-LIST OF ARTICLES-

Thursday, December 31, 2009

(115)---FACTORS DETERMINING OPTION VALUE

Factors Determining Option Value

The seller of an option gives away the good outcomes of the asset held by him to the option buyer for a price or premium.

How is this price or premium determined? The value of a call option at maturity is either zero or the difference between the price of the share (that is, the underlying asset) and exercise price. Thus,

Value of call option = Maximum share price – Exercise price

The option holder will exercise his option only when it is beneficial to do so. The call option will be beneficial to its buyer when the exercise price is less than the price of the share (the underlying asset). When the call option is out of the money (the exercise price is more than the price of the underlying asset), the minimum value of the call option at expiration will be zero.

How is the value of an option with time to expiration determined?

The value of an option depends on the following factors,
  1. Exercise price and the share (underlying asset) price
  2. Volatility of returns on the share
  3. Time to expiration
  4. Interest rates


Exercise price and value of underlying asset

Two important determinants of options are the value of the underlying asset and the exercise price. If the underlying asset were share, the value of a call option would increase as the share price increases. At the expiration date, the holder will know the share price, and he will exercise his option if the exercise price is lower than the share price. The excess of the share price over the exercise price is the value of the option at the expiration of the option. If the share price is more than the exercise price, a call option is said to be in the money. The deeper in the money is an option, the more is its value.


Volatility of underlying asset

How is the value of a call option affected by the volatility of the underlying asset? Let us consider an example.

Suppose you hold a two 2 months option on the share of Company Y. The exercise price is 100$ and the current market price is 100$. The option will be worthless if the share price remains 100$ at maturity. But prior to expiration, the option will be valuable if there are chances that the share price may rise above 100$.


Time to option expiration

The present value of the exercise price also depends on the time to expiration of the option. The present value of the exercise price will be less if time to expiration is longer and consequently, the value of the option will be higher. Further, the possibility of share price increasing with volatility increases if the time to expiration is longer. Longer is the time to expiration, higher is the possibility of the option to be more in the money.


Interest rates

The holder of a call option pays exercise price not when he buys the option, rather, later on, when he exercises his option. Thus, the present value of the exercise price will depend on the interest rate. The value of a call option will increase with the rising interest rate since the present value of the exercise price will fall. The effect is reversed in the case of a put option. The buyer of a put option receives the exercise price and therefore, as the interest rate increases, the value of the put option will decline.

Monday, December 28, 2009

(114)---STRIPS AND STRAPS

Strips and Straps

You can design strategies that are variations of a straddle. Strips and straps are two such variations.

A strip is a combination of two puts and one call with the same exercise price and expiration date.

A strap, one of the other hands, entails combining two calls and one put.

We assume that the exercise price for puts and calls is 100$ and that share price at expiration is 90$, 100$ or 110$. The investor would have positive pay off irrespective of the price movement, expect when the price equals the exercise price. The potential pay off would be higher under a strap strategy for share price above the exercise price.

Strangle: Combining call and put at different exercise prices

A strangle is a portfolio of a put and a call with the same expiration date but with different exercise prices.

The investor with combine an out of the money call with an out of the money put. That is, he will buy a call with an exercise price higher than the underlying share’s current price and a put with an exercise price lower than the underlying share’s current price. The effect of this strategy is similar to the effect of a straddle expect that the pay off range will be larger.

Spread: Combining put and calls at different exercise prices

The put and call options on the same share may have different exercise prices, and an investor may combine them. A spread is a combination of a put and a call with different exercise prices.

Saturday, December 26, 2009

(113)---COMBINING CALL AND PUT OPTIONS AT THE SAME EXERCISE PRICE

Combining Call and Put Options at the Same Exercise Price

Suppose Company Y is considering the acquisition of Company X. It has offered to buy 20 percent of Company X shares. The price of Company X share has started increasing. The price could decline substantially if Company Y’s attempt fails.

How could you take advantages of rising prices and at the same time avoid the risk if the price falls? You can do so by simultaneously purchasing both put and call options at the same exercise price.

A company Y is a combined position created by the simultaneous purchase or sale of a put and a call with the same expiration date and the same exercise price.

Suppose the exercise price is 105$ for both put and call options. What will be your pay off if the price of Company X’s share increases to 120$ in three months? You will forgo put option, but you will exercise call option. So your pay off will be the excess of the share price over the call exercise price 120$-105$=15$.

On the contrary, suppose that the acquisition attempt fails and Company X share price falls to 95$ in three months. In this situation, you will exercise put options and let the call option lapse. Your pay off will be the excess of exercise price over the share price 105$-95$=10$. Thus, when you invest in a Company Y, you will benefit whether the price of the share falls or rises.

What will be the position of the seller of a company Y? He will lose whether the price of the share increases or decreases. But the seller of a Company Y will collect put and call premium. Thus, his lose will be reduced or his net pay off may be even positive.

Thursday, December 24, 2009

(112)---BUYING A SHARE AND SELLING A CALL

Buying a Share and Selling a Call

A naked option is a position where the option writer does not hold a share in her portfolio that has a counterbalancing effect. The investor can protect herself by talking a covered position.

A covered call position is an investment in a share plus the sale of a call on that share. The position is covered because the investor holds a share against a possible obligation to deliver the share. The total value or pay off of a covered call at expiration is the share price minus the value of the call.


The value of call is deducted because the investor has taken a short position; that is he is under an obligation to deliver the share to the buyer of the call option if he chooses to exercise his option. The buyer of the call will do so when the exercise price is lower than the share price.

An Example,


Assume that a call option is at the money; that is both the current price of the share and the exercise price is 100$. Further, suppose the possible share price at expiration is either 110$ or 90$.

When the share price is equal to or less than the exercise price, the investor’s pay off will equal to the share price.

The investor’s maximum pay off to a covered call cannot exceed the exercise price in the rising market. He sacrifices the opportunity of earning capital gains in favorable of enhancing the current income by premium. Investors who are in any case planning to sell shares at a price equal to the exercising price will follow the strategy.

Wednesday, December 23, 2009

(111)---COMBINATIONS OF PUT, CALL AND SHARE

Combinations of Put, Call and Share Options

Theoretically, an investor can from portfolio of options with any assets. In practice, stock options are most popular. A share, a put and a call can be combined together to create several pay off opportunities. Some of these combinations have significant implications.

Combination of share and a put option

A long position involves buying and holding shares or any other assets to benefit from capital gains and dividend.

An investor may create a long position in the shares of a firm. A long position investment strategy is risky.

The investor will incur loss if the share price declines. An investor will gain if the share price rises in the future. However, he will incur loss if the price in future turns out to be lower than the current price. An investor can however, guard himself against the risk of loss in the share value by purchasing a put option that has the exercise price equal to the current market price of the share.

Put option at the money is called a protective put. The combination of a long position in the share and a protective put helps to avoid the investor’s risk when the share price falls.

If the price of the share increases, the investor gains and the value of his portfolio at expiration will be equal to the share price.

The value of put to him will be zero since he will not exercise his options. On the other hand, if then share price falls, the value of the investor’s portfolio will be equal to the share price plus the value of the put option. Since the put was at the money when the investor sold it, the value of his portfolio will be at least equal to the share price at that time.

Monday, December 21, 2009

(110)---PUT OPTION

Put Option

A put option is a contract that gives the holder a right to sell a specific share or any other asset at an agreed exercise price on or before a given maturity period.

Suppose you expect price of company Y share to fall in the near future. Therefore, you buy a 3 month put option at an exercise price of 50$. The current market price of company Y share is 48$. If the price actually falls to 35$ after three months, you will exercise your option. You will buy the share for 35$ from the market and deliver it to the put option seller to receive 50$. Your gain is 15$, ignoring the put option premium, transaction cost and taxes.

You will forgo your put option if the share price rises above the exercise price; the put option is worthless for you and its value is zero. A put buyer gains when the share price falls below the exercise price. Ignoring the cost of buying the put option called put premium, his loss will be zero when the share prices rises above the exercise price since he will not exercise his option.

Put option pay off

An investor hopes that the price of company Y share will fall after three months. Therefore he purchases a put option on company Y share with a maturity of three months of premium of 5$. Then exercise price is 30$. The current market price of Company Y share is 28$. How much is profit or loss of the put buyer and the put seller if the price of the share at the time of the maturity of the option turns out to be 18$, or 25$, or 28$, or 30$, or 40$?

The put option buyer s maximum loss is confined to 5$ that is the put premium. His profit equal to exercise price less the sum of share price and premium. Since the share price cannot fall below zero, he has a limited profit potential. The put buyer will always exercise his option if the exercise is more than the share price. His break even share price is 25$ that is the exercise price premium.

For the seller of a put option, the profit will be limited to 5$ the amount of premium. His loss potential depends on the price of the share. But it cannot exceed 25$ that is the difference between the exercise price, 30$ and the premium 5$.

Saturday, December 19, 2009

(109)---CALL OPTION

Call Option

A call option on a share or any asset is a right to buy the share at an agreed exercise price. Suppose that the current share price of company X share is 130$. You expect that price in a three month period will go up to 150$. But you do fear that the price may also fall below 130$. To reduce the chance of your risk and at the same time to have an opportunity of marking profit, instead of buying the share, you can buy a three month call option on company X share at an agreed exercise price of, say, 125$.

Ignoring the option premium, taxes, transaction costs and the time value of money, will you exercise of your option if the price of the share is 130$ in three months?

You will exercise your option since you get a share worth 130$ by paying an exercise price of 125$. You will gain 5$ that is, the pay off or the value of your call option at expiration is 5$. Your call option is in the money at maturity.

What will you do if the price of the share is 120$ when the call option on company X expires?
Obviously, you will not exercise the option. You gain nothing. Your call option is worthless, and it is out of the money at expiration. You may notice that the value of your call option can never be less than zero.


Call Premium

A call buyer exercises his right only when the outcomes are favorable to him. The seller of call option, being the owner of the asset, gives away the good outcomes in favor of the option buyer. The buyer of a call option must, therefore, pay up front a price, called call premium, to the call seller to by the option.

The call premium is a cost to the option buyer and a gain to the call seller. What is the net pay off of the buyer and the seller of a call option when the call premium (that the buyer has to pay to the seller) in involved?

Friday, December 18, 2009

(108)---OPTIONS

Options

In a broad sense, an option is a claim without any liability. It is a claim contingent upon the occurrence of certain conditions. Thus, an option is a contingent claim. More specifically, an option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specific period of time.

The option to buy an asset is known as a call option, and the option to sell an asset is called an exercise price or a strike price. The asset on which the put or call option is created is referred to as the underlying asset. Depending on when an option can be exercised, it is classified on two categories,
  • European option. When an option is allowed to be exercised only the maturity dates, it is called a European option.
  • American option. When the option can be exercised any time before its maturity, it is called an American option.

When will an option holder exercise his right? He will exercise his option when doing so provides him a benefit over buying or selling the underlying asset from the market at the prevailing price.
There are three possibilities,

  1. In the money. A put or a call option is said to in the money when it is advantageous for the investor to exercise it. In the case of in the money call options, the exercise price is less than the current value of the underlying asset, while in the case of the in the money put options, the exercise price is higher than the current value of the underlying asset.
  2. Out of the money. A put or a call option is out the money if it is not advantageous for the investor to exercise it. In the case of the out of the money call option, the exercise price is higher than the current value of then underlying asset, while in the case of the out of money put options, the exercise is lower than the current value of the underlying asset.
  3. At the money. When the holder of a put or a call option does not lose or gain whether or not he exercise his option, the option is said to be at the money. In the case of the out of the money options the exercise price is equal to the current value of the underlying asset.


Options do not come free. The involve cost. The option premium is the price that the holder of an option has to pay for obtaining a call or a put option. The price will have to be paid, generally in advance, whether or not the holder exercises his option.

Wednesday, December 16, 2009

(107)---OPTIONS AND THEIR VALUATION

Options and Their Valuation

Options mean things to different people. It may refer to choice or alternative or privilege or opportunity or preference right.

To have options is normally regarded good. One is considered unfortunate without any options. Options are valuable since they provide protection against unwanted, uncertain happenings. They provide alternatives to bail out from a difficult situation. Options can be exercised on happening of certain events.

Options may be explicit or implicit. When you buy insurance on your house, it is an explicit option that will protect you in the event there is a fire or a theft in your house. If you own share of a company, your liability is limited. Limited liability is an implicit option to default on the payment of debt.

Options have assumed considerable significance in finance. They can be written on any asset, including shares, binds, portfolios, stock indices, currencies excreta. They are quite useful in risk management. How are options defined in finance? What gives value to options? How are they valued?

Options

In a broad sense, an option is a claim without any liability. It is a claim contingent upon the occurrence of certain conditions.

Depending on when an option can be exercised, it is classified in one of the following two categories.
  • European option
    When an option is allowed to be exercised only on the maturity date, it is called a European option.
  • American option
    When the option can be exercised any time before its maturity, it is called American option.

Monday, December 14, 2009

(106)---CAPITAL ASSET PRICING MODEL AND THE OPPORTUNITY COST OF EQUITY

Capital Asset Pricing Model and the Opportunity Cost of Equity

Shareholders supply capital to a form. In return, they expect to receive dividends. They can also realize cash by selling their shares.

The firm has discretion to retain entire or a part of profits. If dividends were distributed to shareholders, they would have an opportunity to invest cash so receive in securities in the capital markets and earn a return.

When a firm retains profits, there is loss of opportunity for which shareholders need to be compensated. The expected rate of return from a security of equivalent risk in the capital market is the cost of the lost opportunity. Shareholders require the firm to at least earn this rate on their capital invested in projects.

From the firms point of view the expected rate of return from a security of equivalent risk is the cost of equity.

We need the following information to estimate a firms cost of equity,
  • The risk free rate
  • The market premium
  • The beta of the firms share

The use of the industry beta is preferable for those companies whose operations match up with the industry operations.

The industry beta is less affected by random variations. Those companies that have operations quite different from a large number of companies in the industry may stick to the use of their own betas rather than the industry beta.

Let us emphasize that there is no theory for the selection of beta. Beta estimation and selection is an art as well, which one learns with experience.

Sunday, December 13, 2009

(105)---DETERMINANTS OF BETA (2).

Determinants of Beta

As we discussed above beta depend on three fundamental factors: the nature of business, the operating leverage and the financial leverage. About the nature of business we discussed earlier, fro this post we discussing about other two factors.

Operating Leverage

Operating leverage refers to the use of fixed costs. The degree of operating leverage is defined as the change in an economy’s earning before interest and tax due to change in sales. Since variable costs change in direct proportion of sales and fixed costs return constant, the variability in earning before interest and tax when sales change is caused by fixed costs.

Higher the fixed cost, higher the variability in earning before interest and tax for a given change in sales. Other things remaining the same, companies with higher operating leverage are more risky.

Operating leverage intensifies the effect of cyclically on a company’s earnings. As a consequence, companies with higher degree of operating leverage have high betas.

Financial Leverage

Financial leverage refers to debt in a firm’s capital structure. Firms with debt in the capital structure are called leverage firms.

The interest payments on debt are fixed irrespective of the firm’s earnings. Hence, interest changes are fixed costs of debt financing. The fixed costs of operations result in operating leverage and caused earnings before interest and tax to vary with changes in sales.

Similarly, the fixed financial costs result in financial leverage and cause profit after tax to vary with changes in earning before interest and tax. Hence, the degree of financial leverage is defined as the change in a company’s profit after tax due to change in its earnings before interest and tax. Since financial leverage increases the firm’s financial risk, it will increase the equity beta of then firm.

Friday, December 11, 2009

(104)---DETERMINANTS OF BETA

Determinants of Beta

We have explained that beta is the ratio of covariance between returns on market and a security to variance of the market returns.

But what drives the variance and covariance? The variance and covariance and therefore, beta depend on three fundamental factors: the nature of business, the operating leverage and the financial leverage.
Those factors are discussed below.

Nature of Business

All economics go through business cycles. Firms behave differently with business cycles. The earnings of some companies fluctuate more with the business cycles. Their earnings grow during the growth phase of the business cycle and decline during the contraction phase.

For example, the earnings of consumer product firms or the cargo firms are tied with the business cycle and they go up or down with business cycle. On the other hand, the earnings of utility companies remind unaffected by the business cycle. If we regression a company’s earnings with the aggregate earnings of all companies in the economy, we would obtain a sensitivity index, which we can call the companies accounting beta. The real or the market beta is based on share market returns rather than earnings. The accounting betas are significantly correlated with the market betas.

This implies that if a firms earnings are more sensitive to business conditions, it is likely to have higher beta.

We must distinguish between the earnings variability and the earnings cyclically. A company’s earnings may be highly variable, but it may not have high beta. The earnings variability is an example of a specific risk that can be diversified. Cyclically of a companies earnings on the other hand, is the variability of its earnings Vi's-à-Vi's the aggregate earnings of the economy.

Wednesday, December 9, 2009

(103)---BETA ESTIMATING

Beta Estimation

Net present value of an investment is the discounted value of its future cash flows. The capital asset pricing model risk return framework provides us with a method of determining the discount rate of an investment.

The risk of a portfolio of securities is measured by its variance or standard deviation. The variance of a portfolio is the sum of;
  • The variances of individual securities times the square of their respective weight and,
  • The covariance that is the correlation coefficient between securities times their standard deviations of securities times twice the product of their respective weights.

In a well diversified portfolio the weights of individual securities will be very small and therefore, the variance of individual securities will be quite insignificant. But the covariance between the securities will be significant, and its magnitude will depend on the correlation coefficients between securities.

The covariance will be negative if all securities in the portfolio are negatively correlated. In practice, securities may have some correlation because they all have a tendency to more with the market.

This logic introduces the concepts of diversifiable risk and non diversifiable risk. The unique or the unsystematic risk of a security can be diversified when it is combined with other securities to form a well diversified portfolio.

On the other hand, the market or the systematic risk of the security cannot be diversified because like other securities, it also moves with the market.

There are two methods to calculate systematic risk of a security,

  1. Direct method.
  2. The market model.

Monday, December 7, 2009

(102)---STEPS IN CALCULATING EXPECTED RETURN UNDER ARBITRAGE PRICING THEORY

Steps in Calculating Expected Return under Arbitrage Pricing Theory

The following three steps are involved in estimating the expected return on an asset under Arbitrage pricing theory,
  1. Searching for the factors that affect the assets return
  2. Estimating of risk premium for each factor
  3. Estimating of factor beta

Factors

What factors are important in explaining the expected return? How are they identified? Arbitrage pricing theory does not indicate the factors that explain assets returns. The factors are empirically derived from the available data. Different assets will be affected differently by the factors.
The following factors were found important in a research study in the USA,

  • Industrial production
  • Changes in default premium
  • Changes in the structure of interest rates
  • Inflation rate
  • Changes in the real rate of return

Is this an exhaustive list of macro economic factors? All do not agree. In another study, it has been found that price to book value rations and sizes are correlated with the actual returns. These measures have been found as good proxy of the risk.

Risk premium

What is the risk premium for each factor? Conceptually it is the compensation, over and above the risk free rate of return that investors require for the risk contributed by the factor. One could use past data on the forecast ed and actual values to determine the premium.

Factors beta

The beta of the factor is the sensitivity of the assets return to the changes in the factor. We can use regression approach to calculate the factor beta. For example a firm’s returns could be regressed to inflation relate to determine the inflation beta.

Sunday, December 6, 2009

(101)---CONCEPT OF RISK UNDER ARBITRAGE PRICING MODEL

Concept of Risk under Arbitrage Pricing Model

The risk arising from the firm-specific factors is diversifiable. It is unsystematic risk. The risk arising from the market related factors cannot be diversified. This represents systematic risk. In capital asset pricing model, market risk primarily arises from the sensitivity of an assets returns to the market retains and this is reflected by the assets beta.

Just one factor the market retains affects the firms retain. Hence, capital asset pricing model is one factor model. The betas of the form would differ depending on their individual sensitivity to market. On the other hand Arbitrage pricing model assumes that market risk can be caused by economic factors such as changes in gross domestic product, inflation, and the structure of interest rates and these factors could affects firms differently.

For example; different firms may feel the impact of inflation differently. Therefore, under Arbitrage pricing model, multiple factors may be responsible for the expected return on the share of a firm. Therefore, under Arbitrage pricing model the sensitivity of the assets return to each factor is estimated. For each firm, there will be as many betas as the number of factors.

Saturday, December 5, 2009

(100)---CONCEPT OF RETURN UNDER ARBITRAGE PRICING THEORY

Concept of Return under Arbitrage Pricing Theory

In Arbitrage Pricing Theory, the return of an asset is assumed to have two components, predictable and unpredictable return.

The predictable or expected return depends on the information available to shareholders that a bearing on the share prices. The unpredictable or uncertain return arises from the future information. This information may be the firm specific and the market related macro economic factors.

The firm specific factors are special to the firm and affected only the firm. The market related factors affect all firms. Thus the uncertain return may come from the firm specific information and the market related information.

It is important to notice that the economy wide information may be future divided into the expected part and the unexpected or surprise part.

For example, the government may announce that inflation rate would be 5% next month. Since this information is already known, market would have already accounted for this and share prices would reflect it. After a month the government announces that the actual inflation rate was 6%. Share holders known now that the inflation is 1% higher than the anticipated rate. This is surprise news to them. The expected part of information influences the expected return while the surprise part affects the unexpected part or return.

Thursday, December 3, 2009

(99)---THE ARBITRAGE PRICING THEORY

The Arbitrage Pricing Theory

The capital asset pricing model is not always able to account for the difference is assets, returns using their betas. This paved way for the development of an alternative approach, called the arbitrage pricing theory, for estimating the assets “expected returns”.

Arbitrage pricing theory unlike capital asset pricing model, does not assume that investors employ mean variance analysis for their investment decisions. However, like capital asset pricing model, arbitrage pricing theory is found on the notion that investors are rewarded for assuming non diversifiable risk, diversifiable risk is not compensated beta is considered as the most important single factor in capital asset pricing model that captures the systematic risk of an asset.

In arbitrage pricing theory there are a number of industry specific and macro economic factors that affect the security returns. Thus a number of factors may measure the systematic risk of an asset under arbitrage pricing theory.

The fundamental logic of arbitrage pricing theory is that investors always indulge in arbitrage whenever they find differences in the returns of assets with similar risk characteristics.

Wednesday, December 2, 2009

(98)---LIMITATIONS OF CAPITAL ASSET PRICING MODEL

Limitations of Capital Asset Pricing Model

Capital asset pricing model has the following limitations,
  • It is based on unrealistic assumptions.
  • It id difficult to test the validity of Capital asset pricing model.
  • Betas do not remain stable over time.
Unrealistic assumptions
Capital asset pricing model is based on a number of assumptions that are far from the reality. For example it is very difficult to find a risk free security. A short term highly liquid government security is considered as a risk free security. It is unlikely that the government will default, but inflation causes uncertain about the real rate of return. The assumption of the equality of the lending and borrowing rates is also not correct. In practice these rates differ. Further investors may not hold highly diversified portfolios or the market indices may not well diversify. Under these circumstances capital asset pricing model may not accurately explain the investment behavior of investors and beta may fail to capture the risk of investment.
Difficult to validity
Most of assumptions may not be very critical for its practical validity. Therefore is the empirical validity of capital asset pricing model. Need to establish that the beta is able to measure the risk of a security and that there is a significant correlation between beta and the expected return. The empirical results have given mixed results. The earlier tests showed that there was a positive relation between returns and betas. However the relationship was not as strong as predicted by capital asset pricing model. Further these results revealed that returns were also related to other measures of risk, including the firm specific risk. In subsequent research some studies did not find any relationship between betas and returns. On the other hand other factors such as size and the market value and book value ratios were found as significantly related to returns.
All empirical studies testing capital asset pricing model have a conceptual problem. We need data on expected prices to test it. Unfortunately, in practice the researchers have to work with the actual past data. Thus this will introduce bias in the empirical results.
Betas do not remain stable over time
Stability of beta, beta is a measure of a securities future risk. But investors do not further data to estimate beta. What they have are past data about the share prices and the market portfolio. Thus, they can only estimate beta based on historical data. Investors can use historical beta as the measure of future risk only if it is stable over time. Most research has shown that the betas of individual securities are not stable over time. This implies that historical betas are poor indicators of the future risk of securities.
Capital asset pricing model is a useful device for understanding the risk return relationship in spite of its limitations. It provides a logical and quantitative approach for estimating risk. It is better than many alternative subjective methods of determining risk and risk premium. One major problem is that many times the risk of an asset is not captured by beta alone.

Monday, November 30, 2009

(97)---IMPLICATIONS AND RELEVANCE OF CAPITAL ASSET PRICING MODEL

Implications and Relevance of Capital Asset Pricing Model

Capital asset pricing model (CAPM) based on a number of assumptions. Given those assumptions, it provides a logical basis for measuring risk and linking risk and return.
Capital asset pricing model (CAPM) has the following implications,

  • Investors will always combine a risk free asset with a market portfolio of risky assets. They will invest in risky assets in proportion to their market value.
  • Investors will be compensated only for that risk which they cannot diversify. This is the market related systematic risk. Beta which is a ratio of the covariance between the asset returns and the market returns divided by the market variance is the most appropriate measure of an asset’s risk.
  • Investors can expect returns from their investment according to the risk. This implies a liner relationship between the asset’s expected return and its beta.
The concepts of risk and return as developed under capital asset pricing model (CAPM) have intuitive appeal and they are quite simple to understand. Financial managers use these concepts in a number of financial decisions making such as valuation of securities, cost of capital measurement, investment risk analysis excreta. However in spite of its intuitive appeal and simplicity capital asset pricing model (CAPM) suffers from a number of practical problems.
Limitations of Capital asset pricing model
Capital asset pricing model has the following limitations,
  1. It is based on a number of unrealistic assumptions.
  2. It is difficult to test the validity.
  3. Betas do not remain stable over time. (Beta is a measure of a security’s risk).

Sunday, November 29, 2009

(96)---PORTFOLIO THEORY AND ASSET PRICING MODELS

Portfolio Theory and Asset Pricing Models

The portfolio is a bundle or a combination of individual asset or securities. The portfolio provides a normative approach to investors to make decisions to invest their wealth in asset or securities under risk. It is based on the assumption that investors are risk averse.

This implies that investors hold well diversified portfolios instead of investing their entire wealth in a single or a few assets.

One important conclusion of the portfolio theory is that if the investors hold a well diversified portfolio of assets, then their concern should be the expected rate of return and risk of the portfolio rather than individual assets and the contribution of individual asset to the portfolio risk.

The second assumption of the portfolio theory is that the returns of the assets are normally distributed. This means that the expected value and variance or standard deviation analysis is the foundation of the portfolio decisions.

Further we can extend the portfolio theory to derive a framework for valuing risky assets. This framework is referred to as the capital asset pricing model (CAPM). An alternative model for the valuation of risky assets is the arbitrage pricing theory (APT).

Friday, November 27, 2009

(95)---NORMAL DISTRIBUTION AND STANDARD DEVIATION

Normal Distribution and Standard Deviation

The normal distribution is a smooth, symmetric, continuous, bell shaped curve as shown. The distribution is neither skewed nor peaked. The spread of the normal distribution is characterized by the standard deviation.

What is the probability of obtaining a return exceeding or lower than the expected return?
In case of normally distributed returns, it depends only on the standard deviation. It is useful to notice certain properties of a normal distribution.


The distribution tabulated is a normal distribution with mean zero and standard deviation. Such a distribution is known as a standard normal distribution. However any normal distribution can be standardized and hence the table of normal probabilities will serve for any normal distribution.

The formula to standardize is,
S = (R – E (R))/ б
R = Return which we are interested
E (R) = Expected return
Б = Number of standard deviations from the expected return

Thursday, November 26, 2009

(94)---EXPECTED RETURN AND RISK

Expected Return and Risk

Instead of using historical data for calculating return and risk, we may use forecast ed data. Suppose you are considering buying one share of sunshine industries which has market price of 522.50$ today. The company pays dividend of 5$ per share. You want to hold the share for one year. What is the expected rate of return? This will depend on the dividend on the dividend per share you would actually receive and the market price at which you could sell the share. You do not know both the outcomes. The outcomes may depend on the economic conditions, the performance of the company and other factors. You will have to think of the outcomes of dividend and the share price under possible economic scenarios to arrive at a judgment about the expected return.

Expected Rate of Return

You can put the information summaries the range of returns under the possible states of economic conditions along with probabilities together to calculate the expected rate of return. The expected rate of return is the sum of the product of each outcome and its associated probability.

Risk Preference

The information about the expected return and standard deviation helps an investor to make decision about investments. This depends on the investor’s risk preference. Generally investors would prefer investments with higher rates of return and lower standard deviation. According to the economic principle of diminishing marginal utility, as a person gets more and more wealth his utility for additional wealth increases at a declining rate.

Sunday, November 22, 2009

(93)---HISTORICAL CAPITAL MARKET RETURNS

Historical Capital Market Returns

What rates of returns on shares and other financial instructions have investors earned? You can use indicates for the share prices and other securities for this purpose. We present year by year rates of return for the following financial instruments,
  1. Ordinary shares.
  2. Long term government bonds.
  3. Call money market (This is a portfolio of inter bank transaction).
  4. Treasury bills.
We can summarize the historical capital market returns by two numbers; the average return and the standard deviation. As we have discussed earlier standard deviation summarizes variability and it is a measure of total risk.
Historical risk premium
We can compare the high risk average return on the stock market with the low risk average returns on the government securities. The risk free government security is treasury bills. It is free from risk of default and the variability on its returns is the lowest. This excess return is a compensation for the higher risk of the return on the stock market it is commonly referred to as risk premium.

Tuesday, November 17, 2009

(92)---RISK OF RATES OF RETURN

Risk of Rates of Return

The variability of rates of return may be defined as the extent of the deviations or dispersion of individual rates of return from the average rate of return. There are two measures of this dispersion, variance or standard deviation.

The following steps are involved in calculating variance or standard deviation of rates of return of assets or securities using historical returns,

  • Calculate the average rate of return.
  • Calculate the deviation of individual rates of return from the average rate of return and square.
  • Calculate the sum of the square of the deviations as determined in the preceding step and divide it by the number of periods or observations less one to obtain variance.
  • Calculate the square root of the variance to determine the standard deviation.

Monday, November 16, 2009

(91)---RISK AND RETURN

Risk and Return

Risk and return are most important concepts in finance. In fact, they are the foundation of the modern finance theory.

What is the risk? How is it measured? What is return? How is it measured? How are assets valued in capital markets? How do investors make their investment decisions? We are going to discuss these questions in our future posts.

Return on a single asset

Total return = Dividend + Capital gain

Unrealized capital gain or loss

If an investor holds a share and does not sell it at the end of the period, the difference between the beginning and ending share prices is the unrealized capital gain or loss.
The investor must consider the unrealized capital gain or loss as part of his total return. The fact of the matter is that if the investor so wanted, he could have sold the share and realized the capital gain or loss.

Sunday, November 8, 2009

(90)---EQUITY CAPITALIZATION RATE

Equity Capitalization Rate

In our previous posts we discussed how the present value of a share can be calculated, after that we must know how to calculate expected dividends and required rate of return.

The required rate of return will depend upon the risk of the share. Then required rate of return will be equal to the risk free rate of interest plus the risk premium to account for the share’s risk.

In a well functioning capital market, the market price is the fair price of a share. We can use give below equation to estimate the capitalization or the required rate of return of the share,

Ke = (DIV1 / Po) + g

A blind faith in the formula can be misleading. One should be cautious in using the formula.

  • Estimating errors.
  • Unsustainable high current growth.
  • Errors in forecasting dividends.
Linkages between Share price, Earnings and Dividends
Why do investors buy shares? Do they buy them for dividends or for capital gain?
Investors may choose between growth shares or income shares.

  • Growth shares are those, which offer greater opportunities for capital gains.
  • Dividend yield on such shares would generally be low since companies would follow a high retention policy in order to have a high growth rate.
  • Income shares are pay higher rate of dividends, and offer low prospects for capital gains.
Because of the higher payout policy followed by companies their share prices tend to grow at a lower rate.

Monday, November 2, 2009

(89)---VALUATION OF ORDINARY SHARES

Valuation of Ordinary Shares

Valuation of ordinary shares is relatively more difficult, because
  1. The rate of dividend on ordinary shares is not known.
  2. The payment of equity dividend is discretionary.
The general principal of valuation applies to the share valuation the value of a share today depends on cash flow expected by investors and risk associated with those cash inflows.
Normally a shareholder does not hold shares in perpetuity. He holds shares for some time, receives the dividends and finally sells them to a buyer to obtain capital gains. When he sells share, a new buyer is also simply purchasing a stream of future dividends and a liquidation price when he also sells the shares.

Single period valuation
Po = (DIV + P1) / (1+ Ke)

Multi Period valuation
Po = {(DIV1 + P1) / (1+ Ke)} + {(DIV 2+ P2) / (1+ Ke)2 }+ ……………….+ {(DIV n+ Pn) / (1+ Ke)n}

Thursday, October 29, 2009

(88)---VALUATION OF PREFERENCE SHARES

Valuation of Preference Shares

A company may issue two types of shares,
  • Preference shares.
  • Ordinary shares.
Preference shares have preference over ordinary shares in terms of payment of dividend and repayment of capital.
They may be issued with or without a maturity period.


  • Redeemable preference shares with maturity.
  • Irredeemable preference shares are shares without any maturity.
  • Cumulative preference shares unpaid dividends accumulate and are payable in the future.
  • Not cumulative shares do not accumulate dividends.
Features of Preference and Ordinary Shares
Following are the features preference shares,

  • Preference shareholders have claim on assets and income prior to ordinary shares.
  • The dividend rate is fixed in case of Preference shares.
  • A company can issue convertible Preference shares.
  • Both redeemable and irredeemable Preference shares can be issued.

We can value Preference shares like below
Po = PDIV {(1/kp) – [1/kp (1+kp)n]} + Pn / (1+Kp)n
Valuation of irredeemable preference shares
Po = PDIV / Kp
Yield on Preference shares
Kp = PDIV / Kp

Saturday, October 24, 2009

(87)---DEFAULT RISK AND CREDIT RATING

Default Risk and Credit Rating

Default risk is the risk that a company will default on its promised obligations to bond holders. Bondholders can avoid the default risk by investing their funds in the government bonds instead of the corporate bonds.
Investors invest in corporate bonds if they are compensated for assuming the default risk.
Hence companies in order to induce investors to invest in their bonds, offer a higher return than the return on the government bonds. This difference called default premium.

How do Investors asses the default risk of bonds?
In most countries there are credit rating companies that rate bonds according to their safety (In USA Moody’s and Standards and Poor’s and others provide bond ratings).
  1. High Investment Grades
    AAA (Highest Safety)
    Debentures rated “AAA” are judged to offer highest safety of timely payment of interest and principal.
    AA (High safety)Debentures rated “AA” are judged to offer high safety of timely payment of interest and principal. They differ in safety from “AAA” issues only marginally.
  2. Investment GradesA (Adequate safety)Debentures rated “A” are judged to offer adequate safety of timely payment of interest and principal. However changes in circumstances can adversely affect such issues more than those in the higher rated categories.
    BBB (Moderate safety)
    Debentures rated “BBB” are judged to offer sufficient safety of timely payment of interest and principal for the present however changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for debentures in higher rated categories.
  3. Speculative Grades
    BB (Inadequate Safety)
    Debentures rated “BB” are judged to carry inadequate safety of timely payment of interest and principal.
    B (High Risk)Debentures rated “B” are judged to have greater susceptibility to default while currently interest and principal payments are met adverse business or economic conditions would lead to lack of liability or willingness to pay interest or principal.C (Substantial Risk)Debentures rated “C” are judged to have factors present that make them vulnerable to default.
    D (In Default)
    Debentures rated “D” are judged to have grater susceptibility to default.

Wednesday, October 21, 2009

(86)---THE TERM STRUCTURE OF INTEREST RATES

The Term Structure of Interest Rates


There are several interest rates in practice, both companies and the government offer bonds with different maturities and risk features.
Debt in a particular risk class will have its own interest rate. Yield curve shows the relationship between the yields to maturity of bonds and their maturities. It is also called the term structure of interest rates.
The upward sloping yield curve implies that the long term yields are higher than the short term yields. This is the normal shape of the yield curve.
However, many economies in high-inflation periods have witnessed the short-term yields being higher than the long term yields. The inverted yield curves result when the short-term rates are higher than the long term rates.


There are three theories that explain the yield curve or the term structure of interest rates,

  1. The expectation theory.
  2. The liquidity premium theory.
  3. The market segmentation theory.



(1).The expectation theory


This theory supports the upwards sloping yield curve since investors always expect the short-term rates to increase in the future. This implies that the long term rates will be higher than the short-term rates.


(2).The liquidity premium theory


The liquidity premium theory provides an explanation for the expectation of the investors. The prices of the long-term bonds are more sensitive than the prices of the short-term bonds to the changes in the market rates of interest.
Hence investors prefer short-term bonds to the long-term bonds. The investors will be compensated for this risk by offering higher returns on long term bonds. This extra return which is called liquidity premium, gives the yield curve its upward bias. However the yield curve could still be inverted if the declining expectations and other factors have more effect than the liquidity premium.



(3).The segmented markets theory


The market segmentation theory assume that the debt market is divided into several segment based on the maturity of debt, in each segment the yield of debt depends on the demand and supply.
Investor’s preferences of each segment arise because they want to mach the maturities of assets and liabilities to reduce the susceptibility to interest rate changes.

Monday, October 19, 2009

(85)---BOND VALUATION AND CHANGES IN INTEREST RATE


Bond valuation and Changes in interest rate

The value of the bond declines as the market interest rate increases, bond values decline with rising fund interest rates because the bond cash flows are discounted at higher interest rates.

Bond Maturity and Interest rate RiskThe value of a bond depends upon the market interest rate. As interest rate changes, the value of a bond also varies. There is an inverse relationship between the value of a bond and the interest rate. The bond value would decline when the interest rate rises and vice verse. Interest rates have the tendency of rising or falling in practice. Thus investors of bonds are exposed to the interest rate risk, which is the risk arising from the fluctuating interest rates.
Bond Duration and Interest Rate Sensitivity
That bond prices are sensitive to changes in the interest rates, and they are inversely related to the interest rates. The intensity of the price sensitivity depends on a bond’s maturity and the coupon rate of interest. The longer maturity of a bond, the higher will be its sensitivity to the interest rate changes. Similarly, the prices of a bond with low coupon rate will be more sensitive to the interest rate changes.

A bond’s maturity and coupon rate provide a general idea of its price sensitivity to interest rate changes. However, the bond’s price sensitivity can be more accurately estimated by its duration. A bond’s duration is measured as the weighted average of times to each cash flow. Duration calculation gives importance to the timing of cash flows, the weight is determined as the present value of cash flow to the bond value. Hence two bonds with similar maturity but different coupon rates and cash flow patterns will have different durations.

The volatility or the interest rate sensitivity of a bond is given by its duration and YTM. A bond’s volatility, referred to as its modified duration,
Volatility of bond = Duration / (1+ YTM)

Friday, October 16, 2009

(84)---VALUATION OF BOND AND SHARES

Valuation of Bond and Shares

IntroductionAsset can be real or financial, like shares and bonds are called financial assets, asset like plant and machinery are called real assets. Real assets can be valued easily but there is no easy way to predict the prices of share and bonds.
The unpredictable nature of the security prices is, in fact, a logical and necessary consequence efficient capital markets.



Concepts of ValueThere are many concepts of value that are used for different purposes,

  • Book value-Assets are recorded at historical cost, and they are depreciated over years. Book value may include intangible assets at acquisition cost minus amortized value.
  • Replacement value-Ignore the benefits of intangibles and utility of existing assets.
  • Liquidation value-If company sold its assets it would be liquidation value.
  • Going concern value
  • Market value-Price which the asset or security is being sold or brought in the market.

Features of a BondA bond is a long-term debt instrument or securities issued by the government do not have any risk default.
The main features of a bond are

  • Face value.
  • Interest rate.
  • Maturity.
  • Redemption value.
  • Market value.
Bonds maybe classified into three categories.
(1).Bonds with maturity.
(2).Pure discount bonds.
(3).Perpetual bonds.
(1).Bonds with Maturity
Issue bonds that specify the interest rate and the maturity period.
  • Value of bond with maturity
    B0=INT X [(1/Kd)-(1/Kd(1+Kd)n] Bn/(1+Kd)n
    Bond Value = Present value of interest + Present value of maturity value
  • Yield to Maturity
    Kd= INT/ B0

(2).Pure Discount Bonds
Bonds do not carry an explicit rate of interest, it provides for the payment of a lump sum amount at a future date.
  • B0 = M / (1+Kd)n

(3).Perpetual Bonds
Also called consols, has an indefinite life and therefore, it has no maturity value.
  • B0 = INT / Kd

Saturday, October 10, 2009

(83)---VALUATION.

Valuation

Concepts- value and return.

Most financial decisions affect the firm’s cash flows in different time periods.
The recognitions of the time value of money and risk is extremely vital in financial decision making.


Time Preference for Money.


Time preference for money is an individual’s preference for possession, of a given amount of money now, rather than the same amount at some future time.
There for reasons attributed for it,

  1. Risk
  2. Preference for consumption
  3. Investment opportunities


Required rate of return

Time preference of money is generally expressed by an interested rate.
Required rate of return = risk free rate + risk premium
  • Interest rate will be positive even in the absence of any risk it called risk free rate.
  • An investor will be exposed to some degree of risk there fore he would require a rate of return, called risk premium


The risk free rate compensates for time while risk premium compensates for risk. The required rate of return may also be called the opportunity cost of capital of comparable risk.

Future value
  • For a single cash flow
    Fn = P (1+i) n
    Fn = Future Sum
    P = Principal
    I = Interest rate
    n = Number of years

  • Future value of a lump Sum
    Fn = P X CVFn,i
    Fn = Future Sum
    P = Principal
    CVF = Compound value factor for n periods at I rate of interest

  • Future value of an annuity
    Annuity is fixed payment or receipt each year for a specified number of years.
    Fn = A X CVFAn,iFn = Future sum
    CVFAn,I = Compound value factor for annuity = ((1+i)n-1)/i)

  • Sinking FundSinking fund is a fund which is created out of fixed payments each period to accumulate to a future sum after a specified period.
    A = Fn X SFFn,i
    SFFn,I = ((i)/(1+i)-1)


Present Value
Present value of a future cash flow is the amount of current cash that is of equivalent value to the decision maker.
  • For a single cash flow.
    P = Fn (1/(1+i)n)

  • Present value of a lump sum.
    PV = Fn X PVAn,i

  • Present value of an annuity.
    PV = A X PVFAn,i
    A = Annuity
    PVFAn,i= Present value annuity factor

  • Present value of perpetuity.
    Perpetuity is an annuity that occurs indefinites.
    P = A/ i

  • Present value of an uneven cash flow.
    P = (A1 X PVF1) + (A2 X PVF2) +………………………+ (An X PVAFn)
Net Present ValueNet present value of a financial decision is the difference between the present value of cash inflows and the present value of cash outflows.
That the financial objective should be monetize the shareholders wealth. Wealth is defined as net present value.

Sunday, October 4, 2009

(82)---NATURE OF FINANCIAL MANAGEMENT.

Nature of financial management

Introduction

Financial management is that managerial activity which is concerned with the planning and controlling of the firms financial resources.

Finance functions


It may be difficult to separate the Finance factions from production marketing and other functions but the functions them selves can be reading identified
  • Long – term asset mix or investment desertions
  • Capital – mix or financing decision
  • Profit allocation or dividend decision
  • Short –term asset mix or liquidity decision
Financial manager’s role
A Financial manager is a person who is responsible in a significant way to carry out the finance functions. These main finance functions are
  • Fund raising
  • Fund allocation
  • Profit planning
  • Understanding capital markets
IN THE FUTURE WE COVERED FINANCIAL MANAGEMENT TWO TIMES PER EVERY WEEK.
TOPICS.
  1. Valuation.
  2. Investment decisions.
  3. Financing and dividend decisions.
  4. Ling term financing.
  5. Financial and profit analysis.
  6. Working capital management.
  7. Managing value and risk.

Thursday, September 17, 2009

(81)---How important is credit card debt management?


After what the economy has been reeling under, how can one undermine the importance of credit card debt management? It can also be said the other way round. How important is money management whether you use plastic money or cash. A credit card is money in disguise!

Of late there has been a lot of hue and cry about effective credit card management skills and managing credit card debts. It has been observed on several instances that even if you have mastered the art of money management, you may encounter unforeseen events that can sweep you off the ground. How you rise up to such a situation and how well you are equipped to counteract the financial crisis essentially reflects your money management skills.

Credit cards can be your foe or friend depending on how you use them. It is very important to keep in mind that whatever you do with your finances gets recorded in your credit report. And there is a close association with your credit score and your financial well being. Your credit score also indicates how financially responsible you are.

Given below are few measures that you can adopt to remain financially in good health


  • When you use credit cards, you are using someone else' money, so how can you misuse cash that doesn't belong to you. But that is what most of the consumers do. Use credit cards only if you are in dire need of cash. Just because you have been allowed to use credit doesn't necessarily mean that you have to exploit it.

  • After fulfilling your financial obligations each month, make sure you keep aside some cash for building an emergency fund. You will realize the importance of an emergency fund only if you face financial hardship.

  • Avoid taking fresh credit unless you are done with your existing credit card debts. When you are making payments for your monthly financial obligations, make sure you don't strain your purse. Maintain the comfort level in making payments. In other words, live within your means.

  • As far as investment is concerned, choose an investment vehicle that will give you good returns. This may not be possible if you are a beginner. But you can always take help of a stock/forex broker to get best returns.

  • Keep aside money for your retirement.

You will manage your finances well only if you are aware of the consequences of money mismanagement and what it can lead to.

Friday, August 28, 2009

(80)---TREATMENTS FOR WORKING PROGRESS IN PROCESS COSTING


Opening and closing working progress

If opening or closing stocks of work in progress exist; the calculations of the cost per unit required some additional computations. It is obvious that partly completed production working progress will have a lower unit cost than fully completed production.
Consequently, when opening and closing stocks of work –in-progress exist unit costs cannot be computed by simply dividing the total cost by the number of units still in the process. For example, if 8,000 units were started a completed during period and another 2,000 units were partly completed, than then these two items cannot be added together to ascertain the unit cost. We must convert the work in progress into finished equivalents also referred to as equivalent production so that the unit cost can be obtained.


Elements of costs with different degrees of completion

A complication which may arise concerning equivalent units is that in any given stock of work in work in process into all of the elements which make up the total cost may have reached the same degree of completion. For example, materials may be added at the start of the process and are thus fully complete, whereas labor and manufacturing overheads may be added throughout the process. Materials may be 100% complete, while labor and overheads may only be partially complete. Where the situation arises separate equivalent production calculation must of each element of cost.

Previous process cost

As production moves through processing, the outputs of one process become the input of the next process. The next process will carry out additional conversion work and may add this achieved by labeling the transferred cost form the previous process ‘previous process cost’ and treating this item as a separate element of cost. Note that this element of cost will always be fully complete as far as closing work in progress in concerned.

Opening Working progress

When opening stocks of working progress exist an assumption must be made regarding the allocation of this opening stock to the current accounting period to determine the unit cost for the period. Two alternative assumptions are possible.

First one may assume the opening work-in progress is inextricably merged with the units introduced in the current period and can no longer be identifies separately the weighted average method.

Second one may assume that the opening work in progress is the first group of units to be processed and completed during the current month the first in first out method.

Monday, August 24, 2009

(79)---TREATMENTS FOR LOSSES IN PROCESS COSTING

Normal and abnormal losses.

Certain losses are inherent in the production process and cannot b eliminated.
These losses occur under efficient operating conditions and are referred to as Normal or uncontrollable losses.

In addition to losses which cannot be avoided, there are some losses which are not expected to occur under efficient operating conditions, for example the improper mixing of ingredients, the use of inferior materials and the incorrect cutting of cloths. These losses are not an inherent part of the production process and are referred to as abnormal or controllable losses.
  • Normal loss is the loss expected during a process. It is not given a cost.
  • Abnormal losses is the extra loss resulting when actual loss is greater than normal or expected loss ,and it is given a costs.
  • Abnormal l gain is the gain resulting when actual loss in less than the normal or expected loss ,and it is given a ‘negative cost’

Since an abnormal loss is not given a cost, the cost producing these units is borne by the good units of output.
Abnormal loss and gain units are valued at the same rate as “good” units. Abnormal events do not therefore affect the cost of good production. Their costs are analyzed separately in an abnormal loss or abnormal gain account.

Scrap value of loss.

Loss may have a scrap value. For scrap value the following basic rules are applied in accounting for this value in the process accounts.
  • Revenue from scrap is treated, not as an addition to sales revenue, but as a reduction in costs.
  • The scrap value of normal loss is therefore used to reduce the material costs of the process.
    DEBIT Scrap account
    CREDIT Process loss account
  • The scrap value of abnormal loss is used to reduce the costs of abnormal loss
    DEBIT Scrap account
    CREDIT Abnormal loss account
    With the scrap value of abnormal loss, this therefore reduces the write off of cost to the profit and loss account.
  • The scrap value of abnormal gain rises because the actual units sold as scrap will be less than the scrap value of normal loss. Because there are fewer units of scrap than expected, there will be less revenue from scrap as a direct consequence of the abnormal gain. The abnormal gain account should therefore be debited with the scrap value.
  • The scrap account is completed by recording the actual cash received from the sale of scrap.
    DEBIT Cash received
    CREDIT Scrap account
    With the cash received from the sale of the actual scrap.

Tuesday, August 11, 2009

(78)---PROCESS COSTING

Process Costing.

Process costing / continuous operational costing is defined in as “The costing method applicable where goods or services result from a sequence of continuous or repetitive operations or process. Costs are averaged over the units produced during the period”.
Process costing is used where it is not possible to identify separate units of production, or jobs, usually because of the continuous nature of the production processes involved. It is common (but not essential) to identify process costing which continuous production such as the following.


  • Oil refining.
  • Paint.
  • The manufacture of soap.
  • Food and drink.
The features of process costing which make it different from specific order costing methods such as job costing or batch costing are as follows.
  1. The output of one process is the input to subsequent process unit a completed product is produced.
  2. The continuous nature of production in may processes means that there will usually be closing work in progress which must be valued. In process costing it is not possible to build up cost records of the cost of each individual unit of output because production in progress is an indistinguishable homogeneous mass.
  3. There is often a loss in process due to spoilage, wastage, evaporation and so on.
  4. Output from production may be a single product, but there may also be a by product (or by products) and joint products.
Framework for dealing with process costing.
Process costing is centered on four steps. The exact work done at each step will depend on the circumstances of the question, but the approach can always be used.

Step 1- Determine output and losses.

  • Determine expected output.
  • Calculate normal loss and abnormal loss and gain.
  • Calculate equivalent units if there is closing or opening work in progress.
Step 2- Calculate cost per unit of output, losses and WIP.
  • Calculate cost per unit or cost per equivalent unit.
Step 3- Complete accounts.
  • Complete the process account.
  • Write up the other accounts required by the question such as abnormal loss/gain accounts, scrap accounts and so on.

Friday, July 17, 2009

(77)---PERFORMANCE MEASUREMENT - THE BALANCE SCORECARD

Performance measures-The balance scorecard.

Although segment of a business may be measured by a single performance indicator such as Return on Investment (ROI), Profit or Cost variance, it might be more appreciate to use multiple measures of performance where each measure reflects a different aspect of achievement. Where multiple measures are used, several may be non-financial.

The most popular approach in current management thinking is the use of what is called a “balance scorecard” consisting of a variety of indicators both financial and non-financial.

As CIMA official terminology the balance scorecard is an approach to the provision of information to management to assist strategic policy formulate and achievement. It empresses the need to provide the users with a set of information which addresses all relevant areas of performance in an objective and unbiased fashion. The information provided may include both financial and non-financial elements, and areas such as profitability, customer satisfaction, internal efficiency and innovation.

Wednesday, July 15, 2009

(76)---INFORMATION SYSTEM AND PERFORMANCE MEASURES.

Information system and performance measures.

Traditional information systems hold historic information of quantitative and monetary nature which has usefully been produced internally. To deal with the type of performance measures describe above, information system must be capable of holding descriptive results from a customer survey, for example, This type of information may come from external consultancies or from internal sources, service businesses being in a good position for collecting survey information because the customer is often at the point of delivery of the service and is therefore easily accessible for data collection.

In addition to adapting to collection and storing descriptive data, information systems must be capable of monitoring non-monetary data, such as customer waiting time and the speed of service delivery. To be most effective this type of information must be instantly available. Therefore the speed with which the data is processed into management information is likely to have to increase.

Tuesday, July 14, 2009

(75)---PERFORMANCE APPRAISAL SERVICE INDUSTRIES & NON-PROFIT MAKING ORGANIZATION.

Performance appraisal in service industries.

Service businesses do not produce any tangible output and, as it is difficult to measures performance, the tendency has been to concentrate on the easily quantifiable aspects of cost and productivity.

However, the non-tangibility of output makes even productivity difficult to measure. Fitzgerald et al advocate the use of a range of performance measures covering six “dimensions


(a). Competitive performance, focusing on factors such as sales growth and market share.
(b). Financial performance, concentrating on profitability, liquidity and market ratios.
(c). Quality of service, looks at matters like reliability, courtesy, competence and availability.
(d). Flexibility, is an apt heading for organization’s to deliver at the right speed, to respond to process customer specifications, and to cope with fluctuations in demand.
(e). Resource utilization, considers how efficiently resources are being utilized. This can be problematic because of the complexity of the inputs to a service and the outputs from it.
(f). Innovation, is assessed in terms of both the innovation process and the success of individual innovations. In a modern environment in which product quality, product differentiation and continues improvement are the order of the day, a company that can find innovative ways of satisfying customers wants has an important competitive advantage.


Performance measurement for Non-Profit Making Organization (NPMO).

Commercial organizations generally have market competition and the profit motive to guide the process of managing resources economically, efficiently and effectively. However, non-profit making organization (NPMOs) cannot by definition be judged by profitability nor do they generally have to be successful against competition, so other methods of assessing performance have to be used.

Performance is usually judge in terms of inputs and outputs and this tie in with the “value for money” criteria that an often used to assess NPMOs.
  • Economy (spending money frugally)
  • Efficiency (getting out as much as possible for what goes in)
  • Effectiveness (getting done, by means, by means of (a)and (b) what was supposed to be done)

More formally, effectiveness is the relationship between an organization outputs and its objectives, efficiency is the relationship between inputs and outputs, and economy equates to cost control in the commercial sector.

The problems with measuring the performance of NPMOs are therefore as follows.
  • For many NPMOs, particularly government bodies, it is extremely difficult to define their objectives at all, let alone fine one which can serve a yardstick function in the way that profit does for commercial bodies.
  • NPMOs tend to have multiply objectives, so that even if they can all be clearly identified it is impossible to say which the overriding objective is.
  • Outputs can seldom be measured in a way that is generally agreed to be meaningful. (For example, are good exam results alone an adequate measure of the quality of teaching?)