated government securities and Treasury bills
(except 14 days) helps banks to manage their liquidity as well as undertake switch to maximize
the return. REPOs are also used to signal changes in interest rates. REPOs bridge securities nd
banking business.
A REPO is the purchase of one loan against the sale of another. They involve the sale of
securities against cash with a future buy back agreement. There are no restrictions on the tenor
of REPOs. They are well established in US and spread to Euro market in the second half of
1980s to meet the trading demand from dealers and small commercial banks with limited access
to international inter-bank funding. REPOs are a substitute for traditional inter-bank credit.

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

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

_____________________________________________

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

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

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

Liquidity Adjustment Facility (LAF)

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

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

(i) Cash Reserve Ratio (CRR)

(ii) Statutory Liquidity Ratio

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

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

Selective Credit Controls

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

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

Advances to Priority Sector

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

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

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

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

CAMEL refers to a system of bank rating initially introduced in the US as an effective

supplement to bank supervision. It refers to five key criteria, such as

Capital adequacy -C
Asset quality -A
Management -M
Earnings -E
Liquidity -L

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

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

Autonomy for Central Bank

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

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

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

Monetary Policy in India

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

Monetary policy is implemented with the help of an intermediate target which the bank could
influence. Central banks depending upon their institutional and financial structure and the level
of maturity of markets use three types of nominal anchors or targets to serve as guide posts in the
conduct or monetary policy.
Reforms in the government securities market which ensured market related interest rates
provided some of the basic conditions for developing a secondary market. The bank rate since
April 1997 is used as a reference rate and signaling device by RBI to reflect the stance of
monetary policy. Liquidity is augmented through Liquidity Adjustment Facility (LAF) and
export credit refinance to banks and liquidity support to primary dealers.

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

COMMERCIAL BANKING

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

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

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

 The Singapore International Monetary Exchange (SIMEX)

 Eurex is one of the world’s leading derivatives exchanges, providing European featuring
open and low-cost electronic access globally. Eurex was established in 1998 with the
merger of Deutsche Terminbörse (DTB, the German derivatives exchange)
 SOFFEX (Swiss Options and Financial Futures).
 The Chicago Board of Trade (CBOT), established in 1848 which is the world’s oldest
futures and options exchange.

Branch Vs Unit Banking System

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

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

Retail Vs Wholesale Banking

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

Characteristics of Commercial Banks

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

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

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

Functions of Commercial Bank

 To change cash for bank deposits and bank deposits for cash
 To transfer bank deposits between individuals and / or companies
 To exchange deposits for bills of exchange, government bonds, the secured and unsecured
promises of trade and industrial units.
 To underwrite capital issues. They are also allowed to invest 5% of their incremental
deposit liabilities in shares and debentures in the primary and secondary markets.

Payment Systems
Commercial banks are institutions which combine various types of transactions services with
financial intermediation. Banks provide three types of transactions to convert deposits into notes
and coins to enable holders of deposits to undertake transactions in cash. Bank deposits are used
as a means of settling debts. Banks exchange cash and deposits from one currency into cash and
deposits of another currency.
 Commercial banks are at the very center of the payment systems. Bank money constitutes 38
percent of the money supply of the Indian economy. An efficient payment system is vital to a
stable and growing economy and the banks role is important.

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

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

Credit Analysis: Traditional Technique

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

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

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

 Credit risk: This risk arises when a bank cannot get back the money from loan or
investment. Credit risk is the risk of losing money when loans default.
 Interest risk: This risk arises when the market value of a bank asset, loan or
security falls when interest rates rise. Interest rate risk management may be
approached either by on-balance adjustment or off-balance sheet adjustment or a
combination of both.

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

 Operational risk: This risk arises out of inability to control operating expenses,
especially non interest expenses such as salaries and wages. In view of the
phenomenal increase in the volume of financial transactions, proper systems for
measurement, monitoring and control of operation risk should be set up. Suitable
methodologies for estimating and maintaining economic capital should be
developed.
Foreign Exchange Risk
Foreign exchange risk arises out of the fluctuations in value of assets, liabilities, income or
expenditure when unanticipated changes in exchange rates occur. An open foreign exchange
position implies a foreign exchange risk.

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

Liabilities Rs. Crores % Assets Rs. Crores `Rs.%

1 Capital 18447 1.66 Cash and balances 85371 7.69
2 Reserves & surplus 43834 3.95 with RBI
Balance with banks 81019 7.30
and money at call
and short notice
3 Deposits 900307 81.08 Investments 413871 37.27
Demand 129339 11.65 Government 288178 25.95
Savings 188483 16.97 securities
Term 582485 52.46 Other approved 25243 2.27
Non approved 100450 9.05
4 Borrowings 45350 4.09 Loans and adv. 443469 39.94
5 Other 102420 9.22 Bills purchased 43051 3.88
liabilities and and discounted
provisions Cash credit and 241596 21.76
(Unclassified over drafts
liabilities to Term loans 158822 14.30
banking systems Fixed assets 15480 1.39
and participation Other assets 71158 6.41
certificates issued
by SCBs)
Total Liabilities 1110368 100.00 Total assets 11110368 100.00

SEBI – SECURITIES AND EXCHANGE BOARD OF INDIA

Securities and Exchange Board of India (SEBI):

The establishment of the Securities and Exchange Board of India (SEBI), on the lines of the
Securities and Investment Board of the UK, is a major development in the Indian capital market.
SEBI, which was established on the 12th April 1988, is required to take a holistic view of the
Indian securities markets. SEBI is required to regulate and promote the securities market by:
 Providing fair dealing in the issues of securities and ensuring a market place where funds
can be raised at a relatively low cost;
 Providing a degree of protection to the investors and safeguard their rights and interests so
that there is a steady flow of savings into the market;
 Regulating and developing a code of conduct and fair practices by intermediaries in the
capital market like brokers and merchant banks with a view to make them competitive and
professional.

The Securities and Exchange Board Act, 1992, provides for the establishment of a board to
protect the interest of investors in securities and to promote the development and regulation of
securities market. The Board consists of a Chairman, two members from the Government of
India, Ministry of Law and Finance, one member from the RBI and two other members. The
head office of the SEBI is in Bombay.

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

Functions of the Board (SEBI)

The Board may provide the following functions:
 Regulating business in stock exchanges and any other securities market
 Registering and regulating the working of stockbrokers, sub-brokers, share transfer agents,
bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers,
underwriters, portfolio managers, investment advisors and other intermediaries associated
with securities market.
 Registering and regulating the working of depositories, custodians of securities, FIIs credit
rating agencies.
 Registering and regulating the working of venture capital funds an collective investment
schemes, including mutual funds.
 Promoting and regulating Self-Regulatory Organizations (SROs)
 Prohibiting fraudulent and unfair trade practices relating to securities market
 Prohibiting insider trading in securities
 Regulating substantial acquisition of shares and takeover of companies
 Calling for information from undertaking inspection, conducting inquiries and audits of
the stock exchanges, mutual funds, intermediaries and self-regulatory organizations in the
securities market
 Levying fees and other charges for carrying out its work.

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

Private corporate sector did not show much enthusiasm to offer capital to the public till 1980,
because of the following factors:
 Small size of the operations and narrow capital base
 Availability of loan capital on easy terms from the term-lending institutions
 Fear of losing control over the company
 Highly regulated environment

The decades of 80s, however, witnessed a sea change in the funds mobilization efforts of
companies through public issued of equity and debt, encouraged by the deregulation of capital
markets and other economic reforms. As a result, the annual funds mobilization in the new
issues market, which was only to the tune of about Rs.700 million in 60s and Rs.900 million in
70s and increased substantially during the 80s. The funds mobilized in 1990-91 were 3.3 percent
of gross domestic savings (GDS) and 10.5 percent in 1994-95 and much higher in 2006-07.

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

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

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

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

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

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

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

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

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

Cumulative convertible preference shares: CCPS is an instrument giving regular returns, at

say, 10 percent, during the gestation period from three to five years and equity benefits thereafter.
In India, the Government introduced CCPS in 1984. However, it has failed to catch the
investors’ interest mainly because the rate of return was considered too low in the initial years
and the provision for conversion into equity was also unattractive, if the company failed to
perform well.
Derivative securities: Securities with options to buy or sell are called derivative securities. CDs,
CCPSs and warrants are example of derivative securities.

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

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

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

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

 Help in determining fair prices based on demand and supply forces and all-available
information.
 Providing easy marketability and liquidity for investors
 Facilitation in capital allocations in primary markets through price signaling
 Enabling investors to adjusting portfolios of securities

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

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

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

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

Derivatives Market:
Derivatives are securities derived from other securities (called underlying securities) like equity,
debt, or any other type of security. They also include contracts that derive their values from
prices or index of prices. In India, the OTC derivatives are not allowed; the legal derivatives
must trade on recognized stock exchanges only.

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

Trading and Settlement:

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

Investors can hold and trade in securities in dematerialized form.

Dematerialization of shares: Dematerialization is a process of changing paper certificates of

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

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

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

The following features may be observed about dematerialization:

 Fall in settlement and other charges
 No stamp duty
 Depository facility has affected changes in the stock market microstructure
 Breadth and depth of investment culture has further got extended to interior areas of the
country faster
 Explicit transaction cost has been falling
 Increased growth in turnover

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

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

Circuit breaker: Extreme volatility in the stock market is not considered healthy. The circuit
breaker or price bands system helps to control the extreme volatility. From 2nd July 2001, SEBI
move to a system of index-based circuit breaker system market-wide. The system applied when
the market moves in either direction by either direction by specified circuit breakers (limits). The
three stages of the market movement are 10 percent, 15 percent and 20 percent. Whenever these
limits are breached, depending on the extent of breach, the stock exchange authorities will halt
the market for a specified period.

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

SEBI GUIDELINES FOR TAKEOVERS

The salient features of some of the important guidelines are as follows:

Disclosure of share acquisition/holding: Any person who acquires 5 percent or 10 percent or

14 percent shares or voting rights of the target company should disclose his holdings at every
stage to the target company and the Stock Exchanges within 2 days of acquisition or receipt of
intimation of allotment of shares.

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

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

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

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

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

Offer price: The acquirer is required to ensure that all the relevant parameters are taken into
consideration while determining the offer price and that justification for the same is disclosed in
the letter of offer.
Disclosure: The offer should disclose the detailed terms of the offer, identity of the offerer,
details of the offerer’s existing holdings in the offeree company etc. and the information should
be made available to all the shareholders at the same time and in the same manner.

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

MUTUAL FUNDS

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

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

Mutual Funds in India

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

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

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

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

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

Benefits of Mutual Funds

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

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

Types of Mutual Funds

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

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

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

Return from Mutual Funds

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

Mutual fund Holder’s Account

There are three types of accounts offered by most of the mutual funds. The investors select the
type that matches their objectives. The various accounts are:

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

Accumulation Account: An investor is allowed to open an account, with a very small initial
investment and continuous adding to the funds, periodically. Accumulation account may be
voluntary or contractual.
Withdrawal Account: Under this plan, the individual investor can withdraw the amount of funds
on a regular basis, which suits elderly people to supplement their pension benefits.

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

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

Expenses and Expense Ratios

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

FOREIGN INSTITUTIONAL INVESTORS (FII)

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

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

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

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

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

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

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

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

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

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

• a bank, insurance company, registered investment company (generally speaking, a mutual

fund), business development company, or small business investment company;
 • an employee benefit plan, within the meaning of the Employee Retirement Income
Security Act, if a bank, insurance company, or registered investment adviser makes the
investment decisions, or if the plan has total assets in excess of $5 million;
• a charitable organization, corporation, or partnership with assets exceeding $5 million;
• a director, executive officer, or general partner of the company selling the securities;
• a business in which all the equity owners are accredited investors;
• a natural person who has individual net worth, or joint net worth with the person’s spouse,
that exceeds $1 million at the time of the purchase;
• a natural person with income exceeding $200,000 in each of the two most recent years or
joint income with a spouse exceeding $300,000 for those years and a reasonable
expectation of the same income level in the current year; or
• a trust with assets in excess of $5 million, not formed to acquire the securities offered,
whose purchases a sophisticated person makes.

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

Institutional investors as financial intermediaries

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

Institutional investor types

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

Globalization of financial markets

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

When considered from a strictly local standpoint, institutional investors are sometimes called
foreign institutional investors (FIIs). This expression is mostly used in emerging markets such as
Malaysia and India.
In countries like India, statutory agencies like SEBI have prescribed norms to register FIIs and
also to regulate such investments flowing in through FIIs. In 2008, FIIs represented the largest
institution investment category, with an estimated US$ 751.14 billion.

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

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

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

• Caisse de dépôt et placement du Québec (C$237.3 billion [2007])

• Canada Pension Plan (C$116.6 Billion [2007])
• Ontario Teachers' Pension Plan (C$106 billion [2006])
• British Columbia Investment Management (C$83.4 billion [2007])
• Alberta Investment Management (C$73.3 billion [2007])

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

The major investor associations are:

• Investment Management Association

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

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

SEBI (FIIs) REGULATION, 1995

The regulations stipulate that foreign institutional investors have to be registered with the SEBI
and obtain a certificate from the SEBI. For the purpose of grant of the certificate the following
particulars are taken into account by SEBI.
 (a) The applicant’s track record, professional competence, financial soundness, experience,
general reputation of fairness and integrity
(b) Whether the applicant is regulated by appropriate foreign regulatory authority.
(c) Whether the applicant has been granted permission by the RBI under Foreign Exchange
Regulation Act, for making investment in India as a foreign institutional investor.
(d) Where the applicant is
(i) an institution established or incorporated outside India as a pension fund,,
mutual fund or investment trust; or
(ii) an asset management company or nominee company or bank or institutional
port-folio manager, established or incorporated outside India and proposing
to make investment in India on behalf of broad based funds; or
(iii) a trustee or power of attorney holder established or incorporated outside
India and proposing to make investment in India on behalf of broad-based
funds.
The certificate is granted in form “B” subject to payment of prescribed fees which is valid for 5
years and can be renewed thereafter. Provision is also made for registration of sub-accounts on
whose behalf FII proposes to make the investment in India. The purchase of shares of each
company should not be more than 10 percent of the total issued capital of the company.

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

FOREIGN DIRECT INVESTMENT

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

Policy for Foreign Direct Investment

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

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Non Resident Indians (NRI)
Non-resident Indian (NRI) deposits have been a major source of external financing, especially
since the mid-eighties. The deposit schemes can be put into two broad categories: (i) deposits
denominated in Indian rupees and (ii) foreign currency denominated deposits.
A part of the increase in the NRI deposits during the eighties could be attributed to genuine
savings of the Indians working abroad while the surge over the latter half of the eighties was
partly due to interest rate differential over the prevailing international interest rates.

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

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

DIFFERENCE BETWEEN FII & FDI

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

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

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

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

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

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

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

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

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

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

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