2016 – Solved Question Paper | Financial management | Final Year – Masters of Commerce (M.Com) | Dibrugarh University

2016 – Solved Question Paper | Financial management | Final Year – Masters of Commerce (M.Com) | Dibrugarh University

2016

COMMERCE

Paper: 201

(Financial Management)

Full Marks: 80

Time: 3 hours

The figures in the margin indicate full marks for the questions

1. (a) Elucidate the change of traditional concept of finance to the new approach under Financial Management. (16)

-> The following points highlight the three main approaches to financial management. The approaches are: 1. Traditional View 2. Modern View 3. Liquidity and Profitability.

Approach 1- Traditional View:

Financial management is primarily concerned with acquisition, financing and management of assets of business concern in order to maximize the wealth of the firm for its owners. The basic responsibility of the Finance manager is to acquire funds needed by the firm and investing those funds in profitable ventures that will maximize firm’s wealth, as well as, yielding returns to the business concern.

The success or failure of any firm is mainly linked with the quality of financial decisions. The focus of Financial management is on efficient and judicious use of resources to attain the desired objective of the firm.

The basic objectives of Financial management centres around (a) the procurement funds from various sources like equity share capital, preference share capital, debentures, term loans, working capital finance, and (b) effective utilization of funds to maximize the profitability of the firm and the wealth of its owners.

The responsibilities of the Finance managers are linked to the goals of ensuring liquidity, profitability or both and are also related to the management of assets and funds of any business enterprise.

The traditional view of financial management looks into the following functions, that a Finance manager of a business firm will perform:

(a) Arrangement of short term and long-term funds from financial institutions.

(b) Mobilization of funds through financial instruments like equity shares, preference shares, debentures, bonds etc.

(c) Orientation of finance function with the accounting function and compliance of legal provisions relating to funds procurement, use and distribution.

With the increase in complexity of modern business situation, the role of a Finance manager is not just confined to procurement of funds, but his area of functioning is extended to judicious and efficient use of funds available to the firm, keeping in view the objectives of the firm and expectations of the providers of funds.

Approach 2- Modern View:

The globalization and liberalization of world economy has caused to bring a tremendous reforms in financial sector which aims at promoting diversified, efficient and competitive financial system in the country. The financial reforms coupled with diffusion of information technology has caused to increase competition, mergers, takeovers, cost management, quality improvement, financial discipline etc.

Globalization has caused to integrate the national economy with the world economy and it has created a new financial environment which brings new opportunities and challenges to the individual business concern. This has led to total reformation of the finance function and its responsibilities in the organization.

Financial management in India has changed substantially in scope and complexity in view of recent Government policy. Today’s Finance managers are seized with problems of financial distress and are trying to overcome it by innovative means. In the current economic scenario, financial management has assumed much greater significance.

It is now a question of survival of entities in the total spectrum of economic activity, with pragmatic readjustment of financial management. The information age has given a fresh perspective on the role of financial management and Finance managers. With the shift in paradigm it is imperative that the role of Chief Finance Officer (CFO) changes from Controller to a Facilitator.

In view of modern approach, the Finance manager is expected to analyse the firm and to determine the following:

(i) The total funds requirement of the firm,

(ii) The assets to be acquired, and

(iii) The pattern of financing the assets.

The Finance manager of a modern business firm will generally involve in the following three types of decisions:

(1) Investment decisions,

(2) Finance decisions, and

(3) Dividend decisions.

(1) Investment Decisions:

Investment decisions are those which determine how scarce resources in terms of funds available are committed to projects. The project may be as small as purchase of equipment or as big as acquisition of an entity.

Investment in fixed assets requires supporting investment in working capital in the form of inventory, receivables, cash etc. Investment which enhance internal growth is termed as ‘internal investment’ and acquisition of entities represents ‘external investment’.

The investment decisions should aim at investment in assets only when they are expected to earn a return greater than a minimum acceptable return, which is also called as ‘hurdle rate’. The minimum return should reflect whether the money raised from debt or equity meets the returns on investments made elsewhere on similar investments.

The hurdle rate has to be set at higher for riskier projects and has to reflect the financing mix used i.e., the proportion of debt and equity. The Finance function involves not only in investment decisions, but also in disinvestment decisions, for example withdrawing from unsuccessful projects or restructuring with a strategic motive.

Investment decisions relate to the careful selection of viable and profitable investment proposals, allocation of funds to the investment proposals with a view to obtain net present value of the future earnings of the company and to maximize its value.

It is the function of a Finance manager to carefully analyze the different alternatives of investment, determination of investment levels in different assets i.e., fixed assets and current assets.

The investment decisions of a Finance manager cover the following areas:

(a) Ascertainment of total volume of funds, a firm can commit.

(b) Appraisal and selection of capital investment proposals.

(c) Measurement of risk and uncertainty in the investment proposals.

(d) Prioritizing of investment decisions.

(e) Funds allocation and its rationing.

(f) Determination of fixed assets to be acquired.

(g) Determination of levels of investments in current assets viz., inventory, receivables, cash, marketable securities etc., and its management.

(h) Buy or lease decisions.

(i) Asset replacement decisions.

(j) Restructuring, reorganization, mergers and acquisitions.

(k) Securities analysis and portfolio management etc.

(2) Finance Decisions:

The financing objective asserts that the mix of debt and equity chosen to finance investments should maximize the value of investments made. The debt equity mix should minimize the hurdle rate allows the firm to take more new investments and increase the value of existing investments.

Financing decisions relate to acquiring the optimum finance to meet financial objectives and seeing that working capital is effectively managed. Financing decisions call for good knowledge of costs of raising finance, procedures in hedging risk, different financial instruments and obligations attached to them etc. Important principle to consider in financing is that long-term assets should be financed with long-term debt and short-term assets should be financed with short-term debt.

Firms that violate this basic rule do so at their own risk. It is one of the important functions of a Finance manager is procurement of funds for the firm’s investment proposals and its working capital requirements.

In fund raising decisions, he should keep in view the cost of funds from various sources, determination of debt-equity mix, the advantages and disadvantages of debt component in the capital mix, impact of taxation and depreciation in maximization of earnings per share to the equity holders, consideration of control and financial strain on the firm in determining level of gearing, impact of interest and inflation rates on the firm etc.

The Finance manager involved in the following finance decisions:

(a) Determination of degree or level of gearing.

(b) Determination of financing pattern of long-term funds requirement.

(c) Determination of financing pattern of medium and short-term funds requirement.

(d) Raising of funds through issue of financial instruments viz., equity shares, preference shares, debentures, bonds etc.

(e) Arrangement of funds from banks and financial institutions for long-term, medium-term and short-term needs.

(f) Arrangement of finance for working capital requirement.

(g) Consideration of interest burden on the firm.

(h) Consideration of debt level changes and its impact on firm’s bankruptcy.

(i) Taking advantage of interest and depreciation in reducing the tax liability of the firm.

(j) Consideration of various modes of improving the earnings per share and the market value of the share.

(k) Consideration of cost of capital of individual components and weighted average cost of capital to the firm.

(l) Analysis of impact of different levels of gearing on the firm and individual shareholder.

(m) Optimization of financing mix to improve return to the equity shareholders and maximiza­tion of wealth of the firm and value of the shareholders’ wealth.

(n) Portfolio management.

(o) Consideration of impact of over capitalization and under capitalization on the firm’s profitability.

(p) Consideration of foreign exchange risk exposure of the firm and decisions to hedge the risk.

(q) Study of impact of stock market and economic conditions of the country on modes of financing.

(r) Maintenance of balance between owners’ capital to outside capital.

(s) Maintenance of balance between long-term funds and short-term funds.

(t) Evaluation of alternative use of funds.

(u) Setting of budgets and review of performance for control action.

(v) Preparation of cash-flow and funds flow statements and analysis of performance through ratios to identify the problem areas and its correction, etc.

For financing decisions, the capital structure is broadly divided into:

(a) Equity, and

(b) Debt.

Equity:

The raising funds through issue of shares attract flotation costs. The shareholder expects the return in the form of dividends and capital appreciation of their investment reflected in the increase in stock market price.

The dividend payments are made only if the distributable profits are available with the company, after payment of interest charges and tax payments. Any further issue of shares by the existing companies may dilute the controlling interest.

The equity is considered as low risk but most expensive way of funding the company’s projects. The equity funds are not returnable except in the case of liquidation. However, the buy-back of shares is allowed under the provisions of the Companies Act, 1956.

The equity holders will participate in the policy decisions of the company. In company form of business, only legal personality exists, hence all decisions are carried through the agents who work for remuneration. Therefore, agency problems arise with the managers.

Debt:

The debt funds are raised in the form of debentures, bonds, term loans etc. The expectation of the providers of debt is obtain return in the form of interest payments which should commensurate with the risk attached to their investment. The debt is repaid as per the agreement. The interest should be paid irrespective of the profitability of the firm.

The portion of debt component in capital structure will facilitate the trading on equity Le. the interest on debt is payable at a fixed rate and if the firm’s return on capital employed is more than the interest payable, the excess return over fixed interest will be added to the profits available to equity providers.

But the high proportion of gearing i.e., excess reliance on debt funds will increase the financial risk of the firm. The cost of debt is always lower than cost of equity, since any interest payable will reduce the tax liability of the firm. The non-repayment of interest and principal amounts in time may sometimes call for liquidation of the company.

(3) Dividend Decisions:

Dividend decisions concerned with the determination of quantum of profits to be distributed to the owners and the frequency of such payments. The dividend decisions will effect in two ways (a) the amount to be paid out and its influence on share price, and (b) the amount of profit to be retained for internal investment which maximizes the value of firm and ultimately improves the share value of the firm.

The level and regular growth of dividends represent a significant factor in determining a profit-making company’s market value and the value of its shares in the stock market. The dividend decisions of a Finance manager is mainly concerned with the decisions relating to the distribution of earnings of the firm among its equity holders and the amounts to be retained by the firm.

The Finance manager will involve in taking the following dividend decisions:

(a) Determination of dividend and retention policies of the firm.

(b) Consideration of impact of levels of dividend and retention of earnings on the market value of the share and the future earnings of the company.

(c) Consideration of possible requirement of funds by the firm for expansion and diversification proposals for financing existing business requirements.

(d) Reconsideration of distribution and retentions policies in boom and recession periods.

(e) Considering the impact of legal and cash-flow constraints on dividend decisions.

The investment, finance and dividend decisions are interrelated to each other and, therefore, the Finance manager while taking any decision, should consider the impact from all the three angles simultaneously.

In the words of Ezra Solomon “the function of Financial management is to review and control decision to commit and recommit funds to new and on going uses. Thus in addition to raising funds, Financial management is directly concerned with production, marketing and other, functions within an enterprise whatever decisions are made about the acquisition or distribution of assets”.

This statement will reflect the modern view of financial management. From the point of view of modern corporate firm, financial management is related not only to fund raising but encompasses the wider perspective of managing the finances for the company efficiently. Hence, Financial management is nothing but managerial decision making on asset mix, capital mix and profit allocation.

The corporate finance theory centres around three important objectives of a finance function:

(a) Allocation of funds i.e. investment decisions,

(b) Generation of funds i.e. financing decisions, and

(c) Distribution of funds i.e., dividend decisions.

The guiding factors for the above said finance decisions are as follows:

(i) The wealth maximization objective of firm, and

(ii) The existence of efficient capital markets.

The whole subject of financial management is based on following tenets:

(a) The owners will have primary interest in the firm’s success and growth.

(b) The shareholder’s wealth is the determinant of current share price.

(c) The firm will go on spending on capital investment proposals so long as it generates positive net present values.

(d) The firm’s capital structure and dividend decisions are irrelevant, since they are guided by the management control over firm and also depends on the efficiency of capital market.

Interrelationship of Investment, Financing and Dividend Decisions:

The corporate finance theory has broadly categorized the financial decisions into investment, financing and dividend decisions. All these financial decisions aims at the maximization of shareholders’ wealth through maximization of firm’s wealth.

i. Investment Decisions:

The firm should select only those capital investment proposals whose net present value is positive and the rate of return on the projects should exceed the marginal cost of capital. In situations of capital rationing, the investment proposals are selected based on maximization of net present value. The profitability of each individual project will contribute to the overall profitability of the firm and leads to creation of wealth.

ii. Financing Decisions:

The financing of capital investment proposals are done in two forms of finances in general i.e., equity and debt. The finance decisions should consider the cost of finance available in different forms and the risks attached to it. The reduction in cost of capital of each component would lead to reduction in overall weighted average cost of capital.

The principle of trading on equity should be kept in view while selecting the debt-equity mix or capital structure decisions. The relative advantages and risk attached to debt financing and equity financing should also be considered. The lower cost of capital and minimization of risks in financing will lead to the profitability of the organization and create wealth to the owners.

iii. Dividend Decisions:

The dividend distribution policies and retention of profits will have ultimate effect on the firms wealth. The company should retain its profits in the form of reserves for financing its future growth and expansion schemes. The conservative dividend payments will adversely affect the firms’ share prices in the market. Therefore, an optimal dividend distribution policy will lead to the maximization of shareholders’ wealth.

In conclusion, it is viewed that the basic aim of the investment, financing and dividend decisions is maximize the firm’s wealth. If the firm enjoys the stability and growth, its share prices in the market will improve and will lead to capital appreciation of shareholders’ investment; and ultimately maximizes the shareholders wealth.

Approach 3- Liquidity and Profitability:

Ezra Solomon states that “liquidity measures a company’s ability to meet expected as well as unexpected requirements of cash to expand its assets, reduce its liabilities and cover up any operating losses.”

The balancing of liquidity and profitability is one of the prime objectives of a Finance manager. One of the important problems faced by Finance manager is the dilemma of liquidity vs. profitability. Liquidity ensures the ability of the firm to honour its short-term commitments.

The liquidity means the firm’s ability to pay trade creditors as and when due, ability to honour its bills payable on due-dates, ability to pay salaries and wages on time when it is due, ability to meet unexpected expenses etc. It also reflects the firm’s ability to convert its assets into cash, cash equivalents and other most liquid assets.

The liquidity of the firm indicates the ability of the organization to realize value in money, and its ability to pay in cash the obligations that are due for payment. To maintain concern’s liquidity, the Finance manager is expected to manage all its current assets and liquid assets in such a way as to ensure its affectivity with a view to minimize its costs. Under profitability objective, the Finance manager has to utilize the funds in such a manner as to ensure the highest return.

Profitability concept signifies the operational efficiency of an organization by value addition through the utilization of resources i.e., men, materials, money and machines. It refers to a situation in terms of efficiency in utilization of resources to achieve profit maximization for the owners.

There is an inverse relationship between profitability and liquidity. The higher the liquidity the lower will be the profitability and vice versa. Liquidity and profitability are competing goals for the Finance manager. Under liquidity management, the Finance manager is expected to manage all its current assets including near cash assets in such a way as to ensure its affectivity with a view to minimize costs.

Sometimes, even if the profit from operations is higher, the firm may face liquidity problems due to the fact that the amount representing the profit may be in the form of either in fixed assets like plant, buildings etc. or in the form of current assets like inventory, debtors – other than in the form of cash and bank balances. In situations where the firm faces the liquidity problems, will hamper the working of the company which result in lower profitability of the firm.

If, more assets of the firm are held in the form of highly liquid assets it will reduce the profitability of the firm. Lack of liquidity may lead to lower rate of return, loss of business opportunities etc.

Therefore, a firm should maintain a trade-off situation where the firm maintains its optimum liquidity for greater profitability and the Finance manager has to strike a balance between these two conflicting objectives. If, more assets of the firm are held in the form of highly liquid assets, it will reduce the profitability of the firm.

(b) Elucidate the assumptions underlying the financial objectives under Financial Management. (16)

2. (a) In Financial Statement how would you make comparative analysis and common size analysis. (8+8=16)

-> Comparative Statement:

The comparative statements are that statement which shows the comparison between the component of the financial statement of the business for the period of more the two years. The components of the two or more years are shown side by side on the same page and then calculate the change from the base year of all the elements. It is the tools for the analysis of the financial statements of the business.

Common Size Statement

The Common-Size statement is that statement that shows the percentage to a common base of all accounts of the financial statement of the business for the period of more than two years. The components of the two or more years are shown side by side in vertical order on the same page and then calculate the percentage on the common base of net sales of both years of all the elements. It is the tools for the analysis of the financial statements of the business.

Difference between Comparative and Common Size Statement

Basis of Difference

Comparative

Common Size

Meaning

The comparative statements are that statement which shows the comparison between the component of the financial statement of the business for the period of more the two years

The Common-Size statement is that statement which shows the percentage to a common base of all accounts of the financial statement of the business for the period of more than two years.

Base of Comparison

In this, the value of thebasis year compared with the value of the current year.

In this, the value of the current year compared with the current year.

Number of Years required

Minimum Financial Statements of two years are required.

The financial Statement of One year is required.

Results expressed in

The results are expressed in the pictorial as well as percentage form.

The results are expressed in the percentage form.

Type of Comparison included

It included both types of Intra and inter-firm comparison.

It included only inter-firm comparison.

Helps in

It helps in the decision making for the management for future planning.

It helps the stakeholder in the decision of the investment.

Useful in

It is useful to compare the current year results with the prevision year.

It is useful to compare the current year results with its competitors’ results.

(b) How would you justify the use of DuPont system of Financial Analysis? (16)

-> 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) Explain the pros and cons of Equity financing to pros and cons of Rights issues. (16)

-> Advantages vs. Disadvantages of Equity Financing

Advantages of Equity Financing:

1. Less Overhead: When obtaining equity financing, there is no loan to payback with interest. In early stage, business feels relief from fewer burdens as they do not need to make a month to month loan installment. This can be especially important factor to consider if the business doesn’t generate profits during initial stage.

2. Focus on your product rather than finance: Equity financing is the changeless answer for finance needs of an organization. No organization’s principle objective or target can be money management, as organization cannot spend all the time looking after finance and loans periodically. A product base company will have a goal of delivering outstanding products to the customers or consumers. Equity finance gives that benefit to concentrate on high quality product and services. It keeps business administration teams far from the raising funds again and again by approaching various financial institutions or moneylenders.

3. No More Credit Issues: When applying for the loan, there are chances that you need good credit rating. In case of poor financial record of the business then the best and reliable option would be to take advantages of equity financing rather than applying for debt financing .

4. Get talent and skills: With equity financing, you may shape your partnership or large company with more skilled and experienced people. Some better talents may be all around you. Assuming that your business could get profits and benefits from skilled and business communities.

5. You can anytime apply for loans: When an organization is highly financed by equity, then major equity stakeholders has all the control over money related matters as well as business strategies and planning. A bank or some other moneylenders require an organization to contribute approximately 20 to 25% by equity to finance other 75 to 80% obligation. Lower equity finance companies have higher growth rate and smooth business operations which intern is easier for acquiring of debt finance during need.

Disadvantages of Equity Financing:

1. Profits are shared: Your financial institutions or investors will expect some share from business profit. It could be an advantageous exchange as well, that you are profiting from the cash they bring or potential business experience and skills.

2. Loss of control: There is a cost to pay for equity financing and the majority of its potential advantages that your investor provides to your business. You will have to share the control of your business which seems to be biggest disadvantages of equity financing.

3. Costly way of raising fund: Equity finance is thought to be the most expensive way of fund raising when compared with debt finance. The undeniable reason is the higher required rate of come back from equity shareholders. Since investing through equity shares is a high-risky investment , financial investors will obviously expect a higher rate of return.

4. Flotation Cost: Financing through equity is the most tedious and troublesome method for fund raising. It require a follow huge numbers of statutory compliance and also various costs like charge of a merchant financier, underwriting fees, brokerage, guaranteeing charge, and bunches of other fees as expenses .

5. Underwriting of Shares: When applying for initial public offer (IPO), the organization regularly requires an appoint of underwriters. The activity of a underwriters is to expect the risk of membership. Financiers would consent to subscribe the offers to an agreement in-case not subscribed by the public offering and will charge an expense for that administration. The charge might be as paid in advance or might be an equity shares on the discounted rate.

6. Arising Conflict: Sharing proprietorship and working with others could prompt nearly pressure and even clash in the ideas, growth, and administration style and for business operations. It can be an issue to one has to consider. Many owners of the companies leave in frustration when they fail to consider this disadvantage of equity financing at the earlier stage.

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 effected 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.

4. (a) Do you think Commercial and Captive Finance Companies play a very important role in short-term financing. Justify. (16)

->

(b) Elaborate with examples unsecured and secured borrowing under 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) Give an overview of the emerging derivatives market structure in India. (16)

-> Apart from traditional financial markets, two markets are emerging, namely the derivatives market has come into recently and the banc assurance market, which is like to emerge in an important way once banks start undertaking insurance business derivatives in the Indian financial markets are of recent origin barring trade related forward contracts in the forex market. Futures markets in the commodity segment, however, have existed for a long time. Recently, over-the counter (OTC) as well as exchange traded derivatives have been introduced, marking an important development in the structure of financial markets in India. Forward contracts in the forex market have also been liberalized. Exchange traded derivatives tend is more standardized and offer greater liquidity than OTC contacts, which are negotiated between counterparties and tailored to meet the needs of the parties to the contract. Exchange traded derivatives also offer centralized limits on individual positions and have formal rules for risk and burden sharing.

In India, OTC derivatives, viz. Interest Rate Swaps (IRS) and Forward Rate Agreements (FRAS) were introduced in July 1999, while one exchange trade derivative. Viz, Stock Index. Futures were introduced by the two largest stock exchanges in June 2000. The FRA is an off-balance sheet contract between. two parties under which one party agrees on the start date (or trade date) that on a specified future date (the settlement date) that party, rt, the party that agrees, would lodge a notional deposit with the other for a specified sum of money for a specified period of time (the FRA period) at a specified rate interest (the contract rate) The party that has agreed to make the notional deposit has, thus, sold the FRA to the other party who has bought it. The IRS is a contract between two counterparties for exchanging interest payment for a specified period based on a notional principal amount. The notional principal is used to calculate interest payments but is not exchanged. Only interest payments are exchanged. The IRS and FRA were introduced with a view to deepening the money market as also to enable banks, Primary Dealers and financial institutions to hedge interest rate risks. The IRS has emerged as the more popular of the two instruments in the Indian market, accounting for nearly all of the 928 outstanding deals, amounting to Rs. 12,620 crore of notional principal as on November 17, 2000. The overnight call money rates and the forex forward have emerged as the most popular benchmark rates.

A resident of India who had borrowed foreign exchange in accordance with the FEMA, may enter into an interest rate swap or currency swap o coupon swap or foreign currency option or interest rate cap/collar or Forward Rate Agreement (FRA) contract with an authorized dealer (AD) in India or with a branch outside India of an authorized dealer fro hedging his loan exposure and unwinding from such hedges provided that (1) the contract does not involve rupee, (u) foreign currency borrowing has been duly approved, (ii) the notional principal amount of the hedge does not exceed the outstanding amount of the loan, and (iv) the maturity of the hedge does not exceed the un-expired maturity of the underlying loan. As resident in India can enter legally into a foreign exchange derivative contract without the prior permission of the Reserve Bank. Among the non-residents, while FIls may enter into a forward contract with rupees as one of the currencies with an AD in India, non-resident Indians and Overseas Corporate Bodies could take forward cover with an AD to hedge (1) dividend due on shares held in India, (ii) balances in FCNR (B) and NR (E) A, and (iii) the amount of investment made under portfolio scheme. The Reserve Bank may also consider allowing residents to hedge their commodity price risk (including gold but excluding oil and petroleum products (subject to certain conditions.

This market has emerged as an important segment of the forex market in India in the recent years. It comprises customers, such as, corporates, exporters, importers, and individuals. Authorised Dealers (Ads) and the Reserve Bank. Of late, FIls have emerged as major participants in this segment. The marker operates from major centres with Mumbai accounting for bulk of the transactions. Till February 1992, forward contract were permitted only against trade related exposures and these contract could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entitles, unrestricted booking and cancellation of forward contracts for all genutne exposures, whether trade related or not, were permitted. At present, the forward contracts market is active up to six months where two-way quotes are available. The maturity profile has recently elongate with quotes available up 10 one year. With the gradual opening up of the capital account, forward premium is now increasingly getting aligned with the interest rate differential. Importers and exporters also influence the forward market in many ways. Besides, banks are allowed to grant foreign Though the Futures & Options segment provides a nation-wide market, Mumb leads the city-wise distribution of contracts traded at 49.08 per cent followed by Delhi (including Ghaziabad) at 24.38 per cent Kolkata (including Howrah) at 12 per cent, and others accounted for balance share of trading. The others include cities such as Kochi, Erukulam, Parur, Kalamasserry, Always at 2.44 per cent each, Ahmedabad (2.25 per cent), Chennai (2.01 per cent), Hyderabad, Secunderabad and Kukatpally at 1.54 per cent and others at 5.80 per cent.

If there is a winner of the current bull run on the bourses, it is undoubtedly the infantile derivatives segment. In the battle for turnover, the derivatives segment has overshadowed the long-established cash market.

Today, in less than three years, the derivatives segment has only overtaken the traditional cash market, but has also emerged as an ideal hedging mechanism in the equities market. The derivatives market was able to beat the cash market in terms of monthly turnover for the first time in February 2003. Then the derivatives segment of the equity market clocked a total monthly turnover of Rs. 49,395 crore compared with the total cash market’s Rs 48,289 crore. By July 2003 the derivatives segment has recorded a turnover of Rs. 109,850 crore, while the cash market segment has been pushed behind with a turnover of Rs. 78,878 crore. The average daily turnover in the derivatives market has touched Rs. 4,776 crore against the cash market turnover of Rs. 3,429 crore. For the past six months (except in the month of May 2003), the monthly volume in the derivatives segment has been higher than in the cash market.

The growing volume turnover indicates a healthy sign. The derivatives segments has brought in a lot of liquidity and depth to the market, and the mind-boggling turnover statistics of the derivatives segment speak for themselves. But why are derivatives such a big hit in Indian market? Generally, the reasons cited are: (i) The derivatives products-index futures, index options, stock futures and stock options provide a carry forward facility for investors to take a position (bullish or bearish) on an index or a particular stock for period ranging from one to three months; (ii) They provide a substitute for the infamous badla system; (ul) The current daily settlement in the cash market has left no room for speculation. The cash market has turned into a day market, leading to increasing attention to derivatives; (iv) Unlike the cash of full payment or delivery, investors don’t need much funds to buy derivatives products. By paying a small margin, one can take a position in stocks or market index: (v) The derivatives volume is also picking up in anticipation of reductions of contract size and finally everything works in a rising market. Unquestionably, there is also a lot of trading interest in the derivatives market.

Futures are more popular in the Indian market as compared to options. The popularity of stock futures can be traced to their similarity to the earlier badla system of carrying forward of trades. Stock futures encourage speculation in the capital market and with speculation being an integral part of the market; the popularity of the product is not a surprise. Also stock futures have the advantage of giving higher exposure by paying a small margin. Also stock futures product like index futures and stock futures are easy to understand as compared to options product. Options’ being more complicated product is nor very much popular in the market if the compare futures, stock futures are much more population as compared to index futures. Starting off with a measly turnover of Rs. 2,811 crore. in November 2001, the stock futures turnover jumped to Rs. 14,000 crore by March 2002, Rs. 32,752 crore in May 2003 and Rs. 70,515 crore in July 2003 Similarly, index futures started its turnover journey with Rs. 35 crore-figure way back in June 2000. The trading interest picked up steadily and jumped to Rs. 524 crore in March 2001, Rs. 1,309 crore in June 2001, Rs. 2747 crore in February 2002, Rs. 3,500 crore in November 2002 and Rs. 14,743 crore in July 2003. Infact, the stock futures were a hit right from their launch. It is important to note that the Securities & Exchange Board of India introduced stock futures in November 2001 after it launched all the other derivative products and now it accounts for nearly 65% of total volumes. In the month of July alone, stock futures considered to be the riskiest of the lot recorded a turnover of Rs. 70,515 crore followed by stock options, index futures and index options.

However, contrary to international experience, the volumes have been so far low in the Indian derivatives market. SEBI’s Technical Group on New Derivative Products has recently. examined this issue, and made the following recommendations: (i) In order to generate volume, the system of sub-brokers be used for trading in derivatives market; (ii) In order to facilitate free arbitrage between cash and derivatives market, financial institutions and mutual funds may be permitted to short sell in the cash market. Such short sale may, however, be restricted to the extent of corresponding exposure in the derivatives market. Moreover, such transactions can also be permitted through a separate dedicated fund; (iii) Arbitage between cash and futures market will also help in between price discovered in both the markets.

RBI has allowed FIls to trade in derivatives market, subject to the condition that the overall open position of the FII shall not exceed 100 per cent of market value of the concerned FII’s total investment. Managed future funds should be permitted to take position in the derivatives market without having any exposure in the cash market. Also, FIls intending to invest funds in the cash market should also be permitted to take long position in the futures market to hedge their transactions.

SEBI and RBI should jointly examine the issuesconcerning trading in derivatives by Fls and FIls.

In development countries, one important character of insurance business and of long-term life insurance, in particular, is that insurance policies is seen as a possible source of competition for the banking industry, as the insurance industry developes on a competitive basis. There are, however, other considerations, that point to the possible complement rites and synergies between the insurance and banking business.

The most important source of complementarily arises due to the critical role that banks could play in distributing and marketing of insurance products. So, far, direct branch network LIC, GIC and its subsidiaries together with their agents have been instrumental in marketing of insurance products in India. With further simplification of insurance products, however, the vast branch network and the depositor base of commercial banks are expected to play an important role in marketing insurance products over the counter. The eagerness on the part of several banks and NBFCs to enter into insurance business following the opening up of the industry to private participation reflects this emerging process.

The present interest of banks to enter into insurance business also mirrors the global trend. In Europe the synergy between banking and insurance has given rise to the concept of ‘bancasssurance a package of financial services that can fulfill both banking and insurance needs. In France, for example, over half of the insurance products are sold through banks. In the US, banks lease space to insurers and retail products of multiple insurers, in the way the shops sell products. The institutional framework within which this functional overalaps are taking place has been varied floatating of separate insurance companies by banks, banks’ buying stakes in existing insurance companies, and swap of shares and mergers. Insurance companies have also sought to acquire stakes in some banks.

In India, the Reserve Bank, in recognition of the symbiotic relationship between banking and the insurance industries, has identified three routes of banks’ participation in the insurance business, riz, (i) providing fee-based insurance services without risk participation, (ii) investigating in an insurance company for providing infrastructures and services support and (iii) setting up of a separate joint-venture Insurance company with risk participation. The third route, due to its risk aspects, involves compliance to stringent entry norms. Further, the bank has to maintain an ‘arms length’ relationship between its banking business and its insurance outfit. For banks entering into insurance business with risk participation, the prescribed entity (viz. separate joint-venture company) also enables to avoid possible regulatory overlaps between the Reserve Bank and the Government/IRDA. The joint-venture insurance company would be subjected entirely to the IRDA/Government regulations.

Besides commercial banks, rural cooperative credit institutions are also envisaged as an important vehicle for distributing insurance products in under-served rural areas. The Task Force to Study the Co-operative Credit System and Suggest. Measures for its, Strengthening noted that this could have the attendant benefit of portfolio diversification for these institutions.

(b) Give an overview of the Global Derivatives market trend. (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).

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