Full Marks: 80
Time: Three Hours
The figures in the margin indicate full marks for the questions.
1. (a) Explain the interrelationship between shareholder value as the core concept with functions of financial management, business and macroeconomic environment. (16)
(b) What is Traditional concept of Finance? Explain its transition to the new approach. (4+12)
-> 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
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.
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.
2. (a) What are common-size statements and what purpose do they serve? Assuming your own figures in respect of the balance sheets of two companies – Big company and Small company, explain how common size statements facilitate inter-firm comparison. (16)
(b) Explain the 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
Net Profit Margin=Net Income/Revenue
Asset Turnover=Sales/Average Total Assets
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) Evaluate the following as sources of capital employed: (6+5+5=16)
1) Equity shares.
-> Equity shares are long-term financing sources for any company. These shares are issued to the general public and are non-redeemable in nature. Investors in such shares hold the right to vote, share profits and claim assets of a company. The value in case of equity shares can be expressed in various terms like par value, face value, book value and so on.
Types of Equity Shares Available?
Ordinary Shares –
Such shares are issued by a company to procure funds to meet long-term expenses borne by a business. They have associated ownership benefits provided to an investor, wherein the individual gains exposure to various management segments involved in running operations. An individual possessing a large number of these types of equity shares have substantial voting rights.
Preference Equity Shares –
Preference equity shares are generally issued to an investor as a guarantee of the payment of cumulative dividend before returns are distributed among ordinary shareholders. However, preference shares do not have any associated voting and membership rights which are provided on common shares.
Classification among preference shares can also be made, depending upon its participating or non-participating capacity. If an investor purchases participating preference shares, he/she is entitled to the stipulated amount of profits, as well as bonus returns, depending upon the performance of a company during a particular financial year. Owners of non-participating equity shares are eligible for no such benefits.
Bonus Shares –
These types of equity shares are issued out of retained earnings of a business, wherein the profits are distributed among investors in the form of an additional stake in a company. Contrary to other types of equity instruments, bonus shares do not increase total market capitalization value of a company. It just represents capitalization of excess funds generated from production.
Rights Shares –
These shares are issued by a company to premium investors at a discounted price as an invitation to increase its stake in the respective business. A firm only sells shares to rights for a stipulated time to raise the required finances to meet its expenditures incurred.
Features of Equity Shares
Equity shares have the following characteristics, which make it one of the most popular investment tools in a stock market –
1. Most types of equity shares include voting rights to an investor, allowing him/her to choose individuals responsible to run the business. Electing efficient managers allows a company to increase its annual turnover, thereby increasing investors’ average dividend income.
2. Equity shareholders are eligible to realise additional profits generated by a company in a fiscal year. This increases the total wealth of individual investors having a considerable investment in equity shares of a company.
3. Even though equity shares are not repaid until a business closes down, equity shares already issued can be traded in the secondary capital market. Thus, investors can withdraw funds from a company upon their discretion. This ensures massive wealth creation through capital appreciation of such shares.
Invest in Equity Shares:-
Investing in best equity shares have the following benefits, such as –
- High Income
Equity share market is an ideal segment of the capital market responsible for the remarkable income of investors. Wealth creation not only works through capital appreciation of such securities but also high dividend earnings received by individuals.
- Hedge Against Inflation
Investment in profitable equity shares increases the standard of living of individuals through asset value appreciation. Money invested in equity shares offer manifold returns, higher than the rate of erosion of an individual’s purchasing power due to inflation. Thus, the real value of investments tends to rise over time.
- Portfolio Diversification
Investors having a low aptitude for risk tend to stick with debt instruments, as it is less volatile. However, stock and bond market fluctuations are inversely related when it comes to aggregate demand. Thus, when the bond market is underperforming, risk-averse investors can profit from investment in best equity shares through stock market investments.
2) Preference Shares.
-> Preference shares also commonly known as preferred stock, is a special type of share where dividends are paid to shareholders prior to the issuance of common stock dividends. Ergo, preference share holders hold preferential rights over common shareholders when it comes to sharing profits. Consequently, if a company lands into bankruptcy, preference shareholders are issued dividends first or have the first right to the company’s assets before common stock investors. For preference shareholders, the dividend is fixed however; they don’t hold voting rights as opposed to common shareholders.
Investors who have been in the stock market for longer than most go after preference share types. The dividends earned on these shares are significantly higher than ordinary shares. Their popularity can be established by the fact that many preference shareholders do not own any other stock except for this variety.
It has been observed that more and more companies are coming out with different types of preference shares. In essence, they have traces of both equity and debt shares. From this angle, these shares are also categorised as hybrid financing instruments.
Over the last few years, as the bear market run continues globally, more investors are looking towards preference shares as a viable means of gaining significant returns in the long run.
Features of Preference Shares
Several features have made these financial instruments the chosen vessels for investors. Most of these characteristics have made them superior earners even during low economic growth phases. The most attractive features are:
- Preference shareholders have significantly more heft than standard shareholders of any company. They have the first rights to all dividends paid by the companies whose shares they own.
· Holders of these shares do not have any voting rights in any business proceedings. The features, thus, also falls among the major disadvantages of preference shares. It might seem like a major handicap for any investor; however, it is precisely the reason why so many companies offer these shares. The aspect is also similar to debenture owners.
· One feature which is under-advertised is that the dividends are paid to the shareholders on specific dates. It is not entirely dissimilar to a monthly income.
· If an investor decides to buy a special type of these shares, they should look for irredeemable preference shares. These shares allow the holder to have a certain say on their maturity dates.
- One of the advantages of preference shares is that they are identical to PAT for most corporations. The taxation element is decided on the dividends that are payable on every pre-arranged dividend fund.
Different Types Of Preference Shares
There are many types of preference shares prevalent in India; enumerated below :-
- Cumulative Preference Share: Cumulative shares have a provision that allows investors to be paid dividends in arrears. It so happens that a company doesn’t have the financial capacity to pay dividends to its shareholders. Unless dividends are not paid to preference shareholders, they cannot be paid to common shareholders. In such a scenario, the company decides to pay cumulative dividends in the next year . Sometimes, interest earned by the shareholders on arrear dividends is also given to the cumulative preferred stock holders. The calculation is as follows –
Quarterly Dividend = [Rate of dividend * Par Value ] divided by 4
Cumulative dividends paid per share = Quarterly dividend * Total Number of payments missed.
- Non Cumulative Preference Shares: Non cumulative preferred shareholders are eligible to be paid dividends only from a year’s profit. So a non cumulative preferred stock does not issue unpaid dividends to the shareholders neither can holders of such stock claim unpaid dividends in the future.
- Redeemable Preference Shares: In case of redeemable shares,a company has the right to buy back the shares for its own use from shareholders at a fixed date or by giving prior notice after a period of time.
- Irredeemable Preference Shares: These shares can only be redeemed by the company at the time of liquidation or when the company winds up operations.
o Participating preference shares: Participating preference shares is where the company issuing the dividends pays increased dividends to the shareholders along with the preference dividend. This is done at a fixed rate. Additionally, participating preference shareholders have rights on the surplus asset of the company at the time of its liquidation.
- Non Participating Preference Shares: In case of non participating preference shares the shareholders are entitled only to the dividends at a fixed rate and not to the surplus profit. The extra profit is distributed among the common shareholders.
- Convertible Preference Shares: Shareholders of such shares have the option to convert the common shares to prefer shared. These shares are opted by investors who wish to receive preferred share dividend as well as want to benefit from an increase in the common shares. So the benefits are twofold- fixed returns by means of preferred dividends as well as the opportunity to earn higher returns as the common stock price increases. This conversion can happen within a certain period as per prior agreement, stated in the memorandum.
- Non Convertible Preference Shares: Shareholders of these shares do not hold the rights to convert to issuer’s common shares.
- Preference shares with a callable option: For shareholders having preference shares with a callable option, the issuing company holds the right to call in or buy back the stocks at a predetermined price after a set date. The call price, date post which the shares can be called and the call premium are mentioned in the prospectus.
- Adjustable Rate Preference Shares: For such shareholders, the dividend rate depends on the prevailing interest rates in the market, and hence is not fixed.
-> Debentures are a debt instrument used by companies and government to issue the loan . The loan is issued to corporates 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 and Disadvantages of Debentures
Advantages of Debentures
- Investors who want fixed income at lesser risk prefer them.
· As a debenture does not carry voting rights, financing through them does not dilute control of equity shareholders on management .
· Financing through them is less costly as compared to the cost of preference or equity capital as the interest payment on debentures is tax deductible.
- The company does not involve its profits in a debenture.
· The issue of debentures is appropriate in the situation when the sales and earnings are relatively stable.
Disadvantages of Debentures
· Each company has certain borrowing capacity. With the issue of debentures, the capacity of a company to further borrow funds reduces.
· With redeemable debenture, the company has to make provisions for repayment on the specified date, even during periods of financial strain on the company.
· Debenture put a permanent burden on the earnings of a company. Therefore, there is a greater risk when the earnings of the company fluctuate.
Types of Debenture
1. Secured and Unsecured:
Secured debenture creates a charge on the assets of the company, thereby mortgaging the assets of the company. Unsecured debenture does not carry any charge or security on the assets of the company.
2. Registered and Bearer:
A registered debenture is recorded in the register of debenture holders of the company. A regular instrument of transfer is required for their transfer. In contrast, the debenture which is transferable by mere delivery is called bearer debenture.
3. Convertible and Non-Convertible:
Convertible debenture can be converted into equity shares after the expiry of a specified period. On the other hand, a non-convertible debenture is those which cannot be converted into equity shares .
4. First and Second:
A debenture which is repaid before the other debenture is known as the first debenture. The second debenture is that which is paid after the first debenture has been paid back.
(b) What is a Convertible debenture? State the pros and cons of financing by convertible debentures in India. (5+8+3=16)
-> Convertible debentures meaning can be described as a long-term debt instrument. Typically, a convertible debenture is issued by a company and can be converted into equity shares eventually. Notably, the decision to convert debentures into equity shares lay with shareholders, and they are treated as the creditor or lender. Regardless, in some cases, issuers may possess the conversion rights.
These are unsecured bonds or loans, which means there is often no underlying collateral service as security. Generally, businesses issue such long-term debt instruments to avail tax-saving benefits. For instance, companies that issue convertible debentures are entitled to claim tax deductions on the amount of interest paid to investors.
It must be noted that convertible debentures yield a lower interest when compared to pure debt instruments. Such debentures can be exchanged for stocks at specific times; in turn, enabling bondholders to offset at least some risks involved with putting money in them.
Types of Convertible Debentures
These debentures are of two kinds, namely –
1. Fully convertible debentures
2. Partly convertible debentures
Features of convertible debentures:-
- Conversion price – It is essentially the price at which an ordinary share is issued and subsequently allotted to debenture holders. The conversion price depends on factors like – current book value, market price, anticipated appraisal in equity share value, etc. Higher conversion prices lead to lower addition to the capital base.
- Conversion rate – The ratio indicates the number of equity shares received against a convertible bond.
- Quantum of conversion – It is the number of debentures to be converted and is expressed in terms of a percentage of its face value.
- Coupon payment – Its value depends on an issuer’s credit quality and prevailing interest rates. The break-even analysis proves useful in comparing coupon payouts against dividend yields of common shares.
- Convertible value – It is the value of these debentures that is mainly based on an investor’s right to receive equity shares. It is the conversion ratio multiplied with the market price of each equity share.
- Timing of conversion – It usually ranges between a year (from the date of allotment) and 5 years.
- Market Price – This price is decided as per the investment and conversion value of this debt instrument. Essentially, the market price is given as the value the market attaches to a convertible debenture.
- Premium – It is merely the sum of money by which the market price of a convertible debenture is more than its overall conversion value.
Benefits of Convertible Debentures
From a business’ point of view, these debentures are considered to be among the quickest and most feasible ways of raising funds. Companies issue debentures, and with the funds rose, they accelerate the growth and profitability of their venture.
The most popular benefits of convertible debentures for investors are as follows –
· Investors receive a fixed-rate and also have the option to partake in stock price appraisal.
· In case an issuer’s stock price declines, investors are entitled to hold onto the bonds until maturity.
· Convertible debenture holders are paid before other stockholders in the event of liquidation of the company.
· Being a hybrid investment instrument, investors are entitled to fixed interest payouts and also have the option of converting their loan to equity when the company is performing well or when its stock prices are rising.
To gain a better picture of convertible debentures example, intending investors should make it a point to weigh in the debt-instruments limitations as well.
Limitation of Convertible Debentures
The most noteworthy drawbacks of convertible debentures as investment options include –
· When compared to traditional bonds, convertible debenture holders accrue a lower interest rate.
· Debenture holders may be subject to the risk of company default. In such a situation, the company will be unable to repay even the principal amount to investors.
· In case the stock prices decline after the conversion of debentures into equity, investors could lose their invested money.
Investors should factor these limitations while gauging the suitability of convertible debentures. Subsequently, they should develop strategies to hedge the associated risks and increase income through investment in this debt instrument.
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 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).