2015

COMMERCE

Paper: 201

(Financial Management)

Full Marks: 80

Time: 3 hours

The figures in the margin indicate full marks for the questions

1. (a) Give the definition and scope of Financial Management. Narrate briefly the functions of Financial Management. (3+5+8=16)

-> Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders?

3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost.

4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved.

5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.

Scope of Financial Management

Financial management helps a particular organisation to utilise their finances most profitably. This is achieved via the following three conducts.

1. Investment decision – Investment decision depicts investing in a fixed asset; it is also referred to as capital budgeting. Investment decisions can be of either long-term or short-term basis.

· Long-term investment decisions allow committing funds towards resources like fixed assets. Long-term investment decisions determine the performance of a business and its ability to achieve financial goals over time.

· Short-term investment decisions or working capital financing decisions mean committing funds towards resources like current assets. It occupies funds for a shorter period, including investments in inventory, liquid cash, etc. Short-term investment decisions directly affect the liquidity and performance of an organization.

Financing decision – This scope of financial management indicates the possible sources of raising finances from various resources. They are of 2 different types –

· Financial planning decisions attempt to estimate the sources and possible application of accumulated funds. A proper financial planning decision is crucial to ensure the availability of funds whenever required.

· Capital structure decisions involve identifying various sources of funds. It facilitates the selection of the best external sources for short or long-term financial requirements.

Dividend decision – It involves decisions taken with regards to net profit distribution. It is divided into two categories –

• Dividend for the shareholders.

· Retained profits (usually depends on a particular company’s expansion and diversification plans).

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise.

2. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties.

3. Choice of sources of funds: For additional funds to be procured, a company has many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions

c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible.

5. Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in two ways:

a. Dividend declaration – It includes identifying the rate of dividends and other benefits like bonus.

b. Retained profits – The volume has to be decided which will depend upon expansional, innovational, diversification plans of the company.

6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw materials, etc.

7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

(b) Discuss, in detail, the modern concept of finance. In what respects, the modern concept differs from the traditional concept? (10+6=16)

-> Finance function is the most important of all business functions. It remains a focus of all activities. It is not possible to substitute or eliminate this function because the business will close down in the absence of finance. The need for money is continuous.

It starts with the setting up of an enterprise and remains at all times. The development and expansion of business rather needs more commitment for funds. The funds will have to be raised from various sources. The sources will be selected in relation to the implications attached with them. The receiving of money is not enough, its utilisation is more important.

The money once received will have to be returned also. If its use is proper then its return will be easy otherwise it will create difficulties for repayment. The management should have an idea of using the money profitably. It may be easy to raise funds but it may be difficult to repay them. The inflows and outflows of funds should be properly matched.

Approaches to Finance Function:

A number of approaches are associated with finance function but for the sake of convenience, various approaches are divided into two broad categories:

1. The Traditional Approach

2. The Modern Approach

1. The Traditional Approach:

The traditional approach to the finance function relates to the initial stages of its evolution during 1920s and 1930s when the term ‘corporation finance’ was used to describe what is known in the academic world today as the ‘financial management’. According to this approach, the scope, of finance function was confined to only procurement of funds needed by a business on most suitable terms.

The utilisation of funds was considered beyond the purview of finance function. It was felt that decisions regarding the application of funds are taken somewhere else in the organisation. However, institutions and instruments for raising funds were considered to be a part of finance function.

The scope of the finance function, thus, revolved around the study of rapidly growing capital market institutions, instruments and practices involved in raising of external funds.

The traditional approach to the scope and functions of finance has now been discarded as it suffers from many serious limitations:

(i) It is outsider-looking in approach that completely ignores internal decision making as to the proper utilisation of funds.

(ii) The focus of traditional approach was on procurement of long-term funds. Thus, it ignored the important issue of working capital finance and management.

(iii) The issue of allocation of funds, which is so important today, is completely ignored.

(iv) It does not lay focus on day to day financial problems of an organisation.

2. The Modern Approach:

The modern approach views finance function in broader sense. It includes both rising of funds as well as their effective utilisation under the purview of finance. The finance function does not stop only by finding out sources of raising enough funds; their proper utilisation is also to be considered. The cost of raising funds and the returns from their use should be compared.

The funds raised should be able to give more returns than the costs involved in procuring them. The utilisation of funds requires decision making. Finance has to be considered as an integral part of overall management. So finance functions, according to this approach, covers financial planning, rising of funds, allocation of funds, financial control etc.

The new approach is an analytical way of dealing with financial problems of a firm. The techniques of models, mathematical programming, simulations and financial engineering are used in financial management to solve complex problems of present day finance.

The modern approach considers the three basic management decisions, i.e., investment decisions, financing decisions and dividend decisions within the scope of finance function.

Aims of Finance Function:

The primary aim of finance function is to arrange as much funds for the business as are required from time to time.

This function has the following aims:

1. Acquiring Sufficient Funds:

The main aim of finance function is to assess the financial needs of an enterprise and then finding out suitable sources for raising them. The sources should be commensurate with the needs of the business. If funds are needed for longer periods then long-term sources like share capital, debentures, term loans may be explored.

A concern with longer gestation period should rely more on owner’s funds instead of interest-bearing securities because profits may not be there for some years.

2. Proper Utilisation of Funds:

Though raising of funds is important but their effective utilisation is more important. The funds should be used in such a way that maximum benefit is derived from them. The returns from their use should be more than their cost.

It should be ensured that funds do not remain idle at any point of time. The funds committed to various operations should be effectively utilised. Those projects should be preferred which are beneficial to the business.

3. Increasing Profitability:

The planning and control of finance function aims at increasing profitability of the concern. It is true that money generates money. To increase profitability, sufficient funds will have to be invested. Finance function should be so planned that the concern neither suffers from inadequacy of funds nor wastes more funds than required.

A proper control should also be exercised so that scarce resources are not frittered away on uneconomical operations. The cost of acquiring funds also influences profitability of the business. If the cost of raising funds is more, then profitability will go down. Finance function also requires matching of cost and returns from funds.

4. Maximising Firm’s Value:

Finance function also aims at maximising the value of the firm. It is generally said that a concern’s value is linked with its profitability. Even though profitability influences a firm’s value but it is not all. Besides profits, the type of sources used for raising funds, the cost of funds, the condition of money market, the demand for products are some other considerations which also influence a firm’s value.

Modern Concept vs. traditional Concept:-

Traditional Approach to Financial Statement Analysis:

1. Meaning:

Traditional approach to financial statement analysis includes the Profit and Loss Account (i.e. Income Statement) and the Balance Sheet.

2. Method of Preparation:

Preparation of these statements are very simple.

3. Supplying Information:

These statements are not so informative.

4. Reliability:

Traditional approach to financial statement analysis are neither so reliable nor so dependable for the purpose of analysis of financial statements.

5. Information:

The detailed information relating to financial information is not available from these statements as they do not exhibit the required material information.

6. Presentation:

Presentation of these statements is very old.

7. Specificity:

An individual’s specific infor­mation, say, the liquidity position of a firm, is not available from these statements accurately.

8. Use:

Usually these statements are prepared by the small firms.

9. Area of Application:

Under Traditional approach to financial statement analysis, Profit and Loss Account or Income Statement helps us to know the result of the operation at the end of the year. The other statement, viz. the Balance Sheet, helps us to understand the financial position as a whole at the end of the financial year.

10. Preparation and Presentation:

Preparation and presentation of these statements are quite simple and mandatory for all firms.

Modern Approach to Financial Statement Analysis:

1. Meaning:

Modern approach to financial statement analysis includes Cash Flow Statement, Funds Flow Statement, Ratio Analysis, Budgetary Control etc.

2. Method of Preparation:

Preparation of these statements are not so simple.

3. Reliability:

These statement are quite informative.

4. Reliability:

These statements are proved to be quite reliable and dependable for the purpose of analysis of financial statements.

5. Information:

These statements, no doubt, exhibit the required material information for the purpose of analysis of financial statements.

6. Presentation:

Presentation of these statements is quite new and more informative than the Traditional Approach.

7. Specificity:

Modern approach to financial statement analysis is quite possible to understand any specific information from these statements, say, and the liquidity position.

8. Use:

These statements are usually pre­pared by the big business houses.

9. Area of Application:

Under Modern approach to financial statement analysis, in addition to the benefits that are available under traditional approach, the other material information viz. liquidity position, solvency position, profi­tability and management efficiency position can easily be understood accurately.

10. Preparation and Presentation:

Preparation and presentation of these statements are not so simple and the preparation of these statements is not mandatory for all firms.

2. (a) Explain the different techniques of analysis of financial statements. (16)

-> Finance is a very important part of any business, it is like a tongue for any industry, and Financial analysis is a term used to describe the process of analyzing the characteristics of any business or business project.

Financial analysis includes deploying financial information to determine an organization’s performance and create strategies about how it can be improved further. The financial analysis additionally centres on the sources of funds, which an organization has used for making its resources.

Usually, financial analysts do their work in Excel, or using an accounting page to investigate historical information and make projections of how they figure the organization will act later on.

If you are an investor, then how can you decide where to invest and where not to? So, here financial statement analysis can help you a lot by making you aware of the financial condition of the company. Let’s move towards deep discussion about financial analysis.

About Financial Analysis

Financial analysis is the procedure of assessing organizations, projects, financial plans, and other account-related exchanges to decide their performance and appropriateness. Commonly, financial analysis is used to break down whether an element is steady, fluid, or productive enough to warrant a financial investment.

Whenever conducted internally, financial analysis can assist administrators with settling on future business choices or review historical trends for past triumphs. If directed externally, financial analysis can assist investors in picking the best possible investment opportunities.

Financial analysis is a fundamental piece of all business tasks as it encourages litigable insights into the health and limit of the association later on. Thus, there are several familiar means to analyze financial data such as measuring ratios from financial statements and correlating these ratios to historical data of companies or other opponent corporations .

In simple words, financial analysis helps company owners in understanding their business performance, financial status, and growth rate.

There are some key elements of financial analysis , such as

• Income statement which indicates the performance of any business gains for a particular period,
• Balance sheet which indicates the financial statements like assets and liabilities, and
• Cash flow statement which indicates the cash inflows and outflows.

Types of Financial Analysis

Two major types of financial analysis are fundamental analysis and technical analysis.

· Fundamental Analysis

The fundamental analysis gives you the point of view of an organization’s characteristic incentive by analyzing related economic and monetary components. Normally, analysts use this procedure to assess the main considerations that impact security’s worth.

Thus, fundamental analysis is a strategy that gives you a superior conviction to recognize organizations for long haul speculation and create wealth.

Analysts lean toward this procedure to discover stocks that are presently exchanging at underestimated or exaggerated and afterwards choose an honest assessment of those stocks to help the investors in their investment choices. In this type, evidence gleaned from the financial statement is utilized to assume the company’s worth.

· Technical Analysis

On the other hand, in technical analysis analysts assess the investment openings by examining past measurable things, for example, volume and cost. Technical analysts accept that the costs of the stock are bound to follow the previous pattern instead of move abnormally.

In the stock market, everything is identified with market psychology, technical analysis uses past information outlines to dissect these feelings and market changes to all the more likely comprehend patterns identified with stock.

· Technical analysts accept the way that history will rehash itself and we can better comprehend the occasions to contribute if we comprehend the previous examples or patterns.

· Technical analysis endeavours to comprehend the market emotion behind price trends by glancing for patterns and trends instead of evaluating a security’s fundamental aspects.

Requirement of Financial Analysis Tools

It is significant to see how well a company is getting along and where it is going in the short and the long haul while investing in the stock market. This is the place where the tools of financial analysis come helpful.

It’s insufficient to pore over an organization’s budget report. To sort out the numbers one must utilize the techniques of financial statements analysis to extricate significant experiences into the organization’s presentation.

Though, these techniques have far broader use beyond just the stock market. So, here we will see the list of exciting use trials of the tools of financial analysis.

· Banks can make verdicts on the solvency of a company by using these tools.

· Corporations can use these to make industry conclusions like where to distribute resources and which group to shutter.

· Security organizations and credit rating agencies could utilize the methods of financial analysis to examine several threats.

· Auditors and regulators might use these to sniff out feasible disparities in a corporation’s financial statement or even company transactions.

5 Techniques of Financial Analysis

Here we will see a list of some of the techniques of financial statement analysis that an investor can think of investing in a business.

1. Vertical Analysis

In this method, the factors of a business are shown in the form of a percentage of a fixed value. In this way, the percentage of all the factors can be used to determine where the business is heading. Also, this can be used to find out the relation between different factors and their effects on each other.

2. Trend Analysis

This method involves analyzing how stock markets are headed. This simply means that the stock prices will be determined beforehand. In this way, if the anticipated price is high, then it means investing will be profitable. If not, then it is a dull market.

Thus, this is one of the unique tools of financial analysis because it can be used to anticipate the effect of a range of outer factors on a stock.

3. Cash Flow Analysis

In this technique, the net income and expenses of a company are used to determine the working capital and net requirements of the business. Also, it determines the debt and expansion in the market.

4. Ratio Analysis

This method compares a particular company with its competition in the market. It simply means which other companies are of the same size and type.

These ratios include- earnings to price ratio, the net income to sales ratio, and the return on assets ratio. It can be used to determine the better company in the same industry.

5. Horizontal Analysis

Now, coming towards horizontal analysis, it is the most famous method of financial statement analysis. This method is generally used to identify the change in various factors of a business.

These factors include net income, sales, cost etc. The amount of change in these factors over a particular period helps in analyzing the future of any particular project or business.

(b) Write brief notes on: (4×4=16)

1) Acid Test ratio.

-> The acid-test ratio (ATR), also commonly known as the quick ratio , measures the liquidity of a company by calculating how well current assets can cover current liabilities. The quick ratio uses only the most liquid current assets that can be converted to cash within 90 days or less.

All of the information necessary to calculate the acid-test ratio can be found on a company’s balance sheet and includes the following:

Current assets or all assets that can be converted into cash within one year:

· Cash and cash equivalents

· Marketable securities

· Accounts receivable

Current liabilities or a company’s debts or obligations that are due within one year:

• Short-term debt

· Accounts payables

· Accrued liabilities and other debts

Calculating the Acid-Test Ratio

The quick ratio is calculated by totaling cash and equivalents, accounts receivables, and marketable investments, and dividing the total by current liabilities as shown below:

Quick ratio= Cash & Cash equivalent + Short term investment/Current liabilities.

Ideally, companies should have a ratio of a 1.0 or greater, meaning the company has enough current assets to cover their short-term debt obligations or bills. The acid-test ratio can be impacted by other factors such as how long it takes a company to collect its accounts receivables, the timing of asset purchases, and how bad-debt allowances are managed. Certain tech companies may have high acid-test ratios, which is not necessarily a negative, but instead indicates that they have a great deal of cash on hand.

The acid-test ratio is a more conservative measure of liquidity because it doesn’t include all of the items used in the current ratio, also known as the working capital ratio. The current ratio , for instance, measures a company’s ability to pay short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The acid-test ratio is more conservative than the current ratio because it doesn’t include inventory, which may take longer to liquidate.

2) Debt-Turnover ratio.

-> The Debtors Turnover Ratio also called as Receivables Turnover Ratio shows how quickly the credit sales are converted into the cash. This ratio measures the efficiency of a firm in managing and collecting the credit issued to the customers.

One important thing that needs to be taken care of is, generally the companies use total sales in the place of net sales, which gives an inflated turnover ratio. Thus, while calculating this ratio, only the net credit sales is to be taken into consideration.

Ideally, a company compares its debtors turnover ratio with the companies that have similar business operations and revenue and lie within the same industry The formula to compute Debtors Turnover Ratio is:

Debtors Turnover Ratio = Net Credit Sales/Average Account Receivable.

Where, Average Account Receivable includes trade debtors and bill receivables.

Higher the Debtors turnover ratio, better is the credit management of the firm.

Example: Suppose a firm has total sales of Rs 5,00,00 out of which the credit sales are Rs 2,50,000. The opening balance of account receivables is Rs 2,00,000 and the closing balance at the end of financial year is Rs 1,00,000. The debtors turnover ratio will be:

Debtors Turnover Ratio = 2,50,000/1,50,000 = 1.67 times

Credit sales = 2,50,000
Average Account Receivables = (2,00,000+1,00,000) /2 = 1,50,000

4) DuPont System of Financial Analysis.

-> The DuPont analysis (also known as the DuPont identity or DuPont model) is a framework for analyzing fundamental performance popularized by the DuPont Corporation. DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE) . The decomposition of ROE allows investors to focus on the key metrics of financial performance individually to identify strengths and weaknesses.

Formula and Calculation of DuPont Analysis

The DuPont analysis is an expanded return on equity formula, calculated by multiplying the net profit margin by the asset turnover by the equity multiplier .

DuPont Analysis=Net Profit Margin × AT × EM

Where:

Net Profit Margin=Net Income/Revenue

AT=Asset turnover

Asset Turnover=Sales/Average Total Assets

EM=Equity multiplier

Equity Multiplier=Average Total Assets/Average Shareholders’ Equity

A DuPont analysis is used to evaluate the component parts of a company’s return on equity (ROE). This allows an investor to determine what financial activities are contributing the most to the changes in ROE. An investor can use analysis like this to compare the operational efficiency of two similar firms. Managers can use DuPont analysis to identify strengths or weaknesses that should be addressed.

There are three major financial metrics that drive return on equity (ROE): operating efficiency , asset use efficiency, and financial leverage. Operating efficiency is represented by net profit margin or net income divided by total sales or revenue. Asset use efficiency is measured by the asset turnover ratio . Leverage is measured by the equity multiplier, which is equal to average assets divided by average equity.

3. (a) Examine the merits and limitations of debentures as a source of long-term finance of companies. (8+8=16)

-> Debentures are a debt instrument used by companies and government to issue the loan . The loan is issued to corporate based on their reputation at a fixed rate of interest . Debentures are also known as a bond which serves as an IOU between issuers and purchaser. Companies use debentures when they need to borrow the money at a fixed rate of interest for its expansion. Secured and Unsecured, Registered and Bearer, Convertible and Non-Convertible, First and second are four types of Debentures .

Advantages of debenture:-

1. Debenture are Preferred by Investors

Since they attract cautious investors by offering definite security and safety of investment, issue of debentures can raise more funds.

2. Debenture are Less Investment Risk

The interest on debentures is a charge against profits. The date and rate of payment are certain. So the investors can get interest whether the company makes a profit or not. The company is also benefited from the point of view of tax, as the interest is a charge against its profit.

3. Less Costly

Usually, the rate of interest is lower than the rate of dividend payable on preference shares and equity shares. So raising of capital through debentures is less costly.

4. Maintenance of Control

Debenture financing permits the company to raise long-term funds without diluting the present control.

5. Ability to trade on Equity

The company can trade on equity. In this way, equity shareholders are able to enhance their total earnings from the company.

6. Remedy against Over Capitalization

Whenever the company feels that it is over capitalized, it can redeem the redeemable debentures. This will help the company to overcome the defects of over capitalization.

7. Debenture is Reliable

The amount derived from debenture issue helps the company to implement expansion programmes. This helps the company not to depend on fair weather. Sources like public deposits.

8. Market Response

The company can easily dispose of the debentures in the open market because debentures are having a satisfactory market response.

9. Useful for Conversion

The company may convert different loans into debentures carrying lower rate of interest.

Disadvantages of Debentures

1. Debentures are not suitable for all Companies

It is not suitable for companies with fluctuating income and companies producing goods, which have an elastic demand.

2. Permanent Burden

Since the company has to pay interest whether it makes a profit or incurs loss, it becomes a permanent burden on the financial resources of the company.

3. Requires huge Fixed Assets

Most of the debentures are secured. So companies with less fixed assets cannot raise money through debentures.

4. No Voting Rights

The debenture holders have no voting rights. This may discourage some investors.

5. Difficulty in Repayment

During depression, the company will find it difficult to repay the principal and fixed interest.

6. Affecting the capacity to raise Loans

If debentures are issued, generally they are secured against all the assets. Because of this, the company may find it difficult to raise further loans and advances from banks, industrial financing institutions or from outsiders.

(b) Write explanatory notes on: (8+8=16)

1) Rights Issue of Equity Shares.

-> A rights issue is a primary market offer to the existing shareholders to buy additional shares of the company on a pro-rata basis within a specified date at a discounted price than the current market price.

It is important to note that the rights issue offer is an invitation that provides an opportunity for existing shareholders to increase their shareholding. It is a right that a shareholder may or may not choose to exercise and not an obligation to buy the shares.

Advantages and Disadvantages of Right Issue of Shares

The rights issue refers to buying the existing shares of a company at a discounted price on a particular ratio. Equity capital can be fulfilled using a rights issue. The rights issue gives the option to the existing shareholders to purchase shares at a lower price on or before a specified date, to remain their existing shareholding percentage. The following are the advantages and disadvantages of the right issue.

Advantages of Right Issue of Shares

1. The right issue is a fast source of raising funds

Issuing rights is the fastest method and the cheapest source of raising capital for a firm. Our shareholders can buy new shares at a discount for a certain period on the right issue. The right issue involves less rigorous rules and regulations as it is more of an internal matter in the company.

2. The right issue incurs low cost

A company can initiate the rights issue process to its existing shareholders at indigent times without incurring underwriting fees. The company also saves money that is spent on advertising, underwriting fee, etc. The company does not have to incur such expenses compared with raising fresh equity from an IPO.

3. The right issue provides an option for the shareholders to maintain the same ownership

The number of additional share purchases allowed to an existing shareholder is always in proportion to his existing shareholding. Shareholders have the option to maintain their original proportion of share ownership.

Existing shareholders will have more certainty of getting shares, when a fresh issue is made to the existing shareholders, instead of the general public. The share price of the right issue will be less than the current share price which attracts the existing shareholders.

4. Raise funds without a form of debt

The right issue is a process to raise capital wherein the company can raise capital without any increase in debt. The company can raise the capital from its existing shareholders without altering the shareholder’s holding percentage. The scope of the right issue is purely in the form of equity and it eliminates any scope for debt.

5. The board of directors cannot misuse share issuing option

The board cannot misuse the opportunity of issuing new shares at a lower price. The right issue shares offered proportionately to the existing shareholders according to their existing holdings. Directors do not have much control over the right issue.

Disadvantages of Right Issue of Shares

1. The existing shareholding percentage may get diluted

Existing shareholders have the option either to ‘subscribe’ to the right issue or ‘ignore’ to the right issue. If a shareholder ‘ignore’ the right issue then their shareholding percentage will get diluted. This is due to the extra shares issued by the company if it is ‘ignore’ by existing shareholders. If more shareholders ‘ignore’ the right issue then there are chances of stake dilution of the existing shareholders. As the existing shareholder percentage gets reduced with the initiation of new shareholders, it could be a troublesome situation for the existing shareholders.

2. After the right issue share price gets decrease

After the right issue, a certain percentage of shares will be newly introduced at a discounted price. This results in a dilution of the previous share price. Dilution occurs because a new large number share spreads the company’s net profit.

3. Limitation of fund raise

Most of the stock exchanges have put certain limits or restrictions on the amount of a company could rise through a rights issue. This limit is usually decided based on the existing equity value of the firm. The company cannot raise an amount compared to an IPO (Initial Public Offering). Raising funds through the right issue might create pressure on the company if a company has undervalued stocks.

4. The negative effect of the company’s public image

The right issue is an indication of liquidity crises that a company suffers. Generally, companies will practice the right issue option in the case of a financial crisis. The brand name of the company could negatively be affected when the right issue is announced. In another way, the shareholders also could assume that the company is struggling to run its business and could tend to sell their shares, which could then reduce the share price further.

2) Term Loan.

-> A term loan is a loan from a bank for a specific amount that has a specified repayment schedule and either a fixed or floating interest rate . A term loan is often appropriate for an established small business with sound financial statements. Also, a term loan may require a substantial down payment to reduce the payment amounts and the total cost of the loan.

Types of Term Loans

Term loans come in several varieties, usually reflecting the lifespan of the loan.

• A short-term loan , usually offered to firms that don’t qualify for a line of credit, generally runs less than a year, though it can also refer to a loan of up to 18 months or so.
• An intermediate-term loan generally runs more than one—but less than three—years and is paid in monthly installments from a company’s cash flow.
• A long-term loan runs for three to 25 years, uses company assets as collateral, and requires monthly or quarterly payments from profits or cash flow. The loan limits other financial commitments the company may take on, including other debts, dividends, or principals’ salaries, and can require an amount of profit set aside for loan repayment.

Features of Term Loans:

Term loan is a part of debt financing obtained from banks and financial institutions.

The basic features of term loan have been discussed below:

1. Security:

Term loans are secured loans. Assets which are financed through term loans serve as primary security and the other assets of the company serve as collateral security.

2. Obligation:

Interest payment and repayment of principal on term loans is obligatory on the part of the borrower. Whether the firm is earning a profit or not, term loans are generally repayable over a period of 5 to 10 years in installments.

3. Interest:

Term loans carry a fixed rate of interest but this rate is negotiated between the borrowers and lenders at the time of dispersing of loan.

4. Maturity:

As it is a source of medium-term financing, its maturity period lies between 5 to 10 years and repayment is made in installments.

5. Restrictive Covenants:

Besides asset security, the lender of the term loans imposes other restric­tive covenants to themselves. Lenders ask the borrowers to maintain a minimum asset base, not to raise additional loans or to repay existing loans, etc.

6. Convertibility:

Term loans may be converted into equity at the option and according to the terms and conditions laid down by the financial institutions.

4. (a) Analyze the advantages and disadvantages of Trade Credit as a source of short-term financing. (8+8=16)

-> Trade Credit is the credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment and is commonly used by business organizations as a source of short-term financing. Trade credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. It is granted prudently to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from industry to industry and from person to person. As we know, trade is the purchase and sale of goods on profit motive. So, trade credit strictly refers to the routine business activity.

Advantage:

1. Increased Sales

A customer will buy more of a supplier’s products if they don’t have to pay cash immediately for their purchases. The most common credit term offered by sellers is payment within 30 days. Rarely do you see credit terms extended beyond this time.

2. Customer Loyalty

The extension of credit terms tells the buyer that the seller considers them trustworthy and has confidence that they will pay their bills when they’re due. The buyer rewards the seller’s vote of confidence by continuing to make purchases.

3. Competitive Advantage

A seller who is able to offer trade credit to buyers has an advantage over his competitors, if they are not able to offer credit terms. This makes sense. Naturally, a buyer would prefer to purchase on credit terms than to pay cash for all of his purchases.

4. Incentives for Customers to Pay

Even when they offer 30 days credit, sellers often encourage their customers to pay sooner by offering them a 2 percent discount if they pay with 10 days. The existence of this potential discount is a huge incentive for buyers to pay earlier. If a buyer does not take advantage of the 2 percent discount, this means that he’s paying a very high interest rate to delay payment for the additional 20 days.

Disadvantage:

1. Negative Effect on Cash Flow

The most immediate effect of trade credit is that sellers do not receive cash immediately for sales. Sellers have their own bills to pay and extending credit terms to buyers creates a hole in their companies’ cash flow.

2. Must Investigate Creditworthiness of Customers

Just like a bank, a vendor who extends credit to customers needs to analyze their credit ratings. This takes money and time. Obtaining business credit reports, such as Dun & Bradstreet, cost money, and making calls to check on references takes time. A vendor may need to hire an additional person who has credit analysis skills to help make the decisions about extending terms of payment.

3. Monitoring Accounts Receivable

Extending credit creates more outstanding accounts receivable, and someone needs to monitor these customers to make sure that they are paying on time. A company that is making its sales in cash does not have this problem.

4. Financing Accounts Receivable

The extension of credit terms to buyers means that the seller has to finance these receivables. A seller may have to lean on his own suppliers to receive trade credit, borrow on his bank line of credit or use the company’s accumulated retained earnings. All of these methods have an inherent cost of capital.

5. Possibility of Bad Debts

Inevitably, the extension of trade credit will lead to some buyers not paying their debts. When this happens, an employee needs to spend time making collection calls to the late payers, and, eventually, the seller may need to write off the unpaid receivables and take a loss.

Extending credit terms to buyers is common in most industries. Businesses must offer some level of extended payments to be competitive in their markets. However, offering credit terms requires taking risks and spending additional time monitoring and collecting accounts receivable.

(b) Make a comparison between unsecured borrowing and secured borrowing as a source of short-term finance. (16)

-> Secured Loan

Secured loans are protected by an asset. The item purchased, such as a home or a car, can be used as collateral. The lender will hold the deed or title until the loan is paid in full. Other items can be used to back a loan too. This includes stocks, bonds, or personal property.

Secured loans are the most common way to borrow large amounts of money. A lender is only going to loan a large sum with a promise that it will be repaid. Putting your home on the line is a way to make sure you will do all you can to repay the loan.

Secured loans are not just for new purchases. Secured loans can also be home equity loans or home equity lines of credit. These are based on the current value of your home minus the amount still owed. These loans use your home as collateral.

A secured loan means you are providing security that your loan will be repaid. The risk is if you can’t repay a secured loan, the lender can sell your collateral to pay off the loan.

Advantages of Secured Loans:

• Lower Rates
• Higher Borrowing Limits
• Longer Repayment Terms

Examples of Secured Loans:

• Mortgage – A mortgage is a loan to pay for a home. Your monthly mortgage payments will consist of the principal and interest, plus taxes and insurance.
• Home Equity Line of Credit – A home equity loan or line of credit (HELOC) allows you to borrow money using your home’s equity as collateral.
• Auto Loan – An auto loan is an auto financing option you can obtain through the dealer, a bank, or credit union.

· Boat Loan – A boat loan is a loan to pay for a boat. Similar to an auto loan, a boat loan involves a monthly payment and interest rate that is determined by a variety of factors.

· Recreational Vehicle Loan – A recreational vehicle loan is a loan to pay for a motorhome. It may also cover a travel trailer.

Unsecured Loan

Unsecured loans are the reverse of secured loans. They include things like credit cards, student loans, or personal (signature) loans . Lenders take more of a risk by making this loan, because there is no asset to recover in case of default. This is why the interest rates are higher. If you’re turned down for unsecured credit, you may still be able to obtain secured loans. But you must have something of value that can be used as collateral.

An unsecured lender believes that you can repay the loan because of your financial resources. You will be judged based on the five C’s of credit:

· Character – can include credit score, employment history, and references

• Capacity – income and current debt
• Capital – money in savings or investment accounts

· Collateral – personal assets offered as collateral, like a home or car

• Conditions – the terms of the loan

These are yardsticks used to assess a borrower’s ability to repay the debt, and can include the borrower’s situation as well as general economic factors.

Note that the five C’s of credit are different for personal loans vs. business loans.

Examples of Unsecured Loans:

• Credit Cards – There are different types of credit cards, but general credit cards bill once a month and charge interest if you do not pay the balance in full.

· Personal (Signature) Loans – These loans can be used for many purposes, and can vary from a few hundred to tens of thousands of dollars.

· Personal Lines of Credit – Similar to a credit card, a personal line of credit has an approved limit that you can use as needed. You can use this line of credit for almost anything, and you are only charged interest on the amount you spend.

• Student Loans – Student loans are used to pay for college and are available through both the Department of Education and private lenders. Although it is an unsecured loan, tax returns can be garnished to pay unpaid student loans.
• Some Home Improvement Loans

Difference between Secured loan and Unsecured loan:-

· The most important difference between a secured and unsecured loan is the collateral required to attain the loan. A secured loan requires you to provide the lender with an asset that will be used as collateral for the loan. Whereas and unsecured loan doesn’t require you to provide an asset as collateral in order to attain a loan.

· Another key difference between a secured and unsecured loan is the rate of interest. Secured loans usually have a lower rate of interest when compared to an unsecured loan. This is because unsecured loans are considered to be riskier loans by lenders than secured loans.

· Secured loans are easier to obtain while unsecured loans are harder to obtain, as it is less risky for a banker to dispense a secured loan.

· Secured loans usually have longer repayment periods when compared to unsecured loans. In general, secured loans offer a borrower a more desirable contract that an unsecured loan would.

· Secured loans are easier to obtain for the mere fact that they are less risky for a lender to give out, while unsecured loans are comparatively harder to obtain.

5. (a) Write a note on basic financial derivatives and the functions of Future markets. (8+8=16)

-> Derivatives are financial contracts whose value is linked to the value of an underlying asset . They are complex financial instruments that are used for various purposes, including hedging and getting access to additional assets or markets.

Most derivatives are traded over-the-counter (OTC). However, some of the contracts, including options and futures, are traded on specialized exchanges. The biggest derivative exchanges include the CME Group (Chicago Mercantile Exchange and Chicago Board of Trade), the Korea Exchange, and Eurex .

History of the Market

Derivatives are not new financial instruments. For example, the emergence of the first futures contracts can be traced back to the second millennium BC in Mesopotamia. However, the financial instrument was not widely used until the 1970s. The introduction of new valuation techniques sparked the rapid development of the derivatives market. Nowadays, we cannot imagine modern finance without derivatives.

Types of Derivatives

1. Forwards and futures

These are financial contracts that obligate the contracts’ buyers to purchase an asset at a pre-agreed price on a specified future date. Both forwards and futures are essentially the same in their nature. However, forwards are more flexible contracts because the parties can customize the underlying commodity as well as the quantity of the commodity and the date of the transaction. On the other hand, futures are standardized contracts that are traded on the exchanges.

2. Options

Options provide the buyer of the contracts the right, but not the obligation, to purchase or sell the underlying asset at a predetermined price. Based on the option type, the buyer can exercise the option on the maturity date (European options) or on any date before the maturity (American options).

3. Swaps

Swaps are derivative contracts that allow the exchange of cash flows between two parties. The swaps usually involve the exchange of a fixed cash flow for a floating cash flow. The most popular types of swaps are interest rate swaps , commodity swaps, and currency swaps.

Advantages of Derivatives

Unsurprisingly, derivatives exert a significant impact on modern finance because they provide numerous advantages to the financial markets:

1. Hedging risk exposure

Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.

2. Underlying asset price determination

Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.

3. Market efficiency

It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

4. Access to unavailable assets or markets

Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.

Disadvantages of Derivatives

Despite the benefits that derivatives bring to the financial markets, the financial instruments come with some significant drawbacks. The drawbacks resulted in disastrous consequences during the Global Financial Crisis of 2007-2008. The rapid devaluation of mortgage-backed securities and credit-default swaps led to the collapse of financial institutions and securities around the world.

1. High risk

The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.

2. Speculative features

Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.

3. Counter-party risk

Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a possibility of counter-party default.

The function of futures markets

The coffee futures exchanges were originally created to bring order to the process of pricing and trading coffee and to diminish the risk associated with chaotic cash market conditions. The futures prices that serve as benchmarks for the coffee industry are openly negotiated in the markets of the coffee futures exchanges (primarily New York and London).

To support a futures market, a cash market must have certain characteristics: sufficient price volatility and continuous price risk exposure to affect all levels of the marketing chain; enough market participants with competing price goals; and a quantifiable underlying basic commodity with grade or common characteristics that can be standardized.

The futures exchange is an organized marketplace that:

• Provides and operates the facilities for trading;
• Establishes, monitors and enforces the rules for trading; and
• Keeps and disseminates trading data.

The exchange does not set the price! It does not even participate in coffee price determination. The exchange market supports five basic pricing functions:

• Price discovery;
• Price risk transfer;
• Price dissemination;
• Price quality;
• Arbitration.

The exchange establishes a visible, free market setting for the trading of futures and an option which helps the underlying industry find a market price (price discovery) for the product and allows the transfer of risk associated with cash price volatility. As price discovery takes place, the exchange provides price dissemination worldwide.

Continuous availability of pricing information contributes to wider market participation and to the quality of price. (More buyers and sellers in the marketplace mean better pricing opportunities.) Greater participation means that price discovery reflects the conditions of the commodity market as a whole. To ensure the accuracy and efficiency of the trading process, the exchange also resolves trading disputes through arbitration.

(b) Critically analyze the recent trends in global derivatives market. (16)

-> Trading in exchange-trade financial derivatives contracts continued to grow rapidly in 2003, with turnover expanding by 26% to $874 trillion. The compares with increases of 17% in 2002 and 55% in 2001. Business in 2003 was brisk all of the broad market risk categories. Money market contracts accounted for most of the increase in trading in dollar terms but activity in the small market for currency contracts grew at the most rapid pace.

European fixed income business benefits from deepening liquidity

Worldwide trading in fixed income contracts, the largest segment of exchange-trade markets, rose by 27% to $794 trillion. Money market contracts, including futures and options on Eurodollar, Euribor and euryen rates, accounted for the biggest increase in activity in dollar terms, rising by $137 billion, or 25%, to $683 trillion. However, longer-term contracts, largely on government bonds, expanded at a faster pace, up by 41% to 5111 trillion.

One of the most notable developments in the area of money market products was the particularly strong expansion of activity on European exchanges European trading of such instruments, principally on Euribor, jumped by 64% to $278 trillion, compared with an increase of 7% in North America to $369 trillion. Trading in options on European money market rates was particularly buoyant, up by 111% to 583 trillion compared with an increase in futures of 50% to $195 trillion

One of the most notable developments in the area of money market products was the particularly strong expansion of activity on European exchanges. European trading of such instruments, principally on Euribor, jumped by 64% to $278 trillion, compared with an increase of 7% in North America to $369 trillion. Trading in options on European money market rates was particularly buoyant, up by 111% to $83 trillion compared with an increase in futures of 50% to $195 trillion. Trading in European money market instruments has been catching up rapidly with that in North America since 2002. Changing expectations about the stance of monetary policy in the euro zone played a role in the expansion of the short-term segment but activity also appears to have been boosted by a deepening of liquidity in over-the-counter (OTC) derivative instruments indexed to Euribor. In particular, the euro denominated interest rate swap market continued to grow vigorously in 2003, generating a flow of secondary hedging transactions in Euribor futures. The notably strong increase in exchange-traded options may have resulted from a shift of business away from the OTC derivatives market. Volatility in several types of option products traded in the OTC market, including interest, rate swaptions, reached unusually high levels in the second half of 2003. This may have prompted some market participants to switch to exchange- traded instruments.

Activity in longer-term fixed income instruments was also more buoyant on European exchanges than in other major geographical areas. European business in such contracts rose by 49% to 566 trillion, compared with an increase of 36% to 536 trillion in North America. As was the case for European trading in short-term rate contracts, European business in options on government bonds was especially active. Trading in such options rose by 86% to 55.6 trillion compared with an increase in futures of 46% to $60 trillion. Trading in government bond contracts in Europe and North America was fuelled by sharp swings in long-term interest rates in the first three quarters of 2003. The rally in fixed income markets in the first half of the year and its subsequent reversal from the end of June created a heavy volume of rebalancing transactions. Financial institutions, in particular, actively use fixed income futures and options to adjust the duration of their assets and liabilities as the level of interest rates changes. Such “immunization strategies create a positive link between transactions and market movements.

Stock index bustness driven by Astan activity

Global activity in stock index contracts rose by 20% to $75.5 trillion. Business expanded at widely differing rates across the major geographical areas. Turnover in the Asia Pacific region rose by 48% to $27.8 trillion and that in Europe by 19% to $14.7 trillion. The notable increase in activity in Asia was once again largely attributable to robust trading in options on the Korea Stock Exchange’s KOSPI 200 index, with a rise in turnover of such instruments of 49% to $21 trillion. Options trading in Korea was introduced in 1997 but has expanded i exponentially in recent years. Meanwhile, business in Japanese stock index contracts rose by 40% to 53 trillion, a tentative recovery following the stagnation observed in recent years. By contrast, activity in North America was much weaker, with transactions growing by 45 to $32.3 trillion. The upward movement of US equity markets from March onwards was accompanied by significantly lower volatility, realized and implied, which may have acted to weaken investor demand for protection.

Contracts on individual stocks, for which is measured only in terms of the number of contracts, also expanded by 20% in 2003 to 17 billion. Business on North American exchanges rose by 17% to $837 million contracts, while that on European exchanges grew by 8% to 592 million. Trading in the Asia-Pacific region jumped by 112% to 43 million contracts, largely because of the introduction of trading in options in India. Activity in the rest of the world received a boost from a 96% increase in futures and options in Brazil to 176 million.

Currency contracts recover on dollar weakness

Exchanges-traded currency contracts, which account for less than 1% of overall turnover in financial instruments, grew by 51% to $1.4 trillion in 2003. Such contracts appear to have been recovering in recent years from a long period of stagnation. This recovery stems largely from a significant increase in the turnover of dollar/euro futures on the Chicago Mercantile Exchange (CME), the largest marketplace in the world for exchange-traded currency contracts. Trading in such contracts was boosted by protection-seeking as the dollar depreciated sharply in the foreign exchange market. Trading in dollar/yen futures also rose notably, fuelled by the G7 countries’ call in September for more exchange rate flexibility. Market participants noted that the introduction by the CME of round-the-clock electronic trading for its currency contracts in April 2001 had helped enlarge the pool of traders in such instruments. Electronic trading may enable exchanges to complete more effectively with the much larger OTC market for currency instruments.

Commodity contracts grow with the rise of commodity prices

Business in commodity contracts, as measured by the number of contracts traded also expanded in 2003. Overall, turnover rose by 10% to 530 million contracts. Trading in contracts on precious and non-precious metals, which together account for one third of total turnover in commodity contracts, was particularly brisk, up by 26% and 30% respectively. Activity in contracts on non-precious metals appears to have been fuelled by stronger expectations of a pickup in global economic activity. Transactions in contracts on precious metals, especially gold, mirrored to some extent the movements of the dollar, playing the role of safe asset when the slide in the US currency accelerated. By comparison, business in agricultural commodities and energy products was lackluster, with turnover rising by 4% and 2% respectively.

The recent developments in information technology have contributed to the sharp growth in the OTC derivatives,

over the last few years, accompanied by the modernization of commercial and investment banking and the globalization of financial activities. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared with the latter. The episodes of turbulence in financial markets in 1998 revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features, compared to exchange-traded derivatives:

1. The management of counter-party (credit) risk is. decentralized and located within individual institutions;

2 There are no formal centralized limits on individual position, leverage, or margining;

3. There are no formal rules for risk and burden sharing;

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by both a regulatory authority and the exchange’s self regulatory organization, although they are affected. indirectly by national legal systems, banking, supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (1) the dynamic nature of gross credit exposures; (ii) information asymmetries; (ii) the effect of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions, and (v) the central role of OTC derivatives markets in the global financial system. Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts, occur which significantly alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwiding of positions.

There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counter party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systematic financial incidents, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian laws consider them illegal.

The structure of OTC derivatives markets has also been importantly influenced by developments in the major financial systems. In Japany the withdrawal of Japanese financial institutions from international activity and weak credit ratings for the major financial institutions have also meant their withdrawal from global derivatives markets (though market participants suggest that some major Japanese institutions with relatively high credit ratings may have remained involved in trading with foreign counterparties). However, Japanese financial institutions (including lower-rated city banks, regional banks, and insurance companies) are active in a domestically oriented derivatives market, principally involving yen-denominated interest rate swaps in which Japanese institutions pay floating rates and received fixed rates (e.g., synthetic bond positions funded at floating rates). Given the importance of counterparty credit quality, major global financial institutions have largely stayed out of this market – which is said to account for about half of the yen interest rate swaps market (or some $5 trillion in notional principal). This market is evidently broadly this connected from international markets, with swaps generally indexed to domestic rather than international interbank floating rates (e.g., TIBOR rather than LIBOR).