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MF 0010 Security Analysis and Portfolio Management Set- 1

Q.1 Frame the investment process for a person of your age group.

Ans. As investors, we would all like to beat the market handily, and we would all like to pick"great" investments on instinct. However, while intuition is undoubtedly a part of the processof investing, it is just part of the process. As investors, it is not surprising that we focus somuch of our energy and efforts on investment philosophies and strategies, and so little on the

investment process. It is far more interesting to read about how Peter Lynch picks stocks andwhat makes Warren Buffett a valuable investor, than it is to talk about the steps involved increating a portfolio or in executing trades. Though it does not get sufficient attention,understanding the investment process is critical for every investor for several reasons:

1. The investment process outlines the steps in creating a portfolio, and emphasizes thesequence of actions involved from understanding the investors risk preferences toasset allocation and selection to performance evaluation. By emphasizing thesequence, it provides for an orderly way in which an investor can create his or her ownportfolio or a portfolio for someone else.

1. The investment process provides a structure that allows investors to see the source ofdifferent investment strategies and philosophies. By so doing, it allows investors totake the hundreds of strategies that they see described in the common press and ininvestment newsletters and to trace them to their common roots.

1. The investment process emphasizes the different components that are needed for aninvestment strategy to by successful, and by so doing explain why so many strategiesthat look good on paper never work for those who use them.

The best way of describing this book is by noting what it does not do. It does not emphasizeindividual investors or push an investment philosophy. It does not focus heavily on coming upwith strategies that beat the market, though there is reference to some of them in the courseof the book. Instead, it talks about the process of investing and how this process is the sameno matter what investment philosophy one might have.

The book is built around the investment process. The process always starts with the investorand understanding his or her needs and preferences. For a portfolio manager, the investor is aclient, and the first and often most significant part of the investment process is understandingthe clients needs, the clients tax status and most importantly, his or her risk preferences. Foran individual investor constructing his or her own portfolio, this may seem simpler, butunderstanding ones own needs and preferences is just as important a first step as it is for theportfolio manager.

The next part of the process is the actual construction of the portfolio, which we divide intothree sub-parts. The first of these is the decision on how to allocate the portfolio acrossdifferent asset classes defined broadly as equities, fixed income securities and real assets(such as real estate, commodities and other assets). This asset allocation decision can also beframed in terms of investments in domestic assets versus foreign assets, and the factorsdriving this decision. The second component is the asset selection decision, where individualassets are picked within each asset class to make up the portfolio. In practical terms, this isthe step where the stocks that make up the equity component, the bonds that make up thefixed income component and the real assets that make up the real asset component arepicked. The final component is execution, where the portfolio is actually put together, whereinvestors have to trade off transactions cost against transactions speed. While the importanceof execution will vary across investment strategies, there are many investors who have failedat this stage in the process.

The final part of the process, and often the most painful one for professional moneymanagers, is the performance evaluation. Investing is after all focused on one objective andone objective alone, which is to make the most money you can, given the risk constraints youoperate under. Investors are not forgiving of failure and unwilling to accept even the best of

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excuses, and loyalty to money managers is not a commonly found trait. By the same token,performance evaluation is just as important to the individual investor who constructs his orher own portfolio, since the feedback from it should largely determine how that investorapproaches investing in the future.

These parts of the process are summarized in Figure 1, and we will return to this figure toemphasize the steps in the process as we move through the book. The book is built aroundthe same structure. It begins with a chapter that provides an overview of investment

management as a business. The first major section is on understanding client needs andpreferences, where we look at not only how to think about risk in investing but also at how tomeasure an investors willingness to take risk. The second section looks at the asset allocationdecision, while the third section examines different approaches to selecting assets. The fourthsection takes a brief look at the execution decision, and the fifth section develops differentapproaches to evaluating performance.

Q.2 From the website of BSE India, explain how the BSE Sensex is calculated.

Ans. Introduction SENSEX, first compiled in 1986, was calculated on a "MarketCapitalization-Weighted" methodology of 30 component stocks representing large, well-established and financially sound companies across key sectors. The base year of SENSEXwas taken as 1978-79. SENSEX today is widely reported in both domestic and internationalmarkets through print as well as electronic media. It is scientifically designed and is based onglobally accepted construction and review methodology. Since September 1, 2003, SENSEX isbeing calculated on a free-float market capitalization methodology. The "free-float market

capitalization-weighted" methodology is a widely followed index construction methodology onwhich majority of global equity indices are based; all major index providers like MSCI, FTSE,STOXX, S&P and Dow Jones use the free-float methodology.

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The growth of the equity market in India has been phenomenal in the present decade. Rightfrom early nineties, the stock market witnessed heightened activity in terms of various bulland bear runs. In the late nineties, the Indian market witnessed a huge frenzy in the 'TMT'sectors. More recently, real estate caught the fancy of the investors. SENSEX has captured allthese happenings in the most judicious manner. One can identify the booms and busts of theIndian equity market through SENSEX. As the oldest index in the country, it provides the timeseries data over a fairly long period of time (from 1979 onwards). Small wonder, the SENSEXhas become one of the most prominent brands in the country.

Index Specification:

Base Year 1978-79

Base IndexValue

100

Date of Launch 01-01-1986

Method of calculation

Launched on full market capitalization method and effective September01, 2003, calculation method shifted to free-float market capitalization.

Number of

scrips

30

IndexConstituents

Click here for list of constituents

Indexcalculationfrequency

Real Time

Indexcalculationand Maintenance

Click here for Index calculation and maintenance

Index Reach Click here for scrip-wise, sector wise market capitalization, weightage etc.

MarketCapitalizationand TurnoverCoverage

Click here for market capitalization and turnover coverage

HistoricalValues of Index

Index, Price Earnings, Price to Book Value ratio and Dividend Yield %

HistoricalNotices

Click to search Historical Notices on Index Replacements

HistoricalReplacements

Click here for historical replacements

SENSEX Calculation Methodology

SENSEX is calculated using the "Free-float Market Capitalization" methodology, wherein, thelevel of index at any point of time reflects the free-float market value of 30 component stocksrelative to a base period. The market capitalization of a company is determined by multiplyingthe price of its stock by the number of shares issued by the company. This marketcapitalization is further multiplied by the free-float factor to determine the free-float marketcapitalization.

The base period of SENSEX is 1978-79 and the base value is 100 index points. This is often

indicated by the notation 1978-79=100. The calculation of SENSEX involves dividing the free-float market capitalization of 30 companies in the Index by a number called the Index Divisor.The Divisor is the only link to the original base period value of the SENSEX. It keeps the Indexcomparable over time and is the adjustment point for all Index adjustments arising out of

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corporate actions, replacement of scrips etc. During market hours, prices of the index scrips,at which latest trades are executed, are used by the trading system to calculate SENSEX on acontinuous basis.

Dollex-30 BSE also calculates a dollar-linked version of SENSEX and historical values ofDollex series of BSE indices') this index are available since its inception.

SENSEX - Scrip Selection Criteria

1. Equities of companies listed on Bombay Stock Exchange Ltd. (excluding companiesclassified in Z group, listed mutual funds, scrips suspended on the last day of themonth prior to review date, scrips objected by the Surveillance department of theExchange and those that are traded under permitted category) shall be consideredeligible

2. Listing History: The scrip should have a listing history of at least three months at BSE.An exception may be granted to one month, if the average free-float marketcapitalization of a newly listed company ranks in the top 10 of all companies listed atBSE. In the event that a company is listed on account of a merger / demerger /amalgamation, a minimum listing history is not required.

3. The scrip should have been traded on each and every trading day in the last threemonths at BSE. Exceptions can be made for extreme reasons like scrip suspension etc.

4. Companies that have reported revenue in the latest four quarters from its coreactivity are considered eligible.

5. From the list of constituents selected through Steps 1-4, the top 75 companies basedon free-float market capitalisation (avg. 3 months) are selected as well as anyadditional companies that are in the top 75 based on full market capitalization (avg. 3months).

6. The filtered list of constituents selected through Step 5 (which can be greater than 75companies) is then ranked on absolute turnover (avg. 3 months).

7. Any company in the filtered, sorted list created in Step 6 that has CumulativeTurnover of >98%, are excluded, so long as the remaining list has more than 30 scrips.

8. The filtered list calculated in Step 7 is then sorted by free float market capitalization.Any company having a weight within this filtered constituent list of

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readily available shares in the market. Subsequently all BSE indices with the exception ofBSE-PSU index have adopted the free-float methodology.

Major advantages of Free-float Methodology A Free-float index reflects the markettrends more rationally as it takes into consideration only those shares that are available fortrading in the market.

Free-float Methodology makes the index more broad-based by reducing the

concentration of top few companies in Index. A Free-float index aids both active and passive investing styles. It aids active managers

by enabling them to benchmark their fund returns vis- -vis an investible index. Thisenables an apple-to-apple comparison thereby facilitating better evaluation ofperformance of active managers. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best suited for the passive managers as it enables them to trackthe index with the least tracking error.

Free-float Methodology improves index flexibility in terms of including any stock fromthe universe of listed stocks. This improves market coverage and sector coverage ofthe index. For example, under a Full-market capitalization methodology, companieswith large market capitalization and low free-float cannot generally be included in theIndex because they tend to distort the index by having an undue influence on the indexmovement. However, under the Free-float Methodology, since only the free-floatmarket capitalization of each company is considered for index calculation, it becomespossible to include such closely-held companies in the index while at the same timepreventing their undue influence on the index movement.

Globally, the Free-float Methodology of index construction is considered to be anindustry best practice and all major index providers like MSCI, FTSE, S&P and STOXXhave adopted the same. MSCI, a leading global index provider, shifted all its indices tothe Free-float Methodology in 2002. The MSCI India Standard Index, which is followedby Foreign Institutional Investors (FIIs) to track Indian equities, is also based on theFree-float Methodology. NASDAQ-100, the underlying index to the famous Exchange

Traded Fund (ETF) - QQQ is based on the Free-float Methodology.

Definition of Free-float Shareholding of investors that would not, in the normal coursecome into the open market for trading are treated as 'Controlling/ Strategic Holdings' andhence not included in free-float. Specifically, the following categories of holding are generallyexcluded from the definition of Free-float:

Shares held by founders/directors/ acquirers which has control element Shares held by persons/ bodies with "Controlling Interest" Shares held by Government as promoter/acquirer Holdings through the FDI Route Strategic stakes by private corporate bodies/ individuals Equity held by associate/group companies (cross-holdings) Equity held by Employee Welfare Trusts Locked-in shares and shares which would not be sold in the open market in normal

course.

The remaining shareholders fall under the Free-float category.

Determining Free-float Factors of Companies BSE has designed a Free-float format,which is filled and submitted by all index companies on a quarterly basis. (Format available onwww.bseindia.com). BSE determines the Free-float factor for each company based on thedetailed information submitted by the companies in the prescribed format. Free-float factor isa multiple with which the total market capitalization of a company is adjusted to arrive at the

Free-float market capitalization. Once the Free-float of a company is determined, it isrounded-off to the higher multiple of 5 and each company is categorized into one of the 20bands given below. A Free-float factor of say 0.55 means that only 55% of the marketcapitalization of the company will be considered for index calculation.

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Free-float Bands:

% Free-Float Free-Float Factor % Free-Float Free-Float Factor

>0 - 5% 0.05 >50 - 55% 0.55

>5 - 10% 0.10 >55 - 60% 0.60

>10 - 15% 0.15 >60 - 65% 0.65

>15 - 20% 0.20 >65 - 70% 0.70

>20 - 25% 0.25 >70 - 75% 0.75>25 - 30% 0.30 >75 - 80% 0.80

>30 - 35% 0.35 >80 - 85% 0.85

>35 - 40% 0.40 >85 - 90% 0.90

>40 - 45% 0.45 >90 - 95% 0.95

>45 - 50% 0.50 >95 - 100% 1.00

Index Closure Algorithm The closing SENSEX on any trading day is computed taking theweighted average of all the trades on SENSEX constituents in the last 30 minutes of tradingsession. If a SENSEX constituent has not traded in the last 30 minutes, the last traded price is

taken for computation of the Index closure. If a SENSEX constituent has not traded at all in aday, then its last day's closing price is taken for computation of Index closure. The use ofIndex Closure Algorithm prevents any intentional manipulation of the closing index value.

Maintenance of SENSEX One of the important aspects of maintaining continuity with thepast is to update the base year average. The base year value adjustment ensures thatreplacement of stocks in Index, additional issue of capital and other corporateannouncements like 'rights issue' etc. do not destroy the historical value of the index. Thebeauty of maintenance lies in the fact that adjustments for corporate actions in the Indexshould not per se affect the index values.

The BSE Index Cell does the day-to-day maintenance of the index within the broad indexpolicy framework set by the BSE Index Committee. The BSE Index Cell ensures that SENSEXand all the other BSE indices maintain their benchmark properties by striking a delicatebalance between frequent replacements in index and maintaining its historical continuity. TheBSE Index Committee comprises of capital market expert, fund managers, market participantsand members of the BSE Governing Board.

On-Line Computation of the Index During trading hours, value of the Index is calculatedand disseminated on real time basis. This is done automatically on the basis of prices at whichtrades in Index constituents are executed.

Adjustment for Bonus, Rights and Newly Issued Capital SENSEX calculation needs to be

adjusted for issue of Bonus or Rights shares If no adjustments were made, a discontinuitywould arise between the current value of the index and its previous value despite the non-occurrence of any economic activity of substance. At the BSE Index Cell , the base value isadjusted, which is used to alter market capitalization of the component stocks to arrive at theSENSEX value.The BSE Index Cell keeps a close watch on the events that might affect theindex on a regular basis and carries out daily maintenance of all BSE Indices.

Adjustments for Rights Issues When a company, included in the compilation of theindex, issues right shares, the free-float market capitalization of that company isincreased by the number of additional shares issued based on the theoretical (ex-right)price. An offsetting or proportionate adjustment is then made to the Base Market

capitalization (see 'Base Market capitalization Adjustment' below). Adjustments for Bonus Issue When a company, included in the compilation of theindex, issues bonus shares, the market capitalization of that company does not

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undergo any change. Therefore, there is no change in the Base Market capitalization,only the 'number of shares' in the formula is updated.

Other Issues Base Market capitalization adjustment is required when new shares areissued by way of conversion of debentures, mergers, spin-offs etc. or when equity isreduced by way of buy-back of shares, corporate restructuring etc.

Base Market capitalization Adjustment

The formula for adjusting the Base Market capitalization is as follows: New Base Market

capitalization = Old Base Market capitalization x New Market capitalization / Old Marketcapitalization To illustrate, suppose a company issues right shares which increases the marketcapitalization of the shares of that company by say, Rs.100 crores. The existing Base Marketcapitalization (Old Base Market capitalization), say, is Rs.2450 crores and the aggregatemarket capitalization of all the shares included in the index before the right issue is made is,say Rs.4781 crore. The "New Base Market capitalization " will then be:

2450 x (4781+100)-------------------------- = Rs.2501.24 crores

4781

This figure of Rs. 2501.24 crore will be used as the Base Market capitalization for calculatingthe index number from then onwards till the next base change becomes necessary.

Index Review Frequency The BSE Index Committee meets every quarter to discuss indexrelated issues. In case of a revision in the Index constituents, the announcement of theincoming and outgoing scrips is made six weeks in advance of the actual implementation ofthe revision of the Index.

Q.3 Perform an economy analysis on Indian economy in the current situation.

Ans. India economic analysis provides various inputs on economic condition of this south-east Asian country. It can be done both at a microeconomic as well as a macroeconomic level.

India economic analysis could also be described as being an explanation of various economicphenomena going on in this country.

Recent macroeconomic developments in India In April 2008, industrial sector in Indiahad recorded a growth of 7 percent. However, this figure is lesser than 11 percentdevelopment, which had been achieved in April 2007. Much of this critical condition could beattributed to an increase in prices of oil. Measures that have been taken by Reserve Bank ofIndia, like upward revision of repo rate and CRR, have also contributed to decrease inindustrial production.

Manufacturing and electric sector have suffered as well in recent times. Their growth rates

have come down too. For manufacturing sector it was 7.5 percent and for electricity sector,rate of development stood at 1.4 percent in April 2008. This rate is significantly low whencompared to statistics of April 2007, when rates of development for manufacturing andelectricity were 12.4 percent and 8.7 percent respectively. In case of manufacturing sectormuch of this slump could be attributed to increase in input costs like expenses of oil, rawmaterials, rates of interest and prices of goods and services. Mining sector has beencomparatively better off as it has managed to grow at a rate of 8 percent in April 2008compared to 2.6 percent that was achieved in April 2007. In core infrastructural industries,there has been deceleration as well, but it is still better off compared to non infrastructuralindustries in India. Growth in April 2008 has been around 3.6 percent, which is less than 5.9percent achieved in April 2007. Industries like crude oil production, electricity and petroleumrefinery have been performing below expectations but coal, finished steel and cement have

performed better than April 2007.

Inflation in India In financial year 2007-08, average inflation in India was around 4.66percent. This rate was lower than average inflation of financial year 2006-07. In 2007-08,

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fiscal high prices of food items were primary cause behind high rates of inflation. That highrate of inflation had to be controlled by banning a number of necessary commodities as wellas various financial steps. High prices of oil were responsible for proportionately high rate ofinflation in 2008-09.

Q.4 Identify some technical indicators and explain how they can be used todecide purchase of a companys stock.

Ans. A technical indicator is a series of data points that are derived by applying a formula tothe price and/or volume data of a security. Price data can be any combination of the open,high, low or closing price over a period of time. Some indicators may use only the closingprices, while others incorporate volume and open interest into their formulae. The price datais entered into the formula and a data point is produced. For example, say the closing pricesof a stock for 3 days are Rs. 41, Rs. 43 and Rs. 43. A number of technical indicators are in use.Some of the technical indicators are discussed below for the purpose of illustration of theconcept :

Moving average :The moving average is a lagging indicator which is easy to construct andis one of the most widely used. A moving average, as the name suggests, represents anaverage of a certain series of data that moves through time. The most common way to

calculate the moving average is to work from the last 10 days of closing prices. Each day, themost recent close (day 11) is added to the total and the oldest close (day 1) is subtracted. Thenew total is then divided by the total number of days (10) and the resultant averagecomputed. The purpose of the moving average is to track the progress of a price trend. Themoving average is a smoothing device. By averaging the data, a smoother line is produced,making it much easier to view the underlying trend. A moving average filters out randomnoise and offers a smoother perspective of the price action.Moving average convergence divergence (MACD) : MACD is a momentum indicator andit is made up of two exponential moving averages. The MACD plots the difference between a26-day exponential moving average and a 12-day exponential moving average. A 9-daymoving average is generally used as a trigger line. When the MACD crosses this trigger and

goes down it is a bearish signal and when it crosses it to go above it, its a bullish signal. Thisindicator measures short-term momentum as compared to longer term momentum andsignals the current direction of momentum. Traders use the MACD for indicating trendreversals.Relating Strength Index : The relative strength index (RSI) is another of the well-knownmomentum indicators. Momentum measures the rate of change of prices by continuallytaking price differences for a fixed time interval. RSI helps to signal overbought and oversoldconditions in a security. RSI is plotted in a range of 0-100. a reading above 70 suggests that asecurity is overbought, while a reading below 30 suggests that is oversold. This indicatorhelps traders to identify whether a securitys price has been unreasonably pushed to itscurrent levels and whether a reversal may be on the way.Stochastic Oscillator : The stochastic oscillator is one of the most recognized momentum

indicators. This indicator provides information about the location of a current closing price inrelation to the periods high and low prices. The closer the closing price is to the periods high,the higher is the buying pressure, and the closer the closing price is to the periods low, themore is the selling pressure. The idea behind this indicator is that in an uptrend. The priceshould be closing near the highs of the trading range, signaling upward momentum in thesecurity. In downtrends, the price should be closing near the lows of the trading range,signaling downward momentum. The stochastic oscillator is plotted within a range of zero and100 and signals overbought conditions above 80 and oversold conditions below 20.

Q.5 Compare Arbitrage pricing theory with the Capital asset pricing model.

Ans: In economics and finance, arbitrage is the practice of taking advantage of a pricedifference between two or more markets: striking a combination of matching deals thatcapitalize upon the imbalance, the profit being the difference between the market prices.When used by academics, an arbitrage is a transaction that involves no negative cash flow at

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any probabilistic or temporal state and a positive cash flow in at least one state; in simpleterms, it is the possibility of a risk-free profit at zero cost.In principle and in academic use, an arbitrage is risk-free; in common use, as in statisticalarbitrage, it may refer to expectedprofit, though losses may occur, and in practice, there arealways risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins),some major (such as devaluation of a currency or derivative). In academic use, an arbitrageinvolves taking advantage of differences in price of a single asset or identical cash-flows; incommon use, it is also used to refer to differences between similarassets (relative value or

convergence trades), as in merger arbitrage. People who engage in arbitrage are calledarbitrageurs (IPA: / rb tr r/)such as a bank or brokerage firm. The term is mainlyapplied to trading in financial instruments, such as bonds, stocks, derivatives, commoditiesand currencies.Conditions for arbitrage Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets ("the law of oneprice").

2. Two assets with identical cash flows do not trade at the same price.3. An asset with a known price in the future does not today trade at its future price

discounted at the risk-free interest rate (or, the asset does not have negligible costs ofstorage; as such, for example, this condition holds for grain but not for securities).

Arbitrage is not simply the act of buying a product in one market and selling it in another for ahigher price at some later time. The transactions must occur simultaneously to avoidexposure to market risk, or the risk that prices may change on one market before bothtransactions are complete. In practical terms, this is generally only possible with securitiesand financial products which can be traded electronically, and even then, when each leg ofthe trade is executed the prices in the market may have moved. Missing one of the legs of thetrade (and subsequently having to trade it soon after at a worse price) is called 'executionrisk' or more specifically 'leg risk'.

In the simplest example, any good sold in one market should sell for the same price inanother.Traders may, for example, find that the price of wheat is lower in agricultural regions

than in cities, purchase the good, and transport it to another region to sell at a higher price.This type of price arbitrage is the most common, but this simple example ignores the cost oftransport, storage, risk, and other factors. "True" arbitrage requires that there be no marketrisk involved. Where securities are traded on more than one exchange, arbitrage occurs bysimultaneously buying in one and selling on the other.See rational pricing, particularlyarbitrage mechanics, for further discussion. Mathematically it is defined as follows:

andwhere Vt means a portfolio at time t.Examples

Suppose that the exchange rates (after taking out the fees for making the exchange) inLondon are 5 = $10 = 1000 and the exchange rates in Tokyo are 1000 = $12 = 6.Converting 1000 to $12 in Tokyo and converting that $12 into 1200 in London, for aprofit of 200, would be arbitrage. In reality, this "triangle arbitrage" is so simple that italmost never occurs. But more complicated foreign exchange arbitrages, such as thespot-forward arbitrage (see interest rate parity) are much more common.

One example of arbitrage involves the New York Stock Exchange and the ChicagoMercantile Exchange. When the price of a stock on the NYSE and its correspondingfutures contract on the CME are out of sync, one can buy the less expensive one andsell it to the more expensive market. Because the differences between the prices arelikely to be small (and not to last very long), this can only be done profitably withcomputers examining a large number of prices and automatically exercising a trade

when the prices are far enough out of balance. The activity of other arbitrageurs canmake this risky. Those with the fastest computers and the most expertise takeadvantage of series of small differences that would not be profitable if takenindividually.

http://en.wikipedia.org/wiki/Statistical_arbitragehttp://en.wikipedia.org/wiki/Statistical_arbitragehttp://en.wikipedia.org/wiki/Arbitrage#Riskshttp://en.wikipedia.org/wiki/Relative_value_(economics)http://en.wikipedia.org/wiki/Convergence_tradehttp://en.wikipedia.org/wiki/Merger_arbitragehttp://en.wikipedia.org/wiki/Wikipedia:IPA_for_Englishhttp://en.wikipedia.org/wiki/Financial_instrumentshttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Law_of_one_pricehttp://en.wikipedia.org/wiki/Law_of_one_pricehttp://en.wikipedia.org/wiki/Discountinghttp://en.wikipedia.org/wiki/Risk-free_interest_ratehttp://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Merchanthttp://en.wikipedia.org/wiki/Rational_pricinghttp://en.wikipedia.org/wiki/Rational_pricing#Arbitrage_mechanicshttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Triangle_arbitragehttp://en.wikipedia.org/wiki/Interest_rate_parityhttp://en.wikipedia.org/wiki/New_York_Stock_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Statistical_arbitragehttp://en.wikipedia.org/wiki/Statistical_arbitragehttp://en.wikipedia.org/wiki/Arbitrage#Riskshttp://en.wikipedia.org/wiki/Relative_value_(economics)http://en.wikipedia.org/wiki/Convergence_tradehttp://en.wikipedia.org/wiki/Merger_arbitragehttp://en.wikipedia.org/wiki/Wikipedia:IPA_for_Englishhttp://en.wikipedia.org/wiki/Financial_instrumentshttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Law_of_one_pricehttp://en.wikipedia.org/wiki/Law_of_one_pricehttp://en.wikipedia.org/wiki/Discountinghttp://en.wikipedia.org/wiki/Risk-free_interest_ratehttp://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Merchanthttp://en.wikipedia.org/wiki/Rational_pricinghttp://en.wikipedia.org/wiki/Rational_pricing#Arbitrage_mechanicshttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Triangle_arbitragehttp://en.wikipedia.org/wiki/Interest_rate_parityhttp://en.wikipedia.org/wiki/New_York_Stock_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Futures_contract

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Economists use the term "global labor arbitrage" to refer to the tendency ofmanufacturing jobs to flow towards whichever country has the lowest wages per unitoutput at present and has reached the minimum requisite level of political andeconomic development to support industrialization. At present, many such jobs appearto be flowing towards China, though some which require command of English are goingto India and the Philippines. In popular terms, this is referred to as offshoring. (Notethat "offshoring" is not synonymous with "outsourcing", which means "to subcontract

from an outside supplier or source", such as when a business outsources itsbookkeeping to an accounting firm. Unlike offshoring, outsourcing always involvessubcontracting jobs to a different company, and that company can be in the samecountry as the outsourcing company.)

Sports arbitrage numerous internet bookmakers offer odds on the outcome of thesame event. Any given bookmaker will weight their odds so that no one customer cancover all outcomes at a profit against their books. However, in order to remaincompetitive their margins are usually quite low. Different bookmakers may offerdifferent odds on the same outcome of a given event; by taking the best odds offeredby each bookmaker, a customer can under some circumstances cover all possibleoutcomes of the event and lock a small risk-free profit, known as a Dutch book. This

profit would typically be between 1% and 5% but can be much higher. One problemwith sports arbitrage is that bookmakers sometimes make mistakes and this can leadto an invocation of the 'palpable error' rule, which most bookmakers invoke when theyhave made a mistake by offering or posting incorrect odds. As bookmakers becomemore proficient, the odds of making an 'arb' usually last for less than an hour andtypically only a few minutes. Furthermore, huge bets on one side of the market alsoalert the bookies to correct the market.

Exchange-traded fund arbitrage Exchange Traded Funds allow authorized participantsto exchange back and forth between shares in underlying securities held by the fundand shares in the fund itself, rather than allowing the buying and selling of shares inthe ETF directly with the fund sponsor. ETFs trade in the open market, with prices setby market demand. An ETF may trade at a premium or discount to the value of theunderlying assets. When a significant enough premium appears, an arbitrageur will buythe underlying securities, convert them to shares in the ETF, and sell them in the openmarket. When a discount appears, an arbitrageur will do the reverse. In this way, thearbitrageur makes a low-risk profit, while fulfilling a useful function in the ETFmarketplace by keeping ETF prices in line with their underlying value.

Some types ofhedge funds make use of a modified form of arbitrage to profit. Ratherthan exploiting price differences between identical assets, they will purchase and sellsecurities, assets and derivatives with similar characteristics, and hedge any significantdifferences between the two assets. Any difference between the hedged positions

represents any remaining risk (such as basis risk) plus profit; the belief is that thereremains some difference which, even after hedging most risk, represents pure profit.For example, a fund may see that there is a substantial difference between U.S. dollardebt and local currency debt of a foreign country, and enter into a series of matchingtrades (including currency swaps) to arbitrage the difference, while simultaneouslyentering into credit default swaps to protect against country risk and other types ofspecific risk.

Comparison between APT & CAPM

APT applies to well diversified portfolios and not necessarily to individual stocks. With APT it is possible for some individual stocks to be mispriced - not lie on the SML. APT is more general in that it gets to an expected return and beta relationship without

the assumption of the market portfolio. APT can be extended to multifactor models. Both the CAPM and APT are risk-based models. There are alternatives.

http://en.wikipedia.org/wiki/Industrializationhttp://en.wikipedia.org/wiki/People's_Republic_of_Chinahttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/Philippineshttp://en.wikipedia.org/wiki/Offshoringhttp://en.wikipedia.org/wiki/Arbitrage_bettinghttp://en.wikipedia.org/wiki/Internethttp://en.wikipedia.org/wiki/Bookmakershttp://en.wikipedia.org/wiki/Customerhttp://en.wikipedia.org/wiki/Dutch_bookhttp://en.wikipedia.org/wiki/Exchange-traded_fundhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Country_riskhttp://en.wikipedia.org/wiki/Industrializationhttp://en.wikipedia.org/wiki/People's_Republic_of_Chinahttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/Philippineshttp://en.wikipedia.org/wiki/Offshoringhttp://en.wikipedia.org/wiki/Arbitrage_bettinghttp://en.wikipedia.org/wiki/Internethttp://en.wikipedia.org/wiki/Bookmakershttp://en.wikipedia.org/wiki/Customerhttp://en.wikipedia.org/wiki/Dutch_bookhttp://en.wikipedia.org/wiki/Exchange-traded_fundhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Country_risk

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Empirical methods are based less on theory and more on looking for some regularitiesin the historical record.

Be aware that correlation does not imply causality. Related to empirical methods is the practice of classifying portfolios by style e.g.

o Value portfolioo Growth portfolio

The APT assumes that stock returns are generated according to factor models such as:

As securities are added to the portfolio, the unsystematic risks of the individualsecurities offset each other. A fully diversified portfolio has no unsystematic risk.

The CAPM can be viewed as a special case of the APT. Empirical models try to capture the relations between returns and stock attributes that

can be measured directly from the data without appeal to theory. Difference in Methodology CAPM is an equilibrium model and derived from individual portfolio optimization. APT is a statistical model which tries to capture sources of systematic risk. Relation

between sources determined by no Arbitrage condition. Difference in Application APT difficult to identify appropriate factors. CAPM difficult to find good proxy for market returns. APT shows sensitivity to different sources. Important for hedging in portfolio

formation. CAPM is simpler to communicate, since everybody agrees upon.

Q.6 Discuss the different forms of market efficiency.

Ans. A financial market displays informational efficiency when market prices reflect all

available information about value. This definition of efficient market required answers to twoquestions : what is all available information? & what does it mean to reflect allavailable information ?. different answers to these questions give rise to different versionsof market efficiency.

What information are we talking about? Information can be information about past prices,information that is public information and information that is private information. Informationabout past prices refers to the weak form version of market efficiency, information thatconsists of past prices and all public information refers to the semi-strong version of marketefficiency and all information (past prices, all public information and all private information)refers to the strong form version of market efficiency. Prices reflect all available informationmeans that all financial transactions which are carried out at market prices, using theavailable information, are zero NPV activities.

The weak form the EMH states that all past prices, volumes and other market statistics(generally referred to as technical analysis) cannot provide any information thatwould prove useful in predicting future stock price movements. The current pricesfully reflect all security-market information, including the historical sequence of prices, ratesof return, trading volume data, and other market-generated information. This implies thatpast rates of return and other market data should have no relationship with future rates ofreturn. It would mean that if the weak form of EMH is correct, then technical analysis isfruitless in generating excess returns. the semi-strong form suggests that stock prices fullyreflect all publicly available information and all expectations about the future.

OLD information then is already discounted and cannot be used to predict stock pricefluctuations. In sum, the semi-strong form suggests that fundamental analysis is also fruitless;knowing what a company generated in terms of earnings and revenues in the past will nothelp you determine what the stock price will do in the future. This implies that decisions made

FFFRR SSGDPGDPII ++++=

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on new information after it is public should not lead to above-average risk-adjusted profitsfrom those transactions.Lastly, the strong form the EMH suggests that stock prices reflect all information,whether it be public (say in SEBI filings) or private (in the minds of the CERO andother insiders). So even with material non-public information, EMH asserts that stock pricescannot be predicted with any accuracy.

MF 0011 Mergers and Acquisitions Set- 1

Q.1 What are the basic steps in strategic planning for a merger?

Ans. Basic steps in Strategic planning in Merger : Any merger and acquisition involvethe following critical activities in strategic planning processes. Some of the essential elementsin strategic planning processes of mergers and acquisitions are as listed here below :

1. Assessment of changes in the organization environment2. Evaluation of company capacities and limitations3. Assessment of expectations of stakeholders4. Analysis of company, competitors, industry, domestic economy and internationaleconomies

5. Formulation of the missions, goals and polices6. Development of sensitivity to critical external environmental changes7. Formulation of internal organizational performance measurements8. Formulation of long range strategy programs9. Formulation of mid-range programmes and short-run plans10. Organization, funding and other methods to implement all of the proceeding elements11. Information flow and feedback system for continued repetition of all essential elementsand for adjustment and changes at each stage12. Review and evaluation of all the processes

In each of these activities, staff and line personnel have important Responsibilities in thestrategic decision making processes. The scope of mergers and acquisition set the tone forthe nature of mergers and acquisition activities and in turn affects the factors which havesignificant influence over these activities. This can be seen by observing the factorsconsidered during the different stages of mergers and acquisition activities. Properidentification of different phases and related activities smoothen the process of involved inmerger

Q.2 What are the sources of operating synergy?

Ans. Sources of Operating SynergyOperating synergies are those synergies that allowfirms to increase their operating income, increase growth or both. We would categorizeoperating synergies into four types:

1. Economies of scale that may arise from the merger, allowing the combined firm tobecome more cost-efficient and profitable. Economics of scales can be seen in mergers offirms in the same business For example : two banks combining together to create a largerbank. Merger of HDFC bank with Centurian bank of Punjab can be taken as an example of costreducing operating synergy. Both the banks after combination can expect to cut costsconsiderably on account of sharing of their resources and thus avoiding duplication offacilities available.

2. Greater pricing power from reduced competition and higher market share, which shouldresult in higher margins and operating income. This synergy is also more likely to show up in

mergers of firms which are in the same line of business and should be more likely to yieldbenefits when there are relatively few firms in the business. When there are more firms in theindustry ability of firms to exercise relatively higher price reduces and in such a situation thesynergy does not seem to work as desired. An example of limiting competition to increase

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pricing power is the acquisition of universal luggage by Blow Plast. The two companies werein the same line of business and were in direct competition with each other leading to asevere price war and increased marketing costs. After the acquisition blow past acquired astrong hold on the market and operated under near monopoly situation. Another example isthe acquisition of Tomco by Hindustan Lever.

3. Combination of different functional strengths, combination of different functionalstrengths may enhance the revenues of each merger partner thereby enabling each company

to expand its revenues. The phenomenon can be understood in cases where one companywith an established brand name lends its reputation to a company with upcoming product lineor a company. A company with strong distribution network merges with a firm that hasproducts of great potential but is unable to reach the market before its competitors can do so.In other words the two companies should get the advantage of the combination of theircomplimentary functional strengths.

4. Higher growth in new or existing markets, arising from the combination of the two firms.This would be case when a US consumer products firm acquires an emerging market firm,with an established distribution network and brand name recognition, and uses thesestrengths to increase sales of its products.Operating synergies can affect margins and growth,and through these the value of the firms involved in the merger or acquisition.Synergy resultsfrom complementary activities. This can be understood with the following example Example :Consider a situation where there are two firms A and B. Firm A is having substantial amount offinancial resources (having enough surplus cash that can be invested somewhere) while firmB is having profitable investment opportunities ( but is lacking surplus cash). If A and Bcombine with each other both can utilize each other strengths, for example here A can investits resource in the opportunities available to B. note that this can happen only when the twofirms are combined with each other or in other words they must act in a way as if they areone.

Q.3 Explain the process of a leveraged buyout.

Ans. In the realm of increased globalized economy, mergers and acquisitions have assumedsignificant importance both with the country as well as across the boarders. Such acquisitionsneed huge amount of finance to be provided. In search of an ideal mechanism to finance andacquisition, the concept of Leverage Buyout (LBO) has emerged. LBO is a financing techniqueof purchasing a private company with the help of borrowed or debt capital. The leveragedbuyout are cash transactions in nature where cash is borrowed by the acquiring firm and thedebt financing represents 50% or more of the purchase price. Generally the tangible assets ofthe target company are used as the collateral security for the loans borrowed by acquiringfirm in order to finance the acquisition. Some times, a proportionate amount of the long termfinancing is secured with the fixed assets of the firm and in order to raise the balance amountof the total purchase price, unrated or low rated debt known as junk bond financing is utilized.

Modes of purchaseThere are a number of types of financing which can be used in an LBO.These include :

Senior debt : this is the debt which ranks ahead of all other debt and equity capital in thebusiness. Bank loans are typically structured in up to three trenches : A, B and C. The debt isusually secured on specific assets of the company, which means the lender can automaticallyacquire these assets if the company breaches its obligations under the relevant loanagreement; therefore it has the lowest cost of debt. These obligations are usually quitestringent. The bank loans are usually held by a syndicate of banks and specialized funds.

Typically, the terms of senior debt in an LBO will require repayment of the debt in equalannual installments over a period of approximately 7 years.

Subordinated debt : This debt ranks behind senior debt in order of priority on anyliquidation. The terms of the subordinated debt are usually less stringent than senior debt.Repayment is usually required in one bullet payment at the end of the term. Since

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subordinated debt gives the lender less security than senior debt, lending costs are typicallyhigher. An increasingly important form of subordinated debt is the high yield bond, oftenlisted on Indian markets. High yield bonds can either be senior or subordinated securities thatare publicly placed with institutional investors. They are fixed rate, publicly traded, long termsecurities with a looser covenant package than senior debt though they are subject tostringent reporting requirements.

Mezzanine finance :This is usually high risk subordinated debt and is regarded as a type of

intermediate financing between debt and equity and an alternative of high yield bonds. Anenhanced return is made available to lenders by the grant of an equity kicker whichcrystallizes upon an exit. A form of this is called a PIK, which reflects interest paid in kind, orrolled up into the principal, and generally includes an attached equity warrant.

Loan stock :This can be a form of equity financing if it is convertible into equity capital. Thequestion of whether loan stock is tax deductible should be investigated thoroughly with thecompanys advisers.

Preference share : This forms part of a companys share capital and usually givespreference shareholders a fixed dividend and fixed share of the companys equity.

Ordinary shares : This is the riskiest part of a LBOs capital structure. However, ordinaryshareholders will enjoy majority of the upside if the company is successful.

Q.4 What are the cultural aspects involved in a merger. Give sufficient examples.

Ans. The value chains of the acquirer and the acquired, need to be integrated in order toachieve the value creation objectives of the acquirer. This integration process has threedimensions: the technical, political and cultural. The technical integration is similar to thecapability transfer discussed above. The integration of social interaction and politicalrelationships represents the informal processes and systems which influence peoples abilityand motivation to perform. At the time of integration, the acquirer should have regard to

these political relationships, if acquired employees are not to feel unfairly treated.An important aspect of integration is the cultural integration of the acquiring and acquiredfirms. The culture of an organization is embodied in its collective value systems, beliefs,norms, ideologies myths and rituals. They can motivate people and can become valuablesources of efficiency and effectiveness. The following are the illustrative organizationaldiverse cultures which may have to be integrated during post-merger period:

Strong top leadership versus Team approach

Management by formal paper work versus management by wandering around

Individual decision versus group consensus decision

Rapid evaluation based on performance versus Long term relationship based on loyalty

Rapid feedback for changes versus formal bureaucratic rules and procedures

Narrow career path versus movement through many areas

Risk taking encouraged versus one mistake you are out

Risky activities versus low risk activities

Narrow responsibility arrangement versus Everyone in this company is salesman (or costcontroller, or product quality improver etc.)

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Learn from customer versus We know what is best for the customer

The above illustrative culture may provide basis for the classification of organizational culture.There are four different types of organizational culture as mentioned below:

Power - The main characteristics are: essentially autocratic and suppressive of challenge;emphasis on individual rather than group decision making

Role- The important features are: bureaucratic and hierarchical; emphasis on formal rulesand procedures; values fast, efficient and standardized culture service

Task/achievement- The main characteristics are: emphasis on team commitment; taskdetermines organization of work; flexibility and worker autonomy; needs creativeenvironment

Person/support- The important features are: emphasis on equality; seeks to nurturepersonal development of individual members

Poor cultural fit or incompatibility is likely to result in considerable fragmentation, uncertainty

and cultural ambiguity, which may be experienced as stressful by organizational members.Such stressful experience may lead to their loss of morale, loss of commitment, confusion andhopelessness and may have a dysfunctional impact on organizational performance. Mergersbetween certain types can be disastrous. Differences in culture may lead to polarization,negative evaluation of counterparts, anxiety and ethnocentrism between top managementteams of the acquired and acquiring firms. In assessing the advisability of an acquisition, theacquirer must consider cultural risk in addition to strategic issues. The differences betweenthe national and the organizational culture influence the cross-border acquisition integration.

Thus, merging firms must consciously and proactively seek to transform the cultures of theirorganizations.

Q.5 Study a recent merger that you have read about and discuss the synergies

that resulted from the merger.

Ans. Synergy is the additional value that is generated by the combination of two or morethan two firms creating opportunities that would not be available to the firms independently.

There are two main types of synergy :1. Operating synergy2. Financial synergy

Operating Synergy Operating synergies are those synergies that allow firms to increasetheir operating income, increase growth or both. We would categorize operating synergies

into four types:

1. Economies of scale that may arise from the merger, allowing the combined firm tobecome more cost-efficient and profitable. Economics of scales can be seen in mergers offirms in the same business For example : two banks combining together to create a largerbank. Merger of HDFC bank with Centurian bank of Punjab can be taken as an example of costreducing operating synergy. Both the banks after combination can expect to cut costsconsiderably on account of sharing of their resources and thus avoiding duplication offacilities available.

2. Greater pricing power from reduced competition and higher market share, which shouldresult in higher margins and operating income. This synergy is also more likely to show up in

mergers of firms which are in the same line of business and should be more likely to yieldbenefits when there are relatively few firms in the business. When there are more firms in theindustry ability of firms to exercise relatively higher price reduces and in such a situation thesynergy does not seem to work as desired. An example of limiting competition to increase

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pricing power is the acquisition of universal luggage by Blow Plast. The two companies werein the same line of business and were in direct competition with each other leading to asevere price war and increased marketing costs. After the acquisition blow past acquired astrong hold on the market and operated under near monopoly situation. Another example isthe acquisition of Tomco by Hindustan Lever.

3. Combination of different functional strengths, combination of different functionalstrengths may enhance the revenues of each merger partner thereby enabling each company

to expand its revenues. The phenomenon can be understood in cases where one companywith an established brand name lends its reputation to a company with upcoming product lineor a company. A company with strong distribution network merges with a firm that hasproducts of great potential but is unable to reach the market before its competitors can do so.In other words the two companies should get the advantage of the combination of theircomplimentary functional strengths.

4. Higher growth in new or existing markets, arising from the combination of the two firms.This would be case when a US consumer products firm acquires an emerging market firm,with an established distribution network and brand name recognition, and uses thesestrengths to increase sales of its products. Operating synergies can affect margins andgrowth, and through these the value of the firms involved in the merger or acquisition.Synergy results from complementary activities. This can be understood with the followingexample Example : Consider a situation where there are two firms A and B. Firm A is havingsubstantial amount of financial resources (having enough surplus cash that can be investedsomewhere) while firm B is having profitable investment opportunities ( but is lacking surpluscash). If A and B combine with each other both can utilize each other strengths, for examplehere A can invest its resource in the opportunities available to B. note that this can happenonly when the two firms are combined with each other or in other words they must act in away as if they are one.

Financial SynergyWith financial synergies, the payoff can take the form of either highercash flows or a lower cost of capital (discount rate). Included are the following:

A combination of a firm with excess cash, or cash slack, (and limited projectopportunities) and a firm with high-return projects (and limited cash) can yield a payoffin terms of higher value for the combined firm. The increase in value comes from theprojects that were taken with the excess cash that otherwise would not have beentaken. This synergy is likely to show up most often when large firms acquire smallerfirms, or when publicly traded firms acquire private businesses.

Debt capacity can increase, because when two firms combine, their earnings and cashflows may become more stable and predictable. This, in turn, allows them to borrowmore than they could have as individual entities, which creates a tax benefit for thecombined firm. This tax benefit can either be shown as higher cash flows, or take theform of a lower cost of capital for the combined firm.

Tax benefits can arise either from the acquisition taking advantage of tax laws or fromthe use of net operating losses to shelter income. Thus, a profitable firm that acquires amoney-losing firm may be able to use the net operating losses of the latter to reduceits tax burden. Alternatively, a firm that is able to increase its depreciation chargesafter an acquisition will save in taxes, and increase its value.

Clearly, there is potential for synergy in many mergers. The more important issues arewhether that synergy can be valued and, if so, how to value it. This result has to beinterpreted with caution, however, since the increase in the value of the combined firm after amerger is also consistent with a number of other hypotheses explaining acquisitions, includingunder valuation and a change in corporate control. It is thus a weak test of the synergy

hypothesis. The existence of synergy generally implies that the combined firm will becomemore profitable or grow at a faster rate after the merger than will the firms operatingseparately. A stronger test of synergy is to evaluate whether merged firms improve their

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performance (profitability and growth) relative to their competitors, after takeovers. On thistest, as we show later in this chapter, many mergers fail.

Q.6 What are the motives for a joint venture, explain with an example of a jointventure.

Ans:- As there are good business and accounting reasons to create a joint venture with acompany that has complementary capabilities and resources, such as distribution channels,

technology, or finance, joint ventures are becoming an increasingly common way forcompanies to form strategic alliances. In a joint venture, two or more parent companiesagree to share capital, technology, human resources, risks and rewards in a formation of anew entity under shared control. Broadly, the important reasons for forming a joint venturecan be presented below:

Internal Reasons to Form a JV

Spreading Costs:You and a JV partner can share costs associated with marketing,product development, and other expenses, reducing your financial burden.

Opening Access to Financial Resources: Together you and a JV partner might have

better credit or more assets to access bigger resources for loans and grants than youcould obtain on your own.

Connection to Technological Resources: You might want access to technologicalresources you couldn't afford on your own, or vice versa. Sharing innovative and

proprietary technology can improve products, as well as your own understanding oftechnological processes.

Improving Access to New Markets: You and a JV partner can combine customer contactsand together even form a joint product that accesses new markets.

Help Economies of Scale: Together you and a JV partner can develop products or services

that reduce total overall production expenses. Bring your product to market cheaperwhere the customer can enjoy the cost savings.

External Reasons to Form a JV

Develop Stronger Innovative Product: Together you and a JV partner may be able toshare ideas to develop a product that is more competitive in your industry.

Improve Speed to Market: With shared access to financial, technological, and distributionresources, you and a JV partner can get your joint product to market faster and moreefficiently.

Strategic Move Against Competition: A JV may be able to better compete against anotherindustry leader through the combination of markets, technology, and innovation.

Strategic Reasons

Synergistic Reasons: You may find a JV partner with whom you can create synergy, whichproduces a greater result together than doing it on your own.

Share and Improve Technology and Skills: Two innovative companies can sharetechnology to improve upon each other's ideas and skills.

Diversification - There could be many diversification reasons: access to diversemarkets, development of diverse products, diversify the innovative working

force, etc.Don't let a JV opportunity pass you by because you don't think it will fit in with

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your own small business. Small and big companies alike can benefit from thereasons listed above. Analyze how your company can benefit internally, externally,and strategically, and then find a joint venture partner that will fit with yourneeds.

MF 0012 Taxation Management Set- 1

Q.1 Tax evasion is a menace to the people, economy and the country. In the wakeof recent Swiss bank account scandal give your views on the following:a. How does it affect the Indian economy and the growth prospects?

Ans. In view of the facts set out so far, it becomes necessary to look at the extent ofcompliance of tax laws in India. Though many estimates of black money have been comingforth, an attempt was made to determine the extent of tax evasion in the Mumbai Income Tax

charge, which collected about 35% of the Income Tax collections of the country and 43% ofthe corporate tax collections. The study was made on the basis of results of the survey andsearch cases for all the years covered by such cases. It came to light that none of thetaxpayers concerned declared for taxation purposes anything more than 25% of their trueincomes after 1999. The figure arrived at was given to the press specifying the basis on whichit was so calculated. Not a single protest was received from any of the taxpayer, includingcompanies. The said figure was thereafter cited for some more time, and even thereafter noprotest was received. There was, therefore, every reason to believe this estimate. However,there appears 10 to be higher tax evasion in the case of companies. Some of the companieshave shown their entire capital as having come from the countries regarded as Tax Havens.Considering the extent of Indian monies stacked in Swiss Bank Accounts, and bank accountsof the developed countries, and comparing the same with the annual income tax collections ofthe Central Government, it appears that the real income admitted for taxation purposes isless than 25% . The extent of evasion appears to be very much higher in the case ofcompanies as the companies have resorted to evolution of tax evasion devices in theaccounts and such methods have not yet been properly investigated by the Income TaxDepartment. There are companies which have camouflaged their capital investments andshown it in the books as if it is explained capital for income tax purposes.

The Indian Scenario - Peculiar problems of tax evasion : It will be appropriate at thisstage to highlight some of the key problems from the view point of computerisation in India :

(a) Investments in Real Estate :The one field where black monies have been invested on

the largest scale is that of real estate properties. Lands were sold for only 20% of their realvalues and the balance 80% given in cash out of the tax evaded monies, ever since 1947. Butlater on when the tax rates were lowered to 30% for individuals and 35% for companies, theblack portion got reduced to 40% . It may be a difficult task to trace such black transactionsthrough the computer system, suggested for adoption on the U.S. pattern for India. But it iscommon knowledge that the black monies invested in land have been reinvested in bankaccounts, shares and in other properties, apart from real estate property. It is now confirmedknowledge that in regard to buildings constructed, only 40% of the cost is shown to incometax. It is possible to detect such investment by analysis of the data obtained from the tradeand industry governing commodities used for construction of buildings. Further, as all thetransactions relating to sale of real estate properties are now recorded in computersmaintained by the Registration Offices all over the country, and if the same data is brought onthe computers of the Income Tax Department, it should be possible to know many owners ofproperty who have not filed their tax returns at all so far. In India, there are only 3 crores oftax assessees at present, and thus a large number of people with taxable income haveevidently chosen not to file income tax returns.

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(b) Gold and Jewellery Holdings : India is having the largest private holdings of gold anddiamond jewellery among all the countries of the world. In the searches conducted by theIncome Tax Department, huge unaccounted cash balances and gold and diamond jewelleryhave been found in the bank lockers maintained by tax payers in bogus names and in theirown names. At current market rates, purchases of gold, silver and diamonds may now reachabout Rs. 80,000 crores a year. Gold and diamond traders are mostly keeping theirtransactions outside bank accounts. They are also giving vouchers to the effect that raw gold

has been given by the customers, though, in fact, it would have come from the tradersthemselves. Therefore, it is necessary to introduce a law requiring them to transact onlythrough bank cheques and issue computerized bills, to facilitate proper flow of information tothe computer system of the tax department.

(c) Shares, Mutual Funds, etc : There are vast investments in shares and debentures,travelers cheques, mutual funds and the primary bonds issued by the Reserve Bank of India.

The data regarding company shares and other investments mentioned can be easilytransferred to the computer system of the Income Tax Department. The Mumbai StockExchange is having a separate computer system with complete data on daily transactions andthe Income Tax Department has so far not made use of such data. There is also the datagenerated in the computers of the organizations in charge of demat of shares. Like-wise, the

data on post office savings and other accounts is easy to be brought on the computers of thetax department for verification with the individual returns, which are available with theGovernment itself.

d) Undisclosed Stock in-trade held by companies and traders : Many firms andindividuals have also a tendency to keep undisclosed business assets like cars and privateassets, unaccounted cash holdings etc., They have ability to give extensive bribes to protectbusiness and other interests. All such practices would varnish once fear is caused among thetax payers about the use of computerized data for taxation purposes.

(e) Benami Investments : Benami investments are typical of the Indian economy. Even bigcompanies have indulged in such practices to impart total secrecy to their undisclosedaccounts. It may be difficult to determine whether the investment found in the computers ofthe income tax department is benami or not, and benami shares will have to be tracedsometimes by extensive studies to be conducted by teams of revenue officers. This problemrequires comprehensive study because it is peculiar to the Indian Taxation System.

(f) Swiss Bank and other undisclosed bank accounts held abroad: Swiss BankAccounts are shrouded in secrecy and hence no information will be available to the computersystem of the Income Tax Department. The amounts in Swiss Bank Accounts, which are heldin foreign currency, have been utilised by big companies and other taxpayers in India toimport huge machineries at vastly underinvoiced prices. Such practices enable payment ofsecret trade commissions in foreign currency and unaccounted funds in Indian currency to

those contesting general elections. Several major companies have converted Swiss Accountholdings into benami shares and debentures. The large amounts of Swiss Bank deposits have,thus, been utilized and every year, there are additions to the Swiss Bank Account holdings.

b. Does black money cause Inflation?

Ans. Illegally earned money is called black money. It is the result of hoarding, smuggling, taxevasion and dealing in immovable property for which the consideration is paid in black. It hasbeen beyond the control of the Government. The black money has already created a seriousproblem in our country.

The Indian economy stands badly shattered because of the huge amount of this taintedwealth lying in the coffers of the rich. It has given rise to parallel economy operating in thecountry. As a result, the prices continue to rise in spite of all government efforts to control

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them. The poor go on becoming poorer while the rich go on becoming richer. The gapbetween the haves and the have nots is widening every day.

Black money is used by the rich in various evil activities. They use this money for corruptingand demoralizing social and political life. They display it in ostentatious living and wastefulluxuries. They bribe Government officers and lead them to corruption and dishonesty. Theypurchase political bosses and control the strings of the Government. Thus the entire socialstructure comes to be badly polluted. It is difficult to form an exact idea of the amount of

black money in circulation in the country. Searches and raids by Income Tax authorities areconducted from time to time. Such raids yield crores of rupees. But the people are, at times,cleverer than the Government. They seek the aid of the best legal brains and get the lawtwisted in their favour. Most of the offenders use all their money and influence and go scotfree whenever they are caught. The Government has, at various times, announced somevoluntary disclosure schemes for unearthing the black money. These schemes have provedsuccessful to a very limited extent. What has come to the surface is believed only to be thetip of the huge iceberg lying hidden underneath. The 1997 Voluntary Disclosure Schemeannounced by the Government of India unearthed a big amount of black money as the taxrate in this scheme had been reduced to thirty per cent.

The black money, according to some reliable estimates has gone up to Rs. 10,000 crores inour country. It is to a great extent responsible for a great rise in prices because thepurchasing power of the people has increased. People having black money are leading a lifeof luxury whereas the poor people are leadinng a miserable life. Some leading economists ofthe country have suggested stringent measures to the government to unearth black moneybut successive governments have been rejecting those measures. The vested interestsalways stand in the way of effective measures and get them diluted.

The government of the day appears to be doing its best to unearth black money. A number ofsteps have been taken. Taxation structure and system have been made easier. At differenttimes, the government has brought forward several schemes and asked the people to declaretheir wealth. There has been some success. A lot soil remains to be done.

It must be clear to all that the nation cannot shut her eyes to this state of affairs. Smugglersand black-marketeers can no longer be tolerated. They are striking at the very roots of ourdemocratic structure. All steps to weed the black moneyout of circulation must be taken asearly as possible.The government must come down with a heavy hand on smugglers, taxevaders, black-marketeers and hoarders. Black money is a curse. It must be rooted out frompublic life.

Q.2 Detail death cum retirement gratuity under Sec 17(1) iii of IT Act. Iscommutation of pension a viable option in terms of tax planning?

Ans. Death-cum-retirement gratuity or any other gratuity which is exempt to the extentspecified from inclusion in computing the total income under clause (10) of Section 10. Anydeath-cum-retirement gratuity received under the revised Pension Rules of the CentralGovernment or, as the case may be, the Central Civil Services (Pension) Rules, 1972, or underany similar scheme applicable to the members of the civil services of the Union or holders ofposts connected with defence or of civil posts under the Union (such members or holdersbeing persons not governed by the said Rules) or to the members of the all-India services orto the members of the civil services of a State or holders of civil posts under a State or to theemployees of a local authority or any payment of retiring gratuity received under the PensionCode or Regulations applicable to the members of the defence service. Gratuity received incases other than above on retirement, termination etc is exempt up to the limit as prescribedby the Board. Under the provisions of Section 10(10) of the IT Act, any death-cum-retirement

gratuity of a government servant is completely exempt from income tax. However, in respectof private sector employees gratuity received on retirement or on becoming incapacitated oron termination or any gratuity received by his widow, children or dependants on his death isexempt subject to certain conditions.

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The maximum amount of exemption is Rs. 3,50,000;. Of course, this is further subject tocertain other limits like the one half-month's salary for each year of completed service,calculated on the basis of average salary for the 10 months immediately preceding the yearin which the gratuity is paid or 20 months' salary as calculated. Thus, the least of these itemsis exempt from income tax under Section 10(10).

Any payment in commutation of pension received under the Civil Pension(Commutation)Rules of the Central Government or under any similar scheme applicable to the members ofthe civil services of the Union, or holders of civil posts/posts connected with defence, underthe Union,or civil posts under a State, or to the members of the All India Services/DefenceServices, or, to the employees of a local authority or a corporation established by aCentral,State or Provincial Act, is exempt under sub-clause (i) of clause (10A) of Section 10. Asregards payments in commutation of pension received under any scheme of any otheremployer, exemption will be governed by the provisions of sub-clause (ii) of clause (10A) ofsection 10. Also, any payment in commutation of pension received from a Regimental Fund orNon-Public Fund established by the Armed Forces of the Union referred to in Section10(23AAB) is exempt under sub-clause (iii) of clause (10A) of Section 10. The entire amount ofany payment in commutation of pension by a government servant or any payment incommutation of pension from LIC [Get Quote] pension fund is exempt from income tax underSection 10(10A) of IT Act.

However, in respect of private sector employees, only the following amount of commutedpension is exempt, namely: (a) Where the employee received any gratuity, the commutedvalue of one-third of the pension which he is normally entitled to receive; and (b) In any othercase, the commuted value of half of such pension. It may be noted here that the monthlypension receivable by a pensioner is liable to full income tax like any other item of salary orincome and no standard deduction is now available in respect of pension received by a taxpayer.

Q.3 Explain the essential conditions to be satisfied by a firm to be assessed asfirm under Section 184.

Ans. Position of Firm under the Income Tax Act Legally, a partnership firm does nothave a separate entity from that of the partners constituting the firm as the partners are theowners of the firm. However, a firm is treated as a separate tax entity under the Income TaxAct. Salient features of the assessment of a firm are as under:

1. A firm is treated as a separate tax entity.

2. While computing the income of the firm under the head Profits and gains of business orprofession, besides the deductions which are allowed u/ss 30 to 37, special deduction isallowed to the firm on account of remuneration to working partners and interest paid to thepartners. However, it is subject to certain limits laid down u/s 40 (b).3. Share of profit which a partner receives from the firm (after deduction of remuneration andinterest allowable) shall be fully exempt in the hands of the partner. However, only that partof the interest and remuneration which was allowed as a deduction to the firm shall betaxable in the hands of the partners in their individual assessment under the head profits andgains of business or profession.4. The firm will be taxed at a flat rate of 30% plus education cess @ 3% plus for the financialyear 2010-11.5. The firm will be assessed as a firm provided conditions mentioned under Section 184 aresatisfied. In case these conditions are not satisfied in a particular assessment year, the firmwill be assessed as affirm, but no deduction by way of payment of interest, salary, bonus,commission or remuneration, by whatever name called, made to the partner, shall be allowed

in computing the income chargeable under the head profits and gains of business orprofession and such interest, salary, bonus, commission or remuneration shall not bechargeable to income tax in the hands of the partner.

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Assessment of firm From point (5) stated above, it can be concluded that for taxationpurposes, a firm can be of two types:

1. Firm assessed as firm (provided conditions mentioned u/s 184 are satisfied).and the firmshall be eligible for deduction on account of interest, salary etc while computing its incomeunder the head business and profession). However, it will be subject to the maximum of thelimit specified under Section 40(b)

2. If the prescribed conditions are not satisfied, no deduction shall be allowed to the firm onaccount of such interest, salary, bonus etc.

Essential conditions to be satisfied by a firm to be assessed as firm (Section 184)

1. In the first assessment year: The firm will be assessed as a firm, also known as FirmAssessed as Such (FAAS) if the following conditions are satisfied:

(a) Partnership is evidenced by an instrument i.e. there is a written document giving theterms of partnership.(b) The individual share of the partners is specified in that instrument.

(c) Certified copy of partnership deed must be filed: A certified copy of the said instrument ofpartnership shall accompany the return of income in respect of the assessment year for whichthe assessment as a firm is first sought.

Where certified copy is not filed with the return there is no provision for condonation of delay.However where the return itself is filed late then there is no problem if the certified copy isfiled along with such return as the condition that it shall accompany the return of income issatisfied. Further Delhi ITAT in the case of Ishar Dass Sahini & Sons v CIT held that whereuncertified Photostat copy of the instrument of partnership is submitted along with the returnof income and the certified copy is produced at the time of assessment, it will satisfy thiscondition.

2. In the subsequent assessment years: If the above three conditions are satisfied thefirm will be assessed as such (FAAS) in the first assessment year. Once the firm is assessed asfirm for any assessment year, it shall be assessed in the same capacity for every subsequentyear if there is no change in the constitution of the firm or the share of the partners. Whereany such change had taken place in the previous year, the firm shall furnish a certified copyof the revised instrument of partnership along with the return of income for the assessmentyear relevant to such previous year. Read the box for some important points to be consideredin this regard.

Circumstance where the firm will be assessed as a firm but shall not be eligible for deductionon account of interest, salary, bonus, etc. [Section 184(5)]

The firm will be assessed as a firm but shall not be eligible for any deduction on account ofinterest, salary and bonus etc if there is failure on the part of the firm as is mentioned in

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Section 144 (relating to Best Judgment Assessment) and where the firm does not comply withthe three conditions mentioned under Section 184.

Q.4 List out the steps to compute total income.

Ans. Step 1 Determination of residential statusThe residential status of a person hasto be determined to ascertain which income is to be included in computing the total income.

The residential statuses as per the Income-tax Act are shown below In the case of an

individual, the duration for which he is present in India determines his residential status.Based on the time spent by him, he may be (a) resident and ordinarily resident, (b) residentbut not ordinarily resident, or (c) non-resident. The residential status of a person determinesthe taxability of the income. For e.g., income earned outside India will not be taxable in thehands of a non-resident but will be taxable in case of a resident and ordinarily resident.

Step 2 Classification of income under different headsThe Act prescribes five heads ofincome. These are shown below HEADS OF INCOMESALARIES INCOME FROM PROFITS AND GAINS CAPITAL INCOMEHOUSE PROPERTY OF BUSINESS OR GAINS FROM OTHERPROFESSION SOURCES

These heads of income exhaust all possible types of income that can accrue to or be receivedby the tax payer. Salary, pension earned is taxable under the head Salaries. Rental incomeis taxable under the head Income from house property. Income derived from carrying onany business or profession is taxable under the head Profits and gains from business orprofession. Profit from sale of a capital asset (like land) is taxable under the head CapitalGains. The fifth head of income is the residuary head under which income taxable under theAct, but not falling under the first four heads, will be taxed. The tax payer has to classify theincome earned under the relevant head of income.

Step 3 - Exclusion of income not chargeable to tax There are certain income which arewholly exempt from income-tax e.g. Agricultural income. These income have to be excluded

and will not form part of Gross Total Income. Also, some incomes are partially exempt fromincome-tax e.g. House Rent Allowance, Education Allowance. These incomes are excludedonly to the extent of the limits specified in the Act. The balance income over and above thepresc