Tag: Capital

  • Venture Capital: Definition Advantages Disadvantages

    Venture Capital: Definition Advantages Disadvantages

    What does Venture Capital mean? They define and comprise two words that are, “Venture” and “Capital”. It is a type of funding for a new or growing business. It usually comes from venture-capital firms that specialize in building high-risk financial portfolios.

    The concept of Venture Capital explained by their points in Meaning, Introduction, Definition, Characteristics, Advantages, and Disadvantages.

    Capital invested in a project in which there is a substantial element of risk, typically a new or expanding business. The venture is a course of processing, the outcome of which is uncertain but to which attended the risk or danger of “loss”. “Capital” means resources to start an enterprise. To connote the risk and adventure of such a fund, the generic name Venture-Capital existed coined.

    #Meaning of Venture Capital:

    Venture capital’s a type of private equity, a form of financing provide by firms or funds to small, early-stage, emerging firms that exist deemed to have high growth potential, or which have demonstrated high growth. This is a very important source of financing for a new business. Here money is provided by investors to start a business that has a strong potentiality of high growth and profitability. The provider of venture capital also provides managerial and technical support. Venture capital stands also known as risk capital.

    #Introduction of Venture Capital:

    Venture capital’s considered the financing of high and new technology-based enterprises. It exists said that Venture-capital involves investment in new or relatively untried technology, initiated by relatively new and professionally or technically qualified entrepreneurs with inadequate funds. The conventional financiers, unlike Venture capitals, mainly finance proven technologies and established markets.

    However, high technology need not be a prerequisite for them. They have also existed described as “unsecured risk financing”. The relatively high risk of venture capital’s compensated by the possibility of high returns usually through substantial capital gains in the medium term. They are in the broader sense is not solely an injection of funds into a new firm; it is also an input of skills needed to set up the firm, design its marketing strategy, organize and manage it.

    Thus it is a long-term association with successive stages of the company’s development under high-risk investment conditions, with a distinctive type of financing appropriate to each stage of development. Investors join the entrepreneurs as co-partners and support the project with finance and business skills to exploit the market opportunities. Venture capital’s not passive finance.

    It may be at any stage of the business/production cycle, that is, start-up, expansion or to improve a product or process; which exist associated with both risk and reward. They make higher capital gains through appreciation in the value of such investments when the new technology succeeds. Thus the primary return sought by the investor is essentially capital gain rather than steady interest income or dividend yield.

    #Definition of Venture Capital:

    “The support by investors of entrepreneurial talent with finance and business skills to exploit market opportunities and thus obtain capital gains.”

    They commonly describe not only the provision of start-up finance or “seed corn” capital but also development capital for later stages of business. A long-term commitment of funds exists involved in the form of equity investments, with the aim of eventual capital gains rather than income and active involvement in the management of customers’ business.

    #Characteristics of Venture Capital:

    The following features/characteristics below are;

    Participation In Management:

    They provide value addition by managerial support, monitoring, and follow-up assistance. It monitors physical and financial progress as well as a market development initiative. It helps by identifying the key resource person. They want one seat on the company’s board of directors and involvement, for better or worse, in the major decision affecting the direction of the company.

    This is a unique philosophy of “hands-on management” where Venture capitalist acts as complementary to the entrepreneurs. Based upon the experience of other companies, a venture capitalist advises the promoters on project planning, monitoring, financial management, including working capital and public issue. Their investor cannot interfere in day to day management of the enterprise but keeps close contact with the promoters or entrepreneurs to protect his investment.

    High Risk:

    By definition, their financing is highly risky and chances of failure are high as it provides long-term start-up capital to high risk-high reward ventures.

    Venture capital assumes four types of risks, these are:

    • Management risk; Inability of management teams to work together.
    • Market risk; Product may fail in the market.
    • Product risk; Also, Product may not be commercially viable.
    • Operation risk; Operations may not be cost effective resulting in increased cost decreased gross margins.

    High Tech:

    As opportunities in the low technology, area tend to be few of lower order, and hi-tech projects generally offer higher returns than projects in more traditional areas, venture-capital investments stand made in high tech. areas using new technologies or producing innovative goods by using new technology.

    Not just high technology, any high-risk ventures where the entrepreneur has conviction but little capital gets venture finance. Venture capital’s available for expansion of existing business or diversification to a high-risk area. Thus technology financing had never been the primary objective but incidental to venture capital.

    Length of Investment:

    Venture capitalists help companies grow, but they eventually seek to exit the investment in three to seven years. An early-stage investment may take seven to ten years to mature; while most of the later-stage investment takes only a few years. The process of having significant returns takes several years and calls on the capacity and talent of venture capitalists and entrepreneurs to reach fruition.

    Illiquid Investment:

    Their investments are illiquid, that is, not subject to repayment on demand or following a repayment schedule. Investors seek to return ultimately using capital gains when the investment stands sold at the marketplace.

    The investment is realized only on the enlistment of security or it is lost if the enterprise is liquidated for unsuccessful working. It may take several years before the first investment starts to lock for seven to ten years. Venture capitalist understands this illiquidity and factors this in their investment decisions.

    Equity Participation & Capital Gains:

    Investments are generally in equity and quasi-equity participation through direct purchase of shares, options, convertible debentures where the debt holder has the option to convert the loan instruments into the stock of the borrower or debt with warrants to equity investment.

    The funds in the form of equity help to raise term loans that are a cheaper source of funds. In the early stage of business, because dividends can delay, equity investment implies that investors bear the risk of venture and would earn a return commensurate with success in the form of capital gains.

    #Advantages and Disadvantages of Venture Capital:

    The following advantages and disadvantages below are;

    Advantages of Venture Capital:

    Business expertise: Aside from financial backing, obtaining venture-capital financing can provide a start-up or young business with a valuable source of guidance and consultation. This can help with a variety of business decisions, including financial management and human resource management. Making better decisions in these key areas can be vitally important as your business grows.

    Additional resources: In several critical areas, including legal, tax, and personnel matters, a VC firm can provide active support, all the more important at a key stage in the growth of a young company. Faster growth and greater success are two potential key benefits.

    The advantages of venture capital are as follows:

    • New innovative projects financed through venture-capital which generally offers high profit­ability in long run.
    • In addition to capital, venture-capital provides valuable information, resources, technical assistance, etc., to make a business successful.

    Disadvantages of Venture Capital:

    Loss of control: The drawbacks associated with equity financing, in general, can compound with venture-capital financing. You could think of it as equity financing on steroids. With a large injection of cash and professional, and possibly aggressive, investors, it is likely that your VC partners will want to exist involved. The size of their stake could determine how much say they have in shaping your company’s direction.

    Minority ownership status: Depending on the size of the VC firm’s stake in your company; which could be more than 50%, you could lose management control. Essentially, you could be giving up ownership of your own business.

    The disadvantages of venture capital are:

    • It is an uncertain form of financing.
    • Benefit from such financing can realize in long run only.
    Venture Capital Introduction Definition Characteristics Advantages and Disadvantages
    Venture Capital: Introduction, Definition, Characteristics, Advantages, and Disadvantages, #Pixabay.

    #Know and understand the Dimensions of Venture Capital:

    It is associated with successive stages of the firm’s development with distinctive types of financing, appropriate to each stage of development. Thus, there are four stages of the firm’s development, viz., development of an idea, startup, fledgling, and establishment. The first stage of development of a firm is the development of an idea for delineating precise specifications for the new product or service and establishing a business plan.

    The entrepreneur needs seedling finance for this purpose. Venture capitalist finds this stage the most hazardous and difficult; because the majority of the business projects are abandoned at the end of the seedling phase. The Start-up stage is the second stage of the firm’s development. At this stage, the entrepreneur sets up the enterprise to carry into effect the business plan to manufacture a product or to render a service.

    In this process of development, venture-capitalist supply start-up finance. In the third phase, the firm has made some headway, entered the stage of manufacturing a product or service, but is facing enormous teething problems. It may not be able to generate adequate internal funds. It may also find its access to external sources of finance very difficult.

    To get over the problem, the entrepreneur will need a large amount of fledgling finance from the venture capitalist. In the last stage of the firm’s development when it stabilizes itself; and may need, in some cases, establishment finance to explicit opportunities of scale. This is the final injection of funds from venture capitalists. It has been estimated that in the U.S.A., the entire cycle takes a period of 5 to 10 years.

  • Capital Formation: Significances, Process, Stages, and also Meaning

    Capital Formation: Significances, Process, Stages, and also Meaning

    What does Capital Formation Mean? Capital formation means increasing the stock of real capital in a country. The following points highlight the Capital Formation: Significances, Process, Stages, and also Meaning; Significances of Capital Formation, Process of Capital Formation, Stages of Capital Formation, and Meaning of Capital Formation! Capital-formation refers to all the produced means of further production, such as roads, railways, bridges, canals, dams, factories, seeds, fertilizers, etc. Read and share the given article in English. Understand the Indian Capital Market!

    Explain and Introduction to Capital Formation.

    In other words, capital formation involves making more capital goods such as machines, tools, factories, transport equipment, materials, electricity, etc., which are all used for the future production of goods. For making additions to the stock of Capital, saving and investment are essential.

    #Meaning of Capital Formation:

    Capital-formation or accumulation plays a predominant role in all types of economics whether they are of the American or the British type, or the Chinese type. Development is not possible without capital-formation.

    According to Professor Nurkse,

    “The meaning of (Capital Formation) is that society does not apply the whole of its current productive activity to the needs and desires of immediate consumption, but directs a part of it to the tools and making of capital goods: tools and instruments, machines and transport facilities, plant and equipment— all the various forms of real capital that can so greatly increase the efficacy of productive effort. The essence of the process, then, is the diversion of a part of society’s currently available resources to the purpose of increasing the stock of capital goods so as to make possible an expansion of consumable output in the future.”

    Saving and investment are essential for capital formation. According to Marshall, saving is the result of waiting or abstinence. When a person postpones his consumption to the future, he saves his wealth which he utilizes for further production, If all people save like this, the aggregate savings increase which is utilized for investment purposes in real capital assets like machines, tools, plants, roads, canals, fertilizers, seeds, etc.

    But savings are different from hoardings. For savings to be utilized for investment purposes, they must be mobilized in banks and financial institutions. And the businessmen, the entrepreneurs, and the farmers invest these community savings on capital goods by taking loans from these banks and financial institutions.

    #The Top significance of Capital the Formation:

    Capital formation or accumulation is regarded as the key factor in the economic development of an economy. The vicious circle of poverty, according to Prof. Nurkse, can easily be broken in underdeveloped countries through capital formation.

    It is the capital formation that accelerates the pace of development with fuller utilization of available resources. As a matter of fact, it leads to an increase in the size of national employment, income, and output thereby the acute problems of inflation and balance of payment.

    The following top Significance below is:

    Use of Human Capital Formation:

    Capital formation plays an extraordinary role in the qualitative development of human resources. Human capital formation depends on people’s education, training, health, social and economic security, freedom and welfare facilities for which sufficient capital in needed.

    Labor force needs up-to-date implements and instruments is sufficient quantity so that with the increase in population there will be an optimum increase in production and increased labor is easily absorbed.

    Improvement in Technology:

    In underdeveloped countries, capital formation creates overhead capital and necessary environment for economic development.

    This helps to instigate technical progress which makes impossible the use of more capital in the field of production and with an increase of capital in production, the abstract form of capital changes.

    It is seen that present changes in the capital structure lead to changes in the structure and size of technique and public is thereby more influenced.

    High Rate of Economic Growth:

    The higher rate of capital formation in a country means the higher rate of economic growth. Generally, the rate of capital formation or accumulation is very low in comparison to advanced countries.

    In the case of poor and underdeveloped countries, the rate of capital formation varies between one percent to five percent while in the latter’s case, it even exceeds 20 percent.

    Agricultural and Industrial Development:

    Modern agricultural and industrial development needs adequate funds for the adoption of the latest mechanized techniques, input, and setting of different heavy or light industries.

    Without sufficient capital at their disposal, leads to a lower rate of development thus, capital formation. In fact, the development of these both sectors is not possible without capital accumulation.

    Increase in National Income:

    Capital formation improves the conditions and methods for the production of a country. Hence, there is much increase in national income and per capita income. This leads to an increase in the quantity of production which leads to again rise in national income.

    The rate of growth and the quantity of national income necessarily depends on the rate of capital formation.

    So, the increase in national income is possible only by the proper adoption of different means of production and productive use of the same.

    Expansion of Economic Activities:

    As there is an increase in the rate of capital formation, productivity increases quickly and available capital is utilized in a more profitable and extensive way. In this way, complicated techniques and methods are utilized for the economy.

    This results in the expansion of economic activities. Capital formation increases investment which effects economic development in two ways.

    Firstly, it increases the per capita income and enhances the purchasing power which, in turn, creates a more effective demand.

    Secondly, investment leads to an increase in production. In this way, by capital formation, economic activities can be expanded in underdeveloped countries, which in fact, helps to get rid of poverty and attain economic development in the economy.

    Less Dependence on Foreign Capital:

    In underdeveloped countries, the process of Capital formation increases dependence on internal resources and domestic savings by which dependence on foreign capital is declined.

    Economic development leaves the burden of foreign capital, hence to give interest to foreign capital and bear expenses of foreign scientists, the country has to be burdened by improper taxation to the public.

    This gives a setback to internal savings. Thus, by the way of capital formation, a country can attain self-sufficiency and can get rid of foreign capital’s dependence.

    Increase in Economic Welfare:

    By the increase in the rate of capital formation, the public is getting more facilities. As a result, the common man is more benefited economically. Capital formation leads to an unexpected increase in their productivity and income and this improves their standard of living.

    This leads to improvement and enhancement in the chances of work. This helps to raise the welfare of the people in general. Therefore, capital formations the principal solution to the complex problems of poor countries.

    Capital Formation Significances Process Stages and also Meaning
    Capital Formation: Significances, Process, Stages, and also Meaning! Image credit from #Pixabay.

    #The Top 3 Process of Capital Formation:

    The process of capital formation involves three steps:

    1. Increase in the volume of real savings.
    2. Mobilization of savings through financial and credit institutions, and.
    3. Investment of savings.

    Thus the problem of capital formation becomes two-fold: one, how to save more; and two, how to utilize the current savings of the community for capital formation. We discuss the factors on which capital accumulation depends.

    1. How to Increasing Savings?

    The following savings below are:

    Power and Will to Save: 

    Savings depend upon two factors: the power to save and the will to save. The power to save the community depends upon the size of the average income, the size of the average family, and the standard of living of the people.

    Highly progressive income and property taxes reduce the incentive to save. But low rates of taxation with due concessions for savings in provident fund, life insurance, health insurance, etc. encourage savings.

    The perpetuation of Income Inequalities: 

    A perpetuation of income inequalities had been one of the major sources of capital formation in 18th century England and early 20th century Japan. In most communities, it is the higher income groups with a high marginal propensity to save that do the majority of savings.

    Increasing Profits: 

    Professor Lewis is of the view that the ratio of profits to national income should be increased by expanding the capitalist sector of the economy, by providing various incentives and protecting enterprises from foreign competition. The essential point is that the profits of business enterprises should increase because they know how to use them in productive investment.

    Government Measures: 

    Like private households and enterprises, the government also saves by adopting a number of fiscal and monetary measures. These measures may be in the form of a budgetary surplus through an increase in taxation (mostly indirect), reduction in government expenditure, expansion of the export sector, raising money by public loans, etc.

    2. How to Mobilization can Savings?

    The next step for capital formations the mobilization of savings through banks, investment trusts, deposit societies, insurance companies, and capital markets. “The Kernal of Keynes’s theory is that decisions to save and decisions to invest are made largely by different people and for different reasons.”

    To bring the savers and investors together there must be well-developed capital and money markets in the country. In order to mobilize savings, attention should be paid to the starting of investment trusts, life insurance, provident fund, banks, and cooperative societies.

    Such agencies will not only permit small amounts of savings to be handled and invested conveniently but will allow the owners of savings to retain liquidity individually but finance long-term investment collectively.

    3. How to Investment can Savings?

    The third step in the process of capital formations the investment of savings in creating real assets. The profit-making classes are an important source of capital formation in the agricultural and industrial sectors of a country.

    They have an ambition for power and save in the form of distributed and undistributed profits and thus invest in productive enterprises, besides, there must be a regular supply of entrepreneurs which are capable, honest and dependable. To these may be added, the existence of such infrastructure as well-developed means of transport, communications, power, water, educated and trained personnel, etc.

    #The Top 3 Stages of Capital Formation:

    The following stages below are:

    Creation of savings:

    Capital formation depends on savings. Saving is that part of national income which is not spent on consumption goods. Thus, if national income remains unchanged more saving implies less consump­tion. In other words, in order to save more and more people have to curtail their consumption voluntarily.

    If people reduce their consumption savings will increase. If consumption falls some resources used in the production of consumption goods will be released. The creation of money-savings in a country depends mainly on the people’s ability to save and partly on their willingness to save.

    Conversion of savings into investment:

    However, generation of sav­ings is not enough. Often people save money but this saving largely goes waste because saving is held in the form of idle balance (as in rural areas), or to purchase unproductive assets like gold and jewelry. This is why society’s actual savings falls below its potential savings. Thus, the genera­tion of savings is just a necessary and not a sufficient condition of capital formation.

    The actual production of capital goods:

    This stage involves the con­version of money-savings into the making of capital goods, or what is known as investment. The latter, in turn, hinges on the existing technical facilities available in the country, existing capital equipment, entrepreneurial skill, and venture, the rate of return on investment, the rate of interest, govern­ment policy, etc. 

    Thus the third stage of capital formations concerned with the actual production of capital goods. The process of capital formation is not complete unless business firms acquire capital goods so as to be able to expand their production capacity.

  • Why Entrepreneurs Required the Capital? to Pursue Business!

    Why Entrepreneurs Required the Capital? to Pursue Business!

    Entrepreneurs Required the Capital; Founders design startups to effectively develop and validate a scalable business model. First, You’ve dreamed of starting a business for years, and now you’re on the verge of making it a reality. You can hardly contain your excitement. Whether you’re selling a product or service, you’ve got a lot to offer the world. But for Entrepreneurs, the best business plans can be thwarted by a lack of start-up capital. So, what is the question we are going to discuss; Why Entrepreneurs Required the Capital? to Pursue Business!

    Here are the Guidelines that how to set up a Business? Learn more about Why Entrepreneurs Required the Capital? or Why Entrepreneurs need the Capital!

    A startup or start-up is started by individual founders or entrepreneurs to search for a repeatable and scalable business model. Business is primarily done for the sake to earn the profit and secondly to satisfy the demand another customer, both the objects are reciprocal of each other because of the business does not fulfill the demands of the customer.

    Then, it could never be able to earn profits and if it could be able to fulfill the demands of the customers then sometimes positively the entrepreneur has to raise the capital in the business to med the market ends by fulfilling the demands and supply of the market to balance the business activities, but they are more difficult for the entrepreneur to raise capital at the 24 hours. Therefore, he has to evaluate the business position in all the respect and as well as the market conditions.

    The following concept explains why Capital is Required:

    At Increasing the Volume of Sale and Production:

    When the sales and the production demands rise from the limits and volume of capital already invested in the business then the business requires more capital to compete for the market and production demands. This is a positive trend for the raising of business capital because in such trends the profits of the business increase.

    When Launching a New Product or Brand:

    According to Boston Consulting Group when an organization introduced a new product in the market at such a situation it has to be introduced in the market and the same should be familiar to the interested groups of the market, such product at this step is the question mark in the market because at such situation it has to gain the acceptance of the customers.

    This is the closing stage of the new brand until it attain the acceptance of the market stakeholders and therefore, in such circumstances, the organization or concern need capital for the proper launching, marketing, and publicity of the brand that at an early stage as much as it could possibly be introduced to more and more stakeholders.

    Commencing New Project:

    It is a good step for all the businesses when the business achieve its settled goals and objective and go for a new one but in the same time this is the situation when the same business is going to take a risk of new project whether such project is in connection to the last projects or is new project according to the market situation and demands.

    At such a stage, the organization is of the need to plan and arrange funds to meet the requirements of the project, so that the project could be started in time and the objectives, so predicted could be achieved.

    Sudden Loss:

    Sudden loss is the situation which some time complete ruin the business activities and sometimes require more capital to survive in the market. Such losses often happen in uncertainties or natural uncertainties such as earth quite, storms, economic crisis, the death of the partner and etc.

    In all the above-referred situation a business requires capital, sometimes such demand is for prosperity and progress of the concern but on the other hand sometimes it is for to survive in the market, therefore, every business strategy when it is preparing it is prepared the prosperous happening but by neglecting uncertainties, that’s why such loss is called sudden losses.

    Some Sources of Capital to Start a Business:

    There is no one best way to get funding for a small business. There are multiple types of business financing options available. One way to finance a start-up business is by approaching a bank for a start-up capital loan. While this is a typical method for funding a new business, investors are also a good place to start.

    There are thousands of businessmen and women who are always looking for a business to invest in. The positive of securing a private investor is that they share the financial risk with you. Having a stake in the business gives investors the motivation to make sure you have everything you need to make the business successful. Another option is the Individual Development Accounts (IDAs).

    These are grants with strings attached. IDAs are savings accounts that match the deposits of individuals with modest means. For every dollar saved in an IDA, savers receive a corresponding match. Savers agree to complete financial education classes and use their savings for an asset-building purpose, such as to capitalize a business.

    Requirements will vary by location. Another possibility is forgivable loans. This type of loan is made with the understanding that if the borrower meets certain requirements, repayment of the loan will not be required. A forgivable loan is actually a grant; but, a stipulation may be that you are required to hire and train employees, for example.

    10 things are explained How to collect capital for your startup Business:
    • Bootstrapping.
    • Crowd-funding As A Funding Option.
    • Get Angel Investment.
    • Get Venture Capital.
    • Get Funding From Business Incubators & Accelerators.
    • Raise Funds By Winning Contests.
    • Raise Money Through Bank Loans.
    • Get Business Loans From Microfinance Providers or NBFCs.
    • Govt Programs That Offer Startup Capital, and.
    • Quick Ways To Raise Money.

    Funding Options to Raise Capital:

    The main element which is the basic need of every business is the financial resources available with the entrepreneurs for the commencement of the business, with the passage of time and by the growth of the concern these requirements changed and increased consistently to the business situations.

    At the eleventh hours, it is more difficult for the entrepreneur to obtain those resources therefore, the entrepreneur has to increase the capital if he posses the funds otherwise he has to raise funds as loans from friends or alternatively has to secure loans and finances from the banks.

    Managing of funds from Asset Management:

    When the business required capital than first of all the management of the business observe and evaluate the position of the business that how they can generate funds and the first step which the management take for the managing of the funds or raising the capital is asset management.

    It is a crucial process for the management of funds because it creates more liabilities and requires more calculation of the facts and availabilities with the organization.

    #Working Capital Financing:

    Having dealt with the size of investment in current assets, the methods of financing of working capital needs our attention. Working capital is financed both internally and externally through long-term and short-term funds, through debt and ownership funds. In financing working capital, the maturity pattern of sources of finance depended much coincide with credit period of sales for better liquidity.

    Generally, it is believed that funds for acquiring the fixed assets should be raised from long term sources and short-term sources should be utilized for raising working capital. But in recent modern enterprises, both types of sources are utilized for financing both fixed and current assets.

    #Equity Financing:

    Equity financing means the capital which the owner of the business invests in the business at the starting stage. Equity is capital invested in a business by its owner and it is “at risk” on a permanent basis. Equity finance does not require collateral and offers the investor some form of ownership position in the venture.

    All ventures have some equity, as all ventures are owned by some person or institution. Although the owner sometimes not be directly involved that is provided by the owner. The liabilities in respect of equity financing vary in lieu of the amount of equity as well as in regard to the size and nature of the concern.

    Generally, capital or the equity may be fully invested by the entrepreneur such as an educational institution or food places. Ventures of multiple levers require more than one entrepreneur which also include and consist of private stakeholders or venture equity introduced by the entrepreneurs. Equity is generally on debt financing basis which inconsistency make the capital base of the venture.

    Why Entrepreneurs Required the Capital to Pursue Business
    Why Entrepreneurs Required the Capital? to Pursue Business! #Pixabay.

    #Debt Financing:

    Debt financing is also called asset-based financing. Debt financing is the financing method involving a bearing instrument, usually, a loan debt financing requires the entrepreneur to pay back the number of funds borrowed as well fee expressed in terms of the interest rate. Short term debt (less than one year), the money is usually used to provide working capital to final inventory, account receivable, or the operation of the business. Introduction to Public Finance, Expenditure, Revenue, and Debt.

    The funds are typically repaid from resulting sales and profits during the year. Long term debt (lasting more than one year) is frequently used to purchase some asset such as machinery, land, building or vehicle. The entrepreneur needs to be careful that the debt is not so large that regular interest payment becoming difficult. Small enterprises have fewer choices than large firms for obtaining debt financing.

    They are excluded from financial resources such as money raised through the sale of bonds, debenture, and commercial paper. Commercial banks provide unsecured and secured loans. An unsecured loan is a personal or signature loan that grants on the basis of business strength and reputation.

    An unsecured loan is usually a small loan but they can be quite useful for meeting emergency cash flow requirements such as paying wages or bills. The unsecured signature loan usually must be paid back within the year and they will have high-interest charges. The entrepreneur also establishes personal “lines of credit” through their banks and these are treated in the same way as a credit card account that must be paid down or cleared each month.

    The secured loan is those with security pledge to the bank as assurance that the loan will be paid. There are too many types of security will consider, such as a guarantor, another creditworthy person or company that agrees to pay the loan in the vent the borrower default but the most security is in the form of tangible assets pledged as collateral.

  • Indian Capital Market: Understand their concept by Nature, Classification, Growth, and Development!

    Indian Capital Market: Understand their concept by Nature, Classification, Growth, and Development!

    What does the Capital Market mean? The capital market is a market which deals in long-term loans. It supplies industry with fixed and working capital and finances medium-term and long-term borrowings of the central, state and local governments. The Capital Market functions through the stock exchange market. A stock exchange is a market which facilitates buying and selling of shares, stocks, bonds, securities, and debentures. The capital market deals in ordinary stock are shares and debentures of corporations, and bonds and securities of governments. So, what is the topic we are going to discuss; Indian Capital Market: Understand their concept by Nature, Classification, Growth, and Development!

    Here are explained; Indian Capital Market: The Concept of Market understand by their Nature, Classification, Growth, and Development!

    The capital market plays an important role in immobilizing saving and channel is in them into productive investments for the development of commerce and industry. It is not only a market for old securities and shares but also for new issues shares and securities. In fact, the capital market is related to the supply and demand for new capital, and the stock exchange facilitates such transactions.

    Thus the capital market comprises the complex of institutions and mechanisms through which medium-term funds and long­-term funds are pooled and made available to individuals, business and governments. It also encompasses the process by which securities already outstanding are transferred.

    Nature of Indian Capital Market:

    Like the money market, capital market in In­dia is dichotomized into organized and unor­ganised components. The institution of the stock exchange is an im­portant component of the capital market through which both new issues of securities are made and old issues of securities are pur­chased and sold. The former is called the “new issues market” and the latter is the “old issues market”. The stock exchange is, thus, a specialist market place to facilitate the exchanges of old securities. It is known as a “secondary market” for securities.

    The stock exchange dealings for “listed” securities are made in an open auction market where buyers and sellers from all over the country meet. There is a well-defined code of bye-laws according to which these dealings take place and complete publicity is given to every transaction. As far as the primary mar­ket or new issues market is concerned, it is the public limited companies instead of a stock market that deals in “old issues” that raises funds through the issuance of shares, bonds, debentures, etc. However, to conduct this busi­ness, the services of specialized institutions like underwriters and stockbrokers, merchant banks are required.

    The capital market in India is divided into the gilt-edged market and the industrial securities market. The gilt-edged market refers to the market for Govt. and semi-govt. securities. The industrial securities market refers to the market for equities and deben­tures of companies.

    The industrial securities mar­ket is further divided into:

    • New issues market, and.
    • Old capital market.

    Both markets are equally important but often the new issue market is much more important from the point of economic growth. Economic liberalization provides a strong stimulus to the security market. There is a tremen­dous growth in the number of issues, the amount raised, listed companies, listed stock, market turno­ver, and capitalization etc. Security market wit­nessed steep rising curve in the decades of 80s.

    Many new financial instruments were introduced; new institutions like Stock Holding Corporation of India Ltd, National Stock Exchange, Over the Coun­ter Exchange of India Ltd. etc. were created. Further, various steps were taken to protect the interests of investors and streamlining the trading mechanism. Computerization is done for faster set­tlement of transactions. Screen-based trading pro­vides the full transparency of the transactions. After the abolition of the managing agency system in 1970, the importance of the capital market in India cannot be overemphasized.

    The Indian capi­tal market has now been a very vibrant and grow­ing market. It is one of the leading capital markets in developing countries. We have the second largest number of listed companies (6500) in the world, next only to the USA have the largest number of exchanges in any country—23 Stock Exchanges. We have 15 million investors. And in the decade of 80s, the amount raised from the Indian capital mar­ket went up from Rs. 200 crores a year to Rs. 10,000 crores a year.

    The Indian capital market is the market for long term loanable funds as distinct from money market which deals in short-term funds. It refers to the facilities and institutional arrangements for borrowing and lending “term funds”, medium term, and long term funds. In principal capital market loans are used by industries mainly for fixed investment. It does not deal in capital goods but is concerned with raising money capital or purpose of investment.

    The Classification of Indian Capital Market:

    The capital market in India includes the following institutions;

    • Commercial Banks.
    • Insurance Companies (LIC and GIC).
    • Specialized financial institutions like IFCI, IDBI, ICICI, SIDCS, SFCS, UTI etc.
    • Provident Fund Societies.
    • Merchant Banking Agencies, and.
    • Credit Guarantee Corporations.

    Individuals who invest directly on their own insecurities are also suppliers of the fund to the capital market. Thus, like all the markets the capital market is also composed of those who demand funds (borrowers) and those who supply funds (lenders). An ideal capital market attempts to provide adequate capital at a reasonable rate of return for any business, or industrial proposition which offers a prospective high yield to make borrowing worthwhile.

    The Indian capital market is divided into the gilt-edged market and the industrial securities market. The gilt-edged market refers to the market for government and semi-government securities, backed by the RBI. The securities traded in this market are stable in value and are much sought after by banks and other institutions. The industrial securities market refers to the market for shares and debentures of old and new companies. This market is further divided into the new issues market and old capital market meaning the stock exchange.

    The new issue market refers to the raising of new capital in the form of shares and debentures, whereas the old capital market deals with securities already issued by companies. The capital market is also divided between the primary capital market and secondary capital market. The primary market refers to the new issue market, which relates to the issue of shares, preference shares, and debentures of non-government public limited companies and also to the realizing of fresh capital by government companies, and the issue of public sector bonds.

    The secondary market, on the other hand, is the market for old and already issued securities. The secondary capital market is composed of industrial security market or the stock exchange in which industrial securities are bought and sold and the gilt-edged market in which the government and semi-government securities are traded.

    The Growth of the Indian Capital Market:

    The following growth below are;

    Before Independence of Indian Capital Market:

    Indian capital market was hardly existent in the pre-independence times. Agriculture was the mainstay of the economy but there was hardly any long term lending to the agricultural sector. Similarly, the growth of industrial securities market was very much hampered since there were very few companies and the number of securities traded in the stock exchanges was even smaller.

    Indian capital market was dominated by the gilt-edged market for government and semi-government securities. Individual investors were very few in numbers and that too was limited to the affluent classes in the urban and rural areas. Last but not least, there were no specialized intermediaries and agencies to mobilize the savings of the public and channelize them to invest.

    After Independence of Indian Capital Market:

    Since independence, the Indian capital market has made widespread growth in all the areas as reflected by the increased volume of savings and investments. In 1951, the number of joint stock companies (which is a very important indicator of the growth of capital market) was 28,500 both public limited and private limited companies with a paid up capital of Rs. 775 crore, which in 1990 stood at 50,000 companies with a paid up capital of Rs. 20,000 crore. The rate of growth of investment has been phenomenal in recent years, in keeping with the accelerated tempo of development of the Indian economy under the impetus of the five-year plans.

    Indian Capital Market Understand their concept by Nature Classification Growth and Development
    Indian Capital Market: Understand their concept by Nature, Classification, Growth, and Development! Image credit from #Pixabay.

    The Development of Indian Capital Market:

    Here we detail about the eight developments in the Indian capital market.

    Financial Intermediation:

    The Indian capital market has grown due to the innovation of the mechanism of indirect financing. This innovation has enhanced the efficiency of the flow of funds from ultimate savers to ultimate users through newly established financial intermediaries like UTI, LIC, and GIC. The LIC has been mobilizing the savings of households to build a “life fund”.

    It has been deploying a part of “life fund” to purchase the shares and debentures of the companies. Until 1991 UTI was amongst the top ten shareholders in one out of every three companies listed in the Stock Exchange in which it had a shareholding. Likewise, UTI has been mobilizing savings of households through the sale of “units” to invest in securities of “blue-chip” companies.

    In short, financial intermediaries like LIC, UTI, and GIC have activated the growth process of the Indian capital market. It is evident from the rising intermediation ratio. The intermediation ratio is a ratio of the volume of financial instruments issued by the financial institutions, i.e., secondary securities to the volume of primary securities issued by non-financial corporate firms rose from 0.27 during 1951-56 to 0.37 during 1979-80 to 1981-82.

    Underwriting of Securities:

    The New Issue Market as a segment of the capital market can be activated through institutional arrangements for the underwriting of new issues of securities. During the pre-independence period, the volume of securities underwritten was quite minimal due to lack of an adequate institutional arrangement for the provision of underwriting. Stockbrokers and banks used to perform this function.

    In recent years, the volume and amount of securities underwritten have tremendously increased owing to the increasing participation of specialized financial institutions like LIC and UTI and the developed banks like 1FC1,1CICI and IDBI in underwriting activities. It is evident from the fact that the number of securities underwritten was only 55 percent in 1960-61, whereas at present it is about 99 percent.

    Response to the Offer of Public Issues of Shares and Bonds:

    Traditionally investors in India being risk-investors had been reluctant to invest in shares of public limited companies. Hence, industrial securities as a form of investment were not popular in India before 1951. However, since 1991 public response to corporate securities has been improving. But equity-cult has yet to be developed in rural areas.

    It is important to point out that the public response to new issues of shares and bonds depends upon number of factors such as rates of return on industrial securities relative to rates of return on non-marketable financial assets and real assets, government’s monetary policy and fiscal policy and above all legal protection to investors in recent years.

    All the above-mentioned factors have contributed to the growth of public response to the new issue of corporate securities. In short, growing response to public issues has strengthened the Indian capital market. It is evident from the fact that the number of shareholders rose from 60 lakh in 1985 to 160 lakh in 1994.

    Merchant Banking:

    The role of merchant banking in India’s capital market can be traced back to 1969 when Grind lays Bank established a special cell called the “Merchant Banking”. Since then all the commercial banks have set up the “Merchant Banking Division” to play an important role in the capital market. The merchant banking division of commercial banks advises the companies about economic viability, financial viability and technical feasibility of the project.

    They conduct the initial ‘spade work” to find out the investment climate to advise the company whether the public issue floated would be fully subscribed or under-subscribed. The merchant banks in India act as the underwriter as well as the manager of new issues of securities. The Securities and Exchange Board of India (SEBI) regulates all merchant banks as far as their operations relating to issue activity are concerned. To sum up, the emergence of merchant banking has strengthened the institutional base of the Indian capital market.

    Credit Rating Agencies:

    Of late, credit rating agencies have emerged in the financial sectors. This is an important development for the growth of the Indian capital market. Investment Information and Credit Rating Agency of India (ICRA) rates bonds, debentures, preference shares, Corporate Debentures, and Commercial Papers.

    As Credit Rating Information Services of India Ltd. (CRISIL) is a pioneer in credit rating, it rates debt instruments of banks, financial institutions, and corporate firms. The credit assessment of companies issuing securities helps in the growth of New Issue Market segment of the capital market.

    Mutual Funds:

    Mutual funds companies are investment trust companies. Mutual funds schemes are designed to mobilize funds from individuals and institutional investors, who in exchange get units which Can be redeemed after a certain lock-in period, at their Net Asset Value (NAV). The mutual fund schemes provide tax benefits and buyback facility. The Unit Trust of India (UTI) can be regarded as the pioneer in the setting up of mutual funds in India. Of late, commercial banks have also launched in India mutual funds schemes.

    Can-stock scheme of the Canara bank and LIC’s scheme, such as Dhanashree, Dhanaraksha, and Dhanariddhi are mutual funds schemes. Since mutual funds schemes help to mobilize small savings of the relatively smaller savers to invest in industrial securities, so these schemes contribute to the growth of the capital market. The total assets of mutual funds companies increased from Rs. 66,272 crore in 1993-94 to Rs. 99,248 crore in 2005 and to Rs. 4,13,365 crore in 2008. The investment of mutual funds in the secondary market influences the share prices in the stock exchange.

    Stock Exchange Regulation Act:

    The growth of capital market would not have been possible had the Government of India not legislated suitable laws to protect the investors and regulate the Stock Exchanges. Under this Act, only recognized stock exchanges are allowed to function. This Act has empowered the Government of India to inquire into the affairs of a Stock Exchange and regulate it’s working. into the affairs of a Stock Exchange and regulate it’s working.

    The Government of India established the Securities and Exchange Board of India (SEBI) on April 12, 1988, through an through an extraordinary notification in the Gazette of India. In April 1992, SEBI was granted statutory recognition by passing an Act. Since 1991, SEBI has been evolving and implementing various measures and practices to infuse greater transparency in the capital market in the interest of investing public and orderly development of the securities market.

    Liberalization Measures:

    Foreign Institutional Investors (FII) have been allowed access to the Indian capital market. Investment norms for NRIs have been liberalized, so that NRIs and Overseas Corporate Bodies can buy shares and debentures, without prior permission of RBI. This was expected to internationalize the Indian capital market.

    To sum up, the Indian capital market has registered an impressive growth since 1951. However, it is only since the mid-1980s that new institutions, new financial instruments, and new regularity measures have led to speedy growth of the capital market. The liberalization measures under the New Economic Policy (NEP) gave a further boost to the growth of the Indian capital market.

  • Understand the Modigliani Miller Proposition with the Capital Structure Theory!

    Understand the Modigliani Miller Proposition with the Capital Structure Theory!

    What is the Modigliani Miller? The Modigliani–Miller theorem is an influential element of economic theory; it forms the basis for modern thinking on capital structure. Modigliani and Miller approach to capital theory, devised in the 1950s advocates capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. So, what is the topic we are going to discuss; Understand the Modigliani Miller Proposition with the Capital Structure Theory!

    Here are explained formula of the Modigliani Miller Proposition for the Capital Structure Theory!

    The capital structure of a company is the way a company finances its assets. A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity or a mix of both debt and equity. Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition.

    Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. They theorized that the market value of a firm is determined by its earning power and by the risk of its underlying assets and that its value is independent of the way it chooses to finance its investments or distribute dividends.

    Modigliani and Miller’s Capital Structure Irrelevance Proposition:

    The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. In this simplified view, the weighted average cost of capital (WACC) should remain constant with changes in the company’s capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC.

    Additionally, since there are no changes or benefits from increases in debt, the capital structure does not influence a company’s stock price, and the capital structure is therefore irrelevant to a company’s stock price. However, as we have stated, taxes and bankruptcy costs do significantly affect a company’s stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs.

    Modigliani Miller Proposition:

    The following Proposition is two types below are:

    Proposition-I

    The Modigliani-Miller Proposition-I Theory (MM-I) states that under a certain market price process, in the absence of taxes, no transaction costs, no asymmetric information and in a perfect market, the cost of capital and the value of the firm are not affected by the change in capital structure. The firm’s value is determined by its real assets, not by the securities it issues. In other words, capital structure decisions are irrelevant as long as the firm’s investment decisions are taken as given.

    The Modigliani and Miller explained the theorem was originally proven under the assumption of no taxes. It is made up of two propositions that are (i) the overall cost of capital and the value of the firm are independent of the capital structure. The total market value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that risk class. (ii) The financial risk increase with more debt content in the capital structure. As a result, the cost of equity increases in a manner to offset exactly the low-cost advantage of debt. Hence, the overall cost of capital remains the same.

    The assumptions of the MM theory are:

    1. There is a perfect capital market. Capital markets are perfect when: 1) Investors are free to buy and sell securities. 2) Investors can trade without restrictions and can borrow or lend funds on the same terms as the firms do. 3) Investors behave rationally. 4) Investors have equal access to all relevant information. 5) Capital markets are efficient. 6) No costs of financial distress and liquidation, and 7) There are no taxes.
    2. Firms can be classified into homogeneous business risk classes. All the firms in the same risk class will have the same degree of financial risk.
    3. All investors have the same view for the investment, profits, and dividends in the future; they have the same expectation of a firm’s net operating income.
    4. The dividend payout ratio is 100%, which means there are no retained earnings.

    In the absence of the tax world, base on MM Proposition-I, the value of the firm is unaffected by its capital structure. In other words, regardless of whether a company has liabilities, the total risk of its securities holders will not change even the capital structure is changed. As the weighted average cost of capital unchanged, so must the same as the total value of the company.  That is VL = VU = EBIT/equity, where VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity, VU is the value of an unlevered firm = the price of buying a firm composed only of equity and EBIT is earnings before interest and tax. Whether or not the company has loans or the loans for high or low, investors are all accessible through the following two kinds of investment on their own to create the desired type of earning.

    1. Direct investments in the company’s stock borrowing
    2. If shares of levered firms are priced too high, investors will try to take advantage of borrowing on their own and use the money to buy shares in unlevered firms. The use of debt by the investors is known as homemade leverage.

    The investors of homemade leverage can obtain the same return as the levered firms, therefore, for investors; the value of the firm is not affected by the debt-equity mix.

    The MM Proposition I assumptions are quite unrealistic, there have some implications,

    1. Capital structure is irrelevant to shareholder wealth maximization.
    2. The value of the firm is determined by the firm’s capital budgeting decisions.
    3. Increasing the extent to which a firm relies on debt increases both the risk and the expected return to equity – but not the price per share.

    Based on the inadequate of MM Proposition-I, Franco Modigliani and Merton H.Miller revised their theory in 1963, which is MM Proposition-II.

    Proposition-II

    The Modigliani-Miller Proposition II Theory (MM II) defines the cost of equity is a linear function of the firm’s debt/equity ratio. According to them, for any firm in a given risk class, the cost of equity is equal to the constant average cost of capital plus a premium for the financial risk, which is equal to debt/equity ratio times the spread between average cost and cost of debt. Also, Modigliani and Miller recognized the importance of the existence of corporate taxes.

    Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the value of the corporation can be achieved by maximizing debt component in the capital structure. This theory of capital structure for the study provided an important and analytical framework. According to this approach, value of a firm is VL = VU = EBIT (1-T) / equity + TD where TD is tax savings. MM Proposition II is assuming that the tax shield effect of each is the same, and continued insight.

    Leverage firms are increased in interest expense due to reduced tax liability, has also increased the allocation to the shareholders and creditors of the cash flow. The above formula can be deduced from the company debt the more the greater the tax saving benefits, the greater the value of the company. The revised capital structure of the MM Proposition-II pointed out that the existence of tax shield in a perfect capital market conditions cannot be reached, in an imperfect financial market, the capital structure changes will affect the company’s value.

    Therefore, the value and cost of capital of the corporation with the capital structure changes in different leverage, the value of the levered firm will exceed the value of the unlevered firm. MM Proposition theory suggests that the higher the debt ratio is more favorable to corporate, but through borrowing adds an interest tax shield it may lead to costs of financial distress. Financial distress occurs when promises to creditors are broken or honored with difficulty.

    Financial distress may lead to bankruptcy. The trade-off theory of capital structure theory in MM based on the added risk of bankruptcy and further improves the capital structure theory, to make it more practical significance. A firm that follows the trade-off theory sets a target debt to value ratio and then gradually moves towards the target. The target is determined by balancing the tax benefits of using debt against the costs of financial distress that rise at an increasing rate with the use of leverage.

    It so predicts the moderate amount of debt as optimal. But there is evidence that the most profitable firm in an industry tend to borrow the least, while their probability of entering in financial distress seems to be very low. This fact contradicts the theory because if the distress risk is low, an increase in debt has a favorable tax effect. Under the trade-off theory, high profits should mean more debt-servicing capacity and more taxable income to shield and therefore should result in a higher debt ratio.

    Understand the Modigliani Miller Proposition with the Capital Structure Theory
    Understand the Modigliani Miller Proposition with the Capital Structure Theory! Image credit from #Pixabay.

    Understand the Capital Structure Decision in Corporate Finance:

    Corporate finance is a specific area of finance dealing with the financial decisions corporations make and the tools as well as analysis used to make these decisions. The discipline as a whole may be divided among long-term and short-term decisions and techniques with the primary goal being maximizing corporate value while managing the firm’s financial risks. Capital investment decisions are long-term choices that investment with equity or debt, and the short-term decisions deal with the balance of current assets and current liabilities which is managing cash, inventories, and short-term borrowing and lending.

    Corporate finance can be defined as the theory, process, and techniques that corporations use to make the investment, financing and dividend decisions that ultimately contribute to maximizing corporate value. Thus, a corporation will first decide in which projects to invest, then it will figure out how to finance them, and finally, it will decide how much money, if any, to give back to the owners. All these three dimensions which are investing, financing and distributing dividends are interrelated and mutually dependent. The capital structure decision is one of the most fundamental issues in corporate finance.

    The capital structure of a company refers to a combination of debt, preferred stock, and common stock of finance that it uses to fund its long-term financing. Equity and debt capital are the two major sources of long-term funds for a firm. The theory of capital structure is closely related to the firm’s cost of capital. As the enterprises to obtain funds need to pay some costs, the cost of capital in the investment activities is also the main consideration of the rate of return.

    The weighted average cost of capital (WACC) is the expected rate of return on the market value of all of the firm’s securities. WACC depends on the mix of different securities in the capital structure; a change in the mix of different securities in the capital structure will cause a change in the WACC. Thus, there will be a mix of different securities in the capital structure at which WACC will be the least.

    The decision regarding the capital structure is based on the objective of achieving the maximization of shareholders wealth. With regard to the capital structure of the theoretical basis, the most well-known theory is Modigliani-Miller theorem of Franco Modigliani and Merton H.Miller. Yet the seemingly simple question as to how firms should best finance their fixed assets remains a contentious issue.

    The Designing an Optimal Capital Structure:

    The optimal capital structure refers to a proportion of debt and equity at which the marginal real cost of each available source of financing is the same. This is also viewed as a capital structure that maximizes the market price of shares and minimizes the overall cost of capital of the firm. Theoretically, the concept of optimal capital structure can easily be explained, but in operational terms, it is difficult to design an optimal capital structure because of a number of factors, both quantitative and qualitative, that influence the optimum capital structure. Moreover, the subjective judgment of the finance manager of the firm is also an influencing factor in designing the optimum capital structure of a firm. Designing the capital structure is also known as capital structure planning and capital structure decision.

  • How do you Understand the Time Value of Money in Cost of Capital?

    What is the Time Value of Money? If an individual behaves rationally, then he would not equate money in hand today with the same value a year from now. In fact, he would prefer to receive today than receive after one year. The time value of money or TVM is a basic financial concept that holds that money in the present is worth more than the same sum of money to be received in the future. The time value of money is the greater benefit of receiving money now rather than later. It is founded on time preference. How do you Understand the Time Value of Money in Cost of Capital?

    Here is explained the Time Value of Money in Cost of Capital.

    Time value of money (TVM) is the idea that money that is available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. The time value of money explains why interest is paid or earned: Interest, whether it is on a bank deposit or debt, compensates the depositor or lender for the time value of money. It also underlies investment. Investors are willing to forgo spending their money now only if they expect a favorable return on their investment in the future, such that the increased value to be available later is sufficiently high to offset the preference to have money now.

    The reasons cited by him for preferring to have the money today include:

    • The uncertainty of receiving the money later.
    • Preference for consumption today.
    • Loss of investment opportunities, and.
    • The loss in value because of inflation.

    The last two reasons are the most sensible ones for looking at the time value of money. There is a ‘risk-free rate of return’ (also called the time preference rate) which is used to compensate for the loss of not being able to invest in any other place. To this, a ‘risk premium’ is added to compensate for the uncertainty of receiving the cash flows.

    The required rate of return = Risk-free rate + Risk premium

    The risk-free rate compensates for the opportunity lost and the risk premium compensates for risk. It can also be called as the ‘opportunity cost of capital’ for investments of comparable risk. To calculate how the firm is going to benefit from the project we need to calculate whether the firm is earning the required rate of return or not. But the problem is that the projects would have different time frames of giving returns. One project may be giving returns in just two months, another may take two years to start yielding returns.

    If both the projects are offering the same %age of returns when they start giving returns, one which gives the earnings earlier is preferred. This is a simple case and is easy to solve where both the projects require the same capital investment, but what if the projects required different investments and would give returns over a different period of time? How do we compare them? The solution is not that simple. What we do in this case is bring down the returns of both the projects to the present value and then compare.

    Before we learn about present values, we have to first understand future value.

    Future Value:

    Future value is the amount that is obtained by enhancing the value of a present payment or a series of payments at the given rate of interest to reflect the time value of money. If we are getting a return of 10 % in one year what is the return we are going to get in two years? 20 %, right. What about the return on 10 % that you are going to get at the end of one year? If we also take that into consideration the interest that we get on this 10 % then we get a return of 10 + 1 = 11 % in the second year making for a total return of 21 %. This is the same as the compound value calculations that you must have learned earlier.

    Future Value = (Investment or Present Value) * (1 + Interest) No. of time Periods

    The compound values can be calculated on a yearly basis, or on a half-yearly basis, or on a monthly basis or on a continuous basis or on any other basis you may so desire. This is because the formula takes into consideration a specific time period and the interest rate for that time period only. To calculate these values would be very tedious and would require scientific calculators. To ease our jobs there are tables developed which can take care of the interest factor calculations so that our formulas can be written as:

    Future Value = (Investment or Present Value) * (Future Value Interest Factor n, i)

    where n = no of time periods and i = is the interest rate.

    Present Value:

    When a future payment or series of payments are discounted at the given rate of interest up to the present date to reflect the time value of money, the resulting value is called present value. When we solve for the present value, instead of compounding the cash flows to the future, we discount the future cash flows to the present value to match with the investments that we are making today. Bringing the values to present serves two purposes:

    • The comparison between the projects become easier as the values of returns of both areas of today, and.
    • We can compare the earnings from the future with the investment we are making today to get an idea of whether we are making any profit from the investment or not.

    For calculating the present value we need two things, one, the discount rate (or the opportunity cost of capital) and two, the formula. The present value of a lump sum is just the reverse of the formula of the compound value of the lump sum:

    Present Value = Feature Value/(1 + i)n

    Or to use the tables the change would be:

    • Present Value = Future Value * (Present Value Interest Factor n, i).
    • where n = no of time periods and i is the interest rate.

    Perpetuity:

    If the annuity is expected to go on forever then it is called perpetuity and then the above formula reduces to:

    Present Value= A/i

    Perpetuities are not very common in financial decision making as no project is expected to last forever but there could be a few instances where the returns are expected to be for a long indeterminable period. Especially when calculating the cost of equity perpetuity concept is very useful.

    For growing perpetuity, the formula changes to:

    Present Value= A/i – g

    All these calculations take into consideration that the cash flow is coming at the end of the period.

    Present Value of Future Money Formula:

    The formula can also be used to calculate the present value of money to be received in the future. You simply divide the future value rather than multiplying the present value. This can be helpful in considering two varying present and future amounts. In our original example, we considered the options of someone paying your $1,000 today versus $1,100 a year from now. If you could earn 5% on investing the money now, and wanted to know what present value would equal the future value of $1,100 – or how much money you would need in hand now in order to have $1,100 a year from now – the formula would be as follows:

    PV = $1,100 / (1 + (5% / 1) ^ (1 x 1) = $1,047

    The calculation above shows you that, with an available return of 5% annually, you would need to receive $1,047 in the present to equal the future value of $1,100 to be received a year from now. To make things easy for you, there are a number of online calculators to figure the future value or present value of money.

    Time value of money principle also applies when comparing the worth of money to be received in future and the worth of money to be received in further future. Time value of money is the concept that the value of a dollar to be received in future is less than the value of a dollar on hand today. One reason is that money received today can be invested thus generating more money. Another reason is that when a person opts to receive a sum of money in future rather than today, he is effectively lending the money and there are risks involved in lending such as default risk and inflation.

  • What is Working Capital? Analysis, with Management

    What is Working Capital? Analysis, with Management

    Working Capital – Its meaning is basically an indicator of an organization’s short-term financial position and is also a measure of its overall efficiency. They obtain by subtracting the current liabilities from the current assets. It is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entities. Along with fixed assets such as plants and equipment, they consider a part of operating capital. So, what is the question going to learn; What is Working Capital? Analysis, with Management.

    Here explains; Working Capital, Its meaning, definition, Analysis, with Management.

    Working capital meaning, also known as net-working-capital, is the difference between a company’s current assets, like cash, accounts receivable, and inventories of raw materials and finished goods, and its current liabilities, like accounts payable. Capital is another word for money and it is the money available to fund a company’s day-to-day operations essentially, what you have to work with. In financial speak, it is the difference between current assets and current liabilities.

    Current assets are the money you have in the bank as well as any assets you can quickly convert to cash if you needed it. Current liabilities are debts that you will repay within the year. So, it is what’s leftover when you subtract your current liabilities from what you have in the bank. In broader terms, It is also a gauge of a company’s financial health. The larger the difference between what you own and what you owe short-term, the healthier the business. Unless, of course, what you owe far exceeds what you own. Then you have negative working capital and are close to being out of business.

    It can calculate as – Working capital Formula:

    Working Capital = Current Assets – Current Liabilities

    What is the meaning of working capital? Also called net working capital, a liquidity ratio measures a company’s ability to pay off its current liabilities with its current assets. It calculates by subtracting current liabilities from current assets.

    Working capital Definition: They can understand as the capital needed by the firm to finance current assets. It is the amount of a company’s current assets minus the number of its current liabilities. They represent the funds available to the enterprise to finance regular operations, i.e. day to day business activities, effectively. It helps gauge the company’s operating liquidity, i.e. how efficiently the company can cover the short-term debt with short-term assets. Current Assets represent those assets that can easily transform into cash within one year. On the other hand, current liabilities refer to those obligations which are to pay within an accounting year.

    Sources of Working Capital:

    The sources for working capital can either be long-term, short-term, or even spontaneous. Spontaneous working capital majorly derives from trade credit including notes payable and bills payable while short-term capital sources include dividend or tax provisions, cash credit, public deposits, trade deposits, short-term loans, bills discounting, inter-corporate loans, and also commercial paper. For the long-term, capital sources include long-term loans, provision for depreciation, retained profits, debentures, and share capital. These are major working capital sources for organizations based on their requirements.

    Here are some additional factors to consider:
    • The types of current assets and how quickly they can convert to cash. If the majority of the company’s current assets are cash and cash equivalents and marketable investments, a smaller amount of capital may be sufficient. However, if the current assets include slow-moving inventory items, a greater amount of capital will be needed.
    • The nature of the company’s sales and how customers pay. If a company has very consistent sales via the Internet and its customers pay with credit cards at the time they place the order, a small amount of capital may be sufficient. On the other hand, for a company in an industry where the credit terms are net 60 days and its suppliers must be paid in 30 days; the company will need a greater amount of capital.
    • The existence of an approved credit line and no borrowing. An approved credit line and no borrowing allow a company to operate comfortably with a small amount of capital.
    • How accounting principles apply. Some companies are conservative in their accounting policies. For instance, they might have a significant credit balance in their allowance for doubtful accounts and will dispose of slow-moving inventory items. Other companies might not provide for doubtful accounts and keep slow-moving inventory items at their full cost.

    Types of Working Capital:

    There are several types of working capital based on the balance sheet or operating cycle view. The balance sheet view classifies working capitals into the net (current liabilities subtracted from current assets featuring in the company’s balance sheet) and gross working capital (current assets in the balance sheet).

    On the other hand, the operating cycle view classifies working capitals into temporary (the difference between net & permanent capital) and permanent (fixed assets) capital. Temporary capital can further break down into reserve and regular capital as well. These are the types of working capital depending on the view that chose. Two types of Working Capital;

    First types, Value;
    • Gross Capital: It denotes the company’s overall investment in the current assets.
    • Net Capital: It implies the surplus of current assets over current liabilities. A positive net capital shows the company’s ability to cover short-term liabilities; whereas a negative net capital indicates the company’s inability to fulfill short-term obligations.
    Second types, Time;
    • Temporary Capital: Otherwise know as variable capital; it is that portion of capital which needs by the firm along with the permanent capital, to fulfill short-term capital needs that emerge out of fluctuation in the sales volume.
    • Permanent Capital: The minimum amount of capital that a company holds to carry on the operations without any interruption, calls permanent capital.

    Other types of working capital include Initial working capital and Regular working capital. The capital requires by the promoters to initiate the business knows as initial working capital. On the other hand, regular it is one that requires the firm to carry on its operations effectively.

    What is Working Capital Analysis?

    It is one of the most difficult financial concepts to understand for the small-business owner. In fact, the term means a lot of different things to a lot of different people. By definition, it is the amount by which current assets exceed current liabilities. The working capital analysis uses to determine the liquidity and sufficiency of current assets in comparison to current liabilities, you definitely understand their meaning also. This information needs to determine whether an organization needs additional long-term funding for its operations, or whether it should plan to shift excess cash into longer-term investment vehicles.

    However, if you simply run this calculation each period to try to analyze working capital; you won’t accomplish much in figuring out what your working capital needs are and how to meet them. A useful tool for the small-business owner is the operating cycle. The operating cycle analyzes the accounts receivable, inventory, and accounts payable cycles in terms of days. In other words, accounts receivable analyze by the average number of days it takes to collect an account. Inventory analyze by the average number of days it takes to turn over the sale of a product. Accounts payable analyze by the average number of days it takes to pay a supplier invoice.

    Explains the analysis:

    The first part of the working capital analysis is to examine the timelines within which current liabilities are due for payment. This can most easily discern by examining an aged accounts payable report, which divides payables into 30-day time buckets. By revising the format of this report to show smaller time buckets; it is possible to determine cash needs for much shorter time intervals. The timing of other obligations, such as accrued liabilities, can then be layered on top of this analysis to provide a detailed view of exactly when obligations must pay.

    Next, engage in the same analysis for accounts receivable, using the aged accounts receivable report, and also with short-term time buckets. The outcome of this analysis will need to revise for those customers that have a history of paying late so that the report reveals a more accurate assessment of probable incoming cash flows.

    A further step is to examine any investments to see if there are any restrictions on how quickly they can be sold off and converted into cash. Finally, review the inventory asset in detail to estimate how long it will be before this asset can be converted into finished goods, sold, and cash received from customers. The period required to convert inventory into cash may be so long that this asset is irrelevant from the perspective of being able to pay for current liabilities.

    What is Working Capital Management?

    Above the meaning of working capital, you understand them; It is nothing but the difference between current assets and current liabilities. In other words, skilled executive capital management means ensuring adequate liquidity in the business; be able to meet short-term expenses and debt. Working Capital Management a strategy adopt by business managers to monitor the working capital of the business. It is a fundamental concept that calculates and assesses a company’s financial and operational health.

    There is a strategy adopted by business managers to monitor the capital (that means current assets and current liabilities) by the business managers. It is a fundamental concept that calculates and assesses a company’s financial and operational health. Working capital management deals with controlling the proposed free credit period for account capital management; believe that the effective implementation of the credit policy remains the optimum stock and cash level.

    It speeds up the company’s capital cycle and makes the situation of liquidity easier. Managers also try and extend the available credit from the payment of the account and thus take advantage of the business credit; which is generally considered to be free working capital for a certain period. It is an easily understood concept that can be linked to a person’s home. It seems that a person collects cash from his income and how he is planning to spend on his needs.

    Important area:

    Working capital management is a very important area of business when selling mid-market businesses. Effective working capital management means that the business owner will keep their level as low as possible; while still there will be enough funds to run the business. At the point of sale, a buyer will look at historical levels to set non-cash working capital in a reasonable amount to leave the acquisition after the business.

    Sellers will usually be able to extract extra cash from the business before the sale. If the average non-cash is maintained at a low level on the historical level, buyers will usually ask for the comparative level. The same is true if the inefficient level of working capital is maintained at a higher level. On sale, the level will have a direct impact on the total cash earnings received by the vendors.

    What is Working Capital Analysis with Management
    What is Working Capital? Analysis, with Management. Formula!
  • What are the Assumptions of CAPM? Explained

    What are the Assumptions of CAPM? Explained

    Assumptions of CAPM; The Capital Asset Pricing Model (CAPM) measures the risk of security about the portfolio. It considers the required rate of return of security in the light of its contribution to total portfolio risk. CAPM enables us to be much more precise about how trade-offs between risk and return are determined in the financial markets. In CAPM the expected rate of return can also think of as a required rate of return because the market is assumed to be in equilibrium. Even though the CAPM is competent to examine the risk and return of any capital asset such as individual security, an investment project or a portfolio asset, we shall be discussing CAPM concerning risk and return of a security only. So, what is the question; What are the Assumptions of CAPM? Explained.

    Here are explain What are the Assumptions of the Capital Asset Pricing Model (CAPM)?

    The capital market theory is an extension of the portfolio theory of Markowitz. Also, the portfolio theory explains how rational investors should build efficient portfo­lio based on their risk-return preferences. Capital Market Asset Pricing Model (CAPM) incorporates a relationship, explaining how assets should be priced in the capital market. As Betas differ according to the market proxy, that they measure against, then in effect, CAPM, has not been and cannot test. We may recall that CAPM states that;

    Return = Risk-free rate + Beta (Market Return – Risk-free rate)

    A security with a zero Beta should give a risk-free return. In actual results, these zero beta returns are higher than the risk-free return indicating that there are some non-Beta risk factors or some leftover unsystematic risk. Besides, although, in the long-run, high Beta portfolios have provided larger returns than low-risk ones, in the short-run, CAPM Theory and the empirical evidence diverge strikingly; and, also, sometimes the relationship between risk and return may turn out to be negative which is contrary to CAPM Theory.

    It can thus be concluded that CAPM Theory is a neat Theoretical exposition. As well as, The CML and SML are the lines reflecting the total risk and systematic risk elements in the portfolio analysis, respectively. But in the actual world, the CAPM is not in conformity with the real world risk-return trends and empirical results have not always supported the Theory at least in the short-run.

    Assumptions of Capital Market Theory:

    • Investors are expected to make decisions based solely on risk-return assessments.
    • The purchase and sale transactions can undertake in infinitely divi­sible units.
    • Investors can sell short any number of shares without limit.
    • There is perfect competition and no single investor can influence prices, with no transaction costs, involved.
    • Personal income tax is assumed to be zero.
    • Investors can borrow/lend, the desired amount at riskless rates.

    Assumptions of CAPM (Capital Asset Pricing Model):

    The CAPM base on the following assumptions points.

    • Risk-averse investors.
    • Maximizing the utility of terminal wealth.
    • The choice based on risk and return.
    • Similar expectations of risk and return.
    • Identical time horizon.
    • Free access to all available information.
    • There is a risk-free asset and there is no restriction on borrowing and lending at the risk-free rate.
    • There are no taxes and transaction costs, and.
    • The total availability of assets fixed and assets are marketable and divisible.

    The following some key points also very helpful explaining Assumptions of CAPM:

    • Investors are risk-averse and use the expected rate of return and standard deviation of return as appropriate measures of risk and return for their portfolio. In other words, the greater the perceived risk of the portfolio; also, the higher return a risk-averse investor expects to compensate for the risk.
    • Investors make their decisions based on a single period horizon.
    • Transaction costs are low enough to ignore and assets can be bought and sell in any quantity. As well as, the investor limits only by his wealth and the price of the asset.
    • Taxes do not affect the choice of buying assets, and.
    • All individuals assume that they can buy assets at the going market price; and, they all agree on the nature of the return and the risk associated with each investment.

    What are the Assumptions of CAPM Explained
    What are the Assumptions of CAPM? Explained. Image credit from ilearnlot.com.

  • What does mean Capital Asset Pricing Model (CAPM)?

    What does mean Capital Asset Pricing Model (CAPM)?

    The Capital Asset Pricing Model (CAPM) establishes a linear relationship between the required rate of return of a security and its systematic or un-diversifiable risk or beta. CAPM a model use to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. As well as, CAPM enables us to be much more precise about how trade-offs between risk; and, return determine in the financial markets. So, what is the question; What does mean Capital Asset Pricing Model (CAPM)?

    Here are explain What is the Capital Asset Pricing Model (CAPM)? with Meaning and Definition.

    In CAPM the expected rate of return can also think of as a required rate of return because the market is assumed to be in equilibrium. Also, the Expected Rate of Return is the return that an investor expects to earn. Required Rate of Return of security the minimum expected the rate of return needed to induce an investor to purchase it.

    1] According to A,

    “CAPM is a method of determining the fair value of an investment based on the time value of money and the risk incurred.”

    2] According to B,

    “CAPM is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.”

    3] According to C,

    “CAPM is used to estimate the fair value of high-risk stock and security portfolios by linking the expected rate of return with risk.”

    Capital asset pricing model (CAPM) is a model that establishes a relationship between the required return and the systematic risk of an investment. As well as, It estimates the required return as the sum of the risk-free rate; and, the product of the security’s beta coefficient and equity risk premium. Also, Investors face two kinds of risks: systematic risk and unsystematic risk. As well as, Systematic risk is the risk of the whole economy or financial system [Hindi] going down and causing low or negative returns.

    For example;

    The risk of recession, enactment of unfavorable regulation, etc. Systematic risk can’t avoid adding more investments to the portfolio (i.e. diversification) because a downturn in the whole economy affects all investments.

    Unsystematic risk, on the other hand, is the risk specific to a particular investment. For example, unfavorable court ruling affecting the company, major disruption in the company’s supply chain, etc. Such risks can mitigate by adding additional investments to a portfolio. For example, a portfolio of 100-stocks is less prone to the negative performance of one company due to any specific event affecting it.

    CAPM calculate according to the following formula:

    Rrf + [Ba x (Rm – Rrf) ] = Ra

    Where in:

    • Ra = Expected return on a security.
    • Rrf = Risk-free rate.
    • Ba = Beta of the security, and.
    • Rm = Expected return on the market.

    Since unsystematic risk can eliminate through diversification; Also, the capital asset pricing model doesn’t provide any reward for taking such a risk. It measures the required return based on the level of systematic risk inherent in a particular investment.

    What does mean Capital Asset Pricing Model (CAPM)
    What does mean Capital Asset Pricing Model (CAPM)? Image credit from ilearnlot.com.

  • Understand Capital and Revenue Expenditure in Accounting

    Understand Capital and Revenue Expenditure in Accounting

    What leads to an increase in capital in the course of business operations is income; what leads to a reduction in capital is expense or loss. But transactions also cover the acquisition of assets, like the purchase of an office building, raising a loan, payment of liabilities, etc.; all transactions are not expenses or incomes. To know the net profit earned or loss suffered, the expenses, losses, and incomes must be assembled in the Profit and Loss Account; the transactions concerning assets and liabilities will affect items in the Balance Sheet which portrays the financial position. So, what has discussed this article: Understand Capital and Revenue Expenditure in Accounting.

    The Concept of Capital and Revenue Expenditure, in the Accounting, explains why they exist in Financial Management.

    The following expenditures below are;

    Capital Expenditure:

    What is Capital Expenditure? Capital expenditures (CAPEX) refer to funds that are used by a company for the purchase, improvement, or maintenance of long-term assets to improve the efficiency or capacity of the company. Capital expenditure can be tangible, such as a copy machine, or it can be intangible, such as a patent. In many tax codes, both tangible and intangible capital expenditures are counted as assets because they have the potential to be sold if necessary.

    Revenue Expenditure:

    What is Revenue Expenditure? A revenue expenditure (REVEX) is a cost that is charged to expense as soon as the cost is incurred. By doing so, business is using the matching principle to link the expense incurred to revenues generated in the same reporting period. The amount incurred on maintaining the earning capacity of the business, The benefit of which is direct and would be in the same accounting year itself in which such expenditure has been incurred is termed as revenue expenditure.

    The Concept of Capital and Revenue Expenditure:

    Expenses, losses, and incomes are also known as revenue items since they together will show up the net profit or revenue earned. Other transactions are of capital nature. One must be clear in one’s mind regarding the nature of an item of expenditure. This is an important aspect of the matching principle and without it; financial statements cannot be properly prepared.

    Capital expenditure is that expenditure which results in the acquisition of an asset, tangible or intangible, which can be later sold and converted into cash or which results in an increase in the earning capacity of a business or which affords some other advantage to the firm.

    In a nutshell, if the benefits of expenditure are expected to accrue for a long time, the expenditure is capital expenditure. Obvious examples of capital expenditure are land, building, machinery, patents, etc. All these things stay with the business and can be used over and over again.

    Other examples are money paid for goodwill (the right to use the established name of an outgoing firm) since it will attract the old firm’s customers and, thus, result in higher sales and profits; money spent to reduce working expenses.

    For example, conve$ion of hand-driven machinery to power-driven machinery and expenditure enabling a firm to produce a large quantity of goods. Expenditure which does not result in an increase in capacity or in the reduction of day-to-day expenses is not the capital expenditure unless there is a tangible asset to show for it.

    It should be noted that all amounts spent up to the point an asset is ready for use should be treated as capital expenditure. Examples are fees paid to a lawyer for drawing up the purchase deed of land, overhaul expenses of second-hand machinery, etc. Interest on loans raised to acquire a fixed asset is particularly noteworthy.

    Such interest can be capitalized, i.e., added to the cost of the asset but only for the period before the asset is ready for use interest paid for the subsequent period cannot be capitalized. An item of expenditure whose benefit expires within the year or expenditure which merely seeks to maintain the business or keep assets in good working condition is revenue expenditure

    Examples are salaries and wages, fuel used to drive machinery, electricity used to light the factory or offices, etc. Such expenditure does not increase the efficiency of the firm, nor does it result in the acquisition of something permanent.

    The following items of expenditure seem to be revenue expenditure, but in actual practice, these are treated as capital expenditure since they lead to the business being established and run efficiently:

    • Expenses for the formation of a company—preliminary expenses.
    • Cost of issuing shares and debentures and raising loans, such as legal expenses underwriting commission, etc.
    • Interest on capital up to the point production is ready to commence, where the nature of the business is such that construction work must go on for a long period before production can start.
    • Expenses on acquisition and installation of assets, for example, legal fees to acquire property, or expenses incurred to renovate machinery bought secondhand or wages of workmen who install the machinery.

    Diminution in the value of assets due to wear and tear or passage of time is the revenue loss. For instance, a piece of machinery is bought at the beginning of the year for $ 1, 00,000; at the end of the year, its value to the business may only be $ 90,000. The diminution—known as depreciation—is a revenue loss. Stocks of materials bought will be an asset unless consumed—to the extent, the materials are used up, they will be revenue expenditure, so also the cost of goods sold.

    However, the distinction is not always easy. In actual practice, there is a good deal of difference of opinion as to whether a particular item is capital or revenue expenditure. A cinema converts its ordinary screen into one for cinemascope. Is the expenditure-revenue or capital?

    One may say that since the eating capacity of the hall does not change, the expenditure is revenue expenditure. On the other hand, it may be argued that since cinemascope pictures attract large audiences, the hall will be full oftener. Therefore, the expenditure will result in higher earnings and should be classified as capital expenditure. There is truth on both sides.

    Understand Capital and Revenue Expenditure in Accounting
    Unde$tand Capital and Revenue Expenditure in Accounting, Image credit from #Pixabay.