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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
Return
It is chased by risk.
Return
It differs by: Nature of financial instrument. Maturity period. Host of other factor
2 Risk
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.
3 Marketability
Judging Marketability
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 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.
(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.
(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:
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
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
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.
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.
Boom period: prices of stock Depression period: prices of stock Analysis of price behavior of individual scrip will help to locate buy &sell point.
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.
(6) Amount of investment : Higher amount invested in any security, more will be the risk.
Huge amount in one particular security is always risky.
(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
a) MARKET RISK Arises out of changes in the pattern of demand & supply in the market.
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.
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
Work sheet
1. Explain systematic risk. 2. Explain market risk with example. 3. Explain interest rate risk.
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.
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
These risk influences the operating income of a firm and dividend also.
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.
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.
By offering attractive compensation plans, a highly motivated labour force can be formed.
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 .
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.
WORK SHEET
1. How can the production of single product be a risk factor? 2. Explain external business risk.
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.
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
Minimizing risk Investors aims at: o Income o Capital appreciation o Liquidity o Marketability o Safety o Hedge against inflation
WORK SHEET
1. Explain financial risk. 2. Explain marketability risk.
Protection against market risk Protection against interest rate risk Protection against inflation Protection against business & financial risks
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.
(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.
(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
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
This method is called maturity diversification it can yield better results to the investor.
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.
(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
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.
(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.
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.
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.
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.
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
The rate of dividend vary from year to year depending upon the profitability of the company during the accounting year.
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.
Project can be based on : Diversification programme Production capacity Technical methods Financial position Change in capital structure Sales Fund allotment.
Investors rely on goodwill, as it indicates the regularity with which they can receive their income from the company by investing in its securities.
If the profitability is more for the company, it only benefits its investors ultimately. Return on investment varies depending upon Government policies.
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.