Hot Terminologies

Monday, February 12, 2018

February 12, 2018

Optimal Capital Structure

Background

An organization needs two types of financial resources to invest in assets. One is short term source of financing and another is long term source of financing. Basically  the liabilities that are payable with in one year are called shot term financing and the liabilities that are payable with in more than one year period are called long-term source financing. 


The aggregate of short-term and long-term financing is called Total Financing. And the ratio of difference sources in total financing is called Financing Structure.  With in the financial structure, only the portion of long-term source of capital is called capital structure. 

Sources of long term financing.


  1. Equity share capital
    It is main long term source of capital for many companies. It is irredeemable or perpetual source of capital. Company ought not to bear fixed cost of capital on it. It means the cost(return) is not prefix on equity share capital. Equity shareholders are owner of the company. They participate on the residual income of the company.  Though the cost is not fixed on it, it is costly source than others because equity shareholder has claim on residual income and assets after paying other liabilities. Company pays dividend on it. ( See also : What is Rights Offering ? Options to shareholders and its effect on their wealth )
  2. Long-term Bond/debenture 
    Company pays interest on long-term bond/debenture. Company must pay interest to the debenture holder/bondholder no matter there is profit or loss. The interest rate may be fixed for every year until maturity. The interest might be tied up with market interest rate.
    Note : The bond/note/debenture that has interest rate tied up with market interest rate especially with interest rate on government securities is called Floating Rate Note (FRN).
  3. Preference share capital
    It is hybrid kind of capital that has mix kind features of equity share capital and debenture. It has fixed rate of dividend but the claim is subordinated to debenture holders. 

Determining Optimal Capital Structure


The portion of long term financing sources on total capitalization is called capital structure. For example, if there $200000 Common stock, $150000 Preference share capital, $150000 Debenture, the summation of all these source $500000 is called total capitalization. And among the total capitalization, 40% Common stock, 30% Preference Share, 30% Debt is called capital structure.

Optimal Capital Structure
Change in capital structure implies change in cost of capital. But Why and How ? First, using debt implies low cost of capital in initial time because debt capital has lower cost than that of share capital. But when we regularly increase the use of debt, there will be lower liquidity on an organization. As a result cost of debt should be increased and that implies increase in cost of capital. Second, Making increase in debt capital implies higher risk on equity shareholders investment and their expected rate of return goes higher, the cost of capital also goes higher. 

According to above discussion, we can conclude that, the capital structure where the cost of capital becomes minimum and value of firm becomes maximum is called optimal capital structure.

We have to calculate Weighted Average cost of capital(WACC) to determine optimal capital structure.

WACC= Weight of Debt*after tax cost of debt+ Weight of equity* Cost of equity.

Now we have to take a look in to following table become more clear about optimal capital structure.

Calculation of WACC


In the above table the cost of capital is 12% when there is no use of debt. Then after we use debt capital 10% and reduce equity capital to 90%, the cost of capital reduced to 11.78%. The cost of capital is reduced till we use 20% debt. But when we increase the use of debt to 30% from 20%, the cost of capital started to increase. It means use of debt can reduce cost of capital to a limit only. The cost of capital is minimum when we structured our capital using 20% Debt and rest 80% Equity share capital which is Optimal Capital Structure.


February 12, 2018

Floating Rate Note (FRN)

Background 

I have discussed about the nature of debt instrument and common stock regarding their risk and return from the point of view of investors and company.(Read the Background Part of this post )
Floating rate note is issued for more than one years to maximum five years where as Floating rate bond is issued for more than 5 years specially more than 10 years in practice. That's why we don't have to be confused in the term note and bond, Our concern is to know "Floating rate" that may be on note or bond. 

In normal note/bond instrument their is fixed interest rate for every payment period until maturity. The fixed interest rate is mentioned on Bond Indenture. For instance, 12% note indicates that the interest rate will be fixed for every year (may be semiannually, quarterly). 
But the floating rate note doesn't have fixed interest rate. It is a debt instrument with variable interest rate. In floating rate note the interest rate is tied up with the market interest rate. Generally it is tied up with the interest rate of government securities.

Why Floating Rate Note ? 

It is difficult to sale debenture/bond/note when the interest of capital market is not stable. Investors want to invest in short term debt instrument when the market interest rate is continuously growing. On the other hand, investors want to invest in long term debt instrument when the market interest rate is descending. The company has to pay higher interest on the debt instrument when there is expectation of increase in market interest rate. Floating interest note is issued to minimize the risk of investors and to prevent additional cost of capital for the company from the change in market interest rate. 

Pro and Cons of Floating Rate Note

Floating Rate Note surely minimize the risk on investors. Similarly, it minimize the risk of company regarding the possibility of paying higher interest due to change in market interest rate.

In contrast to the advantages, when the market interest rate falls downward investors yield on note also adjusted downward. It doesn't happen on fixed interest rate note/bond.

Final Words

The interest rate of floating rate note is increased with the increase in market interest rate. And the interest rate of floating rate note is decreased with the decrease in market interest rate. As a result, the price and interest rate risk in minimized. 

See also :

Sunday, February 11, 2018

February 11, 2018

Loan Amortization Schedule

Background

Before reaching to the main topic, we should know why amortization schedule is prepared for. The loan provider and loan taker both have to know about loan amortization schedule. Suppose you are willing to buy a car. And it costs $100000. But you only have $20000. When you visit the car showroom, the manager persuade you to pay however you have now and make finance for 2 year and equal amount should be paid at the end of the each six month. Now you have to pay equal amount at the end of every six month which include certain portion of principal amount and rest portion of interest amount. To know how much should we pay at the end of each six month and how the total loan is amortized at the end of 2 year, we have to make loan amortization schedule.

From loan amortization schedule we will be able to know the portion of loan and interest on our semiannual payment. At first we have to calculate semiannual installment and then after we have to segregate the interest amount and principal amount. 

Calculation of Installment

As the above data we supposed,
Total Cost of car= $100000
Down Payment = $20000
Loan amount= $80000
Interest Rate= 12%p.a.= 12/2= 6% semiannually
Interest amount =%80000 *.06=$4800 
Period of Loan= 2 years (semiannual payment)= 2*2= 4 semiannual payment.

We have,
Semiannual installment= Loan amount/PVIFA6%,4 peroid= 80000/3.4651= $23087 
 It means we have to pay $23087 semiannually.

NOTE:

When the payment is advance or at the beginning of each month.

Monthly installment = Loan amount/(1+PVIFAi%,n-1)

But here we assume that the payment is made end of the each month.

Loan Amortization Schedule (Loan Repayment Schedule)













Now we are going to make loan amortization schedule for above example that we are doing.


Loan Amortization Schedule.
Interest= Beginning amount* semiannual interest rate.
For example, Interest amount for period 3= 42328*0.06= 2593.68
Justification : At the end of the period, ending balance must be nil. But in the above table we have o.5208 balance at the end of the period. The reason behind it is that we have rounded the figure after decimal point.

Final Words

In the same way we can calculate periodic installment and format loan amortization schedule for advance payment. Advance payment is just like you have to pay first installment at the beginning of the period. I have mentioned above the method of calculating periodic installment on advance payment. There is slightly difference in amortization schedule. The beginning amount well be 80000 at the period 0, interest will be nil at the beginning payment. Then after everything is as it is.

Friday, February 9, 2018

February 09, 2018

Rights Offering (Issue)

Background

Company used to raise their capital by using debt capital and equity capital. If a company collects its capital by issuing long-term-debt instrument such as bond, debenture is called debt capital. On debt capital a company should pay certain percentage cost every year no matter the company is on profit or loss. The cost of debt capital is already fixed at the time of issuing (Expect Floating Interest Rate Bond). On the other hand, Equity capital has their residual claim on profit after paying interest on debt capital and distributing dividend to preferred stock. If a investor is holding certain units of share of a company, he can only claim on residual income. He can't receive dividend when the company is suffering from loss. It means Common stock has high risk than other from the point of view of an investors. That's why common stock holder are provided some rights. These are :

  • Collective rights
  • Voting right 
  • Preemptive rights

    With out approval of shareholders ,company can not take any new action regarding capital structure, dividend distribution and like that. This right of shareholders is called Collective rights.

    Shareholders cal elect the members of Board of Directors through election. Debenture holder, Bond Holder even Preferred Stock holder don't have right to vote on election of BOD. This is common shareholders voting right.

    Meaning of Rights Offering (Issue)

    As we discussed that the another right of common stock holder is preemptive right. This article also focus on preemptive right of shareholder. Let, a company has already issued 100000 units of share from Initial Public Offering(IPO). After one year if a company wants to raise $2000000 capital through equity share the company has to issue 20000 shares (assuming par value is $100). But according to the Preemptive right of common stock holder, the company issue 20000 shares only for existing 100000 shareholder. These 20000 shares can be purchased by the existing shareholders. That is called Rights Offering.
    If a company issue equity shares only for its existing shareholders is called rights offering. On this offering or issue general public can not apply for buying the shares.

    Advantages of Rights Offering


    • Low flotation cost for the company.
    • Fast collection of the fund.
    • No Dilution Effect. 
    • It is cheaper than public offering. 

    Disadvantages of Rights Offering 

    • If a company is performing lower than previous year and investors are willing to sell stock that they are holding over the period and the company issues right share, investors will have to either exercise their right of sell their right. Otherwise they suffer another loss. 

    Options to Shareholders 

    • Shareholders can exercise their right.
    • Shareholders can sell their right.
    • Shareholders can exercise some right and sell rest right.
    • Do nothing.

    Calculation of Value of a Right and Ex-right price.

    We have to be clear about value of right and ex-right price before taking any action among the options the shareholders have. The price at which an investors can sell his right is called value of right. The adjusted market price after rights offering is called ex-right price. 

    Lets consider the above example,


    Existing No. of share= 100000 shares

    Fund to be raised=$2000000

    Subscription price(Ps)=$100
    Current Market Price(P0)= $220
    No of share to be issued= Fund to be raised/Subscription price=2000000/100=20000 shares. 
    No of rights required to purchase a share(#) = existing no of share/ no. of share to be issued=100000/20000=5 rights
    Value of a Right= (Ps-P0)/(#+1)=(220-100)/(5+1)=$20 per right
    Ex-right Price(Pe)= P0-Value of a right= 220-20=$200 per share.

    Effect of Rights Offering on Shareholders Wealth.

    Let a investors has following wealth
    Equity Shares of ABC Company (500 @ $220 (market price)= $110000
    Cash = $20000
    Total =$130000

    No of shares he can purchase = No of shares he has got/ #= 500/5=100 Shares.

    We have already discussed that shareholder have on option to exercise their right. What would be the effect on shareholders if the shareholders take one of the following three options :
    1. If the shareholder exercise his all right. (No effect)

    Equity Shares of ABC Company (600@ $200 (market price)=$120000
    Cash (20000-100 shares @$100) = $10000
    Total = $130000

         2.  If the shareholder Sell his all right. (No. Effect)

    Equity Shares of ABC Company (500@ $200 (market price)= $100000
    Cash (20000+500 rights @200) = $30000
    Total = $130000

         3.  If the shareholder neither sell neither exercise his right. (Loss)

    Equity Shares of ABC Company (500@ $200 (market price)= $100000
    Cash = $20000
    Total = $120000

    Conclusion 

    Rights offering is the preemptive right of common stock holder. When a company issue common shares only for its existing share holder, it is known as rights offering. Point to be noted is that a investors must either exercise his right or sell his right. Otherwise he will surely suffer from the loss. Because price after the rights offering surely decrease by the same amount of value of right. 

    See also : Calculation of Installment and Preparation of Loan Amortization Schedule. 

    Wednesday, February 7, 2018

    February 07, 2018

    Stock Volatility

    Background

    Stock volatility is the mostly used term in financial market, specially in stock market. Rational investors always evaluate the stock's risk and return before investing in stock. We can measure average return and expected return easily. With the help of historical return over past years we can calculate Average Return.
    In the same way we can calculate expected return from the probability data. For calculating expected return we have to multiply the return in different stage of economy to the corresponding probability. And the sum will be expected return.

    In this way we can calculate stock's return. In summary, Average return is the return of a stock calculated by the historical return data and Expected return is the return of a stock that is calculated according to the probability of occurring the return in future.

    Just calculating return is not sufficient to take decision either invest in the stock or not. For that we have to calculate Risk. And the risk is determined by measuring volatility of a stock.


    What is Volatility of a Stock ?

    Stock Volatility is a statistical measure of the dispersion of returns for a given stock. We can measure a stock's volatility either by using the standard deviation or variance. Investors must know about stock volatility to take decision to invest on of the alternative. Higher standard deviation indicates higher volatility of the stock that implies higher risk on the stock. Similarly lower standard deviation indicates that there is lower risk than previous stock. 
    That's what volatility is the deviation of return from the average return of a stock. That indicates the changing behavior of a stock return. If a stock has haphazard kind of return over the past years or in expected years, definitely it has high volatility. It measures how far the stock returns are spread from the average return or expected return.
    Investors use stock volatility to compare similar investment opportunities. Having same level of return investors prefer to invest to the stock that has lower volatility i.e. lower standard deviation. 

    Computation of Stock volatility 

    Here also we may have two conditions. We may have historical data or Probability data. If we have historical data, first we calculate average return of a stock that we have already calculated in Table 1. Then we have to make a new column to find deviation of returns from the average (avg Return-Return). Then we calculate (avg Return-Return). Square root of (avg Return-Return)2/(n-1)  is the standard deviation of the return and this is volatility of a stock.
    If we have probability data than what to do? Nothing different. We have calculated expected return in above Table 2. Then we calculate (E(R)-R)2* Probability. The Square root of (E(R)-R)2* Probability is the standard deviation of the return or the volatility of the stock. The volatility of the stock is calculated below when we have availability of probability return data.


    Hence the volatility of stock j is 1.79%. We cannot say anything more that that with calculating the standard deviation of a stock. Because Standard deviation shows the total risk of a stock. Let say, we have calculated Expected return 8% and Standard Deviation 1.79%. These are not enough information to take decision either invest money to the stock or not. For taking decision we have to compare this stock J' return and volatility to another similar kind of stock. Then we can take decision. 


    Help of Volatility Information of Stocks' for Investors. 

    Volatility of a stock helps investors to take decision either to invest to one stock or to another stock. It means, investors may have more than 2 investment alternatives. Let's say Stock A has 7% expected return and Stock J has 8% expected return. Volatility(Standard deviation) of Stock is 1.79% and same for the Stock J. 
    E(R)A=7%       E(R)J=8%
    S.D(A)=1.79% S.D.(J)=1.79%
    In this case Stock J and Stock A has similar risk, so investor mush select Stock J to invest because it has higher return than stock A.
    Suppose, Stock J and Stock A has similar return that is 8%. And Stock A has Standard Deviation 2% and Stock J has 1.79%. Then having similar return i.e.8%, investor wills to minimize risk. Stock J should be preferred because it has lower risk than stock A. That's why Volatility Measures the riskiness of a stock.

    But, When two stock have different return and risk, then we have to take help of coefficient of variation(C.V). CV measures the per unit risk. 
    Let,  E(R)A=7%       E(R)J=8%
             S.D(A)=2% S.D.(J)=2.1%
    Then CV(A)=SD(A)/ E(R)A=2/7=0.286
    CV(J)=SD(J)/ E(R)J=2.1/8=0.263
    Looking at surface, Stock J has higher risk than Stock A. That's why we have to calculate per unit risk of the stock using coefficient of variation. Stock J has lower per unit risk than Stock A, that's why stock J is preferable to invest. 

    Conclusion 

    Simply, Standard Deviation of a stock return is the volatility of stock. Somehow variance also measure volatility of stock. But their is not vast difference between standard deviation and variance because square root of variance is standard deviation. Higher standard deviation means higher volatility which indicates higher risk. Lower standard deviation means lower volatility which indicates lower risk.

    See also : What is rights Offering ? It's Advantages, disadvantages, Options to shareholders and the effect of rights offering in shareholder's wealth.

    February 07, 2018

    Security Market ( Financial Market)

    Meaning of Security Market

     

    Socio-Economic welfare of a country mostly depends upon the effective operation of financial market because financial market establishes a relation between fund supplier and fund seeker which implies to establish a mechanism of flowing the liquidity with in an economy.
    Share, debenture or other transferable and marketable securities that are issued by government or organizations to fulfill their financial needs are known as financial assets. And the market related with buying or selling (exchange) of such financial assets is known as Security Market. Security market is also known as financial market.
    At all security markets represent the markets where capital is raised, securities are traded, securities prices and interest are determined and tax and regulatory policies are enforced.


    Types of Security Market

    On the basis of the maturity period of traded security, whole security market can be classified into two types. 

    Money Market

    Those markets that facilitate the flow of short-term fund(with maturities of less than one year) are called money market.
    The money market instruments(security that are traded in money market) can be stated as follows :

    • Treasury Bill
    • Banker's Acceptance
    • Commercial Paper
    • Certificate of Deposit etc.

    Capital Market

    Those markets that facilitate the flow of long-term fund(with maturities of more than one year) are called capital market.
    Them capital market instruments(security that are traded in capital market) can be stated as follows :
    • Treasury Note
    • Treasury Bond
    • Common Stocks
    • Corporate Bond
    • Preferred Stock
    • Units of Mutual Funds etc.
    On the basis of the nature of traded security, whole security market can be classified into two types. 

    Primary Market

    Those markets where securities are issued and sold as first time ever. Company's IPOs, FPOs, Rights offering falls upon primary market. For example when a company issue 100000 shares @100 each at first time (That is called Initial Public Offering), these 100000 shares are bought by investors for the first time.

    Secondary Market

    The market where those securities which have issued in primary market are traded (buying and selling) is known as secondary market. It is also called Stock Market. Standard & Poor(S&P), a stock market of America, is an example of Secondary market. Where the price of securities is determined by demand and supply of securities. 

    Other Types of Security Market 

    Organized Stock market

    The stock market which is established under the prevailing law of a country for the purpose of trading stocks and securities that are already issued in primary market. NEPSE is Nepal's Organized Stock Market. S&P is American Organized Stock Market. Here Participants put order to buy or sell their securities and the autonomous technology of stock market settles transactions automatically according to the order. The price of securities in this market is determined by demand and supply of securities. 

    OTC market

    The full form of OTC market is Over The Counter Market. It is decentralized market. In this market, participants trade their securities with one another by communicating via several means of communication. Sometimes, Stock marked banned some of the securities to trade at secondary market. And some of the company can not fulfill the basic requirements to make their listed in secondary marked and make able to trade. These kinds of securities are traded at OTC market. Risk factor is higher in this market comparing with secondary/stock market. 

    General Market Conditions

    On the basis of the price of securities that are being traded into secondary market security market have two following conditions :

    Bull Market

    When the price of security is growing, it is called bull market. Investors are optimistic in this situation. Bull market indicates recovery condition of an economy. 

    Bear market

    When the price of security is declining, it is called Bear market. Investors are pessimistic here. Bear market indicates slow down condition of an economy. 

    In summary, Security market is those market where investors can buy and sell their securities that they are holding or buy securities at first time. We mush have to consider the securities market classification mainly into two types that are Primary market, where securities can be bought at first time from IPO,FPO and another is Secondary Market, where securities that are bought from primary market can be traded. 

    See Also : What is Stock volatility ? Why did we consider it regarding making investment decision ?