Meaning of Financial Management

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

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting).Investment in current assets are also a part of investment decisions called as working capital decisions.

2. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.

3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two:

a. Dividend for shareholders- Dividend and the rate of it has to be decided.

b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise.

Functions of Financial Management

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

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

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

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions c. Public deposits to be drawn like in form of bonds.

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

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

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

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

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

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

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

Objectives of Financial Management

The objectives or goals or financial management are- (a) Profit maximization, (b) Return maximization, and (c) Wealth maximization. We shall explain these three goals of financial management as under:

(1) Goal of Profit maximization. Maximization of profits is generally regarded as the main objective of a business enterprise. Each company collects its finance by way of issue of shares to the public. Investors in shares purchase these shares in the hope of getting medium profits from the company as dividend It is possible only when the company's goal is to earn maximum profits out of its available resources. If company fails to distribute higher dividend, the people will not be keen to invest their money in such firm and persons who have already invested will like to sell their stocks. On

the other hand, higher profits are the barometer of its efficiency on all fronts, i.e., production, sales an management. A few replace the goal of 'maximization of profits' to 'fair profits'. 'Fair Profits' means general rate of profit earned by similar organisation in a particular area.

(2) Goal of Return Maximization. The second goal of financial management is to safeguard the economic interest of the persons who are directly or indirectly connected with the company, i.e., shareholders, creditors and employees. The all such interested parties must get the maximum return for their contributions. But this is possible only when the company earns higher profits or sufficient profits to discharge its obligations to them. Therefore, the goal of maximization of returns is inter-related.

3. Goal of Wealth Maximization. Frequently, Maximization of profits is regarded a the proper objective of the firm but it is not as inclusive a goal as that of maximizing it value to its shareholders. Value is represented by the market price of the ordinary share of the company over the long run which is certainly a reflection of company's investment and financing decisions. The log run means a considerably long period in order to work out a normalized market price. The management can make decision to maximize the value of its shares on the basis of day-today fluctuations in the market price in order t raise the market price of shares over the short run at the expense of the long fun by temporarily diverting some of its funds to some other accounts or by cutting some of its expenditure to the minimum at the cost of future profits. This does not reflect the true worth of the share because it will result in the fall of the share price in the market in the long run. It is, therefore, the goal of the financial management to ensure its shareholders that the value of their shares will be maximized in the long-run. In fact, the performances of the company can well be evaluated by the value of its share.The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be-

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

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

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

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

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

Financial management emerged as a distinct field of study at the turn of this century. Its evolution may be divided into three broad phases (though the demarcating lines between these phases are somewhat arbitrary) : the traditional phase, the transitional phase, and the modern phase

The traditional phase lasted for about four decades. The following were its important features :

The focus of financial management was mainly on certain episodic events like formation, issuance of capital, major expansion, merger, reorganization, and liquidation in the life cycle of the firm.

The approach was mainly descriptive and institutional. The instruments of financing, the institutions and procedures used in capital markets, and the legal aspects of financial events formed the core of financial management.

The outsider’s point of view was dominant. Financial management was viewed mainly from the point of the investment bankers, lenders, and other outside interests.

The transitional phase being around the early forties and continued through the early fifties. Though the nature of financial management during this phase was similar to that of the traditional phase, greater emphasis was placed on the day-to-day problems faced by finance managers in the areas of funds analysis, planning, and control. These problems, however, were discussed within limited analytical frameworks.

The modern phase began in the mid-fifties and has witnessed an accelerated pace of development with the infusion of ideas from economic theory and application of quantitative methods of analysis. The distinctive features of the modern phase are :

The scope of financial management has broadened. The central concern of financial management is considered to be a rational matching of funds to their uses in the light of appropriate decision criteria.

The approach of financial management has become more analytical and quantitative.

The point of view of the managerial decision maker has become dominant.

Since the being of the modern phase many significant and seminal developments have occurred in the fields of capital budgeting, capital structure theory, efficient market theory, option pricing theory, arbitrage pricing theory, valuation models, dividend policy, working capital management, financial modeling, and behavioural finance. Many more exciting developments are in the offing making finance a fascinating and challenging field.

Interface of Financial Management with other Functional Areas

Marketing-Finance Interface

There are many decisions, which the Marketing Manager takes which have a significant impact on the profitability impact on the profitability of the firm. For example, he should have a clear understanding of the impact the credit extended to the customers is going to have on the profits of the company. Otherwise in his eagerness to meet the sales targets he is liable to extend liberal terms of credit, which is likely to put the profit plans out of gear. Similarly, he should weigh the benefits of keeping a large inventory of finished goods in anticipation of sales against the costs of maintaining that inventory. Other key decisions of the Marketing Manager, which have financial implications, are:

>Pricing>Product promotion and advertisement>Choice of product mix>Distribution policy.

Production-Finance Interface

As we all know in any manufacturing firm, the Production Manager controls a major part of the investment in the form of equipment, materials and men. He should so organize his department that the equipments under his control are used most productively, the inventory of work-in- process or unfinished goods and stores and spares is optimized and the idle time and work stoppages are minimized. If the production manager can achieve this, he would be holding the cost of the output under control and thereby help in maximizing profits. He has to appreciate the fact that whereas the price at which the output can be sold is largely determined by factors external to the firm like competition, government regulations, etc. the cost of production is more amenable to his control. Similarly, he would have to make decisions regarding make or buy, buy or lease etc. for which he has to evaluate the financial implications before arriving at a decision.

Top Management-Finance Interface

The top management, which is interested in ensuring that the firm's long-term goals are met, finds it convenient to use the financial statements as a means for keeping itself informed of the overall effectiveness of the organization. We have so far briefly reviewed the interface of finance with the non-finance functional disciplines like production, marketing etc. Besides these, the finance function also has a strong linkage with the functions of the top management. Strategic planning and management control are two important functions of the top management. Finance function provides the basic inputs needed for undertaking these activities.

Economics - Finance Interface

The field of finance is closely related to economics. Financial managers must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy. They must also be able to use economic theories as guidelines for efficient business operation. The primary economic principle used in managerial finance is marginal analysis, the principle that financial decisions should be

made and actions taken only when the added benefits exceed the added costs. Nearly all-financial decisions ultimately come down to an assessment of their marginal benefits and marginal costs.

Accounting - Finance Interface

The firm's finance (treasurer) and accounting (controller) activities are typically within the control of the financial vice president (CFO). These functions are closely related and generally overlap; indeed, managerial finance and accounting are often not easily distinguishable. In small firms the controller often carries out the finance function, and in large firms many accountants are closely involved in various finance activities. However, there are two basic differences between finance and accounting; one relates to the emphasis on cash flows and the other to decision making. complex and diverse responsibilities.

Corporate Finance

DefinitionThe division of a company that is concerned with the financial operation of the company. In most businesses, corporate finance focuses on raising money for various projects or ventures. For investment banks and similar corporations, corporate finance focuses on the analysis of corporate acquisitions and other decisions.

Corporate finance merely refers to the process of acquiring assets, managing them where possible and obtaining the best return from them during their lifetime. It could also extend to other peripheral functions such as getting rid of unwanted assets in a legal and viable manner. Ultimately corporate finance seeks to ensure that the organization has enough resources to fund its own business plans. Without corporate finance the organization comes to a standstill.

The global environment may not just be understood in terms of multinational companies. It is much more because governments and international bodies have in influence and are affected by the processes that happen in what we call the global business environment. If one wants to

understand the inter connectivity of all these issues, one only needs to look at the devastating effect that the global economic downturn has had on all businesses in general and financial institutions in particular.

What Role does Corporate Finance Play?The function of corporate finance will require that suitably qualified staff are hired and trained so that they can carry out their core function of managing the company’s asset in such a way as to ensure funding for all the agreed priorities. Through its various activities, corporate finance provides employment to a significant section of the community directly since they work in the firm. However it also manipulates capital markets thus being actively involved in economic activity.There will be different activities that lie within the remit of the corporation finance team’s functions. In order to raise capital the department might have to create forums that are specifically designed to encourage investors to come to the organization. The team will also be at the forefront of negotiating joint venture with prospective partners whether they are private individuals or professional venture capitalist organizations. Where the organization decides to sell stocks the corporate finance executives will be at the heart of the negotiations of price and terms.

Apart from the employment activities of those directly involved in executing these activities, corporate finance sustains the micro and macroeconomic fabric of both nations and the globe. In order to perform all of these activities a lot of human resource input is required. The list of specified professionals that are involved in corporate finance activities includes accountancy staff and even legal staff that are concerned with contract design.

Financial Market

In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis.

Both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy such as a gift economy.

In finance, financial markets facilitate:

The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) International trade (in the currency markets)

and are used to match those who want capital to those who have it.

Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends.

In mathematical finance, the concept of a financial market is defined in terms of a continuous-time Brownian motion stochastic process.

Definition

In economics, typically, the term market means the aggregate of possible buyers and sellers of a certain good or service and the transactions between them.

The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the

NYSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.

Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges.

Financial markets can be domestic or they can be international.

Types of financial markets

The financial markets can be divided into different subtypes:

Capital markets which consist of: o Stock markets, which provide financing through the issuance of

shares or common stock, and enable the subsequent trading thereof.

o Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

Commodity markets, which facilitate the trading of commodities. Money markets, which provide short term debt financing and

investment. Derivatives markets, which provide instruments for the management

of financial risk. Futures markets, which provide standardized forward contracts for

trading products at some future date; see also forward market. Insurance markets, which facilitate the redistribution of various risks. Foreign exchange markets, which facilitate the trading of foreign

exchange.

The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities.The transaction in primary market exist between investors and public while secondary market its between investors

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], 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 NSE and BSE, 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.

Stock Market-

Primarily there are two types of stock markets – the primary market and the secondary market. This is true for the Indian stock markets as well. Basically the primary market is the place where the shares are issued for the first time. So when a company is getting listed for the first time at the stock exchange and issuing shares – this process is undertaken at the primary market. That means the process of the Initial Public Offering or IPO and the debentures are controlled at the primary stock market. On the other hand the secondary market is the stock market where existing stocks are brought and sold by the retail investors through the brokers. It is the secondary market that controls the price of the stocks. Generally when we speak about investing or trading at the stock market we mean trading at the secondary stock market. It is the secondary market where we can invest and trade in the stocks to get the profit from our stock market investment.

Now these are the broadest classification of the stock markets that is true for any country as well as India. But the Indian stock markets can be divided into further categories depending on various aspects like the mode of operation and the diversification in services. First of the two largest stock exchanges in India can be divided on the basis of operation. While the Bombay stock exchange or BSE is a conventional stock exchange with a trading floor and operating through mostly offline trades, the National Stock

Exchange or NSE is a completely online stock exchange and the first of its kind in the country. The trading is carried out at the National Stock Exchange through the electronic limit order book or the LOB. With the immense popularity of the process and online trading facility other exchanges started to take up the online route including the BSE where you can trade online as well. But the BSE is still having the offline trading facility that is carried out at the trading floor of the exchange at its Dalal Street facility.

Apart from these classifications there are also different types of stock market in India and the classification is made on the type of instrument that is being traded at the market. Both the Bombay Stock Exchange and the National Stock Exchange have these types of stock markets.

Equity market or the cash segment – The first type of market is the equity market or the cash segment where stocks are traded. In this type of trading the buyers of the stocks book a buying order with a bid price and the order is executed through the broker at a negotiated ask price offered by the sellers at the market. In most cases the deal is closed or the stocks are brought at the best available ask price. In this type of trading the buyer pays the entire amount of the value of the stocks that is determined by multiplying the number stocks with the current price of the stock. Once the buyer pays the entire amount along with the brokerage and taxes of the transaction the stocks are deposited to the DP account of the buyer.

Derivative Market – In the derivative market trading is done mainly through two instruments – the Future contract and the Option contract. In both these types of contracts the stocks are bought and sold in lot. The number of stocks for each lot depends on the valuation of the stock and the valuation of the lot is determined by the number of the stocks in a lot multiplied with the current market price of the stock. For trading in derivative market you have to buy either the future contract or the option contract. In a future contract you are bound to close the deal within a specific time and at a fixed rate. While in case of option contract you can also choose to ignore the contract.

Money market

The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit, federal funds, and short-lived mortgage- and asset-backed securities. It provides liquidity funding for the global financial system.

The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months. Money market trades in short-term financial instruments commonly called "paper." This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.

The core of the money market consists of banks borrowing and lending to each other, using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency.

Finance companies, such as GMAC, typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Certain large corporations with strong credit ratings, such as General Electric, issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf via commercial paper lines.

In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the US Treasury issues Treasury bills to fund the US public debt.

Trading companies often purchase bankers' acceptances to be tendered for payment to overseas suppliers.

Retail and institutional money market funds Banks Central banks

Cash management programs Arbitrage ABCP conduits, which seek to buy higher yielding paper,

while themselves selling cheaper paper. Merchant Banks

Common money market instruments Certificate of deposit - Time deposits, commonly offered to

consumers by banks, thrift institutions, and credit unions. Repurchase agreements - Short-term loans—normally for less than

two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.

Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value.

Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the United States.

Federal agency short-term securities - (in the U.S.). Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.

Federal funds - (in the U.S.). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.

Municipal notes - (in the U.S.). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.

Treasury bills - Short-term debt obligations of a national government that are issued to mature in three to twelve months.

Money funds - Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors.

Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future.

Short-lived mortgage- and asset-backed securities

Foreign Exchange Market

The foreign exchange market (forex, FX, or currency market) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.

The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding currencies and lend (invest in) high-yielding currencies, and which (it has been claimed) may lead to loss of competitiveness in some countries.

In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of

its huge trading volume, leading to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e. trading

from 20:15 GMT on Sunday until 22:00 GMT Friday; the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of

fixed income; and the use of leverage to enhance profit margins with respect to account

size.

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007.

The $3.98 trillion break-down is as follows:

$1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps $43 billion currency swaps $207 billion in options and other products

The foreign exchange market is the largest and most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998).[3] Of this $3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion was traded in outright forwards, FX swaps and other currency derivatives.

Trading in London accounted for 36.7% of the total, making London by far the most important global center for foreign exchange trading. In second and third places respectively, trading in New York City accounted for 17.9%, and Tokyo accounted for 6.2%.

Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.

Most developed countries permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. All these developed countries already have fully convertible capital accounts. A number of emerging countries do not permit FX derivative products on their exchanges in view of controls on the capital accounts. The use of foreign exchange derivatives is growing in many emerging economies. Countries such as Korea, South Africa, and India have established currency futures exchanges, despite having some controls on the capital account. Unlike a stock market, the foreign exchange market is divided into levels of access.

At the top is the inter-bank market, which is made up of the largest commercial banks and securities dealers.

Financial instruments

Spot

A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira, EURO and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction.

Forward

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties.

Swap

The most common type of forward transaction is the FX swap. In an FX swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.

Future

Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

Option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.

Government Securities Market

Government Securities are securities issued by the Government for raising a public loan or as notified in the official Gazette. They consist of Government Promissory Notes, Bearer Bonds, Stocks or Bonds held in Bond Ledger Account. They may be in the form of Treasury Bills or Dated Government Securities.

Government Securities are mostly interest bearing dated securities issued by RBI on behalf of the Government of India. GOI uses these funds to meet its expenditure commitments. These securities are generally fixed maturity and fixed coupon securities carrying semi-annual coupon. Since the date of maturity is specified in the securities, these are known as dated Government Securities, e.g. 8.24% GOI 2018 is a Central Government Security maturing in 2018, which carries a coupon of 8.24% payable half yearly.

Features of Government Securities

1. Issued at face value2. No default risk as the securities carry sovereign guarantee.3. Ample liquidity as the investor can sell the security in the secondary

market4. Interest payment on a half yearly basis on face value5. No tax deducted at source6. Can be held in D-mat form.7. Rate of interest and tenor of the security is fixed at the time of

issuance and is not subject to change (unless intrinsic to the security like FRBs).

8. Redeemed at face value on maturity9. Maturity ranges from of 2-30 years.10.Securities qualify as SLR investments (unless otherwise stated).

The dated Government securities market in India has two segments:

1. Primary Market: The Primary Market consists of the issuers of the securities, viz., Central and Sate Government and buyers include Commercial Banks, Primary Dealers, Financial Institutions, Insurance Companies & Co-operative Banks. RBI also has a scheme of non-competitive bidding for small investors (see SBI DFHI Invest on our website for further details).

2. Secondary Market: The Secondary Market includes Commercial banks, Financial Institutions, Insurance Companies, Provident Funds, Trusts, Mutual Funds, Primary Dealers and Reserve Bank of India. Even Corporates and Individuals can invest in Government Securities. The eligibility criteria is specified in the relative Government notification.

Auctions: Auctions for government securities are normally multiple- price auctions either yield based or price based.

Yield Based: In this type of auction, RBI announces the issue size or notified amount and the tenor of the paper to be auctioned. The bidders submit bids in term of the yield at which they are ready to buy the security. If the Bid is more than the cut-off yield then its rejected otherwise it is accepted

Price Based: In this type of auction, RBI announces the issue size or notified amount and the tenor of the paper to be auctioned, as well as the coupon rate. The bidders submit bids in terms of the price. This method of auction is normally used in case of reissue of existing Government Securities. Bids at price lower then the cut off price are rejected and bids higher then the cut off price are accepted. Price Based auction leads to a better price discovery then the Yield based auction.

Occasionally RBI holds uniform-price auctions also.

Underwriting in Auction: One day prior to the auction, bids are received from the Primary Dealers (PD) indicating the amount they are willing to underwrite and the fee expected. The auction committee of RBI then examines the bid on the basis of the market condition and takes a decision on the amount to be underwritten and the fee to be paid. In case of devolvement, the bids put in by the PD’s are set off against the amount underwritten while deciding the amount of devolvement and in case the

auction is fully subscribed, the PD need not subscribe to the issue unless they have bid for it.

G-Secs, State Development Loans & T-Bills are regularly sold by RBI through periodic public auctions. SBI DFHI Ltd. is a leading Primary Dealer in Government Securities. SBI DFHI Ltd gives investors an opportunity to buy G-Sec / SDLs / T-Bills at primary market auctions of RBI through its SBI DFHI Invest scheme (details available on website ). Investors may also invest in high yielding Government Securities through “SBI DFHI Trade” where “buy and sell price” and a buy and sell facility for select liquid scrips in the secondary markets is offered.

Derivatives Markets

The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. As Derivatives are merely contracts between two or more parties, anything like weather data or amount of rain can be used as underlying assets.The Derivatives can be classified as Future Contracts, Forward Contracts, Options, Swaps and Credit Derivatives.

The Types of Derivative MarketThe Derivative Market can be classified as Exchange Traded Derivatives Market and Over the Counter Derivative Market.

Exchange Traded Derivatives are those derivatives which are traded through specialized derivative exchanges whereas Over the Counter Derivatives are those which are privately traded between two parties and involves no exchange or intermediary. Swaps, Options and Forward Contracts are traded in Over the Counter Derivatives Market or OTC market.

The main participants of OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest.

In the Exchange Traded Derivatives Market or Future Market, exchange acts as the main party and by trading of derivatives actually risk is traded between two parties. One party who purchases future contract is said to go “long” and the person who sells the future contract is said to go “short”. The holder of the “long” position owns the future contract and earns profit from it if the price of the underlying security goes up in the future. On the contrary, holder of the “short” position is in a profitable position if the price of the underlying security goes down, as he has already sold the future contract. So, when a new future contract is introduced, the total position in the contract is zero as no one is holding that for short or long.

The trading of foreign exchange traded derivatives or the future contracts has emerged as very important financial activity all over the world just like trading of equity-linked contracts or commodity contracts. The derivatives whose underlying assets are credit, energy or metal, have shown a steady growth rate over the years around the world. Interest rate is the parameter which influences the global trading of derivatives, the most.

Derivatives markets broadly can be classified into two categories, those that are traded on the exchange and the those traded one to one or ‘over the counter’. They are hence known as

Exchange Traded Derivatives OTC Derivatives (Over The Counter)

OTC Equity Derivatives

Traditionally equity derivatives have a long history in India in the OTC market.

Options of various kinds (called Teji and Mandi and Fatak) in un-organized markets were traded as early as 1900 in Mumbai

The SCRA however banned all kind of options in 1956.

Derivative Markets today

The prohibition on options in SCRA was removed in 1995. Foreign currency options in currency pairs other than Rupee were the first options permitted by RBI.

The Reserve Bank of India has permitted options, interest rate swaps, currency swaps and other risk reductions OTC derivative products.

Besides the Forward market in currencies has been a vibrant market in India for several decades.

In addition the Forward Markets Commission has allowed the setting up of commodities futures exchanges. Today we have 18 commodities exchanges most of which trade futures.e.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI).

In 2000 an amendment to the SCRA expanded the definition of securities to included Derivatives thereby enabling stock exchanges to trade derivative products.

The year 2000 will herald the introduction of exchange traded equity derivatives in India for the first time.

Equity Derivatives Exchanges in India

In the equity markets both the National Stock Exchange of India Ltd. (NSE) and The Stock Exchange, Mumbai (BSE) have applied to SEBI for setting up their derivatives segments.

The exchanges are expected to start trading in Stock Index futures by mid-May 2000.

BSE's and NSE’s plans

Both the exchanges have set-up an in-house segment instead of setting up a separate exchange for derivatives.

BSE’s Derivatives Segment, will start with Sensex futures as it’s first product.

NSE’s Futures & Options Segment will be launched with Nifty futures as the first product.

Types of Traders in a Derivatives Market

Hedgers: Hedgers are those who protect themselves from the risk associated with the price of an asset by using derivatives. A person keeps a close watch upon the prices discovered in trading and when the comfortable price is reflected according to his wants, he sells futures contracts. In this way he gets an assured fixed price of his produce.

In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. Hedgers are often businesses, or individuals, who at one point or another deal in the underlying cash commodity.

Take an example: A Hedger pay more to the farmer or dealer of a produce if its prices go up. For protection against higher prices of the produce, he hedges the risk exposure by buying enough future contracts of the produce to cover the amount of produce he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if the price of the produce raise enough to offset cash loss on the produce.

Speculators: Speculators are some what like a middle man. They are never interested in actual owing the commodity. They will just buy from one end and sell it to the other in anticipation of future price movements. They actually bet on the future movement in the price of an asset.

They are the second major group of futures players. These participants include independent floor traders and investors. They handle trades for their personal clients or brokerage firms.

Buying a futures contract in anticipation of price increases is known as ‘going long’. Selling a futures contract in anticipation of a price decrease is known as ‘going short’. Speculative participation in futures trading has increased with the availability of alternative methods of participation.

Speculators have certain advantages over other investments they are as follows:

If the trader’s judgment is good, he can make more money in the futures market faster because prices tend, on average, to change more quickly than real estate or stock prices.

Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract as margin, yet he can ride on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a performance bond. The actual value of the contract is only exchanged on those rare occasions when delivery takes place.

Arbitrators: According to dictionary definition, a person who has been officially chosen to make a decision between two people or groups who do not agree is known as Arbitrator. In commodity market Arbitrators are the person who takes the advantage of a discrepancy between prices in two different markets. If he finds future prices of a commodity edging out with the cash price, he will take offsetting positions in both the markets to lock in a profit. Moreover the commodity futures investor is not charged interest on the difference between margin and the full contract value.

International Capital MarketInternational capital market is that financial market or world financial center where shares, bonds, debentures, currencies, hedge funds, mutual funds and other long term securities are purchased and sold. International capital market is the group of different country's capital market. They associate with each other with Internet. They provide the place to international companies and investors to deal in shares and bonds of different countries.

After invention of computer and Internet and revolution of financial market in 2010, almost all financial markets are converted in international capital markets. We can give the example of Hong Kong, Singapore and New York world trade centre. International capital market was started with dealing of foreign exchange. After globalization of financial sector, companies have to take certificate for dealing in international market. Suppose, Indian company wants to sell shares in France, for this, Indian company should take certificate named global depository receipt (GDR).

International capital market's daily turnover has crossed $ 5 trillion. International capital market is very helpful for reducing the risk of small company because in international market, you can buy different countries companies shares, debentures and mutual funds. Different countries have different business environment, so if any country is facing loss and due to financial crisis, your investment in that country may suffer losses but you can fulfill this loss from other country's investment. So, overall risk will be reduced by this technique.

Financial Institutions-

In financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries. Most financial institutions are highly regulated by government.

Broadly speaking, there are three major types of financial institutions:[1]

1. Deposit-taking institutions that accept and manage deposits and make loans, including banks, building societies, credit unions, trust companies, and mortgage loan companies

2. Insurance companies and pension funds; and3. Brokers, underwriters and investment funds.

The Financial Institutions in India mainly comprises of the Central Bank which is better known as the Reserve Bank of India, the commercial banks, the credit rating agencies, the securities and exchange board of India, insurance companies and the specialized financial institutions in India.

Reserve Bank of India:

The Reserve Bank of India was established in the year 1935 with a view to organize the financial frame work and facilitate fiscal stability in India. The bank acts as the regulatory authority with regard to the functioning of the various commercial bank and the other financial institutions in India. The bank formulates different rates and policies for the overall improvement of the banking sector. It issue currency notes and offers aids to the central and institutions governments.

Commercial Banks in India:

The commercial banks in India are categorized into foreign banks, private banks and the public sector banks. The commercial banks indulge in varied activities such as acceptance of deposits, acting as trustees, offering loans for the different purposes and are even allowed to collect taxes on behalf of the institutions and central government.

Credit Rating Agencies in India:

The credit rating agencies in India were mainly formed to assess the condition of the financial sector and to find out avenues for more improvement. The credit rating agencies offer various services as:

Operation Up gradation Training to Employees Scrutinize New Projects and find out the weak sections in it Rate different sectors

The two most important credit rating agencies in India are: CRISIL ICRA

Securities and Exchange Board of India:

The securities and exchange board of India, also referred to as SEBI was founded in the year 1992 in order to protect the interests of the investors and to facilitate the functioning of the market intermediaries. They supervise market conditions, register institutions and indulge in risk management.

Insurance Companies in India:

The insurance companies offer protection against losses. They deal in life insurance, marine insurance, vehicle insurance and so on. The insurance companies collect the little saving of the investors and then reinvest those savings in the market. The insurance companies are collaborating with different foreign insurance companies after the liberalization process. This step has been incorporated to expand the Indian Insurance market and make it competitive.

Specialized Financial Institutions in India:

The specialized financial institutions in India are government undertakings that were set up to provide assistance to the different sectors and thereby cause overall development of the Indian economy. The significant institutions falling under this category includes:

Board for Industrial & Financial Reconstruction Export-Import Bank Of India Small Industries Development Bank of India National Housing Bank

RBI-

Financial Supervision

The Reserve Bank of India performs this function under the guidance of the Board for Financial Supervision (BFS). The Board was constituted in November 1994 as a committee of the Central Board of Directors of the Reserve Bank of India.

Objective

Primary objective of BFS is to undertake consolidated supervision of the financial sector comprising commercial banks, financial institutions and non-banking finance companies.

Constitution

The Board is constituted by co-opting four Directors from the Central Board as members for a term of two years and is chaired by the Governor. The Deputy Governors of the Reserve Bank are ex-officio members. One Deputy Governor, usually, the Deputy Governor in charge of banking regulation and supervision, is nominated as the Vice-Chairman of the Board.

BFS meetings

The Board is required to meet normally once every month. It considers inspection reports and other supervisory issues placed before it by the supervisory departments.

BFS through the Audit Sub-Committee also aims at upgrading the quality of the statutory audit and internal audit functions in banks and financial institutions. The audit sub-committee includes Deputy Governor as the chairman and two Directors of the Central Board as members.

The BFS oversees the functioning of Department of Banking Supervision (DBS), Department of Non-Banking Supervision (DNBS) and Financial Institutions Division (FID) and gives directions on the regulatory and supervisory issues.

Functions

Some of the initiatives taken by BFS include:

i. restructuring of the system of bank inspections ii. introduction of off-site surveillance,

iii. strengthening of the role of statutory auditors and iv. strengthening of the internal defences of supervised institutions.

The Audit Sub-committee of BFS has reviewed the current system of concurrent audit, norms of empanelment and appointment of statutory auditors, the quality and coverage of statutory audit reports, and the important issue of greater transparency and disclosure in the published accounts of supervised institutions.

Current Focus

supervision of financial institutions consolidated accounting legal issues in bank frauds divergence in assessments of non-performing assets and supervisory rating model for banks.

Legal Framework

Umbrella Acts

Reserve Bank of India Act, 1934: governs the Reserve Bank functions Banking Regulation Act, 1949: governs the financial sector

Acts governing specific functions

Public Debt Act, 1944/Government Securities Act (Proposed): Governs government debt market

Securities Contract (Regulation) Act, 1956: Regulates government securities market

Indian Coinage Act, 1906:Governs currency and coins Foreign Exchange Regulation Act, 1973/Foreign Exchange

Management Act, 1999: Governs trade and foreign exchange market "Payment and Settlement Systems Act, 2007: Provides for regulation

and supervision of payment systems in India"

Acts governing Banking Operations

Companies Act, 1956:Governs banks as companies Banking Companies (Acquisition and Transfer of Undertakings) Act,

1970/1980: Relates to nationalisation of banks Bankers' Books Evidence Act Banking Secrecy Act Negotiable Instruments Act, 1881

Acts governing Individual Institutions

State Bank of India Act, 1954 The Industrial Development Bank (Transfer of Undertaking and

Repeal) Act, 2003 The Industrial Finance Corporation (Transfer of Undertaking and

Repeal) Act, 1993 National Bank for Agriculture and Rural Development Act National Housing Bank Act Deposit Insurance and Credit Guarantee Corporation Act

Main Functions

Monetary Authority:

Formulates, implements and monitors the monetary policy. Objective: maintaining price stability and ensuring adequate flow of

credit to productive sectors.

Regulator and supervisor of the financial system:

Prescribes broad parameters of banking operations within which the country's banking and financial system functions.

Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public.

Manager of Foreign Exchange

Manages the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and promote

orderly development and maintenance of foreign exchange market in India.

Issuer of currency:

Issues and exchanges or destroys currency and coins not fit for circulation.

Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.

Developmental role

Performs a wide range of promotional functions to support national objectives.

Related Functions

Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker.

Banker to banks: maintains banking accounts of all scheduled banks.

SEBI-The Securities and Exchange Board of India (frequently abbreviated SEBI) is the regulator for the securities market in India. It was formed officially by the Government of India in 1992 with SEBI Act 1992 being

passed by the Indian Parliament. Chaired by U.K. Sinha, SEBI is headquartered in the popular business district of Bandra-Kurla complex in Mumbai, and has Northern, Eastern, Southern and Western regional offices in New Delhi, Kolkata, Chennai and Ahmedabad.

Functions and responsibilities

SEBI has to be responsive to the needs of three groups, which constitute the market:

the issuers of securities the investors the market intermediaries.

SEBI has three functions rolled into one body quasi-legislative, quasi-judicial and quasi-executive. It drafts regulations in its legislative capacity, it conducts investigation and enforcement action in its executive function and it passes rulings and orders in its judicial capacity. Though this makes it very powerful, there is an appeals process to create accountability. There is a Securities Appellate Tribunal which is a three-member tribunal and is presently headed by a former Chief Justice of a High court - Mr. Justice NK Sodhi. A second appeal lies directly to the Supreme Court.

SEBI has enjoyed success as a regulator by pushing systemic reforms aggressively and successively (e.g. the quick movement towards making the markets electronic and paperless rolling settlement on T+2 basis). SEBI has been active in setting up the regulations as required under law.

SEBI has also been instrumental in taking quick and effective steps in light of the global meltdown and the Satyam fiasco.[citation needed] It had[when?]

increased the extent and quantity of disclosures to be made by Indian corporate promoters. More recently, in light of the global meltdown,it liberalised the takeover code to facilitate investments by removing regulatory strictures. In one such move, SEBI has increased the application limit for retail investors to Rs 2 lakh, from Rs 1 lakh at present. [3]

IRDA-

The Insurance Regulatory and Development Authority (IRDA) is a national agency of the Government of India, based in Hyderabad. It was formed by an act of Indian Parliament known as IRDA Act 1999, which was amended in 2002 to incorporate some emerging requirements. Mission of IRDA as stated in the act is "to protect the interests of the policyholders, to regulate, promote and ensure orderly growth of the insurance industry and for matters connected therewith or incidental thereto."

In 2010, the Government of India ruled that the Unit Linked Insurance Plans (ULIPs) will be governed by IRDA, and not the market regulator Securities and Exchange Board of India.[1]

Duties,Powers and Functions of IRDA

Section 14 of IRDA Act, 1999 laysdown the duties,powers and functions of IRDA

1. Subject to the provisions of this Act and any other law for the time being in force, the Authority shall have the duty to regulate, promote and ensure orderly growth of the insurance business and re-insurance business.

2. Without prejudice to the generality of the provisions contained in sub-section (1), the powers and functions of the Authority shall include,

1. issue to the applicant a certificate of registration, renew, modify, withdraw, suspend or cancel such registration;

2. protection of the interests of the policy holders in matters concerning assigning of policy, nomination by policy holders, insurable interest, settlement of insurance claim, surrender value of policy and other terms and conditions of contracts of insurance;

3. specifying requisite qualifications, code of conduct and practical training for intermediary or insurance intermediaries and agents;

4. specifying the code of conduct for surveyors and loss assessors;5. promoting efficiency in the conduct of insurance business;6. promoting and regulating professional organisations connected

with the insurance and re-insurance business;7. levying fees and other charges for carrying out the purposes of

this Act;

8. calling for information from, undertaking inspection of, conducting enquiries and investigations including audit of the insurers, intermediaries, insurance intermediaries and other organisations connected with the insurance business;

9. control and regulation of the rates, advantages, terms and conditions that may be offered by insurers in respect of general insurance business not so controlled and regulated by the Tariff Advisory Committee under section 64U of the Insurance Act, 1938 (4 of 1938);

10.specifying the form and manner in which books of account shall be maintained and statement of accounts shall be rendered by insurers and other insurance intermediaries;

11.regulating investment of funds by insurance companies;12.regulating maintenance of margin of solvency;13.adjudication of disputes between insurers and intermediaries or

insurance intermediaries;14.supervising the functioning of the Tariff Advisory Committee;15.specifying the percentage of premium income of the insurer to

finance schemes for promoting and regulating professional organisations referred to in clause (f);

16.specifying the percentage of life insurance business and general insurance business to be undertaken by the insurer in the rural or social sector; and

17.exercising such other powers as may be prescribed from time to time,

UNIT- II

Sources of Long term finance

A company might raise new funds from the following sources:

· The capital markets: i) New share issues, for example, by companies acquiring a stock market listing for the first time

ii) Rights issues

· Loan stock

· Retained earnings

· Bank borrowing

· Government sources

· Business expansion scheme funds

. Venture capital

· Franchising.

Ordinary (equity) shares

Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value, typically of $1 or 50 cents. The market value of a quoted company's shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares.

A new issue of shares might be made in a variety of different circumstances:

a) The company might want to raise more cash. If it issues ordinary shares for cash, should the shares be issued pro rata to existing shareholders, so that control or ownership of the company is not affected? If, for example, a company with 200,000 ordinary shares in issue decides to issue 50,000 new

shares to raise cash, should it offer the new shares to existing shareholders, or should it sell them to new shareholders instead? i) If a company sells the new shares to existing shareholders in proportion to their existing shareholding in the company, we have a rights issue. In the example above, the 50,000 shares would be issued as a one-in-four rights issue, by offering shareholders one new share for every four shares they currently hold.

ii) If the number of new shares being issued is small compared to the number of shares already in issue, it might be decided instead to sell them to new shareholders, since ownership of the company would only be minimally affected.

b) The company might want to issue shares partly to raise cash, but more importantly to float' its shares on a stick exchange.

c) The company might issue new shares to the shareholders of another company, in order to take it over.

New shares issues

A company seeking to obtain additional equity funds may be:

a) An unquoted company wishing to obtain a Stock Exchange quotation

b) An unquoted company wishing to issue new shares, but without obtaining a Stock Exchange quotation

c) a company which is already listed on the Stock Exchange wishing to issue additional new shares.

The methods by which an unquoted company can obtain a quotation on the stock market are:

a) an offer for sale

b) A prospectus issue

c) A placing

d) An introduction.

Offers for sale:

An offer for sale is a means of selling the shares of a company to the public.

a) An unquoted company may issue shares, and then sell them on the Stock Exchange, to raise cash for the company. All the shares in the company, not just the new ones, would then become marketable.

b) Shareholders in an unquoted company may sell some of their existing shares to the general public. When this occurs, the company is not raising any new funds, but just providing a wider market for its existing shares (all of which would become marketable), and giving existing shareholders the chance to cash in some or all of their investment in their company. When companies 'go public' for the first time, a 'large' issue will probably take the form of an offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can be obtained more cheaply if the issuing house or other sponsoring firm approaches selected institutional investors privately.

Rights issues

A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings.

For example, a rights issue on a one-for-four basis at 280c per share would mean that a company is inviting its existing shareholders to subscribe for one new share for every four shares they hold, at a price of 280c per new share.

A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share.

Preference shares

Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference

dividend can only be paid if sufficient distributable profits are available, although with 'cumulative' preference shares the right to an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders.

From the company's point of view, preference shares are advantageous in that:

· Dividends do not have to be paid in a year in which profits are poor, while this is not the case with interest payments on long term debt (loans or debentures).

· Since they do not carry voting rights, preference shares avoid diluting the control of existing shareholders while an issue of equity shares would not.

· Unless they are redeemable, issuing preference shares will lower the company's gearing. Redeemable preference shares are normally treated as debt when gearing is calculated.

· The issue of preference shares does not restrict the company's borrowing power, at least in the sense that preference share capital is not secured against assets in the business.

· The non-payment of dividend does not give the preference shareholders the right to appoint a receiver, a right which is normally given to debenture holders.

However, dividend payments on preference shares are not tax deductible in the way that interest payments on debt are. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher than for interest on debt to compensate for the additional risks.

For the investor, preference shares are less attractive than loan stock because:

· they cannot be secured on the company's assets

· the dividend yield traditionally offered on preference dividends has been much too low to provide an attractive investment compared with the interest yields on loan stock in view of the additional risk involved.

Loan stock

Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company.

Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky the coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive $10 interest each year. The rate quoted is the gross rate, before tax.

Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital.

Debentures with a floating rate of interest

These are debentures for which the coupon rate of interest can be changed by the issuer, in accordance with changes in market rates of interest. They may be attractive to both lenders and borrowers when interest rates are volatile.

Security

Loan stock and debentures will often be secured. Security may take the form of either a fixed charge or a floating charge.

a) Fixed charge; Security would be related to a specific asset or group of assets, typically land and buildings. The company would be unable to dispose of the asset without providing a substitute asset for security, or without the lender's consent.

b) Floating charge; With a floating charge on certain assets of the company (for example, stocks and debtors), the lender's security in the event of a default payment is whatever assets of the appropriate class the company then owns (provided that another lender does not have a prior charge on the assets). The company would be able, however, to dispose of its assets as it chose until a default took place. In the event of a default, the lender would

probably appoint a receiver to run the company rather than lay claim to a particular asset.

The redemption of loan stock

Loan stock and debentures are usually redeemable. They are issued for a term of ten years or more, and perhaps 25 to 30 years. At the end of this period, they will "mature" and become redeemable (at par or possibly at a value above par).

Most redeemable stocks have an earliest and latest redemption date. For example, 18% Debenture Stock 2007/09 is redeemable, at any time between the earliest specified date (in 2007) and the latest date (in 2009). The issuing company can choose the date. The decision by a company when to redeem a debt will depend on:

a) how much cash is available to the company to repay the debtb) the nominal rate of interest on the debt. If the debentures pay 18% nominal interest and the current rate of interest is lower, say 10%, the company may try to raise a new loan at 10% to redeem the debt which costs 18%. On the other hand, if current interest rates are 20%, the company is unlikely to redeem the debt until the latest date possible, because the debentures would be a cheap source of funds.

There is no guarantee that a company will be able to raise a new loan to pay off a maturing debt, and one item to look for in a company's balance sheet is the redemption date of current loans, to establish how much new finance is likely to be needed by the company, and when.

Mortgages are a specific type of secured loan. Companies place the title deeds of freehold or long leasehold property as security with an insurance company or mortgage broker and receive cash on loan, usually repayable over a specified period. Most organisations owning property which is unencumbered by any charge should be able to obtain a mortgage up to two thirds of the value of the property.

As far as companies are concerned, debt capital is a potentially attractive source of finance because interest charges reduce the profits chargeable to corporation tax.

Retained earnings

For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows:

a) The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true. However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash.

b) The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders.

c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.

d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares.

Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods.

A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors.

Bank lending

Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days.

Short term lending may be in the form of:

a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day;

b) a short-term loan, for up to three years.

Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.

Lending to smaller companies will be at a margin above the bank's base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans will sometimes be available, usually for the purchase of property, where the loan takes the form of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility, he will consider several factors, known commonly by the mnemonic PARTS.

- Purpose- Amount- Repayment- Term- Security

P The purpose of the loan A loan request will be refused if the purpose of the loan is not acceptable to the bank.

A The amount of the loan. The customer must state exactly how much he wants to borrow. The banker must verify, as far as he is able to do so, that the amount required to make the proposed investment has been estimated correctly.

R How will the loan be repaid? Will the customer be able to obtain sufficient income to make the necessary repayments?

T What would be the duration of the loan? Traditionally, banks have offered short-term loans and overdrafts, although medium-term loans are now quite common.

S Does the loan require security? If so, is the proposed security adequate?

Leasing

A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time.

Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment. There are two basic forms of lease: "operating leases" and "finance leases".

Operating leases

Operating leases are rental agreements between the lessor and the lessee whereby:

a) the lessor supplies the equipment to the lessee

b) the lessor is responsible for servicing and maintaining the leased equipment

c) the period of the lease is fairly short, less than the economic life of the asset, so that at the end of the lease agreement, the lessor can either

i) lease the equipment to someone else, and obtain a good rent for it, orii) sell the equipment secondhand.

Finance leases

Finance leases are lease agreements between the user of the leased asset (the lessee) and a provider of finance (the lessor) for most, or all, of the asset's expected useful life.

Suppose that a company decides to obtain a company car and finance the acquisition by means of a finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in a finance leasing arrangement, and so will purchase the car from the dealer and lease it to the company. The company will take possession of the car from the car dealer, and make regular payments (monthly, quarterly, six monthly or annually) to the finance house under the terms of the lease.

Other important characteristics of a finance lease:

a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is not involved in this at all.

b) The lease has a primary period, which covers all or most of the economic life of the asset. At the end of the lease, the lessor would not be able to lease the asset to someone else, as the asset would be worn out. The lessor must, therefore, ensure that the lease payments during the primary period pay for the full cost of the asset as well as providing the lessor with a suitable return on his investment.

c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner) and to keep most of the sale proceeds, paying only a small percentage (perhaps 10%) to the lessor.

Why might leasing be popular

The attractions of leases to the supplier of the equipment, the lessee and the lessor are as follows:

· The supplier of the equipment is paid in full at the beginning. The equipment is sold to the lessor, and apart from obligations under guarantees or warranties, the supplier has no further financial concern about the asset.

· The lessor invests finance by purchasing assets from suppliers and makes a return out of the lease payments from the lessee. Provided that a lessor can find lessees willing to pay the amounts he wants to make his return, the lessor can make good profits. He will also get capital allowances on his purchase of the equipment.

· Leasing might be attractive to the lessee:

i) if the lessee does not have enough cash to pay for the asset, and would have difficulty obtaining a bank loan to buy it, and so has to rent it in one way or another if he is to have the use of it at all; or

ii) if finance leasing is cheaper than a bank loan. The cost of payments under a loan might exceed the cost of a lease.

Operating leases have further advantages:

· The leased equipment does not need to be shown in the lessee's published balance sheet, and so the lessee's balance sheet shows no increase in its gearing ratio.

· The equipment is leased for a shorter period than its expected useful life. In the case of high-technology equipment, if the equipment becomes out-of-date before the end of its expected life, the lessee does not have to keep on using it, and it is the lessor who must bear the risk of having to sell obsolete equipment secondhand.

The lessee will be able to deduct the lease payments in computing his taxable profits.

Hire purchase

Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the exception that ownership of the goods passes to the hire purchase customer on payment of the final credit instalment, whereas a lessee never becomes the owner of the goods.

Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.ii) The supplier delivers the goods to the customer who will eventually purchase them.iii) The hire purchase arrangement exists between the finance house and the customer.

The finance house will always insist that the hirer should pay a deposit towards the purchase price. The size of the deposit will depend on the finance company's policy and its assessment of the hirer. This is in contrast to a finance lease, where the lessee might not be required to make any large initial payment.

An industrial or commercial business can use hire purchase as a source of finance. With industrial hire purchase, a business customer obtains hire purchase finance from a finance house in order to purchase the fixed asset. Goods bought by businesses on hire purchase include company vehicles, plant and machinery, office equipment and farming machinery.

Government assistance

The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop the national economy, especially in high technology industries and in areas of high unemployment. For example, the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small indigenous businesses in that country.

Venture capital

Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A businessman starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term 'venture capital' is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management buy-out or a major expansion scheme.

The institution that puts in the money recognises the gamble inherent in the funding. There is a serious risk of losing the entire investment, and it might

take a long time before any profits and returns materialise. But there is also the prospect of very high profits and a substantial return on the investment. A venture capitalist will require a high expected rate of return on investments, to compensate for the high risk.

A venture capital organisation will not want to retain its investment in a business indefinitely, and when it considers putting money into a business venture, it will also consider its "exit", that is, how it will be able to pull out of the business eventually (after five to seven years, say) and realise its profits. Examples of venture capital organisations are: Merchant Bank of Central Africa Ltd and Anglo American Corporation Services Ltd.

When a company's directors look for help from a venture capital institution, they must recognise that:

· the institution will want an equity stake in the company· it will need convincing that the company can be successful· it may want to have a representative appointed to the company's board, to look after its interests.

The directors of the company must then contact venture capital organisations, to try and find one or more which would be willing to offer finance. A venture capital organisation will only give funds to a company that it believes can succeed, and before it will make any definite offer, it will want from the company management:

a) a business plan

b) details of how much finance is needed and how it will be used

c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a profit forecast

d) details of the management team, with evidence of a wide range of management skills

e) details of major shareholders

f) details of the company's current banking arrangements and any other sources of finance

g) any sales literature or publicity material that the company has issued.

A high percentage of requests for venture capital are rejected on an initial screening, and only a small percentage of all requests survive both this screening and further investigation and result in actual investments.

Franchising

Franchising is a method of expanding business on less capital than would otherwise be needed. For suitable businesses, it is an alternative to raising extra capital for growth. Franchisors include Budget Rent-a-Car, Wimpy, Nando's Chicken and Chicken Inn.

Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local business, under the franchisor's trade name. The franchisor must bear certain costs (possibly for architect's work, establishment costs, legal costs, marketing costs and the cost of other support services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on the subsequent regular payments by the franchisee for an operating profit. These regular payments will usually be a percentage of the franchisee's turnover.

Although the franchisor will probably pay a large part of the initial investment cost of a franchisee's outlet, the franchisee will be expected to contribute a share of the investment himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the investment cost.

The advantages of franchises to the franchisor are as follows:

· The capital outlay needed to expand the business is reduced substantially.· The image of the business is improved because the franchisees will be motivated to achieve good results and will have the authority to take whatever action they think fit to improve the results.

The advantage of a franchise to a franchisee is that he obtains ownership of a business for an agreed number of years (including stock and premises, although premises might be leased from the franchisor) together with the backing of a large organisation's marketing effort and experience. The franchisee is able to avoid some of the mistakes of many small businesses,

because the franchisor has already learned from its own past mistakes and developed a scheme that works.