Entrepreneurial Finance


Entrepreneur Success Series

Resource Note # 8

The purpose of this note is to introduce fundamentals of finance for a prospective entrepreneur.

SECTION 1: CAPITAL AND SOURCING

1.1       Meaning of Capital

The term capital refers to wealth in the form of money or other assets owned by a person (or organization), for a purpose such as starting a company. The capital requirements of the business concern may be classified into two categories:

(a) Fixed capital

(b) Working capital

1.1.1    Fixed Capital

Fixed capital is the capital, which is needed for financing the permanent or long-term requirements of the business concern, such as land, buildings, plant, machinery and equipment.  These assets being of a permanent nature, the sources of funds used to acquire such assets are also of permanent and non-recurring nature. 

1.1.2    Working Capital

Working capital is the capital which is needed to meet the day-to-day operating expenses of the business concern. Normally working capital consists of various components of current assets such as inventories, bills receivable, debtors, cash, and bank balance and prepaid expenses, as reduced by current liabilities, such as creditors and bills payable.

1.2       Capitalization

Capitalization refers to the quantum of funds deployed by a firm to run its business. Capitalization is sum total of share capital, long term debt (including debentures), reserves and surplus. 

1.2.1    Types of Capitalization

Capitalization may be classified into the following three important types based on its nature:

  1. Over Capitalization
  2. Under Capitalization
  3. Watered Capitalization
  1. Overcapitalization

Overcapitalization refers to the company in the case of which its Capitalization exceeds the true value of its Fixed Assets plus Working Capital. If the actual earnings are lower than the expected returns, the company is usually overcapitalised.

Overcapitalization arises due to the following causes:

  • Acquisition of Assets at Higher Prices: 
  • Higher Promotional Expenses:
  • Underutilisation of available funds
  • Insufficient Provision for Depreciation
  • Liberal Dividend Policy:

2. Undercapitalization

Undercapitalization is the opposite of overcapitalization and it will occur when the true value of the company’s Fixed Assets plus Working Capital exceeds its capitalization. Under Capitalization may result due to –

  • Acquisition of Assets during Recession. 
  • Appreciation of asset value over the life span of the company
  • Conservative Dividend Policy:

3. Watered Capitalization

Watered Capitalization occurs in the case of an overcapitalized company. It is the difference between capitalization of the company and the true value of its assets. 

1.3       Estimation of Capital Requirements

Before approaching the capital market to raise finance, it is essential to determine or estimate the capital requirements of the company. 

1.3.1    Estimation of Fixed Capital

The amount of fixed capital required in a business concern can be determined on the basis of the following considerations 

  1. Nature of Business
  2. Type of Manufacturing Process
  3. Scale of Operation
  4. Mode of Acquiring Fixed Assets – Cash down, hire purchase or instalment basis.
  5. Technique of Production

1.3.2    Working Capital Estimation

Generally, the quantum of working capital is determined by the level of production and the factors which influence the amount of cash, inventories, receivables and other current assets required to support given volume of production. Level of inventories reflect management’s attitude toward risk associated with the effect of stock-outs. Level of debtors and creditors reflects company’s credit policies.

1.3.3    Assessment of Working Capital

Working capital requirement assessment requires 

Calculation of average value of Raw Material Inventory, Work in Progress inventory and Finished Goods inventory 

  • Calculation of funds tied up in Trade Receivables and availedof Trade Creditors
  • Calculation of Cash and Cash Convertibles required for normal running of business, calculation of trade payables.

1.4       Operating Cycle 

The operating cycle is also known as the cash conversion cycle. In the context of a manufacturer, the operating cycle has been described as the amount of time that it takes for a manufacturer’s cash invested into products, to be converted back into cash. In terms of number of days, it is the sum of average number of days for which raw material is held in stock before being converted into finished goods plus average number of days for which finished goods inventory is held in stock before being sold plus average collection period from customers. This sum is reduced by average number of days taken to make payment to trade creditors. 

Shorter the Operating cycle, less is the requirement of funds to finance working capital – or, looked at from a different angle, higher is the potential for supporting higher volume of business with a given amount of funds.  

1.5       Sources of Finance

1.5.1    Sources of Long-term Financial Requirements

  1. Term Loan from Financial Institutions and Bank – or from a consortium of banks if the amount is large.
  2. Lease Finance or Hire-Purchase from specialized financing agencies
  3. Venture Capital
  4. Private Equity
  5. International Finance and Syndication of loans

1.5.2    Sources of Financing of Working Capital

Sources of financing working capital differ as per the classification of working capital into permanent working capital and variable working capital. Permanent working capital is the minimum investment required in working capital irrespective of any fluctuation in business activity, variable working capital is the additional working capital requirement arising out of seasonal demand of the product or a special event.

Sources of financing permanent working capital are the Owners’ funds, Long term Debentures and  Term loan from banks. Variable working capital may be financed from trade creditors, bank loans or commercial paper (which is a kind of a promissory note in the money market) – even dealer deposits and customer advances.

1.6       Cost of Capital

Each of the sources of funds described above has a cost. Some of the costs are Explicit such as interest payable on loans, debentures and deposits.  Some like Share Capital and Reserves have Implicit costs, in that there is no contractual cost payable to the financer but they are expected to be rewarded. Whether shareholders are properly rewarded or not, gets reflected ultimately in Market price of the company’s share. The implicit costs therefore need to be taken seriously. Some of the costs – such as interest paid on loans, is a deductible expense while computing corporate tax, hence their actual impact is reduced to the extent of average rate of tax. As an illustration, if the rate of interest on bank loan is 14% and the average rate of tax is 30%, the actual cost of bank interest to the company is (14% less tax credit of 30% of 14 i.e. 4.2) – which is 9.8%.

The cost of equity is implicit as stated above. There are methods to compute the cost of equity. A popular method to compute cost of equity is through the following formula.

Cost of Equity = (Dividend as a % of Market Price) + (Ratio of earnings ploughed back i.e. reinvested in the Company x % Return on Equity).  The latter is computed as (Earnings after taxes / Equity Capital + Reserves).  

In view of factors stated, each source of finance is costed separately. A weighted average cost of all the sources is however computed – the weights being generally in the proportion of amounts of finance. The Weighted Average Cost of Capital (WACC) is an important figure which guides investment decisions in the case of a company. Normally, all investments must earn a rate of return which is higher than the WACC.  The example below will clarify the WACC computation. Corporate tax of 30% has been assumed, which will affect cost of bank loans and debentures. It will not cost of equity, which assumed as 16%.

Component(A)Amount, Rs. Million(B)% of Total, or Weightage (C)% Bare Cost(D)% Post-Tax Cost (E)Weighted Cost, (E) x (C)
Bank Loan20.0040%1510.54.20
Debentures5.0010%117.70.77
Equity25.0050%16168.00
 50.00   12.97

1.7       Leverage

In business analysis, leverage refers to relationship between two variables as reflected in percentage change in one variable consequent upon a percentage change in another variable. There are two measures of leverage which are of relevance in the context of managing finances – Operating Leverage and Financial Leverage. 

1.7.1    Operating Leverage

The operating leverage (DOL) measures percentage change in Earnings (defined as Earnings before interest and tax) as a result of percentage change in Sales. The reason that the earnings increase at a rate higher than percentage increase in Sales, is that Fixed Costs remain the same at both the original and the increased level of Sales. The formula for measuring the degree of operating leverage (DOL) is as follows. 

This can be illustrated by an example.

 Year 1,Rs. ‘000Year 2,Rs. ‘000
Sales10001200
   
Variable Cost, 60% of Sales (V)600720
Fixed Cost, (F)250250
   
Earnings before Interest & Tax [S- (V+F)]150230
% Increase in Sales(From 1000 to 1200)20%
% Increase in EBIT(From  150 to 230)53%

The result from percentage reduction in Sales from year 1 to Year 2 will be similar. Percentage decrease in EBIT as compared to Percentage decrease in Sales will be higher. 

1.7.2    Financial Leverage

The Financial Leverage measures percentage change in Earnings Per Share (EPS) as a result of percentage change in Earnings Before Interest and Tax (EBIT). The reason that EPS may increase at a rate higher than percentage increase in EBIT that the Interest Costs remain the same at both the original and the increased level of EBIT. The formula for measuring degree of Financial Leverage (DFL) is as follows.

This can be illustrated by an example.  Assume that the company’s capital structure includes Equity of Rs. 7 Million (700,000 shares of Rs. 10 each) and Loans, carrying 14% Interest, of Rs. 3 Million. Corporate Tax is 30%. 

 Year 1, Rs. ‘000Year 2, Rs. ‘000
Earnings Before Interest and Tax (EBIT)10001200
Interest on Rs, 3M, at 14%420420
Earnings Before Tax (EBT)580780
Corporate Tax, 30% of above174234
Earnings After Tax – EAT406546
No. of Shares (‘000)700700
Earnings Per Share (EPS)- [ EAT/ No. of Shares]0.580.78
% Increase in EBIT(From 1000 to 1200)20%
% Increase in EPS(From  0.58 to 0.78)34%

The result from percentage reduction in EBIT will be similar. Percentage decrease in EPS as compared to Percentage decrease in EBIT will be higher.  

1.8       Ratios for Measuring Debt/ Equity Relationship

Financial Leverage is the result of existence of Debt in the Capital Structure. A number of ratios are computed to measure the extent of Debt in the capital structure as compared to Equity. Finance practitioners have also devised norms which indicate whether the debt is within safe limits, keeping in view solvency problems which may arise due a firm’s incapability of servicing the debt. (Servicing of debt involves payment of interest and the repayment instalment on time). 

  1. Debt-Equity Ratio – Total Debt/ Net Worth (Norm, less than 1.5, closer to 1)
  2. Total Debt Ratio (TD Ratio) – Total Debt/ Total Assets (Norm – Less than .5)
  3. Debt Service Coverage Ratio – (Earnings after tax + Interest) / (Interest + Repayment Instalment) [Norm, higher than 1.5]
  4. Interest coverage ratio – (Earnings before Depreciation, Interest and Tax) / Interest

SECTION 2: BUSINESS FEASIBILITY

2.1       Testing the Business Idea

A feasibility study is carried out with the aim of finding out the workability and profitability of a business venture. Financial feasibility analysis consists of evaluating the financial conditions and operating performance of the investment and forecasting its future condition and performance. A financial decision is dependent on two specific factors, expected return and expected risk, and a financial feasibility analysis is a means for examining these two factors.

The results of a financial feasibility analysis are only as reliable as the data used as input for the analysis. Data has to be collected from the project’s owners and from outside sources; often specialists within the field of the project are needed to make estimates and forecasts, in order to get as accurate assessment as possible. The degree of precision in the input depends on the specific situation and it is often preferable to develop ranges of potential outcomes rather than precise answers.

2.2       Investment Decision 

The investment decision may be referred to as capital budgeting.  A sound appraisal technique should be used to measure the Economic worth and feasibility of an investment project. The financial objectives of an investment decision may be stated as follows. 

  • It should consider all cash flows to determine the true profitability of the project.
  • It should provide for an objective and unambiguous way of separating good projects from bad projects.
  • It should help ranking of projects according to their true profitability.
  • It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.
  • It should help to choose among mutually exclusive projects, those which maximize wealth.
  • It should be a criterion which is applicable to any conceivable investment project, independent of others.

2.3       Evaluation Criteria:

The evaluation criteria may be grouped as follows:

2.3.1    Discounted Cash Flow (DCF) criteria

  1. Net Present Value (NPV)
  2. Internal rate of return (IRR)
  3. Profitability index (PI)

The net present value of a project is ascertained by deducting a project’s initial investment from the sum total of cash inflows discounted at a rate equal to the firm’s cost of capital/discounted rate. NPV represents the additional value created with the cash available in hand now.

NPV= Present value of cash inflows- Present value of cash outflows

The Present value of cash flow is calculated by discounting the cash flow by the expected rate of return. This can be expressed as:

Internal Rate of Return:

The internal rate of return (IRR) method is another example of discounted cash flow technique, which takes account of the magnitude and timing of cash flows. Other terms used to describe the IRR method are yield on an investment, marginal efficiency of capital, rate of return over cost, time adjusted rate of rate of internal return. The IRR of a project is that rate of discount which produces a NPV of zero when used to discount the project’s cash flows. It is the rate at which the discounted cash inflows are equal to the discounted cash outflows.

The IRR is the rate that equates the investment outlay with the present value of cash inflow received, after one period. This also implies that the rate of return is the discounted rate. The IRR equation is the same as the one used for NPV method. In the NPV method the required rate of return, is known and the NPV is found, while in IRR method the value of r has to be determined at which the NPV become zero.

Profitability Index

Profitability Index is defined as the rate of present value of the future cash benefits at the required rate of return to the initial cash outflow of the investment. Symbolically, Profitability Index is expressed as

CFt = Present value of cash inflows.

R = rate of return

IC = initial cash outlay

t = time period.

It can be understood simply as total of all future discounted cash flows, divided by the initial cash outlay. The above ratio is an indicator of the profitability of the project. If the ratio is equal to or greater than 1, it shows that project has an expected yield equal to or greater than the discount rate. If the index is less than 1, it indicates that project has an expected yield less than the discount rate.

Profitability index can be used for ranking the projects. Those having higher PI rank higher.

2.3.2    Non- discounted Cash Flow Criteria

  1. Payback (PB)
  2. Accounting rate of return (ARR)
  3. Net Present Value (NPV): 

Payback

This technique estimates the time required by the project to recover, through cash inflows, the firm’s initial outlay. Beginning with the project with the shortest payout period, different projects are arranged in order of time required to recapture their respective estimated initial outlays. The payback period for each investment proposal is compared with the maximum period acceptable to management and proposals are then ranked and selected in order of those having minimum payout period.

The Average Accounting Rate of Return (ARR) Method:

This method computes average return earned by the project over its life span. Return gained year after year is added together and divided by total number of years to compute an arithmetical average. (The yearly figures of return are taken as they are, not discounted). The average return divided by initial investment is the accounting rate of return. The rate of return is compared with a pre-defined norm to decide whether or not to accept the project. Projects having a higher accounting rate rank higher over others. Since this method uses accounting rate of return, it is sometimes described as the financial statement method. 

2.4       Financial Ratios

Financial statements are records of actual financial activities of a business entity and are therefore not available for prospective projects. However, financial ratios of a comparable firm can be computed to gain understanding about financial relationship between revenue, expenses, assets and liabilities. These are found very useful to make realistic projections.  Financial ratios can be divided into five categories; liquidity ratios, asset management ratios, profitability ratios, market trend ratios and debt management ratios. The terms used in description of the ratios refer to figures readily available from the Balance Sheet and the Profit and Loss Statement of the companies.  

2.4.1    Liquidity Ratios

Liquidity ratios compare Current Assets, which reflect potential liquidity of the firm, with Current Liabilities, which represent claims made on Liquidity. It is expected that Current Assets not only exceed Current Liabilities, but possess an adequate safety margin as well.

  1. Current Ratio – Current Assets/ Current Liabilities. 
  2. Quick Ratio – Quick Assets (i.e. Current Assets – Inventories) / Current Liabilities 

2.4.2    Profitability ratios

Profitability ratios show the combined effects of liquidity, asset management, anddebt on operating results. The ratios are used to measure whether abusiness entity is able to generate profits based on its earnings, expenses, and debt obligations. As stated earlier, the ratios from Financial Statements from comparable organizations can be used to gain understanding and to make projections.

  1. Gross Profit Percentage: (Gross Profit/ Sales) x 100 
  2. Net Profit Percentage: (Net Profit after tax / Sales) x 100 
  3. Operating Expense Percentage: (The relevant operating expense – say Material Cost / Sales) 
  4. Return on Total Assets:  Earnings Before Interest and Tax / Total assets (Total of Asset side minus the Current Liabilities)
  5. Return on Equity: Earnings after tax/ (Equity Capital + Reserves)
  6. Earnings per Share:  Earnings After Tax/ No. of Equity Shares 

2.5       Breakeven Analysis

The break-even point refers to the revenues needed to cover a company’s total amount of fixed and variable expenses during a specified period of time, say one year. This is a vital piece of information since it clearly specifies the level of sales which the project must achieve in order not to incur a loss. The revenues could be stated in rupees (or other currencies), in units, hours of services provided, etc.

The break-even calculations are based on the assumption that all expenses incurred, do not change directly with sales. The part of the expenses that change with sales are called Variable Costs. The other part, which do not change with sales but are static period after period, are called fixed costs. The difference between sales and the variable costs is called ‘contribution margin’ or just ‘contribution’. Contribution can also be expressed as a ratio, which is (contribution/sales). To illustrate, if monthly sales are Rs. 3 million, and the variable costs, Rs. 1.65 Million, the contribution in rupees will come to (3M – 1.65M), 1.35 million. The contribution ratio will be (1.35M/ 3M), i.e. 0.45. 

The basic calculation of the break-even point in rupee sales for a period is: fixed expenses (fixed manufacturing, fixed selling, general & administrative expenses, fixed interest) for the period divided by the contribution margin. In the above illustration, if the fixed monthly expenses are Rs. 900,000, the break-even point will come to (900,000/.45) i.e. Rs. 2 Million. Since the actual sales are Rs. 3 Million, the project will make a profit. 

In practice, not all expenses being incurred can be classified either as ‘fixed’ or ‘variable’. There is third category which may be called ‘semi-variable’. Such expenses change as volume of sales increases or decreases, but not in the same proportion. It is necessary to identify these items and analyse each of them into its ‘fixed’ component and ‘variable’ component, to the extent possible. The break-even analysis can proceed after clubbing the ‘fixed’ components with other fixed costs and likewise for variable costs. 

2.6       Projected Financials

In order to ensure that the project is feasible when launched, and stays feasible over the foreseeable future, two important criteria that it should meet are Profitability and Solvency. The profitability criterion should ensure that it provides an adequate rate of return on the investments made and the solvency criterion should see that it is able to meet all its payment obligations (to suppliers, bank, employees, shareholders, service-providers, government etc.) as and when they arise. The financial feasibility of new business can be best understood by projecting its financial performance over a span of 5-10 years.

Three important projections for a project are the following.

  1. Projected Profit and Loss Statement
  2. Projected Balance Sheets
  3. Projected Cash Flow Statement

All the three statements are linked to each other. 

The Profit and Loss statement shows projected revenues, the corresponding expenses and profit/loss from period to period – usually one year; but in the initial period, even shorter time span, such as a quarter or a half-year may be used. It is possible that the Projected Profit and Loss Statement shows loss in the initial period, it must however turn into profit within a short period. 

The Balance Sheets show investments planned initially, and in subsequent years. Both these get reflected into Fixed Assets in the Balance Sheet. As the business grows, additional investments in Current Assets such as Inventories and Bills Receivables will also be required which appear as a part of Current Assets. The liability side shows the sources of funds which finance the Fixed and the Current Assets. Three sources which are common are Owners’ Equity, Profit during the year reinvested into business and Loans, both long term as well as short term. The business should be able to find adequate sources to meet the requirement of funds, shown on the asset side, only then the Assets and Liabilities ‘balance’.

The Cash Flow Statement shows combined effect of the Profit and Loss Statement and the Balance Sheet. Profit during the year and finances raised externally appear as Sources and additional investment in Fixed and Current Assets during the period appear as Applications. Periodic repayment of loans, taxes paid, interest payable to bank also appear under ‘Applications’. It is expected that after meeting all obligations, there should be a positive cash balance at the end of every period. (Negative cash balance is theoretically not possible – that means insolvency).  

It is customary to prepare projected financials using spreadsheet software like EXCEL. The spreadsheet software especially comes handy since several items in the Projections are computationally linked to each other. Ready tools are also available to facilitate preparation of these statements.

2.7       Transfer Pricing

A project which may have started as a subsidiary or as a related business venture of a larger business entity has to encounter a special issue. The price at which it sells its products or services to the other related businesses has to be fair – neither artificially high or low. This is necessary for two reasons. Since the new business is eventually evaluated on the basis of its profitability, the prices earned by it need to be fair. The second reason is related to income tax payable. Artificially high or low prices may lead to disputes with tax authorities, since it may artificially inflate or deflate tax liability of the concerned new business as well as the other related businesses – which in effect may look like tax evasion.

The Arm’s Length principle

When two unrelated companies trade with each other, a market price for the transaction will generally result. This is known as “arms-length” trading, because it is the product of genuine negotiation in a market.  This arm’s length price is usually considered to be acceptable for tax purposes.

The OECD Guidelines for setting transfer prices between business entities and subsidiaries that function across countries, state a number of methods that can be used to determine arm’s-length prices for intra-group transactions. There are five main OECD methods for transfer pricing: Comparable Uncontrolled Price (i.e. market price), Cost Plus Price, Resale Price, Transactional Net Margin Method and the Profit Split Method. When comparable prices are available in the market, those are most likely to be used. This is not, however, always possible. Methods such as Cost-Plus or Profit split between the buyer and the seller are more common under such circumstances. 

SECTION 3: THE MANAGEMENT OF RISK

3.1       Types of Risk 

Over years Financial Risk Management has emerged as an independent profession. The risks that the business may endure are not all financial, but all have financial repercussions. It is therefore necessary to identify these risks and create safeguards. The risks can be briefly summarized as below.

  1. Credit Risk –  The risk of default of a counterparty due to inability or unwillingness to honour a contract.
  2. Market Risk – The possibility of loss to a firm caused by changes in the market variables (prices, sources, availability etc.)
  3. Interest Rate Risk – The risk due to changes in the interest rates, also risk of change in the value of security
  4. Forex Risk – Risk of erosion in revenues or inflation in costs due to exchange rate changes
  5. Equity price risk – Risk of losses due to adverse movements in equity prices
  6. Commodity price risk –  Risk of losses due to adverse price movements in commodity 
  7. Liquidity Risk – Inability to settle liabilities when due as a result of a mismatch between cash inflows and outflows
  8. Operational Risk – Risks arising from inadequacies in people, processes and controls
  9. Legal Risk –  Arising due to possibility of actions of the firm not being in conformity with laws
  10. Reputation Risk – Possibility of financial loss resulting from negative public opinion
  11. Information Technology Risk – Risk of system validity, system backup, disaster recovery, system failure, security and programming errors 
  12. Country or political risk – Risk of hindrance to business operations due to political instability, confiscation, nationalization, expropriation of firm’s assets
  13. Competition Risk – Risk having to cope with unknown competitors
  14. Product/Industry Risk – Risk of product going out of fashion and decline in demand
  15. Strategic/ Business Risk – Obsolescence of business due to innovation and inventions

3.2       Approaches to risk management 

The conventional approach toward risk management, which consists of Identify Risks – Analyse and prioritize – Plan and schedule – Track, Report and Control, applies to all risks listed above, and that will be the core of risk management.

Risks are managed through a four-fold approach consisting of –

  1. 1.Risk Avoidance (e.g. staying away from activities/ technologies involving risk)
  2. Risk Mitigation (e.g. providing for exit option in a contract)
  3. Transfer of Risk (e.g. Taking Insurance where available)
  4. Risk Acceptance (e.g. taking a calculated risk, where probable benefit from a risky decision is high). 

Risks arise as a result of inadequate information about the input, processes and the outcome related to the task. Risk management therefore focuses on obtaining and analysing the relevant information. It is believed that it is worthwhile spending money on obtaining information as long as the cost of information is less than expected loss arising out of a risky decision. Several quantitative and I.T.-based tools are used to gain insights from the available information. Big Data and Analytics is being used by several organizations for managing risks.

3.3       Use of Hedging to manage financial risks 

A hedge is a mechanism which reduces the risk of adverse price movements in an asset – meaning commodities, foreign exchange, securities etc. Hedging is implemented through a futures contract which is entered into on the respective exchange through a broker – Commodity Exchange and Stock Exchange. (The latter deals in foreign exchange transactions as well). The reason why an ‘exchange’ is required is because an individual on his own will be unable to locate a counterparty for the deal he desires to enter into.

The way in which a hedging can be used can be better explained through an example. Assume that your company deals in food items for which wheat is the essential raw material. You are worried that 3 months from now, when the newly harvested wheat may come into market, prices will be too high. You have budgeted certain purchase price and you would like to ensure that you operate around that price. (The prices may go down and you may stand to gain, but you do not mind losing a possible gain. Your concern is that you do not want to make a loss – which in fact is an important assumption). The sequence of hedging transactions will now be as follows. 

  • You buy a futures contract on commodity exchange for 1000 tonnes of wheat at Rs. 20000/T, 3 months from now. (Contract 1).
  • If there is no intermediate requirement until maturity of the contract, the job is done. Irrespective of fluctuations, you will get the wheat at your budgeted price.
  • What if there is an intermediate requirement? Assume that, your company needs to buy 500 tonnes,2 months later, when the market price is Rs. 22000/T.  This will result into a loss of 500 X Rs. 2000 i.e. Rs. 10 lakhs, compared to your budget.
  • Your futures contract will now come handy. In order to cover the loss, an ‘equal and opposite’ transaction will be entered into, 1 month from that date, to match with timing of your contract 1. This means that 500 tonnes of wheat will be ‘sold’ at approximately the same price i.e. Rs. 22000/T. (Contract 2).
  • At the end of 3 months, 1000 tonnes of wheat will be purchased at Rs 20000/T as per Contract 1. Out of these, 500 tonnes will be immediately ‘sold’ at Rs. 22000/T as per Contract 2, which will result in a gain of Rs. 10 lakhs. This will offset the earlier loss.
  • Similar methodology can be used for foreign exchange or for shares. 

Hedging is a mechanism regularly employed by finance managers to protect their organizations against market risks.

References

Books & Journals

M Pandey (2010 10th Edition) – Financial Management; Vikas Publishing House Pvt. Ltd, Noida, UP, INDIA

M Y Khan & P K. Jain (2007 5th Edition) ;Financial Management; Tata McGraw Hill Education Pvt Ltd; New Delhi, INDIA

Anna RegínaBjörnsdóttir  ( 2010); Financial Feasibility Assessments, Building and Using Assessment Models for Financial Feasibility Analysis of Investment Projects, University of Iceland

Internet Sources

http://www.icsi.edu/Webmodules/Publications/FULL%20BOOK-PP-FTFM-PDF%20FILE.pdf

“Casualty Actuarial Society – Dynamic Risk Modeling Handbook” http://www.casact.org/research/drm/drm_handbook.pdf

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