Capital budgeting

 

Capital budgetingWhat Is Capital Budgeting?

Capital budgeting is the process of planning and taking decisions regarding the long-term investments of the company in fixed assets. Such long-term investments are called as capital investments and the amount spent for such long-term investments is called as capital expenditure. By doing capital budgeting it can be determined whether the potential long-term investment projects of the company are worth pursuing or not. Capital budgeting is also called as investment appraisal.

Importance Of Capital Budgeting:-

Capital budgeting decisions are very crucial for a company because of the following reasons:-

  • Capital budgeting decisions have long-term implications on the operations of the company and may affect the long-term survival of the company in case of a wrong decision.
  • Capital investments involve commitment of large amount of funds which remain blocked for a long period of time and so it is necessary to take decisions of capital investments very carefully by doing capital budgeting.
  • Capital budgeting decisions are mostly irreversible because it is very difficult to find a market for the capital goods. The only alternative is to scrap the assets and incur heavy loss.
  • The company has many capital investment proposals which can be undertaken. Capital budgeting helps in deciding which proposal or proposals are beneficial and should be undertaken by the company.
  • Capital budgeting decisions have a major effect on the value of the firm and the wealth of its shareholders. Correct capital budgeting decisions enhance the value of the firm and maximizes the shareholder’s wealth.

Classification Of Capital Investment Projects:-

Capital investment projects can be classified into four types:-

(1) Replacement Projects:-

Existing fixed assets of the company are replaced with similar fixed assets on account of them being worn out or becoming out-dated because of new inventions.

(2) Expansion Projects:-

The company expands its business by increasing the current operations to a larger scale like increasing the production capacity to produce more products because of high demand.

(3) Diversification projects:-

The company diversifies its business by starting a new product line different from the existing one or enters into new markets to reduce risk.

(4) Mandatory projects:-

The company has to compulsorily undertake such projects as required by the government and are usually related to safety or environment which do not directly result into profits.

Capital Investment Projects May be –
Independent Projects Or Mutually
Exclusive Projects:-

Independent projects are unrelated and are not dependent on each other. Independent projects are the projects that do not compete with each other in such a way that the acceptance of one rejects the others. Accepting or rejecting one project does not affect the decision on other projects. All the independent projects can be accepted if they meet the investment criteria and can be pursued simultaneously.
Mutually exclusive projects are related to each other. They compete with each other in such a way that the acceptance of one rejects the others. Accepting or rejecting one project affects the decision on other projects. Only one project can be accepted which is the most profitable among the other alternative projects which meet the investment criteria. So mutually exclusive projects cannot be pursued simultaneously.

Capital Budgeting Techniques:-

There are various techniques or methods used in capital budgeting to evaluate the capital investment proposals. These techniques can be divided into two heads:-
(A) Non-discounting techniques
(B) Discounting techniques

(A) Non-Discounting Techniques:-

Non-discounting methods do not consider the time value of money. There are two non-discounting techniques used in capital budgeting which are as under:-

(1) Payback period:-

Payback period is the period within which the cost of capital investment would be completely recovered. It indicates the number of years required to recover the initial investment in the project from the future cash inflows generated by the project.
 The payback period in case of the project generating equal cash inflows annually is calculated as:-
payback period = initial investment in project ÷ annual cash inflows of project
 The payback period in case of the project generating unequal cash inflows annually is calculated by adding up the cash inflows till the total is equal to the initial investment in the project.
 The management decides the maximum acceptable payback period for independent projects. If the payback period is less than or equal to the maximum acceptable payback period decided by management, the project is accepted and if the payback period is more than the maximum acceptable payback period decided by management, the project is rejected. In case of mutually exclusive projects, the project with the shortest payback period is selected.
Advantages of payback period method:-
(i) It is simple to calculate and easy to understand.
(ii) It shows the liquidity of the project by indicating the period within which the cost of a project can be recovered.
Disadvantages of payback period method:-
(i) It ignores the time value of money.
(ii) It ignores the cash inflows after the payback period.

Example:-

A project requires an initial investment of Rs 800000 and is expected to generate cash inflows of Rs 200000 annually for five years (equal cash inflows each year).

The payback period of the project would be
Rs 800000 ÷ Rs 200000 = 4 years

If a project requires an initial investment of Rs 500000 and is expected to generate cash inflows of Rs 100000, Rs 125000, Rs 75000, Rs 150000 and Rs 100000 respectively for five years. (unequal cash inflows each year)

In this case we need to add the cash inflows. While adding the cash inflows we see that in the first four years Rs 450000 (100000+125000+75000+150000) of the initial investment is recovered. Fifth year generates cash inflow of Rs 100000 whereas only Rs 50000 (500000-450000) remains to be recovered. The period which will be required to recover Rs 50000 will be
Rs 50000 ÷ Rs 100000 × 12 = 6 months
So the payback period of the project would be
4.6 years i.e. 4 years and 6 months.

(2) Accounting rate of return:-

Accounting rate of return is also called as average rate of return. It calculates the average annual accounting profit the project would generate in relation to the average investment in the project or its average cost.
 Accounting rate of return is calculated as under:-
Accounting rate of return = average annual profit – depreciation & taxes ÷ average investment in project × 100
Average annual profit = profit of all the years ÷ number of years
Average investment in project = initial investment – scrap value ÷ 2
 The management decides the minimum acceptable average rate of return for independent projects. If the average rate of return is more than the minimum acceptable average rate of return decided by management, the project is accepted and if the average rate of return is less than the minimum acceptable rate of return decided by management, the project is rejected. In case of mutually exclusive projects, the project yielding the highest average rate of return is selected.
Advantages of accounting rate of return method:-
(1) It is simple to calculate and easy to understand.
(2) It considers the profit of all the years involved in the life of the project.
Disadvantages of accounting rate of return method:-
(1) It ignores the time value of money.
(2) It considers accounting profit and not cash inflows.

Example:-

A project requires an initial investment of Rs 1000000 and is expected to generate profit of Rs 80000, Rs 120000, Rs 130000, Rs 110000 and Rs 100000 respectively for five years after depreciation and tax. At the end of the fifth year, the equipment in the project can earn a scrap value of Rs 70000.

First we need to find out the average annual profit.
Average annual profit = 80000 + 120000 + 130000 + 110000 + 100000 ÷ 5
                                         = 540000 ÷ 5
                                         = Rs 108000

Next we need to find out the average investment.
Average investment = 1000000 – 70000 ÷ 2
                                      = 930000 ÷ 2
                                      = Rs 465000

Accounting rate of return = 108000 ÷ 465000 × 100
                                                = 23.23%

(B) Discounting Techniques:-

Discounting techniques consider the time value of money. There are four discounting techniques used in capital budgeting which are as under:-

(1) Discounted payback period:-

Discounted payback period improves the payback period method by taking into consideration the time value of money. It indicates the number of years required to recover the initial investment in the project from the discounted cash inflows generated by the project i.e present value of future cash inflows generated by the project. For discounting the future cash inflows, an appropriate discount rate is used which is usually the weighted average cost of capital.
Advantages of discounted payback period method:-
(1) It is easy to understand.
(2) It considers the time value of money.
Disadvantages of discounted payback period method:-
(1) It ignores the cash inflows after the payback period.
(2) It requires to calculate the weighted average cost of capital.

Example:-

A project requires an initial investment of Rs 400000 and is expected to generate cash inflows of Rs 150000 annually for five years. The discount rate is 15%.

First we need to calculate the discounted cash inflows for each year by using the discount rate of 15%.
Discounted cash inflows for 1st year = 150000 ÷ (1.15) = Rs 130435
Discounted cash inflows for 2nd year = 150000 ÷ (1.15)2 = Rs 113422
Discounted cash inflows for 3rd year = 150000 ÷ (1.15)3 = Rs 98627
Discounted cash inflows for 4th year = 150000 ÷ (1.15)4 = Rs 85763
Discounted cash inflows for 5th year = 150000 ÷ (1.15)5 = Rs 74577

Now we need to add the discounted cash inflows. While adding the discounted cash inflows we see that in the first three years Rs 342484 (130435+113422+98627) of the initial investment is recovered. Fourth year generates discounted cash inflow of Rs 85763 whereas only Rs 57516 (400000-342484) remains to be recovered. The period which will be required to recover Rs 57516 will be
Rs 57516 ÷ Rs 85763 × 12 = 8 months
So the discounted payback period of the project would be
3.8 years i.e. 3 years and 8 months.

(2) Net present value:-

Net present value is the difference between the present value of future expected cash inflows and the present value of cash outflows. Cash outflows are the initial investment in the project or cost of the project and any future expected cash outflows of the project. If the present value of cash inflows is more than the present value of cash outflows, the net present value is positive and if the present value of cash inflows is less than the present value of cash outflows, the net present value is negative. The cash inflows and outflows are brought to their present values by using an appropriate discount rate which is usually weighted average cost of capital.
 Net present value is calculated as under:-
Net present value = present value of cash inflows – present value of cash outflows
In case of independent projects, the projects with a positive net present value are accepted and in case of mutually exclusive projects, the project with the highest positive net present value is selected.
Advantages of net present value method:-
(1) It considers the time value of money.
(2) It is consistent with the goal of maximizing shareholder wealth.
(3) It considers cash flows from the project throughout its life.
Disadvantages of net present value method:-
(1) It may not give satisfactory results if the mutually exclusive projects involve different investment outlay.
(2) The output of net present value method is monetary amount and not a rate of return.
(3) It requires to calculate the weighted average cost of capital.

Example:-

A project requires an initial investment of Rs 1200000 and there are no other cash outflows expected. The project is expected to generate cash inflows of Rs 300000, Rs 400000, Rs 550000 and Rs 200000 respectively for four years. At the end of the fourth year, the machine in the project can earn a scrap value of Rs 100000. The discount rate is 10%.

First we need to calculate the discounted cash inflows for each year by using the discount rate of 10% and add them.
Discounted cash inflows for 1st year = 300000 ÷ (1.10) = Rs 272727
Discounted cash inflows for 2nd year = 400000 ÷ (1.10)2 = Rs 330579
Discounted cash inflows for 3rd year = 550000 ÷ (1.10)3 = Rs 413223
Discounted cash inflows for 4th year = 300000 (200000+100000) ÷ (1.10)4 = Rs 204904
Total discounted cash inflows = Rs 1221433 (272727+330579+413223+204904)
Present value of cash inflows = Rs 1221433
Present value of cash outflows = Rs 1200000

Net present value = present value of cash inflows – present value of cash outflows
                                 = Rs 1221433 – Rs 1200000
                                 = Rs 21433

So the net present value of the project is Rs 21433 which is positive net present value.

(3) Profitability index:-

Profitability index is a variation of net present value. It is the ratio of present value of expected cash inflows to the present value of expected cash outflows of a project. Net present value method is an absolute measure as it finds the monetary amount of difference between the present value of expected cash inflows and present value of expected cash outflows whereas profitability index is a relative measure as it finds the ratio.
 Profitability index is calculated as under:-
Profitability index = present value of cash inflows ÷ present value of cash outflows
In case of independent projects, those projects are accepted whose profitability index is more than 1 and in case of mutually exclusive projects, the project with highest profitability index is selected provided it is more than 1. Profitability index of more than 1 suggests that the present value of project’s expected cash inflows is more than the present value of its expected cash outflows i.e. the net present value is positive and a profitability index of less than 1 suggests that the present value of project’s expected cash inflows is less than the present value of its expected cash outflows i.e. the net present value is negative. If the profitability index is exactly 1, it means that the present value of project’s expected cash inflows and expected cash outflows is equal i.e. the net present value is zero.
Advantages of profitability index:-
(1) It considers the time value of money.
(2) It considers the cash flows from the project throughout its life.
(3) It is useful in selecting projects when in capital rationing situation.
Disadvantage of profitability index:-
(1) It requires to calculate the weighted average cost of capital.

Example:-

A project requires an initial investment of Rs 700000 and there are no other cash outflows expected. The project is expected to generate cash inflows of Rs 200000, Rs 250000, Rs 150000 and Rs 150000 respectively for four years. There is no scrap value expected. The discount rate is 12%.

First we need to calculate the discounted cash inflows for each year by using the discount rate of 12% and add them.
Discounted cash inflows for 1st year = 200000 ÷ (1.12) = Rs 178571
Discounted cash inflows for 2nd year = 250000 ÷ (1.12)2 = Rs 199298
Discounted cash inflows for 3rd year = 150000 ÷ (1.12)3 = Rs 106767
Discounted cash inflows for 4th year = 150000 ÷ (1.12)4 = Rs 95328
Total discounted cash inflows = Rs 579964 (178571+199298+106767+95328)
Present value of cash inflows = Rs 579964
Present value of cash outflows = Rs 700000

Profitability index = present value of cash inflows ÷ present value of cash outflows
                                  = Rs 579964 ÷ Rs 700000
                                  = 0.83

So the profitability index of the project is 0.83 which is less than 1.

(4) Internal rate of return:-

Internal rate of return is the rate of return on a capital investment project. It is the discount rate at which the present value of expected cash inflows and present value of expected cash outflows of a project is equal. In other words, it is the discount rate at which the net present value of a project is zero.
 There is no fixed formula to calculate the internal rate of return. It is found out by trial and error method either by using a calculator or by using Microsoft excel. Different discount rates are tried till the discount rate which brings net present value of the project to zero is found out. If the net present value is positive, a higher discount rate is tried and if the net present value is negative, a lower discount rate is tried. This process is continued till the discount rate where net present value becomes zero or close to zero is found.
The management decides the minimum acceptable rate of return for independent projects which is usually the weighted average cost of capital. If internal rate of return is more than the weighted average cost of capital, the project is accepted and if the internal rate of return is less than the weighted average cost of capital, the project is rejected. In case of mutually exclusive projects, the project yielding the highest internal rate of return is selected provided it is more than the weighted average cost of capital.
Advantages of internal rate of return method:-
(1) It considers the time value of money.
(2) It considers cash flows from the project throughout its life.
(3) The output of internal rate of return method is in the form of a rate of return and not a monetary amount.
Disadvantages of internal rate of return method:-
(1) It is comparatively difficult to calculate as it requires trial and error.
(2) There is a problem of multiple internal rate of returns in case of unconventional cash flows involved in a project i.e. expected cash inflows followed by expected cash outflows in the next year and again followed by expected cash inflows next year and so on.
(3) Internal rate of return method assumes that the cash inflows from the project should be reinvested to yield a return equal to internal rate of return which is unrealistic.

Example:-

A project requires an initial investment of Rs 600000 and there are no other cash outflows expected for the project. The project is expected to generate cash inflows of Rs 300000, Rs 350000 and Rs 250000 respectively for three years. There is no scrap value expected.

We can try to find out the internal rate of return by trying different discount rates until the net present value of the project is zero or close to zero. If we try 24% discount rate, the net present value comes to 684 (total discounted cash inflows of Rs 600684 minus initial investment of Rs 600000). If we try 24.1% discount rate, the net present value comes to (-) 193 (total discounted cash inflows of Rs 599807 minus initial investment of Rs 600000). So we can say that the discount rate that brings net present value to zero or close to zero is between 24% and 24.1%. If we try 24.075% discount rate, the net present value comes to (-) 15 (total discounted cash inflows of Rs 599985 minus initial investment of Rs 600000) which is close to zero. So we can conclude that the internal rate of return of the project is approximately 24.075%. To get the exact internal rate of return, Microsoft excel can be used.

Capital Rationing:-

Capital rationing is a situation in which the company may not be able to undertake all the profitable capital investment projects because of lack of adequate funds to finance all the profitable projects. In such a situation, the company has to allot the limited available funds among the most profitable projects. The company estimates the amount of maximum investment it can make for undertaking all the profitable projects. So the company creates a capital budget. Then the company ranks all the profitable projects starting from the most profitable to the least profitable i.e. in the descending order of their profitability  and starts selecting from the most profitable project to the next profitable one till the maximum investment amount the company can invest is reached.

Example:-

A company has a capital budget of Rs 5000000 and has four profitable capital investment proposals as under:-

  Project A Project B Project C Project D
Initial investment Rs 2000000 Rs 1500000 Rs 1000000 Rs 1200000
Present value of cash inflows Rs 2500000 Rs 1700000 Rs 1200000 Rs 1800000
Profitability index 1.25 1.13 1.20 1.50

The company will rank projects as (1) project D (2) project A (3) project C and (4) project B based on their profitability.
Then the company will select the (1) project D first then (2) project A next and then (3) project C.
The company cannot undertake (4) project B because of lack of funds. Project B requires Rs 1500000 investment while the company has only Rs 800000 (5000000-4200000) remaining out of its total capital budget of Rs 5000000 after selecting the first three projects.(1200000+2000000+1000000)

 

 

 

 

 


 

 

 

 

 

 

 

 

 

Fixed and working capital

 

Fixed and working capitalWhat Is Fixed Capital?

Fixed capital is that portion of the total capital of the company which is invested in tangible fixed assets such as land and building, plant and machinery, furniture, etc as well as in intangible fixed assets such as goodwill, patents, copyrights, etc that stay in the business permanently or at least for more than one accounting year.

What Is Working Capital?

Working capital is that portion of the total capital of the company which is required for conducting the day-to-day operations of business. It is required on a continuous basis in business. 
 Working capital can be gross working capital or net working capital.
Gross working capital means all the current assets of the company such as cash, debtors, inventories, etc and net working capital means all the currents assets of the company minus all the current liabilities of the company such as creditors, short-term loans, etc.
Gross working capital = all current assets
Net working capital = all current assets – all current liabilities
 Working capital could be positive or negative. If the currents assets exceed the current liabilities, it is called as positive working capital and if the current liabilities exceed the current assets, it is called as negative working capital or working capital deficit.
 Working capital is also called as circulating capital.

Difference Between Fixed Capital And Working Capital:-

Fixed Capital Working Capital
Fixed capital is long-term in nature. Fixed capital investment stays in the business for a long period of time i.e. many years. Working capital is short-term in nature. Working capital investment stays in the business for a short period of time i.e. for a year.
Fixed capital is not required continuously in business. It is required mostly when a company wants to make a big investment such as purchase of some fixed asset or expansion of business. Working capital is required continuously to conduct day-to-day operations of business such as purchase of raw materials, paying salaries, etc.
Fixed capital investments have low liquidity. For e.g. an fixed asset cannot be sold easily to get cash. For that a certain asset disposal procedure has to be followed. Working capital has high liquidity. For e.g. A company can convert its current assets such as debtors into cash relatively easily.
The main sources of fixed capital are shares, debentures and long-term loans which are repayable after many years. The main sources of working capital are profits retained by the company, fixed deposits, trade creditors, short-term loans, shares and debentures.
The amount of fixed capital required is more than working capital. The amount of working capital required is less than fixed capital.

Operating Cycle:-

Operating cycle is an important measure of the working capital management and operating efficiency of the company. Operating cycle is the average amount of time a company takes to turn the cash used to purchase inventory of raw materials into cash again by its eventual sale as finished products. Operating cycle starts when the company spends money to purchase stock of raw materials and ends when the company receives money from the customers who buy the finished products made from those raw materials. Operating cycle is also called as cash conversion cycle.

 The company purchases raw materials from the suppliers on credit or cash. If they are purchased on credit, the suppliers are termed as creditors and the company pays them some time after the purchase of raw materials from them as per the credit terms given by them. The raw materials so purchased are kept in the storeroom for some time. Then the raw materials lie in the factory as work-in-progress till the process of converting them into finished products takes place. After the raw materials are turned into finished products, they are kept in the godown till the time they are sold. Then the finished products are finally sold to the customers on credit or cash. If they are sold on credit, the customers are termed as debtors and they pay the company some time after the sale of goods to them as per the credit terms given to them. This whole process is called as operating cycle of the company.

 Operating cycle is generally measured in days, and shorter the operating cycle, the better. Shorter operating cycle ensures liquidity and reduces the need of financing. Shorter operating cycle ensures that the cash does not get tied up in the operations of the business and can also be utilized for other activities of the company.

 operating cycle is made up of three elements – days inventory outstanding, days sales outstanding and days payables outstanding. The formula for calculating operating cycle is :-
Operating cycle = days inventory outstanding + days sales outstanding – days payables outstanding.

operating cycle

Capital structure and cost of capital

Capital structure and cost of capital
What Is Capital Structure?

Capital structure is the mix or combination of various sources of funds that are used by a company to finance its operations and growth. There are two main sources of finance that are used by a company:- (1) Debt, which consists of long-term debt and short-term debt. (2) Equity, which consists of common shares and preference shares.
 A company should have an optimal capital structure. Optimal capital structure has the optimal or ideal balance between the debt and equity in the capital structure. An optimal capital structure minimizes the weighted average cost of capital and maximizes the value of the firm.

What Is Cost Of Capital?

The company raises funds from various sources to finance its operations and growth. Each of these sources have a cost associated with them. So cost of capital is the cost of raising the funds from various sources. Cost of capital can also be defined as the minimum rate of return which the investors expect for providing  capital to the company. Cost of capital plays a very important role in deciding the capital structure of a company and also in the capital budgeting decisions.
 Cost of capital is comprised of :-
(1) Cost of debt.
(2) Cost of preferred equity i.e. preference shares.
(3) Cost of common equity i.e. equity shares.

(1) Cost Of Debt:-

Cost of debt is the rate of interest that the company pays on its borrowings such as debentures, bonds, term loans from banks and financial institutions and short-term debt. Interest on debt is a tax-deductible expense so generally after- tax cost of debt is considered. The rate of interest can be calculated from the interest expenses of the company as a percentage of the outstanding debt. For e.g. if the interest expenses of the company for the year 2015 are Rs 246.40 crores and the outstanding debt of the company for the year 2014 is Rs 1540 crores. So the cost of debt of the company would be 16% (246.40 × 100 ÷ 1540). This is the before-tax cost of debt. Now we need to calculate the after-tax cost of debt. Let us assume that the tax rate is 20%. So the after tax-cost of debt of the company would be 12.8% {16 × (1 – 0.20)}.

(2) Cost Of Preferred Equity:-

Preference shares carry a fixed rate of dividend and the dividend is not tax-deductible. Preference shares have the properties of both debt instruments and equity shares. The cost of preferred equity is the rate of dividend fixed by the company on its preference shares. The rate of preference dividend can be calculated as under:-
Preference dividend ÷ net proceeds from issue of preference shares × 100
For e.g. if a company received Rs 1240 crores from the issue of preference shares and paid Rs 173.60 crore annually as dividend on those shares. So the cost of preferred equity would be 14% (173.60 ÷ 1240 × 100).

(3) Cost Of Common Equity:-

Unlike the debt and preferred shares, common shares do not have a fixed cost associated with them. Cost of common equity is the return that the common shareholders expect from their investment in common shares and if the company does not deliver the expected return, the common shareholders would sell their shares and the price of shares would fall. The most commonly used method for calculating the cost of common equity is Capital Asset Pricing Model (CAPM). The formula for calculating cost of common equity under Capital Asset Pricing Model is:-
Risk-free rate + (beta × risk premium)
Risk-free rate:- Risk-free rate is the risk-free interest rate that is obtained by investing in risk-free securities like government bonds.
Beta:- Beta measures how much the price of a company’s stock moves against the market as a whole. The market has a beta of 1. The price of the company’s stock that moves more than the market has a beta above 1 and the price of the company’s stock that moves less than the market has a beta below 1.
Risk premium:- It is the equity market risk premium which the common shareholders expect over and above the risk-free rate to compensate them for taking extra risk by investing in common shares.
For e.g. the risk-free interest rate for a 10-year-old government bond is 8%. The beta of company’s common stock is 1.3 and the risk premium expected by the common shareholders is 6%. So the cost of common equity would be 15.8%
{8 + (1.3 × 6)}.

Weighted Average Cost Of Capital:-

Weighted Average Cost of Capital (WACC) is the combined average cost of all the sources of capital i.e. debt, preferred equity and common equity used by a company. So all the sources of capital are taken into consideration to calculate the Weighted Average Cost of Capital. WACC can also be defined as the average rate of return which all the investors expect for providing capital to the company. For calculating WACC, cost of each source of capital is weighted in proportion to the share each source of capital has in the company’s capital structure.

Example Of Weighted Average Cost Of Capital:-

For calculating Weighted Average Cost of Capital following things are needed:-
– Market value of debt and cost of debt.
– Market value of preferred equity and cost of preferred equity.
– Market value of common equity and cost of common equity.

Market value of debt is not easily available. So we have to take the value of debt which is in the company’s balance sheet. Earlier we had taken the value of debt as Rs 1540 crores and calculated the after-tax cost of debt as 12.8%. We will use the same figures in the calculation of WACC.

Market value of preferred equity is also not available easily. So we have to take the value of preference share capital in the company’s balance sheet. Earlier we had taken the value of preference share capital as Rs 1240 crores and calculated the cost of preferred equity as 14%. We will use the same figures in the calculation of WACC.

Let us assume that the total market value of common equity is Rs 16800 crores. We had earlier calculated the cost of common equity as 15.8%. So we will take the same in the calculation of WACC.

So now we have all the required information to calculate WACC. We can find out the WACC by using the below method:-

Market value of debt ÷ (market value of debt + market value of preferred equity + market value of common equity) × cost of debt

1540 ÷ (1540 + 1240 + 16800) × 12.80 = 1.00

Market value of preferred equity ÷ (market value of debt + market value of preferred equity + market value of common equity) × cost of preferred equity

1240 ÷ (1540 + 1240 + 16800) × 14 = 0.89

Market value of common equity ÷ (market value of debt + market value of preferred equity + market value of common equity) × cost of common equity

16800 ÷ (1540 + 1240 + 16800) × 15.80 = 13.56

1.00 + 0.89 + 13.56 = 15.45

So the weighted Average Cost of Capital of the company is 15.45%.

 

 

 

Financial ratios

Financial ratios

There are various kinds of financial ratios which are calculated and used by the investors and analysts. These financial ratios are calculated from the information in the financial statements of the company and are used in the fundamental analysis of the company. The financial ratios are compared with the financial ratios of the last few years of the same company (intra-firm comparison) and with the financial ratios of other companies in the same industry (inter-firm comparison).

Financial ratios can be classified into the following broad categories:-

– Profit margin ratios
– Turnover ratios
– Solvency ratios
– Liquidity ratios
– Investment valuation ratios

Profit Margin Ratios:-

Profit margin ratios indicate how efficiently the company is able to generate profit from its operations. Following are the various types of profit margin ratios:-

Gross Margin Ratio:-

Gross margin ratio is also called as gross profit ratio. Gross margin ratio compares the gross profit of the company to the net sales. Gross profit is calculated by subtracting the cost of goods sold from the net sales. Cost of goods sold indicates all the direct costs incurred by the company on all the products sold. Gross margin ratio should be high enough to cover the indirect costs, taxes, interest and depreciation expenses.
Formula for calculating gross margin ratio:-
Gross margin ratio = gross profit ÷ net sales × 100

Net Margin Ratio:-

Net margin ratio is also called as net profit ratio. Net margin ratio compares the net profit of the company to the net sales. Net profit is the profit earned by the company after subtracting all the expenses incurred by the company. A company should have a high net margin ratio which is possible if all the concerned expenses incurred by the company are kept in control.
Formula for calculating net margin ratio:-
Net margin ratio = net profit ÷ net sales × 100

Operating Margin Ratio:-

Operating margin ratio is also called as operating profit ratio or EBITDA ratio. Operating margin ratio compares the operating profit of the company to the net sales. Operating profit is calculated by subtracting the cost of goods sold and operating expenses from the net sales. Operating expenses are the indirect costs of the company. Operating margin ratio should be high enough to cover taxes, interest, depreciation and amortization expenses.
Formula for calculating operating margin ratio:-
Operating margin ratio = operating profit ÷ net sales × 100

Return On Equity Ratio:-

Return on equity ratio shows how much profit the company generates with the money invested by both the preference and equity shareholders. It measures how efficiently the company generates profit for every unit of shareholders equity.
Formula for calculating return on equity ratio:-
Return on equity ratio = net profit ÷ average shareholders equity × 100
Shareholders equity = equity share capital + preference share capital + reserves and surplus
Average shareholders equity = shareholders equity (current year) + shareholders equity (previous year) ÷ 2

Return On Common Equity Ratio:-

Return on common equity ratio shows how much profit the company generates with the money invested by equity shareholders i.e common shareholders. It measures how efficiently the company generates profit for every unit of common shareholders equity.
Formula for calculating return on common equity ratio:-
Return on common equity ratio = net profit – preference dividend ÷ average common shareholders equity × 100
Common shareholders equity = equity share capital + reserves and surplus
Average common shareholders equity = common shareholders equity (current year) + common shareholders equity (previous year) ÷ 2

Return On Capital Employed Ratio:-

Return on capital employed shows how much profit the company generates with the total capital employed by the company. It measures how efficiently the company generates profit for every unit of capital invested.
Formula for calculating return on capital employed ratio:-
Return on capital employed ratio = earnings before interest and tax ÷ average capital employed × 100
Capital employed = equity share capital + preference share capital + reserves and surplus + long-term debt
Average capital employed = capital employed (current year) + capital employed (previous year) ÷ 2

Return On Assets Ratio:-

Return on assets ratio shows how much profit the company generates by using its assets. It measures how efficiently the company generates profit for every unit of asset the company has.
Formula for calculating return on assets ratio:-
Return on assets ratio = net profit ÷ average total assets × 100
Total assets = long-term assets + current assets
Average total assets = total assets (current year) + total assets (previous year) ÷ 2

Turnover Ratios:-

Turnover ratios are also called as activity ratios. Turnover ratios indicate how efficiently the company runs its various operations. Following are the various types of turnover ratios:-

Accounts Receivable Turnover ratio:-

Accounts receivable turnover ratio is also called as debtors turnover ratio. Accounts receivable turnover ratio shows how efficiently the company issues credit to its customers and recovers it . It indicates how many times the company collects its average accounts receivable during a period. A high accounts receivable turnover ratio is considered as good.
Formula for calculating accounts receivable turnover ratio:-
Accounts receivable turnover ratio = credit sales ÷ average accounts receivables
accounts receivables = debtors
average accounts receivables = debtors (current year) + debtors (previous year) ÷ 2

A variant of the accounts receivable turnover ratio called as average collection period is also calculated. Average collection period indicates the number of days, on an average, the company takes to collect its accounts receivable. It measures the average number of days the company requires to convert its accounts receivables into cash. A lower average collection period is considered as a good sign as it implies that the company is taking less time to recover credit given to the customers thus ensuring liquidity.
Formula for calculating average collection period:-
Average collection period = 365 ÷ accounts receivable turnover ratio

Accounts Payable Turnover Ratio:-

Accounts payable turnover ratio is also called as creditors turnover ratio. Accounts payable turnover ratio shows the rate at which the company pays its suppliers for the credit purchases made from them. It indicates how many times the company pays its average accounts payable during a period. A low accounts payable turnover ratio is considered as good.
Formula for calculating accounts payable turnover ratio:-
Accounts payable turnover ratio = credit purchases ÷ average
accounts payables

Accounts payables = creditors
Average accounts payables = creditors (current year) + creditors (previous year) ÷ 2

A variant of the accounts payable turnover ratio called as average payment period is also calculated. Average payment period indicates the number of days, on an average, the company takes to pay its accounts payable. It measures the average number of days the company requires to pay the suppliers for the credit purchases made from them. A higher average payment period is considered as a good sign as it implies that the company can pay its credit bills after a longer period of time thus ensuring liquidity.
Formula for calculating average payment period:-
Average payment period = 365 ÷ accounts payable turnover ratio

Inventory Turnover Ratio:-

Inventory turnover ratio is also called as stock turnover ratio. Inventory turnover ratio shows how efficiently the company turns its inventory into sales. It indicates how many times, on an average, the company sold and replaced its inventory during a period. A high inventory turnover ratio is considered as good.
Formula for calculating inventory turnover ratio:-
Inventory turnover ratio = cost of goods sold ÷ average inventory
Average inventory = inventory (Current year) + inventory (previous year) ÷ 2

A variant of the inventory turnover ratio called as inventory turnover days or days inventory outstanding is also calculated. Inventory turnover days indicate the number of days, on an average, the company takes to turn its inventory into sales. If the inventory turnover days are less, it is considered as a good sign as it implies that the sales of the company are rapid and not much of the company’s capital is tied up in inventory.
Formula for calculating inventory turnover days:-
Inventory turnover days = 365 ÷ inventory turnover ratio

Assets Turnover Ratio:-

Assets turnover ratio shows how efficiently the company uses its assets to generate sales. A high assets turnover ratio is considered as good which shows that the company is efficiently using its assets to generate sales.
Formula for calculating assets turnover ratio:-
Assets turnover ratio = net sales ÷ average total assets

Total assets = long-term assets + current assets
Average total assets = total assets (current year) + total assets (previous year) ÷ 2

Solvency Ratios:-

Solvency ratios are also called as leverage ratios. Solvency ratios indicate the company’s capacity to meet its debt obligations especially long-term debt obligations. They determine the chances of company’s survival in the long run. There are two types of solvency ratios which are as under:-

Debt-To-Equity Ratio:-

Debt-to-equity-ratio is also called as financial leverage ratio. Debt-to-equity ratio indicates the relative proportion of borrowed capital i.e. debt and owned capital i.e. shareholder’s equity in the capital structure of the company. A low debt-to-equity ratio is considered as good indicating that the company has less amount of debt in its capital structure and hence more stable. A high debt-to-equity ratio is considered as bad indicating that the company has higher amount of debt in its capital structure and hence less stable. Debt has to be repaid so there are more chances of the company becoming insolvent if it is not able to repay the high amount of debt it has taken.
Formula for calculating debt-to-equity ratio:-
Debt-to-equity ratio = total debt ÷ total equity

Total debt = long-term debt + short-term debt
Total equity = preference share capital + equity share capital + reserves and surplus
If the preference shares are redeemable then they are taken as debt.

Interest Coverage Ratio:-

Interest coverage ratio is also called as times interest earned ratio. Interest coverage ratio determines how easily the company can pay interest on its outstanding debt. It shows how well the earnings of the company cover the interest costs. A high interest coverage ratio is considered as good indicating that the company is earning sufficiently to easily meet its interest expenses. Whereas a low interest coverage ratio indicates that the company is not earning enough to easily meet its interest expenses and is in danger of becoming insolvent if the earnings become even less.
Formula for calculating interest coverage ratio:-
Interest coverage ratio = earnings before interest and tax ÷ interest expense

Liquidity Ratios:-

Liquidity ratios indicate the company’s capacity to meet its short-term debt obligations. They test the short-term solvency of the company. There are three types of liquidity ratios which are as under:-

Current Ratio:-

Current ratio is also called as working capital ratio. Current ratio tests the liquidity of the company by finding out the proportion of current assets available to pay the current liabilities. Higher the current ratio, the better it is. Higher current ratio indicates that the company has higher amount of current assets compared to current liabilities and can easily pay off the current liabilities from the current assets. Whereas a lower current ratio is not good as it indicates that the company has lower amount of current assets compared to current liabilities and the company may struggle to pay off the current liabilities from the current assets.
Formula for calculating current ratio:-
Current ratio = current assets ÷ current liabilities

Quick Ratio:-

Quick ratio is also called as acid test ratio. Quick ratio refines the current ratio by removing inventory from the current assets as inventory cannot be liquidated easily. Quick ratio is a better indicator of liquidity than current ratio.
Formula for calculating quick ratio:-
Quick ratio = current assets – inventory ÷ current liabilities

Cash Ratio:-

Cash ratio refines the quick ratio by removing any receivables from the current assets. Cash ratio considers only highly liquid current assets and cash itself.
Formula for calculating cash ratio:-
Cash ratio = cash and cash equivalents + marketable securities ÷ current liabilities

Investment Valuation Ratios:-

Investment valuation ratios are also called as market valuation ratios. Investment valuation ratios are used by investors and analysts in the relative valuation of companies. Following are the various types of investment valuation ratios:-

Price/Earnings Ratio:-

Price/earning ratio or P/E ratio is also called as price/earning multiple or P/E multiple. price/earnings ratio tells how much the investors are willing to pay for the company’s earnings. It tells the price that the investors are ready to pay for each unit of profit earned by the company.
 Higher the price/earnings ratio, the more investors are willing to pay for each unit of company’s profit as they are expecting higher earnings growth of the company in future and so are paying more for today’s earnings. Growth investors view high price/earnings ratio stocks as an attractive investment opportunity. while the value investors view high price/earnings ratio stocks as overvalued and hence not good for investment.
 Lower the price/earnings ratio, the less investors are willing to pay for each unit of company’s profit as they do not expect much earnings growth of the company in future. Value investors view low price/earnings ratio stocks as an attractive investment opportunity as they consider stocks with low price/earnings ratios to be currently undervalued and will perform better in future. While the growth investors view low price/earnings ratio stocks as not good for investment as they do not expect the company’s earnings to grow much in future.
Formula for calculating price/earnings ratio:-
Price/earnings ratio = market price per share ÷ earnings per share
Earnings per share = net profit – preference dividend ÷ number of equity shares outstanding

Price/Earnings Growth Ratio:-

Price/earnings growth ratio or PEG ratio refines the price/earnings ratio by including the company’s estimated earnings growth. It compares the stock’s price/earnings ratio with its estimated earnings per share growth. Price/earnings growth ratio is used along with the price/earning ratio. Price/earnings growth ratio can offer a suggestion to the growth investors as to whether a stock’s high price/earnings ratio is a refection of promising earnings growth prospects of the company or excessive high price of the stock. Price/earnings growth ratio can also offer a suggestion to the value investors as to whether a stock’s low price/earnings ratio is because of under-valuation of the stock or poor earnings growth prospects of the company.
 Price/earnings growth ratio varies from person to person as expected earnings per share growth rate is an estimate.
Formula for calculating price/earnings growth ratio:-
Price/earnings growth ratio = price/earnings ratio ÷ expected
earnings per share growth

Price/Book Ratio:-

Price/book ratio or P/B ratio is used to compare the company’s book value to its current market price. A higher price/book ratio indicates that the stock is currently over-valued and not good for investment. While a lower price/book ratio indicates that the stock is currently under-valued and good for investment. However a lower price/book value ratio might also indicate that something is wrong with the company. Price/book ratio is generally used for companies with more liquid assets such as banks and financial companies.
Formula for calculating price/book ratio:-
Price/book ratio = market price per share ÷ book value per share

Book value per share = equity share capital + reserves and surplus – revaluation reserves ÷ number of equity shares outstanding

Enterprise value/EBITDA Ratio:-

Enterprise value/EBITDA ratio or EV/EBITDA ratio is also called as enterprise multiple. Enterprise value/EBITDA ratio compares the enterprise value with earnings before interest, tax, depreciation and amortization (EBITDA). If the enterprise value/EBITDA ratio is lower, it is considered that the company’s stock is under-valued and hence good for investment and the company is a good takeover candidate from the acquirer’s perspective. While a higher enterprise value/EBITDA ratio means that the company’s stock is over-valued and hence not good for investment and the company is not a good takeover candidate from the acquirer’s perspective.
Formula for calculating enterprise value/EBITDA ratio:-
Enterprise value/EBITDA ratio = enterprise value ÷ EBITD
A
Enterprise value = market value of equity + market value of debt – cash

Dividend Yield Ratio:-

Dividend yield ratio shows the relationship between dividend per share and the market price per share. It indicates how much a company pays out in dividend each year in relation to the market price of its shares. Dividend yield ratio is useful for the investors who are more interested in the dividend income than capital gains. Generally, higher the dividend yield ratio, the better it is. But sometimes a high dividend yield ratio may be because of decrease in the market price of the company’s stock recently because of poor financial performance and the company may have to reduce the amount of dividend in future.
Formula for calculating dividend yield ratio:-
Dividend yield ratio = annual dividend per share ÷ market price per share × 100

Dividend Payout Ratio:-

Dividend payout ratio shows the portion of net profit of the company that is paid to the shareholders in the form of dividends during the year. In other words, dividend payout ratio shows the portion of net profit, the company gives as dividend to the shareholders and the portion of net profit, the company retains in the business for its operations. A high dividend payout ratio means that the company is paying a large portion of the net profit as dividend to its shareholders and retaining less portion of net profit in the business. While a low dividend payout ratio means the company is doing the opposite. A high dividend payout ratio is preferable to the investors who are more interested in earning regular dividend income instead of capital gains.
Formula for calculating dividend payout ratio:-
Dividend payout ratio = annual dividend per share ÷ earnings per share × 100
                                                                  Or
Dividend payout ratio = total dividend ÷ net profit × 100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock market related terms

Stock market related terms

Following are some of the important and commonly used stock market related terms and concepts:-

Delivery And Intraday:-

Delivery is also called as investment. When a person buys shares of a company and holds them for a certain period of time say one week, one month, six months, two years, three years, five years or even more before selling them, it is called as delivery or investment. When he buys the shares, it is said that he has taken delivery of the shares and when he sells the shares, it is said that he has given delivery of shares. A demat account is required for delivery. When the shares are purchased, they are added to the demat account and when the shares are sold, they are deducted from the demat account.

Intraday is also called as day trading or margin trading. When a person buys and sells the shares of a company on the same day (long) or sells and buys the shares of a company on the same day (short), it is called as intraday or day trading or margin trading. Demat account is not required for intraday.

Long And Short:-

When a trader in intraday trading first buys a company’s shares to sell them later in the day, it is said that he is long and when he later sells those shares, it is said that he has done a long trade. The trader in a long trade expects the price of the shares to go up so that he can make profit by selling shares at a price higher than the price at which he bought them. But if the price of shares go down, he incurs loss.

When a trader in intraday trading first sells a company’s shares to buy them back later in the day, it is said that he is short and when he later buys back those shares, it is said that he has done a short trade or short sell. The trader in a short trade expects the price of shares to go down so that he can make profit by buying shares at a lower price than the price at which he sold them. But if the price of shares go up, he incurs loss.
Short sell involves selling the shares which the trader does not hold. He borrows the shares from his broker and sells them in the market and then buys them back from the market and returns them to the broker.

IPO And FPO:-

IPO means initial public offering. IPO is a process in which private unlisted companies issue shares to the public for the first time in the primary capital market to raise capital. Those issued shares are then listed on the stock exchange for the purpose of trading.

FPO means follow on public offering. FPO is a process in which already listed companies issue more shares to the public in the primary capital market to raise additional capital. Every issue of shares made by a company after the IPO is called as FPO.

There are two methods by which a company can issue shares to the public in IPO or FPO:-
(1) Fixed price method:-
In the fixed price method, the company decides a fixed price at which it is willing to offer its shares to the public and the investors have to buy the shares at that price. The issue price is decided in advance by the company and informed to the investors.
(2) Book building method:-
Book building is a price and demand discovery method. In the book building method, the company does not decide a particular fixed price at which it is willing to offer its shares to the public but instead gives a price band within which the investors have to bid for the shares. The bids are collected from the investors at various prices which are within the price band specified by the company. The issue price is decided by the company after the bidding is over based on the demand generated in the bidding process at various prices. The issue price that is decided is called as cut-off price.

Oversubscription And Undersubscription Of Shares:-

A company offers certain number of shares to the public in an IPO or FPO.

Shares of a company are said to be oversubscribed if the public applies for more shares than the number of shares offered by the company. For e.g. a company offers 500000 shares to the public but the public applies for 600000 shares, it is a case of oversubscription and it is said that the company’s issue of shares is oversubscribed.

Shares of a company are said to be undersubscribed if the public applies for less shares than the number of shares offered by the company. For e.g a company offers 500000 shares to the public but the public applies for 450000 shares, it is a case of undersubscription and it is said that the company’s issue of shares is undersubscribed.

Face Value, Book Value And Market Value Of Shares:-

When a company issues shares to the public in IPO, it gives a basic value to each share. This value is called as face value. Face value is also called as par value or nominal value. Face value of a share may be Re.1 , Rs 2, Rs 5 or rs 10. Face value of shares do not change except in the case of stock split or reverse stock split.

Book value of a share is the actual worth of the share in the company’s books. Book value of a share is the amount of money that the shareholders would get per share held by them, if the company is wound up or liquidated. Book value per share indicates the amount per share that the shareholders would get after all the assets are liquidated and all the debts are paid off by the company.
Formula for calculating book value per share is:-
Total paid up equity capital + free reserves – revaluation reserves
                       Number of equity shares outstanding

Market value of a share is the current price at which the company’s shares are being traded in the stock exchange. The market value per share is determined by the demand and supply of the company’s shares in the stock market.

Market Capitalization:-

Market capitalization or market cap is the total market value of all the shares outstanding of a company. Market cap is calculated as under:-
Market cap= number of equity shares outstanding * current market value per share.
This gives the total market capitalization of the company. Market cap keeps changing according to the changes in the market value of the company’s shares.
There is also a free float factor which is called as free float market capitalization. Free float market cap takes into consideration only those shares issued by a company that are readily available for trading in the market. It excludes promoter’s shareholding, Director’s shareholding, government shareholding, shares held by persons with controlling interest, etc and locked-in shares which would not be sold in the market. Free float market cap is calculated as under:-
Free float market cap= freely tradable equity shares * current market value per share.

Large Cap, Mid Cap And Small Cap Companies:-

Depending upon their market capitalization, companies are classified into three categories- large cap companies, mid cap companies and small cap companies.

Large cap companies are those companies which have large market capitalization and are generally old and well established companies. Stocks of most of the large cap companies are included in the market index. Stocks of large cap companies are called as large cap stocks.

Mid cap companies are those companies which have medium market capitalization. Some of the mid cap companies have the potential to become large cap companies. Stocks of mid cap companies are called as mid cap stocks.

Small cap companies are those companies which have small market capitalization and are generally new companies which are in the early stage of development. Some of the small cap companies have high growth potential. Stocks of small cap companies are called as small cap stocks.

Blue Chip Companies:-

Blue chip companies are large cap companies which are well-recognized, well established and financially sound. They have stable earnings and are known for their high quality products or services and also the ability to pay regular dividends to their shareholders. Stocks of blue chip companies are called as blue chip stocks and are generally included in the market index.

Fundamental And Technical Analysis:-

Fundamental analysis is the method of evaluating a company’s stock by determining its value which is called as intrinsic value or fair value. If a stock’s market value is currently less than its intrinsic value, it is said that the stock is undervalued and hence good for investment and if a stock’s market value is currently more than its intrinsic value, it is said that the stock is overvalued and hence not good for investment.
Fundamental analysis involves quantitative and qualitative analysis.
Quantitative analysis includes analysis of a company’s financial statements such as profit and loss account, balance sheet, cash flow statement.
Qualitative analysis includes analysis of various factors such as economy and the industry in which the company operates, company’s competitors, quality of the company’s management, company’s products and services, etc.
Fundamental analysis is mostly used by long-term investors. 

Technical analysis is the method of analyzing a company’s stock by studying the historical statistics generated such as past prices and trading volume and predicting the future price movements by identifying a trend or pattern in the statistics.
Technical analysis involves studying various technical indicators such as moving average, support/resistance levels, MACD, relative strength index, stochastic, etc. For studying these indicators various charting software are used.
Technical analysis is mostly used by day traders and short-term investors.

Bull And Bear Market:-

Bull market refers to a market that is on the rise which is indicated by a sustained increase in share prices, high economic growth and strong investor confidence in the economy. In bull market, there is more demand and less supply of shares as more people are buying the shares which leads to the increase in share prices.
An investor or trader who thinks that the market will go up is called a bull. The bull has an optimistic view of the market.

Bear market refers to a market that is on the decline which is indicated by a sustained decrease in share prices, low economic growth and low investor confidence in the economy. In bear market, there is less demand and more supply of shares as more people are selling the shares which leads to the decrease in share prices.
An investor or trader who thinks that the market will go down is called a bear. The bear has an pessimistic view of the market.

Stop-Loss:-

Stop-loss is an order placed with the broker to buy or sell a stock when a certain specified price i.e. stop price stipulated by the trader or investor is reached. Stop loss is used to keep the losses in limit. A stop-loss order becomes a market order once the stop price is reached.
If a trader or investor buys a stock, he will give a sell stop-loss order specifying a price below his buying price at which the stock should be sold in case the position goes against him. So his loss would be limited to the stop price specified by him and not more, in case the price of the stock goes down.
If a trader short sells a stock, he will give a buy stop-loss order specifying a price above his selling price at which the stock should be bought back in case the position goes against him. So his loss would be limited to the stop price specified by him and not more, in case the price of the stock goes up.

Volatility:-

Volatility is the measurement of the rate at which the price of a stock moves up and down i.e. fluctuates over a period of time. If the price of a stock fluctuates rapidly over a short period of time , it is said that the stock has high volatility or the stock is highly volatile. If the price of a stock does not fluctuate a lot, it is said that the stock has low volatility or the stock is less volatile.
Beta is one of the important measure of a stock’s volatility in relation to the market. According to beta measure, the market has a beta of 1. Stocks that fluctuate more than the market have a beta above 1 and the stocks that fluctuate less than the market have a beta below 1. High beta stocks are more risky but have potential for high returns while low beta stocks are less risky but give low returns.

Market Maker:-

Market maker is a firm which provides liquidity to the stocks by standing ready to buy and sell stocks on a continuous basis at publicly quoted prices. Market makers hold certain number of shares of a particular company to facilitate trading in that company’s shares. Market makers maintain bid i.e. buy and ask i.e. sell prices for a particular company’s shares and buy and sell from their own accounts. They make profit from the bid-ask spread i.e. difference between the price at which they would buy and the price at which they would sell the shares.
for e.g. an investor wants to buy or sell 100 shares of a company. For that there must be a willing seller or willing buyer respectively. It is unlikely that the investor is always going to find someone who is interested in selling or buying the exact number of shares of the same company at the exact same time. That’s where the market makers step in by selling the shares to the investor or buying the shares from the investor from their own accounts even if there are no willing sellers or buyers available at that time.

Insider Trading:-

Insider trading is the buying and selling of shares by company’s insiders such as directors, employees ,etc and their relatives and friends or anyone connected with the company such as merchant bankers, share transfer agents, debenture trustees, auditors, lawyers, etc and their relatives and friends. Insider trading can be illegal or legal.
Insider trading is illegal if the insiders trade shares of the company on the basis of some unpublished price sensitive information which is only available to them and not to the public and try to profit from such information. Such illegal insider trading attracts penalty.
Insider trading can be legal if the insiders trade shares of the company on the basis of published and publicly available information and inform such trade to the SEBI.
Information about legal insider trading transactions is available on the websites of BSE and NSE.

Circuit Breaker:-

If the value of a market index or the price of a stock decreases below a specified percentage or increases beyond a specified percentage of the previous day’s close price, it is said that the index or stock has entered into a circuit. If the index value or stock price decreases below the specified percentage, it is said that the index or stock has hit the lower circuit level and if the index value or stock price increases beyond the specified percentage, it is said that the index or stock has hit the upper circuit level.
After the index or a stock hits a lower or upper circuit level, circuit breaker is applied by which the trading in whole market is halted for some time or even for the whole day in case of index hitting the circuit level and the trading in particular stock is halted for some time or even for the whole day in case of individual stocks hitting the circuit level. The purpose of circuit breaker is to curb excessive volatility in the stock market and to control the stock market when it moves below or beyond a reasonable limit.

 

 

 

 

 

Insurance

Insurance
What Is Insurance?

Insurance is a form of risk management primarily used to hedge against the risk of an uncertain loss. It is the equitable transfer of risk of a loss from one party to another in exchange for premium. The party bearing the risk of loss is called as insurer and the party whose risk of loss is covered is called as insured. The insurer sells the insurance policy to the insured and is called as the insurance company while the insured buys the insurance policy from the insurer and is called as the policyholder.

What Is Insurance Premium?

Insurance premium is the financial cost of obtaining the insurance cover. It is the amount of money paid by the insured i.e policyholder to the insurer i.e insurance company in exchange for the risk of loss covered by the insurance company. Insurance premium may be paid either as a lump sum or in installments during the period of the policy.

What Is Sum Assured?

Sum assured is the minimum amount of money that a life insurance company would pay to the beneficiaries of the policyholder if he dies during the policy period. It is also called as the coverage amount and is the total amount for which the policyholder is insured.

What Is Sum Insured?

Sum insured is the maximum amount of money that a general insurance company would pay to the policyholder in case of loss or damage to his property during the policy period. It is also called as the coverage amount and is the total amount for which the property of the policyholder is insured.

Types Of Insurance:-

Insurance is divided in two broad categories:-
(1) Life insurance
(2) General insurance

 (1) Life Insurance:-

Life insurance is a contract between the life insurance company and the policyholder in which the life insurance company agrees to pay a fixed sum of money (sum assured) and bonus, if any to the beneficiaries (family members) of the policyholder if the policyholder dies during the period of policy and the policyholder agrees to pay a certain amount of premium to the insurance company.

There are various types of life insurance. Some of the important ones are given below:-

– Term life insurance:-

Term life insurance policy is for a specific period. If the policyholder dies within the period of policy then a fixed sum of money i.e sum assured is paid to the beneficiaries of the policyholder by the insurance company. If the policyholder survives the period of policy then nothing is paid by the insurance company. The premium paid by the policyholder is not returned back by the insurance company. Term insurance policies have the lowest amount of premium.

– Endowment policy:-

Endowment policy is also for a specific period. If the policyholder dies within the period of policy then a fixed sum of money i.e sum assured and also the bonus, if any is paid to the beneficiaries of the policyholder by the insurance company. If the policyholder survives the period of policy then he himself is paid the sum assured along with the bonus, if any by the insurance company. Endowment plans have higher amount of premium than the term life insurance policies.

 – Whole life insurance:-

Whole life insurance policy does not have a specific time period. It does not end till the death of the policyholder. It provides cover throughout the life of the policyholder, provided he pays the premium amount regularly. After the death of the policyholder, his beneficiaries are paid a fixed sum of money i.e sum assured. The policyholder is not paid anything during his lifetime.

 – Money back policy:-

In the money back policy the policyholder gets periodic payments from the insurance company during the period of policy. Some portion of the sum assured is paid out at regular intervals. If the insured person dies during the policy period, his beneficiaries get the full amount of sum assured without any deductions for the payments made till date. If the policyholder survives the period of policy, he gets the balance amount of sum assured after deducting the payments made till date.

 – Unit-linked insurance plan:-

Unit-linked insurance plan (ULIP) is a combination of insurance and investment. In ULIP, a portion of the premium paid by the policyholder is used for providing life insurance cover and the remaining portion is invested in various equity and debt funds. The policyholder can choose the type of fund according to his investment need. If the policyholder dies during the policy period, his beneficiaries get the full amount of sum assured plus the returns earned on the amount invested in equity or debt fund. If the policyholder survives the period of policy, he only gets the returns earned on the amount invested in equity or debt fund and not the premiums paid by him.

 (2) General Insurance:-

Any insurance other than the life insurance is called as general insurance. General insurance does not cover human life so it is also called as non-life insurance.

There are various types of general insurance. Some of the important ones are given below:-

– Home insurance:-

Home insurance is also called as homeowner’s insurance. It provides monetary compensation to the policyholder in the event of his home or its contents being damaged by fire, theft or accidents. Generally damages to the home caused by natural calamities such as floods and earthquakes are not covered in home insurance policies.

– Health insurance:-

Health insurance is also called as medical insurance. Health insurance provides monetary compensation to the policyholder for the medical expenses he incurs because of illness. It provides coverage for medicines, visits to the doctor, hospital stays, surgery, etc.

– Auto insurance:-

Auto insurance is also called as motor or vehicle insurance. Auto insurance provides monetary compensation to the policyholder for the loss or damages to his vehicle because of theft or accident. The vehicle may be a car, two-wheeler or commercial vehicle. Insurance on a car is called as car insurance, insurance on a two-wheeler is called as two-wheeler insurance and insurance on a commercial vehicle is called as commercial vehicle insurance. It is compulsory to purchase an auto insurance policy if a person owns any type of vehicle.

– Travel insurance:-

Travel insurance provides monetary compensation to the policyholder for the medical expenses he incurs while travelling and also other losses he incurs while travelling whether within his own country or other country. Travel insurance also provides coverage for trip cancellation, trip interruption, lost or stolen luggage, etc.

Principles Of Insurance:-

Following are the important principles of insurance:-

Utmost good faith:-

Both the parties to the insurance contract i.e insurer and insured should display good faith towards each other. The insurer must provide the insured complete, correct and clear information regarding  the terms and conditions of the insurance contract and the insured must willingly disclose to the insurer all the material facts regarding the risk that is going to be covered by the insurer. If the insured hides any fact or gives false information to the insurer, the insurance contract becomes voidable at the discretion of the insurer. The principle of utmost good faith applies to both life and general insurance.

Insurable interest:-

The insured must have insurable interest in the subject matter of insurance. The insurable interest is present when the insured person gets a financial or other type of benefit from the continuous existence of the insured object and the loss or damage to that insured object would cause the insured person to suffer a financial or other type of loss. The insured person must establish that he actually has a financial interest in preserving the object that is being insured. In case of life insurance, the insurable interest is present when the beneficiaries get a financial or other type of benefit from the continuous survival of the insured person and the death of the insured person would cause the beneficiaries to suffer a financial or other type of loss. So the principle of insurable interest applies to both life and general insurance.

Indemnity:-

Indemnity means an obligation to provide compensation for loss. According to principle of indemnity, insurance is used only for getting protection against unpredicted financial and other losses and not for making profit. The insurer agrees to compensate the insured only for the actual loss suffered and the amount of compensation paid by the insurer is in proportion to the incurred losses. The amount of compensation is limited to the amount mentioned in the insurance contract or the actual loss whichever is less and the compensation amount is not paid by the insurer if the loss does not happen during the period of policy. The principle of indemnity applies only to general insurance.

 Contribution:-

This principle is a corollary of the principle of indemnity and is applicable when the insured person has taken out more than one policy on the same subject matter. According to principle of contribution, the insured person can claim the compensation only to the extent of actual loss either from all the insurers proportionately or from any one insurer. If he gets full compensation from one insurer, then he does not have right to claim compensation from other insurers. The insurers have to share the compensation to be given to the insured in proportion to the amount insured by each of them.

 Subrogation:-

This principle is another corollary of the principle of indemnity. Subrogation refers to the right of the insurer to stand in place of the insured person after the settlement of a claim of compensation. After the insurer compensates the insured for example, a damaged property and if the damaged property has any value left then the ownership right of such damaged property shifts to the insurer. If any third party is responsible for the damage to property of insured person because of which the claim of compensation was made then the insurer can take legal action against that third party for recovering the amount of compensation the insurer had to pay to the insured person. The insurer is entitled to get the right to the damaged property only to the extent of the amount of compensation he paid to the insured person and not more. If the insurer recovers from the third party, an amount in excess of the paid compensation then he has to pay this excess amount to the insured person.

 Proximate cause:-

According to this principle, to find out whether the insurer is liable to compensate for the insured person’s loss or not, the proximate or nearest cause of loss must be looked into. The loss caused to the insured person’ property can be because of more than one cause and the property may be insured against some causes and not against others. In such a case, the proximate or nearest cause of loss must be found out. If the proximate cause is covered in the insurance contract, the insurer is liable to pay compensation to the insured person and if the proximate cause is not covered, the insurer is not liable to pay compensation to the insured person. The principle of proximate cause applies only to general insurance.

 Loss minimization:-

According to this principle, it is the duty of the insured person to take all the steps possible to minimize the loss to the insured property. He should not behave in a careless manner just because there is an insurance cover for the property. The principle of loss minimization applies only to general insurance.

 Insurance Underwriters:-

Insurance underwriters are the persons who decide whether to provide insurance cover to the potential clients or not and if it is to be provided then under what terms. They evaluate the risk of potential clients and decide whether to accept the risk and insure them or not. They also decide how much coverage should be given to the potential clients and how much they should pay for it i.e  they decide the amount of sum assured/insured and premium of policy. Each insurance company has its own set of underwriting guidelines to help the underwriter determine whether the company should accept the risk of insuring the potential clients or not. The aim of insurance underwriters is to protect the insurance company from risks that would result into a loss, if accepted.

Insurance Regulatory And Development Authority (IRDA):-

Insurance Regulatory and Development Authority (IRDA) is the regulator and developer of the insurance industry in India. IRDA was established in 1999 by an act of parliament known as IRDA act, 1999. The head office of IRDA is located in Hyderabad. The main objective of IRDA is to protect the interests of the insurance policyholders and to regulate, promote and ensure orderly growth of the insurance industry in India.
For more information about IRDA you can visit the site https://www.irda.gov.in

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives

Derivatives

What Are Derivatives?

Derivatives are contracts which derive their value from the value of one or more other assets known as underlying assets. The value of derivatives is dependent on the value of underlying assets. The underlying assets could be stocks, market indexes, commodities, currencies, etc. The derivatives whose value is dependent on the value of stocks or market indexes are called as equity derivatives, the derivatives whose value is dependent on the value of commodities are called as commodity derivatives, the derivatives whose value is dependent on the value of currencies are called as currency derivatives and so on.

Types Of Derivatives:-

Futures:-

Future is a standardized contract to buy or sell an underlying asset at a specified future date at a specified price. In the futures contract both the buyer and seller are obligated to buy and sell the underlying asset i.e both the buyer and seller are obligated to fulfill the contract.

Futures contracts based on the underlying assets stocks and market indexes are called as equity futures, futures contracts based on the underlying assets commodities are called as commodity futures, futures contracts based on the underlying assets currencies are called as currency futures and so on.

A person buys a futures contract when he expects the price of an underlying asset to increase and so buys the futures contract of that underlying asset. He makes a profit if the price of that underlying asset increases as expected by him or incurs a loss if the price of that underlying asset decreases. On the other hand a person sells a futures contract when he expects the price of an underlying asset to decrease and so sells the futures contract of that underlying asset. He makes a profit if the price of that underlying asset decreases as expected by him or incurs a loss if the price of that underlying asset increases.

A person has to deposit certain amount of money in his brokerage account before entering into futures contract which is called as initial margin. The initial margin money is a certain percentage of the total value of futures contract. Futures contract is marked-to-market daily which involves daily settlement of profit and loss. The daily loss is deducted from the money in the person’s brokerage account and daily profit is added in his brokerage account. This process is called as mark-to-market settlement. If a person’s loss exceeds the amount of money in his brokerage account before the expiry of futures contract, then he gets a margin call which requires him to put additional money in his brokerage account to the extent of the excess loss incurred to settle that day’s loss.

After the expiry of the futures contract it can be settled either by (1) physical delivery of the underlying asset i.e the buyer of futures contract gets delivery of the underlying asset and makes payment at the price specified in the futures contract and the seller of futures contract gives delivery of the underlying asset and receives payment at the price specified in the futures contract or (2) the futures contract can be cash settled i.e the difference between the price specified in futures contract and the current market price of the futures contract is calculated. If the current market price of futures contract is more than the price specified in futures contract then that difference is a profit for the buyer of futures contract and his brokerage account is credited by that amount and the seller’s brokerage account is debited by that amount as it is a loss for him and if the current market price of futures contract is less than the price specified in futures contract then that difference is a profit for the seller of futures contract and his brokerage account is credited by that amount and the buyer’s brokerage account is debited by that amount as it is a loss for him.
(generally all futures contracts are settled in cash and physical settlement does not take place).

Futures contract can be squared off i.e closed before the expiry date. A person who has bought the futures contract can sell it to square off and a person who has sold the futures contract can buy it to square off. In this way futures contract can be closed before the expiry date and the person can book his profit or loss. The futures contract must be of the same underlying asset and same expiry date to square off.

Futures contract can be of 1 month (near month), 2 months (next month) or 3 months (far month) duration and always expires on the last Thursday of the expiry month and if the last Thursday of the expiry month is a holiday, then it expires on the previous business day.

Example of futures:-
Lets take an example of equity futures contract with the underlying asset stock. Suppose a person buys a futures contract of ABC co Ltd as he feels that the stock price of ABC co Ltd is going to rise. He decides to buy one futures contract i.e one lot of ABC co Ltd which consists of 300 shares. The futures price of ABC co Ltd is rs 2100 per share and the initial margin required is 20% of the total futures value of Rs 630000 (2100*300). So he deposits Rs 126000 (20% of 630000) in his brokerage account and buys one futures contract of ABC co Ltd.

On the expiry day lets assume that the futures price of ABC co Ltd is rs 2400 per share. So he earns a profit of Rs 90000 (300*300) as the price of ABC co Ltd’s stock has gone up as he expected. If on the other hand lets assume that the future price of ABC co Ltd is rs 1900 per share on the expiry day. In this case he would incur a loss of rs 60000 (300*200) as the price of ABC co Ltd’s stock  has gone down.

He can also square off his position in the futures contract before the expiry date by selling the futures contract of ABC co Ltd of the same expiry date and book his profit or loss as the case maybe.

Options:-

Option is a contract which gives the buyer/holder of the contract the right but not the obligation to buy or sell an underlying asset at a specified date at a specified price known as the strike price and the seller/writer of the options contract is obligated to settle the contract as per the terms when the buyer/holder of the contract exercises his right. The buyer/holder of the options contract purchases this right from the seller/writer of the options contract for a consideration which is called as premium. In the options contract only the seller/writer is obligated to buy and sell the underlying asset and not the buyer/holder i.e only the seller/writer is obligated to fulfill the contract and not the buyer/holder.

Options contracts based on the underlying assets stocks and market indexes are called as equity options, options contracts based on the underlying assets commodities are called as commodity options, options contracts based on the underlying assets currencies are called as currency options and so on.

There are two types of options:-
(1) Call option:- Call option gives the buyer/holder of the option the right to buy an underlying asset at the specified price i.e strike price at a specified date. But the buyer/holder does not have the obligation to buy it. The seller/writer of the option on the other hand has the obligation to sell the underlying asset to the buyer/holder if he decides to exercise his right to buy. Call option is purchased by a person when he expects the price of underlying asset to increase.
(2) Put option:- Put option gives the buyer/holder of the option the right to sell an underlying asset at the specified price i.e strike price at a specified date. But the buyer/holder does not have the obligation to sell it. The seller/writer of the option on the other hand has the obligation to buy the underlying asset from the buyer/holder if he decides to exercise his right to sell. Put option is purchased by a person when he expects the price of underlying asset to decrease.

The buyer/holder of the options contract has to pay a certain amount of money called as premium to the seller/writer of the options contract at the time of buying the options contract and the loss of buyer/holder is limited to this amount of premium and his profit potential is unlimited. Whereas the seller/writer of the options contract has to deposit certain amount of money called as margin in his brokerage account before selling/writing the options contract and the profit of seller/writer is limited to the amount of premium he receives from the buyer/holder and his risk of loss is unlimited.

Options can be American or European:-
(1) American option:- American style option can be exercised on or before its expiry date. In India all the stock options are American style options.
(2) European option:- European style option can be exercised only on its expiry date and not before. In India all the index options are European style options.

options can be at-the-money, in-the-money or out-of-money:-
(1) At-the-money:- An option is said to be at-the-money when the strike price of the option is equal or nearly equal to the current market price of the underlying asset. This is true for both the call and put options.
(2) In-the-money:- An option is said to be in-the-money when the strike price of the option is below the current market price of the underlying asset in case of call option and if the strike price of the option is above the current market price of the underlying asset in case of put option.
(3) Out-of-money:- An option is said to be out-of-money when the strike price of the option is above the current market price of the underlying asset in case of call option and if the strike price of the option is below the current market price of the underlying asset in case of put option.

Intrinsic value and time value of options:-
Intrinsic value of the options contract is the amount by which the strike price of the option is in-the-money. It is the difference between the current market price of the underlying asset and the strike price of the option. It can be viewed as the immediate exercise value of the option. For a call option, intrinsic value= current market price of the underlying asset- strike price of the option. For a put option, intrinsic value= strike price of the option- current market price of the underlying asset. The intrinsic value of an option must be a positive number or zero. It cannot be negative. If an option is at-the-money then the intrinsic value of that option is zero.
Time value of the options contract is the amount by which the price of the option i.e premium exceeds its intrinsic value. It is also called as extrinsic value of the option. For a call option, time value= call premium- intrinsic value. For a put option, time value= put premium- intrinsic value.

After the expiry of the options contract it can be settled either by (1) physical delivery of the underlying asset i.e the buyer/holder of options contract (with call option) gets delivery of the underlying asset and makes payment at the strike price to the seller/writer in case he exercises his right to buy and the seller/writer gives delivery of the underlying asset and receives payment at the strike price or the buyer/holder of options contract (with put option) gives delivery of the underlying asset and receives payment at the strike price in case he exercises his right to sell and the seller/writer gets delivery of the underlying asset and makes payment at the strike price. If the buyer/holder of the option does not exercise his right to buy or sell then the option expires unexercised and the buyer/holder loses the premium amount paid by him and the seller/writer keeps the premium amount. (2) The options contract can be cash settled i.e if the current premium value of the option on expiry day is more than the premium value at the time of purchasing the options contract, then that difference is a profit to the buyer/holder and his brokerage account is credited with the profit amount and he also gets back the premium amount which he paid. The seller/writer’s account is debited with the loss amount. If the current premium value of the option on expiry day is less than the premium value at the time of purchasing the options contract, then that difference is a loss to the buyer/holder and this loss is deducted from the amount of premium which he paid at the time of purchasing the option contract and he gets the remaining amount of premium back after deducting the loss. The seller/writer gets to keep the amount of premium which is lost by the buyer/holder as his profit. Sometimes the premium value of an option becomes zero on the expiry date. In such a case the buyer/holder loses the entire amount of premium which he paid at the time of purchasing the options contract and the seller/writer gets to keep that whole amount of premium as his profit.
(generally all options contracts are settled in cash and physical settlement does not take place).

Options contract can be squared off i.e closed before the expiry date. The buyer/holder of a call option can sell a call option and the buyer/holder of a put option can sell a put option to square off their position in the options contract. In this way options contract can be closed before the expiry date and the buyer/holder can book his profit or loss. The options contract must be of the same underlying asset, strike price and expiry date to square off.

options contract can be of 1 month (near month), 2 months (next month) or 3 months (far month) duration and always expires on the last Thursday of the expiry month and if the last Thursday of the expiry month is a holiday, then it expires on the previous business day.

Example of options:-
Lets take an example of equity options contract with the underlying asset being market index- nifty. Suppose a person feels that the nifty index value is going to decrease and hence buys a put option of nifty options contract with a strike price of 8300 and pays a premium of rs 50 per unit which is the premium value at that time. One contract i.e one lot of nifty options contract currently consists of 75 units and so he pays the total premium amount of rs 3750 (75*50). The current value of nifty index in the spot market at the time of purchasing the options contract is 8400. So he buys a out-of-money nifty options contract.

After purchasing the options contract, if the value of nifty index in spot market starts to decrease then the premium value of the options contract would start to increase and if the value of nifty index in spot market starts to increase then the premium value of the options contract would start to decrease. This is because he has purchased a put option with the expectation of decrease in nifty index value.

On the expiry day lets assume that the value of nifty index in spot market is 8275 and the premium value of the options contract has become rs 90 per unit. So he would earn a profit of rs 40 per unit (90-50) which amounts to Rs 3000 (40*75). He would earn profit as the nifty index value in spot market has gone down as he expected. Overall he would get Rs 6750 (90*25) credited in his brokerage account. The option seller/writer would suffer a loss of Rs 3000.  If on the other hand lets assume that value of nifty index in spot market is 8410 and the premium value of the options contract has become Rs 5 per unit on expiry day. In this case he would incur a loss of Rs 45 per unit (50-5) which amounts to Rs 3375 (45*75). He would incur loss as the nifty index value in spot market has gone up. He would get Rs 375 (5*75) credited in his brokerage account. The option seller/writer would earn a profit of Rs 3375. If in this case the premium value had become 0 on expiry day then he would have lost all his premium amount to the option seller/writer i.e his loss would have been Rs 3750 and the option seller/writer would have earned a profit of Rs 3750.

He can also square off his position in the options contract before the expiry date by selling the put option of nifty index of the same expiry date and strike price and book his profit or loss as the case maybe.

Difference Between Futures And Options:-

Futures Options
In the futures contract both the buyer and seller are obligated to buy and sell the underlying asset at the specified price and on the specified date. Both the buyer and seller are required to fulfill the contract. In the options contract only the seller/writer is required to fulfill the contract. The buyer/holder has the right to buy (in case of call option) or sell (in case of put option) the underlying asset at the specified price but not the obligation. Seller/writer has the obligation to sell or buy the underlying asset if the buyer/holder exercises his right.
 In the futures contract, both the buyer and seller have unlimited profit potential and also the risk of incurring unlimited loss.  In the options contract, the buyer/holder has unlimited profit potential and his risk of loss is limited. The seller/writer on the other hand has risk of incurring unlimited loss and his profit is limited to the amount of premium.
Upfront margin money is required to be deposited by both the buyer and seller before entering into the futures contract. The buyer/holder is required to pay premium money while the seller/writer is required to deposit margin money before entering into the options contract.

Forwards:-
Forward is a customized contract to buy or sell an underlying asset at a specified future date at a specified price. Forwards contract is similar to a futures contract but is a customized contract and not standardized. Forwards contract is not traded on the stock exchanges like NSE and is not exchange regulated. It is traded over-the-counter.

Difference Between Futures And Forwards:-

 Futures Forwards
Futures contract is a standardized contract. Forwards contract is a customized contract.
Futures contract is traded on the stock exchange. Forwards contract is traded on the over-the-counter exchange.
In the futures contract there is daily settlement of profit and loss as futures contracts are marked-to-market. In the forwards contract there is no daily settlement of profit and loss as forwards contracts are not marked-to-market.
In the futures contract there is no counterparty risk because of the presence of clearing house. In the forwards contract there is high counterparty risk because of the absence of clearing house.
In the futures contract there is liquidity for the parties as they can square-off their contract before the expiry date. In the forwards contract there is no liquidity for the parties as they cannot square-off their contract before the expiry date.

Minimum Contract Value Of Derivatives:-

The minimum contract value or size of equity derivatives traded in the Indian market is Rs 500000. It applies to both futures and options. SEBI has specified that the value of a equity derivative contract should not be less than Rs 500000 at the time of introducing the contract in the market.

 

 

 

 

 

 

 

 

 

 

 

 

 

Mutual funds

Mutual funds

What Is A Mutual Fund?

Mutual fund is a collective investment scheme that pools money from a number of investors who share a common financial goal. The money pooled is then invested in various financial securities such as shares, debentures, money market securities and other securities according to the investment objective of the scheme. The income earned through these investments is shared among the investors in proportion to their investment in the mutual fund scheme which is denoted by the units held by them.

Types Of Mutual Funds:-

There are various types of mutual fund schemes:-

(A) Based On The Maturity Period:-

 Open-ended funds:-

Open-ended funds are open for the investors to enter and exit at anytime even after the New fund offer (NFO). The investors can buy the units of the open-ended fund from the fund itself at the current Net asset value (NAV) of the fund and the existing investors can return the units of the open-ended fund to the fund itself and get their money back at the current re-purchase price of the fund. Open-ended funds do not have a fixed maturity period. Some existing investors exit the fund while some new investors enter the fund because of which the unit capital of an open-ended fund keeps changing on a continuous basis.

  Close-ended funds:-

Close-ended funds have a fixed maturity period. Close-end funds allow the investors to enter the fund only during its New fund offer (NFO) and the existing investors to exit the fund only after the end of the specified maturity period. The investors can buy the units of the close-ended fund from the fund itself only during its New fund offer (NFO). Thereafter the investors who want to buy units of close-ended fund can buy them from a seller on the stock exchange where the units are listed. Similarly existing investors can return the units of the close-ended fund to the fund itself and get their money back only after the end of the specified maturity period. The existing investors who want their money back before the end of maturity period can sell their units to a buyer on the stock exchange where the units are listed. The unit capital of an close-ended fund does not change as the sale and purchase of its units takes place between the buyers and sellers on the stock exchange after the New fund offer (NFO) and not to or from the fund itself.

 Interval funds:-

Interval funds combine the features of both open-end and close-end mutual funds. They are largely close-ended but become open-ended at pre-specified intervals. During the interval period the investors can purchase units from the fund itself at the current Net asset value (NAV) and the existing investors can return their units to the fund itself and get their money back at the current re-purchase price. After the end of the interval period the fund again becomes a close-ended fund.

 (B) Based On The Investment Objective:-

Equity funds:-

Equity funds are also called as growth funds. In the equity fund schemes, major portion of the investors money is invested in the equity shares of different companies. The net asset value (NAV) of equity funds fluctuate with the fluctuations in share prices of the companies in which the fund has invested. The aim of equity funds is to provide capital appreciation over medium to long-term to the investors. Equity fund schemes are more risky than the other schemes.

 Debt funds:-

Debt funds are also called as income funds. In the debt fund schemes, major portion of the investors money is invested in debt securities such as debentures, bonds, government securities, etc. The aim of debt funds is to provide regular and steady income to the investors while preserving the capital. Debt fund schemes are less risky compared to the equity fund schemes.

Hybrid funds:-

Hybrid funds are also called as balanced funds. In the hybrid fund schemes, investors money is invested in equity shares as well as in the debt securities according to a specified proportion. The aim of hybrid funds is to provide both capital appreciation and regular income to the investors. Hybrid fund schemes are less risky than the equity schemes but more risky than the debt schemes.

Liquid funds:-

Liquid funds are also called as money market funds. In the liquid fund schemes, investors money is invested in short-term money market instruments such as treasury bills, commercial papers, certificates of deposit, etc. The aim of liquid funds is to provide easy liquidity and preservation of capital while earning moderate income. Liquid fund schemes are less risky than the other schemes.

 (c) Other Funds:-

Sector funds:-

In sector fund schemes, investors money is invested in the equity shares of companies that belong to a specific sector or industry such as pharmaceuticals, IT, automobiles, etc. The returns on these funds are dependent on the performance of the respective sectors or industries.

 Tax saving funds:-

Tax saving fund schemes offer tax benefit to the investors like the Equity linked savings scheme (ELSS). In ELSS, investors money is invested in equity and equity related securities. Investment in ELSS qualifies for tax deduction under section 80c of the Indian Income Tax Act. The scheme has a lock-in period of 3 years.

 Index funds:-

Index funds replicate the performance of a particular stock market index such as Nifty or Sensex. In index fund schemes, investors money is invested in only those stocks of companies who represent the index and in the same proportion of those stocks weightage in the index. The aim of index funds is to achieve approximately the same return as the index. Net asset value (NAV) of index funds rise and fall according to the rise and fall in the index but not exactly by the same percentage due to the tracking error.

 Exchange traded funds (ETF):-

Exchange traded funds (ETF) are index funds that are listed and traded on the stock exchanges like stocks. ETF track a particular stock market index and its units are bought and sold on the stock exchange through market makers who offer a price quote for buying and selling units at all times. Only big investors can buy and sell units of ETF from the fund itself. Retail investors have to buy and sell units of ETF on the stock exchange through market makers. ETF prices change throughout the day as they are bought and sold. Apart from Equity ETF, there are also other types of ETF such as Gold ETF that track the price of gold.

 Fund of funds:-

In Fund of funds scheme, investors money is invested in the units of other mutual fund schemes. Just as other mutual funds where investors money is invested in different securities, in Fund of funds scheme the investors money is invested in the units of different mutual fund schemes. The aim of Fund of funds is to achieve even greater diversification than the other mutual fund schemes. The expenses of Fund of funds schemes are higher than the other mutual fund schemes because they also include the expenses of those mutual fund schemes in which the Fund of funds invest.

 Advantages Of Mutual Funds:-

Following are the advantages of investing in mutual funds:-

– There is professional management of the investors money by the fund managers who are highly skilled and experienced and are backed by a dedicated investment research team.

– Mutual funds invest the investors money in various securities of different companies and in different sectors. This portfolio diversification reduces the risk significantly.

– Mutual funds are relatively less expensive way to invest compared to direct investing as the they benefit from the economies of scale and pay lower transaction costs which results into lower costs for the investors.

– Mutual funds are liquid investments. The investors can exit the mutual fund scheme and get their money back anytime they want at the Net asset value (NAV) price in case of open-ended funds and they can sell their units in the stock exchange at the prevailing market price in case of close-ended funds.

– Investing in mutual fund save investors time as they do not have to do any research and analysis regarding their investment as the fund manager of the scheme along with his research analysts does this for the investors.

– In India dividend earned on mutual funds is tax free in the hands of the investors.

– All the mutual funds in India are regulated and regularly monitored by the Securities and Exchange Board of India (SEBI) who makes strict regulations to protect the interests of the investors.

Disadvantages Of Mutual Funds:-

Following are the disadvantages of investing in mutual funds:-

– Investors do not have any control on their invested money as all the investment decisions are taken by the fund manager.

– There are costs and expenses associated with mutual fund investment such as entry or exit loads, management fees, etc.

– There are many mutual fund schemes available for investors to choose from. Choosing the right mutual fund scheme according to the requirement is not easy.

New Fund Offer (NFO):-

Launch of a new mutual fund scheme is called New Fund Offer (NFO). It is an invitation to the investors to invest their money in the mutual fund scheme by subscribing to its units. Units of a mutual fund scheme are offered to the investors for the first time through NFO. The NFO of a mutual fund scheme is open for a fixed period during which the investors can buy the units of the scheme. In case of open-ended schemes, the investors can buy units even after the end of NFO period from the fund itself at the prevailing Net Asset Value (NAV) when the open-ended scheme opens again for subscription after the initial allotment of units in the NFO. In case of close-ended schemes, the investors can buy the units only during the period of NFO from the fund itself. After the end of NFO period they can only buy the units on the stock exchange where the scheme is listed.

Mutual Fund Loads:-

Some mutual fund companies charge their investors to cover their marketing and distribution expenses. Such charge imposed on the investors by the mutual fund companies is called as load. There are two types of load which can be charged by the mutual funds.
(1) Entry load:- Entry load is also called as Front-end load. It is the load which is charged to the investors at the time of their entry into the mutual fund scheme i.e when they purchase the units from the fund. The entry load percentage is added to the prevailing Net Asset Value (NAV) at the time of allotment of units.
(2) Exit load:- Exit load is also called as Back-end load. It is the load which is charged to the investors at the time of their exit from the mutual fund scheme i.e when they return the units to the fund. The exit load percentage is deducted from the prevailing Net Asset Value (NAV) at the time of redemption of units.

 Net Asset Value (NAV):-

The performance of a particular scheme of mutual fund is denoted by its Net Asset Value (NAV). Net Asset Value is the market value of the assets of the scheme minus its liabilities.
Market value of assets= market value of securities held by the scheme + dividend accrued + interest accrued + cash.
This is the total Net Asset Value of the scheme.
To calculate the Net Asset Value per unit, total net asset value is divided by the number of outstanding units of the scheme.
Example of Net Asset Value calculation:-
The market value of the securities held by a mutual fund scheme is rs 5000000. Dividend accrued is rs 400000 and interest accrued is rs 300000. The scheme has cash of rs 100000. The liabilities of the scheme are rs 1000000. The scheme has 200000 units outstanding.
The total Net Asset Value of the scheme would be:-
rs 5000000 + rs 400000 + rs 300000 + rs 100000 – rs 1000000
rs 5800000 – rs 1000000
= rs 4800000
The Net Asset Value per unit would be:-
rs 4800000
rs 200000
= rs 24

 Constituents Of Mutual Funds:-

Following are the important constituents of mutual funds in India:-

 Sponsor:-

sponsor is a person who, acting alone or in combination with another body corporate, establishes a mutual fund. The Sponsor gets the mutual fund registered with Securities and Exchange Board of India (SEBI).

 Trustees:-

Mutual funds in India are established in the form of a trust and are managed by either a board of trustees or a trust company. Trustees protect the interest of the unit holders i.e the investors and are the primary guardians of their funds and assets.

Asset management company:-

Asset management company is appointed by the trustees. It is the investment management firm that invests the funds of the investors in the securities according to the stated investment objective of the mutual fund scheme. Asset management company manages various schemes of a mutual fund and invests the funds raised under various schemes according to the provisions of the trust deed.

Custodian and depositories:-

Mutual funds buy and sell securities in large volumes. So keeping a track of such transactions is a specialized activity. For this purpose custodians are appointed for safekeeping of physical securities while dematerialized securities are held in depository through a depository participant.

Registrars and transfer agents:-

Registrar and transfer agents are responsible for issuing and redeeming units of the mutual fund schemes and providing other related services such as preparation of transfer documents and updating investor records.

Association Of Mutual Funds In India (AMFI):-

Association of Mutual Funds in India (AMFI) is the association of Securities and Exchange Board of India (SEBI) registered mutual funds in India. It was incorporated on 22nd August, 1995 as a non-profit organization to develop the Indian mutual fund industry and to protect and promote the interests of mutual funds and their investors. AMFI also conducts the training and certification of all intermediaries such as distributors and others who are engaged in the mutual fund industry and regulates the conduct of distributors and takes disciplinary action against them for violations of code of conduct. AMFI also undertakes nationwide investor awareness programmes to promote proper understanding of the concept and working of mutual funds. For more information about AMFI you can visit the site www.amfiindia.com

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate actions

Corporate actions

What Is Corporate Action?

Corporate action is an event initiated by a public company that brings a material change to the company or securities issued by the company which affects the holders of securities of the company such as shareholders and debenture holders.

Categories Of Corporate Actions:-

Corporate actions can be grouped into three categories which are as under:-

(1) Mandatory corporate actions:-

Participation of security holders is compulsory for these corporate actions. But the security holders do not have to do anything in mandatory corporate actions. Examples of mandatory corporate actions are dividend payment to shareholders, interest payment to debt holders, bonus issue of shares, mergers, acquisitions, spinoffs, stock split, reverse stock split, name change of company, etc.

(2) Voluntary corporate actions:-

Participation of security holders is not compulsory for these corporate actions. The security holders can decide whether they want to participate in the corporate action or not. A response from the security holders is required to process the corporate action. Examples of voluntary corporate actions are rights issue of shares, buy-back of shares, etc.

 (3) Mandatory with option corporate actions:-

Participation of security holders is compulsory for these corporate actions but they are presented with options. If a security holder does not submit his option to the company, the default option is applied. For example cash dividend or stock dividend with one of the options as default.

Types Of Mandatory Corporate Actions And Their Explanation:-

Following are the important types of mandatory corporate actions that are initiated by a Public company:-

Dividend payment:-

Dividend is the payment made by a company to its shareholders from the profits made by the company. When a company earns profit, it re-invests some part of it in the business which is called as retained earnings and distributes the remaining part of the profit to the shareholders which is called as dividend. Dividend can be equity dividend or preference dividend. Dividend paid to equity shareholders is called as equity dividend and the dividend paid to preference shareholders is called as preference dividend. The amount of equity dividend depends upon the profit made by the company. Higher the profit, higher is the amount of equity dividend. Whereas the amount of preference dividend is fixed. It does not depend upon the profit made by the company. The company has to pay preference dividend at a fixed rate or fixed amount irrespective of the amount of profit earned by the company. There are two main types of  equity dividend:-
(1) Interim dividend:-
Interim dividend is the dividend that is paid in between the two annual general meetings of the company before finalizing the accounts and preparation of final financial statements. Interim dividend is generally paid by the company when it has earned heavy profit during the year and wants to distribute some of it among the shareholders.
(2) Final dividend:-
Final dividend is the regular dividend paid by the company annually at the end of the financial year. It is proposed by the board of directors and approved by the shareholders in the annual general meeting of the company. Final dividend is paid after finalizing the accounts and preparation of final financial statements.

 Interest payment:-

Interest is the amount of fee paid by the borrower to the lender at a fixed rate for using the borrowed money. It is the cost of borrowing money for the borrower and the income from lending money for the lender. The company pays interest on the loans taken from various banks and financial institutions as well as on the debt securities issued such as debentures and bonds. Interest can be of two types:-
(1) Simple interest:-
Simple interest is the interest paid only on the principal amount borrowed. No interest is paid on the interest accrued during the term of the loan or debt security.
(2) Compound interest:-
Compound interest is the interest paid not only on the principal amount borrowed but also on the interest accrued during the term of the loan or debt security. The interest accrued on the principal amount is added back to the principal amount i.e re-invested and the whole amount is then treated as the new principal for the calculation of interest for the next period.

 Stock split:-

Stock split is a process where a company reduces the face value of its shares and issues proportionate number of new shares of the new reduced face value to the existing shareholders so that the proportionate holding value of shareholders remains the same. Stock split increases the number of outstanding shares of the company. The main objective of stock split is to make shares of the company affordable to small investors and to improve the liquidity of the shares in stock market. After stock split, the share capital and market capitalization of the company remains unchanged but the market value of shares reduce since the number of outstanding shares increase.
Example:- A company has 100000 shares outstanding and face value per share is rs 5. The market value per share is rs 100. The company is going to split the stock 2 for 1.
After the stock split, the company would have 200000 shares outstanding and face value per share would be rs 2.5 and the market value per share would be rs 50.
Suppose a shareholder owned 200 shares of that company before stock split at rs 100 per share and had shares worth rs 20000 (200*100). After stock split, he would own 400 shares at rs 50 per share. So he would still own shares worth rs 20000 (400*50).

 Reverse stock split:-

Reverse stock split is a process where a company increases the face value of its shares and issues proportionate number of new shares of the new increased face value to the existing shareholders so that the proportionate holding value of shareholders remains the same. Reverse stock split decreases the number of outstanding shares of the company. The main objective of reverse stock split is to prevent the company from getting delisted from the stock exchange because of low price of its shares. After reverse stock split, the share capital and market capitalization of the company remains unchanged but the market value of shares increase since the number of outstanding shares decrease.
Example:- A company has 100000 shares outstanding and face value per share is rs 5. The market value per share is rs 100. The company is going to reverse split the stock 1 for 2.
After the reverse stock split, the company would have 50000 shares outstanding and face value per share would be 10 and the market value per share would be rs 200.
Suppose a shareholder owned 200 shares of that company before reverse stock split at rs 100 per share and had shares worth rs 20000 (200*100). After reverse stock split, he would own 100 shares at rs 200 per share. So he would still own shares worth rs 20000 (100*200).

 Issue of bonus shares:-

Bonus shares are the free shares given by a company to its existing equity shareholders. They are given without any cost to the existing equity shareholders of the company in proportion to their current shareholding in the company. The issue of bonus shares is called as bonus issue. Bonus shares are issued by the company by using the free reserves which are accumulated by the company by retaining part of the profit over the years instead of paying dividend. When the company issues bonus shares, the reserves get converted into capital. After the issue of bonus shares, the share capital of the company increases while the market capitalization of the company remains unchanged but the market value of shares decrease as the number of outstanding shares increase. The total shareholding value of the shareholders will not increase after bonus issue but will remain the same.
Example:- A company has 10000 shares outstanding and face value per share is rs 10 and the share capital is rs 100000 (10000*10). The market value per share is rs 25. The company announces bonus shares in the ratio of 1:1 i.e 1 bonus share for each share owned by the shareholder.
After the issue of bonus shares, the company would have 20000 shares outstanding but the face value per share will remain unchanged which is rs 10 per share. The share capital of the company would be rs 200000 (20000*10) and market value per share would be rs 12.50.
Suppose a shareholder owned 100 shares of that company before bonus issue. Before bonus issue he had shares worth rs 2500 (100*25). After bonus issue, he would own 200 shares at rs 12.50 per share. He would still own shares worth rs 2500 (200*12.50).

 Difference Between Stock Split And Bonus Issue:-
Stock Split Bonus Issue
The same existing shares of the shareholders are split into two in stock split. Free additional shares are given to the shareholders over their existing shares in bonus issue.
After stock split the share capital of the company remains the same. After bonus issue the share capital of the company increases as the reserves are converted into share capital.
After stock split face value of the company’s share decreases. After bonus issue face value of the company’s share remains the same.
Mergers:-

Merger is also called as amalgamation. Merger is a process in which two companies of nearly equal size combine together to form a new company altogether rather than remaining separately owned and managed. Neither of the two companies survive independently. It involves the mutual decision of two similar sized companies to combine and become one company. After merger, both the companies shares are surrendered and new company’s shares are issued in their place.

 Acquisitions:-

Acquisition is also called as takeover. Acquisition is a process in which a larger company purchases another smaller company and clearly establishes itself as the owner. The purchased company no longer exists. The purchasing company is called as acquirer company and the purchased company is called as acquired company or target company. The acquirer company buys the equity shares and therefore control of the target company.

 Spin-offs:-

Spin-off is also called as spin-out. Spin-off is a process in which a company splits off sections or divisions of itself as separate business. The sections which are split off function as independent companies separate from the parent company.

 Types Of Voluntary Corporate Actions And Their Explanation:-

Following are the important types of voluntary corporate actions that are initiated by a public company:-

Issue of rights shares:-

Rights shares are the shares offered by a company to its existing equity shareholders at a cheaper price than the current market price of that company’s shares in the market. They are offered to the existing equity shareholders in proportion to their current shareholding in the company. The issue of rights shares is called as rights issue. The existing shareholders are given a specified time period within which they have to inform their decision to the company as to whether they want to subscribe to the rights issue or not. The shareholders may or may not subscribe to the rights issue. If some shareholders do not subscribe to the rights issue, their shareholding value would get diluted. After the issue of rights shares, the share capital and market capitalization of the company increases and the number of outstanding shares also increase while the market value of shares decrease.
Example:- A company has 50000 shares outstanding and face value per share is rs 10 and the share capital is rs 500000 (50000*10). The market value per share is rs 50 and the market cap is rs 2500000 (50000*50). The company has offered rights shares in the ratio of 1:1 i.e 1 rights share for each share owned by the shareholder and the offer price per share is rs 40.
Lets assume that all the existing shareholders accept the offer of rights shares. So after the rights issue, the company would have 100000 shares outstanding and the share capital of the company would be rs 1000000 (100000*10). The market cap of the company would be rs 4500000 (2500000)+(50000*40) and the market value per share would be rs 45 (4500000/100000*10).
Suppose a shareholder owned 100 shares of that company before rights issue at rs 50 per share. After subscribing to the rights issue, he would own 200 shares at the average buy price of rs 45 per share (50+40/2) which would be same as the current market price. But if he does not subscribe to the rights issue, his buying price would remain at rs 50 per share while the market price would be rs 45 per share. So he would be in a loss of rs 5 per share and his shareholding value would be diluted to rs 4500 (100*45) from rs 5000 (100*50) because of the extra shares issued.

 Buy-back of shares:-

Buy-back of shares is a process in which a company purchases its own equity shares either from:-
– Existing shareholders on a proportionate basis
– Open market through book building process or stock exchange
– Odd lot holders
The main objectives of buy-back are:-
– Increasing the promoters shareholding in the company
– Preventing takeover bids
– To achieve or maintain a target capital structure
– To increase the share value
– To pay surplus cash not required
The company can purchase its own shares by using either:-
– Free reserves
– Securities premium account
– Proceeds of an earlier issue of securities
After the buy-back of shares, the share capital and market cap of the company decreases while the market price of the shares increase as the number of outstanding shares decrease.

 

 

 

 

 

 

 

 

 

Stock exchanges

Stock exchanges

What Is A Stock Exchange?

Stock exchange is a key institution of the secondary capital market. Stock exchange facilitates the purchase and sale of various kinds of securities. It is an organized market place for buying and selling various types of securities by the investors thus providing liquidity to the securities. Stock exchange allows buying and selling of already issued securities. The companies and government issue securities to the public in the primary capital market and then these securities are listed on the stock exchanges for trading among investors. So stock exchange is also called as secondary capital market. All the transactions in securities at the stock exchange are done only through the registered members of stock exchange  called as brokers. Investors cannot directly trade securities in stock exchange. They can do so only through the brokers who transact on behalf of them at the stock exchange.

Major Stock Exchanges Around The World:-

Following are some of the biggest and well-known stock exchanges in the world:-

New York stock exchange (NYSE):-

New York stock exchange is located in the New York city in United States of America. NYSE is the world’s largest stock exchange by market capitalization. NYSE relied on floor trading for many years but now more than half of the trades on NYSE are done electronically. For more information about NYSE you can visit the site www.nyse.com

 NASDAQ stock exchange:-

NASDAQ originally stood for National Association of Securities Dealers Automated Quotations. NASDAQ is an American stock exchange and the second largest stock exchange in the world by market capitalization and is world’s first and largest electronic stock exchange. All the trades on NASDAQ are done electronically and floor trading does not exist. NASDAQ was founded in 1971. For more information about NASDAQ you can visit the site www.nasdaq.com

 Tokyo stock exchange:-

Tokyo stock exchange is located in the Tokyo city in Japan. It is the largest stock exchange in Asia by market capitalization and third largest in the world. For more information about Tokyo stock exchange you can visit the site www.tse.or.jp/english/

 London stock exchange:-

London stock exchange is located in the London city in United Kingdom. It was founded in 1801. For more information about London stock exchange you can visit the site www.londonstockexchange.com

Stock Exchanges In India:-

National Level Stock Exchanges:-

There are two major national level stock exchanges in India:-

(1) National Stock Exchange of India Ltd (NSE):-

National Stock Exchange of India Ltd was incorporated in 1992. Its head office is in Mumbai. NSE was established to provide a modern, fully automated screen-based trading system with national reach. NSE provides a fully automated screen based trading system for trading of securities. The trading system is known as National Exchange for Automated Trading (NEAT) system which is a order driven system. NSE does not have trading floor and all the trades take place electronically through the trading terminals. For more information about NSE you can visit the site www.nseindia.com

 (2) Bombay Stock Exchange Ltd (BSE):-

Bombay Stock Exchange was established in 1875. Its head office is in Mumbai. BSE is the oldest stock exchange in Asia and the first stock exchange in India to get permanent recognition from the Government of India. More than five thousand companies are listed on BSE making it the world’s number one exchange in terms of listed companies. Earlier BSE used to have floor trading system but in 1995, BSE switched to automated screen based trading system called as BSE online Trading (BOLT) system which is an order driven system. So all the trades on BSE now take place electronically through the trading terminals. For more information about BSE you can visit the site www.bseindia.com

 Regional Stock Exchanges:-

Regional stock exchanges were setup regionally to enable regional companies in the respective geographical regions to raise capital and to spread the equity cult among the investors all over the country. The first regional stock exchange in India to operate was Ahmadabad Stock Exchange which was followed by Calcutta Stock Exchange. Because of the introduction of automated trading and the extension of nationwide reach of NSE and BSE with their terminals all over the country, the relevance of regional stock exchanges in lost today. There is very limited amount of trading done on the regional stock exchanges and some of the regional stock exchanges have been closed down and some are in the process of closing down. Currently the following regional stock exchanges are still functioning in India:-
– Ahmadabad Stock Exchange
– Calcutta Stock Exchange
– Bangalore Stock Exchange
– Delhi Stock Exchange
– Madhya Pradesh Stock Exchange
– Madras Stock Exchange
– Bhubaneswar Stock Exchange
– Cochin Stock Exchange
– Guwahati Stock Exchange
– Jaipur Stock Exchange
– Ludhiana Stock Exchange
– Magadh Stock Exchange
– Vadodara Stock Exchange
– UP Stock Exchange
– Pune Stock Exchange

 OTC Exchange Of India (OTCEI):-

Over-the-counter Exchange of India was incorporated in 1990 as a company under the companies act and also got recognized as a stock exchange. It is based in Mumbai. OTCEI is the first screen based nationwide stock exchange in India and the first stock exchange to introduce market making in India. The screen based trading system of OTCEI is called as OTCEI Automated Securities Integrated System (OASIS) which is a combination of order driven and quote driven system. OTCEI is a floor less exchange. Companies that are listed on OTCEI are small companies who are looking to gain access to the capital market but cannot meet the listing requirements of large stock exchanges. For more information about OTCEI you can visit the site www.otcei.net

 What Is An Index?

Index, also called as indice, is a statistical indicator that reports the changes in the market value of a group of stocks. It gives a general idea about whether the prices of most of the stocks have gone up or gone down. Index can be broad-based index or sector specific index. The main index of a stock exchange is broad-based index and is comprised of major companies stocks listed on that stock exchange and reflects the price movement or performance of the entire stock market. Whereas sector specific index is comprised of stocks of companies which belong to the same specific sector and reflects the price movement or performance of that particular sector only.

Major Stock Indexes In The world:-

Following are some of the closely watched indexes in the world:-

Dow Jones Industrial Average:-

Dow Jones Industrial Average is the index of New York Stock Exchange but it also comprises of stocks of companies that are listed on NASDAQ. Dow Jones Industrial Average comprises of 30 large companies stock based in America.

NASDAQ Composite:-

NASDAQ composite comprises of more than 3000 companies stock listed on NASDAQ stock exchange. Since both American as well as non-American companies are listed on NASDAQ, the index comprises of both American and non-American companies stocks.

 Standard and Poor’s 500:-

Standard and poor’s 500 comprises of stocks of companies that are listed on New York Stock Exchange as well as those that are listed on NASDAQ Stock Exchange. S&P 500 comprises of 500 leading companies stock based in America.

 Nikkei 225:-

Nikkei 225 comprises of 225 top rated Japanese companies stock listed on the Tokyo Stock Exchange.

 FTSE 100:-

FTSE 100 comprises of 100 largest companies stock listed on the London Stock Exchange.

Stock Indexes In India:-

There are two major indexes in India which are closely followed:-

(1) Nifty:-

CNX Nifty is an index of all the major companies stock listed on the National Stock Exchange of India Ltd. Nifty comprises of 50 companies stock representing twenty-three sectors of the economy. These 50 stocks are reviewed and modified from time to time according to the position of respective companies. Nifty is owned and managed by India Index Services and Products Ltd (IISL). Nifty is computed using the free float market capitalization weighted method.

 (2) Sensex:-

S&P BSE sensex is an index of all the major companies stock listed on Bombay Stock Exchange Ltd. Sensex comprises of 30 companies stock representing key sectors of the economy. These 30 stocks are reviewed and modified from time to time according to the position of respective companies. Sensex is computed using the free float market capitalization weighted method.

 In addition to the above major broad-based indexes, there are many other indexes in India which are closely watched such as CNX mid cap and CNX small cap which comprises of medium and small companies stocks listed on NSE respectively, S&P BSE mid cap and small cap which comprises of medium and small companies stocks listed on BSE respectively. Sectoral indexes such as CNX auto, CNX IT, CNX metal, etc which comprises of stocks of companies of respective sectors listed on NSE, sectoral indexes of BSE such as S&P BSE Bankex, S&P BSE capital goods, S&P BSE oil and gas, etc which comprises of stock of companies of respective sectors listed on BSE.

What Is Listing Of Securities?

Listing of securities means admission of securities of a public company on the stock exchange for trading. The company wanting to get its securities listed on a stock exchange is required to enter into a listing agreement with that stock exchange. The listing agreement contains the terms and conditions of listing and the disclosures that shall be made by the company on a continuous basis to the stock exchange. Because of listing, the liquidity of the securities is ensured making it easy to buy and sell the companies securities on the stock exchange. The listing agreement signed by a company with the stock exchange provides for timely disclosure of information to investors by the company thus enabling them to take important decisions regarding their investment in the company. Listing also improves the public image of a company.

What Is Delisting Of Securities?

Delisting of securities means permanent removal of securities of a listed company from the stock exchange. Because of delisting, the securities of the company would no longer be traded on that stock exchange from which the securities are delisted.  Delisting of securities can be of two types- compulsory delisting, which refers to the permanent removal of securities of a listed company by the stock exchange as a penalty for not complying with the various requirements of the listing agreement and voluntary delisting, where a company decides on its own to permanently remove its securities from the stock exchange.

Settlement Of Trades:-

Settlement of trade is the process in which payment is made by the investors who have purchased the securities and securities are delivered by the investors who have sold the securities. The process of settlement of trades is managed by the stock exchange through the clearing house who ensures that the settlement takes place smoothly.
The period within which the settlement of trades is done is called as the settlement cycle. It is the period within which the buyers of securities receive the securities and sellers of securities receive the money.
In India, all the trades done on BSE and NSE are settled by the method of Rolling settlement. Under Rolling settlement, all the trades done on a particular day are settled after a given number of business days. Trades in rolling settlement are currently settled on a T+2 basis i.e trade day + 2nd working day after the trade day. For e.g a trade executed on Monday (T day) would be compulsorily settled by Wednesday (2nd working day), a trade executed on Tuesday (T day) would be compulsorily settled by Thursday (2nd working day) and so on. All the intervening holidays such as bank holidays, stock exchange holidays, Saturdays and Sundays are excluded for arriving at the settlement day. All the trades in equity shares and fixed income securities listed on BSE and NSE are settled on T+2 basis.
The pay-in and pay-out of funds and securities takes place on the 2nd working day after the trade day. Pay-in is the process in which securities sold are delivered to the stock exchange by the sellers (securities pay-in) and the funds for the securities purchased are made available to the stock exchange by the buyers (funds pay-in). Pay-out is the process in which the securities purchased are delivered to the buyers (securities pay-out) and the funds for securities sold are given to the sellers (funds pay-out) by the stock exchange.

 What Is Demutualization Of Stock Exchanges?

Demutualization of stock exchange means converting a traditional ‘not for profit’ stock exchange into a ‘for profit company’ which changes the legal structure of that stock exchange from a mutual form to a business corporation form. In a demutualized stock exchange the ownership, management and trading rights are in separate hands. Through demutualization a stock exchange becomes a corporate entity and transforms from a non-profit organization to a profit-making company like other corporate entities.
Historically stock exchanges were formed as mutual organization by trading members i.e brokers for their common benefit. These stock exchanges owned by trading members tend to work towards the interest of the members alone which could be detrimental to the rights of investors and others. Due to separation of ownership and trading rights in the demutualized stock exchanges, there is no conflict of interest between the members and stock exchange and there is greater management accountability. Also demutualized stock exchanges are more professionally managed than the mutual stock exchanges.
In India, both the national level stock exchanges i.e BSE and NSE are demutualized. NSE was established as a demutualized stock exchange while BSE became demutualized in 2007.