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INVESTMENT ATTRIBUTES FOR EVALUATING INVESTMENT

To enable the evaluation and a reasonable comparison of various investment avenues, the investor should study the following attributes:

Rate of return

Risk
Marketability Taxes (Tax Shelter) Convenience

1 Return

It is a reward to the investor. It is either in form of regular income or capital appreciation

Return

It is chased by risk.

Higher the risk higher the returns.

Return
It differs by: Nature of financial instrument. Maturity period. Host of other factor

2 Risk

A possibility of meeting danger.


An estimation about the degree of happening of the loss.

2 Risk

Measurable
Some are controllable & others cannot be.

Definition of Risk
Risk is a change that the expected Or perspective gains or profits may not materialize.

Risk Arises Due To


Wrong decision Wrong timing of investment Type of instrument Quantum of amount

Risk Arises Due To


Method of investment Nature of industry National &international factors

3 Marketability

It is desirable that an investment


instrument be marketable. The higher the marketability the better it is for the investor

Marketability Investment is highly marketable:


It can be transacted quickly. The transaction cost (including brokerage and other charges) is low. The price change between 2 transactions is negligible.

Judging Marketability

The liquidity of a market may be judged in terms of : Depth Breadth resilience

Judging Marketability

Depth refers to the existence of buy as well as sell orders around the current market price.

Judging Marketability
Breadth implies the presence of such orders in substantial volume. Resilience means that new orders emerge in response to price changes

Factors considered during investment

Can he make a substantial withdrawal without much penalty.

Factors considered Can he take a loan against the accumulated balance at an interest rate not much higher than our earning rate of interest on the provident fund account.

WORK SHEET
1. What are the various investment attributes used in evaluating investments? 2. Explain marketability of shares.

We shall look out the other attributes in evaluating investments

(4) Taxes
Some of our investments would provide us with tax benefits while other would not. Tax planning lead to a substantial increase in the amount of savings.

Taxes
Various tax incentives are offered by the government make savings possible: Provision of Income Tax Act Provision of Wealth Tax Act

Tax benefits
Tax benefits are mainly of 3 types Initial tax benefits Continuing tax benefit Terminal tax benefit

Initial Tax benefits It is the tax gained at the time of making the investment. E.g.; deposit in public provident fund a/c you get a tax benefit under sec 80c of the Income Tax Act.

Continuing tax benefit


It is gained on the periodic return from the investment. E.g. dividend income & income from certain sources are tax- exempt, up to certain limit.

Terminal tax benefit


It is the tax relief the investor gains when he liquidates the investment. E.g. withdrawal from provident fund a/c is not subject to tax.

(5) Convenience
It is the ease with which an investment can be made and managed. The degree of convenience would vary from one investment instrument to the other.

We shall point out the objectives of investment & The term Risk in detail

Objective of investment
For most of the investors, their objective in investment is to:

Earn fair returns


On their money invested.

Decision to be made in investment


What securities should be held? How much funds should be allocated to each?

Such decisions are made by estimating the:


Risk& returns Associated with available securities during the holding period. But risk & return are inseparable.

Investors concern
Is in 2 principal properties The return that can be expected from holding a security & The risk that the return that is achieved will be less than the return that was expected.

Risk

It is the opposite of safety. Enhancement of safety involves reduction of risk.

Degree of risk varies


Based on the features of the securities. The mode of investment. The issuer of the security.

Meaning of risk

The possibility that the actual return may not be same as expected.

Meaning of risk
A situation where the possibility of happening or non-happening of an event can be quantified & measured

Risk & Uncertainty

They both go together. They are the integral part of the security.

Difference
Risk The decision maker is aware of the possible consequence of an investment decision Uncertainty Refers to a situation where the outcome is not known to the decision maker.

Causes of risk
The factors causing risk in investment are: Price Interest External factors Internal factors

WORK SHEET
1. What is the main objective in investing? 2. Distinguish between risk & uncertainty. 3. Point out the various causes of risk.

LETS NOW STUDY ABOUT THE VARIOUS FACTORS CAUSING RISK

External factors
They are beyond the control of an organization.

They broadly affect investments. They are also known as systematic risks.

Internal factors

Factors causing internal risk are within the industry They are also called as unsystematic risks.

FACTORS RESPONSIBLE FOR CAUSING INTERNAL RISK IN INVESTMENT

(1)Incorrect decision taken with regard to investment:


Decision: what to buy & sell? Depends on estimation of: fair intrinsic value of shares. Over & under valuation of share.

(2) Failure to judge the correct timing of investment:


Timing of purchase & sale of securities is important due to cycle of fluctuations of stock

Boom period: prices of stock Depression period: prices of stock Analysis of price behavior of individual scrip will help to locate buy &sell point.

(3) Selection of the highly risky investment instruments:

Unorganized sectors shares are highly risky.


e.g. chit funds, corporate shares

Instruments that ensures certainty of payment of interest and principal are less risky. e.g. bank deposits, post office certificates

(4) Unsatisfactory credit worthiness of the issuer: When credit worthiness of issuer is not satisfactory, risk arises. Securities of government & semi government bodies have degree of credit worthiness. Securities of private sectors are not credit worthy.

(5) Maturity period: If investments have a longer maturity period:

They invite more risk. Because of the duration of the investment.

(6) Amount of investment : Higher amount invested in any security, more will be the risk.
Huge amount in one particular security is always risky.

Judicious mix of investments in small quantities may be ideal.

(7) Security : Investment may be secured or unsecured.


If, secured by collateral securities, then the risk will be less.

(8) Nature of Business: Business is prone to ups & downs Prosperity alone should not be considered.

Nature of Business:
Unfavorable trend in the industry will affect the company. So, selection of risky industry creates trouble.

(9) Terms of Lending: Factors that causes risk in investment under terms of lending are: Periodicity of servicing Redemption period These factor should be taken into concern.

(10) Demand & Supply forces: Fluctuation in prices make the securities risky
The investor has to predict demand & supply or else the security prices will show a wide variation.

(11) National & international factors: Changes in foreign market also influences the market of other part of the world.
Changes in conditions within the country are reflected in security prices.

Work sheet
Each group take one factor each, relate it to any investment avenue and present your example found.

CLASSIFICATION OF RISKS

RISKS

SYSTEMATIC RISKS

UNSYSTEMATIC RISKS

OTHER RISKS

1.SYSTEMATIC RISKS External factors causes systematic risks. They are non-diversifiable.
They arise out of the factors: Market Nature of industry State of economy

Systematic risk

Market risk

Interest Rate risk

Purchasing power risk

a) MARKET RISK Arises out of changes in the pattern of demand & supply in the market.

It is based on changing flow of information (or) expectation.


Investors reaction towards tangible &intangible event affect market risk.

Tangible event affecting market risk: Political, social & economic reasons such as business recession & depression . Intangible event: Psychological factors affecting market risk: unexpected war, instability government, etc.

The fall & rise in price of security causes fear of loss in minds of investors.
When investors react to loss: Excessive selling happens pushing price down. When investors react to gain: Results in more buying increasing price.

AVOID MARKET RISK Being conservative while framing their portfolios. Careful combination of different stocks on the portfolio. Carefully plan the time of purchase. Concentrate only on growth stocks.

b) INTEREST RATE RISK


Prevailing interest rate in the market determines the prices of the securities

This risk is determined by the uncertainty of market in future.


Due to fluctuations in interest rate.

Interest rate demand for securities by speculators ( buy with borrowed funds. demand for security prices.

The effect of variation in interest rate will be different for LENDING & BORROWING INSTITUTIONS.

Companies that uses borrowed funds will spend much of their income in payment of interest . This leads to : Earning Dividends Share prices

Movement of prices in the stock market is of 4 types:


Long - term cyclical (bull & bear markets) Intermediate or within the cycle Short - term

Ways to reduce interest rate risk Diversifying in various kinds of securities.


Buying securities of different maturity rates.

Ways to reduce interest rate risk


Buy government securities. This leads to lowering the prices of securities issued by private sector.

Work sheet
1. Explain systematic risk. 2. Explain market risk with example. 3. Explain interest rate risk.

See in detail about purchasing power risk & Unsystematic risk

c) PURCHASING POWER RISK


It refers to the impact of inflation & deflation on the investment. It is also known as inflation risk. Rise in price is called inflation. Inflation causes loss of purchasing power variations in returns.

Variation is return is caused by : loss of purchasing power of currency & inflation causes it. E.g.; when a person purchases a stock he foregoes the opportunity to buy another desired share. If price of desired share increases, the investor loses more purchasing power.

Inflation is of two types: I. Demand pull II. Cost push

Demand pull Supply of goods is scarce. Demand is in excess.


Factors of production are fully employed.

Demand pull
Economy could not supply the needed goods in short run. Pushes the price upwards.

Cost push
Cost of production High price level Laborers demand high wages to cope up with increased cost of living.

Cost push
Thus cost push inflation has a spiraling effect on price level. The changes in price level are measured by price index.

Consumer who wishes to postpone the present consumption for making investment faces rising prices & shortage of funds. Investor must include in his investment an allowance for purchasing power risk while he invest his fund.

2.Unsystematic Risk It arises out of uncertainty surrounding a particular firm or industry due to factors like : Strikes Lock-outs Consumer preference Management policies

Sources Unsystematic risk arises from 3 sources: Business risk Financial risk Default or Insolvency risk

(A) Business risk


It caused by the prevailing environment of the business.

These risk influences the operating income of a firm and dividend also.

(A) Business risk


Every company expects itself to pay to its shareholders a certain rate of dividend & plough back some profits.

Categories of business risk


Business risk can be divided into 2 broad categories: Internal business risk & External business risk

Internal business risk


It is associated with the limiting internal environment of the firm. It varies from firm to firm depending upon the constraints in the firm. The firms success depends on the ability of the firm to cope up with these risk.

Types Important internal risk includes: Fluctuation in sales Research & development Personnel management Fixed cost Production of single product

i) Fluctuations in sale
Company strives to maintain its market share. Loss of a customer leads to loss of profit. They build a strong customer-base by employing appropriate channel of distribution & sales force.

ii) Research & Development


To overcome the problem of obsolescence, the company has to concentrate on In-House research & development.

It should be undertaken constantly to introduce new products.

Expenditure incurred on research & development will help to promote the operational efficiency of the firm in the long run.

Work sheet
1. Explain purchasing power risk. 2. Explain business risk.

WE SHALL STUDY THE OTHER INTERNAL RISK

iii) Personnel management Operational efficiency depends on the management of personnel .


Frequent strikes & lock outs would affect the rate of production

Consequently Labour productivity suffers.

By offering attractive compensation plans, a highly motivated labour force can be formed.

Compensation plans can be: The employees morale


Higher productivity Less wastage in the production processes.

iv) Fixed costs

Proper control over cost can minimize the risk that arise out of the cost behavior of the factors of production.

High fixed cost during recession is disadvantageous to the firms. The firm cannot aim at reducing the fixed cost during recession & low demand for the product .

So, the fixed cost proportion has to be kept reasonably.

So, it does not affect the profitability of the firm.

v) Production of Single product


When single product is produced by the firm the rate of internal risk will be The fall in demand for the product would profitability.

Overcome production of single product risk


If the firm has number of products items :demand in one product compensated by demand for another product.

B) External business risk


It is associated with circumstances beyond a firms control. Factors influencing it: a. Business cycle b. Demographic factors c. Government policies d. Social & regulatory factors

Business cycle Fluctuations of business cycle leads to fluctuations in the earning of the firm. During recession: demand for product will fall

Business cycle
Most of the firms close their business. During boom: there is a great demand for the product.

Successful firm will be able to move counter cyclically during the recession.

Effect
The effect of business cycle varies. In some cases, recession may lead to fall in profit & growth rate of the firm. In other cases, the firm with inadequate customer base are forced to close down their business.

Demographic factors Success of business operations depends on the health, education & skills of employees beside their attitude towards work.

Demographic factors
A country with educated & good citizens produces excellent entrepreneurs & successful business units.

Government policies
Every government pursues its own polices. Whenever there is a change in government, there is a significant change in the overall policies affecting the business.

Any changes in policies towards: nationalization, disinvestment, foreign direct investment & Role of multi national companies Affect the cost & availability of funds for investment in securities.

Social & regulatory factors


Regulatory factors affecting the revenue of the firms: Environment protection act Price control Fixation of quotas Import & export control Monetary & fiscal policies

Risk is more in prevalent in industries related to public utility services.


Governments tariff policy has a direct bearing on earnings of telecom sector. RBIs directives with regards to interest rate , lending policies affect the profitability of banking sector.

WORK SHEET
1. How can the production of single product be a risk factor? 2. Explain external business risk.

LETS STUDY ABOUT THE FINANCIAL RISK IN DETAIL

Financial risk
It is related to the way a company handles its financial activities. It is ascertained by studying the capital structure of the firm.

Financial risk
Capital structure = loaned + owned capital Presence of debts makes fixed payment in form of interest.

Payment on preferred stock are meet with profit earned by the company.

Financial risk
Residual earnings available to the equity shareholders are less.

If NO interest & fixed dividend payment more profit available to equity shareholders.

Debt financing
It is otherwise known as financial leverage.

Has 3 effect on equity shareholders: Increases variability of their returns Affect their expectation on returns Increases their risk of being ruined

To company It is advantageous to corporate body. It enables the company to have It is advantageous to corporate body. It enables the company to have funds at low cost.

Earnings than cost of borrowed funds shareholders earnings increases.


If debt earnings are than debt financing bankruptcy of equity shareholding.

Default or Insolvency Risk


It arises out of the inability of the borrower in satisfying the needs of the investor. If borrowers credit standing is higher & if he becomes insolvent Investor gets no return.

Default or Insolvency Risk


Investment in financially healthy companies may turn useless if: It becomes sick Share price falls below its face value.

Other Risk It includes: Political risk Management risk Marketability risk


These risk vary in form , size & effect

Political risk
It is associated with the investment in foreign securities They arise out of: Change in foreign government Nationalization of business enterprises Inability of foreign government to handle its indebtedness.

Management risk
Management risk arises out of : Errors or due to the inefficiency of the management causing financial loss to the company.

Marketability Risk
It arises out of: Loss of liquidity Monetary loss in conversion from one asset to another

Marketability Risk- investors


Some features of securities causing some setbacks to investors while marketing their securities are:

Marketability Risk- investors


Call ability Lack of sinking fund Debenture redemption reserve fund Reserve for repayment of principal

Minimizing risk Investors aims at: o Income o Capital appreciation o Liquidity o Marketability o Safety o Hedge against inflation

All investors dislike risk but they cannot eliminate it completely


So, the investor should know how to manage risk while making investment.

They should pay attention to minimization of risk.

WORK SHEET
1. Explain financial risk. 2. Explain marketability risk.

VARIOUS METHODS TO MINIMIZE RISK.

Methods to minimize risk

Protection against market risk Protection against interest rate risk Protection against inflation Protection against business & financial risks

1. Protection against market risk


(i) Investor should study the movement in share prices of the past. It provides a basis to predict the trend in future price change.

When stock prices shows growth pattern, the upward trend will continue for some time. Some stocks may be cyclical stocks , which cannot move against cyclical phase. So it is advisable to avoid cyclical stocks.

(ii) The volatility of the stocks is represented by standard deviation & beta.
These are included in indices & made available with national stock exchange news bulletin.

By analyzing these information investors can make investment decisions.

(iii) Investor should carefully decide the timing of purchasing & sale of securities.
Purchase securities at lower price & sell at higher price.

Investor should hold the stock for long time to take advantage of rising trend in the market.

2.Protection against interest rate risk

(i) The investor should hold the investment till maturity. Selling them before maturity period in fear of fall in interest rate Investor will incur heavy loss on the capital invested.

(ii) If investor wants to hold securities for short period , he may buy

Treasury bills & bonds of short maturity.

Money invested in them can be reinvested in market depending upon the prevailing rate of interest.

(iii) Investor can invest there fund in bonds with different maturity dates.
Amount realized on different dates can be reinvested according to changes in

the investment climate.

This method is called maturity diversification it can yield better results to the investor.

3. Protection against inflation


(i) Bonds carry fixed rate of interest, so bonds with reasonable rate of interest would act as a hedge against inflation.

3. Protection against inflation


(ii) During inflation: consumer price index will be rising. At that time investment in short term securities would be beneficial than long term.

(iii) Inflation can be overcome through investment diversification.

Choose various investment avenues such as: real estates Precious metals Bank deposits Insurance schemes Along with securities

Different forms of investment could not guarantee total elimination of risk. They can minimize the loss due to the declining purchasing power

4. Protection against business & financial risk (i) Analyze the strength & weakness of the industry to which company belongs.

4. Protection against business & financial risk


If the weakness could not be controlled by Government interference Those companys securities should not be chosen for investment.

(ii) Analysis of profitability of the company will enable the investor to understand the financial soundness of the company. Companies that are not consistent in terms of earning should be avoided.
It is better to invest in securities of the company with consistent track record

(iii) Analyses of capital structure Presence of debt in capital structure commits company to make regular payment of fixed interest. Investor should be aware of earning per equity share.

During boom period securities of the companies with high debt equity ratio can be chosen.

WORK SHEET
State the various methods that would be adopted by the investor while investing in : 1. Equity & preference share 2. Bank deposits. 3. Debentures

RETURN ON INVESTMENT

Forms of return Returns may take several forms: Investor expect to receive interest on debenture Dividend on shares

Meaning It is the motivating force in the investment process.


By historical returns, investors can assess how well they have benefited from investment in past.

It is essential for investor to distinguish between realised return & expected return.

Distinction between realised & expected return Realised return: return that was earned or could have been earned. Expected return: return from an asset that investor anticipate over a future period It is a predicted return.

Investors expectation An investor will be willing to make investment only if the expected return is adequate. But in reality investors do not realise the expected return always.

Components in return on investment


It has 2 components: (i) Periodic cash receipt component: it is the form of : Interest Dividend

(ii) Change in the price of the asset: It is also called as capital gain or loss. It is the difference between purchasing price & the price at which the asset is sold.

Determination of gain or loss


If sales price is more than the purchase price, gain will arise. If purchase price is more than the sales price, loss is incurred.

When an investment instrument is considered HIGHLY MARKETABLE?

It can be transacted quickly. The transaction cost (including brokerage and other charges) is low. The price change between 2 transactions is negligible.

Returns A securitys total return consists of income & price change. Debentures purchased at par & held to maturity give only income in form of interest.

Example for returns If non dividend paying shares are bought & sold after five months, they will produce only capital gain or loss.

Example for returns


With reference to investment in equity shares, return consist of dividends & the capital gain or loss at time of sale of these shares.

Return defined in form of equation P1- P0+D1 P0 K=expected rate of return from the investment P0 = market price at time 0 P1 = market price at time 1 D1= cash dividend for the period 1 K =

The equation shows that the expected return K is the total of capital gain or loss (P1- P0) & cash dividend (D1) over the period. This equation is used to determine the rate of return on any investment.

WORK SHEET
1. What is meant by returns? 2. Explain return in the form of equation.

FACTORS DETERMINING THE


RETURN ON INVESTMENT

Price of the stock Type of the stock Issue price of the stock Reserve for dividend Future projects of the company Goodwill of the company Government rules & policies.

(i) Price of the stock


Returns depends on price of the securities held Securities are classified into : Fixed income bearing securities Variable income bearing securities.

Debt instrument: carry a fixed rate of interest which is expressed as a percentage on the face value of securities. It is easy to find out return on the basis of the face value of security

Equities: they do not carry any fixed rate of dividend.


Dividend income is receivable as a percentage on the face value of equity share.

The rate of dividend vary from year to year depending upon the profitability of the company during the accounting year.

(ii) Type of the stock


For Funds invested on preference shares: dividend is fixed. Funds invested in the form of equity shares: return may vary every year. In certain year no dividend may be paid.

(iii) Issue price of the stock


Shares are issued by company on different terms: Issued at par (issue price = face value) Issued at discount Issued at premium

Companies that issue shares at premium enjoy popularity. In such companies the issue price will be higher than its face value. The issue price of shares at premium generally indicates the financial soundness and profitability of the company.

(iv) Reserve for dividend


Companies act allows companies to create reserves for distribution of dividend. Companies maintain dividend equalisation fund in order to maintain a stable return even during lean period. Creation of reserves for dividend affects return on shares.

(v) Future projects of the company


Company have several future plans in order to achieve growth & objectives. Companies project is always related to its future investment. Returns vary depending on projects undertaken

Project can be based on : Diversification programme Production capacity Technical methods Financial position Change in capital structure Sales Fund allotment.

(vi) Goodwill of the company


Goodwill represents the profitability of the company & its reputation among public. Investors prefer companies with considerable goodwill.

Investors rely on goodwill, as it indicates the regularity with which they can receive their income from the company by investing in its securities.

(vii) Government rules & policies


Distribution of income by the company is governed by the rule & policies of the government. Subsidies, duty exemption are the factors that encourage companies to enhance profitability.

If the profitability is more for the company, it only benefits its investors ultimately. Return on investment varies depending upon Government policies.

COMPARISON OF VARIOUS INVESTMENT AVENUES

WE HAVE STUDIED THE VARIOUS INVESTMENT ATTRIBUTES &


COMPARED THEM

WORK SHEET
1. State the various factors affecting the returns on investment. 2. Evaluate the various types of investment by comparing it with investment attributes.

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