Basic Module for Interview Preps (1)

7/27/2019 Basic Module for Interview Preps (1)

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THE FINANCE ASSOCIATION AT XLRI || 2013-14

Basic Module for

Interview Preps

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SOURCES OF FUNDS:

A firm uses Capital for its functioning and as we know Capital is a scarce resource, therefore it entails a

cost to the firm. Capital can be raised from two sources, Debt and equity. Thus, a firm has two

stakeholders that expect returns from the company, Equity holders or the owners and the Debt holders

or Creditors. Debt holders or Creditors are the ones that provide loan to the company and charge aninterest on the same. The rate of interest is called as the cost of debt. However, since a firm gets a tax

deduction on the interest expense, cost of debt should be adjusted for the tax shield.

STOCK:

A company has two sources of funding - equity or debt. Equity represents the amount of capital invested

in the company by the founders/owners. This equity may be divided into stocks, each representing a

partial ownership in the company. Stocks are issued to raise capital from the stock markets to fund large

scale economic activities, like new projects or expansion. In this case, stocks are issued and people can

buy stocks (shares) to become shareholders. A shareholder ’s liability is limited to the percentage of his

ownership or his share in the company.

TYPES OF STOCK

Common Stock - This is the most general category of stock. They represent ownership and the

associated voting rights in the company proportionate to the number of shares that you have. Any

claim on the assets of the company is only residual in the sense that, in case of liquidation, a

common stock-holder would be the last one to get paid. The higher risk is compensated by higher

returns in terms of dividends and potential appreciation in market price.

Preferred Stock - A preferred stock is of a nature which is in between that of debt and equity. There

might be some ownership rights and limited voting rights. The benefits of owning preferred stock isthat dividends are usually guaranteed unlike a common stock and they have a preference over

common stockholders in case of liquidation.

A convertible preferred stock is generally a preferred stock which is convertible in the sense that

it can be exchanged after some period of time (at the discretion of the stock-holder) into

common stock.

Why go for equity financing, instead of cheaper debt financing?

The biggest disadvantage of debt financing as opposed to equity financing is that it creates

the burden of loan repayment at all times irrespective of whether the company needs more

funding (for startup costs etc.) or not. With equity financing, your investors understand the

risk of the business and understand that payments (dividends) would be cut during periods

when the company makes a loss or when it needs to reinvest funds for growth and

expansion.

With equity financing, companies do not run the risk of having a bad credit rating (which

would make future funding unavailable) if loan repayments are not made on time.

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Also since, shareholders have the right to vote in a meeting, they can keep a check on the

management and offer significant business insights and value-additions like supplier

networks etc. (depending on who your investors are) that the management might not

always have.

Preferred stock as a mechanism to discourage takeovers- as a poison pill…

Companies can have provisions that allow the directors to formulate the terms and conditions

of some preferred shares. In this case, the board would embed a term of a “poison pill” within a

preferred share. The ‘poison pill’ is a warrant or an option that allows holders of the share to get

new shares (as a bonus or for substantial discount) if the management of the company changes

hand. This would discourage an existing shareholder to acquire more shares as he would have to

incur the future liability in the form of potentially significant dilution of his stake. Thus the

acquirer would be discouraged from pursuing a takeover and would have to negotiate with the

incumbent board for diluting the provisions of such shares.

DEBT:

Debt financing is a means for a company (or an individual) to raise finances without diluting the

ownership of the entity. It involves borrowing funds from the creditors to meet monetary requirements

in return for paying interest on those funds followed by return of principal. The level of interest (which

the creditor earns) is proportionate to the risk involved in the application of the money borrowed.

Applications:

Debt financing is considered the chief means of meeting long term capital requirements. This allows the

company to obtain funds without transferring ownership (unlike equity financing). The interest

payments on many debts are also tax deductible which makes them all the more attractive. Similarly,

money market instruments allow a company to meet its liquidity requirements at a low transaction cost

and a low rate of interest. These also are the reasons why debt is a cheaper source of financing than

equity.

What risks does an investor face when issuing debt to a company?

An investor lending money to a company is typically not actively involved in the management of the

firm except in cases of financial distress. Consequently he faces the risk of the company

misappropriating the funds for riskier investments (or other activities unrelated to the contract) as a

result of lack of vigilance. They also face the risk of a company taking additional debt and thus

increasing its debt/equity ratio which affects the company’s financial health. If the latter debt is

taken from banks or other senior debtors, then the individual could be subordinated to the new

lenders and this would affect his/her repayment expectations during liquidation.

What does a high debt-equity ratio indicate?

A high debt-equity ratio indicates that the company has been financing its operations by a relatively

large quantity of debt . The exact number which decides whether the debt proportion is excessive or

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not, varies across sectors. A high ratio would mean that a large part of the company ’s earnings

would go towards servicing the interest on the debt taken. This eats into the portion that remains

for the equity holders. In extreme cases, when the earnings are not sufficient to meet the interest

cost, the company may get bankrupt leaving potentially nothing for the equity investors.

FIXED INCOME INSTRUMENTS:

Definition:

Fixed income instruments, as the name suggests, are financial instruments which give fixed periodic

income and may have an eventual return of the principal on maturity(the expiry date of contract). Thus,

the cash flows till the maturity of the instrument are known in advance and do not change with

changing interest rates, though products classified under this heading do not necessarily reflect this

definition anymore.

Examples of a fixed income security:

Government and Sovereign bonds, asset backed securities, corporate bonds (also preferred stock can be

considered fixed income instrument) and various derivatives like swaps, options etc.

For example consider a municipal bond issued by the Government of India with a notional value of Rs.

100 and which pays an interest of 5% per annum for 5 years, payable annually. Here, the investor would

receive Rs. 5 annually for 4 years and Rs. 105 on maturity, i.e. interest of Rs. 5 and principal payback of

Rs. 100 (at the end of 5 years).

Applications:

Fixed income instruments are meant for investors who wish to have constant and relatively secure cash

flows. This would be useful for investors with less risk appetite, like retired people for whom the stability

of assured cash flows is appealing. It is important to note that the present value of the fixed cash flows

would change with change in interest rates and other macroeconomic factors. So, an investor with asignificant risk appetite and who is looking to take a bet on movement of interest rates or other factors

may still invest in these instruments.

How do changing interest rates affect the value of a fixed income instrument?

The value of a fixed income instrument moves conversely with the interest rates. For example

consider a bond that was bought at par for $100 and which pays a coupon of 6%. Now, if the general

level of interest rates falls (due to deflation or other changes in market conditions), the bond is

offering a higher return at par as compared to market rates. Thus its price would rise and it would

start trading above par. The opposite would happen if the general level of interest rates rises.

COMMODITY MARKETS:

Definition:

A commodity market is a place (physical or electronic) where market participants can trade in raw

materials and primary products. Just like the stock market, there are selected exchanges which allow the

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investors to deal in standardized contracts and regulate the trading and investment in commodities.

Trading in commodities has increased significantly over the recent years.

Examples of Commodity Markets:

The largest commodity exchange in the world is the CME group (NASDAQ: CME) in the United States.

Second in line is the Tokyo Commodity Exchange of Japan. The most prominent commodity exchange inIndia is the Multi Commodity Exchange (MCX) which is the world ’s sixth largest commodity exchange.

MONEY MARKET INSTRUMENTS

Definition:

Money Market Instruments, commonly termed as “paper” are short-term investment vehicles. These,

unlike their long term counterpart viz. bonds and equities, typically have a maturity of less than one

year. A money market is defined as a platform where participants with short term borrowing / lending

needs meet and negotiate.

Examples of a Money Market Instrument: Some examples of “paper” include Treasury Bills (issued by Government), Commercial Paper (issued by

companies), Certificates of Deposit (issued by financial institutions), Repurchase Agreements (repo and

reverse repo facilities by central banks), etc.

Applications:

The key application of money market instruments is to provide short term liquidity. For corporates the

utility of the money market is in terms of working capital management as explained in the example

above. In the case of individuals, short term investing opportunities are met by instrument such as T-

Bills and Certificates of Deposit.

INTEREST RATE INSTRUMENTS

LIBOR

Definition:

The London Interbank Offered Rate or Libor is the rate at which banks offer to lend (unsecured) to other

banks in the London money market. Introduced in 1984, by the British Banker ’s Association, it’s a

standard which is widely used as a benchmark for a variety of financial instruments especially in the US

Dollar.

Published around 11 AM each day, it is the trimmed average (where the bottom and the top quartiles

are dropped) of the inter-bank deposit rates in various currencies offered by various banks for variousmaturities. Given that it’s the average rate of unsecured funding for leading banks, it can be said to

represent the funding rate for creditworthy organizations, though the creditworthiness has come under

doubt in the recent financial crisis.

The minimum and maximum maturity for which Libor rates are quoted is overnight and 12m

respectively.

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Applications:

Widely used as the benchmark for a lot of financial instruments such as mortgages, floating rate notes,

interest rate swaps, Libor provides the basis for most of the Fixed Income markets in the world.

Floating rate notes and Interest rate swaps are sometimes quoted in Libor (for some maturity) + credit

risk premium based on the credit worthiness of the issuer or the swap rate in question.

DERIVATIVES

Definition:

Derivatives, as the name suggests are the financial contracts between two counter-parties that derive

their value from some underlying asset. The underlying can be a stock, interest rate, bond, commodity,

currency or anything under the sun that can be measured. (In strict sense interest rate is not an asset,

but there are some derivative products such as interest rate swaps which derive their value from

interest rate movement.) For example, trading of weather derivatives is quite common in United States.

The value of the derivative is a function of the value of the underlying.

Derivatives basically fall into two categories - Forwards (includes forwards, futures, swaps, etc.) and

Contingency Claims (includes options).

Applications:

Two main applications of derivatives are hedging and speculating. There is no clear demarcation

between hedging and speculating. General understanding is that one who owns the underlying is

hedging his risk whereas the one who enters into a position (long / short) without holding a position in

the underlying is said to be speculating.

FORWARD CONTRACTS

Definition:

A forward is a financial contract between two parties in which one party agrees to buy a fixed amount of

the underlying security from the other on a fixed date at some predetermined price. The buyer is said to

hold a long position whereas the seller is holding the short position. The fixed date at which the transfer

is to take place is called the maturity date and the predetermined price is called the strike price. The

cash transaction takes place only at the maturity of the forward.

A forward is a customizable product and thus traded OTC (Over the Counter). A party willing to exit thecontract can do so by either getting into an opposite contract with same or some other party.

FUTURES

Definition:

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A future is a forward contract with daily settlement of price (A future contract is basically a forward

contract with an exchange with daily settlement of prices). It is a standardized exchange-traded product.

The standardization is in terms of size of the lot (the number of underlying in one contract) and maturity

date. Depending on liquidity, one can enter or exit its position on a future contract. As it is an exchange

traded product with daily settlement of price, there is virtually no risk of default from the counter party.

FORWARD PRICES

Spot prices Vs forward prices:

The spot price of any asset class, a commodity such as Gold, Oil etc., or a fixed income instrument such

as a bond or an equity stock, is defined as the current market price. This essentially translates to the

latest transaction price. This price is determined by the demand and supply of the actual asset in the

market.

Forward price is a price at which the buyer and seller agree to exchange the asset at some specified

future date. This price is determined by the expectation of supply and demand during the period before

expiry.

SWAPS

Definition:

A swap is a financial contract to exchange benefits from a series of underlying financial contracts during

a fixed period over the duration of the swap. Swaps can be of various types such as currency swap,

interest rate swaps, commodity swaps, equity swaps etc.

While entering into a swap the counter-parties may (e.g. in case of currency) or may not (e.g. in case of

interest rate) exchange the underlying asset (the principal amount). After that for each fixed period,they exchange the returns on these assets. At maturity they finally exchange back the initial assets (only

if the underlying was exchanged at the inception of Swap).

OPTIONS

Definition:

An option, as the name suggests is a financial instrument that provides the holder an 'option'. In

contrast to forward, an option contract provides the holder a right but not the obligation to enter into a

trade over the underlying asset.

There are two parties involved in an option contract. The one who has the right is called option holder

and the one who has the obligation is called option writer. Option holder is the one who decides on

whether the trade will take place or not. Because of this asymmetric nature of option, holder (buyer)

needs to pay some premium to the writer (seller).

Types of Options:

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There are two most common types of options:

1. Call option: It is a right to buy the underlying asset at the maturity on a predetermined price

2. Put option: It is a right to sell the underlying asset at the maturity on a predetermined price

Such options are called European options. American options provide the right to exercise on any day on

or before the maturity

CAPITAL BUDGETING

Capital budgeting entails making decisions to invest present funds in long-term projects in order to earn

future returns.

Importance:

Firstly, capital budgeting has immense significance for corporations. Capital projects make up a

considerable portion of the long-term assets on the balance sheet of companies. The outlays on

these projects can be so big that the future of corporations may be decided by capital budgeting

decisions. Reversal of capital decisions cannot be done at a low cost, hence mistakes in the selection

of capital projects can be very costly.

Secondly, many other corporate decisions also have scope for the application of capital budgeting

principles, as adopted for the specific case. Examples of such areas of application are investments in

working capital, mergers and acquisitions, leasing and bond refunding.

Thirdly, the valuation principles in capital budgeting are quite similar to those used in portfolio

management and security analysis. Thus, the diverse use of capital budgeting methods extends to

these areas also.

Fourthly, the focus of capital budgeting is on ultimately maximizing shareholder value. Thus, correct

capital budgeting decisions have payoffs for a number of stakeholders in the company.

Basic principles of capital budgeting

Cash flows are the basis for decisions. Accounting concepts, such as net income, are not the basis

for decisions.

Timing of cash flows is crucial.

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Cash flows are based on opportunity costs. Here we consider what the incremental cash flows are

due to the investment, as compared to the cash flows without the investment.

Cash flows are adjusted for tax payments, i.e. after-tax cash flows are taken.

Financing costs are not accounted for. Even though financing for a project may be done by raising

debt and equity capital, these costs are ignored. Instead, the operating cash flows are focused on

and the costs of debt (and other capital) are reflected in the discount rate.

Cash flows are recorded only when they actually occur and not when work is undertaken or a

liability is incurred.

Few basic concepts relevant for Capital Budgeting:

Sunk Cost- A sunk cost is one that has already been incurred. It is a past and irreversible outflow.

Because sunk costs are bygones and cannot be changed, they cannot be affected by the decision to

accept or reject the project, and so they should be ignored.

Opportunity Cost- An opportunity cost is the worth of the next-best alternative that has beenforgone in order to pursue the current course of action. In capital budgeting, the opportunity cost of

capital or the discount rate is the expected rate of return that is foregone by investing in the project

chosen rather than investing in the next-best alternative.

Incremental Cash flows- An incremental cash flow is a cash flow that is the result of a specific

decision made: the cash flow with a decision minus the cash flow without that decision. If

opportunity costs are correctly assessed, the incremental cash flows provide a sound basis for

capital budgeting.” (Corporate Finance and Portfolio Management) Most managers naturally

hesitate to throw good money after bad. For instance, they are reluctant to invest more money in a

losing division. But occasionally turnaround opportunities can be encountered in which theincremental NPV on investment in a losing division is strongly positive

PROJECT VALUATION METHODS

PAYBACK METHOD:

The payback period is the number of years required to recover the initial investment in a project.

This period is sometimes referred to as" the time that it takes for an investment to pay for itself."

The basic premise of the payback method is that the more quickly the cost of an investment can berecovered, the more desirable is the investment.

Drawbacks of the payback period are apparent.

o Since the cash flows are not discounted at the project’s required rate of return, the payback

period ignores the time value of money and the risk of the project.

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o The payback period ignores cash flows after the payback period is reached. Thus this

method provides a good measure of payback and not of profitability.

But its simplicity and easy calculation make it useful as an indicator of project liquidity. Thus a

project with a two-year payback may be more liquid than a project with a longer payback.

The discounted payback period partially addresses the shortcomings in the payback period method.

It takes the cumulative discounted cash flows from the project into consideration while calculating

the number of years it takes to recover the original investment. Thus, it takes the time value of

money and risk of the project into account, but this method also ignores the cash flows that occur

after the discounted payback period is reached. For a project with negative NPV, there will not be

any discounted payback period since it never recovers its original investment. The discounted

payback period must be greater than the payback period without discounting.

NET PRESENT VALUE METHOD:

For a project with a single initial investment outlay, the net present value (NPV) is the present value

of the future after-tax cash flows discounted at the relevant discount rate minus the investment

outlay.

Interpretation:

Positive NPV investments increase investor wealth whereas negative NPV investments decrease it.

Many investments have cash outflows that occur not only at time zero, but also at future dates. In

this case, all cash outflows are taken as negative and discounted at the required rate of return just

as in the case of positive cash inflows at different points of time.

INTERNAL RATE OF RETURN

For a project with one initial investment outlay, the IRR is the discount rate that makes the present

value of the expected incremental after-tax cash inflows equal to the investment outlay. In other

words, it is that discount rate that will cause the net present value of a project to be equal to zero

Interpretation:

The decision rule for the IRR is to invest if the IRR exceeds the required rate of return (r) for a

project:

COMPARISON- NPV vs IRR

Invest if: IRR > r

Do not invest if: IRR < r

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NPV is a theoretically sound method that provides a direct measure of the expected increase in firm

value. Its main drawback is that it does not take the size of the project into consideration.

IRR provides information about “how much below the IRR (estimated return) the actual project

return could fall, in percentage terms, before the project becomes uneconomic (has a negative

NPV)” (Corporate Finance, Portfolio Management, and Equity Investments). Thus, the IRR reflects

the margin of safety that the NPV does not.

Project Ranking conflicts- In the case of two mutually exclusive projects, the decision rules for NPV

and IRR, as applied, might give conflicting decisions. For instance, for two mutually exclusive

projects A and B, project A might have a larger NPV than Project B whereas Project B has a higher

IRR than Project A. Differing patterns of future cash flows and dissimilar project sizes are some of

the causes of this situation. The thumb rule here is to always choose the project based on NPV.

Multiple IRR Problem- For projects with cash outflows not only at time zero, but also at other points

during its life or at the end of its life (projects with unconventional cash flows), there may be more

than one IRR

When can IRR and NPV give different results?

A few cases where NPV and IRR may give conflicting results are:

o Size disparity problem: when the projects being compared have different sizes, as in

investments. Two projects may have the same IRR but one project may be 10 times the size of

the other, in which case in absolute terms, the bigger project adds value.

o Time disparity problem: when the lives of the two projects are different.

In such cases, the NPV is a better measure as it is seen as a better way of judging the maximization

of shareholders’ value.

PROFITABILITY INDEX

The profitability index (PI) is the present value of a project’s future cash flows divided by the initial

cash outlay. It can be expressed as

PI = PV of future cash flows/ Initial investment = 1 + ( NPV/ Initial investment)

The investment decision for PI is as follows:

Invest if PI > 1

Do not invest if PI < 1

AVERAGE ACCOUNTING RATE OF RETURN

The average accounting rate of return (AAR) can be defined through the following formula:

AAR = Average net income/ Average book value

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FINANCE TERMS:

1) LONG POSITION

The buying of a security such as a stock, commodity or currency, with the expectation that the asset

will rise in value, is taking a long position on the asset.

In the context of options, the buying of an options contract is taking a long.

2) SHORT POSITION

The sale of a borrowed security, commodity or currency with the expectation that the asset will fall

in value, is taking a short position on the asset.

In the context of options, it is the sale (also known as "writing") of an options contract.

3) FREE CASH FLOWS

Free cash Flow is the surplus cash available to the firm after making all its expenditures including

investments both in assets as well as working capital.

Free Cash Flow = EBIT*(1-t) + Depreciation/Amortization – Changes in Working Capital – Investment

in fixed assets

This cash flow is also called the Free cash flow to the Firm and is available to all the security holders

of the organization including equity and debt holders alike.

Since debt holders also have a claim on the cash flow described above, we can further find out cash

flow available to equity holders called Free Cash Flow to Equity (FCFE). FCFE additionally takes into

consideration repayment of debt as well as new debt capital raised by the firm. It is given by:

FCFE = FCFF + New debt – Debt Repayment – Preferred Dividends- Interest*(1-t)

4) ECONOMIC VALUE ADDED

EVA = income earned – cost of capital * capital employed

A measure of the kind of returns the shareholders are getting.

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The advantage of using EVA is that it does not just look at the earnings of the firm but also takes into

consideration the returns on capital required or the cost of the capital. If a firm/division has a

positive income but negative EVA, it means that the profits earned are not enough to cover the cost

of capital and thus the capital can be better employed elsewhere.

5) WEIGHTED AVERAGE COST OF CAPITAL

WACC= D* rd (1-T) /(D+E)+E*re/(D+E)

Where, D is the market value of the Debt, E is the market value of the Equity, T is the Tax rate and rd

and re are the cost of debt and equity respectively.

6) ENTERPRISE VALUE

EV is a measure of a company's value, often used as an alternative to straightforward

market capitalization. Enterprise value is calculated as market cap plus debt, minority

interest and preferred shares, minus total cash and cash equivalents.

Think of enterprise value as the theoretical takeover price. In the event of a buyout, an

acquirer would have to take on the company's debt, but would pocket its cash. EV differs

significantly from simple market capitalization in several ways, and many consider it to be a

more accurate representation of a firm's value. The value of a firm's debt, for example,

would need to be paid by the buyer when taking over a company, thus EV provides a much

more accurate takeover valuation because it includes debt in its value calculation.

7) ALTMAN’S Z-SCORE

A predictive model created by Edward Altman in the 1960s. This model combines five different

financial ratios to determine the likelihood of bankruptcy amongst companies.

Generally speaking, the lower the score, the higher are the odds of bankruptcy. Companies with Z-

Scores above 3 are considered to be healthy and, therefore, unlikely to enter bankruptcy. Scores in

between 1.8 and 3 lie in a grey area.

This is a relatively accurate model -- real world application of the Z-Score successfully predicted 72%

of corporate bankruptcies two years prior to these companies filing for Chapter 7.

8) WORKING CAPITAL

The total capital employed of a firm is basically invested in (1) Fixed/Long term assets and (2)

Working capital. Fixed/Long term assets are the assets on the balance sheet with future benefits of

more than one year such as plant & machinery, building, land, etc. which are required to run the

company.

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Working capital is the amount of money that a company has tied up in funding its day-to-day

operations. A company has to tie up money to fund its stocks, credit sales and other current assets,

but this is offset by its ability to fund this from current liabilities such as purchases on credit.

Working Capital= Current Assets – Current Liabilities

Working capital is an indicator of the liquidity of the company. It is basically the ability of the

company to meet up with the short-term (typically less than one year) obligations. However, quality

of current assets should also be taken into account while checking the liquidity. Uncertain

receivables and high inventory can often limit the capacity of working capital to judge liquidity.

Also, too high an amount of working capital is a sign of inefficiency in the company. Working capital

can be managed by managing the current assets such as inventories, receivables and cash and

current liabilities such as accounts payable. Also the working capital requirement depends on the

industry and modus operandi of the company as explained in the example below

A company can have negative working capital- which can be reflective of the bargaining power that

the company has with its suppliers.

ECONOMICS GLOSSARY

1) Demand:

Demand for a commodity of the individual household can be defined as the quantity of the

commodity that it is willing to buy in the market in a given period of time at a given price.

2) Law of Demand:

The quantity demanded of a commodity varies inversely with its price, other determinants of

demand, namely money income of the individual household, taste and preferences of the

individual household and prices of other commodities, remaining unchanged.

3) Supply:

Supply by an individual seller (or firm) is the quantity of a commodity that he is willing to sell in

the market in a given period of time at a given price.

4) Law of Supply:

The quantity of a commodity supplied varies directly with its price, other determinants of supply

namely, goals of the firm, prices of other commodities, prices of factors of production used in

making the commodity and state of technology, remaining unchanged.

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5) Accounting Year or Fiscal Year or Financial Year:

Fiscal year generally has a beginning on 1st April. Unlike a calendar year which starts from

January and ends in December of each year, a fiscal year starts from April and ends in March.

Example: CY 2012 implies Calendar Year 2012 which runs from 1st January 2012 - 31st December

2012. FY 2011-12 or FY 2012 implies Fiscal Year 2012 which runs from 1st

April 2011 - 31st

March2012. Generally, companies and governments in India follow the fiscal year for accounting while

the companies and governments abroad follow the Calendar Year.

6) Gross Domestic Product (GDP):

Monetary value of all the final goods and services produced within the domestic territory of a

country in an accounting year.

GDP was first developed by Simon Kuznets for a US Congress report in 1934. After the Bretton

Woods conference in 1944, GDP became the main tool for measuring the country's economy.

GDP can be determined in 3 ways : Product or Output Approach, Income Approach, Expenditure

Approach. An illustration to explain the three methods is given below.

7) Per Capita GDP:

GDP divided by the total population of the country. GDP per Capita is often considered as a

measure of the standard of living. It is not a measure of personal Income.

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8) Nominal GDP:

GDP measured at prices of the current period. Example: GDP for FY 2013 calculated at prices

prevailing in FY 2013 is the nominal GDP.

9) Real GDP:

GDP measured at prices of a base period. Example: GDP for FY 2013 calculated at prices

prevailing in FY 2005 is the real GDP. The base year used by India for calculation of GDP is FY

2004-05 currently.

The main difference between nominal and real GDP is that the latter is adjusted for inflation,

while the former is not. As a result, nominal GDP will often appear higher than real GDP. But, it

can be misleading when inflation is not accounted for in the GDP figure because the GDP will

appear higher than it actually is.

10) Inflation:

Rise in the general level of prices for goods and services over a sustained period of time.

Inflation causes a fall in the purchasing power. Example: if the rate of inflation for bread is 2%,

then it means that bread which used to cost Rs. 10, will now be available only at Rs. 10.20.

11) Measures of Inflation - Wholesale Price Index (WPI):

WPI is an index that measures and tracks the changes in price of goods in the stages before the

retail level over a period of time. WPIs report monthly to show the average price changes of

goods sold in bulk, and they are a group of the indicators that follow growth in the economy.

Although some countries still use the WPIs as a measure of inflation, many countries, including

the United States, use the producer price index (PPI) instead. India uses WPI as a measure of

inflation.

12) Measures of Inflation - Consumer Price Index (CPI):

CPI measures the change in price levels of goods and services bought by households i.e. it

measures the retail change in prices for households over a period of time. It is used by central

banks for inflation targeting and for monitoring price stability. India has introduced a national

CPI from January 2011 which is eventually expected to replace WPI over time.

13) Money:

Anything which is acceptable in an economy as a measure of value, a medium of exchange, a

standard for deferred payments and as a store of value

14) Demand for Money:

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The demand for money arises for transactions purpose, speculative purpose and precautionary

purpose.

15) Supply of Money:

It is the stock of money which is in circulation in an economy at any point of time.

16) M0 or Reserve Money:

It represents the currency in circulation + Bankers’ deposits with the RBI + Other deposits with

the RBI

17) M1or Narrow Money:

Currency with public + Demand Deposits with banks + Other deposits with RBI

18) M2:

M1 + Post Office Savings Bank Deposits

19) M3 or Broad Money:

It is a measure of the stock of money in the nation with reference to which monetary targets are

set by the Reserve Bank of India. It is M1 + Time Deposits with banking system.

20) M4:

M3 + post office savings bank deposits

An illustration for the different measures of money supply is given below:

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21) Index of Industrial Production (IIP):

It is a short term indicator measuring industrial growth till the actual result of detailed industrial

surveys become available. It is an abstract number, the magnitude of which represents the

status of production in the industrial sector fir a given period of time as compared to a reference

period of time. It is a statistical device which enables us to arrive at a single representative

figure to measure the general level of industrial activity in the economy.

22) HSBC Purchasing Manager Index (HSBC PMI):

Compiled by HSBC and Markit (global financial information services company), it is an indicator

of financial activity reflecting purchasing manager’s acquisition of goods and services. It is

provided on a monthly basis representing different sectors and covers only private sector. A no.

of 50 on the index signifies no change, where as anything above 50 shows an improvement and

vice versa. This data is compiled for 12 principal emerging markets and includes India and China

among other countries.

23) Exports:

Sale of goods and services that leads to inflow of foreign currencies is called exports.

24) Imports:

Purchase of goods and services from foreign countries leading to outflow of domestic currency.

25) Net Exports:

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It is the amount by which foreign spending on a home country's goods and services exceeds the

home country's spending on foreign goods and services. For example, if India exports $200

worth of goods and imports $150 worth of goods in a given year, then, net exports would be

positive $50 billion. Factors affecting net exports include prosperity abroad, tariffs and exchange

rates.

26) Balance of Trade:

The difference between a country's imports and its exports of physical goods is the BoT. It does

not include export and import of services, also referred to as invisibles. Balance of trade is

the largest component of a country's balance of payments. Debit items include imports, foreign

aid, domestic spending abroad and domestic investments abroad. Credit items include exports,

foreign spending in the domestic economy and foreign investments in the domestic economy. A

country has a trade deficit if it imports more than it exports and a trade surplus if it exports

more than it imports.

27) Current Account Balance:

The net balance arising from Merchandise and Invisibles which includes transfers and income

from investment as well.

Current Account Balance = Net Merchandise Balance + Net Balance from Invisibles

Net Merchandise Balance = Exports of Goods – Imports of Goods

Net Balance from Invisibles = Net Exports of Invisibles (Software Services, Financial Services etc.)

+ Transfers + Income (Investment Income, Compensation of employees etc.)

28) Current Account Deficit:

It occurs when a country's total imports of goods, services and transfers is greater than the

country's total export of goods, services and transfers.

29) Capital Account:

Capital Account is a national account that shows the net change in asset ownership for a nation.

The capital account is the net result of public and private international investments flowing in

and out of a country. The capital account includes foreign direct investment (FDI), portfolio and

other investments, plus changes in the reserve account. The capital account and the currentaccount together constitute a nation's balance of payments.

30) Foreign Direct Investment (FDI):

FDI is an investment made by a company or entity based in one country, into a company or

entity based in another country. These investments tend to be more long term in nature since

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repatriating this money into the country of origin is a cumbersome task. Government and RBI try

to create a conducive environment to attract FDI in the country. Posco spending money to set

up a steel plant in India is an example of FDI. Uninor entering into the Indian telecom market by

way of a partnership with Unitech is another example.

31) Foreign Institutional Investment (FII):

FIIs are investments made in the financial markets depending on the opportunity available. Also

termed as hot money, this money can come in very quickly and can also be taken out very

quickly. Large FII inflows and outflows have a big role to play in the volatility in the stock

markets.

32) Foreign Exchange Reserves:

It comprises of Foreign Currency Assets, Gold, Special Drawing Rights (SDRs) and Reserve

Position in the IMF.

33) Special Drawing Rights (SDR):

It is an international reserve asset, created by the International Monetary Fund (IMF) in 1969 to

supplement its member countries’ official reserves. It is neither a currency, not a claim on the

IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Its value is

based on a basket of 4 key international currencies (Euro, Japanese Yen, British Pound and

United States Dollar) and SDRs can be exchanged for freely usable currencies.

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34) Bank Rate:

It is the rate at which the Reserve Bank of India (RBI) is ready to buy or rediscount bills of

exchange or other commercial papers. Since discounting/rediscounting by the RBI has remained

in disuse, the Bank Rate has not been active. The Bank Rate acts as the penal rate charged on

banks for shortfalls in meeting their reserve requirements (cash reserve ratio and statutoryliquidity ratio). The Bank Rate is also used by several other organizations as a reference rate for

indexation purposes. RBI has decided to align Bank Rate to the Marginal Standing Facility (MSF)

rate, which in turn is linked to the policy repo rate under the Liquidity Adjustment Facility (LAF).

35) Cash Reserve Ratio (CRR):

CRR is the share of net demand (savings and current account deposits) and time liabilities (fixed

deposits) that banks must maintain as cash balance with the RBI. The RBI requires banks to

maintain a certain amount of cash in reserve as a percentage of their deposits to ensure that

banks have sufficient cash to cover customer withdrawals. RBI adjusts this ratio on occasion, as

an instrument of monetary policy, depending on prevailing conditions.

Example: Say a bank’s net demand and time liabilities increase by Rs 100, and if the CRR is 6%,

the banks will have to hold additional Rs 6 with RBI and the bank will be able to use only Rs 94

for investments and lending / credit purpose. Therefore, higher the CRR, the lower is the

amount that banks will be able to use for lending and investment. This power of RBI to reduce

the lendable amount by increasing the CRR makes it an instrument in the hands of a central

bank through which it can control the amount that banks lend. Thus, it is a tool used by RBI to

control liquidity in the banking system.

36) Statutory Liquidity Ratio (SLR):

SLR is the share of net demand and time liabilities that banks must maintain in safe and liquid

assets, such as, government securities, cash and gold. This is to ensure that banks don’t end up

investing all the common people’s money in risky assets.

37) Repo Rate or Liquidity Adjustment Facility (LAF):

It implies repossess or repurchase obligation. It is the rate which RBI charges the banks when

they borrow from it. It is collateralised borrowing i.e. banks have to offer a collateral, namely

Government securities, to RBI in order to borrow from it. From 3rd May, 2011, RBI, based on

recommendations submitted by a group chaired by Mr. Deepak Mohanty, has made repo rate asthe single independently varying rate. All rates are pegged to repo rate. This is expected to more

accurately signal the monetary policy stance.

When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can

say that in case RBI wants to make it more expensive for the banks to borrow money, it

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increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it

reduces the repo rate.

38) Reverse Repo Rate:

It is the rate that RBI offers the banks for parking their funds with it. It is also collateralised

borrowing i.e. RBI offers collateral, namely Government securities, to the banks for parking their

surpluses with RBI.

The banks use this tool when they feel that they are stuck with excess funds and are not able to

invest anywhere for reasonable returns. An increase in the reverse repo rate means that the RBI

is ready to borrow money from the banks at a higher rate of interest. As a result, banks would

prefer to keep more and more surplus funds with RBI.

39) Marginal Standing Facility (MSF):

Under this facility, banks can avail overnight, up to one per cent of their respective net demand

and time liabilities outstanding at the end of the second preceding fortnight. The rate of interest

charged on amount availed under this facility is 1% or 100 basis points above the LAF repo rate,

or as decided by RBI from time to time. This is also collateralized borrowing i.e. banks have to

offer Government Securities to RBI for borrowing the money. Banks can borrow funds through

MSF when there is a considerable shortfall of liquidity. This measure has been introduced by RBI

to regulate short-term asset liability mismatches more effectively.

40) Difference between LAF-repo rate and MSF:

Banks can borrow from the Reserve Bank of India under LAF-repo rate, by pledging government

securities over and above the SLR requirement. However, because of borrowing under MSF, incase a bank’s SLR falls below the mandatory level prescribed by the RBI, the bank is exempted

from seeking a waiver from RBI for default in SLR compliance

41) Annual Financial Statement:

The ordinary man confuses the finance minister's budget speech for the annual budget. But as

laid down in the constitution, the budget actually refers to the annual financial statement tabled

in Parliament along with the 13-15 other documents. Divided into three parts - Consolidated

Fund, Contingency Fund and Public Account - it has a statement of receipts and expenditure of

each.

42) Consolidated Fund:

This is the core of the government’s finances. All revenues, money borrowed and receipts from

loans it has given flow into this account. All government expenditure is made from this fund.

Any expenditure from this fund requires the nod of Parliament.

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43) Contingency Fund:

All urgent or unforeseen expenditure is met from this Rs. 500-crore fund, which is at the

disposal of the President. Any amount withdrawn from this fund is made good from the

Consolidated Fund.

44) Public Account:

All money in this fund belongs to others, such as public provident fund. The government merely

works as a banker in respect of this fund.

45) Revenue Receipts:

All receipts like taxes that do not entail sale of assets. It includes Tax Revenues and Non Tax

Revenues

Revenue Receipts = Tax Revenues + Non Tax Revenues

Tax Revenues = Direct Taxes (Personal Income Tax, Corporation Tax) + Indirect Taxes (Excise

Duties, Custom Duties, Service Tax etc.)

Non Tax Revenues: Interest Receipts + Dividend and Profits + External Grants

46) Revenue Expenditure:

All expenditure that does not entail creation of assets constitutes Revenue Expenditure.

Revenue Expenditure = Defence Expenditure + Subsidies + Interest Payments + Grants to States

& Union Territories

47) Revenue Deficit:

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Excess of Revenue Expenditure over Revenue Receipts

48) Capital Receipts:

All receipts which arise from liquidating assets.

Capital Receipts = Market Borrowings + Small Savings + Provident Funds + Special Deposits +

Recovery of Loans + Disinvestment Receipts + External Loans

49) Capital Expenditure:

All spending done to create assets

Capital Expenditure = Loans and Advances (to Public Sector Enterprises, States and Union

Territories, foreign government) + Defence expenditure + other capital outlay

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50) Revenue Vs Capital:

The budget has to distinguish all receipts/expenditure on revenue account from other

expenditure. So all receipts in, say, the consolidated fund, are split into Revenue Budget

(revenue account) and Capital Budget (capital account), which include non-revenue receipts and

expenditure.

51) Revenue / Capital Budget:

The government has to prepare a Revenue Budget (detailing revenue receipts and revenue

expenditure) and a Capital Budget (capital receipts & capital expenditure).

52) Total Receipts:

Revenue Receipts + Capital Receipts

53) Total Expenditure:

Revenue Expenditure + Capital Expenditure

54) Gross Fiscal Deficit (GFD) or Fiscal Deficit: The total borrowing by the Government of India by

various means to finance total expenditure.

Fiscal Deficit = Total Expenditure - (Revenue Receipts + Capital Receipts - Borrowings)

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55) Primary Deficit: Gross Fiscal Deficit - interest payments

56) Ways and Means Advances (WMAs):

WMAs represent the borrowing by the Government from the RBI to tide over temporary

mismatch in cash flow. Over-reliance on WMAs means revenues are lagging behind expenses.

That’s why the government has to knock on the RBI’s doors.

57) Currency Appreciation:

Less of domestic currency needs to be paid out for each unit of a foreign currency. Example:

Rupee moving from Rs. 50 per $ to Rs. 45 per $.

Implication: Imports become cheaper and exports become expensive.

58) Currency Depreciation:

More of domestic currency needs to be paid out for each unit of a foreign currency. Example:

Rupee moving from Rs. 45 per $ to Rs. 50 per $.

Implication: Imports become expensive and exports become cheaper.

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Documents

Basic Module for Interview Preps (1)