Finance Dossier 2023

An Initiative by Academic Committee in collaboration with the Placement Committee.

Prepared under the guidance of Dr. Narayani Ramachandra and Prof. Rajesh Madhavan

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INDEX

ACCOUNTING ................................................................................................................. 6

GAAP (GENERALLY ACCEPTED ACCOUNTING PRINCIPLES) ...................... 9

TYPES/BRANCHES OF ACCOUNTS.................................................................. 11
GOLDEN RULE OF ACCOUNTING ................................................................... 11
WHAT IS THE DIFFERENCE BETWEEN RESERVES ANDPROVISIONS? ..... 16
THERE ARE TWO TYPES OF GOODWILL ........................................................ 17
ACCOUNTING CONVENTION ........................................................................... 18
LIST OF ACCOUNTING STANDARDS AS PER ICAI ....................................... 18
 AS 1: Disclosure of Accounting Policies ........................................................ 18
 AS 2: Valuation of Inventories ....................................................................... 18
 AS 3: Cash Flow Statements .......................................................................... 18
 AS 4: Contingencies and Events Occurring After the Balance Sheet Date ...... 18
 AS 5: Net Profit or Loss for the Period, Prior Period Items, and Changes in
Accounting Policies ............................................................................................... 18
 AS 6: Depreciation Accounting ...................................................................... 19
 AS 7: Construction Contracts ......................................................................... 19
 AS 8: Accounting for Research and Development .......................................... 19
 AS 9: Revenue Recognition ........................................................................... 19
 AS 10: Accounting for Fixed Assets............................................................... 19
 AS 11: The Effects of Changes in Foreign Exchange Rates ............................ 19
 AS 12: Accounting for Government Grants .................................................... 19
 AS 13: Accounting for Investments ................................................................ 19
 AS 14: Accounting for Amalgamations .......................................................... 19
 AS 15: Employee Benefits ............................................................................. 19
 AS 16: Borrowing Costs ................................................................................ 19
 AS 17: Segment Reporting ............................................................................. 19
 AS 18: Related Party Disclosures ................................................................... 19
 AS 19: Leases ................................................................................................ 19
 AS 20: Earnings per Share ............................................................................. 19
 AS 21: Consolidated Financial Statements ..................................................... 19
 AS 22: Accounting for Taxes on Income ........................................................ 19

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 AS 23: Accounting for Investments in Associates in Consolidated Financial
Statements ............................................................................................................. 19
 AS 24: Discontinuing Operations ................................................................... 19
 AS 25: Interim Financial Reporting ................................................................ 19
 AS 26: Intangible Assets ................................................................................ 19
 AS 27: Financial Reporting of Interests in Joint Ventures ............................... 19
 AS 28: Impairment of Assets ......................................................................... 19
 AS 29: Provisions, Contingent Liabilities, and Contingent Assets .................. 19

CORPORATE FINANCE .................................................................................................... 45

ELEMENTS OF CORPORATE FINANCE ........................................................... 45

TYPES OF RISK ............................................................................................................ 56
BUSINESS VALUATION............................................................................................. 57
VALUATION TECHNIQUES OVERVIEW ......................................................... 57

PORTFOLIO MANAGEMENT .......................................................................................... 67

OBJECTIVES OF PORTFOLIO MANAGEMENT ............................................... 67

TYPES OF PORTFOLIO MANAGEMENT .......................................................... 67
COMMON PORTFOLIO MANAGEMENT STRATEGIES .................................. 68
PROCESS OF PORTFOLIO MANAGEMENT ..................................................... 68
KEY ELEMENTS OF PORTFOLIO MANAGEMENT ......................................... 69
PHASES OF PORTFOLIO MANAGEMENT ....................................................... 70
DIFFERENCE BETWEEN SHARES AND BONDS ............................................. 72
FACTORS TO BE CONSIDERED WHILE SELECTING SHARES ..................... 72
METHODS OF SECURITY SELECTION ............................................................ 73
BONDS ................................................................................................................. 74
INVESTMENT VS SPECULATION ..................................................................... 76
HEDGE ................................................................................................................. 76
HEDGING, SPECULATION AND ARBITRAGE ................................................ 79
BETA .................................................................................................................... 79
METHODS OF PORTFOLIO EVALUATION ...................................................... 81
WHAT IS AN IPO? ............................................................................................... 84
MARKOWITZ MODEL OF RISK RETURN OPTIMIZATION ........................... 86
EFFICIENT MARKET HYPOTHESIS (EMH) ..................................................... 87

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FINANCIAL MODEL ........................................................................................... 89
MUTUAL FUND .................................................................................................. 89
EXCHANGE TRADED FUNDS (ETFs) ............................................................... 90
MERGERS AND ACQUISITIONS ....................................................................... 90
CAPITAL STRUCTURE AND ITS THEORIES ................................................... 93
SHARE CAPITAL................................................................................................. 94
WORKING CAPITAL ................................................................................................... 97
COMPOSITION OF WORKING CAPITAL ......................................................... 99
IS NEGATIVE WORKING CAPITAL BAD? ..................................................... 100
NEGATIVE WORKING CAPITAL .................................................................... 100
WHAT IS DELISTING? ...................................................................................... 101
VALUATION MODELS ..................................................................................... 102

EQUITY

DEFINITION ...................................................................................................... 104

TYPES OF MARKETS… ................................................................................... 106
IPO ...................................................................................................................... 107
FPO ..................................................................................................................... 109
PRIVATE EQUITY............................................................................................. 110
RATIO ANALYSIS…..........................................................................................112
STOCK MARKET TERMS.................................................................................. 114

DERIVATIVES

DEFINITION ........................................................................................................ 117

TYPES… .............................................................................................................. 118
FUTURES ............................................................................................................ 121
RISK ASSESSMENT ........................................................................................... 122
MARGIN CONCEPT ........................................................................................... 124
MARK TO MARKET (MTM).............................................................................. 125
OPTIONS… ......................................................................................................... 126
INTRINSIC AND TIME VALUE… .................................................................... 128

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FIXED INCOME

RISKS IN FIXED INCOME ................................................................................. 134

MONEY MARKET INSTRUMENTS .................................................................. 135
FIXED RATE AND VARIABLE RATE BOND. ................................................. 136
ARE DEBENTURES FIXED INCOME INSTRUMENTS? .................................. 136
OTHER TYPES OF DEBENTURES .................................................................... 137
BOND VALUATION ........................................................................................... 137
BONDS VS DEBENTURES ................................................................................. 138
FREQUENTLY ASKED QUESTIONS................................................................. 138

ALTERNATIVE INVESTMENTS .................................................................................... 140

DEFINITION .......................................................................................................... 140

ACCREDITED INVESTORS AND RETAIL INVESTORS ............................... …140
TYPES OF ALTERNATIVE INVESTMENT ..................................................... …141
WHAT IS HEDGING? ........................................................................................ …141
TYPES OF HEDGE FUNDS ............................................................................... …141
HEDGE FUNDS VS MUTUAL FUNDS ................................................................ 141
VENTURE CAPITAL… ........................................................................................ 142
PRIVATE EQUITY ................................................................................................ 144
REAL ESTATE…............................................................................................ …. 144
COMMONDITIES ................................................................................................. 146
CRYPTOCURRENCY ........................................................................................... 147
COLLECTABLES ................................................................................................. 149
PEER TO PEER LENDING ................................................................................... 149

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ACCOUNTING

According to the American Institute of Certified Public Accountants [AICPA]; “Accounting

is the art of recording, classifying and summarizing in a significant manner and in terms of
money, transactions and events, which are, in part at least, of a financial character and
interpreting the result thereof”.

BOOK-KEEPING

Book-keeping is that branch of knowledge that tells us how to record business transactions. It
is often routine and clerical in nature. It is importantto note that only those transactions related
to business that can be expressed in terms of money are recorded. The book-keeping activities
include recording in the journal, posting to the ledger, and balancing accounts.

Difference between Book-Keeping and Accounting

Basis Book Keeping Accounting

Definition Bookkeeping deals with Accounting refers to the
identifying and recording process of summarizing,
financial transactions only interpreting, and
communicating the financial
data of an organization
Decision Making Data provided by Management can take important
bookkeeping is not decisions based onthe data
sufficient for decision obtained from
making accounting
Analysis No analysis is required inthe Accounting analyses the dataand
bookkeeping creates insights for the
business
Persons Involved The person concerned with The person concerned with
bookkeeping is known as a accounting is known as an
bookkeeper accountant
Determining Bookkeeping does not showthe Accounting helps in showing a
Financial financial position of a clear picture of the financial
Position business position of a business

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Basic Accounting Concepts

Accounting Concepts are the necessary assumptions, conditions orpostulates upon which the
accounting is based. These are Rules of accounting that should be followed in the preparation
of all accounts and financial statements.

 Business Entity Concept: According to this concept, the business has a separate legal
identity than the person who owns the business. The accounting process is carried out for
the business and not for theperson who is carrying out the business.

 Dual Aspect Concept: According to this concept, every transactionhas two effects. This
basic relationship between assets and liabilitieswhich means that the assets are equal to
the liabilities remains the same.

 Going Concern Concept: According to this concept, the organization is going to be in

existence for an indefinite period of time and is not likely to close down the business in
a shorter period of time.

 Accounting Period Concept: According to this concept, the indefinite period of time is
divided into shorter time periods, each one being in the form of Accounting period, in
order to facilitate thepreparation of financial statements on periodical basis. Typically, an
accounting period consists of 12 months.

 Money Measurement Concept: According to this concept, only those transactions are
recorded in the accounting records, which canbe expressed in terms of money. This is the
major drawback of financial accounting as it does not record non-monetary transactions

 Matching Concept: According to this concept, while calculating the profits during the
accounting period in a correct manner, all the expenses and costs incurred during the
period, whether paid or not, should be matched with the income generated during the
period.

 Accrual Concept: Revenue is recognized when earned, and expenses are recognized
when assets are consumed. If we sell some items or render some service, that becomes
our point of revenue generation irrespective of whether we received cash or not. Likewise,
all the expenses paid in cash or payable are considered and the advance payment of
expenses, if any, is deducted.

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Accounting Cycle/ Accounting Process

Recording of
Transaction

and Loss A/c Journal

Trial Balance Ledger

Basic Accounting Terms

Accounting Entry – A record of financial transactions in the books of account like journal,
ledger, cash book, etc.
Accounting Period – The period of time for which financial statements are customarily
prepared.
Accounting Year – Accounting year means a year commencing on the first day of the
accounting period. Generally, in the case of a business enterprise
/educational body, it would refer to the period from the 1st of April of a yearto the 31st of March
next year.
Amortization – Amortization is the accounting practice of spreading the cost of an intangible
asset over its useful life. Intangible assets are not physical in nature but they are, nonetheless,
assets of value. It is basicallydepreciation on Intangible assets.

Asset – Anything the company owns that has monetary value. These are listed in order of
liquidity from Cash (most liquid) to land (least liquid). Assets are tangible objects or intangible
rights owned by a business enterprise/ and carrying probable future benefits
Bad Debts – Debts owed to the business enterprises, which are considered to be irrecoverable,
e.g., arrears of taxes, fees and other revenue left uncollected and considered to be irrecoverable.
It is a business loss debited

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to Profit and Loss A/c as expense.
Depreciation - The term depreciation refers to an accounting method used to allocate the cost
of a tangible or physical asset over its useful life. Depreciation represents how much of an
asset's value has been used. It allows companies to earn revenue from the assets they own by
paying for them over a certain period of time.

Equity – Equity refers to the value left over after liabilities have been removed. This is the
portion of the company that is owned by the investors and owners.
Fixed Asset – Asset held for the purpose of providing services and that are not held for resale
in the normal course of operations of the businessenterprise.
Inventory - The values of those goods which are lying unsold at the end ofthe accounting year.
It is also known as ‘Stock’. As these items are sold to customers,the inventory account will be
lower.

Liability - All debts that a company has yet to pay are referred to as Liabilities. Common
liabilities include accounts payable, payroll, and loans
Investments- An investment is an asset or item accrued with the goal of generating income or
recognition. It can also be defined as the expenditure incurred by producers on the purchase of
capital goods such as machinery, plant, etc.

Account receivable: The sum of money owed by your customers after goods or services have
been delivered and/or used.
Account payable: The amount of money you owe creditors, suppliers, etc., in return for goods
and/or services they have delivered

GAAP (GENERALLY ACCEPTED ACCOUNTING PRINCIPLES)

Generally accepted accounting principles (GAAP) refer to a common set ofaccounting rules,
standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public
companies in the U.S. must follow GAAP when their accountants compile their financial
statements.

Accountants use generally accepted accounting principles (GAAP) when preparing financial
statements. GAAP is a set of standards related to balance sheet identification, outstanding share
measurements, and other accounting issues, and its standards are based on double-entry
accounting, a method that enters each expense or incoming revenue in two places on a
company's balance sheet.

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FINANCIAL ACCOUNTING

Financial accounting is the systematic procedure of recording, classifying, summarizing,

analyzing, and reporting business transactions. The primary objective is to reveal the profits
and losses of a business. Financial accountingprovides a true and fair evaluation of a business.
It, therefore, safeguards the interests of stakeholders.

Types of Financial Accounting

There are two primary types of financial accounting: the accrual method andthe cash method.
The main difference between them is the timing in which transactions are recorded.

Accrual Method
In Accrual method of Financial Accounting, Revenue is recorded when it is earned (when a
bill is sent), not when it actually arrives (when the bill is paid). Expenses are recorded upon
receiving an invoice, not when paying it. For example, imagine a company receives a
Rs.10,000 payment for a consulting job to be completed next month. Under accrual accounting,
the company is not allowed to recognize Rs.10,000 as revenue, as it has technically not yet
performed the work and earned the income.

Cash Method
In Cash method of Financial Accounting, Transactions are recorded only when cash is
involved. Revenue and expenses are only recorded when the transaction has been completed
via the facilitation of money.
In the example above, the consulting firm would have recorded Rs.10,000 ofconsulting revenue
when it received the payment. Even though it won’t actually perform the work until the next
month, the cash method calls for revenue to be recognized when cash is received.

BASICS FOR JOURNAL ENTRIES

What is a Journal Entry?

A Journal Entry is used to record a business transaction in the accounting record of the
business. The logic behind a journal entry is to record every business transaction in at least two
places known as double-entry accounting. For e.g. when you generate a sale for cash, this
increases both the revenue account and the cash account or if you buy goods on credit, this
increases boththe accounts payable account and the inventory account.

Before moving on to the Journal Entries, first we have to understand the typesof accounts
involved and their nature.

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TYPES/BRANCHES OF ACCOUNTS
There are 3 types of Accounts

 Real Account- Assets & Liabilities

 Personal Account- Owner’s Capital Account, Debtors, Creditors, etc.
 Nominal Account- Expenses, Losses, Income, Gains

GOLDEN RULE OF ACCOUNTING

 Personal Accounts – (a) Debit the receiver (b) Credit the giver
 Real Accounts – (a) Debit what comes in (b) Credit what goes out
 Nominal Accounts – (a) Debit all expenses and losses (b) Credit all incomes and gains

Basic Journal Entry Format

Particulars Debit Credit

Account name/ number Rs .xxx
Account name/ number Rs. xxx

Some basic Journal Entries

 Mr. A started a business and introduced a capital of Rs.10,00,000 in cash.

 He purchased Machinery in cash for Rs. 2,00,000.
 He bought an inventory of Rs.50,000 for cash.
 He also bought an inventory for Rs. 20,000 on credit.
 He made sales of Rs. 80,000 in cash and of Rs. 40,000 on credit.
 He paid Rs. 40,000 to creditors and received Rs. 20000 from debtors.
 He paid salaries of Rs. 10,000 to his staff.
 He withdraws Rs. 5,000 from his business for some personal use.

Prepare Journal Entries for the above-given transactions in the books ofXYZ Ltd.

Particulars Debit Credit

Cash A/c Rs .10,00,000
To Capital A/c Rs. 10,00,000
( Being capital introduced in business)

Particulars Debit Credit

Machinery A/c Rs .2,00,000

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To Cash A/c Rs. 2,00,000
(Being machinery purchased for cash)

Particulars Debit Credit

Inventory A/c Rs .50,000
To Cash A/c Rs. 50,000
(Being Inventory purchased for cash)

Particulars Debit Credit

Inventory A/c Rs .20,000
To Creditors A/c Rs. 20,000
(Being inventory purchased on credit)

Particulars Debit Credit

Cash A/c Rs .80,000
Debtors A/c Rs. 40,000
To Sales A/c Rs.1,20,000
(Being sales made for cash and credit)

Particulars Debit Credit

Creditors A/c Rs .40,000
To Cash A/c Rs. 40,000
(Being amount paid to creditors)

Particulars Debit Credit

Cash A/c Rs .20,000
To Debtors A/c Rs. 20,000
(Being amount received from debtors)

Particulars Debit Credit

Salaries A/c Rs .10,000
To Cash A/c Rs. 10,000
(Being salaries paid to staff)

Particulars Debit Credit

Capital A/c Rs .5000
To Drawings A/c Rs. 5000
(Being amount withdrawn from business)

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LEDGER
A ledger in accounting refers to a book that contains different accounts where records of
transactions pertaining to a specific account is stored. It is also known as the Book of final
entries or principal book of Accounts. It is a book where all transactions either debited or
credited are stored.
A Ledger is a book that contains all the accounts whether personal, real, or nominal, which are
first entered in a journal.
The information stored in a ledger account contains both starting and endingbalances which are
adjusted during the course of the accounting period withrespective debits and credits.

Ledger Format
The ledger consists of two columns prepared in a T format. The two sides ofdebit and credit
contain date, particulars, folio number and amount columns. The ledger format is as follows.
Name of the A/c
Date Particulars J.F Amount Date Particulars J.F Amount
.

Ledger Posting
The process of transferring entries from a journal to the respective ledger accounts is known
as ledger posting. For this process, first, the entries are recorded in journals and then transferred
to their respective ledger accounts.
Ledger Accounts Example-
 Cash
 Capital
 Machine
 Inventory
 Creditors
 Debtors
 Sales
 Salaries
 Drawings

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TRIAL BALANCE
A Trial Balance is a statement that keeps a record of the final ledger balanceof all accounts in a
business. It has two columns – debit and credit. A trial isprepared at the end of a year and is
used to prepare financial statements like a Profit and Loss Account or Balance Sheet. The main
objective of a Trial Balance is to ensure the mathematical accuracy of the business transactions
recorded in a company’s ledgers.
A trial balance is a financial report showing the closing balances of all accounts in the general
ledger at a point in time. Creating a trial balance is the first step in closing the books at the end
of an accounting period.

Format of Trial Balance

There are three methods by which you can prepare a Trial Balance
 Total Method- Total Method records each ledger account’s debit and credit columns to
the Trial Balance. Both columns should be equal as this method follows the double-entry
bookkeeping method.

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 Balance Method- This method uses each ledger account’s final debit/credit balance in the
Trial Balance. Once the balance figures ofall accounts are listed, the Trial Balance (both
on the debit and credit side) helps check the accuracy of all transactions.
 Total cum Balance Method- This method is a combination of boththe Total Method and
Balance Method. The Trial Balance has four columns – two for the credit and debit totals
of a ledger account and two for that account’s credit/debit balances.

Before we move to Final Accounts, Some Important Concepts that we need to

understand.
 Revenue Expenditure: Revenue expenditure is referred to as the expenditure incurred by
an organization to manage the day-to-day functions of a business, which include employee
wages, inventory, rent, electricity, insurance, stationery, postage, and taxes.
 Capital Expenditure: The expenditures that are incurred by an organization for long-
term benefits are known as capital expenditures. These expenditures serve the purpose of
increasing thecapacity or capabilities of the long-term asset by either enhancing oradding
new assets to the organization.
 Revenue Receipt: Revenue receipts are money earned by a businessthrough its day-to-
day operational activities. These are recurring in nature and directly affect the profit and
loss of the business.
 Capital Receipt: Capital receipts are cash inflow in business arising from financial
(capital) activities and not the operating activities of the business. These are receipts
resulting from activities that are occasional or not of routine nature. Capital Receipts are
not the regular or main source of income for an organization. Thus it either creates a
liability or reduces the assets of the business entity.
 Contingent Liabilities: Contingent liabilities are those liabilities that may or may not be
incurred by a business dependingon the outcome of a future event. The existence of this
kind of liability is completely dependent on the occurrence of a probable event in the
future. Example – Let’s suppose that Apple files a case of a patent violation on Samsung
and Samsung not only realizes that it may haveto pay for violations but also estimates how
much in total. In this case, Samsung will record the estimated amount in its books of
accounts as a Contingent Liability.

 Contingent Assets: Contingent assets are an accounting tool used toaccount for uncertain
future events. A contingent asset is a financial item with a value that does not exist until its
actual receipt of payment has occurred. It is created only when the event it represents
comes about and matures into cash or some other kind.

 Fictitious Assets: Fictitious assets have no physical existence or realizable value, but the
company shows them as a cash expenditure in the books of accounts. They are a part of
the assets column in the financial statements, and they are expenses or losses that do not
get written off during the accounting period of their occurrence.

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WHAT IS THE DIFFERENCE BETWEEN RESERVES AND
PROVISIONS?

WHAT IS DEPRICIATION?
Depreciation is a practice that helps to spread the cost of a tangible asset overa specific period,
which is usually the course of its useful life. The primary purpose of depreciating an asset is to
match the expense of purchasing it withthe income it can generate for the company. Physical
assets like plants, furniture, machinery, land, buildings, etc., are subject to depreciation. These
assets might have resale or salvage value at the end of their useful life.
There are two methods of computing depreciation-

 Straight Line Method: In this method, a fixed amount is deducted from the value of an
asset every year over its useful life. It is also known as the ‘Original Cost Method’ or the
‘Fixed Installment Method’. For example, a company obtains machinery valued at Rs.
100000 with a useful life of 10 years. In the Straight Line Method, the annual
depreciation amount for the machinery gets calculated as Rs. 10000 (Rs. 100000/10
years), which means that the asset’s valuewill decline by Rs. 10000 every year.

 Written down value Method: In this method, the yearly depreciation amount is
calculated using a fixed percentage. This method is also known as the ‘Diminishing
Balance Method’ or the ‘Reducing Installment Method. For example, a company obtains
furniture for Rs. 50000, and the depreciation rate is 10%. Using the written-down value
method, the depreciation amount for each year would be as follows:

First-year = Rs. 5000 [10% of Rs. 50000],

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Second year = Rs. 4500 [10% of (Rs. 50000 – Rs. 5000)],

Second year = Rs. 4050 [10% of (Rs. 45000 – Rs. 4500)], and so on.

WHAT IS AMORTISATION?

Amortization refers to the decreased cost of an intangible item over a certainperiod of time. We
can also understand amortisation as depreciation on Intangible assets. It occurs on a straight-
line basis, wherein a fixed amount gets deducted regularly from the value of assets like patents
and trademarks, copyrights, franchise agreements, etc.

GOODWILL
Goodwill is an intangible asset associated with the purchase of one company by another.
Specifically, goodwill is recorded in a situation in which the purchase price is higher than the
sum of the fair value of all visible solid assets and intangible assets purchased in the acquisition
and the liabilities assumed in the process.
If the fair value of Company ABC's assets minus liabilities is Rs. 12 crore, and a company
purchases Company ABC for Rs. 15 Crore, the premium value following the acquisition is Rs.
3 crores. This Rs. 3 crore will be included on the acquirer's balance sheet as goodwill.

There are 2 types of goodwill

 Purchased Goodwill- Purchased goodwill is the difference between the value paid for an
enterprise as a going concern and the sum of its assets less the sum of its liabilities, each
item of which has been separately identified and valued.
 Inherent Goodwill- It is the value of the business in excess of the fair value of its
separable net assets. It is referred to as internally generated goodwill, and it arises over a
period of time dueto the good reputation of a business. It can also be called as self-
generated or non-purchased goodwill.

ACCOUNTING CONVENTION

Accounting Conventions is a practice adopted by an entity based on a general agreement

between the accounting agencies and assisting the accountant during the preparation of the
Company's financial statements.

 Convention of Consistency: The financial statements can only be matched if the

companyconsistently follows the accounting policies during the period. However,
modifications can be carried out in exceptional circumstances. In case a change is made,
it should be disclosed. 
 Convention of Disclosure: This policy states that the financial statements should be
qualified to disclose all relevant information to users such as owners, creditors, lenders,
investors, citizens and other stakeholders to assist them in making informed decisions. 
 Convention of Conservatism: The anticipated profits should be ignored but all
anticipated losses should be provided for in the booksof accounts of an entity. This means
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that all prospective losses are taken into consideration, however, no doubtful income is
taken into consideration in recording of transactions by an entity. 
 Convention of Materiality - Data is recorded separately if it is material enough,
otherwise it can be clubbed or combined and recorded as a common data.

WHAT ARE ACCOUNTING STANDARDS?

Accounting standards refer to the set of guidelines, rules, and procedures that companies use to
prepare and present their financial statements. These standards provide a framework for the
consistent and accurate recording, measurement, and reporting of financial transactions, which
enables stakeholders to make informed decisions based on reliable and comparable financial
information.

List of Accounting Standards as Per ICAI

 AS 1: Disclosure of Accounting Policies

 AS 2: Valuation of Inventories
 AS 3: Cash Flow Statements
 AS 4: Contingencies and Events Occurring After the Balance Sheet Date
 AS 5: Net Profit or Loss for the Period, Prior Period Items, and Changes in Accounting
Policies
 AS 6: Depreciation Accounting
 AS 7: Construction Contracts
 AS 8: Accounting for Research and Development
 AS 9: Revenue Recognition
 AS 10: Accounting for Fixed Assets
 AS 11: The Effects of Changes in Foreign Exchange Rates
 AS 12: Accounting for Government Grants
 AS 13: Accounting for Investments
 AS 14: Accounting for Amalgamations
 AS 15: Employee Benefits
 AS 16: Borrowing Costs
 AS 17: Segment Reporting
 AS 18: Related Party Disclosures
 AS 19: Leases
 AS 20: Earnings per Share
 AS 21: Consolidated Financial Statements
 AS 22: Accounting for Taxes on Income
 AS 23: Accounting for Investments in Associates in Consolidated Financial Statements
 AS 24: Discontinuing Operations
 AS 25: Interim Financial Reporting
 AS 26: Intangible Assets
 AS 27: Financial Reporting of Interests in Joint Ventures
 AS 28: Impairment of Assets
 AS 29: Provisions, Contingent Liabilities, and Contingent Assets

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FINANCIAL STATEMENTS
The Financial Statements of the business basically include four parts-
Income Statement: The purpose of the income statement is to find the company’s net income
for the year. Accountants take all accounting transactions (including non-cash ones) and do a
“revenue–expense” analysisto determine the year’s profit.
Balance Sheet: The Balance Sheet is based on the following equation – Assets = Liabilities +

Shareholders’ Equity.

It states that a business entity possesses and owes.

Shareholders’ Equity Statement: It is a statement that includes shareholders’ equity, retained
earnings, reserves, and other stock-related items. It is an indicator of the changes in the
ownership interest of the stakeholders.
Cash Flow Statement: The cash flow statement combines three statements
– cash flow from operating activities, cash flow from financing activities, andcash flow from
investing activities.

1. PROFIT & LOSS / INCOME STATEMENT

A profit and loss account, in simplest terms, is a record of all the incomeand expenses of the
business during a particular period of time. Such a period can be the entire financial year,
an interim period like half financial period, or a quarter. Every business whether it is a sole
proprietorship to a company needs to maintain a profit and loss account to get their correct
financial position at the end of the required period. All the cash and non-cash income and
expenses of the business are recorded in the profit and loss account.

A profit and loss statement is prepared based on certain basic principles of accounting.
These principles include the principle of accrual accounting, matching principle, and
revenue recognition. It shows various stages of profits earned by the business organization
like gross profit or loss, the operating margin, or the net profit or loss incurred by the
business.

Basic formula for calculating profit/loss

Net Income = (Revenue + Gains) – (Expenses + Losses)

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Format of Income Statement

Components of Income Statement

Revenue from Operations- It refers to the revenue earned from the basic operating
business activities of an organization. For Non-financing companies, it consists of the
following.
o Sale of Products
o Sale of Services
o Other Operating Revenues

For financing companies, revenue from operations includes the following.

o Interest
o Dividends
o Other Financial Services

Other Incomes- This income includes the income earned other than from the operating
activities of a business. It comprised of the following incomes.
o Interest Income (in case of Non-Financing Company)
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o Dividend Income (in case of Non-Financing Company)
o Net Gain or Loss on Sale of Investments
o Other Non-Operating Incomes (i.e. after deducting expenses directly related to such
income)

Expenses- These can be bifurcated in the following given below types.

o Cost of Materials Consumed- It includes all the materials consumed during the
process of manufacturing. It can also be calculated with the help of the given below
formula.

o Material Consumed = Opening Stock of Raw Material +

Purchase of Raw Material – Closing Stock of Raw Material

o Purchase of Stock-in-Trade- It includes all the goodspurchased by a trading concern

with the intention of reselling.

o Change in Inventories, Work-in-Progress, and Stock-in- Trade- It is a difference of

the opening and closing balance ofinventories (stock), work-in-progress, and stock-
in-trade.

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2) CASH FLOW STATEMENT

A cash flow statement is a financial statement that exhibits the flow of incoming and
outgoing cash in an enterprise. This statement is used to assess the ability to generate and
utilize cash by assessing business gains from continuous progress and external sources for
cash inflow as well asa cash outflow in terms of payments made and other input charges in
the business. In short, a cash flow statement records the cash flow in a business.

Format of Cash flow Statement

Particulars Amount
Cash flow from Operating Activities XXX
Net profit/loss XXX
Adjustment for XXX
Add: Depreciation or all Non cash expenses XXX
Add: Goodwill Written off XXX
Add: Preliminary Expenses Written off XXX
Add: Discount on Issue of Debenture XXX
Add:Loss on sale of FA XXX
Less: Profit on Sale of FA XXX
Operating Profit before working capital Changes XXX
Less:Increase in CA - XXX
Add:Decrease in CA XXX
Add:Increase in CL XXX
Less:Decrease in CL - XXX
Cash generated from/ used in Operating activities XXX
Less: Tax paid - XXX
Net cash from/ Used in Operating activities XXX

Cash flow from Investing Activities

Purchase of Fixed assets/ Investment - XXX
Sale of Fixed assets/ Investment XXX
Dividend Received XXX
Interest Received XXX
Rent Received XXX
Net CAsh from/ used in Investing activities XXX

Cash flow from Financing Activities

Issue Shares XXX
Issue Debentures XXX
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Borrowed Loans XXX
Paid Loans XXX
Redemption of Debenture/Preference share - XXX
Interest Payment - XXX
Dividend paid - XXX
Net Cash from/ used in Financing activities XXX

Net increase in cash and Cash Equivalents XXX

The Structure of the Cash Flow Statement

OPERATING Operating activities are those cash flow activities that either
ACTIVITIES generate revenue or record the money spent on producing a
product or service.
Operational business activities include inventory transactions,
interest payments, tax payments, wages to employees, and
payments for rent. Any other form of cash flow, such as
investments, debts, and dividends are not included in this
Section.
FINANCING Records the cash flow between the company and its owners
ACTIVITIES and creditors. Financial activities include transactions
involving debt, equity, and dividends, Cost of debts.
In these transactions, incoming cash is recorded when capital is
raised (such as from investors or banks), and outgoing cash is
recorded when dividends are paid.

INVESTING Records the gains and losses caused due to investment in assets
ACTIVITIES like property, plant, or equipment (PPE) thus reflecting overall
change in the cash position for a company.

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3) STATEMENT OF RETAINED EARNINGS

A statement of retained earnings shows changes in retained earnings overtime, typically one
year. Retained earnings are profits not paid out to shareholders as dividends; that is, they
are the profits the company has retained. Retained earnings increase when profits increase;
they fall when profits fall.
The statement of retained earnings is also called a statement of shareholders’ equity or a
statement of owner’s equity.

Retained earnings are not the same as cash. In order to track the flow ofcash through your
business — and to see if it increased or decreased overtime — look to the statement of cash
flows. The general calculation structure of the statement is:

Beginning retained earnings + Net income - Dividends = Endingretained earnings.

The following example shows the most simplified version of astatement of retained
earnings:

Statement of Retained Earnings

for the year ended 12/31x2

Retained earnings at December 31, 20X1 Rs.150,000

Net income for the year ended December 40,000

31, 20X2

Dividends paid to shareholders -25,000

Retained earnings at December 31, 20X2 Rs.165,000

4) BALANCE SHEET

Balance sheet is defined as ‘a statement which sets out the assets and liabilities of a
business firm and which serves to ascertain the financial position of the same on any
particular date’.

It is a statement showing the financial position of a business. Balance sheet is prepared by

taking up all accounts (assets and properties) together with the net result obtained from the
profit and loss account.

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The balance sheet displays three key things: your assets, your liabilities, and your equity.
The balance sheet can show the current value of a business for the period it covers.
Looking at your balance sheet can help you understand if you can meet your financial
obligations.

Format: The Balance sheet of a business concern can be presented in thefollowing two
forms.

i. Horizontal form or the Account form

ii. Vertical form or Report form

HORIZONTAL FORM OR ACCOUNT FORM

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Horizontal format lists all liabilities on the left-hand side and all assets on the right-hand
side of the balance sheet. It is also called a T-shaped Balance sheet.

In a horizontal format, assets and liabilities are presented descriptively. The liabilities and
assets are listed in the 1st and 3rd column of the balance sheet respectively whereas, the
amounts associated with them are listed in the 2nd and 4th columns respectively.

This format is not ideal for both inter-firm and intra-firm comparisons because the
information presented only relates to the current year. It is easier to compare the
information in a vertical format balance sheet.

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VERTICAL FORM OR REPORT FORM

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Components of Balance Sheet
o Shareholders’ Equity: Shareholder’s equity is the amount of moneystockholders have
invested in a company. It includes the following:
 Retained Earnings- It is the amount of a company’s gains that are reinvested into
its business instead of returning to the shareholders in the form of dividends.
 Share Capital- Share capital is the funding a company has raised through issuing
common or preferred stock.
 Authorized share capital is the maximum amount of share capital a company is
allowed to raise.
 Issued share capital is the total amount of shares a company opts to sell to
investors.

o Liabilities: This section of the balance sheet shows the money that acompany owes to
others, like loan expenses, recurring expenses, other forms of debt, etc. Now, liabilities
can be further subdivided into two categories:
 Current Liability- Current liabilities are company’s short term financial
obligations that are due within one year or within a normal operating cycle. These
are typically settled usingcurrent assets, which are assets that are used up within
one year.
Mentioned below are a few current liabilities Example
 Accounts payable
 Short Term Debt
 Accrued Expenses
 Dividend Payable
 Non-current Liability- Non-current liabilities are referred to as the long-term
debts or financial obligations. These are also known as long-term liabilities. These
obligations are not duewithin twelve months or the accounting period as opposed
tocurrent liabilities.
Mentioned below are a few non-current liabilities Examples:
 Debentures
 Bonds Payable
 Long-term loans
 Deferred tax liabilities
 Long-term lease

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o Assets: In the assets section of the balance sheet, you will find itemsof value that can be
converted into cash. These items will be listed inorder of liquidity, that is, how easily they
can be converted to cash. Assets can be subdivided into two categories:
 Current Assets- The assets that can be converted easily into cash within a year or
less are called current assets. Given below are some examples:
 Prepaid Expenses
 Inventory
 Accounts Receivable
 Marketable Securities
 Cash and cash equivalents
 Non-current Assets- Those assets that cannot be converted into cash within a year
are called long-term assets. You can further subdivide them into the following:
 Fixed Assets- Machinery, Buildings, Properties etc.
 Intangible Assets- Patents, copyrights, franchiseagreements etc.
 Long-term securities- Investments that companycannot sell within a
year.

DU-PONT ANALYSIS
In simple words, it breaks down the ROE to analyse how corporate can increase the return for
their shareholders.

Return on Equity = Net Profit Margin * Asset Turnover Ratio * Financial Leverage = (Net
Income / Sales) * (Sales / Total Assets) * (Total Assets / Total Equity)

DuPont analysis is a framework for analysing fundamental performance originally popularized

by the DuPont Corporation, now widely used tocompare the operational efficiency of two
similar firms.

DuPont analysis is a useful technique used to decompose the different drivers of return on
equity (ROE). There are two versions of DuPont analysis, one utilizing decomposing it into
3steps and another 5 steps.

There are two variants of DuPont analysis: the original three-step equation, and an extended
five-step equation. The three-step equation breaks up ROE into three very important
components:

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Three-step Du-Pont Analysis

In a 3-step DuPont analysis, the equation states that if a company’s net profit margin, asset
turnover, and financial leverage are multiplied, you will arriveat the company’s return on equity
(ROE).
The company can increase its Return on Equity if it-
o Generates a high Net Profit Margin
o Effectively uses its assets so as to generate more sales
o Has a high Financial Leverage

The 3 steps have been discussed above, which is calculated as

ROE= (Net Income/ Sales) * (Net Sales/Total Assets) * (Total Assets/Total Equity)
Or
(Profit Margin * Total) / (Asset Turnover * Equity Multiplier)

Five-step DuPont Analysis

The five-step, or extended, DuPont equation breaks down net profit margin further. From the
three-step equation we saw that, in general, rises in the net profit margin, asset turnover and
leverage will increase ROE. The five-step equation shows that increases in leverage don't
always indicate an increase in ROE.

The 5 step DuPont analysis has two additional components:

ROE = (Net Income/ Pre-tax Income) * (Net Sales/Total Assets) * (TotalAssets/Total Equity)
* (Pre-tax Income/ EBIT)* (EBIT/Sales)

= Tax Burden * Asset Turnover * Equity Multiplier * Interest Burden *Operating Margin.

FINANCIAL RATIOS

LIQUIDITY RATIO
Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Current Assets - Prepaid Expenses - Stock) / (Current Liabilities –Bank
Overdraft)

Proprietary Ratio = Equity Shareholders’ funds / Total Asset

Cash Ratio = (Cash + Cash Equivalents) / Total Liabilities

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SOLVENCY RATIO

Debt-Equity Ratio = Long-term debts / Net worth

Debt Ratio = Total Debt / Total Assets

Interest Coverage Ratio = Earnings Before Interest and Tax / Interest Expense

VALUATION RATIOS

Price to Earnings Ratio (P/E) = Price per share / Earnings per share

Price/Cash Flow (P/CF) = SharePrice / Operating Cash Flow per Share

PE Ratio = Price to Earnings / Growth Rate

Price to Sales Ratio (P/S) = Market Capitalization /Total Revenue

PERFORMANCE RATIOS

Return on Equity = Net Income / Shareholders’ Equity

Return on Assets = Net Income / Total Assets

Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue

Operating Profit Margin = Operating Profit / Revenue

Net Profit Margin = Net Profit / Revenue

ACTIVITY RATIOS

Inventory turnover = Net Sales / Average Inventoryat Selling Price

Receivables turnover = Net Sales / Average accounts receivable

Payables turnover = Total supply purchase / Average Accounts Payable

Fixed asset turnover = Net Sales / Average Fixed Assets

Total asset turnover = Net Sales / Average Total Assets

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WHAT IS COST ACCOUNTING?

Cost Accounting is defined as "the process of accounting for cost which begins with the
recording of income and expenditure or the bases on which they are calculated and ends with
the preparation of periodical statements and reports for ascertaining and controlling costs."

COST MANAGEMENT

It is an application of management accounting concepts, methods of collections, analysis and

presentation of data to provide the information needed to plan, monitor and control costs.

OBJECTIVES OF COST & MANAGEMENT ACCOUNTING

The main objectives of Cost and Management accounting are explained as below:
 Determining the cost- The collection and estimation of costs is the basic objective of
cost accounting. For each cost object, costs are accumulated, assigned, and determined.
 Determination of Selling Price & Profitability- The cost accounting system helps in
determination of selling price and thus profitability of a cost object.
 Cost Control- Maintaining discipline in expenditure is one of the main objectives of a
good cost accounting system. It ensures that expenditures are in consonance with
predetermined set standard and any variation from these set standards is noted and
reported on continuous basis.
 Cost Reduction- Cost reduction is an approach of management where cost of an object
is believed to have a scope of further reduction.

Difference b/w Cost Reduction and Cost Control

Cost Control Cost Reduction

1. Cost control aims at maintaining the 1. Cost reduction is concerned withreducing
costs in accordance with the costs. It challenges all standard sand
established standards. endeavours to improvise them
continuously
2. Cost control seeks to attain lowest 2. Cost reduction recognises no condition as
possible cost under existing permanent, since a change will result in
conditions. lower cost.
3. In case of cost control, emphasisis 3. In case of cost reduction, it is on present
on past and present and future.
4. Cost control is a preventive 4. Cost reduction is a corrective function.
function It operates even when an efficient cost
control system exists.

5. Cost control ends when targets 5. Cost reduction has no visible end and is a
are achieved. continuous process.

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SCOPE OF COST ACCOUNTING

Costing Cost

Accounting

Cost Analysis
Scope of
Cost Accounting Cost Comparisons

Cost Control

Cost Reports

Statutory Compliances

Difference between Cost & Management Accounting

Basis Cost Accounting Management Accounting

(i) Nature It records the It records both qualitative and

quantitativeaspect only. quantitative aspect.
(ii) Objective It records the cost of It provides information to
producing a product management for planning and
andproviding a co-ordination.
service.
(iii) Area It only deals with cost It is wider in scope as it includes
Ascertainment. financial accounting, budgeting,
taxation, planning etc.
(iv) Recording of It uses both past and It is focused with the projection
data present figures. of figures for future.

(v) Development Its development is related Its development is related to

to industrial revolution. the need of modern business
world.
(vi) Rules and It follows certain It does not follow any
Regulation principlesand procedures specificrules and regulations.
for recording costs of
different products.

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Classification of Costs

It means the grouping of costs according to their common characteristics. The important ways
of classification of costs are:
(i) By Nature or Element
(ii) By Functions
(iii) By Variability or Behaviour
(iv) By Controllability
(v) By Normality
(vi) By Costs for Managerial Decision Making

ELEMENT OF COST

Material Cost Employee (Labour) Cost Other Expenses

Direct Material Indirect Direct Indirect Direct Indirect

Cost Material Cost Employee Employee Expenses Expenses
(Labour) Cost (Labour) Cost

Production Administration Selling and

Overheads Overheads

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BASIC COSTING TERMS

 Direct Materials: Materials that are present in the finished product (cost object) or can be
economically identified in the product are termed as direct materials. For example, cloth
in dress making.

 Direct Labour: Labour that can be economically identified or attributed wholly to a cost
object is termed as direct labour. For example, employees engaged on the actual production
of the product.
 Direct Expenses: All expenses other than direct material or direct labour which are
specially incurred for a particular cost object and can be identified in an economically
feasible way are termed as Direct Expenses.

 Indirect Materials: Materials which do not normally form part of the finished product
(cost object) are known as indirect materials.

 Indirect Labour: Labour cost which cannot be allocated but can be apportioned to or
absorbed by cost units or cost centres is known as indirect labour.

 Indirect Expenses: Expenses other than direct expenses are known as indirect expenses.
These cannot be directly, conveniently and wholly allocated to cost centres. Factory rent
and rates, insurance ofplant and machinery, power, light, heating, repairing, telephone etc.,
are some examples of indirect expenses.

 Overheads: The aggregate of indirect material costs, indirect labour costs and indirect
expenses is termed as Overheads. The main groups into which overheads may be subdivided
are as follows:
 Production or Works Overheads: Indirect expenses which are incurred in the
factory and for the running of the factory. E.g.: rent, power etc.
 Administration Overheads: Indirect expenses related to management and
administration of business. E.g.: office rent, lighting, telephone etc.
 Selling Overheads: Indirect expenses incurred for marketing of a commodity.E.g.:
Advertisement expenses, commission to sales persons etc.

 Distribution Overheads: Indirect expenses incurred for dispatchof the goods E.g.:
warehouse charges, packing(secondary) and loading charges.

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Direct Materials
Prime Cost
Direct Employees
(Labours)
Direct Expenses
Factory Overheads
Indirect Material Factory Cost
orWorks Cost
Indirect Labour Indirect Administration Overheads

Expenses Cost of Goods Sold

Selling and Distribution
Overheads
Cost of Sales

METHODS OF COSTING

 Job Costing: Job costing is a type of accounting that monitors costs and revenues by
“work” and allows for uniform profitability reporting by the job. An accounting system
must allow job numbersto be allocated to specific expenses and revenues to support job
costing.

 Contract Costing: Contract costing is the tracking of costs associated with a specific
contract with a customer. For example, a company submits a bid for a large construction
project with a possible customer. The two sides also agree in a contract that the company
will be reimbursed in a specified method.

 Batch Costing: Batch cost is a collection of costs paid when a groupof items or services is
manufactured that cannot be traced back to individual products or services within the group.
It may be essential to assign the batch cost to individual units within a batch for cost
accounting reasons.

 Process Costing: Process costing is an accounting method for tracking and accumulating
direct expenses in a manufacturing process and allocating indirect costs. Costs are given to
items in huge batches, which can span a month’s worth of production.

 Unit Costing: A company’s unit cost is the cost of producing, storing, and selling one unit
of a given product. All fixed and variableexpenses in production are included in unit costs.
A cost unit is a unit of measurement used to determine the volume of a service or product.

 Multiple Costing: When things are sold that contain various other processed parts,
multiple costing, also known as composite costing, is an accounting method used when
these parts cost differently. Eachof the elements made by other processes, like the ultimate
product, has a cost connected with it.

 Operating Costing: Operating costs, often known as operational expenses, are expenses
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connected to the running of a business or a product, component, piece of equipment, or
facility. They seem to bethe costs of resources used by a company just to stay in business.

TECHNIQUES OF COSTING

Marginal Costing

The premise of marginal costing is to divide all costs into fixed and variablecosts. Fixed costs
are unrelated to production levels. As the name implies, these costs stay constant regardless of
manufacturing volume.
Variable expenses fluctuate according to production levels. They are proportionate in every
way. The variable cost per unit, on the other hand, remains constant. In marginal costing, we
solely take these variable expenses into account when determining production costs.

Standard Costing

Standard costing is a process in which a company compares the expenses incurred for the
manufacture of goods to the expenditures that should have been incurred. In essence, it is a
comparison of actual costs vs conventionalexpenses. Variances are the discrepancies between
the two.

Historical Costing

Historical costing is the process of determining and recording costs after theyhave occurred. It
serves as a record of what has occurred and, as a result, is a post-mortem of the actual costs.

Direct Costing

All direct expenses are charged to operations, processes, or products, whereas all indirect costs
are written off against profits in the period in whichthey occur.

Absorption Costing

There is no distinction between fixed and variable costs in absorptioncosting. In addition,

all costs, whether fixed or variable, are taken into account when calculating the cost of
production. Full costing is anothername for absorption costing.

Uniform Costing

Uniform costing, unlike marginal costing, is not a different approach to cost accounting. It is
one of the most recent costing and cost control approaches. It refers to all or many units in the
same industry accepting and adhering to the same costing concepts and methods by mutual
agreement.

Activity-Based Costing

Activity-based costing (ABC) is a methodology for more precisely allocating overhead costs
by assigning them to activities. Once costs are assigned to activities, the costs can be assigned
to the cost objects that use those activities. ABC works best in complex environments, where
there aremany machines and products, and tangled processes that are not easy to sortout.
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COST SHEET
A cost sheet (cost statement) contains information on the total cost of production, from
purchasing raw materials to selling goods. The cost sheet provides a detailed bifurcation of the
cost incurred by the entity incurred oneach unit of a product or service in a particular period.

Format of Cost Sheet

Items excluded from costs while preparing cost sheet

The following items of expenses, losses or incomes are excluded from the costsheet:
 Related to Capital Assets
 Appropriation of Profits
 Amortisation of Fictitious or Intangible Assets
 Abnormal gains and losses or items of a purely financial nature

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Examples of such items can be:
 Loss on Fixed Assets
 Interest on Capital
 Expenses relating to previous period
 Bad debts
 Penalties and fines
 Profit on sale of fixed assets
 Dividend Paid
 Capital issue expenses, etc.

BUDGET AND BUDGETING

Meaning of Budget: A budget is an instrument of management use an aid in the planning,

programming and control of business activity.It is basically a blue print of the projected plan
of action expressed in quantitative terms for a specified period of time.

Meaning of Budgeting: Budgeting is a process of designing, implementingand operating of

budget. The main emphasis in budgeting process is the provision of resources to support plans.

BUDGETARY CONTROL

It is a system of Management control and accounting in which all the operations are forecasted
and planned in advance to the extent possible and the actual results compared with the
forecasted and planned results.

Budgetary Control involves:

 Establishment of Budgets
 Continuous comparison of actuals with budgets for achievement of targets.
 Revision of Budgets after considering the changes in the circumstances
 Fixation of the responsibility for failure to achieve the budget targets

Components of Budgetary Control System:

 Physical Budgets: Those budgets which contain information inquantitative terms such
as physical units of sales, production etc. This may include quantity of sales, quantity of
production, inventories, and manpower budgets are physical budgets.
 Cost Budgets: Budgets which provides cost information in respect of manufacturing,
administration, selling and distribution, etc. for e.g. manufacturing cost, selling cost,
administration cost, and research and development cost budgets are cost budgets.
 Profit Budgets: A budget which enables the ascertainment of profit. For e.g. sales budget,
profit and loss budget, etc.

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 Financial Budgets: A budget which facilitates in ascertaining the financial position of a
concern, for e.g. cash budgets, capital expenditure budgets, budgeted balance sheet etc.

COST-VOLUME-PROFIT ANALYSIS

Cost-Volume-Profit (CVP) analysis is a cost accounting method used to analyze the relationship
between cost, volume, and profit. It helps to determine the impact of cost, volume, and pricing
changes on a company’s profitability.

Companies use it to determine the breakeven point, the point at which total revenue equals total
costs, and to project how changes in costs, volumes, and prices will affect a company’s future
profit. This information is useful for pricing, production, and cost control decisions.

Components of CVP analysis

 Fixed costs: These don’t fluctuate with sales or product production changes. Examples
of fixed costs include rent and advertising.
 Variable costs: These are the costs that change as the quantity of products changes.
Examples of variable costs include raw materials and direct labor.
 Contribution margin is the difference between the total variable costs and a company’s
total revenue.
 Contribution ratio: This is the contribution margin expressed as a percentage.

 Sales volume: The number of products businesses sell during a specific period

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 Breakeven point: This is when the total costs and revenue are equal, meaning the business
is neither making a loss nor a profit.

 Selling price: The amount a customer pays for the product.

CORPORATE FINANCE

 Corporate finance deals with the capital structure of a corporation, including its funding
and the actions that management takes to increase the value of thecompany.
 The ultimate purpose of corporate finance is to maximize the value of a business through
planning and implementation of resources, while balancing risk and profitability.
 It is concerned with how businesses fund their operations in order to maximize profits and
minimize costs.
 It deals with the day-to-day demands on business cash flows as well as with long-term
financing goals (e.g., issuing bonds).
 Corporate finance also deals with monitoring cash flows, accounting, preparing financial
statements, and taxation.

ELEMENTS OF CORPORATE FINANCE

The important activities that govern corporate finance:

1. Capital Budgeting: Capital budgeting is a process that businesses use to evaluate potential
major projects or investments. As part of capital budgeting, a company might assess a
prospective project's lifetime cash inflows and outflows to determine whether the potential
returns it wouldgenerate meet a sufficient target benchmark. The capital budgeting process
is also known as investment appraisal.

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Any corporate decisions with an impact on future earnings can be examined using this
framework. Decisions about whether to buy a new machine, expand business in another
geographic area, or replace a delivery truck, to name a few, can be examined using a
capital budgeting analysis.

Importance of Capital Budgeting

 Capital budgeting decision often involves the purchase of costly long- term assets with
lengthy lifespan, the choice made may have an impact on the firm's future success.
 The principles underlying the capital budgeting process also apply to other corporate
decisions, such as working capital management and making strategic mergers and
acquisitions.
 Making good capital budgeting decisions is consistent with management's primary goal of
maximizing shareholder value.

There are several capital budgeting analysis methods that can be used to determine the
economic feasibility of a capital investment.

a.) Time Value of Money: The time value of money (TVM) is the concept that a sum of money
is worth more now than the same sum will be at a future date due to its earnings potential
in the interim. A sum of money in the hand has greater value than the same sum to be paid
in the future. The time value of money is also referred to as the present discounted value.

The time value of money is used to make strategic, long-term financial decisions such as
whether to invest in a project or which cash flow sequence is most favourable. Inflation has
a negative impact on the time value of money because our purchasing power decreases as
prices rise.

Example: You have won a cash prize! You have two payment options:

 A: Receive $10,000 now, OR

 B: Receive $10,000 in three years. Which option would you choose?

The answer depends on the time value of money (TMV).

By receiving $10,000 today, you are poised to increase the future value of your money by
investing and gaining interest over a period of time. For Option B, you don't have time on
your side, and the payment received in three years would be your future value. If you are
choosing Option A, your future value will be $10,000 plus any interest acquired over the
three years. The future value for Option B, on the other hand, would only be $10,000.

Opportunity cost is key to the concept of the time value of money. Money can grow only
if it is invested over time and earns a positive return. Money that is not invested loses value
over time. Therefore, a sum of money that is expected to be paid in the future, no matter
how confidently it is expected, is losing value in the meantime.

Formula to calculate the time value of money:

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FV = PV x [1 + 𝑖/𝑛] X t

Where:

FV=Future value of money

PV=Present value of money

i=Interest rate

n=Number of compounding periods per year

t=Number of years

b.) Net Present Value: The Net Present Value (NPV) method involves discounting a stream
of future cash flows back to present value. The cash flows can be either positive (cash
received) or negative (cash paid). The present value of the initial investment is its full-face
value because the investment is made at the beginning of the time period. The ending cash
flowincludes any monetary sale value or remaining value of the capital asset at theend of the
analysis period, if any. The cash inflows and outflows over the lifeof the investment are then
discounted back to their present values.
The Net Present Value is the amount by which the present value of the cash inflows exceeds
the present value of the cash outflows. Conversely, if the present value of the cash outflows
exceeds the present value of the cash inflows, the Net Present Value is negative.
NPV= Cash Flow – Initial investment
(1+i)t

where: i=Required return or discount rate

t= Time period
If the NPV of an investment is positive, meaning it's expected to make a profit, it's worth
consideration. If it's neutral or negative, it should be rejected.

NPV Formula
Pros
 Considers the time value of money
 Incorporates discounted cash flow using a company’s cost of capital
 Returns a single rupee value that is relatively easy to interpret
 May be easy to calculate when leveraging spreadsheets or financial
calculators.

Cons

 Relies heavily on inputs, estimates, and long-term projections

 Doesn’t consider project size or return on investment (ROI)
 May be hard to calculate manually, especially for projects with many years of cash
flow
43
 Is driven by quantitative inputs and does not consider non-financial metrics

c.) Payback Period: Payback Period represents the amount of time required for the cash flows
generated by the investment to repay the cost of the original investment. It helps determine
how long it takes to recover the initial costs associated with an investment. This metric is
useful before making any decisions, especially when an investor needs to make a snap
judgment about an investment venture.
The payback period disregards the time value of money and is determined by counting the
number of years it takes to recover the funds invested. For example, if it takes five years to
recover the cost of an investment, the payback period is five years. This period does not
account for what happens after payback occurs. Therefore, it ignores an
investment's overall profitability. Many managers and investors thus prefer to use NPV asa
tool for making investment decisions.
For example, assume that an investment of $600 will generate annual cash flows of $100
per year for 10 years. The number of years required to recoup the investment is six years.
The Payback Period analysis provides insight into the liquidity of the investment (length of
time until the investment funds are recovered). However, the analysis does not include cash
flow payments beyond the payback period.
In the example above, the investment generates cash flows for an additional four years
beyond the six-year payback period. The value of these four cash flows is not included in
the analysis. Suppose the investment generates cash flow payments for 15 years rather than
10. The return from the investment is much greater because there are five more years of cash
flows. However, the analysis does not take this into account and the Payback Period is still
six years.
Payback Period = Investment
Annuity

Decision: If the PBP is less than the maximum acceptable payback period, accept the
project.

d.) Discounted Payback Period: The discounted payback period is a capital budgeting
procedure used to determine the profitability of a project. A discounted payback period gives
the number of years it takes to break even from undertaking the initial expenditure, by
discounting future cash flows and recognizing the time value of money. The metric is used
to evaluate the feasibility and profitability of a given project.

The more simplified payback period formula, which simply divides the totalcash outlay for
the project by the average annual cash flows, doesn't provide as accurate of an answer to the
question of whether or not to take on a project because it assumes only one, upfront
investment, and does not factor in the time value of money.

The discounted payback period formula shows how long it will take to recoup an investment
based on observing the present value of the project's projected cash flows. The basic method
of the discounted payback period is taking the future estimated cash flows of a project and
44
discounting them to the present value. This is compared to the initial outlay of capital for the
investment.

The period of time that a project or investment takes for the present value of future cash flows
to equal the initial cost provides an indication of when the project or investment will break
even. The point after that is when cash flowswill be above the initial cost.

Decision: The shorter a discounted payback period is, means the sooner a project or
investment will generate cash flows to cover the initial cost.

e.) Internal Rate of Return: The internal rate of return (IRR) is the annual rate of growth that
an investment is expected to generate. IRR is calculated using the same concept as net present
value (NPV), except it sets the NPV equal to zero.

The ultimate goal of IRR is to identify the rate of discount, which makes the present value
of the sum of annual nominal cash inflows equal to the initial net cash outlay for the
investment. IRR is ideal for analysing capital budgeting projects to understand and compare
potential rates of annual returnover time.

In addition to being used by companies to determine which capital projects to use, IRR can
help investors determine the investment return of various assets.

In capital planning, one popular scenario for IRR is comparing the profitability of
establishing new operations with that of expanding existing operations. For example, an
energy company may use IRR in deciding whether to open a new power plant or to renovate
and expand an existing power plant.

While both projects could add value to the company, it is likely that one will be the
more logical decision as prescribed by IRR. Note that because IRR does not account
for changing discount rates, it’s often not adequate for longer-term projects with
discount rates that are expected to vary.

IRR vs. Return on Investment (ROI)

Companies and analysts may also look at the return on investment (ROI) when making
capital budgeting decisions. ROI tells an investor about the total growth, start to finish, of the
investment. It is not an annual rate of return. IRR tells the investor what the annual growth rate
is. The two numbers normally would be the same over the course of one year but won’t be the
same for longer periods of time.

ROI is the percentage increase or decrease of an investment from beginning to end. It is

calculated by taking the difference between the current or expected future value and the original
beginning value, divided by theoriginal value, and multiplied by 100.

ROI figures can be calculated for nearly any activity into which an investment has been made
and an outcome can be measured. However, ROI is not necessarily the most helpful for lengthy
time frames. It also has limitations in capital budgeting, where the focus is often on periodic
cash flows and returns.

Formula of IRR
45
0=NPV=t=1∑T(1+IRR) tCt−C0

where: Ct= Net cash inflow during the periodtC0= Total initial investment costs
IRR= The internal rate of return
t= The number of time periods

Decision- If the IRR is greater than the cost of capital, accept the project. If the IRR is less
than the cost of capital, reject the project.

f.) Modified Internal Rate of Return (MIRR): The modified internal rate of return (MIRR)
assumes that positive cash flows are reinvested at the firm's cost of capital and that the initial
outlays are financed at the firm's financing cost. By contrast, the traditional internal rate
of return (IRR) assumes the cash flows from a project are reinvested at the IRR itself.
The MIRR, therefore, more accurately reflects the cost and profitability of a project.

The MIRR is used to rank investments or projects of unequal size. The calculation is a
solution to two major problems that exist with the popular IRR calculation. The first main
problem with IRR is that multiple solutions can be found for the same project. The second
problem is that the assumption that positive cash flows are reinvested at the IRR is
considered impractical in practice. With the MIRR, only a single solution exists for a given
project, and the reinvestment rate of positive cash flows is much more valid in practice.

The MIRR allows project managers to change the assumed rate of reinvestedgrowth from
stage to stage in a project. The most common method is to inputthe average estimated cost
of capital, but there is flexibility to add any specific anticipated reinvestment rate.

Decision: A project can be accepted if its MIRR is greater than the cost of capital (hurdle
rate) and rejected if the rate is lower than the cost of capital.

g.) Profitability Index: The profitability index (PI), alternatively referred to as value investment
ratio (VIR) or profit investment ratio (PIR), describes an index that represents the
relationship between the costs and benefits of a proposed project.

The profitability index is calculated as the ratio between the present value of future expected
cash flows and the initial amount invested in the project. A higher PI means that a project
will be considered more attractive. The PI is especially useful when a company has limited
resources and can't pursue all potential projects, as it can be used to prioritize which projects
to pursue first.

The profitability index is helpful in ranking various projects because it lets investors quantify
the value created per each investment unit. A profitabilityindex of 1.0 is logically the lowest
acceptable measure on the index, as any value lower than that number would indicate that
the project's present value (PV) is less than the initial investment. As the value of the
profitability indexincreases, so does the financial attractiveness of the proposed project.

The profitability index can be computed as:

46
PV of Future cash flows
Profitability index=
Initial Investment

Profitability Index Pros and Cons

Pros

 Accounts for the time value of money

 Allows comparisons across different projects

Cons

 Does not consider ongoing future costs

 Ignores project size
 Bad forecasts or assumptions can make the analysis unreliable

Decision- If the Profitability Index is greater than one, the capital investment is accepted. If
it is less than one, the capital investment is rejected.

h.) Average Rate of Return (ARR): The average rate of return is the average annual amount
of cash flow generated over the life of an investment. This rate is calculated by aggregating
all expected cash flows and dividing by the number of years that the investment is expected
to last. It is commonly used by investors to decide whether to invest in an asset.

For example, an investment in real estate is expected to generate returnsof $22,000 in

the first year, $32,000 in the second year, and $36,000 inthe third year. The average of
this amount is $30,000. The initial investment was $300,000, so the average rate of return
is 10% (calculatedas the $30,000 average return divided by the $300,000 investment).

The key flaw in this calculation is that it does not account for the time value of money.
Cash flows in later periods are worth less than cash flows in more recent periods. In
addition, it can be difficult to create reliable cash flow estimates for future periods.

ARR= (Average annual profit after tax/ Average Investment) * 100

Decision - If the ARR is higher than the minimum rate established by the management,
accept the project. If the ARR is less than the minimum rate established by the management.

2.) Capital Structure (Financing Decision): Capital structure is the particular combination of
debt and equity used by a company to finance its overall operations and growth.

Equity capital arises from ownership shares in a company and claims to its futurecash flows
and profits. Debt comes in the form of bond issues or loans, while equity may come in the
form of common stock, preferred stock, or retained earnings. Short-term debt is also
considered to be part of the capital structure.

When analysts refer to capital structure, they are most likely referring to a firm's debt-to-
equity (D/E) ratio, which provides insight into how risky a company's borrowing practices
are. Usually, a company that is heavily financed by debt has a more aggressive capital
structure and therefore poses a greater risk to investors. This risk, however, may be the
47
primary source of the firm's growth.

The optimal capital structure is estimated by calculating the mix of debt and equity that
minimizes the WACC of a company while maximizing its market value. The lower the cost
of capital, the greater the present value of the firm’s future cash flows, discounted by the
WACC. Thus, the chief goal of any corporatefinance department should be to find the optimal
capital structure that will result in the lowest WACC and the maximum value of the company
(shareholder wealth).

Weighted average cost of capital (WACC) represents a firm’s average after- tax cost of
capital from all sources, including common stock, preferred stock, bonds, and other forms
of debt. WACC is the average rate that a company expects to pay to finance its assets. WACC
is the rate we use to discount those future cash flows to the present if the value of a company
equals the present valueof its future cash flows.

WACC is a common way to determine required rate of return (RRR) because it expresses,
in a single number, the return that both bondholders and shareholdersdemand to provide the
company with capital. A firm’s WACC is likely to be higher if its stock is relatively volatile
or if its debt is seen as risky because investors will require greater returns.

Importance of Capital Structure

Capital structure is vital for a firm as it determines the overall stability of a firm. Here are some
of the other factors that highlight the importance of capital structure

1. A firm having a sound capital structure has a higher chance of increasing the market price
of the shares and securities that it possesses. It will lead to a higher valuation in the market.
2. A good capital structure ensures that the available funds are used effectively. It prevents
over or under capitalisation.
3. It helps the company in increasing its profits in the form of higher returns to stakeholders.
4. A proper capital structure helps in maximising shareholder’s capital while minimising the
overall cost of the capital.
5. A good capital structure provides firms with the flexibility of increasing or decreasing the
debt capital as per the situation.

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Types of Capital Structure
The meaning of Capital structure can be described as the arrangement of capital by using
different sources of long-term funds which consists of two broad types, equity and debt. The
different types of funds that are raised by a firm include preference shares, equity shares,
retained earnings, long-term loans etc. These funds are raised for running the business.

Equity Capital

Equity capital is the money owned by the shareholders or owners. It consists of two different
types

 Retained earnings: Retained earnings are part of the profit that has beenkept separately
by the organisation and which will help in strengthening the business.

 Contributed Capital: Contributed capital is the amount of money which the company
owners have invested at the time of opening the company or received from shareholders as
a price for ownership of the company.

Debt Capital

Debt capital is referred to as the borrowed money that is utilised in business. There are different
forms of debt capital.

 Long Term Bonds: These types of bonds are considered the safest of the debts as they
have an extended repayment period, and only interest needs to be repaid while the
principal needs to be paid at maturity.
 Short Term Commercial Paper: This is a type of short-term debt instrumentthat is used
by companies to raise capital for a short period of time.

3.) Working Capital Management: Working capital management requires monitoring a

company's assets and liabilities to maintain sufficient cash flow to meet its short-term operating
costs and short-term debt obligations. Managing working capital primarily revolves around
managing accounts receivable, accounts payable, inventory, and cash. It involves tracking
various ratios, including the working capital ratio, the collection ratio, and the inventory ratio.
Working capital management can improve a company's cash flow management and earnings
quality by using its resources efficiently.

Types of Working Capital

In its simplest form, working capital is just the difference between current assets and current
liabilities. However, there are many different types of working capital that each may be
important to a company to best understand its short- term needs.

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 Permanent Working Capital: Permanent working capital is the amount of resources
the company will always need to operate its business without interruption. This is the
minimum number of short-term resources vital to operations.
 Regular Working Capital: Regular working capital is a component of permanent
working capital. It is the part of the permanent working capital that is actually required
for day-to-day operations and makes up the "most important" part of permanent working
capital.
 Reserve Working Capital: Reserve working capital is the other component of
permanent working capital. Companies may require an additional amount of working
capital on hand for emergencies, seasonality, or unpredictable events.
 Fluctuating Working Capital: Companies may be interested in only knowing what
their variable working capital is. For example, companies may opt into paying for
inventory as it is a variable cost. However, the company may have a monthly liability
relating to insurance it does not have the optionto decline. Fluctuating working capital
only considers the variable liabilities the company has complete control over.
 Gross Working Capital: Gross working capital is simply the total amount of current
assets of a business before considering any short-term liabilities.
 Net Working Capital: Net working capital is the difference between current assets and
current liabilities.

4.) Dividend decision: The dividend is that portion of the profit that is distributed to the
shareholders. The decision involved here is how much of the profit earned by the company
after paying the taxes is to be distributed to the shareholders. It also includes the part of the
profit that should be retained in the business. When the current income is re-invested, the
retained earnings increase the firm’s future earning capacity. This extent of retained
earnings also influences the financing decision of the firm. The dividend decision should
be taken keeping in view the overall objective of maximizing shareholders’ wealth. In
corporate finance, the dividend decision refers to the choice made by a company's
directors regarding the size and timing of any cash payments given to the company's
stockholders.

Factors affecting Dividend Decision

a.) Amount of Earnings: Dividends are paid out of the current and previous year’s
earnings. More earnings will ensure greater dividends, whereas fewer earnings will
lead to the declaration of a low rate of dividends.

b.) Stability of Earning: A company that is stable and has regular earnings can afford to
declare higher dividend as compared to those company which doesn’t have such
stability in earnings.

c.) Stability of Dividend: Some companies follow the policy of playing a stable dividend
because it satisfies the shareholders and helps in increasing companies’ reputation. If
earning potential is high, it is declared as a high dividend, whereas if the earning is
temporary ornot increasing, then it is declared as a low or normal dividend.

d.) Growth Opportunities: Companies with growth opportunities prefer to retain more
money out of their earnings to finance the new project. So, companies that have growth
prospects in near future willdeclare fewer dividends as compared to companies that
don’t have any growth plan.

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e.) Cash flow Position: Payment of dividends is related to the outflow of cash. A company
may be profitable, but it may have a shortage of cash. In case the company has surplus
cash, then the company can pay more dividends, but during a shortage of cash, the
company can declare a low dividend.

f.) Taxation Policy: The rate of dividends also depends on the taxation policy of the
government. In the present taxation policy, dividend income is tax-free income to the
shareholders, so they prefer higher dividends. However, dividend decision is left to
companies.

g.) Stock market reaction: The rate of dividend and market value of a share are directly
related to each other. A higher rate of dividends has a positive impact on the market price
of the shares. Whereas, a low rate of dividends may hurt the share price in the stock
market. So, management should consider the effect on the price of equity shares while
deciding the rate of dividend.

TYPES OF RISK

The systematic risk is a result of external and uncontrollable variables, which are not industry
or security specific and affects the entire market leading to the fluctuation in prices of all the
securities. Systematic risk cannot be eliminated by diversification of portfolio. It is divided into
three categories that are explained as under:

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

• Inflation risk: Alternatively known as purchasing power risk as it adversely affects the
purchasing power of an individual. Such risk arises due to a rise in the cost of production, the
rise in wages, etc.

• Market risk: The risk influences the prices of a share, i.e., the prices will rise or fall
consistently over a period along with other shares of the market.

On the other hand, unsystematic risk refers to the risk which emerges out of controlled and
known variables that are industry or security specific. Diversification proves helpful in
avoiding unsystematic risk. It has been divided into two category business risk and financial
risk, explained as under:

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

• Financial risk: Alternatively known as leveraged risk. When there is a change in the capital
structure of the company, it amounts to a financial risk. The debt – equity ratio is the
expression of such risk.

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BUSINESS VALUATION

The valuation of a business is the process of determining the current worth of a business,
using objective measures, and evaluating all aspects of the business. A business valuation
might include an analysis of the company's management, its capital structure, its future
earnings prospects or the market value of its assets. The tools used for valuation can vary
among evaluators, businesses, and industries.

Business valuation determines the economic value of a business or business unit. Business
valuation can be used to determine the fair value of a business for a variety of reasons,
including sale value, establishing partner ownership and taxation.

VALUATION TECHNIQUES OVERVIEW

1.) Discounted Cash Flow Method: Discounted cash flow (DCF) refers to
a valuation method that estimates the value of an investment using its expected future cash
flows. DCF analysis attempts to determine the value of an investment today, based on
projections of how much money that investment willgenerate in the future.

It can help those considering whether to acquire a company or buy securities make their
decisions. Discounted cash flow analysis can also assist business owners and managers in
making capital budgeting or operating expenditures decisions. The purpose of DCF analysis is
to estimate the money an investor would receive from aninvestment, adjusted for the time value
of money. .
DCF=
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛
+ +
(1+𝑟)1 (1+𝑟)2 (1+𝑟)3

where:CF1 = The cash flow for year one

CF2=The cash flow for year two

𝐶𝐹𝑛=The cash flow for additional yearsr=The

discount rate

Advantages and Disadvantages of DCF

Advantages

 Discounted cash flow analysis can provide investors and companies with an idea of
whether a proposed investment is worthwhile.
 It is analysis that can be applied to a variety of investments and capitalprojects where
future cash flows can be reasonably estimated.
 Its projections can be tweaked to provide different results for various what if scenarios.
This can help users account for different projections that might be possible.

Disadvantages

 The major limitation of discounted cash flow analysis is that it involves estimates, not
52
actual figures. So, the result of DCF is also an estimate. That means that for DCF to be
useful, individual investors and companies must estimate a discount rate and cash flows
correctly.
 Furthermore, future cash flows rely on a variety of factors, such as market demand, the
status of the economy, technology, competition, andunforeseen threats or opportunities.
These can't be quantified exactly.
Investors must understand this inherent drawback for their decision-making.
 DCF shouldn't necessarily be relied on exclusively even if solid estimates canbe made.
Companies and investors should consider other, known factors as well when sizing up an
investment opportunity. In addition, comparable company analysis and precedent
transactions are two other, common valuation methods that might be used.

Decision: If the DCF is higher than the current cost of the investment, theopportunity could
result in positive returns and may be worthwhile.

a.) Free cash flow to the firm (FCFF): It represents the amount of cash flow from
operations available for distribution after accounting for depreciation expenses, taxes,
working capital, and investments. FCFF is a measurement of a company's profitability
after all expenses and reinvestments. It is one of the many benchmarks used to compare
and analyze a firm's financial health. A negative value indicates that the firm has not
generated enough revenue to cover its costs and investment activities.

The calculation for FCFF can take several forms, and it's important to understand each
version. The most common equation is the following:

FCFF=NI+NC+(I×(1−TR))−LI−IWC
where: NI=Net income, NC=Non-cash charges, I=Interest, TR=Tax Rate, LI=Long-
term Investments, IWC=Investments in Working Capital

FCFF=CFO+(IE×(1−TR))−CAPEX
where: CFO=Cash flow from operations, IE=Interest Expense
CAPEX=Capital expenditures

FCFF=(EBIT×(1−TR))+D−LI−IWC
where: EBIT=Earnings before interest and taxes, D=Depreciation

FCFF=(EBITDA×(1−TR))+(D×TR)−LI−IWC
where: EBITDA=Earnings before interest, taxes, depreciation and amortization

The Difference between Cash Flow and Free Cash Flow to the Firm (FCFF)

Cash flow is the net amount of cash and cash equivalents being transferred into and

out of a company. Positive cash flow indicates that a company's liquid assets areincreasing,
enabling it to settle debts, reinvest in its business, return money to shareholders, and pay
expenses.

Cash flow is reported on the cash flow statement, which contains three sections detailing
53
activities. Those three sections are cash flow from operating activities, investing activities, and
financing activities.

FCFF is the cash flows a company produces through its operations after
subtracting any outlays of cash for investment in fixed assets like property, plant, and
equipment, and after depreciation expenses, cash flow taxes, working capital, and interest are
accounted for. In other words, free cash flow to the firm is the cash left over after a company
has paid its operating expenses and capital expenditures.

FCFF can be calculated using this version of the formula:

FCFF=CFO+(IE×(1−TR))−CAPEX

In the above example, FCFF would be calculated as follows:

54
FCFF= $8,519 Million+($300 Million×(1−.30))− $3,349 Million= $5.38 Billion

2.) Stock Valuation: Stock valuation is the method of calculating theoretical values of
companies and their stocks. The main use of these methods is to predict future market prices,
or more generally, potential market prices, and thus to profit from
price movement – stocks that are judged undervalued (with respect to their theoretical value)
are bought, while stocks that are judged overvalued are sold, in the expectation that
undervalued stocks will overall rise in value, while overvalued stocks will generally decrease
in value. A target price is a price at which
an analyst believes a stock to be fairly valued relative to its projected and historical earnings.
The dividend discount model (DDM) is a quantitative method used for predicting the price
of a company's stock based on the theory that its present-day price is worth the sum of all of
its future dividend payments when discounted backto their present value.

It attempts to calculate the fair value of a stock irrespective of the prevailing market
conditions and takes into consideration the dividend payout factors and the market expected
returns. If the value obtained from the DDM is higher than the current trading price of shares,
then the stock is undervalued and qualifies for a buy, and vice versa.

3.) Discount rates and WACC: The Discount Rate represents the minimum return expected to
be earned on an investment given its specific risk profile. In practice, the present value (PV)
of the future cash flows generated by a company is estimated using an appropriate discount
rate that should reflect the risk profile of the underlying company, i.e., the opportunity cost
of capital. Discount rate estimates the risk and potential returns of an investment – so a
higher rate impliesgreater risk but also more upside potential.

The weighted average cost of capital (WACC) is the rate at which a company’s future cash
flows need to be discounted to arrive at a present value for the business. It reflects the
perceived riskiness of the cash flows. Put simply, if the value of a company equals the present
value of its future cash flows, WACC is the rate we use to discount those future cash flows
to the present.

55
There are basically 2 elements of WACC – Cost of Equity and Cost of Debt

a.) Cost of debt –The cost of debt is the total interest expense owed on a debt. Put simply,
the cost of debt is the effective interest rate or the total amount of interest that a company or
individual owes on any liabilities, such as bonds and loans. This expense can refer to either the
before-tax or after-tax cost of debt. The degree of the cost of debt depends entirely on the
borrower's creditworthiness, so higher costs mean the borrower is considered risky. The cost
of debt is the effective rate that a company pays on its debt, such as bonds and loans. The key
difference between the pretax cost of debt and the after-tax cost of debt is the fact that interest
expense is tax-deductible.

Suppose you run a small business and you have two debt vehicles under the enterprise. The
first is a loan worth $250,000 through a major financial institution. The second is a $150,000
loan through a private investor. The first loan has an interest rate of 5% and the second one
has a rate of 4.5%.

First, let's calculate the total amount of interest you'll pay each year on both of these loans:

 Loan 1: $250,000 x 5% = $12,500

 Loan 2: $150,000 x 4.5% = $6,750

We can add these two figures together to get the total annual interest, which is $19250.

In order to calculate the effective rate before taxes, we divide this figure by thetotal amount
of the debt:

$19,250 ÷ $400,000 = 0.0481

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Therefore, the effective before-tax rate of these debts is 4.81%

b.) Cost of Equity: The cost of equity is the return that a company requires to decide if an
investment meets capital return requirements. Firms often use it as a capital budgeting
threshold for the required rate of return. A firm’s cost of equity represents the
compensation that the market demands in exchange for owning the asset and bearing the
risk of ownership. The traditional formula for the cost of equity is the dividend
capitalization model and the capital asset pricing model (CAPM).

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return –Risk-Free Rate
of Return)

In this equation, the risk-free rate is the rate of return paid on risk-free investments such as
Treasuries. Beta is a measure of risk calculated as a regression on the company’s stock price.
The higher the volatility, the higher the beta and relative risk compared to the general market.
The market rate of return is the average market rate. In general, a company with a high beta—
that is, a company with a high degree of risk—will have a higher cost of equity.

Equity Risk Premium: Equity Risk Premium (ERP) is defined as the extra yield that can be
earned over the risk-free rate by investing in the stock market. Equity risk premium is a long-
term prediction of how much the stock market will outperform risk-free debt instruments.
Equity risk premium predicts how much a stock might outperform risk-free investments over
the long term. Calculating the risk premium can be done by taking the estimated expected
returns on stocks and subtracting themfrom the estimated expected return on risk-free bonds.

CALCULATION OF TERMINAL VALUE.

Terminal value (TV) is the value of an asset, business, or project beyond the forecasted
period when future cash flows can beestimated. Terminal value assumes a business will
grow at a set growth
rate forever after the forecast period. Terminal value often comprises a largepercentage of
the total assessed value.

To calculate the terminal value, we use perpetual growth method, wherein –

Perpetual Growth = A/R-G

where: A = Free cash flow of the year immediately next to your terminal/stable growth period,
R = Discount rate, G = Growth

The two most common methods for calculating terminal value are perpetualgrowth (Gordon
Growth Model) and exit multiple.

The Gordon growth model (GGM) is a formula used to determine the intrinsic value of a
stock based on a future series of dividends that grow at a constant rate. It is a popular and
straightforward variant of the dividend discount model (DDM). The GGM assumes that
dividends grow at a constant rate in perpetuity and solves for the present value of the infinite
series of future dividends. Because the model assumes a constant growth rate, it is generally
only used for companieswith stable growth rates in dividends per share.

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The three key inputs in the model are dividends per share (DPS), the growth ratein dividends
per share, and the required rate of return (ROR).
𝐷1
P=
𝑟−𝑔

where: P=Current stock price

g=Constant growth rate expected for dividends, in perpetuity r=Constant cost
of equity capital for thecompany (or rate of return)D1=Value of next year’s
dividends

4.) Relative Valuation: Relative valuation is a valuation methodology that involves the use
of certain standardized multiples that can derive value and enable inter firm comparison
and value benchmarking. The popularity of this approach stems from the fact that it is
easier to explain and less quantitative than the DCF approach. The prices can be
standardized using a common variable such as earnings, cash flow, book value or
revenues.

When judging the performance of an investment, it is best to look at its return relative to
other investments and not in a vacuum. It is thus useful to compare the relative valuation
of industry peers or competitors in order to find the bestopportunity to invest.

The following are some commonly used multiples-

- Earnings Multiple
 Price/Earnings ratio (P/E) - Used for various industries such as FMCG, Pharma etc.
 EV/EBITDA - Used for industries such as Auto/Auto Parts, Infrastructure etc

- Book Value Multiples

 Price/Book Value (of equity) – (P/B) – Used for Financial Services (Banks)

- Revenue Multiples
 EV/Sales - Used for companies making losses at EBIT/EBITDA level

- Industry Specific Variables

 Price per ton of cement capacity
 Embedded value multiple in Insurance Industry

5.) Sum Of the Parts Analysis (SOTP): Sum-of-the-parts ("SOTP") or "break-up" analysis
provides a range of values for a company's equity by summing the valueof its individual
business segments to arrive at the total enterprise value (EV).
Equity value is then calculated by deducting net debt and other non-operating adjustments.
For a company with different business segments, each segment is valued using ranges of
trading and transaction multiples appropriate for that particular segment. Relevant
multiples used for valuation, depending on the individual segment's growth and
profitability, may include revenue, EBITDA, EBIT, and net income. A DCF analysis for
certain segments may also be a usefultool when forecasted segment results are available or
estimable.
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SOTP analysis is used to value a company with business segments in different industries
that have different valuation characteristics. Below are two situations in which a SOTP
analysis would be useful:
 Defending a company that is trading at a discount to the sum of its parts from a hostile
takeover.
 Restructuring a company to unlock the value of a business segment that is not getting
credit for its value through a spin-off, split-off, tracking stock,or equity (IPO) carve-
out.

6.) Asset Based Approach: An asset-based approach is a type of business valuation that
focuses on a company's net asset value (NAV), or the fair-market value of its total assets
minus its total liabilities, to determine what it would cost to recreate the business.
Adjustments are made to the company’s historical balance sheet in order to present each
asset and liability item at its respective fair market value. Examplesof potential
normalizing adjustments include:

• Adjusting fixed assets to their respective fair market values.

• Feducing accounts receivable for potential uncollectable balances if an allowance
for doubtful accounts has not been established or if it is not sufficient to cover the
potentially uncollectable amount.
• Reflecting any unrecorded liabilities such as potential legal settlements or
judgments.

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

7.) Comparables approach: There are two primary comparable approaches. Trading
comparables is the most common and looks at market comparables for a firm and its peers.
Common market multiples include the following: enterprise value to sales (EV/S), enterprise
multiple, price to earnings (P/E), price to book (P/B) and price to free cash flow (P/FCF).
The specific ratio to be used depends on the objective ofthe valuation. The valuation could
be designed to estimate the value of the operation of the business or the value of the equity
of the business. When calculating the value of the operation the most commonly used ratio
is the EBITDA multiple, which is the ratio of EBITDA (Earnings Before Interest Taxes
Depreciation and Amortization) to the Enterprise Value (equity value plus Net Debt).

Enterprise value (EV) is a measure of a company's total value, often used as a more
comprehensive alternative to equity market capitalization. EV includes in its calculation the
market capitalization of a company but also short-term and long- term debt as well as any
cash on the company's balance sheet. Enterprise value is a popular metric used to value a
company for a potential takeover. Enterprise value = Market capitalization + Total debt –
Cash and cash equivalents When valuing theequity of a company, the most widely used
multiple is the Price Earnings Ratio (PE) of stocks in a similar industry, which is the ratio
of Stock price to Earnings per Share of any public company.

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PORTFOLIO MANAGEMENT

Portfolio management is the art and science of selecting and overseeing a group of investments
that meet the long-term financial objectives and risk tolerance of a client, acompany, or an
institution. Investment portfolio management involves building and overseeing a selection of
assets such as stocks, bonds, and cash that meet the long-termfinancial goals and risk tolerance
of an investor.

Active portfolio management requires strategically buying and selling stocks and other assets
in an effort to beat the performance of the broader market. Passive portfolio management
seeks to match the returns of the market by mimicking the makeup of an indexor indexes.

Investors can implement strategies to aggressively pursue profits, conservatively attempt to

preserve capital, or a blend of both. Portfolio management requires clear long-term goals,
clarity from the IRS on tax legislation changes, understanding of investor risk tolerance, and a
willingness to study investment options.

Portfolio management requires the ability to weigh strengths and weaknesses, opportunities
and threats across the full spectrum of investments. The choices involve trade-offs, from debt
versus equity to domestic versus international, and growth versus safety.

OBJECTIVES OF PORTFOLIO MANAGEMENT

The fundamental objective of portfolio management is to help select best investment options
as per one’s income, age, time horizon and risk appetite.
Some of the core objectives of portfolio management are as follows –
 Capital appreciation
 Maximising returns on investment
 To improve the overall proficiency of the portfolio
 Risk optimisation
 Allocating resources optimally
 Ensuring flexibility of portfolio
 Protecting earnings against market risks

TYPES OF PORTFOLIO MANAGEMENT

In a broader sense, portfolio management can be classified under 4 major types, namely –

• Active portfolio management: In this type of management, the portfolio manager is mostly
concerned with generating maximum returns. Resultantly, they put a significant share of
resources in the trading of securities. Typically, they purchase stocks when they are
undervalued and sell them off when their value increases.

• Passive portfolio management: This particular type of portfolio management is concerned

with a fixed profile that aligns perfectly with the current market trends. The managers are more
likely to invest in index funds with low but steady returns which may seem profitable inthe long run.

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• Discretionary portfolio management: In this particular management type, the portfolio
managers are entrusted with the authority to invest as per their discretion on investors’ behalf.
Based on investors’ goals and risk appetite, the manager may choose whichever investment
strategy they deem suitable.

• Non-discretionary management: Under this management, the managers provide advice on

investment choices. It is up to investors whether to accept the advice or reject it. Financial
experts often recommended investors to weigh in the merit of professional portfolio managers’
advice before disregarding them entirely.

COMMON PORTFOLIO MANAGEMENT STRATEGIES

Every investor's specific situation is unique. Therefore, while some investors may be risk-
averse, others may be inclined to pursue the greatest returns (while also incurring the greatest
risk). Very broadly speaking, there are several common portfolio management strategies an
investor can consider:

 Aggressive: An aggressive portfolio prioritizes maximizing the potential earnings ofthe

portfolio. Often invested in riskier industries or unproven alternative assets, an investor
may not care about losses. Instead, the investor is looking for the "home run" investment
by striking it big with a single investment.
 Conservative: On the other hand, a conservative portfolio relates to capital preservation.
Extremely risk-adverse investors may adopt a portfolio management strategy that
minimizes growth but also minimizes the risk of losses.
 Moderate: A moderate portfolio management strategy would simply blend an aggressive
and conservative approach. In an attempt to get the best of both worlds, a moderate
portfolio still invests heavily in equities but also diversifies and may be more selective in
what those equities are.
 Income-Orientated: Often a consideration for older investors, some folks who do not
have income may rely on their portfolio to generate income that can be used to live off of.
Consider how a retiree no longer has a stable pay check. However, that retiree may no
longer be interested in generating wealth but instead of using their existing wealth to live.
This strategy priorities fixed-income securities or equities that issue dividends.
 Tax-Efficient: As discussed above, investors may be inclined to focus primarily on
minimizing taxes, even at the expense of higher returns. This may be especially important
for high-earners who are in the highest capital gains tax bracket. This mayalso be a priority
for young investors who have a very long way until retirement.

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PROCESS OF PORTFOLIO MANAGEMENT

KEY ELEMENTS OF PORTFOLIO MANAGEMENT

Asset Allocation: The key to effective portfolio management is the long-term mix of assets.
Generally, that means stocks, bonds, and cash equivalents such as certificates of deposit.
There are others, often referred to as alternative investments, such as real estate, commodities,
derivatives, and cryptocurrency. Asset allocation is based on the understanding that different
types of assets do not move in concert, and some are morevolatile than others. A mix of assets
provides balance and protects against risk.

Investors with a more aggressive profile weight their portfolios toward more volatile
investments such as growth stocks. Investors with a conservative profile weight their portfolios
toward stabler investments such as bonds and blue-chip stocks.

Diversification: The only certainty in investing is that it is impossible to consistently predict

winners and losers. The prudent approach is to create a basket of investments that provides
broad exposure within an asset class. Diversification involves spreading the risk and rewardof
individual securities within an asset class, or between asset classes. Because it is difficult to
know which subset of an asset class or sector is likely to outperform another, diversification
seeks to capture the returns of all of the sectors over time while reducing volatility at any given
time.

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Rebalancing: Rebalancing is used to return a portfolio to its original target allocation at
regular intervals, usually annually. This is done to reinstate the original asset mix when the
movements of the markets force it out of kilter.
For example, a portfolio that starts out with a 70% equity and 30% fixed-income allocation
could, after an extended market rally, shift to an 80/20 allocation. The investor has made a
good profit, but the portfolio now has more risk than the investor can tolerate.

Rebalancing generally involves selling high-priced securities and putting that money to work
in lower-priced and out-of-favor securities. The annual exercise of rebalancing allows the
investor to capture gains and expand the opportunity for growth in high-potential sectorswhile
keeping the portfolio aligned with the original risk/return profile.

Tax-Efficiency: A potentially material aspect of portfolio management relates to how your

portfolio is shaped to minimize taxes in the long-term. This pertains to how different retirement
accounts are used, how long securities are held on for, and which securities are held.

For example, consider how certain bonds may be tax-exempt. This means that any dividends
earned are not subject to taxes. On the other hand, consider how the IRS had different rules
relating to short-term or long-term capital gains taxes. For individuals earning less than
$41,675 in 2023, their capital gains rate may be $0.

PHASES OF PORTFOLIO MANAGEMENT

1. Security Analysis

Security analysis is the first step of the process of portfolio management. To construct a right
portfolio, you need perfect securities. Here perfection is about the matchability with your risk
aspects and returns expectation. In this step, all the securities from your portfolio are analyzed.
As well as at the same time the potential securities which can be good buying opportunities
available in the market are also considered. Keeping your financial goal on the line, portfolio
managers shortlist the best securities for your portfolio.
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2. Portfolio Analysis
Portfolio analysis is the second step in portfolio management. After collecting the best possible
securities, the process of shaping portfolio starts. With the number of potential securities, a
number of portfolios created. These portfolios are also known as feasible portfolios. These
feasible portfolios are further analyzed to pick the exact match of yourrequirements.

3. Portfolio Selection
Portfolio selection is the third and most important step of the portfolio management process.
Feasible portfolios are the permutation and combinations of the securities. It's a rough layout
from which optimum selection needs to be done. The number of portfolios the optimum and
exact portfolio is selected in the selection process. The portfolio is selected on the basis of your
investment capabilities and return expectation. Portfolio manager selects the portfolio which
will create wealth for you without hampering your risk appetite.

4. Portfolio Revision
After selecting the portfolio, the portfolio manager and his team of analysts, keep an eye onthe
portfolio. This also a key step in the process of portfolio management. It's like maintaining
your car, after purchasing it. Once, you have created a portfolio, monitoring it closely to ensure
profits it's also important. In this step, the portfolio manager ensures the close monitoring as
well as take the informed decision as and when required.

5. Portfolio Evaluation
To achieve a specific financial goal, consistent evaluation of the performance is necessary. The
risk-return ratio is consistently evaluated in this step. This is the last step of the portfolio
management process. Here, the portfolio manager ensures the tracking of the strategies
implemented.

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DIFFERENCE BETWEEN SHARES AND BONDS

FACTORS TO BE CONSIDERED WHILE SELECTING SHARES

• Expected return: The expected return can be in the way of interest or dividends as well as
capital gain or loss. It is important to factor the expected return while investing in stocks in
order to minimize the losses.

• Liquidity: Liquidity of an investment refers to how quickly the investment can be exchanged
for or converted into money. Liquidity can be through sale on the stock exchange or redemption
on maturity of the instrument.

• Volatility: Volatility refers to the range or pace of fluctuations that an investment endures.
The higher the range and pace of fluctuations, higher is the risk of profits or losses.

• Risk-return analysis: For any investor, it is important to understand what kind of risk their
investment attracts. Listed securities have the potential to generate more than average returns
compared to the traditional or the conventional instruments but at the same time carry a higher
risk.

• Time horizon: Time Horizon refers to the period of time a particular investor is expecting
to hold their investment before selling it.

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METHODS OF SECURITY SELECTION

1.) Altman Z-score: The Altman Z-score is the output of a credit-strength test that gauges a
publicly traded manufacturing company's likelihood of bankruptcy. The Altman Z-score
is a formula for determining whether a company, notably in the manufacturing space, is
headed for bankruptcy. The formula takes into account profitability, leverage, liquidity,
solvency, and activity ratios.

An Altman Z-score close to 0 suggests a company might be headed for bankruptcy, while
ascore closer to 3 suggests a company is in solid financial positioning.

Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

where: A = working capital / total assetsB = retained earnings / total assets

C = earnings before interest and tax / total assets D = market value of equity / total
liabilities
E = sales / total assets

A score below 1.8 means it's likely the company is headed for bankruptcy, while
companieswith scores above 3 are not likely to go bankrupt. Investors can use Altman Z-
scores to determine whether they should buy or sell a stock if they're concerned about the
company's underlying financial strength. Investors may consider purchasing a stock if its
Altman Z- Score value is closer to 3 and selling or shorting a stock if the value is closer
to 1.8.

2.) Modified C-score: C-score, developed by James Montier, takes into account six parameters
to determine whether a company is cooking its books. It indicates the probability of
financial manipulations based on a quantitative method. To make the formula much more
effective, we at Value Research have added three more points to it making it nine
parameters in total. A lower score means there is no evidence of creative accounting and
vice versa.

3.) Piotroski score: The Piotroski score is a ranking between zero and nine that incorporates
nine factors that speak to a firm's financial strength. It was named for Joseph Piotroski, a
Chicago Accounting Professor who created the scale, based on certain aspects of
a corporation's financial statements. The nine aspects are based on accounting results over
a number of years; a point is awarded each time a standard is met, resulting in an overall
score. If a company has a score of eight or nine, it is considered a good value. Ifa company
has a score of between zero and two points, it is likely not a good value

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BONDS

CHARACTERISTICS OF BONDS
Most bonds share some common basic characteristics including:

 Face value (par value) is the money amount the bond will be worth at maturity; it is also
the reference amount the bond issuer uses when calculating interest payments. For
example, say an investor purchases a bond at a premium of $1,090, and another investor
buys the same bond later when it is trading at a discount for $980. When thebond
matures, both investors will receive the $1,000 face value of the bond. 
 The coupon rate is the rate of interest the bond issuer will pay on the face value ofthe
bond, expressed as a percentage.1 For example, a 5% coupon rate means that
bondholders will receive 5% x $1,000 face value = $50 every year.
 Coupon dates are the dates on which the bond issuer will make interest payments.
Payments can be made in any interval, but the standard is semi-annual payments.
 The maturity date is the date on which the bond will mature and the bond issuerwill
pay the bondholder the face value of the bond.
 The issue price is the price at which the bond issuer originally sells the bonds. Inmany
cases, bonds are issued at par.

VARIETIES OF BONDS

The bonds available for investors come in many different varieties. They can be separated by
the rate or type of interest or coupon payment, by being recalled by the issuer, or becausethey
have other attributes. Below, we list some of the most common variations:

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Zero-Coupon Bonds: Zero-coupon bonds (Z-bonds) do not pay coupon payments and instead
are issued at a discount to their par value that will generate a return once the bondholder is
paid the full-face value when the bond matures. U.S. Treasury bills are a zero-coupon bond.

Convertible Bonds: Convertible bonds are debt instruments with an embedded option that
allows bondholders to convert their debt into stock (equity) at some point, depending on certain
conditions like the share price. The convertible bond may be the best solution for thecompany
because they would have lower interest payments while the project was in its earlystages. If
the investors converted their bonds, the other shareholders would be diluted, but the company
would not have to pay any more interest or the principal of the bond.

Callable Bonds: Callable bonds also have an embedded option, but it is different than what is
found in a convertible bond. A callable bond is one that can be “called” back by the company
before it matures. A callable bond is riskier for the bond buyer because the bond is more likely
to be called when it is rising in value. Remember, when interest rates are falling, bond prices
rise. Because of this, callable bonds are not as valuable as bonds that aren’t callable with the
same maturity, credit rating, and coupon rate.

Puttable Bond: A puttable bond allows the bondholders to put or sell the bond back to the
company before it has matured. This is valuable for investors who are worried that a bond may
fall in value, or if they think interest rates will rise and they want to get their principal back
before the bond falls in value. The bond issuer may include a put option in the bond that
benefits the bondholders in return for a lower coupon rate or just to induce the bond sellers to
make the initial loan. A puttable bond usually trades at a higher value than a bondwithout a
put option but with the same credit rating, maturity, and coupon rate because it is more valuable
to the bondholders.

FACTORS TO BE CONSIDERED WHILE SELECTING BONDS

1. Expected return and risk capacity: Before making any investment decision it is vital for any
investor to do a self- assessment of the risks involved. Identify your risk threshold and basis
this you can decide on an investment strategy that works out after considering your overall
target return on investment and potential cost of risk. This is crucial while decidingto invest
in high-yield bonds, investment-grade bonds, government bonds or a mix of all.

2. Maturity date and investment horizon: Investors should choose bonds after considering the
date of expected return and their investment horizon or the duration up to which they expect
to hold their investment. They should compare this to the maturity date of the bondsthey’re
considering for investment and choose accordingly.

3. Buy-back option of bond issuer: Another unique aspect of bonds is the buy-back option that
some issuers include in the bond investment terms. This allows the issuer to redeem thebonds
before the maturity date in response to market performance or falling interest rates. An investor
must evaluate this aspect while choosing bonds to invest in.

4. Debt Obligations of Bond Issuer: Bonds are issued by companies as a loan, so technically
investors are lending their funds to the bond issuer. So, you should evaluate the bond issuer
like anyone else you would be willing to give a loan to. The issuer should have a strong ability
to return the principal and interest as promised. In order to evaluate this, investors must track
past, present and future expected financial performance of the issuing company.

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5.Whether a bond is secured: One of the most important factors while investing in bonds is to
check if it’s secured or unsecured. This determines whether you will get your money back in
case the company defaults or claims insolvency.

INVESTMENT VS SPECULATION

HEDGE

To hedge, in finance, is to take an offsetting position in an asset or investment that reduces the
price risk of an existing position. A hedge is therefore a trade that is made with the purpose of
reducing the risk of adverse price movements in another asset. Normally, a hedgeconsists of
taking the opposite position in a related security or in a derivative security based on the asset
to be hedged.

Why Do You Need to Hedge?

Hedging is an important risk management technique for investors. It helps to minimize
potential losses and protect profits by offsetting risks associated with investments. There are
several reasons why investors may choose to hedge, including:
1. Protection against market volatility: Hedging can be used to protect against market
volatility, especially in unpredictable or uncertain market conditions. By hedging, investors can
limit their exposure to market risks and minimize potential losses.

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2. Diversification: Hedging can be a way to diversify an investment portfolio by offsetting
risks associated with specific assets or sectors. This can help to reduce the overall risk of the
portfolio and increase its stability.
3. Managing downside risk: By hedging, investors can manage downside risk, meaning they
can limit their losses in the event that the market moves against their position.

TYPES OF HEDGE STRATEGIES

Hedging strategies are diverse and vary depending on the asset being hedged, market
conditions, and the investor's risk tolerance. Here are some of the most common types of
hedging strategies:

1. Futures Hedging: Futures contracts are agreements to buy or sell an asset at a future date
and a predetermined price. Investors can use futures contracts to hedge against future price
changes in the underlying asset. For example, if an investor owns a stock and fears a drop in
its value, they could sell a futures contract at the current price to lock in the current value and
protect against a decline in the future.
2. Options Hedging: Options are contracts that give the buyer the right, but not the
obligation, to buy or sell an asset at a predetermined price on or before a specific date. Investors
can use options contracts to hedge against losses or to limit potential gains. For example, an
investor who owns a stock and wants to protect against a decline in its value can buy a put
option at a predetermined strike price. If the stock price drops below the strike price, the option
can be exercised, allowing the investor to sell the stock at the higher strike price.
3. Forward Contract Hedging: Forward contracts are similar to futures contracts but are
customized agreements between two parties. They involve buying or selling an asset at a
specific price and time in the future. Investors can use forward contracts to lock in a price for
an asset and protect against future price fluctuations.
4. Pair Trading: Pair trading involves taking long and short positions in two highly
correlated securities simultaneously. This strategy is used to profit from a difference in price
between two securities while reducing overall market risk.
5. Currency Hedging: Investors can use currency hedging strategies to protect against
fluctuations in foreign exchange rates. This involves using financial instruments such as futures
contracts, options contracts, or forward contracts to lock in a specific exchange rate.

SHORT AND LONG HEDGE

A short hedge is an investment strategy used to protect (hedge) against the risk of a declining
asset price in the future. Companies typically use the strategy to mitigate risk on assets they
produce and/or sell. A short hedge involves shorting an asset or using a derivative contract
that hedges against potential losses in an owned investment by selling at a specified price.

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A long hedge involves purchasing a futures contract (or other long position) to protect against
rising prices It is often used by manufacturers who require certain inputs and do notwant to
risk prices rising on those commodities.

Advantages of Hedging

 It can be used to secure profits.

 Allows merchants to endure difficult market conditions. 
 It significantly reduces losses.
 It enhances liquidity by allowing investors to invest in a variety of asset classes.
 It also saves time since the long-term trader does not have to monitor/adjust his portfolio
in response to daily market volatility. 
 It provides a more flexible pricing strategy since it necessitates a lesser margin
expenditure.
 On effective hedging, it provides the trader with protection from commodity price
changes, inflation, currency exchange rate changes, interest rate changes, and so on.
 Hedging using options allows traders to employ complicated options trading techniques
in order to optimize profit.
 It contributes to increased liquidity in financial markets.

Disadvantages of Hedging

 Hedging involves cost that can eat up the profit.

 Risk and reward are often proportional to one other; thus, reducing risk meansreducing
profits.

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 For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to
follow.
 If the market is performing well or moving sidewise, then hedging offer little benefits.
 Trading of options or futures often demand higher account requirements like more
capital or balance. 
 Hedging is a precise trading strategy and successful hedging requires good tradingskills
and experience. 

A cross hedge is used to manage risk by investing in two positively correlated securities that
have similar price movements. Although the two securities are not identical, they have enough
correlation to create a hedged position, providing prices move in the same direction. Cross
hedges are made possible by derivative products, such as commodity futures.

Hedging, Speculation and Arbitrage

Hedging is a risk management technique used to reduce any substantial losses or gains suffered
by an individual or an organisation. Suppose a long-term investor owns a portfolio of stocks
worth Rs 10 lakhs. The price movement of a stock is dependent both on the micro (profitability
of the company, its growth potential, business model, management competencyetc.) and the
macro factors (GDP growth of the country, interest rates, overall state of economy etc.). Such
an investor can hedge his portfolio by selling Index Futures (like Nifty future) and thereby
removing the risk of macro variables from his portfolio.

Arbitrage involves the simultaneous buying and selling of an asset in order to profit from small
differences in price. Often, arbitrageurs buy stock on one market (for example, a financial
market in the United States like the NYSE) while simultaneously selling the same stock on a
different market (such as the London Stock Exchange). Since arbitrage involves the
simultaneous buying and selling of an asset, it is essentially a type of hedge and involves limited
risk, when executed properly. Arbitrageurs typically enter large positions since they are
attempting to profit from very small differences in price.

Speculation, on the other hand, is a type of financial strategy that involves a significant amount
of risk. Financial speculation can involve the trading of instruments such as bonds,
commodities, currencies and derivatives. Speculators attempt to profit from rising and falling
prices. A trader, for example, may open a long (buy) position in a stock index futures contract
with the expectation of profiting from rising prices. If the value of the index rises, the trader
may close the trade for a profit. Conversely, if the value of the index falls, the trade might be
closed for a loss

BETA

Beta (β) is a measure of the volatility—or systematic risk—of a security or portfolio compared
to the market as a whole. Stocks with betas higher than 1.0 can be interpreted asmore volatile
than the S&P 500. The S&P 500 has a beta of 1.0.

Beta is used in the capital asset pricing model (CAPM), which describes the relationship
between systematic risk and expected return for assets (usually stocks). CAPM is widely used
as a method for pricing risky securities and for generating estimates of the expected returns of
assets, considering both the risk of those assets and the cost of capital.

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Portfolio beta

Portfolio beta is the measure of an entire portfolio’s sensitivity to market changes while stock
beta is just a snapshot of an individual stock’s volatility. Since a portfolio is a collection of
multiple stock holdings the formulas used to calculate beta for each will look different.
An investor looking to minimize risk and maximize overall return and value will want to
understand how to use both formulas. This is helpful when analyzing diversification and
making informed decisions on which investments will hurt or help your portfolio performance.

Settlement period in Indian Stock Market

The settlement cycle in stock markets refers to the time between the trade date, when an order
is executed in the market, and the settlement date, when participants exchange cash for
securities or shares. The day of the trade is known as the “trade date” and is signified as “T”.
On this day, the amount is deducted from the purchaser A/c and the broker provides him with
a contract note as a proof of the transactions. Earlier in 2003, the regulator had shortened the
settlement cycle from T+3 rolling settlement to T+2. Now regulator plans to reduce it further
to T+1 settlement cycle for completion of share transactions to enhance market liquidity.

TYPES OF PORTFOLIO STRATEGIES

Active Portfolio Strategy: An investor with an active strategy aims to beat the benchmark
returns. This is an investment approach where the investors use the forecasting and assumption
techniques to help determine the securities to purchase and gain profit. An investor who follows
this technique needs to be active in the market and make the trade frequently. The one who
uses the active portfolio strategy aims for the long-term moving capital consistently into
profitable securities.
Passive Portfolio Strategy: The passive strategy is the total opposite of the active strategy,
which is more of a hands-off approach. This strategy aims to track the market-weighted index
strategy, also known as the passive strategy or the ‘index investing.’ The investors who follow
this approach are the ones who believe that it is impossible to beat the market.

Aggressive Portfolio Strategy: Another portfolio strategy is the aggressive portfolio strategy
used by the risk-takers. As the name implies, the investment technique maximizes the returns
by taking a relatively higher risk. This is when an investor approaches to invest in expensive
stocks and provide great returns. Capital growth is the primary objective rather than

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preserving capital. The motive behind these investments is that ‘Big rewards carry big risk.’
These are the stocks chosen from the companies that have shown rapid growth and are expected
to generate rapid earnings over the next few years.

Defensive Portfolio Strategy: The other type of portfolio strategy is the defensive portfolio
strategy. It involves the collection of stocks after carefully observing the trends such as market
returns, earnings growth, and dividend history. In this, the investors are conservative about the
investments and the type of strategy they are willing to manage their portfolio. The ones on the
less risky side regularly balance their portfolio to maintain the intended asset allocation.

METHODS OF PORTFOLIO EVALUATION

Portfolio performance measures are a key factor in the investment decision. There are three
sets of performance measurement tools to assist with portfolio evaluations—the Treynor,
Sharpe, and Jensen ratios. Portfolio returns are only part of the story—without evaluating risk-
adjusted returns, an investor cannot possibly see the whole investment picture.

Treynor Measure: Jack L. Treynor was the first to provide investors with a composite measure
of portfolio performance that also included risk. Treynor's objective was to find aperformance
measure that could apply to all investors regardless of their personal risk preferences. Treynor
suggested that there were really two components of risk: the risk produced by fluctuations in
the stock market and the risk arising from the fluctuations of individual securities.

Treynor introduced the concept of the security market line, which defines the relationship
between portfolio returns and market rates of returns whereby the slope of the line measures
the relative volatility between the portfolio and the market (as represented by beta). The beta
coefficient is the volatility measure of a stock portfolio to the market itself. The greater the
line's slope, the better the risk-return tradeoff.

Sharpe Ratio: The Sharpe ratio is almost identical to the Treynor measure, except that therisk
measure is the standard deviation of the portfolio instead of considering only the systematic
risk as represented by beta. Conceived by Bill Sharpe, this measure closely follows his work
on the capital asset pricing model (CAPM) and, by extension, uses total risk to compare
portfolios to the capital market line.

The Sharpe ratio is defined as:

Sharpe ratio= 𝑃𝑅−𝑅𝐹𝑅
𝑆𝐷

where: PR=portfolio return, RFR=risk-free rate, SD=standard deviation

Jensen Measure: Similar to the previous performance measures discussed, the Jensen measure
is calculated using the CAPM. Named after its creator, Michael C. Jensen, theJensen measure
calculates the excess return that a portfolio generates over its expectedreturn. This measure of
return is also known as alpha.

The Jensen ratio measures how much of the portfolio's rate of return is attributable to the
manager's ability to deliver above-average returns, adjusted for market risk. The higher the
ratio, the better the risk-adjusted returns. A portfolio with a consistently positive excess return
will have a positive alpha while a portfolio with a consistently negative excess returnwill have
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a negative alpha.

The formula is broken down as follows:

Jenson’s alpha=PR−CAPM

where: PR=portfolio return, CAPM=risk-free rate+β(return of market risk-free rate of return)

Modigliani-Miller theorem (M&M): The Modigliani-Miller theorem (M&M) states that the
market value of a company is correctly calculated as the present value of its future earnings
and its underlying assets, and is independent of its capital structure.

At its most basic level, the theorem argues that, with certain assumptions in place, it is
irrelevant whether a company finances its growth by borrowing, by issuing stock shares, or by
reinvesting its profits. Developed in the 1950s, the theory has had a significant impact on
corporate finance.

Assumptions of the MM Model

• There are no taxes.

• Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
• There is a symmetry of information. This means that an investor will have access to thesame
information that a corporation would, and investors will thus behave rationally.
• The cost of borrowing is the same for investors and companies.
• There is no floatation cost, such as an underwriting commission, payment to merchant
bankers, advertisement expenses, etc.
• There is no corporate dividend tax.

CAPITAL ASSET PRICING MODEL

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk,
or the general perils of investing, and expected return for assets, particularly stocks. It is a
finance model that establishes a linear relationship between the required return on an
investment and risk. The model is based on the relationship between an asset's beta, the risk-
free rate (typically the Treasury bill rate), and the equity risk premium, or the expected return
on the market minus the risk-free rate.
CAPM evolved as a way to measure this systematic risk. It is widely used throughout finance
for pricing risky securities and generating expected returns for assets, given the riskof those
assets and cost of capital.

There are some limitations to the CAPM, such as making unrealistic assumptions and relying
on a linear interpretation of risk vs. return. Despite its issues, the CAPM formula isstill widely
used because it is simple and allows for easy comparisons of investment alternatives.

The formula for calculating the expected return of an asset given its risk is as follows:

ERi=Rf+βi (ERm−Rf)

Where: ERi=expected return of investment,

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Rf=risk-free rate

βi=beta of the investment (ERm−Rf) =market risk premium

The following are assumptions made by the CAPM model:

 All investors are risk-averse by nature.

 Investors have the same time period to evaluate information. 
 There is unlimited capital to borrow at the risk-free rate of return.
 Investments can be divided into unlimited pieces and sizes. 
 There are no taxes, inflation, or transaction costs.
 Risk and return are linearly related

Arbitrage Pricing Theory (APT)

Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an
asset's returns can be predicted using the linear relationship between the asset’s expectedreturn
and a number of macroeconomic variables that capture systematic risk. It is a useful tool for
analyzing portfolios from a value investing perspective, in order to identify securities that may
be temporarily mispriced.

The Formula for the Arbitrage Pricing Theory Model Is

iE(R)i=E(R)z+(E(I)−E(R)z) × βn

where: E(R)i=Expected return on the asset

Rz=Risk-free rate of return

βn=Sensitivity of the asset price to macroeconomic factor n

Ei=Risk premium associated with factor i

The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an
alternative to the capital asset pricing model (CAPM). Unlike the CAPM, which assume
markets are perfectly efficient, APT assumes markets sometimes misprice securities, before
the market eventually corrects and securities move back to fair value. Using APT, arbitrageurs
hope to take advantage of any deviations from fair market value.

WHAT IS AN IPO?
An initial public offering (IPO) refers to the process of offering shares of a private corporation
to the public in a new stock issuance for the first time. An IPO allows acompany to raise equity
capital from public investors.

The transition from a private to a public company can be an important time for private investors
to fully realize gains from their investment as it typically includes a share premiumfor current
private investors. Meanwhile, it also allows public investors to participate in the offering.

Companies must meet requirements by exchanges and the Securities and Exchange
Commission (SEC) to hold an IPO. IPOs provide companies with an opportunity to obtain
capital by offering shares through the primary market. Companies hire investment banks to
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market, gauge demand, set the IPO price and date, and more. An IPO can be seen as an exit
strategy for the company’s founders and early investors, realizing the full profit from their
private investment.

STEPS OF AN IPO

1. Proposals: Underwriters present proposals and valuations discussing their services,

the best type of security to issue, offering price, number of shares, and estimated time
frame for the market offering.
2. Underwriter: The company chooses its underwriters and formally agrees tounderwrite
terms through an underwriting agreement.
3. Team: IPO teams are formed comprising underwriters, lawyers, certified public
accountants (CPAs), and Securities and Exchange Commission (SEC) experts.
4. Documentation: Information regarding the company is compiled for required IPO
documentation. The S-1 Registration Statement is the primary IPO filing document. It
has two parts—the prospectus and the privately held filing information. The S-1
includes preliminary information about the expected date of the filing. It will be revised
often throughout the pre-IPO process. The included prospectus is also revised
continuously.
5. Marketing & Updates: Marketing materials are created for pre-marketing of the new
stock issuance. Underwriters and executives market the share issuance to estimate
demand and establish a final offering price. Underwriters can make revisions to their
financial analysis throughout the marketing process. This can include changing the IPO
price or issuance date as they see fit. Companies take the necessary steps to meet
specific public share offering requirements. Companies must adhere to both exchange
listing requirements and SEC requirements for public companies.
6. Board & Processes: Form a board of directors and ensure processes for reporting
auditable financial and accounting information every quarter.
7. Shares Issued: The company issues its shares on an IPO date. Capital from the primary
issuance to shareholders is received as cash and recorded as stockholders' equity on the
balance sheet. Subsequently, the balance sheet share value becomesdependent on the
company’s stockholders' equity per share valuation comprehensively.
8. Post IPO: Some post-IPO provisions may be instituted. Underwriters may have a
specified time frame to buy an additional number of shares after the initial public
offering (IPO) date. Meanwhile, certain investors may be subject to quiet periods.

IPO ALTERNATIVES

Direct Listing: A direct listing is when an IPO is conducted without any underwriters. Direct
listings skip the underwriting process, which means the issuer has more risk if the offering
does not do well, but issuers also may benefit from a higher share price. A direct offering is
usually only feasible for a company with a well-known brand and an attractive business.

Dutch Auction: In a Dutch auction, an IPO price is not set. Potential buyers can bid for the
shares they want and the price they are willing to pay. The bidders who were willing to pay
the highest price are then allocated the shares available.

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PERFORMANCE OF IPOs

Several factors may affect the return from an IPO which is often closely watched by investors.
Some IPOs may be overly hyped by investment banks which can lead to initial losses.
However, the majority of IPOs are known for gaining in short-term trading as they become
introduced to the public. There are a few key considerations for IPO performance.

Lock-Up: If you look at the charts following many IPOs, you'll notice that after a few months
the stock takes a steep downturn. This is often because of the expiration of the lock-up period.
When a company goes public, the underwriters make company insiders, such as officials and
employees, sign a lock-up agreement.

Lock-up agreements are legally binding contracts between the underwriters and insiders of the
company, prohibiting them from selling any shares of stock for a specified period. The period
can range anywhere from three to 24 months. Ninety days is the minimum period stated under
Rule 144 (SEC law) but the lock-up specified by the underwriters can last muchlonger. The
problem is, when lockups expire, all the insiders are permitted to sell their stock.The result is
a rush of people trying to sell their stock to realize their profit. This excess supply can put
severe downward pressure on the stock price.

Waiting Periods: Some investment banks include waiting periods in their offering terms. This
sets aside some shares for purchase after a specific period. The price may increase ifthis
allocation is bought by the underwriters and decrease if not.

Flipping: Flipping is the practice of reselling an IPO stock in the first few days to earn a quick
profit. It is common when the stock is discounted and soars on its first day of trading.

Tracking IPO Stocks: Closely related to a traditional IPO is when an existing company spins
off a part of the business as its standalone entity, creating tracking stocks. The rationale behind
spin-offs and the creation of tracking stocks is that in some cases individual divisionsof a
company can be worth more separately than as a whole. For example, if a division has high
growth potential but large current losses within an otherwise slowly growing company,
it may be worthwhile to carve it out and keep the parent company as a large shareholder then
let it raise additional capital from an IPO.

From an investor’s perspective, these can be interesting IPO opportunities. In general, a

spin-off of an existing company provides investors with a lot of information about the parent
company and its stake in the divesting company. More information available for potential
investors is usually better than less and so savvy investors may find good opportunities from
this type of scenario. Spin-offs can usually experience less initial volatility because investors
have more awareness.

MARKOWITZ MODEL OF RISK RETURN OPTIMIZATION

The Markowitz model is an investment technique. It is used to create a portfolio that would
yield maximized returns. In 1952, Harry Markowitz published his model in the Journal of
Finance. Markowitz is an American economist. He is considered the creator of the modern
portfolio theory. The theory is also known as the Markowitz Mean Variance Model.

The Markowitz model of portfolio suggests that the risks can be minimized through
diversification. Simultaneously, the model assures maximization of overall portfolio returns.
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Investors are presented with two types of stocks—low-risk, low-return, and high-risk, high-
return stocks. Risks are also divided into two—systematic risk and unsystematic risk. The
Harry Markowitz model uses mathematical calculations to reduce risks; it builds an ideal
portfolio.

Nonetheless, real-world investments cannot eliminate a certain level of risk. Thus, investors
must possess some risk appetite. New investors especially benefit from this theory—the
Markowitz model of portfolio popularized diversification. Not to mention the importance of
understanding and avoiding systematic portfolio risks.

On the downside, the limitations of Markowitz model stem from its overreliance on
assumptions. These flaws can make the conclusions irrelevant to prevailing market conditions.

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Assumptions

Markowitz’s assumptions are as follows:

 The model assumes that investors are rational and will always behave in a certain
manner.
 The model assumes that there are only two different types of assets—low returns and
high returns.
 Harry Markowitz argues that markets will always work in a certain direction and will
always be efficient. But this is not always the case.
 Diversification is important. But the theory assumes diversification is the only way to
minimize investment risks. 
 The Markowitz model of portfolio assumes that every investor has unlimited access to
information about market changes. In reality, investors often lack the time and expertise
to gather relevant data.
 Markowitz assumes that all investors are risk-averse, but that is not universally true.
 The model mentions a bracket of bearable loss—but not all real-world investors can
afford that.

Advantages And disadvantages

The advantages are as follows:

 The portfolio becomes resistant to systematic risk

 Diversification helps investors understand different sectors.
 Such portfolios suit both long-term wealth creation and short-term profits.
 A variety of financial instruments fit this investment strategy. 

The disadvantages are as follows:

 This approach is often called Markowitz Mean Variance Model. It is more inclined
towards variance and tends to overlook potential risks. 
 It does not guarantee good returns and is only based on historical data.
 The model does not account for associated costs like broker commissions, taxes, and
other charges. 
 The whole model is based on irrelevant stock market assumptions. In reality, stock
markets are as unpredictable as they are volatile. 

Why is the Markowitz Model important?

The important features of the Markowitz theory are as follows:

• It helps new amateur investors in creating a diversified portfolio.

• The theory aids in regulating risks to minimize losses. Simultaneously, the investments
run a good chance of registering lucrative profits.
• Investors can use the model to identify and replace nonperforming investments.

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EFFICIENT MARKET HYPOTHESIS (EMH)
The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is
a hypothesis that states that share prices reflect all information and
consistent alpha generation is impossible.

According to the EMH, stocks always trade at their fair value on exchanges, making it
impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.
Therefore, it should be impossible to outperform the overall market through expert stock
selection or market timing, and the only way an investor can obtain higher returns is by
purchasing riskier investments.

Proponents of EMH posit that investors benefit from investing in a low-cost, passive portfolio.
Opponents of EMH believe that it is possible to beat the market and that stockscan deviate
from their fair market values.

What Does It Mean for Markets to Be Efficient?

Market efficiency refers to how well prices reflect all available information. The efficient
markets hypothesis (EMH) argues that markets are efficient, leaving no room to make excess
profits by investing since everything is already fairly and accurately priced. This implies that
there is little hope of beating the market, although you can match market returns through
passive index investing.

Variation of the Efficient Market Hypothesis

Weak Form: The weak form suggests that today’s stock prices reflect all the data of past prices
and that no form of technical analysis can be effectively utilized to aid investors inmaking
trading decisions.

Advocates for the weak form efficiency theory believe that if the fundamental analysis isused,
undervalued and overvalued stocks can be determined, and investors can research companies'
financial statements to increase their chances of making higher-than-market- average profits

Semi-Strong Form: The semi-strong form efficiency theory follows the belief that becauseall
information that is public is used in the calculation of a stock's current price, investors cannot
utilize either technical or fundamental analysis to gain higher returns in the market.

Those who subscribe to this version of the theory believe that only information that is not
readily available to the public can help investors boost their returns to a performance level
above that of the general market.

Strong Form: The strong form version of the efficient market hypothesis states that all
information—both the information available to the public and any information not publicly
known—is completely accounted for in current stock prices, and there is no type of information
that can give an investor an advantage on the market.
Advocates for this degree of the theory suggest that investors cannot make returns on
investments that exceed normal market returns, regardless of information retrieved or research
conducted.

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FINANCIAL MODEL
Financial modeling is the process of creating a summary of a company's expenses and earnings
in the form of a spreadsheet that can be used to calculate the impact of a future event or
decision.

A financial model has many uses for company executives. Financial analysts most often use
it to analyze and anticipate how a company's stock performance might be affected by future
events or executive decisions. Financial analysts use them to explain or anticipate the impact
of events on a company's stock, from internal factors such as a change of strategy or business
model to external factors such as a change in economic policy or regulation.

Financial models are used to estimate the valuation of a business or to compare businesses to
their peers in the industry. They also are used in strategic planning to test various scenarios,
calculate the cost of new projects, decide on budgets, and allocate corporate resources

MUTUAL FUND
A mutual fund is a financial vehicle that pools assets from shareholders to invest in securities
like stocks, bonds, money market instruments, and other assets. Mutual funds areoperated by
professional money managers, who allocate the fund's assets and attempt to produce capital
gains or income for the fund's investors. A mutual fund's portfolio is structured and maintained
to match the investment objectives stated in its prospectus.

Mutual funds give small or individual investors access to professionally managed portfoliosof
equities, bonds, and other securities. Each shareholder, therefore, participates proportionally
in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and
performance is usually tracked as the change in the total market cap of the fund—derived by
the aggregating performance of the underlying investments.

TYPES OF MUTUAL FUND

There are several types of mutual funds available for investment, though most mutual funds
fall into one of four main categories which include stock funds, money market funds, bond
funds, and target-date funds.

1.) Stock Funds: As the name implies, this fund invests principally in equity or stocks.
Within this group are various subcategories. Some equity funds are named for the sizeof
the companies they invest in: small-, mid-, or large-cap.

2.) Bond Funds: A mutual fund that generates a minimum return is part of the fixed income
category. A fixed-income mutual fund focuses on investments that pay a set rate of
return, such as government bonds, corporate bonds, or other debt instruments. These
funds are often actively managed and seek to buy relatively undervalued bonds in order
to sell them at a profit. These mutual funds are likely to pay higher returns and

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bond funds aren't without risk. For example, a fund specializing in high-yield junkbonds
is much riskier than a fund that invests in government securities.

3.) Index Funds: Index Funds invest in stocks that correspond with a major market index
such as the S&P 500 or the Dow Jones Industrial Average (DJIA). This strategy requires
less research from analysts and advisors, so there are fewer expenses passed on to
shareholders and these funds are often designed with cost-sensitive investors inmind.

4.) Balanced Funds: Balanced funds invest in a hybrid of asset classes, whether stocks,
bonds, money market instruments, or alternative investments. The objective of this fund,
known as an asset allocation fund, is to reduce the risk of exposure across asset classes.

5.) Money Market Funds: The money market consists of safe, risk-free, short-term debt
instruments, mostly government Treasury bills. An investor will not earn substantial
returns, but the principal is guaranteed. A typical return is a little more than the amount
earned in a regular checking or savings account and a little less than the
average certificate of deposit (CD).

6.) Income Funds: Income funds are named for their purpose: to provide current incomeon
a steady basis. These funds invest primarily in government and high-quality corporate
debt, holding these bonds until maturity to provide interest streams. While fund holdings
may appreciate, the primary objective of these funds is to provide steady cash flow to
investors. As such, the audience for these funds consists of conservative investors and
retirees.
7.) International/Global Funds: An international fund, or foreign fund, invests only in assets
located outside an investor's home country. Global funds, however, can invest anywhere
around the world. Their volatility often depends on the unique country's economy and
political risks. However, these funds can be part of a well-balanced portfolio by
increasing diversification, since the returns in foreign countries may be uncorrelated with
returns at home.

EXCHANGE TRADED FUNDS (ETFs)

A twist on the mutual fund is the exchange-traded fund (ETF). They are not considered mutual
funds but employ strategies consistent with mutual funds. They are structured as investment
trusts that are traded on stock exchanges and have the added benefits of the features of stocks.

ETFs can be bought and sold throughout the trading day. ETFs can also be sold short or
purchased on margin. ETFs also typically carry lower fees than the equivalent mutual fund.
Many ETFs also benefit from active options markets, where investorscan hedge or leverage
their positions.

ETFs also enjoy tax advantages from mutual funds. Compared to mutual funds, ETFs tend to
be more cost-effective and more liquid.

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MERGERS AND ACQUISITIONS

PROCESS OF M & A (Mergers and Acquisition)

The M&A Process is a multi-step process and can be short depending on the size and
complexity of the transaction involved. Mergers and Acquisitions are part of company
operations. Two entities combine their assets fully or in part to form a new entity or function
as one or the other.

We’ve divided this into eight broad steps:

1.) Developing Strategy: The M&A process starts with developing a strategy that involves
various aspects. First, the buyer identifies the motivation behind the mergers and
acquisitions transaction process, the type of transaction they want to conduct, and the
amount of capital they are willing to spend for this transaction. These are some factors
that the buyer considers while developing the strategy.

2.) Identifying and Contacting Targets: After the buyer has developed the M&A strategy,
they start identifying potential targets in the market that fit their criteria. Finally, a list of
all potential targets is made, and the buyer starts contacting the targets to express interest
in them. The main purpose of this step is to obtain more information about thetargets and
measure their level of interest in such a transaction.

3.) Information Exchange: After the initial conversation goes well and both the parties have
shown interest in going ahead with the transaction, they begin the initial documentation,
which generally includes submission of a Letter of Intent to officially express interest in
the transaction and signing a confidentiality document assuring that the proceedings and
discussions of the deal will not go out. After that, the entities exchange information such
as financials, company history, etc., so that both parties can better assess the deal’s
benefits to their respective shareholders.

4.) Valuation and Synergies: After both sides have more information about the counterparty,
they begin an assessment of the target and the deal as a whole. The seller is trying to
determine a good price that would result in the shareholders gaining from the deal. The seller
is trying to assess a reasonable offer for the target. The buyer
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is also trying to assess the extent of synergies in M&A that they can gain from this
transaction in forms of cost reduction, increased market power, etc.

5.) Offer and Negotiation: After the buyer has completed their valuation and assessment, they
submit an offer to the shareholders of the target. This offer could be a cash offer or a stock
offer. The seller analyzes the offer and negotiates for a better price if they feel that the
offer is not reasonable. This step can take a long time to be completed because neither
party wants to give the upper hand to the other by showing their hurry to close the deal.
So often, there is competition among the buyers to offer a better price and terms to the
target.

6.) Due Diligence: After the target has accepted the offer from the buyer, the buyer begins
due diligence of the target entity. Due diligence consists of a thorough review of every
aspect of the target entity, including products, customer base, financial books, human
resources, etc. The objective is to ensure that there are no discrepancies in the information
provided earlier to the buyer and based on which the offer was made. If some
discrepancies come up, it could lead to a bid revision to justify the actual information.

7.) Purchase Agreement: Assuming that everything has gone well, including the government
approvals and no antitrust laws kicking in, both parties begin drafting the final agreement,
which outlines the cash/stock that would be given to the target shareholders. It also
includes when such a payment would be made to the target shareholders.

8.) Deal Closure and Integration: After the purchase agreement has been finalized, both
parties close the deal by signing the documents, and the buyer gains control of the target.
After the deal’s closure, the management teams of both entities work together to integrate
them into the merged entity.

IMPORTANCE OF CAPITAL STRUCTURE

Calculating and managing a capital structure is required for growing a business. Severalsalient
features need to be considered while creating the structure. Some of these are:

 A capital structure must be designed in a way so that the value of the company is higher
than the cost of capital

 The perfect evaluation assures the most economical and safe ratio between different
policies

 Those structures are more preferred if they provide the minimum risk factor

 An optimal capital structure must be straightforward and flexible according to the

market conditions

 It must involve rules, terms, and conditions which are attractive and efficient

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 An optimal capital structure must correlate with all legal requirements to prevent the
hassle

CAPITAL STRUCTURE AND ITS THEORIES

Capital structure theory refers to a systematic approach to financing business activities through
a combination of equities and liabilities. There are several competing capital structure theories,
each of which explores the relationship between debt financing, equity financing, and the
market value of the firm slightly differently. Capital structure is also referred to as the degree
of debts in the financing or capital of a business firm.

1.) Net income Approach: David Durand first suggested this approach in 1952, and hewas
a proponent of financial leverage. He postulated that a change in financial leverage
results in a change in capital costs. In other words, if a company takes on more debt to
leverage investments, its capital structure increases in size and
the weighted average cost of capital (WACC) decreases, which results in higher firm
value. It postulates that the market analyses a whole firm, and any discount has no
relation to the debt-to-equity ratio. If tax information is provided, it states that WACC
decreases with an increase in debt financing, and the value of a firm will increase.

In this approach to Capital Structure Theory, the cost of capital is a function of the
capital structure. It's important to remember, however, that this approach assumes
an optimal capital structure. Optimal capital structure implies that at a certain ratio of
debt and equity, the cost of capital is at a minimum, and the value of the firm is at a
maximum.

2.) Modigliani and Miller's Approach: The M&M theorem is a capital structure approach
named after Franco Modigliani and Merton Miller in the 1950s. Modigliani and Miller
were two professors who studied capital structure theory and collaborated to develop
the capital-structure irrelevance proposition. This proposition states that in perfect
markets, the capital structure a company uses doesn't matter because the market value
of a firm is determined by its earning power and the risk of its underlying assets.
According to Modigliani and Miller, value is independent of the method of financing
used and a company's investments. The M&M theorem made two propositions:

 Proposition I: This proposition says that the capital structure is irrelevant to the value
of a firm. The value of two identical firms would remain the same, and value would
not be affected by choice of finance adopted to finance the assets. The value of a firm
is dependent on the expected future earnings. It is when there are no taxes. 
 Proposition II: This proposition says that the financial leverage boosts the value of a
firm and reduces WACC. It is when tax information is available. 

Assumptions of Modigliani- Miller Approach

 There is no transaction cost.

 Information is available to all without cost.
 Investors are free to purchase and sell securities.

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 Taxes do not exist.
 The dividend pay-out ratio is 100 % i.e., no retained earnings.

3.) Net operating income theory: Also known as the irrelevant theory, it was also postulated
by David Durand. It depicts that the company’s market value is not affected by changes
in the capital structure. The value of the firm and its overallcost of capital remains
same irrespective of the proportion of debt (or financial leverage) in capital
structure. Assumptions are as follows −
 Debt and equity are source of financing.
 Dividend pay-out ratio is 1.
 No taxes.
 No retained earnings.
 Constant debt capitalisation.
 Constant WACC.
 Difference between firm value and value of debt is value of equity.
 Cost of equity is larger than cost of debt.

4.) Traditional theory: The traditional theory was postulated by Ezra Solomon. The
assumptions of this approach are quite related to the net income theory. The main
principle behind this theory was to increase the proportion of debt to a certain limit in
the capital structure. The traditional theory of capital structure states that when
the weighted average cost of capital (WACC) is minimized, and the market value of
assets is maximized, an optimal structure of capital exists. This is achieved by utilizing
a mix of both equity and debt capital. This point occurs where the marginal cost of debt
and the marginal cost of equity are equated, and any other mix of debt and equity
financing where the two are not equated allows an opportunity to increase firm value
by increasing or decreasing the firm’s leverage.

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SHARE CAPITAL
Share capital is the money a company raises by issuing common or preferred stock. Theamount
of share capital or equity financing a company has can change over time with additional public
offerings.

DIFFERENT TYPES OF SHARE CAPITAL:

1.) Authorized Share Capital: The total capital that a corporation accepts from its investors
by issuing shares that are listed in the firm’s official documents is known as authorized
share capital. Because a corporation is registered with this capital, it is also known as
Registered Capital or Nominal Capital. The firm has the authority to take the necessary
actions to expand the limit of authorized capital in order to issue more shares, but it is not
permitted to issue shares that exceed the limit of authorized capital in any case.
Issued Share + Unissued Share = Authorized Share.

2.) Issued Share Capital: The portion of Authorized Share Capital that is issued to the public
for subscription is known as Issued Share Capital. Issuance, allocation, or allotment are
the terms used to describe the act of issuing shares. To put it another way, Issued Share
Capital is the subset of Authorized Share Capital. A subscriber becomes ashareholder after
the allotment of shares.

3.) Unissued Share Capital: Companies, as previously stated, commonly issue shares from
time to time. As a result, their authorized and issued share capital will differ. The difference
between the two sums will be the company’s unissued share capital. This unissued capital
refers to the number of shares that a firm has available to raise capital.

4.) Subscribed Capital: The portion of issued capital that has been sold to the public is known
as subscribed capital. It is not necessary for the issued Capital to be fully subscribed by
the general public. It is the portion of the issued capital for which the corporation has
received an application. Let’s look at an example: If a firm issues 16000 shares of one
hundred rupees each and the public only applies for 12000, the issued capital is Rs 16 lakh
and the subscribed capital is Rs 12 lakh. The total number of outstanding and treasury
shares is equal to the number of issued shares

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5.) Called-Up Capital: Called-up Capital is the portion of the Subscribed Capital that
comprises the shareholder’s payment. The capital is not given to the company in its whole
at once. It makes use of a portion of the subscribed capital when it is required in
instalments. Uncalled Capital refers to the remainder of the Subscribed Capital.

6.) Paid-Up Capital: Paid-up Capital is the portion of Called-up Capital that is paid by the
shareholder. The shareholder does not have to pay the sum requested by the corporation.
The shareholder may pay half of the called-up Capital, referred to as Reserved Capital, to
the company.

7.) Uncalled Share Capital: When a company issue shares to its shareholders, it expects them
to pay for them. They may, however, choose not to do so. Uncalled share capital refers to
shares that have been issued but not yet been claimed. This capital also refers to the
shareholders’ contingent liabilities. It is the remaining amount after deducting the called-
up capital from the total number of shares allotted.

8.) Reserve Share Capital: Reserve capital is the amount of stock that a firm can’t sell unless
it goes bankrupt. These shares are usually issued following a special resolution that
receives more than three-quarters of the vote. Companies, likewise, cannot changetheir
articles of incorporation to overturn this choice. Reserve share capital serves a specific
purpose: to make liquidation easier.

9.) Fixed and circulating share capital: A company’s subscribed capital includes circulating
share capital. Operational assets, such as bank reserves, book debts, invoices receivable,
and so on, provide this capital. These funds comprise funds used for a company’s
fundamental operations. Fixed capital, which is made up of a company’s fixed assets, is
also closely related.

CONCEPTS OF VALUE IN BUSINESS VALUATION

a.) Fair market value is to be used in all instances where a business is valued for estate tax
purposes. The value of the entity is based on a price that would be reached in a
transaction between a hypothetical buyer and seller in an arm’s-length transaction.

b.) Fair value arises in instances where shareholders seek a resolution for damages, they
incur from actions taken by the management of a company. When utilizing fair value,
the value of a company is determined at a point in time immediately preceding the
action that resulted in the erosion of the stock’s value.

c.) Investment value is a value that is determined between specific parties subject to the
transaction, rather than hypothetical parties. The analyst considers the proposed use of
the business by the acquirers, their potential economic benefit stream, and their
required rate of return in determining a value.

d.) Book value- it means the value of a business, as reflected in the audited financial
statements of an enterprise.

e.) Intrinsic Value- It is the total value of business after considering all hidden and latent
facts. It is also defined as the present value of future earnings.

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f.) Replacement Value- It is the cost of acquiring a new asset of equal utility.

g.) Salvage Value- The amount realisable upon sale or other disposition of an asset after
it is no longer useful to the current owner and is to be taken out of service.

h.) Going Concern Value- Going concern value is a value that assumes the companywill
remain in business indefinitely and continue to be profitable. Going concern value is
also known as total value.

WORKING CAPITAL

Working capital, also known as net working capital (NWC), is the difference between a
company’s current assets—such as cash, accounts receivable/customers’ unpaid bills, and
inventories of raw materials and finished goods—and its current liabilities, such as accounts
payable and debts. It's a commonly used measurement to gauge the short-term health of an
organization. High working capital isn’t always a good thing. It might indicate that the business
has too much inventory, not investing its excess cash, or not capitalizing on low- expense debt
opportunities.

Working capital is also a measure of a company’s operational efficiency and short-term

financial health. If a company has substantial positive NWC, then it could have the potential
to invest in expansion and grow the company. If a company’s current assets do not exceed its
current liabilities, then it may have trouble growing or paying back creditors. It might even go
bankrupt.

Limitations of Working Capital

Working capital can be very insightful to determine a company's short-term health. However,
there are some downsides to the calculation that make the metric sometimes misleading.

 Working capital is always changing. If a company is fully operating, it's likely that
several—if not most—current asset and current liability accounts will change. Therefore,
by the time financial information is accumulated, it's likely that the working capital position
of the company has already changed.

 Working capital fails to consider the specific types of underlying accounts. For example,
imagine a company whose current assets are 100% in accounts receivable. Though the
company may have positive working capital, its financial health depends on whether its
customers will pay and whether the business can come up with short-term cash.

 On a similar note, assets can quickly become devalued. Accounts receivable balances may
lose value if a top customer files for bankruptcy. Inventory is at-risk
of obsolescence or theft. Physical cash is also at risk of theft. Therefore, a company's
working capital may change simply based on forces outside of its control.

 Working capital assumes all debt obligations are known. In mergers or very fast-paced
companies, agreements can be missed or invoices can be processed incorrectly. Working
capital relies heavily on correct accounting practices, especially surrounding internal
control and safeguarding of assets.

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Types of Working Capital

The following is a list of factors that influence a company’s working capital.

 Policy on Credit: If a corporation extends easy credit terms to its consumers, it invests
in long-term accounts receivable

 Tightening the lending rules can lower this investment, but some consumers may be
turned away

 Rate of Change: Fast-expanding companies tend to increase their investments in

accounts receivable and inventories

 Working capital will continue to rise until the company’s revenues are large, making it
impossible to pay for these receivables and inventories

 A company’s working capital needs will decrease when its revenue declines; this frees
up cash

 Terms of Payment for Payables: A corporation can save money on working capital by
receiving a free loan from its suppliers by negotiating longer payment terms

 Working capital measures how much money a company has available to spend

 Flowchart of the Manufacturing Process: Inventories tend to balloon when companies

overestimate their production requirements and underestimate actual demand

 A just-in-time system, on the other hand, only manufactures things when they are
ordered, reducing the need for inventory

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 Seasonality: An inventory asset may be necessary if a firm sells most of its products in
one year

 Outsourcing labour or paying more for items to be manufactured at the last minute
might lessen this investment in inventory

Composition of working capital

Working Capital = Current Assets - Current Liabilities

-Current assets are cash, accounts receivable, short-term investments, and inventory

-If most of the value of current assets is in A/R and inventory, that may make the working
capital number look good, but to actually get at that working capital the entity would have to
collect on some accounts and/or sell some inventory

-both of which can take time. Management of working capital means managing different
components of current assets and current liabilities.

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

• Controlling the level of cash

• Controlling inflows of cash

• Controlling outflows of cash

• Optimum use of surplus cash

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

goods. There are three major motives for holding inventories, namely, transaction motive,
precautionary motive and speculative motive. But, holding inventories involves costs, i.e.,
ordering costs and carrying costs. Hence, inventories need to be maintained at an optimum size.
Inventory management is a trade-off between cost of acquiring and cost of holding inventories.

Management of Accounts Receivable: Like inventories, maintaining accounts receivable also

involves certain costs such as capital costs, administrative costs, collection costs and defaulting
costs, i.e., bad debts. The size of accounts receivable depends on the level of sales, credit policy,
terms of trade, efficiency of collection, etc. A larger size of accounts receivable increases
profitability and reduces liquidity and vice versa. Therefore, accounts receivable

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need to be maintained at an optimum size. The optimum size of accounts receivable occurs at
a point where there is a ―trade-off between profitability and liquidity.

Management of Accounts Payable: Accounts payable emerges due to credit purchase. The
underlying objective of accounts payable is to slow down the payments process as much as
possible. But it should be noted that the saving of interest cost should be offset against loss of
credit standing of the enterprise. The enterprise has, therefore, to ensure that the payments to
the creditors are made at the stipulated time periods after obtaining the best credit terms
possible. The salient points to be noted on effective management of accounts payable are:

• Obtain most favourable credit terms with the prevailing credit practice

• Make payments on maturity or due dates

• Keep good track record of past dealings with the suppliers

• Avoid tendency to divert payables

• Provide full information to the suppliers

• Keep a constant check on incidence of delinquency

IS NEGATIVE WORKING CAPITAL BAD?

It depends. Generally, it is bad if a company's current liabilities balance exceeds its current
asset balance. This means the company does not have enough resources in the short-term to
pay off its debts, and it must get creative in finding a way to make sure it can pay its short-
term bills on time. A short-period of negative working capital may not be an issue depending
on a company's place in its business life cycle and if it is able to generate cash quickly to pay
off debts.

Negative working capital

Negative working capital is formed either when short term liabilities are used for long term
purposes or current assets faces a blow e.g., current liabilities or funds used for long term assets,
abnormal loss of inventory, bad debts, consistently selling goods at loss etc. For working
capital to go negative current assets must go below the current liabilities and it canhappen in
following four situations.

1.) Abnormal Loss in Inventory: If there is a loss in inventory due to wastage of material,
fire in the store, theft, etc. or any such reason which will diminish the value of inventory
in the balance sheet will result in negative working capital. If the goods are lying in store
for long and company is not able to sell, the value will deteriorate.
2.) Bad Debts: If a company faces a lot of bad debts, it can lead to Negative Working
Capital. It may be because of bad selection of customers, credit extension to customers
with bad credit records, excessively aggressive selling approach etc.

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3.) Goods Sold at Loss Consistently: If we are selling at negative margin, it will takecurrent
assets below the current liabilities
4.) Cash Used for Investing in Fixed Assets: Using cash from Retained Earnings to invest
in fixed assets or long-term investments.

WHAT IS DELISTING?
Delisting is the removal of a listed security from a stock exchange. The delisting of a security
can be voluntary or involuntary and usually results when a company ceases operations,
declares bankruptcy, merges, does not meet listing requirements, or seeks to become private.

What Are Common Reasons Companies Get Delisted?

While there is no infallible method to predict stock delisting, there are certain warning
indicators that may suggest that a stock is at risk of being removed from trading. These were
discussed briefly above; below is a more comprehensive list of indicators that may indicate
when a company's stock may be delisted. Be mindful that this list may not be exhaustive.

 Regulatory Compliance: If a company fails to meet the listing standards specified by

the stock exchange such as maintaining a minimum share price, a minimum market
capitalization, or publishing regular financial reports, the company runs the risk of
being delisted.
 Financial Difficulty: Companies that are facing financial difficulties such as dropping
sales, mounting debts, or sustained losses may be at a higher risk of havingtheir stock
delisted from the market.
 Legal Problems: Serious violations of regulatory standards might result in delisting.
Examples of such violations include fraud, accounting issues, or a failure to comply
with applicable securities laws. 
 Bankruptcy: Delisting of a firm's Stock may result from bankruptcy or considerable
reorganization. If a firm declares bankruptcy or goes through considerable
reorganization, the stock of that company may be delisted.
 Low Trading Volumes: Stocks that have persistently low trading volumes may be at
risk of being delisted, as exchanges frequently have minimum requirements in place to
ensure investor interest and sufficient liquidity. 
 Governance Standards: A failure to comply to standards for corporate governance,
such as having an insufficient number of independent directors or an ineffective audit
committee, may both raise concerns and lead to delisting of the company. 
 Changes in Listing Requirements: There may be changes to the listing requirements
of the exchange where the stock is listed, and these changes might put corporations at
danger of delisting if they fail to meet the new criteria within the allotted amount of
time.

Can a Delisting Be Good for a Company?

Delisting isn’t always as bad as people make it out to be. Many household names havechosen to delist
their shares and go private for good reason. And some, such as Dell, prospered from the benefits of
being private.

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Can a Delisted Company Get Re-Listed?

Yes, it is possible for a delisted company to get re-listed. A lot depends on the circumstances
of being delisted. Those forced to leave often find it difficult to get their affairs back in order
and bounce back, especially without the funding opportunities that the stock market provides.

VALUATION MODELS

1.) Absolute valuation models attempt to find the intrinsic or "true" value of an investment
based only on fundamentals. Looking at fundamentals simply means youwould only focus
on such things as dividends, cash flow, and the growth rate for a single company, and not
worry about any other companies. Valuation models that fall into this category include the
dividend discount model, discounted cash flow model, residual income model, and asset-
based model.

a.) Dividend Discount Model: The Dividend Discount Model, also known as DDM, is in
which stock price is calculated based on the probable dividends that one will pay. They will
be discounted at the expected yearly rate. It is a way of valuing a company based on the
theory that a stock is worth the discounted sum of all of its future dividend payments. In
other words, it is used to evaluate stocks based on the net present value of future dividends.
The primary advantage of using dividends as the definition of cash flows is that it is
theoretically justified. The shareholders’ investment today is worth the present value of the
future cash flows he expects to receive, and ultimately, he will be repaid for his investment
in the form ofdividends. In DDM, value of company for shareholders is the present value of
all expected future dividends, discounted at the cost of equity.

Dividends are appropriate as a measure of cash flow in the following cases: -

 The company has a history of dividend payments.

 The dividend policy is clear and related to the earnings of the firm.

V0= D1/(1+RE) + D2/(1+RE) 2 + …+Dn/(1+RE) n

Where, V0 = Equity value at time 0 (present moment)

D1= Dividend expected to be received at the end of year 1

Re= Cost of equity (required rate of return for this stock)

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b.) Residual income: Residual income is the money that continues to flow after an initial
investment of time and resources has been completed. Examples of residual income include
artist royalties, rental income, interest income, and dividend payments.

The term residual income is used in other contexts:

 In personal finance, residual income can refer to an individual's discretionary income,

or the total amount of money left over after paying all personal debts andobligations.
 In corporate finance, residual income is a measurement of corporate performancethat
reflects the total income generated after paying all relevant costs of capital. 

The residual income approach is most suitable for:

 Firms that don’t have dividend histories.

 Firms that have negative free cash flow for the foreseeable future.
 Firms with transparent financial reporting and high-quality earnings.

Residual Income vs. Passive Income

The differences are subtle. Residual income may be passive income but passive income isn't
necessarily residual.

In personal finance, passive income may be derived from stock dividends or from renting a
room on Airbnb. There was an initial outlay of money to buy the stocks or the house, but a
tangential benefit that costs little in additional time or effort has been derived from the initial
investment. It is residual income as well as passive income.

 Passive income is earned with little or no effort required after the initial investment.
 Residual income, for an individual, means the free cash available for spending after all
obligations are met.

Is Residual Income Taxable?

Yes, almost all residual income is taxable. Maybe the income from some tax-exempt municipal
bonds is not taxed. Otherwise, whether you got the tax from stock dividends orrenting your
spare bedroom, it's taxable income.

c.) Free cash flow (FCF): FCF is the money a company has left over after paying its
operating expenses (OpEx) and capital expenditures (CapEx). The more free cash flowa
company has, the more it can allocate to dividends, paying down debt, and growth
opportunities. There are several ways to calculate free cash flow, including using
operating cash flow, using sales revenue, and using net operating profits. If a company
has a decreasing free cash flow, that is not necessarily bad if the company is investing in
its growth. Free cash flow is just one metric used to gauge a company’s financial health;
others include return on investment (ROI), debt-to-equity (D/E) ratio, and earnings per
share (EPS).

Free Cash Flow= Operating Cash Flow −Capital Expenditures

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Advantages and Disadvantages of Free Cash Flow

Pros

 Provides insight into a company's financial health

 Shows a company can pay its debts
 Can indicate future growth

Cons

 Capital expenditures can vary greatly from year to year

 High FCF may disguise a lack of investment in assets or equipment

d.) Discounted Cash Flow (DCF): Discounted cash flow (DCF) analysis is a method of
valuing the intrinsic value of a company (or asset). In simple terms, discounted cash flow
tries to work out the value today, based on projections of all of the cash that it could make
available to investors in the future. It is described as "discounted" cash flow because of
the principle of "time value of money" (i.e., cash in the future is worth less than cash
today).

The advantage of DCF analysis is that it produces the closest thing to an intrinsic stock
value - relative valuation metrics such as price-earnings (P/E) or EV/EBITDA ratios aren't
very useful if an entire sector or market is overvalued. In addition, the DCF method is
forward- looking and depends more on future expectations than historical results. The
method is also based on free cash flow (FCF), which is less subject to manipulation than
some other figures and ratios calculated out of the income statement or balance sheet. The
steps involved are as follows:

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

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

C. Calculate Discount Rate

D. Calculate the Terminal Value

E. Calculate fair value of company and its equity

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EQUITY

WHAT IS EQUITY?

Equity is the amount of money that is invested into the business by the proprietor. Also, known
as Owner’s equity as well as shareholders equity. As per the accounting equation, it is calculated
by deducting total liabilities from the total assets of the company.
EQUITY = ASSETS – LIABILITIES
E.g. – If the company has issued 10,000 shares and each share was worth Rs.20 then the total
value of Equity will be Rs. 2,00,000.

WHAT IS AN EQUITY MARKET?

An equity market is a platform where the issuers of equity as well as the investors come together
in order to purchase and sell shares. Shares are issued or traded on the stock exchanges as well
as over the counter markets.

PARTICIPANTS IN AN EQUITY MARKET

 Individual Investors and traders – An investor is someone who invests their money
in the stock market with the purpose of getting financial returns on the same. An
investor can either be active or passive.
1. An active investor is a regular investor who checks for various investment
opportunities in the market to increase wealth.
2. In contrast, a passive investor is someone who thinks about the long-term
benefits of investments following a buy-and-hold strategy.

 Regulators – The Ministry of Finance setup a body on 12th April 1988 to regulate the
stock exchanges in India known as The Securities and Exchange Board of India (SEBI).
The primary purpose of SEBI is to ensure the smooth functioning of the stock exchanges
and protection of the interests of the investors.

 Stock exchanges – Stock exchange is a medium where traders and investors can buy
or sell securities, including stocks, bonds, and other financial instruments. The stock
exchanges are regulated by the Securities and Exchange Board of India (SEBI).

1. Bombay stock exchange (BSE) – It is the oldest stock exchange in India and
the tenth oldest in the world. BSE was established in 1875 in Mumbai by a
cotton merchant called Premchand Roychand. The index of the BSE is known
as SENSEX30. It considers the top 30 companies listed on the exchange as per
market capitalization.
2. National stock exchange (NSE) – With headquarters in Mumbai, the NSE was
India’s first stock exchange which was entirely electronic. The Index of the NSE
is known as NIFTY50. It considers the top 50 companies listed on the exchange
as per market capitalization.

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 Companies – Those companies that issue shares on the stock exchange are known as
listed companies. Investors and traders can purchase or sell shares of such companies.
As of January, 2023 a total of 5311 companies were listed on the Bombay stock
exchange (BSE) and 2,113 companies were listed on the National stock exchange
(NSE).

 Foreign Institutional Investors - A foreign institutional investor is an investor in a

financial market outside its official home country. Developing countries like India see
a high volume of FII since they have a high growth potential. All FIIs in India must
register with the Securities and Exchange Board of India (SEBI) to participate in the
market.

 Market Intermediaries –

1. Brokers - A broker is an individual or firm that acts as an intermediary between

an investor and a securities exchange. Brokers are the only ones who are allowed
to place orders on the stock exchange since they are members of the same.
Therefore, Investors and traders seek the services of such brokers.

2. Clearing House – A clearing house is an intermediary that provides security

and efficiency to the transaction by ensuring that both the buyer and the seller
honour their contractual obligations.

3. Clearing Members – They help clear and settle the deals that have been
executed by trading members.

4. Clearing Bank – They are commercials banks that act as a bridge between a
clearing member and a clearing corporation. Their primary objective is to ensure a
quick transfer of money from the payers account to the payee’s account.

5. Depositories – Just like a bank holds your funds, a depository holds your
financial assets. Earlier these assets used to be in the form of a physical
certificate but now these have been turned into digital certificates known as a
DEMAT Certificate. In India, there are two depositories –

National Securities Depository Limited (NSDL) - NSDL was set up by the

National Stock Exchange in 1996 and headquartered in Mumbai. In order to be
registered with NSDL DPs should have a minimum net worth of Rs.3 crores.

Central Depository Services Limited (CDSL) - CSDL was set up by the

Bombay Stock Exchange in 1999 and headquartered in Mumbai. In order to be
registered with CDSL DPs should have a minimum net worth of Rs.2 crores.

6. Depository Participants (DPs) – They are the ones who connect the
depositories to the Investors by opening accounts of the investors in the
depository they are registered with.

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7. Credit Rating Agencies (CRA) – A CRA is a company that assesses the
creditworthiness of a borrower by evaluating their ability to pay-back the loan
and the interest on time and the probability of the borrower defaulting on the
same. CRISIL and ICRA are one of the major credit rating agencies in India.

TYPES OF MARKETS –

 Primary market – In the primary market, companies sell new stocks and bonds to the
public for the first time. This is the place where securities come into existence forthe first
time. This is the first opportunity that investors have to contribute capital to a company
through the purchase of its stock. A company's equity capital is comprised of the funds
generated by the sale of stock on the primary market.

 Secondary Market – In the secondary market, those securities that have already been
listed on the primary Market, are purchased and sold by investors. Companies are not
involved in this. For example, if you go to buy Amazon (AMZN) stock, you are dealing
only with another investor who owns shares in Amazon. Amazon is not directly involved
with the transaction.

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WHAT IS AN IPO?
An initial public offering (IPO) is the process of offering shares of a private corporation tothe
public for the first time. In order to issue an IPO, companies must get the valid permissions
from the Securities and Exchange commission (SEC). After issuing an IPO a private company
turns into a public company.

Since founders of companies put their own money as investment, an IPO allows the founders
to dilute their stake by providing an Exit strategy.

WHAT IS AN IPO PROCESS?

An IPO process has some parts, first is the promotion of the IPO to the underwriters as well
as the general public. Some companies give public statements before the offering is done in
order to generate interest. The second part is appointing underwriters to take charge of the
IPO and carry on the process. The last part is the final offering itself.

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WHAT ARE THE STEPS INVOLVED IN AN IPO PROCESS?

Merchant Bankers – Companies opt for the services of Merchant bankers in order to get
advice on how much capital should the companies raise and also act as intermediaries
between the company and the Investors.
Application – Companies need to file an application with SEBI and on receiving the
approval of application prepare a draft prospectus.
Draft Red Herring Prospectus (DRHP) – Companies need to prepare the DRHP, the
primary registration document, if they are looking to float an IPO.
Registration – Once the documentation is done, it needs to be approved by SEBI after
verifying the necessary disclosures.
IPO Price – On SEBI’s approval the company start with the pricing of the IPO. The two
types of pricing methods are –
1) Fixed Price IPO – Under this method, the price of the company’s IPO is decided in
advance.
2) Book Building – Under this method, Investor are given a price range and they place
their bids within that range.
IPO Launch - The company issues its shares on an IPO date. Capital from the primary
issuance to shareholders is received as cash and recorded as stockholders' equity on the
balance sheet.

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ADVANTAGES OF AN IPO

 First mover advantage - Due to the possibility that the price of the company's shares may
increase on the secondary market, the first-mover advantage enables investor to purchase
them at a competitive price.

 Achieve long-term goals - Investing in an IPO is essentially investing in stocks, and

holding stocks for a long time can cause your money to increase significantly and assist
you in achieving your long-term objectives.

 Transparency - The official websites of the stock exchanges where they have beenlisted
provide real-time access to public information about the firm, including its history, future
goals, and pricing. You can then decide on an investment with confidence.

 Opportunity to invest in good unlisted companies – An IPO allows the investors to

invest in those companies that have high growth prospects. Many companies issuetheir
IPO at a reasonable price which increases the chances of the investor to make listing gains.

WHAT IS AN OFFER FOR SALE (OFS)?

Promoters of publicly traded firms can reduce their shareholding and sell their shares in a
transparent manner through an Offer for Sale on the Exchange's bidding platform.

In 2012, SEBI introduced the OFS Mechanism to the Indian market in order to allow the
promoters of public companies to dilute their stake and comply with the minimum
shareholding requirements of at least 25% stake. Now, the OFS option is available to non-
promoters as well.

WHAT IS A FOLLOW-ON PUBLIC OFFER (FPO)?

After a company's IPO, more shares can be issued in a follow-on public offer (FPO), often
referred to as a secondary offering. FPOs are typically announced by businesses to raise stock
or lower debt.

TYPES OF FPO?

 Dilutive – When a business issues extra shares to raise capital and sells those shares
on the open market, it engages in a diluted follow-on offering. The earnings per share
(EPS) declines as the number of shares rises. The most common uses for the money
raised through an FPO are debt reduction and capital structure changes. The addition
of cash is beneficial to the company's long-term prospects and, as a result, to its shares.

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 Non-Dilutive - Holders of current, privately held shares can sell previously issued
shares on the open market through non-diluted follow-on offerings. When stock is sold
non-diluted, the cash proceeds are given to the shareholders who sold the stock on the
open market. The company's EPS stays the same because no additional shares are
issued.

WHAT IS PRIVATE EQUITY?

Private equity (PE) is ownership or a stake in a company that is not listed on the market. Private
equity, a source of investment capital, is provided by high-net-worth individuals (HNIs) and
enterprises that buy shares in private businesses or take over publicly traded companies with
the intention of delisting them from stock exchanges.

Depending on the company and fund, investors may be required to invest a minimum capital.
Some funds have an entry threshold of $250,000, while others can demand millions more.

The quest of a positive return on investment (ROI) serves as the primary driving force behind
such agreements. They raise capital and manage it to produce positive returns forshareholders.
Top performers from Fortune 500 businesses and premier management consulting firms are
drawn to the private equity (PE) industry in corporate America.

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PRIVATE EQUITY (PE) FIRMS

Private equity (PE) firms have a range of investment preferences. Some of them are –

 Passive Investors – Investors who are completely dependent on management to

expand the business and generate returns since sellers see them as a commoditized
product.

 Active Investors - Active private equity (PE) companies have a broad network of
contacts and connections with CEOs and CFOs in a particular industry, which canaid
in boosting revenue. They are also proficient in generating operational efficiencies.

LEVERAGED BUYOUTs (LBOs)

 LBOs are just what they sound like. A private equity (PE) firm acquires a company,
and the acquisition is financed with debt secured by the company's business and assets.

 By using the company as a type of collateral, the acquirer (the PE firm) hopes to raise
money to buy the company. Acquiring private equity (PE) firms can take over
management of businesses through an LBO while only investing a small portion of the
purchase price.

RATIO ANALYSIS

Liquidity Ratios – Liquidity ratios are useful in assessing a company's ability to service its
debts with current assets. In times of financial difficulty, the business might use its assets and
sell them to raise money for debt repayment.

Solvency Ratios – Solvency ratios are used to assess a company's long-term survival.
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Solvency ratios determine a company's debt levels in relation to its assets, yearly earnings, and
equity. Governmental organizations, institutional investors, banks, and other organizations
utilize solvency ratios to assess a company's solvency.

Activity Ratios – Activity ratios are used to gauge how effectively a business is operating. It
establishes how the company is utilizing its resources to produce the most money. They are
also known as Efficiency ratios. These ratios are very important for business since if they
improve, a company is able to create revenue and profits much more effectively.

Profitability Ratios - Profitability ratios are used to assess a company's capacity to turn a
profit in relation to its costs. When a company's profitability ratio is higher than it was during
the preceding accounting period, that company is doing well. The can also be used to analyze
the performance of competitors by comparing their financial results to those of competitors.

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USES OF RATIO ANALYSIS

 Comparing Financial Performance – Ratios helps in comparing the financial

performance of two companies.
 Trend Line - Businesses frequently utilize ratios to identify any performance trends.
Businesses analyze financial statement data that has been gathered from financial
statements over a number of accounting periods. Future financial performance can be
predicted using any trends noticed.
 Operational Efficiency - Ratios can also be used to assess how effectively assets and
liabilities are managed. It aids in deciding whether the company'sresources are being used
too much or too little.

TERMS RELATED TO THE STOCK MARKET

 Bull Market (Bullish) - If you expect the stock prices to go up, you are bullish on the stock
price. From a broader perspective, if the stock market index is going up during a particular
period, it is referred to as a bull market. Example – The market was bullish from mid-2020
to early 2022.

 Bear Market (Bearish) – If you expect the stock prices to go down, you are bearishon the
stock price. From a broader perspective, if the stock market index goes down during a
particular period, it is referred to as a bear market. Example – The market was bearish from
early 2008 to late 2009.

 Trend – The term ‘trend’ usually refers to the general market direction and its associated
momentum in the market. For example, if the market is declining fast, the trend is said to
be bearish. If the market is trading flat with no movement, then the trend is said to be
sideways.

 Market capitalization – Also known as Market Cap, it tells you how big a company is.
Market cap is obtained by multiplying the stock price by its outstanding number of shares.
It is a good comparison metric when looking analyzing two companies. Companies can be
classified on the basis of size as-
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1. Small Cap (up to Rs.5000 crores)
2. Mid Cap (up to Rs.25000 crores)
3. Large Cap (Above Rs.25000 crores)

 Volume - Volume indicates how many trades are executed in a particular stock in a
particular period. It shows the number of people that are buying or selling a particular stock.

 Face value of a stock – The face value (FV) or par value indicates the nominal value of a
share. It is the value assigned to it when it was issued.
 Bid and Ask Price – Bid price refers to the maximum price that the buyer of a share is
ready to pay and Ask Price refers to the minimum price that the seller will accept for the
share. Spread refers to the difference between the two prices.

 52-week high/low – 52-week high is the highest price point at which a stock has traded
during the last 52 weeks likewise, a 52-week low marks the lowest price point at which the
stock has traded during the last 52 weeks. The 52-week high and low gives a sense of the
range within which the stock trades during the year.

 All time high – This refers to the highest price the stock had ever traded from when it was
listed.

 All time low - It refers to the lowest price the stock had ever traded from since listing.

 Long Position – Long position or going long is a reference to the direction of your trade.
For example, if you have bought the Nifty Index with an expectation that the index will
trade higher, you have a long position on Nifty.

 Short Position – Going short or shorting is a counter-intuitive process wherein you sell
your share with the expectations of its value going down in the near future and then you
repurchase it after a few days at a lower price.

Position 1st Leg 2nd Leg Expectation Make money when You will lose money if

Long Buy Sell Bullish Stock goes up Stock price drops

Short Sell Buy Bearish Stock goes down Stock price goes up

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 Earnings per share (EPS) - EPS tells you how much money the company is making in
profits per every outstanding share of stock. The higher the EPS is, the more money your
shares of stock will be worth because investors are willing to pay more for higher profits.

EPS = Total profit of a company

Total no. of share

 Dividend yield - Dividends are the profits that companies share with their shareholders.
Dividend yield is obtained by dividing the dividend per share by the stock price. A
relatively low dividend yield could mean that the company is retaining more earnings
toward developing the firm instead of paying shareholders, which hints that the company
might have high growth prospects.

 Square off – Square off is a term used to indicate that you intend to close an existing
position. If you are long on a stock squaring off the position means selling the stock and if
you are shorting on a stock it means repurchasing the stock.

 Intraday - Intraday means "within the day." In the financial world, the term is usedto
describe securities that trade on the markets during regular business hours. Day traders pay
close attention to intraday price movements, timing trades in an attempt to benefit from the
short-term price fluctuations.

 OHLC - For now, open is the price at which the stock opens for the day, high is the highest
price at which the stock trade during the day, low is the lowest price at which the stock
trades during the day, and close is the closing price of the stock.

 Market Segment - A market segment is a division within which a certain type of financial
instrument is traded. Each financial instrument is characterized by its risk and reward
parameters. The exchange operates in three main segments –

1. Capital Market (CM) – Capital market segments offer tradable securities, suchas stocks
and exchange-traded funds (ETFs). So if you were to buy or sell shares of a company,
you are essentially operating in the capital market segment.
2. Futures and Options (FO) – Futures and Options, generally referred to as the equity
derivative segment, are where leveraged products are traded.
3. Currency Derivatives (CDS) – The CDS segment is where currency pairs like USD INR,
EUR INR, and JPY INR are traded.

 P/E Ratio – The P/E ratio helps determine the actual market value of the stock compared
to the company’s earnings. Generally, companies that are leaders in their sectors will always
command a higher P/E than the other companies in the same sector.

P/E Ratio = Market price of share

Earnings per share

 Upper and lower circuit – In order to control excessive volatility due to some news the
stock exchange can set an upper circuit (the highest price a stock can reach) or a lower
circuit (the lowest price a stock can reach).
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DERIVATIVES
A Derivative is a financial instrument that has no value of its own. A derivative gets its worth
or value from that of an underlying asset, which could be stocks, bonds, commodities,
currencies, indices, etc.

WHAT IS AN UNDERLYING ASSET?

Underlying asset are the financial assets upon which a derivative’s price is
based. Options are an example of a derivative. A derivative is a financial instrument with a
price that is based on a different asset. Underlying assets give derivatives their value. For
example, an option on stock XYZ gives the holder the right to buy or sell XYZ at the strike
price up until expiration. The underlying asset for the option is the stock of XYZ.

Example - In cases involving stock options, the underlying asset is the stock itself. For
example, with a stock option to purchase 100 shares of Company X at a price of $100, the
underlying asset is the stock of Company X. The underlying asset is used to determine the
value of the option up till expiration. The value of the underlying asset may change before the
expiration of the contract, affecting the value of the option. The value of the underlyingasset
at any given time lets traders know whether the option is worth exercising or not.

FEATURES OF DERIVATIVES

A derivative contract also involves a transaction between a buyer and a seller. Here are thekey
components of a derivative contract:

 Lot size or contract size stands for the number of units being exchanged. For example,
a crude oil derivative may have a lot size of 100 barrels.
 The expiry date is when the derivative transaction must take place. You cannot trade
the contract once the expiration date has passed.
 Price is the pre-agreed rate at which you will settle the contract.

ADVANTAGES OF DERIVATIVES
 Lock in prices
 Hedge against risks
 Can be leveraged
 Diversify portfolio

DISADVANTAGES OF DERIVATIVES
 Hard to value
 Subject to counterparty default (if OTC)
 Complex to understand
 Sensitive to supply and demand factors

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HOW DERIVATIVES ARE TRADED

 Over-the-counter (OTC) – They are traded directly between the buyer and seller. OTC
is what a direct transaction between a Vegetable seller and buyer would looklike. The
two parties are free to modify the contract conditions because there is no middleman.
An OTC derivative is an example of a forward contract.

 Exchange-traded derivatives – They are purchased and sold using an exchange as an

intermediary. The exchange connects buyers and sellers of derivatives, just like the
grocery store connects the buyer of vegetables with the farmer (the seller). Exchange-
traded derivatives, however, are subject to rules established by the exchange. Thus,
there is less room for customization and the contracts are more uniform. An
exchange-traded derivative is an example of an option contract.

TYPES OF DERIVATIVES

 Forwards - A forward market is the place where buyers and sellers exchange goodsfor
money. When both the parties agree, the price is fixed.
The exchange has a predetermined price as well as a date. The Forward market was
established to protect farmers from price swings.

There were many drawbacks to forwards like –

 Liquidity risk
 Default risk
 Counterparty risk;
 Regulatory risk;
 Rigidity.

To counter these risks, Futures contracts were introduced.

 Futures - Futures are financial derivative contracts that bind parties to buy or sell an
asset at a specified price and future date. Regardless of the current market price on the
expiration date, the buyer must purchase or the seller must sell the underlying asset for
the stated price. Financial securities and tangible commodities are examples of
underlying assets. Futures can also be used for the purpose of hedging.

 Options - Options are equities-based derivatives. A buyer may use an options contract
to acquire or sell the underlying asset. The holder is not obligated to buy or sell, unlike
futures. The ability to purchase an asset at a specific price and time is provided by call
options as well as the ability to sell an item at a predetermined price and time. There is
a deadline to exercise any option contract. The price specified is the option strike price.
Options are traded by retail or online brokers.

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 Swaps – Through swaps, any two parties can exchange cash flows. Swaps involve the
conversion of fixed to variable cash flow. Swaps of interest rates, commodities, and
currencies are frequent examples of Swaps.

 Eurodollar Futures - Eurodollars are a sort of U.S. dollar deposit maintained in a bank
outside the U.S. The term "Eurodollar" was coined since the majority of the initial
dollar-denominated deposits were held in European banks.



FUTURES

In a Futures contract, which is a type of derivatives contract, the buyer and seller agree to buy
and sell a specific amount of underlying asset on a future date at a particular price. All contract
specifications are standardized as per the exchange on which it is tradable and the exchange
guarantees trade settlement of the contract as well.

In short, a Futures contract is a standardized contract that oblige parties to buy or sell an asset
at a particular rate, regardless of the current market price at the expiration date. Futures don’t
have liquidity risk, default risk, lack of flexibility, etc.

If Seema entered into a Futures contract with Anant to purchase a kilo of tomatoes at Rs. 10/kg,
even if the market rate was Rs. 8.5/kg, the Futures contract would require Seema to honour the
contract.

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PRICING OF FUTURE CONTRACTS
Futures prices normally exceed spot or cash prices due to the cost of carry and converge tothe
spot price on expiry.

1. Futures price is the price which has been agreed upon for the future delivery of theasset
at the time of entering into the contract.

2. Spot price or cash price is the current market price of the underlying asset.

Cost of Carry or CoC is the cost that an investor incurs for holding a certain Futures contract
until it expires.

Futures price = Spot price + Cost of carry

HOW DO FUTURES WORK?

 All Futures contracts come with a settlement guarantee from the clearing corporationof
the stock exchange. It is an agency designated to settle trades on the stock exchanges.
That removes any default risk.
 All Futures contracts have a pre-defined expiry but anyone can exit from these contracts
at any point of time before the expiry by trading on the exchange, thereforeprovide
enough flexibility.

 Futures are freely traded on stock exchanges and anyone can participate in these
contracts. Therefore, they are extremely liquid.

 Every Futures contract has some underlying asset and the contract derives its value
from that underlying asset. The underlying asset could be shares, an index, currency,
commodity and interest rates.
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E.g. - If you buy a Futures contract of Reliance Industries, then Reliance shares are the
underlying asset. Similarly, if you buy a Nifty Futures contract, then the underlying asset would
be the value of the Nifty index. If the Nifty value goes up, the price of Nifty Futures contracts
will also move in the same direction. So, if Nifty moves up by 100 points, we can also expect a
similar movement in the price of Nifty Futures.

RISK ASSESSMENT WITH PAY-OFF GRAPHS

A pay-off graph illustrates the profit or loss based on the changing price of the underlying asset.

The graph usually looks like this:

 The X-axis represents the spot price. Spot price is the current or prevailing market price
of the underlying asset that can be bought or sold for immediate delivery.

 The Y-axis depicts the profit or loss.

a) Pay-off graph for Seema (buyer)

Based on the graph, you can see that as the spot price increases, the Forwards contract will be
beneficial for Seema. It will be a loss for Anant.

If the price of tomatoes increases, Seema earns a profit. If the price dips, she incurs a loss. The
breakeven point—where there is no profit or loss—is Rs 10/kg.

b) Pay-off graph for Anant (seller)

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Here, as you can see, when the spot price is lower than the Forwards price, the contract will be
beneficial for Anant.

CALCULATING THE FAIR VALUE

The fair value of a Futures contract is the theoretical value of a Future contract that it should
be traded on. However, the Futures price may differ from the fair value because of short-term
fluctuations in the market that are influence by demand and supply. A large deviation could
result in an arbitrage opportunity, assuming that the Futures price will eventually revert back
to the fair value.

In order to calculate the fair value of a Futures contract, this formula can be used -Futures Price

= Spot Price *(1+r*t) – Dividends

Where,

r = Risk-free interest rate (91-day Treasury-bill or T-bill return is considered as a risk-free

rate)

t = time in years

The market price of the Futures contract may be different from calculated fair value.

MARGIN CONCEPT IN FUTURES CONTRACT

Futures contracts work on leverage or the idea of borrowing. Whenever you want to take a
position, you don’t have to pay the full lot value. You only need to pay a certain percentage of
the lot value to take a position in Futures contracts.

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INITIAL MARGIN

The initial margin is the minimum amount of money that both buyers and sellers need at the
time of getting into any Futures contract. Let us assume that on June 14, 2021, an individual
buys a one-month Futures contract on Stock A, with a market price of Rs. 2,500 and contract
size of 200 shares. The total value of the contract would be Rs. 5 lakhs (Rs. 2,500*200). If the
initial margin is 15% of the contract value, then both parties have to deposit at least Rs. 75,000
with their respective brokers.

 The initial margin is based upon the volatility in the price of the stock – higher volatilitywould
lead to a higher initial margin on a Futures contract.

 The exchange can increase or reduce the margin depending on volatility.

 It may also change the margin in a contract between the contract period and the investor will
need to comply with the new margin requirement.

MAINTENANCE MARGIN

Maintenance margin is the sum of money that has to be maintained by both buyer and seller in
their margin accounts once trading has started. This amount or percentage is lesser than the
initial margin.

From the previous example, the initial margin was 15% of the contract value. So, the
maintenance margin could perhaps be 12%. This means that the buyer and seller have to have
at least Rs. 60,000 (12% * 500,000) in their account at any point.

As the contract begins, this margin amount may increase or decrease depending upon the value
of the stock, but the balance cannot not fall below the maintenance margin level. If it does, then
the buyer or the seller have to deposit the differential amount.

As you can see in the image below, the initial margin on the Nifty June Futures contract, at the
price of Rs. 15,750 is Rs. 162,731.

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MARK-TO-MARKET (MTM) PROFIT/LOSS

Mark-to-market (MTM) is valuing assets according to their most recent market price. An
important feature of Futures contracts is that gains and losses are settled on each trading day.
This means that the value of the contract is marked to its current market value. The exchange,
with the help of brokers and clearing houses, collects this MTM margin from the party making
a loss and pays the same to other party making a gain.

For example, if an investor buys one lot of ‘Stock A’ Futures of 200 shares on July 6, 2020 at
a price of Rs. 2,500, he is required to deposit a margin of 15% of the lot value i.e.
15%*200*2500 = Rs. 75,000. On July 7, the next trading day, if the price of Futures closes at
Rs. 2,530, then the investor has made a gain of Rs. 6,000 (Rs. 30*200). This gain will be
credited to his account and debited from the account of the seller on account of MTM
settlement. The position will start from Rs. 2,530 on the next day.

OPTIONS

DEFITNITION - A derivative instrument that gives the buyer an option rather than an
obligation to honor a contract known as an Option.

Options contracts are different from Futures contracts because one party has the right to
buy or sell an underlying while another party has an obligation. The right to buy is a Call
Option while the right to sell is a Put Option. Options contracts provide the buyer with the
Option to exercise their right. The buyer may choose to exercise his right only if it is favourable.
If a transaction is not in the buyer’s favour, they are not required to go through with it. On the
other hand, the seller doesn’t have any right but has an obligation. If a buyer wants to exercise
his right, the seller must compulsorily oblige and honour the contract.

HOLDER – The buyer of the contract

WRITER – The seller of the contract.

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EXAMPLE:
For instance, if Seema purchased an Option to buy tomatoes from Anant at Rs.10/kg, she may
choose not to exercise this Option if the current market price is Rs.8/kg for tomatoes. That puts
Anant in a spot. That is why Seema will have to make an upfront payment to Anant, say of
10% of the contract value, to compensate for the risk Anant is taking, which is non-refundable.
Please note that Call and Put are different types of Options - selling a Call Option is not
equivalent to buying a Put Option.

IMPORTANT TERMINOLOGY

 Lot Size - Lot size in Options contract is the same as that in Futures contracts. For
example, TCS Options contract lot size is 300. It refers to the total number of units in a
single contract.

 Expiry Date - Just like Futures contracts, Options contracts also expire on the last
Thursday of the month. Weekly expiry contracts on the Index Option are also available
in the market and expire on the Thursday of the week.

 Strike Prize - The strike price refers to the rate at which an investor has entered into
the Options contract. Various strike prices are available in the market. They can be
available at prices lower than the spot price and or higher than the spot price. Take a
look at the image below. For instance, if you are trading in the Nifty 15,700 contract,
the strike price, in this case, is 15,700. You will also see that Spot Nifty is at 15,709 on
July 28, 2021 and strike prices are available from 13,850 to 17,200 for contracts with
an August expiry.

OPTION PREMIUM
Premium is the price that the party going long (or the buyer) pays above the spot price to
acquire an Options contract. It is the cost the Option buyer/holder pays to acquire the right, but
not the obligation, to either buy or sell the underlying asset.

Options premiums are traded for a single unit of the underlying asset which is then multiplied
with the lot size to get the total premium for the contract.

For example, assume that an Options price for the Call Option on Stock A is Rs.150 and lot
size is 100.
Total premium = Rs.150*100 = Rs.15000

In the case of a Call Option buyer, you are purchasing a right to buy an underlying asset and
paying a premium to the seller. So, we will add the premium cost to the strike price to calculate
the breakeven point. Thus, Call Option buyers will earn a profit if the spot price moves above
the breakeven point.

The breakeven point for the Call Option = Strike Price + Premium.

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MARGIN CONCEPTS
Unlike Futures, an Option buyer is not required to pay any margin amount. This is because the
buyer is exposed to limited risk, which is already compensated for with the premium paid. All
one must do is pay the Option premium to get the right (but remember, not the obligation) to
buy or sell the underlying asset.

INTRINSIC VALUE AND TIME VALUE

When it comes to Option premiums, there are two concepts you need to know, namelyintrinsic
value and time value.

Option premium = Intrinsic value + Time value

The intrinsic value of Call Options is calculated by subtracting the strike price from the current
market price. Intrinsic value is the amount of benefit that an Option buyer receives if they
exercise the Option. In case of a Put Option, intrinsic value can be determined by subtracting
the spot price from the strike price. All Options expire at the intrinsic value on expiry.

The formulae for determining intrinsic value are stated below:

Intrinsic value of a Call Option = Max {0, (Spot price – Strike price)}Intrinsic value of a Put
Option = Max {0, (Strike price – Spot price)}

LONG CALL, SHORT CALL, LONG PUT AND SHORT PUT

A long Call position is useful when you are strongly bullish about the underlying stock or
index. You expect a huge upside rally in the stock before the expiry of a contract.
Let’s understand this with an example.

A short Call is an obligation to sell an underlying asset to a Call buyer at the strike price if the
Call option is exercised by the buyer of an Option. Short Call position or Call Option writing
is useful when you are mildly bearish about the market. You expect the underlying asset to stay
in the narrow range i.e., either stick to its current price or show a slightly downside movement.

A long Put refers to buying a Put Option, i.e., the right, not the obligation, to sell the asset at a
predetermined price. A long-put position is useful when you are strongly bearish about the
underlying asset. You expect a huge downside in the stock before the expiry of the contract.

A short Put Option is when one has the obligation to buy on an underlying asset. The buyer
of a Put Option can then exercise the right to sell the asset at the agreed price. A short Put
Option is useful when you are mildly bullish about the market.

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FUTURE VS OPTION CONTRACTS

In the case of Futures contracts, both long and short, must buy and sell the underlying as per
contract specifications even though the market price at expiry might not favour either.

For example, suppose a trader short (agrees to sell) 1-month Futures of XYZ Ltd. at Rs.70 and
at expiry, XYZ’s stock move up to Rs.75, then he would have ideally wanted to move out of
the contract since he is incurring a loss in this position. He cannot back out from his
commitment in a Futures contract, but he can do so in an Options contract by going long on
Put Options.

Therefore, in Futures, losses and gains are linear, but in Options buying, losses are limited to
the premium, and gains can be unlimited.

For those who want to hedge against unlimited losses, entering into an Options contract is more
sensible than a Futures contract.

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FIXED INCOME

Definition – Those investment securities that pay the investors fixed interest or dividend
payment until their maturity date are known as fixed income. When the maturity period
reaches, the principal amount that the investors had invested are repaid. The difference between
fixed income and equity is that equity may pay out no cash flow to investors but the payments
of fixed income security are known in advance and remain fixed throughout.

In an event of a company’s bankruptcy, fixed income investors are often paid before
common stockholders.

WHO SHOULD INVEST IN FIXED INCOME?

Conservative investors who seek a diversified portfolio should invest in fixed income. The
percentage of the portfolio of an investor in fixed income depends on his investment style.
Fixed income is mainly for the conservative investors because the risk involved in fixed income
sources have a lower risk as compared to equity or variable income securities.
However, fixed income is also a key asset type if an investor looks to diversify his portfolio.

Example – A company issues a 5% bond with a face value of Rs.10000 that matures in 5 years.
The investor buys a bond for Rs.10000 and he will not be paid back before the maturity of
these five years. However, over the course of these five years, the company that issued the bond
makes interest payment which are called coupon payments. As a result the company pays
Rs.500 per year for the period of 5 years. Coupon payments can also be paid by companies
monthly, quarterly or semi-annually.

KEY COMPONENTS – We judge a fixed income security based on these key components
which is credit quality, yield, maturity, taxes and liquidity

 CREDIT QUALITY – Credit quality is defined as the measurement of an individual

or a company’s creditworthiness. This means it a way to evaluate their ability to pay
their debts. A higher credit rating represents a better chance of the debt to be repaid.
When we want to judge the investment quality of a fixed income, we look at its credit
quality.

Credit quality is expressed in terms of credit rating or credit score. Having a good credit
rating means that the bond issuer will pay less to borrow money. The bond issuers will
pay lower interest rate to the creditors as their credit rating is good.

The most widely used credit scores in India are CIBIL, Experian, CRIF, Highmark
and Equifax. A credit score of a person is a 3 digit number between 300 and 900.
The higher the number, the better it is. This number is decided based on the history of
repayment, credit files and loan history.

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 YEILD – The yield on a security is the measure of the return to the holder of a security.
It takes into account, the return on the investment as well as the market value of the
bond.

There are various types of yield and there is a way to calculate the yield.

Current Yield = Annual Coupon Payment

Current Yield Market Value of the Bond

Yield to maturity is an estimate of the total rate of return anticipated to be earned

by an investor who buys a bond at a given market price and holds it to maturity. Unlike current
yield, yield to maturity takes into account the payment of principal to the bondholder when the
bond matures.

Par yield assumes that the market value of the security is equal to the face value of the bond.

 MATURITY- Maturity is when the security holder is liable to pay the security’s
principal amount. The maturity can be 1-5 years, 5-12 years and can be more than 12
years. When a fixed income security is selected, it should be based on the financial goal
of the person purchasing the security.

 TAXES – There are some fixed income securities which provide tax exemption such
as green, municipal and government bonds.

 LIQUIDITY – Liquidity refers to ability in which assets can be converted into cash. If
a security can be easily converted into cash in a short time period, it is considered a
more liquid security.

CASH FLOWS AND THEIR CALCULATION

In order to understand the calculation of bond values, we must first understand what cash flows
are and how to calculate present values of future cash flows to judge whether an investment is
feasible or not.

Cash Flows – When a company makes an investment, they expect the investment to generate
returns. The returns from these investments are called cash inflows. However, the investment
is made now but we are going to receive the cash inflows in the future. In order to judge whether
the investment is profitable or not, we need to calculate the present value of these cash inflows.
This present value is known as discounted cash flow (DCF).

Net Present Value (NPV) – NPV is the difference between want an investment costs and the
current value of future stream of payments. It is used to assess the investment’s return over
time. In order to calculate NPV, we need to estimate the timing and future cash flows.

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Internal Rate Of Return (IRR) – The discounting rate at which the NPV becomes 0 isknown
as IRR.

Let us understand this with the help of an example-:

Q) An investment of Rs.1500 is made and the expected inflows are 200 in the first year, 500 in
the second year & 700 in the third and fourth year. The discounting percentage is 10%.

A) Formula to calculate the present value of cash inflow = Cash Inflow

(1+ Discount rate) ^ No. of year

Present value of First Cash Inflow = 200 = 200 = 182

(1 + 10/100)^1 1.1

Present value of Second Cash Flow = 500 = 500 = 413

(1 + 1.1)^2 (1.1) ^2

Similarly, the total discounted cash inflows are Rs. (182 + 413 + 525 + 478) = 1598. The
initial investment was Rs.1500.

NPV = Total discounted cash inflows – initial investment

= 1598 – 1500
= 98

A positive NPV means that the investment should be made. A negative NPV means that
the investment should not go ahead.

 Fixed Deposit (FD) – A fixed deposit is a financial instrument provided by banks or

non- banking financial instruments which provides the investors a higher rate of interest
than a regular savings account, until a given maturity date.
In this case, the investor puts in a lump sum in your bank or financial institution at an
agreed rate of interest. After the end of the tenure, the principal along with the
compound interest is paid. Fixed deposits are also known as term deposits.
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 Government Securities – Government securities consist of a range of investment
products offered by a government body. These include treasury bonds, bills and notes.
These securities are considered conservative instruments because they have the backing
of the government that issued them
 Treasury notes come in maturity between two and ten years. They are a
marketable U.S government debt security. They are sold in a multiple of
$100. The interest received by investors here are semi-annual.
 Treasury bonds are similar to treasury notes except that they mature in 20
to 30 years.
 Treasury bills are short term fixed income instruments that mature within 1
year but they do not pay coupon payments. Investors purchase these bills at a
value of less than the face value and earn the difference in maturity.

 Corporate Bonds – Corporate bonds come in various types in which the financial
stability and creditworthiness of the company plays a major role. They come in various
types of prices and interest rates depending on the company. Bonds which have a higher
credit rating pay a lower coupon rate.

 Public Sector Undertaking (PSU) Bonds – These are bonds in which the government
shareholding is generally greater than 51%. It is a medium and long term debt
instrument issued by public companies. The yield of PSU bonds in India is higher than
other debt instruments in the Indian market.
 Money Market Instruments – These include certificates of deposits (CDs),
commercial papers and treasury bills. It is a market for short term financial needs like
working capital needs. Financial players like RBI and LIC are mainly involved in
money market instruments. These are highly liquid and have a maturity below 1 year.
They also provide fixed returns. The types of money market instruments are discussed
later.

 Public Provident Fund (PPF) - The PPF account or Public Provident Fund scheme is
one of the most popular long-term saving-cum-investment products, mainly due to its
combination of safety, returns and tax savings. It offers an attractive rate of interest and
returns on the amount invested. The interest earned and the returns are not taxable under
Income Tax. One has to open a account under this scheme and the amount deposited
during a year will be claimed under section 80C deductions.

ADVANTAGES OF FIXED INCOME

 Income Generation - Fixed-income investments offer investors a steady stream of

income over the life of the bond or debt instrument while simultaneously offering the
issuer much-needed access to capital or money. Steady income lets investors plan for
spending, a reason these are popular products in retirement portfolios.

 Relatively Less Volatile - The interest payments from fixed-income products can also
help investors stabilize the risk-return in their investment portfolio—known as the
market risk. For investors holding stocks, prices can fluctuate resulting in large gains

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or losses. The steady and stable interest payments from fixed-income products can
partly offset losses from the decline in stock prices. As a result, these safe investments
help to diversify the risk of an investment portfolio.

 Guarantees - Also, fixed-income investments in the form of Treasury bonds (T- bonds)
have the backing of the government. Corporate bonds, while not insured are backed by
the financial viability of the underlying company. Should a company declare
bankruptcy or liquidation, bondholders have a higher claim on company assets than do
common shareholders.

RISKS OF FIXED INCOME

Credit and Default Risk - As mentioned earlier, treasuries and CDs have protection through
the government and FDIC. Corporate debt, while less secure still ranks higher for repayment
than do shareholders. When choosing an investment take care to look at the credit rating of the
bond and the underlying company. Bonds with ratings below BBB are of low quality and
consider junk bonds.

Interest Rate Risk - Fixed-income investors might face interest rate risk. This risk happens in
an environment where market interest rates are rising, and the rate paid by the bond falls
behind. In this case, the bond would lose value in the secondary bond market. Also, the
investor's capital is tied up in the investment, and they cannot put it to work earning higher
income without taking an initial loss. For example, if an investor purchased a two-year bond
paying 2.5% per year and interest rates for 2-year bonds jumped to 5%, the investor is locked
in at 2.5%. For better or worse, investors holding fixed-income products receive their fixed rate
regardless of where interest rates move in the market.

Inflationary Risks - Inflationary risk is also a danger to fixed-income investors. The pace at
which prices rise in the economy is called inflation. If prices rise or inflation increases, it eats
into the gains of fixed-income securities. For example, if fixed-rate debt security pays a 2%
return and inflation rises by 1.5%, the investor loses out, earning only a 0.5% return in real
terms.

MONEY MARKET INSTRUMENTS

Commercial Bills – These are money market instruments and their working is similar to the
bills of exchange. Businesses use them to fulfil their short-term money requirements. These
instruments provide a very good liquidity and at the same time can be transferred from one
person to another in case a situation of immediate cash requirement arises.

Certificate of Deposits – They are also called CD’s. These are accepted by commercial banks
as negotiable term deposits. They are usually issued through a promissory note. They are issued
to individuals, corporates and trusts. Banks also issue these CDs at a discount and the duration
lies between 3 months to 1 year. If an institution other than banks issue them, the period is 1
year to 3 years.

Commercial Paper – Instead of borrowing money from banks, corporates sometimes issue
commercial paper ranging from 15 days to 1 year. The policies of these commercial papers are
laid down by the RBI.

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STOCKS VS. BONDS (Stocks are not fixed income)

THE TWO TYPES OF BONDS DEPENDING ON RATE OF INTEREST ARE –

Fixed Rate and Variable Rate Bond.

Fixed rate bonds, as the name suggests pay the same interest sate throughout their whole period.
One the other hand, variable rate bonds are those bonds in which the rate of interest changes
based on the market rates.

ARE DEBENTURES FIXED INCOME INSTRUMENTS?

A debenture is a bond or debt instrument that does not have any collateral backing and they
rely on the creditworthiness and reputation of the corporation issuing the debenture. Both
corporations and Government Issue debentures to raise money. Some debentures can convert
to equity shares while others cannot.
The difference between debentures and bonds is that debentures are documented in an
indenture. An indenture is a contract between the issuer of the debenture nad the debenture
holder. This contract contains all the details such as the maturity period, interest rate and other
features. In order to understand whether a debenture is a fixed income instrument, we have to
understand what is a convertible debenture and a non-convertible debenture.

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Convertible Debentures – These debentures can be converted into equity shares after a specific
period. They have the benefit of both debt and equity. Whether the debentures are converted to
equity shares or not are dependent on the debenture holders. Convertible debentures are
appealing to the investors as they change them to equity if they feel that thecompany’s stock
will rise. However, they are not considered as fixed income instruments.

Non-Convertible Debentures - They cannot be converted into equity but the rate of interest here
is higher than that in convertible debentures. Higher rated non-convertible debentures are
considered as fixed income investments.

The other types of debentures are –

1. Redeemable and Irredeemable Debentures – In case of redeemable debentures, the

issuer of the bond must repay the debt in full on the exact date and terms mentioned in
the indenture. In case of irredeemable debentures, the issuer is not liable to repay the
full amount by a certain date. This is why these debentures are also known as perpetual
debentures. Redeemable debentures are thus a much safer option.

2. Registered and Bearer Debentures- In case of registered debentures, the debts are
registered to the issuer. In this case, the transfer in securities must be done by a clearing
facility so that the interest is paid to the correct bondholder. In case of bearerdebentures,
the bonds are not registered with the issuer and owner of the debenture is entitled to
interest by simply holding the bond.

3. Secured and unsecured bonds – Secured bonds are backed by some form of collateral
security such as property or other assets that can be seized to repay the creditors.
Unsecured bonds are not backed by any collateral security and thus are more risky and
without any baking for the investor in this debenture.

BOND VALUATION

Calculating the present value of a bond’s future interest payments in known as bond valuation.
The face value and interest payments of a bond remain constant. An investor uses bond
valuation to determine the rate of return for a bond investment. Using this rate of return, he
determines whether investing in the bond is good or not. As we discussed, the coupon payments
are received at a fixed time interval, but it we need to calculate the present value ofthese coupon
payments.

Bonds can be purchased at par (which is the face value of the bond), below par or above par.
There is an inverse relation between interest rate and value of a bond. If interest rate increases,
the value of the bond will decrease since the coupon rate will be lower than the interest rate.
Thus, the bond will be traded at a discount. However, once the maturity period isreached, the
bondholder will be paid the face value even though he purchased at a value lower than the face
value.

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FORMULA

PV of all the CFs = CF 1 + CF 2 + ............................ CF N

(1 + R) ^1 (1 + R) ^2 (1 + R) ^N

PV of the bond = PV of all the CFs + FV

(1+ R)^N
Here,
CF = Cash Flows
R = Discount Rate
FV = Future value of the bond
N = Maturity period

BONDS VS DEBENTURES
The difference between bonds and debentures are shown in the table below. Debenture is a
type of bond only. It is unsecured and has a larger maturity period

FREQUENTLY ASKED QUESTIONS

Q1 What are coupon payments?

Coupon payments are the cash flows that are offered by a particular security at fixed intervals.
The amount of cash flow depends on the coupon rate which is a percentage of the fixed value
of the security.

Q2 What is the difference between fixed income security and equity?

The holders of fixed income securities are the creditors of those who issue the security. Onthe
other hand, equity represents a share in the ownership of the company. Equity shareholders are
not the creditors of the company.

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Q3 Name some of the key components of fixed income security?
Some of the key components of fixed income security are credit quality, yield, maturity, taxes
and liquidity

Q4 What is the difference between coupon rates and yield?

The difference between coupon rate and yield arises because the market value of a security
might not be the same as the face value or par value of the security. Coupon payments are
calculated on the face value, the coupon rate becomes different from the implied yield.

Q5 What is the difference between fixed and floating rate securities?

Fixed income rate securities are those in which the interest payable is fixed beforehand.
However, in floating interest rate securities, the interest payment is reset at pre-determined
intervals according to pre-determined benchmarks.

Q6 What is WACC?
WACC stands for weighted average cost of capital. It is a firm’s average cost of capital,
calculated after tax. This cost is from all sources including common stock, preferred stock,
bonds and other forms of debt. The average rate that a company expects to pay in order to
finance its assets is known as WACC.

Q7 What are callable securities?

Callable securities are those which can be called by the issuer at a predetermined time by
repaying the holder of the security a certain amount which is fixed under the terms of the
security.

Q8 What is Yield to Maturity (YTM)?

YTM measures the total income of the investor over the lifetime of the security. It consists of
Coupon income, compound interest earned on the coupon income and the capital gain/loss
from the price paid for the security and the proceeds from the redemption or maturity of the
security.

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ALTERNATIVE INVESTMENTS

DEFINITION

Alternative Investments are those financial assets which are not part of conventional
investment categories. Conventional categories consist of bonds, stocks and cash. Alternative
investments include hedge funds, venture capital, private equity, derivatives, commodities and
more. Most of the alternative investments are liquid in nature. They were meant for accredit
investors but they have also become feasible for the retail investors

ACCREDITED INVESTORS AND RETAIL INVESTORS

Accredited Investors – They can be an individual or a business entity who are allowed to deal
in securities that are not available to the general public. In order to become an accredited, one
has to fulfil the eligibility criteria set by the market regulator. In India, the accredited investor
was introduced by the SEBI for high net individual (HNI) – people or business entity who have
over 2 crores of investable assets and have a net worth of 25 crores. They must also have a
liquid net worth of 5 crores and total annual gross of 50 lakhs has to be maintained.
HNI who satisfy SEBI’s requirements to invest in listed companies are Accredited Investors.

Retail Investors - These are the individual investors who buy and sell securities in the market
from their demat account or buy a basket of stocks in the form of mutual funds or EFTs –
Electronic Fund Transfers. They are key to funding the corporates in the capital markets. Retail
investors have a small ticket size (amount of capital invested) but their impact on the market is
significant.

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TYPES OF ALTERNATIVE INVESTMENT

1.) Hedge Funds – These are the funds of private investors managed by professional fund
managers who adopt a wide range of strategies to earn above average returns on
investment. It is considered a risky alternative investment choice and usually requires
a high or a medium net worth and thus targets wealthy clients. Hedge funds also charge
a higher fees than conventional investments funds.

Investment in hedge funds are not considered liquid as they require the investors to
keep the money for at least one year. This period is known as a lock up period. There
are also restrictions on withdrawals as they are only allowed on certain intervals such
as quarterly or semi-annually.

WHAT IS HEDGING

Hedging is a strategy applied by investors to minimize the risk in their portfolio. The act of
minimizing the risk is known as hedging. This a very common term used. The way hedging is
done is that you invest in a very low risk stock to make up for your high risk investment which
an investor might have taken in another stock. For example, if an investor has invested in a high
risk equity stock, he can hedge it by investing in a bond.

TYPES OF HEDGE FUNDS ARE –

 Equity Hedge Funds which can be specific to a country or can be global. These funds
invest in lucrative stocks in order to hedge the risk against the downturns in equity
markets by shorting overvalued stocks or stock indices.
 Global macro hedge funds are actively managed that attempt to profit from broad
market swings caused by political or economic events.
 A relative value hedge fund seeks to exploit temporary differences in the prices of
related securities, taking advantage of price or spread inefficiencies
 An activist hedge fund aims to invest in businesses and take actions that boost the
stock price which may include demands that companies cut costs, restructure assets or
change the board of directors.

HEDGE FUND STRATEGIES

A fixed income hedge fund strategy is one which gives investors solid returns with minimum
monthly volatility and aims for capital preservation taking both long and shortterm positions
in fixed income securities.

An event-driven hedge fund strategy takes advantage of temporary stock mispricing,

spawned by corporate events like restructurings, mergers and acquisitions, bankruptcy, or
takeovers

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A long/short hedge fund strategy is an extension of pairs trading, in which investors go long
and short on two competing companies in the same industry based on their relative valuations.

Examples of Hedge Funds in India

Munoth Hedge Fund

Forefront Alternative Investment TrustIIFL Opportunities Fund

Motilal Oswals Offshore hedge fundSinglar India Opportunities Trust India Zen Fund

HEDGE FUNDS VS MUTUAL FUNDS

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1. VENTURE CAPITAL
Venture capital (VC) is a form of private equity and a type of financing that investors
provide to start-up companies and small businesses that are believed to have long-term
growth potential. Venture capital generally comes from well-off investors, investment
banks, and any other financial institutions. Venture capital doesn't always have to be
money. In fact, it often comes as technical or managerial expertise. VC is typically
allocated to small companies with exceptional growth potential or to those that grow
quickly and appear poised to continue to expand.

The difference between venture capital (VC) and private equity (PE) is that venture
capital tends to focus on emerging companies who seek substantial amount of funds for
the time being. The main downside of VC is that the investors get equityin the company
and a say in the company’s decision. Private equity tends to fund already established larger
companies seeking equity infusion in the company and founders looking to transfer their
ownership in the company.

ADVANTAGES OF VENTURE CAPITAL

 They provide fund to new businesses that do not have access to stock marketsas well as
lack of cash flow to take debts. Moreover, venture capital is beneficial for both the parties
involved (the start-up company as well as the investor) because business get the capital
they want and the investors equity in a company that they consider promising and set to
go big in the future.
 Venture Capitalists also provide mentoring to the companies they invest in and help the
new companies to establish themselves in the market and make aname. They also provide
networking services to these start-ups as they have alot of connections in the industry.
 Venture Capitalists also help in talent acquisition in the companies theyinvest in. A strong
VC can be leveraged into further investments.

DISADVANTAGES OF VENTURE CAPITAL

 The VCs often demand a large share of the company equity and thus look tomake their
personal benefit overlook what is in the best interest of the company.
 The company’s loose creative control as they are often forced to implementthe idea given
by the VC. The investors demand immediate return.
 VCs may pressurise companies to exit investments rather than pursue longterm goals.
These quick exits are not in favour of the company always.

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TYPES OF VENTURE CAPITAL

Pre-Seed: This is the earliest stage of business development when the founders try to turnan
idea into a concrete business plan. They may enrol in a business accelerator to secure early
funding and mentorship.

Seed Funding: This is the point where a new business seeks to launch its first product. Since
there are no revenue streams yet, the company will need VCs to fund all of its operations.

Early-Stage Funding: Once a business has developed a product, it will need additional capital
to ramp up production and sales before it can become self-funding. The business willthen need
one or more funding rounds, typically denoted incrementally as Series A, Series Betc.

DIFFERENCE BETWEEN VCs and ANGEL INVESTORS

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2. PRIVATE EQUITY
Private equity (PE) refers to capital investment made into companies that are not publicly
traded. Most PE firms are open to accredited investors or those who are deemed high-net-
worth, and successful PE managers can earn over a million dollars a year. Leveraged
buyouts (LBOs) and venture capital (VC) investments are two keyPE investment sub-
fields.

3. DERIVATIVES
A derivative is a contract between two parties which derives its value/price from an
underlying asset. The most common types of derivatives are futures, options, forwardsand
swaps.

More about Private Equity and Derivatives has been covered in the Equity &
Derivatives Chapter.

4. REAL ESTATE

Real estate as an investment includes investing in physical properties or property-based

securities such as real estate investment trusts (REITs), real estate mutual funds, or crowd
funding platforms. In addition to capital appreciation of tangible assets, investors strive
foroperating income to potentially provide ongoing, stable cash flow.

Real estate investment is the practice of purchasing property as an investment rather than
as aprimary residence, in order to generate income. It may be simply defined as any piece
of land, structure, infrastructure, or other tangible assets that are often immobile yet
transferrable to get a profit from it.

ADVANTAGES OF REAL ESTATE INVESTMENT

Appreciation of Value - Due to a lack of available land, real estate values will undoubtedly
rise, particularly in urban areas. It is said that real estate investments yield higher returns over
time.
Sufficient Cash Flow via Rental Income - By investing in real estate, you can induce cash
inflow easily. A yearly rental income is a great way to make a good income. It offers great fiscal
security to the investor. However, income from your reimbursement parcels ensures hassle-free
retirement.
Safe and Secured option - Compared to crypto and stock markets, real estate is a safer
investment option and has grown consistently over the past few decades.
 Tax Benefits - You could save money on taxes by investing in real estate. There are
many tax reductions for putting resources into land. You can save up to INR 1.5 lakh
on the principal amount if you choose a home loan under Section 80C. In a similar vein,
according to Section 24, you can reduce the amount of interest you pay by up to

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2 lakhs. You will also be able to lower your taxable income and make real estate
investing more affordable

 Unaffected by inflation - When the rate is high, rent and property prices must also
increase. This indicates that you will benefit from an increase in the cost of living. Apart
from that, mortgage payments are unaffected by inflation, therefore their value
decreases as a result of inflation.

 Fewer Risks - Property investing often has fewer risks than other investment
alternatives like equities, especially when done over a lengthy period of time. Most
thriving real estate markets see annual increases in property values as well as gradual
increases in equity. The longer you keep your property, the bigger the earnings will be,
therefore choosing this option has reduced risk.

TYPES OF REAL ESTATE INVESTMENT

Residential Real Estate - This category includes villas, townships, single-family homes,
multi-family homes, and apartment buildings. . From an investment standpoint, each of these
options offer distinct prospects. For instance, the longevity of the construction and the rising
value of land will drive up the prices of well-built villas and independent houses over time.
Contrary to this, the value of apartments may not increase after ten to fifteen years of use.
Therefore, they must be sold within five to seven years.

Commercial Real Estate - These include investments in shopping malls, schools and office
buildings. They are more expensive to invest than in residential properties but there are higher
chances to profit.

Industrial Real Estate - Industrial properties are buildings and factories used for
manufacturing goods and storage. In order to keep residents safe from pollutants, they are
typically located far from the city. Despite the property’s recent conversion from agricultural
land to industrial use, its value will be significantly higher than that of the nearby farmlands.

Land Real Estate - Land real estate is India’s least-priced and safest real estate properties i.
You need not worry about theft, damage, and upkeep when purchasing real estate as an
investment. Yet, creating passive income from real estate investments also calls for certain

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unconventional strategies that might only sometimes be successful. However, investing in it is
an excellent idea because it can end up being very profitable.

5. COMMODITIES
Commodities are raw materials such as gold, silver, oil, or agricultural products. Investors can
invest in these tangible goods that have real world uses and often perpetual demand due to the
underlying characteristics of what they are. For example, gold's price is arguably morestable
because it used in a variety of industries.

What is investing in commodities?

There are several ways to consider investing in commodities. One is to purchase varying
amounts of physical raw commodities, such as precious metal bullion. Investors can also invest
through the use of futures contracts or exchange-traded products (ETPs) that directly track a
specific commodity index. These are highly volatile and complex investments that aregenerally
recommended for sophisticated investors only. Another way to gain exposure to commodities
is through mutual funds that invest in commodity-related businesses. For instance, an oil and
gas fund would own stocks issued by companies involved in energy exploration, refining,
storage, and distribution.

ADVANTAGES OF COMMODITY INVESTING

 Diversification - Over time, commodities and commodity stocks tend to provide

returns that differ from other stocks and bonds. A portfolio with assets that don't move
in lockstep can help you better manage market volatility. However, diversification does
not ensure a profit or guarantee against loss. 

 Potential Returns - Individual commodity prices can fluctuate due to factors such as
supply and demand, exchange rates, inflation, and the overall health of the economy.
In recent years, increased demand due to massive global infrastructure projects has
greatly influenced commodity prices. In general, a rise in commodity prices has had a
positive impact on the stocks of companies in related industries

 Potential hedge against inflation – Inflation which can erode the value of stocks and
bonds—can often mean higher prices for commodities. While commodities have shown
strong performance in periods of high inflation, investors should note that commodities
can be much more volatile than other types of investments.

RISK OF COMMODITY INVESTING

 Principal Risk - Commodity prices can be extremely volatile and the commodities
industry can be significantly affected by world events, import controls, worldwide
competition, government regulations, and economic conditions, all of which can have
an impact on commodity prices. There's a chance your investment could lose value. 

 Volatility - Mutual funds or exchange-traded products (ETPs) that track a single sector
or commodity can exhibit higher than average volatility. Also, commodity funds or
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ETPs that use futures, options, or other derivative instruments can further increase
volatility. 

 Foreign and emerging market exposure- Apart from the risks associated with
commodity investing, these funds also carry the risks that go along with investing in
foreign and emerging markets, including volatility caused by political, economic, and
currency instability. 

 Asset concentration - While commodity funds can play a role in a diversification

strategy, the funds themselves are considered non-diversified as they invest a
significant portion of their assets in fewer individual securities that are generally
concentrated in 1 or 2 industries. As a result, changes in the market value of a single
investment could cause greater fluctuations in share price than would occur in a more
diversified fund.


6. CRYPTOCURRENCY
The emerging form of digital currency, crypto currency is seen as an alternative investment
as it outside the traditional scope of stocks and bonds. Though some may claim crypto currency
does not offer a strong hedge against other risk-on investments, it may provide capital
appreciation or passive income due to staking rewards.

Definition - A crypto currency is a form of digital asset based on a network that is distributed
across a large number of computers. This decentralized structure allows them to exist outside
the control of governments and central authorities.

HOW DOES CRYPTO CURRENCY WORK?

Crypto currencies can be mined, purchased from crypto currency exchanges, or rewarded for
work done on a blockchain. Not all e-commerce sites allow purchases using crypto currencies.
In fact, crypto currencies, even popular ones like Bitcoin, are hardly used
for retail transactions. However, crypto currency values have made them popular as trading
and investing instruments. To a limited extent, they are also used for cross-border transfers.

WHAT IS BLOCKCHAIN?

Central to the appeal and functionality of Bitcoin and other cryptocurrencies is blockchain
technology. As its name indicates, a blockchain is essentially a set of connected blocks of
information on an online ledger. Each block contains a set of transactions that have been
independently verified by each validator on a network. Every new block generated must be
verified by each node before being confirmed, making it almost impossible to forge transaction
histories. The contents of the online ledger must be agreed upon by a network ofindividual
nodes, or computers that maintain the ledger. Experts say that blockchain technology can serve
multiple industries, supply chains, and processes such as online votingand crowd funding.
Financial institutions such as JPMorgan Chase & Co. (JPM) are testing the use of blockchain
technology to lower transaction costs by streamlining payment processing.

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LEGALITY OF CRYPOTOCURRENCY IN INDIA

Cryptocurrencies as a payment medium in India are not regulated by any central authority.
There are no rules and regulations or any guidelines laid down for settling disputes while
dealing with cryptocurrency. So, trading in cryptocurrency is done at investors' risk.

TYPES OF CRYPTOCURRENCY

 Utility – They provide specific functions depending on their respective blockchain.

 Transactional – They are used for payment purposes. Bitcoin is the most famous
example of a transactional crypto. In India, cryptocurrency is not a legal tender.
 Governance – These represent voting rights on a blockchain
 Platform - These support the applications built to use a blockchain.
 Security – These represent ownership of an asset that has been transferred to a
blockchain. MS Token is an example of a securitized token.

7. COLLECTABLES
DEFINITION - Anything that can be sold for far more than what it was originally worth is
known as a collectable. These are items whose value increases over time. These are rare but
there are some collectables which are made in mass. Collectables include photographs and
works of art. In order to get the most money from collectables, the investor must make sure
that they are in a proper condition.

Collectables can be purchased online as well from government websites. Collectables tend to
have a lower return than stock market index funds and most bond funds. Diamonds and
stamps are considered the best collectables. Even these collectables provide lower returns but
are very safe in nature. The risk involved in it is negligible.
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8. PEER TO PEER LENDING
Investing in peer-to-peer lending translates to making loans to individuals or businesses
through online platforms that connect borrowers with investors. Peer-to-peer lending takes a
very similar form as investing with bonds, though it is done on more private markets and often
entail transacting with riskier clients (thus with higher potential rewards).

ADVANTAGES

Borrowers can benefit from P2P lending in a variety of ways, including lower interest rates,
increased lending opportunities, a more transparent and efficient loan process, and faster loan
approval times when compared to traditional financial institutions.

P2P lending is a good investment option depending on an individual's financial goals and risk
tolerance. P2P lending can provide higher returns than traditional savings accounts or bonds,
but it is critical to carefully consider the risks and conduct extensive research before making
an investment. Diversifying one's investment portfolio to include a mix of P2P lending and
other investment options may also be prudent.

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THANK YOU

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