PAPER III -5.ADVANCED FINANCIAL MANAGEMENT Unit 1 An overview of Corporate Financing Patterns of Corporate Financing in India.

Overview of Pattern of Corporate Financing in India

The pattern of corporate financing in India has been different throughout its economic history. The outline of corporate financing in India has been determined by the economic rules and regulations that operate at different points of time.

Pattern of Corporate Financing in India from 1960 to 1990

During the 30-year period in Indian economy ranging from 1960 to 1990 the stress of Indian economy was on public finance. There were a lot of rules and regulations regarding various economic issues like rates of interest and many more. During the middle part of the decade of 80s there was some change in the Indian economic scenario.The performance of the capital markets in India improved.

Pattern of Corporate Financing in India from 1990 onwards

After 1992 a lot of reforms have been made in the capital markets of India. The performance of the stock markets of India was remarkable in the 1990s. This was keeping with the healthy state of the Indian economy in and around that time. All this altered the trend of corporate financing in India. The dependency on banks for loans or other financial assistance reduced to a significant extent. The equity capital that was gained from the capital markets came up as a suitable alternative for them. The Gross Domestic Product of India rose steadily in this period. The Gross Domestic Product went up by about 4.3% in 1992-93. The Gross Domestic Product of India again increased by almost 2% in the year 1995-96. The growth rate of the Gross Domestic Product of India has been impressive in the recent years.

Role of Banking Sector in Pattern of Corporate Financing in India

The banking sector of India has played an important role in the context of the development of Indian economy. The banks of India have been doing well with the distribution of funds and monetary resources for the purpose of the development of India's economy.

Equity versus Debt

Debt vs. equity financing is one of the most important decisions facing managers who need capital to fund their business operations. Debt and equity are the two main sources of capital available to businesses, and each offers both advantages and disadvantages. "Absolutely nothing is more important to a new business than raising capital," Steve Jefferson wrote in Pacific Business News (Jefferson, 2001). "But the way that money is raised can have an enormous impact on the success of a business."

DEBT FINANCING
Debt financing takes the form of loans that must be repaid over time, usually with interest. Businesses can borrow money over the short term (less than one year) or long term (more than one year). The main sources of debt financing are banks and government agencies, such as the Small Business Administration (SBA). Debt financing offers businesses a tax advantage, because the interest paid on loans is generally deductible. Borrowing also limits the business's future obligation of repayment of the loan, because the lender does not receive an ownership share in the business. However, debt financing also has its disadvantages. New businesses sometimes find it difficult to make regular loan payments when they have irregular cash flow. In this way, debt financing can leave businesses vulnerable to economic downturns or interest rate hikes. Carrying too much debt is a problem because it increases the perceived risk associated with businesses, making them unattractive to investors and thus reducing their ability to raise additional capital in the future.

EQUITY FINANCING
Equity financing takes the form of money obtained from investors in exchange for an ownership share in the business. Such funds may come from friends and family members of the business owner, wealthy "angel" investors, or venture capital firms. The main advantage to equity financing is that the business is not obligated to repay the money. Instead, the investors hope to reclaim their investment out of future profits. The involvement of high-profile investors may also help increase the credibility of a new business. The main disadvantage to equity financing is that the investors become part-owners of the business, and thus gain a say in business decisions. "Equity investors are looking for a partner as well as an investment, or else they would be lenders," venture capitalist Bill Richardson explained in Pacific Business News (Jefferson, 2001). As ownership interests become diluted, managers face a possible loss of autonomy or control. In addition, an excessive reliance on equity financing may indicate that a business is not using its capital in the most productive manner. Both debt and equity financing are important ways for businesses to obtain capital to fund their operations. Deciding which to use or emphasize, depends on the long-term goals of the business

and the amount of control managers wish to maintain. Ideally, experts suggest that businesses use both debt and equity financing in a commercially acceptable ratio. This ratio, known as the debt-to-equity ratio, is a key factor analysts use to determine whether managers are running a business in a sensible manner. Although debt-to-equity ratios vary greatly by industry and company, a general rule of thumb holds that a reasonable ratio should fall between 1:1 and 1:2. Some experts recommend that companies rely more heavily on equity financing during the early stages of their existence, because such businesses may find it difficult to service debt until they achieve reliable cash flow. But start-up companies may have trouble attracting venture capital until they demonstrate strong profit potential. In any case, all businesses require sufficient capital in order to succeed. The most prudent course of action is to obtain capital from a variety of sources, using both debt and equity, and hire professional accountants and attorneys to assist with financial decisions.

Factors influencing Capital Structure

Meaning of Capital Structure

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. The capital structure involves two decisionsa. Type of securities to be issued are equity shares, preference shares and long term borrowings( Debentures). b. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into twoi. ii. Highly geared companies- Those companies whose proportion of equity capitalization is small. Low geared companies- Those companies whose equity capital dominates total capitalization.

For instance - There are two companies A and B. Total capitalization amounts to be Rs. 20 lakh in each case. The ratio of equity capital to total capitalization in company A is Rs. 5 lakh, while in company B, ratio of equity capital is Rs. 15 lakh to total capitalization, i.e, in Company A, proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered to be a highly geared company and company B is low geared company.

Factors Determining Capital Structure

1. Trading on Equity- The word equity denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general

rate of companys earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high. 2. Degree of control- In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the companys management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares. 3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans. 4. Choice of investors- The companys policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors. 5. Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the companys capital structure generally consists of debentures and loans. While in period of boons and inflation, the companys capital should consist of share capital generally equity shares. 6. Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures. 7. Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits. 8. Stability of sales- An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.

9. Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.

Importance of Capital Structure Capital Structure Planning :

Capital structure planning is very important to survive the business in long run. After simple watching the balance sheet of company, you see two sides of balance sheet. One side is liability side and other side is asset side. Liability side is the mixture of finance of company which company has collected from internal and external sources and it has been used or will be used for development of company. Liability side of balance sheet is made under perfect capital structure planning. Finance manager and other promoters decides which source of fund or funds should be selected after monitoring the factors affecting capital structures. So, capital structure planning makes strong balance sheet. The right capital structure planning also increases the power of company to face the losses and changes in financial markets. Following points shows the importance of capital structure and its planning.

1. To reduce the overall risk of company When we make capital structure before actual getting money from money supplier, we can do many adjustments for reducing our overall risk. Suppose, we have made capital structure in which we add three sources of fund, one is equity share, and other is debenture and last is pref. shares. Because we know that we have to pay debt at its maturity at any cost and its interest at fixed rate. So, we try to get minimum debt in new business because in new business our rate of return will be less than rate of interest and for getting more loan means taking high risk of return more amount of interest even there is no profit. But, if our business will be succeeded, at that time, we can increase estimated amount of debt by just changing the value of debt in capital structure (written just for planning) in excel sheet. We can easily pay the interest because our ROI is very high. At that, time company can enjoy the trading on equity. But finance manager should also careful watch whether shareholders are more expected regarding dividend or not. Because high expectation will also against the development of our company. 2. To do adjustment according to Business Environment Company also adjusts different sources expected amount according to business environment. Suppose in future, if government of India cuts off his relation with China, from where our company is getting fund, it will definitely tough for us to get more money from China. But proper planning of capital structure of future sources will be helpful for us to enlarge our area for getting money. In finance, it is called maneuverability. It means to create mobility of sources of fund by including maximum alternatives in planned capital structure. Suppose, if RBI increases the interest rate, it means your cost for getting debt will be high, at that time, you can choose any other cheap source of fund. 3. Idea generation of new source of fund Good planning of capital structure will make versatile to finance manager for getting money from new sources. If you have studied Wikipedias page of venture capital or private equity sources, you would precisely understand that how finance managers of company are generating new and new idea for getting money from public at low risk. Promoters or managers do 10 minutes meeting with investors and motivate them by showing the special event which they have made in PPT

Theories of Capital Structure

1st Theory of Capital Structure Name of Theory = Net Income Theory of Capital Structure This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and

decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital. For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share. High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value. 2nd Theory of Capital Structure Name of Theory = Net Operating income Theory of Capital Structure Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same. 3rd Theory of Capital Structure Name of Theory = Traditional Theory of Capital Structure This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand: Ist Stage In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm. 2nd Stage In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure. 3rd Stage Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital. 4th Theory of Capital Structure

Name of theory = Modigliani and Miller MM theory or approach is fully opposite of traditional approach. This approach says that there is not any relationship between capital structure and cost of capital. There will not effect of increasing debt on cost of capital. Value of firm and cost of capital is fully affected from investor's expectations. Investors' expectations may be further affected by large numbers of other factors which have been ignored by traditional theorem of capital structure.

Role of EBITDefinition of 'Earnings Before Interest & Tax - EBIT'

An indicator of a company's profitability, calculated as revenue minus expenses, excluding tax and interest. EBIT is also referred to as "operating earnings", "operating profit" and "operating income", as you can re-arrange the formula to be calculated as follows: EBIT Revenue - Operating = Expenses Also known as Profit Before Interest & Taxes (PBIT), and equals Net Income with interest and taxes added back to it.

Investopedia explains 'Earnings Before Interest & Tax EBIT'

In other words, EBIT is all profits before taking into account interest payments and income taxes. An important factor contributing to the widespread use of EBIT is the way in which it nulls the effects of the different capital structures and tax rates used by different companies. By excluding both taxes and interest expenses, the figure hones in on the company's ability to profit and thus makes for easier cross-company comparisons. EBIT was the precursor to the EBITDA calculation, which takes the process further by removing two non-cash items from the equation (depreciation and amortization).

EPS Analysis Definition of 'Earnings Per Share - EPS'

The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.

Calculated as:

When calculating, it is more accurate to use a weighted average number of shares outstanding over the reporting term, because the number of shares outstanding can change over time. However, data sources sometimes simplify the calculation by using the number of shares outstanding at the end of the period. Diluted EPS expands on basic EPS by including the shares of convertibles or warrants outstanding in the outstanding shares number.

Investopedia explains 'Earnings Per Share - EPS'

Earnings per share is generally considered to be the single most important variable in determining a share's price. It is also a major component used to calculate the price-to-earnings valuation ratio. For example, assume that a company has a net income of $25 million. If the company pays out $1 million in preferred dividends and has 10 million shares for half of the year and 15 million shares for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from the net income to get $24 million, then a weighted average is taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M). An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with less equity (investment) that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company. Investors also need to be aware of earnings manipulation that will affect the quality of the earnings number. It is important not to rely on any one financial measure, but to use it in conjunction with statement analysis and other measures.

Cost of Capital Capital is the term used by firms for funds needed for investment purposes, i.e., capital equipment (not for day to day operating needs)

 This capital carries a cost because each source of capital funding costs money to raise (i.e., issuing stock costs a lot of money) Definition of 'Cost Of Capital'
The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk. Sources of Capital Borrowing: issue Bonds, bank loans, Issuing Preferred stock Issuing Common stock Net Income (earnings) Each of these sources carries a different cost based on the required rate of return of each provider (source) of these funds

Computation of Cost of Capital for each source of Finance Learning Goals Determining the value of K, the required rate of return for an investor Sources of capital funding (Debt, Equity) Cost of each type of funding Calculation of the weighted average cost of capital funding (WACC) = K Construction and use of the marginal cost of capital schedule (MCC) for decision making

Weighted Average cost of capital. Definition of 'Weighted Average Cost Of Capital - WACC'
A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate Businesses often discount cash flows at WACC to determine the Net Present Value (NPV) of a project, using the formula: NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Investopedia explains 'Weighted Average Cost Of Capital WACC'

Broadly speaking, a companys assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

Tricks of the Trade

To accurately calculate WACC, you need to know the specific rates of return required for each source of capital. For example, different sources of finance may attract different levels of taxation, or interest, which should be accounted for. A true WACC calculation could therefore be much more complex than the example provided here.

Critics of WACC argue that financial analysts rely on it too heavily, and that the algorithm should not be used to assess risky projects, where the cost of capital will necessarily be higher to reflect the higher risk. Investors use WACC to help decide whether a company represents a good investment opportunity. To some extent, WACC represents the rate at which a company produces value for investorsif a company produces a return of 20% and has a WACC of 11%, then the company creates 9% additional value for investors. If the return is lower than the WACC, the business is unlikely to secure investment. Although the WACC formula seems simple, different analysts will often come up with different WACC calculations for the same company depending on how they interpret the companys debt, market value, and interest rates.

Unit - 2 Valuation of Bonds and Shares : Basic Valuation Model Valuation of Bonds Valuation of Equity Shares: Parameters in the Dividend Discount Model Dividend Growth Model and the NPVGO Model - P/E Ratio Approach Book Value Approach. Unit - 3 Components of Working Capital Working Capital What is working capital? Working capital is the money needed to fund the normal, day to day operations of your business. It ensures you have enough cash to pay your debts and expenses as they fall due, particularly during your start-up period. Very few new businesses are profitable as soon as they open their doors. It takes time to reach your breakeven point and start making a profit. The working capital cycle The working capital cycle measures the time between paying for goods supplied to you and the final receipt of cash to you from their sale. It is desirable to keep the cycle as short as possible as it increases the effectiveness of working capital. The working capital cycle is made up of four core components:

Cash (funds available) Creditors (accounts payable) Inventory (stock on hand) Debtors (accounts payable) Diagram of the working capital cycle The key to successful cash management is to be in control of each step in the cycle. If you can quickly convert your trading operations into available cash, you will be increasing the liquidity in your business and will be less reliant on cash from customers, extended terms from suppliers, overdrafts, and loans. What's the right level of working capital? The right level of working capital depends on the industry and the particular circumstances of the business. For example: Businesses that only sell services, and do not need to pay cash for inventory need a lower level of working capital. Businesses that take a substantial amount of time to make of sell a product will need a higher level of working capital. It is important you work out the right level of working capital you will need. If the working capital is too: high - your business has surplus funds which are not earning a return; and low - may indicate that your business is facing financial difficulties. The formula used to calculate working capital for your business is: (NOTE: You will need figures from your most recent balance sheet) working capital ($ value) = current assets - current liabilities This calculation will not give you a sense of whether your working capital safety margin is wide enough. The working capital ratio (current ratio/liquidity ratio) will give you a better measure of liquidity. Working capital as a percentage of sales Most business owners have a clear idea of their weekly, monthly, or quarterly sales levels, so you may prefer to calculate how much working capital you need as a percentage of sales.

The formula used to calculate an estimate of working capital as a percentage of sales for your business is: (NOTE: You will need figures from your most recent balance sheet and profit and loss statement) Working capital = (Inventory + accounts receivable - accounts payable) as a % of sales Sales x 100 and: Working capital ($ value) = sales x (working capital as a % of sales) For example: Working capital as a percentage of sales of 35% means that you need $35 for every $100 of sales to fund the sale to allow for the time delay in the working capital cycle. This method is useful for businesses going through a period of growth and expansion to work out how much extra working capital you need if turnover increased by a certain amount. Policies Liquidity Profitability Linkages Factors determining Working Capital

FACTORS DETERMINING WORKING CAPITAL REQUIREMENT

The working capital needs of a firm are determined and influenced by various factors. A wide variety of considerations may affect the quantum of working capital required and these considerations may vary from time to time. The working capital needed at one point of time may not be good enough for some other situation. The determination of working capital requirement is a continuous process and must be undertaken on a regular basis in the light of the changing situations. Following are some of the factors which are relevant in determining the working capital needs of the firm: 1. Basic Nature of Business: The working capital requirement is closely related to the nature of the business of the firm. In case of a retail shop or a trading firm, the amount of working capital required is small enough. Most of the transactions are undertaken in cash and the length of the operating cycle is generally small. The trading concerns usually have smaller needs of working capital, however, in certain cases, large inventories of goods may be required and consequently the working

capital may be large. In case of financial concerns (engaged in financial business) there may not be stock of goods but these firms do have to maintain sufficient liquidity all the times. In case of manufacturing concerns, different types of production processes are performed. One unit of raw material introduced in the production schedule may take a long period before it is available as finished goods for sale. Funds are blocked not only in raw materials but also in labor expenses and overheads at every stage of production. The operating cycle is usually a longer one and sales are made generally on credit terms. So, in case of manufacturing concerns, there is a requirement of substantial working capital. 2. Business Cycle Fluctuations: Different phases of business cycle i.e., boom, recession, recovery etc. also affect the working capital requirement. In case of boom conditions, inflationary pressure appears and business activities expand. As a result, the overall need for cash, inventories etc. increases resulting in more and more funds blocked in these current assets. In case of recession period however, there is usually a dullness in business activities and there will be an opposite effect on the level of working capital requirement. There will be a fall in inventories and cash requirement etc. 3. Seasonal Operations: If a firm is operating in goods and services having seasonal fluctuations in demand, then the working capital requirement will also fluctuate with every change. In a cold drink factory, the demand will certainly be higher during summer season and therefore, more working capital is required to maintain higher production, in the form of larger inventories and bigger receivables. On the other hand, if the operations are smooth and even through out the year then the working capital requirement will be constant and will not be affected by the seasonal factors. 4. Market Competitiveness: The market competitiveness has an important bearing on the working capital needs of a firm. In view of the competitive conditions prevailing in the market, the firm may have to offer liberal credit terms to the customers resulting in higher debtors. Even larger inventories may be maintained to serve an order as and when received; otherwise the customer may go to some other supplier. Thus, the working capital tends to be high as a result of greater investment in inventories and receivable. On the other hand, a monopolistic firm may not require larger working capital. It may ask the customers to pay in advance or to wait for some time after placing the order. 5. Credit Policy: The credit policy means the totality of terms and conditions on which goods are sold and purchased. A firm has to interact with two types of credit policies at a time. One, the credit policy of the supplier of raw materials, goods etc., and two, the credit policy relating to credit which it extends to its customers. In both the cases, however, the firm while deciding its credit policy, has to take care of the credit policy of the market. For example, a firm might be purchasing goods and services on credit terms but selling goods only for cash. The working capital requirement of this firm will be lower than that of a firm which is purchasing cash but has to sell on credit basis.

6. Supply Conditions: The time taken by a supplier of raw materials, goods etc. after placing an order, also determines the working capital requirement. If goods are received as soon as or in a short period after placing an order, then the purchaser will not like to maintain a high level of inventory of that good. Otherwise, larger inventories should be kept e.g., in case of imported goods. It is often seen that the shopkeepers may not be keeping stock of all items, but whenever there is a demand, they procure from the wholesaler/producer and supply it to their customers. Thus, the working capital requirement of a firm is determined by a host of factors. Every consideration is to be weighted relatively to determine the working capital requirement. Further, the determination of working capital requirement is not once a while exercise, rather a continuous review must be made in order to assess the working capital requirement in the changing situation. There are various reasons which may require the review of the working capital requirement e.g., change in credit policy, change in sales volume etc.

sources of Working Capital Finance Short Term Sources of Working Capital Finance
Factoring Instalment Credit Invoice Discounting

Factoring is a traditional source of short term funding. Factoring facility Instalment credit is a form arrangements tend to be of finance to pay for restrictive and entering goods or services over a into a whole-turnover period through the factoring facility can lead payment of principal and to aggressive chasing of interest in regular outstanding invoices from payments. clients, and a loss of control of a companys credit function. Income received in advance Income received in advance is seen as a liability because it is money that does not correlate to that specific accounting or business Advances received from customers

Invoice Discounting is a form of asset based finance which enables a business to release cash tied up in an invoice and unlike factoring enables a client to retain control of the administration of its debtors.

Bank Overdraft

A liability account used to A bank overdraft is when record an amount someone is able to spend received from a customer more than what is actually before a service has been in their bank account. The provided or before goods overdraft will be limited. A have been shipped. bank overdraft is also a type

year but rather for one that is still to come. The income account will then be credited to the income received in advance account and the income received in advance will be debited to the income account such as rent. Commercial Papers Trade Finance

of loan as the money is technically borrowed.

Letter of Credit A letter of credit is a document that a financial institution issues to a seller of goods or services which says that the issuer will pay the seller for goods/services the seller delivers to a thirdparty buyer. The issuer then seeks reimbursement from the buyer or from the buyers bank. The document is essentially a guarantee to the seller that it will be paid by the issuer of the letter of credit regardless of whether the buyer ultimately fails to pay. In this way, the risk that the buyer will fail to pay is transferred from the seller to the letter of credits issuer.

A commercial paper is an unsecured promissory note. Commercial paper is a money-market security issued by large corporations to get money to meet short term debt obligations e.g.payroll, and is only backed by an issuing bank or corporations promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings will be able to sell their commercial paper at a reasonable price.

An exporter requires an importer to prepay for goods shipped. The importer naturally wants to reduce risk by asking the exporter to document that the goods have been shipped. The importers bank assists by providing a letter of credit to the exporter (or the exporters bank) providing for payment upon presentation of certain documents, such as a bill of lading. The exporters bank may make a loan to the exporter on the basis of the export contract.

Long Term Sources of Working Capital Finance

Shares Capital
Shares capital refers to the portion of a companys equity that has been obtained (or will be obtained) by trading stock to a shareholder for cash or an equivalent item of capital value. Share capital comprises the nominal values of all shares issued (that is, the sum of their par values).

Share capital can simply be defined as the sum of capital (cash or other assets) the company has received from investors for its shares.

Debenture
A debenture is a document that either creates a debt or acknowledges it, and it is a debt without collateral. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. A debenture is like a certificate of loan evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the companys capital structure, it does not become share capital. Debentures are generally freely transferable by the debenture holder.

Loan from financial institution

A loan is a type of debt which it entails the redistribution of financial assets over time, between the lender and the borrower. In a loan, the borrower initially receives or borrows an amount of money from the lender, and is obligated to pay back or repay an equal amount of money to the lender at a later time. Typically, the money is paid back in regular installments, or partial repayments; in an annuity, each installment is the same amount. Acting as a provider of loans is one of the principal tasks for financial institutions like banks. A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral. Unsecured loans are monetary loans that are not secured against the borrowers assets.

-Inventory Management
Defining Inventory
Inventory is an idle stock of physical goods that contain economic value, and are held in various forms by an organization in its custody awaiting packing, processing, transformation, use or sale in a future point of time. Any organization which is into production, trading, sale and service of a product will necessarily hold stock of various physical resources to aid in future consumption and sale. While inventory is a necessary evil of any such business, it may be noted that the organizations hold inventories for various reasons, which include speculative purposes, functional purposes, physical necessities etc. From the above definition the following points stand out with reference to inventory:

All organizations engaged in production or sale of products hold inventory in one form or other. Inventory can be in complete state or incomplete state. Inventory is held to facilitate future consumption, sale or further processing/value addition.

All inventoried resources have economic value and can be considered as assets of the organization.

Different Types of Inventory

Inventory of materials occurs at various stages and departments of an organization. A manufacturing organization holds inventory of raw materials and consumables required for production. It also holds inventory of semi-finished goods at various stages in the plant with various departments. Finished goods inventory is held at plant, FG Stores, distribution centers etc. Further both raw materials and finished goods those that are in transit at various locations also form a part of inventory depending upon who owns the inventory at the particular juncture. Finished goods inventory is held by the organization at various stocking points or with dealers and stockiest until it reaches the market and end customers. Besides Raw materials and finished goods, organizations also hold inventories of spare parts to service the products. Defective products, defective parts and scrap also forms a part of inventory as long as these items are inventoried in the books of the company and have economic value.

Types of Inventory by Function

INPUT Raw Materials Consumables required for processing. Eg : Fuel, Stationary, Bolts & Nuts etc. required in manufacturing Maintenance Items/Consumables Packing Materials

PROCESS Work In Process Semi Finished Production in various stages, lying with various departments like Production, WIP Stores, QC, Final Assembly, Paint Shop, Packing, Outbound Store etc. Production Waste and Scrap

OUTPUT Finished Goods Finished Goods at Distribution Centers through out Supply Chain

Finished Goods in transit Finished Goods with Stockiest and Dealers Spare Parts Stocks & Bought Out items Defectives, Rejects

Rejections and Defectives

Local purchased Items required for production

and Sales Returns Repaired Stock and Parts Sales Promotion & Sample Stocks

Receivables Management

Receivables Management
Managing and collecting commercial receivables (unpaid receivables between companies or organisations) is linked to the credit insurance business and the information business. Coface has succeeded in considerably reducing its claims expenses by setting up efficient receivables management processes, developing excellent knowledge of local payment and collection regulations and practices, accurately predicting the commercial and financial behaviour of buyers throughout the world and closely monitoring changes in their behaviour. Coface RBI (Recovery Business Intelligence) provides a tailor-made service for the recovery of large trade debts in all countries. In the field of debt collection, Coface RBI responds to the needs of credit managers and financial groups with regard to atypical or complex transactions. Collecting debts is a full time job that requires experienced, fully trained and efficient resources. Coface allows you to take advantage of its negotiating skills and legal expertise to collect cash on your behalf, either in our name or yours, on a confidential basis. You can benefit from our experience and recognition in this field: - Better manage your amount of outstandings, - Maintain your trading relationship with a valued customer either on domestic or international level - Be fully informed of progress, - Get liquidity and cash flow - Increase own company financial attractiveness - Save personal resources

Money Market Instruments.

Money Market Instruments provide the tools by which one can operate in the money market. Types Of Money Market Instruments Treasury Bills: The Treasury bills are short-term money market instrument that mature in a year or less than that. The purchase price is less than the face value. At maturity the government pays the Treasury Bill holder the full face value.The Treasury Bills are marketable, affordable and risk free. The security attached to the treasury bills comes at the cost of very low returns. Certificate of Deposit: The certificates of deposit are basically time deposits that are issued by the commercial banks with maturity periods ranging from 3 months to five years. The return on the certificate of deposit is higher than the Treasury Bills because it assumes a higher level of risk. Advantages of Certificate of Deposit as a money market instrument 1. Since one can know the returns from before, the certificates of deposits are considered much safe. 2. One can earn more as compared to depositing money in savings account. 3. The Federal Insurance Corporation guarantees the investments in the certificate of deposit. Disadvantages of Certificate of deposit as a money market instrument: 1. As compared to other investments the returns is less. 2. The money is tied along with the long maturity period of the Certificate of Deposit. Huge penalties are paid if one gets out of it before maturity.

 Commercial Paper: Commercial Paper is short-term loan that is issued by a corporation use for financing accounts receivable and inventories. Commercial Papers have higher denominations as compared to the Treasury Bills and the Certificate of Deposit. The maturity period of Commercial Papers are a maximum of 9 months. They are very safe since the financial situation of the corporation can be anticipated over a few months. Banker's Acceptance: It is a short-term credit investment. It is guaranteed by a bank to make payments. The Banker's Acceptance is traded in the Secondary market. The banker's acceptance is mostly used to finance exports, imports and other transactions in goods. The banker's acceptance need not be held till the maturity date but the holder has the option to sell it off in the secondary market whenever he finds it suitable. Euro Dollars: The Eurodollars are basically dollar- denominated deposits that are held in banks outside the United States. Since the Eurodollar market is free from any stringent regulations, the banks can operate at narrower margins as compared to the banks in U.S. The Eurodollars are traded at very high denominations and mature before six months. The Eurodollar market is within the reach of large institutions only and individual investors can access it only through money market funds. Repos: The Repo or the repurchase agreement is used by the government security holder when he sells the security to a lender and promises to repurchase from him overnight. Hence the Repos have terms raging from 1 night to 30 days. They are very safe due government backing.

Unit - 4 Mergers and Acquisitions :

An entrepreneur may grow its business either by internal expansion or by external expansion. In the case of internal expansion, a firm grows gradually over time in the normal course of the business, through acquisition of new assets, replacement of the technologically obsolete equipments and the establishment of new lines of products. But in external expansion, a firm acquires a running business and grows overnight through corporate combinations. These combinations are in the form of mergers, acquisitions, amalgamations and takeovers and have now become important features of corporate restructuring. They have been playing an important role in the external growth of a number of leading companies the world over. They have become popular because of the enhanced competition, breaking of trade barriers, free flow of capital across countries and globalisation of businesses. In the wake of economic reforms, Indian industries have also started restructuring their operations around their core business activities through acquisition and takeovers because of their increasing exposure to competition both domestically and internationally. Mergers and acquisitions are strategic decisions taken for maximisation of a company's growth by enhancing its production and marketing operations. They are being used in a wide array of fields such as information technology, telecommunications, and business process outsourcing as well as in traditional businesses in order to gain strength, expand the customer base, cut competition or enter into a new market or product segment. Mergers or Amalgamations A merger is a combination of two or more businesses into one business. Laws in India use the term 'amalgamation' for merger. The Income Tax Act,1961 [Section 2(1A)] defines amalgamation as the merger of one or more companies with another or the merger of two or more companies to form a new company, in such a way that all assets and liabilities of the amalgamating companies become assets and liabilities of the amalgamated company and shareholders not less than nine-tenths in value of the shares in the amalgamating company or companies become shareholders of the amalgamated company. Thus, mergers or amalgamations may take two forms:

Merger through Absorption:- An absorption is a combination of two or more companies into an 'existing company'. All companies except one lose their identity in such a merger. For example, absorption of Tata Fertilisers Ltd (TFL) by Tata Chemicals Ltd. (TCL). TCL, an acquiring company (a buyer), survived after merger while TFL, an acquired company (a seller), ceased to exist. TFL transferred its assets, liabilities and shares to TCL. Merger through Consolidation:- A consolidation is a combination of two or more companies into a 'new company'. In this form of merger, all companies are legally dissolved and a new entity is created. Here, the acquired company transfers its assets, liabilities and shares to the acquiring company for cash or exchange of shares. For

example, merger of Hindustan Computers Ltd, Hindustan Instruments Ltd, Indian Software Company Ltd and Indian Reprographics Ltd into an entirely new company called HCL Ltd. A fundamental characteristic of merger (either through absorption or consolidation) is that the acquiring company (existing or new) takes over the ownership of other companies and combines their operations with its own operations. Besides, there are three major types of mergers:

Horizontal merger:- is a combination of two or more firms in the same area of business. For example, combining of two book publishers or two luggage manufacturing companies to gain dominant market share. Vertical merger:- is a combination of two or more firms involved in different stages of production or distribution of the same product. For example, joining of a TV manufacturing(assembling) company and a TV marketing company or joining of a spinning company and a weaving company. Vertical merger may take the form of forward or backward merger. When a company combines with the supplier of material, it is called backward merger and when it combines with the customer, it is known as forward merger. Conglomerate merger:- is a combination of firms engaged in unrelated lines of business activity. For example, merging of different businesses like manufacturing of cement products, fertilizer products, electronic products, insurance investment and advertising agencies. L&T and Voltas Ltd are examples of such mergers.

Acquisitions and Takeovers An acquisition may be defined as an act of acquiring effective control by one company over assets or management of another company without any combination of companies. Thus, in an acquisition two or more companies may remain independent, separate legal entities, but there may be a change in control of the companies. When an acquisition is 'forced' or 'unwilling', it is called a takeover. In an unwilling acquisition, the management of 'target' company would oppose a move of being taken over. But, when managements of acquiring and target companies mutually and willingly agree for the takeover, it is called acquisition or friendly takeover. Under the Monopolies and Restrictive Practices Act, takeover meant acquisition of not less than 25 percent of the voting power in a company. While in the Companies Act (Section 372), a company's investment in the shares of another company in excess of 10 percent of the subscribed capital can result in takeovers. An acquisition or takeover does not necessarily entail full legal control. A company can also have effective control over another company by holding a minority ownership. Advantages of Mergers & Acquisitions The most common motives and advantages of mergers and acquisitions are:-

Accelerating a company's growth, particularly when its internal growth is constrained due to paucity of resources. Internal growth requires that a company should develop its operating facilities- manufacturing, research, marketing, etc. But, lack or inadequacy of resources and time needed for internal development may constrain a company's pace of growth. Hence, a company can acquire production facilities as well as other resources from outside through mergers and acquisitions. Specially, for entering in new products/markets, the company may lack technical skills and may require special marketing skills and a wide distribution network to access different segments of markets. The company can acquire existing company or companies with requisite infrastructure and skills and grow quickly. Enhancing profitability because a combination of two or more companies may result in more than average profitability due to cost reduction and efficient utilization of resources. This may happen because of:-

Economies of scale:- arise when increase in the volume of production leads to a reduction in the cost of production per unit. This is because, with merger, fixed costs are distributed over a large volume of production causing the unit cost of production to decline. Economies of scale may also arise from other indivisibilities such as production facilities, management functions and management resources and systems. This is because a given function, facility or resource is utilized for a large scale of operations by the combined firm. Operating economies:- arise because, a combination of two or more firms may result in cost reduction due to operating economies. In other words, a combined firm may avoid or reduce over-lapping functions and consolidate its management functions such as manufacturing, marketing, R&D and thus reduce operating costs. For example, a combined firm may eliminate duplicate channels of distribution, or crate a centralized training center, or introduce an integrated planning and control system. Synergy:- implies a situation where the combined firm is more valuable than the sum of the individual combining firms. It refers to benefits other than those related to economies of scale. Operating economies are one form of synergy benefits. But apart from operating economies, synergy may also arise from enhanced managerial capabilities, creativity, innovativeness, R&D and market coverage capacity due to the complementarity of resources and skills and a widened horizon of opportunities.

Diversifying the risks of the company, particularly when it acquires those businesses whose income streams are not correlated. Diversification implies growth through the combination of firms in unrelated businesses. It results in reduction of total risks through substantial reduction of cyclicality of operations. The combination of management and other systems strengthen the capacity of the combined firm to withstand the severity of the unforeseen economic factors which could otherwise endanger the survival of the individual companies.

A merger may result in financial synergy and benefits for the firm in many ways:-

By eliminating financial constraints By enhancing debt capacity. This is because a merger of two companies can bring stability of cash flows which in turn reduces the risk of insolvency and enhances the capacity of the new entity to service a larger amount of debt By lowering the financial costs. This is because due to financial stability, the merged firm is able to borrow at a lower rate of interest.

Limiting the severity of competition by increasing the company's market power. A merger can increase the market share of the merged firm. This improves the profitability of the firm due to economies of scale. The bargaining power of the firm vis--vis labour, suppliers and buyers is also enhanced. The merged firm can exploit technological breakthroughs against obsolescence and price wars.

Procedure for evaluating the decision for mergers and acquisitions The three important steps involved in the analysis of mergers and acquisitions are:

Planning:- of acquisition will require the analysis of industry-specific and firm-specific information. The acquiring firm should review its objective of acquisition in the context of its strengths and weaknesses and corporate goals. It will need industry data on market growth, nature of competition, ease of entry, capital and labour intensity, degree of regulation, etc. This will help in indicating the product-market strategies that are appropriate for the company. It will also help the firm in identifying the business units that should be dropped or added. On the other hand, the target firm will need information about quality of management, market share and size, capital structure, profitability, production and marketing capabilities, etc. Search and Screening:- Search focuses on how and where to look for suitable candidates for acquisition. Screening process short-lists a few candidates from many available and obtains detailed information about each of them. Financial Evaluation:- of a merger is needed to determine the earnings and cash flows, areas of risk, the maximum price payable to the target company and the best way to finance the merger. In a competitive market situation, the current market value is the correct and fair value of the share of the target firm. The target firm will not accept any offer below the current market value of its share. The target firm may, in fact, expect the offer price to be more than the current market value of its share since it may expect that merger benefits will accrue to the acquiring firm. A merger is said to be at a premium when the offer price is higher than the target firm's pre-merger market value. The acquiring firm may have to pay premium as an incentive to

target firm's shareholders to induce them to sell their shares so that it (acquiring firm) is able to obtain the control of the target firm. Regulations for Mergers & Acquisitions Mergers and acquisitions are regulated under various laws in India. The objective of the laws is to make these deals transparent and protect the interest of all shareholders. They are regulated through the provisions of :

The Companies Act, 1956 The Act lays down the legal procedures for mergers or acquisitions :

Permission for merger:- Two or more companies can amalgamate only when the amalgamation is permitted under their memorandum of association. Also, the acquiring company should have the permission in its object clause to carry on the business of the acquired company. In the absence of these provisions in the memorandum of association, it is necessary to seek the permission of the shareholders, board of directors and the Company Law Board before affecting the merger. Information to the stock exchange:- The acquiring and the acquired companies should inform the stock exchanges (where they are listed) about the merger. Approval of board of directors:- The board of directors of the individual companies should approve the draft proposal for amalgamation and authorise the managements of the companies to further pursue the proposal. Application in the High Court:- An application for approving the draft amalgamation proposal duly approved by the board of directors of the individual companies should be made to the High Court. Shareholders' and creators' meetings:- The individual companies should hold separate meetings of their shareholders and creditors for approving the amalgamation scheme. At least, 75 percent of shareholders and creditors in separate meeting, voting in person or by proxy, must accord their approval to the scheme. Sanction by the High Court:- After the approval of the shareholders and creditors, on the petitions of the companies, the High Court will pass an order, sanctioning the amalgamation scheme after it is satisfied that the scheme is fair and reasonable. The date of the court's hearing will be published in two newspapers, and also, the regional director of the Company Law Board will be intimated. Filing of the Court order:- After the Court order, its certified true copies will be filed with the Registrar of Companies.

Transfer of assets and liabilities:- The assets and liabilities of the acquired company will be transferred to the acquiring company in accordance with the approved scheme, with effect from the specified date. Payment by cash or securities:- As per the proposal, the acquiring company will exchange shares and debentures and/or cash for the shares and debentures of the acquired company. These securities will be listed on the stock exchange.

NPV of a Merger
osts and Benefits of Merger When a company A acquires another company say B, then it is a capital investment decision for company A and it is a capital disinvestment decision for company B. Thus, both the companies need to calculate the Net Present Value (NPV) of their decisions. To calculate the NPV to company A there is a need to calculate the benefit and cost of the merger. The benefit of the merger is equal to the difference between the value of the combined identity (PVAB) and the sum of the value of both firms as a separate entity. It can be expressed as Benefit = (PVAB) (PVA+ PVB) Assuming that compensation to firm B is paid in cash, the cost of the merger from the point of view of firm A can be calculated as Cost= Cash - PVB Thus NPV for A = Benefit Cost = (PVAB (PVA + PVB)) (Cash PVB) the net present value of the merger from the point of view of firm B is the same as the cost of the merger for A. Hence, NPV to B = (Cash - PVB) NPV of A and B in case the compensation is in stock In the above scenario we assumed that compensation is paid in cash, however in real life compensation is paid in terms of stock. In that case, cost of the merger needs to be calculated caarefully. It is explained with the help of an illustration Firm A plans to acquire firm B. Following are the statistics of firms before the merger Market price per share Number of Shares Market value of the firm A Rs.50 500,000 Rs.25 B Rs.20 250,000 Rs.5

million

million

The merger is expected to bring gains, which have a PV of Rs.5 million. Firm A offers 125,000 shares in exchange for 250,000 shares to the shareholders of firm B. The cost in this case is defined as Cost = PVAB - PVB Where a represents the fraction of the combined entity received by shareholders of B. In the above example, the share of B in the combined entity is = 125,000 / (500,000 + 125,000) = 0.2 assuming that the market value of the combined entity will be equal to the sum of present value of the separate entities and the benefit of merger. Then,
PVAB = PVA+ PVB+ Benefit = 25 Cost = PVAB - PVB =

+ 5 + 5 = Rs.35 million

0.2 x 35 5= Rs.2 million

thus NPV to A =Benefit Cost = 5 2 = Rs.3 million NPV to B = Cost to A = Rs 2 million

Defensive Strategies to prevent take over attempts

Other Takeover Defenses Poison pill is sometimes used more broadly to describe other types of takeover defenses that involve the target taking some action. Although the broad category of t a k e o v e r d e f e n s e s ( m o r e c o m m o n l y k n o w n a s " s h a r k r e p e l l e n t s " ) i n c l u d e s t h e traditional shareholder rights plan poison pill. Other anti-takeover protections include: Classified boards with staggered terms. Limitations on the ability to call special meetings or take action by written consent. Supermajority vote requirements to approve mergers. Supermajority vote requirements to remove directors. The target adds to its charter a provision which gives the c u r r e n t shareholders the right to sell their shares to the acquirer at an increased price(usually 100% above recent average share price), if the acquirer's share of the company reaches a

critical limit (usually one third). This kind of poison p i l l c a n n o t s t o p a d e t e r m i n e d a c q u i r e r , b u t e n s u r e s a h i g h p r i c e f o r t h e company. The target takes on largedebtsin an effort to make the debt load too high to be attractivethe acquirer would eventually have to pay the debts. T h e c o m p a n y b u y s a n u m b e r o f s m a l l e r c o m p a n i e s u s i n g a stock swap ,diluting the value of the target's stock. The target grants its employees stock optionsthat immediately vest if thecompany is taken over. This is intended to give employees an incentive to continue working for the target company at least until a merger is completedi n s t e a d o f l o o k i n g f o r a n e w j o b a s s o o n a s t a k e o v e r discussions begin H o w e v e r , w i t h t h e r e l e a s e o f t h e " golden handcuffs", many discontentedemployees may quit immediately after they've cashed in their stock options.This poison pill may create an exodus of talented employees. In many high-tech businesses, attrition of talentedhuman resourcesoften means an emptyshell is left behind for the new owner. Peoplesoftguaranteed its customers in June 2003 that if it were acquiredwithin two years, presumably by its rivalOracle Corporation, and products u p p o r t w e r e r e d u c e d w i t h i n f o u r years, its customers would receive a r e f u n d o f b e t w e e n t w o a n d f i v e t i m e s t h e f e e s t h e y h a d p a i d f o r t h e i r Peoplesoft software licenses. The hypothetical cost to Oracle was valued atas much as US$1.5 billion. Peoplesoft allowed the guarantee to expire inA p r i l 2 0 0 4 . I f P e o p l e S o f t h a d n o t p r e p a r e d i t s e l f b y a d o p t i n g e f f e c t i v e takeover defenses, it is unclear if Oracle would have significantly raised itsoriginal bid of $16 per share. The increased bid provided an additional $4.1 billion for PeopleSoft's shareholders. The practice of having staggered elections for the board of directors . F o r example, if a company had nine directors, then three directors would be upf o r r e - e l e c t i o n e a c h y e a r , w i t h a t h r e e - y e a r t e r m . T h i s w o u l d p r e s e n t a potential acquirer with the position of having a hostile board for at least ayear after the first election. In some companies, certain percentages of the board (33%) may be enough to block key decisions (such as a full merger agreement or major asset sale), so an acquirer may not be able to close anacquisition for years after having purchased a majority of the target's stock.As of December 31, 2008, 47.05% of the companies in the S&P Super 1500had a classified board Recent Developments Shareholder Input on Poison PillsM o r e c o m p a n i e s a r e g i v i n g s h a r e h o l d e r s a s a y o n poison pills. According to F a c t S e t S h a r k R e p e l l e n t d a t a , s o f a r t h i s y e a r 2 1 c o m p a n i e s t h a t a d o p t e d o r extended a poison pill have publicly disclosed they plan to put the poison pill to ashareholder vote within a year. That's already more than 2008's full year total of 18and in fact is the most in any year since the first poison pill was adopted in the early 1980s.

Leveraged Buy outs Spin-offs and Restructurings

Spin-Offs and Split-Offs

Spin-Offs
In a spin-off, the parent company (ParentCo) distributes to its existing shareholders new shares in a subsidiary, thereby creating a separate legal entity with its own management team and board of directors. The distribution is conducted pro-rata, such that each existing shareholder receives stock of the subsidiary in proportion to the amount of parent company stock already held. No cash changes hands, and the shareholders of the original parent company become the shareholders of the newly spun company (SpinCo).

Strategic Rationale
Divesting a subsidiary can achieve a variety of strategic objectives, such as:

Unlocking hidden value Establish a public market valuation for undervalued assets and create a pure-play entity that is transparent and easier to value Undiversification Divest non-core businesses and sharpen strategic focus when direct sale to a strategic or financial buyer is either not compelling or not possible Institutional sponsorship Promote equity research coverage and ownership by sophisticated institutional investors, either of which tend to validate SpinCo as a standalone business Public currency Create a public currency for acquisitions and stock-based compensation programs Motivating management Improve performance by better aligning management incentives with SpinCo's performance (using SpinCo, rather than ParentCo, stock-based awards), creating direct accountability to public shareholders, and increasing transparency into management performance Eliminating dissynergies Reduce bureaucracy and give SpinCo management complete autonomy Anti-trust Break up a business in response to anti-trust concerns

Corporate defense Divest "crown jewel" assets to make a hostile takeover of ParentCo less attractive

Transaction Structure
In general, there are four ways to execute a spin-off:

Regular spin-off Completed all at once in a 100% distribution to shareholders Majority spin-off Parent retains a minority interest (< 20%) in SpinCo and distributes the majority of the SpinCo stock to shareholders Equity carve out (IPO) / spin-off Implemented as a second step following an earlier equity carve-out of less than 20% of the voting control of the subsidiary Reverse Morris Trust Implemented as a first step immediately preceding a Reverse Morris Trust transaction

ParentCo's existing credit agreements may impose restrictions on divestitures that are material in nature. It is important to determine if any credit terms will be violated if ParentCo spins off a subsidiary that materially contributes to its business.

Tax Implications
A spin-off is usually tax-free under Internal Revenue Code (IRC) Section 355, meaning that no taxable gain is recognized by either the parent entity or the parent's existing shareholders. To qualify for favorable tax treatment, the spin-off must meet the requirements of Section 355:

The parent and subsidiary must both have been engaged in an "active trade or business" the entire 5 years preceding the spin-off, and neither entity may have been acquired during that period in a taxable transaction. ParentCo and SpinCo must continue in an active trade or business following separation. ParentCo must have tax control before the spin-off, defined as ownership of at least 80% of the vote and value of all classes of subsidiary stock. ParentCo must relinquish tax control as a result of the spin-off (< 80% vote and value). The spin-off must have a valid business purpose, and cannot be used as a "device" to distribute earnings (dividends). The parent's shareholders, collectively, must retain continuity of interest in both parent and subsidiary for a 4-year period beginning 2 years before the spin-off by maintaining 50% equity ownership interest in both companies (a change in control of either ParentCo or SpinCo during this period could trigger a tax liability for the ParentCo). This is the anti-Morris Trust rule.

If the unusual event that a spin-off does not qualify for tax-free treatment, there are two levels of tax:

Ordinary income at the shareholder level equal to the FMV of subsidiary stock received (similar to a dividend) and Capital gain on the sale of stock at the parent entity level equal to the FMV of subsidiary stock distributed less the parent's inside basis in that stock.

Any cash received by shareholders in lieu of fractional shares of SpinCo is generally taxable to shareholders.

Accounting for Spin-Offs

From the announcement of the spin-off until the date it is completed, the parent accounts for the disposition of its subsidiary in a single line item on its balance sheet called Net Assets of Discontinued Operations, or similar. The parent also segregates the net income attributable to the subsidiary on its income statement in an account called Income from Discontinued Operations, or similar. The spin-off is recorded at book value on the transaction date as follows:
Parent's Journal Entry dr. Retained Earnings cr. Net Assets of Discontinued Operations Subsidiary's Journal Entry dr. Assets cr. Liabilities cr. Equity $$ $ $$ $ $$ $ $$ $ $$ $

Monetization Techniques
The parent company will often extract value from the subsidiary before spinning it off by levering up SpinCo and siphoning the cash proceeds as a special tax-free dividend (courtesy of the 100% DRD) or pushing down debt to SpinCo. The special dividend and amount of debt pushdown are both limited in size to ParentCo's inside basis in the subsidiary's assets. If either

exceeds the inside basis, the spin-off is taxable to the extent of the excess. The amount of debt ParentCo can push down to SpinCo is also limited by SpinCo's ability to service the debt. Exhibit 4.1 Monetization of Verizon's Spin-Off of Idearc The following is excerpted from an Idearc 8-K filing detailing its spin-off from Verizon, and outlines how Verizon monetized the spin-off: On November 17, 2006, Verizon Communications Inc. ("Verizon") spun off the companies that comprised its domestic print and Internet yellow pages directories publishing operations. In connection with the spin-off, Verizon transferred to Idearc Inc. ("Idearc") all of its ownership interest in Idearc Information Services LLC and other assets, liabilities, businesses and employees primarily related to Verizon's domestic print and Internet yellow pages directories publishing operations (the "Contribution"). The spin-off was completed by making a pro rata distribution to Verizon's shareholders of all of the outstanding shares of common stock of Idearc. In connection with the spin-off, on November 17, 2006, and in consideration for the Contribution, Idearc (1) issued to Verizon additional shares of Idearc common stock, (2) issued to Verizon $2.85 billion aggregate principal amount of Idearc's 8% senior notes due 2016 and $4.3 billion aggregate principal amount of loans under Idearc's tranche B term loan facility (collectively, the "Idearc Debt Obligations") and (3) transferred to Verizon approximately $2.4 billion in cash from cash on hand, from the proceeds of loans under Idearc's tranche A term loan facility and from the proceeds of the remaining portion of the loans under Idearc's tranche B term loan facility. Creative monetization techniques such as debt-for-debt and debt-for-equity swaps, or exchanges, allow ParentCo to extract value in excess of its basis in SpinCo's stock without affecting the taxfree nature of the spin-off.

Debt-for-Debt Swaps
In a debt-for-debt swap, the parent company (ParentCo) uses an investment bank as an intermediary to retire debt in connection with a spin-off. Generally speaking, a debt-for-debt swap is executed as follows:
1. ParentCo contributes assets to SpinCo in exchange for all of SpinCo's common stock and SpinCo notes 2. An investment bank purchases previously-issued ParentCo debt securities in the market 3. ParentCo swaps with the investment bank its SpinCo notes for a like amount of its own debt securities, which it then retires 4. The investment bank sells the SpinCo notes

A debt-for-equity swap is mechanically similar to a debt-for-debt swap, except that ParentCo swaps its SpinCo notes for ParentCo stock. Thus, the debt-for-equity swap resembles a stock repurchase rather than debt retirement.

Capital Markets Implications of Spin-Offs

The separate business entities created in a spin-off sometimes differ in many ways from the consolidated company, and may no longer be suitable investments for some original shareholders. Spun-off companies are often much smaller than their original parents, and are frequently characterized by higher growth. Institutional investors committed to specific investment styles (e.g. value, growth, large-cap, etc.) or subject to certain fiduciary restrictions may need to realign their holdings with their investment objectives following a spin-off by one of their portfolio companies. For example, index funds would be forced to indiscriminately sell SpinCo stock if SpinCo is not included in the particular index. As institutional investors "rotate out" of, or sell, their parent and/or new subsidiary stock, the stocks may face short-term downward pricing pressure lasting weeks or even months until the shareholder bases reach new equilibriums. Shareholder churn and the corresponding potential for short-term pricing pressure can affect timing of a spin-off when CEOs are sensitive to stock price performance. On the other hand, spin-offs are commonly executed in response to shareholder pressure to divest a subsidiary, perhaps because the hypothetical sum-of-the-parts valuation exceeds the current value of the consolidated enterprise. In these cases, the parent and/or new subsidiary stock may experience upward pricing pressure following a spin-off that mitigates downward pressure due to shareholder rotation. In the long run, stocks of the individual companies should theoretically trade higher in aggregate than stock of the consolidated company when the spin-off is well-received by investors. Also, when SpinCo is highly levered as a result of debt pushdown or loans incurred prior to spinoff, shareholder returns receive a boost when SpinCo generates returns in excess of its cost of capital. The effect is identical to how the use of leverage in LBO transactions magnifies returns to financial buyers.

Sponsored Spin-Offs
In a sponsored spin-off, a financial sponsor (e.g. private equity fund) generally makes a prearranged "anchor" investment in a newly spun company (SpinCo). Participation by a sophisticated investor is viewed favorably by the market because it validates SpinCo as a standalone business and serves as an endorsement of SpinCo's management team. The mechanics of a sponsored spin-off are similar to those in Morris Trust transactions. To qualify for tax-free treatment, the transaction must meet the conditions of Section 355 described above. Additionally, Section 355(e), known as the anti-Morris Trust rule, limits the sponsor's investment to less than 50% of the vote and value of SpinCo's outstanding stock when the investment is made in connection with the spin-off. In general, if the sponsor's participation

is arranged prior to or within 6 months after the spin-off, the sponsor can acquire no more than a minority interest in SpinCo without compromising the tax-free nature of the transaction. As a result of the Section 355(e) restriction, the sponsor will not have legal control over SpinCo following the investment. Also, unlike traditional privately held portfolio companies, SpinCo will be a public company subject to SEC reporting requirements whose share price will fluctuate in market. The sponsor has several exit options. If the sponsor's equity stake appreciates in value, it can readily sell the appreciated SpinCo shares in the market. If the shares decline in value and the sponsor continues to view SpinCo as a good investment, the sponsor may acquire additional shares at a low price and gain control of SpinCo following the 2-year waiting period, possibly even taking SpinCo private. The sponsored spin-off may be alternatively structured as an investment in ParentCo, rather than SpinCo. In this case, ParentCo would spin off assets not wanted by the sponsor prior to the sponsor's investment in ParentCo. Since any subsequent event compromising tax-free treatment of the original transaction would create a tax liability for ParentCo, the sponsor would be sure to include a tax indemnification clause in the transaction agreement. You can learn more about sponsored spin-offs in articles posted on TheDeal.com and AltAssets.com.

Split-Offs
In a split-off, the parent company offers its shareholders the opportunity to exchange their ParentCo shares for new shares of a subsidiary (SplitCo). This tender offer often includes a premium to encourage existing ParentCo shareholders to accept the offer. For example, ParentCo might offer its shareholders $11.00 worth of SplitCo stock in exchange for $10.00 of ParentCo stock (a 10% premium). If the tender offer is oversubscribed, meaning that more ParentCo shares are tendered than SplitCo shares are offered, the exchange is conducted on a pro-rata basis. If the tender offer is undersubscribed, meaning that too few ParentCo shareholders accept the tender offer, ParentCo will usually distribute the remaining unsubscribed SplitCo shares pro-rata via a spin-off. A split-off is viewed as a sale for accounting purposes with a recognized gain or loss equal to the difference between the market price of the new SplitCo stock issued and ParentCo's inside basis in SplitCo's assets. Because the split-off is tax-free, provided that it meets the requirements set forth by Section 355, there is no corresponding gain or loss recognized for tax purposes. The split-off is a tax-efficient way for ParentCo to redeem its shares. However, since split-offs require shareholders to tender their ParentCo shares to receive new shares of the subsidiary, they suffer from lower certainty of execution and are mechanically more complex relative to spinoffs. Another notable disadvantage of split-offs is the potential for shareholder lawsuits if the exchange ratio (premium) offered by ParentCo is deemed unfair by activist shareholders. On the

other hand, shareholder churn may be lower for a split-off than for a spin-off because the subscription feature of a split-off better aligns shareholders' preferences with their equity holdings than does a pro rata spin-off. An equity carve-out is typically executed ahead of a split-off to establish a public market valuation for SubCo's stock. Although the split-off can be conducted without a preceding carveout, execution is more challenging given the difficulty in measuring the appropriate premium without an established market value for SubCo. The preceding carve-out therefore all but eliminates the possibility of shareholder lawsuits related to the premium.

Fraudulent Conveyance
When SpinCo incurs a loan and dividends the proceeds to the ParentCo, as described above, creditor claims of fraudulent conveyance may arise if SpinCo later declares bankruptcy because it is unable to service its debt. Similar creditor claims may also arise if the spin-off leaves ParentCo insolvent. Therefore, it is necessary to ensure that both SpinCo and ParentCo are adequately capitalized following the spin-off.

Financial Distress Definition

Tight cash situation in which a business, household, or individual cannot pay the owed amounts on the due date. If prolonged, this situation can force the owing entity into bankruptcy or forced liquidation. It is compounded by the fact that banks and other financial institutions refuse to lend to those in serious distress. When a firm is under financial distress, the situation frequently sharply reduces its market value, suppliers of goods and services usually insist on COD terms, and large customer may cancel their orders in anticipation of not getting deliveries on time.

Reorganization of Firms.
By Shefali Anand and Nikita Garia Are you worried about what will happen to you, now that your company is being reorganized? If you wont be happy in the new role post-reorganization, then it might be time to explore life outside your company. Whether your company is undergoing a strategic restructuring, a cost-cutting exercise or has just been acquired by another company, a large-scale change can be a source of much stress for employees.

More In Career Journal

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Will I lose my job? How will the work environment change? Will I have a new boss? Could there be changes to my pay and benefits? are common questions that plague employees, says Len Gray, Asia Pacific leader for mergers-and-acquisition consulting at Mercer. These could be questions facing employees of securities firm MF Global Sify Securities India Pvt. right now, as their U.S. parent MF Global Holdings Ltd. recently went bankrupt. MF Global Sifys head has said the India unit is not affected, but its likely to find itself in the hands of new owners in the near future. While employees dont have much say in times of reorganization, it helps to brace yourself for what may lie ahead. Here are some tips to survive your companys reorganization: Get the facts straight: Instead of fretting about the unknown, try to get answers to the question about your future. A good starting point is to understand the managements vision after the restructuring or acquisition. Youve got to listen very carefully about what the company is saying, says Dony Kuriakose, director of Edge Executive Search Pvt., a Delhi-based search firm. For instance, if your company has been acquired because of its special expertise or its presence in a certain geographical area where the acquiring company isnt present, your unit is relatively secure. If its a pure growth play, youre not likely to lose your job, says Mr. Gray of Mercer. But if the purchasing company is not saying anything, or is giving a vague message, its potentially worrisome. If one company is acquiring another that is in the same business, theres a higher chance of layoffs. Look at the acquiring companys organization structure. If there are overlaps, those areas may be more at risk than others, says Mr. Gray. The Spiel: You can look for a companys message either in internal communications from your senior management or HR personnel, or in external communications, such as press releases, investor presentations, and interviews top management gives to the media. Sometimes company communication may not be specific or the individual may not be able to make a very robust deduction about their career, says Jayesh Pandey, India head for talent and

organization performance at consulting firm Accenture. He says its best to ask your boss directly about what you can expect. Self-Assessment: Its possible that your supervisor is unsure of all the upcoming changes, or specifically how your position will be impacted. In that case, do your own assessment of how vulnerable you are to potential job cuts. A stellar performance record and being in the good books of the managers makes you relatively safe. If you have some unique skills, it is that much more difficult for the company to get rid of you, says Mr. Kuriakose. On the other hand, if your skills are not up-to-date with the latest technology and knowledge in your industry, thats bad news. Some types of jobs are more susceptible to job losses than others. In a cost-cutting exercise, socalled cost overheads such as jobs of administration or finance are more likely to be cut versus jobs which bring revenue, such as sales directors. Suppose your division is poor-performing and is being shut down in this case the chances of survival are lower. For stellar performers, the company might provide an alternative career path, says Mr. Pandey. Sometimes companies cut staff based on the date of employment: newer employees are let go first. In mergers and acquisitions, management-level staff is at higher risk of losing jobs. There could be two people with equal capability but now the company has space only for one, says Subeer Bakshi, director of talent and rewards practice at consulting firm Towers Watson. While none of these are fool-proof ways of knowing your future, they can give you some idea of where you stand. Your options: If you are confident about being retained and happy with the new look of the company, great. But if you are not so sure about your job, or if you wont be happy in the new role postreorganization, then it might be time to explore life outside your company. If your self-assessment showed that your skills are not on track with what the job market needs, then consider a skill inventory build-up, says Mr. Pandey. This could involve taking up a training course, or joining a management program, or potentially moving to another function within your organization to add to your skills. If skills are not an issue, its time to look for a job.

Recruiters say that the stigma associated with being fired is slowly going away in corporate India because cost-cutting is happening in almost all industries. Its reasonable to say I lost my job in a restructuring, says Mr. Kuriakose of Edge. To separate the wheat from the chaff though, his recruitment firm usually asks for references from the candidates previous employer. Update your profile on LinkedIn, and go to as many networking events as possible. Most of the good people are already in touch with prospective employers, says Mr. Pandey. For the in-betweeners: If you are not sure whether youll be retained but not ready to move out if you can avoid it, your best bet is to stay focused on your job. If possible, with renewed enthusiasm. Employees who add value tend to survive better than those who complain or are too doubtful, says Mr. Bakshi of Towers Watson. Be open to change, and think of your companys reorganization as an opportunity to grow your career. If you are unwilling to change your own behavioryou will face a kind of career slowdown, says Mr. Pandey. Finally, network, network, network especially within your own company. If you arent already known by the managers and top leaders, make yourself more visible. If the company is still deciding on where the cuts will come, you still have a chance. Between the Johnny that you know and the Johnny that you dont know, youll likely keep the Johnny that you know, says Mr. Kuriakose.

Unit - 5 Financial Planning Model Financial Planning Model Your Gateway to Financial Happiness!
We hope that you are taking good care of your finances with manageME7. Most of the time we continue adhering to money management without realizing our future financial needs. Also, we do not emphasize much on various ways to achieve the financial goals and evaluate the planning criteria from time-to-time. Therefore, for making a sound proof plan, we had come up with a financial model in this particular edition, which would help you plan your expenses and provide you an optimum way to achieve your financial goals. With the help of financial planning model, you will be able to determine your financial troubles, look for the best strategies to achieve your financial goals and monitor the implemented strategy at frequent intervals. You may refer the following steps to achieve your financial goals which works as your financial planning model: 1. Identify your financial goals & objectives: The first step in the financial planning model is realization of your financial goals. To make it more simple for you, categorize your financial objectives into short term and long term goals. For example - saving money for buying a house can be a long term goal and a short term goal is can be your planning for a trip in the year end. If you have set clear financial objectives in front of you, it becomes easier for you to achieve them.

2. Identify the hurdles in achieving the financial goals: The next step in the model is to identify the hurdles you face in achieving your financial goals. For example, a sudden increase in the rate of interest may compel you to pay more on monthly EMIs. You need to consider every factor that acts as a boulder in achieving your financial goals.

3. Look for all possible alternatives: The third step is to look for various remedies which can help you achieve your financial goals with minimum effort in less time. For instance - for buying a home, you may stick to the monthly saving rule or can choose one among a number of credit giving companies for the application of home loan. Accordingly, you can look for various other alternatives that can help you in achieving your financial goals. 4. Choose the best alternative: Based upon the assessment of previous steps, you need to choose one optimum alternative. This step is very crucial because it is the final strategy which will be helping you in accomplishing your financial goals. We should dig all pros and cons of every alternative we have been provided before actually finalizing the best solution, as this would help us to achieve our financial goals more effectively. 5. Implement the selected alternative: In this step, simply you need to implement the best remedy to achieve your financial goals and adhere to it on regular basis.

6. Monitor and Evaluate the results: This is the last and final step that should never be ignored by you. You need to decide the time lines for evaluating the performance of the alternatives you have implemented so far . This would help you to know whether you are following the right path or moving towards the wrong direction. If the performance is good and you have achieved your goal, you can plan for your next financial goals wherein you will need to follow the same steps again, right from the beginning of the financial planning model. Or else, if you have not achieved the desired result by implementing the best solutions, then you need to look for the loopholes. When you come to know that you can not reap the benefits from the implemented alternatives, you need to follow step 3 again and look for other alternatives which can help you in achieving your financial goals.

Percent of Sales Method Percentage of Sales Method

The Percentage of Sales Method is a Financial Forecasting approach which is based on the premise that most Balance Sheet and Income Statement Accounts vary with sales. Therefore, the key driver of this method is the Sales Forecast and based upon this, Pro-Forma Financial Statements (i.e., forecasted) can be constructed and the firms needs for external financing can be identified. The calculations illustrated on this page will refer to the Balance Sheet and Income Statement which follow. The forecasted Sales growth rate in this example is 25%
Balance Sheet ($ in Millions) Assets Current Assets Cash Accounts Receivable Inventory 200 400 600 1999 Liabilities and Owners' Equity Current Liabilities Accounts Payable Notes Payable Total Current Liabilities 400 400 800 Sales Cost of Goods Sold Taxable Income Taxes Net Income Dividends 500 500 Addition to Retained Earnings 1999 Income Statement ($ in Millions) 199 9 120 0 900 300 90 210 70 140

Total Current Assets1200 Long-Term Liabilities Long-Term Debt Fixed Assets Net Fixed Assests 800 Total Long-Term Liabilities Owners' Equity Common Stock ($1 300 Par) Retained Earnings 400

Total Owners' Equity Total Assets 2000 Total Liab. and Owners' Equity

700 2000

Percentages of Sales
The first step is to express the Balance Sheet and Income Statement accounts which vary directly with Sales as percentages of Sales. This is done by dividing the balance for these accounts for the current year (1999) by sales revenue for the current year. The Balance Sheet accounts which generally vary closely with Sales are Cash, Accounts Receivable, Inventory, and Accounts Payable. Fixed Assets are also often tied closely to Sales, unless there is excess capacity. (The issue of excess capacity will be addressed in External Financing Needed section.) For this example, we will assume that Fixed Assets are currently at full capacity and, thus, will vary directly will sales. Retained Earnings on the Balance Sheet represent the cumulative total of the firm's earnings which have been reinvested in the firm. Thus, the change in this account is linked to Sales; however, the link comes from relationship betwen Sales growth and Earnings The Notes Payable, Long-Term Debt, and Common Stock accounts do not vary automatically with Sales. The changes in these accounts depend upon how the firm chooses to raise the funds needed to support the forecasted growth in Sales. On the Income Statement, Costs are expressed as a percentage of Sales. Since we are assuming that all costs remain at a fixed percentage of Sales, Net Income can be expressed as a percentage of Sales. This indicates the Profit Margin. Taxes are expressed as a percentage of Taxable Income (to determine the tax rate). Dividends and Addition to Retained Earnings are expressed as a percentage of Net Income to determine the Payout and Retention Ratios respectively.

Determinants of growth

The Fundamental Determinants of Growth

With both historical and analyst estimates, growth is an exogenous variable that affects value but is divorced from the operating details of the firm. The soundest way of incorporating growth into value is to make it endogenous, i.e., to make it a function of how much a firm reinvests for future

growth and the quality of its reinvestment. We will begin by considering the relationship between fundamentals and growth in equity income, and then move on to look at the determinants of growth in operating income.

Growth In Equity Earnings

When estimating cash flows to equity, we usually begin with estimates of net income, if we are valuing equity in the aggregate, or earnings per share, if we are valuing equity per share. In this section, we will begin by presenting the fundamentals that determine expected growth in earnings per share and then move on to consider a more expanded version of the model that looks at growth in net income.

Growth in Earnings Per Share

The simplest relationship determining growth is one based upon the retention ratio (percentage of earnings retained in the firm) and the return on equity on its projects. Firms that have higher retention ratios and earn higher returns on equity should have much higher growth rates in earnings per share than firms that do not share these characteristics. To establish this, note that

where, gt = Growth Rate in Net Income NIt = Net Income in year t Given the definition of return on equity, the net income in year t-1 can be written as:

where,

ROEt-1 = Return on equity in year t-1 The net income in year t can be written as:

Assuming that the return on equity is unchanged, i.e., ROE t = ROEt-1 =ROE,

where b is the retention ratio. Note that the firm is not being allowed to raise equity by issuing new shares. Consequently, the growth rate in net income and the growth rate in earnings per share are the same in this formulation. Illustration 11.5: Growth in Earnings Per Share In this illustration, we will consider the expected growth rate in earnings based upon the retention ratio and return on equity for three firms Consolidated Edison, a regulated utility that provides power to New York City and its environs, Procter & Gamble, a leading brand-name consumer product firm and Reliance Industries, a large Indian manufacturing firm. In Table 11.5, we summarize the returns on equity, retention ratios and expected growth rates in earnings for the three firms.

Table 11.5: Fundamental Growth Rates in Earnings per Share

Return on Consolidated Edison Equity 11.63% 29.37% 19.43% Retention Ratio 29.96% 49.29% 82.57% Expected Growth Rate 3.49% 14.48% 16.04%

Procter & Gamble

Reliance Industries

Reliance has the highest expected growth rate in earnings per share, assuming that it can maintain its current return on equity and retention ratio. Procter & Gamble also can be expected

to post a healthy growth rate, notwithstanding the fact that it pays out more than 50% of its earnings as dividends, because of its high return on equity. Co Ed, on the other hand, has a very low expected growth rate because its return on equity and retention ratio are anemic.

Growth in Net Income

If we relax the assumption that the only source of equity is retained earnings, the growth in net income can be different from the growth in earnings per share. Intuitively, note that a firm can grow net income significantly by issuing new equity to fund new projects while earnings per share stagnates. To derive the relationship between net income growth and fundamentals, we need a measure of how investment that goes beyond retained earnings. One way to obtain such a measure is to estimate directly how much equity the firm reinvests back into its businesses in the form of net capital expenditures and investments in working capital. Equity reinvested in business = (Capital Expenditures Depreciation + Change in Working Capital (New Debt Issued Debt Repaid)) Dividing this number by the net income gives us a much broader measure of the equity reinvestment rate: Equity Reinvestment Rate = Unlike the retention ratio, this number can be well in excess of 100% because firms can raise new equity. The expected growth in net income can then be written as: Expected Growth in Net Income = Illustration 11.6: Growth in Net Income

To estimate growth in operating income based upon fundamentals, we look at three firms Coca Cola, Nestle and Sony. In Table 11.6, we first estimate the components of equity reinvestment and use it to estimate the reinvestment rate for each of the firms. We also present the return on equity and the expected growth rate in net income at each of these firms.

Table 11.6: Expected Growth in Net Income

Change in Net Debt Net Coca Cola Nestle Sony Income $ 2177 m SFr 5763m JY 30.24b Net Cap Working Ex 468 2470 26.29 Capital 852 368 -4.1 Issued (paid) -$104.00 272 3.96 Equity Reinvestm ent Rate 65.41% 44.53% 60.28% ROE 23.12 % 21.20 % 1.80% Expected Growth Rate 15.12% 9.44% 1.09%

The pluses and minuses of this approach are visible in the table above. The approach much more accurately captures the true reinvestment in the firm by focusing not on what was retained but on what was reinvested. The limitation of the approach is that the ingredients that go into the reinvestment capital expenditures, working capital change and net debt issued are all volatile numbers. Note that Coca Cola paid off debt last year, while reinvesting back into the business and Sonys working capital dropped. In fact, it would probably be much more realistic to look at the average reinvestment rate over three or five years, rather than just the current year. We will return to examine this question in more depth when we look at growth in operating income.

Determinants of Return on Equity

Both earnings per share and net income growth are affected by the return on equity of a firm. The return on equity is affected by the leverage decisions of the firm. In the broadest terms, increasing leverage will lead to a higher return on equity if the pre-interest, after-tax return on capital exceeds the after-tax interest rate paid on debt. This is captured in the following formulation of return on equity:

where,

t = Tax rate on ordinary income The derivation is simple1[1]. Using this expanded version of ROE, the growth rate can be written as:

The advantage of this formulation is that it allows explicitly for changes in leverage and the consequent effects on growth. Illustration 11.7: Breaking down Return on Equity To consider the components of return on equity, we look, in Table 11.7, at Con Ed, Procter & Gamble and Reliance Industries, three firms whose returns on equity we looked at in Illustration 11.5.

Table 11.7: Components of Return on Equity

Book ROC Consolidated Edison Procter & Gamble Reliance 8.76% 75.72% 17.77% 77.80% 10.24% 94.24% D/E

Book Interest rate 7.76% 5.95% 8.65%

Tax Rate ROE

35.91% 11.63% 36.02% 28.63% 2.37% 11.94%

Comparing these numbers to those reported in Illustration 11.5, you will note that the return on equity is identical for Con Ed but significantly lower here for the other two firms. This is because
1

both Procter & Gamble and Reliance posted significant non-operating profits. We have chosen to consider only operating income in the return on capital computation. To the extent that firms routinely report non-operating income, you could modify the return on capital. The decomposition of return on equity for Reliance suggests a couple of areas of concern. One is that the high return on equity in Illustration 11.5 reported by the firm is driven by three factors high leverage, a significant non-operating profit and a low tax rate. If the firm loses its tax breaks and the sources of non-operating income dry up, the firm could very easily find itself with a return on capital that is lower than its book interest rate. If this occurs, leverage could bring down the return on equity of the firm.
Average and Marginal Returns The return on equity is conventionally measured by dividing the net income in the most recent year by the book value of equity at the end of the previous year. Consequently, the return on equity measures both the quality of both older projects that have been on the books for a substantial period and new projects from more recent periods. Since older investments represent a significant portion of the earnings, the average returns may not shift substantially for larger firms that are facing a decline in returns on new investments, either because of market saturation or competition. In other words, poor returns on new projects will have a lagged effect on the measured returns. In valuation, it is the returns that firms are making on their newer investments that convey the most information about a quality of a firms projects. To measure these returns, we could compute a marginal return on equity by dividing the change in net income in the most recent year by the change in book value of equity in the prior year:

Marginal Return on Equity = For example, Reliance Industries reported net income of Rs 24033 million in 2000 on book value of equity of Rs 123693 million in 1999, resulting in an average return on equity of 19.43%: Average Return on Equity = 24033/123693 = 19.43%

The marginal return on equity is computed below: Change in net income from 1999 to 2000 = 24033- 17037 = Rs 6996 million Change in Book value of equity from 1998 to 1999 = 123693 104006 = Rs 19,687 million Marginal Return on Equity = 6996/19687 = 35.54%

The Effects of Changing Return on Equity

So far in this section, we have operated on the assumption that the return on equity remains unchanged over time. If we relax this assumption, we introduce a new component to growth the effect of changing return on equity on existing investment over time. Consider, for instance, a firm that has a book value of equity of $100 million and a return on equity of 10%. If this firm improves its return on equity to 11%, it will post an earnings growth rate of 10% even if it does not reinvest any money. This additional growth can be written as a function of the change in the return on equity.

Addition to Expected Growth Rate = where ROEt is the return on equity in period t. This will be in addition to the fundamental growth rate computed as the product of the return on equity in period t and the retention ratio. Total Expected Growth Rate = While increasing return on equity will generate a spurt in the growth rate in the period of the improvement, a decline in the return on equity will create a more than proportional drop in the growth rate in the period of the decline. It is worth differentiating at this point between returns on equity on new investments and returns on equity on existing investments. The additional growth

that we are estimating above comes not from improving returns on new investments but by changing the return on existing investments. For lack of a better term, you could consider it efficiency generated growth . Illustration 11.8: Effects of Changing Return on Equity: Con Ed

In Illustration 11.5, we looked at Con Eds expected growth rate based upon its return on equity of 11.63% and its retention ratio of 29.96%. Assume that the firm will be able to improve its overall return on equity (on both new and existing investments) to 13% next year and that the retention ratio remains at 29.96%. The expected growth rate in earnings per share next year can then be written as:

Expected Growth rate in EPS = After next year, the growth rate will subside to a more sustainable 3.89% (0.13*0.2996). How would the answer be different if the improvement in return on equity were only on new investments but not on existing assets? The expected growth rate in earnings per share can then be written as: Expected Growth rate in EPS = ROEt* Retention Ratio= 0.13* 0.2996 = 0.0389 Thus, there is no additional growth created in this case. What if the improvement had been only on existing assets and not on new investments? Then, the expected growth rate in earnings per share can be written as:

Expected Growth rate in EPS =

Growth in Operating Income

Just as equity income growth is determined by the equity reinvested back into the business and the return made on that equity investment, you can relate growth in operating income to total reinvestment made into the firm and the return earned on capital invested.
When a firm has a stable return on capital, its expected growth in operating income is a product of the reinvestment rate, i.e., the proportion of the after-tax operating income that is invested in net capital expenditures and non-cash working capital, and the quality of these reinvestments, measured as the return on the capital invested. Expected GrowthEBIT = Reinvestment Rate * Return on Capital where,

Return on Capital = In making these estimates, you use the adjusted operating income and reinvestment values that you computed in Chapter 4. Both measures should be forward looking and the return on capital should represent the expected return on capital on future investments. In the rest of this section, you consider how best to estimate the reinvestment rate and the return on capital.

Reinvestment Rate
The reinvestment rate measures how much a firm is plowing back to generate future growth. The reinvestment rate is often measured using the most recent financial statements for the firm. Although this is a good place to start, it is not necessarily the best estimate of the future reinvestment rate. A firm s reinvestment rate can ebb and flow, especially in firms that invest in relatively few, large projects or acquisitions. For these firms, looking at an average reinvestment

rate over time may be a better measure of the future. In addition, as firms grow and mature, their reinvestment needs (and rates) tend to decrease. For firms that have expanded significantly over the last few years, the historical reinvestment rate is likely to be higher than the expected future reinvestment rate. For these firms, industry averages for reinvestment rates may provide a better indication of the future than using numbers from the past. Finally, it is important that you continue treating R&D expenses and operating lease expenses consistently. The R&D expenses, in particular, need to be categorized as part of capital expenditures for purposes of measuring the reinvestment rate.

Return on Capital
The return on capital is often based upon the firm's return on existing investments, where the book value of capital is assumed to measure the capital invested in these investments. Implicitly, you assume that the current accounting return on capital is a good measure of the true returns earned on existing investments and that this return is a good proxy for returns that will be made on future investments. This assumption, of course, is open to question for the following reasons. The book value of capital might not be a good measure of the capital invested in existing investments, since it reflects the historical cost of these assets and accounting decisions on depreciation. When the book value understates the capital invested, the return on capital will be overstated; when book value overstates the capital invested, the return on capital will be understated. This problem is exacerbated if the book value of capital is not adjusted to reflect the value of the research asset or the capital value of operating leases. The operating income, like the book value of capital, is an accounting measure of the earnings made by a firm during a period. All the problems in using unadjusted operating income described in Chapter 4 continue to apply. Even if the operating income and book value of capital are measured correctly, the return on capital on existing investments may not be equal to the marginal

return on capital that the firm expects to make on new investments, especially as you go further into the future. Given these concerns, you should consider not only a firm s current return on capital, but any trends in this return as well as the industry average return on capital. If the current return on capital for a firm is significantly higher than the industry average, the forecasted return on capital should be set lower than the current return to reflect the erosion that is likely to occur as competition responds. Finally, any firm that earns a return on capital greater than its cost of capital is earning an excess return. The excess returns are the result of a firm s competitive advantages or barriers to entry into the industry. High excess returns locked in for very long periods imply that this firm has a permanent competitive advantage. Illustration 11.9: Measuring the Reinvestment Rate, Return on Capital and Expected Growth Rate Embraer and Amgen In this Illustration, we will estimate the reinvestment rate, return on capital and expected growth rate for Embraer, the Brazilian aerospace firm, and Amgen. We begin by presenting the inputs for the return on capital computation in Table 11.8. Table 11.8: Return on Capital BV of Embraer Amgen EBIT 945 $1,996 EBIT (1-t) BV of Debt 716.54 1321.00 $1,500 $323 Equity 697.00 $5,933 Return on Capital 35.51% 23.98%

We use the effective tax rate for computing after-tax operating income and the book value of debt and equity from the end of the prior year. For Amgen, we use the operating income and book value of equity, adjusted for the capitalization of the research asset, as described in Illustration 9.2. The after-tax returns on capital are computed in the last column.

We follow up by estimating capital expenditures, depreciation and the change in non-cash working capital from the most recent year in Table 11.9. Table 11.9: Reinvestment Rate
Capital EBIT(1-t) es 716.54 182.10 $1,500.32 $1,283.00 n 150.16 $610.00 Change in Reinvestm Reinvestme ent nt Rate -141.06 -19.69% $794.00 52.92% Capital -173.00 $121.00

expenditur Depreciatio Working Embraer Amgen

Here again, we treat R&D as a capital expenditure and the amortization of the research asset as part of depreciation for computing the values for Amgen. In the last column, we compute the reinvestment rate by dividing the total reinvestment (cap ex depreciation + Change in working capital) by the after-tax operating income. Note that Embraers reinvestment rate is negative because of non-cash working capital dropped by 173 million in the most recent year. Finally, we compute the expected growth rate by multiplying the after-tax return on capital by the reinvestment rate in Table 11.10 Table 11.10: Expected Growth Rate in Operating Income Reinvestment Rate Embra er Amgen -19.69% 52.92% 35.51% 23.98% -6.99% 12.69% Return on Capital Expected Growth Rate

If Amgen can maintain the return on capital and reinvestment rate that they had last year, it would be able to grow at 12.69% a year. Embraers growth rate is negative because its reinvestment rate is negative. In the Illustration that follows, we will look at the reinvestment rate in more detail.

Caveats of Financial Planning Models.

Smaller startups are often less concerned with long-term planning than getting off the ground and surviving. While many businesses may benefit from long-term financial planning, the more established businesses tend to have the resources and stability to analyze the long-term.

Why do companies bother with financial planning? Because financial planning establishes guidelines for the firm. Additionally, a company's growth rate and financial policy are linked. The goal of financial planning is to:

Identify the firm's financial goals Analyze the difference between goals and current financial status State actions needed for the firm to achieve its financial goals.

All these points are taken care of by the experts providing Finance homework help and assignment help at Transtutors.com.

Of course, financial plans are only as accurate as the assumptions that go into the plan. The GIGO principle applies garbage in, garbage out.

There are other concerns about financial planning models.

Financial models don't uncover which financial policies are best. Financial planning models are too simple. In reality, their assumptions don't always hold. In practice, especially in large corporations, financial planning relies on a top-down approach. Senior managers determine a growth target, and financial planners tweak the plan with overly optimistic figures to match that target.

Short-Term & Long-Term Defined

The short-term is usually defined as the coming year. The long-term is usually defined as longer than one year. Often, the long-term is defined as the coming two to five years. What is Corporate Financial Planning?

A financial plan is a statement of what needs to be done in the future to achieve company goals.

Long-term financial planning is required to implement decisions that have long lead times. For example, if a company wants to build a factory next year, contractors probably have to be lined up this year.

Financial plans are made up of the combined capital budgeting analyses of each the firms projects. So, the smaller investment proposals of each operational unit are added up and treated as one big project.

Financial plans are meant to:

Make the link between different investment proposals and the financing choices available to the firm. Help the firm work through finding the best investment and/or financing option. Help the firm avoid surprises by identifying what may happen in the future if certain events take place.

A financial plan can serve to provide guidelines but don't rely on the plan blindly.

Financial planning models do not always ask the right questions. A primary reason is that they tend to rely on accounting relationships and not financial relationships. In particular, the three basic elements of firm value tend to get left out, namely, cash flow size, risk, and timing.

Because of this, financial planning models sometimes do not produce output that gives the user many meaningful clues about what strategies will lead to increases in value. Instead, they divert the user's attention to questions concerning the association of, say, the debt-equity ratio and firm growth.

The financial model we used for the Hoffman Company was simplein fact, too simple. Our model, like many in use today, is really an accounting statement generator at heart. Such models are useful for pointing out inconsistencies and reminding us of financial needs, but they offer very little guidance concerning what to do about these problems.

In closing our discussion, we should add that financial planning is an iterative process. Plans are created, examined, and modified over and over. The final plan will be a result negotiated between all the different parties to the process. In fact, long-term financial planning in most corporations relies on what might be called the Procrustes approach.1 Upper-level Finance has a goal in mind, and it is up to the planning staff to rework and to ultimately deliver a feasible plan that meets that goal.

Measures of Corporate Performance : RoI, RoE, EVA, MVA,

In todays competitive world, value and value creation for shareholders are among the most important goals of businesses. For the sake of achieving his goals, the investor needs some instruments in order to evaluate the potential value of each opportunity of investment. It is clear that these instruments are not capable of predicting the exact future, they just provide some piece of information and advice that help the investor in the decisions he makes. Among these criteria, the most common types are Return on assets (ROA), Return on equity (ROE) and cash flow from operations (CFO). Despite the numerous applications of these instruments, theoretically, they are not related with shareholders value or creation wealth. In recent years, the modern evaluation methods based on economic profit such as Economic value added (EVA), Market value added (MVA), Refined economic value added (REVA), adjusted economic value added (AEVA), cash value added (CVA), shareholder value added (SVA) and created shareholder value (CSV) replace the accounting of accounting measures and have widely drawn the attentions. These criteria follow the performance assessment with regard to the changes in the value and alongside maximizing the long-term shareholder

returns. Thus, in the financial literature, there has been an observed attempt to develop new financial performance measures (Ittner and Larcker, 1998).

Balanced Score Card

Traditional financial reporting systems provide an indication of how a firm has performed in the past, but offer little information about how it might perform in the future. For example, a firm might reduce its level of customer service in order to boost current earnings, but then future earnings might be negatively impacted due to reduced customer satisfaction. To deal with this problem, Robert Kaplan and David Norton developed the Balanced Scorecard, a performance measurement system that considers not only financial measures, but also customer, business process, and learning measures. The Balanced Scorecard framework is depicted in the following diagram:

Diagram of the Balanced Scorecard

Financi al

Custom er

Strate gy

Busines s Process es

Learnin g &

Growth

The balanced scorecard translates the organization's strategy into four perspectives, with a balance between the following:

between internal and external measures between objective measures and subjective measures between performance results and the drivers of future results

Beyond the Financial Perspective

In the industrial age, most of the assets of a firm were in property, plant, and equipment, and the financial accounting system performed an adequate job of valuing those assets. In the information age, much of the value of the firm is embedded in innovative processes, customer relationships, and human resources. The financial accounting system is not so good at valuing such assets. The Balanced Scorecard goes beyond standard financial measures to include the following additional perspectives: the customer perspective, the internal process perspective, and the learning and growth perspective.

Financial perspective - includes measures such as operating income, return on capital employed, and economic value added. Customer perspective - includes measures such as customer satisfaction, customer retention, and market share in target segments. Business process perspective - includes measures such as cost, throughput, and quality. These are for business processes such as procurement, production, and order fulfillment. Learning & growth perspective - includes measures such as employee satisfaction, employee retention, skill sets, etc.

These four realms are not simply a collection of independent perspectives. Rather, there is a logical connection between them - learning and growth lead to better business processes, which in turn lead to increased value to the customer, which finally leads to improved financial performance.

Objectives, Measures, Targets, and Initiatives

Each perspective of the Balanced Scorecard includes objectives, measures of those objectives, target values of those measures, and initiatives, defined as follows:

Objectives - major objectives to be achieved, for example, profitable growth. Measures - the observable parameters that will be used to measure progress toward reaching the objective. For example, the objective of profitable growth might be measured by growth in net margin. Targets - the specific target values for the measures, for example, +2% growth in net margin. Initiatives - action programs to be initiated in order to meet the objective.

These can be organized for each perspective in a table as shown below.

Objecti Measur Targ Initiati ves es ets ves Financi al Custo mer Proces s Learni ng

Balanced Scorecard as a Strategic Management System

The Balanced Scorecard originally was conceived as an improved performance measurement system. However, it soon became evident that it could be used as a management system to implement strategy at all levels of the organization by facilitating the following functions:

1. Clarifying strategy - the translation of strategic objectives into quantifiable measures clarifies the management team's understanding of the strategy and helps to develop a coherent consensus. 2. Communicating strategic objectives - the Balanced Scorecard can serve to translate high level objectives into operational objectives and communicate the strategy effectively throughout the organization. 3. Planning, setting targets, and aligning strategic initiatives - ambitious but achievable targets are set for each perspective and initiatives are developed to align efforts to reach the targets. 4. Strategic feedback and learning - executives receive feedback on whether the strategy implementation is proceeding according to plan and on whether the strategy itself is successful ("double-loop learning"). These functions have made the Balanced Scorecard an effective management system for the implementation of strategy. The Balanced Scorecard has been applied successfully to private sector companies, non-profit organizations, and government agencies.

Practices of Indian Companies.

In order to be sustainable, businesses need to recognize and effectively address the complex relationship of good corporate performance, social development, and environmental protection. Good corporate governance is now being recognized as a key risk management tool and a tool for socio-economic development to enhance economic efficiency, growth, and stakeholder confidence. The paradigm shift in the global business environment has led to the Indian government promoting inclusive growth and CSR as a policy among corporates in India. However, a lot more needs to be done in this direction. Very limited India-centric studies and activities have been undertaken on this subject. TERI in association with National Foundation for Corporate Governance (NFCG) is jointly working towards adopting good governance practices and uptake of sustainability reporting.

Objectives of the initiative

Understand the current status of Corporate Governance and Sustainability Reporting initiatives in India Assess the needs, challenges, and opportunities to adopt good governance practices and uptake of sustainability reporting, and Identify best practices undertaken in the industry, if any

Expected Outcomes

A report stating current status of Corporate Governance and Sustainability Reporting in India Inculcating latest thinking/global practices on Governance and Sustainability suited to the Indian context Increased uptake of quality reporting of Companies sustainability performance. Better understanding and appreciation of the concept of Business ethics and Sustainability Reporting among Corporates in India.

Risk Management Tools

Risk Management Tools We offer five risk management tools, designed to protect CME Globex customers and clearing firms:

Cancel on Disconnect Credit Controls Risk Management Interface (RMI) Drop Copy FirmSoft

Use the drop-down below to learn more about these tools.

FirmSoft is a browser-based order management tool that provides real-time access to information on working and filled CME Globex orders, across multiple firm IDs. FirmSoft provides important risk mitigation functionality during system failures. With FirmSoft, customers can view and cancel orders for iLink and EOS Trader. FirmSoft users can view:

current order status fill information, including partial fills and fills from mass quotes cancel replace history CME Globex timestamps

If enabled to do so, FirmSoft users can cancel:

an individual order a group of orders all working orders and mass quotes

FirmSoft Launched in April 2009, FirmSoft leverages a completely redesigned order management database to optimize performance and reliability, and an updated interface for improved usability. FirmSoft 6.0 makes accessing FirmSoft easier than ever:

SMART Click registration and profile management platform Improved clearing firm administration tools Secure Socket Layer (SSL) Internet connectivity Microsoft Internet Explorer 6.0 & 7.0, and Mozilla Firefox 3

Clearing Firm Administrator Access to FirmSoft 6.0 To request access to the Clearing Firm Administration tools within FirmSoft, please
1. Create a SMART Click user ID and profile online

2. Complete and submit the Schedule 9 to the CME Globex Connection Agreement New FirmSoft 6.0 Users To request access to FirmSoft , new users will need to:

Create a SMART Click user ID and profile online Login to the SMART Click profile management tool and request a token Give your SMART Click user ID and token to your Clearing Firm FirmSoft administrator.
o

If you do not know who your Clearing Firm FirmSoft administrator is, please contact your CME Globex Account Manager

You will receive an e-mail confirmation once your FirmSoft access has been enabled

Hedging
What is hedging? Hedging is the process of managing the risk of price changes in physical material by offsetting that risk in the futures market. Hedging can vary in complexity from a relatively simple activity, through to a highly complex strategies, including the use of options.

The ability to hedge means that industry can decide on the amount of risk it is prepared to accept. It may wish to eliminate the risk entirely and can generally do so quickly and easily using the LME. Managing price risk means achieving greater control of either the cost of inputs, or revenues from sales, or both; planning for the future based on assured costs and revenues; and eliminating concerns that a sharply adverse move in the price of material could turn an otherwise flourishing and efficient business into a loss maker. Hedging by trade and industry is the opposite of speculation and is undertaken in order to eliminate an existing physical price risk, by taking a compensating position in the futures market. Speculators come to the futures market with no initial risk. They assume risk by taking futures positions. Hedgers reduce or eliminate the chance of further losses or profits, while the speculators risk losses in order to make profits. Before starting a hedging programme it is essential to assess the risk due to exposure to the price of physical material. Once the hedger has an understanding of the tools available at the LME, it is relatively easy to select the appropriate action to manage this risk. It is important that this action is properly managed at all times and that the appropriate controls and approval procedures are in place. It is generally advisable to work with an LME broker so that expert advice can be taken in devising a hedging programme.

Options Futures and Swaps. Definition

A swap is a derivative in which two parties agree to exchange a set of cash flows (or leg) for another set. A notional principal amount is used to calculate each cash flow; these are rarely exchanged by the parties. A swap is usually used to hedge a risk, such as an interest-rate risk, or to speculate on a price change. It may also be used to access an underlying asset in order to earn a profit or loss from any change in price while avoiding posting the notional amount in cash or collateral. An option is a financial instrument that gives the holder the right to engage in a future transaction on an underlying security or futures contract. The holder is under no obligation to exercise this right. There are two main types of option. A call option gives the holder the right to purchase a specified quantity of a security at a fixed price (the strike price) on or before the specified expiration date. A put option gives the holder the right to sell. If the holder chooses to

exercise the option, the party who sold, or wrote, the option is obliged to fulfil the terms of the contract. Futures are traded on a futures exchange and represent an obligation to buy or sell a specified underlying instrument on a specified date (the delivery date or final settlement date) in the future at a specified price (the futures price). The settlement price is the price of the underlying asset on the delivery date. Both parties to a futures contract are legally bound to fulfil the contract on the delivery date. If the holder of a futures position wishes to exit their obligation before the delivery date, they must offset it either by selling a long position or buying back a short position. Such an action effectively closes the futures position and its contractual obligations. Back to top

Advantages

The use of derivatives means that some financial risks can be transferred to other parties who are more willing or better suited to take or manage those risks and can thus be a useful tool for risk management. Purchasing derivatives can be a safer choice if there is a possibility of a looming bear market as they are hedged, unlike equities. Buying now at a future price can be cheaper than buying at market price in the future, bearing in mind that the spot price could be less expensive. A long call option requires no obligation when it is due.

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Disadvantages

If the market changes dramatically, it is possible to lose financially if the derivatives are being used as a speculative instrument. If you hold the put option on a derivative, you are obliged to adhere to it if the holder of the call chooses to exercise their right to sell or buy.

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Dos and Donts

Do

Take time to consider which derivative is most suitable for the transaction you have in mind. Consult a financial intermediary or seek other expert guidance if you are unsure.

Dont

Dont enter into a contract that will lock you in if theres the slightest possibility that you may need to exit before its expiration date