Capital Investment and Financing Decisions
MS 42 Solved Free Assignment 2022
MS 42 Free Solved Assignment July & Jan 2022
Q1- What do you understand by Cost of Capital? How is Cost of Capital of individual components computed?
Ans- Cost of Capital – Cost of capital is a company’s calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project, such as building a new factory.
The term cost of capital is used by analysts and investors, but it is always an evaluation of whether a projected decision can be justified by its cost.
Investors may also use the term to refer to an evaluation of an investment’s potential return in relation to its cost and its risks.
Many companies use a combination of debt and equity to finance business expansion. For such companies, the overall cost of capital is derived from the weighted average cost of all capital sources.MS 42 Solved Free Assignment 2022
This is known as the weighted average cost of capital (WACC).
The Cost of Capital is an important financial concept. It links the company’s long-term financial decisions with the shareholders’ value as determined in the market place.
Two basic conditions must be fulfilled so that the company’s cost of capital can be used to evaluate new investment Cost of Capital of individual components computed- Computation of cost of capital from individual sources of funds helps in determining the overall cost of capital for the firm.
There are four basic sources of long-term funds for a business firm
1– Long-term Debt and Debentures,
2– Preference Share Capital,
3– Equity Share Capital,
4– Retained Earning MS 42 Free Solved Assignment
Though all of these sources may not be tapped by the firm for funding its activities, each firm will have some of these sources in its capital structure.
The specific cost of each source of funds is the after-tax cost of financing.
The procedure for determining the costs of debt, preference and equity capital as well as retained earnings is discussed in the following sub-sections.
1 – Cost of Long-Term Debt MS 42 Solved Free Assignment 2022
Cost of long-term debt represents the minimum rate of return that must be earned on debt financed investments if the firm’s value is to remain intact. Long-term debt may be issued at par, at premium or discount.
It may be perpetual or redeemable. The technique of computation of cost in each case has been explained in the following paragraphs.
(a) The formula for computing the Cost of Long-term debt at par is
Kd = (1 – T) R
K = Cost of Long-Term Debt
T – Marginal Tax Rate
R – Debenture Interest Rate
Example, if a company has issued 10% debentures and the tax rate is 60, the cost of debt will be
(1-6) 10 – 4%
(b) In case the debentures are issued at premium or discount, the cost of the
debt should be calculated on the basis of net proceeds realized. The formula will be as follows. MS 42 Solved Free Assignment 2022
Kd = Cost of debt after tax
I = Annual Interest Payment
Np = Net Proceeds of Loans MS 42 Free Solved Assignment
T = Tax Rate
Example, a company issues 10% irredeemable debentures of Rs. 1,00,000. The company is in 60% tax bracket.
(2- Cost of Preference Capital Cost of preference share capital represents the rate of return that must be earned on preferred stocks financed investments to keep the earnings available to residual stockholders unchanged.
Cost of preference shares can be estimated by dividing the dividend stipulated per share by the current market price of the share.
Cost of Preference Capital = Dividend
Face Value – Issue Cost
Example, A Company is planning to issue 9% preference shares expected to sell at Rs. 85 par value. The costs of issuing and selling the shares are expected to be Rs. 3 per share.
The first step in finding out the cost of the preference capital is to determine the rupee amount of preference dividends, which are stated as 9% of the share of Rs. 85 par value.
Thus 9% of Rs. 85 is Rs. 7.65. MS 42 Solved Free Assignment 2022
After deducting the floatation costs. the net proceeds are Rs. 82 per share.
(3–Cost of Equity Capital :- “Cost of equity capital is the cost of the estimated stream of net capital outlays desired from equity sources” E.W. Walker.
According to James C. Van Horne, cost of equity capital can be thought of as the rate of discount that equates the present value of all expected future dividends per share, as perceived by investors at the margin as in the current market price per share n a nutshell,
it is the discount rate which equates present value of all expected dividends in future with net proceeds per share/current market price.
It represents the minimum rate of return that must be earned on new equity stock financed investment in order to keep the earnings available to the existing residual owners of the firms unchanged. MS 42 Solved Free Assignment 2022
Cost of equity capital is by for the most difficult to measure because of the following reasons:
i) The cost of equity is not the out of pocket cost of using equity capital.
ii) The cost of equity is based upon the stream of future dividends as
expected by shareholders (very difficult to estimate).
iii) The relationship between market price with earnings is known. Dividends
also affect the market value (which one is to be considered).
The following are the approaches to computation of cost of equity capital:
(a) E/P Ratio Method : Cost of equity capital is measured by earning price ratio. Symbolically,
Eo (current earnings per share)
Po (current market price per share)
The limitation of this method are:
Earnings do not represent real expectations of shareholders.
Earnings per share is not constant.
Which earnings-current earnings or average earnings (Not clear).
The method is useful in the following circumstance:
The firm does not have debt capital.
All the earnings are paid to the shareholders.
There is no growth in earnings
(b) E/P Ratio + Growth Rate Method : This method considers growth in
earnings. A period of 3 years is usually being taken into account for growth. The formula will be as follows MS 42 Solved Free Assignment 2022
Eo (1+b)3 Ро
Where (1+b) – Growth factor, where b is the growth rate as a percentage and estimated for a period of three years.
Example. A firm has Rs. 5 EPS with 10% growth rate of earnings over a period of 3 years. The current market price of equity share is Rs. 50.
Rs.5 (1 +.10)3x 100
Rs.5(1.331)x100 = 6.665 x 100
4–Cost of Retained Earnings: Corporate managers and some analysts normally consider the funds retained in the firm as cost free funds because it does not cost anything to the firm to make use of a part of its earnings not distributed to the shareholders. However, this is not true. MS 42 Solved Free Assignment 2022
It definitely cost the shareholders something and this is an opportunity cost representing sacrifice of the dividend income which the shareholders would have otherwise received it and invested the same elsewhere to earn a return thereon.
Thus, the minimum cost of retained earnings is the cost of equity capital (Ke).
Ezra Solomon suggested the concept of external yield to measure cost of retained earnings.
Ezra Solomon suggested the concept of external yield to measure cost of retained earnings.
Algebraically, the approach can be explained as:
(D1 + G) (1 - TR)(1-B) PO = Ke (1-TR) (1-B)
Ke = Cost of equity capital based on dividend growth method
TR = Shareholders’ Tax Rate
B = Percentage Brokerage cost
Example A firm’s cost of equity capital is 12% and Tax rate of majority of shareholders is 30%. Brokerage is 3%.
= 12% (1-0.30) (1-0.03) = 8.15% MS 42 Free Solved Assignment
Q2- Explain the nature of a project and discuss the ‘Project Life Cycle’?
Ans- NATURE OF A PROJECT – The term ‘project’ has a wider meaning to include a set of activities. For example, construction of a house is a project.
It includes many activities like digging of foundation pits, construction of foundations, construction of walls, construction of roof, fixing of doors and windows, fixing of sanitary fitting, wiring etc. MS 42 Solved Free Assignment 2022
Further, project is the non-routine nature of activities.
In fact, a project is an organized programme of pre-determined group of activities that are nonroutine in nature and that must be completed within the given time limit.
It is a non-routine, nonrepetitive, one-off undertaking, normally with discrete time, financial and technical performance goals.
THE PROJECT LIFE CYCLE
Most projects go through similar stages on the path from origin to completion. We define these stages, as shown in Figure 4.1, as the project’s life cycle.
The projec is born (its start-up phase) and a manager is selected, the project team and initial resources are assembled, and the work program is organized.
The work gets under way and momentum quickly builds. Progress is made. This continues until the end is in sight.MS 42 Solved Free Assignment 2022
But completing the final tasks seems to take an inordinate amount of time, partly because there are often a number of parts that must come together and partly because team members “drag their feet” for various reasons and avoid the final steps
The pattern of slow-rapid-slow progress toward the project goal is common. Anyone who has watched the construction of a home or building has observed this phenomenon.
For the most part, it is a result of the changing levels of resources used during the successive stages of the life cycle.
Figure 4.2 depicts project effort, usually in terms of man-hours or resouces expended per unit of time (or number of people working on the project) plotted against time, where time is broken up into the several phases of project life.
Minimal effort is required at the beginning-when the project concept is being developed and is being subjected to project selection processes.
If this hurdle is passed, activity rate increases as planning is done, and the real work of the project gets under way. MS 42 Solved Free Assignment 2022
This rises to a peak and then begins to taper off as the poject nears completion, finally ceasing when evaluation is complete and the project is terminated.
In some cases, the effort may never fall to zero because the project team, or at least a cadre group, may be maintained for the next appropriate project that comes along. The new project will then emerge.
The ever-present goals of performance, time, and cost are the major considerations throughout the project’s life cycle. MS 42 Free Solved Assignment
Early in the life cycle, performance takes precedence. Team members focus on how to achieve the project’s performance goals.
We refer to the specific methods adopted to reach these goals as the project’s technology because these methods require the application of a science or art.
Fig- Time distribution of project effort When the major “how” problems are solved, project workers sometimes get preoccupied with improving performance, often beyond the levels required by the original specifications.
This search for additional performance delays the schedule and pushes up the costs.
The middle stages of the life cycle are typified by a growing concern with cost control.
During the latter stages of the life cycle, focus of attention is on time.
With projects nearing completion, there tends to be more flexibility in cost and efforts are directed towards bringing things into conformity with the approved schedule-as much as possible, even if it means cost penalties.
It would be a great source of comfort if one could predict with certainty, at the start of a project, how the performance time, and cost goals would be met.
In a few cases, for example routine construction projects, we can generate reasonably accurate predictions, but often we cannot.
Q3- What is ‘Cost Benefit Analysis’? How are the results of cost benefit analysis used for project choice.’?
Ans- ‘Cost Benefit Analysis’- Another aspect of economic appraisal is social cost-benefit analysis. MS 42 Solved Free Assignment 2022
Cost benefit analysis is concerned with the examination of a project from the viewpoint of maximization of net social benefit. MS 42 Free Solved Assignment
While cost-benefit analysis originated to evaluate public investment, it is also used in project appraisal.
Earlier, project appraisal covered only private costs and benefits, at present, social costs and benefits are also reckoned.
Cost-benefit appraisal of a project proposes to describe and quantify the social advantages and disadvantages of a policy in terms of a common monetary unit.
An enterprise or project adopting cost benefit analysis approach has, as its objective function, net benefits to society whereas the objective function of a private project is net private benefit or profit. MS 42 Solved Free Assignment 2022
Net social benefit entails that gains and losses be valued in a common unit. The unit should reflect society’s strength of preference for each outcome.
The economist uses as a measure of this preference, the consumer’s willingness to pay (WTP) for a good.
This will be reflected in the price he pays, though not fully. In many cases the prices are not observable or are distorted. MS 42 Free Solved Assignment
In these circumstances cost-benefit analysis must seek surrogate prices or shadow prices to measure what the society would be willing to pay if there is a market? Net social benefits are found by deducting from benefits (WTP) compensation required (cost).
Social costs and benefits and private costs and benefits differ because of market imperfections, externalities and income distribution.
Market Imperfections Private costs and profits reflect social costs and benefits only under perfect competition. MS 42 Solved Free Assignment 2022
Since markets were largely regulated and prices were administered earlier in our country, resources used by private sector were underpriced.
The recent phenomenon of deregulation, which has freed several resources prices from control, may lead in future to near approximation of conditions in perfect competition.
For instance, foreign exchange rate is now determined by markets. Since 1991, the interest on debentures is not fixed by government.
In several markets regulation and administrated prices are being lifted Externalities The difference between private costs and benefits and social costs and benefits arises mainly because of economic effects a transaction has on third parties.
The effects may be benefits or costs. MS 42 Free Solved Assignment
A project, for instance, when it creates infrastructural facilities like roads, the area adjacent may be benefited. Such benefits are, however, not included in assessing the benefits arising out of the project. MS 42 Solved Free Assignment 2022
Actually, such benefits are invariably underprovided and subsidies may have to be paid to ensure their provision.
On the other hand, a project may have harmful environmental effects. Such costs are not internalized and not paid for by consumers or producer.
As a result, costs are imposed on society, which are not accounted for. The activity in question may also be over-extended.
The problem of externalities relating to environmental effects received impetus from the thesis propounded by World Bank that prudent environmental policies may often make poor countries less poor. MS 42 Solved Free Assignment 2022
Not only is sound environmental policy essential for durable development but many of the policies that improve the environment will also strengthen development.
They are also powerfully re-distributive since it is often the poor that suffer from environmental degradation Redistribution Strictly from the viewpoint of the promoter or owner,
it is of no consequence as to how the project’s benefits are distributed among society.
But to society or government, it is essential to have information as to who benefits from the investment in various projects. MS 42 Free Solved Assignment
For instance, industrial projects are put forward and promoted whether in private or public sector to alleviate poverty and improve income distribution.
All our five-year plans have poverty alleviation as their basic objective.
It is, however, not appreciated that the provision of opportunities through industrial projects cannot be availed of by the poor.
The poor are unskilled and illiterate and do not have the skills that factory type of employment demands.MS 42 Solved Free Assignment 2022
To benefit the poor, emphasis should be on provision of opportunities through Grih Udyog (cottage industry) or rural cooperatives an on repetitive tasks which demand little skill, such as textile printing, assembly and agro-material processing.
The structure of investment should not be to elongate the productive process or make it indirect.
Our plans have not been able to relieve poverty because projects promoted are of the factory type.
They are not suitable for integrating poor into market oriented activity results of cost benefit analysis used for project choice- So far, it has been shown that cost-benefit analysis proceeds on the explicit basis that a project or policy is deemed socially worthwhile if its benefits exceed the costs it generates.
The appropriate formula for expressing the social worth whileness of a project has not been discussed in detail, nor have guidelines been offered for assisting the choice among alternative projects. MS 42 Solved Free Assignment 2022
Lastly, constraints on the objective function have not been incorporated
The Choice Context MS 42 Free Solved Assignment
The necessary condition for the adoption of a project is that discounted benefits should exceed discounted costs. This rule can be stated as:
GPV(B)> GPV(K) NPV(B)>0
where GPV(B) refers to the ‘GROSS PRESENT VALUE’ of benefits, and NPV(B) refers to the “NET PRESENT VALUE’ of benefits, so that
NPV(B) = GPV(B)-GPV(K)
The present values are calculated at the relevant social discount rate. A social discount rate may be considered equivalent to the opportunity cost of public investments.
It can also be seen in terms of an accounting price which reflects the society’s trade-off of the present benefits against the future benefits.
Formulated in this way, the “worth of a project is expressible as a unique absolute magnitude, with costs and benefits measured in the same units.
In practice, however, the rule will require some modification in the light of the constraints on the objective function and allowances for risk and uncertainty.
The types of choice facing the decision-maker can be classified as follows:
i) Accept-reject. Faced with a set of independent projects and no constraint
on the number which can be undertaken, the decision-maker must decide which, if any, is worth while. MS 42 Solved Free Assignment 2022
The decision rule should enable him to accept or reject each individual project.
ii) Ranking. If some input, such as capital, is limited in supply it may well be
that all ‘acceptable projects cannot be undertaken.
In this case, projects must be ranked or ordered in terms of that objective function.
The decision rule for accept-reject situations cannot be easily generalised to cover these situations.
iii) Choosing among exclusive projects. Frequently, projects are not independent of each other.
One form of interdependence exists when one project can only be undertaken to the exclusion of another project- e.g. two different ways of achieving the same objectives.
The projects are then mutually exclusive’ and the decision rule must enable the decision-maker to choose between the alternatives.
A special case of mutual exclusion exists when any given project can be undertaken now or in a later period. MS 42 Solved Free Assignment 2022
There is a problem in choosing the optimal point in time to start the project.
This is the problem of ‘time-phasing and, once again, the decision rule should offer guidance on this issue. MS 42 Free Solved Assignment
Q4- Explain the various non traditional sources of long term financing.?
Ans- Various non traditional sources of long term financing – Long-term finance is raised when the need for funds is for more than one year.
Typically, long-term finance is required for acquisition of fixed assets having a life more than one year or investments, which have long-term impact on the earnings of the company.
For instance, if a firm wants to buy a patent or brand, which in turn contributes to the sales of the firm for a long-term, it requires long-term funds for such acquisition.
While equity and debt are conventional source of finance, such source of finance is not available for many investments.
Some time, the investment needs may not be large enough for the financial managers to approach banks or financial institutions. They look for alternative source of finance under these circumstances. MS 42 Solved Free Assignment 2022
In the following sections, we will discuss four such sources of alternative long-term finance available for the firms. They are
(a) Leasing and Hire-purchase
(b) Suppliers’ Credit
(c) Asset Securitization and
(d) Venture capital.
(1–Leasing and Hire-Purchase Firms need finance to acquire assets. Instead of borrowing and acquiring assets, it is possible for firms to acquire the assets on lease.
There are two types of leasing – operational lease and financial lease. Operational lease is used when the assets are used for temporary period and the asset is returned at the end of the short period.
Suppose a firm gets an extra order for which it requires some additional equipment.
Such additional equipment can be taken on lease for few days, say three weeks and at the end of the three weeks, the equipment is returned to the owner.
Some of the assets that are normally acquired under operational lease arrangement are computers, vehicles, generators, small movable equipment, etc.
While operational lease is not considered a source of finance, financial lease is used when the assets are required permanently or for a long period.
Normally, the assets are ultimately purchased by the firm from the lessor at a nominal value.
During the period of lease, the firm which acquired the assets on lease (called lessee) can use the assets but it is not the owner of the asset.
The ownership rests with the company which provided the assets on lease. During the period of lease, the lessee has to pay lease rent to the lessor.
Lessee is not entitled for any depreciation whereas lessor can claim depreciation for the assets for tax purpose. MS 42 Solved Free Assignment 2022
Hirepurchase is similar to financial lease. A hire-purchase transaction is usually defined as one where the hirer (user) has, at the end of the fixed term of hire, an option to buy the asset at a token value.
In other words, financial leases with an option to buy the asset at the end of the lease term can be called a hire-purchase transaction.
(2– Suppliers Credit The concept of supplier credit is fairly simple and in existence for a long time.
Under this, the equipment suppliers provide long-term credit and accept the payment for the supply of equipment over a longer period of time say 5 to 8 years.
In that process, the company which acquires the assets neither take bank loan nor approach has leasing company for credit but directly takes the credit from the supplier of the equipment. MS 42 Free Solved Assignment
In other words, the supplier of equipment acts as a lender or lessor. The question is how it is superior to other forms of acquiring the assets.
First of all, the buyer need not approach any other agency for credit. Normally, suppliers provide short period of credit, and in this special case, the suppliers provide long-term credit.
Since there is no intermediary to fund the acquisition between the seller and buyer, it reduces the cost.
In addition, it is possible that the supplier may be a cash rich company or may get funds at a much lower rate than the buyer. MS 42 Solved Free Assignment 2022
For instance, the credit rating of the supplier is far above than the credit rating of buyer or seller may be in another country where the interest rates are low.
There are specialised government agencies to provide funds to the suppliers in order to improve the export sales or to help a particular sector.
Though suppliers provide long-term credit to the buyers, there is no need for the suppliers to stuck with such huge long-term receivables because they can get finance under certain specific scheme against such receivables.
They can also sell such receivables through securitization.
(3–Asset Securitization Securitization is fairly a simple concept. It is the process through which an asset (fixed or current) is converted into financial claim. It other words, it brings liquidity to an illiquid asset. MS 42 Solved Free Assignment 2022
The concept is very popular in housing finance. Let us explain the concept with a simple example. Suppose a housing finance company has Rs. 100 cr.
During the first six months, it accepts the loan proposals and lent Rs. 100 cr. at an average interest rate of 10% and the duration of the loan is 15 years.
Suppose the housing finance company gets some more loan applications say for Rs. 20 cr. in seventh month.
The company has to look for new source of finance to fund the new loan proposals since it has already invested the entire capital and converted them into illiquid long-term 15 years receivables.
The growth of the housing finance company is thus restricted to its ability to raise additional funds. Securitization assumes importance in this context.
Suppose a group of pension companies is willing to buy Rs. 100 cr. 15-years receivables from the housing finance company discounting the receivables at say 9%.
With this new cash flow, the housing finance company can finance new loans without making any fresh borrowing. MS 42 Solved Free Assignment 2022
In other words, the housing finance company has sold its 15-year illiquid receivables and raised money against it. MS 42 Free Solved Assignment
The process of selling makes the concept slightly different from simple bill discounting concept.
Under securitization, an intermediary agency is created, which initially buys the illiquid asset and against that it issues securities, which are tradeable in the market through listing.
Thus, it is also called asset-backed securities or mortgaged backed securities.
The value of the securities is improved by taking credit rating and often through insurance cover.
Securitization improves operating cycle of the capital in the sense the housing finance company can recycle the capital several times and finance more houses without borrowing on its book. Every time when the cycle is completed, the firm receives profit.
You might wonder why pension funds or other companies prefer to buy housing loans instead of investing or lending to housing finance company. The logic is fairly simple.
For instance, if the pension funds give loan to housing finance company, there is no guarantee that housing finance company will lend money to quality loan proposals. The lender has no control on the business of borrower.
On the other hand, in buying the existing loan, the pension company can ask a credit rating agency to assess the quality of loans. In this process, the risk is reduced considerably.
In addition, lending will block the funds of pension funds for a longterm whereas an investment in securitized asset brings liquidity for the funds invested.
So it is a rare case of win-win situation for both the housing finance company and pension fund investors. MS 42 Solved Free Assignment 2022
Like pension fund, there are many investors who are looking for such investments, which essentially creates liquidity for these kinds of securities.
Though this concept is yet to become popular in India, already several securitization deals have taken place.
While securitization as a concept was developed to help finance companies to covert their loans into liquid assets, it is now extensively used in several other business situations.
It is possible for manufacturing or service firms to raise long-term funds through securitization.
For example, many electricity boards, whose balance sheet is very weak and no financial institutions would be willing to lend money to such companies, have raised long-term funds at a cheaper interest rate by securitizing future receivables of some good clients.
By securitizing, the company actually sells the receivables to the intermediary agency (called Special Purpose Vehicle or SPV), which collects the money and distributes to the holders of such securities. MS 42 Solved Free Assignment 2022
Figure shows the structure of future flow securitization. There are several variation of this model but the essential principle is to protect the interest of investors.
It is possible for companies producing commodities, where the demand is predictable, raise longterm resources by securitizing their future receivables. Companies like Reliance Petroleum have done such securitization.
The amount thus raised can be used to strengthen long-term or permanent working capital needs of the firms or invest in fixed assets to expand the capacity.
(4– Venture Capital While leasing/hire-finance, suppliers’ credit or securitization are debt financing, venture capital is a equity finance.
Venture capital is investment in early-stage, high-growth projects, which are high-risk with the potential to give extraordinarily high returns over a period ranging from three to seven years.MS 42 Solved Free Assignment 2022
The risk factor being high, the probability of failure is also high.
The returns to the venture capitalist are from the handful of the projects, which succeed.
Venture capital investment is generally in equity or quasi-equity instruments in unlisted companies, often set up to commercialise a novel idea.
The venture capitalist will, in the normal course of business, like to have a 20% to 50% stake in the company invested in.
The returns to the venture capitalist are at the time of disinvestment from the venture backed unit.
This could be in several ways, such as buy-back of the stake of the venture capitalist by the promoters, disinvestment of the investment at time of an IPO, or during a merger or acquisition transaction.
Venture capital investment is “hands-on” investment, where the investor mentors and advises the promoters of the business in which the investment has been made.
The venture capitalist is an investor who guides the project through its different stages of growth by identifying avoidable pitfalls and directs the business along possible avenues of growth. MS 42 Solved Free Assignment 2022
The venture capitalist is, therefore, a partner who brings much more than money to the project. Venture capitalists receive several proposals for investment.
Many projects, which find it difficult to raise funds from banks and other financial institutions, approach venture capitalists for assistance. Venture capitalists conduct a preliminary project appraisal. MS 42 Free Solved Assignment
This includes verification of whether the project is in the area of their investment and a review of the promoters of the business.
If the venture capitalists are interested in the project they offer a term sheet to the promoters.
The term sheet is a summary of the proposed principal terms and conditions of a venture capital investment.
It sets out the broad terms and conditions of investment and is signed by both the venture capitalist and the proposed venture capital investee.
Signing of a term sheet by both parties is a statement of good faith and is not an obligation until an agreement is signed by the parties.
It is normally subject to satisfactory completion of due diligence review and signing of legal documents such as an equity subscription agreement.
Q5- Discuss the factors contributing to financial engineering and explain about financial engineering in fixed income securities..?
Ans- FACTORS CONTRIBUTING TO FINANCIAL ENGINEERING-financial, engineering produces products or in some cases solutions that add value to the users. Why users of financial products or solutions want some value-added products?
An understanding of such needs will be useful to appreciate the role of financial engineering and the products and solutions that come out of financial engineering.
John Finnerty (1988) identified eleven factors that are primarily responsible for financial innovation. These factors are briefly discussed below:
(1–Tax Advantage: If there is a way to save tax or defer tax, every one will exploit the opportunity. Often financial engineering helps to develop such products.
For instance, if you buy a zero coupon bond in the secondary market, the difference between the redemption value and the purchase price is treated as capital gains whereas interest received from interest paying bonds are treated as regular income.
Since the tax rate for capital gains is substantially lower (it is 10% now for long-term capital gains) than marginal tax rate of high net worth investors (it is 30% for individuals and 35% for corporate entities), it make sense for companies to issue zero-coupon bonds.
Small investors wanting to show the income as regular income will buy the same in primary market whereas high networth investors will buy from secondary market.
Mutual funds is also tax-efficient medium through which you can change the character of the income from one to another.MS 42 Solved Free Assignment 2022
For instance, if you invest in bond market fund, which in turn invest the money in bonds and receive interest income, you can still show the income as capital gain by choosing certain schemes.
You can convert capital gains into dividend and vice versa.
Thus, mutual fund is a financially engineered structure to get tax advantage and of course, it is also a vehicle through which investors can achieve diversification at low investment.
There are several other examples. While operating leasing is a plain vanilla product, financial leasing is an engineered product, which often used to gain certain tax advantage.
Some years back, many companies have done ‘sale and lease back’ transactions to exploit loopholes in tax laws, which was plugged subsequently.
Similarly, a non-tax paying company and tax paying investors can save tax by investing in preference shares.
It is possible for a company to issue ‘convertible preference shares’ such that the preference shares can be converted into non-convertible debenture on default of dividend Of course,
many of the financially engineered product to exploit tax law loopholes are effectively killed by the government by amending the tax laws and sometime with retrospective effect.
The life of such products or solutions is generally short but opportunities come regularly
(2–Reduced Transaction Cost: Financial products and solutions come with high transaction cost. MS 42 Solved Free Assignment 2022
For instance, if a firm issues debenture for 7-year period, it has to repay at the end of seventh year but invariably it has to approach the market again with another bond issue in the near future since growth demands fresh funds.
An alternative is issue of fairly a long-term bond, say 99-years with call and put options and in that process tremendous transaction cost is reduced.
Add more features to take care of various concern like changes in credit rating, etc. and you will get truly financially engineered product to handle transaction cost.
Mutual funds and several products of derivative markets are aimed to reduce either transaction cost or at least recurring transaction cost to a large extent.
(3–Reduced Agency Cost: Agency relationship between promoter/managers and other shareholders/stakeholders creates certain cost, which latter bear.
Employee Stock Option (ESOP) is a financial innovative product, which swaps part of salary for equity such that the value of equity increases only if mangers perform well.
Leveraged Buyout (LBO) through issue of junk bonds is a financial process through which inefficient management is replaced with efficient one and productivity of the assets is improved.MS 42 Solved Free Assignment 2022
Compare this with a situation where banks and financial institutions were not able to take action against defaulting companies except initiating time consuming court action and in meanwhile productivity of assets are deteriorate further.
(4–Risk Reallocation: Financial engineering plays a major role in this respect too. We briefly discussed this point in introduction.
Through financial engineering, it is possible to reallocate the risk to different parties and of course such reallocation comes with a price.
For instance, fixed interest rate bond is plain instrument in which both investors and issuer are exposed to interest rate risk. A floating rate bond takes away the risk.
However floating rate brings new problem and issuers are exposed to higher cost of borrowing. A swap transaction can shift such risk from company to counter party.
Like this, you can create an environment in which you can trade ‘risk’!! We will see more examples in subsequent sections.MS 42 Solved Free Assignment 2022
(5–Increased Liquidity: Liquidity reduces the cost and improves efficiency of pricing. Liquidity is affected due to rigidity and inability to assess the risk level.
For instance, real assets in general are less liquid compared to financial assets.
Land is not as liquid as bonds issued by a company dealing in buying and selling of land. Equity and bonds of leasing companies are more liquid than assets funded by leasing companies.MS 42 Free Solved Assignment
Loan portfolio is less liquid if some banks want to sell the loan portfolio compared to stocks and bonds of the bank. Through securitization, financial engineering can improve the liquidity. MS 42 Solved Free Assignment 2022
Another example, is openend mutual funds, which give option to enter and exit at anytime and of course with certain cost (entry and exit load).
(6–Regulatory or Legislative Factors: Regulation or deregulation, both make life complex.
A regular public issue in the US market is highly costly for an Indian company since the regulations are very high and the cost of compliance of such regulations is high.
ADR and GDR are financially engineered products, which allow companies to issue shares in US and other markets without attracting such high level of regulations.
Depository and electronic-trading are positive side of regulations, which reduces level of risk and also transaction cost.
Mutual funds are introducing several new products within regulation to attract investors and tap new sources of funds.MS 42 Solved Free Assignment 2022
Insurance is another highly regulated industry but you can witness so many products offered by them. If regulation puts certain restrictions, you have to be more innovative to keep the interests of investors.
If regulation removes certain restrictions and allows competition, you have to be equally innovative to compete and retain your investors.
For instance, RBI puts lot of restrictions on companies raising deposits from public.
FINANCIAL ENGINEERING IN FIXED INCOME SECURITIES
Fixed income securities have seen large-scale innovation and new products. As was mentioned in the introduction of the Unit, zero-coupon bond and convertible bonds are some of the early part of new products.MS 42 Free Solved Assignment
A zero-coupon bond enables the borrowers to defer interest payment whereas it gives an option for the investors to show the appreciation either income or capital gain depending on tax preference.
An optionally convertible bond reduces interest cost to borrowers whereas investors get an option for converting the same into equity depending on the performance of the company, which may not be assessable at the time of investment.
Another major innovation in bonds was floating rate bond, which takes away the interest rate risk. MS 42 Solved Free Assignment 2022
A number of subsequent innovations on floating rate bond aim to deal with different types of risk. A typical floating rate bond contains a float part and fixed part.
For example, it can be bank rate or LIBOR + fixed premium say 4% or 2%. When the interest rate moves upward in the market,
the bank rate or LIBOR also moves up and hence investors get higher interest rate. When the rate declines, borrowers are not stuck with higher interest liability.
Thus, float part effectively handles the interest rate risk.
Here interest rate risk means additional interest liability on account of fixed interest commitment that the borrower has to bear when the interest rates are moving down in the market. MS 42 Solved Free Assignment 2022
Similarly, when the interest rate moving upward, the investors of fixed interest rate bonds loose money as the prices of bonds decline. In other words, the market prices of bonds move up and down based on changes in the market interest rates.
Instead of fixing the float to Bank Rate or LIBOR, if the issuer and investor fix the float to some other value, they can tackle different types of risk.
For instance, a commodity producer or oil company is exposed to considerable amount of commodity or oil price risk.MS 42 Free Solved Assignment
Prices of commodities, oil, metal, etc., are highly volatile and producers of these products are exposed to high level of risk.
In other words, in a balance sheet context, the asset side risk (also called business or operating risk) is very high. Naturally, for these companies, a pure fixed interest paying debt will add more problems. MS 42 Solved Free Assignment 2022
For some reasons, if the prices of the products crash, it may hurt the business considerably. While debt creates such adverse effect in a falling prices, it creates value when price moves upward.
The issue before the finance managers of these companies is how to resolve the negative effect of the debt in a falling market price while retaining profit opportunity when the prices move up. MS 42 Solved Free Assignment 2022
It is resolved by linking floating rate with the commodity price index. That is, the investors will get higher interest rate when the market price of the commodity moves up and gets lower return when the prices fall.
For instance, if the interest rate of such floating bond is 4%+changes in oil price or price index, the bond holders will get a return of 4% only if the price remains same.
If the price increases by 3%, then bond holders will get 7%. Normally, there will be a floor rate and cap rate for such issues.
In the above case if the floor is 4% and cap is 10%, the interest rate will be minimum of 4% (even in cases when the oil price declines by 10%) and maximum of 10% (even when the oil price increases by 20%).
So, the instrument, by and large, retains, the characteristics of debt but it brings some equity flavour into the instrument What about the users of such commodities, metals and oils? They are also exposed to price risk. MS 42 Solved Free Assignment 2022
When the prices of input moves up, it may not be always possible for the company to adjust the end product price. This will hurt the profitability of the company particularly cause distress if the company also has fixed interest rate debt.
Inverse floating rate bonds, where interest is linked to commodity price changes but in a inverse direction.MS 42 Free Solved Assignment
That is, interest liability will be lower when the price of input moves upward. Similarly, when the priceof input moves downward, then interest liability will be more.
The borrower would be happy to share part of the profit caused by lower input price with the lender provided the lender agrees to share the loss when the input price increases.
You may be wondering why no one bothers to develop such instruments for consumers, who are ultimately affected by the prices.
They can invest in the bonds and shares of those companies until financial engineers come out with a product. As was discussed earlier, financial engineering developed several innovative products in debt instrument.
We mentioned earlier that zero-coupon bond is one of the earliest innovations. But the problem is, investors who are looking for regular investments that will avoid such instrument. MS 42 Solved Free Assignment 2022
To overcome this and also to create some additional liquidity, issuers of such zero-coupon bonds have started issuing baby bonds, which are also zerocoupon bonds.
Those who are looking for regular income can sell the baby bonds while retaining the mother bond Of course, tax treatment for such baby bonds was also one of the reasons for such innovations.
Can you create Zero-coupon bond (ZCB) from an interest-paying bond? There is nothing impossible before financial engineer.
It works like this. If you carefully look into interest-paying bond, it is a structure in which you invest today some amount and borrower will pay you regularly interest at the end of every period (say six months) and principal on maturity (say 10 years).
Thus you will be getting 20 cash inflows. Investment bankers issued 20 different series securities backed by investments in such interest paying securities and the 20 such securities are zero coupon bonds with different maturity.
That is, series 1 will mature at the end of 6 months and the face value of the same is equal to first interest payment. MS 42 Solved Free Assignment 2022
Series 2 will mature at the end of 12 months and the face value is equal to second interest payment.MS 42 Free Solved Assignment
Such that series 20 will mature at the end of 10 years and the face value is equal to principal and last instalment interest.
All these zero-coupon bonds are discounted and issued today such that investment banker collects the face value of the interest paying bond plus a small commission.
Those investors, who have surplus for 6 months, will invest in series 1, those who have surplus for 12 months will invest in series 2, etc.
Interestingly, all investors of ZCB get benefit more than what they would get otherwise for investing money for such term Innovation in debt instruments in general
(a) aims to remove interest rate risk
(b) bring a bit of equity flavour into the instrument and
(c) improve tax efficiency of the product. Suppose a firm borrows money in dollar but does not want to take the risk of foreign exchange rate fluctuations.
It is possible to issue a bond in one currency, pay interest in another currency and repay in a different currency.MS 42 Solved Free Assignment 2022
Alternatively, you can peg the interest rate to the changes in foreign exchange rate fluctuations. In essence, foreign exchange risk is transferred from the company to others.
In other words, any risk can be handled, restructured and transferred from a person who is not willing to take such risk to a person who is willing to assume such risk.