Financial Matters

Marginal Costing Formulas

noreply@blogger.com (B.S) — Mon, 24 Mar 2008 06:36:00 +0000

Marginal Costing Equation: We know that profit is difference between sales & total cost. Total can bifurcated in to Fixed & Variable costs. Thus,

Profit = Sales – Total Cost. (Variable + Fixed Cost).

Fixed Cost + Profit = Sales – Variable Cost.

The above equation termed as Marginal Costing equation.

Fixed Cost: F.C ,as the name suggests, remain fixed in amount. The amount spent towards such an expensive remains the same irrespective of the Volume of production. They may have to be incurred even if there is no production. For ex: rent of factory building has to be paid irrespective of whether or not production is taking place. Ex: Salaries, Audit fees, go down rent etc.,

Variable Cost: Variable cost varies in direct proportion to the volume of production. No variable costs are included if production is stopped. As production increases, variable costs increase. However, Variable cost P.U will not change. For Ex: if it is estimated that 2 units are required to produce 1 unit of finished product, then material cost will continue to increase as the number of units finished stock desired increases. All direct costs are Variable cost. Commission to sales persons, Certain taxes., etc.

Semi -Variable Cost: S.V.C change with the changes in out put of production, but the change not proportionate. For the purpose of analysis, S.V.C are split in to Fixed Cost and Variable Cost. S.V.C normally has a fixed cost component, which needs to be incurred irrespective of no. of units produced. Telephone expenses are a example of S.V.C. Telephone exp. Can be split in to a fixed component of a rent, that needs to be paid whether or not the telephone is used. The charge for every call made constitutes the variable component.

Two point Method: Under this method, the out put at two different levels is compared with corresponding amount of semi variable expenses. Since fixed costs, the change in amount of expenses is on account of variable costs, divided by the change in out put, gives the variable costs per unit. If the number of units at a given level of output are multiplied with variable cost per unit, we get the variable proportion in the total amount of expenses at the given level. The difference between the two amounts gives us the ‘Fixed Cost’ component in the semi – variable cost.

Contribution: Contribution is the difference between sales and Variable Costs. Since sales & Variable Cost can be both be expressed in P.U. terms, contribution is usually expressed in P.U. terms.

Contribution = Sales –Variable Cost

Contribution P.U. = Selling Price P.U.= Selling Price P.U. – Variable Cost P.U.

Total contribution = Contribution P.U. X No. of Units.

“ “ Total Sales – Total Variable Cost.

P/v Ratio: P/v Ratio stands for Profit /Volume Ratio. However, it is ratio of contribution to sales. (The term Profit is used as fixed costs are not considered in Marginal Costing technique & profit is same as Contribution).

= P/v Ratio = Contribution / Sales; Sales-Variable Costs/ Sales;

1-V.C/Sales; Change in Profit(Contribution)/Change in Sales;

BEP ( Break – Even Point ):

BEP= Fixed Cost / P/V Ratio;

In Units : Fixed Cost / Contribution P.U;

Fixed costs / Selling Price P.U. – Variable Cost P.U;

BEP (Sales in Volume) BEP in Units X Selling Price P.U

= Fixed Cost X Total Sales / Total Sales – Total Variable Cost.

Units for Desired Profit = Fixed Cost + Desired Profit/ Contribution P.U.

Sales for Desired Profit = Fixed Cost / Desired Profit / P/v Ratio.

Margin of Safety (MOS) = Total Sales – BEP Sales

Example:

Sales Rs.50, 000; Fixed Cost Rs.1, 00,000; Profit Rs.1, 50,000;

Find out the following (i) P/V Ratio (iii) BEP (iv) MOS

Sol: P/V Ratio = Contribution / Sales

Contribution = Sales – Variable Cost; Fixed Cost + Profit / Sales

Sales = Rs.50, 000, Profit = Rs.1, 50, 000

1, 00, 000 + 1, 50, 000 / 5, 00, 000

= 0.5 or 50%.

I.e. P/v Ratio = 0.5 or 50%;

BEP = Fixed Cost / P/V Ratio

Fixed Cost = Rs.1, 00, 000; P/V Ratio = 0.5 or 50%;

BEP = 1, 00, 000 / 50%

= 2, 00, 000

Margin of Safety (MOS) = Total Sales – Break – Even Sales

.5, 00, 000 – 2, 00, 000 = 3, 00, 000.

Balance Sheet Ratios

noreply@blogger.com (B.S) — Tue, 18 Mar 2008 11:33:00 +0000

Balance Sheet Ratios

Current or Working Capital Ratio: (Test of Liquidity)

*C.R = Current Assets/ Current Liabilities

Since C.A are expected to be converted in to cash with in the normal period and since C.L are satisfied by use of C.A. The C.A generally considered being an indicator of the ability of the business to pay its current debts promptly.

C.R is also a measure of the liquidity of the business. And also to determine the solvency of the business enterprise, that is the probable ability of the business to meet its debts promptly & with out loss.

Satisfactory Current Ratio

The ultimate results of all factors is that the financial analysts usually accept that an organization have its C.L covered at least twice by C.A. Thus a minimum 2 to 1 (2:1) C.R is often referred as a ‘rule of thumb’. Standard of liquidity of business, especially from the point of view of short term creditors such as bankers.

Factors affecting Current Ratio

The ability of the business to convert debtors, Bills Receivables & stock in to cash determines the extent of C.R. 1 to 1 (1:1) C.R is sufficient in business enterprise in which there is quick stock turnover & collection of debtors because in that case the requirement of working capital would be low. On the other hand a business engaged in the prolonged manufacturing process requires more working capital & hence a high C.R.
Seasonal fluctuations also have considerable impact on the C.R. A larger amount of working capital is needed in the peak season when there are heavy purchases of raw materials &production is in full swing. The liabilities may be assumed. As goods are sold, the stock of goods is replaced debtors & B. Receivables. While cash is diminished by the expenses of operation. The cycle is completed when the repayment of Liabilities.

Window Dressing:

For keeping C.R. at a satisfactory level the enterprises uses manipulation or malpractice. It is commonly known as Window Dressing. One of the most common devices used to enhance C.R. is to avoid purchase of goods just before the closing of the books of accounts. The Balance sheet also window Dressed by sale of Fixed Assets, Sale of Debentures.

Liquid, Quick or Acid Test Ratio:

= *Quick Assets-(stock +prepaid Exp.) / C.L–(Bank over Draft)

Satisfactory Level:

It indicates a satisfactory liquidity position for the simple reason that the ratio is more than the required yardstick of 1 to 1 (1:1). It may be emphasized that sometimes the investors are more liquid than the debtors & B. Receivables, especially under condition of scarcity.

Balance sheet Ratios Regarding Long Term Position:

Proprietary Ratio (Equity – Asset Ratio/ Net worth – Total Asset Ratio (Test of Solvency)

= *Total Shareholders Equity / Total Assets

The ratio should probably be expressed in percentage which can never exceed 100% & it would at the most equal to 100 when there are out side liabilities.

The ratio is of particularly importance of the investors because the presence of a high performance of shareholders fund indicates that there is relatively little danger of winding up or forced reorganization in the event of default in payments to outside liabilities.

Satisfactory Level:

A low proprietary ratio indicates that in the event of financial difficulties the sharejolders may receive little if any of their original investment.

Then the higher proprietary ratio des not it self show that the business is sound. An equity ratio of say 80% or 100% would not necessarily good because sometimes funds from outsiders can be used to the long run advantage of the business enterprises.

2. Asset Proprietorship Ratio:

i. Fixed Asset to Proprietors Fund

ii. C.A to Proprietors fund

F.A to P.F : It expresses the relation of the F.A with funds contributed by the owners or shareholders. In this there are no fictitious assets.

F.A/P.F*100

If the ratio is unduly high the enterprise may be handicapped as 100 much capital is not circulating but it is locked up in F.A.

C.A to P.F: This ratio designed to express the percentage of the amount invested in the C.A to the total funds of the Proprietors.

Total C.A / Total P.F *100

Funds Flow Analysis

noreply@blogger.com (B.S) — Tue, 18 Mar 2008 11:25:00 +0000

The Funds flow analysis explains the various sources from which funds are raised and uses to which funds are put. It shows the change in assets and liabilities from the end of one period of time to the end of another period of time (i.e. between two Balance sheet dates). An analysis of statement helps us in answering question such as what is the amount of funds generated from Operations. How were the Fixed Assets of Organisation Financed? Whether the liquidity position of the organization increased? Etc.

Concept of Funds

The term fund has been defined and interpreted differently by different experts. Broadly the term fund refers to all the financial resources of the company. On the other extreme, fund has been understood as Cash only. However, the most acceptable meaning if funds is working capital. Working capital is the excess of current assets over current liabilities.

Concept of Flow

The flow of funds refers to transfer of economic values from one asset or equity to another. When funds mean working capital, flow of funds refers to changes in assets and liabilities, which cause a change in working capital of the organisaton. To identify a flow of funds, we have to understand the difference between current and Non – current Accounts.

Current Accounts and Non – Current Accounts.

Any account which is either current asset or a current liability is a current account. An account which is neither current asset nor current liability is Non – Current Account.

The concept of current accounts is important as fund implies working capital, which is the difference between current assets and current liabilities. If there is a change in a current account, there is a Possibility of Flow of funds If there is no change in any of the current accounts, there is cannot be any flow of funds.

General Rule

Transactions that involve only current Accounts do not result in a flow. In other words, if both the accounts getting impacted on account of a transaction are Current accounts there is no change in position of funds.
Similarly, transactions that involve only Non – Current Accounts also do not result in a flow.
Transactions that involve one current account and one non – current account results in a flow of funds.

Examples:

Cash Purchases Rs.10,000/-

In this transactions two current accounts are affected i.e. Cash & Stock. Firstly there is a decrease in cash. Therefore, C. Assets will fall by Rs10,000/-. However there is increase in Stock Therefore, C .Assets will rise by Rs.10,000/-. There is no effect in Current Assets and Working Capital. So, there is no flow of Funds.

Bills Payable accepted Rs.5,000/-

In this transaction two Current Liabilities are affected. Creditors are reduced by Rs.5,000/-. However, Bills Payable increase by Rs.5,000/-. No net change in Current Liabilities and Working Capital. So, there is no flow of funds.

3. Cash Paid to Creditors Rs.2,000/-

In this transaction, cash gets reduced by Rs.2,000/-. Thus, C.A decreased by Rs.2,000/-. However, creditors are also reduced by Rs.2,000/-. Consequently, C.L decrease by Rs.2,000/-. Since Working Capital is the difference in C.A and C.L, it remains same as the change in C.A is equal to the change in C.L There is no flow of funds.

4. Issue of Bonus shares to equity share holders out of General Reserve in the ratio 1:1

The effect of this transaction is the Equity share capital of the company gets doubled. However, the reserves of the company come down. Both accounts are non-current accounts. The current accounts are not affected. There is no flow of funds.

5. Land Purchased for Rs.3,00,000/-, payment made by cheque.

In this account cash at Bank, a current account gets reduced. Consequently, there is a fall in working capital to the extent of Rs.3,00,000/-. A new asset, land is acquired. However, it being a non-current account, it does not affect the working capital. Therefore the net affect is a fall in working capital to the extent of Rs.3,00,000/-. There is an outflow of funds.

6. Sale of Building for Rs.10,00,000/-

In this transaction, the amount received on sale is current asset. The current asset increased by Rs.10,00,000/-. Consequently, working capital increased by Rs.10,00,000/-. The business has to part with an asset worth Rs.10,00,000/-, but building being a non-current account, it does not affect working capital. There is an inflow of funds.

Preparation of Funds Flow Statement

The funds flow statement is prepared to reflect the changes in the financial position of an organization during a particular period. As such, Balance sheets of the organization at the beginning and end of the particular period are the basic documents that are needed for preparation of funds flow statement

The fund flow statement can also be presented in a vertical form. In such a case, all sources are listed down, totaled and then all Applications are listed at one place and totaled. The totals should be the Increase and decrease in Working capital.

Statement of changes in Working Capital

This statement follows the statement of Sources and Application of Funds. The primary purpose of the statement is to explain the net change in Working Capital, as arrived in the Funds Flow Statement. In this statement, all current Assets and Current Liabilities are individually listed. Against each account, the figure pertaining to that account at the beginning and at the end of accounting period shown. The net change in its position also shown. The changes taking place with respect to each account should and up to equal the net change in working capital, as shown by the Funds Flow statement.

While entering the effect of change in a current account on working capital, the following rules must be followed.

An increase in Current Assets means an increase in Working Capital;
An decrease in Current Assets means an decrease in Working Capital;
An increase in Current Liabilities means an decrease in Working Capital;
An decrease in Current Liabilities means an increase in Working Capital;

Time Value of Money

noreply@blogger.com (B.S) — Tue, 18 Mar 2008 11:22:00 +0000

The time value of money is the basis of the mathematics of finance determination of the time value of money in financial decision making is extremely important. The objective of wealth maximization much of the subject matter of financial management is future oriented. The financial decision taken day has implications for a number of years i.e. if spreads into the future

Ex Firms have to acquire fixed assets for which they have to pay a certain sum of money to the vendors (cash outflows). The benefits arising out of the acquisition of such assets will be spread over a number of years. In the future till the waking life of the assets.

On the other hand funds have to be procured from different sources such as rising of capital through new issues. Bank borrowings, term loams from financial institutions, sale of debentures & so on. These as well as an obligation to pay interest/Dividend & return the principle in future.

It is on the basis of comparison pf the cash out flows & the benefits (cash inflows) that financial decisions are made for a meaningful comparison. One basic requirement of compatibility is the incorporation of time element in the calculations.

In other words in order to have a logical and meaningful comparison between cash flows and that accrue in different time period. It is necessary to convert the sums of money to a common point of time.

Definition: “Time value of money means that the value of a unit of money of different in different time periods”.

The value of sum of money receive today is more than its value received after some time. The sum of money received in future is valuable than it is today. The present worth of rupee receive after sometime will be less than a rupee receive today.

The main reason for the time preference for money is to be found in the reinvestment opportunities for funds which are received early. The funds so invested will earn a rate of return. This would not be possible if the funds are received at a later time.

The capital budgeting decision s generally involves the current cash outflows in terns of the amount required for purchasing a new machine or lunching a new project and the execution of the scheme generates future cash inflows during its useful life.

Ex: Assume that the project cost (current cash outflows) as Rs.10lakhs. Assume it has a life of only one year in which it is estimated to have cash inflows Rs.10.80lakhs (at the end of first year). This project is acceptable as it adds Rs.80,000 as profit. However when we take into account a rate of interest. Say 10% the earlier conclusion has to be realized as without the project the sum could have amounted to Rs.11lakhs.

If the decision us made to raise at loan of Rs.10lakhs from a financial institution or by issuing debentures for a period of 10 years. The firm is not only under obligation to make interest payment as and when it becomes due on debt of fixed intervals, but also must make a provisions. So that it can we pay Rs.10lakhs when the loan or debenture becomes due. Thus time value of money is of critical significance. This requires the development of processors and techniques for evaluating future incomes in terms of the present.

Financial Management

noreply@blogger.com (B.S) — Tue, 18 Mar 2008 11:00:00 +0000

Introduction:

Financial Management is that managerial activity which is concerned with the planning & controlling of firms financial recovers.

Firms creating manufacturing capacities for production of goods and services to their customers and sell it to earn Profit. Funds are acquiring manufacturing and other facilities.

A firm secure whatever capital it needs and employs it in activities (Finance activity) which generate returns a invested capital. (Production & marketing Service)

The function of raising fund interesting them in asset and distributing returns earned from asset to share holders are respectively known as financing investment and dividend decisions.

Real Assets:

1.Tangible Assets:

Plant & Machinery

Building

Furniture

2. In Tangible Assets:

Goodwill

Patents & Copy Rights

3. Financial Assets:

Debentures

Lease obligation

Borrowings

Finance may be defined as the Art and Science of managing money. The major areas of financing are

(i) Financial Services:

It is concerned with the designed and delivery of advice and financial products to the individuals, business and Govt. with the areas of banking and related institutions, personals financial planning, investments, real estate, insurance and so on.

(ii) Financial Management:

It is concerned with the duties of financial managers in the business firm. Financial managers actively manage the financial affairs of any type of business. Namely financial and non-financial, private & public, large & small, Profit Seeking & not for profit. They performs varied tasks as budgeting, financial forecasting. cash management, credit administration, investment analysis find management and so on.

Managing financial management:

The term F.M has been defined differently by different authors. According to Solomon “Financial management is concerned with the efficient use of an important economic resource, namely Capital funds”

There are two basic aspects of F.M

(i) Procurement of Funds

(ii) Effective use of these funds.

(i) Procurement of Funds: Since funds can be obtained from different sources therefore their procurement always considered as a complex problem by business concerns. Funds procured from different sources have different characteristics in terms of risk control & cost.

The funds raised by the issue of equity shares are the best from the risk point of view for the company. Since these are no question of repayment of equity capital except when the company is under liquidation from the cost point of view. However, equity capital is usually the most expensive source of funds. This is because the dividend expectations of share holders are normally higher than prevalent interest rate and also because dividend is an appropriation of profits not allowed as an expense under the income tax act. Also the issue of new shares to public may dilate the control of the existing share holders.

(ii) Effective of Utilisation of funds:

The financial manager is also responsible for effective utilization of funds he has to point out situation where the funds are being kept idle or where proper use of funds is not being made.

All the funds are procured at a certain cost and after entailing a certain amount of risk. If these funds are not utilized in the manner so that they generate an income higher than the cost of procure them. There is no point in running the business. This is also an important consideration on dividend decision.

Analysis of Variance - Sales Variance

noreply@blogger.com (B.S) — Fri, 14 Mar 2008 08:51:00 +0000

Sales variance.

The analysis of variances will be complete only when the difference between the actual profit and standard profit is fully analyzed.

Profit method of calculating sales variances:

The sales variances according to this method can be analyzed as:

1. Total sales margin variance (TSMV).

Actual Profit – Budgeted Profit Or Actual Quantity Of Sales X Actual Profit Per Unit – Budgeted Quantity Of Sales X Budgeted Profit Per Unit.

2. Sales margin variance (SMV) due to volume:

It is that portion of total sales margin variance which arises due to the number of articles sold being more or less than the budgeted quantity of sales.

Standard Profit Per Unit (Actual Quantity Of Sales – Budget Quantity Of Sales)

3. Sales Margin variance (SMV) due to selling price:

It is that portion of total sales margin variance which is due to the difference between the actual price of quantity of sales affected and the standard price of those sales. It is calculated as:

(actual selling price per unit – standard selling price per unit)

Value method of calculating sales variance:

Sales variances calculated according to value method show the effect on sales value and enable the sales manager to know the effect of the various sales efforts on his overall sales value figures. Sales variances according to this method may be as follows:

1. Sales value variance (SVV):

It is the difference between the standard value and the actual value of sales affected during a period.

It is calculated as:

Sales value variance = actual value of sales – budgeted value of sales.

2. Sales price variance:

It is that portion of sales value variance which arises due to the difference between actual price and standard price specified.

The formula is:

SPV = actual quantity sold (actual price – standard price)

3. Sales volume variance (S.Vol.V):

It is that portion of the sales value variance which arises due to the difference between actual quantity of sales and standard quantity of sales.

Formula:

Sales volume variance = standard price (actual quantity of sales – budgeted quantity of sales.

Analysis of Variance - Labour Variance

noreply@blogger.com (B.S) — Fri, 14 Mar 2008 08:45:00 +0000

Labour variance

Labour variances can be analyzed as follows:

a) Labour cost variance:

It is the difference between the standard cost of labour allowed (as per standard laid down) for the actual output achieved and the actual cost of labour employed. It is also known as wages variance.

Labour cost variance= standard cost of labour – actual cost of labour.

b) Labour rate variance:

It is that portion of the labour cost variance which arises due to the difference between the standard rate specified and the actual rate paid.

It is calculated as follows:

Rate of pay variance = actual time taken (standard rate – actual rate)

c) Total labour efficiency variance:

It is that part of labour cost variance which arises due to the difference between standard labour cost of standard time for actual output and standard cost of actual time paid for.

It is calculated as follows:

Total labour efficiency variance = standard rate (standard time for actual output – actual time paid for)

d) Labour efficiency variance:

It is that portion of labour cost variance which arises due to the difference between standard labour hours specified for the output achieved and the actual labour hours spent.

Labour efficiency variance = standard rate (standard time for actual output – actual time worked)

e) Labour idle time variance:

It is calculated only when there is abnormal idle time. It is the portion of labour cost variance which is due to the abnormal idle time of workers. While calculating labour efficiency variance abnormal idle time is deducted from actual time expended to ascertain the real efficiency of the workers.

Labour idle time variance is expressed as:

Idle time variance = abnormal idle time x standard rate.

Total labour cost variance = labour rate of pay variance + total labour efficiency variance

f) Labour Mix variance or Gang composition variance:

It is like materials mix variance and is a part of labour efficiency variance. This variance shows to the management as to how much of the labour cost variance is due to the change in the composition of labour force.

It is calculated as follows:

i) If there is no change in the standard composition labour force and total time expended is equal to the total standard time, the formula is:

Labour mix variance = standard cost of standard composition (for actual time taken) – standard cost of actual composition (for actual time worked).

ii) If the standard composition of labour force is revised due to shortage of a particular type of labour and total time expended is equal to the total standard time, the formula is:

Labour Mix variance = standard cost of revised standard composition (for actual time taken) – standard cost of actual composition (for actual time worked).

iii) If the total actual time of labour differs from the total standard time of labour, the formula is:

Total time of actual labour composition (standard cost of standard

-------------------------------------------------- x composition) – (standard cost of

Total time of standard labour composition actual composition)

iv) If the standard is revised and the total actual time of labour differs from the total standard time of labour, the formula for the calculation of labour mix is:

Labour mix variance =

Total time of actual labour composition (standard cost of revised standard ------------------------------------------------- x composition) – (standard cost of

Total time of revised standard labour actual composition)

composition

g) Labour yield variance:

It is like material yield variance and arises due to the difference between yield that should have been obtained by actual time utilized on production and actual yield obtained. It can be calculated as follows:

Standard labour cost per unit (actual yield in units – standard yield in units expected from the actual time worked on production)

h) Substitution variance:

This is a variance in labour cost which arises due to the substitution of labour when one grade of labour is substituted by another. This is denoted by difference between the actual hours at standard rate of standard worker and the actual hours at standard rate of actual worker.

Substitution variance = (actual hours x standard rate for standard worker) – (actual hours x standard rate for actual worker)

Analysis of Variance - Material variance

noreply@blogger.com (B.S) — Fri, 14 Mar 2008 08:31:00 +0000

Analysis of Variance:-

Control is a very important function of management analysis of variances is helpful in controlling the performance and achieving the profits that have been planned.

The deviation of the actual cost or profit or sales from the standard cost or profit or sales is known as “variance”.

1. Material variance:

In case of Materials, the following may be the variances:-

Material cost variance

i. Material price variance
ii. Material usage or quantity variance
a) Material Mix variance
b) Material yield variance

Material cost variance (MCV)

It is the difference between the standard cost of materials allowed (as per standards laid down) for the output achieved and the actual cost of materials used.

Material cost variance :

standard cost of materials for actual output.- Actual cost of materials used.

Material price variance (MPV)

It is that portion of the material cost variance which is due to the difference between the standard cost of materials used for the output achieved and the actual cost of materials used.

Material price variance = actual usage (standard unit price – actual unit price)

Here, actual usage = actual quantity of materials (in units) used

Standard unit priced = standard price of material per unit

Actual unit price = actual price of material per unit.

c) Material usage (or quantity) variance (MQV)

It is that portion of the material cost variance which is due to the difference between the standard quantity of materials specified for the actual output and the actual quantity of materials used.

Material usage variance = standard price per unit (standard quantity – actual quantity)

d) Material Mix variance (MMV):

It is that portion of the material usage variance which is due to the difference between standard and the actual composition of a mixture. It is calculated as the difference between the standard price of standard mix and standard price of actual mix.

i. Actual weight of mix and the standard weight of mix do not differ:-

Material mix variance is calculated with the help of the following formula:

Standard unit cost (standard quantity – actual quantity)

(Or)

Standard cost of standard mix – standard cost of actual mix.

If the standard is revised due to shortage of a particular type of material, the MMV is calculated as follows:

Standard unit cost (revised standard quantity – actual quantity)

(Or)

Standard cost of revised standard mix – standard cost of actual mix.

e) Material yield variance (MYV):

It is that portion of the material usage variance which is due to the difference between the standard yield specified and the actual yield obtained.

(i) When standard and actual mix does not differ:-

In such a case, yield variance is calculated with the help of the following formula:-

Yield variance = standard rate (actual yield – standard yield)

Standard cost of standard mix

Where standard rate = ----------------------------------------

Net stand output (i.e., Gross output – standard loss)

(ii) When actual mix differs from standard mix:-

In such a case, formula for the calculation of yield variance is almost the same.

Standard rate = standard cost of revised standard mix

---------------------------------------------

Net standard output

Formula for yield variance in such a case is:-

Yield variance = standard rate (actual yield – revised standard yield).

Standard Costing

noreply@blogger.com (B.S) — Fri, 14 Mar 2008 08:22:00 +0000

Standard cost and standard costing

Standard cost:

Standard cost is a predetermined cost. It is a determination in advance of production of what should be the cost. When Standard costs are used for the purpose of cost-control, the technique is known as Standard Costing.

Eric L. Kohler has defined Standard cost as follows:

“Standard cost is a forecast or predetermination of what actual cost should be under projected conditions, serving as a cost control and as a measure of production efficiency or standard of comparison when ultimately aligned against

Actual cost. It furnishes a medium by which the effectiveness of current results can be measured and the responsibility for deviations can be placed.

Standard costing:

It is the preparation of standard costs and applying them to measure the variations from actual costs and analyzing the causes of variations with a view to

maintain maximum efficiency in production. It is a technique, which use standards for costs and revenue for the purpose of control through variance analysis.

Standard costing is a technique which is complimentary to the actual costing or historical costing system. The system of standard costing can be useful in all types of industries, but it is more commonly used in industries producing standardized products.

(ii) Standard costing Vs. Budgetary control:

Both Standard costing and Budgetary control achieve the same objective of maximum efficiency and cost reduction by establishing predetermined standards, comparing actual performance with the predetermined standards and taking corrective measures, where necessary.

Though both are useful tools to the management in controlling costs, they defer in following respects:

1. To be able to establish standard costs, some form of budgeting is essential as there is the need to forecast the level of output and prescribed set of working conditions in the periods in which the standard costs are to be used.

2. Standards are based on technical assessments whereas budgets are leased on past actual adjusted to future trends.

3. Budgetary control deals with the operations of a department of business as a whole while standard costing is applied to manufacturing of a product, process or processes or providing a service.

4. Standards are set mainly for production and production expenses where as budgets are compiled for all items of income and expenditure.

5. Budgets set up maximum limits of expenses above which the actual expenditure should not normally exceed.

6. Budgets are projection of financial accounts, standard costs are projection of cost accounts because budgetary control adopts a more general approach of giving service to the management than does standard costing.

7. Budgets are anticipated or expected costs meant to be used for forecasting requirements of material, labour, cash, etc.

8. In budgetary control, variances are not revealed through the accounts but are revealed in total.

Both standard costing and budgetary control are complimentary to each other and for maximum efficiency both should be used simultaneously.

Standard costing Vs. Estimated cost

Standard costs and estimated costs are predetermined costs, but their objectives are different.

1. The object of estimated cost is to have a reasonable assessment of what a cost ‘will be’ whereas standard cost aims at what a cost ‘should be’.

2. Estimated costs are calculated on the basis of past performance adjusted in the light of anticipated changes in the future standard costs, on the other hand, are determined on a scientific basis keeping in view certain factors and conditions of efficiency.

3. Estimated costs are used by the concerns for fixing selling prices of products, for taking a decision to manufacture or to buy, for quoting the selling price of a job, etc.

4. Estimated costs are used by the concerns which adopt historical costing system of ascertaining cost where as standard costs are used by the concern, which follow standard costing system.

5. Standard costs are used as a regular system of accounts from which variances are found out. Whereas use of estimated cost as a statistical data only.

6. Standard costs are to be fixed for each element of cost where as estimated cost can be for a part of the business and also for a particular purpose.

(iv) Standard costing and Marginal costing.

Standard costing is a system of accounting in which all expenses (fixed and variable) are considered for the determination of standard cost for a prescribed set of working conditions on the other hand, Marginal costing is a technique in which only variable expenses are taken to ascertain the marginal cost. Both standard costing and marginal costing are completely independent of each other and may be installed jointly. This system of joint installation may be named as marginal standard costing or standard marginal costing system.

Break - Even Analysis

noreply@blogger.com (B.S) — Fri, 14 Mar 2008 08:07:00 +0000

Break even analysis is a vital tool for the management accountant. In a very narrow interpretation of the term, break even analysis is understood as a system of determination of that level of activity where total cost is equal to total sales. However, break even analysis also involves determination of probable profit at any given level of activity.

Break even point:

A business is said to ‘break even’ when its total sales are equal to its total costs. It is a point of ‘no profit no losses. Break even point can be calculated ‘in units’ or ‘in value’. (i.e.) it can be expressed as the number of units to be produced and sold to ‘break-even’, or the sales required to be attained in rupees, so that there is a situation of “no profit – no loss”.

Cost- volume profit analysis (relation ship):

Cost volume profit (CVP) analysis is often misunderstood to be same as break- even analysis. Break even analysis, however, is only a part of CVP analysis studies the relationship between cost, number of units produced and sold, selling price and profit individually and collectively taken.

The scope of CVP analysis covers the study of behavior of cost in relation to volume, sensitivity of profits to variation in output, break even analysis, price formulation, etc. and provides valuable insight into effects of profit on account of various management decisions.

The scope of CVP analysis covers the study of behavior of cost in relation to volume, sensitivity of profits to variation in output, break even analysis, price formulation, etc. and provides valuable insight into effects on profit on account of various management decisions.

The main objectives of cost volume- profit analysis are given below:

i) The analysis helps to forecast profit fairly and accurately as it is essential to know the relationship between profits and costs on the one hand and volume on the other.

ii) This analysis is useful in setting up flexible budget which indicates costs at various levels of activity.

iii) This analysis assists in evaluation of performance for the purpose of control.

iv) This analysis also assists on formulating price policies by showing the effect of different price structures on cost and profits.

Analysis of break even chart:

A break even chart explains about the break even point, angle of incidence and margin of safety for a particular product of a business.

i) The lower the break even point, the better it is:

A low break even point implies that the organization can survive even if it is operating at lower level of activity.

ii) The larger the angle of incidence, the greater is the benefit:

Angle of incidence represents the difference between total sales and total cost. The larger the angle, the greater is the spread. The profits increase in a greater proportion with the increase in production. However, a fall in number of units produced will also have an adverse

iii) The larger the margin of safety the better it is:

Margin of safety reflects the cushion the organization has against a possible fall in sales. The greater the margin of safety, the more comfortable the organization will be. It has a greater capacity to with stand recessionary phases.

Break even chart:

The break even chart is a graphic representation of cost and revenue data which brings out their inter relationship, at different levels of activity.

Steps to construct break even graph:

i) Let the X-axis represent the volume or level of activity and the Y-axis represents the costs and revenue in rupees.

ii) Draw the fixed cost line parallel to X-axis, from the point in Y-axis which represents the amount of fixed cost.

iii) With the help of the data given, construct the total cost line. The total cost is the total of variable costs at any given level of activity and the fixed cost. The total cost line will intersect the Y- axis at the point of fixed cost, as total cost is equal to fixed cost at ‘zero’ level of activity.

iv) With the help of data given construct the ‘total revenue’ chart. The total revenue cost will pass through the origin as the revenues at ‘zero’ level of activity is nil.

v) The break even point is the point of intersection of the total cost line and the total revenue line.

vi) The angle between the two lines of total cost and total revenue is called ‘angle of incidence’.

Assumptions underlying break even chart:

i) All costs can be separated into fixed and variable costs.

ii) Fixed costs will remain constant and will not change with the change in level of output.

iii) Variable costs will fluctuate in the same proportion in which the volume of output varies. In other words, prices of variable cost factors i.e., wage rates; price of material, etc. will remain unchanged.

iv) Selling price will remain constant even though there may be competition or change in volume if production.

v) The number of units produced and sold will be the same so that there is no opening or closing stock.

vi) There will be no change in operating efficiency.

vii) There is only one product or in the case of many products, product mix will remain unchanged.

viii) Product specifications and methods of manufacturing and selling will not change.

Marginal Costing

noreply@blogger.com (B.S) — Fri, 14 Mar 2008 08:00:00 +0000

Marginal costing definition:

According to ICMA London “marginal cost is the amount for any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit”. Marginal costing is the technique of applying the concept of marginal cost in decision making process. Marginal costing is a technique that distinguishes between fixed and variable costs. The “marginal” cost of a product is its variable cost.

Applications of marginal costing: marginal costing is a very useful tool for management because of its following applications and merits:

A. Cost control:

Marginal costing divides the total cost into fixed and variable cost. Fixed cost can be controlled by the top management and that to a limited extent. Variable costs can be controlled by the lower level of management. Marginal cost by concentrating all efforts on the variable costs can control and thus provides a tool to the management for control of total cost.

In marginal costing fixed costs are not eliminated at all. These are shown separately as a deduction from the contribution instead of merging with cost of sales and inventories. This helps the management to have a control on fixed costs.

B. Profit planning:

Marginal costing helps the profit planning, i.e., planning for future operations in such a way as to maximize the profits to maintain a specified level of profit. Absorption costing fails to bring out the correct effect of change in sale price, variable cost are product mix on the profits of the concern but that is possible with the help of marginal costing.

Profits are increased or decreased as a consequence of fluctuations in selling prices, variable costs and sales quantities in case there is fixed capacity to produce and sell.

C. evaluation of performance:

The different products, departments, markets and sales divisions have different profit earning potentialities. Marginal cost analysis is very useful for evaluating the performance of each sector of a concern.

Performance evaluation is better done if distinction is made between fixed and variable expenses

D. Decision making:

The information provided by the total cost method is not sufficient in solving the management problems. Material costing techniques is used in providing assistance to the management in vital decision making, especially in dealing with the problems requiring short-term. Decisions where fixed costs are excluded.

The following are the important areas, where managerial problems are simplified by use of the marginal costing:

i. Fixation of selling price.

Ii. Key or limiting factor

iii. Make or by decisions

iv. Selection of a suitable product mix.

v. Effect of change in price.

vi. Maintaining a desired level of profit

vii. Alternative methods of production

viii. Diversification of products.

ix. Closing down or suspending activities.

x. Alternative course of action

The important areas where managerial problems are simplified by use of the marginal costing are:

1. Fixation of selling Price:

Although the prices are more controlled by market conditions and other economic factors than by decisions of management yet fixation of selling prices is one of the most important functions of management. This function is to be performed:

(a) Under normal circumstances

(b) In times of competition

(d) In accepting additional orders for utilizing idle capacity

(e) In exporting and exploring new markets.

2. Key (or limiting) factor:

A key factor that factor which puts a limit on production and profit of a business. Usually the limiting factor is sales. A concern may not be able to sell as much as it can produce. But sometimes a concern can sell all it produces but production is limited due to the storage of materials, labour and plant capacity or capital.

3. Make or buy decision:

A concern can utilize its idle capacity by making component parts instead of buying them from market.

Factors that influence make or buy decision:

In a make or buy decision, the following cost and non-cost factors must be considered specifically.

Cost factors:

a) Available of plant facility

b) Quality and type of item which effects the production schedule.

c) The space required for production of item

d) Any special machinery or equipment required.

e) Any transportation involved due to the location of the product, i.e., the “feeder point”.

f) Cost of acquiring special know-how required for the item.

4. Selection of a suitable product mix:

When a factory manufacturers more than one product, a problem is faced by the management as to which product mix will give the maximum profits. The best product mix is that which yields the maximum contribution.

5. Effect of change in sales price:

Management is confronted with the problem of cut in prices of products from time to time on account of competition, expansion programmed or government regulations. It is therefore, necessary to know the effect of a cutting price of the products. The effect of cutting selling price per unit will be that contribution per unit will reduce.

6. Maintaining a desired level of profits:

Management may be interested in maintaining a desired level of profits. The volume of sales needed to have a desired level of profits can be ascertained by the marginal costing technique.

7. Alternative methods of production:

Marginal costing is helpful in comparing the alternative methods of production (i.e.,) machine work or hand work. The method which gives the greatest contribution is to be adopted keeping of course, the limiting factor in view. Where fixed expenses change, the decision will be taken on the basis of profit contributed by each.

8. Diversification of products:

Sometimes it becomes necessary for a concern to introduce a new product to the existing product or products in order to utilize the idle capacity or to capture a new market or for other purposes. General fixed costs will however, be charged to the old product/products.

9. Closing down all suspecting activities:

Sometimes it becomes necessary for a firm to temporary suspends or closes the activities of a particular product, department or factory as a whole due to trade recessions. The decision to close down or suspend its activities will depend on whether products are making a contribution towards fixed costs or not.

10. Alternative course of action:

When deciding between alternative courses of action, it shall be kept in mind that whatever course of action is adopted, certain fixed expenses will remain unaffected. The criterion, therefore, which weighs is the effect of alternative course of action upon the marginal costs in relation to the revenue obtained. The course of action which yields the greatest contribution is the most profitable to be followed by the management.

Process Costing

noreply@blogger.com (B.S) — Fri, 14 Mar 2008 07:45:00 +0000

Definition of process costing:

Process costing is that form of operation costing which is used to ascertain the cost of the product at each process or stage of manufacture.

Application of process costing

The industries in which process costs may be used are many. In fact a process costing system can usually be devised in all industries except where job, batch or unit operation costing is necessary.

Examples of industries, where process costing is applied are:-

1. Chemical works – Textile, weaving, spinning, etc.

2. Paper mills – Paint, Ink and varnishing, etc.

Advantages of process costing

The following are the main advantages of process costing:

1. It is possible to determine process costs periodically at short intervals. Unit cost can be computed weekly or even daily if overhead rates are used on predetermined basis.

2. It is simple and less expensive to find out the process cost.

3. It is possible to have managerial control by evaluating the performance of each process.

4. It is easy to allocate the expenses to processes in order to have accurate cost.

5. It is easy to quote the prices with standardization of process. Standard costing can be established easily in process type of manufacture

Fundamental principles of process costing:

The following are the fundamental principles of process costing:-

1. Cost of materials, wages and overhead expenses are collected for each process or operation in a period.

2. Adequate records in respect of output and scrap of each processor operation during the period are kept.

3. The cost per finished output of each process is obtained by deviating the total cost incurred during a period by the number of units produced during the period after taking into consideration the losses and amount realized from sale of scrap.

4. The finished product along with its cost is transferred from one process to the next process just like raw materials of that process.

Elements of production costing

The following are the main elements of production cost in process costing:-

1. Materials:

Generally in process costing, all the material required for production is issued to the first process, where after processing it is passed to the next process and soon. Some operation on the material is performed in each process which has been passed from the first process.

2. Labour:

Generally, the cost of direct labour is very small part of the cost of production in industries adopting process costing. The direct labour element becomes smaller and smaller while the overhead element increases with the introduction of more and more automatic machinery.

3. Production overhead:

The overhead element of total cost is generally very high in process costing great care is required to ensure that each process is charged with a reasonable share of production overhead. The actual overheads are debited to each process account.

In process costing, the four main aspects which are to be discussed are;

1. Process losses

2. Inter process profits

3. work-in-progress and effective or equivalent production.

4. Joint and by-products.

Normal process loss:-

If the loss is unavoidable on account of inherent nature of production processes. Such loss can be estimated in advance on the basis of past experience or data. The normal process loss is recorded only in items of quantity and the cost per unit of usable production is increased accordingly, where scrap possesses some value as a waste product or a raw material for an earlier process, the value thereof is credited to the process account. This reduces the cost of normal output; process loss is shared by usable units.

Abnormal process loss:-

Any loss caused by unexpected or abnormal conditions such as plant break down, sub-standard materials, careless, accident etc. or loss in excess of the margin anticipated for normal process loss should be regarded as abnormal process loss. The unit of abnormal loss is calculated as under.

Abnormal loss = actual loss – normal loss.

The valuation of abnormal process loss should be done with the help of the following formula.

Value of abnormal loss

Normal cost of normal output

= ------------------------------------ x units of abnormal loss

Normal output

All cases of abnormal process loss should be thoroughly investigated and steps taken to prevent these recurrence in future. Abnormal process loss should not be allowed to affect the cost of production as it is caused by abnormal or unexpected conditions. Such loss representing the cost of materials, labour and overhead incurred on the wastage should be transferred to an abnormal loss account. If this abnormal loss has got any scrap value, it should be credited to abnormal loss account and the balance is ultimately written off to costing profit and loss account.

COST CONCEPTS

Cost:

The Institute of Cost and Management Accountants (ICMA) has defined cost as “the amount of expenditure, actual or notional, incurred on or attributable to a specified thing or activity”. It is the amount of resources sacrificed to achieve a specific objective. A cost must be with reference to the purpose for which it is used and the conditions under which it is computed. To take decisions, managers wish to know the cost of something. This something is called a “cost unit”.

2. Cost unit:

A cost unit is any thing for which a separate measurement of costs if desired. A product, service, department, project or an educational course can all be cost units. Cost units are chosen not for their own sake but to aid decision making. Thus a cost unit is a “quantitative unit or product or service in relation to which costs are ascertained”. The cost unit to be used at any given situation is that which is most relevant to the purpose of cost ascertainment.

3. Cost centre:

According to ICMA London, cost center is “a location, person or items of equipment in respect of which costs may be ascertained and related to cost units for cooses”. It is simply a method by which costs are gathered together, according to their incidence, usually by means of cost center codes. It is the smallest element of an organization in respect of which costs are charged and ascertained.

Maintenance department, a public relation office, a printing machine are all examples of cost centers.

The establishment of cost centers serves two important purposes. Firstly cost ascertainment is made possible by collecting and charging cost to each cost center. Secondly, cost control is ensured as costs can be more closely looked at and more easily monitored by a responsible official. The setting up of a cost centers depends on numerous factors such as organization of factory, requirement of the costing system and management policy.

COSTING - Job Costing

noreply@blogger.com (B.S) — Fri, 14 Mar 2008 07:10:00 +0000

JOB COSTING

Job-costing is the system of costing used to find out the cost of non-standing jobs. These jobs are generally made according to customer’s specifications. It is followed in business connected with printing, binding, repairing machine tool manufacturing, etc. In such concerns, it is necessary to keep a separate record of each job from the time the work on the job begins till is completed. A separate job card or cost sheet is maintained for each job or product in which all expenses of materials, labour, over-heads are recorded and cost of completing a job or manufacturing a product is found. The method of ascertainment or estimation of costs is similar to that of unit costing.

While preparing the job cost sheet, in the absence of specific information, quotation for a job must absorb factory over-heads as a percentage of direct wages. If different departments are involved, over-head absorption rates must be separately calculated for each department, office, selling and distribution over-heads must be absorbed as a percentage of factory cost.

Fixed expenses are spread over normal; production or total number of hours available for work, as they are incurred irrespective of whether or not production activity is carried out. Actual output or actual hours are not considered.

PROFORMA OF JOB COST SHEET

Job cost sheet of ___________ for the period ended ___________

Particulars	Rs.	Rs.	Cost per unit (Rs.)
Direct materials consumed
Opening stock of raw material	xxx
Add: purchase of raw materials	xxx
Add: Carriage on purchases	xxx
	xxx
Less: C/stock of raw materials	xxx	xxx	xxx
Direct wages		xxx	xxx
Direct expenses		xxx	xxx
Prime cost		xxx	xxx
Add: factory over-heads		xxx
		xxx
Less: sale of scrap		xxx
		xxx
Add: work in progress (beginning)		xxx
		xxx
Less: work in progress (closing)		xxx
works cost or factory cost		xxx	xxx
Add: Administration over-heads		xxx
Cost of production of goods sold		xxx
Add: opening stock of finished goods		xxx
		xxx
Less: closing stock of finished goods		xxx
Cost of goods sold		xxx	xxx
Add: selling and distribution over-heads		xxx
Cost of sales or total cost		xxx	xxx
Net Profit		xxx	xxx
Sales		xxx	xxx

Cost sheet or a statement of cost.

A cost sheet or a statement of cost is a statement that is prepared to present information regarding the various elements of cost incurred in production during a defined period of time. The cost sheet is generally prepared at short intervals (weekly or monthly) and presents the total cost as well as cost per unit of products manufactured during the period.

The cost sheet does not have a statutory format. It is not part of the accounting system. The purpose of cost sheet is to present the elements of cost. Cost sheet may have information pertaining to the previous year in an additional column. Alternatively, standard costs may also be provided.

Cost sheet shows the breakup of total cost into various elements, sales value of goods and profit earned (or loss incurred) during a period.

Treatment of certain items in preparation of cost sheet.

1. Expenses not included in cost sheet:-

Cost sheet includes only such expenses that are a charge against profit. Expenditure incurred towards servicing of debt (interest payments), acquisition of assets (capital expenditure) appropriation of profits and payments representing distribution of profits are not included in the preparation cost sheet.

The following is the proforma of cost sheet:

Job cost sheet of ___________ for the period ended ___________

Particulars	Rs.	Rs.	Cost per unit (Rs.)
Direct materials consumed
Opening stock of raw material	xxx
Add: purchase of raw materials	xxx
Add: Carriage on purchases	xxx
	xxx
Less: C/stock of raw materials	xxx	xxx	xxx
Direct wages		xxx	xxx
Direct expenses		xxx	xxx
Prime cost		xxx	xxx
Add: factory over-heads		xxx
		xxx
Less: sale of scrap		xxx
		xxx
Add: work in progress (beginning)		xxx
		xxx
Less: work in progress (closing)		xxx
works cost or factory cost		xxx	xxx
Add: Administration over-heads		xxx
Cost of production of goods sold		xxx
Add: opening stock of finished goods		xxx
		xxx
Less: closing stock of finished goods		xxx
Cost of goods sold		xxx	xxx
Add: selling and distribution over- heads		xxx
Cost of sales or total cost		xxx	xxx
Net Profit		xxx	xxx
Sales		xxx	xxx

Interest on capital, income-tax paid, advance payment of income-tax, sales tax paid, provision for doubtful debts provision for discount on debtors, expenses incurred for raising capital such as underwriting commission, and brokerage, goodwill/preliminary expenses written off, abnormal losses, transfer to sinking fund, profit or loss on sale of an asset, debenture interest, discount received, dividends received, etc.

Cash discount and bad debts:-

There is a difference of opinion in the treatment of cash discount allowed and bad debts. Bad debts in the cost of taking a credit risk. However, some other experts opine that these expenses are a normal part of selling efforts by any business and hence must be considered as selling and distribution over-heads.

Incomes not included in cost sheet:-

The cost sheet does not include any incomes. The only exceptions are sales and sale of scrap. For Ex.:- interest income, dividend income, rent, transfer fees, etc., are not included in cost sheet.

Scrap:

Scrap is incidental residue. Scrap can be of direct material itself (remnants of cost, wood pieces or it may refer to the remains after the production process. In the first case, the amount realized from the sale of such scrapped material must be deducted from the cost of direct material consumed. In the second case, the value of scrap must be deducted from the total of factory over-heads.

Defectives: -

Defectives are finished or semi-finished products that have a defect in them. Such defects need to be rectified. This process is done in the factory. It is quite normal to have defectives. If the cost of rectification is normal, then such costs are taken as part of factory over-heads. However, if the number of defectives is very large, then such abnormal expenses are not taken in cost sheet.

Drawing office: -

It is a part of factory where drawings, designs etc., are made. Expenses on drawings made specifically for a product are direct expenses. However, all other expenditure is part of factory over-head. Unless specifically mentioned, it must be treated as factory over-head.

Calculation of cost per unit:

The following steps must be followed:

All elements of cost, starting from direct materials consumed to cost of production, must be divided by number of units produced.

The value of opening stock and closing stock of finished goods should not be divided with any figure. Hence, cost of production per unit and cost of goods sold per unit will be same. Selling and distribution over-heads should be divided by number of units sold.

Work-In-Progress:

The value of work-in-progress at the end of the period for which the cost sheet is being prepared is added to the total of factory over-heads. The closing value is deducted from the total. The net figure goes to the outer column of cost sheet. If work-in-progress is valued at prime cost, then the opening value of work-in-progress is added to the total of Direct Material, Direct Wages and Direct Expenses. The closing value is deducted from the same. The final figure obtained is the ‘price cost’.

Value of closing stock:-

If the value of closing stock of finished goods is not available, it can be found from the following formula:

Value of c/stock = closing stock (in units) x cost of production per unit.

Apportionment of expenses:

If an expense has been incurred jointly towards two or more heads, it must be apportioned amongst such heads on a reasonable basis. The salary of General Manager will have to be apportioned amongst factory, office and selling and Distribution over-heads in the ratio of time spent by him on the issues pertaining to the three heads.

Outstanding Expenses:

In preparation of cost sheet, even outstanding expenses are included.

For ex.: If direct wages paid are Rs. 10000 and direct wages outstanding are Rs.1000, then the cost sheet will show a cost of Rs.11000 towards Direct expenses.

Subsidy:-

Subsidy is a concession given by the government. The organization receiving subsidy can afford to reduce its desired selling price of its products to the extent of subsidy received.

Dual pricing:

If the industry is subject to dual pricing, the open market price must recover the loss in revenue on account of supplying part of the goods at levy price.

Percentage of some other expenses:

If the information is not provided for number of units, factory overheads are estimated and charged on the basis of its percentage to direct wages in the previous year. Similarly, administration, selling and distribution overheads are changed on the basis of their percentage to works cost in the previous year.

Fixed and variable costs:-

Variable expenses are expenses that vary in direct proportion to number of units produced. Fixed expenses remain fixed in amount irrespective of the number of units produced.

The World's Billionaires

noreply@blogger.com (B.S) — Wed, 12 Mar 2008 08:08:00 +0000

The World's Billionaires - 2007-08

Warren Buffett

Age: 77

Source: telecom

Country: United States

Industry: Investments

Net Worth: $62.0 bil

Education: University of Nebraska Lincoln, Bachelor of Arts / Science
Columbia University, Master of Science

2. Carlos Slim Helu & family

Age: 68

Net Worth: $60.0 bil

Country: Mexico

Industry: Communications

3. William Gates III

Age: 52

Source: Microsoft

Net Worth: $58.0 bil

Country : United States

Industry: Software

Education: Harvard University, Drop Out

4. Lakshmi Mittal

Age: 57

Source: steel

Net Worth: $45.0 bil

Country: India

Industry: Manufacturing

Education: St Xavier's College Calcutta, Bachelor of Arts / Science

5. Mukesh Ambani

Age: 50

Source: petrochemicals

Net Worth: $43.0 bil

Country: India

Industry: Manufacturing

Education: University of Bombay, Bachelor of Chemical Engineering
Stanford University, Master of Business Administration

6. Anil Ambani

Age: 48

Source: diversified

Net Worth: $42.0 bil

Country: India

Industry: Diversified

Education: University of Bombay, Bachelor of Arts / Science
University of Pennsylvania Wharton School, Master of Business Administration

7. Ingvar Kamprad & family

Age: 81

Net Worth: $31.0 bil

Country: Sweden

Industry: Retailing

8. KP Singh

Age: 76

Source: real estate

Net Worth: $30.0 bil

Country: India

Industry: Real Estate

9. Oleg Deripaska

Age: 40

Source: Russian Aluminum

Net Worth: $28.0 bil

Country : Russia

Industry: Diversified

10. Karl Albrecht

Age: 88

Net Worth: $27.0 bil

Country Of Citizenship: Germany

Industry: Retailing

Financial Matters - Financial Planning

noreply@blogger.com (B.S) — Mon, 10 Mar 2008 07:38:00 +0000

FINANCIAL PLANING:

A financial planner is some one who uses the financial planning process to help another person determine how to meet his or her life goals. The key function of a financial planner is to help people identify their financial planner needs, their present priorities and the product that are most suitable to meet their needs. The financial planner normally possess detailed knowledge of a wide range of financial planning tools and products, but the planners major role is to help clients choose the best products for each need the planner can take a “ big picture “ view of a client’s financial situation and make financial planning recommendation that are right for the client.

The planner can look at all of client’s need including budgeting and savings, taxes, investments , insurance and retirement planning or, the planner may work with his client on a single financial issue but within the context of his overall situation. This big picture approach to a client’s financial goals sets the planner apart from other financial advisers, like tax advisors and insurance agents, who may have been trained to focus on a particular area of a person’s financial life.

BENEFITS OF FINANCIAL PLANNING:

It may be necessary for a person to save for many years to create adequate income in the retirement phase. It is important that financial plans are tax efficient. The simplest plans may mean little more than making contributions into a suitable financial products. The most complex plans will involve detailed knowledge of law, taxation and investment principles. A mildest this complex environment for an investor, financial planning provides direction and meaning to financial decisions. It allows one to understand how each financial decision one makes affects others areas of one’s finances. By viewing each financial decisions as part of a whole, one can consider its short and long-term effects and on one’s life goals. One can also adapt more easily to changes in life and feel more secure that one’s goals are on track.

Ability to establish long-term relationships:

A financial planner is just selling products, but is instead taking responsibility for the financial well-being of his clients. With such an approach, it is easy to build lasting relationships, unlike in a transaction- oriented, products selling where a customers has to be found a new for every fresh investment.

Ability to build a profitable business:

By offering value added service, the financial planner takes the emphasis away from price and is able to retain enough to build a profitable business. Cleary, clients are less likely to ask for a rebate if they perceive good advices and value being offered them. If one does not offer such advices, then it is merely a commodity service where there is intense competition, difficulty in retention and narrow margins.

FUNDAMENTALS TRAITS OF SUCCESSFUL FINANCIAL PLANING

Building trust with the client by empathizing with them and understanding their aspirations, concerns and needs, good listening skills and the ability to ask the right questions.

Good knowledge of financial products and options, their risk- return profile, and strong understanding of the behavior and track record of various investment and assets classes.

Familiarity with taxation and estate planning issues.

An understanding of the various stages in client’s life and wealth cycle and the assets allocations that make sense for each of these stages.

Independent judgment and balanced thinking. Which is a key value that must be shared with clients when they overreact and get overly elated or dejected based on market sentiment.

An organized way of working, with one of the critical elements being a written financial plan which documents client needs and resources, a specific investment strategy and the progress made towards achieving those objectives.

Regular contract with clients, especially during times when the client’s portfolio has declined in value and they are feeling disillusioned. This is the time to remind clients that the only measure of a successful investment is how well it helps in achieving the client’s goals. Clients should realize that such setback are temporary, the natural price one pays when aspiring for growth, and that overtime the portfolio should perform to their expectations.

Finally, a clear focus on the overall financial well-being of a client, rather than on individual transactions. In an ideal sense, the in financial planner should link his remuneration to the overall achievement of client goals, rather than relying on a fee from each transaction. This ensures that there is consistency and alignment between planner and client- the better off a client is as a result of professional investment advices, the higher the rewards for the planner.

Financial Matters - Multi Commodity Exchange ( MCX )

noreply@blogger.com (B.S) — Wed, 05 Mar 2008 10:55:00 +0000

MULTI COMMODITY EXCHANGE:

Multi Commodity Exchange of India (MCX), which is one of the only fourNational multi commodity exchange in India.

MCX is promoted by the Finance Technologies. It is a Demultualized Exchange. It has a National wide presence. It is a Largest Volumes for Gold in India and other metals. It has a Strategic Alliance with the Bombay Bullion Association Ltd, the Solvent Extractors Association of India and Bombay Metal Exchange Ltd.

Commodities Traded On the MCX Platform:

Products

MCX offers the following products for trade

Gold

Gold M

Gold HNI

Silver

Silver M

Silver HNI

Castor Seeds, Castor (disa), Castor oil

Soya seeds, refined soy Oil, Soy Meal

RBD palm lien

Crude palm oil, Groundnut oil

Sesame Seeds

Mustard Seeds, Mustard Seeds oil

Cotton seed, cotton seed oilcake

Crude oil

Pepper, red chili, jeers turmeric

Steel long, staple cotton, mediums staple cotton

Chana, urad, yellow peas, tur

Rice, basmati rice, wheat, maize, sarbati rice

Rubber, gur, guar seeds, sugar M-30, Sugar S-30, guar gum bandhani, guar gum

Cashew kernel, guar seeds, bandhani, menthe oil

Timings:

Commodities are traded in two sessions, 10 am to 5 p. m and 5.45 to 11.30 p.m. except steel, crude palm oil, ground nut oil, RBD palm lien, Black pepper, Rubber, kappa’s, castor oil and seed and guar seed.

DELIVERY PROCEDURE

The client should follow the following procedure to take delivery of the commodity.

1^st day- Buyer /seller informs the Exchange about their intentions.

2^nd day- Buyer is required to make payment in accordance to the quantity allocated to him.

6^th day- Seller is required to deliver the goods at the delivery centers specified by the exchange by 12 noun. Buyer can peck up the delivery from 12 noun to 4 pm.

7^th day- the payment will be released to the seller.

Financial Matters - National Commodity and Derivative Exchange Ltd. ( NCDEX )

noreply@blogger.com (B.S) — Wed, 05 Mar 2008 10:44:00 +0000

NATIONAL COMMODITY AND DERIVATIVES EXCHANGE LTD :

National commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven Commodity exchange. It is a public limited company registered under the companies Act 1956 with the register of Companies, Maharashtra in Mumbai an April 23, 2003. It has an independent board of directors and professionals not having any vested interest. In commodity markets. Participant to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

NCDEX is regulated by forward markets commission in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the company’s act, stamp, act contract act, forward commission (regulation) act and various.

Other legislation, which impugners on its working, it is located in Mumbai and offers facilities to its members in about 91 cities throughout India at the movement. NCDEX currently facilitates trading of ten commodities gold, silver, and soybean oil, rapeseed mustard seed, expeller rapeseed, mustard seed oil, RBD polyolefin, crude palm oil and medium and long staple. Varieties at subsequent phases trading in more commodities would be facilitated.

Structure of NCDEX:

NCDEX has been formed with following objectives:

To create a world-class commodity exchange platform the market participants.
To bring professionalism and transparency into commodity trading.
To inculcate best international practices like de-modularization, technology plat form, low cost solutions and information‘s dissemination without noise etc. into the trade.
To provide nation wide reach and consistent offering.
To bring together the entities that the market can trust.

Promoters:

A consortium of institutions promotes NCDEX. These include the ICICI Bank Ltd., Life Insurance Corporations of India, and National Bank for Agriculture Rural Development, and National Stock Exchange of India Ltd., NCDEX is the only commodity exchange in the country promoted by national level institutional. This unique percentage enables it to offer variety of benefits. Which is currently in short supply in the commodity markets. The four institutional promoters of NCDEX are prominent players in their respective fields and bring with them institution building experience, trust, nation wide reach, technology and risk management skills.

Governance:

NCDEX is run by and independent Board of Directors. Promoters do not participate in the day-to day activities of the exchange. The directors are appointed in accordance with the provisions of the articles of association of the company. The board is responsible for managing and regulating all the operations of the exchange and commodities transactions. It formulates the rules and regulations related to the operations of the exchange. Board appoints an executives committee and other committee and other committees for the purpose of managing activities of the exchange.

The executives committee consists of managing Directors of the exchange who would be acting as the Chief Executive of the exchange, and also other members appointed by the board. Apart from the executives committee the board has constitute committee like Membership committee and Business Strategy committee, which help the Board in privy formulation.

Exchange Membership:

Membership of NCDEX is open to any person, association of persons, partnerships, co-operative societies, company’s etc. that fulfills the eligibility

Criteria set by the exchange. All the members of the exchange have to register themselves with the competent authority before commencing their operations.

The members of NCDEX fall into two categories, trading cum clearing members

(TCM) and professional clearing members (PCM).

Commodities Traded On The NCDEX Platform:

In December 2003, the National Commodity and Derivatives Exchange Ltd. (NCDEX) launched futures trading in nine major commodities. To begin with contracts in gold, silver, soybean, Soya oil, rape/ mustard seed, rapeseed oil, crude palm oil and RBD palmolein are being offered.

We have a brief look at the various commodities that trade on the NCDEX and look at some commodity specific issues. The commodity markets can be classified as markets trading the following types of commodities.

Agricultural Products
Precious Metal
Other Metals
Energy

Of course, the NCDEX has commenced trading in futures on agricultural products and precious metals. For derivatives with commodity as the underlying, the exchange must specify the exact nature of the agreement between two parties who trade in the contract. In particular it must specify the underlying assets, the contract size stating exactly how much of the assets will be delivered under one contract, where and when the delivery will be made. In this chapter we look at the various underlying assets for the futures contracts traded on the NCDEX. Trading clearing and settlement details will be discussed later.

Agricultural Commodities:

The NCDEX offer futures trading in the following agricultural commodities refined soy oil, mustard seed, expeller custard oil, RBD palmolein, crude palm oil, medium staple cotton and long staple cotton. Of these we study cotton in detail and have a quick look at the others.

Precious metals:

The NCDEX offers futures trading in following in precious metals gold and silver.

Products Price influence factors

Crude palm oil various production, market and policy related

Factors, climatic Conditions and demand- supply

Of palm and its competitions.

RBD palm oil Supply – demand, various oil seed, in country, Export

Import polices.

Soy oil Sole competitors, price of domestically produced oil

Seed

Rapeseed oil Domestic production of rapeseed during the year.

Gold Gold prices follow more or less the international price

Trends, demand and in festivals time.

Silver Demand supply, consumption, Economic and

And political factors.

Financial matters - History of Commodities Trading

noreply@blogger.com (B.S) — Wed, 05 Mar 2008 10:35:00 +0000

HISTORY OF COMMODITIES TRADING

Historically, the biggest have been made in commodities trading. It started centuries before stock markets came into being. The first organized future market in India was established in 1875 by the ‘Bombay Cotton Trade Association’ to trade in cotton.

Before the outbreak of the Second World War, India had a thriving futures market for a number of commodities such as groundnut oil, rice, raw jute, precious metals like gold, silver etc by 1960; s India had the necessary legislation in place with commodity futures considered as a reasonably successful trading market. In mid 1960’s, due to wars. Natural calamities and the consequent shortages, futures trading in most commodities ware banned.

It took three decades before commodity futures could be re-initiated into India market, This long period of hibernation for commodity futures un India has come to be know as the “lost decades” With the liberalization of the economy, emphasis was once again, to develop commodity futures trading. The kabra Committee set up in 1993 to examine commodity futures trading recommended futures trading in several commodities. Accordingly futures trading for 16 commodities and their by-products, and international futures trading for pepper and castor oil were permitted, by 2002. India had 20 commodity exchanges, trading around 42 commodities, with international contracts being traded for pepper and castor oil.

The history of commodities in India is arranged in chronological order.

1875 - Bombay cotton Trade Association.

1920 – Futures Market in Bullion-Mumbai.

1952 – Forward Contracts (Regulation) Act.

1975 – Futures Trading Prohibited.

1980 – Khusro Committee Recommendation.

1997 – Trading resumed in certain selected Commodities.

2003 – Government Grants Permission for setting up NMCE’s.

Reasons for failure of commodity futures exchanges so far

Single commodity exchanges with low liquidity.
Open out cry trading, which restricted trading to specific regions and prevented national reach national reach.
Dominance of speculators band inadequate participation from hedgers, which resulted in high basis risk, as integration between physical and futures market was limited.
Inefficient clearing and settlement procedures.
Exchanges with inadequate infrastructure, logistics and financial funding.

Recent Developments:

Forward Market Commission (FMC) the governing body for commodity trading in India in 2002, invited applications from associations companies’ consortium of organizations it set up a Nation-wide Multi Commodity Exchange.

The aim was to create a nation wide efficient commodity exchange, which could provide price discovery and offer price-risk management to all participants involved in the commodity business cycle. The modern exchanges will enable multiple commodities trading on online world standard trading platforms, with nation wide reach.

The exchanges will now provide real time price and trade data dissemination. The new exchanges maintain capital settlement guarantee funds and have stringent capital adequacy norms for brokers, which ensure trade guarantee to participants.

The exchanges will enable deliveries in electronic form. Warehouse receipts exchanged through the depository participant’s facilities efficient settlement procedures and will attract participants from all key sections of the commodity business cycle. The institutions managing the new exchanges comprise banks and government organizations, which bring with them institutional building experience, trust, nation wide reach, technology and risk management skills. The new changes will have rule-based management by professionals having no trade interest.

Financial Matters - Dematerialisation of Securities ( CSDL )

noreply@blogger.com (B.S) — Tue, 04 Mar 2008 10:35:00 +0000

DEMATERIALISATION OF SECURITIES:

Objectives :-

To enable Beneficial Owners to convert their scripts existing in physical form to electronic balances in accounts maintained by CDSL, through DPs.

Features :-

Dematerialization is a process by which the scrips existing in paper form are converted into electronic balances maintained in securities accounts held by the BO with a DP of CDSL.

1. However, to Dematerialize the share certificates an investor has to

2. Fill up a Dematerialization request form, which is available with the DP.

3. Submit share certificates along with the forms (Write “Surrendered for Demat” on the face of the certificate before submitting it for demat).

4. Receive credit for the dematerialized shares within 15 days.

Only those securities held in the form of certificates registered in one’s name individually or jointly can be dematerialized. Moreover, the securities must belong to the list of securities admitted for dematerialization at CDSL. Securities held in street name (Market deliveries) cannot be dematerialized.

If one wants to dematerialize the securities of a company that is not admitted with CDSL, then the investor should request the company to have that security admitted with CDSL and once that has been done, he can get it dematerialized.

SEBI has laid down a separate procedure for simultaneous transfer and demat of share’s in one’s favour. The transfer cum demat facility is available only in respect of securities of those issuer companies, who have entered into special arrangement with the depositories. After the company / RTA has transferred the shares in the name of the Transferee, it will send option letter to the transferee to ascertain whether he wishes to have them dematerialized. Incase the transferee opts to receive them in demat mode; he will submit the option letter along with the DRF to the DP. DP will forward the DRF and the option letter to the company / RTA, whereupon company / RTA will demat them and the BO account will be credited.

In demat form the market lot is one share and therefore, there is no question of odd lot. Dematerialized shares do not have any distintives or certificate numbers. In demat all shares are fully fungible, which means that any 100 shares of a company are similar to any other 100 shares of that company.

While CDSL does not levy any charges for dematerialization of securities, DPs collect dematerialization charge together with postage / courier charges.

PROCEDURE FOR DEMATERIALIZATION :-

To Materialize any physical security, one will have to open a demat account with a DP of one’s Choice.

Thereafter, all one has to do is to fill in a DRF (Demat Request Form) and submit the same with the shares / securities Certificates to the DP for dematerialization.

DP defaces and sends these certificates to the Issuer / Registrar who credits an equivalent number of securities in the demat account maintained with CDSL. For each scrip, a separate DRF has to be used.

The investor shall fill up the following details in the DRF :

Investors account number with the DP

DP ID

DP Name

ISIN

Name of the Issuer

Type of the Security

Total quantity to be maintained

Name (s) of the holder (s)

Certificate Details : Folio No., Distinctive Nos., Certificate Nos., No. of Securities

Lock in status.

The registered holder (s) shall sign the DRF.

As per the specimen signature (s) recorded with the DP and

As per the specimen signature (s) recorded with the Issuer / RTA.

The Investor shall also surrender the physical certificate to be dematerialized along with the duly filled DRF to the DP. Immediately on receipt of DRF along with the scripts the DP should give the counter acknowledgement to the BO

The DP shall verify the following :

· Whether the DRF is complete.

· Whether the Certificate details mentioned on the DRF and on the Certificate enclosed, tally.

· Whether the name (s) of the holder (s) and the order of the names of the holders appearing on the certificates exactly tally with those records under the BO Account maintained with CDSL.

· Whether all the holders have signed the DRF and the signatures of the account holders tally with those recorded by the DP.

· If there is any discrepancy in any of the details, the DP will get it rectified from the investor and the error free DRFs will be taken up for further processing by the DP.

The DP shall capture the details from the DRF & Certificate through the front-end system provided by the CDSL and shall generate the DRN on the same day or latest by the next working day from the date of receipt of DRF.

In case the Securities are in “ Lock – In “ status the following details need to be specified:

Ø Lock in Reason

Ø Lock in Release date.

The DP shall then write down the DRN on the DRF and deface the certificates by affixing a rubber stamp “ Surrendered for Dematerialization “. The DP has to take proper care that the stamp should be affixed in such a manner that no material information such as distinctive numbers, Folio Nos., etc., on the Certificate is smudged or becomes illegal.

The DP shall then mutilate the certificates, by punching two holes at the top of the certificates.

The DP shall then give a “System Generated acknowledgement” of the demat request to the BO. This acknowledge will contain details such as BO A/c No., BO Names, ISIN, Name of the Issuer & Type of Security, Quantity, Distinctive / Certificate / Folio No., Date of request, DRN. The DP shall authorize this acknowledgement by putting his seal / rubber stamp & Signature of the authorized signature (may be printed on the letterhead of the DP).

CDSL shall electronically send the DRF data to the issuer /RTA after the DRN is generated. The process is done automatically by the system.

The DRF shall be authorized by the DP by putting his seal & signature. The certificates & the original DRF shall be sent to the issuer / RTA along with a covering letter printed on the DPs letterhead. This covering letter content will be generated by the CDSL system. A copy of the DRF is to be maintained by the DP for its own reference and records.

The DP then shall capture the dispatch details on the front – end system such as the dispatch reference no., dispatch date, name of the courier, etc. The DP must dispatch the physical documents within a maximum of 2 days from the date of DRN Generation.

For items marked confirmed from the Issuer / RTA, CDSL activates the balances in the BO account and they will be treated as fully dematerialized securities.

DP will print the statement of holding for the BO account for which the balances have been activated by CDSL and mail / delivery the same to the BO.

The dematerialized process must be completed within 15 days or as specified by the CDSL from time to time.

Incase of rejection of certificates, unless there is a compelling reason, the RTA / Issuer will print fresh certificates in lieu of the defaced certificates and return the same under the objection to the DP concerned , along with an appropriate rejection letter.

Financial Matters - CSDL

noreply@blogger.com (B.S) — Tue, 04 Mar 2008 09:06:00 +0000

Benefits of opening an account with CDSL system

1) The unique centralized database of CDSL enables DPs to debit / credit securities instantaneously to the Beneficial Owner’s account thereby avoiding any transit position.

2) CDSL’s unique client ID number ensures debit / credit of securities only to the intended account, as the system does not accept a transaction, where account number is keyed in incorrectly.

3) CDSL offers a facility to the clearing House / Clearing Corporation under which securities sold purchased by any BO on BSE can be directly delivered from / received in the BO account without routing them through the broker’s pool account.

4) CDSL does not collect any custody fees from its DPs. Thus BOs can except a lower charge in respect of securities held in CDSL accounts. The transaction cost of settlement of securities through CDSL is lower in most cases.

ACCOUNT TYPES WITHIN CDSL

The account structure in CDSL is designed to meet the following objectives.

ü To maintain proper records.

ü To Segregate accounts of Beneficial Owners from each other and form the depository participants.

ü To enable RTA / Issuers to access an index of all accounts, this represents the balances of all holdings in a particular ISIN (International Security Identification Number).

ü To enable Depository Participants to enquire about only those Beneficial Owner accounts that do they service. The Beneficial Owner master file account details and the current and historic details of transactions and balances will be available to DPs.

ü To provide a flexible accounting structure to support the settlement requirements of the market.

ü To account for dematerialized securities at BO level.

FEATURES:-

1) All beneficial Owner accounts are operated at Depository Participant level, however data is maintained at CDSL Level.

2) BOs do not have direct access to CDSL system, except through “ Smartcards “ for enquiry purpose, as and when provided.

PROCEDURE FOR OPENING DEMATS ACCOUNT:-

The process of opening a demat account through a DP of CDSL is very easy and simple. It is similar to the opening of a bank account.

1. Investor as choose a DP from the list of CDSL DPs published in CDSL Infoline or accessible through the CDSL website www.cdslindia.com

2. The investor should submit an application form to the DP.

3. Before demat account is opened, the investor will have to execute an agreement on a stamp paper to be provided by the DP, which defines the rights and obligations of both, the investors and the DP.

4. On opening an account, a unique BO ID (Beneficial Owner Identification) Number is allotted, which should be quoted in all future transactions.

5. Under the Depository system, there is no restriction on opening more than one BO account in the same or identical names with the same or other DPs subject to the condition that all requirements are compiled with.

6. There is also no compulsion on any investor to open this demat account with the same DP as that of his broker, Investor can open account with the DP of his choice and carry on his trading activity through a broker of his choice. Where any DP offers special charge with the brokers DP may have some advantages.

However a BO belonging to any one of the categories specified under the CDSL Bye laws need not enter into an agreement with the DP, if the DP has entered into an agreement with the BO pursuant to securities & Exchange Board of India (Custodian of securities) Regulations 1996. The BO Categories are as under:

Ø Public Financial Institutions as defined in section 4A of the Companies Act, 1956.

Ø A Bank included for the time being in the second schedule to the Reserve Bank of India Act, 1951.

Ø Foreign Bank operating in India with the approval of RBI.

Ø State Financial Corporation established under the provisions of section 3 of the State Financials Corporations Act, 1951.

Ø An Institution engaged in providing financial services, promoted by any of the Institutions mentioned herein above, jointly and severally.

Ø A Custodian of securities who has been granted a certificates of Registration by the Board under sub-section (1A) of section 12 of the SEBI Act, 1992.

Ø Foreign Institutional Investor as defined under section 2(f) of the SEBI (Foreign Institutional Investors) Regulations, 1995.

Ø A Mutual Funds as defined under Section 2(q) of the SEBI (Mutual Funds) Regulations, 1992 and Registered with SEBI under regulation 9 thereof.

Financial Matters - Maintenance of Accounts & Types of Accounts ( NSDL )

noreply@blogger.com (B.S) — Tue, 04 Mar 2008 08:34:00 +0000

Maintenance of Accounts at the Central System:

The NSDL central system known as DM maintains accounts of all account holders in the depository system. All the transactions entered at any point in the computer system connected to it are first effected in the central system and subsequently at these Computers. Thus, the central system of NSDL has the records of all details of every transaction conducted in the depository system.

Distributed Database:

Each of the computer systems connected to NSDL system has its own database relating to its clients. This helps in giving prompt and accurate service to the clients. However each of the databases is reconciled with the data at the central system everyday in order to ensure that the data in the distributed database tallies with the central database.

Common Software:

NSDL develops software required by depository participants, Companies, R&T Agents and clearing corporations for conducting depository operations. Thus, the computer systems used by all the entities will have common software given by NSDL. However, depending on the business potential, branch networks and any other specific features, DPs may develop software of their own for coordination, communication and control and provide service to their clients. Such exclusive software is called “back office software “.DPM system given NSDL gives “export and import” facility to take out the transaction details to be used by back office software and to feed in transaction details generated from the back office software.

Account Opening :

Any investor who wishes to avail depository services must first open an account with a depository participant of NSDL. The process of opening a demat account is very similar to a bank account. The investor can open an account an account with any depository participant of NSDL. An investor may open an account with several DPs or he may open several accounts with a single DP. There are several DPs offering various depository-related services. Each DP is free to fix its own fee structure. Investors have the freedom to choose a DP based on criteria like convenience, comfort, service levels, safety reputation and charges. After exercising this choice, the investor has to enter into an agreement with the DP. The form and contents of this agreement are specified by the business rules of NSDL. In this chapter we deal with the procedure for account opening under the NSDL system.

Types of Accounts

Type of depository account depends on the operations to be performed. There are three types of demat accounts which can be opened with a depository participant viz. (a) Beneficiary Account (b) Clearing Account and (c) Intermediary Account.

Beneficiary Account:

This is an account opened by investors to hold their securities in dematerialized form with a depository and to carry out the transactions of sale and purchase of such securities in book- entry form through the depository system. A beneficiary account holder is legally entitled for all rights and liabilities attached to the securities (i.e. equity shares, debentures, government securities, etc.) held in that account. Therefore, the account is called “beneficial owner account “. A beneficiary account can be in the name of an individual, corporate, HUF, Minor, Bank, Financial Institution, Trust, etc. or the broker himself for the purpose of his personal investments in demat form. The account is opened with a DP.

Documents for Verification:

For the purpose of verification, all investors have to submit the following documents along with the prescribed account opening form.

Proof of Identity :- A beneficiary account must be opened only after obtaining a proof of identity of the applicant.

Proof of address :- The account opening form should be supported with proof of address such as verified copies of ration card / passport / voter ID / PAN card / driving license / bank passbook.

In case any account holder fails to produce the original documents for verification within the aforesaid period of 30 days, it must be immediately brought to the notice of NSDL. Failure to produce the original documents within the prescribed time would invite appropriate action against such account holders, which could even include freezing of their accounts.

Common Information:

The process of opening an account with a depository, nature of such an account , and various factors to be considered for opening a depository account are explained below. Some details are common to all types of accounts. These are :

1. Name of the holder

2. Date of birth (for individual accounts )

3. Occupation

4. Address & phone / fax number

5. Bank details like name of bank, type of account (current / savings). Account number, branch address, MICR, etc.

6. PAN number, if applicable

7. Details of nomination

8. Specimen signatures

Clearing Member Account:

The entities that are authorized to pay in and receive the pay out from a clearing corporation / clearing house against trades done by them or their clients are known as clearing members. CMs are identified in the system through their CM-BP ID. All pay-out transactions are carried out through their accounts.

There are two types of clearing members:

1. All members of a stock exchange popularly known as brokers, are clearing members.

2. Custodians who are permitted by the stock exchange to act as a clearing member.

Intermediary Account:

As per SEBI Regulations on Stock lending and borrowing, only an approved intermediary can lend and borrow stocks from clients. This intermediary borrows from lenders and lends to borrowers. Intermediaries registered with SEBI as approved intermediary may open an intermediary account with a DP of its choice, for executing stock lending and borrowing transactions made through them. An intermediary account may be opened only after obtaining registration from SEBI under an approved Stock Lending Scheme, and getting the approval of the depository for opening the account.

Closure of Account:

Closure on client’s request – A DP can close a depository account on receipt of an application in the prescribed format. The application should be made by the account holder or by all the joint-holders. An account can be closed only when there is no balance in the account. In case there is any balance in the account sought to be closed, the following steps are necessary.

(a) Re-materialization of all securities standing to the credit of the account at the time of making the application for closure; or

(b) Transferring the balance to the credit of another account opened by the same account holder (s) either with the same participant or with a different participant.

Freezing of Accounts:

Accounts freezing means suspending any further transaction from a depository account till the account is de-frozen. A depository account maintained with a DP may be frozen in certain cases.

1. If a written instruction is received from the client by the DP, requesting freezing of account; or

2. If written instructions are received from the depository pursuant to an order of the Central or State Government, SEBI, or any order by the court, tribunal, or any statutory authority.

An account may be frozen only for debits (preventing transfer of securities out of the account ). By freezing an account for debits only, no securities can be debited from the account , however, the client can receive securities in his account. An account can also freezed for debits as well as credits (preventing any movement of balances out of the account ). No transaction can take place in such an account until it is reactivated. A frozen account may be de-frozen or re-activated, by taking the reverse steps.

1. On the valid written request of the account holder where he had requested freezing.

2. On directions of depository made in pursuance of the order of the appropriate authority.

The DP should immediately inform the client about change in status of the account from ‘active’ to ‘suspended’ and vice-versa.

TRADING AND SETTLEMENT:

Settlement of off-market transactions :

Any trade that is cleared and settled without the participation of a clearing corporation is called off-market trade. Transfer from one beneficiary account to another due to a trade between them is called off-market transaction. Large deals between institution, trades among private parties, transfer of securities between a client and sub-broker, large trades in debt instruments are normally settled through off-market route

1. Seller gives delivery instructions to his DP to move securities from his account to the buyer’s account.

2. Buyer automatically receives the credit of the securities into his account on the basis of standing instruction for credits.

3. Buyer receives credit of securities Into his account only if he gives receipt instructions, if standing instructions have not been given.

4. DP needs to be extra careful in verifying the signature of the client if unusual quantities of securities are being debited to the account.

5. Funds move from buyer to seller outside the NSDL system.

Financial Matters - National Securities Depository Limited ( NSDL )

noreply@blogger.com (B.S) — Tue, 04 Mar 2008 08:26:00 +0000

National Securities Depository Limited ( NSDL )

National Securities Depository Limited is the first depository to be set-up in India. It was incorporated on December 12, 1995. The Industrial Development Bank of India (IDBI) – the largest development bank in India, Unit Trust of India (UTI) – the largest Indian mutual fund and the National Stock Exchange (NSE) – the largest stock exchange in India, sponsored the setting up of NSDL and subscribed to the initial capital. NSDL commenced operations on November 8, 1996.

Ownership:

NSDL is a public limited company incorporated under the Companies Act 1956. NSDL had a paid up equity capital of Rs.105crore. The paid up capital has been reduced to Rs.80cr since NSDL has bought back its shares of the face value of Rs.25cr in the year 2000. However, its net worth is above the Rs.100cr, as required by SEBI regulations.

The following organizations are shareholders of NSDL as on March 31, 2002:

1. Industrial Development Bank of India.

2. Unit trust of India.

3. National Stock Exchange.

4. State Bank of India.

5. Global Trust Bank Limited.

6. Citibank NA.

7. Standard Chartered Bank.

8. HDFC Bank Limited.

9. The Hong Kong and Shanghai Banking Corporation Limited.

10. Deutsche Bank.

11. Dena Bank.

12. Canara Bank.

Management of NSDL:

NSDL is a public limited company managed by a professional Board of Directors. The day-to-day operations are conducted by the Managing Director. To assist the MD in his functions, the Board appoints an Executive Committee (EC) of not more than 15 members. The eligibility criteria and period of nomination, etc. are governed by the bye-laws of NSDL.

Bye-laws of NSDL :

Bye-laws of National Securities Depository Limited have been framed under powers conferred under section 26 of the Depositories Act 1996 and approved by Securities

and Exchange Board of India. The bye-laws contain fourteen chapters and pertain to the areas listed below.

1. Short title and commencement

2. Definitions

3. Board of Directors

4. Executive Committee

5. Business Rules

6. Participants

7. Safeguards to protect interest of clients and participants

8. Securities

9. Accounts / transactions by book entry

10. Reconciliation, accounts and audit

11. Disciplinary action

12. Appeals

13. Conciliation

14. Arbitration

Functions:-

NSDL performs the following functions through depository participants (DPs):

· Enables the surrender and withdrawal of securities to and from the depository (dematerialization and re-materialization).

· Maintains investor holdings in the electronic form.

· Effects settlement of securities traded on the exchanges.

· Carries out settlement of trades not done on the stock exchange (off-market trades).

· Transfer of securities.

· Pledging / hypothecation of dematerialized securities.

· Electronic credit in public offerings of companies or corporate actions.

· Receipt of non-cash corporate benefits like bonus rights, etc. in Electronic Form.

· Stock lending and borrowing.

Services Offered by NSDL :

NSDL offers a host of services to the investors through its network of DPs:

· Maintenance of beneficiary holdings through DPs.

· De materialization

· Off-market Trades.

· Settlement in dematerialized securities.

· Receipt of allotment in the dematerialized form.

· Distribution of corporate benefits.

· Re-materialization.

· Pledging and hypothecation facilities.

· Freezing / locking of investor’s account.

· Stock lending and borrowing facilities.

Fees Structure of NSDL:

NSDL charges the DPs and not the investors directly. These charges are fixed. The DPs, in turn, are free to charge their clients, i.e., the investors for their services. Thus, there is a two- tier fee structure.

Inspection, Accounting and Internal Audit :

NSDL obtains audited financial reports from all its DPs once every year. NSDL also carries out periodic visits to the offices of its constituents – R & T agents, DPs and clearing corporations - -to review the operating procedures, systems maintenance and compliance with the bye-laws, business rules and SEBI Regulations.

Additionally, DPs are required to submit to NSDL internal audit reports every quarter. Internal audit has to be conducted by a chartered accountant or a company secretary in practice.

The Board of Directors appoints a Disciplinary Action Committee (DAC) to deal with any matter relating to DPs clients, issuers and R & T agents. The DAC is empowered to suspend or expel a DP, declare a security as ineligible on the NSDL, freeze a DP account and conduct inspection or call for records and issue notices.

Settlement of Disputes:

All disputes, differences and claims arising out of any dealings on the NSDL, irrespective of whether NSDL is a party to it or not, have to be settled under the Arbitration and Conciliation act 1996.

Financial Matters - Dematerialisation

noreply@blogger.com (B.S) — Tue, 04 Mar 2008 08:10:00 +0000

One of the methods for preventing all the problems that occur with physical securities is through dematerialization (demat). India has adopted the demat route in which the book entry is made electronically against securities that are cancelled. The share certificates are shredded (i.e., its paper form is destroyed) and a corresponding credit entry of the number of securities (written on the certificates) is made in the account opened with the Depository participant (DP).

Each security is identified in the depository system by ISIN and short name. For example, a person owing 100 shares in ABC Ltd. in physical form will record his ownership as below:

Company Name: ABC Ltd.

No. of Shares:100

Distinctive Nos.: 932654701 to 932654800

Certificate No.: ABC001263

Folio No.: A658542

International Securities Identification Number (ISIN):

Each of the securities dematerialized in the NSDL depository bears a distinctive ISIN – an identification number. International Securities Identification Number (ISIN) is a unique identification number for each security issued in any of the international standards organization (ISO) member countries in accordance with the ISIN standard (ISO 6166).

Securities that can be dematerialized:

The entire depository system in India is governed by the rules made by the market regulator – SEBI. According to the SEBI (Depositories and participants) Regulations, 1996, the following securities are eligible for holding in dematerialized form.

1) Shares, scripts, stocks, bonds debentures, debenture stock or other marketable securities of similar nature of any incorporated company or body corporate including underlying shares of ADRs and GDRs.

2) Units of mutual funds, rights under collective investment schemes and venture capital funds, commercial paper, certificate of deposit, securitised debt, money market instruments and unlisted securities.

A list of securities available for demat in NSDL depository is made known to all DPs by way of circulars sent through email.

Physical form of securities can be converted into book entry form in NSDL depository system only if the company which has issued the securities, has entered into an agreement with NSDL to offer demat facility.

PROCEDURE FOR DEMATERIALISATION

Client / investor submits the DRP (Demat Request Form) and physical certificates to DP.DP checks whether the securities are available for demat. Clients defaces the certificates by stamping ‘Surrender for Dematerialization’. DP punches two holes on the name of the company and draws two parallel lines across the face of the certificate.

DP enters the demat request in his system to be sent to DEPOSITORY.DP dispatches the physical certificates along with DRF to the R & T agent.

Depository records the details of the electronic request in the system and forwards the request to the R & T agent.

R & T agent, on receiving the physical documents and the electronic request, verifies and checks them. Once the R & T agent is satisfied, dematerialization of the concerned securities is electronically confirmed to Depository.

Depository credits the dematerialized securities to the beneficiary account of the investor and the DP electronically the DP issues a statement of transactions to the client.

RE-MATERIALISATION:

Rematerialization is the exact reverse of dematerialization. It refers to the process of issuing physical securities in place of the securities held electronically in book-entry form with a depository. Under this process, the depository account of a beneficial owner is debited for the securities sought to be re- materialized and physical certificates for the equivalent number of securities is / are issued.

A beneficial owner holding securities with a depository has a right to get his electronic holding converted into physical holding at any time. The beneficial owner desiring to receive physical security certificates in place of the electronic holding should make a request to the issuer or its R & T Agent through his DP in the prescribed re-materilization request form (RRF).

Upon receipt of the request, the DP verifies the balance available to the extent of the request contained in the RFR and electronically intimates the request to the depository.

The depository there up on blocks the balance of the DP and intimates the RFR to the issuer or the RTA.

Upon the acceptance of the RFr, the issue company or the RTA issues share certification within 30 days.

Financial Matters - Depository System

noreply@blogger.com (B.S) — Tue, 04 Mar 2008 07:53:00 +0000

Meaning of the term “Depository “

Depository means a place to deposit something for safekeeping as bank in which funds or securities are deposited by other under the terms of depository agreements. The Depositories Act, 1996 defines a depository to mean “a Company formed and registered under the companies Act, 1956 and which has been granted a certificate of registration under sub-section (IA) of section 12 of the Securities and Exchange Board of India Act, 1992. The principal function of a depository is to dematerialize securities and enable their transactions in book-entry form. The securities are transferred by debiting the transferor’s depository account and crediting the transferee’s depository account. The SEBI Regulations, 1996, SEBI has notified regulations on 16^th May 1996, which specify the norms for the functioning and Operations of depository system is very similar to a banking environment.

Eligibility Criteria for a Depository:

Any of the following may promote a Depository:

A public financial institution as defined in section 4A of the Companies Act, 1956;

A bank included in the second schedule to the Reserve Bank of India Act, 1934;

A foreign bank operating in India with the approval of the Reserve Bank of India;

A recognized stock exchange;

An institution engaged in providing financial services where not less than 75% of the equity is held jointly or severally by these institutions;

A custodian of securities approved by Government of India,

Registration:

As per the provisions of the SEBI Act, a depository can deal in securities only after obtaining a certificate of registration from SEBI. The sponsors of the proposed depository should apply to SEBI for a certificate of registration in the prescribed form.

Commencement of Business:

A Depository that has obtained registration as stated above, can function only if it obtains a certificate of commencement of business from SEBI. A Depository must apply for and obtain a certificate of commencement of business from SEBI within one year from the date of receiving the certificate of registration from SEBI.

Agreement between the Depository and Issuers:

If either the issuer ( a company which has issued securities ) or the investor opts to hold his securities in a demat form, the issuer enters into an agreement with the depository to enable the investors to dematerialize their securities. No such agreement is necessary where the state or Central Government is the issuer of government securities.

A Depository participant (DP) is described as an agent of the depository. They are the intermediaries between the depository and the investors. The relationship between the DPs and the depository is governed by an agreement made between the two under the Depositories Act. In a strictly legal sense, a DP is an entity who is registered as such with SEBI under the provisions of the SEBI Act. As per the provisions of this Act, a DP can offer depository related services only after obtaining a certificate of registration from SEBI.

Depository Participants:

The regulations have selected various categories of market participants who are eligible to become depository participants who have a well established customer interface network.

These categories are:-

a) Public Financial Institutions.

b) Scheduled Banks.

c) RBI approved Foreign Banks Operating in India.

d) State Financial Corporations.

e) Certified Custodians of Securities.

f) Clearing corporations of Stock Exchanges.

g) Registered Stock Brokers.

h) Non-Banking Financial Companies.

Services provided by a DP :

Following services can be availed of through a DP:

ü Dematerialization, i.e., getting physical securities converted into electronic form.

ü Rematerialization, i.e., getting electronic securities balances held in a BO account converted into physical form.

ü To maintain record of holdings in the electronic form.

ü Settlement of trade by delivering / receiving underlying securities from / BO accounts.

ü Settlement of off-market trades i.e., transactions between BOs entered outside the stock exchange.

ü Providing electronic credit in respect of securities allotted by issuers under IPO or otherwise.

ü Receiving on behalf of demat account holders non-cash corporate bonus such as, allotment of bonus and rights share in electronic form or securities ensuring upon consolidation, stock spilt or merger / amalgamation of companies.

ü Pledging of dematerialized securities & facilitating security lending and browsing, if the DP is registered as an “Approved Intermediary” for the purpose.

Services of Depository:

A Depository established under the Depositories Act can provide any service connected with recording of allotment of securities or transfer of ownership of securities in the record of a depository. Any person willing to avail the services of the depository can do so by entering into an agreement with the depository through any of its participants. A depository can provide depository services only through a DP. A depository cannot directly open accounts and provide services to clients. Every depository in its bye-laws must state which securities are eligible for demat holding. Generally, the following securities are eligible for dematerialization:

(a) Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate.

(b) Unit of mutual funds, rights under collective investment schemes and venture capital funds, commercial paper, certificates of deposit, securitised debt, money market instruments, government securities and unlisted securities.

(c) Securities admitted to NSDL depository are notified to all DPs through circulars sent by email everyday. Investors are informed about these securities through NSDL’s website-www.nsdl.co.in - and NEST update-a monthly newsletter of NSDL.

Functions of Depository:

1) Dematerlization: One of the primary functions of depository is to eliminate or minimize the movement of physical securities in the market. This is achieved through dematerilization of securities.

2) Account Transfer: The depository gives effects to all transfers resulting from the settlement of trades and other transactions between various beneficial owners by recording entries in the accounts of such beneficial owners.

3) Transfer and Registration: A transfer is the legal change of ownership of a security in the records of the issuer. For effecting a transfer, certain legal steps have to be taken like endorsement, execution of a transfer instrument and payment of stamp duty.

4) Corporate Actions: A depository may handle corporate actions in two ways. In the first case, it merely provides information to the issuer about the persons entitled to receive corporate benefits. In the other case, depository itself takes the responsibility of distribution of corporate benefits.

5) Pledge and Hypothecation: Depositories allow the securities placed with them to be used as collateral to secure loans and other credits. In a manual environment, borrowers are required to deliver pledged securities in physical form to the lender or its custodian. These securities are verified for authencity and often need to be transferred In the name of lender.

6) Linkages with clearing system: Whether it is a separate clearing corporation attached to a stock exchange or a clearing house (department) of a stock exchange, the clearing system performs the functions of ascertaining the pay-in (sell) or pay-out (buy) of brokers who have traded on the stock exchange.

DEPOSITORY PROCESS IN INDIA:

The system consists of four constituents. They are I) The Depository ii) the depository participants, iii) the beneficial owner and iv) the issuer.

The Depository :- The depository is entrusted with securities for effecting the transfer of ownership of the securities. He is the custodian of his clients “ securities “. The depository has no right over the security except with the transfer of it.

The Depository participants :- The depository participants is the link between the depositories and the owner of securities. He is deemed an agent of the depository. The depository, therefore is responsible for the acts of omission and commission on the part of the DP. The depository, therefore is responsible for the acts of omission and commission on the part of the DP. The depository and DP are registered with SEBI, which regulates their functioning.

The Beneficial owner :- the beneficial owner is the real owner of the security. He lodges his securities with the depository in the form of book entries. He has all rights and liabilities associated with the securities.

The issuer :- It is the company, which issues the security.

The issuer avails choice to the investors for holding securities either in physical form or through the depository, which makes the investor to choose and communicate back to the issuing company at the time of initial offer itself. Then the issuer intimates the depository details about the allotment of securities. The depository in turn records the names of allottes of the securities in their records as the beneficial owners. The name of the depository is entered by the issuer as the registered holder of the security. The investor is free to alter his choice either at the time of applying for securities or at any time thereafter. An investor who wishes to avail himself of the services will have to open an account with depository through a DP. The investor has to enter into an agreement with the DP after which he is issued a client number.

Financial Matters - Options

noreply@blogger.com (B.S) — Mon, 03 Mar 2008 08:02:00 +0000

HISTORY OF OPTIONS:

Although options have existed for a long time, they wee traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the seventeenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firms would then attempt to find a seller or writer of the option either from its own clients of those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price.

This market however suffered form two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honor the contract. In 1973, Black, Merton and scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for option developed so rapidly that by early’ 80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back.

Option made their first major mark in financial history during the tulip-bulb mania in seventeenth-century Holland. It was one of the most spectacular get rich quick binges in history. The first tulip was brought Into Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising. That was when options came into the picture. They were initially used for hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. Later, however, options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. The writers of the put options also prospered as bulb prices spiraled since writers were able to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs.

INTRODUCTION TO OPTIONS:

In this section, we look at the next derivative product to be traded on the NSE, namely options. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirement) to enter into a futures contracts, the purchase of an option requires as up-front payment.

DEFINITION:

Options are of two types- calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyers the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

PROPERTIES OF OPTION

Options have several unique properties that set them apart from other securities. The following are the properties of option:

Limited Loss

High leverages potential

Limited Life

PARTIES IN AN OPTION CONTRACT:

There are two participants in Option Contract.

Buyer/Holder/Owner of an Option:

The Buyer of an Option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

Seller/writer of an Option:

The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

TYPES OF OPTIONS:

The Options are classified into various types on the basis of various variables. The following are the various types of options.

1. On the basis of the underlying asset:

On the basis of the underlying asset the option are divided in to two types:

Index options:

These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled.

Stock options:

Stock Options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.

2. On the basis of the market movements :

On the basis of the market movements the option are divided into two types. They are:

Call Option:

A call Option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. It is brought by an investor when he seems that the stock price moves upwards.

Put Option:

A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. It is bought by an investor when he seems that the stock price moves downwards.

3. On the basis of exercise of option:

On the basis of the exercise of the Option, the options are classified into two Categories.

American Option:

American options are options that can be exercised at any time up to the expiration date. Most exchange –traded options are American.

European Option:

European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.

FACTORS AFFECTING THE PRICE OF AN OPTION:

The following are the various factors that affect the price of an option they are:

Stock Price:

The pay-off from a call option is an amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount; by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa.

Strike price:

In case of a call, as a strike price increases, the stock price has to make a larger upward move for the option to go in-the –money. Therefore, for a call, as the strike price increases option becomes less valuable and as strike price decreases, option become more valuable.

Time to expiration:

Both put and call American options become more valuable as a time to expiration increases.

Volatility:

The volatility of a stock price is measured of uncertain about future stock price movements. As volatility increases, the chance that the stock will do very well or very poor increases. The value of both calls and puts therefore increases as volatility increase.

Risk- free interest rate:

The put option prices decline as the risk-free rate increases where as the price of call always increases as the risk-free interest rate increases.

Dividends:

Dividends have the effect of reducing the stock price on the X- dividend rate. This has a negative effect on the value of call options and a positive effect on the value of put options.

PRICING OPTIONS:

An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the price of an option.

There are various models which help us get close to the true price of an option. Most of these are variants of the celebrated Black- Scholes model for pricing European options. Today most calculators and spread-sheets come with a built-in Black- Scholes options pricing formula so to price options we don’t really need to memorize the formula. All we need to know is the variables that go into the model.

The Black-Scholes formulas for the price of European calls and puts on a non-dividend paying stock are:

Call option

CA = SN (d₁) – Xe^{- rT} N (d₂)

Put Option

PA = Xe^{- rT} N (- d₂) – SN (- d₁)

Where d₁ = ln (S/X) + (r + v²/2) T

v√T

And d₂ = d₁ - v√T

Where

CA = VALUE OF CALL OPTION

PA = VALUE OF PUT OPTION

S = SPOT PRICE OF STOCK

N = NORMAL DISTRIBUTION

VARIANCE (V) = VOLATILITY

X = STRIKE PRICE

r = ANNUAL RISK FREE RETURN

T = CONTRACT CYCLE

e = 2.71828

r = ln (1 + r)

OPTIONS TERMINOLOGY:

Option price/premium:

Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

Expiration date:

The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price:

The price specified in the option contract is known as the strike price or the exercise price.

In-the-money option:

An in-the-Money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option:

An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

Out- of–the money option:

An out-of-the-money (OTM) option is an option that would lead to a negative cash flow it was exercised immediately. A call option on the index is out-of-the-the money when the current index stands at a level which is less than the strike price (i.e. spot price < style=""> If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option:

The option premium can be broken down into two components- intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.

Time value of an option:

The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value.

DISTINCTION BETWEEN FUTURES AND OPTIONS

FUTURES

OPTIONS

1. Exchange defines the product

2. Price is zero, strike price moves

3. Price is Zero

4. Linear payoff

5. Both long and short at risk

1. Same as futures

2. Strike price is fixed, price moves

3. Price is always positive

4. Nonlinear payoff

5. Only short at risk