{A help guide to the theories}

short explanation of the important topics in

BBS 4th year
prepared
By
sijan raj joshi
References (Books):
Paudel, Rajan, B., Baral, Keshar, J., Joshi, Padam, R., Gautam, Rishi, R.,
Rana, Surya, B.(2016). Fundamentals of Corporate Finance. Kathmandu:
Asmita Publications.

Paudel, Rajan, B., Baral, Keshar, J., Joshi, Padam, R., Gautam, Rishi, R.,
Rana, Surya, B.(2016). Fundamentals of Financial Markets and
Institutions. Kathmandu: Asmita Publications.

Paudel, Rajan, B., Kehar J. Baral, Rishi Raj Gautam, Gyan B. Dahal. Surya
B. R.(2008). Fundamental of Financial Management. Kathmandu: Asmita
Publications.
 Elements of investment

Converting saving into Expectation of Greater Future outcome

investment. return

Real assets:
Financial assets:
Property, plant
&machinery, Stocks , shares , bonds,
equipments treasury securities
Investment refers to the commitment
of current resources in the
expectation of deriving greater
resources in the future.
• Return is the reward for investing.
• Increase in the value of assets or capital gain .
• Sacrifice of certain present value for the (possibly
uncertain) future value
• For example:
• When we buy bonds, stocks ,a piece of land (Real
estate) we pay now in an expectation of higher
return in the future.
 Key terms to remember while
investing.
• Saving : excess of income over expenditure.
• Real assets : assets used to produce goods and services.
• For example:
• Property ,plant & machinery , human capital
• Financial assets: represents claims on income &others assets . Defines the
allocation of wealth or income.
• For example:
• Stocks , bonds ,treasury security.
• speculation=an activity in an expectation of wind fall gain in a very short
period of time with excessive risk.
• Gambling =A game to satisfy personal desires . it is a game of chance of
money.
• Ordinary income = income received in ordinary course of business.
• Capital gain = The amount by which the proceeds from the sale of a capital
asset exceed its original purchase price.
 Types of investments
• Securities or properties
• Direct or indirect investment
• Debt , equity or derivatives securities
• Low or high risk investment
• Short-term or long-term investment
• Domestic or foreign investment
 Types of investors

Individual investors: solo

Manage their own funds to achieve personal investment goal.

Institutional investors: groups

Manages other peoples money.
For Example : mutual funds ,pension funds , provident funds , life
insurance companies , banks .
 Investment process
Financial institutions
• Banks
• Savings and loan associations
• Credit unions
• Insurance companies
• Pension funds

Surplus Deficit units

Direct
units
transactions

Financial Markets
•Money (short-term) market
•Capital (long-term) market
Investment vehicles refers to investment alternatives
in which investors can invest their funds.
 Some important terms
• Fixed-income securities= The securities that provide
fixed return to investors.
• Closed-end funds=sell shares to raise fixed amount of
money
• Open-end funds=issue shares and stand ready to buy
back shares from the investors.
• Derivatives securities=Derive their value from an under
lying security or assest.
• Investment goals= refers to financial objectives we
wish to achieve by investing
• portfolio = refers to an investment in a set of securities.
 Short-term vehicles examples
• Treasury bills : obligations issued by the
government
• Negotiable certificates of deposit : issued by
commercial banks
• Commercials papers : promissory notes issued
by larger , well known companies
• Bankers acceptance: draft written by the
buyer to the seller and accepted by a bank.
 Investing Environment
refers to the surroundings in which
investment decisions are made.
• Now account: bank checking account that pays interest
on balances.
• MMDA account: Bank deposit account with limited
check writing privileges.
• MMMF: professionally managed portfolios of
marketable securities that provide instant liquidity.
• Ethics : moral principles that control or influence a
persons behaviors.
• Ethical investment : The integration of personal values
,social considerations and economic factors into the
investment decisions.
 markets and transactions
• Security : The legal representation of the right
that allows holders to receive prospective
future benefits under stated terms and
conditions
• Securities markets :
Market where transactions of securities take
place.
Note : we mainly focus on securities markets in
investment.
 Types of securities markets
(on the basis of short-long term)

Money
• Market which deals with the trading of
short-term securities.
• Such as treasury bills, commercial papers ,
bankers acceptance etc.
market • Highly liquid and large in trade.

Capital
• Market which deals with the trading of
long-term securities.
• Such as common stocks, preferred stock,
corporate bonds , government bonds etc.
market • Less liquid and limited in trade.
 Classification of capital market

• Markets in which corporations

Primary raise new capital by selling
securities to investors.
market • IPOS

• Markets which deals with

Secondary trading of outstanding securities
between investors to investors.
market • FPOS
 Type 3

Broker • The organized markets buy and

sell orders of investors are
executed through the licensed

market brokers.

Dealer • A security market mechanism

where in multiple dealers post
prices at which they are agreed to

market buy or sell a specific security.

Organized • A physical location where
securities are traded under some
stock established rules and regulations
through the license brokers.
exchanges

Over the • The informal type of secondary

market where no listing of
counter securities is required.

market
 Alternative trading system
which takes place outside the broker
and dealer market.
• The OTC market transactions of
The third exchange listed securities.

market

• The market that executes transactions

The fourth directly through electronic
communication networks between
institutional buyers and sellers.
market
 General market conditions

Bull • A market condition that shows

securities prices are arising and
investors are building up

market confidence in the market .

Bear • A market condition that shows

securities prices are falling and
investors are pessimistic about

market the market.

 Types of securities transactions
Long purchase Short selling

Buying securities today in the expectation Selling the securities today by borrowing
to sell them when the price will rise in the and buying back to refund in future when
future. price will decline.

Buy low and sell high strategy. Sell high and buy low strategy.
ROR=(P1-P0)+C1/P0 ROR=(PO-P1)-C1/P0
 Nepal stock exchange(NEPSE)
The organized securities market in nepal that provide
floor for trading of securities through licensed brokers
• Functions of NEPSE
• It provides facility of listing by corporations. this helps to bring
the securities in secondary markets transactions.
• Facilitates the execution of buy and sell orders of investors
through securities brokers.
• Supervises and monitors the actions of its members, licensed
brokers and listed corporations.
• Facilitates the settlement of transactions timely that takes
place between buyers and sellers through securities brokers.
• Also operates over the counter market for those securities
which are not listed or which have been delisted from the
NEPSE.
 Investment banker
financial institution in security offering process.
Who underwrites new securities for resale .
• Functions of investment bankers
• Underwriting : a specific amount from the
issue of security
• Distributing: marketing new issue of
securities.
• Advising : expert in marketing of new
securities (advice and counsel)
• Making a market : to keep it reasonably liquid.
 Investment banking process
Stage 1 decision- raising capital
A)Amount to be raised
B)Types of securities issued
C)Competitive bid vs negotiated deal
D)Selection of investment banker

Stage 2 decision-raising capital

A)Reevaluating the initial decision
B)Best effort or underwriter issues
C)Issuance cost
D)Setting the offering price
E)Selling procedures
F)Self registration
G)Maintanance of secondary market
 Merger and acquisition
Merger is combination of two or more than two
corporations maintaining the identity of one of
the corporations.

Acquisition is the process of acquiring the assets

in the course of the merger.
 Rationale for merger
• Synergy value: 2+2=5 combined effect
• Economies of scale : reduce cost and more production
• Strategic motive: 2
• Positioning: taking advantage of future opportunities that can be exploited.
• Gap filling: combining two firms to fill up the strategic gap.
• Organizational competencies : core strength of merging corporation
• Accessing towards broader market.
• Business motives:
• Bargain purchase : cheaper to acquire another firm than to invest
internally.
• Diversification :smooth out earning and more consistent long-term growth
and profit.
• Short-term growth : slow growth and profitability
• Undervalued target : represents a good investment.
 Types of merger and acquisition

Horizontal merger Vertical merger Conglomerate merger

• Merging of two firms • The merger in which one • Merging of two firms in
that produces and sells firm acquires either a completely different
customer or industries.(engaged in
an identical or similar supplier(different stages of different line of business)
product. production and • Provides opportunities for
• To obtain economies of distribution.) firms to reduce the cost of
scale in production and • Increase profitability capital and overheads
operation by • Forward integration with • Achieve efficiencies
eliminating duplication customer
of facilities • Backward integration with
• Reduce competition supplier
 Hostile versus friendly take over
• Acquiring firm: firm which take over the other firm.
• Target firm : the firm being acquired.
• Friendly takeover : merger carried out with the agreement of the
management group of target firm.
• Hostile takeover : acquiring the target firm without the approval of
its management .

• Merger analysis is the process that involves valuing the target firm
setting the bid price and setting the post merger issues.

• Corporate alliance refers to the corporative deals among or

between the companies in which they agree to operate as single
company but retain the separate ownership.
• To share information , resources. Capabilities and innovation and
technology.
15 marks theory
for BBS 4th year
finance group
 Insurance and types of insurance
companies
• Insurance is a contract between an insured and the insurer to
cover loss of life or damage of property.
• Insurer in the insurance company providing insurance policy.
• Insured in the customer of the insurance policy.
• A company that sells insurance policies which ensure to
compensate against loss from occurrence of specified events in
return of insurance premium.
• The money paid for the insurance policy is insurance premium.
• Income sources is insurance premium and investment return
• Expenses is the payments on insurance policies and operating
expense of insurance company.
• Profit of insurance companies depends on the income and
expenses.
 Types of insurance
• Life insurance
• A contract between an insured person and
insurer in which the insurer agrees to pay a
designated beneficiary a sum of money in
return of the premium ,upon the death of the
insured person
• Protection against the possibility of untimely
death ,illness and retirement.
 Health insurance
• An insurance contract that covers medical
treatment expenses against any disease.
• Medical treatment expenses
• Hospitalization cost against any disease during
the insured period.
• Offered with the package of life insurance
policy.
 Property and casualty insurance
• An insurance contract that covers personal
and commercial injury and liability such as
accidents , theft and fire.
• Fire insurance
• Homeowners multiple peril insurance
• Commercial multiple peril insurance
• Automobile liability and physical damage
insurance
 Liability insurance
• An insurance contract that covers risk of loss against
legal liability exposure.
• Employee liabilities related to working conditions
• Liability related to any employee at work.
• Non industrial risk related to commercial enterprise.
• Professional liabilities that arises from the practice of a
particular profession.
• Product liabilities that arises from the sale of products
to customers and resulting damage to any customer
due to fault in the product.
 Disability insurance
• An insurance contract that covers risk resulted from
disability to work.
• It can be short-term or long-term.
• Short term provides cash to help ease the financial
stress of a covered illness or injury if the person is
unable to work for short period , usually up to six
month.
• Long term is generally offered by employers to their
employees . It provides income to an employees
family when the employee cannot work because of
an injury or sever long term illness
 Long term care insurance
• An insurance contract that provides the
custodial care to individuals.
• It covers home care, assisted living , adult
daycare , nursing care, and so forth.
• Focus on individual who are unable to care
themselves.
 Structured settlements
• An insurance agreement that makes a series
of payments to injured victims to meet future
medical expenses and basic living needs.
• A stream of tax-free payments necessary to
meet future medical expenses and basic living
needs.
 Guaranteed investment contract
• An insurance contract that guarantees the
principal repayments plus interest earned at a
predetermined annual rate all paid at the
maturity.
• It is similar to investing in zero coupon bond .
• It generally yields higher return than saving
accounts and treasury securities.
 Annuity contract
• A contract between an investor and an
insurance company in which the insurance
company promises to make a series of
payment to the investors over a period in
return of a lump sum payment to the
insurance company.
• Transforming investors wealth into series of
income.
 Derivatives securities
• Financial instruments
• Determining the value of an asset depending
up on the market price of the underlying
assets.
• The assets derived from assets in general , the
value of such asset depends on the market
value of the underlying assets.
 option
An option is a contract that gives its holder the
right to buy or sell an asset at some
predetermined price within a specified period
of time.
• Exercise price is the predetermined price of an
underlying asset.
• Option premium is the price of an option
 Types of option
• Call option
• An option to buy an underlying asset at
predetermined price within a specific period
of time
• To buy or purchase asset.
• Value of call option
• VC = max[0,(S-X)]
 Put option
• An option that gives its holder the right to sell
an asset at predetermined price.
• To sell an asset.
• Value of put option
• VP =max[0,(X-S)]
 Basic features of put and call options
• A negotiable contract: negotiable instrument
• High leverage : to the investors. Higher return
• Seller versus buyer : issued by the investors

• Disadvantages
• No dividend no right of ownership
• No interest on debt instrument
• Limited period of time
• High possibility of loss
 Risk in investment
• Risk is the possibility of occurrence of
unfavorable outcome.
• Risk averse investor prefers higher return for a
given level of risk or lower risk for a given level
of return.
• High risk = high return
• Low risk = low return
 Sources of risk
• Business risk
• The variation in the return due to the inherent
attributes of operational of a firm.
• Factors such as
• Variability in demand
• Price of the product
• Cost of inputs
• Economic condition
• Market competition and so on
 Financial risk
• Additional risk above business risk imposed on
firms common stockholders because of the
use of the debt capital.
• Use of debt
• Difficulty in paying interest and principal.
 Purchasing power risk
• The risk that arises due to the loss in
purchasing power of money caused by change
in price level in the economy.
• High inflation erodes the purchasing power of
money.
 Interest rate risk
• The risk that there is a chance of decline In
value of investment due to the adverse
change in market interest rate.
• Common for bonds and preferred stock
• High interest rate leads to higher risk in
investment.
 Liquidity risk
• The risk of being unable to sell securities
quickly at reasonable price.
• Marketability of securities
• High liquidity = less risky
• Low liquidity = high risky
 Market risk
• The risk that the value of an investment is
adversely affected due to the change in market
forces like political , socio-economic, and other
changes.
• Political factor
• Economic factor
• Socio-cultural factor
• Technological factor
• Legal factor
 Components of risk
Systematic
risk
non
diversifiable
risk

Total
risk
Unsystematic
risk
diversifiable
risk
 Concept
• Also known as non diversifiable
Systematic risk.
• Relevant to well diversified market
risk port folios

• Also known as diversifiable risk

Unsystematic • Uncorrelated to market portfolio
but unique to individual
risk investment.
 Difference
Systematic risk Unsystematic risk

It is also known as non diversifiable risk. It is also known as diversifiable risk.

It cannot be controlled It can be controlled

Whole market is affected A specific firm is affected

Occurs due to change in general state of Occurs due to strikes , production cost ,
economy , inflation , monetary and fiscal other acts of the specific firm.
policy ,political events , war and so on.
 Corporate finance risk management
concept
• Risk management is the identification of the
possible events that could have adverse financial
consequences and taking the measures to
prevent or minimize the financial losses.
• Identification of possible events
• Creating adverse effect financial consequences
• Taking preventive measure
• Prevent or minimize the financial loss
 Reasons to manage risks
1. To increase Debt capacity
2. To Maintain the optimum capital budgeting
3. To handle financial distress
4. To gain comparative advantage in hedging
5. To borrow cost
6. To minimize tax effects
7. To manage compensating system
 Classification of risk in corporate
finance
1. Pure risk = chance of only loss
2. Speculative risk=chance of both loss and gain
3. Demand risk =associated with demand for products
4. Input risk =associated with input( raw material /labor)
5. Financial risk = associated with financial transactions
6. Property risk = associated with destruction of property due to
natural calamities
7. Personal risk= associated with employees of firms
8. Environment risk =associated with environment pollution
9. Third party risk = associated with action of employees , product ,
services
10. Transferrable risk = risk transferred to insurance companies
examples property risk
 Risk management approach
1. Identify the potential risk : identify sources and
single out potential risk
2. Measure the potential effect of each risk: ignore
the low intensity risk and focus on high intensity
risk
3. Decide the risk handling methods : reduce
relevant risk affecting the company adversely.
4. Choose appropriate method
5. Evaluation of risk handling methods: taking
decisions based on the wealth maximization
 The risk handling methods
A. Buying the insurance policy :transferable risk
B. Transferring the function : particular function of a
company that produces risk to third party.
C. Using the derivatives securities: purchase the
common stock and write the option on them avoid
the foreign currency risk.
D. Reducing the probability of the occurrence of an
adverse event mainly of property risk
E. Reduce the magnitude of loss from an adverse event :
downsize loss from identified adverse events.
F. Avoiding the activity that increase the risk
 institutions that obtain the funds from the surplus units by
issuing financial claims against themselves to market
participants.
Roles of financial intermediaries
1. Maturity intermediation : the intermediation
for matching the maturity period of financial
assets and liabilities
2. Reducing risk via diversification :
transforming risky assets to less risky assets
3. Reducing the cost of contracting and
information processing.
4. Providing a payment mechanism
 Services provided by financial
institutions
1. Transforming the financial assets
2. Exchanging of financial assets
3. Under writing services
4. Investment advices
5. Management of portfolios
 Types of financial institutions
1. Depository institutions
• Commercial banks
• Credit unions
• Saving and loan association
• Mutual saving banks
2. Non depository institutions
• Insurance companies
• Pension funds
• Finance companies
• Mutual funds
Hedge funds : alternative investment vehicles available
only to sophisticated investors , such as institutions and
individual with significant assets.
• Types of hedge funds
• Market directional hedge funds
• Corporate restructuring hedge funds
• Convergence trading hedge funds
• Opportunistic hedge fund
 Pension funds
a sum of money paid to retiree or his/her
surviving dependents as retirement benefits.
• Types of pension funds
1) Defined benefit plan : a scheme in which the
employer agrees to provide the qualifying employee a
specific cash benefit up on retirements.
2) Insured benefit plan : purchases insurance annuity
policy from the life insurance companies.
3) Defined contribution plan : plan sponsor or employer
is responsible only for making specified contributions
into the plan or behalf of qualifying participants.
4) Hybrid plan : cash balance plan (combination of
defined plan and defined contribution plan.)
 Advantages and disadvantage of using internet
• Advantages
• Reduction in transaction cost
• Control on trading : removes middleman between investor and the securities they
want.
• Intermediacy of transaction : less time consuming

• Disadvantages
• Mentoring relationship : involves risk
• Risk of investment frauds
• False information

• Online investment tools helps investors to plan and analyze their investment
portfolios. Tools are as follow :
• Planning : online calculator and worksheet
• Screening :short out investment to investment objectives
• Charting : study the historical price movement patterns , technical analysis
• Stock quotes and portfolio tracking: watch on investment made, tracking activities.
 Major important terms
1. Corporate finance refers to the management of financial resources of a business entity.
2. Agency problems is the conflict of interest between the shareholders and managers and
shareholders and creditors.
3. Business ethics refers to a companies attitude and conduct towards its employees , customers ,
community , and stock holders.
4. Corporate social responsibility means concern for the welfare of the society at large.
5. Corporate governance refers to a set of processes, customs , policies and laws that affects the
way a company is directed , administered and controlled .
6. Efficient stock market refers to the market where the securities are fairly priced.
7. Random walk hypothesis refers the notion that stock prices moves randomly.
8. Efficient market hypothesis refers the notion that stock prices reflect all available information.
9. Fishers classical approach of interest rate states that the interest rate is determined by the
interplay of supply of savings and demand for investment.
10. Loan-able fund theory refers that the interest rate is determined by the interplay of demand and
supply of loan-able funds.
11. Liquidity preference theory states that the interest rate is determined by the interplay of supply
of money (cash balance) and the public aggregate demand for holding money