FACULTY OF COMMERCE

2024 - 25
SEMESTER-6

SUBJECT:
STRATEGIC FINANCIAL MANAGEMENT (B.I
& F Spec.)

UNIT 1
INTRODUCTION TO STRATEGIC FINANCIAL
MANAGEMENT
COMPILED BY:

DR. DHARINI PATEL DR. SHIMONI TRIVEDI

STUDY MATERIAL FOR REFERENCE

Unit 1 – Introduction to Straategic Financial Management

1 Meaning and Nature of Strtegic Financial Management

2 Functions of Strategic Financial Management
3 Importance of Strategic Financial Management
4 Elements of strategic financial management
5 Financial Policy and Strategic Planning
6 Interface of financial policy and strategic management
7 Strategic Planning process and major types of strategies and policies
8 Importance of financial planning
9 Characteristics of Financial planning
10 Steps in financial planning
11 Concept of financial modelling
12 Different tools and techniques of financial modelling
Meanign and Nature of Strategic Financial Management
The term strategic financial management is a combination of two terms viz. strategy and
finance. Strategy, by definition, implies a long-term perspective. Hence, as explained
above strategic financial management is about the management of the finances of any
company in such a manner that it enables the meeting of the long-term goals. The
assumption here is that the company has a clear idea of what its long-term financial goals are.
This is because, in the absence of such knowledge, it is impossible to make any long-term
decisions.
Strategic financial management is the process of managing the finances of a company to meet
the organisation's goals. It's a management approach that uses financial tools and a mix of
techniques to create a strategic plan. It also ensures the strategy is implemented as planned
and is achievable in the long term.
Before a company can manage itself strategically, it first needs to define its objectives
precisely, identify and quantify its available and potential resources, and devise a specific
plan to use its finances and other capital resources toward achieving its goals.
Strategic management also involves understanding and properly controlling, allocating, and
obtaining a company's assets and liabilities, including monitoring operational financing items
like expenditures, revenues, accounts receivable and payable, cash flow, and profitability.
Strategic financial management encompasses furthermore involves continuous evaluating,
planning, and adjusting to keep the company focused and on track toward long-term goals.
When a company is managing strategically, it deals with short-term issues on an ad hoc basis
in ways that do not derail its long-term vision
Functions Performed by Strategic Financial Management
Strategic financial management encompasses the entire spectrum of financial activities
performed by any organization. Some of the key decisions which are enabled by strategic
financial management have been mentioned below.
▪ Decisions Regarding Capital Investments: The point of view of strategic financial
management makes organizations view their capital investment decisions in a new
light. For example, the recent 15-20 years have seen the emergence of asset-light
businesses.
For instance, Uber, Airbnb, Facebook are all leaders in their own industries. However, they
own very few assets. Companies that use strategic financial management to make decisions
about their long-term assets would have noticed this trend earlier than other companies.
Hence, they would have invested in making long-term commitments towards illiquid assets
which may end up providing a sub-optimal return in the long run.
It is strategic financial management that sensitizes the organization about the effectiveness of
its decision when a broader time frame is considered. It is no coincidence that companies
which place a higher emphasis on strategic financial management have invested heavily in
the digitization of their business even though it might be eating into their profits in the short
run.
 ▪ Decisions Regarding Location: Companies that take a strategic point of view about
their investments also use different methods to select where they will locate their
business.
For example, many American companies have been located in China in the past. However, if
the decision were to be made now, fewer companies would choose to locate in China. This is
because of the continuous tensions and trade wars between the two countries.
This is what makes long-term location in China a riskier proposition than locating in another
country that may be slightly more expensive in the short run but less prone to trade wars in
the future.
▪ Decisions Regarding Mergers and Acquisitions: Strategic financial management
helps companies take a careful look at their business models. It is during this deep
dive that companies often discover whether organic growth is best for them or
whether they too can choose the inorganic way. The guiding principle remains the
same.
If the company can absorb the costs of acquiring another company and add value in the long
run, such an acquisition would be justified. However, strategic financial management ensures
that companies keep their long-term goals in mind before taking a decision regarding an
acquisition.
Why is Strategic Financial Management Important?
As important as it is for a company to keep a long-term perspective and take a sustainable
approach, the importance of short-term performance should not be underestimated. Strategic
financial management strikes a balance between these two aspects by making sure that the
company stays focused on its long-term goals while also addressing its immediate financial
needs.
For example, suppose a company has to make a decision which will either help them
maximise profits in the short term, or maximise wealth in the long term. If the company takes
the long-term approach, it may lose out on immediate revenue or market share, which can
impact its short-term financial performance. And if the company decides to go for short term
profit maximisation, it might boost its immediate financial metrics, but it could also put its
future growth in danger.
Strategic financial management helps managers make decisions in such complex situations.
They evaluate the trade-offs and ensure that both short-term needs and long-term goals are
balanced. Since the ultimate goal is long-term stability and creating wealth for shareholders,
strategic financial management encourages decisions that generally contribute to sustainable
growth rather than just quick profits. Not only that, a good strategy helps companies mitigate
risks, improves resource allocation, and attracts more investors
Strategic financial management is important to businesses because it essentially identifies the
possible strategies for a company to maximise its market value and keep them on track to
reaching long-term goals. This includes ensuring the strategic plan is followed efficiently: in
both short-term actions and in the future.

The Elements of Strategic Financial Management

A company will apply strategic financial management throughout its organizational
operations, which involves designing elements that will maximize the firm's financial
resources and use them efficiently. Here a firm needs to be creative, as there is no one-size-
fits-all approach to strategic management, and each company will devise elements that reflect
its own particular needs and goals. However, some of the more common elements of strategic
financial management could include the following.
Planning
• Define objectives precisely.
• Identify and quantify available and potential resources.
• Write a specific business financial plan.
Budgeting
• Help the company function with financial efficiency, and reduce waste.
• Identify areas that incur the most operating costs, or exceed the budgeted cost.
• Ensure sufficient liquidity to cover operating expenses without tapping external
resources.
• Uncover areas where a firm may invest earnings to achieve goals more effectively.
Managing and Assessing Risk
• Identify, analyze, and mitigate uncertainty in investment decisions.
• Evaluate the potential for financial exposure; examine capital expenditures (CapEx)
and workplace policies.
• Employ risk metrics such as degree of operating leverage calculations, standard
deviation, and value-at-risk (VaR) strategies.
Establishing Ongoing Procedures
• Collect and analyze data.
• Make financial decisions that are consistent.
• Track and analyze variance—that is, differences between budgeted and actual results.
• Identify problems and take appropriate corrective actions.
Strategies Based on Industry
Just as financial management strategies will vary from company to company, they also can
differ according to industry.
Firms that operate in fast-growing industries—like information technology or technical
services—would want to choose strategies that cite their goals for growth and specify
movement in a positive direction. Their objectives, for example, might include launching a
new product or increasing gross revenue within the next 12 months.
On the other hand, companies in slow-growing industries—like sugar manufacturing or coal-
power production—could choose objectives that focus on protecting their assets and
managing expenses, such as reducing administrative costs by a certain percentage.
Financial Policy and Strategic Planning
Financial policy and strategic planning are both important aspects of a business's long-term
success. They guide a business's operations and resources to achieve its goals.
Financial policy
• A comprehensive plan that outlines how a business allocates its capital
• Includes the types of capital, sources of capital, and when capital investments will be
made
• Improves internal processes and external reporting
Strategic planning
• An organizational management activity that helps a business set priorities and focus
its resources
• Helps ensure that everyone in the business is working towards the same goals
• Involves assessing the business's current state and defining its vision and objectives
How they work together
• Financial policies guide strategy, while strategies help achieve the objectives outlined
in the policies
• A business's finance strategy should align with its overall strategic plan
Some key components of strategic planning and financial policy
• Risk management: Identifying and controlling potential threats to the business's
capital, earnings, and operations
• Budgeting: Determining how to allocate financial resources to different parts of the
business
• Forecasting: Using performance data to make short- and long-term projections
Strategic Planning Process and Major Types of Strategic and Policies
A strategic planning process involves identifying an organization's long-term goals, analyzing
its internal and external environment, and developing strategies to achieve those goals,
typically including steps like defining a vision, conducting a SWOT analysis, setting
objectives, and creating action plans; major types of strategies include corporate strategy,
business strategy, and functional strategy, while policies are guidelines that dictate decision-
making within the organization based on the chosen strategy.
A strategic planning process involves identifying an organization's long-term goals, analyzing
its internal and external environment, and developing strategies to achieve those goals,
typically including steps like defining a vision, conducting a SWOT analysis, setting
objectives, and creating action plans; major types of strategies include corporate strategy,
business strategy, and functional strategy, while policies are guidelines that dictate decision-
making within the organization based on the chosen strategy.
Key Stages in Strategic Planning:
• Initialization:
Defining the organization's vision, mission, and values.
• Environmental Analysis:
Conducting a SWOT analysis to identify internal strengths and weaknesses, and external
opportunities and threats.
• Strategy Formulation:
Developing strategic objectives and choosing the most suitable strategy to achieve them.
• Implementation:
Putting the chosen strategy into action through tactical plans and operational activities.
• Evaluation and Monitoring:
Regularly assessing the effectiveness of the strategy and making adjustments as needed.
Major Types of Strategies:
• Corporate Strategy: The overall direction of the company, including decisions about
diversification, acquisitions, and market focus.
• Business Strategy: How a company competes within a specific market or product
line.
• Functional Strategy: Specific plans for individual departments within the
organization, like marketing, finance, or operations.
Types of Policies:
• Quality Policies: Guidelines for maintaining high standards in product or service
quality.
• Human Resource Policies: Policies regarding employee recruitment, development,
and performance management.
• Financial Policies: Guidelines for managing the organization's finances, including
budgeting and investment strategies.
• Marketing Policies: Policies related to pricing, promotion, and distribution
strategies.
• Environmental Policies: Policies outlining the company's commitment to
sustainability and environmental responsibility.

CONCEPT OF FINANCIAL PLANNING

Financial planning is the practice of putting together a plan for your future, specifically
around how you will manage your finances and prepare for all of the potential costs and
issues that may arise. The process involves evaluating your current financial situation,
identifying your goals and then developing and implementing relevant recommendations. It is
holistic and broad, and it can encompass a variety of services. Rather than focusing on a
single aspect of your finances, it views clients as real people with a variety of goals and
responsibilities. It then addresses a number of financial realities to figure out how to best
enable people to make the most of their lives. Financial planning is not the same as asset
management. Asset management generally refers to managing investments for a client. This
includes choosing the stocks, bonds, mutual funds and other investments in which a client
should invest their money and also a step-by-step approach to meet one’s life goals. A
financial plan acts as a guide as you go through life’s journey. Essentially, it helps you be in
control of your income, expenses and investments such that you can manage your money and
achieve your goals. It involves looking at a client’s entire financial picture and advising them
on how to achieve their short- and long-term financial goals. From saving for education and
planning for retirement to effectively managing taxes and insurance, financial planners
develop valuable relationships with their clients to provide them with confidence today and a
more secure tomorrow. It is the process of estimating the capital required and determining its
competition. It includes framing financial policies in relation to procurement, investment and
administration of funds of an enterprise. It helps in determining how a business will afford to
achieve its strategic goals and objectives. Usually, a company creates a financial plan
immediately after the vision and objectives have been set.
The financial plan describes each of the activities, resources, equipment and materials that are
needed to achieve these objectives, as well as the timeframes involved.
The Financial Planning activity involves the following tasks:
i. Assess the business environment
ii. Confirm the business vision and objectives
iii. Identify the types of resources needed to achieve these objectives
iv. Quantify the amount of resource i.e., labour, equipment, materials.
v. Calculate the total cost of each type of resource
vi. Summarize the costs to create a budget
vii. Identify any risks and issues with the budget set.

DEFINITIONS OF FINANCIAL PLANNING

In simple words Financial Planning can be defined as “the process of estimating the capital
required and determining it’s composition. It is the process of framing financial policies in
relation to procurement, investment and administration of funds of an enterprise.”
According to Walker, E.W. and Baughn, W.H. states that “Financial Planning pertains
only to the function of finance and includes the determination of the firm’s financial
objectives, financial policies and financial procedures.
According to R.M. Shrivastava “Financial Plan is the act of deciding in advance the
quantum of capital requirement and its forms.”
In the opinion of Cohen and Robbins “Financial planning should determine the financial
resources required to meet the company’s operating programme. Forecast the extent to which
these requirements will be met by internal generation of funds and the extent to which they
will be met from external sources. Develop the best plans to obtain the required external
funds .Establish and maintain a system of financial control governing the allocation and use
of funds. Formulate programmes to provide the most effective profit volume- cost
relationship. Analyse the financial results of operations, report facts to the top management
and make recommendations on future operations of the firm.”
OBJECTIVES OF FINANCIAL PLANNING
Financial planning anticipates future cash requirements and ensures smooth cash flow at all
times and allows you to control your financial matters by avoiding excessive debt and
dependence on others. It improves personal relationships as all financial decisions become
well planned and are communicated to others effectively. The objectives of a sound financial
plan are to make you cash ready by creating reserves to meet the following needs: -
1. Medical Emergencies: Medical expenses are an area where the cash flows out
unexpectedly. Therefore, the first part of your financial plan should be focused on protecting
yourself and your family through a good medical claim policy. Doing so will also take care of
any unexpected expenses related to medical emergencies. Besides protection from medical
expenses, you can also avail of tax benefits under the Income Tax Act.
2. Insurance: The term insurance component of financial planning offers you the much-
needed protection for uncertainties. Term policies require low premiums and provide
maximum protection, making them cost efficient.It also provides you tax exemptions under
India’s Income Tax Act. Further, you can apply for policies to protect major assets such as
your home and vehicle from theft, fire or other unforeseen incidents.
3. Children’s future: One of the prime objectives of a financial plan is to keep us prepared
for our children’s expenses, like their education and wedding. Mutual fund investments can
help secure our children’s future. Investment in equity mutual funds or children’s fund can
help build a corpus of wealth until they turn into young adults.
4. Retirement: Proper financial planning will help you plan better for your retirement period
right from the beginning of your career. You can choose investment instruments such as
mutual funds, bank fixed deposits or invest in the stock market through expert advice. This
will help in timely creating a retirement fund so that you lead a happy and relaxed retired life.
5. Determining capital requirements: Capital requirements have to be looked with both
aspects: short- term and long- term requirements. This will depend upon factors like cost of
current and fixed assets, promotional expenses and long- range planning.

IMPORTANCE OF FINANCIAL PLANNING

Financial planning plays an important role in giving direction to your goals. It helps you to
set short-term and long-term goals in life and helps you make financial decisions more easily.
It instils discipline in terms of managing and handling your money. One can cut on
unnecessary expenses and start saving with the help of financial planning. Following are
certain points that will help you understand the importance of financial planning : -
1.Helps in managing income: A good financial plan helps you to manage your income
better. As we all know that everyone need money for their basic needs but occasionally tend
to splurge on unnecessary luxuries. Planning your finances will keep a check on your
expenses and help you make savings. As you will have a budget ready, you can easily assess
whether you are overspending or are within budget. This will help you understand how much
you need to save and to reach your goals and also helps in ensuring a reasonable balance
between outflow and inflow of funds so that stability is maintained.

2. Help choose investments: It is essential to have a financial plan for choosing investments
in line with your income, risk capacity and goals. Financial Planning ensures that the
suppliers of funds are easily investing in companies which exercise financial planning. This
will help you maintain a balanced investment portfolio at all times. A sound financial plan
will also help you assess your tax obligations at the beginning of a financial year. So you can
plan your finances accordingly in such a manner that you pay the least amount as tax legally.
3. Manage inflation: Financial planning helps you to manage inflation by planning your
budget in a better way. This eventually gives you peace of mind because then only you will
be able to get a clear picture of your future finances. You will be aware of when your
investments will give returns and how and when you will achieve your goals. It reduces
uncertainties with regards to changing market trends which can be faced easily through
enough funds.
4. Takes care of the estate: A financial plan will guide those taking care of your finances to
manage your estate efficiently. Financial planning includes estate planning, which means the
smooth distribution of your wealth after your death. In essence, a proper financial plan makes
things smoother. Life is unpredictable, any incident can happen at any moment and you may
need money urgently.
5. Retirement lifestyle: Relaxed retirement life is possible only if your finances are in a
healthy state and are in order. This means having enough cash reserves for medical expenses
and other emergencies. A proper financial plan will have your retirement goals listed,
including your income and expenses as detailed as possible. Financial planning helps in
making growth and expansion programmes which help in long-run survival.

CHARACTERISTICS OF A SOUND FINANCIAL PLAN

While preparing a financial plan for any business unit, the following aspects should be kept in
view so as to ensure the success of such exercise in meeting the organisational objectives.
(a) The plan must be simple: Now-a-days you have a large variety of securities that can be
issued to raise capital from the market. But it is considered better to confine to equity shares
and simple fixed interest bearing debentures.
(b) It must take a long term view: While estimating the capital needs of a firm and raising
the required funds, a long-term view is necessary. It ensures that the plan fully provides for
meeting the capital requirement on long term basis and takes care of the changes in capital
requirement from year to year.
(c) It must be flexible: While the financial plan is based on long term view, one may not be
able to properly visualise the possible developments in future. Not only that, the firm may
also change its plans of expansion for various reasons. Hence, it is very necessary that the
financial plan is capable of being adjusted and revised without any difficulty and delay so as
to meet the requirements of the changed circumstances.
(d) It must ensure optimal use of funds: The plan should provide for raising reasonable
amount of funds. As stated earlier, the business should neither be starved of funds nor have
surplus funds. It must be strictly need based and every rupee raised should be effectively
utilised. There should be no idle funds.
(e) The cost of funds raised should be fully taken into account and kept at the lowest
possible level: It must be ensured that the cost of funds raised is reasonable. The plan should
provide for a financial mix (combination of debt and equity) that is most economical in terms
of cost of capital, otherwise it will adversely affect the return on shareholders’ funds.
(f) Adequate liquidity must be ensured: Liquidity refers to the ability of a firm to make
available the necessary amount of cash as and when required. It has to be ensured in order to
avoid any embarrassment to the management and the loss of goodwill among the investors. In
other words, the investment of funds should be so planned that some of these can be
converted into cash to meet all possible eventualities.

DIFFERENT TYPES OF FINANCIAL PLANNING

A financial planner may offer a variety of services to you. These services will often be
considered in concert with one another. This helps the planner put together an overall plan
that considers all aspects of your current situation and future aspirations. Here are eight
common services that are generally offered as part of financial planning:
1. Tax planning: Financial planners often help clients address certain tax issues. They
can also figure out how to maximize your tax refunds and minimize your tax liability.
Certain advisors may also be able to actually help you with preparing your taxes and
filing your annual taxes.
 2. Estate planning: Estate planning seeks to make things a bit easier for your loved
ones after you die. Preparing a will may be part of a financial planner’s services.
Estate planning also helps prepare for any estate tax you may be subject to.

3. Retirement planning: You presumably want to stop working someday.Retirement

planning services help you prepare for that day. They ensure that you’ve saved
enough money to live the lifestyle you want in retirement.

4. Philanthropic planning: It’s always nice to give something to people who need it or
help a cause close to your heart. Financial planning can help you ensure you’re doing
it efficiently and getting all the tax benefits you’re eligible for.

5. Education funding planning: If you have children or other dependents who wish to
pursue a college degree, you may want to help them to pay for it. Financial planning
can help make sure you are able to do so.

6. Investment planning: Though financial planning doesn’t have to include the actual
management of your assets – but most often does – it can still help with your
investment portfolio by mapping out how much you should be investing and in which
types of investments.
7. Insurance planning: A financial planner can help you evaluate your insurance needs.
Some financial planners are also licensed insurance agents and can sell you insurance
themselves. However, they’ll likelyearn a commission, which would create a conflict
of interest.
8. Budgeting: This is perhaps the cornerstone of financial planning. A planner can
make sure you are spending the right amount given your income and can also make
sure that you aren’t going into debt.

FINANCIAL PLANNING PROCESS

Financial Planning Process is a collaborative, iterative approach that financial planning
professionals use to consider all aspects of a client’s financial situation when formulating
financial planning strategies and making recommendations. It involves evaluating an
individual’s or family’s current financial situation, identifying financial goals, creating a plan
to achieve those goals, implementing the plan, and regularly monitoring and adjusting the
plan as needed. Financial planning is creating a vision for your financial future and following
through on it. So the process of financial planning helps in evaluating your net worth and risk
profile, setting short to long-term financial goals, and revising your goals over time, if
necessary. The process is arranged into six elements:
1. Establish and define the relationship with the client: The financial planning
professional informs the client about the financial planning process, the services the financial
planning professional offers, and the financial planning professional’s competencies and
experience. The financial planning professional and the client determine whether the services
offered by the financial planning professional and his or her competencies meet the needs of
the client. The financial planning professional considers his or her skills, knowledge and
experience in providing the services requested or likely to be required by the client. The
financial planning professional determines if he or she has, and discloses, any conflicts of
interest. The financial planning professional and the client agree on the services to be
provided. The financial planning professional describes, in writing, the scope of the
engagement before any financial planning is provided, including details about: the
responsibilities of each party (including third parties); the terms of the engagement; and
compensation and conflicts of interest of the financial planning professional. The scope of the
engagement is set out in writing in a formal document signed by both parties or formally
accepted by the client and includes a process for terminating the engagement.
2.Collect the client’s information: The financial planning professional and the client
identify the client’s personal and financial objectives, needs and priorities that are relevant to
the scope of the engagement before making and/or implementing any recommendations. The
financial planning professional collects sufficient quantitative and qualitative information and
documents about the client relevant to the scope of the engagement before making and/or
implementing any recommendations.
3. Analyze and assess the client’s financial status:The financial planning professional
analyzes the client’s information, subject to the scope of the engagement, to gain an
understanding of the client’s financial situation. The financial planning professional assesses
the strengths and weaknesses of the client’s current financial situation and compares them to
the client’s objectives, needs and priorities.
4.Develop the financial planning recommendations and present them to the client: The
financial planning professional considers one or more strategies relevant to the client’s
current situation that could reasonably meet the client’s objectives, needs and priorities;
develops the financial planning recommendations based on the selected strategies to
reasonably meet the client’s confirmed objectives, needs and priorities; and presents the
financial planning recommendations and the supporting .
5.Implement the financial planning recommendations: The financial planning
professional and the client agree on implementation responsibilities that are consistent with
the scope of the engagement, the client’s acceptance of the financial planning
recommendations, and the financial planning professional’s ability to implement the financial
planning recommendations. Based on the scope of the engagement, the financial planning
professional identifies and presents appropriate product(s) and service(s) that are consistent
with the financial planning recommendations accepted by the client.
6. Review the client’s situation: The financial planning professional and client mutually
define and agree on terms for reviewing and revaluating the client’s situation, including
goals, risk profile, lifestyle and other relevant changes. If conducting a review, the financial
planning professional and the client review the client’s situation to assess progress toward
achievement of the objectives of the financial planning recommendations, determine if the
recommendations are still appropriate and confirm any revisions mutually considered
necessary.

Section A- Answer in detail

1.Discuss the concept of Strategic Financial Management.
2.Write about the functions of Strategic financial Management.
3.Write about the meaning and elements of Strategic Financial Management.
4.Write a note on Major typpes of strategies and types of policies.
5.Explain concept of financial planning.
6.Discuss in detail the objectives of financial planning.
7.Explain importance of financial planning.
8. Explain sound characteristics of financial plan.
9. Explain different types of financial planning.
10. Explain in detail the process of financial planning.
Section B- MCQ
1.What is strategic financial management?
A) A process that deals only with short-term financial goals
B) A process that manages finances to meet long-term company goals
C) A method of maximizing short-term profits
D) A technique used to cut down on company expenses
2. What does strategy imply in the context of strategic financial management?
A) Short-term goals
B) A long-term perspective
C) Focus on operational efficiency
D) Daily financial transactions
3. What is the first step before a company can manage itself strategically?
A) Identifying potential investors
B) Defining its objectives precisely
C) Cutting down operational costs
D) Acquiring other companies
4. Which of the following is NOT a part of strategic financial management?
A) Planning
B) Budgeting
C) Risk Management
D) Minimizing product quality
5. What is a key decision in strategic financial management regarding long-term assets?
A) Expanding the number of employees
 B) Investing in illiquid assets
C) Reducing the product's price
D) Focusing on short-term market trends
6. Which company is an example of an asset-light business mentioned in the passage?
A) Google
B) Uber
C) Tesla
D) Coca-Cola
7. Why might some companies choose to locate outside of China according to the passage?
A) To avoid high labor costs
B) Due to trade wars and tensions
C) To target the European market
D) For tax benefits
8. Strategic financial management helps companies decide whether to focus on:
A) Organic growth or mergers and acquisitions
B) Short-term profits
C) Reducing operating costs
D) Increasing market share
9. Strategic financial management strikes a balance between:
A) Quick profits and long-term goals
B) Increasing debt and cutting costs
C) Expanding market share and reducing risks
D) Short-term liquidity and long-term investment
10. What is the ultimate goal of strategic financial management?
A) Maximizing short-term revenue
B) Long-term stability and creating wealth for shareholders
C) Increasing market share quickly
D) Boosting operational efficiency
11. Strategic financial management helps businesses mitigate:
A) Product defects
B) Risks and improve resource allocation
C) Employee turnover
D) Customer dissatisfaction
12. What is involved in the planning element of strategic financial management?
A) Reviewing employee performance
B) Identifying and quantifying available resources
C) Setting short-term operational goals
D) Focusing on marketing strategies
13. Budgeting in strategic financial management helps the company to:
A) Set market trends
B) Ensure sufficient liquidity to cover operating expenses
C) Reduce product prices
D) Allocate resources to long-term investments
14. What does managing and assessing risk involve in strategic financial management?
A) Identifying uncertainties in investment decisions
B) Cutting down marketing expenses
C) Reducing overall debt
D) Hiring external consultants
15. What is an example of a company in a fast-growing industry?
A) Sugar manufacturing companies
 B) Coal-power production companies
C) Information technology companies
D) Textile manufacturing companies
16. Companies in slow-growing industries are more likely to focus on:
A) Expanding market share
B) Managing expenses and protecting assets
C) Launching new products
D) Boosting gross revenue quickly
17. A comprehensive plan for allocating a business's capital is called:
A) Budgeting
B) Financial policy
C) Risk management
D) Strategic planning
18. What is the purpose of strategic planning in business?
A) To increase short-term profits
B) To help a business set priorities and focus resources
C) To manage employee performance
D) To minimize risk and losses
19. The alignment between financial policies and strategies ensures that:
A) The business is only focused on short-term goals
B) There is consistency in decision-making
C) The company avoids market competition
D) Risk is completely eliminated
20. What is a typical element of a strategic financial management process?
A) SWOT analysis
B) Tracking customer feedback
C) Reducing employee turnover
D) Focusing solely on digital marketing
21. What does the 'Initialization' stage in strategic planning involve?
A) Conducting a SWOT analysis
B) Setting specific financial goals
C) Defining the organization's vision, mission, and values
D) Developing action plans
22. Which of the following is NOT a part of the strategic planning process?
A) Strategy formulation
B) Market share analysis
C) Environmental analysis
D) Evaluation and monitoring
23. What is the focus of corporate strategy?
A) Specific plans for individual departments
B) Decisions about diversification and acquisitions
C) Short-term profit maximization
D) Focus on operations management
24. What does functional strategy refer to?
A) The overall direction of the company
B) Strategies for individual departments such as finance or marketing
C) Strategies for mergers and acquisitions
D) The company's vision and mission
25. Which type of policy deals with maintaining high standards in products or services?
A) Financial policy
 B) Quality policy
C) Human resource policy
D) Marketing policy
26. What is an example of a financial policy?
A) Guideline for recruiting new employees
B) Budgeting and investment strategies
C) Pricing strategies for products
D) Sustainability guidelines
27. What is an example of an environmental policy?
A) Guidelines for capital allocation
B) Procedures for employee training
C) A company’s commitment to sustainability
D) Marketing strategies for global expansion
28. What is the main goal of risk management in strategic financial management?
A) To identify and control threats to capital, earnings, and operations
B) To reduce employee turnover
C) To increase market share
D) To set short-term financial goals
29. What does forecasting in financial policy help a company to do?
A) Set the company’s vision
B) Make short- and long-term projections
C) Manage employee performance
D) Identify new marketing strategies
30. What is the importance of continuous evaluation in strategic financial management?
A) To adjust strategies and stay on track towards long-term goals
B) To minimize employee costs
C) To increase immediate profits
D) To reduce market competition
31. What is the primary function of budgeting in strategic financial management?
A) Reducing total revenue
B) Ensuring financial efficiency and liquidity
C) Increasing short-term profits
D) Cutting operational costs dramatically
32. What type of strategic planning is most applicable to companies focusing on growth?
A) Corporate strategy
B) Functional strategy
C) Business strategy
D) Marketing strategy
33. Which of the following is NOT a key function of strategic financial management?
A) Capital investment decisions
B) Short-term profit maximization
C) Budgeting
D) Risk management
34. Why is strategic financial management considered essential for long-term success?
A) It focuses solely on increasing revenue
B) It ensures both short-term and long-term financial health
C) It avoids making any investments
D) It decreases marketing expenses
35. What is the goal of risk metrics like standard deviation and VaR in strategic financial
management?
 A) To predict market trends
B) To evaluate the potential for financial exposure
C) To identify new customers
D) To minimize employee costs
36. is concerned with the acquisition, financing and management of assets with
some overall goal in mind.
a) Financial Management
b) Profit Maximization
c) Agency Theory
d) Social Responsibility
37. The objective of financial management is to maximize wealth.
a) Stakeholders
b) Shareholders
c) Rondhalders
d) Directors
38. Which of the following are microeconomic variables that help define and explain the
discipline of finance?
a) at risk and return
b) capital structure
c) Inflation
d) All of the above
39. The ability of a firm to convert an asset to cash is called _____.
a)Liquidity
b) Solvency
c) Return
d)Marketability
40. The balance sheet is alternately known as _____.
a)Assets statement
b)Statement of financial position
c)Statement of profit and loss
d)None of the given options
41. Trading & Profit & loss account and balance sheet is prepared from ___.
a)Ledger balance
b)Cash and bank balances.
c)Cash hook and hank boole
d)Trial Balance
42. Balance Sheet shows the _____.
a)Profit earned by the business
b)Total capital employed
c)Financial position of the business
d)Trading results of the business
43. ___ of a firm refers to the composition of its long-term funds and its capital structure:
a)Capitalisation
b)Over Capitalisation
c)Under Capitalisation
d)Market Capitalisation
44. ___ capital structure means an ideal combination of borrowed and owned. capital
that may attain the marginal goal.
a)Preference share
b)Optimum
c)Equity
d)Debt
45.Financial management deals with which two things ?
a)Operations management and procurement
b)Warehousing and managing a company's finances
c)Raising money and managing a company's finances
d)Marketing and production management
46.Which of the following is not identified as one of the four main financial objectives of a
firm?
a)Profitability
b)Liquidity
c)Efficiency
d)Timeliness
47.The four main financial objectives of a firm are _____.
a)Efficiency, effectiveness, strength, and flexibility
b)Power, success, efficiency, and effectiveness
c)Success, strength, liquidity, and profitability
d)Profitability, liquidity, efficiency, and stability
48. is the ability of a firm to earn a profit.
a)Profitability
b)Liquidity
c)Efficiency
d)Stability
49.A company's ability to meet its short-term financial obligations is referred to as ____.
a)Stability
b)Efficiency
c)Effectiveness
d)Liquidity
50.The appropriate objective of an enterprise is _____.
a)Maximization of sale
b)Maximization of owners' wealth.
c)Maximization of profits.
d)None of these
51.The Job of a finance manager is confined to ____.
a)Raising funds
b)Management of cash
c)Raising of funds and their effective utilization.
d)None of these.
52.Financial decision involves _____.
a)Investment financing and dividend decision
b)Investment, financing and sales decision
c)Financing dividend and cash decision
d)None of these.
53.A company's is money owed to it by its customers.
a)Liquidity
b)Accounts Receivable
c)Accounts Payable
d)Inventory
54.A company's is its merchandise materials, and products waiting to be sold.
a)Inventory
b)Liquidity
c)Accounts Receivable
d)Owners Equity
55. is how productively a firm utilizes its assets relative to its revenue and its
profits.
a)Efficiency
b)Effectiveness
c) stability
d)Liquidity
56.The strength and vigor of a firm's overall financial posture is referred to us:
a)Liquidity
b)Stability
c)Effectiveness
d)Profitability
57.A financial statement is an ____.
a)Written report that quantitatively describes a firm's financial health
b)Set of ratios which depict relationships between a firm's financial Troms
c)Itemised forecast of a company's income, expenses, and capital Needs
d)Estimate of a firm's future income and expenses
58. are an estimate of a firm's future income and expenses, based on its past
performance, its current circumstances, and its future plans.
a)Financial statements
b)Profitability statements
c)Statements of cash flow
d)Forecasts
59. are itemized forecasts of a company's income, expenses, and capital needs. and are
also an important tool for financial planning and control.
a)Profitability statements
b)Budgets
c)Owners equity statements
d)Statements of cash flows
60.Which of the following selections correctly matches the financial statement with its
description?
a)Income statement/tells how much a firm is making or losing
b)Income statement/depicts the structure of a firm's assets and liabilities
c)Balance sheet/tells how much a fin is making or losing
d)Statement of cash flows/ depicts the structure of a firm's assets and liabilities
61.___depict relationships between items on a firm's financial statements.
a)Financial proportions
b)Fiscal relations
c)Financial ratios
d)Fiscal proportions
62. reflect past performance and are usually prepared on a quarterly and annual basis
a)Chronological financial statements
b)Ad-hoc financial statements
c)Historical financial statements
d)Concurrent financial statement
63.A firm's reflects the results of its operations over a specified period and
shows whether it is making a profit or is experiencing a loss
a)Statement of cash flows
b)Balance sheet
c)Statement of owners' equity
d)Income statement
64. A firm's working capital consists of investment in
a)Current assets
b)Current Liabilities
c)Short term assets
d)Both (a) and (c)
65.Which of the following is return paid to shareholders out of profit of a company?
a)Profit
b)Dividend
c)Bonus shares
d)Ex-gratia
66.A source of funds is a ____.
a)Decrease in a current asset
b)Decrease in a current liability
c)Increase in a current liability
d) both a and c
67.Ratio analysis allows a firm to compare its performance to _____.
a)Other firms in the industry
b)Other time periods within the firm
c)Other industries
d)None of the above
68.Shareholder wealth in a firm is represented by:
a)The number of people employed in the firm
b)The book value of the firm's assets less the book value of its liabilities.
c)The amount of salary paid to its employees.
d)The market price per share of the firm's common stock.

69.Financial management deals with two things-raising money and ____.

a)Operations management
b)Production management
c)Warehousing
d)Managing a company's finances
70.The most practical way to Interpret or make sense of a firm's historical financial statements
is through ____.
a)Profit analysis
b)Estimate statement
c)Ratio analysis
d)Forecast Hypothesis

References:
-Strategic Financial Management: Himalayan Publication Latest Edition
-Strategic Financial Management : By I.M.Pandey-2023
-Strategic Financial Management : By M.C. Jensen
-Strategic Fianacial Management: By Prasanna Chandra
-Strategic Finacial Management : By ICAI

*******
 FACULTY OF COMMERCE
2024- 25
W

SEMESTER-6
SPECIALIZATION: BANKING, INSURANCE &FINANCE

SUBJECT : STRATEGIC FINANCIAL MANAGEMENT

UNIT 2- Investments Decisions, Project

Planning and Control
.

Dr. BIMAL SOLANKI Dr. SHIMONI TRIVEDI

STUDY MATERIAL FOR REFERENCE ONLY

INDEX:

Sr.No TOPIC
1. Investments Decisions and Project Cash Flow estimate
2. Discounted Cash Flow and Non Discounted Cash Flow Techniques for
project appraisal and Relevant cost analysis for projects
3. Captial rationing and Social cost benefit analysis
4. Investment decisions under Uncertainities

Introduction
financial management aims at procuring the funds in the most economic and prudent manner
and optimum utilization of the funds in order to maximize value of the firm. Broad areas of
decisions concerning financial management are: investment decisions, financing decisions
and dividend decisions. The investment decisions may relate to long-term investment or
short-term investment. The long-term investment decisions are related to investment in long-
term assets or projects for generating future benefits. Such decisions are popularly known as
capital budgeting decisions. In accounting, any expenditure for earning future income over a
long period of time is known as capital expenditure. Therefore, long term investment
decisions are also known as capital expenditure decisions.
1.Investment decision
Long term investment decisions are considered as the most important decisions in
financial management, as it involves substantial amount of investment, difficulties in
estimating the benefits to be derived out of such investment over the future periods
involving many uncertainties, possibility of incurring huge amount of losses if such
decisions are required to be reversed. Therefore, such decisions involve a largely
irreversible commitment of resources with long term implications having its huge impact
on the future growth and profitability of the firm.

Types of long-term investment Decisions: such decisions may relate to the new investments
in case of a newly established firm or an existing firm, e.g., purchase of a new machinery,
setting up of a new plant, taking up a new project, etc. Apart from new investments, there
may be investments for replacement or modernization or expansion programme. Investment
may also be required for diversification into new product lines, new market etc.

Phases in long-term investment Decisions: Like any other managerial decision making,
long-term investment decisions also involve the following steps: Planning, Analysis,
Selection, Implementation and Review. at the planning stage, the project proposal or proposal
for the long term investment considering the need and availability of different investment
opportunities is identified. Thereafter, a detailed analysis of marketing, technical, financial,
economic (social cost benefit) and ecological aspects of different alternative investment
opportunities is required to be conducted. Based on the detailed analyses, the best alternative
fulfilling the selection criteria like NPV > 0 or IRR> K or Benefit Cost Ratio >1, etc. is to be
selected. Then the actual investment is made for purchasing the asset or setting up the
manufacturing facilities, etc. Once the investment is made towards commissioning a project
or setting up a manufacturing facilities, process of periodical performance review should be
started with a view to compare the actual performance with the planned or projected
performance.
Different Analyses for Evaluating an investment Proposal: Apart from analyzing the
financial viability of an investment proposal, other analyses like market analysis, technical
analysis, economic analysis or social cost-benefit analysis, ecological or environmental
analysis are also required to be carried on. Market analysis focuses on the demand for the
proposed products or services desired to be provided through the investment proposal,
expected market share, etc. Technical analysis considers the preliminary tests, layout of the
factory, availability of inputs, etc. Economic analysis or Social Cost Benefit analysis focuses
on the possible impact of the investment proposal from the societal point of view, e.g.,
construction of a river bridge may result in the unemployment of the ferry operators.
Therefore, while estimating the benefits receivable from the bridge, the compensation or
rehabilitation of displaced ferry operators should not be lost sight of. Ecological analysis or
Environmental analysis considers the impact of the proposed investment on the environment.
Many projects like power project, projects relating to chemical, leather processing etc., may
have significant environmental implications, hence, the assessment of the likely damage
caused by such projects on the environment and cost of controlling or restoring such damages
should also form part of the analyses.

ESTIMATION OF PROJECT CASH FLOW

financial analysis of long-term investment decisions basically involves estimating cost of the
asset / project and benefits receivable thereon over the economic life of the asset or project
for which investments are made.
Estimating cost is relatively easier as it is made in the current period, but estimating benefits
is very difficult as it relates to future period involving risk and uncertainty. For estimating
benefits, two alternatives are available –
(i)Cash Inflow and (ii) Accounting Profit.

The cash flow approach is considered as superior to accounting profit approach and cash
flows are theoretically better measures of net economic benefits associated with the long-
term investments. Moreover, as cost of investment
is represented by cash outflows, benefit out of such investment is better represented through
cash inflows. The difference between the two measures – (1) cash flow and accounting profit
(2) arises because of inclusion of some non – cash items
e.g., depreciation, in determining accounting profit. Moreover, accounting profit differs
depending on accounting policies, procedures, methods (e.g., method of depreciation, method
of inventory valuation) used.
Moreover, the cash flow approach takes cognizance of the time value of money. Usually,
accrual concept is followed in determining accounting profit, e.g., revenue is recognized
when the product is sold, not at the time when the cash is collected from such sale; similarly
revenue expenditure is recognized when it is incurred, not at the time actual payment is made.
Thus, the cash flows as a measure of cost and benefit of an investment proposal is better to
use for evaluating the financial viability of a proposal and for this purpose, the incremental
cash flows are considered. For new investment decisions, all the cash flows are incremental
but in case of investment decisions relating to replacement of old assets by the new ones, the
incremental costs (cash outflows) and incremental benefits (cash inflows) are to be estimated.
The cash flows associated with a proposal may be classified into:
(i) Initial Cash Flow, (ii) Subsequent Cash Flow and (iii) Terminal Cash Flow.
(i) Initial Cash Flow: Any long term investment decision will involve large amount of initial
cash outlay. It reflects the cash spent for acquiring the asset, known as initial cash outflow.
For estimating the initial cash outflow, the
following aspects are taken into consideration.
(a) The cost of the asset, installation cost, transportation cost and any other incidental cost,
i.e., all the costs to be incurred for the asset in order to bring it to workable condition, are to
be taken into consideration.
(b) Sunk cost which has already been incurred or committed to be incurred, hence, which has
no effect on the present or future decision, will be ignored as it is irrelevant cost for the
decision. For example, a plot of land which is owned by the firm and lying idle is the sunk
cost, hence, the cost of such plot of land will not be considered for estimating the initial cost.
But, if it has any alternative use, the opportunity cost of such alternative use is the relevant
cost and such opportunity cost will have to be considered. On the other hand, if a new plot of
land is required to be purchased for the proposal, the cost of such plot of land is
the relevant cost and will form part of initial investment.
(c) For investment decisions relating to replacement of an existing asset usually involve
salvage value which is considered as cash inflow and subtracted from the cash outflow
relating to the installation of the new asset. If the existing asset is the only asset in the
concerned block of asset, the incidence of income tax
on gain or loss on sale of the existing asset is also to be considered, as the block of asset will
cease to exist due to sale of the asset. The tax impact on gain on sale of asset represent burden
of tax, hence cash outflow and tax impact on loss on sale represent savings of tax, hence, cash
inflow. Therefore, tax on gain
on sale of asset has to be added and tax on loss on sale has to be subtracted in order to
determine initial cash outflow. However, if there are other assets in the same block, the
question of gain or loss on sale of asset will not arise, only the sale proceed from sale of old
asset will be deducted from the total initial cash
outflow.
(d) Change in working capital requirement due to the new investment decision requires to be
considered.
If additional working capital is required, it will increase the initial cash outflow. On the other
hand, in a replacement situation, if requirement of working capital is decreased, such
decrease in working capital requirement will reduce the total initial cash outflow.

Initial Cash Outflow:

Cost of the new asset including installation, transportation and other incidental costs related
to the asset
( + ) Change in working capital requirement (Addition for increase, Subtraction for decrease)
(–) Salvage value of the old asset (in case of replacemenst of old asset)
(–) Tax savings for loss on sale of asset (if the block ceases to exist due to sale of old asset),
or
(+) Tax payable for profit on sale of asset (if the block ceases to exist due to sale of old asset)
(ii) Subsequent Cash Flow
in conventional cash flow, cash outflow occurs at the initial period and a series of cash
inflows occur in the
subsequent periods. On the other hand, non-conventional cash flow involves intermittent cash
outflows in
the subsequent periods also for major repairing, additional working capital requirement, etc.
Therefore, apart from estimating initial cash flow, subsequent cash flows are also required to
be estimated. For estimating future cash inflows, i.e., cash inflows of the subsequent periods,
the following aspects need to be considered.
(i) Cash inflows are to be estimated on an after tax basis.
(ii) Depreciation being a non-cash item is to be added back to the amount of profit after taxes.
(iii) Interest being financial charge will be excluded for estimating cash inflow for investment
decisions (Interest Exclusion Principal). However, interest (on debt capital) is taken into
consideration for determining weighted average cost of capital which is used for discounting
the cash inflows to arrive at its present
value.

Net Cash Inflow after Taxes (CFAT):

Net sales revenue
less: cost of goods sold
Less: General Expenses (other than Interest)
Less: Depreciation
Profit before Interest and Taxes (PBIT or EBIT)
less: taxes
Profit after Taxes (excluding Interest) [PAT]
Add: Depreciation
Net Cash Inflow after Taxes
In short, CFAT = EBIT (1 – t) + Depreciation [where, t is income tax rate]
If PAT is taken from accounting records, which is arrived at after charging Interest, ‘Interest
Net of Taxes’ is to be
added back along with the amount of Depreciation, i.e.,
PAT after charging Interest
Add: Depreciation
Add: Interest Net of Taxes (i.e., Total Interest – Tax on Interest)
Net Cash Inflow after Taxes

(iii) Terminal Cash Flow: In the last year, i.e., at the end of the economic life of the asset or
at the time of termination of the project, usually some additional cash inflows occur in
addition to the operating cash inflows, viz.,salvage value of the asset, release of working
capital (the working capital that is introduced at the beginning will no longer be required at
the end of the life of the asset or at the termination of the project). Moreover, tax impact on
gain or loss on sale of the asset if the block of asset ceases to exist.

Terminal Cash Inflow: Salvage or Scrap Value + Tax Savings on Loss on Sale of Asset or (-)
Tax Burden on Gain on Sale of Asset + Release of Working Capital

RELEVANT COST ANALYSIS FOR PROJECTS

relevant costs or revenues are those expected future costs or revenues that differ among
alternative courses of action. It is a future cost/revenue that would arise as a direct
consequence of the decision under review and it differs among the alternative courses of
action. Any decision making relates to the future as nothing can be done to alter the past and
the function of decision making is to select courses of action for the future. Relevant cost
analysis or relevant costing is used for various managerial decisions like:
• Make or buy decision
• Accepting or rejecting a special order
• Continuing or discontinuing a product line
• Using scarce resources optimally, etc.
In the context of investment decisions, incremental cash flows are considered as relevant. The
sunk costs, which have already been incurred, or committed costs which are committed to be
incurred in future, are considered as irrelevant, as it will have no impact on whatever
decisions are taken. However, the opportunity costs, imputed costs, out of pocket costs,
avoidable costs and differential costs are relevant.

DISCOUNTED CASHFLOW AND NON-DISCOUNTED CASH FLOW

TECHNIQUES FOR PROJECT APPRAISAL AND RELEVANT COST ANALYSIS
FOR PROJECTS

For financial appraisal of the project / investment proposals different techniques are used.
They are generally classified into Discounted Cash Flow (DCF) and Non Discounted Cash
Flow (Non-DCF) or traditional techniques.

In DCF techniques, time value of money is taken into consideration while in Non- DCF
techniques it is ignored. As the investment decisions involve long period of time and value of
money does not remain same over this period
of time, DCF techniques are preferred in financial appraisal of the project proposals.

Non-DCF Techniques
(i) Pay Back Period
(ii) Pay Back Reciprocal
(iii) Pay Back Profitability
(iv) Average or Accounting Rate of Return (ARR)

DCF Techniques
(i) Discounted Pay Back Period
(ii) Net Present Value (NPV)
(iii) Profitability Index or Benefit Cost Ratio
(iv) Internal Rate of Return (IRR)
(v) Modified NPV
(vi) Modified IRR
(vii) Adjusted Present Value

Non-DCF Techniques
(i) Pay Back Period
Payback period represents the time period required for recovery of the initial investment in
the project. It is the period within which the total cash inflows from the project equals the
cash outflow (cost of investment) in the project.
The lower the payback period, the better it is, since initial investment is recouped faster.
In case of uniform net cash inflows over time, i.e., if same amount of net cash inflows are
generated every year, the Pay Back Period will be:
Initial Investment ÷ Net Cash Inflow after Tax per annum.
Advantages of Payback Period
1. This method is simple to understand and easy to operate.
2. It clarifies the concept of profit or surplus. Surplus arises only if the initial investment is
fully recovered.
3. Hence, there is no profit on any project unless the life of the project is more than the
payback period.
4. This method is suitable in the case of industries where the risk of technological
obsolescence is very high and
hence only those projects which have a shorter payback period should be financed.
5. This method focusses on projects which generates cash inflows in earlier years, thereby
eliminating projects bringing cash inflows in later years. As time period of cash flows
increases, risk and uncertainty also increases.Thus payback period tries to eliminate or
minimise risk factor.
6. This method promotes liquidity by stressing on projects with earlier cash inflows. This is a
very useful evaluation tool in case of liquidity crunch and high cost of capital.
7. The payback period can be compared to break-even point, the point at which the costs are
fully recovered.

Limitations of Payback Period

1. It lays emphasis on capital recovery rather than profitability.
2. It does not consider the cash flows after the pay back period. Hence, it is not a good
measure to evaluate where the comparison is between two projects, one involving a long
gestation period and the other yielding quick results but only for a short period.
3. This method becomes an inadequate measure of evaluating two projects where the cash
inflows are uneven. There may be projects with heavy initial inflows and very less inflows in
later years. Other projects with moderately higher but uniform CFAT may be rejected
because of longer payback.
4. This method ignores the time value of money. Cash flows occurring at all points of time are
treated equally while value of money changes over time.

(ii) Payback Reciprocal

It is the reciprocal of Payback Period, i.e., 1÷ Pay Back Period. Therefore,
Payback Reciprocal = average Annual Net Cash Inflow after Taxes (i.e. CFAT p.a) initial
investment Higher the payback reciprocal, better is the project.

The Payback Reciprocal is considered to be an approximation of the Internal Rate of Return,

if-
(a) The life of the project is at least twice the payback period and
(b) The project generates equal amount of the annual cash inflows.

(iii) Accounting or Average Rate of Return Method (ARR)

Accounting or Average Rate of Return means the average annual yield on the project, i.e.,
Average ProfitAfter Tax ÷ Average Investment. Project with Higher ARR is preferred. In
this method

Profit After Taxes (instead of CFAT) is generally used for evaluation.

Where equal amount of depreciation is charged every year,
Average Investment = Half of the Depreciable Part ( Cost – Salvage Value) + Non-
Depreciable Part (Salvage Value).
In other cases, average investment is to be determined taking the book value of the
investment of different years separately and average is to calculated accordingly.

Advantages of ARR
1. It is simple to understand.
2. It is easy to operate and compute.
3. Income throughout the project life is considered.
4. In this method the net income after depreciation is used, therefore it is theoretically sound.

Limitations of ARR
1. It does not consider cash inflows (CFAT), which is important in project evaluation rather
than PAT.
2. It ignores time value of money, which is important in capital budgeting decisions.

(iii) Pay Back Profitability: As the profitability beyond the Pay Back Period is not taken
into consideration in Pay Back Period method, the projects with higher pay back period are
rejected though such projects with longer
life may generate higher benefits after recovering its initial investment. In Pay Back
Profitability method, the profitability beyond the pay back period is considered and projects
generating higher benefits after the recovery of initial investment are considered for selection.

Pay Back Profitability = Net Cash Inflow after Taxes after recovering the Initial Investment,
i.e., Total Net Cash Inflow after Taxes – Initial Investment

DCF Techniques
As mentioned earlier, the DCF techniques consider the time value of money while Non-DCF
techniques ignore the same. For incorporating time value of money, cash flows are
discounted using appropriate discounting factor
(marginal cost of capital or weighted average cost of capital, as the case may be) in order to
derive Present Value of such cash flows over the life of the project and thereafter decision is
taken using different appraisal methods using the present value of the cash flows.

(i) Discounted Payback Period

Discounted Payback Period is the pay back period calculated on the basis of discounted cash
flows, i.e., present value of cash flows, over the life of the project.

Procedure for computation of Discounted Payback Period

Step 1: Determine the Total Cash Outflow of the project. (Initial Investment)
Step 2: Determine the Cash Inflow after Taxes (CFAT) for each year.

Step 3: Determine the present value of net cash inflow after taxes (CFAT)
= CFAT of each year x PV Factor for that year.
Step 4: Determine the cumulative present value of CFAT of every year.
Step 5: Find out the Discounted Payback Period as the time at which cumulative DCFAT
equals Initial Investment.
• This is calculated on “time proportion basis” (usually following simple interpolation
method).
Selection Criteria or Decision Making Rule:
• The projects are selected on the basis of minimum Discounted Payback Period. If any
maximum / benchmark
period is fixed by the management, projects with the discounted pay back period less than
that period are
considered for selection.

Net Present Value Method (NPV)

The Net Present Value of an investment proposal is defined as the sum of the Present Values
of all future Cash
Inflows less the sum of the Present Values of all Cash Outflows associated with the proposal.
Thus, NPV is calculated
as under - NPV = Present value of Cash Inflows -- Present value of Cash Outflows. = Sum of
[CFATt ÷ (1+k )t] – Initial Investment*
* In case of conventional cash flows, cash outflow relates to initial cash outlay, i.e., initial
investment for acquiring the asset. However, cash outflow may occur after the initial
investment also (Non-conventional Cash Flow) and
in that case, present value of cash outflow has to be determined in the same way as to that of
Cash Inflows.
cfatt = Net Cash Inflows after Taxes of the tth period.
K = Weighted Average Cost of Capital or Marginal Cost of Capital

Selection Criteria:
If NPV > 0, i.e., if NPV is positive, the project is acceptable
If NPV > 0, i.e., if NPV is negative, the project is not acceptable
If NPV = 0, it refers to the point of indifference, i.e., the project may be or may not be
accepted.

Present value of Cash Inflows and Outflows: Cash inflow and outflow of each period is
discounted to ascertain its present value. For this purpose, the discounting rate is generally
taken as the Cost of Capital since the project
must earn at least what is paid out on the funds blocked in the project. The Present Value
tables may be used to calculate the present value of various cash flows. In case of Uniform
Cash Inflows p.a, Annuity Tables may be used.
However, instead of using the PV factor tables, the relevant discount factor can be computed
as
1/(1 + k)t . where, k = cost of capital and t= year in which the inflow or outflow takes place.
Hence, PV factor at 10% after one year = 1 / (1.10)1 = 0.9091
Similarly, PV factor at the end of two years = 1 / (1.10)2 = 0.8264 and so on.
Note: The underlying assumption in NPV method is that the cash inflows are immediately
reinvested at a rate of return equal to the Firm’s Cost of Capital.
Advantages
(i) It considers the time value of money. Hence it satisfies the basic criterion for project
evaluation.
(ii) Unlike payback period, all cash flows (including post-payback returns) are considered.
(iii) NPV constitutes addition to the wealth of Shareholders and thus focuses on the basic
objective of financial management.
(iv) Since all cash flows are converted into present value (current rupees), different projects
can be compared on NPV basis. Thus, each project can be evaluated independent of others on
its own merit.

Limitations
(i) It involves complex calculations in discounting and present value computations.
(ii) It involves forecasting cash flows and application of discount rate. Thus accuracy of NPV
depends on accurate estimation of these two factors which may be quite difficult in practice.
(iii) NPV and project ranking may differ at different discount rates, causing inconsistency in
decision- making.
(iv) It ignores the difference in initial outflows, size of different proposals etc, while
evaluating mutually exclusive projects.

(iii) Profitability Index (PI) or Desirability Factor or Benefit Cost Ratio

Benefit-Cost Ratio / Profitability Index or Desirability Factor is the ratio of present value of
operating cash inflows to the present value of Cash Outflows.
PI [or] Desirability Factor [or] Benefit Cost Ratio =Present Value of Cash Inflows (benefits) /
Present Value of Initial Investment (costs)

Significance: Profitability Index represents present value of benefit for each rupee of cash
outlay.The higher the PI, the better it is, since the greater is the return for every rupee of
investment in the project.

Decision Making or Acceptance rule:

If PI > 1, the project is acceptable.
If PI = 1, Project generates cash flows at a rate just equal to the Cost of Capital. Hence, it
may be accepted or
rejected. This constitutes an Indifference Point.
If PI < 1, the Project is not acceptable.
Note: When NPV > 0, PI will always be greater than 1. Both NPV and PI use the same
factors i.e. Discounted Cash
Inflows (A) and Discounted Cash Outflows (B), in the computation. NPV = A - B, whereas
PI = A / B.

Advantages:
(i) This method considers the time value of money.
(ii) It is a better project evaluation technique than Net Present Value and helps in ranking
projects where Net Present Value is positive.
(3) It focuses on maximum return per rupee of investment and hence is useful in case of
investment in divisible projects, when availability of funds is restricted.
Disadvantages:
(i) In case a single large project with high Profitability Index is selected, possibility of
accepting several small projects which together may have higher NPV than the single project
is excluded.
(ii) Situations may arise where a project with a lower profitability index selected may
generate cash flows in such a way that another project can be taken up one or two years later,
the total NPV in such case being more than the one with a project with highest Profitability
Index.
(iii) In case of more than one proposal, which are mutually exclusive, with different
investment patterns or values, profitability index alone cannot be used as a measure for
choosing.

(iv) Internal Rate of Return (IRR) and Modified Internal Rate of Returns (MIRR)
internal Rate of Return (IRR)
Internal Rate of Return (IRR) is the rate of discount at which the sum of Discounted Cash
Inflows equals the Discounted Cash Outflows. In other words, the Internal Rate of Return of
a project is the discount rate which makes
Net Present Value of the project equals to zero.
IRR refers to that discount rate (i), such that Present value of cash inflows = Present value of
cash outflows Or, Present value of cash inflows – present value of cash outflows = 0 Or, NPV
= 0 Therefore, at IRR, NPV = 0 and PI = 1.

Procedure for computation of IRR :

Step 1: Determine the present value of cash outflows and cash inflows using cost of capital
(K) as the discounting factor. The rationale behind use of K as the discounting factor to start
with is that, the NPV can be easily determined. If NPV is less than zero (i.e., P.V. of cash
inflows is equal to P.V. of cash outflows), no further calculation is necessary because it
indicates that IRR is less than K, so the project is not acceptable. On the other hand if NPV is
greater than zero, i.e., P.V. of cash inflows are more than the present value of cash
outflows, the discount rate has to be increased in order to reduce the present value of cash
inflows so as to make it equal or close to the present value of cash outflow. If increase in
discount rate results in negative NPV, the rate of discount has to be decreased in order to
increase the present value of cash inflows. The
process of increase and decrease in discount rate is continued till the present value of cash
inflow either equals to or becomes very close to the present value of present value of cash
outflow.

Step 2: Identify the two discount rates for which the NPV is little more than and slightly less
than zero.
Step 3: Compute the change in NPV over the two selected discount rates.
Step 4: On proportionate basis (or using simple interpolation method), compute the discount
rate at which NPV is Zero.

Advantages
(i) Time value of money is taken into account.
(ii) All cash inflows of the project, arising at different points of time are considered.
(iii) Decisions can be easily taken by comparing IRR with the cost of capital.
All projects having IRR above the Cost of Capital will be automatically accepted.
Disadvantages
(i) It is tedious to compute.
(ii) Decision making becomes difficult in case of Multiple IRRs
(iii) It may conflict with NPV in case of difference in inflow/ outflow patterns, or size of
investment, or life of the alternative proposals.
(iv) The presumption that all the future cash inflows of a proposal are reinvested at a rate
equal to the IRR may not be practically valid.

(v) Modified Net Present Value (MNPV)

One of the limitations of NPV method is that reinvestment rate in case of NPV is Cost of
Capital (k). However, in case of MNPV, different reinvestment rates for the cash inflows
over the life of the project may be used. Under this
modified approach, terminal value of the cash inflows is calculated using such expected
reinvestment rate (s).
Thereafter, MNPV is determined with present value of such terminal value of the cash
inflows and present value of the cash outflows using cost of capital (k) as the discounting
factor.
Terminal value is the sum of the compounded value of cash inflows of different years at the
end of the life of the project. If the life of the project is ‘n’ years, cash inflow of period ‘t’ is
CFt and reinvestment rate is ‘r’, the terminal value will be ( )n t t cf − _ .

(vi) Modified IRR

One of the limitations of IRR as mentioned above is that reinvestment rate in case of IRR is
IRR itself. This can be overcome changing the reinvestment rate incorporating the expected
reinvestment rate for future periods over
the life of the projects and using such expected reinvestment rate for calculating the terminal
value of the cash inflows for different years of the life of the project. Thereafter, MIRR is
determined with present value of such
terminal value of the cash inflows and present value of the cash outflows. In other words, the
MIRR is the discount rate which will make present /discounted value of terminal value of
cash inflows equal to present/discounted
value of cash outflow.
Modified NPV or Modified IRR may be used to resolve the conflict in ranking of the
alternative projects under NPV and IRR methods arising out of differences in timing of cash
flows, i.e., in one project, the cash inflows in the initial years may be more than the other or
vice versa.

(vii) ADJUSTED NET PRESENT VALUE: For determining NPV, weighted average cost of
capital is used as the discounting factor, based on the assumption that every project is
financed by the same proportions of debt and equity as found in the capital structure of the
firm. However that may not be true. Moreover, tax advantages (savings in tax) due to use of
borrowed fund is not usually considered in financial appraisal of investment proposals
discussed so far. But impact of debt financing can be incorporated using Adjusted Present
Value Method with an adjustment of tax aspects of debt financing with the Base Case NPv.

Base Case NPV is the NPV under the assumption that the project is all-equity financed.
Adjusted NPV = Base case NPV + NPV of Tax Shields arising out of financing decisions
associated with the
project.
CAPITAL RATIONING
There may be situations where a firm has a number of independent projects that yield a
positive NPV or having IRR more than its cut off rate, PI more than 1, i.e., the projects are
financially viable, hence, acceptable. However, the
most important resource in investment decisions, i.e. funds, are not sufficient enough to
undertake all the projects.
In such a case, the projects are selected in such a way so that NPV becomes maximum in
order to maximize wealth of shareholders. Investment planning in such situation is Capital
Rationing.

There are two possible situations of Capital Rationing

(i) Generally, firms fix up maximum amount that can be invested in capital projects, during a
given period of time, say a year. This budget ceiling imposed internally is called as Soft
Capital Rationing or Internal Capital Rationing.
(ii) There may be a market constraint on the amount of funds available for investment during
a period. This inability to obtain funds from the market, due to external factors is called Hard
Capital Rationing or External Capital Rationing. Different proposals may be classified into
two categories: DIVISIBLE and INDIVISIBLE
In case of divisible projects, part acceptance of the project is possible.
Indivisible projects are either to be accepted in its entirety or to be rejected, i.e., part
acceptance is not possible.
for divisible projects, Pi approach help in selecting the proposals providing the highest NPV.
for indivisible projects, through trial and error methods, best combination of the projects
with the highest NPV may be ascertained.

For Divisible Projects

Rank the projects following PI and arrange them in descending order. Go on selecting the
projects till the fund is available.
For indivisible Projects
Determine all the feasible combination of the projects and rank them according to total NPV
of the combinations. Select the combination with the highest NPV.

Social Cost Benefit Analysis (SCBA)

In evaluation of investment proposals, more emphasis is given on the return on investment as
the firms usually face
the limitations or scarcity of funds. However, the impact of investment proposals from the
larger social point of
view is considered in Social Cost Benefit Analysis (SCBA). The social costs and benefits of a
project differ from the
costs incurred and benefits earned in monetary terms primarily due to market imperfections,
externalities, taxes,
concern for savings and redistribution, merit and demerit goods. As the focus of SCBA is on
the social costs and
benefits of the projects, the perspectives and parameters provided by the macro level plans
often serve as the
basis of SCBA.
The purpose of SCBA to supplement and strengthen the existing techniques of financial
analysis.

Need for Social Cost Benefit Analysis (SCBA)

(i) Monetary Cost Benefit Analysis fails to consider the external effects of a project, which
may be positive like development of infrastructure or negative like pollution and imbalance
in environment.
(ii) Taxes and subsidies are monetary costs and gains, but these are only transfer payments
from social point of view and therefore irrelevant.
(iii) Market prices used to measure costs and benefits in project analysis, do not represent
social values due to imperfections in market.
(iv) SCBA is essential for measuring the redistribution effect of benefits of a project as
benefits going to poorer section are more important from social point of view than one going
to sections which are economically better off.
(v) Projects, manufacturing life necessities like medicines, or creating infrastructure like
construction of road or electricity generation are more important than projects for
manufacture of liquor and cigarettes. Thus merit
wants are important appraisal criterion for SCBA.

Relevance of Social Cost Benefit Analysis for Private Enterprises

(i) SCBA is one of the most important criteria for taking up any project by the
Government enterprises. For example, if government wants to take up a project
relating to expansion of road for which Hawkers are to be removed, it has to
consider the rehabilitation of the hawkers and cost involved therein. SCBA is
important for private corporations also which have a moral responsibility to
undertake socially desirable projects.
(ii) If the private sector includes social cost benefit analysis in its project evaluation
techniques, it will ensure that it is not ignoring its own long-term interest, since
projects that are socially beneficial and acceptable are expected to survive in the
long run. Therefore, SCBA is important for private enterprises also.

Methodology of SCBA
Two principal approaches for SCBA are: (i) UNIDO approach and (ii) Little-Mirrlees (L-
M) approach. The L-M approach has considerable similarity with the UNIDO approach.
However, there are certain important differences
as well. The Financial Institutions like ICICI, IDBI, and IFCI evaluate the project
proposals primarily from the financial point of view and also incorporate the larger social
aspect in their analyses. These institutions follow the simplified version of L-M approach
with some minor variation.

INVESTMENT DECISIONS UNDER UNCERTAINTIES

Uncertainty refers to the outcomes of a given event which are too unsure to be assigned
probabilities.

Risk refers to a set of unique outcomes for a given event which can be assigned
probabilities. in investment decisions, cash outflows and cash inflows over the life of the
project are estimated and on the basis of such estimates, decisions are taken following
some appraisal criteria (nPV, irr, etc.). risk and uncertainties are involved in the
estimation of such future cash flows as it is very difficult to predict with certainty what
exactly will happen in future. Therefore, the risk with reference to capital budgeting is
referred to as the variability in actual returns of a project over its working life in relation
to the estimated return as forecast at the time of the initial capital budgeting
decision. The difference between the risk and uncertainty, therefore, lies in the fact that
variability is less in risk than in uncertainty.
So, the risk exists when the decision maker is in a position to assign probabilities to
various outcomes. This happens when the decision maker has some historical data on the
basis of which he assigns probabilities to other projects of the same type.
Different techniques that are used to deal with the risk and uncertainties in capital
investment decisions are briefly discussed below.
• Pay Back period: The firms using pay back period in investment decisions considers
risk and uncertainties indirectly. The principle for selection of projects under pay back
period is that lower the pay back period,
better is the project. Therefore, project with the lowest pay back period is ultimately
selected and thereby risk and uncertainties of the longer future is avoided through
recovery of initial investments at the earliest opportunity.

• Risk Adjusted Discount Rate (RAD):

Any investor usually expects higher return for taking higher risk. The same concept is
incorporated in the Risk Adjusted Discount Rate (RAD) Method of dealing with risk in
the context of capital investment decisions. If the risk of the project is similar to the
existing project, the weighted average cost of capital is used as the discounting rate. But,
if the project involves higher risk, a higher discounting rate is used for adjusting the risk
involved. the discounting rate over and above the weighted average cost of capital is
known as risk premium. The risk premium takes care of the project risk and may vary
from project to project depending on the risk involved in it. so, rad rate is the aggregate of
weighted average cost of capital and risk premium.
Due to increase in the discount rate, present value will be less and value of nPV or irr,
etc., will be less and more conservative estimate of benefits will take care of risk and
uncertainties.
The risk-adjusted discount rate method can be formally expressed as follows:
Risk-adjusted Discount Rate = Weighted Average Cost of Capital (k) + Risk
premium (Ø)
Under capital asset pricing model, the risk premium is the difference between the market
rate of return and the risk free rate multiplied by the beta of the project.

The risk adjusted discount rate accounts for risk by varying the discount rate depending
on the degree of risk of investment projects. A higher rate will be used for riskier projects
and a lower rate for less risky projects. The net
present value will decrease with increasing risk adjusted rate, indicating that the riskier a
project is perceived,
the less likely it will be accepted. If the risk free rate is assumed to be 10%, some rate
would be added to it, say 5%, as compensation for the risk of the investment, and the
composite 15% rate would be used to discount the
cash flows.
• Certainty Equivalent (CE) Approach
Under this approach, the estimated cash flows over the life of the project proposal, i.e.,
risky cash flows, are converted to its certainty equivalent. Certainty equivalent of
estimated cash flow will indicate the cash flows
that are likely to be received with almost certainty (certain cash flows or riskless cash
flows) and the certain cash flows are derived through multiplying the estimated risky cash
flows of the future periods by Certainty
Equivalent Co-efficient of the respective periods.

CE Co-efficient = Riskless cash flow / Risky cash flow

Standard Deviation in Capital Budgeting

Standard Deviation is considered as the best measures of dispersion or variability. Higher
value of standard deviation indicates higher variability and vice versa. Higher variability
means higher risk. As future cash flows
cannot be estimated with certainty, it involves risk. Therefore, risk in investment analysis
can be measured using standard deviation. Investment proposal with lower standard
deviation will indicate lower variability in cash
flow estimates, hence such investment proposal may be preferred to the proposal having
higher standard deviation. For comparing different alternative investment proposals,
coefficient of variation is preferred to
standard deviation because coefficient of variation is a relative measure (which is derived
through dividing standard deviation by expected NPV) while standard deviation is an
absolute measure.

Hillier’s model & Hentz’s model

Hillier’s model
H.S.Hillier argues that the uncertainty or the risk associated with a capital expenditure
proposal is shown by the standard deviation of the expected cash flows. In other words,
the more certain a project is lesser would be the
deviation of various cash flows from the mean cash flows. Let us take the example of a
bank deposit where the rate of interest stipulated is subject to changes according to the
Reserve Bank Regulations. It is also known with
a fair degree of certainty that even if the rate of interest is revised downwards or upwards,
such changes are not quite high. But in case of any business, actual cash flows and
estimated cash flows may widely differ because of existence of many factors, which are
difficult to predict with certainty, affecting the cash flows. Now there may be at best two
or three possible cash flows: the first at the contracted rate of interest, the second at a rate
of interest one step higher and third at a rate of interest two steps higher. it is quite
obvious that the standard deviation of this proposal would be much lower as compared to
the standard deviation of the cash flows related to an
investment proposal. In the latter case there are a large number of variables which would
affect the cash inflows and therefore, the variation in the cash inflows would be much
higher resulting in a higher standard deviation.
Hillier argues that working out the standard deviation of the various ranges of possible
cash flows would be helpful in the process of taking cognisance of uncertainty involved
with future projects.

Hillier has developed a model to evaluate the various alternative cash flows that may arise
from a capital expenditure proposal. He considers the correlation of cash flows from year
to year. Accordingly, cash flows may
be independent, i.e., uncorrelated, perfectly correlated or neither uncorrelated nor
perfectly correlated, say, moderately If
(i) If cash flows are uncorrelated: Standard Deviation of the NPV of the project is
calculated in the following way.
S.D.(σ) = 2 2t [_ _t /(1+ i) ]
(ii) If the cash flows over the life of the project are perfectly correlated, the Standard
Deviation is determined
using the formula given below.
S.D.(σ) = t t [_ _ /(1+ i) ]
In the above formula, ‘i’ denotes risk free interest rate and ‘σt’denotes Standard
Deviation of cash flows occurring
at ‘t’-th period.

Hertz’s model
Hertz has suggested that simulation technique which is a highly flexible tool of
operational research may be used in capital budgeting exercise. He argues that planning
problems of a firm are so complex that they cannot be described by a mathematical
model. Even if we do so we may make certain inherent assumption because of
which the solution may not be reliable for practical purposes. Moreover, in most of the
solutions, due to the uncertainties involved, a satisfactory mathematical model cannot be
built. He, therefore suggests that a simulation model may be developed for the investment
decision making also.

Hertz proposes that the distribution be described for each variable. This may be on the
basis of past data and/ or by subjective estimate of the executives. The executives need to
be aided by O/R expects to enable them to describe the distribution and its parameters.
first of all the decision maker would be asked to pick up a value that he believes that there
is the same chance of his estimate being too high as there is of its being too low. This
furnishes the mean. For an ideal of the variability, he would be asked to select two points,
one each side the mean and equally distant from it, so that he believed that the probability
of the true value of mean being between these two points. Form this normal distribution
may be derived.
Having derived the distributions of all the input variables, i.e., mean standard deviation
and shape of distribution for each variable the simulation experiment may be performed
by considering different levels of these factors.
For example, in the first run a very high operating cost with a low market share, etc,. may
be used for computing net present value. In the next run, it may be moderate operating
cost with a very large market size. Similarly, large number of runs, it may be moderate
operating cost with a very large market size. Similarly, large number of runs can be made
which would cover most of the possible situations.
 Section A
Answer in detail .
1. What is Investment decision ? Explain types of long term investment decisions.
2. Discuss the Concept of estimation of project cashflow.
3. Expalin Non DCF and DCF techniques in brief.
4. Explain advantages and disadvantages of :
(1) Pay back period
(2) ARR
(3) Discounted Pay back period
(4) NPV
(5) Profitability index
(6) IRR
(7) MNPV
5. Explain the concept of capital rationing.
6. Explain need for social cost benefit analysis.
7. Expalin investment decision under uncertainities.
8. Explain Hilters Model in detail.
9. Explain Hentz’s Model in detail.

10. ABC Chemicals is evaluating two alternative systems for waste disposal, System A and
System B, which have lives of 6 years and 4 years respectively. The initial investment
outlay and annual operating costs for the two systems are expected to be as follows:

System A System B

Initial Investment Outlay 5 million 4 million

Annual Operating Costs 1.5 million 1.6 million
Salvage value 1 million 0.5 million

If the hurdle rate is 15%, which system should ABC Chemicals choose? The PVIF @ 15% for
the six years are as below:

Year 1 2 3 4 5 6
PVIF 0.8636 0.7564 0.6575 0.5718 0.4972 0.4323

11. Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs `
36,000 and project B ` 30,000. You have been given below the net present value
probability distribution for each project.
Project A Project B

NPV estimates (`) Probability NPV estimates (`) Probability

15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1

(i) Compute the expected net present values of projects A and B.

(ii) Compute the profitability index of each project.

12. Find out Pay back period - Initial investment is `100 lakh is same for both the projects A
& B. The net cash inflows after taxes for project a is `25 lakh per annum for 5 years and those
for project B over its life of 5 years are ` 20 lakh, 25 lakh, 30 lakh, 30 lakh and 20 lakh
respectively.

13. S Ltd. has ` 10,00,000 allocated for capital budgeting purposes. The following
proposals and associated profitability indexes have been determined:
Project Amount Profitability Index
1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05
Which of the above investments should be undertaken? Assume that projects are indivisible
and there is no alternative use of the money allocated for capital budgeting.

14. Electromatic Excellers Ltd. specialise in the manufacture of novel transistors. They have
recently developed technology to design a new radio transistor capable of being used as an
emergency lamp also. They are quite confident of selling all the 8,000 units that they would
be making in a year. The capital equipment that would be required will cost `.25 lakhs. It will
have an economic life of 4 years and no significant terminal salvage value. During each of the
first four years promotional expenses are planned as under:

1st Year 1 2 3 4
Advertisements 1,00,000 75,000 60,000 30,000
Others 50,000 75,000 90,000 1,20,000

Variable cost of production and selling expenses: `250 per unit.

Additional fixed operating costs incurred because of this new product are budgeted at 75,000
per year. The company’s profit goals call for a discounted rate of return of 15% after taxes on
investments on new products.The income tax rate on an average works out to 40%. You can
assume that the straight line method of depreciation will be used for tax and reporting. Work
out an initial selling price per unit of the product that may be fixed for obtaining the desired
rate of return on investment.
Present value of annuity of Re. 1 received or paid in a steady stream throughout 4 years in the
future at 15% is 3.0079.

Section B- MCQ

1. Which of the following elements is not normally

A.An objective
B.Uncertainty
C.No defied endpoint
D.Uniqueness

2. Successful project management does NOT include which of the following

factors?
A. Responsiveness to clients
B.Competent team members
C.Interchangeable stall
D.Control mechanisms

3. Which is the first stage in the project management model?

A. Project control
B. Project planning
C. Project definition
D. Understanding the project environment

4. A clear hierarchy of objectives in the project definition would not normally contain.
A. Control mechanisms
B. The purpose
C. Success criteria
D. Desired end result

5. A critical path network diagram does not .

A. Calculate earned-value
B. Calculate the duration of the whole project
C. Identify the particularly important activities
D. Help determine the amount of float

6. Which of the following are features of Belbin's 'resource investigator role?

A. Unorthodox, discerning, single-minded
B. Sobar, unemotional and prudent
C. Extroverted, enthusiastic and communicative
D. Painstaking orderly and conscientious

7. Which of the following is not a main element of the project management process?

A. Schedule
B. Plan.
C. Estimation.
D. Systems design.

8. Which of the following is mut a main project objective

A. Cost.
B. Quality.
C. Time.
D. Structure.
9. Which of the following is a mam PRINCE project aim?
A. Stay within budget.
B. Meet specified quantity.
C. Deliver on schedule.
E. All of the above.

10. Which of the following is especially useful for monitoring project progress
against plan?
A. Network diagrams
B. Capacity loading graphs
C. Gantt charts
D. Flow diagrams

11. Which of the following is not a reason to reduce project completion time?

A. Eliminate project critical path.

B. Release resources for other projects
C. Reduce new product development time to market.
D. Gain incentives for early completion.

12. Which of the following are benefits of the network analysis approach?

A. Allows progress to be monitored against plan.

B. Derive error free forecasts
C. Avoid need to use structured approach.
D. Eliminate need for management judgement.

13. A Gantt chart indicates .

A. Elapsed time of different activities on project.
B. Activities occurring in parallel.
C. The sequence of activities.
D. Overall elapsed time on project.

14. A project can be considered to have failed if it .

A. does not meet the users' requirements.
B. does not meet the business requirements.
C. overran significantly on estimated delivery date.
D. was significantly over budget.

15. The three passes involved in the management of large projects are .
 A. heduling, operating, evaluating
B. scheduling, designing, operating
C. planing, scheduling, evaluating.
D. planning, scheduling, controlling.

16. With respect to PERT and CPM, slack

A. is a task or subproject that must be completed.
B. is the latest time an activity can be started without delaying the entire project.
C. is the amount of time a task may be delayed without changing the overall project
completion time.
D. marks the start or completion of a task.

17. A dummy activity is required when .

A. two or more activities have the same ending events.
B. the network contains two or more activities that have identical
starting and ending events.
C. two or more activities have different ending events.
D. two or more activities have the same starting events.

18. Which of the following is a basic assumption of PERT?

A.No activity in the network must be repeated

B. Activity completion times are known with certainty.
C There is only one complete route from the start of a project to the end of a
project.
D. Only critical path activities in the network must be performed.

19. PERT analysis computes the variance of the total project completion time as
A. the sum of the variances of all activities in the project.
B. the sum of the variances of all activities on the critical path.
C. the sum of the variances of all activities not on the critical path.
D. the variance of the final activity of the project.

20. The critical path of a network is the .

A. path with the fewest activities.
B. longest time path through the network.
C. shortest time path through the network.
D. path with the most activities.

21. Which of the following is a direct responsibility of the project manager?

A. Calculating completion probabilities for all tasks in the project.
 B. Drawing the network diagram.
C. Making sure that the people assigned to the project receive the motivation, direction,
and information needed to do their jobs.

D. Performing all of the activities in the project.

22. Dummy activities is .

A. are found in both AOA and AON networks.
B. have a duration equal to the shortest non-dummy activity in the network.
C. cannot be on the critical path.
D. are used when two activities have identical starting and ending events.

23. Which of the following is a limitation of PERT and CPM?

A. They are applicable to only a narrow variety of projects and industries.
B. They can be used only to monitor schedules.
C. The graphical nature of a network delays comprehension of the activity list's
interrelationships.
D. There is an inherent danger of too much emphasis being placed on the critical path.

24. Which of the following is not one of the commonly heard comments of project managers?

A. Where did this project come from?

B. Why are we doing this project?
C. How can all these projects be first priority?
D. Why is this project so strongly linked to the strategic plan?

25. Strategy considered to be under purview of senior management is .

A. Old school thinking
B. A new school of management thought
C. Necessary in a company structure
D. Beneficial to the Project Manager

26. The intended outcome of strategy/projects integration is .

A. Clear organization focus
B. Best use of scarce organization resources
C. Improved communication across projects and departments
D. All of the above

27. Project managers who do not understand the role that their project plays in
accomplishing the organization's strategy tend to make all the following mistakes except
 .
A. Focusing on low priority problems

B. Overemphasizing technology as an end in and of itself

C. Focusing on the immediate customer
D. All the above are likely mistakes

28. Which of the following questions does the organization's mission

statement answer?
A. What are our long-term strategies?
B. What are our long-term goals and objectives?
C. How do we operate in the existing environment?
D. What do we want to become?

29. Strategy formulation includes which of the following activities?

A. Determining alternatives
B. Creating profitability targets
C. Evaluating alternatives.
D. Both a and c are correct

30. The assessment of the external and internal environments is called

analysis.
A. SWOT analysis

B. Competitive
C. Industry
D. Market

32. Which of the following is not one of the requirements for successful implementation of
strategies through projects?
A. Allocation of resources

B. Prioritizing of projects
C. Motivation of project contributors

D. All of these are requirements

33. Project selection criteria are typically classified as .

A. Financial and non-financial
B. Short-term and long-term
C. Strategic and tactical
D. Required and optional

34. Which of the following is not one of the classifications for assessing a project
portfolio?
A. Sacred cow
B. Bread and butter
C. Pearls
D. Oysters

35. The difference between the market value of an investment and its cost is the
.
A. Net present value.
B. Internal rate of return.
C. Payback period.
D. Profitability index.

36. The payback rule can be best stated as .

A. An investment is acceptable if its calculated payback period is less than some
prespecified number of years.
B. An investment should be accepted if the payback is positive and rejected if it is
negative.
C. An investment should he rejected if the payback is positive and accepted if it is negative
D. An investment is acceptable if its calculated payback period is greater than same
prespecified number of years.

37. The length of time required for an investment to generate cash flows sufficient to
recover its initial cost is the .
A. Net present salve,
B. Internal rate of return.
C. Payback period.
D. Profitability index.

38. The discount rate that makes the net present value of an investment exactly equal to
zero is the .
A. Payback period.
B Internal rate of return.
C. Average accounting return.
D. Profitability index

39. Situations where taking one investment prevents the taking of another is(are) called .
A. Net present value profiling.
 B. Operational ambiguity.
C. Mutually exclusive projects.
D. Issues of scale.

40. The internal rate of return (IRR) rule can be best stated as .
A. An investment is acceptable if its IRR is exactly equal to its net present value
(NPV)
B. An investment is acceptable if its IRR is exactly equal to zero.
C. An investment is acceptable if its IRR is less than the required return, else it should
be rejected.
D. An investment is acceptable if its IRR exceeds the required return, else it should be
rejected.

41. The present value of an investment's future cash flows divided by its initial cost is
the .
A. Net present value.
B. Internal use of return
C. Average accounting return
D. Profitability index

42. Net present value .

A. is equal to the initial investment in a project
B. is equal to the present value of the project benefits
C. is equal to zero when the discount rate used is equal to the IRR
D. is simplified by the fact that future cash flows are easy to estimate

43. The decision rule is considered the "best" in principle in .

A. internal rate of return
B. payback period
C. average accounting return
D. net present value

44. Which of the following decision rules is best for evaluating projects for which cash
flows beyond a specified point in time, and the time value of money, can both be
ignored?
A. Payback
B. Net present value
C. Average accounting return
D. Profitability index
45. An investment generates $1.10 in present value benefits for each dollar of invested
costs. This conclusion was most likely reached by calculating the project's:
A. Net present value
B. Profitability index
C. Internal rate of return
D. Payback period

46. Which of the following functions of Production Planning and Control is related to
the timetable of activities?
A. Scheduling
B. Dispatching
C. Expediting
D. Routing

47. Which of the following processes is not a part of the Production Planning and
Control system?
A. Integration of processes
B. Routing
C. Expediting and follow up
D. All of the above

48. The objectives of Production Planning and Control are .

A. Timely delivery of goods and services
B. Improving customer satisfaction
C. Coordinating with multiple departments to ensure that the production process is on
track
D. All of the above

45. The correct sequence of operations in the Production Planning and Control process is .
A. Routing - Scheduling - Follow up Dispatching
B. Scheduling - Follow up - Dispatching Routing
C. Routing - Scheduling - Dispatching Follow up
D. Dispatching - Routing - Scheduling Follow up

46. Production Planning and Control function is crucial for ensuring cost savings and
efficiency in .
A. Planning
B. Production
C. Promotion
 D. None of the above

47. The control activity in Production Planning and Control is performed plan. of
the
A. Before execution
B. After execution
C. During execution
D. None of the above

48. involves anticipating bottlenecks in advance and identifying steps that will ensure a
smooth flow of production.
A. Production planning
B. Production control
C. Production audit
D. None of the above

49. Regulating the production process to ensure an orderly flow of materials is the
objective of .
A. Production planning
B. Production control
C. Production audit
D. None of the above

50. When the size of an organization increases, the functions under production control
should .
A. Get more decentralised
B. Get more centralised
C. Stay the same
D. None of the above

51. Production planning is essential for .

A.Inventory management
B.Quality management
C.Supply management
D.All of the above

52. Production control within a company depends on .

A. Nature of production activities within the organisation
B. Nature of the organisation
C. Size of the organisation
D.All of the above
53. is responsible for the order of processing each activity under Production Planning
and Control.
A. Loading
B. Sequencing
C. Routing
D. Scheduling

54. is concerned with the time required to perform each activity under the Production
Planning and Control process.
A. Loading
B. Sequencing
C. Routing
D. Scheduling

55. Procurement cycle time calculates the total duration for

A. Inspecting the purchased components
B. Receiving raw materials
C. Inspection of raw materials
D. All of the above

56. Material Requirement Planning (MRP) is a computerised system to plan the

requirements for .
A. Finished goods
B. Raw materials
C. Work in progress
D. All of the above

57. The functions of Material Requirement Planning include .

A. Schedule materials for future production
B. Looking at present orders to determine quantities of material required
C. Determine the timing of material requirements, calculate purchase orders based on
stock levels and place purchase orders automatically
D. All of the above

58. Material Requirement Planning is useful for all except .

A. Discrete demand items
B. Dependent demand items
C. Erratic orders
 D. Independent demand items

59. Which of the following describes a process layout?

A. Equipment is general purpose and workers are highly skilled
B. Equipment is specialised and workers are unskilled
C. Equipment is general purpose and workers are unskilled
D. Equipments is specialised and workers are highly skilled

60. Which of the following statements is true?

A. Product layouts are flexible while process layouts are efficient
B. Product layouts are efficient while process layouts are flexible
C. Both product and process layouts are efficient but not flexible
D. Both product and process layouts are flexible but not efficient

61. The process of Production Planning and Control starts with .

A. Expediting
B. Scheduling
C. Estimating
D. Routing

62. The machines used for mass production are .

A. Special purpose
B. General-purpose
C. Manually operated
D. Semi-automatic

63. What is the definition of loading?

A. It is the process of assigning work to the facilities
B. It is the process of sending the raw material to machines for production
C. It is the process of uploading the software to the machine control panel
D. It is the process of sending the finished material to the store

64. Dispatching authorises the start of production operations by .

A. Releasing the material and components from stores to the first process
B. Issuing of drawing instruction sheets
C. Releasing the material from process to process
D. All of the above

65. The purpose of preparing a master schedule is to oversee .

A. Multi-product batch production
B. Single product batch production
 C. Single product continuous production
D. Assembly product continuous production

66. Which of the following processes is not a part of the Production Planning and Control
system?
A. Integration of processes
B. Routing
C. Expediting and follow up
D. All of the above
67. The objectives of Production Planning and Control are .
A. Timely delivery of goods and services
B. Improving customer satisfaction
C. Coordinating with multiple departments to ensure that the production process is on track
D. All of the above
68. Production Planning and Control function is crucial for ensuring cost savings and
efficiency in .
A. Planning
B. Production
C. Promotion
D. None of the above
69. The control activity in Production Planning and Control is performed of the
plan.
A. Before execution
B. After execution
C. During execution
D. Both (a)&(b)
70. Regulating the production process to ensure an orderly flow of materials is the objective
of .
A. Production planning
B. Production control
C. Production audit
D. None of the above

References:

1. SFM- K.M Bansal

2. Strategic Financial Management - ICMAI
3. SFM-Ritu Wadhwa
4. SFM  Prin & Practices- Rajni

*****
 FACULTY OF COMMERCE
2024 – 25
SEMESTER -VI
SUBJECT: STRATEGIC FINANCIAL
MANAGEMENT
[Specialisation : Banking ,Insurance &
Finance]
UNIT 3 : MERGER ACQUISITIONS, CORPORATE
RESTRUCTURING AND BUSINESS ALLIANCE

CA DR. SNEHA MASTER PROF. MEGHAVI THAKAR

STUDY MATERIAL FOR REFERENCE ONLY

 GLS UNIVERSITY
FACULTY OF COMMERCE
SEMESTER VI
STRATEGIC FINANCIAL MANAGEMENT
UNIT 3 : MERGER ACQUISITIONS, CORPORATE RESTRUCTURING
AND BUSINESS ALLIANCE

INDEX

SR. NO. TOPIC

1 Corporate Restructuring - Meaning
2 Reasons for Corporate Restructuring
3 Major Categories of Corporate Restructuring
4 Different forms or types of Corporate Restructuring
5 Evolution of Mergers and Acquisitions in India
6 Different types or Forms of Mergers
7 Consideration in case of Mergers & Acquisitions
8 Determination of Exchange Ratio of Stock for Purchase
Consideration
9 Impact of Mergers and Acquisitions on Society
10 Mergers And Acquisitions – Reasons for Failures
11 Financial Restructuring
12 Section -A Theory Questions
13 Section -B Multiple Choice Questions
14 Section -C Practice Questions

1|Page SEM 6 SFM UNIT 3 MA,CR&BA

[1] Meaning of Corporate Restructuring
Restructuring of business is an integral part of modern business enterprises. The globalization and
liberalization of Control and Restrictions has generated new waves of competition and free trade. This
requires Restructuring and Re-organisation of business to create new synergies to face the
competitive environment and changed market conditions.
Restructuring usually involves major organizational changes such as shift in corporate strategies.
Restructuring can be internally in the form of new investments in plant and machinery, Research and
Development of products and processes, hiving off non-core businesses, divestment, sell-offs, de-
merger etc.
Restructuring can also take place externally through Mergers and Acquisitions (M&As), by forming
joint-ventures and having strategic alliances with other firms.
The aspects relating to expansion or contraction of a firm’s operations or changes in its assets or
financial or ownership structure are known as corporate re-structuring. While there are many forms
of corporate re-structuring, mergers, acquisitions and takeovers, financial restructuring and re-
organisation, divestitures de-mergers and spin-offs, leveraged buyouts and management buyouts are
some of the most common forms of corporate restructuring.
The most talked about subject of the day is Mergers & Acquisitions (M&A). In developed economies,
corporate Mergers and Acquisition is a regular feature. In India, too, mergers and acquisition have
become a part of corporate strategy today. Mergers, acquisitions and corporate restructuring of
businesses in India have grown by leaps and bounds in the last decade.
The terms ‘mergers; ‘acquisitions’ and ‘takeovers’ are often used interchangeably in common
parlance. However, there are differences. While merger means unification of two entities into one,
acquisition involves one entity buying out another and absorbing the same. In India, in legal sense
merger is known as ‘Amalgamation’.
The amalgamations can be by merger of companies within the provisions of the Companies Act, and
acquisition through takeovers. While takeovers are regulated by SEBI, Mergers and Acquisitions
(M&A) deals fall under the Companies Act. In cross border transactions, international tax
considerations also arise.
The term “amalgamation” is used when two or more companies are amalgamated or where one is
merged with another or taken over by another.
An acquisition is when both the acquiring and acquired companies are still left standing as separate
entities at the end of the transaction. A merger results in the legal dissolution of one of the
companies, and a consolidation dissolves both of the parties and creates a new one, into which the
previous entities are merged.
[2] Reasons for corporate restructuring
[a] Cost Reduction and Efficiency Improvement
• Optimizing Resources: Internal restructuring can help a company better allocate its
resources by eliminating redundancies and inefficiencies within its operations. This might
involve consolidating departments, outsourcing non-core functions, or automating
processes.
• Downsizing or Rightsizing: Restructuring may be necessary to reduce overheads by reducing
the workforce or eliminating underperforming business units. It helps align the company’s
size with its current needs and market conditions.

2|Page SEM 6 SFM UNIT 3 MA,CR&BA

[b] Adapting to Market or Industry Changes
• Responding to Economic Conditions: Companies might restructure internally in response to
shifts in the economy, industry trends, or consumer demands. This can include revising
business models, entering new markets, or shifting focus to high-growth areas.
• Technological Advancements: Adopting new technologies may require structural changes to
better integrate these innovations into the company’s operations or product offerings. For
instance, automating manual processes or adopting a digital-first approach.
[c] Enhancing Organizational Agility
• Improved Decision-Making: Internal restructuring can simplify the decision-making process
by flattening hierarchies or decentralizing authority. This increases responsiveness to market
changes and empowers lower levels of management to make decisions faster.
• Fostering Innovation: Streamlining or reengineering business functions can provide more
flexibility and foster an innovative culture. With less bureaucracy, employees can contribute
more effectively to new ideas and strategies.
[d] Improving Financial Health
• Debt Reduction and Cost Management: In response to financial strain or increased
competition, companies may restructure to improve their financial position by cutting costs,
managing debt, or improving cash flow. This might involve scaling back unprofitable divisions
or renegotiating contracts with suppliers.
• Profitability Enhancement: Restructuring may be pursued to improve margins, eliminate
inefficiencies, and maximize profitability. This often involves aligning internal processes to
reduce costs and optimize productivity.
[e] Cultural or Leadership Transformation
• Leadership Change: Sometimes restructuring is driven by a change in leadership, where a
new CEO or management team redefines the company’s direction and operations to align
with their vision.
• Corporate Culture Shift: Companies may restructure to change their corporate culture,
perhaps moving toward a more collaborative, agile, or customer-centric environment. This
often involves changing management practices, values, and communication channels.
[f] Synergy Generation:
Synergy may be defined as follows: V (AB) >V(A) + V (B).
The combined value of two firms or companies shall be more than their individual value.
Synergy is the increase in performance of the combined firm over what the two firms are
already expected or required to accomplish as individual independent firms. This may be the
result of complimentary services or economies of scale or both.
[g] Diversification:
Merger between two unrelated companies would lead to reduction in business risk, which in
turn will increase the market value consequent upon the reduction in discount rate/
required rate of return. Normally, greater the combination of statistically independent or
negatively correlated income streams of merged companies, higher will be the reduction in
business risk in comparison to companies having income streams which are positively
correlated to each other.
[h] Taxation:
The provisions of set off and carry forward of losses as per Income Tax Act may be another
strong reason for the merger and acquisition. Thus, there will be Tax saving or reduction in
tax liability of the merged firm. Similarly, in the case of acquisition the losses of the target
company will be allowed to be set off against the profits of the acquiring company.

3|Page SEM 6 SFM UNIT 3 MA,CR&BA

[i] Growth:
Merger and acquisition mode enables the firm to grow at a rate faster than the other mode
viz., organic growth. The reason being the shortening of ‘Time to Market’. The acquiring
company avoids delays associated with purchasing of building, site, setting up of the plant
and hiring personnel etc.
[j] Consolidation of Production Capacities and increasing market power:
Due to reduced competition, marketing power increases. Further, production capacity is
increased by the combination of two or more plants. The following table shows the key
rationale for some of the well-known transactions which took place in India in the recent
past.

[3] Major Categories of Corporate Restructuring

1. Organizational Restructuring
• Purpose: To reorganize the internal structure of the company, often to improve efficiency,
reduce costs, or streamline decision-making.
• Examples:
o Changing the reporting hierarchy or management structure.
o Merging or splitting departments or business units.
o Flattening organizational levels to improve communication and agility.
o Redefining roles and responsibilities within teams to ensure better alignment with
company goals.
2. Financial Restructuring
• Purpose: To address financial distress, improve liquidity, or optimize the company’s financial
structure.
• Examples:
o Debt restructuring, where terms with creditors are renegotiated, or some debt is
converted into equity.
o Refinancing existing debt to lower interest rates or extend repayment periods.
o Selling non-core assets to raise cash or reduce financial burdens.
o Revising capital allocation to focus on more profitable areas or high-growth
opportunities.
3. Operational Restructuring
• Purpose: To optimize operations by improving efficiency, reducing waste, and aligning
processes with the company’s objectives.
• Examples:
o Reengineering business processes to remove inefficiencies and bottlenecks.
o Implementing new technologies, such as automation or digital tools, to enhance
productivity.
o Outsourcing non-core activities to focus on high-priority tasks.
o Improving supply chain management to reduce costs and increase speed.
4. Cost-Cutting and Downsizing
• Purpose: To reduce operational expenses and streamline the organization, often in response
to financial difficulties or to improve profitability.
• Examples:
o Laying off or redeploying employees to reduce labor costs.
o Eliminating underperforming business units, products, or services.
o Reducing operational overhead, such as office space, utilities, or administrative
expenses.
o Freezing hiring or delaying non-essential expenditures.
4|Page SEM 6 SFM UNIT 3 MA,CR&BA
5. Cultural Restructuring
• Purpose: To change the internal culture or employee engagement strategies to improve
performance, morale, and collaboration.
• Examples:
o Revising company values, ethics, and mission statements to align with evolving
business goals.
o Enhancing communication strategies to foster transparency and trust between
leadership and staff.
o Implementing leadership development programs to build new management
competencies.
o Encouraging collaboration and innovation through team-building exercises or
restructuring work teams.
6. Divisional or Departmental Restructuring
• Purpose: To restructure specific departments or divisions to improve focus, collaboration, or
performance within certain areas of the business.
• Examples:
o Merging departments with overlapping functions to reduce redundancy.
o Splitting a large department into smaller units for better management.
o Shifting focus within divisions, such as moving from product-oriented to customer-
oriented structures.
7. Technological Restructuring
• Purpose: To integrate new technologies into the company’s operations for better efficiency,
competitiveness, and scalability.
• Examples:
o Upgrading IT systems and software to improve workflow, collaboration, and data
management.
o Implementing automation tools to replace manual processes.
o Transitioning to cloud-based systems to reduce infrastructure costs and enhance
flexibility.
o Integrating artificial intelligence, machine learning, or data analytics into operations
for better decision-making.
8. Human Resources Restructuring
• Purpose: To optimize human capital by realigning workforce needs, addressing skill gaps, or
improving employee performance and satisfaction.
• Examples:
o Redefining job roles and responsibilities to better match the company’s strategic
objectives.
o Realigning the workforce to respond to changes in business direction (e.g., from
traditional to digital).
o Implementing new performance management systems to improve employee
productivity and morale.
o Offering retraining and reskilling programs to help employees adapt to new roles or
technologies.

9. Product or Service Restructuring

• Purpose: To revise or streamline the company’s offerings based on market demands,
profitability, or strategic direction.
• Examples:
o Discontinuing underperforming products or services.

5|Page SEM 6 SFM UNIT 3 MA,CR&BA

 o Focusing on more profitable or high-growth product lines.
o Bundling products or services to increase customer value and drive sales.
o Redesigning existing offerings to better align with customer needs or market trends.
10. Corporate Governance Restructuring
• Purpose: To enhance the governance structure to improve transparency, accountability, and
compliance.
• Examples:
o Changing the board of directors or executive leadership to bring in new perspectives
or expertise.
o Revising company policies and procedures to improve internal controls.
o Strengthening audit, compliance, and risk management functions.
11. Strategic Restructuring
• Purpose: To align the company’s strategic direction with changing market conditions or
internal capabilities.
• Examples:
o Shifting the company’s focus from a low-cost strategy to a differentiation strategy.
o Repositioning the company in the market by targeting a different customer segment
or geographic region.
o Aligning the company’s strategy with long-term growth objectives, such as
diversification or international expansion.

[4] Different forms or types of Corporate Restructuring

1] Internal Restructuring [2] External Restructuring
• Differences Between Internal and External Restructuring:

Aspect Internal Restructuring External Restructuring

Changes within the organization Changes with external stakeholders (mergers,

Focus
(structure, operations, culture). acquisitions, partnerships).

Involves external entities or environments

Scope Primarily internal processes and systems.
(e.g., competitors, markets).

Improve efficiency, reduce costs, Expand market reach, strengthen financial

Objective
enhance profitability. position, diversify.

Organizational restructuring, downsizing, M&A, joint ventures, divestitures, and

Examples
process reengineering. financial restructuring.

6|Page SEM 6 SFM UNIT 3 MA,CR&BA

Internal restructuring

Internal restructuring refers to the changes made within an organization to improve its operations,
enhance efficiency, or achieve strategic objectives without changing ownership or involving external
mergers or acquisitions. Here are the primary types of internal restructuring:

1. Operational Restructuring
• Purpose: Streamlining operations, reducing costs, and improving efficiency.
• Examples:
o Closing non-performing units or divisions.
o Optimizing production processes.
o Implementing new technologies or systems.

2. Financial Restructuring
• Purpose: Improving financial stability and liquidity .
• Examples:
o Debt restructuring, including renegotiating terms with creditors.
o Refinancing loans or issuing new debt.
o Reorganizing the capital structure (e.g., altering the debt-equity ratio).

3. Organizational Restructuring
• Purpose: Changing the structure or hierarchy within the organization.
• Examples:
o Flattening organizational layers to reduce hierarchy.
o Creating new departments or merging existing ones.
o Shifting from a functional to a divisional or matrix structure.

4. HR Restructuring
• Purpose: Modifying workforce-related policies and management.
• Examples:
o Downsizing or layoffs to reduce costs.
o Retraining or upskilling employees for new roles.
o Revising compensation structures.

5. Asset Restructuring
• Purpose: Adjusting asset portfolios to better align with business objectives.
• Examples:
o Selling off non-core assets or underperforming business units.
o Redeploying resources to high-growth areas.
o Acquiring new equipment or technology.

6. Cultural Restructuring
• Purpose: Shifting organizational culture to align with new goals.
• Examples:
o Promoting a more collaborative or innovative culture.
o Encouraging diversity and inclusion initiatives.
o Adopting new mission, vision, and value statements.

7|Page SEM 6 SFM UNIT 3 MA,CR&BA

7. Strategic Restructuring
• Purpose: Aligning the business model with long-term goals.
• Examples:
o Pivoting to a new market or product line.
o Changing the company’s mission or vision.
o Exiting low-margin or non-core businesses.

External restructuring

It refers to changes made to a company's structure or operations that are driven by or affect
external factors, such as market dynamics, competitors, legal frameworks, or financial relationships.
These types of restructuring are often focused on improving the company's position in the market,
expanding its reach, or aligning with external forces such as regulatory changes or financial
pressures. Here are the main types of external restructuring:

1. Mergers and Acquisitions (M&A)

• Purpose: To combine or acquire companies in order to increase market share, achieve
synergies, or enter new markets.
• Examples:
o Merging with or acquiring a competitor within the same industry to increase market
share and reduce competition.
o Merging with or acquiring companies within the supply chain (e.g., a supplier or
distributor) to improve operational efficiencies or secure supply lines.
o Merging with or acquiring a company in a completely different industry, typically for
diversification purposes.
o A private company acquires a public company to become publicly traded, by passing
the traditional IPO process.

2. Divestitures
• Purpose: To sell, liquidate, or divest parts of the business (subsidiaries, divisions, or assets)
to focus on core operations, raise capital, or improve financial health.
• Examples:
o Selling a non-core business unit or underperforming asset to focus on higher-margin
or growth-oriented areas.
o Divesting a subsidiary or business unit to improve operational focus or reduce risk
exposure.
o Reducing exposure to certain markets, geographies, or product lines.

3. Spin-Offs
• Purpose: To create a separate, independent company by separating part of the business
(e.g., a subsidiary or division) that will operate independently.
• Examples:
o A large corporation spins off a division into a separate entity to focus more effectively
on different business goals or to unlock value for shareholders.
o A company may spin off a business unit to allow it to grow more freely without the
constraints of being part of a larger organization.

8|Page SEM 6 SFM UNIT 3 MA,CR&BA

4. Joint Ventures (JVs)
• Purpose: To enter into a partnership with one or more companies to pursue a specific
business objective, share risks, and leverage combined resources.
• Examples:
o Two companies form a joint venture to enter a new geographic market, combining
resources and expertise.
o Companies in complementary industries (e.g., technology and healthcare) create a JV
to develop and market a new product or service.

5. Strategic Alliances
• Purpose: To collaborate with other organizations to achieve common goals, such as entering
new markets, sharing technology, or co-developing products, without forming a new legal
entity.
• Examples:
o Companies form strategic alliances to share research and development costs or
jointly market a product.
o Partnerships between companies to offer complementary products or services to
broaden customer bases and market coverage.

6. Restructuring of Financial Relationships

• Purpose: To reorganize the company's financial structure or relations with creditors and
investors, typically to alleviate financial distress or optimize the capital base.
• Examples:
o Debt Restructuring: Renegotiating terms of debt, such as extending repayment
periods or converting debt to equity, often in cases of financial distress.
o Debt-to-Equity Swap: Converting debt obligations into equity to reduce the
company’s debt burden.
o Equity Financing: Issuing new shares or securities to raise capital from external
investors, often to fund growth or pay down debt.
o Refinancing: Replacing old debt with new debt, typically at more favourable terms,
to improve liquidity or reduce interest costs.

7. Strategic Partnerships
• Purpose: To engage in long-term collaborations with external companies to pursue shared
business objectives and expand market presence.
• Examples:
o A company partners with a larger corporation to expand into new markets or launch
new products.
o Strategic partnerships to share distribution networks, technology, or manufacturing
facilities to increase efficiency.

8. International Expansion or Cross-Border Restructuring

• Purpose: To expand operations or enter new international markets by restructuring
operations to cater to the needs of foreign markets.
• Examples:
o A company establishes new subsidiaries or branches in foreign countries to capture
international market share.
o Licensing or franchising its brand and products to international partners, enabling
growth without the need to establish direct operations.

9|Page SEM 6 SFM UNIT 3 MA,CR&BA

9. Corporate Governance Restructuring
• Purpose: To adapt the company's governance structure to better meet external
requirements (e.g., regulations, shareholder interests) or improve management oversight.
• Examples:
o Changes in the board of directors to ensure better oversight and alignment with
investor interests.
o Strengthening corporate governance to comply with new regulatory requirements
o Modifying shareholder voting mechanisms or introducing new governance practices
to improve accountability.

10. Legal Restructuring

• Purpose: To reorganize the company’s legal structure to optimize tax liabilities, comply with
new laws, or improve legal protections.
• Examples:
o Reorganizing the company’s corporate structure (e.g., from a partnership to a
corporation) for tax or liability protection reasons.
o Reincorporating in a different jurisdiction (e.g., moving the company's headquarters
to a tax-friendly country or region).
o Restructuring a company’s subsidiaries for legal reasons or to limit exposure to legal
risks in specific regions.

11. Bankruptcy or Insolvency Restructuring

• Purpose: To reorganize a company’s operations and debts in response to insolvency or
bankruptcy, allowing the business to continue operating or liquidate in an orderly manner.
• Examples:
o Filing for bankruptcy to reorganize the company’s debt and operations, allowing it to
return to profitability.
o A company may use bankruptcy protection to restructure its debts, negotiate with
creditors, and emerge with a cleaner financial slate.

[5] Evolution of Mergers and Acquisitions in India

The evolution of mergers and acquisitions (M&A) in India has been a dynamic process, shaped by
various economic, legal, and regulatory developments over the decades. M&As in India have followed
a trajectory influenced by global trends, domestic economic policies, and changes in the country's
business environment. Below is a breakdown of the evolution of M&As in India:
1. Early Years (1947-1980s): The Era of State Control
• Post-Independence Economic Environment: In the early years after independence, the Indian
government followed a socialist-oriented economic model with heavy state control. The
Monopolies and Restrictive Trade Practices (MRTP) Act of 1969 was introduced to control
monopolies and prevent anti-competitive practices. This framework was designed to regulate
corporate growth and prevent concentration of economic power in a few hands.
• Limited M&A Activity: The regulatory environment was largely restrictive, and business
practices were focused on expansion through organic growth. M&As were rare, as businesses
had limited scope to consolidate due to regulatory restrictions. The Indian economy was
largely closed, with limited foreign investments or acquisitions.

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 • Focus on Public Sector: The government took control of key sectors through nationalization
(e.g., banking, coal, steel, and insurance), further limiting opportunities for private-sector
M&As.
2. Economic Liberalization (1991-2000): The Beginning of Liberalization
• 1991 Economic Reforms: The turning point for M&A activity in India came with the 1991
economic liberalization. The reforms led by then Finance Minister Manmohan Singh included
deregulation, reduced import tariffs, the opening up of sectors to foreign investments, and
the loosening of the previously restrictive M&A regulations.
• Key Developments: The Foreign Exchange Regulation Act (FERA) was replaced by the more
flexible Foreign Exchange Management Act (FEMA) in 2000, making it easier for foreign
investors to engage in M&A activities.
• Increased Private Sector M&As: With the liberalization of the economy, there was a surge in
private-sector mergers and acquisitions, driven by both domestic and foreign companies.
Indian firms began looking at cross-border M&As, while foreign companies started acquiring
Indian businesses.
3. The Growth Era (2000-2007): Cross-Border Expansion and Foreign Investment
• Boom in M&A Activity: The period from 2000 to 2007 saw a significant increase in M&A
activity, particularly due to the growth of the Indian economy, availability of capital, and India’s
emerging position as a global market. The liberalization policies attracted foreign investments,
and the Indian market became increasingly open to cross-border deals.
• Regulatory Developments: The Securities and Exchange Board of India (SEBI) introduced new
regulations such as the Takeover Code (1997), which governed the process of acquisitions and
takeovers in listed companies. These regulations were aimed at ensuring transparency and
fairness in M&A transactions.
• Globalization and Indian Corporates: Indian companies started acquiring foreign firms,
especially in sectors like IT (Infosys, Wipro), pharmaceuticals (Dr. Reddy’s, Ranbaxy), and
telecommunications. This period also witnessed a boom in the IT and outsourcing sectors,
with companies like Tata Consultancy Services (TCS) and Infosys becoming global players.
• Foreign Acquisitions: A notable example was the acquisition of Corus by Tata Steel in 2007 for
$12 billion, marking one of the largest outbound M&A deals by an Indian company at the time.
4. The Global Financial Crisis and Recovery (2008-2014)
• Impact of the 2008 Global Financial Crisis: The 2008 financial crisis slowed down M&A activity
in India as many global companies pulled back from investments, and liquidity became tighter.
Indian companies also faced challenges in financing cross-border acquisitions.
• Government and Regulatory Response: The Indian government introduced measures to
stabilize the economy and encourage M&As. The Competition Act (2002), which replaced the
MRTP Act, focused on regulating anti-competitive practices, further enabling the growth of
M&As.
• Revival Post-Crisis: As the global economy started recovering, there was a resurgence of M&A
activity. Indian companies began to engage in consolidation within the domestic market as
well, leading to significant deals in sectors like telecommunications, banking, and
pharmaceuticals.

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5. Post-2014: A New Era of Strategic M&As and Foreign Investments
• Shift in Focus: In the post-2014 period, M&A activity in India was increasingly driven by the
need for strategic consolidation rather than just growth. Indian firms began focusing on
acquiring companies that could complement or expand their existing portfolios, especially in
sectors like technology, retail, and manufacturing.
• Regulatory Reforms: The introduction of the Goods and Services Tax (GST) in 2017, which
aimed at streamlining the tax structure, also impacted M&A transactions by simplifying the
tax treatment of acquisitions.
• Cross-Border M&As: The years post-2014 saw increased cross-border M&A activity as Indian
companies continued to look beyond their domestic markets. Large deals such as the merger
of Vodafone India and Idea Cellular created one of the largest telecom companies in India,
while the acquisition of Flipkart by Walmart in 2018 marked a major foreign investment in
India’s e-commerce sector.
• Rise of PE and VC Activity: Private equity (PE) and venture capital (VC) firms became more
active in the Indian market, contributing to M&A activity, especially in tech startups and
growth-stage companies. Deals like Paytm’s funding rounds and Zomato’s IPO are examples
of this trend.
6. Recent Trends and the Future Outlook
• Digital Transformation and Technology: As India becomes a hub for technology and digital
businesses, M&A activity has shifted towards technology-driven acquisitions. Companies are
acquiring tech startups in artificial intelligence (AI), fintech, healthtech, and other emerging
industries to stay competitive.
• Evolving Regulatory Landscape: The Competition Commission of India (CCI) has been
proactive in regulating M&As to ensure market competition is not negatively impacted. The
introduction of ease of doing business reforms has also made M&A transactions smoother.
• Resilience and Recovery Post-COVID: The COVID-19 pandemic caused a temporary slowdown
in M&A activity, but as the economy recovers, deal-making is picking up again. Companies are
looking to acquire new technologies, expand their portfolios, and restructure to stay resilient
in a post-pandemic world.
[6] Different Types and Forms of Merger

Mergers can be classified based on their purpose, structure, and the relationship between the entities
involved. Common types include:
1. Horizontal Merger
o Definition: A merger between two companies operating in the same industry and at
the same stage of the production process.
o Purpose: To reduce competition, increase market share, and achieve economies of
scale.
o Example: The merger of two automobile manufacturers or two software development
firms.
o Impact:
▪ Enhances market dominance.
▪ Reduces costs by consolidating operations.
▪ Can lead to regulatory scrutiny due to potential monopolistic behaviour.

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 2. Vertical Merger
o Definition: A merger between two companies operating at different stages of the
production or supply chain.
o Purpose: To streamline operations, reduce dependency on suppliers or distributors,
and increase operational efficiency.
o Example: A car manufacturer merging with a tire supplier.
o Impact:
▪ Ensures better control over the supply chain.
▪ Improves cost management and coordination.
▪ Can increase barriers for competitors.

3. Conglomerate Merger
o Definition: A merger between companies operating in completely unrelated
industries.
o Purpose: To diversify business operations, reduce risk, and explore new markets.
o Example: A food processing company merging with a software company.
o Impact:
▪ Reduces risk through diversification.
▪ May lack synergy, leading to challenges in integration and management.

4. Market-Extension Merger
o Definition: A merger between two companies selling similar products in different
markets.
o Purpose: To expand the market reach and customer base.
o Example: A U.S.-based clothing brand merging with a European clothing retailer.
o Impact:
▪ Facilitates entry into new geographic regions.
▪ Increases market presence and revenue streams.

5. Product-Extension Merger
o Definition: A merger between companies producing related or complementary
products.
o Purpose: To expand the product portfolio and offer a wider range of products to the
same customer base.
o Example: A beverage company merging with a snack manufacturer.
o Impact:
▪ Strengthens product offerings.
▪ Creates cross-selling opportunities.

6. Reverse Merge or Takeover by Reverse Bid

o Definition: A Reverse Merge or Takeover by Reverse Bid is a corporate
strategy where a private company becomes publicly traded or gains
control over a larger company through unconventional acquisition
methods.
▪ Reverse Merge: A private company merges with a public company (typically a
dormant or shell company) to go public without an IPO.
▪ Takeover by Reverse Bid: A smaller company acquires a larger one but assumes
control due to strategic or financial factors.

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 o Purpose:
▪ Reverse Merge: To quickly and cost-effectively list a private company on a stock
exchange.
▪ Reverse Bid: To leverage the larger company's resources, infrastructure, or
market access while retaining control.
o Example:
▪ Reverse Merge: Burger King going public in 2006 by merging with Justice
Holdings, a shell company.
▪ Reverse Bid: Mittal Steel (a smaller company) taking over Arcelor (a larger
company) to create ArcelorMittal.
o Impact:
▪ For Reverse Merge:
➢ Saves time and costs compared to traditional IPOs.
➢ Grants access to public funding while avoiding the uncertainties of IPO
markets.
▪ For Reverse Bid:
➢ Empowers smaller firms with strategic control over larger firms.
➢ Facilitates market entry, product diversification, and infrastructure utilization.

[7] Consideration in case of Mergers & Acquisitions

When companies engage in mergers or acquisitions, the discharge of consideration refers to the
method by which the acquiring company compensates the shareholders of the target company. The
two primary modes of payment are Cash and Stock, each with unique implications and strategic
purposes.

1. Cash Consideration
In a cash consideration, the acquiring company pays the target company’s shareholders in cash for
their shares. The shareholders of the target company receive immediate monetary compensation
instead of ownership in the acquiring company.
Features:
[1] A fixed amount is agreed upon for the transaction.
[2] The target company’s shareholders do not retain any interest in the new or combined entity.

Advantages:
[1] Provides immediate liquidity to the target company’s shareholders.
[2] Simplifies valuation as the payment is in a straightforward cash amount.
[3] Preferred in cases where the target company’s shareholders do not want to participate in the
future performance of the combined company.

Disadvantages:
[1] The acquiring company may need to take on debt or liquidate assets to finance the deal.
[2] No opportunity for the target company’s shareholders to benefit from future synergies or growth.

Example: Facebook’s acquisition of WhatsApp (2014): Facebook paid a significant portion of the $19
billion deal in cash.

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2. Stock Consideration
In a stock consideration, the acquiring company offers its own shares to the target company’s
shareholders in exchange for their shares. As a result, the shareholders of the target company become
part-owners of the acquiring company.
Features:
[1] Valuation is based on the stock price of the acquiring company.
[2] The target company’s shareholders have a stake in the combined entity’s future performance.

Advantages:
[1] Preserves cash for the acquiring company, avoiding the need for borrowing.
[2] Aligns the interests of the target company’s shareholders with the future success of the combined
entity.
[3] Reduces the financial burden on the acquiring company in the short term.

Disadvantages:
[1] Dilutes the ownership of the acquiring company’s existing shareholders.
[2] Valuation becomes dependent on the stock price, which can fluctuate during the deal process.

Example: Disney’s acquisition of 21st Century Fox (2019): Disney paid for the majority of the $71.3
billion deal in stock, allowing Fox shareholders to become Disney shareholders.

3. Mixed Consideration (Cash + Stock)

A combination of cash and stock is offered as consideration, giving the target company’s shareholders
the benefits of immediate liquidity and partial ownership in the acquiring company.
Features:
[1] A predetermined proportion of cash and stock is offered as compensation.
[2] Balances the needs of both companies and their stakeholders.

Advantages:
[1] Provides partial liquidity while allowing target shareholders to participate in the future growth of
the combined entity.
[2] Distributes the financial burden between cash payments and stock issuance for the acquirer.

Disadvantages:
[1] Adds complexity to the negotiation and valuation process.
[2] May still result in ownership dilution for the acquirer’s shareholders.

Example: Microsoft’s acquisition of LinkedIn (2016): The $26.2 billion deal was structured as a mix of
cash and stock.

[8] Determination of Exchange Ratio of Stock for Purchase Consideration

Exchange Ratio is the number of Acquiring Company’s shares exchanged for each share of Selling
company. This should be determined after considering relevant factors like
[i] Synergy Effect
[ii] Future anticipated earnings of Merged Entity
[iii] Combined P/E Ratio = [MVPS/EPS] Etc.

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Commonly used basis to compute Exchange Ratio :

Earnings per Share [EPS] Market Value Per Share [MVPS] Book Value per share [BVPS]
EPS of Selling Co/EPS of MVPS of Selling Co/MVPS of BVPS of Selling Co/BVPS of
Buying Co Buying Co Buying Co

Illustration : 1
Compute Exchange Ratio in a case where M Ltd. is considering possible acquisition of N ltd. from
below given details -
Co. Name Earnings after Tax No of Equity Shares Market Value per Share
M Ltd. 80,00,000 16,00,000 200
N Ltd. 24,00,000 4,00,000 160
[a] If the merger goes through exchange of equity and the exchange ratio is based on the Current
Market Price ,what is the new Earnings per share of M ltd. ?
[b] N Ltd. wants to be sure that earnings available to its shareholders will not be diminished by the
merger , what should be the exchange ratio in that case /

Solution : 1
[a] Exchange Ratio/ Swap Ratio based on Market Value per share =
= MVPS of Selling Co
MVPS of Buying Co
= ₹ 160/₹ 200
= 4/5 [ For every 5 Shares of N Ltd. 4 Shares of M ltd.]
= 4/5 * 4,00,000 = 3,20,000 Shares of M ltd. issued
Revised EPS = Earnings After Tax of M Ltd. + N Ltd.
Shares of M ltd. + Shares of M issued to N
= ₹ 80,00,000 + ₹ 24,00,000
16,00,000 + 3,20,000
= ₹ 5.42 per share
[b] Exchange Ratio/ Swap Ratio to ensure same earnings =
= EPS of Selling Co = ₹ 80,00,000/16,00,000
EPS of Buying Co = ₹ 24,00,000/4,00,000
= 6/5 [ For every 5 Shares of N Ltd. 6 Shares of M ltd.]
= 6/5 * 4,00,000 = 4,80,000 Shares of M ltd. issued
Revised EPS = Earnings After Tax of M Ltd. + N Ltd.
Shares of M ltd. + Shares of M issued to N
= ₹ 80,00,000 + ₹ 24,00,000
16,00,000 + 4,80,000
= ₹ 5 Per Share
Ensuring Same earnings =
Old shares of N ltd. = 5 shares * ₹ 6 = ₹ 30
New Shares of M 4,80,000 * ₹ 5 = ₹ 30

Illustration : 2
Longitude Ltd. is in the process of acquiring Latitude Ltd. on share exchange basis. From the following
data , you are required to determine
1. Pre-Merger Market Value per share
2. Maximum Exchange Ration Longitude Ltd. can offer without dilution of [a] EPS and [b] MVPS

16 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

3. Find Ratio up to FOUR Decimal Points and Number of Shares up to TWO Decimal Points.
Co. Name Profits after Tax No of Equity Earnings per PE Ratio
Shares Share
LONGITUDE Ltd. 120 Lakhs 15,00,000 ₹8 15 Times
LATITUDE Ltd. 80 Lakhs 16,00,000 ₹5 10 Times

Solution : 2
[a] Pre Merger Market Value per Share
MVPS = EPS* P/E RATIO
Longitude Ltd. = 8 *15 = 120
Latitude Ltd. = 5*10 = 50
[b] Exchange Ratio/ Swap Ratio based on Market Value per share =
= MVPS of Selling Co
MVPS of Buying Co
= ₹ 50/₹ 120
= 5/12 [ For every 12 Shares of LATITUDE Ltd. 5 Shares of LONGITUDE ltd.] = Ratio = 0.4167
= 0.4167 * 16,00,000 = 6,66,720 Shares of Longitude ltd. issued
[b] Exchange Ratio/ Swap Ratio based on EPS =
= EPS of Selling Co = ₹ 5
EPS of Buying Co = ₹ 8
= 5/8 [ For every 8 Shares of Latitude Ltd. 5 Shares of Longitude Ltd.] = Ratio = o.6250
= 0.6250 * 16,00,000 = 10,00,000 Shares of Longitude Ltd. issued
Ensuring Same earnings =
Old shares of N ltd. = 5 shares * ₹ 6 = ₹ 30
New Shares of M 4,80,000 * ₹ 5 = ₹ 30

[9] Impact of Mergers and Acquisitions on Society

Mergers and acquisitions impact various societal aspects, including employment, economic growth,
and consumer welfare:
1. Economic Growth
M&A can stimulate economic growth by enhancing the competitiveness of merged entities and
promoting industrial development. Combined resources, technology, and expertise often result in
increased efficiency and expansion into new markets, which fuels overall economic activity.
Example:
When two companies merge, such as in the pharmaceutical industry, they may pool their R&D
efforts, leading to faster development of life-saving drugs. This not only benefits the economy but
also societal health.

2.Employment Opportunities
M&A can create jobs through business expansion, increased investments, and the need for new
expertise to manage larger operations. When companies grow post-merger, they may hire more
employees to meet increased demand or diversify their offerings.
The downside:
On the flip side, M&A often involve cost-cutting measures like downsizing and role consolidation to
eliminate redundancies. This can lead to layoffs, affecting families and local economies. The impact
varies depending on how the merger is managed.

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3. Consumer Benefits
M&A can lead to enhanced products and services by increasing investment in research and
development (R&D). Combined expertise enables companies to innovate and deliver better
solutions to consumers.
Example:
The Vodafone-Idea merger improved mobile connectivity and network coverage in India. By
leveraging their combined infrastructure, the companies offered better services to millions of
consumers.

4. Potential Downsides
In some cases, M&A reduce market competition by creating monopolies or oligopolies. This can
lead to higher prices, reduced quality, and limited choices for consumers.
Disruption to local economies:
When companies downsize post-merger, the resulting closure of offices or factories can harm local
economies. Communities dependent on these operations for employment and services may face
significant economic challenges.

[10] Mergers And Acquisitions – Reasons for Failures

Why do mergers fail? The reasons for merger failures can be numerous.
Some of the key reasons are:
[i] Acquirers generally overpay
[ii] The value of synergy is over-estimated
[iii] Lack of proper Due Diligence/Research
[iv] Poor post-merger integration
[v] Loss of Key Management personnel ; and
[vi] Differences in Corporate Culture & Psychological barriers
Companies often merge in the fear that the bigger competitors have economies of scale and may
destroy them by exercising a stranglehold on raw material supply, distribution etc. What they do not
realize is the drawbacks of being big. The acquiring company’s executives would have drawn up
elaborate plans for the target without consulting its executives which leads to resentment and
managerial attrition. This can be avoided by honest discussions with the target company’s
executives.
Most companies merge with the hope that the benefits of synergy will be realized. Synergy will be
there only if the merged entity is managed better after the acquisition than it was managed before.
It is the quality of the top management that determines the success of the merger. Quite often the
executives of the acquiring company lose interest in the target company due to its smallness. The
small company executives get bogged down repairing vision and mission statements, budgets,
forecasts, profit plans which were hitherto unheard of. The elaborateness of the control system
depends on the size and culture of the company. To make a merger successful:
Decide what tasks need to be accomplished in the post-merger period,
Choose managers from both the companies (and from outside),
Establish performance yardstick and evaluate the managers on that yardstick; and
Motivate them.

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[11] Financial Restructuring

Financial restructuring refers to the kind of internal changes made by the management in Assets and
Liabilities of a company with the consent of its various stakeholders. This is a suitable mode of
restructuring for corporate entities who have suffered from sizeable losses over a period of time.
Consequent upon losses the share capital or net worth of such companies get substantially eroded.
In fact, in some cases, the accumulated losses are even more than the share capital and thus leads to
negative net worth, putting the firm on the verge of liquidation. In order to revive such firms, financial
restructuring is one of the techniques that brings health into such firms having potential and promise
for better financial performance in the years to come. To achieve this desired objective, such firms
need to re-start with a fresh balance sheet free from losses and fictitious assets and show share
capital at its true worth.
To nurse back such firms a plan of restructuring needs to be formulated involving a number of legal
formalities (which includes consent of court, and other stake-holders viz., creditors, lenders and
shareholders etc.). An attempt is made to do refinancing and rescue financing. In restructuring
normally equity shareholders make the maximum sacrifice by foregoing certain accrued benefits,
followed by preference shareholders and debenture holders, lenders, and creditors etc. The sacrifice
may be in the form of waving a part of the sum payable to various liability holders. The foregone
benefits may be in the form of new securities with lower coupon rates to reduce future liabilities. The
sacrifice may also lead to the conversion of debt into equity. Sometime, creditors, apart from reducing
their claim, may also agree to convert their dues into securities to avert pressure of payment. These
measures will lead to better financial liquidity. The financial restructuring leads to significant changes
in the financial obligations and capital structure of a corporate firm, leading to a change in the
financing pattern, ownership and control and payment of various financial charges.
In a nutshell it may be said that financial restructuring (also known as internal re-construction) is
aimed at reducing the debt/payment burden of the corporate firm. This results into:
(i) Reduction/Waiver in the claims from various stakeholders;
(ii) Real worth of various properties/assets by revaluing them timely;
(iii) Utilizing profit accruing on account of appreciation of assets to write off accumulated losses
and fictitious assets (such as preliminary expenses and cost of issue of shares and debentures)
and creating provision for bad and doubtful debts. In practice, the financial re- structuring
scheme is drawn in such a way that all the above requirements of write off are duly met.
Financial Restructuring is unique in nature and is company specific. It is carried out, in practice when
all shareholders sacrifice and understand that the restructured firm (reflecting its true value of assets,
capital and other significant financial para meters) can now be nursed back to health. This type of
corporate restructuring helps in the revival of firms that otherwise would have faced
closure/liquidation.

Illustration: 3

The following is the Balance-sheet of XYZ Ltd. as on March 31st, 2024. (₹ in lakh)
Liabilities Amount Assets Amount
6 lakh Equity Shares of ₹100/- each 600 Land & Building 200
2 Lakh 14% Preference shares of ₹100/- each 200 Plant & Machinery 300
13% Debentures 200 Furniture & Fixtures 50
Debenture Interest accrued and Payable 26 Inventory 150
Loan from Bank 74 Sundry debtors 70
Trade Creditors 300 Cash at Bank 130
Preliminary Expenses 10
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 Cost of Issue of debentures 5
Profit & Loss A/c 485
1,400 1,400
The Company did not perform well and has suffered sizable losses during the last few years. However,
it is now felt that the company can be nursed back to health by proper financial restructuring and
consequently the following scheme of reconstruction has been devised:
(i) Equity shares are to be reduced to ₹25/- per share, fully paid up;
(ii) Preference shares are to be reduced (with Dividend rate of 10%) to equal number of shares of
₹50 each, fully paid up.
(iii) Debenture holders have agreed to forego interest accrued to them. Beside this, they have
agreed to accept new debentures carrying a coupon rate of 9%.
(iv) Trade creditors have agreed to forgo 25 per cent of their existing claim; for the balance sum
they have agreed to convert their claims into equity shares of ₹25/- each.
(v) In order to make payment for bank loan and augment the working capital, the company issues
6 lakh equity shares at ₹ 25/- each; the entire sum is required to be paid on application. The
existing shareholders have agreed to subscribe to the new issue.
(vi) While Land and Building is to be revalued at ₹250 lakh, Plant & Machinery is to be written down
to ₹104 lakh. A provision amounting to ₹ 5 lakh is to be made for bad and doubtful debts.
You are required to show the impact of financial restructuring/re-construction. Also, prepare the new
balance sheet assuming the scheme of re-construction.

Solution : 3
Particulars ₹ in lakhs
(a) Reduction of liabilities payable
Reduction in Equity Share capital (6 lakh shares x ₹ 75 per share) 450
Reduction in Preference Share capital (2 lakh shares x ₹ 50 per share) 100
Waiver of outstanding Debenture Interest 26
Waiver from Trade Creditors (`300 lakhs x 0.25) 75
651
(b) Revaluation of Assets
Appreciation of Land and Building (₹ 250 lakhs - ₹ 200 lakhs) 50
701
Amount of ₹ 701 lakhs utilized to write off losses, fictious assets and over- valued assets.
Particulars ₹ in lakhs
Writing off Profit and Loss account 485
Cost of issue of debentures 5
Preliminary expenses 10
Provision for bad and doubtful debts 5
Revaluation of Plant and Machinery (₹ 300 lakhs – ₹ 104 lakhs) 196
701

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Balance sheet of XYZ Ltd as at 31-03-24 (after re-construction) (₹ in lakhs)
Liabilities Amount Assets Amount
21 lakhs Equity Shares of ₹ 25/- each 525 Land & Building 250
2 lakhs 10% Preference shares of ₹ 50/each 100 Plant & Machinery 104
9% Debentures 200 Furniture & Fixtures 50
Inventory 150
Sundry debtors [70 -5] 65
Cash-at-Bank (Bal.Figure)* 206
825 825
*Opening Cash/Bank Balance of ₹130/- lakhs + Sale proceeds from issue of new equity shares ₹
150/- lakhs – Payment of bank loan of ₹74/- lakhs = ₹ 206 lakhs.
Illustration 4

The Balance Sheet of A & Co. Ltd. as at 31-3-2024 is as follows:

Particulars Notes ₹
Equity and Liabilities
Shareholders’ funds
Share capital 1 11,50,000
Reserves and Surplus 2 (5,35,000)
Non-current liabilities
Long-term borrowings 3 3,75,000
Current liabilities
Trade Payables 3,00,000
Short term borrowings - Bank Overdraft 1,95,000
Other current liabilities 4 1,22,500
Total 16,07,500
Assets
Non-current assets
Property, plant and equipment 5 4,75,000
Intangible assets 6 1,67,500
Non-current investments 7 55,000
Current assets
Inventories 4,25,000
Trade receivables 4,85,000
Total 16,07,500

Notes to Accounts :
1 Share Capital
Equity share capital:
75,000 Equity Shares of ₹10 each 7,50,000
Preference share capital:
4,000 6% Cumulative Preference Shares of ₹100 each 4,00,000
11,50,000
2 Reserves and Surplus
Debit balance of Profit and loss Account (5,35,000)
(5,35,000)
21 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA
 3 Long-term borrowings
Secured
6% Debentures (secured on the freehold property) 3,75,000
3,75,000
4 Other current liabilities
Loan from directors 1,00,000
Interest payable on 6% debentures 22,500
1,22,500
5 Property plant and Equipment
Freehold property 4,25,000
6 Intangible assets
Plant 50,000
Goodwill 1,30,000
Patents 37,500
1,67,500
7 Non-current investments
Investments at cost 55,000
55,000
4,75,000
Other Information :
The Court approved a Scheme of re-organization to take effect on 1-4-2024, whereby:
[1] The Preference shares to be written down to ₹ 75 each and Equity Shares to ₹ 2 each.
[2] Of the Preference Share dividends which are in arrears for four years, three fourths to be waived
and Equity Shares of ₹ 2 each to be allotted for the remaining quarter.
[3] Interest payable on debentures to be paid in cash.
[4] Debenture-holders agreed to take over freehold property, book value ₹ 1,00,000 at a
valuation of ₹ 1,20,000 in part repayment of their holdings and to provide additional cash of
₹1,30,000 secured by a floating charge on company’s assets at an interest rate of 8% p.a.
[5] Patents and Goodwill to be written off.
[6] Inventory to be written off by ₹ 65,000.
[7] Amount of ₹ 68,500 to be provided for bad debts.
[8] Remaining freehold property after giving to debenture holders, to be re- valued at ₹ 3,87,500.
[9] Investments be sold for ₹ 1,40,000.
[10] Directors to accept settlement of their loans as to 90% thereof by allotment of equity shares of
₹ 2 each and as to 5% in cash, and balance 5% being waived.
[11] There were capital commitments totalling ₹ 2,50,000. These contracts are to be cancelled on
payment of 5% of the contract price as a penalty.
Ignore taxation and cost of the scheme.
You are requested to show working reflecting the above transactions (including cash transactions)
and prepare the Balance Sheet of the company after completion of the Scheme.

Solution : 4
Particulars Amount
Equity Share Capital Reduction 6,00,000
Preference share Capital reduction 1,00,000
Appreciation in value of Freehold Property 82,500
22 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA
 Directors’ loan surrender 5,000
Profit on Sale of Investment 85,000
8,72,500

Particulars Amount
Preference Share Dividend satisfied by issue of Equity Shares 24,000
Writing off patents, goodwill, profit and loss account and reducing the value of stock, 8,36,000
making the required provision for doubtful debts
Penalty Paid for cancellation of contract 12,500
8,72,500

Cash/Bank Workings Amount

Op Bal = Nil + Issue of New debentures 1,30,000 + Sale of Investments = 1,40,000 2,70,000
Less : BOD Paid [1,95,000]
Less : Penalty Paid [12,500]
Less : Debenture Interest Paid [22,500]
Less : Paid to Directors [5,000]
Closing Balance 35,000

Balance Sheet of A & Co. Ltd. (And Reduced) as at 1st April, 2024
Particulars Notes ₹
Equity and Liabilities
Shareholders’ funds - Share capital 1 5,64,000
Non-current liabilities - Long-term borrowings 2 3,85,000
Current liabilities - Trade Payables 3,00,000
Total 12,49,000
Assets
Non-current assets
Property, plant and equipment 3 4,37,500
Intangible assets 4 -
Current assets
Inventories 3,60,000
Trade receivables 5 4,16,500
Cash and cash equivalents 35,000
Total 12,49,000
Notes to accounts

1 Share Capital
Equity share capital
1,32,000 Equity shares of ₹ 2 each (of the above 2,64,000
57,000[12,000 for Pref Share Dividend + 45,000 to Directors
for loan ] shares have been issued for consideration other
than cash)
Preference share capital
4,000 6% Preference shares of ₹75 each 3,00,000

23 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

 Total 5,64,000
Long-term borrowings
2 Secured
6% Debentures 2,55,000
8% Debentures 1,30,000
Total 3,85,000
3 Property, plant and equipment
Freehold property 4,25,000
Add: Appreciation under scheme of Reconstruction 82,500
Less: Given to Debenture Holders (1,20,000) 3,87,500
Plant 50,000
Net carrying value 4,37,500
4 Intangible assets
Goodwill 1,30,000
Less: Written off under scheme of Reconstruction (1,30,000)
Net carrying value NIL
Patents 37,500
Less: Written off under scheme of Reconstruction (37,500) -
Net carrying value - NIL
5 Trade Receivables 4,85,000
Less: Provision for doubtful debts (68,500)
4,16,500

[12] SECTION A - Theory Questions.

1. Discuss the meaning and reasons for Corporate Restructuring.

2. Explain the major Categories of Corporate Restructuring.
3. State the Difference between Internal and External restructuring.
4. Discuss various forms of Internal and External restructuring.
5. Explain the evolution of M&A landscape in India.
6. Differentiate between horizontal, vertical, and conglomerate mergers, providing examples
of each.
7. Analyse the societal impacts of mergers and acquisitions, focusing on their effects on
employment and consumer welfare.
8. What are the reasons associated with failures of mergers and acquisitions?
9. Discuss Financial Restructuring in detail with reference to internal restructuring of
Companies.
10. How exchange ratio is worked out in case of Purchase Consideration of Mergers.

[13] SECTION B - Multiple Choice Questions.

1. What does corporate restructuring primarily aim to achieve?

A) Increase employee salaries B) Improve operational efficiency
C) Realign business objectives D) Reduce the number of shareholders

2. Which of the following is NOT a reason for corporate restructuring?

A) Reducing costs B) Increasing employee leisure time
C) Adapting to market changes D) Improving financial health
24 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA
3. What is the main goal of mergers and acquisitions in corporate restructuring?
A) To decrease shareholder equity B) To create synergy
C) To dissolve assets D) To avoid taxation

4. Which Indian law governs mergers and amalgamations?

A) SEBI Regulations B) Companies Act
C) Income Tax Act D) FEMA

5. What is internal restructuring?

A) Mergers between two companies B) Organizational changes within a company
C) Strategic alliances D) Acquisition of another firm

6. External restructuring primarily involves:

A) Mergers and acquisitions B) Cost-cutting initiatives
C) Product redesign D) Employee training programs
7. A process where two or more companies combine to form a new entity is called:
A) Acquisition B) Amalgamation
C) Liquidation D) Spin-off

8. What does the term "synergy" in corporate restructuring mean?

A) Reduction in labour force B) Combined benefits exceeding individual performance
C) Closure of loss-making units D) Acquisition of smaller companies

9. Which of the following is an example of external restructuring?

A) Internal role reorganization B) Downsizing of departments
C) Strategic alliance with another company D) Employee training

10. Downsizing in corporate restructuring is primarily aimed at:

A) Increasing production levels B) Expanding the workforce
C) Reducing costs D) Increasing inventory

11. What is a spin-off in corporate restructuring?

A) Merging with a competitor B) Acquiring a larger firm C) Dissolving an unprofitable division
D) Creating a new independent company from an existing division

12. Which of the following is an internal restructuring strategy?

A) Merger B) Strategic alliance
C) Departmental reorganization D) Acquisition

13. Which body regulates mergers and acquisitions in India?

A) SEBI B) Ministry of Finance
C) Reserve Bank of India D) Income Tax Department

14. A joint venture is an example of:

A) External restructuring B) Internal restructuring
C) Debt restructuring D) Liquidation

25 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

15. Which of the following restructuring types involves reducing liabilities?
A) Spin-off B) Debt restructuring
C) Diversification D) Reverse merger

16. The primary legal document required for amalgamation is:

A) Income tax filing B) Scheme of amalgamation
C) Corporate bond agreement D) Shareholder minutes

17. Cost synergies are achieved when:

A) Two companies merge to avoid taxes B) Cost efficiencies are realized post-restructuring
C) A firm reduces salaries across all employees D) A new product is introduced

18. What is a hostile takeover?

A) Acquisition without the target company's consent
B) Merger between two competitors
C) Strategic partnership D) Debt restructuring

19. Which of the following is NOT a form of corporate restructuring?

A) Spin-off B) Acquisition
C) Employee retirement plans D) Merger

20. Which is an example of financial restructuring?

A) Strategic alliances B) Debt-equity ratio adjustment
C) Employee layoffs D) Introduction of new products

21. Which restructuring type focuses on improving business performance?

A) Financial restructuring B) Operational restructuring
C) Legal restructuring D) External restructuring

22. What is the purpose of a reverse merger?

A) To gain public listing without IPO B) To dissolve a smaller company
C) To sell off divisions D) To reduce costs

23. Diversification restructuring aims to:

A) Reduce operational costs B) Expand into new markets
C) Decrease liabilities D) Avoid competition

24. What is an acquisition?

A) Combination of two companies to form a new entity
B) Purchase of one company by another
C) Splitting one company into smaller units D) Joint partnership between firms

25. Which of these is a key benefit of corporate restructuring?

A) Decreased market value B) Loss of employee morale
C) Increased shareholder value D) Legal complications

26. In an amalgamation, how are the companies combined?

A) To form a new entity B) By dissolving the larger firm
C) Through strategic alliance D) Via debt reduction

26 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

27. What does debt restructuring involve?
A) Merging departments B) Revising terms of debt repayment
C) Creating a new product line D) Employee layoffs

28. Which term refers to restructuring to reduce workforce size?

A) Financial restructuring B) Amalgamation
C) Downsizing D) Debt restructuring

29. The key difference between merger and acquisition is:

A) Legal requirements B) Tax benefits
C) Equal partnership in mergers D) Purpose of restructuring

30. Which of the following is NOT a feature of synergy?

A) Cost reduction B) Revenue enhancement
C) Employee redundancy D) Resource optimization

31. A legal consolidation of two entities to form one is called:

A) Merger B) Acquisition C) Spin-off D) Joint venture

32. Which is an example of operational restructuring?

A) Changing debt terms B) Redesigning internal processes
C) Selling off a subsidiary D) Merging with a competitor

33. A firm creating an independent company from one of its divisions is engaging in:
A) Spin-off B) Merger C) Acquisition D) Diversification

34. Liquidation refers to:

A) Selling assets to pay off debts B) Merging two firms
C) Reducing workforce D) Debt restructuring

35. The term "leveraged buyout" refers to:

A) Acquiring a company using borrowed funds B) Merging with a smaller company
C) Selling off non-core assets D) Adjusting the equity structure

36. What does the MRTP Act of 1969 aim to prevent?

A) Liberalization of industries B) Monopolistic practices
C) Foreign investments D) Tax evasion

37. In the pre-liberalization era, what was the primary focus of the Indian government?
A) Open market policies B) Global competition
C) Self-reliance and state-led industrialization D) Privatization

38. What replaced the MRTP Act to foster healthy competition?

A) FDI Act B) Competition Act, 2002
C) Industrial Policy Act D) SEBI Act

27 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

39. Which company acquired Jaguar Land Rover in 2008?
A) Reliance Industries B) Tata Motors
C) Hindalco D) Infosys

40. What was a key reason for Hindalco's acquisition of Novelis?

A) Enter the technology market B) Enhance aluminium production capabilities
C) Acquire luxury car brands D) Diversify into pharmaceuticals

41. What was a significant effect of economic liberalization in 1991?

A) Increased government control B) Surge in M&A activities
C) Restriction on foreign investments D) Strengthened licensing system

42. What type of merger is defined as one between companies operating in unrelated industries?
A) Horizontal merger B) Vertical merger
C) Conglomerate merger D) Market-extension merger

43. What is the main purpose of a vertical merger?

A) Increase market competition B) Streamline supply chain operations
C) Enter new markets D) Reduce production

44. Which Indian company acquired Hamleys in 2019?

A) Tata Steel B) Reliance Industries
C) Flipkart D) Mahindra

45. The acquisition of Flipkart by Walmart was primarily to:

A) Strengthen its retail expertise B) Enter the Indian e-commerce market
C) Acquire technology patents D) Invest in luxury goods

46. What kind of merger occurs between companies selling similar products in different
markets?
A) Product-extension merger B) Horizontal merger
C) Market-extension merger D) Conglomerate merger

47. Which company is known for its acquisition of Novelis?

A) Tata Motors B) Hindalco
C) Mahindra D) Infosys

48. What is the primary benefit of product-extension mergers?

A) Strengthen product offerings B) Diversify industries
C) Increase regulatory control D) Improve IT infrastructure

49. What type of merger enhances market dominance by reducing competition?

A) Vertical merger B) Horizontal merger
C) Reverse merger D) Leveraged buyout

50. What was the MRTP Act designed to monitor?

A) Tax fraud B) Monopolistic and restrictive practices
C) Trade liberalization D) Cross-border mergers

28 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

51. What did economic liberalization in 1991 allow?
A) 100% FDI in many sectors B) Stricter licensing policies
C) Restriction of mergers D) Monopolistic practices

52. A merger between a car manufacturer and a tire supplier is an example of:
A) Horizontal merger B) Vertical merger
C) Conglomerate merger D) Reverse merger

53. What is a common downside of M&A activity?

A) Job creation B) Reduction in redundancies
C) Potential layoffs D) Increased consumer choices

54. Which type of restructuring involves selling non-core assets?

A) Leveraged buyout B) Divestitures
C) Spin-offs D) Reverse mergers

55. Which company successfully turned around Jaguar Land Rover?

A) Hindalco B) Tata Motors
C) Reliance Industries D) Flipkart

56. What is a significant benefit of horizontal mergers?

A) Diversification of markets B) Achieving economies of scale
C) Accessing supply chains D) Regulatory advantages

57. What was the significance of Tata Steel’s acquisitions in the pre-liberalization era?
A) Expansion under minimal government control B) Entry into the IT sector
C) Access to luxury market D) Enhancing digital capabilities

58. What industry trend characterized M&A activities in the 2010s?

A) Restrictive economic policies B) Digital transformation
C) Decline in cross-border deals D) Licensing restrictions

59. What is the focus of the Competition Act, 2002?

A) Restricting market entry B) Preventing monopolies
C) Promoting healthy competition D) Increasing regulatory fees

60. Which Indian industry saw significant M&A activity due to global demand for
generic drugs?
A) Automobile B) Pharmaceuticals
C) Steel D) Retail

61. What is an example of financial restructuring?

A) Reduction of debt B) Creation of spin-offs
C) Reverse mergers D) IT integration

62. What is the primary benefit of cross-border M&As?

A) Access to local supply chains B) Establishing a global footprint
C) Increasing regulatory scrutiny D) Strengthening local monopolies

29 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

63. Which company led the way in acquiring Novelis?
A) Tata Motors B) Hindalco
C) Flipkart D) Mahindra

64. What merger type occurs between firms producing complementary products?
A) Market-extension merger B) Product-extension merger
C) Vertical merger D) Conglomerate merger

65. What was a key driver for privatizing public sector undertakings in the post-liberalization
era?
A) Increase state control B) Attract private investments
C) Reduce competition D) Strengthen licensing

66. What type of merger occurs between two companies producing similar products to serve
the same customer base?
A) Market-extension merger B) Product-extension merger
C) Conglomerate merger D) Vertical merger

67. What significant change in the regulatory framework occurred post-1991 in India?
A) Introduction of the MRTP Act B) Economic liberalization
C) Rise in licensing policies D) Privatization rollback

68. Which act facilitated privatization and healthy competition in the Indian market?
A) Monopolies and Restrictive Trade Practices Act B) Foreign Direct Investment Act
C) Competition Act, 2002 D) Industrial Development Act

69. What was a major goal of mergers in the pharmaceutical sector in recent years?
A) Enter unrelated markets B) Expand product portfolios and R&D capabilities
C) Reduce international competition D) Downsize operations

70. Which Indian company acquired Flipkart in 2018?

A) Tata Steel B) Walmart
C) Reliance Industries D) Aditya Birla Group

30 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

[14] SECTION C – Practice Questions
Sum : 1 Given below is the Balance sheet of Rebuilt Ltd. as at 31.3.2024:

Particulars Notes ₹
Equity and Liabilities
Shareholders’ funds
Share capital 1 13,50,000
Reserves and Surplus 2 (4,51,000)
Non-current liabilities
Long-term borrowings (Loan) 3 5,73,000
Current liabilities
Trade Payables 2,07,000
Other current liabilities 35,000
Total 17,14,000
Assets
Non-current assets
Property, plant and equipment 6,68,000
Intangible assets 3,18,000
Current assets
Inventories 4,00,000
Trade receivables 3,28,000
Total 17,14,000

Notes to accounts
Particulars ₹
1 Share Capital
Equity share capital 7,50,000
15,000 Equity Shares of ` 50 each
Preference share capital
12,000, 7% Cumulative Preference Shares of ` 50 each
(Preference dividend is in arrears for five years) 6,00,000
Total 13,50,000
2 Reserves and Surplus
Debit balance of Profit and loss Account (4,51,000)
(4,51,000)
3 Long-term borrowings
Loan 5,73,000
5,73,000
4 Property, plant and Equipment
Building at cost less depreciation 4,00,000
Plant at cost less depreciation 2,68,000
6,68,000
5 Intangible assets
Trademarks and Goodwill at cost 3,18,000
3,18,000
The Company is not earning profits, short of working capital and a scheme of reconstruction has
been approved by both the classes of shareholders. A summary of the scheme is as follows:
[1] The equity shareholders have agreed that their ₹ 50 shares should be reduced to ₹ 2.50 by
cancellation of ₹ 47.50 per share. They have also agreed to subscribe for three new equity shares of
₹ 2.50 each for each equity share held.

31 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

[2] The preference shareholders have agreed to cancel the arrears of dividends and to accept for
each ₹ 50 share, 4 new 5% preference shares of ₹ 10 each, plus 6 new equity shares of ₹ 2.50 each,
all credited as fully paid.
[3] Lenders to the company for ₹ 1,50,000 have agreed to convert their loan into share and for this
purpose they will be allotted 12,000 new preference shares of ₹ 10 each and 12,000 new equity
shares of ₹ 2.50 each.
[4] The directors have agreed to subscribe in cash for 40,000, new equity shares of ₹ 2.50 each in
addition to any shares to be subscribed by them under (a) above.
[5] Of the cash received by the issue of new shares, ₹ 2,00,000 is to be used to reduce the loan due
by the company.
[6] The equity share capital cancelled is to be applied:
to write off the debit balance in the profit and loss A/c; and
to write off ₹ 35,000 from the value of plant.
[7[ Any balance remaining is to be used to write down the value of trademarks and goodwill.
Show by working how the financial books are affected by the scheme and prepare the balance
sheet of the company after reconstruction. The nominal capital as reduced is to be increased to ₹
6,50,000 for preference share capital and ₹ 7,50,000 for equity share capital.

Sum 2
Vaibhav Ltd. gives the following ledger balances as at 31st March 2024
Property, Plant and Equipment 2,50,00,000
Investments (Market-value ₹ 19,00,000) 20,00,000
Current Assets 2,00,00,000
P & L A/c (Dr. balance) 12,00,000
Share Capital: Equity Shares of ₹ 100 each 2,00,00,000
6%, Cumulative Preference Shares of ₹ 100 each 1,00,00,000
5% Debentures of ₹ 100 each 80,00,000
Creditors 1,00,00,000
Provision for taxation 2,00,000
The following scheme of Internal Reconstruction is sanctioned:
(i) All the existing equity shares are reduced to ₹ 40 each.
(ii) All preference shares are reduced to ₹ 60 each.
(iii) The rate of Interest on Debentures increased to 6%. The Debenture holders surrender their
existing debentures of ₹ 100 each and exchange the same for fresh debentures of ₹ 70 each
for every debenture held by them.
(iv) Property, Plant and Equipment is to be written down by 20%.
(v) Current assets are to be revalued at ₹ 90,00,000.
(vi) Investments are to be brought to their market value.
(vii) One of the creditors of the company to whom the company owes
₹ 40,00,000 decides to forgo 40% of his claim. The creditor is allotted with 60000
equity shares of ₹ 40 each in full and final settlement of his claim.
(viii) The taxation liability is to be settled at ₹ 3,00,000.
(ix) It is decided to write off the debit balance of Profit & Loss A/c.
Prepare working and show the Balance Sheet of the company after giving effect to the
above

32 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

 Sum 3
Following is the Balance Sheet of ABC Ltd. as at 31st March, 2024:

Particulars Notes ₹
Equity and Liabilities
Shareholders’ funds
Share capital 1 26,00,000
Reserves and Surplus 2 (4,05,000)
Non-current liabilities
Long-term borrowings 3 12,00,000
Current liabilities
Trade Payables 5,92,000
Short term borrowings - Bank overdraft 1,50,000
Total 41,37,000
Assets
Non-current assets
Property, plant and equipment Non-current 4 12,20,000
investment 6 68,000
Current assets 14,00,000
Inventory 14,39,000
Trade receivables 10,000
Cash and cash equivalents 41,37,000
Total
Notes to accounts:

₹
1 Share Capital
Equity share capital:
2,00,000 Equity Shares of ₹ 10 each 20,00,000
6,000, 8% Preference shares of ₹ 100 each 6,00,000
26,00,000
2 Reserves and Surplus
Debit balance of Profit and loss A/c (4,05,000)
(4,05,000)
3 Long-term borrowings
9% debentures 12,00,000
12,00,000
4 Property, Plant and Equipment
Plant and machinery 9,00,000
Furniture and fixtures 3,20,000
12,20,000
5 Non-current investments
Investments (market value of ₹ 55,000) 68,000
68,000
The following scheme of reconstruction was finalized:
(i) Preference shareholders would give up 30% of their capital in exchange for allotment of
11% Debentures to them.
(ii) Debenture holders having charge on plant and machinery would accept plant and machinery
in full settlement of their dues.
(iii) Inventory equal to ₹ 5,00,000 in book value will be taken over by trade payables in full
settlement of their dues.

33 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

(iv) Investment value to be reduced to market price.
(v) The company would issue 11% Debentures for ₹ 3,00,000 and augment its working capital
requirement after settlement of bank overdraft.
Pass necessary Journal Entries in the books of the company. Prepare Working and Balance
Sheet of the company after internal reconstruction.

Sum 4
Company Details:
Alpha Ltd.: Profits After Tax: ₹150 Lakhs, No. of Equity Shares: 20,00,000,
EPS: ₹7.50, PE Ratio: 18
Beta Ltd.: Profits After Tax: ₹90 Lakhs, No. of Equity Shares: 18,00,000,
EPS: ₹5.00, PE Ratio: 12
1. Calculate the Pre-Merger Market Value per share.
2. Determine the Maximum Exchange Ratio based on: (a) EPS (b) MVPS
3. Calculate the Number of Shares issued by Alpha Ltd. for both exchange ratios
(up to 4 decimal points).

Sum 5
Company Details:
Phoenix Ltd.: Profits After Tax: ₹200 Lakhs, No. of Equity Shares: 25,00,000,
EPS: ₹8.00, PE Ratio: 16
Falcon Ltd.: Profits After Tax: ₹120 Lakhs, No. of Equity Shares: 24,00,000,
EPS: ₹5.00, PE Ratio: 14
1. Calculate the Pre-Merger Market Value per share.
2. Determine the Maximum Exchange Ratio based on: (a) EPS (b) MVPS
3. Calculate the Number of Shares issued by Phoenix Ltd. for both exchange ratios (up to 4
decimal points).

Sum 6

Company Earnings After Tax (₹) Number of Equity Shares Market Value per Share (₹)
A Ltd. 50,00,000 10,00,000 150
B Ltd. 20,00,000 4,00,000 100
1. If A Ltd. acquires B Ltd. with an exchange ratio based on market price, calculate:
[a] Exchange Ratio [b] Total new shares of A Ltd. [c] Combined Earnings After Tax
[d] New EPS of A Ltd.
2. If B Ltd. wants its shareholders' EPS not to be reduced, calculate the exchange ratio to ensure that.

Sum 7

Company Earnings After Tax (EAT) Number of Equity Shares Market Value per Share
X Ltd. ₹60,00,000 15,00,000 ₹180
Y Ltd. ₹20,00,000 4,00,000 ₹150
[a] Calculate the Exchange Ratio if the merger is based on the current market price of the shares. Then, find
the new Earnings Per Share (EPS) of X Ltd. after the merger.
[b] What should the exchange ratio be if Y Ltd. wants its shareholders’ earnings per share (EPS) to remain
the same after the merger?

34 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

Sum 8

Company Earnings After Tax (₹) Number of Equity Shares Book Value per Share (₹)
X Ltd. 90,00,000 15,00,000 300
Y Ltd. 30,00,000 5,00,000 200
1. Calculate the exchange ratio if X Ltd. acquires Y Ltd. and the ratio is based on
book value per share.
2. Find the total shares outstanding after the merger.
3. Compute the combined EPS after the merger.

Sum 9

Company Earnings After Tax (₹) Number of Equity Shares EPS (₹)
P Ltd. 1,20,00,000 20,00,000 6
Q Ltd. 30,00,000 6,00,000 5
1. Calculate the exchange ratio based on EPS.
2. Determine the number of new shares issued by P Ltd. to Q Ltd. shareholders.
3. Compute the new EPS for P Ltd. after the merger.

Sum 10

Company Earnings After Tax (₹) Number of Equity Shares Market Value per Share (₹)
Z Ltd. 1,50,00,000 50,00,000 50
W Ltd. 30,00,000 10,00,000 25
Z Ltd. and W Ltd. agree to a negotiated exchange ratio of 1 share of Z Ltd. for every 2 shares of W Ltd.
1. Calculate the total number of new shares issued by Z Ltd.
2. Determine the combined earnings after tax.
3. Compute the new EPS of Z Ltd.

35 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

Above work is a compilation form various Reference Books on Accounting, Financial Management
,Online sources/Websites and Study Materials prepared by Professional Exam conducting
Institutes.
List of References :
Author/ Study Material Source Publication
Dr. Vinod Singhania Taxman
Dr Girish Ahuja, Dr Ravi Gupta Bharat Law House
T.N.Manoharan Snow White
Study Material of ICAI ICAI

36 | P a g e SEM 6 SFM UNIT 3 MA,CR&BA

 FACULTY OF COMMERCE
2024 - 25
SEMESTER-6
SUBJECT:
STRATEGIC FINANCIAL MANAGEMENT
SPECIALIZATION
BANKING , INSURANCE & FINANCE

UNIT NO. 4
LEASE FINANCING, VENTURE CAPITAL AND
STARTUP FINANCE

COMPLIED BY:
DR.BIMAL SOLANKI PROF. SAURIN PATEL

STUDY MATERIAL FOR REFERENCE

GLS UNIVERSITY FACULTY OF COMMERCE
STARATEGIC FINANCIAL MANAGEMENT

Unit-4 Lease Financing, Venture Capital and Startup Finance

1. Types/Forms of Leasing
2. Financial evaluation of leasing
3. Evaluation of Lease vs Buy Options, Pros and cons of leasing.
4. Concept of Venture Capital and its characteristic
5. Methods of Venture capital
6. Factors Determining Venture Capital Investments
7. Basics of Starup financing
8. Innovative ways to finance a startup.
9. Modes of financing for startups
10. SEC-A Long Question
11. SEC-B Short Question
12.. SEC-C M. C. Q.
1] Types/Forms of Leasing
Leasing concept - types, Advantages, Limit Meaning Leasing means an agreement between the
leasing company (called lessor) and the user (called lessee), under which the former undertakes
to buy the capital equipment for use by the latter. The lessor remains owner of the asset during
the specified period and the owner is assured consistent payment over the agreed period. The
lessee has to pay rentals to the lessor. Both the lessee and the lessor face consequences if they
fail to uphold the terms of the contract. A lease is a form of incorporeal right.

Historical Background Leasing was introduced in the United States of America during 1940s
and 1950s. It is estimated that leasing industry in the USA finances about 25 per cent of capital

goods acquisition. The concept of leasing was pioneered in India by the SPIC group which
established “First Leasing Company of India Limited” in 1973 at Chennai. Later on 20th
Century Leasing Company Limited was set up in Mumbai. Now, IFCI, IDBI, ICICI, State Bank
of India, SIDCs, Sundaram Finance and otherentities are running leasing companies in our
country.

Types of Leasing

The three main types of leasing are finance leasing, operating leasing and

contract hire.

1. Finance leasing

 A long-term lease over the expected life of the equipment, usually three

years or more, after which you pay a nominal rent or can sell or scrap the

equipment - the leasing company will not want it any more.

 The leasing company recovers the full cost of the equipment, plus charges,

over the period of the lease.

Although you don't own the equipment, you are responsible

for maintaining and insuring it.

 You must show the leased asset on your balance sheet as a capital item, or

an item that has been bought by the company.

Leases of over seven years, and in some cases over five years, are known as

'long funding leases' under which you can claim capital allowances as if you

had bought the asset outright.

2. Operating leasing
If you are considering operating leasing, remember the following points:

it is useful if you don't need the equipment for its entire working life

the leasing company will take the asset back at the end of the lease

the leasing company is responsible for maintenance and insurance

you don't have to show the asset on your balance sheet

3. Sale and Lease Back:

It is an arrangement wherein the owner of the asset may sell it to the leasing

company and lease it back. Such an arrangement is adopted when the firm faces

shortage of funds. The firm can overcome liquidity problem and at the same time

retain use of the asset.

4. Leveraged Lease:

Under this arrangement, the lessor borrows funds from the lender and provides a

part of the money to acquire the asset. The lessor services the debt out of lease

rentals. Thus, there is third party (lender) in addition to the lessor and the lessee.

The lender is usually a financial institution or a commercial bank. Leverage lease

is used in case of very large assets such as a ship or an aero plane.

Leasing offers the following advantages:

1. Liquidity: The lessee can use the asset to earn without investing money in the asset. He can

employ his funds for working capital needs.

2. Convenience: Leasing is the easiest method of financing fixed assets. No mortgage or

hypothecation is required. Restrictions involved in long-term borrowing from financial

institutions are avoided. Formalities involved in leasing are much less than in case of borrowing
from financial institutions.

3. Hidden Liability:

Lease obligations are not reported as a liability in the company’s balance sheet. On

the other hand, loans raised to buy assets are reported as liability. Thus, leasing

helps the lessee to report a better debt-equity ratio.

4. Time Saving:
The asset is available for use immediately without loss of time in applying for the

loan, wanting for approval and sanction, etc. Lease rentals can be matched with

cash flows of the lessee.

5. No Risk of Obsolescence: The risk of the asset becoming obsolete due to technological
advancements is borne by the lessor.

6. Cost Saving: Lease rentals are deductible from taxable income. The lessee has lower
obligation in bankruptcy than under debt financing.

7. Flexibility:

Leasing arrangement is more flexible. The rental schedule can be adjusted to

accommodate genuine needs and problems of the lessee.

2] Financial evaluation of leasing

Any prospective lease must be evaluated by both the lessee and lessor. The lessee must
determine whether leasing an asset will be less costly than buying it. Whereas the lessor must
decide whether or not the lease will provide a reasonable rate of return. Since, this unit considers
leasing as an alternative to financing, we shall evaluate the effect of lease decision from the point
of view of lessee only.

As such, the decision of the lessee as to whether to take an equipment on lease essentially
involves choosing between leasing and borrowing / buying. An economic evaluation of lease
would thus call for comparison of the financial costs of the lease with the costs of borrowing
necessary funds to purchase the assets. If the cost of the lease is found higher than the cost of
borrowing, it would be in the interest of the company to borrow and buy the asset. The converse
will hold true where cost of borrowing is higher than the cost of leasing. A detailed, step by step,
approach to leasing decision would involve the following:
 1. Calculation of the loan payment schedule.
2. Calculation of saving from investment allowance
3. Calculation of after-tax effect of cash salvage value.
4 Calculation of the after-tax cost of owning
5 Calculation of the after-tax cost of leasing
6 Calculation of the present value of the cost of owing and cost of leasing.
7 Comparison of the present value of owning cost with present value of leasing cost.

Let us illustrate how a leasing decision is made by the finance manager with the help of
an example.

Illustration – 1:

Bajaj Manufacturing Company desires to acquire the services of a machinery worth

Rs.55,000. The machine can be bought with a Rs. 5,000 down payment and10 annual payments
at 6 per cent, using the steady payment method. In case the company owns the machine, it will
receive an investment allowance of Rs. 13,750 in year zero and will realize salvage value of Rs.
10,000 from the sale of the machine at the end of 10 years. The company uses straight line
depreciation to a salvage value of zero over 10 years.

The company has the option of leasing the machinery with no initial payment at annual
payments of Rs.7,500 for 10 years. The company’s cost of capital is 10 per cent. The corporate
tax rate is 50 per cent. Should the company lease or borrow and buy?

The leasing decision can be taken by following the seven-step process outlined above.

Step I : Calculation of the Loan-payment Schedule

With a Rs. 5,000 down payment on a Rs. 55,000 nmachine, the Bajaj Company must
finance Rs. 50,000 for 10 years @ 6 per cent. The annual payment will be:

Amount borrowed
= Rs. 50,000 / 7.360 = Rs. 6,793
Present value factor
Where 7.360 is the 6 per cent, 10 year factor in the annuity table. The annual interest being 6
per cent on the outstanding balance, for the first year, it is (Rs.50,000) (.06) = Rs.3,000. The
principal repayment is (Rs.6793 – 3000) Rs. 3,793. The outstanding balance at the end of
thefirst year is Rs. 50,000 – Rs. 3,793 = Rs. 46,207.

Step II: Calculation of Saving from Investment Allowance

If the purchase option allows the company to realize a tax savings from an
investment allowance, the amount of the saving should be calculated in accordance with the
existing tax provisions. In the present example, the investment allowance has been
determined as Rs.13,750 in year zero. This will be used as tax savings to reduce the after-
tax cost of owning in the year zero.

Step III: Calculation of After-tax Effect of Cash Salvage Value

At the end of the 10 year service life, the machine will have a cash salvage value of
Rs.10,000. This will be a gain and hence taxable. The tax liability will be Rs. 5,000 (50%
of s.

10,000). The after-tax net cash value is Rs.5,000. This Rs. 5,000 is an inflow at the end of
the final year and will reduce the after-tax cost of owning in year 10.

Sept IV: Calculation of the After-tax Cost of Owning

After-tax cost of owning is calculated by subtracting the tax savings from the loan
payment. This is done each year during the term of loan to develop a cash flow stream.

To get the tax shields, we add together the major tax shields that result from
purchasing the machine and multiply them by the tax rate. In the present example, the tax
shields are the depreciation and interest. Other shields could also be involved. For example,
if the lease agreement included maintenance of the assets at no additional charge, the cost of
maintenance would be added to the loan payment as a cost of owning. In this situation, the
tax shield from the maintenance expense would be added to depreciation and interest in
calculating the tax savings.

In our problem, the first-year depreciatio n using the straight line method is Rs. 5,500
and the first- year interest is Rs. 3,000. The total tax shield is Rs. 8,500 and the tax saving is
Rs. 8,500 times 50 per cent or Rs. 4,250. We can subtract Rs. 4,250 from the loan
payment of Rs. 6,793 to get Rs. 2,543 as the after-tax cost of owning for the first year.

Step V: Calculation of After-tax Annual Lease Cost

This entire lease payment may be used as an operating expense and hence provides a tax
shield. The after-tax cost of the lease payment is derived with the help of the following
formula:

After-tax lease = (Lease Payment (I-Tax rate)

Substituting the formula with figures given in out problem (Rs.7,500) (1-5) = Rs. 3,750

Step VI : Calculation of Present Value of Cost of Leasing & Owning

Since the cash flows that arise in a lease/buy decision are most predictable that are
cash flows of capital expenditure projects, these cash flows should therefore be discounted at
risk- free rate rather than the overall cost of capital.

The cost of debt can be taken as a riskless rate. This rate is usually lower than the
cost of capital and commonly used for determining the present value factor for cash flows
other than cash salvage value. In our calculations, we shall use the cost of debt as the
discount factor for all cash flows with the exception of cash salvage value which will be I
discounted at overall cost of

capital. We have discounted future cash flows at 6 per cent rate while cash salvage value
has been discounted at 10 per cent rate. Table 10.3 exhibits present value of after tax cost of
leasing and owning.

Step VII: Comparison of Present Value of Owning Cost with Leasing Cost.
After calculating the present value of owing cost with leasing cost, difference between the
two is worked out to determine advantage or loss of owning. present value of advantage to
owning.
A comparison of the present value after-tax leasing cost with that of owing cost leads to
owning advantage of Rs. 15629 which means owning cost is less than leasing cost. If
leasing cost were less than the owning cost, there would have been leasing advantage. In the
present case, the management of Bajaj Manufacturing Company should go for borrowing
and buying the machine.

Illustration - 2:
 ABC Ltd. is considering to buy a machine costing Rs. 1,10,000, Rs. 10,000 payable
down and the balance in 10 annual equal installments inclusive of interest chargeable at
15%. Another option before it is to acquire the asset on a lease rental of Rs. 15,000 per
annum for 10 years. As a financial manager, decide between these two options that:
1. Scrap value of Rs. 20,000 is realizable if the asset is purchased
2. The firm provides 10% depreciation on straight line method on the original cost.
3. The tax rate is 50%, and after tax cost of capital is 15%.

Solution:
Option I – To buy the asset: In this option, the firm has to pay Rs. 10,000 down and the
balance Rs. 1,00,000 together with interest @ 15% payable in 10 annual equal installments.
The annuity amount may be calculated by dividing Rs. 1,00,000 by the Present Value
Annuity Factor (PVAF) for 19 years at 15% i.e., annual repayment = Rs. 1,00,000/5.019 =
Rs. 19,925

It may be noted that (i) depreciation of Rs. 11,000 has been provided for all the years,
this is 10% of the original cost of Rs. 1,10,000; (ii) The asset is fully depreciated during its
life of 10 years, therefore, the book value at the end of 10 th year would be zero. As the asset
is having a salvage value of Rs. 20,000, this would be capital gain, and presuming it to be
taxable at the normal rate of 50%, the net cash inflow on account of salvage value would be
Rs. 10,000 only. This is further discounted to find out the present value of this inflow.

Option II – Evaluation of Lease option: In case the asset is acquired on le ase, there is a
lease rent of Rs. 15,000 payable at the end of every year for the next 10 years. This lease
rental is tax deductible, therefore, the net cash outflow would be only Rs.7,500 (after tax).
The PVAF for 10 years @ 15% is 5.019. So, the present value of annuity of Rs. 7,500 is

Present value of annuity of outflow = Rs. 7,500 x 5.019 = Rs. 37,643

If the firm opts to by the asset, the present value of outflow comes to Rs. 51,336; and
incase of lease option, the present value of outflows comes to Rs. 37,643. Hence, the
firm should opt for the lease option. In this way, the firm will be able to reduce its
costs by Rs. 13,683 i.e., Rs. 51,336-Rs.37,643. This may also be referred to as Net
Benefit of Leasing

3) Evaluation of Lease Vs Buy Option , Problems (Pros) of leasing

As against leasing, hire purchase involves the purchase of an asset on the understanding
that the purchase (called the hirer) will pay in equal periodical instalments spread over a
length of time. Leasing and hire purchase have emerged as a supplementary source of
intermediate long term finance. They are provided mainly by non-banking financial
companies, financial institutions and other organizations.

Lease financing resembles hire purchase in certain ways. Both are similar so far as the
use of the asset by the hirer or the lessee is concerned. In both the cases, the right to use
the equipment is transferred to the hirer, or the lessee.

In case of leasing, the user of the asset (the lessee) is not the owner of the asset. Hence,
depreciation on asset cannot be claimed by the lessee as a deduction from taxable
income. As against this, the hire purchase capitalizes the asset bought under the hire
purchase contract although the ownership does not pass on to him until the last
instalment is paid. Hire purchaser charges depreciation regularly to profit and loss
account. The liability for future hire purchase instalments are shown separately in the
balance sheet.

Under leasing, the entire lease rentals represent a ‘hire charge’ and can therefore be
treated as expenses and hence tax deductible. Under hire purchase, part of the
instalment represents capital outlay and the other part is interest on loan. The part
representing capital outlay is not an expense, but the interest on loan is considered a
revenue expenditure and hence is tax deductible.

In case o f leasing the leased asset is not shown in the balance sheet of the lessee. In
case of hire purchase, the asset is shown in the balance sheet of the hirer. Generally
there is no down payment in case of leasing. But a sizable amount of down payment is
made in case of hire purchase.

(hirer), the following differences may be noted:

Leasing

1 Depreciation and Investment allowance can not be claimed by the lessee

2 The entire lease rental is a tax deductible expenses

3 The lessee, not being the owner of the asset, does not enjoy the salvage value.

Buy Option

1 Depreciation and investment allowance can be claimed by the hirer

2 only the interest component of the hire purchase instalment is tax - deductible

3 The hirer, being the owner of the asset, enjoys the salvage value of the asset.

 Pro of lease
In spite of the increasing importance, the leasing industry is facing the following
problems.
1. Financial Assistance

There is a lukewarm response from the commercial banking sector for financial
assistance to leasing companies, with the result that many leasing companies find it
difficult to support their fund based operations. Banks and financial institutions are
becoming increasingly selective and stringent in extending refinancing facilities, even
against lease receivables despite the superior repayment performance of leasing
companies as compared to most other borrowers.

Those companies which have recently gone to public are finding it difficult in getting
their issues fully subscribed in the face of inadequate public support. At the same time,
well established leasing companies are finding their margins drastically reduced as a
result of incessant competitions brought about by a flood of new leasing companies in
the market. It is feared that the Indian leasing industry which is not in dire straits will
never be able to recover from the present state of difficult funds position with them.
The reason is keen competition.

While rental rates have firmed up, there are problems in recovery arising from the
unsatisfactory financial performance of many lessees. The inability of the lessors to
receive their dues has exacerbated the cash flow problems.

2. Sale Tax

Consequent to the 46th Amendment to the Constitution, various States have enacted
legislation that subject lease rental to sales tax. This is inequitable as leased assets are
already

subject to sales tax at the time of purchase. The problem is further compounded as the
legislation in various states is not uniform, so much so that there is concern that a
transaction, subject to sales tax in one state, may be taxed once again in another state.
Since the cost of effectiveness of leasing is significantly affected, there is thus, an
urgent need to provide relief to the industry from such inequitable taxation.

3. Risk of Obsolescence

The modern techno-dynamic age has given chance for obsolescence at a high rate due
to technological improvements in production of machinery and process. It will be
beneficial for the lessee to have equipment on operating lease, where the risk of
obsolescence is borne by the leasing company. At the same time, the leasing company
will get much trouble since it has to bear the capital loss in case of obsolescence.

4. Cut Throat Competition

The immediate future of leasing companies in India is bleak, since many companies
entered in field almost at the same time. It leads to cut throat competition and in the
process lease rentals have come down to much uneconomic levels. It has been reported
that the rate of interest is worked out to be 13 to 14 per cent which is very much below
the average cost of capital and as such the survival of many companies is at stake. A
buoyant market did not exist for all these companies in the segments they wished to
operate. With rising competition, the major players are diversifying their activities to
other activities.
Further, the leasing industry has been facing competition from the manufacturing
sector. This segment has been concentrating mostly in lease financing items where 100
per cent depreciation write off is available.

4) Concept of Venture Capital and its characteristic

In developing countries like India, venture capital concept has been understood in
thissense. In our country venture capital comprises only seed capital, finance for high
technology and funds to turn research and development into commercial production.

In broader sense, venture capital refers to the commitment of capital and knowledge
for the formation and setting up of companies particularly to those specialising in new
ideas or new technologies. Thus, it is not merely an injection of funds into a new firm
but also a simultaneous input of skills needed to set the firm up, design its marketing
strategy, organise and manage it.

In western countries like the USA and UK, venture capital perspective scans a much
wider horizon along the above sense. In these countries, venture capital not only
consists of supply of funds for financing technology but also supply of capital and
skillsfor fostering the growth and development of enterprises.

Characteristics of Venture Capital:

Venture capital as a source of financing is distinct from other sources of financing

because of its unique characteristics, as set out below:

1. Venture capital is essentially financing of new ventures through

equity participation. However, such investment may also take the form of long-term
loan, purchase of options or convertible securities. The main objective underlying
investment in equities is to earn capital gains there on subsequently when the
enterprise becomes profitable.

2. Venture capital makes long-term investment in highly potential

ventures of technical savvy entrepreneurs whose returns may be available after a long
period, say 5-10 years.

3. Venture capital does not confine to supply of equity capital but

also supply of skills for fostering the growth and development of enterprises. Venture
capitalists ensure active participation in the management which is the entrepreneur’s
business and provide their marketing, technology, planning and management
expertise to the firm.

4. Venture capital financing involves high risk return spectrum.

Some of the venturesmay yield very high returns to more than Compensates for heavy
losses on others which may also have earning prospects.

In nut shell, a venture capital institution is a financial intermediary between

investorslooking for high potential returns and entrepreneurs who need institutional
capital asthey are yet not ready/able to go to the public.
Importance/ Functions of Venture Capital:

Venture capital is growingly becoming popular in different parts of the world because
of the crucial role it plays in fostering industrial development by exploiting vast and
untapped potentialities and overcoming threats.

Venture capital plays this role with the help of the following major functions: Venture
capital provides finance as well as skills to new enterprises and new venturesof
existing ones based on high technology innovations. It provides seed capital to
finance innovations even in the pre-start stage.

In the development stage that follows the conceptual stage, venture capitalist
developsa business plan (in partnership with the entrepreneur) which will detail the
market opportunity, the product, the development and financial needs.

In this crucial stage, the venture capitalist has to assess the intrinsic merits of the
technological innovation, ensure that the innovation is directed at a clearly defined
market opportunity and satisfies himself that the management team at the helm
ofaffairs is competent enough to achieve the targets of the business plan.

Therefore, venture capitalist helps the firm to move to the exploitation stage, i.e.,
launching of the innovation. While launching the innovation the venture capitalist
will seek to establish a time frame for achieving the predetermined development
marketing,sales and profit targets.

In each investment, as the venture capitalist assumes absolute risk, his role is not
restricted to that of a mere supplier of funds but that of an active partner with total
investment in the assisted project. Thus, the venture capitalist is expected to perform
not only the role of a financier but also a skilled faceted intermediary supplying a
broadspectrum of specialist services- technical, commercial, managerial, financial and
entrepreneurial.

Venture capitalist fills the gap in the owner’s funds in relation to the quantum of
equity required to support the successful launching of a new business or the optimum
scale of operations of an existing business. It acts as a trigger in launching new
business and asa catalyst in stimulating existing firms to achieve optimum
performance.

5) Methods of Venture Capital.

The Venture Capital method tries to extrapolate the actual value of the startup
depending on the expected return for an investor in the moment of his exit from the
company. The three components necessary for the valuation throughout this method
are: size of the investment, expectations over the employed capital by the investor and
the estimation of the startup value in the exit moment.
Considering the return that the investor wishes to obtain, and analyzing the market
standards, an approximation to the quantity the venture should reach in its exit point
is calculated. Based on this data, the investor can determine the total disbursement
which he’s willing to undertake once the adjustments consequence of the dilution
effect have been made.

The premise of the methodology is therefore very simple.

Return On Investment (ROI) = Terminal or Harvest Value/Post Money Valuation

So equivalently, the post money quantity is equal to the terminal or harvest value
divided by the desired Return On Investment, the return that the venture capitalist
desires to make through the involvement in the company. However, we shall clarify
different concepts present in this equation, which might be ambiguous for any
potential reader.

The harvest or terminal value is what the investor anticipates selling the company for
during the timeline planned for the project, which usually implies 5 to 8 year after
making the initial entry. The price of the sale shall be formed by creating a coherent
and rational expectation about the incoming future revenues in the final year, the one
in which we are going to exit the company.

Dilution is a factor taken into account through this method, referring to future
subsequent investment procedures though which we modify the set of players present
in the company. Although some other methods can be used to cover the issue of
dilution, the author presents an easy and straight forward way to readjust the pre-
money valuation in the current round, reducing it by that estimated level of dilution
from incoming investors. Again, this is just an estimation, since the amount and
conditions of an additional entry are impossible to forecast.

In order to estimate the share quantity which, the venture must grant the investor, the
analyst must first calculate the part of the full venture which is going to be acquired
through the investment. This proportion calculus shall be done through two different
ways, each one implying different methodology but in reality, the solution obtained is
equal. First, the so called NPV method.

f=INV/POST=Amount of new investment/Post-money valuation after the investment

The second one is the IRR method, where:

f=FV(INV)/Exit Value=Future value of investment in first round at projected exit

date/Company valuation upon exit

This fraction of the ownership demanded (f) results in a similar quantity through both
approaches as long as the same compounded discount rate is used to obtain both the
actual value of the exit. Once the proportion has been set, the exact issuance number
is the next unknown part, and can be easily calculated if we have the original shares
of the entrepreneur.
Because of the simplicity of the calculus, the venture capital method depends highly
on the assumptions originally formed. To face this issue, sensitivity tables are used to
evaluate and realize which modification of the model input are necessary, as well as
how the variable defines the output. Despite this, many company founders are often
way too optimistic and take out of the table the real scenario of possible venture
failure, mostly because they are not able to see the weaknesses that the business
model might present. Venture Capitalist do not have the job of convincing the
entrepreneurial team that its venture has flaws during the time of evaluation, as it is
something to be done once the company has been acquired or when negotiating it.
Instead of that, a much higher rate is applied, accounting for the menace that those
risks imply.

But how can be the rate adjusted?

To adjust such input to the much higher level of risk, the rate must be adjusted to
reflect the potential risk of failure of the venture. The mathematics used to adjust it
are:

i1∗=(1+i0)/(1−p) −1

i1: Modified discount rate i0: Original discount rate p: Chance of bankruptcy

The rates of return demanded by the venture capitalists differ from case to case, but
authors try to give an indicative percentage in depending on the stage of the company
acquired

6) Factors determining Venture Capital investment.

Logically, a more vibrant economy should attract more venture capital invest- ments,
and this conclusion is supported by many studies. Gompers et al. (1998) examined
various venture capital firms between 1972 and 1994, aiming to iden- tify factors
influencing venture capital investments. The study found that certain elements, such
as research and development (R&D) increase venture capital in- vestments.
Interestingly, the research also revealed that general economic growth positively
affects venture capital investments. The authors proposed that this cor- relation is
likely because economic growth stimulates a broader demand for fi- nance.

A couple of years later Gompers & Lerner (2000) studied valuations in the private
equity market. The study concluded that valuations rise during “hot” periods, referred
to as times when overall economic conditions are good. This rise is primarily driven
by demand, which pushes private equity investment prices higher. This indicates that
the growth of GDP increases the prices of un- derlying companies which increases the
profits of the venture capital fund but simultaneously the amount of money increases
during the funding period. More- over, Lerner (2002) argued that the impact of
venture capital investments on in- novation diminishes during rapid growth,
indicating that when the venture cap- ital market becomes overheated, these
investments have a reduced effect on driv- ing innovation.

It is reasonable to assume that high tax rates could also be one po- tential barrier for
startups. For instance, if the startup cannot invest fully its prof- its into growth it
could be one factor that slows venture capital investments. In- tuitive thinking seems
to be partly true, because Gompers et al. (1998) examined that reductions in capital
gains tax increase venture capital investments. Also, a more recent study by Guzman
(2018) found that personal income tax does not have any statistical significance on
the performance of startups.

Jeng & Wells (2000) studied venture capital investments in 21 coun- tries. The
authors created a panel OLS model to study how investor protection, IPOs, labor
market, and GDP growth have affected venture capital markets. Re- searchers noticed
that the rule of law and GDP growth did not affect venture capital markets. However,
they highlighted that venture capitalists typically in- vest during economic booms, as
the demand for venture capital funds tends to rise in such periods.

Several studies (Félix et al. 2013; Gompers et al. 1998) have found a positive
correlation between long-term interest rates and venture capital invest- ments. Both
studies noted that this is primarily driven by the demand side, where wealthy private
investors and institutions tend to allocate more capital toward riskier investments
when the overall economy is performing well and growing.

Félix et al. (2013) investigated the factors driving venture capital in- vestments across
23 European countries between 1998 and 2003. Their study was the first to examine
the impact of unemployment on venture capital investments and found that
unemployment has a significant negative effect on all phases of venture capital
investments, from early to later stages.

Capital markets

Based on previous literature, the depth of capital markets appears to be a debated

topic with venture capital. Croce et al. (2013) examined which European coun- tries
create the most attractive environments for venture capital investors. Their study
concluded that the United Kingdom provided the best environment, pri- marily due to
the depth of its capital markets and strong investor protection. Sim- ilarly, Schertler
(2003) conducted a panel OLS model study covering 14 European countries from
1988 to 2000 and finding that stock market capitalization was a key factor driving
venture capital investments. Moreover Gompers et al. (1998) came to a similar
conclusion that the depth of capital markets has a positive effect on attracting venture
capital investments.
However Jeng & Wells (2000) noted that market capitalization does not have a
significant impact on venture capital investments. They did, however, come to the
same conclusion as Gompers et al. (1998) and Schertler (2003) identi- fying that the
number of IPOs has the most significant impact on venture capital investments. By
distinguishing the different stages of venture capital invest- ments, they concluded
that the positive significance vanished when observing early-stage venture capital
investments and IPOs.

Interestingly, since the year 2000, Initial Public Offerings (IPOs) have proven to be a
significant factor in the venture capital markets. A notable trend has been the listing
of European start-ups on U.S. stock exchanges. This is pri- marily attributed to the
higher valuations, awarded by the U.S. market. Pisoni & Onetti (2018) utilized
Crunchbase, one of the largest start-up funding platforms, to gather data on mergers
and acquisitions (M&A) and explore exit strategies employed by start-ups in the U.S.
and Europe. Their research, covering the pe- riod from 2012 to 2016, revealed that
U.S. companies acquired 44% of European start-ups. Moreover, they highlighted a
growing trend in the latter years of the observation period, with U.S. companies
increasingly acquiring European start- ups. However, as Gompers & Lerner (2000)
pointed out, in regions where the venture capital scene is particularly active, the
demand side drives venture capi- tal investment prices higher. This may be one of the
reasons why European startups are increasingly looking to relocate to the U.S. for
better opportunities.

3 Legislation and investor protection

One of the critical factors venture capitalists seek is patents which assumably
generate safety for investors. One of the most signifi- cant issues that Europe lacks is
that intangible assets are almost impossible to patent. Compared to the U.S Europe
cannot patent intangible assets (Ueda, 2004). Nahata et al. (2014) studied over 10000
companies across 30 coun-

tries and examined how cultural differences affect to the success of venture cap- ital
investments. They found two key factors in their study. First, countries that rank
higher in legal indices, accounting for investor protection and the rule of law,
experience a positive impact on VC -investment success. Second, they found that
when VC -investors are unfamiliar with the local business culture and legal system, it
introduces an additional risk factor due to information asymmetry. As a result,
cultural differences can also manifest in trust issues and challenges re- lated to
contracting. However, they also concluded that more significant cultural differences
lead to better company performance. Nahata et al. (2014) explained this by noting that
VC -investors are cautious and spend more time screening during the investment-
making process when cultural differences are significant. Fascinatingly,
when comparing different continents, the aspect of le-gality yields varied outcomes.
Cumming et al. (2006) suggest that in the context of homogeneous countries, like
those in Europe, legality or the rule of law is not a significant factor. However, in the
case of heterogeneous countries, such as those around the Pacific Ocean, the presence
of a solid legal system significantly enhances the likelihood of successful business
exits.

Jia et al. (2021) conducted a study on the impact of GDPR on Euro- pean enterprises,
employing a differences-in-differences methodology across various age groups,
industries, and business models (B2B, B2C). Their findings revealed an immediate
decrease in venture capital activity following the rule of the law, particularly affecting
data-centric and consumer-focused ventures.

3.4 Entrepreneurial culture

Typically, a start-up’s first financing comes from the entrepreneur itself. Almost
always starting a business requires some amount of capital, an entrepreneur’s time,
the ability to take risks, and some innovation. Gompers et al. (1998) found that,
among country-specific factors, research and development (R&D) is a cru- cial driver
of innovation on a global scale. They also highlighted that economic growth creates
additional opportunities for innovation to flourish. Furthermore, they emphasized that
the combination of robust R&D efforts and strong eco- nomic growth is crucial for
fostering a thriving environment where innovations can take root and drive venture
capital success. Similarly, Jeng & Wells (2000) concluded that innovations and
demographic changes create possibilities again innovations.

Startups, often high-tech or innovative companies, rely strongly on highly educated

professionals, making a flexible labor market and access to skilled talent essential.
Jeng & Wells, (2000) argued that labor market flexibility is particularly crucial during
early-stage venture capital (VC) investment rounds. They found that labor market
friction negatively impacts early-stage VC invest- ments, but this effect diminishes as
companies grow and mature.

social networks have a significant role in the deal-making in venture capital scene.
Nguyen et al. (2023) studied how social networks affect venture capital from different
location groups. They found that venture capital firms invest more in firms with
stronger social ties. Nguyen et al. (2023) pointed out that this also relieves local bias
where venture companies invest only in companies they know.

Iyigun & Owen (1998) studied human capital with a two-period overlapping model.
Their hypothesis suggested that there are two types of peo- ple: professionals who
invest their time in education and entrepreneurs who learn by doing. They observed
that in higher-income countries, human capital represented by time spent in school is
less significant compared to its importance in middle-income countries. Researchers
concluded that this is familiar with ex east-bloc countries where there are lot of
expertise in different fields but a lack of entrepreneurship. According to Iyigun &
Owen (1998) these countries are well suited to economic boom periods, but their
future will be constrained by their labor forces missing ability for entrepreneurship.

7) Basics of startup financing.

Startup financing means some initial infusion of money needed to turn an idea (by
starting a business) into reality. While starting out, big lenders like banks etc. are not
interested in a startup business. The reason is that when you are just starting out,
you're not at the point yet where a traditional lender or investor would be interested in
you. So that leaves one with the option of selling some assets, borrowing against
one’s home, asking loved ones i.e. family and friends for loans etc. But that involves
a lot of risk, including the risk of bankruptcy and strained relationships with friends
and family.

So, the pertinent question is how to keep loans from family and friends strictly
business like. This is the hard part behind starting a business -- putting so much at risk
but doing so is essential. It's what sets entrepreneurs apart from people who collect
regular salaries as employees.

A good way to get success in the field of entrepreneurship is to speed up initial

operations as quickly as possible to get to the point where outside investors can see
and feel the business venture, as well as understand that a person has taken some risk
reaching it to that level.

Some businesses can also be bootstrapped (attempting to found and build a company
from personal finances or from the operating revenues of the new company).They can
be built up quickly enough to make money without any help from investors who
might otherwise come in and start dictating the terms.

In order to successfully launch a business and get it to a level where large investors
are interested in putting their money, requires a strong business plan. It also requires
seeking advice from experienced entrepreneurs and experts -- people who might
invest in the business sometime in the future.

8) Innovative ways to finance a startup.

Every startup needs access to capital, whether for funding product development,
acquiring machinery and inventory or paying salaries to its employee. Most
entrepreneurs think first of bank loans as the primary source of money, only to find
out that banks are really the least likely benefactors for startups. So, innovative
measures include maximizing non-bank financing.
Here are some of the sources for funding a startup:

(i) Personal financing: It may not seem to be innovative but you may
be surprised to note that most budding entrepreneurs never thought of saving any
money to start a business. This is important because most of the investors will not put
money into a deal if they see that you have not contributed any money from your
personal sources.

(ii) Personal credit lines: One qualifies for personal credit line based
on one’s personal credit efforts. Credit cards are a good example of this. However,
banks are very cautious while granting personal credit lines. They provide this facility
only when the business has enough cash flow to repay the line of credit.

(iii) Family and friends: These are the people who generally believe in
you, without even thinking that your idea works or not. However, the loan obligations
to friends and relatives should always be in writing as a promissory note or otherwise.

(iv) Peer-to-peer lending: In this process group of people come

together and lend money to each other. Peer to peer lending has been there for many
years. Many small and ethnic business groups having similar faith or interest
generally support each other in their start up endeavors.

(v) Crowdfunding: Crowdfunding is the use of small amounts of

capital from a large number of individuals to finance a new business initiative.
Crowdfunding makes use of the easy accessibility

of vast networks of people through social media and crowdfunding websites to bring
investors and entrepreneurs together.

(vi) Microloans: Microloans are small loans that are given by

individuals at a lower interest to a new business ventures. These loans can be issued
by a single individual or aggregated across a number of individuals who each
contribute a portion of the total amount.

(vii) Vendor financing: Vendor financing is the form of financing in

which a company lends money to one of its customers so that he can buy products
from the company itself. Vendor financing also takes place when many manufacturers
and distributors are convinced to defer payment until the goods are sold. This means
extending the payment terms to a longer period for

e.g. 30 days payment period can be extended to 45 days or 60 days. However, this
depends on one’s credit worthiness and payment of more money.

(viii) Purchase order financing: The most common scaling problem

faced by startups is the inability to find a large new order. The reason is that they
don’t have the necessary cash to produce and deliver the product. Purchase order
financing companies often advance the required funds directly to the supplier. This
allows the completion of transaction and profit flows up to the new business.
(ix) Factoring accounts receivables: In this method, a facility is given
to the seller who has sold the good on credit to fund his receivables till the amount is
fully received. So, when the goods are sold on credit, and the credit period (i.e. the
date upto which payment shall be made) is for example 6 months, factor will pay
most of the sold amount up front and rest of the amount later. Therefore, in this way,
a startup can meet his day to day expenses.

.
9) Modes of Financing for startup.

(i) Bootstrapping : An individual is said to be boot strapping when he

or she attempts to found and build a company from personal finances or from the
operating revenues of the new company.

A common mistake made by most founders is that they make unnecessary expenses
towards marketing, offices and equipment they cannot really afford. So, it is true that
more money at the inception of a business leads to complacency and wasteful
expenditure. On the other hand, investment by startups from their own savings leads
to cautious approach. It curbs wasteful expenditures and enable the promoter to be on
their toes all the time.

Here are some of the methods in which a startup firm can bootstrap:

(a) Trade Credit: When a person is starting his business, suppliers are
reluctant to give trade credit. They will insist on payment of their goods supplied
either by cash or by credit card. However, a way out in this situation is to prepare a
well-crafted financial plan. The next step is to pay a visit to the supplier’s office. If
the business organization is small, the owner can be directly contacted. On the other
hand, if it is a big firm, the Chief Financial Officer can be contacted and convinced
about the financial plan.

Communication skills are important here. The financial plan has to be shown. The
owner or the financial officer has to be explained about the business and the need to
get the first order on credit in order to launch the venture. The owner or financial
officer may give half the order on credit and balance on delivery. The trick here is to
get the goods shipped and sell them before paying to them. One can also borrow to
pay for the good sold but there is interest cost also. So trade credit is one of the most
important way to reduce the amount of working capital one needs. This is especially
true in retail operations.

When you visit your supplier to set up your order during your startup period, ask to
speak directly to the owner of the business if it's a small company. If it's a larger
business, ask to speak to the chief financial officer or any other person who approves
credit. Introduce yourself. Show the officer the financial plan that you have prepared.
(b) Factoring: This is a financing method where accounts receivable
of a business organization is sold to a commercial finance company to raise capital.
The factor then got hold of the accounts receivable of a business organization and
assumes the task of collecting the receivables as well as doing what would've been the
paperwork. Factoring can be performed on a non-notification basis. It means
customers may not be told that their accounts have been sold.

However, there are merits and demerits to factoring. The process of factoring may
actually reduce costs for a business organization. It can actually reduce costs
associated with maintaining accounts receivable such as bookkeeping, collections and
credit verifications. If comparison can be made between these costs and fee payable
to the factor, in many cases it has been observed that it even proved fruitful to utilize
this financing method.

In addition to reducing internal costs of a business, factoring also frees up money that
would otherwise be tied to receivables. This is especially true for businesses that sell
to other businesses or to government; there are often long delays in payment that this
would offset. This money can be used to generate profit through other avenues of the
company. Factoring can be a very useful tool for raising money and keeping cash
flowing.

(c) Leasing: Another popular method of bootstrapping is to take the

equipment on lease rather than purchasing it. It will reduce the capital cost and also
help lessee (person who take the asset on lease) to claim tax exemption. So, it is better
to a take a photocopy machine, an automobile or a van on lease to avoid paying out
lump sum money which is not at all feasible for a startup organization.

Further, if you are able to shop around and get the best kind of leasing arrangement
when you're starting up a new business, it's much better to lease. It's better, for
example, to lease a photocopier say at ` 5,000 per month , rather than pay ` 1,00,000
for it; or lease your automobile or van to avoid paying out ` 5,00,000 or more.

There are advantages for both the startup businessman using the property or
equipment (i.e. the lessee) and the owner of that property or equipment (i.e. the
lessor.) The lessor enjoys tax benefits in the form of depreciation on the fixed asset
leased and may gain from capital appreciation on the property, as well as making a
profit from the lease. The lessee benefits by making smaller payments retain the
ability to walk away from the equipment at the end of the lease term. The lessee may
also claim tax benefit in the form of lease rentals paid by him.

(ii) Angel Investors: Despite being a country of many cultures and

communities traditionally inclined to business and entrepreneurship, India still ranks
low on comparative ratings across entrepreneurship, innovation and ease of doing
business. The reasons are obvious. These include our old and outdated draconian
rules and regulations which provides a hindrance to our business environment for a
long time. Other reasons are red tapism, our time consuming procedures, and lack of
general support for entrepreneurship. Off course, things are changing in recent times.
As per Investopedia, Angel investors invest in small startups or entrepreneurs. Often,
angel investors are among an entrepreneur's family and friends. The capital angel
investors provide may be a one-time investment to help the business propel or an
ongoing injection of money to support and carry the company through its difficult
early stages.

Angel investors provide more favorable terms compared to other lenders, since they
usually invest in the entrepreneur starting the business rather than the viability of the
business. Angel investors are focused on helping startups take their first steps, rather
than the possible profit they may get from the business. Essentially, angel investors
are the opposite of venture capitalists.

Angel investors are also called informal investors, angel funders, private investors,
seed investors or business angels. These are affluent individuals who inject capital for
startups in exchange for ownership equity or convertible debt. Some angel investors
invest through crowdfunding platforms online or build angel investor networks to
pool in capital.

Angel investors typically use their own money, unlike venture capitalists who take
care of pooled money from many other investors and place them in a strategically
managed fund.

Though angel investors usually represent individuals, the entity that actually provides
the fund may be a limited liability company, a business, a trust or an investment fund,
among many other kinds of vehicles.

Angel investors who seed startups that fail during their early stages lose their
investments completely. This is why professional angel investors look for
opportunities for a defined exit strategy, acquisitions or initial public offerings (IPOs).

(iii) Venture Capital Fund: Venture Capital Fund means investment

vehicle that manage funds of investors seeking to invest in startup firms and small
businesses with exceptional growth potential. Venture capital is money provided by
professionals who alongside management invest in young, rapidly growing
companies that have the potential to develop into significant economic contributors.
.

.
Long Questions :-

Q-1 Explain different Types/Forms of Leasing.

Q-2 Explain Concept of Venture Capital and its characteristic.
Q-3 Explain different Methods of Venture Capital.
Q-4 Factors Determining Venture Capital Investments.
Q-5 Explain Innovative ways to finance a startup.

Short Questions:-
Q-1 Explain any Two Modes of Financing for startup.
Q-2 Explain any Two Method of Venture Capital.
Q-3 What is Entrepreneurial culture
Q-4 What is Legislation and investor protection
Q-5 What is Basics of Starup financing

MULTIPLE CHOICE QUESTION

1) Leasing Company is called as _____________

[A] Lessor [B] Lessee [C] Agent [D] Advocate

2) User of Leasing is called as _____________

[A] Lessor [B] Lessee [C] Agent [D] Advocate

3) Leasing means an _________ between the leasing company and the user under which
the former undertakes to buy the capital equipment for use by the latter.
[A] agreement [B] Rent [C] Note [D] Statement

4) ________ means an agreement between the leasing company and the user under which
the former undertakes to buy the capital equipment for use by the latter.
[A] Leasing [B] Rent [C] Buy [D] Sales

5) Leasing means an agreement between the leasing company and the user under which
the former undertakes to ________ the capital equipment for use by the latter.
[A] Produce [B] Buy [C] Sale [D] Advocate

6) The __________ remains owner of the asset during the specified period of time.
[A] Lessor [B] lessee [C] Government [D] Agent

7) Leasing means an agreement between the leasing company and the user under which
the former undertakes to buy the ________ equipment for use by the latter.
[A] Assets [B] Capital [C] Cash [D] Agreement
8) The Lessor remains ________ of the asset during the specified period of time.
[A] Partner [B] Owner [C] Liable [D] None

9) The owner is assured consistent payment over the agreed period, the lessee has
to pay ________ to the lessor.
[A] rentals [B] Commission [C] tax [D] GST

10) The owner is assured consistent payment over the agreed period, the ____ has
to pay rentals to the lessor.
[A] Lessor [B] Lessee [C] Agent [D] Advocate

11) Historical Background Leasing was introduced in the _____________

during 1940s and 1950s.
[A] USA [B] India [C] UK [D] China

12) It is estimated that leasing industry in the USA finances about _________ per cent of
capital goods acquisition.
[A] 20 [B] 25 [C] 30 [D] 35

13) The concept of leasing was pioneered in India by the SPIC group which
established “First Leasing Company of India Limited” in ______ at Chennai.
[A] 1920 [B] 1973 [C] 1983 [D] 1999

14) The concept of leasing was pioneered in India by the SPIC group which
established “First Leasing Company of India Limited” in 1973 at ______.
[A] Chennai [B] Bombay [C] Delhi [D] Bangalore

15) __________ lease over the expected life of the equipment, usually three
years or more, after which you pay a nominal rent or can sell.
[A] A short-term [B] A long-term [C] Infinitive [D] None

16) The leasing company recovers the __________ of the equipment, plus charges
over the period of the lease.
[A] Full Cost [B] rent [C] penalty [D] GST

17) The __________ company recovers the full cost of the equipment, plus charges
over the period of the lease.
[A] Lessor [B] Leasing [C] Government [D] Agent

18) You must show the leased asset on your ___________ as a capital item,
or an item that has been bought by the company.
[A] Cash book [B] Balance sheet [C] P/L a/c [D] None

19) Leases of over seven years, are known as __________ under which you can
claim capital allowances as if you had bought the asset outright. .
[A] Long funding Leases [B] Short Funding leases
[C] Current funding leases [D] None
20) _______ leasing is useful, if you don't need the equipment for its entire working life
[A] Long Fund [B] Operating [C] Sales or return [D] Leverage

21) Under _______ lease arrangement, the lessor borrows funds from the lender and
provides a part of the money to acquire the asset.
[A] Leverage [B] Operating [C] Both [D] None

22) ________ lease is used in case of very large assets such as a ship or an aero plane.
[A] Long Fund [B] Operating [C] Leverage [D] Sales or return

23) Under _____ Lability, Lease obligations are not reported as a liability in the
company’s balance sheet..
[A] Liquid [B] Hidden [C] Convivence [D] None

24) The lessee can use the asset to earn without investing money in the asset, using
less liquidity to do business.
[A] Liquidity [B] Hidden [C] Leverage [D] None

25) Restrictions involved in long-term borrowing from financial institutions are avoided__.
[A] Attached [B] Avoided [C] Compulsory [D] None

26) Leasing is the easiest method of financing _______________.

[A] Fixed assets [B] Current Assets [C] Liquid Assets [D] None

27) The risk of the asset becoming obsolete due to technological advancements is
borne by the lessor.
[A] Leasing [B] Lessor [C] Government [D] Agent

28) Under cost saving Lease rentals are deductible from _______, The lessee
has lower obligation in bankruptcy than under debt financing.
[A] Gross [B] taxable income [C] Net [D] None

29) Under cost saving Lease rentals are deductible from taxable income. The lessee
has lower obligation in _________ than under debt financing.
[A] Bankruptcy [B] Bad debts [C] Solvency [D] None

30) Any prospective lease must be evaluated by______ the lessee and lessor
[A] Any one [B] Both [C] Only one [D] None

31) The lessee must determine whether leasing an asset will be ______ than buying it.
[A] Less costly [B] High Costly [C] reasonable [D] None

32) Since, this unit considers leasing as an alternative to financing, we shall evaluate the
effect of lease decision from the point of view of ___________only.
[A] Agent [B] Lessor [C] Lessee [D] Government
33) An economic evaluation of lease would thus call for comparison of the financial
costs of the lease with the costs of borrowing necessary funds to ____ the assets..
[A] Sale [B] Purchase [C] Produce [D] Process

34) An economic evaluation of lease would thus call for comparison of the ______
costs of the lease with the costs of borrowing necessary funds to purchase the assets..
[A] Financial [B] Process [C] Sales [D] None

35) If the cost of the lease is found _______ than the cost of borrowing, it would be
in the interest of the company to borrow and buy the asset.
[A] Same [B] Higher [C] Lower [D] None

36) If the cost of the lease is found higher than the cost of borrowing, it would be
in the interest of the company to borrow and buy the _______.
[A] Capital [B] Assets [C] Loan [D] Debenture

37) If the purchase option allows the company to realize a tax savings from an
investment allowance, the amount of the saving should be calculated in accordance
with the existing _____________.
[A] tax provision [B] Gross profit [C] Net profit [D] Capital

38) If the purchase option allows the company to realize a tax savings from an
_____allowance, the amount of the saving should be calculated in accordance
with the existing tax provisions..
[A] Discount [B] Penalty [C] Investment [D] Capital

39) After-tax cost of owning is calculated by subtracting the tax savings from the loan
payment. This is done each year during the term of loan
[A] GST [B] tax saving [C] Investment [D] Capital

40) As against leasing, hire purchase involves the purchase of an asset on the understanding
that the purchase will pay in equal periodical instalments spread over a length of time.
[A] Hire sales [B] Hire purchase [C] Rent [D] None

41) Leasing and hire purchase have emerged as a supplementary source of intermediate
long term finance.
[A] Supplementary [B] Symmetry [C] lacking [D] None

42) In case of leasing, the user of the asset (the lessee) is not the______ of the asset.
[A] Tennent [B] Owner [C] Government [D] None

43) _____ on asset cannot be claimed by the lessee as a deduction from taxable income..
[A] Depreciation [B] rent [C] penalty [D] GST

44) Depreciation on asset cannot be claimed by the lessee as a deduction from

taxable income.
[A] Lessor [B] Lessee [C] Government [D] Agent
45) Hire purchase capitalizes the asset bought under the hire purchase contract although
the ___________ does not pass on to him until the last instalment is paid..
[A] Nominee [B] Ownership [C] Both [D] None

46) Hire purchase _________ the asset bought under the hire purchase contract although
the ownership does not pass on to him until the last instalment is paid..
[A] Capitalized [B] Revenue [C] Investment [D] None

47) Hire purchase capitalizes the asset bought under the hire purchase contract although
the ownership does not pass on to him until the ______ instalment is paid..
[A] First [B] Last [C] Advanced [D] None

48) Hire purchaser charges depreciation regularly to _____________.

[A] P/L account [B] Trading account [C] B/S [D] Trail balance

49) The liability for future hire purchase instalments are shown separately in _____ .
[A] P/L account [B] Trading account [C] Balance sheet [D] Trail balance

50) Under leasing, the entire lease rentals represent a ‘hire charge’ and can therefore
be treated as __________ and hence tax deductible.
[A] Assets [B] expenses [C] Income [D] None

51) Under Leasing depreciation and Investment allowance can not be claimed by the ____.
[A] Lessee [B] Government [C] Insurance Company [D] None

52) Under Leasing the ________, not being the owner of the asset, does not enjoy
the salvage value..
[A] Lessor [B] Lessee [C] Government [D] None

53) Under Buy option depreciation and investment allowance can be claimed by the____
[A] Hirer [B] Seller [C] Government [D] None

54) Under Buy Option the _______, being the owner of the asset, enjoys the salvage
value of the asset.
[A] Seller [B] Hirer [C] Government [D] Agent

55) There is a lukewarm response from the ________ banking sector for
financial assistance to leasing companies.
[A] Private [B] Commercial [C] Co-operative [D] None

56) Those companies which have recently gone to _____ are finding it difficult in
getting their issues fully subscribed in the face of inadequate public support.
[A] Public [B] stakeholder [C] Banks [D] Government
57) Consequent to the 46th Amendment to the Constitution, various States have
enacted legislation that subject lease rental to ______.
[A] Income tax [B] Sales tax [C] Service tax [D] None

58) The modern techno-dynamic age has given chance for obsolescence at a high rate
due to ___________ improvements in production of machinery and process.
[A] Management [B] technological [C] Innovating [D] HR

59) It will be beneficial for the lessee to have equipment on_______ lease, where the
risk of obsolescence is borne by the leasing company.
[A] Operating [B] Financial [C] Material [D] Capital

60) It will be beneficial for the lessee to have equipment on operating lease, where
the risk of obsolescence is borne by the ________ company
[A] Lessee [B] Leasing [C] Government [D] None

61) The immediate future of leasing companies in India is bleak, since many
companies entered in field almost at the same time leading to ______________.
[A] Cut throat competition [B] Monopoly
[C] No change [D] None

62) ______capital refers to the commitment of capital and knowledge for the formation
and setting up of companies specializing in new ideas or new technologies..
[A] Coemption [B] Venture [C] Revenue [D] None

63) Venture capital is essentially financing of new ventures through _____ participation.
[A] Equity [B] Preference [C] Debenture [D] Loan

64) ___________ capital financing involves high risk return spectrum

[A] Short [B] Venture [C] Government [D] Agent

65) Venture capitalist fills the gap in the _______funds in relation to the quantum
of equity required to support the successful launching of a new business
[A] Borrowed [B] Owner’s [C] Debenture [D] None

66) ______________ is the use of small amounts of capital from a large number of
individuals to finance a new business initiative.
[A] Crowdfunding [B] Personal Credit [C] Personal finance [D] Bank

67) ___________ are small loans that are given by individuals at a lower interest to a
new business ventures.
[A] Vendor finance [B] Microloans [C] lease loan [D] subsidy
68) When a person is starting his business, suppliers are reluctant to give ________.
[A] Trade discount [B] trade credit [C] Interest [D] Rent

69) Factoring is a financing method where accounts receivable of a business organization

is sold to a commercial finance company to raise _________.
[A] Capital [B] Goods [C] Employment [D] Cash

70) _____ investors provide more favorable terms than other lenders, since they usually
invest in the entrepreneur starting the business rather than the viability of the business.
[A] Factoring [B] Angel [C] Government [D] None

REFRENCES

Lease Financing

1. "Lease Financing" by Investopedia: A comprehensive overview of lease financing,

including its types, benefits, and drawbacks.

2. "Leasing" by AccountingTools: A detailed article on lease accounting, including lease

classification, amortization, and disclosure requirements.

3. "Lease Financing: A Guide" by Business News Daily: A practical guide to lease financing,
including its advantages, disadvantages, and common types of leases.

Venture Capital

1. "Venture Capital" by Venture Capital Association: A comprehensive resource on venture

capital, including its definition, history, and investment process.

2. "Venture Capital: A Guide" by Forbes: A detailed guide to venture capital, including its
types, stages, and key players.

3. "Venture Capital and the Finance of Innovation" by Andrew Metrick: A book that provides
an in-depth analysis of venture capital and its role in financing innovation.

Startup Finance

1. "Startup Finance" by Startup Genome: A comprehensive guide to startup finance,

including funding options, financial planning, and metrics.

2. "The Fundraising Book" by Alejandro Cremades: A practical guide to fundraising for

startups, including strategies, tactics, and best practices.

3. "Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist" by Brad Feld and
Jason Mendelson: A book that provides a comprehensive guide to venture capital deals,
including term sheets, valuations, and negotiations.
 FACULTY OF COMMERCE
2024 - 25
SEMESTER-6

SUBJECT:
STRATEGIC FINANCIAL MANAGEMENT
SP. BANKING, INSURANCE AND FINANCE

UNIT NO. 5
RISK MANAGEMENT AND SECURITIZATION

COMPLIED BY:
DR.DHARINI PATEL PROF. SAURIN PATEL

STUDY MATERIAL FOR REFERENCE

GLS UNIVERSITY FACULTY OF COMMERCE
STARATEGIC FINANCIAL MANAGEMENT

Unit V RISK MANAGEMENT & SECURITIZATION

1. Types of risk faced by organization

2. Evaluation of financial risk
3. Value at Risk (VAR)
4. Methods of identifying and managing financial risks
5. Concept of Securitization
6. Benefits of Securitizations
7. Participants in Securitization
8. Problems of Securitization
9. Securitization instruments
1] What is Risk?
From an organization's perspective Risk is a Threat or Possibility that an action
or event will adversely affect organization's ability to achieve its objectives.
Risk is the point at which you take a risk at something which can either turn out
better for you or could bring about a negative result.
International organizations for standardization ISO 31000 (2009) defines risk
as the 'effect of uncertainty on objectives'. Here uncertainties include possible
incidents and ambiguity caused by inadequate information. It also includes the
impact on goals which may be positive or negative.

2] RISK MANAGMENT
In order to ensure effective Risk management, it is imperative to have an in-depth
understanding of generic business risks in addition to the specific types of risk
that may be applicable to an organization basis the nature of business, objectives
and strategies.
• Risk in general: Risk is the possibility of organization failing to achieve its
objectives.
• One must remember that Risk cannot be eliminated completely and hence
needs to be managed. Companies are often unwilling to take risk to revise
their past strategies that have been successful for them. These organizations
are invariably outrun by their competitors willing to take risk
• Having said this, risk can be analyzed, measured, and managed by ensuring
proper controls are put in place. For example - Risk of investments in financial
instruments can be analyzed and reduced basis the track record of the issuing
company. Similarly, the risk of damage in case of a fire can be quantified basis
the replacement value of the concerned property.
• Risk is usually associated with anticipation of benefits which may be tangible
or intangible. For example - Profits, New business, enhanced reputation.
Effective risk management would comprise in determining the probability of an
incident and taking into consideration its overall impact to assess whether the
risk is worthwhile.
Risk management includes the following key steps:
• Identification of risks

• Assessing the impact and likelihood of those risks occurring

• Deployment of the right risk-management tools and practices

Development of an environment where everyone feels responsible for risk

management .
3] Types of Risk faced by organization.
In today’s competitive world, every organization is faced with a large number of
risks impacting different aspects of the business. These risks should be
appropriately classified to enable development and selection of appropriate risk
management tools and practices. Organizations face a variety of risks, including:
 Financial risk
The risk of losing money on an investment, or struggling to manage debt and
payments. This can be caused by external factors like interest rate fluctuations,
financial downturns, or instability in financial markets.
Financial reporting risk arises from non-compliance with the accounting policies
or reporting requirements of regulators, tax authorities and MIS (management
information). This includes risk of submitting inaccurate or misleading
information; or failing to submit information in a timely manner that could cause
misrepresentation of the company's financial condition to regulators, investors
and other key constituencies.
Thereby, a control that ensures compliance with financial reporting requirement
is categorized as ICOFR (Internal Control over Financial Reporting).
e.g.: Not categorizing or tracking the financial reporting related controls or not
passing entries in appropriate account leading to errors in reporting.
 Strategic risk
The risk of not operating according to a business plan or model. This can make a
company's strategy less effective over time, and make it harder to reach goals.
Strategic risk arises from adverse effects or non-implementation of high-level
business decisions.
e.g.: Lack of right offerings to address customer needs - (Cost effectiveness /
infrastructure) and lack offering of diversified services / products
 Reputational risk
The risk of a company's reputation, brand image, or public perception being
damaged by the actions or decisions of a third party. This can include lawsuits,
outages, regulatory penalties, customer data breaches, or fraud at the vendor's
end.
 Operational risk
The risk of a business suffering financial losses or a disruption in operations due
to errors or failures in its operational processes. This can be caused by human
error, equipment malfunctions, inadequate internal controls, or external events.
Operational risk is the likelihood of a direct or indirect loss being incurred due to
inappropriate or failed procedures, resources and systems or due to any other
external actions.
It arises from potential disruptions of business processes associated with the
delivery of products or services to customers.
 Legal/ Compliance risk
The risk to a company's reputation or finances due to a violation of external laws
and regulations or internal standards. This can result in fines or lost customers.
Compliance risk arises from violations of, or failure to conform with, laws,
regulations or prescribed practices. The above risk can result in possible fine,
criminal and civil monetary penalties, damage payments and voiding of
contracts. Regulatory risk arises due to non adherence of a regulation passed by
the government.
e.g.: If a lease agreement for an office area is not renewed on time.
 Cybersecurity risk
The risk of attacks on supply chain networks, like data leaks or security protocol
breaches. This is a newer threat due to the rapid evolution of technologies and
supply chain digitization
 Staffing/Organisation Risk:
Any risk to maintaining appropriate staffing requirements for ensuring business
stability, growth and continuity is categorized here. This includes risk of
inadequate capacity planning, work environment related risks, HR policies and
practices related risks.
e.g.: Capacity plan not in p-lace for the organisation.
 Credit Risk:
Risk of loss that may arise due to Incomplete, inaccurate evaluation of the
credit rating / risk of the issuers or borrowers
e.g.: Incomplete / inaccurate evaluation of the credit rating / risk of the external
party.
 Insurance Risk:
Insurance is a mechanism whereby an individual / company and the insuring
company agree that in return for a premium paid by the individual/ company,
on the happening of a certain loss event the insuring company promises to pay
compensation. The above risk arises as a result when the insurance policy is
taken for an asset / business where the policy is not in line with the risk event.
e.g.: Inadequate tracking of terms and conditions with respect to insurance
requirements leading to under insurance cover.
  Sovereign/Cross Border Risk:
This is the risk exposure arising from inadequate knowledge regarding laws and
regulations when the business is shifted to a different region, state or county.
e.g.: If a business unit is shifted from India to a Special Economic Zone in the
US. The unit will have to comply with the laws and regulations of SEZ. Risks
that arise due to non- adherence are Cross border risk.
 Market Risk:
The above is a risk that arises when certain changes in market trends have an
impact on the business.
e.g.: Margins being reduced impacting the profits due to economic recession.
 System/Technology Risk:
This will affect business in case the system has a technical problem / the
technology becomes non operational.
e.g.: Link / server/ any technology failure

4] Evaluation of Financial Risk

Financial risk evaluation is a process that involves identifying and analyzing

potential financial losses for a business. The goal is to prioritize risks and take
action to reduce the likelihood of them occurring, or to prepare a response if they
do.
Here are some steps for evaluating financial risk:
 Identify risks
Consider where the business is most likely to lose value, such as through
customer transactions, foreign currencies, or regulations.
 Analyze risks
Determine how likely the risks are to occur and what the potential impact would
be.
 Prioritize risks
Based on likelihood and potential impact, prioritize the risks that require
immediate attention.
 Develop a plan
Create contingency plans to respond to the risks, such as what-if scenario
analysis.
  Monitor and review
Financial risk assessment is an ongoing process, so it's important to monitor and
review the risk management strategies regularly.
Some common types of financial risk include:
 Credit risk: The risk that a customer or borrower will not meet their
financial obligations.
 Operational risk: The risk of failing to succeed in undertakings due to
internal factors, such as poor management or technical failures.
 Legal risk: The risk of financial losses due to legal constraints, such as
lawsuits
Value at Risk (VAR)
VAR is a statistical measurement of the riskiness of a financial entity or
portfolio of assets. It is calculated by assessing the potential loss, the probability
of the loss, and the time frame during which it might occur. VaR is usually
presented as a percentage or a numerical value.
Here are some examples of value at risk (VaR):
 Asset with a 2% one-week VaR of 1%: There is a 2% chance that the
asset will decline by 1% within a week.
 Portfolio with a 5% one-day VaR of $1000: There is a 5% chance that the
portfolio will decline by $1000 during a day.
 Investment with a 1-day VaR of -4.44% at a 99% confidence level for a
$100,000 investment: There is a 1% chance that the investment may lose
$4,439 over the time period
Method of identifying and managing financial risks:-
Financial Risk Management Process includes identifying the risk, assessing and
quantifying the risk, defining strategies to manage the risk, implementing a
strategy to manage the risk and monitoring the effectiveness of the strategy in
managing the risk.
Here are some methods for identifying and managing financial risks:
 Identify risks
Consider risk factors, review balance sheets, and analyze financial
positions. You can also look for weaknesses in the operating plan, compare
metrics to other companies, and use statistical analysis.
 Use tools
Use financial risk checklists, analytics dashboards, and process risk data.
 Conduct stress tests
Subject the institution to hypothetical scenarios to identify areas of potential
loss.
 Analyze the current financial situation
Brainstorm financial risks, and interview internal and external parties.
 Monitor and report
Monitor the effectiveness of strategies to ensure that financial risks are managed
appropriately.
 Develop a mitigation strategy
Based on the type of risks and the organization's risk appetite, develop a strategy
to reduce potential losses.

Financial risk management is important because it helps protect individuals,

organizations, and institutions from financial losses. It also helps promote
stability and long-term viability.

Concept of Securitization
The process of securitization typically involves the creation of pool of assets
from the illiquid financial assets, such as receivables or loans which are
marketable. In other words, it is the process of repackaging or rebundling of
illiquid assets into marketable securities. These assets can be automobile loans,
credit card receivables, residential mortgages or any other form of future
receivables.

What is securitisation?
Securitisation is the process of conversion of existing assets (impaired or or
future cash flows into marketable securities. In other words, securitisation deals
with the conversion of assets which are not marketable into marketable ones.
According to Investopedia, “
Securitization is the process of taking an illiquid asset, or group
of assets and through financial engineering, transforming them into a security

Types of securitisation:
Generally, there are two kinds of securitisation transactions depending on what is
being securitised. They are
1. Asset based securitisation- In this case the assets of the entity are transferred
by the originator to the end investor. Sometimes, these assets may be impaired or
incompetent to generate revenues or income.

2. Future-flows securitisation- In this case, future cash flows or receivables are

transferred to the investor which again may carry the risk of being realised in full
or only in part and sometimes, it needs to be written off as bad debts.

What can be securitised?

Any asset that generates income or stream of cash flows can be securitised.
Typically, there are four classes of financial assets that can be securitised. They
are:
1. Loans like
a) Auto Loans
b) Personal Loans
c) Home Loans
d) Student Loans and
e) Consumer Durable Loans
f) Equipment Loans/Lease

2. Receivables like
a) Credit Sales of goods or services
b) Ticket Sales
c) Credit card payments
d) Toll Receipts

3. Risk Transfers like

a) Weather risk
b) Insurance risk
c) Credit risk
4. Asset based securities like
a) Residential mortgage backed securities
b) Commercial mortgage backed securities

However, Residential mortgage backed securities (RMBS) and Commercial

mortgage backed securities (CMBS) form the major asset class that are
securitised in the securitisation world

2] Features of Securitization
1) Creation of Financial Instruments -
Additional financial instruments by way of new securities are created which are
backed by collaterals.
2) Bundling and Unbundling -
When the mortgaged based assets are combined into a pool on the basis of same
rate of interest and maturity period by the originator, it is bundling and when
these are broken into instruments of fixed denomination by the SPV, it is
unbundling.
3) Tool of Risk Management -
In case of assets are securitized on non-recourse basis, then securitization process
acts as risk management as the risk of default is shifted from the originator.
4) Structured Finance -
The process of securitization is a structured finance as the financial instruments
are tailor made to meet the risk return trade profile of the investors.
5) Securities are divided into tranches -
Portfolio of different receivables or loans are divided into several parts based on
risk and return which are called tranches.
6) Homogeneity -
Under each tranche, the securities issued are of homogenous or similar nature
and even meant for small investors who can afford to invest in small amounts.

3] Benefits of Securitization From the angle of originator

1) Balance Sheet Financing -
When loan/receivables are securitized,
funds are raised without increasing the liability side of the balance sheet of the
company. Financial assets i.e. illiquid mortgaged based assets are sold to SPVs
and in their place, liquid assets in the form of cash is received from the SPVs.
2) More specialization in main business -
By transferring the assets, the entity could concentrate more on its core business
as servicing of loan is transferred to SPV.
3) Helps to improve financial ratios -
It helps to improve the Capital – to - Weighted Asset Ratio effectively in case of
Financial Institutions and Banks. The reason is that by transferring the illiquid
and risky assets to SPVs, the risk weighted assets are reduced.

4) Reduce borrowing Cost –

Since securitized papers are credit rated due to credit enhancement they can be
issued at lower rate of interest as the originator earns a spread, resulting in
reduced cost of borrowings.

5) Diversification of Risk -
Purchase of securities backed by different types of assets provides the
diversification of portfolio resulting in reduction of risk.

6) Regulatory requirement -
Acquisition of asset backed belonging to a particular industry say micro industry
helps banks to meet regulatory requirement of investment of fund in industry
specific.

7) Protection against default –

In case of recourse arrangement, if there is any default by the borrowers
(obligors), then the originator shall make good the default.

4] Participants in Securitization Primary Participants

1) Originator – It is basically the initiator of the securitization

process. It sell the illiquid assets lying in its books to the special purpose vehicle.

2) Special Purpose Vehicle (SPV) – After purchasing the

illiquid assets from the originator, the SPV makes an upfront payment to it. Then,
it converts those illiquid assets into marketable securities and issue it to the
investors.

3) The Investors - Investors are the buyers of securitized papers

which may be an individual, an institutional investor such as mutual funds,
provident funds, insurance companies, mutual funds, Financial Institutions etc.

4) Obligors - They are the parties who owe money to the originators. The
amount due from the obligors is transferred to SPV which in turn passes it on to
the investors of securitized instruments.
5) Agency -
Since the securitization is based on the pools of assets rather than the originators,
the assets have to be assessed in terms of its credit quality and credit support
available. Credit Rating Agencies provide that.

6) Receiving and Paying agent (RPA) -

Also, called Servicer or Administrator, it collects the payment due from
obligor(s) and passes it to SPV.

7) Agent or Trustee -
Trustees are appointed to oversee that all parties to the deal perform in the true
spirit of the terms of agreement. Normally, it takes care of interest of investors
who acquires the securities.

8) Credit Enhancer –
It provides additional comfort to the investors to whom the securitized
instruments are issued in the form of additional collateral or third party guarantee
such as letter of credit or surety bond.

9) Structurer -
It brings together the originator, investors, credit enhancers and other parties to
the deal of securitization. Normally, these are investment bankers i.e. merchant
bankers also called arranger of the deal. It ensures that the deal meets all legal,
regulatory, accounting and tax laws requirements.

Mechanism of Securitization
1) Creation of Pool of Assets -
The process of securitization begins with creation of pool of assets by separation
of assets backed by similar type of mortgages in terms of interest rate, risk and
maturity.

2) Transfer to SPV -
Once assets have been pooled, they are transferred to Special Purpose Vehicle
(SPV) especially created for this purpose.

3) Sale of Securitized Papers -

SPV designs the securitized instruments on the basis of nature of interest, risk,
tenure etc. by converting them into marketable securities and issue them to the
investors. The investors are then given Pass Through Certificate or Pay Through
Security.

4) Administration of assets - The administration of assets then passes

back to originator which collects principal and interest from the underlying assets
and transfer it to SPV, which works as a conduit or channel.
5) Recourse to Originator – In case of default in payment by the borrowers
(obligors), the liability to pay transfers to the originator from the SPV.

6) Repayment of funds – The SPV repays the invested amount to the

investors in the form of interest and principal that arises from the assets pooled.

7) Credit Rating to Instruments - Sometimes before the sale of securitized

instruments, credit rating can be done to assess the risk of the issuer.

5] Problems in Securitization

1) Stamp Duty - Stamp Duty is one of the major obstacles

in India. Under Transfer of Property Act, 1882, a mortgage debt stamp duty may
goes upto 12% in some states of India and this impedes the growth of
securitization in India.

2) Taxation - Taxation is another area of concern in

India. In the absence of any specific provision relating to securitized instruments
in Income Tax Act, experts’ opinion differ a lot. Differences of opinion exists as
to whether SPV as a trustee is liable to be taxed in a representative capacity or
not.

3) Accounting – Confusion exist in accounting aspects also.

Transfer of mortgaged assets to SPV is an off balance sheet transaction in which
the receivables are removed from the balance sheet of the originator. But,
originator is still responsible for collecting the interest and principal amount from
the obligors and transfer it to the SPVs. For this purpose, the experts say that the
originator has to maintain accounting entries. Again, lack of clarity is there when
the securitization is on non-recourse basis.

4) Lack of standardization - Every originator follows his own

procedure for documentation and administration of the securitization process. So,
having lack of standardization is another obstacle in the growth of securitization.

5) Inadequate Debt Market - Lack of existence of a well-

developed debt market in India is another obstacle that hinders the growth of
secondary market of securitized or asset backed securities.

6) Ineffective Foreclosure laws – Since Foreclosure laws are not

supportive to lending institutions, this makes securitized instruments less
attractive as lenders face difficulty in transfer of property if borrowers default.
6] Securitization Instruments

1) Pass Through Certificates (PTCs) – This is a certificate given

to the investors of securitized instruments that interest and principal amount will
be paid to them. They are called PTCs because the interest and the principal
amount is passed through from the borrowers to originators, then to SPVs, and
finally to the investors.

2) Pay Through Security (PTS) – In this case, SPV issues new

securities to the investors in place of a pass through certificate. These securities
are generally considered safe securities from which interest and payment of the
principal amount is almost assured.

3) Securitization Instruments Stripped Securities - Stripped

Securities are created by dividing the cash flows associated with underlying
securities into two or more new securities such as: (i) Interest Only (IO)
Securities (ii) Principle Only (PO) Securities These are generally considered as
volatile and less preferred by the investors.

Pricing of the Securitized Instruments

From Originator’s Angle

From originator’s point of view, the instruments can be priced at a rate at which
originator has to incur an outflow and if that outflow can be amortized over a
period of time by investing the amount raised through securitization.

From Investor’s Angle

From an investor’s angle security price can be determined by discounting best
estimate of expected future cash flows using rate of yield to maturity of a
security of comparable security with respect to credit quality and average life of
the securities.

Securitization in India
It is the Citi Bank who pioneered the concept of securitization in India by
bundling of auto loans into securitized instruments. Thereafter many
organizations securitized their receivables. Although started with securitization
of auto loans it moved to other types of receivables such as sales tax deferrals,
aircraft receivable etc.

The important highlight of the scenario of securitization in Indian Market is that it

is dominated by a few players e.g. ICICI Bank, HDFC Bank, NHB etc. Moreover,
from 2019-20 onwards, the securitization volume has picked up in India
Short Questions :-
1. Write a short note Risk.

2. Why risk management is important?

3. Explain types of risks in short.

4. What is risk treatment?

5. What is meaning securitization?

6. Explain benefits of securitization.

7. Write features of securitization.

Long Questions:-
1. Write the meaning of risk and Risk Management.
2. Write about types of risk faced by organisation.
3. Write the evaluation of financial risk with its meaning.
4. Write methods of identifying and managing financial risks.
5. Write the meaning and benefits of Securitization.
6. Write a note on problems of Securitization.
7. Write a note on participants in securitization.
8. Write about securitization instruments.

MULTIPLE CHOICE QUESTION

1. What is risk from an organization’s perspective?
A. A positive impact on business goals
B. A threat or possibility of adverse effects on objectives
C. The certainty of achieving business goals
D. A method to reduce costs

2. According to ISO 31000 (2009), what does risk include?

A. Only tangible benefits
B. Certain outcomes on objectives
C. Uncertainties and their impact on objectives
D. Elimination of risks
3. What is a key characteristic of risk?
 A. It can be completely eliminated
B. It always leads to positive outcomes
C. It includes both tangible and intangible benefits
D. It is only applicable to financial losses
4. What is the purpose of risk management?
A. Eliminate all risks B. Manage and mitigate risks effectively
C. Focus only on financial risks D. Ignore external factors
5. Which is NOT a key step in risk management?
A. Identification of risks
B. Avoiding all risks
C. Assessing the impact and likelihood of risks
D. Creating a risk-aware environment
6. What does effective risk management involve?
A. Ensuring all risks are taken
B. Ignoring past successes
C. Evaluating risks and their overall impact
D. Avoiding new strategies
7. What is a primary tool in managing investment risks?
A. Random selection of instruments
B. Analyzing the issuing company’s track record
C. Ignoring past performance
D. Assuming minimal risk
8. What is financial risk?
A. The inability to achieve strategic goals
B. Losing money on investments or managing debt poorly
C. Damage to the company’s reputation
D. Violation of legal standards
9. Which risk arises from non-compliance with accounting policies?
A. Strategic risk B. Financial reporting risk
C. Market risk D. Reputational risk
10. What does strategic risk involve?
A. Disruption in operations due to equipment failures
B. Not operating according to a business plan
C. Regulatory penalties
D. Cybersecurity breaches
11. Reputational risk can be caused by:
A. Data breaches B. Regulatory penalties
C. Fraud D. All of the above
12. Operational risk results from:
A. Effective implementation of controls
B. Errors in operational processes
C. Market trends
 D. Financial downturns
13. What does compliance risk arise from?
A. Inappropriate business strategies
B. Violations of laws and regulations
C. Economic recessions
D. Data breaches

14. Cybersecurity risk is primarily due to:

A. Inadequate HR policies B. Supply chain network attacks
C. Fluctuations in interest rates D. Poor staffing practices
15. Which of the following is an example of sovereign/cross-border risk?
A. Server failure in a company
B. Non-compliance with SEZ regulations in a different country
C. Interest rate fluctuations
D. Customer data breaches
16. Market risk is influenced by:
A. External lawsuits B. Changes in market trends
C. Cybersecurity breaches D. Poor internal controls
17. What is an example of system/technology risk?
A. Misrepresentation in financial reporting
B. Server or technology failure
C. Failure to adhere to HR policies
D. Non-compliance with tax regulations
18. What is the first step in evaluating financial risk?
A. Monitor and review B. Analyze risks
C. Identify risks D. Develop a plan
19. Financial risk prioritization is based on:
A. Historical success B. Likelihood and impact of risks
C. Operational efficiency D. Number of risk categories
20. What is Value at Risk (VaR)?
A. A tool for evaluating strategic risks
B. Statistical measurement of financial risk
C. A measure of compliance risks
D. Only applicable to operational risks
21. The full form of VAR is :
A. Value at Risk B. Valuation asset risk
C. Verbal asset Risk D. Verbal at Risk
22. Which risk relates to poor capacity planning?
A. Financial risk B. Staffing/Organization risk
C. Strategic risk D. Compliance risk
23. A lease agreement not renewed on time is an example of:
A. Market risk B. Compliance risk
C. Strategic risk D. Operational risk
24. An incomplete evaluation of credit ratings leads to:
A. Strategic risk B. Credit risk
C. Cybersecurity risk D. Market risk
25. The risk from inadequate tracking of insurance terms is:
A. Financial risk B. Insurance risk
C. Compliance risk D. Strategic risk
26. What type of risk is associated with equipment malfunctions?
A. Financial risk B. Operational risk
C. Market risk D. Reputational risk
27. An economic recession reducing profit margins is an example of:
A. Market risk B. Operational risk
C. Legal risk D. Strategic risk
28. What does an effective control in financial reporting ensure?
A. Faster financial gains B. ICOFR compliance
C. Operational efficiency D. Data protection
29. What does VAR typically express?
A. Likelihood of market gain
B. Probability and potential financial loss
C. Operational efficiency levels
D. Strategic goal-setting methods
30. Risk anticipation includes:
A. Only tangible benefits
B. Ignoring financial losses
C. Assessing benefits like profits or enhanced reputation
D. Avoiding strategic decisions
31. What is the first step in the financial risk management process?
a) Monitor and report b) Define strategies
c) Identify risks d) Conduct stress tests
32. Which of the following is NOT a method for identifying financial risks?
a) Analyzing financial positions b) Brainstorming financial risks
c) Ignoring statistical analysis d) Reviewing balance sheets
33. What tools are suggested for managing financial risks?
a) Balance sheets and stress tests
b) Risk checklists and analytics dashboards
c) Mitigation strategies and future projections
d) None of the above
34. What is the purpose of conducting stress tests?
 a) To implement risk management strategies
b) To identify areas of potential loss under hypothetical scenarios
c) To monitor the effectiveness of financial strategies
d) To assess the organization's balance sheet
35. Developing a mitigation strategy depends on:
a) The organization's risk appetite b) Stress test results
c) The company’s revenue d) Past financial performance
36. Why is financial risk management important?
a) To maximize profits
b) To protect against financial losses and promote stability
c) To eliminate all risks
d) To reduce operational inefficiencies
37. What does the process of securitization involve?
a) Creation of new financial assets
b) Conversion of illiquid assets into marketable securities
c) Reduction of financial risks
d) Monitoring financial positions
38. Which of the following is an example of illiquid assets that can be
securitized?
a) Real estate b) Automobile loans
c) Company equity d) Bank deposits
39. What is securitization primarily used for?
a) Managing operational risks
b) Repackaging illiquid assets into securities
c) Eliminating bad debts
d) Increasing credit limits
40. According to Investopedia, securitization involves:
a) Eliminating cash flow risks
b) Transforming illiquid assets into securities
c) Writing off bad debts
d) Buying new loans
41. Which of the following is NOT a type of securitization?
a) Asset-based securitization
b) Liability-based securitization
c) Future-flows securitization
d) None of the above
42. In future-flows securitization, what is transferred to the investor?
a) Tangible assets
b) Future cash flows or receivables
c) Stock options
d) Bank guarantees
43. Which asset class forms the major component of securitized assets?
 a) Credit risk transfers
b) Consumer durable loans
c) Residential and commercial mortgage-backed securities
d) Toll receipts
44. Which of the following loans can be securitized?
a) Credit card loans b) Equipment loans
c) Student loans d) All of the above
45. Receivables that can be securitized include:
a) Ticket sales b) Residential properties
c) Insurance policies d) Mutual funds
46. Risk transfers in securitization may include:
a) Weather risk b) Credit card debts
c) Tax benefits d) None of the above
47. Which of the following is an example of asset-based securities?
a) Credit sales b) Residential mortgage-backed securities
c) Ticket sales d) Equipment loans
48. What is the primary purpose of asset-based securitization?
a) To secure new loans
b) To transfer ownership of tangible assets
c) To convert impaired assets into revenue-generating securities
d) To hedge against inflation risks
49. Which type of securitization involves assets that may be impaired?
a) Future-flows securitization b) Asset-based securitization
c) Risk-based securitization d) None of the above
50. What type of securitization deals with future receivables?
a) Asset-based securitization b) Future-flows securitization
c) Credit securitization d) Loan-based securitization
51. What can be considered a risk transfer asset?
a) Credit risk b) Mortgage loans
c) Toll receipts d) Consumer loans
52. What is the main benefit of securitization?
a) Reduction of operational costs
b) Conversion of non-marketable assets into marketable securities
c) Decrease in interest rates
d) Increase in loan defaults
53. What is a common example of a receivable in securitization?
a) Real estate holdings b) Credit card payments
c) Bank deposits d) Equity shares
54. Which financial asset is NOT typically securitized?
a) Residential mortgages b) Automobile loans
 c) Company profits d) Credit card receivables
55. What does future-flows securitization rely on?
a) Immediate asset sales b) Predicted cash inflows
c) Tangible asset values d) Loan defaults
56. In securitization, what determines the level of risk?
a) Investor confidence b) Nature of assets being securitized
c) Organization size d) Market trends
57. The securitization process primarily benefits:
a) Retail customers b) Financial institutions and investors
c) Government regulators d) Shareholders exclusively
58. What is the role of monitoring in financial risk management?
a) To ensure strategy effectiveness b) To increase cash inflows
c) To create new assets d) To reduce operational complexity
59. Which type of securitization often includes assets that are not revenue-
generating?
a) Future-flows securitization b) Asset-based securitization
c) Loan securitization d) None of the above
60. What is a key characteristic of securitizable assets?
a) They must be income-generating or have predictable cash flows
b) They must be tangible assets
c) They are owned by investors
d) They must be non-transferable
61. What is created during the securitization process?
A) New laws B) Additional financial instruments
C) Debt-free assets D) Credit-only instruments
62. What does "unbundling" in securitization refer to?
A) Combining assets with the same interest rates
B) Breaking assets into fixed denomination instruments
C) Pooling assets with different risk profiles
D) Selling pooled assets to SPVs
63. How does securitization act as a tool for risk management?
A) By increasing asset liquidity
B) By shifting default risk from the originator
C) By combining assets with similar risk
D) By reducing borrowing costs
64. Which of the following participants converts illiquid assets into marketable
securities?
A) Originator B) Special Purpose Vehicle (SPV)
C) Investors D) Credit Enhancer
65. What are tranches in the context of securitization?
A) Parts of portfolios divided based on risk and return
B) Interest rates applied to pooled assets
C) Certificates of ownership in pooled assets
D) Separate SPVs created for different industries
66. What benefit does securitization provide to originators in terms of their
balance sheets?
A) Reduces liabilities
B) Increases loan tenures
C) Improves liquidity without increasing liabilities
D) Reduces taxation
67. Which of the following is a major problem in the growth of securitization
in India?
A) Lack of investment opportunities B) Absence of SPVs
C) Stamp duty on mortgage debt D) High interest rates on securities
68. What are Pass Through Certificates (PTCs)?
A) Certificates that assure interest and principal payments
B) Securities issued by SPVs in place of PTCs
C) Instruments used to divide cash flows into two or more securities
D) Certificates for investors holding only interest income
69. Which participant ensures legal, regulatory, and tax compliance in
securitization deals?
A) Originator B) Structurer
C) Trustee D) Credit Rating Agency
70. What was the first type of receivables securitized in India?
A) Sales tax deferrals B) Aircraft receivables
C) Auto loans D) Housing loans
Strategic Management

1. "Strategic Management: An Integrated Approach" by Charles W.L. Hill and

Gareth R. Jones - This book provides a comprehensive overview of strategic
management, including analysis, formulation, and implementation.
2. "Competing for the Future" by Gary Hamel and C.K. Prahalad - This book
focuses on strategic management in a rapidly changing business environment.
3. "Strategic Management: Theory and Practice" by David Hunger and Thomas L.
Wheelen - This book covers the fundamentals of strategic management, including
environmental analysis, strategy formulation, and implementation.

Risk Management

1. "Risk Management and Financial Institutions" by John C. Hull - This book

provides a comprehensive overview of risk management in financial institutions,
including market risk, credit risk, and operational risk.
2. "Risk Management: Concepts and Guidance" by Michel Crouhy, Dan Galai,
and Robert Mark - This book covers the fundamentals of risk management,
including risk assessment, risk measurement, and risk mitigation.
3. "Enterprise Risk Management: From Incentives to Controls" by James Lam -
This book provides a comprehensive overview of enterprise risk management,
including risk governance, risk assessment, and risk mitigation.

Securitization

1. "Securitization: The Financial Instrument of the Future" by Vinod Kothari -

This book provides a comprehensive overview of securitization, including its
history, mechanics, and applications.
2. "Securitization and Structured Finance" by Frank J. Fabozzi and Vinod Kothari
- This book covers the fundamentals of securitization and structured finance,
including asset-backed securities and mortgage-backed securities.
3. "Securitization: A Guide to the Asset-Backed Securities Market" by Andrew J.
Kalotay and Frank J. Fabozzi - This book provides a comprehensive overview of
the asset-backed securities market, including securitization, rating agencies, and
regulatory issues.
 FACULTY OF COMMERCE
2024 – 25
SEMESTER -VI
[Specialisation : Banking ,Insurance &
Finance]

SUBJECT: STRATEGIC FINANCIAL

MANAGEMENT

UNIT 6 : FINANCIAL DERIVATIVES

CA DR. SNEHA MASTER PROF. SAURIN PATEL

STUDY MATERIAL FOR REFERENCE ONLY

 GLS UNIVERSITY
FACULTY OF COMMERCE
SEMESTER -VI
SPECIALISATION : BANKING , INSURANCE & FINANCE
SUBJECT : STRATEGIC FINANCIAL MANAGEMENT
UNIT 6 : FINANCIAL DERIVATIVES

INDEX

SR. NO TOPIC

1 DERIVATIVES – INTRODUCTION & IMPORTANCE OF UNDERLYING

ASSET
2 DIFFERENCES BETWEEN CASH AND THE DERIVATIVE MARKET

3 IMPORTANT TERMS USED IN DERIVATIVES

4 FORWARD

5 FUTURES

6 DIFFERENCE BETWEEN FORWARD & FUTURES

7 OPTIONS

8 SWAPS AND SWAPTIONS

9 COMMODITY DERIVATIVES

10 CREDIT DERIVATIVES

11 WEATHER DERIVATIVES

12 LESSONS TO BE SAFE FROM DERIVATIVE MISHAPS

13 SECTION A THEORY QUESTIONS

14 SECTION B MULTIPLE CHOICE QUESTIONS

1|Page SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

[1] INTRODUCTION
Derivative is a product whose value is to be derived from the value of one or more basic variables called
bases (underlying assets, index or reference rate).
The underlying assets can be Equity, Forex, and Commodity.
The underlying has a marketable value which is subject to market risks.
The term “Derivative” indicates that it has no independent value, i.e., its value is entirely derived
from the value of the underlying asset. The underlying asset can be securities, commodities, bullion,
currency, livestock or anything else.
In other words, derivative means forward, futures, option or any other hybrid contract of
predetermined fixed duration, linked for the purpose of contract fulfilment to the value of a specified
real or financial asset or to an index of securities.

The importance of underlying in derivative instruments is as follows:

1] All derivative instruments are dependent on an underlying to have value.
2] The change in value in a forward contract is broadly equal to the change in value in the underlying.
3] In the absence of a valuable underlying asset the derivative instrument will have no value
4] On maturity, the position of profit/loss is determined by the price of underlying instruments.
If the price of the underlying is higher than the contract price the buyer makes a profit. If the price is
lower, the buyer suffers a loss.
5] We can say derivative is a FI that derives its performance from the performance of an underlying
asset.

[2] DIFFERENCES BETWEEN CASH AND THE DERIVATIVE MARKET

1] In cash market tangible assets are traded whereas in derivative market contracts based on tangible
or intangibles assets like index or rates are traded.
2] In cash market, we can purchase even one share whereas in Futures and Options minimum lots are
fixed.
3] Cash market is more risky than Futures and Options segment because in “Futures and Options”
risk is limited up to 20%
4] Cash assets may be meant for consumption or investment. Derivative contracts are for hedging,
arbitrage or speculation.
5] The value of derivative contract is always based on and linked to the underlying security. However,
this linkage may not be on point-to-point basis.
6] In the cash market, a customer must open securities trading account with a securities depository
whereas to trade futures a customer must open a future trading account with a derivative broker.
7] Buying securities in cash market involves putting up all the money upfront whereas buying futures
simply involves putting up the margin money.
8] With the purchase of shares of the company in cash market, the holder becomes part owner of the
company. While in future it does not happen.

2|Page SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

[3] IMPORTANT TERMS USED IN DERIVATIVES:
[A] OPTION-RELATED TERMS
1. Call Option:
A call option gives the holder the right, but not the obligation, to buy an underlying asset at a
specified price (strike price) on or before a specific date (expiration date).
2. Put Option:
A put option gives the holder the right, but not the obligation, to sell an underlying asset at a specified
price (strike price) on or before a specific date (expiration date).
3. Strike Price:
The strike price, also known as the exercise price, is the price at which the option can be exercised.
For call options, the strike price is the price at which the holder can buy the underlying asset. For put
options, the strike price is the price at which the holder can sell the underlying asset.
4. Expiration Date:
The expiration date, also known as the maturity date, is the last day on which the option can be
exercised. After the expiration date, the option becomes worthless.
5. Premium:
The premium is the price paid for the option contract. It is the amount that the buyer pays to the seller
for the right to buy or sell the underlying asset.
[B] FUTURES RELATED TERMS
1. Futures Contract:
A futures contract is an agreement to buy or sell an underlying asset at a specified price on a specific
date. Unlike options, futures contracts obligate the buyer and seller to fulfill the contract.
2. Spot Price:
The spot price is the current market price of the underlying asset. It is the price at which the asset can
be bought or sold immediately.
3. Forward Price:
The forward price is the price agreed upon in a futures contract. It is the price at which the buyer and
seller agree to buy or sell the underlying asset on the specified date.
4. Margin:
The margin is the initial deposit required to enter into a futures contract. It is a percentage of the
contract value, and it serves as collateral to ensure that the buyer and seller fulfill their obligations.
5. Mark-to-Market:
Mark-to-market is the process of adjusting the value of a futures contract to reflect changes in the
underlying asset's price. This process helps to reduce the risk of default by the buyer or seller.

3|Page SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

[C] SWAP-RELATED TERMS
1. Swap:
A swap is an agreement to exchange cash flows based on different underlying assets or interest rates.
Swaps can be used to hedge against interest rate risk, currency risk, or commodity price risk.
2. Fixed Leg:
The fixed leg is the fixed interest rate or payment in a swap. It is the amount that one party agrees to
pay to the other party at regular intervals.
3. Floating Leg:
The floating leg is the variable interest rate or payment in a swap. It is the amount that one party
agrees to pay to the other party based on a floating interest rate or index.
4. Notional Amount:
The notional amount is the underlying amount used to calculate the swap's cash flows. It is not
exchanged between the parties, but it serves as a reference point for calculating the payments.
[D] GENERAL DERIVATIVES TERMS
1. Underlying Asset:
The underlying asset is the asset on which the derivative's value is based. It can be a stock, bond,
commodity, currency, or index.
2. Derivative:
A derivative is a financial instrument whose value is derived from an underlying asset. Derivatives
can be used to hedge against risk, speculate on price movements, or invest in assets.
3. Hedging:
Hedging is the use of derivatives to reduce or manage risk. It involves taking a position in a derivative
that offsets the risk of an underlying asset.
4. Speculation:
Speculation is the use of derivatives to take a position on the price movement of an underlying asset.
It involves buying or selling a derivative with the expectation of making a profit from price
movements.
5. Leverage:
Leverage is the use of borrowed money to increase the potential return on an investment. Derivatives
often involve leverage, which can amplify gains or losses.
[E] RISK MANAGEMENT TERMS
1. Delta:
Delta is the rate of change of an option's price with respect to the underlying asset's price. It measures
the sensitivity of option's price to changes in underlying asset's price.
2. Gamma:
Gamma is the rate of change of an option's delta with respect to the underlying asset's price. It
measures the sensitivity of the option's delta to changes in the underlying asset's price.

4|Page SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

3. Vega:
Vega is the rate of change of an option's price with respect to the underlying asset's volatility. It
measures the sensitivity of the option's price to changes in the underlying asset's volatility.
4. Theta:
Theta is the rate of change of an option's price with respect to time. It measures the sensitivity of the
option's price to the passage of time.
5. Rho:
The rate of change of an option’s price with respect of the risk-free interest rate.

[4] FORWARD
Forward is a type of financial derivative that involves an agreement to buy or sell an underlying asset
at a predetermined price on a specific date in the future. Forwards are customized contracts between
two parties, and they are not traded on public exchanges.
Key Characteristics of Forwards:
1. Underlying Asset: Forwards can be based on various underlying assets, such as commodities,
currencies, stocks, bonds, or indices.
2. Contract Terms: The terms of the forward contract, including the price, quantity, and settlement
date, are agreed upon by the two parties.
3. Customized: Forwards are tailored to meet the specific needs of the parties involved
4. Over-the-Counter (OTC): Forwards are traded OTC, meaning they are not listed on public
exchanges.
5. Settlement: Forwards can be settled in cash or through physical delivery of the underlying asset.
Types of Forwards:
1. Currency Forward: A contract to buy or sell a currency at a predetermined exchange rate on a
specific date.
2. Commodity Forward: A contract to buy or sell a commodity, such as oil or gold, at a predetermined
price on a specific date.
3. Interest Rate Forward: A contract to buy or sell an interest rate instrument, such as a bond or a loan,
at a predetermined interest rate on a specific date.
4. Equity Forward: A contract to buy or sell a stock or a basket of stocks at a predetermined price on a
specific date.
Advantages of Forwards:
1. Customization: Forwards can be tailored to meet the specific needs of the parties involved.
2. Risk Management: Forwards can be used to hedge against potential losses or gains due to price
fluctuations.

5|Page SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

3. Flexibility: Forwards can be settled in cash or through physical delivery of the underlying asset.
Disadvantages of Forwards:
1. Counterparty Risk: The risk that the counterparty may default on their obligations.
2. Liquidity Risk: The risk that the forward contract may not be easily sold or transferred.
3. Regulatory Risk: The risk that changes in regulations may affect the forward contract.
In summary, forwards are customized financial derivatives that involve an agreement to buy or sell an
underlying asset at a predetermined price on a specific date. They offer customization, risk
management, and flexibility but also come with counterparty risk, liquidity risk, and regulatory risk.

[5] FUTURES
Future is a type of financial derivative that involves a contractual agreement to buy or sell an
underlying asset at a predetermined price on a specific date in the future. Futures are standardized
contracts that are traded on public exchanges, such as the Chicago Mercantile Exchange (CME) or the
Intercontinental Exchange (ICE).
Key Characteristics of Futures:
1. Standardized Contracts: Futures contracts are standardized, meaning they have specific terms and
conditions, such as the underlying asset, contract size, and settlement date.
2. Publicly Traded:
Futures are traded on public exchanges, providing liquidity and transparency.
3. Mark-to-Market: Futures are marked-to-market, meaning that the value of the contract is adjusted
daily to reflect changes in the underlying asset's price.
4. Settlement: Futures can be settled in cash or through physical delivery of the underlying asset.
Types of Futures:
1. Commodity Futures: Futures contracts based on commodities, such as oil, gold, or agricultural
products.
2. Financial Futures: Futures contracts based on financial instruments, such as stocks, bonds, or
currencies.
3. Index Futures: Futures contracts based on stock market indices, such as the S&P 500 or the Dow
Jones Industrial Average.
4. Currency Futures: Futures contracts based on currencies, allowing investors to speculate on
exchange rate fluctuations.
Advantages of Futures:

6|Page SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

1. Liquidity: Futures are highly liquid, making it easy to buy and sell contracts.
2. Transparency: Futures are traded on public exchanges, providing transparent pricing and market
data.
3. Risk Management: Futures can be used to hedge against potential losses or gains due to price
fluctuations.
4. Speculation: Futures provide a way for investors to speculate on price movements and potentially
profit from them.
Disadvantages of Futures:
1. Leverage: Futures involve leverage, meaning that investors can lose more money than they initially
invested.
2. Volatility: Futures prices can be highly volatile, making it difficult to predict price movements.
3. Margin Calls: Investors may be required to deposit additional funds or sell positions to meet
margin requirements.
4. Counterparty Risk: Although futures are traded on public exchanges, there is still a risk of
counterparty default.
In summary, futures are standardized contracts that involve a contractual agreement to buy or sell an
underlying asset at a predetermined price on a specific date. They offer liquidity, transparency, and risk
management opportunities but also come with leverage, volatility, and counterparty risks.

[6] DIFFERENCE BETWEEN FORWARD AND FUTURE CONTRACT IS AS FOLLOWS:

S. No. Features Forward Futures

1. Trading Forward contracts are traded on Futures Contracts are traded in a
personal basis or on telephone or competitive arena.
otherwise.
2. Size of Forward contracts are Futures contracts are standardized in
Contract individually tailored and have no terms of quantity or amount as the case
standardized size may be
3. Organized Forward contracts are traded in an Futures contracts are traded on organized
exchanges over-the-counter market. exchanges with a designated physical
location.
4. Settlement Forward contracts settlement Futures contracts settlements are made
takes place on the date agreed daily via. Exchange’s clearing house.
upon between the parties.

7|Page SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

 5. Delivery Forward contracts may be Futures contracts delivery dates are fixed
date delivered on the dates agreed on cyclical basis and hardly takes place.
upon and in terms of actual However, it does not mean that there is
delivery. no actual delivery.
6. Transaction Cost of forward contracts is based Futures contracts entail brokerage fees
costs on bid – ask spread. for buy and sell order.
7. Marking to Forward contracts are Futures contracts are subject to marking
market not subject to marking to market to market in which the loss or profit is
debited or credited in the margin account
on daily basis due to change in price.
8. Margins Margins are not required in In futures contracts every participants is
forward contract. subject to maintain margin as decided by
the exchange authorities
9. Credit risk In forward contract, credit risk is In futures contract since the transaction is
born by each party and, therefore, a two way transaction, the parties need
every party has to bother for the not be bothered about the credit risk.
creditworthiness.

[7] OPTION
An option is a financial derivative that gives the holder the right, but not the obligation, to buy or sell
an underlying asset at a predetermined price (strike price) on or before a specific date (expiration
date). Options are traded on public exchanges, such as the Chicago Board Options Exchange (CBOE),
and can be used for various purposes, including speculation, hedging, and income generation.
Types of Options:
1. Call Option: Gives the holder the right to buy an underlying asset at the strike price.
2. Put Option: Gives the holder the right to sell an underlying asset at the strike price.
Options Terminology:
1. Underlying Asset: The asset on which the option is based, such as a stock, commodity, or currency.
2. Strike Price: The predetermined price at which the option can be exercised.
3. Expiration Date: The last day on which the option can be exercised.
4. Premium: The price paid for the option contract.
5. In-the-Money (ITM): An option that has intrinsic value, meaning the underlying asset's price is
favourable to the option holder.
6. Out-of-the-Money (OTM): An option that has no intrinsic value, meaning the underlying asset's
price is not favourable to the option holder.
7. At-the-Money (ATM): An option that has a strike price equal to the current market price of the
underlying asset.
8|Page SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES
Options Strategies:
1. Buying Calls: Betting on a price increase in the underlying asset.
2. Buying Puts: Betting on a price decrease in the underlying asset.
3. Selling Calls: Betting on a price decrease or stability in the underlying asset.
4. Selling Puts: Betting on a price increase or stability in the underlying asset.
5. Spreads: Buying and selling options with different strike prices or expiration dates to profit from
price movements.
6. Iron Condors: Selling calls and puts with different strike prices to profit from time decay and
volatility.
Options Benefits:
1. Flexibility: Options can be used to speculate, hedge, or generate income.
2. Leverage: Options require a lower upfront investment compared to buying the underlying asset.
3. Risk Management: Options can be used to manage risk and protect against potential losses.
Options Risks:
1. Time Decay: Options lose value over time, especially as the expiration date approaches.
2. Volatility: Options are sensitive to changes in volatility, which can affect their value.
3. Liquidity: Options can be illiquid, making it difficult to buy or sell them.
In summary, options are financial derivatives that give the holder the right to buy or sell an underlying
asset at a predetermined price. They offer flexibility, leverage, and risk management opportunities but
also come with unique risks, such as time decay and volatility.

[8] SWAPS AND SWAPTIONS

Swaps and swaptions are financial derivatives used to manage risk, speculate, or invest in various
markets.
Swaps:
A swap is a financial derivative that involves exchanging cash flows based on different underlying
assets, interest rates, or currencies. Swaps are customized contracts between two parties, and they are
not traded on public exchanges.
Types of Swaps:
1. Interest Rate Swap (IRS): Exchanges fixed interest rate payments for floating interest rate
payments, based on a notional principal amount.
2. Currency Swap: Exchanges cash flows in different currencies, based on a fixed exchange rate.
3. Commodity Swap: Exchanges cash flows based on the price of a commodity, such as oil or gold.

9|Page SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

4. Credit Default Swap (CDS): Provides protection against default by a borrower, in exchange for
regular premium payments.
Swaptions:
A swaption is an option to enter into a swap agreement on or before a specific date. Swaptions give
the holder the right, but not the obligation, to enter into a swap with predetermined terms.
Types of Swaptions:
1. Call Swaption: Gives the holder the right to enter into a swap as the fixed-rate payer.
2. Put Swaption: Gives the holder the right to enter into a swap as the fixed-rate receiver.
3. Bermudan Swaption: Can be exercised on specific dates during the term of the option.
4. European Swaption: Can only be exercised on the expiration date.
Benefits of Swaps and Swaptions:
1. Risk Management: Swaps and swaptions can be used to hedge against interest rate, currency, or
commodity price risks.
2. Flexibility: Swaps and swaptions can be customized to meet specific needs and objectives.
3. Speculation: Swaps and swaptions can be used to speculate on market movements and potentially
profit from them.
Risks of Swaps and Swaptions:
1. Counterparty Risk: The risk that the counterparty may default on their obligations.
2. Market Risk: The risk that changes in market conditions may affect the value of the swap or
swaption.
3. Liquidity Risk: The risk that it may be difficult to buy or sell swaps or swaptions.
In summary, swaps and swaptions are financial derivatives used to manage risk, speculate, or invest in
various markets. Swaps involve exchanging cash flows based on different underlying assets, while
swaptions give the holder the right to enter into a swap agreement. Both swaps and swaptions offer
flexibility and risk management opportunities but also come with unique risks, such as counterparty
risk and market risk.
Difference between Swap And Swaptions
1. Obligation: Swaps are binding contracts,
while swaptions give the holder the right, but not the obligation, to enter into a swap.

2. Flexibility: Swaptions offer more flexibility than swaps, as the holder can choose whether to enter
into the underlying swap or not.

3. Risk Management: Swaps are used to hedge against specific risks,

while swaptions are used to hedge against potential changes in market conditions.

4. Premium: Swaptions require the payment of a premium, while swaps do not.

10 | P a g e SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES
5. Expiration: Swaptions have an expiration date, after which the option to enter into the swap
expires. Swaps do not have an expiration date.
In summary, swaps and swaptions are both financial derivatives used for risk management and
speculation. However, swaps are binding contracts that obligate both parties to fulfil their obligations,
while swaptions give the holder the right, but not the obligation, to enter into a swap.

[9] COMMODITY DERIVATIVES

Trading in commodity derivatives first started to protect farmers from the risk of the value of their
crop going below the cost price of their produce. Derivative contracts were offered on various
agricultural products like cotton, rice, coffee, wheat, pepper etc.
Commodity derivatives, which were traditionally developed for risk management purposes, are now
growing in popularity as an investment tool. Most of the trading in the commodity derivatives market
is being done by people who have no need for the commodity itself.
They just speculate on the direction of the price of these commodities, hoping to make money if the
price moves in their favour.
The commodity derivatives market is a direct way to invest in commodities rather than investing in
the companies that trade in those commodities.
Commodity Market
Commodity markets in a crude early form are believed to have originated in Sumer where small
baked clay tokens in the shape of sheep or goats were used in trade. Sealed in clay vessels with a
certain number of such tokens, with that number written on the outside, they represented a promise to
deliver that number.
In modern times, commodity markets represent markets where raw or primary products are
exchanged. These raw commodities are traded on regulated, commodity exchanges in which they are
bought and sold in standardized contracts.
Some of the advantages of commodity markets are:
[1] Most money managers prefer derivatives to tangible commodities;
[2] Less hassle (delivery, etc);
[3] Allows indirect investment in real assets that could provide an additional hedge against inflation
risk.
Commodity Futures
The process of trading commodities is also known as futures trading. Unlike other kinds of
investments, such as stocks and bonds, when you trade futures, you do not actually buy anything or
own anything. You are speculating on the future direction of the price in the commodity you are
trading. This is like a bet on future price direction. The terms "buy" and "sell" merely indicate the
direction you expect future prices will take.

11 | P a g e SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

In addition to agricultural commodities, there are futures for financial instruments and intangibles
such as currencies, bonds and stock market indexes. Each futures market has producers and
consumers who need to hedge their risk from future price changes. The speculators, who do not
actually deal in the physical commodities, are there to provide liquidity. This maintains an orderly
market where price changes from one trade to the next are small.
Rather than taking delivery or making delivery, the speculator merely offsets his position at some
time before the date set for future delivery. If price has moved in the right direction, he will profit. If
not, he will lose.
Commodity Swaps
Producers need to manage their exposure to fluctuations in the prices for their commodities. They are
primarily concerned with fixing prices on contracts to sell their produce. A gold producer wants to
hedge his losses attributable to a fall in the price of gold for his current gold inventory. A cattle farmer
wants to hedge his exposure to changes in the price of his livestock.
End-users need to hedge the prices at which they can purchase these commodities. A university might
want to lock in the price at which it purchases electricity to supply its air conditioning units for the
upcoming summer months. An airline wants to lock in the price of the jet fuel it needs to purchase in
order to satisfy the peak in seasonal demand for travel.
Speculators are funds or individual investors who can either buy or sell commodities by participating
in the global commodities market. While many may argue that their involvement is fundamentally
destabilizing, it is the liquidity they provide in normal markets that facilitates the business of the
producer and of the end-user.
Types of Commodity Swaps
There are two types of commodity swaps: fixed-floating or commodity-for-interest.
(a) Fixed-Floating Swaps: They are just like the fixed-floating swaps in the interest rate swap market
with the exception that both indices are commodity based indices.
(b) Commodity-for-Interest Swaps: They are similar to the equity swap in which a total return on the
commodity in question is exchanged for some money market rate (plus or minus a spread).
Valuing Commodity Swaps
In pricing commodity swaps, we can think of the swap as a strip of forwards, each priced at inception
with zero market value (in a present value sense). Thinking of a swap as a strip of at-the- money
forwards is also a useful intuitive way of interpreting interest rate swaps or equity swaps.
Commodity swaps are characterized by some peculiarities. These include the following factors for
which we must account:
(i) The cost of hedging;
(ii) The institutional structure of the particular commodity market in question;
(iii) The liquidity of the underlying commodity market;
(iv) Seasonality and its effects on the underlying commodity market;

12 | P a g e SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

(v) The variability of the futures bid/offer spread;
(vi) Brokerage fees; and
(vii) Credit risk, capital costs and administrative costs.
Hedging with Commodity Derivatives
Many times when using commodity derivatives to hedge an exposure to a financial price, there is not
one exact contract that can be used to hedge the exposure. If you are trying to hedge the value of a
particular type of a refined chemical derived from crude oil, you m ay not find a listed contract for
that individual product. You will find an over-the-counter price if you are lucky.
They look at the correlation (or the degree to which prices in the individual chemical trade with
respect to some other more liquid object, such as crude oil) for clues as to how to price the OTC
product that they offer you. They make assumptions about the stability of the correlation and its
volatility and they use that to "shade" the price that they show you.
Correlation is an un-hedgeble risk for the OTC market maker, though. There is very little that he can
do if the correlation breaks down.

[10] CREDIT DERIVATIVES

Credit Derivatives is summation of two terms, Credit + Derivatives. As we know that derivative implies
value deriving from an underlying, and this underlying can be anything we discussed earlier
i.e. stock, share, currency, interest etc.
Initially started in 1996, due to the need of the banking institutions to hedge their exposure of lending
portfolios today it is one of the popular structured financial products.
Plainly speaking the financial products are subject to following two types of risks:
Market Risk: Due to adverse movement of the stock market, interest rates and foreign exchange rates.
Credit Risk: Also called counter party or default risk, this risk involves non-fulfilment of obligation by the
counter party.
While, financial derivatives can be used to hedge the market risk, credit derivatives emerged out to
mitigate the credit risk. Accordingly, the credit derivative is a mechanism whereby the risk is transferred
from the risk averse investor to those who wish to assume the risk.
Although there are number of credit derivative products but shall discuss two types of credit Derivatives
‘Collagenised Debt Obligation’ and ‘Credit Default Swap
[A] Collateralized Debt Obligations (CDOS)
While in securitization the securities issued by SPV are backed by the loans and receivables the CDOs are
backed by pool of bonds, asset backed securities, REITs, and other CDOs. Accordingly, it covers both
Collateralized Bond Obligations (CBOs) and Collateralized Loan Obligations (CLOs).
Types of CDOs
13 | P a g e SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES
The various types of CDOs are as follows:
Cash Flow Collateralized Debt Obligations (Cash CDOs): Cash CDO is CDO which is backed by cash
market debt or securities which normally have low risk weight. This structure mainly relies on the
collateral’s risk weight and collateral’s ability to generate sufficient cash to pay off the securities issued by
SPV.
Synthetic Collateralized Debt Obligations: It is similar to Cash Flow CDOs but with the difference that
instead of transferring ownerships of collateral to SPV (a separate legal entity), synthetic CDOs are
structured in such a manner that credit risk is transferred by the originator without actual transfer of assets.
Normally the structure resembles the hedge funds where in the value of portfolio of CDO is dependent
upon the value of collateralized instruments and market value of CDOs depends on the portfolio
manager’s ability to generate adequate cash and meeting the cash flow obligations (principal and interest)
in timely manner.
While in cash CDO the collateral assets are moved away from Balance Sheet, in synthetic CDO there is
no actual transfer of assets instead economic effect is transferred.
This effect of transfer economic risk is achieved by creating provision for Credit Default Swap (CDS) or
by issue of Credit Linked Notes (CLN), a form of liability.
Accordingly, this structure is mainly used to hedge the risk rather than balance sheet funding. Further, for
banks, this structure also allows the customer’s relations to be unaffected. This was started mainly by
banks who want to hedge the credit risk but not interested in taking administrative burden of sale of assets
through securitization.
Technically, speaking synthetic CDO obtain regulatory capital relief benefits vis-à-vis cash CDOs.
Further, they are more popular in European market due to the reason of less legal documentation
requirements. Synthetic CDOs can also be categorized as follows:
Unfunded: - It will be comprised only CDs.
Fully Funded: - It will be through issue of Credit Linked Notes (CLN).
Partially Funded: - It will be partially through issue of CLN and partially through CDs
Arbitrage CDOs: Basically, in Arbitrage CDOs, the issuer captures the spread between the return
realized collateral underlying the CDO and cost of borrowing to purchase these collaterals. In addition to
this issuer also collects the fee for the management of CDOs. This arbitrage arises due to acquisition of
relatively high yielding securities with large spread from open market.
Risks involved in CDOs
The main types of risk associated with investment in CDOs are as follows:
[1] Default Risk: - Also called ‘credit risk’, it emanates from the default of underlying party to the
instruments. The prime sufferers of these types of risks are equity or junior tranche in the waterfall.
[2] Interest Rate Risk: - Also called Basis risk and mainly arises due to different basis of interest rates. For
example, asset may be based on floating interest rate but the liability may be based on fixed interest rates.
Though this type of risk is quite difficult to manage fully but commonly used techniques such as swaps,
caps, floors, collars etc. can be used to mitigate the interest rate risk.
14 | P a g e SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES
[3] Liquidity Risk: - Another major type of risk by which CDOs are affected is liquidity risks as there may
be mismatch in coupon receipts and payments.
[4] Prepayment Risk: - This risk results from unscheduled or unexpected repayment of principal amount
underlying the security. Generally, this risk arises in case assets are subject to fixed rate of interest and the
debtors have a call option. Since, in case of falling interest rates they may pay back the money.
[5] Reinvestment Risk: - This risk is generic in nature as the CDO manager may not find adequate
opportunity to reinvest the proceeds when allowed for substitutions.
[6] Foreign Exchange Risk: - Sometimes CDOs are comprised of debts and loans from countries other
than the country of issue. In such a case, in addition to above mentioned risks, CDOs are also subject to
the foreign exchange rate risk.
[B] Credit Default Swaps (CDSs)
It is a combination of following 3 words:
Credit : Loan given
Default : Non payment
Swap : Exchange of Liability or Risk
Accordingly, CDS can be defined as an insurance (not in stricter sense) against the risk of default on a
debt which may be debentures, bonds etc
Under this arrangement, one party (called buyer) needing protection against the default pays a periodic premium to
another party (called seller), who in turn assumes the default risk. Hence, in case default takes place then there will
be settlement and in case no default takes place no cash flow will accrue to the buyer alike option contract and
agreement is terminated. Although it resembles the options but since element of choice is not there it more
resembles the swap arrangements.
Amount of premium mainly depends on the price of underlying and especially when the credit risk is more.
Main Features of CDS
The main features of CDS are as follows:
CDS is a non-standardized private contract between the buyer and seller. Therefore, it is covered in the category of
Forward Contracts.
They are normally not traded on any exchange and hence remains free from the regulations of Governing Body.
The International Swap and Derivative Association (ISAD) publishes the guidelines and general rules used
normally to carry out CDS contracts.
CDS can be purchased from third party to protect itself from default of borrowers.
Similarly, an individual investor who is buying bonds from a company can purchase CDS to protect his investment
from insolvency of that company. Thus, this increases the level of confidence of investor in Bonds purchased.
The cost or premium of CDS has a positive relationship with risk attached with loans. Therefore, higher the risk
attached to Bonds or loans, higher will be premium or cost of CDS.
If an investor buys a CDS without being exposed to credit risk of the underlying bond issuer, it is called “naked
CDS”.
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Uses of Credit Default Swap
Following are the main purposes for which CDS can be used:
Hedging- Main purpose of using CDS is to neutralize or reduce a risk to which CDS is exposed to. Thus, by buying
CDS, risk can be passed on to CDS seller or writer.
Arbitrage- It involves buying a CDS and entering into an asset swap. For example, a fixed coupon payment of a
bond is swapped against a floating interest stream.
Speculation- CDS can also be used to make profit by exploiting price changes. For example, a CDS writer assumed
risk of default, will gain from contract if credit risk does not materialize during the tenure of contract or if
compensation received exceeds potential payout
[11] WEATHER DERIVATIVES
While there are some companies whose performance are completely unaffected by weather but there are
many companies whose performance is liable to be adversely affected by the weather. For example, airline
companies, juice manufacturing companies etc. Especially farmers are highly exposed to weather. To
hedge this risk, instruments are required like instruments are used to hedge foreign exchange and other
financial risks. This led to rise of a new class of financial instruments - Weather Derivatives- has been
introduced to enable businesses to manage their volumetric risk resulting from unfavourable weather
patterns. Just as traditional contingent claims, whose payoffs depend upon the price of some fundamental,
a weather derivative has its underlying “asset”, a weather measure. “Weather”, of course, has several
dimensions: rainfall, temperature, humidity, wind speed, etc. There is a fundamental difference between
weather and traditional derivative contracts concerning the hedge objective. The underlying of weather
derivatives is represented by a weather measure, which influences the trading volume of goods. This, in
turn, means that the primary objective of weather derivatives is to hedge volume risk, rather than price
risk, that results from a change in the demand for goods due to a change in weather.
Weather derivatives represent an alternative tool to the usual insurance contract by which firms and
individuals can protect themselves against losing out because of unforeseen weather events. Many factors
differentiate weather derivatives from insurance contracts. The main difference is due to the type of
coverage provided by the two instruments. Insurance provides protection to extreme, low probability
weather events, such as earthquakes, hurricanes and floods, etc. Instead, derivatives can also be used to
protect the holder from all types of risks, including uncertainty in normal conditions that are much more
likely to occur. This is very important for industries closely related to weather conditions for which less
dramatic events can also generate huge losses.
The first weather transaction was executed in 1997 in the Over the Counter (OTC) market by Aquila
Energy Company. The market was jump started during the warm Midwest/Northeast El Nino winter of
1997-1998, when the unusual higher temperatures induced companies to protect themselves from
significant earnings decline. Since then, the market has rapidly expanded.
Like other derivatives a Weather derivative is a contract between a buyer and a seller wherein the seller of
a weather derivative receives a premium from a buyer with the understanding that the seller will provide a
monetary amount in case the buyer suffers any financial loss due to adverse weather conditions. In case no
adverse weather condition occurs, then the seller makes a profit through the premium received.
Pricing a weather derivative is quite challenging as it cannot be stored and following issues are involved: -

16 | P a g e SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

Data: - The reliability of data is a big challenge as the availability of data quite differs from one country to
another and even agency to agency within a country.
Forecasting of weather: - Though various models can be used to make short term and long- term
predictions about evolving weather conditions but it is difficult to predict the future weather behaviour as
it is governed by various dynamic factors. Generally, forecasts address seasonal levels but not the daily
levels of temperature.
Temperature Modelling: - Temperature is one of the important underlying for weather derivatives. The
temperature normally remains quite constant across different months in a year. Hence, there is no such
Model that can claim perfection and universality
[12] LESSONS TO BE SAFE FROM DERIVATIVE MISHAPS
Following are some of the important lessons can be learnt to be safe from Derivative Mishaps.
[1] Don’t buy any derivative product that you don’t understand
This is an important lesson for non-financial corporation not to undertake a trade or derivative product
that they do not understand. As apparent in above mentioned case of Orange County, treasurer Robert
Citron speculated on derivative instruments even though he has no financial background. Similar things
happened in BT’s case where both P&G and Gibson Greetings were misguided.
The best way to avoid such loss is to value the instrument in house because outside persons can misguide
the corporation about the potential dangers.
[2] Due diligence before making Treasury Department as a Profit Centre
Though the main objective of establishing a Treasury Department is to reduce financing costs and manage
risk optimally. But it has been seen that though initially Treasury Department made limited profits from
treasury activities later started taking more risks in anticipation of higher profit. As mentioned in case
study of Orange County the treasurer Citron with initial profit from yield curve play strategy leveraged its
position and led to bankruptcy. The best way to avoid this situation is to avoid linking the treasurer’s
salary with the profit he made for the organization.
[3] Specify the Risk Limits
Proper monitoring is prerequisite for the trader to ensure that he/she should switch from arbitrageur to
speculator. Above mentioned Baring Bank’s case is a leading example for the bankruptcy of same bank as
his positions remained unmonitored and unquestionable by the management.
The best way to avoid the situation of overtrading is to limit the sizes positions that can be taken by a
trader, and it should be accurately reported from risk perspective. The management should ensure that the
limits specified should be strictly obeyed and even daily reports of various positions taken by each trader
(though a star performer) should be obtained and scrutinized before the things goes out of control.
[4] Separation of Front, Middle and Back Offices
The three offices though are interlinked but they discharge separate functions. Accordingly, there should
be a firewall in the functioning of these offices i.e. person of one office should not have the access to the
functioning of other office. Barings bank’s case is a classic example where Nick Leeson carried out
manipulations in back office (which was under his control also) and hid the losses in error account.

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To ensure that these three offices work independently it is essential that role and functions of each office
should be clearly defined and followed.
[5] Ensure that a hedger should not become a speculator
In most of the cases discussed above hedgers/arbitrageur have become speculators and leveraged their
position.
To avoid this situation, it is essential that clear cut risk limits should be defined. Further before entering
into any trading strategy proper risk analysis should be carried out and if proposed strategy is crossing the
limits of Risk Appetite of the company it should be avoided.
[6] Carry out Stress Test, Scenario Analysis etc.
As mentioned in above case of BT where Gibson Greetings was of belief that the interest rates shall
remain lower and to some extent ignored the possibility of increasing of interest rates by 1%. But it
happened and ultimately Gibson Greetings faced a huge loss.
To counter this type of unpredictable situation it is necessary that VAR analysis should always be followed
by Scenario Analysis because as tendency a human being normally can anticipate two to three scenarios.
It will be better to refer the data of at least 10 to 20 years to anticipate a Black Swan event. Further even
Simulation Test can be applied to analyze the results in various possible situations.

[13] SECTION A : THEORY QUESTIONS

[1] State any SIX Important terms used in derivatives.

[2] Discuss Forward and Futures for Financial derivatives.
[3] State the difference between Forward & Futures
[4] Elaborate how Options used in Financial derivatives.
[5] Differentiate Swap and Swaption in Financial derivatives..
[6] Explain advantage and disadvantage of Forwards
[7] Discuss options Strategies in financial derivatives.
[8] Explain in detail Commodity Derivatives.
[9] Write a Note on Weather Derivatives
[10] Discuss the lessons to remember to be safe from derivates mishaps.

[14] SECTION B : MULTIPALE CHOICE QUESTIONS

[1] The payoffs for financial derivatives are linked to
[A] securities that will be issued in the future. [B] the volatility of interest rates.
[C] previously issued securities. [D] government regulations specifying allowable rates of return.

[2] Financial derivatives include

[A] stocks [B] bonds. [C] futures. [D] Cash

[3] Financial derivatives include

[A] stocks. [B] bonds. [C] forward contracts. [D] both [A] and [B] are true.

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[4] Which of the following is not a financial derivative?
[A] Stock [B] Futures [C] Options [D] Forward contracts

[5] By hedging a portfolio, a bank manager

[A] reduces interest rate risk. [B] increases reinvestment risk.
[C] increases exchange rate risk. [D] increases the probability of gains.

[6] Which of the following is a reason to hedge a portfolio?

[A] To increase the probability of gains. [B] To limit exposure to risk.
[C] To profit from capital gains when interest rates fall. [D] All of the above.

[7] Hedging risk for a long position is accomplished by

[A] taking another long position. [B] taking a short position. [C] taking a neutral position.
[D] asking additional long and short positions in equal amounts.

[8] Hedging risk for a short position is accomplished by

[A] taking a long position. [B] taking another short position. [C] taking a neutral position.
[D] taking additional long and short positions in equal amounts.

[9] A contract that requires the investor to buy securities on a future date is called a
[A] short contract. [B] long contract. [C] hedge. [D] cross.

[10] A long contract requires that the investor

[A] sell securities in the future. [B] buy securities in the future.
[C] hedge in the future. [D] close out his position in the future.

[11] A person who agrees to buy an asset at a future date has gone
[A] long. [B] short. [C] back. [D] ahead.

[12] A short contract requires that the investor

[A] sell securities in the future. [B] buy securities in the future.
[C] hedge in the future. [D] close out his position in the future.

[13] A contract that requires the investor to sell securities on a future date is called a
[A] short contract. [B] long contract.
[C] hedge. [D] micro hedge.

[14] If a bank manager chooses to hedge his portfolio of treasury securities by selling
futures contracts, he
[A] gives up the opportunity for gains. [B] removes the chance of loss.
[C] increases the probability of a gain. [D] both [A] and [B] are true.

[15] To say that the forward market lacks liquidity means that
[A] forward contracts usually result in losses. [B] forward contracts cannot be turned into cash.
[C] it may be difficult to make the transaction. [D] forward contracts cannot be sold for cash.

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[16] A disadvantage of a forward contract is that
[A] it may be difficult to locate a counterparty. [B] the forward market suffers from lack of liquidity.
[C] these contracts have default risk. [D] all of the above.

[17] Forward contracts are risky because they

[A] are subject to lack of liquidity [B] are subject to default risk.
[C] hedge a portfolio. [D] both [A] and [B] are true.

[18] The advantage of forward contracts over future contracts is that they
[A] are standardized. [B] have lower default risk.
[C] are more liquid. [D] none of the above.
[19] The advantage of forward contracts over futures contracts is that they
[A] are standardized. [B] have lower default risk.
[C] are more flexible. [D] both [A] and [B] are true.

[20] Forward contracts are of limited usefulness to financial institutions because

[A] of default risk. [B] it is impossible to hedge risk.
[C] of lack of liquidity. [D] both [A] and [C] of the above.

[21] Futures contracts are regularly traded on the

[A] Chicago Board of Trade. [B] New York Stock Exchange.
[C] American Stock Exchange. [D] Chicago Board of Options Exchange.

[22] Hedging in the futures market

[A] eliminates the opportunity for gains. [B] eliminates the opportunity for losses.
[C] increases the earnings potential of the portfolio. [D] both [A] and [B] of the above.

[23] When interest rates fall, a bank that perfectly hedges its portfolio of Treasury securities in the
futures market
[A] suffers a loss. [B] experiences a gain.
[C] has no change in its income. [D] none of the above.

[24] Futures markets have grown rapidly because futures

[A] are standardized. [B] have lower default risk.
[C] are liquid. [D] all of the above.

[25] On the expiration date of a futures contract, the price of the contract
[A] always equals the purchase price of the contract.
[B] always equals the average price over the life of the contract.
[C] always equals the price of the underlying asset.
[D] always equals the average of the purchase price and the price of underlying asset.

[26] The price of a futures contract at the expiration date of the contract
[A] equals the price of the underlying asset. [B] equals the price of the counterparty.
[C] equals the hedge position. [D] equals the value of the hedged asset.

20 | P a g e SEM 6 SFM UNIT 6 FINANCIAL DERIVATIVES

[27] Elimination of riskless profit opportunities in the futures market is
[A] hedging. [B] arbitrage.
[C] speculation. [D] underwriting.

[28] If you sold a short contract on financial futures you hope interest rates
[A] rise. [B] fall. [C] are stable. [D] fluctuate.

[29] If you sold a short futures contract you will hope that interest rates
[A] rise. [B] fall. [C] are stable. [D] fluctuate.

[30] If you bought a long contract on financial futures you hope that interest rates
[A] rise. [B] fall. [C] are stable. [D] fluctuate.

[31] If you bought a long futures contract you hope that bond prices
[A] rise. [B] fall. [C] are stable. [D] fluctuate.

[32] If you sold a short futures contract you will hope that bond prices
[A] rise. [B] fall. [C] are stable. [D] fluctuate.

[33] To hedge the interest rate risk on $4 million of Treasury bonds with $100,000 futures
contracts, you would need to purchase
[A] 4 contracts. [B] 20 contracts. [C] 25 contracts. [D] 40 contracts.

[34] Assume you are holding Treasury securities and have sold futures to hedge against interest rate
risk. If interest rates rise
[A] the increase in the value of the securities equals the decrease in the value of the futures
contracts.
[B] the decrease in the value of the securities equals the increase in the value of the futures
contracts.
[C] the increase ion the value of the securities exceeds the decrease in the values of the futures
contracts.
[D] both the securities and the futures contracts increase in value.

[35] Assume you are holding Treasury securities and have sold futures to hedge against interest rate
risk. If interest rates fall
[A] the increase in the value of the securities equals the decrease in the value of the futures
contracts.
[B] the decrease in the value of the securities equals the increase in the value of the futures
contracts.
[C] the increase in the value of the securities exceeds the decrease in the values of the futures
contracts.
[D] both the securities and the futures contracts increase in value.

[36] When a financial institution hedges the interest-rate risk for a specific asset, the hedge is
called a
[A] macro hedge. [B] micro hedge. [C] cross hedge. [D] futures hedge.

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[37] When the financial institution is hedging interest-rate risk on its overall portfolio, then the
hedge is a
[A] macro hedge. [B] micro hedge. [C] cross hedge. [D] futures hedge.

[38] The number of futures contracts outstanding is called

[A] liquidity. [B] volume. [C] float. [D]open interest.

[39] Which of the following features of futures contracts were not designed to increase liquidity?
[A] Standardized contracts [B] Traded up until maturity
[C] Not tied to one specific type of bond [D] Marked to market daily

[40] Which of the following features of futures contracts were not designed to increase liquidity?
[A] Standardized contracts [B] Traded up until maturity
[C] Not tied to one specific type of bond [D] Can be closed with off setting trade

[41] Futures differ from forwards because they are

[A] used to hedge portfolios. [B] used to hedge individual securities.
[C] used in both financial and foreign exchange markets. [D] a standardized contract.

[42] Futures differ from forwards because they are

[A] used to hedge portfolios. [B] used to hedge individual securities.
[C] used in both financial and foreign exchange markets. [D] marked to market daily.

[43] The advantage of futures contracts relative to forward contracts is that futures contracts
[A] are standardized, making it easier to match parties, thereby increasing liquidity.
[B] specify that more than one bond is eligible for delivery, making it harder for someone to corner
the market and squeeze traders.
[C] cannot be traded prior to the delivery date, thereby increasing market liquidity.
[D] both [A] and [B] of the above.

[44] If a firm is due to be paid in deutsche marks in two months, to hedge against exchange rate risk
the firm should
[A] sell foreign exchange futures short. [B] buy foreign exchange futures long.
[C] stay out of the exchange futures market. [D] none of the above.

[45] If a firm must pay for goods it has ordered with foreign currency, it can hedge its foreign
exchange rate risk by
[A] selling foreign exchange futures short. [B] buying foreign exchange futures long.
[C] staying out of the exchange futures market. [D] none of the above.

[46] If a firm is due to be paid in deutsche marks in two months, to hedge against exchange rate
risk the firm should foreign exchange futures .
[A] sell; short [B] buy; long
[C] sell; long [D] buy; short

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[47]If a firm must pay for goods it has ordered with foreign currency, it can hedge its foreign
exchange rate risk by foreign exchange futures .
[A] selling; short [B] buying; long
[C] buying; short [D] selling; long

[48] Options are contracts that give the purchasers the

[A] option to buy or sell an underlying asset. [B] the obligation to buy or sell an underlying asset.
[C] the right to hold an underlying asset. [D] the right to switch payment streams.

[49]The price specified on an option that the holder can buy or sell the underlying asset is called the
[A] premium. [B] call. [C] strike price. [D] put.

[50] The price specified on an option that the holder can buy or sell the underlying asset is called the
[A] premium. [B] strike price.
[C] exercise price. [D] both [B] and [C] are true.

[51] The seller of an option has the

[A] right to buy or sell the underlying asset. [B] the obligation to buy or sell the underlying asset.
[C] ability to reduce transaction risk. [D] right to exchange one payment stream for another.

[52] The seller of an option is to buy or sell the underlying asset while the purchaser of an
option has the to buy or sell the asset.
[A] obligated; right [B] right; obligation
[C] obligated; obligation [D] right; right

[53] The amount paid for an option is the

[A] strike price. [B] premium.
[C] discount. [D] commission.

[54] An option that can be exercised at any time up to maturity is called a(n)
[A] swap. [B] stock option.
[C] European option. [D] American option.

[55] An option that can only be exercised at maturity is called a(n)

[A] swap. [B] stock option.
[C] European option. [D] American option.

[56] Options on individual stocks are referred to as

[A] stock options. [B] futures options
[C] American options. [D] individual options.

[57] Options on futures contracts are referred to as

[A] stock options. [B] futures options.
[C] American options. [D] individual options.

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[58] An option that gives the owner the right to buy a financial instrument at the exercise price
within a specified period of time is a
[A] call option. [B] put option. [C] American option. [D] European option.

[59] A call option gives the owner

[A] the right to sell the underlying security. [B] the obligation to sell the underlying security.
[C] the right to buy the underlying security. [D] the obligation to buy the underlying security.

[60] A call option gives the seller

[A] the right to sell the underlying security. [B] the obligation to sell the underlying security.
[C] the right to buy the underlying security. [D] the obligation to buy the underlying security.

[61] An option allowing the holder to buy an asset in the future is a

[A] put option. [B] call option. [C] swap. [D] premium.

[62] An option that gives the owner the right to sell a financial instrument at the exercise price
within a specified period of time is a
[A] call option. [B] put option. [C] American option. [D] European option.

[63] A put option gives the owner

[A] the right to sell the underlying security. [B] the obligation to sell the underlying security.
[C] the right to buy the underlying security. [D] the obligation to buy the underlying security.

[64] A put option gives the seller

[A] the right to sell the underlying security. [B] the obligation to sell the underlying security.
[C] the right to buy the underlying security. [D] the obligation to buy the underlying security.

[65] An option allowing the owner to sell an asset at a future date is a

[A] put option. [B] call option. [C] swap. [D] forward contract.

[66] If you buy a call option on treasury futures at 115, and at expiration the market price is 110,
[A] the call will be exercised. [B] the put will be exercised.
[C] the call will not be exercised. [D] the put will not be exercised.

[67] If you buy a call option on treasury futures at 110, and at expiration the market price is 115,
[A] the call will be exercised. [B] the put will be exercised.
[C] the call will not be exercised. [D] the put will not be exercised.

[68] If you buy a put option on treasury futures at 115, and at expiration the market price is 110,
[A] the call will be exercised. [B] the put will be exercised.
[C] the call will not be exercised. [D] the put will not be exercised.

[69] If you buy a put option on treasury futures at 110, and at expiration the market price is 115,
[A] the call will be exercised. [B] the put will be exercised.
[C] the call will not be exercised. [D] the put will not be exercised.

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[70] The main advantage of using options on futures contracts rather than the futures
contracts themselves is that
[A] interest rate risk is controlled while preserving the possibility of gains.
[B] interest rate risk is controlled, while removing the possibility of losses.
[C] interest rate risk is not controlled, but the possibility of gains is preserved.
[D] interest rate risk is not controlled, but the possibility of gains is lost.

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Above work is a compilation form various Reference Books on Financial Management ,Online
sources/Websites/Journals and Study Materials prepared by Professional Exam conducting
Institutes.
List of References :
AUTHOR/ STUDY MATERIAL SOURCE PUBLICATION
STUDY MATERIAL OF ICAI ICAI
OPTIONS, FUTURES, AND OTHER DERIVATIVES JOHN C. HULL

COMMERCIAL LAW PUBLISHERS CA G. SEKAR

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