CONTENTS

1. BASIC INVESTMENT MATHEMATICS .............................................................................................................. 4

1.1 CAPITAL STRUCTURE ............................................................................................................................................ 4

1.2 COST OF CAPITAL ................................................................................................................................................. 4

1.3 PLANNING THE CAPITAL STRUCTURE ................................................................................................................... 5

1.4 EBIT & EPS ......................................................................................................................................................... 5

1.5 CORPORATE BENEFITS .......................................................................................................................................... 6

1.6 VALUATION OF EQUITIES ...................................................................................................................................... 7

1.6.1 Dividend Capitalisation Approach ............................................................................................................... 7

1.6.2 Earnings Per Share & Price-Earnings Approach ........................................................................................ 8

1.6.3 Book Value Approach ................................................................................................................................... 8

1.6.4 Liquidation Value of the Share Approach .................................................................................................... 9

1.7 RISK AND RETURN ................................................................................................................................................ 9

1.7.1 Return ........................................................................................................................................................... 9

1.7.2 Risk ............................................................................................................................................................. 10

1.7.3 Beta ............................................................................................................................................................. 10

1.7.4 Relationship between Risk and Return ....................................................................................................... 11

1.7.5 Unsystematic Risk ....................................................................................................................................... 11

1.7.6 Portfolio Risk .............................................................................................................................................. 11

2. MARKET INDICES ................................................................................................................................................ 13

2.1. METHODS OF COMPUTATION ............................................................................................................................. 13

2.2 ISSUE SIZE CHANGE IN AN INDEX SECURITY ...................................................................................................... 14

2.3 IMPACT COST...................................................................................................................................................... 15

3. TIME VALUE OF MONEY AND CAPITAL BUDGETING .............................................................................. 16

3.1 TIME VALUE OF MONEY ..................................................................................................................................... 16

3.1.1 Future Value of a Single Cash Flow ........................................................................................................... 16

3.1.2 Future Value of an Annuity ......................................................................................................................... 17

3.1.3 Present Value of a Single Cash Flow ......................................................................................................... 17

3.1.4 Present Value of an Annuity ....................................................................................................................... 18

3.2. CAPITAL BUDGETING ........................................................................................................................................ 18

3.2.1. Capital Investment Decision ...................................................................................................................... 18

3.2.2. Average Rate of Return .............................................................................................................................. 19

3.2.3. Payback Period .......................................................................................................................................... 19

3.2.4 Internal Rate of Return ............................................................................................................................... 20

3.2.5. Net Present Value ...................................................................................................................................... 20

4. FINANCIAL STATEMENT ANALYSIS .............................................................................................................. 22

4.1 INTRODUCTION ................................................................................................................................................... 22

4.2 TYPES OF FINANCIAL RATIOS ............................................................................................................................. 22

4.2.1 Liquidity Ratios ........................................................................................................................................... 22

4.2.2 Leverage Ratios .......................................................................................................................................... 23

4.2.3 Turnover Ratios .......................................................................................................................................... 23

4.2.4 Profitability Ratios...................................................................................................................................... 24

4.2.5 Valuation Ratios ......................................................................................................................................... 25

4.3 PROBLEMS OF FINANCIAL STATEMENT ANALYSIS .............................................................................................. 25

5. SECURITIES CONTRACTS (REGULATION) ACT, 1956 .................................................................................. 30

6. SECURITIES CONTRACTS (REGULATION) RULES, 1957 ............................................................................. 36

7. SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992 ...................................................................... 39

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8. SEBI (STOCK BROKERS AND SUB-BROKERS) REGULATIONS, 1992 ........................................................ 43

9. SEBI (DISCLOSURE & INVESTOR PROTECTION) GUIDELINES, 2000 ....................................................... 52

10. SECURITIES AND EXCHANGE BOARD OF INDIA (INSIDER TRADING) REGULATIONS, 1992 ........ 54

11. SEBI (SUBSTANTIAL ACQUISITION OF SHARES AND TAKEOVERS) REGULATIONS, 1997 .............. 56

12. SEBI (PROHIBITION OF FRAUDULENT AND UNFAIR TRADE PRACTICES RELATING TO

SECURITIES MARKETS) REGULATIONS, 1995 .................................................................................................. 59

13. SEBIS STOCK WATCH SYSTEM ..................................................................................................................... 63

13.1 DATABASES ...................................................................................................................................................... 63

13.1.1. Issuer Database ....................................................................................................................................... 63

13.1.2. Securities Database ................................................................................................................................. 63

13.1.3.Trading Database ..................................................................................................................................... 64

13.1.4 Member Database ..................................................................................................................................... 64

13.2 ALERTS ............................................................................................................................................................. 64

13.2.1 Online Real Time Alerts ............................................................................................................................ 64

13.2.2 Online Non real Time Alerts ..................................................................................................................... 64

13.3 PARAMETERS FOR ALERT GENERATION ........................................................................................................... 64

13.3.1 Price Bands System ................................................................................................................................... 64

13.3.2. Auction Market ........................................................................................................................................ 65

13.3.3 Quantity Freeze Percentage (volume of large order) ............................................................................... 66

13.3.4 Price Variation ......................................................................................................................................... 66

13.3.5 High-Low Variation .................................................................................................................................. 66

13.3.6 Open Price Variation ................................................................................................................................ 66

13.3.7 Consecutive Trade Price Variation .......................................................................................................... 66

13.3.8 Quantity Variation .................................................................................................................................... 66

13.3.9 Price movement in relation to the index ................................................................................................... 67

14. OFF-LINE SURVEILLANCE .............................................................................................................................. 70

14.1 MARGINS .......................................................................................................................................................... 70

14.1.1 Mark to Market Margin ........................................................................................................................... 70

14.1.2 Volatility Margin ..................................................................................................................................... 70

14.1.3 Gross Exposure Margin ........................................................................................................................... 71

14.1.4 Daily Margin Payable .............................................................................................................................. 72

14.2 EXCEPTION HANDLING ..................................................................................................................................... 74

14.2.1 Exception Handling in Regular market .................................................................................................... 74

Security shortage ................................................................................................................................................. 74

Bad delivery ......................................................................................................................................................... 74

Company Objections ............................................................................................................................................ 75

Auction Settlement ............................................................................................................................................... 75

14.2.2 Exception Handling for account period settlement in Book Entry segment .............................................. 75

Security shortage ................................................................................................................................................. 75

14.3 CAPITAL ADEQUACY NORMS FOR BROKERS ..................................................................................................... 76

14.3.1 Base Minimum Capital ............................................................................................................................. 76

14.3.2 Additional Base Capital ............................................................................................................................ 76

New CM Members ............................................................................................................................................... 77

14.3.3 Exposure limits .................................................................................................................................... 77

14.4 COMPLIANCE .................................................................................................................................................... 79

14.4.1 Inspection .................................................................................................................................................. 79

14.4.2 Investigation ............................................................................................................................................. 79

15. SURVEILLANCE IN RISK MANAGEMENT .................................................................................................... 80

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DECISIONS OF THE INTER-EXCHANGE SURVEILLANCE GROUP ................................................................ 84

SYLLABUS FOR THE SURVEILLANCE MODULE ............................................................................................ 107

FURTHER READINGS: ........................................................................................................................................... 109

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1. BASIC INVESTMENT MATHEMATICS

1.1 Capital Structure

The two principal sources of long term finance of a firm are equity capital and debt capital. The

term financial leverage indicates the proportion of these two sources of finance employed by a

firm.

A share denotes a unit of owners capital of a corporate. It may further be classified as ordinary or preference. Ordinary shares do not carry any fixed rate of return but carry voting rights. The

equity shareholders are paid an annual dividend depending on the profitability of the firm, which

is proposed by the Board and passed in the Annual General Meeting of the company. Preference

Shareholders are entitled to a fixed percentage of dividend per year and they have preference in

the payment of dividend over the ordinary shares. The preference shares can also be of

Convertible or the non-Convertible types. Sometimes shares issued at the time of the initial

offering (IPOs) or Rights Issue may be accompanied by a warrant which entitles the holder to

subscribe to a fixed number of shares after a mentioned period of time at a fixed price. These

warrants are sometimes listed and traded on the exchange as a security.

Example 1: A limited has issued debentures of face value Rs.100/- each which is to be converted into 5 Equity shares. If the market value of the debenture is Rs.90 what is the

conversion price?

Solution: Conversion price = Face value / Conversion ratio

= 100/5

= 20 i.e. Rs.20/-

Conversion ratio is the number of equity shares being issued per debenture.

Various theories have been evolved to understand the relationship between financial leverage

and cost of capital. One of the most popular approach in this regard was enunciated by

Modigliani and Miller. Some of the terms used in this regard are discussed below.

1.2 Cost of Capital

Cost of Debt capital (Kd) = Annual Interest charges (F) / Market value of Debt (B)

Cost of Equity capital (Ke) = Equity earnings (E) / Market value of Equity (S)

Weighted Average Cost of Capital (Ko) = (We x Ke) + (Wd x Kd)

Where We = Proportion of equity to total capital

Wd = Proportion of debt to total capital

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1.3 Planning the Capital Structure

Various factors that influence the planning of the capital structure of a firm includes: the income

of equity shareholders, risks- business risks and finance risks, ability of the firm to raise capital

and regulatory norms.

The implication of alternative financing plans on Earnings and the shareholders can be anlaysed

by studying EBIT and EPS.

1.4 EBIT & EPS

Net Profit earned before payment of interest and tax is termed as Earnings before Interest and tax

(EBIT). On payment of interest and tax, the firm is left with profit available for distribution of

dividend, also called as Earnings After Tax (EAT).

EAT = EBIT Interest Tax

Earnings After Tax are available for dividend to both types of shareholders, equity as well as

preference.

Equity earning is profit left after payment of preference dividend from EAT.

Earning Per Share (EPS) is defined as the earnings available for distribution to equity

shareholders.

EPS = equity earnings / no. of equity shares

The relationship between EBIT and EPS is as follows:

EPS = (EBIT I) (1-t)/n

Example 2: The capital structure of a firm would be influenced by the following factors

(a) Business and Financial risks

(b) SEBI guidelines for Public Issues

(c) The firms own ability

(d) All of the above Ans. (d)

Example 3: The Earnings Per Share is defined as

(a) EAT Preference dividend / No of equity shares (b) EAT / no. of equity shares

(c) EAT / no. of equity shares plus no. of preference shares

(d) EBIT / no. of equity shares

Ans. (a)

Example 4: The cost of capital of a firm is

(a) cost of Equity capital only

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(b) cost of Debt capital only (c) cost of Debt plus Equity capital (d) none of the above Ans. (c)

Example 5: Which of the firms has a high degree of financial leverage?

(a) A firm with only equity capital

(b) A firm with equal proportion of equity capital and debt

(c) A firm with debt capital which is thrice as much as equity capital

(d) A firm with equity capital which is four times as much as debt capital

Ans. (c)

1.5 Corporate Benefits

Benefits accorded to the equity shareholders in the form of dividend, rights and bonus are termed

collectively as corporate benefits. These are normally given to those investors whose names

appear in the Register of Members of the company before the commencement of the Book

Closure period or before the record date. Dividend is the share of the profit paid out to the

owners of the company. Rights refers to the right to subscribe to a proportionate number of

shares at a specified price. Bonus refers to the method of capitalisation of reserves by offering

free shares to the existing shareholders in proportion to their holding. When bonus shares are

issued, earning per share declines.

Ex-Bonus means without bonus. The buyer of an ex-bonus share is not entitled to the bonus

shares. Bonus shares are allotted on a set date to all those shareholders recorded on the books of

the company as of a previous date of record.

Ex-Dividend is a synonym for "without dividend." The buyer of an ex-dividend share is not

entitled to the next dividend payment. Dividends are paid on a set date to all those shareholders

recorded on the books of the company as of a previous date of record.

Ex-Rights means without rights. Companies raising additional money may do so by offering

their shareholders the right to subscribe to new or additional shares, usually at a discount from

the prevailing market price. The buyer of a share selling ex-rights is not entitled to the rights.

The rights issue involves selling of securities to the existing shareholders in proportion to their

current holding. When a company issues additional equity capital it has to be offered in the first

instance to the existing shareholders on a pro-rata basis as per Section 81 of the Companies Act,

1956. The shareholders may by a special resolution forfeit this right, partially or fully by a

special resolution to enable the company to issue additional capital to the public.

A company making a rights issue sends a letter of offer along with four forms A, B, C, D to the

shareholders, Form A is meant for acceptance of the rights and has a column stating the no. of

shares that the holder is entitled to and also a column for additional shares. Form B is used for

renouncing the rights in favour of someone else. Form C is meant for application by the person

in whose favour the rights have been renounced. Form D is to be used to make a request for split

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forms. The composite application forms must be mailed to the company within a period of 30

days.

Value of a right share:

The value of a share after the rights issue is calculated as follows:

Ex- rights price of a scrip = NPo + M S

N + M

Where N = No. of existing shares held

M = No. of right shares entitled for a holding of N shares

Po = Cum rights price of the scrip

S = Subscription price for the rights.

1.6 Valuation of Equities

1.6.1 Dividend Capitalisation Approach

The intrinsic value (P0) of the stock paying a dividend D and the expected price of P1 and the required rate of return of Rr is given by P0 = (D + P1) / (1+Rr)

Therefore from the above formula, we can derive the required rate of return (Rr) as

Rr = (D / P0) + g where (D / P0) is called as Dividend Yield.

The expected price P0 of the equity share which has a price growth of g and the required rate of return Rr is given by P0 = D/(Rr - g)

Example 6: The dividend per share of ABC Ltd is Rs.5.00. It is expected to grow at a rate of 4%

per year. What is the expected rate of return for the investor when the current market rate of the

share is Rs.50.

Rr = (5.00/50.00) + 4% i.e. 10% + 4% = 14%

In case of companies having the Earnings as the only source of income, then the intrinsic value

of share given the dividend pay out ratio, growth rate and the required rate of return is given by

Intrinsic Value = (Earning per share * Dividend payout ratio)*100

(Discount rate - Growth rate)

Example 7: What is the intrinsic value per share of scrip XYZ Ltd. given the following?

Earning per share : Rs. 3.00

Dividend pay out ratio : 0.6

Discount rate : 15%

Growth rate : 6%

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Solution:

Intrinsic Value = (Earning per share * Dividend payout ratio)*100

(Discount rate - Growth rate)

= (3.00 * 0.6)*100 / (15 - 6) = Rs. 20

1.6.2 Earnings Per Share & Price-Earnings Approach

The other approach used in financial analysis is the PriceEarnings (P/E) ratio approach, the value as per the P/E approach is given by

Value = Earning per share (EPS) * Price Earnings ratio

Where EPS = (Profit after Tax /No. of equity shares outstanding)

P/E = (Market Price of the share / EPS)

Example 8: What is the Price-Earnings ratio of the company if the Profit after Tax is Rs.100

crore. The preference dividend to be paid is Rs.10 crore and the outstanding equity is 90 lakh

shares. The current market rate of the share is Rs.250/-.

EPS = (PAT Preference Dividend)/Issue Capital = (Rs.100 cr. Rs.10 cr.)/ 90 lakh shares = 100

Therefore, P/E = Market Price / EPS = Rs.250 / 100 i.e. 2.5.

Example 9: The market capitalisation of ABC Ltd. on March 31, 1999 is Rs.250 crore. The

company announces a Profit after Tax of Rs.1000 crore. What is the earning price ratio of ABC

Ltd.?

E/P = EPS / Market Price

= PAT / Market Capitalisation

where, Market Capitalisation = Market Price * Issue Capital

Therefore, E/P = Rs.1000 crore / Rs.250 crore i.e. 4.00

1.6.3 Book Value Approach

Book value per share of a company is

Book Value = (net worth of the company / no. of shares outstanding)

where net worth includes equity capital of the company, reserves and surplus. The intrinsic

value thus arrived may vary due to the accounting policy followed by the company.

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Example 10: What is the book value of the firm having a net worth of Rs.2500 crore and the

number of shares outstanding is 50 crore?

Intrinsic Book Value = Rs.2500 core/ 50 crore i.e. Rs.50

1.6.4 Liquidation Value of the Share Approach

The value of the shares on liquidation of the company is calculated after deducting the amount to

be paid to the creditors & the preference shareholders. Thus the value of the share is given by

Value = (Liquidation Value of the companyAmount paid to the creditors & preference shareholders) /No. of equity shares outstanding.

Example 11: The company XYZ Ltd. is liquidated realizing Rs.10 crore from liquidation of it

assets. The company had to pay Rs.1 crore to the creditors. What is the value of the share, if the

total outstanding number of share is 45 lakh.

Value of each share = (Rs.10 crore Rs.1 crore)/ 45 lakh shares; i.e. Rs.20

1.7 Risk and Return

The value of a firm is affected by two key factors: risk and return. Higher the risks higher the

return, other things being equal and vice versa.

1.7.1 Return

The return from an investment is the profit / loss made by the owner during a given period of

time. It is expressed as a percentage of the beginning-of-period value of the investment.

Example 12: The close price of Infosys Technologies on 31-Mar-98 was Rs.1850.15 and the

close price as on 31-Mar-99 was Rs.2930.00. What is the return earned during the period, if the

dividend income during the period is 0.

Return = (Pt - Pt-1)*100/Pt-1 = 100*(2930 - 1850.15)/1850.15 = 58.37%

If the dividend income is also taken into account then the return can be expressed as Return = (D

+ (Pt - Pt-1))*100/Pt-1

The expected rate of return on a portfolio is the sum of the product of the weightage of individual

securities and their returns.

ERp = wi * RI where i = (1, 2, 3, n)

Example 13: Suppose, the portfolio contains three stocks A, B and C which are having

weightages of 25%, 40% and 35% respectively in the portfolio. What would be expected return

of the portfolio if the individual stock returns are 10%, 15% and 20% respectively.

Rp = Wa*Ra + Wb*Rb + Wc*Rc

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= 25%*10% + 40%*15% + 35%*20% = 15.5%

Therefore return on the portfolio is 15.5%.

1.7.2 Risk

Risk is the measure of deviation from the expected value. Risk is measured by Variance, which

is the square of Standard Deviation.

While holding stocks, there is a certain amount of risk that can be removed and certain amount of

risk that cannot be removed.

The risk that cannot be removed is called as Systematic risk or Un-diversifiable risk. Systematic

risk includes shortage in money supply, economic policy followed by the country etc.

However, a part of risk that can be removed is called as Unsystematic risk or Diversifiable risk.

The diversifiable risk is specific to a company like emergence of a competitor, non-availability

of raw materials etc. An investor can reduce such risk by holding stocks of various industries.

Example 14: Portfolio A spreads its money equally over 4 stocks. Portfolio B spreads its money equally over 8 stocks. Portfolio C spreads its money equally over 16 stocks. Portfolio D spreads its money equally over 32 stocks. All these stocks are picked from various industry groups. Which of the four portfolios has the lowest risk?

Ans. Portfolio D is likely to have the lowest unsystematic risk.

1.7.3 Beta

The investors, in order to eliminate the diversifiable risk, hold portfolios of various stock. Hence

the risk is of the portfolio is measured by its non-diversifiable risk. The non-diversifiable is

measured by beta, . Beta measures the extent to which the returns fluctuate as compared to the returns of the market, which is represented by a market index. The value of Beta for a market

index (S&P CNX Nifty) is always 1.

Given the standard deviation of the returns of the security and the index, Beta is given by

Bj = Cov (Rj ,Rm) / 2M i.e. = jm j m/

2M

= jm j/m

where jm is the correlation coefficient between the return on the jth security and the return on

the market portfolio, j is the Std. Dev. of security and m is the Std. Deviation of market index.

Example 15: What is the beta value of the security XYZ which has standard deviation of return

of 10% while the standard deviation of return on the S&P CNX Nifty Index is 5%. The

correlation coefficient between the stock XYZ and the Index is 0.9.

Beta = jm j/m

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= -0.90 * 10% / 5% i.e. - 1.80

Example 16: A portfolio has a beta of 0.5. It is well diversified, and carries little unsystematic

risk. On average, on a day when Nifty rises by 2%, how much does the portfolio value change?

Portfolio value = Beta * Return on index = 0.5*2 = 1%

1.7.4 Relationship between Risk and Return

The Capital Asset Pricing Model, also called as CAPM, explains the relationship between the

risk and return of a security. The relationship between the risk and the return as explained by

CAPM is given be the formula:

RoRj = Rf + j * (RoRm - Rj)

Where RoRj is the required rate of return on the security j; Rf is the risk free rate of return, m is the beta coefficient of security j and RoRm is the expected rate of return on the market portfolio

(market index)

In the above equation (RoRm - Rj) is also called as the risk premium.

Example 17: The stock XYZ Ltd. has a beta of 0.80 and a standard deviation 4 % per day. S & P

CNX Nifty has a standard deviation of 1.3% per day. How much is the unsystematic risk of the

stock?

1.7.5 Unsystematic Risk

Unsystematic Risk = Total Risk Systematic Risk

From CAPM,

Unsystematic Risk = [Var(Security Returns) Var(j*Nifty Returns)]

= [ 4%2 (0.802 * 1.3%2)]

= (14.65) = 3.83%

1.7.6 Portfolio Risk

The portfolio risk is measured by the standard deviation of the portfolio rate of return. The

riskiness of a portfolio consisting of 2 securities is given by the formula:

p = [(wi2 * i

2) + (wj

2 * j

2 ) + (2 * wi * wj * i * p * ij) ]

Where

p is the standard deviation of portfolio return wi is the weightage of security i in the portfolio

wj is the weightage of security j in the portfolio

ij is the corellation coefficient between the returns of securities i and j

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i is the standard deviation of return of security i

j is the standard deviation of return of security j

Note: If the weightages of the securities i and j are not given, then it should be assumed that the

securities have an equal weightage of 50% each in the portfolio.

Example 18: A portfolio consists of two securities A and B. Considering the values as given in

the table below, what is the standard deviation of the portfolio return consisting of these two

securities in the proportion of 45% and 55% respectively.

Correlation coefficient between the returns of securities i and j (ij) 0.75

Standard deviation of return of security i (i) 0.25

Standard deviation of return of security j (j) 0.20

The standard deviation of return on the portfolio would then be

p = [(wi2 * i

2) + (wj

2 * j

2 ) + (2 * wi * wj * i * p * ij) ]

= [(0.452 * 0.252) +(0.552 * 0.202 ) +(2 * 0.45 * 0.55 * 0.25 * 0.20 * 0.75)]

= [( 0.0127) + (0.0121) + (0.0186)]

= (0.0434) = 20.83%

The portfolio risk, therefore, would be 20.83%.

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2. MARKET INDICES

2.1. Methods of Computation

(a) Price Weighted Arithmetic Mean Method. (b) Capitalisation Weighted Arithmetic Mean Method. (c) Price Weighted Geometric Mean Method. (d) Capitalisation Weighted Geometric Mean Method.

Example 1: Index comprises of the following four securities on the base date.

Share Price Total Shares

A 20.00 4000

B 60.00 5000

C 145.00 2000

D 15.00 10000

(a) Price Weighted Arithmetic Mean Method.

Base and Share Weightages.

Share Price Weightage

A 20.00 20.00 / 240.00 0.0830

B 60.00 60.00 / 240.00 0.2500

C 145.00 145.00 / 240.00 0.6042

D 15.00 15.00 / 240.00 0.0625

Base 240.00 Total = 1.0000

Index = 1.0000 1000 = 1000

Prices Today:

Share Price Issue Size

A 45.00 4000

B 50.00 5000

C 150.00 2000

D 15.00 10000

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Share Weightages

Share Price Weightage over Base

A 45.00 45.00 / 240.00 0.1875

B 50.00 50.00 / 240.00 0.2083

C 150.00 150.00 / 240.00 0.6250

D 15.00 15.00 / 240.00 0.0625

PriceTotal 260.00 Total = 1.0833

Base 240.00

Index = 1.0833 1000 = 1083.30 or 260.00/240.00 1083.30

(b) Capitalisation Weighted Arithmetic Mean Method.

Base Capitalisation and Weightages on base day:

Share Price Issue Size Capitalisation Weightage

A 20.00 4000 80,000 80,000/8,20,000 0.098

B 60.00 5000 3,00,000 3,00,000/8,20,000 0.366

C 145.00 2000 2,90,000 2,90,000/8,20,000 0.354

D 15.00 10000 1,50,000 1,50,000/8,20,000 0.183

Base Capitalisation 8,20,000 Total 1.000

Index = 1.000 1000 = 1000

Prices Today:

Share Price Issue Size Capitalisation Weightage over Base Cap

A 45.00 4000 1,80,000 1,80,000/8,20,000 0.219

B 50.00 5000 2,50,000 2,50,000/8,20,000 0.305

C 150.00 2000 3,00,000 3,00,000/8,20,000 0.366

D 15.00 10000 1,50,000 1,50,000/8,20,000 0.183

Total Market Capitalisation 8,80,000 Total 1.073

Base Capitalisation 8,20,000

Index = 1.073 1000 = 1073.00 or 8,80,000/8,20,000 1073.00

2.2 Issue Size Change in an Index Security

Index value should remain constant even if the issue size and issue price changes on account of

corporate action/change in composition.

Index Value (I) = {Market Capitalisation (M)/ Base Capitalisation (B)} Initial Index Value (IIV)

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Change in Market Capitalisation (M) = *Change in Issue Size Issue Price Index should not move with change in issue size.

Therefore

I = {(M + M)/(B +B)} IIV

B +B = (M + M) (IIV/ I)

B +B = M IIV/ I + M IIV/ I

B +B = B + M IIV/ I

New Base Capitalisation = Old Base Capitalisation + M IIV/ I or

Change in Base Capitalisation (B) = M IIV/ I

Example 2: On April 5, the total market capitalisation of S&P CNX Nifty is Rs. 197500 crore

and base capitalisation is Rs. 195000 crore. It is decided to replace Scrip A, a constituent of S&P

CNX Nifty having a market capitalisation of Rs. 1000 crore with scrip B that has a market

capitalisation of Rs. 900 crore with effect from April 6. What is the revised base capitalisation of

the S&P CNX Nifty on April 6?

IIV = 1000

M= 197500

B =195000

I = 197500/195000 = 1012.8205

M = 1000-900= -100

New Base Capitalisation = 195000 + (-100 1000)/1012.8205 New Base Capitalisation = 194901

Hence Index Value = 197400/194901 = 1012.8205

2.3 Impact Cost

Example 3: Given the order book for a security, compute the impact cost to buy 1500 shares of

the security.

Order Book

Buy Quantity Buy Price Sell Price Sell Quantity

1000 98.00 99.00 1000

2000 97.00 100.00 1500

1000 96.00 101.00 1000

Impact cost to buy 1500 shares

Ideal Price: (98.00 +99.00)/2 = 98.50

Actual Buy Price = (1000 99.00 + 500 100.00) / 1500 = 99.33

Impact Cost ={(Actual Price - Ideal Price)/ Ideal Price} 100

Impact cost to buy 1500 shares = {(99.33 - 98.50) / 98.50} 100 = 0.84%.

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3. TIME VALUE OF MONEY AND CAPITAL BUDGETING

3.1 Time Value of Money

Money has time value. A rupee is less valuable in the future than it is today. Time value of

money could be studied under the following heads:

1. Future value of a single cash flow

2. Future value of an annuity

3. Present value of a single cash flow

4. Present value of an annuity

3.1.1 Future Value of a Single Cash Flow

Future value of money (FV) after a period t for which compounding is done at an interest rate of r, where the present value (PV) is given by the equation

FV = PV (1+r)t

This assumes that compounding is done at discrete intervals. However, in case of continuous

compounding, the future value is determined using the formula

FV = PV * ert

where the compounding factor is calculated by taking natural logarithm (log to base e).

Example 1: Calculate the value 5 years hence of a deposit of Rs.1,000 made today if the interest

rate is 10%. By discrete compounding

FV = 1000 * (1+0.10)5 = 1000 * (1.1)

5 = 1000 * 1.61051 = Rs.1,610.51

By continuous compounding:

FV = 1000 * e (0.10 * 5)

= 1000 * 1.648721 = Rs.1,648.72

Example 2: Find the value of Rs. 50,000 deposited for a period of 3 years at the end of the period

when the interest is 10% and continuous compounding is done.

Future Value = 50000* e^(0.01*10*3) = Rs. 67493

The future value (FV) of the present sum (PV) after a period t for which compounding is done m times a year at an interest rate of r, is given by the equation FV = PV (1+(r/m))

t

17

The equation used to convert the nominal rate of interest rm where compounding is done m times a year to a continuously compounded rate rc is given by rc = m ln (1+rm/m)

The effective rate of interest Re, if compounding is done for a shorter period of m times a year, is more than the nominal rate of interest Rn specified. The difference in the effective and nominal rate of interest can be found using the formula

Re = (1 + (Rn/m))m

- 1

Example 3: How much does a deposit of Rs. 5,000 grow to at the end of 3 years, if the nominal

rate of interest is 10 % and compounding is done quarterly?

Future value = 5000 * ((1 + 0.10/4)^(4*3)) = Rs.6724.45

3.1.2 Future Value of an Annuity

The future value (FV) of a uniform cash flow (CF) made at the end of each period till the time of

maturity t for which compounding is done at the rate r is given by FV = CF*(1+r)

t-1 + CF*(1+r)

t-2 + ... + CF*(1+r)

1+CF

= CF [{(1+r)t - 1} / r]

Example 4: Suppose, you deposit Rs. 1,000 annually in a bank for 5 years and your deposits earn

a compound interest rate of 10 per cent, what will be value of this series of deposits (an annuity)

at the end of 5 years? Assuming that each deposit occurs at the end of the year, the future value

of this annuity will be:

=Rs. 1,000 (1.10)4 + Rs. 1,000 (1.10)

3 + Rs. 1,000 (1.10)

2 + Rs. 1,000 (1.10) + Rs. 1,000 = Rs.

1,000 (1.4641) + Rs. 1,000 (1.3310) + Rs. 1,000 (1.2100) + Rs. 1,000 (1.10) + Rs. 1,000

= Rs. 6,105

Example 5: Two equal annual payments of Rs.2000 are made into a deposit account that pays 8%

interest per year. What is the future value of this annuity at the end of 2 years?

FV = 2000((1+0.01*8)^2-1)/0.01*8 = Rs. 4160

In case of continuous compounding, the future value of annuity is determined using the formula

FV = CF * (ert -1)/r

3.1.3 Present Value of a Single Cash Flow

Present value of (PV) of the future sum (FV) to be received after a period t for which compounding is done at an interest rate of r, is given by the equation

Present value in case of discrete compounding: PV = FV / (1+r)t

18

Example 6: What is the present value of Rs.1,000 payable 3 years hence, if the interest rate is 12

% p.a.

PV = 1000 / (1.12)3

i.e. = Rs.711.78

Present value in case of continuous compounding PV = FV * e-rt

Example 7: What is the present value of Rs. 50,000 receivable after 3 years at a discount rate of

10% under continuous discounting?

Present Value = 50,000/(exp^(0.01*10*3)) = Rs. 37041

3.1.4 Present Value of an Annuity

The present value of annuity is the sum of the present values of all the cash inflows/outflows.

Present value of an annuity (in case of discrete compounding)

PV = FV [{(1+r)t - 1 }/ {r * (1+r)

t}]

Present value of an annuity (in case of continuous compounding)

PVa = FVa * (1-e-rt

)/r

Example 8: Future Value of Rs.1000 deposited at the end of each year for 3 years at an interest

rate of 10% compounded annually is

= Rs. 1,000 (1+0.10)2 + Rs. 1,000 (1+0.10)

1 + Rs. 1,000 i.e. Rs. 3310.

Example 9: What is the value at maturity of an annuity of Rs. 50,000, continuously compounded

at an interest of 8% for a period of 3 years?

Value of Annuity = 50,000 *(exp^(0.01*8*3)-1)/0.01*8) = Rs. 169530.72

3.2. Capital Budgeting

3.2.1. Capital Investment Decision

A capital investment decision may be required for a new project or a replacement project or for

modernisation. Capital investments decisions:

- have long-term consequences - are difficult to reverse and - involve substantial outlays on a firm

These decisions involve a study of cost and benefits associated with such projects. The methods

used to evaluate are:

(1) Average rate of return

19

(2) Payback period

(3) Internal rate of return

(4) Net present value

3.2.2. Average Rate of Return

This measure represents the ratio of the average annual profit after tax to the investments made

in the project.

Avg. Rate of Return = Profit after tax

Book value of Investments

If the income and investment is variable and spread over a time period, then the average is taken

to compute the ratio. This is expressed in percentage terms. The higher the return, the more

attractive the project.

The shortcomings of this measure are:

that it is based on accounting income and not on the timing of cash inflows or outflows,

and it does not consider time value of money.

Example 10: What is the average rate of return for the investment proposal, details of which are

given below?

Investment

Period (yr.)

Profit after tax

(Rs. Lakh)

Investment

(Rs. Lakh)

1 1500 8,000

2 1450 7,000

3 1400 5,000

Avg. rate of return = (1500+1450+1400)/3 = 21.75%

(8000+7000+5000)/3

3.2.3. Payback Period

The payback period of an investment project is the time required to recover the initial

investment.

Initial cash outlay

Payback period = _____________________

Annual cash inflow

Thus a shorter payback period for an investment is favoured.

The shortcomings of this evaluation criterion are that it does not consider the dispersion,

magnitude and time value of cash inflows.

Example 11: The firm is considering an investment proposal. The initial cash outlay is Rs. 100

Crore and the annual cash inflows are expected to be Rs. 30 Cr. What is the payback period of

this proposal?

The payback period = 100/30 = 3.33 yrs

20

Example 12: What is the payback period for a project whose cash flows are given below?

Time

Period (yr.)

Annual

Inflows (Rs.

Lakh)

Investment

(Rs. Lakh)

0 - 1,000

1 350 -

2 350 -

3 200 -

4 200 -

5 250 -

In 3 years we recover Rs.900 lakh. Thus the time required to recover Rs. 100 lakh is = (100 /

200) = .5 year

Thus the Payback period = 3.5 yrs (i.e. 3yrs 6 months)

3.2.4 Internal Rate of Return

It is the discounting rate r, which equates the present value of the cash outflows with the expected cash inflows for an investment proposal.

CF1 CF2 CF3 CFn CF0 = ____ + ____ + ____ ++_____ (1+r) (1+r)

2 (1+r)

3 (1+r)

n

Where,

CFn is the cash flow at time intervals,

n is the investment period duration,

For a proposal the IRR may be calculated manually by trial and error and the approximate value

can be interpolated from the closest answers or a financial calculator may be used.

3.2.5. Net Present Value

For an investment proposal, the NPV is the summation of the present value of all cash flows,

where the discounting is done at a required rate of return k. A positive NPV will give an accept signal and negative a reject signal.

CF1 CF2 CF3 CFn NPV = -(CF0 ) + ____ + ____ + ____ ++ _____ (1+r)

1 (1+r)

2 (1+r)

3 (1+r)

n

Where,

CF0 is the initial cash outflow,

CFn is the cash inflow at time intervals,

n is the investment period duration,

21

Example 13: An investment proposal has the following cash flows. If discounting rate is 12%,

then what is the Net present value of the proposal?

Time

Period (yr.)

Initial Investment

(Rs. Lakh)

Expected Annual

Inflows (Rs. Lakh)

0 1,000 -

1 - 350

2 - 350

3 - 200

4 - 200

5 - 250

350 350 200 200 250 NPV = -(1000) + ____ + ____ + ____ + _____ + _____

(1+.12) (1+.12)

2 (1+.12)

3 (1+.12)

4 (1+.12)

5

NPV = -1000 + 1002.84 = Rs. 2.84 lakh

22

4. Financial Statement Analysis

4.1 Introduction

Financial statements need to be properly analysed and interpreted for measuring the performance

and position of a firm. This is of immense help to lenders (short-term as well as long term),

investors, security analysts, managers etc.

A study of the financial ratios is the most common tool of financial statement analysis. Financial

ratio analysis is a study of ratios between various items in financial statements.

4.2 Types of Financial Ratios

4.2.1 Liquidity Ratios

Liquidity is the ability of a firm to meet its short-term (usually up to 1 year) obligations.

4.2.1.1 Current Ratio

Current Ratio = Current Assets / Current Liabilities

Current Assets include cash, debtors, marketable securities, inventories, loans and advances,

prepaid expenses.

Current Liabilities include loans and advances (taken), creditors, accrued expenses and

provisions.

This ratio measures the ability of the firm to meet its current liabilities. Usually, higher the

current ratio, the greater the short term solvency of the firm. The break up of the current assets is

very important to assess the liquidity of a firm. A firm with a large proportion of current assets in

the form of cash and accounts receivable is more liquid than a firm with a high proportion of

inventories even though two firms might have the same ratio.

4.2.1.2 Quick Ratio

Quick Ratio = Quick Assets / Current Liabilities

Quick Assets imply Current assets less inventories.

This ratio is based on very highly liquid assets and inventories are deemed to be the least liquid

of the current assets.

23

4.2.2 Leverage Ratios

Financial leverage refers to the use of debt finance. Debt finance is thought to be a cheaper

source of finance and at the same time a riskier source. Leverage ratios help in assessing the risk

arising from the use of debt finance.

4.2.2.1 Debt Equity Ratio

Debt Equity Ratio = Debt / Equity

Debt - Long term as well as short term.

Equity Share Capital plus Reserves and Surplus (Networth)

It is generally felt that lower the ratio, the greater the degree of protection enjoyed by the

creditors. Generally, incase of capital intensive industries a higher debt-equity ratio is observed.

4.2.2.2 Debt Assets Ratio

Debt Assets Ratio = Debt / Assets

Debt includes Long term as well as short term debt and Assets include total of all assets

4.2.2.3 Interest Coverage Ratio

Interest coverage ratio = Earnings before interest & tax/Interest charges

This ratio measures the margin of safety a firm enjoys with respect to its interest burden. The

higher the ratio, the greater the margin of safety.

4.2.3 Turnover Ratios

4.2.3.1 Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of goods sold / Inventory

Inventory implies balance of the stock of goods at the end of the year.

This ratio reflects the efficiency of inventory management. The higher the ratio, the more

efficient the inventory management.

4.2.3.2 Average Collection Period

Average Collection Period = Receivables / Average Sales per day

4.2.3.4 Receivables Turnover Ratio

24

Receivables Turnover Ratio = Net Sales / Receivables

4.2.3.5 Fixed Assets Turnover Ratio

Fixed Assets Turnover Ratio = Net Sales / Fixed Assets

This ratio is used to measure the efficiency with which fixed assets are employed. A high ratio

indicates an efficient use of fixed assets. Generally this ratio is high when the fixed assets are old

and substantially depreciated.

4.2.4 Profitability Ratios

4.2.4.1 Gross Profit Ratio

Gross Profit Ratio = Gross Profit/Net Sales

Gross Profit implies net sales less cost of goods sold.

This ratio shows the margin left after meeting manufacturing costs and measures the production

efficiency.

4.2.4.2 Net Profit Ratio

Net Profit Margin ratio = Net Profit / Net Sales

This ratio shows the profits left for shareholders as a percentage of net sales. It measures the

overall efficiency of production, administration, selling, financing, pricing and tax management.

4.2.4.3 Net Income to Total Assets Ratio

Net Income to Total Assets ratio = Net income (profit) / Total Assets

This measures how efficiently capital is employed.

4.2.4.4 Return on Investment

Return on Investment = Earnings before Interest and taxes / Total Assets

This measures the performance of the firm without the effect of interest and tax burden.

4.2.4.5 Return on Equity

Return on Equity = Equity earnings / Net Worth

Equity earnings = Profit after tax less preference dividends.

25

Net Worth = Share capital plus reserves and surplus.

This ratio measures the profitability of equity funds invested in the firm. This reflects the

productivity of the ownership capital employed in the firm.

4.2.5 Valuation Ratios

Valuation ratios indicate how the equity stock of the company is assessed in the capital market.

Market value of equity reflects the influence of risk and return.

4.2.5.1 Price Earnings Ratio

Price Earnings Ratio = Marker Price per share / Earnings per share

Market price per share may the price prevailing on a certain day or the average price over a

period of time.

Earning per share is profit after tax divided by the number of outstanding equity shares.

The P/E ratio reflects the growth prospects, corporate image, risks involved and degree of

liquidity of a firm.

4.2.5.2 Yield

Dividend/Initial Price + Price Change/Initial Price

(Dividend Yield) (Capital gains/losses yield)

Companies with low growth prospects offer a high dividend yield and a low capital gains yield.

Companies with high growth prospects offer a low dividend yield and a high capital gains yield.

4.3 Problems of Financial Statement Analysis

Development of benchmarks

Window Dressing

Price Level changes

Variations in accounting policies

Interpretation of Results

Correlation among ratios

26

Illustration:

Balance Sheet of XYZ Co. Ltd as on March 31, 1999 (Rupees in Crore)

Liabilities 1999 1998 Assets 1999 1998

Share Capital Fixed Assets (Net) 33.00 32.20

- Equity 15.00 15.00 Gross Block 59.00

- Preference Less: Depreciation 26.00

Reserves &

Surplus

11.20 10.60 Investments 1.00 1.00

Secured Loans 14.30 13.10 Current Assets,

Loans & Advances

23.40 15.60

- Term Loans 8.30 Cash & Bank 0.20

- Debentures 6.00 Debtors 11.80

Unsecured Loans 6.90 2.50 Inventories 10.60

Current Liabilities

& Provisions

10.50 8.10 Pre-paid expenses 0.80

Miscellaneous

Exps & Losses

0.50 0.50

Total 57.90 49.30 Total 57.90 49.30

27

Income statement for the year ending March 31, 1999 (Rupees in Crore)

1999 1998

Net Sales 70.10 62.30

Less: Cost of goods sold 55.20 47.50

- Stocks 42.10

- Wages and Salaries 6.80

- Other Mfg. Expenses 6.30

Gross Profit 14.90 14.80

Operating expenses 5.60 4.90

- Depreciation 3.00

- General Administration 1.20

- Selling 1.40

Operating Profit 9.30 9.90

Non-operating surplus/deficit (0.40) 0.60

Earnings before interest and tax 8.90 10.50

Interest 2.10 2.20

Profit before tax 6.80 8.30

Tax 3.50 4.10

Profit after tax 3.30 4.20

Dividends 2.70 2.70

Retained earnings 0.60 1.50

1999 1998

Per share data (in Rupees)

Earnings per share 2.20 2.80

Dividend per share 1.80 1.80

Market price per share 21.00 20.00

Book value per share 17.46 17.07

Ratios of XYZ Limited

Liquidity

Current Ratio = Current Assets / Current Liabilities = 23.40/17.40 = 1.34

Quick Ratio = Quick Assets / Current Liablities = 12.80/17.40 = 0.74

Leverage

Debt-Equity Ratio = Debt/Equity = 31.70/26.20 = 1.21

Debt-Assets Ratio = Debt/Assets = 31.70/57.90 = 0.55

Interest Coverage Ratio = EBIT / Debt Interest = 8.90/2.10 = 4.23

28

Turnover

Inventory Turnover = Cost of goods sold/Inventory = 55.20/10.60 = 5.20

Average Collection period = Receivables / Average Sales per day = 11.80/70.1*1/360 = 61 days

Receivables Turnover ratio = Net Sales / Receivables = 70.10/11.80 = 5.94

Fixed Assets Turnover ratio = Net Sales / Fixed Assets = 70.10/33 = 2.12

Profitability Ratios

Gross Profit Margin Ratio = Gross Profit/Net Sales = 14.90/70.10 = 0.21

Net Profit Margin ratio = Net Profit / Net Sales = 3.30/70.10 = 0.047

Net Income to Total Assets ratio = Net income (profit)/Total Assets = 3.30/57.90 = 0.057

Return on Investment = Earnings before Interest and taxes / Total Assets = 8.90/57.90 = 0.154

Return on Equity = Equity earnings / Net Worth = 3.30/26.20 = 0.126

Valuation Ratios

Price Earnings Ratio = Marker Price per share / Earnings per share = 21.0/2.20 = 9.55

Yield = Dividend/Initial Price + Price Change/Initial Price

(Dividend Yield) (Capital gains/losses yield)

= 1.80/20.0 + 1.0/20.0 = 0.14 or 14%

Example 1: A firms current assets and current liabilities are 1600 and 1000 respectively. How much can it borrow on a short-term basis without reducing the current ratio below 1.25?

Let the maximum short-term borrowings be x. The current ratio with this borrowing should be

1.25

1600 + x / 1000 + x = 1.25

x = 1400. Hence the maximum permissible short-term borrowing is 1400.

Example 2: Determine the sales of a firm, given the following information

Current Ratio = 1.4

Quick Ratio = 1.2

Current Liabilities = 1600

Inventory turnover ratio = 8

Current Assets = Current liabilities * Current Ratio = 1600*1.4 = 2240

Current Assets Inventories = Current Liabilities * Quick ratio = 1600*1.2 = 1920 Inventories = 2240 1920 = 320 Sales = Inventories * Inventory ratio = 320*8 = 2560

Example 3: Mohan Inc. has profit before tax of 40 lakh. If the companys interest coverage ratio is 6, what is the total interest charge?

29

Let interest charge be x

PBIT = 40+x

Interest Coverage ratio = PBIT / Interest

6 = (40+x) / x

x = 8. Hence, the total interest charge is 8 lakh.

30

5. SECURITIES CONTRACTS (REGULATION) ACT, 1956

The Securities Contracts (Regulation) Act, 1956 [SC(R)A] was enacted to prevent undesirable

transactions in securities by regulating the business of dealing therein and by providing for

certain other matters connected therewith. This is the principal Act, which governs the trading of

securities in India.

According to Section 2(f) of the SC(R)A, a "recognised stock exchange" means a stock

exchange, which is for the time being recognised by the Central Government under Section 4 of

the Act.

The term "Securities" has been defined in the SC(R)A. As per Section 2(h), the 'Securities'

include-

(i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;

(ii) derivative (iii) units or any other instrument issued by any collective investment scheme to the investors

in such schemes;

(iv) Government securities; (v) such other instruments as may be declared by the Central Government to be securities;

and

(vi) rights or interests in securities.

"Derivative" includes-

i. a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security;

ii. a contract which derives its value from the prices, or index of prices, of underlying securities;

Section 18(a) of the SC(R)A has been enacted to protect the contracts in derivative from being

invalidated by any other law in existence.

Section 18(a) provides that notwithstanding anything contained in any other law for the time

being in force, contracts in derivative shall be legal and valid if such contracts are-

i. traded on a recognised stock exchange; ii. settled on the clearing house of the recognised stock exchange, in accordance with the rules

and byelaws of such stock exchanges.

"Spot delivery contract" has been defined in Section 2(i), which means a contract which provides

for-

31

(a) actual delivery of securities and the payment of a price therefor either on the same day as the date of the contract or on the next day, the actual period taken for the despatch of the

securities or the remittance of money therefor through the post being excluded from the

computation of the period aforesaid if the parties to the contract do not reside in the same

town or locality;

(b) transfer of the securities by the depository from the account of a beneficial owner to the account of another beneficial owner when such securities are dealt with by a depository

The SC(R)A gives Central Government regulatory jurisdiction over -

1. stock exchanges, through a process of recognition and continued supervision, 2. contracts in securities, and 3. listing of securities on stock exchanges.

As a condition of recognition, a stock exchange complies with conditions prescribed by Central

Government. Organised trading activity in securities in any area takes place on a recognised

stock exchange. The stock exchanges determine their own listing requirements which have to

confirm with the minimum listing criteria set out in the Rules.

Some of the Powers under the SCRA are exercisable by SEBI. Some other powers exercisable by

Central Government have been made exercisable by SEBI in terms of notification issued under

Section 29 of the SC(R)A.

Powers exercisable by SEBI

Section Powers

6 Call for periodical returns or direct inquiries to be made 9 Approval of Bye-Laws of recognised stock exchanges

10 Make or amend bye-laws of recognised stock exchanges 17 Licensing of dealers in securities

Powers of Central Government delegated to SEBI under section 29 of the SC(R)A

Section Powers

3 Application for recognition of stock exchanges 4 Grant of recognition to stock exchanges 7 Submission of Annual Report 7A Rules restricting voting rights

8 Direct rules to be made or to make rules 11 Supersede governing body of a recognised stock exchanges 12 Suspend business of recognised stock exchanges 13 Contracts in notified areas illegal in certain circumstances 16 Prohibition of contracts 18 Exclusion of spot delivery contracts

28 Inapplicability of the SC(R)A

32

Recognition of stock exchanges

Any stock exchange, which is desirous of being recognised for the purposes of this Act may

make an application in the prescribed manner to SEBI (Section 3). The application shall be filed

in the prescribed format along with copies of the bye- laws and rules of the stock exchange

If the SEBI is satisfied, after making such inquiry as may be necessary in this behalf and after

obtaining such further information, if any, as it may require, it may grant recognition to the stock

exchange subject to the conditions imposed by the SEBI. These conditions may relate to -

(i) the qualifications for membership of stock exchanges, (ii) the manner in which contracts shall be entered into and enforced as between members, (iii) the representation of the SEBI on each of the stock exchanges by such number of

persons not exceeding three as the SEBI may nominate in this behalf; and

(iv) the maintenance of accounts of members and their audit by chartered accountants whenever such audit is required by the SEBI.

The SEBI may withdraw recognition if it is in the interest of the trade or in the public interest by

serving a written notice on the governing body of the stock exchange in this regard and after

giving an opportunity to the governing body to be heard in the matter.

A person without the permission of the SEBI shall not organise or assist in organising or be a

member of any stock exchange (other than a recognised stock exchange) for the purpose of

assisting in, entering into or performing any contracts in securities, according to section 19.

Periodical returns and books of accounts

Every recognised stock exchange shall furnish prescribed periodical returns to the Securities and

Exchange Board of India.

Every recognised stock exchange and every member thereof shall maintain and preserve for such

periods not exceeding five years such books of account, and other documents as the Central

Government, after consultation with the stock exchange concerned, may prescribe in the interest

of the trade or in the public interest, and such books of account, and other documents shall be

subject to inspection at all reasonable times by the Securities and Exchange Board of India

[Section 6(2)].

Annual reports to be furnished by stock exchanges

Every recognised stock exchange shall furnish the SEBI with a copy of the annual report, and

such annual report shall contain such particulars as may be prescribed (Section 7).

33

Bye-laws of the Stock Exchange

A recognised stock exchange may, subject to the previous approval of the Securities and

Exchange Board of India, make bye-laws for the regulation and control of contracts (Section 9).

Such bye-laws may provide for:

(a) the opening and closing of markets and the regulation of the hours of trade, (b) a clearing house for the periodical settlement of contracts and differences thereunder, the

delivery of and payment for securities, the passing on of delivery orders and the regulation

and maintenance of such clearing house,

(c) the submission to the Securities and Exchange Board of India by the clearing house as soon as may be after each periodical settlement of all or any of the following particulars as

the Securities and Exchange Board of India may, from time to time require, namely:

(i) the total number of each category of security carried over from one settlement period to another.

(ii) the total number of each category of security, contracts in respect of which have been squared up during the course of each settlement period.

(iii) the total number of each category of security actually delivered at each clearing;

(d) the publication by the clearing house of all or any of the particulars submitted to the Securities and Exchange Board of India under clause (c) subject to the directions, if any,

issued by the Securities and Exchange Board of India] in this behalf,

(e) the regulation or prohibition of blank transfers, (f) the number and classes of contracts in respect of which settlements shall be made or

differences paid through the clearing house,

(g) the regulation, or prohibition of badlas or carry-over facilities, (h) the fixing, altering or postponing of days for settlements, (i) the determination and declaration of market rates, including the opening, closing, highest

and lowest rates for securities,

(j) the terms, conditions and incidents of contracts, including the prescription of margin requirements, if any, and conditions relating thereto, and the forms of contracts in writing,

(k) the regulation of the entering into, making, performance, rescission and termination, of contracts, including contracts between members or between a member and his constituent

or between a member and a person who is not a member, and the consequences of default or

insolvency on the part of a seller or buyer or intermediary, the consequences of a breach or

omission by a seller or buyer, and the responsibility of members who are not parties to such

contracts,

(l) the regulation of taravani business including the placing of limitations thereon, (m) the listing of securities on the stock exchange, the inclusion of any security for the

purpose of dealings and the suspension or withdrawal of any such securities, and the

suspension or prohibition of trading in any specified securities,

(n) the method and procedure for the settlement of claims or disputes, including settlement by arbitration,

34

(o) the levy and recovery of fees, fines and penalties, (p) the regulation of the course of business between parties to contracts in any capacity, (q) the fixing of a scale of brokerage and other charges, (r) the emergencies in trade which may arise, whether as a result of pool or syndicated

operations or cornering or otherwise, and the exercise of powers in such emergencies

including the power to fix maximum and minimum prices for securities,

(s) the regulation of dealings by members for their own account, (t) the separation of the functions of jobbers and brokers, (u) the limitations on the volume of trade done by any individual member in exceptional

circumstances,

(v) the obligation of members to supply such information or explanation and to produce such documents relating to the business as the governing body may require.

The bye-laws made under this section may specify the bye-laws, the contravention of which shall

make a contract entered into otherwise than in accordance with the bye- laws void under sub-

section (1) of section 14 and provide that the contravention of any of the bye-laws shall render

the member concerned liable to fine, expulsion from membership, suspension from membership

for a specified period, or any other penalty of a like nature not involving the payment of money.

The Securities and Exchange Board of India may under section 10, either on a request in writing

received by it in this behalf from the governing body of a recognised stock exchange or on its

own motion, if it is satisfied after consultation with the governing body of the stock exchange

that it is necessary or expedient so to do and after recording its reasons for so doing, make bye-

laws, for all or any of the matters specified in section 9 or amend any bye-laws made by such

stock exchange under that section.

Supersession of the governing body of a recognised stock exchange

If SEBI is of the opinion that the governing body of any recognised stock exchange should be

superseded, then the SEBI may serve on the governing body a written notice in this regard

specifying the reasons. The SEBI after giving an opportunity to the governing body to be heard

in the matter, it may, by notification in the Official Gazette declare the governing body of such

stock exchange to be superseded. It may appoint any person or persons to exercise and perform

all the powers and duties of the governing body, and, and where more persons than one are

appointed, may appoint one of such persons to be the chairman and another to be the vice-

chairman thereof.

Suspension of business of recognised stock exchanges

SEBI may direct a recognised stock exchange to suspend such of its business for such period not

exceeding seven days and subject to such conditions as may be specified in the notification. If

the SEBI is of the opinion of the Central Government that the interest of the trade or the public

interest requires that the period should be extended may, by like notification extend the said

period from time to time, according to Section 12.

Contracts in notified areas illegal or void in certain circumstances

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As per section 13, if the SEBI is satisfied, having regard to the nature or the volume of

transactions in securities in any State or area, that it is necessary so to do, it may, by notification

in the Official Gazette, declare this section to apply to such State or area, and thereupon every

contract in such State or area which is entered into after date of the notification otherwise than

between members of a recognised stock exchange in such State or area or through or with such

member shall be illegal.

As per section 14, any contract entered into in any State or area specified in the notification

under section 13 which is in contravention of any of the bye- laws specified in that behalf under

clause (a) of sub-section (3) of section 9 shall be void with regard to the rights of any member of

the recognised stock exchange who has entered into such contract in contravention of any such

bye-laws, and the rights of any other person who has knowingly participated in the transaction

entailing such contravention.

Members may not act as principals in certain circumstances

A member of a recognised stock exchange shall not in respect of any securities enter into any

contract as a principal with any person other than a member of a recognised stock exchange,

unless he has secured the consent or authority of such person and discloses in the note,

memorandum or agreement of sale or purchase that he is acting as a principal, section 15.

Power to prohibit contracts in certain cases

If the SEBI is of opinion that it is necessary to prevent undesirable speculation in specified

securities in any State or area, it may, by notification in the Official Gazette, declare that no

person in the State or area specified in the notification shall, save with the permission of the

Central Government, enter into any contract for the sale or purchase of any security specified in

the notification except to the extent and in the manner, if any, specified therein, according to

section 16.

Section 22(a) provides for a right of appeal to Securities Appellate Tribunal against refusal of

stock exchange to list securities of public companies, if the said companies feel aggrieved with

such refusal. Securities Appellate Tribunal has been given power to vary or set side the decision

of the stock exchange.

Section 29(a) deals with the power of Central Government to delegate the powers (except the

power under Section 30), exercisable by it under the provisions of SCRA to SEBI or RBI subject

to such conditions it may specify.

Section 30 of the SCRA provides power for Central Government to make rules for the purpose of

carrying out into effect the object of this Act.

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6. SECURITIES CONTRACTS (REGULATION) RULES, 1957

The Central Government has made Securities Contracts (Regulation) Rules, 1957, as required by

sub-section (3) of the Section 30 of the Securities Contracts (Regulation) Act, 1956 for carrying

the purposes of that Act. The powers under the SCRR, 1957 are exercisable by SEBI only.

Qualifications for membership of recognised stock exchanges (Rule 8)

A person is eligible to be elected as a member of a recognised stock exchange if he has worked

for not less than two years as a partner with, or as an authorised assistant or authorised clerk or

remisier or apprentice to, a member; or he agrees to work for a minimum period of two years as a

partner or representative member with another member and to enter into bargains on the floor of

the stock exchange and not in his own name but in the name of such other member; or he

succeeds to the established business of a deceased or retiring member who is his father, uncle,

brother or any other person who is, in the opinion of the governing body, a close relative, and if :

(i) he is of twenty-one years of age or more, (ii) he is a citizen of India, (iii) he has not been adjudged bankrupt or he has not been proved to be insolvent, (iv) he has not compounded with his creditors, (v) he has not been convicted of an offence involving fraud or dishonesty; (vi) he is not engaged as principal or employee in any business other than that of securities

except as a broker or agent not involving any personal financial liability,

(vii) he has not been at any time expelled or declared a defaulter by any other stock exchange, (viii) he has not been previously refused admission to membership unless a period of one year

has elapsed since the date of such rejection.

A person who is a member at the time of application for recognition or subsequently admitted as

a member shall continue as such if -

(a) he ceases to be a citizen of India, (b) he is adjudged bankrupt or a receiving order in bankruptcy is made against him or he is

proved to be insolvent;

(c) he is convicted of an offence involving fraud or dishonesty; (d) he engages either as principal or employee in any business other than that of securities except

as a broker or agent not involving any personal financial liability.

Contracts between members of recognised stock exchange

All contracts between the members of a recognised stock exchange shall be confirmed in writing

and shall be enforced in accordance with the rules and bye-laws of the stock exchange of which

they are members (Rule 9).

Books of account and other documents by every recognised stock exchange

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Rule 14 of the SCRR requires every recognised stock exchange shall maintain and preserve the

following books of account and documents for a period of five years:

(1) Minute books of the meetings of-

(a) members;

(b) governing body;

(c) any standing committee or committees of the governing body or of the general body of

members.

(2) Register of members showing their full names and addresses. Where any member of the stock

exchange is a firm, full names and addresses of all partners shall be shown.

(3) Register of authorised clerks.

(4) Register of remisiers of authorised assistants.

(5) Record of security deposits.

(6) Margin deposits book.

(7) Ledgers.

(8) Journals.

(9) Cash book.

(10) Bank pass-book.

Books of account and other documents to be maintained and preserved by every member

of a recognised stock exchange

Rule 15 of the SCRR requires every member of a recognised stock exchange to maintain and

preserve the following books of account and documents for a period of five years:

(a) Register of transactions (Sauda book).

(b) Clients' ledger.

(c) General ledger.

(d) Journals.

(e) Cash book.

(f) Bank pass-book.

(g) Documents register showing full particulars of shares and securities received and delivered.

Every member of a recognised stock exchange shall maintain and preserve the following

documents for a period of two years:

(a) Members' contract books showing details of all contracts entered into by him with other

members of the same exchange or counter-foils or duplicates of memos of confirmation issued to

such other members.

(b) Counter-foils or duplicates of contract notes issued to clients.

(c) Written consent of clients in respect of contracts entered into as principals.

Submission of annual report

According Rule 17, every recognised stock exchange shall within the specified time furnish the

SEBI annually with a report about its activities during the preceding calendar year, which shall

interalia contain detailed information about the following matters:

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(a) changes in rules and bye-laws, if any;

(b) changes in the composition of the governing body;

(c) any new sub-committees set up and changes in the composition of existing ones;

(d) admissions, re-admissions, deaths or resignations of members;

(e) disciplinary action against members;

(f) arbitration of disputes (nature and number) between members and non-members;

(g) defaults;

(h) action taken to combat any emergency in trade;

(i) securities listed and de-listed; and

(j) securities brought on or removed from the forward list.

Every recognised stock exchange shall within one month of the date of the holding of its annual

general meeting, furnish the SEBI with a copy of its audited balance sheet and profit and loss

account for its preceding financial year.

Submission of periodical returns Every recognised stock exchange as per Rule 17 A shall furnish the SEBI periodical returns

relating to-

(i) the official rates for the securities enlisted thereon; (ii) the number of shares delivered through the clearing house; (iii) the making-up prices; (iv) the clearing house programmes; (v) the number of securities listed and de-listed during the previous three months; (vi) the number of securities brought on or removed from the forward list during the previous

three months; and

(vii) any other matter as may be specified by the SEBI

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7. SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

The Securities and Exchange Board of India Act, 1992 has been enacted to provide for the

establishment of a Board to protect the interest of investors in securities and to promote the

development of, and to regulate, the securities market and for matters connected therewith or

incidental thereto. It came into force on the 30th day of January, 1992.

Establishment and incorporation of Board

Major part of the liberalisation process was the repeal of the Capital Issues (Control) Act, 1947

in May 1992. With this, Governments control over issues of capital, pricing of the issues, fixing

of premia and rates of interest on debentures etc. ceased, and the office which administered the

Act was abolished: the market was allowed to allocate resources to competing uses. However to

ensure effective regulation of the market, SEBI Act, 1992 was enacted to empower SEBI with

statutory powers for (a) protecting the interests of investors in securities (b) promoting the

development of the securities market and (c) regulating the securities market. Its regulatory

jurisdiction extends over corporates in the issuance of capital and transfer of securities, in

addition to all intermediaries and persons associated with securities market. SEBI can specify the

matters to be disclosed and the standards of disclosure required for the protection of investors in

respect of issues; can issue directions to all intermediaries and other persons associated with the

securities market in the interest of investors or of orderly development of the securities market;

and can conduct enquiries, audits and inspection of all concerned and adjudicate offences under

the Act. In short, it has been given necessary autonomy and authority to regulate and develop an

orderly securities market. All the intermediaries in the market, such as brokers and sub-brokers,

underwriters, merchant bankers, bankers to the issue, share transfer agents and registrars to the

issue, are now required to register with SEBI and are governed by its regulations. A code of

conduct for each intermediary has been prescribed in the regulations; capital adequacy and other

norms have been specified; a system of monitoring and inspecting their operations has been

instituted to enforce compliance; and disciplinary actions are being taken against the

intermediaries violating any regulation.

The Central Government may, by notification, appoint, for the purposes of this Act, a Board by

the name of the Securities and Exchange Board of India under Section 3 of the SEBI Act. The

Board shall be a body corporate by the name aforesaid having perpetual succession and a

common seal, with power subject to the provisions of this Act, to acquire, hold and dispose of

property, both movable and immovable, and to contract, and shall, by the said name, sue or be

sued. The head office of the Board shall be at Bombay. The Board may establish offices at other

places in India.

The SEBI has offices in Mumbai, Calcutta, New Delhi and Chennai.

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The Board shall consist of the following members, namely:-

(a) a Chairman; (b) two members from amongst the officials of the Ministries of the Central Government dealing

with Finance and Law;

(c) one member from amongst the officials of the Reserve Bank of India constituted under section 3 of the Reserve Bank of India Act, 1934;

(d) two other members, to be appointed by the Central Government.

The general superintendence, direction and management of the affairs of the Board shall vest in a

Board of members, which may exercise all powers and do all acts and things which may be

exercised or done by the Board.

Save as otherwise determined by regulations, the Chairman shall also have powers of general

superintendence and direction of the affairs of the Board and may also exercise all powers and do

all acts and things which may be exercised or done by the Board.

The Chairman and members referred to in clauses (a) and (d) of sub-section (1) shall be

appointed by the Central Government and the members referred to in clauses (b) and (c) of that

sub-section shall be nominated by the Central Government and the Reserve Bank of India

respectively.

The Chairman and the other members referred to in clauses (a) and (d) of sub-section (1) shall be

from amongst the persons of ability, integrity and standing who have shown capacity in dealing

with problems relating to securities market or have special knowledge or experience of law,

finance, economics, accountancy, administration or in any other discipline which, in the opinion

of the Central Government, shall be useful to the Board.

The Board may appoint officers and employees for the efficient discharge of its functions under

this Act.

Functions of the Board

The SEBI shall protect the interests of the investors in securities and to promote and

development of, and to regulate the securities market by such measures as it thinks fit. The

measures referred to therein may provide for -

(a) regulating the business in stock exchanges and any other securities markets; (b) registering and regulating the working of stock brokers, sub-brokers, share transfer agents,

bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers,

underwriters, portfolio managers, investment advisers and such other intermediaries