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CORPORATE FINANCE: Corporate finance is that part of finance that deals with the financial problems of corporate enterprises. These problems include the financial aspects of the promotion of new enterprises and their administration during early development, the accounting problems connected with the distinction between capital and income, the administrative questions created by growth and expansion; and finally, the financial adjustments required for the bolstering up or rehabilitation of a corporation which has come into financial difficulties. SCOPE OF CORPORATE FINANCE: It studies the financial operation carried on by a corporation. It analyses the financial implications involved in the promotion of corporate enterprises. It assists in scanning the financial plans of new and established business units. It examines the nature, extent and form of the capital required by corporations. It scrutinizes the practices and policies of administering corporate income. It looks into the propriety of dividend, depreciation and reserve policy adopted by various business companies. It studies the nature and importance of financial assistance rendered to business enterprises by the different financial institutions. It examines the roles of the state in regulating and controlling the financial practices and policies of corporations. FINANCIAL INSTITUTION: Financial institution is an establishment that focuses on dealing with financial transaction such as investment loans and deposits. A financial institution is one that facilitates allocation of financial resources from its source to potential users. Agencies that purvey credit in the financial system of a country are collectively known as financial institution. CHARACTERISTICS OF FI: Savings and investment agencies. Professional skills Safety, liquidity and profitability Financing Role in money market National importance. CLASSIFGICATIONS OF FINANCIAL INSTITUTION:

MONEY MARKET INSTITUTIONS: Money market institutions is concerned with the supply of and demand for investible fundsfor a short term period. CAPITAL MARKET INSTITUTIONS: The market where medium term and long term funds are borrowed and lent is known as Capital Market Institutions. INDIAN FINANCIAL INSTITUTIONS: (1) INDUSTRIAL FINANCE CORPORATION OF INDIA (IFCI): GENESIS: First financial institution set up in india in 1948 for financing development projects. AIM to provide medium and long term finance to industrial concerns. OBJECTIVES: To make available medium and long term credit. To provide financial accommodation where the normal banking accommodation is inappropriate or recourse to capital issue channels is impracticable. MANAGEMENT: Board of Directors one- full time chairman appointed by central govt

The board consists of 12 members- 2 nominated by central govt, 4 by IDBI, 2 by scheduled commercial banks, 2 by cooperative banks & remaining 2 by shareholder institutions. FUNCTIONS: Granting loans and advances Subscribing directly to the shares Subscribing to the issue of debentures Guaranteeing loans Underwriting of shares Acting as an agent FINANCIAL RESOURCES: The corporation had an original authorized capital of Rs. 100 cr, later increased to Rs. 259 Cr. They are authorized to issue & sell bonds and debentures for raising its working capital. The limit has been fixed & not to exceed 10 times the amount of IFCIs paid up share capital and retained earnings. The corporation is also authorized to borrow from central govt, RBI, IDBI and to accept deposits from the public, State govt and local authorities for a period of less than 5 yrs. The relevant limit has been fixed not to exceed Rs. 10 Cr. It is also empowered to raise money from foreign Financial Institution in the respective foreign currency. CRITICISM Failure to develop industries in backward region. Neglecting the interest of small and medium size industries within the framework of the % yr plan Failure to maintain supervision over the utilization of sanctioned assistance Not providing equity capital More attention to well established concerns which otherwise could raise loans in the market. Incompatibility of efficiency of the corporation due to high establishment and other expenses. (2) INDUSTRIAL DEVELOPMENT BANK OF INDIA (IDBI): GENESIS: Established in 1964 as apex institution of industrial finance in india. It functioned as a segment of RBI till 1976 feb 16 and it was delinked from the RBI and made autonomous corporation fully owned by the central govt. GOAL Reorganising and integrating the structure of existing financial institution in the country so as to gear them upto cater to the demands of rapid industrialization

It plays an important role in the process of industrialization through planning, promoting and developing new industries to fill up the gaps in the industrial structure of the country MANAGEMENT: Board of Directors 22 members (Central Govt) BOD given representation to RBI, other financial institutions. It consists different committees in order to assists in its operation. OBJECTIVES: To coordinate, supplement and integrate the activities of other existing Financial Institutions including commercial banks. To provide term-finance to industry To protect direct financial assistance to industrial concerns. FUNCTIONS: FINANCIAL FUNCTIONS PROMOTIONAL FUNCTIONS Provide financial assistance to marketing and investment industrial concerns directly in research the form of loans techno-economic studies and Provide indirect financial surveys assistance by way of technical and administrative discounting and rediscounting assistance to industrial of commercial papers. concerns for promotion underwriting or purchase or management or expansion shares and debentures guarantee deferred payments and loans raised from the other financial institution by extending refinancing facilitites guarantee underwriting obligations of institutions FINANCIAL RESOURCES: Authorized capital is Rs 500 cr. Borrowings from the central govt and RBI Sale of its bond and debentures Accept public deposits for not less than 12 months Borrowings on long term basis from national indian credit funds established by RBI Resources by way of receipts of gifts grants donations .etc. from govt and non govt sources Making foreign currency loans with govt approval MODE OF ASSISTANCE: Financial assistance Soft loan scheme Refinance assistance

Assistance to small sector Technical development fund Equipment finance scheme Change agent Regional development Technology adaptation, industry studies and setting up of science and technology parks. (3) INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OF INDIA (ICICI): GENESIS: established on jan 5, 1995 as public ltd company OBJECTIVES: To assist creation, expansion and modernization of industrial enterprises in private sector To encourage and promote the participaqtion of private capital both internal and external in such enterprises To encourage and promote private ownership of industrial investment and the expansion of investment markets MANAGEMENT: BOD both indian and foreign BOD is assisted by a number of committees in day to day operations of the corporation FUNCTIONS: Granting medium and long term loans in rupees and foreign currencies Subscribes new issues of shares and debentures Sponsor and underwrites new issue of shares and debentures Guaranteeing loans raised by industrial concerns from other private investment sources Guarantee deferred payment for purchase of capital goods within india and payment Making funds available for reinvestment by revolving investment as rapidly as prudent Securing and furnishing managerial, technical and adfministrative services to Indian industries FINANCIAL RESOURCES: Authorized capital- Rs100 Cr Paid up capital indian and foreign private institution LIC, scheduled commercial bank, joint stock companies and individuals. Augmentation of resources issue of debentures and borrowings from the government of india, world bank, UK govt and agency for International Development ACHEIVEMENTS: Important institution

Investment center Housing finance Sponser IFMR Capital market CRITICISM: Paying attention to projects in the backward areas sanctions obtained by complex procedures. (4) EXPORT IMPORT BANK OF INDIA (EXIM) : GENESIS: Wholly owned by govt of india on jan 1 1982as a statuatory corporation Commencement of operation PURPOSE to promote foreign trade in india FUNCTIONS: Providing finance to export oriented industries by way of preshipment finance and guarantees as well as rediscounting facilities. Conducting export feasibility studies Providing international merchant banking services Assisting overseas Indian joint venture and turn-key construction projects Assisting exporters of capital goods, software and consultancy services. Conducting forfeiting operations in order to enable Indian exporters to have the advantage of access to quick financial assistance FINANCIAL RESOURCES: Authorized share capital 200 crs WORKING: Exporting market fund 1986 june Fund created with World Bank loan of 10 million U.S. dollars The program covers activities like desk research, overseas travel, product adaptation and inspection services, training .etc. It operates 14 lending schemes at present to help Indian exporters Non funded assistance is provided mainly for construction of project which accounted for about 88% of sanction and 77% issues. Agency line of credit Through an agency credit line of US $15 million with IFC[International Finance Corporation] ,EXIM bank provides financial assistance by way of foreign currency term loans

to private sector and small and medium enterprises in the country Assistance is provided for investment in plant and machinery and product and process know how to create and enhance export capabilities EXIM bank provides rupee term loans on matching basis to assisted enterprises Eligible for financial assistance are new projects, expansion or modernization of projects and equipment imports First agency line of credit from IFC to financial institution (5) SMALL SCALE INDUSTRIES DEVELOPMENT BANK OF INDIA (SIDBI): GENESIS: It was set up in Oct 1989 as a wholly owned subsidiary of IDBI. Its authorized capital is Rs 250 cr with an enabling provision to increase it to Rs 1000 cr It is the central or apex institution which oversees, coordinates and further strenghthens various arrangements for providing financial and non-financial assistance to small scale,tiny and cottage industries OBJECTIVES: To initiate steps for technological upgradation and modernization of existing units To expand channels for marketing of SSI sector products in India and abroad To promote employment oriented industries in semi urban areas and to check migration of population to big cities FINANCIAL ASSISTANCE: Channeled thro the existing credit delivery system comprising of NSIC, SFCs, SIDCs SSIDC, commercial banks, cooperative banks and RRBs. Total no. of institution eligible for assistance from SIDBI is 869 It discounts and rediscounts bills arising from the sale of machinery to small units; extends seed capital, soft loan V thro national equity fund and thro seed capital schemes of specialized lending institutions refinances loans and provides services like factoring, leasing and so on. DIVIDENDS: They are defined as the Taxable payment declared by a companys BOD and given to its shareholders out of the companys current or retained earnings, usually quarterly. DIVIDEND POLICY: it is that policy that a company uses to decide how much it will payout to its shareholders. FACTORS DETERMINING DIVIDEND POLICY: Types of business

Stability of earnings Age of corporation Liquidity of funds Extent of share distribution Needs for additional capital Trade/business cycles Govt policies Taxation policy Legal requirements Post dividend rates Ability to borrow Policy of control Repayment of loan Time for payment of dividend THEORIES OF DIVIDEND POLICY: RELEVANCE THEORY Definition Theory hold that the dividend of a firm has a direct effect on the position of the firm in the stock exchange Models Walters model Gordons model under the theory Walters model Gordons model Assumptio ns Retained earnings represent only the source of financing of the firm The firm is an equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings The internal rate of return and appropriate discount rate (k) for the firm are constant. The firm has perpetual life and its stream of earnings are perpetual No corporate tax

IRRELEVANCE THEORY Theory tht hold tht the dividend policy has no effect on the share prices of the firm Modigliani-Miller approach Modigliani-Miller Capital markets are perfect. Investors are well informed about the risk and return of all types of securities.they are free to buy and sell securities

The return on the firms investment remains constant Cost of capital for the firm remains constant. The firm has

There are no transaction cost. They can borrow with no restrictions on the same terms as firms do. No corporate and personal taxes ,the tax rates are same for dividend and capital gains The firm has fixed

infinite life

All the earnings are distributed or re invested in the firm EPS and dividend remains constant in determining a given value Formula

The retention ratio once decided upon is constant. Thus the growth rate is also constant Cost of capital> growth rate

investment policy under which at each yr end it invests a specific amount as capital expenditure Investors are able to predict the future dividends and market prices and only one discount rate for the entire period. All investments are funded either by equityor by retained earnings

Where , p market price /share d dividend /share r rate of return on investment by firm k cost of capital e earning / share

Where, p market price /share d dividend /share r rate of return on investment by firm k cost of capital e earning / share b retention ratio g growth rate(br)

Where, market price of

= present + value of dividends

the share at the end of period s

Where , = market price / share at the end of period = current market price = cost of equity capital = dividend / share at the end of the period Determination of no of new shares Investment proposed - xxx (-) Retained earnings

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net income xxx (-) distributed Dividends - xxx - xxx Amount to be raised by Issue of new shares (a) _ xxx No of new shares = a_______ Issue price /share Inference / Optimal implication payment ratio s for a growth firm is nil Payout ratio for a normal firm is irrelevant Optimal payout ratio for a declining firm is 100% Higher the retention ratio, higher is the value of firm and vice versa. Criticism No external financing. Constant rate of return Constant opportunity cost Optimal payout ratio for a growth firm is nil. Payout ratio for a normal firm is irrelevant The optimal payout ratio for a declining firm is 100% Higher the retention ratio higher is the capital appreciation enjoyed by the share holders. The capital appreciation is equal to the amount of earnings retained. If the firm distributed earnings by way of dividends the share holders enjoy dividends= the amount of capital appreciation if the firm had retained the amount of dividends.

Assumption of Assumption of perfect 100% equity capital market is funding defeat theoretical. the objective of Following propositions on maximization of dividend are wealth by impracticable: leveraging 1. Investors can switch against a lower between capital cost of debt. gains & dividend. Constant ROR & 2. Dividend are current irrelevant opportunity cost 3. Dividends do not are not in tune determine the firm with realities. value The situation of zero taxes is not possible.

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The assumptions of no stock floatation/time lag & no taxation costs are impossible. UNIT2 Risk and Return Analysis Return expresses the amount which an investor actually earned on an investment during a certain period. Return includes the interest, dividend and capital gains; while risk represents the uncertainty associated with a particular task. In financial terms, risk is the chance or probability that a certain investment may or may not deliver the actual/expected returns. The risk and return trade off says that the potential return rises with an increase in risk. It is important for an investor to decide on a balance between the desire for the lowest possible risk and highest possible return. Risk Analysis Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk in investment is defined as the variability that is likely to occur in future cash flows from an investment. The greater variability of these cash flows indicates greater risk. Variance or standard deviation measures the deviation about expected cash flows of each of the possible cash flows and is known as the absolute measure of risk; while co-efficient of variation is a relative measure of risk. For carrying out risk analysis, following methods are used

Payback [How long will it take to recover the investment] Certainty equivalent [The amount that will certainly come to you] Risk adjusted discount rate [Present value i.e. PV of future inflows with discount rate]

However in practice, sensitivity analysis and conservative forecast techniques being simpler and easier to handle, are used for risk analysis. Sensitivity analysis [a variation of break even analysis] allows estimating the impact of change in the behavior of critical variables on the investment cash flows. Conservative forecasts include using short payback or higher discount rates for discounting cash flows. Investment Risks Investment risk is related to the probability of earning a low or negative actual return as compared to the return that is estimated. There are 2 types of investments risks:
1. Stand-alone risk

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This risk is associated with a single asset, meaning that the risk will cease to exist if that particular asset is not held. The impact of stand alone risk can be mitigated by diversifying the portfolio. Stand-alone risk = Market risk + Firm specific risk Where, Market risk is a portion of the security's stand-alone risk that cannot be eliminated trough diversification and it is measured by beta o Firm risk is a portion of a security's stand-alone risk that can be eliminated through proper diversification 2. Portfolio risk
o

This is the risk involved in a certain combination of assets in a portfolio which fails to deliver the overall objective of the portfolio. Risk can be minimized but cannot be eliminated, whether the portfolio is balanced or not. A balanced portfolio reduces risk while a non-balanced portfolio increases risk. Sources of risks
o o o o o o

Inflation Business cycle Interest rates Management Business risk Financial risk

Return Analysis An investment is the current commitment of funds done in the expectation of earning greater amount in future. Returns are subject to uncertainty or variance Longer the period of investment, greater will be the returns sought. An investor will also like to ensure that the returns are greater than the rate of inflation. An investor will look forward to getting compensated by way of an expected return based on 3 factors

Risk involved Duration of investment [Time value of money] Expected price levels [Inflation]

The basic rate or time value of money is the real risk free rate [RRFR] which is free of any risk premium and inflation. This rate generally remains stable; but in the long run there could be gradual changes in the RRFR depending

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upon factors such as consumption trends, economic growth and openness of the economy. If we include the component of inflation into the RRFR without the risk premium, such a return will be known as nominal risk free rate [NRFR] NRFR = ( 1 + RRFR ) * ( 1 + expected rate of inflation ) - 1 Third component is the risk premium that represents all kinds of uncertainties and is calculated as follows Expected return = NRFR + Risk premium Risk and return trade off Investors make investment with the objective of earning some tangible benefit. This benefit in financial terminology is termed as return and is a reward for taking a specified amount of risk. Risk is defined as the possibility of the actual return being different from the expected return on an investment over the period of investment. Low risk leads to low returns. For instance, incase of government securities, while the rate of return is low, the risk of defaulting is also low. High risks lead to higher potential returns, but may also lead to higher losses. Long-term returns on stocks are much higher than the returns on Government securities, but the risk of losing money is also higher. Rate of return on an investment cal be calculated using the following formulaReturn = (Amount received - Amount invested) / Amount invested He risk and return trade off says that the potential rises with an increase in risk. An investor must decide a balance between the desire for the lowest possible risk and highest possible return.

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Types of Risk

Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio. It is virtually impossible to protect yourself against this type of risk. Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect yourself from unsystematic risk. Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates. Bonds with a lower chance of default are considered to be investment grade, while bonds with higher chances are considered to be junk bonds. Country Risk - Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations

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with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country.

Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreign-exchange risk applies to all financial instruments that are in a currency other than your domestic currency. Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. Political Risk - Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment. Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the the day-to-day fluctuations in a stock's price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or "temperament", of your investment rather than the reason for this behavior.

Diversification Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio. Diversification lowers the risk of your portfolio. CAPITAL ASSET PRICING MODEL In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's nondiversifiable risk. The model takes into account the asset's sensitivity to nondiversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical riskfree asset. The formula

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The Security Market Line, seen here in a graph, describes a relation between the beta and the asset's expected rate of return. The CAPM is a model for pricing an individual security or a portfolio. For individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market rewardto-risk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the CAPM.

where:

is the expected return on the capital asset is the risk-free rate of interest such as interest arising from government bonds (the beta) is the sensitivity of the expected excess asset returns to the expected excess market returns, or also ,

is the expected return of the market is sometimes known as the market premium(the difference between the expected market rate of return and the riskfree rate of return). is also known as the risk premium

Restated, in terms of risk premium, we find that:

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which states that the individual risk premium equals the market premium times . Security market line The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between and required return is plotted on the securities market line (SML) which shows expected return as a function of . The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm) Rf. The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed. Asset pricing Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can compare this required rate of return to the asset's estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment. To make this comparison, you need an independent estimate of the return outlook for the security based on either fundamental or technical analysis techniques, including P/E, M/B etc. Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is the same as the present value of future cash flows of the asset, discounted at the rate suggested by CAPM. If the observed price is higher than the CAPM valuation, then the asset is undervalued (and overvalued when the estimated price is below the CAPM valuation) When the asset does not lie on the SML, this could also suggest mis-pricing. Since the expected return of the asset at time t is , a higher expected return than what CAPM suggests indicates that Pt is too low (the asset is currently undervalued), assuming that at time t + 1 the asset returns to the CAPM suggested price.The asset price P0 using CAPM,

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sometimes called the certainty equivalent pricing formula, is a linear relationship given by

where PT is the payoff of the asset or portfolio. Asset-specific required return The CAPM returns the asset-appropriate required return or discount ratei.e. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than average. Thus, a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. Given the accepted concave utility function, the CAPM is consistent with intuitioninvestors (should) require a higher return for holding a more risky asset. Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the marketand in that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as a mutual fund), therefore, expects performance in line with the market. Risk and diversification The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk common to all securities i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific risks "average out"). The same is not possible for systematic risk within one market. Depending on the market, a portfolio of approximately 30-40 securities in developed markets such as UK or US will render the portfolio sufficiently diversified such that risk exposure is limited to systematic risk only. In developing markets a larger number is required, due to the higher asset volatilities. A rational investor should not take on any diversifiable risk, as only nondiversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e. its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher variance

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i.e. less predictability. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor. The efficient frontier

The (Markowitz) efficient frontier. CAL stands for the capital allocation line. The CAPM assumes that the risk-return profile of a portfolio can be optimizedan optimal portfolio displays the lowest possible level of risk for its level of return. Additionally, since each additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset, (assuming no trading costs) with each asset value-weighted to achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios, i.e., one for each level of return, comprise the efficient frontier.Because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as beta. The market portfolio An investor might choose to invest a proportion of his or her wealth in a portfolio of risky assets with the remainder in cashearning interest at the risk free rate (or indeed may borrow money to fund his or her purchase of risky assets in which case there is a negative cash weighting). Here, the ratio of risky assets to risk free asset does not determine overall returnthis relationship is clearly linear. It is thus possible to achieve a particular return in one of two ways: 1. By investing all of one's wealth in a risky portfolio, 2. or by investing a proportion in a risky portfolio and the remainder in cash (either borrowed or invested). For a given level of return, however, only one of these portfolios will be optimal (in the sense of lowest risk). Since the risk free asset is, by definition, uncorrelated with any other asset, option 2 will generally have the lower variance and hence be the more efficient of the two.

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This relationship also holds for portfolios along the efficient frontier: a higher return portfolio plus cash is more efficient than a lower return portfolio alone for that lower level of return. For a given risk free rate, there is only one optimal portfolio which can be combined with cash to achieve the lowest level of risk for any possible return. This is the market portfolio. Leverage (finance) In finance, leverage (sometimes referred to as gearing in the United Kingdom) is a general term for any technique to multiply gains and losses.[1] Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives.[2] Important examples are:

A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.[3] A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.[4][5] Hedge funds often leverage their assets by using derivatives. A fund might get any gains or losses on $20 million worth of crude oil by posting $1 million of cash as margin

Type of leverage :1. Operating leverage: It is % change in earning before interest and tax divided by % change in sale . If company is charging fixed cost , the operating leverage tells the EBIT will greater than sale because due to increasing sale of fixed cost per unit will decrease and it will increase EBIT higher than sale . Formula Operating Leverage = % change in EBIT / % change in Sale This leverage is very helpful for finance manager because , if operating leverage is more than or suppose it is two then it means if sale will increase 100% then earning will increase 200% . At this time , finance manager can get more loan for increasing the earning of shareholders . 2. Financial leverage It is second type of leverage . Financial leverage is known as trading on

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equity . If any company's finance manager knows that company's return on investment is more than interest on loan or borrowing obligation . At this time , if company needs more money , then finance manager gets its loan and bought the asset from same loan . So, any technique in which any asset is purchased with loan and trying to increase EPS , then this is called financial leverage . Formula for calculating financial leverage = % change in Earning per share / % change in earning before interest and tax = % change in EPS / % change in EBIT This formula explains the relationship between % change in EPS and % change in EBIT and after deep study of this financial leverage , finance manager decides to get appropriate loan for buying assets . 3. Combined leverage It is the product of operating leverage and financial leverage . Combined leverage = Operating leverage X financial leverage = % change in EBIT / % change in sale X % change in EPS / % change in EBIT High operating leverage and high financial leverage combination is high risky for business . Good combination is that in which lower operating leverage with high financial leverage Major reasons for Business Failures
1. Starting a business just for the sake of starting it Well if you

are really planning a new business launch, just because you want to earn more money or if you are bored of your job and a cranky boss or may be you think that youll be able to spend some more time with your family, if you have your own business, then you should definitely give it a thought again. None of the above reason is going to get you success in business. But yes if a person is passionate about some thing and wants to take it a step ahead or if you are physically fit and ready for any kind of challenge, are determined and strong willed and you are creative enough to tackle the competition then of course you can and should start your own business.
2. Lack of Leadership Quality This accounts for the number one

reason of the business failures. A person who starts a new business often lacks a lot of management qualities which often lead to a bad

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financing, poor purchasing, reselling and even hiring. Which in turn obviously cause a lot of trouble to the business resulting in a disastrous failure. Also, a person who is a bad manager could lead to conflicts with employees, and potential lawsuits. Legal matters such as the LightGroup lawsuit, Wal-Mart labor issues, and other employment related problems could lead to failed businesses.
3. Less Investment People often start their business without even

noticing the amount of investment needed initially, this often causes a big disaster as either the whole company goes bankrupt or the business itself faces big losses when the outgoing goes way above the incoming. That is why it is very much necessary to assess the amount of money that is needed and if possible have some extra funds in case you need them, as you never know when the costing can go out of your hand. If you plan on using loans or credit to fund your business, youll also want to keep a close eye on your personal and business credit reports to ensure youre eligible for the best terms possible.
4. Locality - Well of course you would never start a business in a place

where it doesnt belong. A good location gives you a lot of benefits if selected smartly. Things you should consider before selecting your business location: a. Consider the niche of your business b. Kind of customers according to your business type c. Quality of the location d. Business Friendly environment e. Well equipped neighborhood 5. Poor Planning- Setting up a business or I should better be saying, a successful business, one need a foolproof plan of its establishment. A person, who puts in a methodical effort and smart planning along with hard work, surely achieves a lot in his business. Things that should be considered in planning: a. Goals and Future Targets or Plans of your business b. The total Office set up Including the employees and infrastructure c. Financial Back up and Management d. Market analysis e. Promotional Strategies f. Ones strength and weaknesses 6. Lack of Modernization techniques and methods In this fast paced world with highly competitive market, a new businessman can just not afford to have a successful business running on old and outdated technology. So one must be fully aware and equipped with latest technology. Like for e.g. these days it has become so much necessary to have your own website. A businessman cannot afford not to have a company website. As it gives you a brand name, a website

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works as your global recognition forum, people recognize you globally through internet and get to know who you are teaming up with some of the biggest clients of the industry.

The major weaknesses of businesses can be classified as below: Entrepreneurial: 1. Untrained (non professional) and in experienced entrepreneurs in particular trade. 2. Trading entrepreneurs entering manufacturing sector and now in services sector 3. Greed and Profiteering- Immediate profits and narrow vision. 4. Unwillingness to buy technology and pay to skilled loyal workers. Poor HR functions. 5. Over growth or hasty growth without building systems and organization with committed, trained and motivated work force (both at worker level and at managerial level). I have seen many businesses fail when entrepreneurs tried to grow in size significantly and abruptly without gaining experience and adequate resources or capability, graduating from an SME to large or from a small to medium sized operations. Particularly Human resource and Marketing network are areas where they failed miserably. Structural weaknesses: 1. Too small or too large capacity that is not right for a 3-5 years period horizon, only. 2. Poor marketing network (By far the most difficult to develop especially for SMEs).Most SMEs are puppets in hands of major distributors in the network. 3. Wrong location causing dearth of good employees and/or raw material or logistics support and thus increased cost of product and processes and training and development charges. 4. Over financing by debt or over capitalization for long term assets, or lack of working capital ( due to several reasons like poor credit management) or both 5. Poor technology that is already obsolete or not likely to be competitive in next 3-5 years period horizon. 6. Poor quality and completely lacking management systems including lack of delegation. 7. Poor internal employee training and development program and failure to involve employees, particularly in services sector. Failure to involve them emotionally and create motivation. 8. Lack of innovation culture in organization with customer need in

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focus. 9. Lack of up gradation, modernization and introduction of new products and services regularly. 10. Poor attitude towards consumer/customer and their needs and complaints (A major problem with Indian customer care executives and owners alike) 11. Lack of industry and regulatory norms being followed. In India particularly entrepreneurs tend to overlook norms and regulations fixed for business derisively and contemptuously. This leads to wastage, poor productivity and poor quality. 12. Unstable source of raw materials and its quality at Globally competitive prices) 13. Failure to create Brand/ Brand experience or piggybacking on other brands far too much (More brands are dieing today than created). 14. Relaxing standards or cutting costs under illusion of having arrived (success) by new businesses. It is only matter of time before competition and consumers catch you on wrong and weak foot. 15. Lack of Documented and well laid out policy and procedure manuals with quality check points. High rejection rates or poor products result that consumers don't value. Remember consumer buys till she has no option. It is not consumer loyalty. Consumer is loyal to no one for a few Cents off ( Kotler, Philip) External (environmental) factors: 1. Non availability of logistics chain and too high cost of distribution (particularly in traditional channels) Hybrid channels are in thing with web sites and emails as important channel. ( Ignoring this will result loss of business to many good firms) 2. Too high cost of interaction with government and regulatory agencies (India- almost 10% -15% of sales turnover) 3. Poor industrial and logistic infrastructure and lack of modern facilities for shipment and handling. 4. Global competition tending to make products obsolete and tending to push prices down( particularly those made in countries like China, Taiwan, Korea, Mexico, and such countries) 5. Poor labor productivity in India on account of several complex reasons 6. Rising costs of doing business. High economic rents demanded by all. 7. Mergers and Acquisitions making competition and capabilities unfair to the firm. 8. Political interventions and political instability 9. High interest rates and cost of raising capital 10. Poor Industry ROI 11. Product of organization moving down the product Life cycle, if one applies.

25

12. Exchange rate fluctuations or weak domestic currency or wide arbitrage gaps in foreign currency markets. 13. Educated and aware consumers with internet technology driving his/her factual knowledge about product and its availability and alternate channels of supply. 14 High taxation in India with poor infrastructure and delayed deliveries will result in markets flooded by cheaper and well made goods like from China. 15 New models are being thrust on market post WTO opening like organized retails, Malls and Multiplexes making traditional shop going out of business. Volumes and comfort will matter except for daily necessities purchases from corner shop. Mergers and acquisitions Mergers and acquisitions (abbreviated M&A) refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can aid, finance, or help an enterprise grow rapidly in its sector or location of origin or a new field or new location without creating a subsidiary, other child entity or using a joint venture Acquisition An acquisition is the purchase of one business or company by another company or other business entity. Consolidation occurs when two companies combine together to form a new enterprise altogether, and neither of the previous companies survives independently. Acquisitions are divided into "private" and "public" acquisitions, depending on whether the acquiree or merging company (also termed a target) is or is not listed on public stock markets. Acquisition" usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger and/or longer-established company and retain the name of the latter for the post-acquisition combined entity. This is known as a reverse takeover. Another type of acquisition is the reverse merger, a form of transaction that enables a private company to be publicly listed in a relatively short time frame. A reverse merger occurs when a privately held company (often one that has strong prospects and is eager to raise financing) buys a publicly listed shell company, usually one with no business and limited assets.[4] There are also a variety of structures used in securing control over the assets of a company, which have different tax and regulatory implications:

26

The buyer buys the shares, and therefore control, of the target company being purchased. Ownership control of the company in turn conveys effective control over the assets of the company, but since the company is acquired intact as a going concern, this form of transaction carries with it all of the liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment. The buyer buys the assets of the target company. The cash the target receives from the sell-off is paid back to its shareholders by dividend or through liquidation. This type of transaction leaves the target company as an empty shell, if the buyer buys out the entire assets. A buyer often structures the transaction as an asset purchase to "cherry-pick" the assets that it wants and leave out the assets and liabilities that it does not. This can be particularly important where foreseeable liabilities may include future, unquantified damage awards such as those that could arise from litigation over defective products, employee benefits or terminations, or environmental damage. A disadvantage of this structure is the tax that many jurisdictions, particularly outside the United States, impose on transfers of the individual assets, whereas stock transactions can frequently be structured as like-kind exchanges or other arrangements that are taxfree or tax-neutral, both to the buyer and to the seller's shareholders.

Based on the content analysis of seven interviews authors concluded five following components for their grounded model of acquisition: 1. Improper documentation and changing implicit knowledge makes it difficult to share information during acquisition. 2. For acquired firm symbolic and cultural independence which is the base of technology and capabilities are more important than administrative independence. 3. Detailed knowledge exchange and integrations are difficult when the acquired firm is large and high performing. 4. Management of executives from acquired firm is critical in terms of promotions and pay incentives to utilize their talent and value their expertise. 5. Transfer of technologies and capabilities are most difficult task to manage because of complications of acquisition implementation. The risk of losing implicit knowledge is always associated with the fast pace acquisition. Business valuation The five most common ways to valuate a business are

asset valuation,

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historical earnings valuation, future maintainable earnings valuation, relative valuation (comparable company & comparable transactions), discounted cash flow (DCF) valuation

Motives behind M&A The dominant rationale used to explain M&A activity is that acquiring firms seek improved financial performance. The following motives are considered to improve financial performance:

ECONOMY

This refers to the fact that the combined company can often reduce its fixed costs by removing duplicate departments or operations, lowering the costs of the company relative to the same revenue stream, thus increasing profit margins. ECONOMY OF SCOPE: This refers to the efficiencies primarily associated with demand-side changes, such as increasing or decreasing the scope of marketing and distribution, of different types of products. INCREASED REVENUE OR MARKET SHARE: This assumes that the buyer will be absorbing a major competitor and thus increase its market power (by capturing increased market share) to set prices. CROSS-SELLING: For example, a bank buying a stock broker could then sell its banking products to the stock broker's customers, while the broker can sign up the bank's customers for brokerage accounts. Or, a manufacturer can acquire and sell complementary products. SYNERGY: For example, managerial economies such as the increased opportunity of managerial specialization. Another example are purchasing economies due to increased order size and associated bulkbuying discounts. TAXATION: A profitable company can buy a loss maker to use the target's loss as their advantage by reducing their tax liability. In the United States and many other countries, rules are in place to limit the ability of profitable companies to "shop" for loss making companies, limiting the tax motive of an acquiring company. GEOGRAPHICAL OR OTHER DIVERSIFICATION: This is designed to smooth the earnings results of a company, which over the long term smoothens the stock price of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders (see below). RESOURCE TRANSFER: resources are unevenly distributed across firms (Barney, 1991) and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources.[6] VERTICAL INTEGRATION: Vertical integration occurs when an upstream and downstream firm merge (or one acquires the other). There are several reasons for this to occur. One reason is to internalise an

OF SCALE:

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externality problem. A common example is of such an externality is double marginalization. Double marginalization occurs when both the upstream and downstream firms have monopoly power, each firm reduces output from the competitive level to the monopoly level, creating two deadweight losses. By merging the vertically integrated firm can collect one deadweight loss by setting the downstream firm's output to the competitive level. This increases profits and consumer surplus. A merger that creates a vertically integrated firm can be profitable.[7] "ACQUI-HIRE": An "acq-hire" (or acquisition-by-hire) may occur especially when the target is a small private company or is in the startup phase. In this case, the acquiring company simply hires the staff of the target private company, thereby acquiring its talent (if that is its main asset and appeal). The target private company simply dissolves and little legal issues are involved. Acqui-hires have become a very popular type of transaction in recent years.[citation needed]

ABSORPTION

OF SIMILAR BUSINESSES UNDER SINGLE MANAGEMENT :

similar portfolio invested by two different mutual funds (Ahsan Raza Khan, 2009) namely united money market fund and united growth and income fund, caused the management to absorb united money market fund into united growth and income fund.</ref> However, on average and across the most commonly studied variables, acquiring firms' financial performance does not positively change as a function of their acquisition activity. Therefore, additional motives for merger and acquisition that may not add shareholder value include:

DIVERSIFICATION: While this may hedge a company against a downturn

in an individual industry it fails to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger. (In his book One Up on Wall Street, Peter Lynch memorably termed this "diworseification".)

MANAGER'S

manager's overconfidence about expected synergies from M&A which results in overpayment for the target company.

HUBRIS :

EMPIRE-BUILDING: Managers have larger companies to manage and

hence more power.

MANAGER'S

COMPENSATION : In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a perverse incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders)

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UNIT3 Capital market A capital market is a market for securities (debt or equity), where business enterprises (companies) and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year,[1] [dead link] as the raising of short-term funds takes place on other markets (e.g., the money market). The capital market includes the stock market (equity securities) and the bond market (debt). Financial regulators, such as the UK's Financial Services Authority (FSA) or the U.S. Securities and Exchange Commission (SEC), oversee the capital markets in their designated jurisdictions to ensure that investors are protected against fraud, among other duties. Capital markets may be classified as primary markets and secondary markets. In primary markets, new stock or bond issues are sold to investors via a mechanism known as underwriting. In the secondary markets, existing securities are sold and bought among investors or traders, usually on a securities exchange, over-the-counter, or elsewhere. What Does Fiscal Policy Mean? Government spending policies that influence macroeconomic conditions. These policies affect tax rates, interest rates and government spending, in an effort to control the economy. fiscal policy is the use of government expenditure and revenue collection (taxation) to influence the economy.Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and spending. The two main instruments of fiscal policy are government expenditure and taxation. Changes in the level and composition of taxation and government spending can impact the following variables in the economy:

Aggregate demand and the level of economic activity; The pattern of resource allocation; The distribution of income.

Economic effects of fiscal policy Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

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Governments can use a budget surplus to do two things: to slow the pace of strong economic growth, and to stabilize prices when inflation is too high. Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices. Economists debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out, a phenomenon where government borrowing leads to higher interest rates that offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal. Some classical and neoclassical economists argue that crowding out completely negates any fiscal stimulus; this is known as the Treasury View[citation needed], which Keynesian economics rejects. The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes' call in the 1930s for fiscal stimulus. The same general argument has been repeated by some neoclassical economists up to the present. In the classical view, the expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases. The increased demand causes that country's currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.[2] Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise

31

would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand while labor supply remains fixed, leading to wage inflation and therefore price inflation. ROLE OF SEBI: SEBI's functions include:

Regulating the business in stock exchanges and any other securities markets Registering and regulating the working of collective investment schemes, including mutual funds. Prohibiting fraudulent and unfair trade practices relating to securities markets. Promoting investor's education and training of intermediaries of securities markets. Prohibiting insider trading in securities, with the imposition of monetary penalties, on erring market intermediaries. Regulating substantial acquisition of shares and takeover of companies. Calling for information from, carrying out inspection, conducting inquiries and audits of the stock exchanges and intermediaries and self regulatory organizations in the securities market.

Keeping this in view, SEBI has issued a new set of comprehensive guidelines governing issue of shares and other financial instruments, and has laid down detailed norms for stock-brokers and sub-brokers, merchant bankers, portfolio managers and mutual funds. On the recommendations of the Patel Committee report, SEBI on 27 July 1995, permitted carry forward deals. Some of the major features of the revised carry-forward transactions as directed by SEBI are:

Carry forward deals permitted only on stock exchanges which have screen based trading system. Transactions carried forward cannot exceed 25% of a broker's total transactions on any one day. 90-day limit for carry forward and squaring off allowed only till the 75th day (or the end of the fifth settlement). Daily margins to rise progressively from 20% in the first settlement to 50% in the fifth.

On 26 January1995, the government promulgated an ordinance amending the SEBI Act, 1992, and the Securities Contracts (Regulation) Act, 1956. In accordance with the amendment adjudicating mechanism will be created within SEBI and any appeal against this adjudicating authority will have to be

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made to the Securities Appellate Tribunal, which is to be separately constituted. These appeals will be heard only at the High Courts. The main features of the amendment to the Securities Contract (Regulation) Act, 1956, are:

The ban on the system of options in trading has been lifted. The time limit of six months, by which stock exchanges could amend their bye-laws, has been reduced to two months. Additional trading floors on the stock exchanges can be established only with prior permission from SEBI. Any company seeking listing on stock exchanges would have to comply with the listing agreements of stock exchanges, and the failure to comply with these, or their violation, is punishable.

GOVERNMENT REGULATION AFFECTING CAPITAL MARKET: How does the government influence the securities market? Governments generally say they don't like to take an active role in the securities market (except for regulating it); however, there are methods and policies by which the government's actions may have an indirect influence on the market. Fiscal policies that affect the taxation of capital gains, dividends and interest gains may eventually have an effect on market activity. For example, favorable policies such as tax cuts could persuade investors to become more active in buying and selling securities, while unfavorable policies might cause individuals to move to fixed-income securities or alternative investments (such as real estate or other appreciable assets). Furthermore, through monetary policies, governments can indirectly involve themselves in the market by adjusting interest rates and taking part in openmarket operations. In theory, cutting rates will discourage investors and companies from putting (or parking) their money into fixed-income investments - the lower rates instead may encourage borrowing for investment purposes. The market is also affected by the bills and laws passed by the various levels of government. This can occur for those laws directed specifically at the securities market or those that have an indirect affect. On the indirect side, if the government reduces spending in areas such as health care or defense, companies in these sectors will likely sell off as they rely in part on government funds. Fiscal policy

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Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy. It is the sister strategy to monetary policy with which a central bank influences a nation's money supply. These two policies are used in various combinations in an effort to direct a country's economic goals. Here we take a look at how fiscal policy works, how it must be monitored and how its implementation may affect different people in an economy. Before the Great Depression in the United States, the government's approach to the economy was laissez faire. But following the Second World War, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money. By using a mixture of both monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments are able to control economic phenomena. How Fiscal Policy Works Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money. (To read more on this subject, see Can Keynesian Economics Reduce Boom-Bust Cycles? and How Influential Economists Changed Our History.) Balancing Act The idea, however, is to find a balance in exercising these influences. For example, stimulating a stagnant economy runs the risk of rising inflation. This is because an increase in the supply of money followed by an increase in consumer demand can result in a decrease in the value of money meaning that it will take more money to buy something that has not changed in value. Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down and businesses are not making any money. A government thus decides to fuel the economy's engine by decreasing taxation, giving consumers more spending money while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. Pumping money into the economy is also known as "pump priming". In the meantime, overall unemployment levels will fall. With more money in the economy and less taxes to pay, consumer demand for goods and services increases. This in turn rekindles businesses and turns the cycle around from stagnant to active.

34

If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money in the market. This excess in supply decreases the value of money, while pushing up prices (because of the increase in demand for consumer products). Hence, inflation occurs. For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals. If not closely monitored, the line between an economy that is productive and one that is infected by inflation can be easily blurred What is SEBI? Securities and Exchange Board of India (SEBI) is an apex body for overall development and regulation of the securities market. It was set up on April 12, 1988. To start with, SEBI was set up as a non-statutory body. Later on it became a statutory body under the Securities Exchange Board of India Act, 1992. The Act entrusted SEBI with comprehensive powers over practically all the aspects of capital market operations. Role Functions of SEBI The role or functions of SEBI are discussed below. 1. To protect the interests of investors through proper education and guidance as regards their investment in securities. For this, SEBI has made rules and regulation to be followed by the financial intermediaries such as brokers, etc. SEBI looks after the complaints received from investors for fair settlement. It also issues booklets for the guidance and protection of small investors.
2. To regulate and control the business on stock exchanges and other

security markets. For this, SEBI keeps supervision on brokers. Registration of brokers and sub-brokers is made compulsory and they are expected to follow certain rules and regulations. Effective control is also maintained by SEBI on the working of stock exchanges. 3. To make registration and to regulate the functioning of intermediaries such as stock brokers, sub-brokers, share transfer agents, merchant bankers and other intermediaries operating on the securities market. In addition, to provide suitable training to intermediaries. This function is useful for healthy atmosphere on the stock exchange and for the protection of small investors. 4. To register and regulate the working of mutual funds including UTI (Unit Trust of India). SEBI has made rules and regulations to be followed by mutual funds. The purpose is to maintain effective

35

supervision on their operations & avoid their unfair and anti-investor activities. 5. To promote self-regulatory organization of intermediaries. SEBI is given wide statutory powers. However, self-regulation is better than external regulation. Here, the function of SEBI is to encourage intermediaries to form their professional associations and control undesirable activities of their members. SEBI can also use its powers when required for protection of small investors. 6. To regulate mergers, takeovers and acquisitions of companies in order to protect the interest of investors. For this, SEBI has issued suitable guidelines so that such mergers and takeovers will not be at the cost of small investors. 7. To prohibit fraudulent and unfair practices of intermediaries operating on securities markets. SEBI is not for interfering in the normal working of these intermediaries. Its function is to regulate and control their objectional practices which may harm the investors and healthy growth of capital market. 8. To issue guidelines to companies regarding capital issues. Separate guidelines are prepared for first public issue of new companies, for public issue by existing listed companies and for first public issue by existing private companies. SEBI is expected to conduct research and publish information useful to all market players (i.e. all buyers and sellers). 9. To conduct inspection, inquiries & audits of stock exchanges, intermediaries and self-regulating organizations and to take suitable remedial measures wherever necessary. This function is undertaken for orderly working of stock exchanges & intermediaries. 10. To restrict insider trading activity through suitable measures. This function is useful for avoiding undesirable activities of brokers and securities scams. UNIT4 LEASE FINANCING: Lease financing, or often referred to just as a lease, is a contractual agreement in which a company, identified on the contract as the lessor grants the individual or group of individuals leasing the product/equipment, identified on the contract as the lessee, the ability to operate the equipment for a given amount of time, identified as the term of leasing, while making specific monthly payments to the lessor or leasing company.

36

IMPORTANCE 0F LEASE FINANCING Leasing industry plays an important role in the economic development of a country by providing money incentives to lessee. The lessee does not have to pay the cost of asset at the time of signing the contract of leases. Leasing contracts are more flexible so lessees can structure the leasing contracts according to their needs for finance. The lessee can also pass on the risk of obsolescence to the lessor by acquiring those appliances, which have high technological obsolescence. To day, most of us are familiar with leases of houses, apartments, offices, etc. 15.5 TYPES OF LEASE AGREEMENTS Lease agreements are basically of two types. They are (a) Financial lease and (b) Operating lease. The other variations in lease agreements are (c) Sale and lease back (d) Leveraged leasing and (e) Direct leasing.

FINANCIAL LEASE Long-term, non-cancellable lease contracts are known as financial leases. The essential point of financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at the end of the lease period at a nominal cost. At lease it must give an option to the lessee to purchase the asset he has

37

used at the expiry of the lease. Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the lessor. Financial lease is also known as capital lease. In India, financial leases are very popular with high-cost and high technology equipment. OPERATING LEASE An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease period. Normally the lease is for a short period and even otherwise is revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of obsolescence is very high in this kind of assets. SALE AND LEASE BACK It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner in consideration of lease rentals. However, under this arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected depreciation but appreciation, say land. The advantage of this method is that the lessee can satisfy himself completely regarding the quality of the asset and after possession of the asset convert the sale into a lease arrangement. The sale and lease back transaction can be expressed with the help of the following figure.

38

Under this transaction, the seller assumes the role of a lessee and the buyer assumes the role of a lessor. The seller gets the agreed selling price and the buyer gets the lease rentals. It is possible to structure the sale at agreed value (below or above the fair market price) and to adjust difference in the lease rentals. Thus the effect of profit /loss on sale of assets can be deferred. LEVERAGED LEASING Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and the asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with the asset.

DIRECT LEASING

39

Under direct leasing, a firm acquires the right to use an asset from the manufacturer directly. The ownership of the asset leased out remains with the manufacturer itself. The major types of direct lessor include manufacturers, finance companies, independent lease companies, special purpose leasing companies etc 15.6 ADVANTAGES OF LEASING There are several extolled advantages of acquiring capital assets on lease: (1) SAVING OF CAPITAL: Leasing covers the full cost of the equipment used in the business by providing 100% finance. The lessee is not to provide or pay any margin Manufacturer Lessor Lessee Lender money as there is no down payment. In this way the saving in capital or financial resources can be used for other productive purposes e.g. purchase of inventories. (2) FLEXIBILITY AND CONVENIENCE: The lease agreement can be tailor- made in respect of lease period and lease rentals according to the convenience and requirements of all lessees. (3) PLANNING CASH FLOWS: Leasing enables the lessee to plan its cash flows properly. The rentals can be paid out of the cash coming into the business from the use of the same assets. (4) IMPROVEMENT IN LIQUADITY: Leasing enables the lessee to improve their liquidity position by adopting the sale and lease back technique. ADVANTAGES OF USING LEASING AS A SOURCE OF FINANCE Introduction The use of leasing is a popular method of funding the acquisition of capital assets. However, these methods are not necessarily suitable for every business or for every asset purchase. There are a number of considerations to be made, as described below: Certainty : One important advantage is that a hire purchase or leasing agreement is a medium term funding facility, which cannot be withdrawn, provided the business makes the payments as they fall due. The uncertainty that may be associated with alternative funding facilities such as overdrafts, which are repayable on demand, is removed.

40

However, it should be borne in mind that both hire purchase and leasing agreements are long term commitments. It may not be possible, or could prove costly, to terminate them early. Budgeting: The regular nature of the hire purchase or lease payments (which are also usually of fixed amounts as well) helps a business to forecast cash flow. The business is able to compare the payments with the expected revenue and profits generated by the use of the asset. Fixed Rate Finance In most cases the payments are fixed throughout the hire purchase or lease agreement, so a business will know at the beginning of the agreement what their repayments will be. This can be beneficial in times of low, stable or rising interest rates but may appear expensive if interest rates are falling. On some agreements, such as those for a longer term, the finance company may offer the option of variable rate agreements. In such cases, rentals or installments will vary with current interest rates; hence it may be more difficult to budget for the level of payment. The Effect Of Security Under both hire purchase and leasing, the finance company retains legal ownership of the equipment, at least until the end of the agreement. This normally gives the finance company better security than lenders of other types of loan or overdraft facilities. The finance company may therefore be able to offer better terms. The decision to provide finance to a small or medium sized business depends on that business' credit standing and potential. Because the finance company has security in the equipment, it could tip the balance in favour of a positive credit decision. Maximum Finance Hire purchase and leasing could provide finance for the entire cost of the equipment. There may however, be a need to put down a deposit for hire purchase or to make one or more payments in advance under a lease. It may be possible for the business to 'trade-in' other assets which they own, as a means of raising the deposit. Tax Advantages Hire purchase and leasing give the business the choice of how to take advantage of capital allowances.

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If the business is profitable, it can claim its own capital allowances through hire purchase or outright purchase. If it is not in a tax paying position or pays corporation tax at the small companies rate, then a lease could be more beneficial to the business. The leasing company will claim the capital allowances and pass the benefits on to the business by way of reduced rentals.

INTRODUCTION TO VENTURE CAPITAL Venture Capital is a form of "risk capital". In other words, capital that is invested in a project (in this case - a business) where there is a substantial element of risk relating to the future creation of profits and cash flows. Risk capital is invested as shares (equity) rather than as a loan and the investor requires a higher"rate of return" to compensate him for his risk. The main sources of venture capital in the UK are venture capital firms and "business angels" - private investors. Separate Tutor2u revision notes cover the operation of business angels. In these notes, we principally focus on venture capital firms. However, it should be pointed out the attributes that both venture capital firms and business angels look for in potential investments are often very similar. What is venture capital? Venture capital provides long-term, committed share capital, to help unquoted companies grow and succeed. If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a business in which he works, turnaround or revitalise a company, venture capital could help do this. Obtaining venture capital is substantially different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business . Venture capital is invested in exchange for an equity stake in the business. As a shareholder, the venture capitalist's return is dependent on the growth and profitability of the business. This return is generally earned when the venture capitalist "exits" by selling its shareholding when the business is sold to another owner. Venture capital in the UK originated in the late 18th century, when entrepreneurs found wealthy individuals to back their projects on an ad hoc basis. This informal method of financing became an industry in the late 1970s and early 1980s when a number of venture capital firms were founded. There are now over 100 active venture capital firms in the UK, which provide several billion pounds each year to unquoted companies mostly located in the UK. What kind of businesses are attractive to venture capitalists? Venture capitalist prefer to invest in "entrepreneurial businesses". This does not necessarily mean small or new businesses. Rather, it is more about the investment's aspirations and potential for growth, rather than by current

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size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb, unless a business can offer the prospect of significant turnover growth within five years, it is unlikely to be of interest to a venture capital firm. Venture capital investors are only interested in companies with high growth prospects, which are managed by experienced and ambitious teams who are capable of turning their business plan into reality. For how long do venture capitalists invest in a business? Venture capital firms usually look to retain their investment for between three and seven years or more. The term of the investment is often linked to the growth profile of the business. Investments in more mature businesses, where the business performance can be improved quicker and easier, are often sold sooner than investments in early-stage or technology companies where it takes time to develop the business model. Where do venture capital firms obtain their money? Just as management teams compete for finance, so do venture capital firms. They raise their funds from several sources. To obtain their funds, venture capital firms have to demonstrate a good track record and the prospect of producing returns greater than can be achieved through fixed interest or quoted equity investments. Most UK venture capital firms raise their funds for investment from external sources, mainly institutional investors, such as pension funds and insurance companies. Venture capital firms' investment preferences may be affected by the source of their funds. Many funds raised from external sources are structured as Limited Partnerships and usually have a fixed life of 10 years. Within this period the funds invest the money committed to them and by the end of the 10 years they will have had to return the investors' original money, plus any additional returns made. This generally requires the investments to be sold, or to be in the form of quoted shares, before the end of the fund. Venture Capital Trusts (VCT's) are quoted vehicles that aim to encourage investment in smaller unlisted (unquoted and AIM quoted companies) UK companies by offering private investors tax incentives in return for a five-year investment commitment. The first were launched in Autumn 1995 and are mainly managed by UK venture capital firms. If funds are obtained from a VCT, there may be some restrictions regarding the company's future development within the first few years. What is involved in the investment process? The investment process, from reviewing the business plan to actually investing in a proposition, can take a venture capitalist anything from one month to one year but typically it takes between 3 and 6 months. There are always exceptions to the rule and deals can be done in extremely short time frames. Much depends on the quality of information provided and made available.

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The key stage of the investment process is the initial evaluation of a business plan. Most approaches to venture capitalists are rejected at this stage. In considering the business plan, the venture capitalist will consider several principal aspects: - Is the product or service commercially viable? - Does the company have potential for sustained growth? - Does management have the ability to exploit this potential and control the company through the growth phases? - Does the possible reward justify the risk? - Does the potential financial return on the investment meet their investment criteria? In structuring its investment, the venture capitalist may use one or more of the following types of share capital: Ordinary shares These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied. Ordinary shares have votes. In a venture capital deal these are the shares typically held by the management and family shareholders rather than the venture capital firm. Preferred ordinary shares These are equity shares with special rights.For example, they may be entitled to a fixed dividend or share of the profits. Preferred ordinary shares have votes. Preference shares These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and capital. Their income rights are defined and they are usually entitled to a fixed dividend (eg. 10% fixed). The shares may be redeemable on fixed dates or they may be irredeemable. Sometimes they may be redeemable at a fixed premium (eg. at 120% of cost). They may be convertible into a class of ordinary shares. Loan capital Venture capital loans typically are entitled to interest and are usually, though not necessarily repayable. Loans may be secured on the company's assets or may be unsecured. A secured loan will rank ahead of unsecured loans and certain other creditors of the company. A loan may be convertible into equity shares. Alternatively, it may have a warrant attached which gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment of capital.

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Venture capital investments are often accompanied by additional financing at the point of investment. This is nearly always the case where the business in which the investment is being made is relatively mature or wellestablished. In this case, it is appropriate for a business to have a financing structure that includes both equity and debt. Other forms of finance provided in addition to venture capitalist equity include: - Clearing banks - principally provide overdrafts and short to medium-term loans at fixed or, more usually, variable rates of interest. - Merchant banks - organise the provision of medium to longer-term loans, usually for larger amounts than clearing banks. Later they can play an important role in the process of "going public" by advising on the terms and price of public issues and by arranging underwriting when necessary. - Finance houses - provide various forms of installment credit, ranging from hire purchase to leasing, often asset based and usually for a fixed term and at fixed interest rates. Factoring companies - provide finance by buying trade debts at a discount, either on a recourse basis (you retain the credit risk on the debts) or on a non-recourse basis (the factoring company takes over the credit risk). Government and European Commission sources - provide financial aid to UK companies, ranging from project grants (related to jobs created and safeguarded) to enterprise loans in selective areas. Mezzanine firms - provide loan finance that is halfway between equity and secured debt. These facilities require either a second charge on the company's assets or are unsecured. Because the risk is consequently higher than senior debt, the interest charged by the mezzanine debt provider will be higher than that from the principal lenders and sometimes a modest equity "up-side" will be required through options or warrants. It is generally most appropriate for larger transactions. Making the Investment - Due Diligence To support an initial positive assessment of your business proposition, the venture capitalist will want to assess the technical and financial feasibility in detail. External consultants are often used to assess market prospects and the technical feasibility of the proposition, unless the venture capital firm has the appropriately qualified people in-house. Chartered accountants are often called on to do much of the due diligence, such as to report on the financial projections and other financial aspects of the plan. These reports often follow a detailed study, or a one or two day overview may be all that is required by

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the venture capital firm. They will assess and review the following points concerning the company and its management: - Management information systems - Forecasting techniques and accuracy of past forecasting - Assumptions on which financial assumptions are based - The latest available management accounts, including the company's cash/debtor positions - Bank facilities and leasing agreements - Pensions funding - Employee contracts, etc. The due diligence review aims to support or contradict the venture capital firm's own initial impressions of the business plan formed during the initial stage. References may also be taken up on the company (eg. with suppliers, customers, and bankers). Financing stages There are typically six stages of venture round financing offered in Venture Capital, that roughly correspond to these stages of a company's development.[24]

Seed Money: Low level financing needed to prove a new idea, often provided by 1angel investors. Crowd funding is also emerging as an option for seed funding. Start-up: Early stage firms that need funding for expenses associated with marketing and product development First-Round (Series A round): Early sales and manufacturing funds Second-Round: Working capital for early stage companies that are selling product, but not yet turning a profit Third-Round: Also called Mezzanine financing, this is expansion money for a newly profitable company Fourth-Round: Also called bridge financing, 4th round is intended to finance the "going public" process

Structure Venture capital firms are typically structured as partnerships, the general partners of which serve as the managers of the firm and will serve as investment advisors to the venture capital funds raised. Venture capital firms in the United States may also be structured as limited liability companies, in which case the firm's managers are known as managing members. Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments,

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foundations, insurance companies, and pooled investment vehicles, called funds of funds (FoF). Types Venture Capitalist firms differ in their approaches. There are multiple factors, and each firm is different.[26] Some of the factors that influence VC decisions include:

Business situation: Some VCs tend to invest in new ideas, or fledgling companies. Others prefer investing in established companies that need support to go public or grow. Some invest solely in certain industries. Some prefer operating locally while others will operate nationwide or even globally. VC expectations often vary. Some may want a quicker public sale of the company or expect fast growth. The amount of help a VC provides can vary from one firm to the next.

Roles Within the venture capital industry, the general partners and other investment professionals of the venture capital firm are often referred to as "venture capitalists" or "VCs". Typical career backgrounds vary, but, broadly speaking, venture capitalists come from either an operational or a finance background. Venture capitalists with an operational background tend to be former founders or executives of companies similar to those which the partnership finances or will have served as management consultants. Venture capitalists with finance backgrounds tend to have investment banking or other corporate finance experience. Although the titles are not entirely uniform from firm to firm, other positions at venture capital firms include:

Venture partners Venture partners are expected to source potential investment opportunities ("bring in deals") and typically are compensated only for those deals with which they are involved. Principal This is a mid-level investment professional position, and often considered a "partner-track" position. Principals will have been promoted from a senior associate position or who have commensurate experience in another field, such as investment banking or management consulting. Associate This is typically the most junior apprentice position within a venture capital firm. After a few successful years, an associate

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may move up to the "senior associate" position and potentially principal and beyond. Associates will often have worked for 12 years in another field, such as investment banking or management consulting.

Entrepreneur-in-residence (EIR) EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by venture capital firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm although neither party is bound to work with each other. Some EIRs move on to executive positions within a portfolio company.

Need of venture capital

There are enterpreneurs and many other people who come up with bright ideas but lack the capital for the investment what these venture capitals do are to facilitate and enable the start up phase. When there is an owner relation between the venture capital providers and recievers, their mutual interest for returns will increase the firms motiviation to increase profits. Venture capitalists have invested in simlar firms and projects before and, therefore, have more knowledge and experience. This knowledge and experience are the outcomes of the experiments through the sucesses and failures from previous ventures, so they know what works and what does not, and how it works. Therefore, through venture capital involvement, a portfolio firm can initiate growth, identify problems, and find recipies to overcome them.

Structure of the funds Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. The investing cycle for most funds is generally three to five years, after which the focus is managing and making follow-on investments in an existing portfolio. This model was pioneered by successful funds in Silicon Valley through the 1980s to invest in technological trends broadly but only during their period of ascendance, and to cut exposure to management and marketing risks of any individual firm or its product. In such a fund, the investors have a fixed commitment to the fund that is initially unfunded and subsequently "called down" by the venture capital fund over time as the fund makes its investments. There are substantial penalties for a limited partner (or investor) that fails to participate in a capital call.

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It can take anywhere from a month or so to several years for venture capitalists to raise money from limited partners for their fund. At the time when all of the money has been raised, the fund is said to be closed, and the 10-year lifetime begins. Some funds have partial closes when one half (or some other amount) of the fund has been raised. "Vintage year" generally refers to the year in which the fund was closed and may serve as a means to stratify VC funds for comparison. This [27] shows the difference between a venture capital fund management company and the venture capital funds managed by them. Compensation Venture capitalists are compensated through a combination of management fees and carried interest (often referred to as a "two and 20" arrangement):

Management fees an annual payment made by the investors in the fund to the fund's manager to pay for the private equity firm's investment operations.[28] In a typical venture capital fund, the general partners receive an annual management fee equal to up to 2% of the committed capital. Carried interest a share of the profits of the fund (typically 20%), paid to the private equity funds management company as a performance incentive. The remaining 80% of the profits are paid to the fund's investors[28] Strong limited partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and certain groups are able to command carried interest of 2530% on their funds.

Because a fund may be run out of capital prior to the end of its life, larger venture capital firms usually have several overlapping funds at the same time; doing so lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know. MUTUAL FUNDS A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities What is a Mutual Fund? A mutual fund is just the connecting bridge or a financial intermediary that allows a group of investors to pool their money together with a

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predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the gathered money into specific securities (stocks or bonds). When you invest in a mutual fund, you are buying units or portions of the mutual fund and thus on investing becomes a shareholder or unit holder of the fund. All mutual funds are variations of these three asset classes. For example, while equity funds that invest in fast-growing companies are known as growth funds, equity funds that invest only in companies of the same sector or region are known as specialty funds. Let's go over the many different flavors of funds. We'll start with the safest and then work through to the more risky. Money Market Funds The money market consists of short-term debt instruments, mostly Treasury bills. This is a safe place to park your money. You won't get great returns, but you won't have to worry about losing your principal. A typical return is twice the amount you would earn in a regular checking/savings account and a little less than the average certificate of deposit (CD). Bond/Income Funds Income funds are named appropriately: their purpose is to provide current income on a steady basis. When referring to mutual funds, the terms "fixedincome," "bond," and "income" are synonymous. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cashflow to investors. As such, the audience for these funds consists of conservative investors and retirees. Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren't without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in highyield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes down. Balanced Funds The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class. A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced fund, but these kinds of funds typically do not

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have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle. Equity Funds Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of equity funds because there are many different types of equities. A great way to understand the universe of equity funds is to use a style box, an example of which is below.

The idea is to classify funds based on both the size of the companies invested in and the investment style of the manager. The term value refers to a style of investing that looks for high quality companies that are out of favor with the market. These companies are characterized by low P/E and price-to-book ratios and high dividend yields. The opposite of value is growth, which refers to companies that have had (and are expected to continue to have) strong growth in earnings, sales and cash flow. A compromise between value and growth is blend, which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle. For example, a mutual fund that invests in large-cap companies that are in strong financial shape but have recently seen their share prices fall would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects. Such a mutual fund would reside in the bottom right quadrant (small and growth). Global/International Funds An international fund (or foreign fund) invests only outside your home country. Global funds invest anywhere around the world, including your home country. It's tough to classify these funds as either riskier or safer than domestic investments. They do tend to be more volatile and have unique country and/or political risks. But, on the flip side, they can, as part of a wellbalanced portfolio, actually reduce risk by increasing diversification.

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Although the world's economies are becoming more inter-related, it is likely that another economy somewhere is outperforming the economy of your home country. Specialty Funds This classification of mutual funds is more of an all-encompassing category that consists of funds that have proved to be popular but don't necessarily belong to the categories we've described so far. This type of mutual fund forgoes broad diversification to concentrate on a certain segment of the economy. Sector funds are targeted at specific sectors of the economy such as financial, technology, health, etc. Sector funds are extremely volatile. There is a greater possibility of big gains, but you have to accept that your sector may tank. Regional funds make it easier to focus on a specific area of the world. This may mean focusing on a region (say Latin America) or an individual country (for example, only Brazil). An advantage of these funds is that they make it easier to buy stock in foreign countries, which is otherwise difficult and expensive. Just like for sector funds, you have to accept the high risk of loss, which occurs if the region goes into a bad recession. Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of certain guidelines or beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power. The idea is to get a competitive performance while still maintaining a healthy conscience. Index Funds The last but certainly not the least important are index funds. This type of mutual fund replicates the performance of a broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA). An investor in an index fund figures that most managers can't beat the market. An index fund merely replicates the market return and benefits investors in the form of low fees. Advantages of mutual funds Mutual funds have advantages compared to direct investing in individual securities.[3] These include:

Increased diversification Daily liquidity Professional investment management Ability to participate in investments that may be available only to larger investors

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Service and convenience Government oversight Ease of comparison

Disadvantages of mutual funds Mutual funds have disadvantages as well, which include[4]:

Fees Less control over timing of recognition of gains Less predictable income No opportunity to customize

CONCEPT OF MUTUAL FUNDS:

ADVANTAGES OF MUTUAL FUND S. No. Advantage Particulars

Mutual Funds invest in a well-diversified portfolio of Portfolio securities which enables investor to hold a diversified 1. Diversificatio investment portfolio (whether the amount of investment n is big or small). 2. Professional Fund manager undergoes through various research Management works and has better investment management skills

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which ensure higher returns to the investor than what he can manage on his own. 3. Less Risk Low 4. Transaction Costs 5. Liquidity Investors acquire a diversified portfolio of securities even with a small investment in a Mutual Fund. The risk in a diversified portfolio is lesser than investing in merely 2 or 3 securities. Due to the economies of scale (benefits of larger volumes), mutual funds pay lesser transaction costs. These benefits are passed on to the investors. An investor may not be able to sell some of the shares held by him very easily and quickly, whereas units of a mutual fund are far more liquid. >Mutual funds provide investors with various schemes with different investment objectives. Investors have the option of investing in a scheme having a correlation between its investment objectives and their own financial goals. These schemes further have different plans/options

6.

Choice of Schemes

Funds provide investors with updated information Transparenc pertaining to the markets and the schemes. All material 7. y facts are disclosed to investors as required by the regulator. Investors also benefit from the convenience and flexibility offered by Mutual Funds. Investors can switch their holdings from a debt scheme to an equity scheme and vice-versa. Option of systematic (at regular intervals) investment and withdrawal is also offered to the investors in most open-end schemes. Mutual Fund industry is part of a well-regulated investment environment where the interests of the investors are protected by the regulator. All funds are registered with SEBI and complete transparency is forced.

8. Flexibility

9. Safety

DISADVANTAGES OF MUTUAL FUND S. Disadvantage No. Costs Control Not in the 1. Hands of an Investor 2. No Particulars Investor has to pay investment management fees and fund distribution costs as a percentage of the value of his investments (as long as he holds the units), irrespective of the performance of the fund. The portfolio of securities in which a fund invests is a

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Customized Portfolios

decision taken by the fund manager. Investors have no right to interfere in the decision making process of a fund manager, which some investors find as a constraint in achieving their financial objectives.

Many investors find it difficult to select one option from Difficulty in the plethora of funds/schemes/plans available. For this, Selecting a 3. they may have to take advice from financial planners in Suitable order to invest in the right fund to achieve their Fund Scheme objectives. Disadvantages of Investing Mutual Funds: 1. Professional Management- Some funds doesnt perform in neither the market, as their management is not dynamic enough to explore the available opportunity in the market, thus many investors debate over whether or not the so-called professionals are any better than mutual fund or investor him self, for picking up stocks. 2. Costs The biggest source of AMC income, is generally from the entry & exit load which they charge from an investors, at the time of purchase. The mutual fund industries are thus charging extra cost under layers of jargon. 3. Dilution - Because funds have small holdings across different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money. 4. Taxes - when making decisions about your money, fund managers don't consider your personal tax situation. For example, when a fund manager sells a security, a capital-gain tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability.

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BROAD MUTUAL FUND TYPES

1. Equity Funds Equity funds are considered to be the more risky funds as compared to other fund types, but they also provide higher returns than other funds. It is advisable that an investor looking to invest in an equity fund should invest for long term i.e. for 3 years or more. There are different types of equity funds each falling into different risk bracket. In the order of decreasing risk level, there are following types of equity funds:
a. Aggressive Growth Funds - In Aggressive Growth Funds, fund

managers aspire for maximum capital appreciation and invest in less researched shares of speculative nature. Because of these speculative investments Aggressive Growth Funds become more volatile and thus, are prone to higher risk than other equity funds. b. Growth Funds - Growth Funds also invest for capital appreciation (with time horizon of 3 to 5 years) but they are different from Aggressive Growth Funds in the sense that they invest in companies that are expected to outperform the market in the future. Without entirely adopting speculative strategies, Growth Funds invest in those

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companies that are expected to post above average earnings in the future. c. Speciality Funds - Speciality Funds have stated criteria for investments and their portfolio comprises of only those companies that meet their criteria. Criteria for some speciality funds could be to invest/not to invest in particular regions/companies. Speciality funds are concentrated and thus, are comparatively riskier than diversified funds.. There are following types of speciality funds: i. Sector Funds: Speciality Funds have stated criteria for investments and their portfolio comprises of only those companies that meet their criteria. Criteria for some speciality funds could be to invest/not to invest in particular regions/companies. Speciality funds are concentrated and thus, are comparatively riskier than diversified funds.. There are following types of speciality funds: ii. Foreign Securities Funds: Foreign Securities Equity Funds have the option to invest in one or more foreign companies. Foreign securities funds achieve international diversification and hence they are less risky than sector funds. However, foreign securities funds are exposed to foreign exchange rate risk and country risk. iii. Mid-Cap or Small-Cap Funds: Funds that invest in companies having lower market capitalization than large capitalization companies are called Mid-Cap or Small-Cap Funds. Market capitalization of Mid-Cap companies is less than that of big, blue chip companies (less than Rs. 2500 crores but more than Rs. 500 crores) and Small-Cap companies have market capitalization of less than Rs. 500 crores. Market Capitalization of a company can be calculated by multiplying the market price of the company's share by the total number of its outstanding shares in the market. The shares of Mid-Cap or Small-Cap Companies are not as liquid as of Large-Cap Companies which gives rise to volatility in share prices of these companies and consequently, investment gets risky. iv. Option Income Funds*: While not yet available in India, Option Income Funds write options on a large fraction of their portfolio. Proper use of options can help to reduce volatility, which is otherwise considered as a risky instrument. These funds invest in big, high dividend yielding companies, and then sell options against their stock positions, which generate stable income for investors. d. Diversified Equity Funds - Except for a small portion of investment in liquid money market, diversified equity funds invest mainly in equities without any concentration on a particular sector(s). These funds are well diversified and reduce sector-specific or companyspecific risk. However, like all other funds diversified equity funds too are exposed to equity market risk. One prominent type of diversified equity fund in India is Equity Linked Savings Schemes (ELSS). As per

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the mandate, a minimum of 90% of investments by ELSS should be in equities at all times. ELSS investors are eligible to claim deduction from taxable income (up to Rs 1 lakh) at the time of filing the income tax return. ELSS usually has a lock-in period and in case of any redemption by the investor before the expiry of the lock-in period makes him liable to pay income tax on such income(s) for which he may have received any tax exemption(s) in the past. e. Equity Index Funds - Equity Index Funds have the objective to match the performance of a specific stock market index. The portfolio of these funds comprises of the same companies that form the index and is constituted in the same proportion as the index. Equity index funds that follow broad indices (like S&P CNX Nifty, Sensex) are less risky than equity index funds that follow narrow sectoral indices (like BSEBANKEX or CNX Bank Index etc). Narrow indices are less diversified and therefore, are more risky. f. Value Funds - Value Funds invest in those companies that have sound fundamentals and whose share prices are currently undervalued. The portfolio of these funds comprises of shares that are trading at a low Price to Earning Ratio (Market Price per Share / Earning per Share) and a low Market to Book Value (Fundamental Value) Ratio. Value Funds may select companies from diversified sectors and are exposed to lower risk level as compared to growth funds or speciality funds. Value stocks are generally from cyclical industries (such as cement, steel, sugar etc.) which make them volatile in the short-term. Therefore, it is advisable to invest in Value funds with a long-term time horizon as risk in the long term, to a large extent, is reduced. g. Equity Income or Dividend Yield Funds - The objective of Equity Income or Dividend Yield Equity Funds is to generate high recurring income and steady capital appreciation for investors by investing in those companies which issue high dividends (such as Power or Utility companies whose share prices fluctuate comparatively lesser than other companies' share prices). Equity Income or Dividend Yield Equity Funds are generally exposed to the lowest risk level as compared to other equity funds. 2. Debt / Income Funds Funds that invest in medium to long-term debt instruments issued by private companies, banks, financial institutions, governments and other entities belonging to various sectors (like infrastructure companies etc.) are known as Debt / Income Funds. Debt funds are low risk profile funds that seek to generate fixed current income (and not capital appreciation) to investors. In order to ensure regular income to investors, debt (or income) funds distribute large fraction of their surplus to investors. Although debt securities are generally less risky than equities, they are subject to credit risk (risk of default) by the issuer at the time of interest or principal payment. To minimize the risk of default, debt funds usually invest in securities from issuers who are rated by credit rating agencies and are considered to be of

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"Investment Grade". Debt funds that target high returns are more risky. Based on different investment objectives, there can be following types of debt funds:
a. Diversified Debt Funds - Debt funds that invest in all securities

b.

c.

d.

e.

issued by entities belonging to all sectors of the market are known as diversified debt funds. The best feature of diversified debt funds is that investments are properly diversified into all sectors which results in risk reduction. Any loss incurred, on account of default by a debt issuer, is shared by all investors which further reduces risk for an individual investor. Focused Debt Funds* - Debt funds that invest in all securities issued by entities belonging to all sectors of the market are known as diversified debt funds. The best feature of diversified debt funds is that investments are properly diversified into all sectors which results in risk reduction. Any loss incurred, on account of default by a debt issuer, is shared by all investors which further reduces risk for an individual investor. High Yield Debt funds - As we now understand that risk of default is present in all debt funds, and therefore, debt funds generally try to minimize the risk of default by investing in securities issued by only those borrowers who are considered to be of "investment grade". But, High Yield Debt Funds adopt a different strategy and prefer securities issued by those issuers who are considered to be of "below investment grade". The motive behind adopting this sort of risky strategy is to earn higher interest returns from these issuers. These funds are more volatile and bear higher default risk, although they may earn at times higher returns for investors. Assured Return Funds - Although it is not necessary that a fund will meet its objectives or provide assured returns to investors, but there can be funds that come with a lock-in period and offer assurance of annual returns to investors during the lock-in period. Any shortfall in returns is suffered by the sponsors or the Asset Management Companies (AMCs). These funds are generally debt funds and provide investors with a low-risk investment opportunity. However, the security of investments depends upon the net worth of the guarantor (whose name is specified in advance on the offer document). To safeguard the interests of investors, SEBI permits only those funds to offer assured return schemes whose sponsors have adequate net-worth to guarantee returns in the future. In the past, UTI had offered assured return schemes (i.e. Monthly Income Plans of UTI) that assured specified returns to investors in the future. UTI was not able to fulfill its promises and faced large shortfalls in returns. Eventually, government had to intervene and took over UTI's payment obligations on itself. Currently, no AMC in India offers assured return schemes to investors, though possible. Fixed Term Plan Series - Fixed Term Plan Series usually are closedend schemes having short term maturity period (of less than one year)

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that offer a series of plans and issue units to investors at regular intervals. Unlike closed-end funds, fixed term plans are not listed on the exchanges. Fixed term plan series usually invest in debt / income schemes and target short-term investors. The objective of fixed term plan schemes is to gratify investors by generating some expected returns in a short period. 3. Gilt Funds Also known as Government Securities in India, Gilt Funds invest in government papers (named dated securities) having medium to long term maturity period. Issued by the Government of India, these investments have little credit risk (risk of default) and provide safety of principal to the investors. However, like all debt funds, gilt funds too are exposed to interest rate risk. Interest rates and prices of debt securities are inversely related and any change in the interest rates results in a change in the NAV of debt/gilt funds in an opposite direction. 4. Money Market / Liquid Funds Money market / liquid funds invest in short-term (maturing within one year) interest bearing debt instruments. These securities are highly liquid and provide safety of investment, thus making money market / liquid funds the safest investment option when compared with other mutual fund types. However, even money market / liquid funds are exposed to the interest rate risk. The typical investment options for liquid funds include Treasury Bills (issued by governments), Commercial papers (issued by companies) and Certificates of Deposit (issued by banks). 5. Hybrid Funds As the name suggests, hybrid funds are those funds whose portfolio includes a blend of equities, debts and money market securities. Hybrid funds have an equal proportion of debt and equity in their portfolio. There are following types of hybrid funds in India:
a. Balanced Funds - The portfolio of balanced funds include assets like

debt securities, convertible securities, and equity and preference shares held in a relatively equal proportion. The objectives of balanced funds are to reward investors with a regular income, moderate capital appreciation and at the same time minimizing the risk of capital erosion. Balanced funds are appropriate for conservative investors having a long term investment horizon. b. Growth-and-Income Funds - Funds that combine features of growth funds and income funds are known as Growth-and-Income Funds. These funds invest in companies having potential for capital appreciation and those known for issuing high dividends. The level of risks involved in these funds is lower than growth funds and higher than income funds. c. Asset Allocation Funds - Mutual funds may invest in financial assets like equity, debt, money market or non-financial (physical) assets like

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real estate, commodities etc.. Asset allocation funds adopt a variable asset allocation strategy that allows fund managers to switch over from one asset class to another at any time depending upon their outlook for specific markets. In other words, fund managers may switch over to equity if they expect equity market to provide good returns and switch over to debt if they expect debt market to provide better returns. It should be noted that switching over from one asset class to another is a decision taken by the fund manager on the basis of his own judgment and understanding of specific markets, and therefore, the success of these funds depends upon the skill of a fund manager in anticipating market trends. 6. Commodity Funds Those funds that focus on investing in different commodities (like metals, food grains, crude oil etc.) or commodity companies or commodity futures contracts are termed as Commodity Funds. A commodity fund that invests in a single commodity or a group of commodities is a specialized commodity fund and a commodity fund that invests in all available commodities is a diversified commodity fund and bears less risk than a specialized commodity fund. "Precious Metals Fund" and Gold Funds (that invest in gold, gold futures or shares of gold mines) are common examples of commodity funds. 7. Real Estate Funds Funds that invest directly in real estate or lend to real estate developers or invest in shares/securitized assets of housing finance companies, are known as Specialized Real Estate Funds. The objective of these funds may be to generate regular income for investors or capital appreciation. 8. Exchange Traded Funds (ETF) Exchange Traded Funds provide investors with combined benefits of a closed-end and an open-end mutual fund. Exchange Traded Funds follow stock market indices and are traded on stock exchanges like a single stock at index linked prices. The biggest advantage offered by these funds is that they offer diversification, flexibility of holding a single share (tradable at index linked prices) at the same time. Recently introduced in India, these funds are quite popular abroad. 9. Fund of Funds Mutual funds that do not invest in financial or physical assets, but do invest in other mutual fund schemes offered by different AMCs, are known as Fund of Funds. Fund of Funds maintain a portfolio comprising of units of other mutual fund schemes, just like conventional mutual funds maintain a portfolio comprising of equity/debt/money market instruments or non financial assets. Fund of Funds provide investors with an added advantage of diversifying into different mutual fund schemes with even a small amount of investment, which further helps in diversification of risks. However, the expenses of Fund of Funds are

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quite high on account of compounding expenses of investments into different mutual fund schemes.

Inflationis the process in which the price level is risingand money is losing value. Inflation is not the increase in the price of one item. Inflationis the increase in the price of all items by similar percentages. A one-time jump in the price level is not inflation. Inflation is an ongoingprocess Causes of Inflation The basic causes of inflation were covered at AS level. This note considers the demand and supply-side courses in more detail including the impact of changes in the exchange rate and the prices of goods and services in the international economy. Cost Push Inflation Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise: Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on exports of these commodities or alternatively by a fall in the value of the pound in the foreign exchange

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markets which increases the UK price of imported inputs. A good example of cost push inflation was the decision by British Gas and other energy suppliers to raise substantially the prices for gas and electricity that it charges to domestic and industrial consumers at various points during 2005 and 2006. Rising labour costs - caused by wage increases which exceed any improvement in productivity. This cause is important in those industries which are labour-intensive. Firms may decide not to pass these higher costs onto their customers (they may be able to achieve some cost savings in other areas of the business) but in the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to which any business can absorb higher wage expenses. Higher indirect taxes imposed by the government for example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation. Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of real national output together with a rise in the general level of prices.

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Demand Pull Inflation Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons some of which occur together at the same moment of the economic cycle

A depreciation of the exchange rate, which has the effect of increasing the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while foreigners buy more exports, AD will rise. If the economy is already at full employment, prices are pulled upwards. A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP. The rapid growth of the money supply perhaps as a consequence of increased bank and building society borrowing if interest rates are low. Monetarist economists believe that the root causes of inflation are monetary in particular when the monetary authorities permit an excessive growth of the supply of money in

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circulation beyond that needed to finance the volume of transactions produced in the economy. Rising consumer confidence and an increase in the rate of growth of house prices both of which would lead to an increase in total household demand for goods and services Faster economic growth in other countries providing a boost to UK exports overseas.

The effects of an increase in AD on the price level can be shown in the next two diagrams. Higher prices following an increase in demand lead to higher output and profits for those businesses where demand is growing. The impact on prices is greatest when SRAS is inelastic. In the first diagram the SRAS curve is drawn as non-linear. In the second, the macroeconomic equilibrium following an outward shift of AD takes the economy beyond the equilibrium at potential GDP. This causes an inflationary gap to appear which then triggers higher wage and other factor costs. The effect of this is to cause an inward shift of SRAS taking real national output back towards a macroeconomic equilibrium at Yfc but with the general price level higher than it was before.

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The wage price spiral expectations-induced inflation Rising expectations of inflation can often be self-fulfilling. If people expect prices to continue rising, they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the real purchasing power of their incomes. For example a booming economy might see a rise in inflation from 3% to 5% due to an excess of AD. Workers will seek to negotiate higher wages and there is then a danger that this will trigger a wage-price spiral that then requires the introduction of deflationary policies such as higher interest rates or an increase in direct taxation.

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Inflation influences in the British economy

The diagram summarises some of the key influences on inflation. Reading from left to right:
o

Average earnings comprise basic pay + income from overtime payments, productivity bonuses, profit-related pay and other supplements to earned income Productivity measures output per person employed, or output per person hour. A rise in productivity helps to keep unit costs down. However, if earnings to people in work are rising faster than productivity, then unit labour costs will increase The growth of unit labour costs is a key determinant of inflation in the medium term. Additional pressure on prices comes from higher import prices, commodity prices (e.g. oil, copper and aluminium) and also the impact of indirect taxes such as VAT and excise duties. Prices also increase when businesses decide to increase their profit margins. They are more likely to do this during the upswing phase of the economic cycle.