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2nd Session

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2. Investment• Definition: An asset or item that is purchased

with the hope that it will generate income or appreciate in value in the future.

Example: – The building of a factory used to produce goods– Purchase of bonds, stocks or real estate property.

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Investments• This area of finance carries special

significance. • Decisions made by individuals and businesses

as they choose securities for their investment portfolios.

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• Two main classes of investment are:

(1) Fixed income investment such as bonds, fixed deposits etc.

(2) Variable income investment such as business ownership (equities), or property ownership.

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Bonds• Illustrated through the help of an example:• Adam purchases a U.S government bond, he is lending

money to the U.S government, known as an issuer.• In return for that money, the issuer provides Adam with

a bond in which it promises to pay a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures.

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Fixed Deposit

• In deposit terminology, the term Fixed Deposit refers to a savings account that pays a fixed rate of interest until a given maturity date.

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Individual looking to

make investments

Gather information about investing

opportunities (Gold, Silver, bonds, stocks,

mutual funds)

Interest Rate in case of

T-bills, bonds, etc.

Rate of Return on different stocks.

Company’s future plans; investments

the company is looking to

undertake in future

Financial position of the

company (Balance sheet)

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Businesses before making an investment determine:

• Proper value of individual securities (Security Analysis).• Optimal way to structure portfolios or the ‘baskets’ of

stocks and bonds (Portfolio Theory).• Determining if stock prices in market have been raised to

unreasonable highs or lows (Market Analysis)

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Security Analysis• Definition: Security Analysis is defined as

estimating the value of security for inclusion or not in the portfolio.

Security Analysis

Fundamental Analysis

Technical Analysis

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Fundamental Analysis• Fundamental analysis attempts

to calculate the intrinsic value of a stock using data such as income statements, its balance sheet, growth prospects etc.

• The stock is bought when stock price falls below intrinsic value.

• Long term approach.• Forward as well as backward

looking.

Technical Analysis• Technical analysis uses past

market activity and stock price trends to predict stock price in the future.

• The stock is bought when trader believes they can sell it on for a higher price.

• Short term approach.• Backward looking.

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Portfolio Theory• Group of securities held together in an investment. • Investors invest in a portfolio rather than a single security as

they are ‘risk averse’. • Portfolio objective; not to put all eggs in one basket.• Diversification of security holding – reduces risk in

investment. • Goal of Portfolio construction: Highest return at given level

of risk ‘efficient portfolio’.

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Market AnalysisCheck:• If stock prices have been raised to

unreasonable heights following a speculative bubble.

• If stock prices are driven down in a fit of irrational pessimism.

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3. Financial Markets and Institutions• Markets where financial securities (such as stocks and

bonds) are bought and sold.• Financial institutions refer to private and public

organizations that act as channels between savers and borrowers of funds.

• Two main types of financial institutions:– Depository banks and credit unions.– Non-depository insurance companies and mutual funds.

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Depository banks and credit unions• Institutions which pay interest on deposits

from the interest earned on loans.

Bank A X (saver) money

interest (7%)

Money from depositors loaned out

Interest (8%)

Y (borrower)

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Non-depository insurance companies and mutual funds

• Institutions which collect funds from different investors and issue them a security in the name of company while it invests the money in different companies.

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Finance

Financial Management

Investment Decisions

Financing Decisions

Managerial Decisions

InvestmentFinancial

Markets and Institutions

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Ownership, Control and Risk

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Forms of Business Organizations• A business can be structured in various ways.• Primary driving force: No. of owners.• Traditionally single owners (proprietorship),

partnership and corporations operate business.

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Sole Proprietorship• Unincorporated business owned by single

individual. • Popular because easier to start and lighter

regulatory and paperwork requirement than any other business form.

Unincorporated means not incorporated as a company

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Sole Proprietorship• Advantages:

1. Easy, inexpensive to form.2. Fewer government regulations.3. Lower income taxes than corporations.4. Owner’s complete control over business activities.5. Income of business not taxed separately.

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Sole Proprietorship• Disadvantages:

1. Unlimited personal liability. For example, Ali, who has a car cleaning business cannot pay his supplier as he was short of

money. His supplier can sue him individually which means if the suit is for enough money, he can end up losing almost all of his personal possessions — his car, savings, and possibly even his home.

2. Difficulty in obtaining capital. Banks are also hesitant to lend to a sole proprietorship because of a perceived lack of credibility

when it comes to repayment if the business fails or owner dies.

3. Life is limited to that of the owner. When the owner dies, the sole proprietorship no longer exists.

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Partnership• Organizational form which feature multiple

individual owners.• Each partners owns different percentage of

firm according to his or her ‘ownership stake’.

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Partnership• Advantages

1. Low cost and easy to form.2. Business profits – split according to pre-arranged

agreement. 3. As compared to sole proprietorship banks are

more willing to grant loan to partnerships.

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Partnership• Disadvantages

– Unlimited personal liability.• For example, if you own only 1 percent of the partnership and the business fails, you will

be called upon to pay 1 percent of the bills and the other partners will be assessed their 99 percent. However, if your partners cannot pay, you may be called upon to pay all the debts even if you must sell off all your possessions to do so. This makes partnerships too risky for most situations.

– Life is limited to the life of the owners. • It may end upon the withdrawal or death of a partner.

– Difficulty in transferring ownership. • Transfer of ownership requires that a new partnership be formed.

– Difficulty in raising large amounts of capital.

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Corporation (Latin ‘corpus’ meaning body)

• Public corporations are legally independent entities entirely separate from their owners.

• Most large businesses are incorporated as companies.

• Corporations hold rights and obligations of individual persons (own property, sign contracts, pay taxes).

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Corporation• Advantages

– Unlimited life• Perpetual existence.

– Transfer of ownership• Through exchange of stock.

– Limited liability• Shareholders are not personally liable for the debts and other liabilities (including legal) for the

business. • For example, in a well-structured corporation, creditors cannot pursue owner's/shareholder's

personal assets for the corporation’s debts. – Ease of raising large amount of capital to operate large businesses

• For example, corporations have the option of issuing bonds or share certificates to investors. • Can borrow money at lower rates.

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Corporation• Disadvantages– Earnings subjected to ‘double taxation’.– Starting a company is a costly and time consuming

process.

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