Finance

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Importance of Capital Budgeting | Finance

capitalImportance of Capital Budgeting | Finance

Capital Budgeting is the long term investment planning, analyzing and deciding process used to evaluate and select capital expenditures consistent with the firm’s goal of owner wealth maximization. Capital expenditures are the long term investments made to expand, replace or renew fixed assets or to obtain some other less tangible benefit. Capital budgeting process contains five distinct but interrelated steps beginning with proposal generation, followed by review and analysis, decision making, implementation and follow up.

Capital Budgeting or investment decision requires special attention because the following reason can be explained the following manner:

1)Growth:

A firm’s decision to invest in long term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm. On the other hand, inadequate investment in asset would make it difficult for the firm to complete successfully and maintain its market share.

2)Risk:

A long term commitment of investment  may also change the risk complexity of the firm. If the adoption of an investment increases average gain but curser frequent fluctuations in its earning, the firm will become more risky.

3)Funding:

Capital Budgeting decisions require large amount of funds which the majority of the firms cannot provide .Since,Investment decision generally involve large amount of funds which make it imperative for the firm to plan its investment very carefully and make an advance arrangement for procuring finances internally or externally.

4)Irreversibility:

Capital budgeting is not reversible.This means that once we made capital budgeting decisions they are not easily reversible.This is because there may neither any market for such second-hand capital goods nor there is any possibility of conversion of such capital assets into other usable assets It is difficult to find a market for such capital items once they have been acquired.The firm will incur heavy losses if such assets are scrapped.

 5)Complexity:

Investment decisions are an assessment of future event which are difficult to predict. It is really a complex problem to correctly estimate the future cash flow of an investment. External Environment causes the uncertainty in cash flow estimation.

Copyright: Shankar Mishra

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Characteristics of Bonds| Finance

bondCharacteristics of Bonds| Finance

A bond is a fixed charge bearing long term debt security issued by the government and non-government organization to collect long term debt capital in which borrower agrees to make payments of interest and principal on the specific dates to the holder of bond instrument.

There are different types of bonds which are introduced by the different organization with the development of market. As a it is difficult to generalize the same characteristics of all types of debt instrument. However, some common characteristics to all debt instruments are as follows;

1)Par Value

Par is the value which is specified in the at the time of issue of bond no matter whether the bond is issued in the market premium or discount. It is also called as face value or maturity value principal.

Generally bond is issued in denomination of Rs 1000. But, it can be issued in multiples of Rs1000 also. In the context of Nepal, bonds must issue in denomination of Rs 1000. Par value is always repayable at the end of maturity period no matter whether the bond is issued at premium or discount.

2) Coupon Interest Rate

Coupon rate is the rate which is specified on the bond certificate. Bond has in general fixed interest rate that remains same up to maturity period. Rupee amount of interest is calculated on the basis of par value even if the bond is sold at premium or discount.

Generally interest is paid on annual basis as well as semiannual basis. The borrower needs to pay fixed interest in each period up to maturity period. In general, the interest rate at the time of bond issue is equal to market interest rate. Bond’s interest rate remains same up to maturity period but market interest rates do not remain same. It changes with the change in demand and supply condition in the market sometimes, however, zero coupon bonds are issued that make no interest payment. Zero coupon bonds are always sold at discount and redeemed at par.

3) Maturity Period

Almost all bonds are issued with finite time period. An investor has right to receive interest in each period upto maturity and right to receive principal at the end of maturity period. The maturity period which is set at the time of bond issue is called original maturity. Of course, the effective maturity of a bond declines each year after it has been issued. The remaining maturity period until the bond matures is called time to maturity. Sometimes however, perpetual bonds are issued without keeping maturity period.

4) Call Provision

Call provision refers to the provision that provides the borrower the right to call the bonds for redemption before maturity period. The borrower exercises the call provision when market interest rate is less than that of bond’s coupon rate or the fund is no longer needed. The time period during which company cannot exercise call provision is called call protection period.

5) Call Price

Call price is the summation  of call premium and face value of a bond. When company exercises call provision, the borrower needs to pay certain premium along with face value to its bondholder.Call premium (Cal penalty) is the excess amount of call price over face value of a bond.

6) Trustee

 Trustee is the representative of bondholders; usually a bank acts as a watch dog to protect the interest of the bondholders. The trustee’s responsibilities are to authenticate the bond issue’s legality at the time of issuance, to watch over the financial condition and to initiate appropriate actions if the borrower does not meet any of these obligations which are specified in the bond indenture. In Nepal, a company must appoint a trustee to issue bond or debenture in the market

7) Sinking Fund Provision

 It is a special provision in which a certain portion of profit is kept as reserve in each year for the redemption of principal amount of bond. Most of the corporation can make periodic sinking fund payments to a trustee to retire a specified amount of bonds in each period.

8)Bond Rating

Bond rating is an indicator of the creditworthiness of specific bond issues.These ratings are often interpreted as an indication of the relative likelihood of default on the Part of the bond issuers such as Aaa, Aa, A, Baa, Ba .cetc. Investment grade bonds are bonds that have been assigned to one of the top four ratings (AAA through BBB by Standard and Poor’s; & Aaa through Baa by Moody’s). Speculative grade bonds are bonds that have been assigned to one of the lower ratings (BB and below by Standard and Poor’s Ba andbelow by Moody’s). Some of these low rated securities are called, derisively junk bonds.

9) Put Provision

Put provision provides the holder the right to sell the bonds back to the company before maturity period at a specified price when the company violates the terms and conditions which are specified in the bond indenture.

10) Convertibility

Convertible feature is used as a sweetener in a new bond issue (or less often a preferred stock issue) to enhance its marketability and/or lower the interest rate. When the bond is issued by keeping convertible feature, bondholders can convert their bonds into common shares of the same company on the option of the bondholder at a specified price within a certain period of time. This convertible feature enables the firm to sell a convertible security at a lower yield than it would have to pay on a straight bond.

11)Bond Indenture

Bond indenture is an agreement paper in which all the terms and conditions associated with bond issue are specified. The terms and conditions may be par value, mode of interest payment, assets pledged as collateral, call provision, call premium, restrictions (covenants) placed by the creditors, rights and responsibilities of the lender and borrower etc.

Copyright : Shankar Mishra

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Theories of term structure of interest rates

market theoryTheories of term structure of interest rates / Yield Curve:

The relationship between short term interest rate and long term interest rate is called term structure of interest rate. It is the interest structure between the interest rates having same risk but different maturity time. Several theories have been proposed to explain the shape of the yield curve.

 

The three major ones are:

  1. Expectation theory
  2. Liquidity Preference theory and
  3. Market Segmentation Theory

1.Expectation theory:

Expectation theory states that the shape of yield curve depends on the investors expectation about future inflation rates. This theory proposes that long term interest rates can act as a predictor of future short term interest rates. Most investors care about future interest rates especially the bond investors. For the bondholders, the future short term interest rate acts as determing factor for the price of the bond. If the interest rate increases, the price of the bond will decrease and vice-versa.Hence, if it is expected to increase the future short term interest it is better to avoid long-term maturity bonds.

2.Liquidity Preference theory:

Liquidity Preference theory states that interest rate always depends on the investor’s preference of bond with different maturity. In other word, if investor prefer more liquidity that will cause to increase the market interest rate and if investor prefer less liquidity that will cause to decrease the market interest rate.

3.Market Segmentation Theory:

 Market Segmentation Theory states that interest rate depends on the demand and supply of short-term and long-term bond in different  market segments(money market and capital market). In other words,this theory states that each lender and each borrower has a preferred maturity ,and assumes that investment is to minimize risk. The way to minimize risk is to match the maturities of securities with holding periods .Borrowers prefer to buy long-term assets  from a long-term loan and short-term loan for short-term purposes.

 Copyright : Shankar Mishra

  Source : Finance I (KEC Publication )

 

 

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Determinant of Market Interest Rate | Fianace

lrpDeterminant of Market Interest Rate | Fianace 

The factors affecting interest rate are called determinants of interest rate. The market interest rate is the function of many factors including the real cost of money , inflation, risk ,etc. There are different determinant of market interest rate which are as follows:

Market Interest Rate ( K)= K* + IP + DRP + LRP +MRP

 

where,

  • K* = Real Risk Free Rate of interest
  • IP = Interest  Premium
  • DRP= Default Risk Premium
  • LRP= Liquidity Risk Premium
  • MRP= Market Risk Premium

1.Real Risk Free Rate of interest (K*) :

Real Risk Free Rate is defined as the interest rate that would exist on a riskless security if no inflation were expected or when inflation is zero. In other words, it is the rate of interest from riskless government securities in the absence of inflation but this real rate of interest is never seen in the economy because inflation is never expected.

2. Nominal Risk free rate:

Nominal rate is defined as the actual rate of interest charged by the supplier of funds and paid by the demander of funds and it is always composed of real risk free rate of interest and premium of inflation.ie;

OK1 = K* + IP1/1

OK2 = K* + (IP1+IP2)/2

OK3 = K* + (IP1+IP2+IP3)/3

3. Default Risk premium (DRP) :

Default Risk premium is the risk that a borrower will default on a loan which means not pay the interest or the principal. Higher the default risk higher will be the interest  rate and vice-versa.

K= K* + IP + DRP

Where , IP = Interest  Premium , DRP= Default Risk Premium

Note: In Government Purposed Security, DRP=0

4. Liquidity Risk Premium (LRP) :

Liquidity Risk Premium  is the premium charged for taking the risk on security with a weak liquidity risk premium.

K = K* + IP +DRP +LRP

5. Maturity Risk Premium (MRP) :

Maturity Risk Premium is the premium charged by the investor for capital loses  due to the changes in the market interest rate.

K = K* + IP +DRP +LRP+MRP

 

Copyright : Shankar Mishra

Source : Finance I ( KEC publication)

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Financial Market |Functions | Finance

finance marketFinancial Market |Functions | Finance

Financial market is a market in which people trade financial securities commodities and their tangible item of value at low transaction cost and at price that reflect supply and demand. Simply we can say financial market is the market in which short term  as well as long-term financial instrument are traded.

 

Functions of Financial market

Some of the major functions of financial market are as follows:

  • Borrowing and lending:

Financial market channels funds from households, firms, governments and foreigners that have saved surplus funds to those who encounter a shortage of funds. Simply we can say it transfer funds from savers(surplus units) to borrowers(deficit units) in the time of need.

  • Price Determination:

Financial markets help to determine the price of the financial assets .The secondary market plays an important role in determining the prices for newly issued assets. The financial markets ensure the accurate and justifiable price of a stock that is about to be sold in the market for the first time.

  • Coordination and Provision of Information:

The exchange of funds is characterized by a high amount of incomplete and asymmetric information. Financial market collect and provide much information to facilitate this exchange.

  • Risk Sharing:

Trade in financial markets is partly motivated by the transfer of risk from leaders to borrowers who use the obtained funds to invest. The financial intermediaries use their experiences to reduce the level of risk. So,the ultimate suppliers of the funds feel themselves to be secured while mobilizing their savings  through financial intermediaries to ultimate users.

  • Liquidity:

The existence of financial markets enables the owners of assets to buy and resell these assets .Generally this leads to an increase in the liquidity of these financial instruments. Financial markets ensure the adequate liquidity in the market through proper channeling of funds from the savers to borrowers.

  • Efficiency :

The facilitation of financial transactions through financial markets leads to decrease in informational cost and transaction costs which from an economic point of view leads to increase in efficiency.

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Partnership Business| Finance

business-partnershipPartnership Business| Finance

Partnership Business is a form of business registered in the books of government ,which is carried on by some persons under one name for sharing the profits and with the agreement of participation in the transactions by all partners or a single partner acting to all.

 

Characteristics of Partnership Business

  • Formation:

In case of formation of partnership business there must be the involvement of at least two persons but the maximum number is not mentioned in the partnership act. For the registration of partnership firm it should be registered under the department of industry or commerce of Nepal  government.

  • Agreement:

There must be the mutual agreement among the partners in the partnership firm. The partners go into the agreement that bind them. Partnership deed is determined clearly before the commencement of business but it differs from business to business. This document may be written or oral. But it must be written so that disputes may be settled according to the provisions of agreement.

  • Unlimited Liability:

This is the prominent feature of partnership that the liability of each partner is not limited to the amount invested but his private property is also liable to pay the business obligations. If the debts is not cleared through the business the business, then the partner has to bear the losses or debts from their own properties as well.

  • Transferability of shares:

There is restriction to transfer share from one partner to another person without the consent of existing partners .So the investment in the partnership remains confined into few hands. One cannot easily transfer his/her share to others without the approval of other remaining partners.

  • Mutual Confidence:

The business of the partnership cannot be conducted successfully without the element of mutual confidence and cooperation of partners. So, the members must have trust and confidence in each other.

  • Investment:

Each partner contributes his share in the capital according to the agreement. Some persons become partners without investing any capital to the business. But they devote their name, energy and ability to their business instead of capital and receive profit.

  • Principal-agent relationship:

This relationship is based on mutual trust and faith among the partners in the interest of the firm. One partner is an agent as well as principal to other partner. He can bind the other person by his act.In the position of an agent he can make contract with another person  or parties on behalf of his concerned  firm. According to this every partner is an agent when he is working on behalf of other partners  and he is the principal when other partners act on his behalf.

  • Sharing of profit and loss:

In partnership firm all the profits and losses are shared by the partners in any ratio as agreed. If it is not given then they share it equally. According to agreement made ,the profits and losses are shared accordingly.

  • Lack of separate legal entity:

Partnership has no separate legal entity .Therefore , it cannot carry out any transaction like agreement ,contract or business activities on its own name independently. All the partners are individually and collectively responsible for the activities of the firm.

  • Joint Management:

Partnership firm can be managed jointly. All the partners have the right to manage the business .However it can also be entrusted to other partner for the management or operation of activities. The partners can become the active partners or sleeping partners on the basis of mutual agreement which is also made on the basis of knowledge ,skills and expertise, time availability and other factors.

 

Copyright:Shankar Mishra

Source: Essentials of Finance by KEC publication

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Sole Proprietorship| Finance

proprietorshipSole Proprietorship| Finance

Sole proprietorship is a form of business run by a single person and in which there is no distinction between the owner and the business. It is also called sole trading and who carries on business of sole trading is called sole trader. The main feature of such type of business is that the individual assumes full responsibility for all the risks connected with the conduct of the business.

 

Some of the main characteristics of such type of business are as follows:

  • Single Ownership:

In Sole proprietorship only one person owns the whole business and the business is exclusively in the hand of that person. He invests or provides the entire capital either from his private resources or by borrowings.

  • One-man management and control:

In Sole proprietorship ,the owner himself manages and makes all the business decisions. He formulates plans and control business according to his desire and capability.

  • Unlimited Liability:

In Sole proprietorship there is the disadvantage of unlimited liability.He/She is personally liable for business debts. His/Her individual property can be used to pay liabilities.Hence,creditors are entitled to have claim even on his private property.

  • No sharing of profit and loss:

The proprietor has the sole right on the profit of the business and if there is loss he has to suffer alone. The sole trader takes all the risks and, bears all losses and receives all profits which makes owner to work hard.

  • No secrete entity:

In Sole proprietorship the proprietor and business are not separate entities legally. Loss in business is his loss and liabilities of the business are its liabilities. Hence, law makes no distinction between the proprietor and business. All the activities are done in the name of the owner. He has individual accountability.

  • Limited Operations:

Sole proprietorship Concern has limited resources and managerial skills. It is confined to local areas. The operations are limited by capital, management skill and time of owner. Hence, it has generally a limited area of operations.

  • Freedom:

A sole trader can start any legal business according to his choice and means. He can start and close the business at any time without any formalities. He can easily expand, change or reduce his business. There is no restriction on it. However, he cannot  start any business on which some legal restrictions are imposed.

  • Secrecy:

It is very easy to maintain secrecy in sole trading. The owner himself makes all the decisions. He is not required to publish the accounts. He keeps all the business secrets to himself. Secrecy helps sole trader to face competition.

  • Personal relation:

A sole trader has always direct relations with his customers. He is able to attend to every aspects and attention are established under this form of organization.eg. doctor’s clinic,retailer,etc.

  • Lack of stability:

The life of sole trader business depends upon the life of the sole trader.Sole trading concern lacks stability.The business ends when the owner closes the business,dies or becomes insolvent.

  • Few Legal Formalities:

Sole trading concern is subject to few legal formalities. It is easy to start. But it must obey the laws.It is subject to minimum government regulations .The legal formalities are very few in comparision to others.

 

Copyright : Shankar Mishra

Source: (Essentials Of Finance by KEC Publication)

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Career in Finance | Finance

career

Career in Finance | Finance

Finance refers to the activities involved in acquisition,management,allocation ,and effective utilization  of the fund.In other words,the process,practices and problems related to the financial aspect of the business organization is the subject matter of finance.Finance literally means money or wealth.It is such a vital component without which a business cannot operate smoothly.Hence it is often called life blood of business system.As human being cannot live without blood,the existance and the survival of a business without sufficient finance is unimaginative.So,it is regarded as the key element for any kind of business whether it is financial or non-financial,public or private ,large or small, profit seeking or not-for-profit.The basic areas of finance are Financial Institutions and Market,Investments and Financial Management.

A career in finance is not about money but it is close to it. The finance industry is multifaceted ,offering a variety of position catering to a number of skills and interest.

  • Commercial Banking:

Commercial banks from large entities to local institution offer a range of financial institution and services from checking and saving, etc. Career option available in this sector include bank teller, loan officer, operation and branch manager.

  • Investment Banking:

Some of the most glamorous and intense financial careers are job in investment banking. It deals with facilitating the insurance of corporate securities and making these security available for investor to purchase to both corporate and wealthy  investor.

  • Hedge funds:

Hedge funds are largely unregulated private investment fund whose manager can buy or sell a wide array of assets and financial product. Hedge fund job includes Financial analyst , Trader, Regulatory compliance officer, Quantitative analyst.

  • Financial Planner :

Financial planner help individual to develop plan that will insure their present and future financial stability. They review clients financial goal and generate an appropriate plan for saving and investing that fits the clients’ individual needs.

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Functions of Financial Management | Finance

financeFunctions of Financial Management| Finance

Financial is oftenly  called  business finance and corporate finance. The primary function of financial management is to obtain funds for business and making profitable use of that fund. In today’s world, financial management is not only the acquisition of funds but also concerns in other areas and plays an important role in collection , management ,utilization of funds.

Function of financial management can be divided into two categories:

  • Executive Finance Functions
  • Routine/Clerical/Incidental finance functions

1)Executive Finance Functions:

The finance manager takes important financial  decisions by his experience,expertise,capability and qualifications.The decision taken will have long term financial implications in the present as well as future of the firm.Some of the important executive functions of financial management are as follows:

1.Investment Decision/Capital Budgeting Decision:

This involves the decision of allocation of capital or commitment of fund to long term asset which would yield benefits in the future.One of its main task is measuring the prospective profitability of new investment.The investment decision determines the total amount of assets held by the firm,the composition of these assets ,and the business risk complexion of the firm as perceived by the supplier of capital.The essence of investment decision is that return from the investment would exceed the firms required rate of return on capital.

2.Financing Decision:

This is the second important function to be performed by financial manager.He/She must decide when,where and how to acquire funds to meet the firm’s investment needs.The firm must maintain an optimal mix of equity and debt capital,also known as capital structure. The firm’s capital structure is said to be optimum when market value of shares is maximized.

3.Dividend Decision:

The financial manager should make a sound dividend policy that determines whether the firm should distribute dividend or not. If the firm should distribute dividend , then how much should be distributed. Since, the optimal dividend policy maximizes the value of the firm,it is one of the important aspects of decision making.

4.Liquidity Decision:

Liquidity is defined as the ability of a firm to make its short term obligations. The management of current assets affects the liquidity of the firm. Hence, current assets should be managed  efficiently for safeguarding the firm against the danger of illiquidity and insolvency.

There is always conflict between profitability and liquidity while managing current assets. If a firm does invest sufficient funds in current assets ,it may become illiquid whereas it would lose profitability as idle current assets would not earn anything. Therefore, the finance manager should estimate the firm’s needs for current assets and make sure that funds would be made available when needed.

5.Financial Forecasting:

Financial Forecasting includes the estimation of financial requirement and development of finance structure .The finance manager should ensure adequate availability of cash for the smooth operation of the firm. Therefore, forecasting should also be made regarding the technical changes ,situation of capital market ,funds necessary for investment ,returns from proposed investment projects ,and the demand for the firm’s product.

6.Analysis and appraisal of financial performance:

The financial manager should perform various financial analysis in order to appraise the finance performance of the business such as ratio analysis,funds flow analysis ,break-even analysis ,trend analysis,etc.

7.Advising to the top level Management:

The another important function of finance manager is to advise the top level management about the financial position of the firm.He should provide advice on some crucial financial problems by giving the comparative study of different financial alternatives.

8.Procurement of fund:

The finance manager should try to find out the sources of fund and procure them.He should decide how much fund should be raise d from different sources through detailed financial planning .

9.Allocation of fund to All parts of Organization :

It includes the proper allocation of funds to the different departments in accordance with their need.

10.Pricing:

Pricing is a crucial part of decision making .If the goods and services were priced lower priced ,then the firm would find difficulty in covering its operating cost. The firm would lose competitive strength if priced excessively. Hence, the finance manager should evaluate the impact of pricing policy on profitability.This helps to determine the price of the firm’s product in a reasonable way.

11.Control:

The finance manager should have the centralized control over the firm’s activities .For this , he should interact with other executives. This ensures the efficient  operation of the firm.

 

2)Routine Functions:

This includes those functions which are performed by lower-level employee.These functions help management to take important decisions.These functions include:

  • Supervision of cash flows and protection of cash balance .
  • Protection and safety of financial documents
  • Recording,keeping and reporting.
  • Preservation of accounting document.
  • Preparing financial statements.
  • Management of credit.
  • Disbursement and collectionof credit .
  • Making incentive schemes such as insurance and pension.
  • Management of payroll,tax-related matters,inventory,fixed assets ,computer operators,etc.

 

 

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