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Mutual Funds [Full Information You Need to Know]

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

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Derivatives [Full Guide]

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.

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Insurance [All You Need to Know]

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

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Capital Budgeting

What 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)

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Basics of Accounting

What Is Accounting?

Accounting is the process of recording, classifying, summarizing, analyzing and interpreting financial transactions and events pertaining to a business and communicating them to the interested parties through the financial statements such as profit and loss account and balance sheet.

What Is Book-Keeping?

Book-keeping is a part of accounting and is concerned with recording of financial transactions of a business on a day-to-day basis as they occur. The main purpose of book-keeping is to maintain systematic record of all financial transactions of a business.

Difference Between Book-Keeping And Accounting:-

Book-Keeping Accounting Book-keeping is a primary stage. Accounting is a secondary stage. It starts where book-keeping ends. Book-keeping work is performed by junior staff. Accounting work is performed by senior staff. The main activity of book-keeping is to systematically record all the financial transactions of business in journal and prepare ledger accounts and ascertain the balance of each ledger account. The main activity of accounting is to prepare trial balance, profit and loss account and balance sheet and communicate such financial information to interested parties.  A book-keeper cannot do the work of an accountant. An accountant can do the work of a book-keeper.  Book-keeper is not required to have a higher level of knowledge as accountant.  Accountant is required to have a higher level of knowledge than a book-keeper. The job of book-keeper is often routine and clerical in nature and does not require analytical skill. The job of accountant is analytical in nature and hence analytical skill is required.

What Is Double Entry System Of Book-Keeping?

Double entry system of book-keeping refers to a system of accounting under which two aspects of a financial transaction are recorded. The two aspects are debit and credit. Every debit has an equal amount of credit and every credit has an equal amount of debit. So total of all debits is equal to the total of all credits. Every financial transaction involves at least two accounts. One account is debited and the other account is credited by the same amount. If a transaction involves more than two accounts, the sum of debit accounts and sum of credit accounts must be equal.

What Is Accounting Equation?

The accounting equation is the foundation of double entry book-keeping system. The equation is:- Assets=Liabilities+Shareholders capital                                or Shareholders capital=Assets-Liabilities                               or Liabilities=Assets-Shareholders capital According to the accounting equation, the total assets of a company are equal to the total liabilities and shareholders capital. The accounting equation displays that assets of a company are either financed by borrowing money or paying with the money of company’s shareholders. The balance sheet reports a company’s assets, liabilities and shareholders capital. It shows that a company’s total amount of assets equals the total amount of liabilities plus shareholders capital. The accounting equation can also be expanded like this:- Assets=Liabilities+Shareholders capital+Retained earnings Retained earnings=Net profit-Dividends

Basis Of Accounting:-

Basis of accounting is the method by which a company’s financial transactions are recorded in the books of accounts. There are two basis or methods of accounting which can be used to record the financial transactions:-

Cash basis of accounting:-

Cash basis of accounting is the method of recording transactions in which revenues and expenses are reflected in the books of accounts for the period in which actual receipts and actual payments are made. Cash basis of accounting recognizes revenues when cash is actually received in business and expenses when cash is actually paid. For e.g if cash is received from the sale of goods, it is recorded as revenue on the date of receipt of cash no matter when the sale was made. Similarly if cash is paid for the purchase of goods, it is recorded as expense on the date of payment of cash no matter when the purchase was made. Sole proprietors and small companies which are not incorporated generally use cash basis of accounting.

Accrual basis of accounting:-

Accrual basis of accounting is the method of recording transactions in which revenues and expenses are reflected in the books of accounts for the period in which they accrue. Accrual basis of accounting recognizes revenues when they are earned and not when cash is actually received and expenses when they are incurred and not when cash is actually paid. For e.g if sale of goods is made today and the cash is received after one week, then it is recorded as revenue today. Similarly if purchase of goods is made today and the cash is paid after two weeks, then it is recorded as expense today. Accrual method allows the revenues to match the expenses which gives more meaningful financial reports. Big incorporated companies all over the world are generally required to compulsorily use accrual basis of accounting. Even in India all the incorporated companies are required to compulsorily maintain the books of accounts according to the accrual basis of accounting. Accrual basis of accounting is also called as mercantile basis of accounting.

Accounting Principles, Concepts And Conventions:-

There are certain rules to be followed in accounting for which a number of principles, concepts and conventions are developed which guide how the financial transactions should be recorded and how the financial statements should be reported. Following are the main ones:-

Money measurement:-

Only those transactions and events which are capable of being expressed in terms of money should be included in the books of accounts. In other words, information which cannot be expressed in terms of money should not be  included in books of accounts. For e.g quality of after sales service of a company or skills of employees of a company do not have any monetary value so they are not to be included in accounting books.

Going concern:-

It is assumed that the company is a going concern and it will continue to operate its business for unspecified long period in the future. It is assumed that the company has neither the intention nor the necessity to liquidate or significantly curtail its operations in near future. Companies that are expected to continue operating for a long period of time are called as going concern.

Accrual:-

Financial statements should be prepared according to the accrual basis of accounting which recognizes all revenues and expenses when they are earned or incurred and not when money is received or paid.

Dual aspect:-

Entry made for each financial transaction is composed of two parts- debit and credit. Every debit has a corresponding credit and every credit has a corresponding debit. Total of all debits must be equal to total of all credits. The two-fold aspect of a transaction is called duality of a transaction.

Business entity :-

A business is treated as a separate entity that is distinct from its owner and all other business entities and hence a distinction is made between (a) personal transactions of the owner and his business transactions and (b) transactions of one business entity and those of other business entities. Personal transactions and business transactions of owner should be accounted separately and transactions of all business entities should be accounted separately. In sole proprietorship, the business entity and the sole proprietor are the same but for the purpose of accounting, they are treated separately.

Historical cost:-

Historical cost is the cost at the time of acquisition of an asset. It is the original cost of the asset at the time of its purchase. The assets must be reported in the financial statements at their historical costs and not their current market value. For e.g. if land was purchased few years back at Rs 500000 and its current market value has become Rs 800000, it should be shown in the balance sheet as Rs 500000 which is its original cost at the time of purchase.

Periodicity:-

A company divides its business activities into artificial time periods which are known as accounting periods. After the end of each accounting period, financial statements such as profit and loss account and balance sheet are prepared and presented to the interested parties or users.

Objectivity:-

A company’s accounting information should be based on verifiable data and must be free from the personal bias of the accountant. Every financial transaction and event recorded in the books of accounts should have adequate evidence to support it and must be not based on the personal opinion or feeling of the accountant. The financial statements so prepared are based on facts and not on opinions.

Substance over form:-

The financial transactions and events should be recorded and presented in accordance with their economic substance and reality rather than just their legal form.

Cost-benefit:-

The cost of providing accounting information in the financial statements should not be more than the benefit from that information to users. It costs the company lot of money to gather all the accounting and other financial information and present it through financial statements and hence the benefit derived from this information should be more than the cost of providing it.

Full disclosure:-

The company should disclose all the relevant and required information to the users in the financial statements so that the users of the financial statements can make a correct assessment about the financial performance and financial position of the company and take informed decisions. The companies provide notes at the end of the financial statements because of the requirement of full disclosure.

Conservatism:-

In the situation of uncertainty and doubt, there should be a conservative approach which means expenses and losses which are uncertain should be recorded even if they are not incurred yet and incomes and gains which are uncertain should not be recorded till the time they are actually earned. The conservatism approach ensures that the profit is not overstated and loss is not understated.

Consistency:-

The company should follow same accounting method or policy for a given category of transactions and events for each accounting period. The company should change the accounting method or policy only if the new method or policy is better than the earlier one and it should disclose such change to the users by   giving a note about it at the end of financial statements.  For e.g a company uses straight line method of depreciation for its particular asset, then it should use that same method for depreciating that asset every accounting period. It ensures consistency and comparability of the financial statements.

Parties Interested In Or Users Of Accounting Information:-

There are various category of people who are interested in the accounting information of a company and use this information to satisfy their respective needs for information. Some of the users of accounting information are:-

Shareholders:-

Shareholders of the company need information to judge the prospects of their investment in the company so that they can decide whether to hold or sell their shares or buy more shares.

Potential shareholders:-

Potential investors need information to judge the prospects of the company so that they can decide whether they should buy the shares of the company or not.

Lenders:-

Lenders need information so that they can know whether the company can return the money lent to them along with the interest when due and on this basis the lenders decide whether to give credit to the company or not.

Suppliers:-

Suppliers need information so that they can know whether the company can pay them in time for the goods sold to them on credit and on this basis the suppliers decide whether to sell raw materials to the company on credit and on what payment terms.

Government and tax authorities:-

Government and tax authorities need information for regulatory purpose and for assessing the tax liabilities of the company.

Management:-

Management of a company need information to review the company’s performance and to take various kinds of decisions.

Employees:-

Employees of a company are interested in information about the profitability and stability of the company. They need information so that they can decide the ability of the company to pay salaries and provide various kinds of employee benefits to them.

Accounting Cycle:-

Accounting cycle consists of the steps or stages that are involved in the accounting process. Accounting cycle starts with the recording of financial transactions and events of a business and ends with the preparation of financial statements. Following are the main steps in the accounting cycle:-

Recording financial transactions:-

Identifying and recording the financial transactions of the business in the journal. The process of recording the transactions in journal is called as journalizing and the transactions recorded in journal are called as journal entries.

Transferring financial transactions to ledger:-

Opening ledger accounts and transferring the transactions recorded in journal to the respective ledger accounts. The process of transferring the transactions to the ledger accounts is called as posting.

Balancing the ledger accounts:-

Ascertaining the difference between the total of debit amount column and total of credit amount column of all the ledger accounts. This process is called as balancing.

Preparing trial balance:-

preparing trial balance which contains a list showing the balances of each and every ledger account opened. Trial balance helps to verify whether the sum of debit balances and sum of credit balances are equal.

Preparing financial statements:-

preparing financial statements such as trading and profit and loss account, balance sheet. Profit and loss account is prepared to ascertain the profit or loss of the company for the accounting period and balance sheet is prepared to ascertain the position of assets and liabilities of the company at the end of the accounting period.

All the above steps are repeated again for each accounting period.

What Is An Account?

An account is a summary of the relevant financial transactions of a business that took place under a particular head during a particular period of time. Every account has two sides- debit side and credit side.

Classification Or Types Of Accounts:-

Accounts can be classified according to the traditional method of classification or modern method of classification which is also called as accounting equation based method of classification.

Traditional method of classification of accounts:-

Under the traditional method of classification, accounts are classified into three types which are as under:-

Personal accounts:-

Personal accounts are the accounts of persons and firms that the company deals with. Personal accounts can be of three types:- (1) Natural persons account:- These are the accounts of real persons that the company deals with. For e.g raj’s account, jai’s account, etc. (2) Artificial persons account:- These are the accounts of firms and organizations that the company deals with. For e.g ABC company Ltd’s account, IBS bank’s account, etc. (3) Representative persons account:- These are the accounts which indirectly represent a group of persons. When accounts are of similar nature and their number is large, they are grouped under one head and a representative personal account is opened. For e.g if salary is due to many employees, then outstanding salary account is opened, if rent is paid in advance, then rent paid in advance account is opened, if interest is received in advance, then interest received in advance account is opened and so on.

Real accounts:-

Real accounts are the accounts of assets, properties and possessions of the company. Real accounts can be of two types:- (1) Tangible real account:- These are the accounts of tangible assets. Tangible assets are the assets which can be seen, touched, felt and measured. For e.g land, building, machinery, furniture, cash, etc. (2) Intangible real account:- These are the accounts of intangible assets. Intangible assets are the assets which cannot be seen, touched, felt but can be measured in value. For e.g goodwill, trademark, copyright, patent, etc.

Nominal accounts:-

Nominal accounts are the accounts which are used in measuring the income and expenses of the company so that the net profit or net loss for the accounting period can be can be calculated. Nominal accounts relate to expenses, losses, income and gains. For e.g purchases account, sales account, salary account, rent account, loss by fire account, discount received or allowed account, etc.

personal and real accounts form part of the balance sheet and nominal accounts form part of the trading and profit and loss account of the company.

Rules for debit and credit when accounts are classified according to the traditional method:-

According to the double entry system of book-keeping and accounting, every financial transaction affects at least two accounts. One account has to be debited and the other account has to be credited. Certain rule has to be followed for each account to decide which account has to be debited and which account has to be credited. These rules are also called as Golden rules of accounting.

Rule for personal accounts:- Debit the receiver and credit the giver.

Rule for real accounts:- Debit what comes in and credit what goes out.

Rule for nominal accounts:- Debit all expenses and losses and credit all income and gains.

Let us look at some examples to understand how to apply the debit and credit rules for financial transactions:-

Example 1 Paid cash to Mr DK In this transaction the two accounts affected are- cash account which is a real account and Mr DK account which is a personal account. As per the rule of personal accounts, we have to debit the account of benefit receiver which in this transaction is Mr DK and as per the rule of real accounts, we have to credit what goes out which in this transaction is cash.

Example 2 Purchased goods on credit from ACK company Ltd In this transaction the two accounts affected are- purchases account which is a nominal account and ACK company Ltd account which is a personal account. As per the rule of personal accounts, we have to credit the account of benefit giver which in this case is ACK company Ltd as it is giving goods to the company on credit and as per the rule of nominal accounts, we have to debit all expenses which in this transaction are purchases.

Example 3 Paid salary to employees In this transaction the two accounts affected are- cash account which is a real account and salary account which is a nominal account. As per the rule of nominal accounts, we have to debit all expenses which in this transaction is salary and as per the rule of real accounts, we have to credit what goes out which in this case is cash.

Example 4 Sold goods for cash In this transaction the two accounts affected are- sales account which is a nominal account and cash account which is a real account. As per the rule of nominal accounts, we have credit all income which in this case is sales and as per the rule of real accounts, we have to debit what comes in which in this case is cash.

Modern method of classification of accounts:-

Under the modern method of classification, accounts are classified into five types which are as under:-

Income accounts:-

These are the accounts of all the revenues earned by the company such as sale of goods or rendering of services, interest received, discount received, profit from sale of investments, etc. Income accounts appear on the credit side of trading and profit and loss account of the company.

Expenses accounts:-

These are the accounts of all the costs and losses incurred by the company to earn the income such as purchase of raw materials, rent paid, advertising expenses, salaries paid, loss by fire, etc. Expenses accounts appear on the debit side of trading and profit and loss account of the company.

Assets accounts:-

These are the accounts of tangible and intangible assets of the company such as plant, machinery, land, building, goodwill, patents, copyright, etc. Assets accounts appear on the balance sheet of the company.

Liabilities accounts:-

These are the accounts of debts and obligations of the company such as loans, trade creditors, outstanding expenses, etc. Liabilities accounts appear on the balance sheet of the company.

Capital accounts:-

These are the accounts of the owners of the company such as equity share capital, drawings, etc. Capital accounts appear on the liabilities side of balance sheet of the company.

Rules for debit and credit when accounts are classified according to the modern method:-

Rule for income accounts:- Debit the decrease and credit the increase.

Rule for expenses accounts:- Debit the increase and credit the decrease.

Rule for assets accounts:- Debit the increase and credit the decrease.

Rule for liabilities accounts:- Debit the decrease and credit the increase.

Rule for capital accounts:- Debit the decrease and credit the increase.

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Indian Financial System

What Is Financial System?

Financial system is an arrangement through which there is transfer or flow of money from the lenders and investors to the borrowers. Financial system facilitates the flow of money from the areas of surplus to the areas of deficit. It helps in the effective mobilization and allocation of financial resources for productive uses in an economy. A sound financial system is important for the smooth functioning of a country’s economy. A financial system consists of various components.

Indian Financial System Consists Of The Following Components:-

Financial markets Financial instruments Regulators Intermediaries Banking system

Financial Markets:-

Money market:-

Money market deals with short-term funding. In money market, funds are made available for a short period. The funds are borrowed or lent for a period of less than one year. The maturity period of instruments in money market range from one day to one year. In India, the money market is regulated and controlled by the Reserve bank of India (RBI). Government is the biggest borrower in the money market in most countries including India.

Capital market:-

Capital market deals with long-term funding. In capital market, funds are made available for a long period. The funds are borrowed or lent for a period of more than one year. In India, the capital market is regulated and controlled by the Securities and Exchange board of India (SEBI). The capital market is divided into two types:- (1) Primary capital market:- Primary capital market provides the channel for sale of new securities. In primary market, private unlisted companies issue shares to the public for the first time which is called Initial public offer (IPO) which leads to the listing of the company on the stock exchange for trading of the issued shares. In primary market, existing listed companies issue further shares to the public to raise capital which is called as Follow on public offer (FPO). The companies also raise capital by issuing debentures to the public in the primary market. Primary market is also called as new issues market. (2) Secondary capital market:- In secondary capital market, buying and selling of the securities issued in primary market is done. Securities issued in primary market are traded in the secondary market. The trading of securities in the secondary market is done through the platform of the stock exchanges and the investors can trade in the stock exchanges only through the brokers.

Difference Between Money market And Capital Market:-

Money market Capital market Money market deals with short-term funding. Capital market deals with long-term funding. In India, the money market is regulated and controlled by Reserve bank of India. In India, the capital market is regulated and controlled by Securities and Exchange board of India. Money market is a highly liquid market. Capital market is a illiquid market. Money market is a wholesale debt market. Capital market is a retail debt and equity market. Money market instruments are less risky than the capital market instruments and the returns on them are lower than capital market. Capital market instruments are more risky than money market instruments and the returns on them are higher than money market.

Financial Instruments:-

Financial instruments can be divided into money market instruments and capital market instruments.

Money Market Instruments:-

Following are some of the important instruments which are issued in the money market:-

Treasury bills ( T-bill):-

Treasury bills are issued by the Government to fulfill its short-term borrowing needs. The maturity periods of treasury bills range from 14 days to 364 days. Currently only 91-day and 364-day treasury bills are issued by the Indian government. Treasury bills are issued at a discount to the face value and on maturity the face value is paid to the holder of treasury bill. The issue price and discount rate are determined by the bidding process through auctions. 91-day treasury bills are auctioned on the basis of uniform price auction method which is also called as dutch auction method and the 364-day treasury bills are auctioned on the basis of multiple price auction method which is also called as french auction method.

Commercial papers (CP):-

Commercial paper is a short-term unsecured promissory note issued by the corporates and financial institutions at a discount to the face value. The maturity period of commercial papers range from 1 day to 270 days. Commercial papers can be issued in both physical and dematerialized form. Commercial papers are generally issued by companies that are financially strong and have a high credit rating.

Certificates of deposit (CD):-

Certificates of deposit are issued in the form of a usance promissory note by banks in the form of a certificate entitling the holder of certificate to receive interest at a fixed rate. The maturity period of certificates of deposit range from 15 days to 365 days. Certificates of deposit can be issued in both physical and dematerialized form. They are like bank term deposits but are freely negotiable instruments unlike bank term deposits.

Call and Notice money:-

When money is borrowed or lent for one day, it is called as call money and when money is borrowed or lent for more than one day but up to fourteen days only, it is called as notice money. Mostly the banks are borrowers and non-banking financial institutions are the lenders.

Capital Market Instruments:-

Following are some of the important instruments which are issued in the capital market:-

Shares:-

A share is one of the units into which the capital of the company is divided. Share is the share in the share capital of a company. A person having the shares of a company is called as shareholder of that company and is regarded as the part owner of the company. Shares are of two types:- (1) Equity shares:- Equity shares are also called as ordinary shares and they represent part or fractional ownership in the company for the equity shareholder and gives right to the equity shareholder of a share in the profits of the company in the form of dividend as and when declared by the company and also voting rights. Equity shareholders are the members of the company. (2) Preference shares:- Preference shares are the shares which give the preference shareholders two preferential rights- first, the right to receive dividend at a fixed rate or fixed amount before any dividend is paid to the equity shareholders and second, the right to receive re-payment of their capital on winding up of the company before the capital of equity shareholders is returned. Because of these two preferential rights they are called as preference shares. Preference shareholders do not have any voting rights and they are not the members of the company. There are various kinds of preference shares which a company can issue:- – Cumulative and non-cumulative preference shares:- If a company does not have adequate profit for a year and so is not able to pay preference dividend then such unpaid dividend gets accumulated and is carried forward to future years and is paid out of the profits earned by the company in those years before paying equity dividend. In case of non-cumulative preference shares, the unpaid dividend does not get accumulated and is not carried forward to future years. So if the company has inadequate profit for a year, then the preference shareholders do not get any dividend for that year. – Redeemable and irredeemable preference shares:- Redeemable preference shares have to be redeemed or repaid by the company after the expiry of a fixed period from the date of issue while irredeemable preference shares cannot be redeemed or repaid by the company except at the time of winding up of the company. – Participating and non-participating preference shares:- Participating preference shareholders have a right to participate in the surplus profits of the company left after payment of dividend to equity shareholders and other preference shareholders in addition to the fixed rate of dividend payable to them. Non-participating preference shareholders do not have any such right to participate in the surplus profits of the company. – Convertible and non-convertible preference shares:- Those preference shares which can be converted into equity shares at the end of a specified period are called as convertible preference shares. The terms of issue must include a right for conversion into equity shares and in absence of any such right for conversion in the terms of issue, the preference shares cannot be converted into equity shares and are called as non-convertible preference shares.

DIFFERENCE BETWEEN EQUITY SHARES AND PREFERENCE SHARES:-

Equity shares Preference shares Equity shares are the owned capital of the company. Preference shares are the borrowed capital of the company. Equity shareholders are the members and part owners of the company. Preference shareholders are not members or part owners of the company. They are just like other lenders to the company. The rate of dividend on equity shares is not fixed. It depends on the profits made by the company. The rate of dividend on preference shares is fixed. Equity shareholders are paid dividend after preference shareholders. Preference shareholders are paid dividend before equity shareholders. Equity shareholders are repaid their capital after preference shareholders in case of winding up of the company. Preference shareholders are repaid their capital before equity shareholders in case of winding up of the company. Equity shareholders have voting rights in the company. Preference shareholders do not have any voting rights in the company.

Debentures:-

Debentures are the long-term borrowed funds of the company. Debentures have a fixed maturity period and have a fixed rate of interest. Debentures are usually in the form of a certificate issued under the common seal of the company . The certificate is an acknowledgement by the company of its indebtedness to the holder of the debentures. There are various kinds of debentures which are issued by a company:- – Secured and unsecured debentures:- Debentures that are secured by a charge on some of the assets or property of the company are called as secured or mortgage debentures. So the holders of such debentures have a right to sell off those assets or property of the company on which the charge is created in case the company defaults in re-payment of the principal amount of debentures or interest. Debentures that do not carry any such charge on the assets or property of the company are called as unsecured debentures. – Registered and bearer debentures:- Registered debentures are registered with the company. The name of every debenture holder is recorded on the debenture certificate and in the company’s register of debenture holders. Registered debentures are non-negotiable instruments and interest on such debentures is payable only to the registered holders of debentures. Bearer debentures are not registered with the company. The names of debenture holders are not registered in the books of the company but the holders are entitled to claim principal amount and interest as and when due. Bearer debentures are negotiable instruments and interest on such debentures is payable to the bearer. Bearer debentures are transferable by mere delivery. – Redeemable and irredeemable debentures:- Redeemable debentures are the debentures that have to be redeemed or repaid by the company after the expiry of a fixed period from the date of their issue whereas irredeemable debentures cannot be redeemed or repaid by the company except at the time of winding up of the company. They are also called as perpetual debentures. – Fully convertible, partly convertible and non-convertible debentures:- Those debentures which can be converted into equity shares at the end of a specified period are called as fully convertible debentures. The terms of issue must include a right for conversion into equity shares. Partly convertible debentures have two portions- one is the convertible portion and the other is the non-convertible portion. The convertible portion is converted into equity shares at the end of the specified period and the non-convertible portion is redeemed or repaid by the company after the expiry of the stipulated period. Non-convertible debentures do not have the option of conversion into equity shares and are redeemed or repaid after the expiry of fixed period.

Bonds:-

Bonds are long-term borrowed funds of the government and also companies. Bonds have a fixed maturity period and have a fixed rate of interest which is called as coupon rate. There are various kinds of bonds which are issued. Some of them are:- – Fixed rate bonds:- The coupon rate remains the same throughout the lifetime of such bonds. – Floating rate bonds:- The coupon rate is not fixed and keeps changing according to the changes in market rates in case of such bonds. – High yield bonds:- These bonds are also called as junk bonds. They are rated below the investment grade and have a higher risk of default as they are issued by companies rated lower by the credit rating agencies. But they pay higher returns to the investors as compared to other bonds because of the higher risk. – Inflation indexed bonds:- These bonds act as a hedge against inflation. they have a fixed coupon rate and the principal amount is adjusted against inflation rate in the country for which an index such as consumer price index (CPI) is used. The coupon on these bonds is paid periodically on the adjusted principal amount. On maturity, the adjusted principal amount or original principal amount, whichever is higher, is paid. – Zero coupon bonds:- These bonds are also called as deep discount bonds. These bonds do not pay any coupon during the lifetime of the bonds. They are issued at a price lower than its face value and the face value is repaid to the investor at the time of maturity of the bond.

DIFFERENCE BETWEEN DEBENTURES AND BONDS:-

Debentures Bonds Debentures are issued mostly by the companies. Bonds are issued mostly by the government. The rate of interest on debentures is generally higher than bonds. The rate of interest on bonds is generally lower than debentures. Debentures carry a higher risk than bonds. Bonds carry a lower risk than debentures. The return on debentures is called as interest and the rate of return is called as interest rate. The return on bonds is called as coupon and the rate of return is called as coupon rate.

Regulators:-

Reserve bank of India (RBI):-

Reserve bank of India is India’s central bank. It was established on 1st April, 1935 in accordance with the provisions of the Reserve bank of India Act, 1934. The central office of RBI was initially established in Kolkata but was later moved to Mumbai in 1937. The RBI is fully owned by the government of India. Following are the main functions of RBI:- – RBI formulates, implements and monitors the monetary policy with a view to maintain price stability and financial stability and to ensure adequate flow of credit to the productive sectors of the economy. – RBI issues and destroys currency notes and coins not fit for circulation to give the public adequate quantity of currency notes and coins in good quality. – RBI acts as a banker to the central government and to those state governments that have entered into an agreement with RBI. – RBI acts as a banker to all the banks operating in India. – RBI plays a key role in the regulation and development of the foreign exchange market in India. – RBI regulates and supervises the banking system in India to ensure orderly development and conduct of banking operations. For more information about RBI you can visit the site http://www.rbi.org.in

Securities and Exchange board of India (SEBI):-

Securities and Exchange board of India is the regulator of the securities market in India. It was established on 12th April, 1992 in accordance with the provisions of the Securities and Exchange board of India Act, 1992. The head office of SEBI is located in Mumbai. Following are the main functions of SEBI:- – Protecting the interests of investors in securities. – Promoting the development of and regulating the securities market. – Regulating the business in stock exchanges and any other securities market. – Registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who may be associated with securities market in any manner. – Registering and regulating the working of depositories and depository participants, custodian of securities, foreign institutional investors, credit rating agencies and any other intermediaries as the board may specify. – Registering and regulating the working of venture capital funds and collective investment schemes including mutual funds. – Promoting and regulating self-regulatory organizations. – Prohibiting fraudulent and unfair trade practices relating to securities market. – Promoting investors education and training of intermediaries of securities market. – Prohibiting insider trading in securities. – Regulating substantial acquisition of shares and takeover of companies. For more information about SEBI you can visit the site http://www.sebi.gov.in

Intermediaries:-

Intermediaries in the financial markets are a important link between the issuers of securities and the investors in securities. They act as a middleman between the borrowers of money who are companies and government and lenders of money who are retail and institutional investors. Following are the main intermediaries in the capital market:-

Merchant bankers:-

Merchant bankers are the intermediaries who provide various services such as managing the public issue of securities like shares, debentures and other securities of companies and providing advisory services regarding such issue management, underwriting of such public issue of securities, advisory services for mergers and acquisitions, advisory services for projects, financial advisory services, etc. All public issue of securities are managed by at least one merchant banker who functions as the lead merchant banker. Merchant banking services are offered by commercial banks and investment banks.

Underwriters:-

Underwriters are the intermediaries who assure the issuing company to take up shares, debentures and other securities to a specified extent in case the public does not fully subscribe to the issue of securities by the company. For this purpose, an agreement is entered between the issuing company and the underwriter. The underwriters help the companies to raise the required capital by assuring to take up the unsubscribed portion of securities issue to a specified extent in case the public response to the issue is not satisfactory. Underwriting service is provided mostly by investment banks.

Registrars and Share transfer agents:-

Registrars to an issue and share transfer agents play an important role in the capital market. Registrars to an issue provide various services such as collecting applications from investors in respect of an issue of shares by the company, keeping a proper record of applications and application money received from investors, assisting in determining the basis of allotment of shares, finalizing the list of investors who are entitled to allotment of shares, processing and dispatching allotment letters and refund orders, etc. Share transfer agents maintain the records of holders of shares issued by the company and also undertake the work of transfer of shares from one investor to other. Share transfer agents transfer those shares which are in the form of physical share certificates. With the introduction of depository system in India, almost all the shares are now in dematerialized form but still there are few companies whose shares are in the form of physical share certificates. Registrar and share transfer services are provided by investment banks.

Bankers to an issue:-

Bankers to an issue collect applications and application money from investors in respect of an issue of shares by the company and refund the application money to those investors who are not allotted shares by the company. Scheduled commercial banks generally act as bankers to an issue.

Debenture trustees:-

Debenture trustees are intermediaries between the companies issuing debentures or bonds and the holders of debentures or bonds. Debenture trustees are appointed by the companies issuing debentures to represent and protect the interest of debenture holders. It is compulsory for the issuing companies to appoint debenture trustees if the maturity period of debentures or bonds is beyond eighteen months irrespective of whether the debentures or bonds are secured or not. The issuing companies pay the fee to debenture trustees. The companies have to appoint one or more debenture trustees by creating a trust deed before giving a letter of offer to the public for subscription to its debentures. Debenture trustees can be scheduled commercial banks, public financial institutions, insurance companies.

Stock brokers and sub brokers:-

Stock brokers and sub brokers play a very important part especially in the secondary capital market. Stock brokers are the members of the stock exchange and help the buyers and sellers of securities to enter into a transaction. If a buyer or seller wants to buy or sell securities in stock exchange, he can only do it through the stock brokers and not directly. The stock brokers execute the buy and sell orders of securities of the investors on their behalf in the stock exchange and charge commission for this service which is called as brokerage. The stock broker issues a contract note to the investors i.e his clients indicating all the details of the trades i.e buy and sell transactions which he has done on their behalf. Sub brokers are the ones who work along with the main stock broker and are not directly registered with the stock exchange as members. They act on behalf of the stock brokers as agents for assisting the investors in buying and selling of securities through the stock brokers. Stock broking service is provided by investment banks and specialized stock broking companies.

Portfolio managers:-

Portfolio managers advise and undertake the management of various securities of the investors i.e clients or funds of clients pursuant to a contract made with them. Portfolio managers can be discretionary or non-discretionary. Discretionary portfolio managers individually and independently manage the securities and funds of each client according to the needs of the client. They take investment decisions by themselves without consulting the clients but according to the investment objective of the clients. Non-discretionary portfolio managers on the other hand manage the securities and funds according to the directions given by the clients. They do not take any investment decisions themselves. Portfolio management service is provided by investment banks.

Custodian of securities:-

Custodian of securities are responsible for safekeeping of various securities of the investors i.e clients , collecting corporate benefits accruing to the clients like dividend, interest, etc, and keeping the clients informed about the corporate actions. Custodian of securities keep only those securities of clients which are in the form of physical certificates. With the introduction of depository service in India, majority of the securities are now in dematerialized form but there are still few investors whose securities are in physical form. Many institutional investors also use services of custodian for safekeeping of their securities. Custodian service is provided by commercial banks and financial institutions.

Depository and Depository Participants:-

Depository is an organization which holds the securities of investors in electronic form at the request of the investors through a registered depository participant. It is just like a bank account but holds securities, facilitates transfer of ownership of securities without handling  them and also facilitates sake keeping of securities of investors. There are two depositories in India which are registered with SEBI. (i) National securities depository Ltd (NSDL) and (ii) Central depository services (India) Ltd (CDSL). Following are the main services provided by the depository:- – De-materialization:- De-materialization is the process by which physical certificates of an investor are converted into an equivalent number of securities in electronic form and credited into his demat account with his depository participant. – Re-materialization:- Re-materialization is the process of converting the dematerialized securities i.e securities in electronic form into physical certificates. – Maintaining record of securities held by beneficial owners:- In the depository system, the depository is the registered owner of securities in the books of the issuing company as against the physical system where the names of actual investors are recorded as registered owners. But all the benefits of the securities are given to the actual investors. So the investors are the beneficial owners of the securities. The depository maintains a record of all securities held by the beneficial owners. – Settlement of trades of beneficial owners:- Depository settles the trades of beneficial owners by giving delivery of securities from beneficial owners accounts in case of sale of securities by beneficial owners and taking delivery of securities in the beneficial owners accounts in case of purchase of securities by them. – Receiving non-cash corporate benefits:- Depository receives non-cash corporate benefits such as bonus shares and rights shares or any other non-cash corporate benefits given by the issuing company in electronic form on behalf of the beneficial owners. – Receiving electronic credit of securities:- Depository receives electronic credit in respect of securities allotted by the issuing company in IPO or FPO on behalf of the beneficial owners. Benefits of depository services:- * Elimination of risks associated with physical certificates such as bad delivery, delays, theft, etc. * Safe and convenient way to hold the securities. * Reduction of paperwork involved in transfer of securities. * Less stamp duty on transfer of securities. * Immediate transfer of securities. * Transmission of securities without contacting the issuing company. * Nomination facility. Depository Participants:- Depository cannot provide services to investors directly. It provides services to the investors through depository participants. Depository participants are the agents of the depository. They are the intermediaries between depository and investors and provide depository services to the investors. The investors have to open a demat account with a depository participant in order to avail the depository services. Depository participants are mostly scheduled commercial banks and stock brokers.

Difference Between Custodian Of Securities And Depository:-

Custodian Of Securities Depository Custodian is responsible for safekeeping of securities of investors in physical form. Depository is responsible for safekeeping of securities of investors in electronic form. Custodian cannot legally transfer beneficial ownership of securities. Depository can legally transfer beneficial ownership of securities.

Credit rating agencies:-

Credit rating agency is a company that provides the investors with assessments of risk of debt instruments issued by a company by giving a rating to indicate the ability and willingness of the issuer company for timely payment of interest and principal amount. The companies issuing debt securities pay the credit rating agencies to provide rating to the debt securities issued by them. The rating is denoted by an alphanumeric symbol such as AA+, BB, AAA, P-1, DA2, etc. Each credit rating agency used different symbols. The rating given is monitored throughout the lifetime of the debt securities and rating given may be upgraded or downgraded if the risk of default becomes lower or higher respectively. Credit rating agencies only indicate the probability of default in payment of principal and interest on debt instruments and do not recommend to buy, sell or hold a debt instrument. In addition to rating of debt instruments, credit rating agencies also provide grades to the initial public offers (IPO) of equity shares of companies by providing assessments of the fundamentals of the issues. It is called as IPO grading and helps the investors who are looking to invest in companies that are unknown in equity market. Currently there are five credit rating agencies in India which are registered with SEBI:- (1) CRISIL Ltd (2) ICRA Ltd (3) Credit analysis and research Ltd (4) Fitch ratings India Pvt Ltd and (5) Brickwork ratings India Pvt Ltd.

Banking System:-

The banking sector in India is regulated by the Reserve bank of India which is India’s central bank. Banks in India are divided into three main categories:-

(1) Commercial banks:-

Commercial banks provide services such as accepting deposits from public, giving loans to businesses and individuals, offering savings and current accounts, providing credit cards, etc. Now-a-days the commercial banks have also started to offer merchant banking services. They offer all these services to earn profit. So the main aim of commercial banks is earning maximum profit. Commercial banks can be further subdivided into four categories:- (a) Public sector banks:- Public sector banks, which are also called as nationalized banks, are the banks in which majority of the stake or shareholding is of government of India. Some examples of public sector banks are State bank of India, Corporation bank, Dena bank, bank of Baroda, etc. (b) Private sector banks:- Private sector banks are the banks in which majority of the stake or shareholding is of private individuals and not government of India. Some examples of private sector banks are HDFC bank, Yes bank, ING vysya bank, etc. (c) Foreign banks:- Foreign banks are the banks which are established and have their head office in a country outside India but operate their branches in India. Some of the examples of foreign banks are Citibank, HSBC, Standard chartered, etc. (d) Regional rural banks:- Regional rural banks were started in 1975 to develop the rural economy and to provide the rural areas of country with banking and financial services. These banks mostly provide finance to the agricultural sector and other rural sectors. Some of the examples of regional rural banks are Maharashtra gramin bank, Himachal gramin bank, Pragathi gramin bank, etc.

(2) Co-operative banks:-

Co-operative banks in India are registered under the co-operative societies Act. They are often formed by persons who share a common interest. The main aim of  co-operative banks is not profit maximization but to provide service to its members and the society. They provide basic banking services like loans, deposits, banking accounts, etc unlike the commercial banks who provide many other services in addition to the basic banking services. Co-operative banks mostly provide finance to the small businesses, salaried people, self-employed professionals, farmers, etc. The co-operative banks have a three-tier structure:- (i) Primary urban co-operative banks (ii) District central co-operative banks (iii) State co-operative banks Some of the examples of co-operative banks are shamrao vithal co-operative bank Ltd, Rupee co-operative bank Ltd, The Maharashtra state co-operative bank Ltd, The Gujarat state co-operative bank Ltd, Pune district central co-operative bank Ltd, Bhopal district central co-operative bank Ltd, etc.

(3) Development banks:-

Development banks are financial institutions that provide finance to the important sectors of the economy such as agriculture, housing, etc at a lower rate. Some of the examples of development banks are National bank for agriculture and rural development (NABARD), Industrial finance corporation of India (IFCI), Industrial development bank of India (IDBI), National housing bank (NHB), etc.

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Bill of Exchange and Promissory Note

What Is A Bill Of Exchange?

Bill of exchange is an unconditional order in writing given by the creditor (seller of goods on credit) to the debtor (buyer of goods on credit) to pay on demand or at a specified future date, a certain sum of money only to or to the order of a specified person or to the bearer. Bill of exchange facilitates purchase and sale of goods on credit. So it is called as credit instrument or negotiable instrument. There are three parties to a bill of exchange:- (1) Drawer:- Drawer is the person who draws or prepares the bill. He is the creditor who sells goods on credit and is entitled to receive money for it. He signs the bill of exchange and sends it to the drawee for acceptance. (2) Drawee:- Drawee is the person on whom the bill is drawn. He is the debtor who purchases goods on credit from drawer and is required to pay money for it. (3) Payee:- Payee is the person to whom the amount of bill is payable. Payee may be a third party or in most cases, the drawer himself.

Due Date Of Bill:-

The date on which the amount of bill becomes payable is the due date or maturity date of the bill. The period between the drawing of bill and due date of bill is the tenure of bill. Three extra days are added in the calculation of due date which are called as grace days. If the bill is payable on demand, it has no due date or maturity date as the amount of bill is payable as and when the bill is presented  for payment and not on a specific date. There are no grace days for bills payable on demand.

Acceptance Of Bill:-

Drawee has to accept the bill of exchange drawn by the drawer. Drawee accepts the bill by putting his signature and optionally writing the word “accepted” on it. By accepting the bill drawee agrees to pay the amount mentioned on bill on maturity of bill or on demand, as the case maybe. On acceptance of the bill by drawee, it becomes a legal document enforceable in the court of law.

Endorsement Of Bill:-

The drawer or holder of the bill of exchange may transfer his rights to some other person by writing his name and signing it. Such an act is called as endorsement of bill of exchange. The person who endorses the bill is called as endorser and the person to whom it is endorsed is called as endorsee. After endorsement, the endorsee is entitled to receive the money. Sometimes the drawer endorses the bill in favor of his creditor for clearing his own debt.

Discounting Of Bill:-

If the drawer or holder of the bill wants to receive money before its due date, he sells the bill to a bank. Such an act is called as discounting of bill of exchange. The bank deducts some amount of the bill which is called as discount and pays the remaining balance amount in cash to the drawer or holder. Discount charged by bank is the interest at a certain rate on the amount of bill for its unexpired period. After discounting, bank becomes the holder of the bill.

Retirement Of Bill:-

If the drawee or acceptor of the bill pays the bill amount before its due date, it is called as retirement of bill of exchange. Drawer generally allows the drawee certain amount of rebate on the bill amount for the unexpired period of the bill.

Renewal Of Bill:-

When the drawee or acceptor of the bill finds that he may not be able to pay the amount of bill on due date, he may approach the drawer before the due date and request him to cancel the original bill and draw a new bill with an extended date. Such cancellation of old bill and drawing of new bill is called as renewal of bill of exchange. The drawee has to pay interest for the extended period. He may be required to pay the interest in cash or the interest may be included in the amount of new bill. Sometimes the drawee pays some part of the bill amount and accepts a new bill with the balance amount with interest.

Honour And Dishonour Of Bill:-

A bill of exchange is said to be honoured when the drawee or acceptor pays the amount of bill to the drawer when it is presented for payment. A bill of exchange is said to be dishonoured when the drawee or acceptor refuses to pay the amount of bill to the drawer when it is presented for payment on its maturity. When the bill is dishonoured, the drawer or holder of the bill may approach a lawyer who is called as “notary public” to collect legal evidence of dishonour. The notary public takes the bill to the drawee and asks for payment. If the drawee does not pay, he notes the fact of dishonour which is called as “noting” and the reason for dishonour. The noting acts as a legal evidence if the drawer files a case in court against the drawee. The notary public charges fees for this service which is called as “noting charges”. Noting charges are to be paid by the drawer but they are recoverable from the drawee who is responsible for the dishonour.

What Is A Promissory Note?

Promissory note is an unconditional undertaking in writing given by the debtor to the creditor to pay on demand or at a specified future date, a certain sum of money only to or to the order of a specified person or to the bearer. Promissory note is a credit instrument or negotiable instrument. There are two parties to a promissory note:- (1) Maker:- Maker is the person who makes or prepares the note. Maker is the debtor who is required to pay the money. (2) Payee:- Payee is the creditor who is entitled to receive the money from maker.

Difference Between Bill Of Exchange And Promissory Note:-

Bill Of Exchange Promissory Note Bill of exchange is prepared by the creditor. Promissory note is prepared by the debtor. Bill of exchange is an unconditional order given by the creditor to debtor. Promissory note is an unconditional promise given by the debtor to creditor. There are three parties to a bill of exchange – drawer, drawee and payee. There are two parties to a promissory note – maker and payee. Drawer and payee can be the same person. Maker and payee cannot be the same person. Bill of exchange requires acceptance from the drawee to be effective. Promissory note does not require any acceptance to be effective.