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IOV-Registered Valuers Foundation SECURITIES OR FINANCIAL ASSETS First edition, April 2019 IOV Registered Valuers Foundation Page | 2  IOV-Registered Valuers Foundation This material has been prepared in ac...

IOV-Registered Valuers Foundation SECURITIES OR FINANCIAL ASSETS First edition, April 2019 IOV Registered Valuers Foundation Page | 2  IOV-Registered Valuers Foundation This material has been prepared in accordance to the syllabus prescribed by IBBI and for the sole purpose of being the referral study material to the 50 hours Mandatory Education Programme. The views and opinions expressed in these materials are those of the authors and not of IOV-RVF, New Delhi. Though prepared and edited with due care, IOV-RVF, New Delhi do not undertake any liability for the views expressed herein. No part of this publication may be reproduced, transmitted or utilized or stored in any form or by any means now known or hereinafter invented, electronic, digital or mechanical, including photocopying, scanning, recording or by any information storage or retrieval system, without prior permission of IOV-RVF. IOV Registered Valuers Foundation Plot. No.3, 2nd Floor, Aggarwal Square, LSC JN, 80Ft Rd, Parwana Road, Pitampura, Delhi-110034.  IOV-Registered Valuers Foundation ACKNOWLEDGEMENT This book is based on studies & research in the field of valuation by prominent research organisations, writers, editors & other contributors. We wish to express our gratitude to eminent valuer members of the Institution of Valuers who played a pivotal role in getting this course material constructed. We would like to thank the Education, Training & Research Committee of IOV-RVF, Chaired by Dr. Goutam Sengupta (Vice Chancellor, Techno India University, Kolkata) for the motivation and support provided during the course of making this book. Inspiration to prepare this course material has been derived by the works of International Valuation Standards Council, Dr. Ashok Nain, Prof. Syamales Datta, Late Dr. P.C. Gupta, Late Dr. Roshan H Namavati, C.H. Gopinatha Rao, Late D. N. Banerj ee, V. Shanmugavel, B. Kanagasabapathy, Ram Mohan Bhave and Gopala Krishna Raju. This book would not be complete without the editing efforts of Nitin Lele, Sandip Deb, R.K. Patel and Gopala Krishna Raju. We sincerely appreciate the contributions of S. Pic haiya, Pramod Athalye, Devend ra Patekar, Vikas Londhe, Abhay Kumar, Munish Aggarwal, Ashok Kumar Gupta, Neeraj Kapoor, Anand Raj, B.V. Ramanna and G.S. Raju And last but not the least, a whole hearted thanks to Centre for Research & Technical Education (CRTE) for their unending support during the whole process of shaping up the book. IOVRVF is grateful to IBBI and Dr. M. S. Sahoo for providing us an opportunity to prepare this course material. Vinay Goel Tanuj Kumar Bhatnagar Managing Director & CEO Director Page | 4 IOV-Registered Valuers Foundation IOV-Registered Valuers Foundation Page | 6  IOV-Registered Valuers Foundation A WORD FROM OUR CHAIRMAN IOV-RVF initiated the training programme for Registered Valuers in India. It brought out a collection of study material last year for the student members of IOV-RVF. The study material predominantly included the IBBI indicated syllabus and was provided to about 3000 members or more who have undergone the IOV-RVF training. The study material was appreciated by faculty members & students alike. It is pertinent to mention here that the contents of the entire study material were the result of many years of facilitating, researching and contributions of eminent & learned members of the Institution of Valuers (IOV), which has a legacy of 50 golden years of enriching its members by way of monthly journals, seminars, workshops and lectures etc. Our government through Ministry of Corporate Affairs (MCA) and the regulating authority (IBBI) is continuously making efforts to upgrade the valuation profession by way of amending the rules, and otherwise in respect of registration, valuation examination including syllabus/course curriculum, eligibility requirements and functions of the valuers etc., in consultation with the Registered Valuer Organisations (RVOs) in their monthly meetings held regularly with IBBI. Due to ever changing hues of valuation arena, developments under IBC, implementation of Companies (Registered Valuers & Valuation) Rules, 2017 and change in examination syllabus for the valuation examination conducted by IBBI, it has become important for IOV-RVF to improvise the content of its study material to upgrade it as per changed environment. It is now the appropriate time to recreate the existing material in a book form for the benefit of aspiring valuers. IOV-RVF believes that a book form can at best be considered as a window to never-ending expanse of knowledge in valuation world. Valuation involves understanding of vide range of subjects including law, economics, technology, business management etc. that a single person is often found inadequate in producing a comprehensive book on subject. IOV-RVF thought it appropriate to include more number of domain experts to contribute to the book so as to overcome this limitation. The result is a vantage point view of valuation practice in India, cumulating the first hand experience of practicing valuers and domain experts. It is pertinent to understand that valuation is based on scientific methodology encompassing interdisciplinary fields such as engineering, finance, economics, law, social science statistics etc. The prime motive of valuation method is to understand ways to arrive at conclusive figures to accommodate all the benefits and liabilities that can accrue to owner of property. Accordingly, in order to understand what it means to carry on the professio n of valuation, students must develop both a foundation of valuation as a subject and an understanding of the critical issues of the valuation profession. This book provides a framework for learning  IOV-Registered Valuers Foundation these necessary topics in a way that emphasizes the uniqueness of each topic and each chapter as per the syllabus. The text also lays emphasis on the necessary skills in building and maintaining the Valuation profession in order to make valuations as per the valuation standards and conducting the valuation assignments in the professional and ethical manner, which is the essence of the government’s efforts in institutionalizing and regulating the valuation profession. This book is primarily aimed at training the aspiring valuers for qualifying IBBI exam by providing them ample opportunities to understand the concepts and absorb first hand experiences which have been illustrated by way of Case Studies and examples. A structured approach has been followed so that the reader is be exposed to General Valuation Practices in India, its role in corporate valuation, IBC-2016 and other statutory requirements under Companies Act-2013, Valuation methods, Valuation Standards, professional and ethical standards, valuation related laws, economics, understanding of case studies, case laws in valuation, environmental issues concerning valuation and report writing. The book primarily focuses on the indicative syllabus as prescribed by IBBI for the purpose of valuation examination. This book places a clear emphasis on Valuers’ understanding for need of ethics, its role towards fellow professionals and the society at large. Valuers’ sensitivity to environmental issues that may create or destroy value of asset has been detailed and amply highlighted. Entire chapter has been contributed to report writing in line with Valuation Rules. Valuers’ task of identifying various interests in property, methods of calculating the monetary value of such interests, marketing propositions of such valued interests under various situations of business cycle have been adequately addressed in this book. Lastly, since the subject is ever-evolving it shall be our endeavor to incorporate the updated developments on issues related to valuation in our forthcoming editions. Dr. Goutam Sengupta Chairman, Governing Board IOVRVF Page | 8 CONTENT MACROECONOMICS 1. National Income Accounting CHAPTER-1 2. Fiscal Policy Page 01 3. Monetary Policy 4. Understanding Business Cycle FINANCE & FINANCIAL STATEMENT ANALYSIS CHAPTER-2 1. Finance Page 33 2. Financial Statement Analysis PROFESSIONAL ETHICS &STANDARDS 1. Model code of Conduct for Registered Valuers as notified by CHAPTER-3 Ministry of Corporate Affairs (MCA) under the Companies Page 41 (Registered Valuers and Valuation) Rules, 2017 2. Ethical Considerations under Terms of Engagements GENERAL LAWS 1. The Company’s Act, 2013 2. The Indian Contract Act, 1872 3. The Sale Of Goods Act, 1930 4. The Transfer Of Property Act, 1882 CHAPTER-4 Page 55 5. The Indians Stamps Act, 1899 6. The Income Tax Act, 1961 7. The Insolvency and Bankruptcy Code, 2016 (IBC) & Regulations 8. The Sarfaesi Act, 2002 FINANCIAL REPORTING UNDER INDIAN ACCOUNTING STANDARDS (IND AS) CHAPTER-5 Page 138 1. Indian Accounting Standard (Ind AS) 113, Fair Value Measurement OVERVIEW OF VALUATION 1. Meaning of Value 2. Premise of Valuation 3. Purpose of Valuation CHAPTER-6 4. Valuation Standards Page 144 5. Valuation Engagements-Scope of Work 6. Valuation Process 7. Valuation Report 8. Documentation VALUATION APPROACHES 1. Meaning of Value 2. Premise of Valuation 3. Purpose of Valuation CHAPTER-7 4. Valuation Standards Page 161 5. Valuation Engagements-Scope of Work 6. Valuation Process 7. Valuation Report 8. Documentation Page | 1  IOV-Registered Valuers Foundation VALUATION APPLICATION 1. Equity / Business Valuation 2. Fixed Income Securities CHAPTER-8 Page 171 3. Option Valuation 4. Valuation of other Financial Assets and Liabilities 5. Intangible Assets 6. Situation Specific Valuation REGULATIONS RELEVANT TO FINANCIAL ASSETS VALUATION CHAPTER-9 1. The Securities and Exchange Board of India Regulations Page 216 2. RBI and FEMA Regulations JUDICIAL PRONOUNCEMENTS ON VALUATION 1. Miheer H. Mafatlal Vs. Mafatlal Industries Ltd. (1997) 1 SCC 579 2. Hindustan Lever Employees' Union Vs. Hindustan Lever Limited And Ors. 3. Brooke Bond Lipton India Ltd.td. 98 Comp Cas 496 CHAPTER-10 Page 243 (Cal) 4. Dinesh Vrajlal Lakhani Vs. Parke Davis (India Ltd.) (2005) 124 Comp Case 728 (Bom HC) 5. Dr. Mrs. Renuka Datla Vs. Solvay Pharmaceutical B.V. & Ors. G.L. Sultania and Another Vs. The Securities and Exchange Board of India GLOSSARY Page 253 Page | 2  S or FA /Chapter-1/Macroeconomics MACROECONOMICS I 01 2. National Income Accounting 3. Fiscal Policy 4. Monetary Policy 5. Understanding Business Cycle Page | 1  IOV-Registered Valuers Foundation MACROECONOMICS I 01 1. NATIONAL INCOME ACCOUNTING Economics is a branch of knowledge concerned with studying production, consumption and transfer of wealth. According to Robbins, “Economics is the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses.” The study of economics is broadly divided into two categories- Microeconomics and Macroeconomics. Microeconomics is the study of individual economic behavior whereas macroeconomics studies the economic behavior of the entire country. Microeconomics studies the decisions made by people and businesses with regards to allocation of resources and price determination. Macroeconomics, on the other hand, studies national aggregates and nationwide policies that affect the economy as a whole. For example, microeconomics studies how firms behave in certain economic conditions, like inflation. Macroeconomics studies the forces that lead to such economic condition, like expansionary monetary policy that causes inflation. Both these branches of economics are interdependent and have an influence on each other. Understanding how national income is created and accounted for is the starting point of macroeconomics. According to Marshall, “The labor and capital of its country acting on its natural resources produce annually a certain net aggregate of commodities, material and immaterial, including services of all kinds. This is the true net annual income or revenue of the country or national dividend. Thus, national income is defined as the total value of all the final goods and services produced in a country within a specific period of time, usually one year. The national income identity is that the amount received as national income is identical to the amount spent as national expenditure which is identical to what is produced as national output. Thus, throughout the course of studying macroeconomics, the terms income, expenditure and output are interchangeable. Each of these variables can be used to measure national income differently. Page | 2  S or FA /Chapter-1/Macroeconomics National Income consists of various concepts, with each relating todifferent methods of measurement. We will have a look at some of these concepts and methods of measuring national income in the following chapter. NATIONAL INCOME ACCOUNTING INCLUDES 1. Gross Domestic Product 2. GDP at Factor Cost 3. Net Domestic Product 4. Nominal and Real GDP 5. GDP Deflator 6. Gross National Product 7. GNP at Market Price 8. GNP at Factor Cost 9. Net National Product 10. NNP at Market Price 11. NNP at Factor Cost or National Income 12. Domestic Income 13. Private Income 14. Personal Income 15. Disposable Income 16. Real Income 17. Per Capita Income NATIONAL INCOME AS A STOCK AND FLOW CONCEPT 1. It refers to the value of an asset at a balance date (point of time), while flow refers to the total value of transactions (income, expenditure, sales, purchases) during an accounting period. 2. Stock refers to a quantity of commodity accumulated a point in time. The quantity of the current production of the company which moves from the factory to the market is called flow. 3. Number of turnovers= 4. Two types of Macroeconomic Aggregates: Page | 3  IOV-Registered Valuers Foundation Stock of Capital 'K' is a timeless concept Stock is always specified for a specific Stock moment. It is an economic variable relating to time Flow refers to income, output, consumption and investment Flow A flow variable has the time dimension, it is specified for a unit of time CONSUMPTION OF GOODS IN AN ECONOMY 1. Consumption of goods and services refers to the quantity of them utilised in a particular time period. 2. Consumption drives the transaction of goods and services, for without demand for consuming goods and services, there would be no supply. It is the intensity of consumer demand which drives the prices. Let’s look at the two main types of goods found in an economy while accounting for national income: Final Goods Intermediate Goods Final goods refer to those goods that are Intermediate goods refer to those goods that used either for consumption or are used either for resale or for further investment. production that year. Goods purchased by consumer Producer goods or semi-finished goods are households for final consumption are included in intermediate goods. included in final goods. Goods purchased by firm for capital These goods are sold between industries for formation or machinery are included in resale and for production of consumer final goods. goods. Final goods are not resold or used for any Intermediate goods are used and further transformation in the process of transformed as inputs in the process of production. production, thus leading to the production of consumer goods. Page | 4  S or FA /Chapter-1/Macroeconomics CAPITAL 1. In economic terms, capital consists of anything that can enhance a person’s power to perform economically useful work. 2. It is an input in the production function. 3. According to Adam Smith, the Father of Economics, capital is “that part of a man’s stock which he expects to afford him revenue”. 4. At any given point in time, capital stock can be used to refer to the total physical capital owned by a firm. GROSS DOMESTIC PRODUCT 1. Gross Domestic Product (GDP)refers to the total value of goods as well as services produced in a country during a year. 2. It is calculated at market prices and is known as GDP at Market Prices. 3. In the calculation of GDP, the following goods and services are excluded:  Value of intermediate goods  Transfer payments  Second hand goods  Goods dealt in parallel economy 4. Dernberg defines GDP at market price as “the market value of the output of final goods and services produced in the domestic territory of the country during an accounting year.” 5. There are three different ways to measure GDP at market price. They yield the same result because National Product = National Income = National Expenditure. Page | 5  IOV-Registered Valuers Foundation THE THREE WAYS TO MEASURE GDP Product Method Nominal GDP Real GDP Value of all goods and GDP by income is a sum GDP by expenditure services produced in of all the factor incomes, method at market price is different industries during i.e. the income people calculated as: C + I + G + a year is added up receive due to the (X - M) production of GDP. Also known as Value The factors of Here, C= consumption Added Method production are land, expenditure, I= investment labor, capital and in fixed capital, G= entrepreneur. They each government expenditure, earn rent, wages, interest and, (X- M)= net exports, and profits respectively. which can be positive or negative. It includes all the 3 sectors Thus, this method Note: Can you please of the economy- primary, includes the rewards of specify what are those secondary and tertiary. For each factor of four factors? I can't find eg: agriculture and allied production. any accurate factors on services, mining, the net. manufacturing, construction, electricity, gas and water supply, transport, communication, trade, banking and insurance, real estate, public administration, defense and other services. GDP AT FACTOR COST 1. GDP at Factor Cost is the sum of net value added by all the producers in a country. 2. It is the sum of domestic factor incomes and fixed capital consumption. 3. So, GDP at factor cost = Net Value Added + Depreciation 4. It includes:  Compensation of employees (wages, salaries)  Operation Surplus (Gross Value Added at factor cost – Compensation of Employees- Depreciation)  Mixed income of self-employed 5. To calculate GDP at factor cost, indirect taxes are subtracted from the GDP at market price, and subsidies are added to the same. The formula can be termed as:  GDP at factor cost = GDP at market price – Indirect Taxes + Subsidies. Page | 6  S or FA /Chapter-1/Macroeconomics 6. In India now, due to the changes made by CSO, National Income is now also calculated using GVA (Gross Value Addition) at basic price, which takes into account the value of intermediate goods, government subsidies and indirect taxes like GST. Now, all the industry estimates are calculated and presented using GVA at basic prices. NET DOMESTIC PRODUCT 1. NDP is the value of the net output of the economy during a year. 2. We arrive at NDP when the value of capital consumption, or, the wear and tear of capital goods, is deducted from the GDP. 3. Thus, NDP = GDP at factor cost – Depreciation. NOMINAL AND REAL GDP 1. Let us first understand the concept of base year, because real GDP can be calculated only with the help of a base year. The base year acts as a standard year against which the recent economic activity can be compared. It is set to an arbitrary level of 100 for easy comparison. 2. A base year is a year which is not very far from the recent years and accounts for little to no economic instability or fluctuations 3. In India, FY 2011-12 is used as the base year for GDP computation. Nominal GDP Real GDP When GDP is measured at its current When GDP is calculated on the basis of fixed price, it is called GDP at current prices prices in some year, it is called GDP at constant or nominal GDP. prices or real GDP. Nominal GDP does not accommodate Real GDP rectifies the overestimation and the rising and falling prices. For underestimation of GDP by choosing a base example, due to inflation, GDP will be year with a normal general price level. The prices high for that particular year. However, are set to 100 (or 1) for base year. that is not indicative of economic growth. In fact, the actual GDP would have decreased, and the increase is only because of the rising inflation. Page | 7  IOV-Registered Valuers Foundation GDPDEFLATOR 1. GDP Deflator is an index of price changes of goods and services included in the GDP. 2. It is calculated by dividing the Nominal GDP in a given year by the real GDP for the same year and multiplying it by 100. 3. Thus, 4. For example, GDP Deflator in 1997-98 = = 135.9 i. This shows that at constant prices (1993-94), GDP in 1997-98 increased by 135.9% due to inflation. GROSS NATIONAL PRODUCT 1. GNP is the total measure of the flow of goods and services at market value resulting from current production during a year in a country, including income from abroad. 2. GNP = C + I + G + X + Z 3. Here, C= consumption expenditure, I= investment expenditure, G= government expenditure, X= net exports (imports-exports) and Z= net income earned by domestic residents from foreign investments – net domestic income earned by foreign residents. 4. Thus GNP takes into account net income receipts from abroad, which is not accounted for in GDP computation. 5. GNP includes four types of final goods and services:  Consumer goods to satisfy immediate wants of the people  Gross private domestic investment in capital goods consisting of fixed capital formation, residential construction and inventories of finished and unfinished goods.  Goods and services produced by the Government  Net exports of goods and services i.e. difference between the value of exports as well as imports of goods and services. 6. In the concept of GNP, there are certain factors that need to be taken into consideration. They are as follows:  GNP is the measure of money. All kinds of goods and services produced in a year in a country are measured in monetary terms at current prices and then added together. To guard against the overestimation or underestimation of GNP due to inflation or deflation, a year with normal prices is taken as base year and GNP at constant prices is calculated in accordance with the index number of that year.  The money value of only the final goods and services is taken into account while calculating GNP. This is done to avoid double counting.  Goods and services rendered free of charge are not included in GNP since it is not possible to have a correct estimation of their market price.  The sale and purchase of old goods, assets, shares and bonds of existing companies is not included in GNP since they are simply transfer goods and make any addition to the national produce of that year. Page | 8  S or FA /Chapter-1/Macroeconomics  The payments made for social security such as pensions, unemployment insurance, interest on public loans, etc. are not included in GNP since there no services offered in lieu of them.  If they are not responsible for current economic production, the profits or losses incurred on account of changes in capital assets as a result of price fluctuations are not included in GNP.  The income earned through illegal activities is not included in GNP. GNP AT MARKET PRICE 1. GNP at market price refers to the gross value of all the final goods and services produced annually in a country plus net income from abroad. 2. When we multiply the total output produced in one year by their market prices prevalent during that year, we get GNP at market prices. 3. Gross National Product (GNP) at market prices = Gross Domestic Product (GDP) at market prices + Net Income from abroad GNP AT FACTOR COST 1. GNP at factor cost is the sum of the money value of the income produced by and accruing to the various factors of production in one year in a country. 2. It is the income that the factors of production receive in return for their services alone. It is the cost of production. 3. It includes all the items mentioned under the income method of GNP less indirect taxes plus subsidies. 4. So, Gross National Product (GNP) at factor cost = GNP at market prices – Indirect Taxes + Subsidies NET NATIONAL PRODUCT 1. NNP includes the value of total output consumption goods and investment goods. 2. For calculating Net National Product (NNP), there is deduction of depreciation from GNP. The word ‘net’ indicates the exclusion of that part of total output which represents depreciation. 3. During the process of production, some fixed equipment wears out, its other components are damaged or destroyed, or still others are rendered obsolete through technological changes. This process is known as depreciation or capital consumption allowance. 4. NNP = GNP – Depreciation 5. NNP is the same as National Income or National Output. Page | 9  IOV-Registered Valuers Foundation NNP AT MARKET PRICE 1. NNP at market price is the net value of final goods and services evaluated at market prices in the course of one year in a country. 2. Deducting depreciation from GNP at market prices results in NNP at market price. 3. Thus, Net National Product (NNP) at market prices = GNP at market prices – Depreciation. NNP AT FACTOR COST 1. NNP at factor cost is the net output evaluated at factor prices. 2. It includes income earned by factors of production through participation in the process of production such wages, rent, interest and profits. 3. NNP at factor cost is also called as National Income 4. To arrive at NNP at factor cost, indirect taxes are subtracted and subsidies are added to NNP at market price. 5. Thus, NNP at factor cost = NNP at market price – Indirect Taxes + Subsidies 6. = GNP at market price – Depreciation – Indirect Taxes + Subsides 7. = National Income 8. NNP at factor cost is higher than NNP at market price when indirect taxes exceed government subsidies. However, NNP at factor cost is lesser than NNP at market price when government subsidies exceed indirect taxes. DOMESTIC INCOME 1. Income generated by the factors of production within the country from its own resources is called domestic income or domestic product. 2. It includes:  Wages and Salaries  Rents, including imputed house rents  Interest  Dividends  Undistributed corporate profits, including surpluses of public undertakings  Mixed incomes including profits of unincorporated firms, partnerships, self - employed persons, etc.  Direct taxes 3. Domestic income does not include income from abroad. Therefore, 4. Domestic Income = National Income – Income earned from Abroad 5. Thus, National Income = Domestic Income + Income earned from Abroad Page | 10  S or FA /Chapter-1/Macroeconomics PRIVATE INCOME 1. Private income is the one obtained by private individuals from any source, which is productive or otherwise, and the retained income of corporations. 2. Private Income = National Income (NNP at factor cost) + Transfer Payments + Interest on Public Debt – Social Security – Profits and Surpluses of Public Undertakings PERSONAL INCOME 1. Personal Income is referred to as total income received by individuals of a nation from all sources, before payment of direct taxes in a year. 2. Personal income is not equal to national income, because, the latter does not include transfer payments that are included in the former. 3. Personal Income = Private Income – Undistributed Corporate Profits – Profit Taxes DISPOSABLE INCOME 1. Disposable income or personal disposable income means the actual income that can be spent on consumption by individuals and families. 2. For calculation of disposable income, direct taxes are subtracted from the personal income. Thus, Disposable Income = Personal Income – Direct Taxes 3. Thus, Disposable Income= National Income – Business Savings – Indirect Taxes + Subsidies – Direct Tax on Persons – Direct tax on Businesses – Social Security Payments + Transfer Payments + Net Income from Abroad REAL INCOME 1. Real Income is the national income represented with regards to a general level of prices of a particular year taken as base. 2. National income is the value of goods as well as services produced, as represented in terms of money at current prices. However, it does not include the real estate economy PER CAPITA INCOME 1. The average income of the people of the country within a year is called Per Capita Income. 2. This concept also includes the measurement of income at current prices and constant prices. 3. 4. Page | 11  IOV-Registered Valuers Foundation METHODS OF MEASURING NATIONAL INCOME 1. There are four methods for measuring National Income. They are- Product Method, Income Method, Expenditure Method and Value-Added Method. 2. The method used to measure national income depends on the availability of data in a country and purpose at hand. Product Method Income Method Expenditure Method Value Added Method The total value of The net income Total expenditure The value added by final goods and payments received by incurred by a nation is industries is services produced all the citizens of a summed up together another method of in a year is country are added up and includes net measuring national calculated at i.e. net income that domestic investment, income. If the market prices. The accrue to all factors of personal consumption difference between data of all production byway of expenditure, net the material output productive net wages, net rent, foreign investment and input of every activities is net interest and net and government industry is added collected and profit. The data is expenditure on goods up, we arrive at assessed at collected from as well as services. gross domestic market prices. different sources. product. Only the final Transfer payments are This is based on the To avoid goods and not included in the assumption that duplication, the services are calculation of national national income value of included, income. equals national intermediate goods intermediary expenditure. used in production goods and is subtracted from services are left total output of out. each industry. 2. BASICS OF FISCAL POLICY WHAT IS FISCAL POLICY? Any ruling government has the ability to influence the manner in which various resources are utilised in the economy. Fiscal Policy is a highly effective tool that enables the government to do so. It is the means through which government uses taxation and it’s spends (public expenses) to bring about stability & growth, thereby, influencing the nation’s economy. According to Culbarston, “By fiscal policy we refer to government actions affecting its receipts and expenditures which ordinarily as measured by the government’s receipts, its surplus or deficit.” Page | 12  S or FA /Chapter-1/Macroeconomics The government manages to influence the economy by adjusting the following:  Tax rates (modifying types of taxes and subsequent levels),  Spending levels (composition and extent of expenditures) A suitable example of such adjustment by the government (to influence the economy) can be seen in relation to income tax, that gets levied on citizens of the country (individual taxpayers) based on a slab system in which various tax rates have been prescribed for variety of slabs. These tax rates do keep rising with a corresponding increase in the income slab. As per Keynesian economics (theory on which Fiscal policy is based), the government may increase / decrease tax rates as well as public expenses to have an effect on the macro- economic productivity levels – leading to inflation control, rise in employment, and stable value of money. This has been one of the theories of John Maynard Keynes, a British economist. SCENARIOS WHERE FISCAL POLICY CAN PLAY A CRITICAL ROLE The appropriate usage of Fiscal policy will be achieved by the government by maintaining the right balance between public expenditures and tax levels. Let us consider a scenario where the nation’s economy is experiencing slowdown, with higher unemployment rate, lower public expenses, and lower profits for businesses. Situation is summarized as under: Economy High Low Public Low Business Slowdown Unemployment Spending Profits For such a situation, the ideal way for government to use Fiscal policy will be to decrease tax rates that would give more spending power to the population. At the same time, government can pump in more money into the economy by opting to build hospitals, roads, schools, colleges, and so on, thereby creating employment opportunities. The combined effect of these measures will reduce the unemployment levels and will increase the demand for goods as well as services by the consumers. Thus, businesses will start booming and change the direction of the economy positively. This overall situation is a case of fiscal expansion – reduction in tax levels and increment in government spending to increase aggregate demand as well as growth. Page | 13  IOV-Registered Valuers Foundation Key Fiscal Expansion Measures Decreased Tax More Spending More More Rates by People Government Employment Investment Opportunities However, too much money in the economy could increase the customer demand for goods and services beyond control, leading to rise in prices. This could lead to high inflation. Situation is summarized as under: Excess Money Increased Increased Higher in Circulation Demand for Prices Inflation Products Levels This scenario may require the government to slow the economy down by increasing tax rates and decreasing consumer spending capacity, as well as reducing government spending. It would lead to less circulation of money in the economy, and reduce the inflation. This situation is a case of fiscal contraction – increment in tax rates and reduction in government spending to decrease aggregate demand and output. Key Fiscal Contraction Measure: Increase Tax Reduced Reduced Less Money in Rates Spending by Government Circulation and People Investment Lower Inflation As seen with above two scenarios, the entire process is cyclical – and based on the situation, government will be able to maintain a fine balance between tax rates and it’s spending levels to keep directing the economy in the right manner. GOVERNMENT BUDGET A government budget refers to an annual financial statement that outlines the estimated government expenses as well as actual government receipts / revenues for the upcoming fiscal year. These budgets can be of three types: 1. Balanced budget 2. Surplus budget 3. Deficit budget Page | 14  S or FA /Chapter-1/Macroeconomics In case of balanced budget, the estimated government expense equals the expected receipts (by the government) for a specific financial year. This helps the government to keep away from injudicious expenditures, and can help to achieve economic stability if implemented appropriately. This type of budget is not suitable during recession and does not provide any solution to issues like unemployment. In case of surplus budget, the estimated government expense is exceeded by the expected government receipts / revenues for a specific financial year. In simple terms, the government’s spending on public welfare is less than the earnings of the government from taxes levied. This kind of budget is suitable during inflation to reduce demand. In case of deficit budget, the estimated government expense exceeds the expected government receipts / revenues for a specific financial year. This type of budget is suitable during recession, to generate more demand, improve employment, and boost the economic growth rate. It is ideal for developing economies such as India. OBJECTIVES OF FISCAL POLICY After understanding how Fiscal policy works, let us list down the objectives of the same for the government: List of Fiscal Policy Objectives To maintain significa ntly hig h employment rates. To curb inflation and bring price stability. To maintain a proper balance between receivables and expenditures of the government. To ensure healthy and sustainable economic growth. To reduce poverty and promote economic development of an underdeveloped natio n. To earn good amount of foreign exchange by promoting exports, and thereby bring ing about balance of trade as well as payments. To ensure balanced regional development of the na tion b y using a major part of the revenue from tax receipts for less / under developed states. COMPONENTS OF FISCAL POLICY The Fiscal Policy comprises of four key components as described under: 1. Taxation Policy Government needs to ensure appropriate tax rates are applied for the economy at any given point in time, as it is able to generate revenue from the taxation applied (direct as well as indirect taxes). A proper balance needs to be maintained because:  Tax rate if lower than normal would result in more consumer spending capability, which may cause a rise in demand and prices, leading to inflation.  Tax rate if higher than normal would lead to less consumer spending capacity, which may cause a decrease in demand, investment and production. Page | 15  IOV-Registered Valuers Foundation 2. Expenditure Policy  In order to pay off external as well as internal debts and corresponding interest, the government plans for expenses on development areas such as infrastructure, health, education, and so on. The government budget helps to fill the gap between government spending (expenses) and income, thereby proving to be an integral component of the Expenditure Policy. The Expenditure Policy considers capital expenditure as well as revenue expenditure. Capital expenditure leads to asset creation and liability reduction. Relevant examples of capital expenditure include loans to states and union territories as well as foreign governments and public enterprises, defense capital, purchasing lands and building as well as shares, and more. Revenue expenditure does not lead to asset creation and liability reduction. Relevant examples of revenue expenditure include grants, subsidies, pension, salaries, interest payments, expenditure on central plans, and so on. 3. Investment & Disinvestment Policy Optimal domestic and foreign investments are necessary to maintain stable economic growth. For the Investment & Disinvestment policy, FDI (Foreign Direct Investment) becomes highly important for integration of the domestic and global economies. 4. Debt / Surplus Management Government has surplus when it receives more than it spends (income > expenditure), and incurs deficit (debt) when it spends more than it receives (income < expenditure). To tackle deficit, the government borrows from domestic as well as international sources. It may even resort to printing of money for handling deficit financing. This concept of deficit financing helps to meet government deficits via the creation of new money. In a nation like India, deficit financing is used to raise resources for economic development, reducing foreign debt, redemption of public debt, as well as for adjustment of balance of payments. Page | 16  S or FA /Chapter-1/Macroeconomics The different types of deficits encountered by government can be seen in below table: Type of Deficit Formula Explanation Additio nal Info Budgetary Deficit Revenue Account Revenue Account Deficit: Expressed as percentage Defic it + Capital when government’s of GDP Account Defic it revenue expenses exceed their revenue receipts Capital Acco unt Deficit: when government’s capital disbursements exceed their capital receipts Revenue Deficit Revenue Expenditure Measures government Borrowing or sale of (planned and negative contribution to assets enables unplanned) – Revenue domestic savings or government to meet this Receipts (tax and non- dissavings (excess deficit. tax) amount spent) on government’s account Effective Revenue Revenue Deficit – Effective Revenue Deficit Grants (for creation of Deficit: excludes the capital assets) revenue expenditures that were made in the form of ‘grants’ for capital asset creation. Fiscal Deficit Total Expenditure – Fiscal Deficit: Total Rise in Fiscal Deficit to be (Revenue Receipts + borrowing needs of the tackled by more Capital Rec eipts government from all borrowing, leading to excluding borrowings) possible sources significant internal debt for the government Primary Deficit Fiscal Deficit – Interest Primary Deficit: Enables us to get an Payments Borrowing needs of overview of how the government to fulfill government conducts its fiscal deficit net of financial affairs in present interest payments scenario Page | 17  IOV-Registered Valuers Foundation All government receipts can be grouped into two main categories: 1. Revenue Receipts These neither create liability, nor lead to reduction in assets of the government. Revenue Receipts can be from tax as well as non-tax revenue. These refer to current income receipts of government from all potential sources. These receipts can be interest, taxes, and dividend on government investments, as well as cess and similar receipts for services offered (and completed) by the government. Revenue Receipts are non-redeemable as government does not have any obligation to return any amount. 2. Capital Receipts These create liability or result in reduction of assets. Let us consider few examples of Capital Receipts that create liabilities are: Borrowing which leads to liability of returning loans, Fund raising from PPF or small saving deposits which creates liability of repaying amounts to PPF holders and small savings depositors. Borrowing is a debt-creating capital receipt. In this case, government has the obligation to pay back the amount (including interest). Examples of Capital Receipts that reduce government assets are: Disinvestment to raise funds through partial or total selling of shares (of public sector undertakings), as well as Recovery of Loans or Advances. Both of these examples are non-debt creating capital receipts. 3. BASICS OF MONETARY POLICY WHAT IS MONETARY POLICY? Just like Fiscal Policy, there exists one more policy which is used in various ways to provide the right direction to the goals of a nation’s economy. This is the Monetary Policy, which is more in terms of borrowing, spending as well as consumption by individuals & private businesses, while the Fiscal Policy is more related to government expenditures, bo rrowing, and taxes. It is the means (or process) through which the Central Bank (or similar monetary authority of a nation) manages supply of money in the economy. In case of India, this Central Bank is RBI (Reserve Bank of India). Some of the activities involved in managing money supply and interest rates include regulation of foreign exchange rates, purchase or sale of government bonds, changing the interest rate, as well as money required to be maintained as reserves by banks. All these activities are aimed to achieve macro-economic objectives (of general economic policy) such as ensuring inflation control, price stability, sustainable economic growth and full employment. Page | 18  S or FA /Chapter-1/Macroeconomics Important facets of the economy impacted by Monetary Policy are: 1. Assist overall economic or sector-specific growth 2. Maintain Forex (Foreign Exchange) rates in a manageable range 3. Obtain stability in GDP (Gross Domestic Product) growth rate 4. Reduce unemployment rate SCENARIOS WHERE MONETARY POLICY CAN PLAY A CRITICAL ROLE Let us consider couple of scenarios where the monetary authority has an influence on the overall economy through its actions to manage money supply. One scenario is where the overall economy is under recession with less money supply, unemployment rates are high, spending capacity of individuals is minimal, investment / spending capabilities of businesses is considerably reduced, and so on. Situation is summarized as under: Recession in High Low Public Low Business Economy + Less Unemployment Spending Spending / Money Supply Investment For such a situation, the Central Bank (monetary authority) can make use of expansionary Monetary Policy, to target reduction of interest rates using various ways that gives rise to consumer spending (and makes saving money less lucrative) capacity and increases demand for different daily goods and services, as well as big investments (like property on loan). This gives a major fillip to short-term growth that gets measured by GDP growth (Gross Domestic Product growth). With lower interest rates on capital, businesses as well as individuals manage to get loans easily, thereby giving a boost to various investments in projects and business-based tasks that generates more employment opportunities. Thus, the monetary authority is able to drive more money circulation in the market, providing the much-needed boost to the economy and enabling it to rise out of the recession. This is possible through the implementation of expansionary or easy Monetary Policy process, which often leads to diminishing of the currency value when compared to other currencies. Page | 19  IOV-Registered Valuers Foundation Expansionary Monetary Policy Measures Decreased More More More Demand More Project Interest Spending by Demand for for Big Investments + Rates Consumers Products Investments Employment However, this improved situation could soon turn into a not so desirable scenario - as the higher supply of money and improved growth rates may lead to increased demand for goods and services, which would lead to rise in prices, and thus cause higher inflation. Such a scenario results in considerably higher cost of living and higher cost of doing business. With unexpected higher inflation, debtors stand to gain as they are able to repay creditors with money that is worth less at that point in time (than when they borrowed it). Thus, creditors lose out as they receive less, while the borrowers (debtors) gain from inflation.Those who are holders of savings accounts in banks also tend to get less value for their money (when they invested). Situation is summarized as under: High Money Increased Demand Increased Prices Higher Inflation Supply for Products Levels This is when the monetary authority needs to adopt the contractionary Monetary Policy to control the inflation. As per this policy, the interest rates are increased which makes borrowing (getting loans) quite costly. This reduces the spending power of individuals, reduces the demand for goods & services, makes saving of money a favourable option, and decreases the circulation of money in the market. Such a scenario may increase the risk of unemployment and economic slowdown. However, this process of contractionary or tight Monetary Policy when applied in appropriate manner helps to bring down inflation in the favourable range. Contractionary Monetary Policy Measures Increased Less Reduced Reduced Inflation Interest Spending by Demand for Circulation of Curbed to Rates Consumers Products Money Desired Range Page | 20  S or FA /Chapter-1/Macroeconomics As seen in both these scenarios, the entire process and chain of events is cyclical – based on which the Central Bank / Monetary authority is able to take the necessary steps to boost the economic growth rate or control the inflation. OBJECTIVES / GOALS OF MONETARY POLICY The Monetary Policy is more related to the interest rates and availability of credit. This policy is adopted to achieve the following set of goals: List of Monetary Policy Objectives To control inflation in the desired range To bring more liquidity in the economy To assist overall economic or sector-specific growth To ensure stable Exchange rate by maintaining Forex (Foreign Exchange) rates in a manageable range To obtain stability in GDP (Gross Domestic Product) growth rate To reduce unemployment rate To ensure price stability To maintain equilibrium for BOP (Balance of Payments) To support equal income distribution Most of India’s five-year plans are targeted to achieve growth, stability as well as social justice. Hence, it is quite common that the objectives of these five-year plans are similar to those of the Monetary Policy implemented by the RBI. FACTORS IMPACTING MONETARY POLICY DECISIONS As a common practice, many of the Monetary Policy decisions from previous decades have been about coinage and printing paper currency for credit creation. In recent years, several other factors that have started impacting the Monetary Policy decisions are as listed under:  Short term interest rates  Long term interest rates  Velocity of money through the economy  Exchange Rates  Quality of Credit  Equities and Bonds (related to debt as well as corporate ownership)  Government expenditure / savings versus Private sector expenditure / savings  Large scale foreign capital flow of money  Financial derivatives like Future Contracts, Options, Swaps, and so on Page | 21  IOV-Registered Valuers Foundation MONETARY POLICY TOOLS The RBI makes use of various tools to achieve its Monetary Policy goals – primarily to manage money supply and liquidity so as to balance inflation as well as support economic growth. Some of the major Monetary Policy tools are listed under: 1. Cash Reserve Ratio (CRR) It refers to the minimum percentage of total deposits of customers in a commercial bank that the bank is required to hold as reserves (either in cash or as deposits) with the RBI (Central Bank). Advantages  To effectively control money supply in an overall economy  To ensure commercial banks do not fall short of money to fulfil the payment needs of their depositors Impact of CRR First Situation: When CRR rises High CRR -> More money of banks with RBI -> Less funds with commercial banks ->Less funds with people -> Decreased demand for goods as well as services -> Reduced prices -> Inflation under control Second Situation: When CRR falls Low CRR -> Less money of banks with RBI -> More funds with commercial banks -> More funds with people -> Increased demand for goods as well as services -> Increased prices -> Inflation rises 2. Statutory Liquidity Ratio (SLR) It refers to the percentage of deposits that a commercial bank needs to maintain with them in various forms of liquid assets (over and above the CRR) such as government approved securities (inclusive of government bonds), gold, and cash. This Statutory Liquidity Ratio can be considered by RBI as the percentage of demand as well as time liabilities. Advantages  Prevents commercial banks from liquidation of their liquid assets when CRR is raised  Helps to control bank credit  Makes banks to invest more in government securities Impact of Statutory Liquidity Ratio (SLR) First Situation: When SLR is High More funds of commercial banks as liquid assets -> Less liquidity with commercial banks -> Less loans offered to people -> Lower consumer spending -> Reduced demand for goods as well as services -> Reduced prices –> Inflation under manageable range Page | 22  S or FA /Chapter-1/Macroeconomics Second Situation: When SLR is Low Less funds of commercial banks as liquid assets -> More liquidity with commercial banks -> More loans offered to people -> Higher consumer spending -> Increased demand for goods as well as services -> Increased prices –> Inflation may go beyond manageable range 3. Repo and Reverse Repo Rate Repo Rate It refers to the interest rate at which RBI lends money to a commercial bank against securities (sold and repurchased by RBI), when the commercial bank needs funds. The whole transaction involving selling of securities by the Reserve Bank of India and subsequent repurchasing at a fixed price is known as Repo. Advantages:  To keep control on inflation rate  To maintain control on liquidity Reverse Repo Rate It refers to the rate at which the Central Bank (RBI in case of India) borrows funds (money) from commercial banks of India. This tool is utilized when there is excess money circulating around in banks. Reverse Repo rate is always going to be lower than the Repo rate, because the Central Bank (RBI) cannot offer more interest on deposits and take low interest on loans. Advantages:  To control supply of money in the economy Impact of Repo and Reverse Repo Rate First Situation: When Repo Rate is High High Repo Rate -> Costlier funds for commercial banks ->Higher rate offered to consumers by banks -> Lesser borrowings and credit taken by people -> Reduced liquidity in economy Second Situation: When Reverse Repo Rate is High High Reverse Repo Rate -> Higher interest rate earned by banks on RBI borrowings -> More money lending from banks to RBI -> Less money lending to people -> Reduced liquidity in economy. 4. Bank rate It indicates the interest rate at which Reserve Bank of India lends funds (in the form of loans and advances) to commercial banks without pledging any security. Also known as ‘discount rate’, the bank rate is usually higher in comparison to Repo rate. Advantages  To maintain control over inflation and liquidity Page | 23  IOV-Registered Valuers Foundation Impact of Bank Rate High Bank Rate -> Increased Interest Rate of loans to banks -> Increased interest rate of bank loans to people -> Less demand for goods as well as services -> Restricted flow of money in economy -> Inflation under control Comparison of Repo Rate and Bank Rate While both these are rates at which RBI lends money to commercial banks, there are significant differences between them as described under: Repo Rate Bank Rate Charged against securities Charged against advances / loans provided by repurchased by the RBI from the RBI to banks banks Always lower than bank rate Always higher than Repo Rate Securities, Collaterals, Bonds, No securities or collaterals involved Agreements are involved Rise in this rate doesn’t impact the Rise in this rate does impact the customers customers directly directly 5. Marginal Standing Funding By this mechanism commercial banks can get loans from RBI for their emergency needs. Commercial banks can take loan only upto 1% of their liabilities and time deposits. 6. Open market operations It refers to purchase and sale of government securities (and bonds) by the Central Bank (RBI) in order to regulate supply of money in the short term. When liquidity is to be brought in the market, RBI buys government securities. When the liquidity in the market is in excess and needs to be curbed, RBI sells the government securities to commercial banks, and decreases the cash float that banks may have. Advantages To effectively manage liquidity in the overall economy Impact of purchasing securities More money in economy → More demand → Higher growth rate Impact of selling Less money in economy → Less demand → Lower prices Page | 24  S or FA /Chapter-1/Macroeconomics 7. In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. Most often, it measures an estimate of the maximum amount of commercial bank money that can be created, given a certain amount of central bank money. That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is equal to an amount which is a multiple of the amount of reserves. This multiple is the reciprocal of the reserve ratio, and it is an economic multiplier. ALTERNATIVE FOR STANDARD MONETARY POLICY An unconventional form of monetary policy, it is usually used when standard monetary policy has become ineffective at combating too low inflation or deflation. Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply. Quantitative easing (QE), also known as large-scale asset purchases, is an expansionary monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to stimulate the economy and increase liquidity. A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other financial institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the money supply. This differs from the more usual policy of buying or selling short-term government bonds to keep interbank interest rates at a specified target value. 4. UNDERSTANDING BUSINESS CYCLES A business cycle is the cycle of fluctuations (upward and downward movement) in the GDP (Gross Domestic Product) around its long term growth trend. Also known as the trade cycle or economic cycle, the business cycle relates to the expansion as well as contraction in economic activity experienced by the overall economy over time. It denotes the increase and drop in production output of goods as well as services in the nation’s economy. The business cycle is considered to be complete when it undergoes a single boom and a single contraction (recession) in sequence. The corresponding period of time (inclusive of this boom and contraction) is referred to as the length of a business cycle. A boom (or expansion) corresponds to a period of rapid economic growth, while a contraction (or recession) is characterized by a period of relative stagnated economic growth. Business cycles are usually measured by considering the growth rate of real GDP (Gross Domestic Product), which is inflation-adjusted. Page | 25  IOV-Registered Valuers Foundation DIFFERENT PHASES OF BUSINESS CYCLE The various phases of business cycles are the fluctuations experienced by the nation’s economy with boom in economic activities in one period and contraction in those activities in the subsequent period. These business cycle phases correspond to the variations in several economic activities with regards to investment, production, wages, employment, prices, and credits (as depicted by the downward and upward fluctuations in the nation’s economy). The 5 major phases of a business cycle include the following: 1. Expansion It is first phase under consideration that corresponds to an increase in various positive economic factors / indicators including income, output, production, employment, wages, profits, sales, demand as well as supply of goods & services. In this expansion phase, the debtors are relatively in a good financial condition and repaying their debts on time, the creditors lend funds at high interest rates, the investment is high and so is the flow of money in the economy. 2. Peak The increase in flow of money in an economy and the overall growth achieved during expansion phase reaches a saturation point – which is the maximum limit of growth. This is referred to as the peak phase, where the increasing growth rate of a business cycle reaches its optimal (maximum) limit. It is in this phase that the economic indicators (including production, employment, sales, prices) are at their highest and do not rise further. As prices are at their peak, consumers start to restructure their budget for spending and plan to spend less. The peak phase triggers the reversal in the trend of overall economic growth (that started with the expansion phase). 3. Recession (or Contraction) The phase that follows the peak phase is the recession phase (or contraction phase). The highest price points touched upon during peak phase lead to consumers deciding to spend less, and thereby reduce the demand for products. This demand continues to fall rapidly during recession phase, without the producers noticing the reduced demand instantly, and who continue to produce leading to more supply in the market (than demand). Such a situation leads to fall in prices and as a result, the relevant positive economic indicators like output, income, wages, etc. begin to fall. 4. Depression When the recession phase continues for long, the economic activities start falling below the normal level, thereby making the growth rate of the economy turn negative. This triggers the depression phase where there is continuous decline for the economic growth and rise in unemployment. Page | 26  S or FA /Chapter-1/Macroeconomics 5. Trough As the depression phase continues to cause rapid decline in expenditure as well as national income, it gives rise to more debtors who are unable to repay their debts. This result in lowering of interest rates which makes banks to give less preference to lending of money to people, thereby leading to having excess cash balances. There is a point where the decline reaches its maximum limit, beyond which the economy cannot slide further. This is the trough phase that corresponds to the negative saturation point of an economy or the lowest possible level to which an economy shrinks. 6. Recovery The recovery phase is the one that witnesses the turnaround post the trough phase, and where the overall economy begins to recover steadily from the negative growth rate. After an economy shrinks to the lowest level on the negative side of growth rate, there happens a trend change (or reversal) for the business cycle in the positive direction. In this recovery phase (that starts from the labour market), demand for products starts increasing due to the lowest prices and eventually supply is built up as well. The people, companies and overall economy start thinking positively for employment and investment, due to which production starts rising. This phase continues till an economy comes back to steady growth rate levels, thereby completing one full business cycle of boom and contraction, with peak and trough being the positive saturation point and negative saturation point respectively. BUSINESS CYCLE Peak Expansion Peak Expansion Recession Recession Depression Recovery Trough Page | 27  IOV-Registered Valuers Foundation SUMMARY OF A COMPLETE BUSINESS CYCLE Phase Characteristics First phase – Expansion -Increased employment -Increased economic growth -Upward pressure on prices Second phase – Peak -Highest or full employment -Highest economic growth -Inflationary / upward pressure on prices Third phase – Contraction / -Reduced employment Recession -Reduced economic growth -Less pressure on prices -Negative Reversal of economic growth Fourth phase - Depression -Continuous fall in employment -Economic growth rate turns negative Fifth phase – Trough -Lowest employment -Lowest economic growth -No pressure on prices Sixth phase – Recovery -Positive Reversal of economic growth -Less pressure on prices -Improving economic growth and employment While a single business cycle may start from expansion phase and end at recovery phase, the actual measurement of business cycle expansion takes place from trough (bottom) of the earlier cycle to the peak of the current cycle, and the measurement of business cycle recession takes place from peak to the trough of the current cycle. VIEWS FROM ECONOMISTS ON BUSINESS CYCLE Economist John Keynes considers the event of business cycles as a consequence of fluctuations in aggregate demand that bring the overall economy to short-term equilibriums which are not the same as full employment equilibrium. Economists such as John Muth and Robert Lucas (Jr.) have been associated with the RBC theory (Real Business Cycle theory), which is a class of macro-economic models as well as theories. Page | 28  S or FA /Chapter-1/Macroeconomics Understanding Real Business Cycle Theory The real business cycle theory considers studying business cycles by making the fundamental assumption that these cycles (and their various phases) are entirely driven by technology shocks instead of monetary shocks or modifications in expectations. These technology shocks comprise of bad weather, innovations, strict safety regulations, and more. The technological shocks are believed to be a result of unanticipated technological development which has an impact on productivity. In other words, the RBC theory considers fluctuations of a business cycle against real shocks (and not nominal shocks), that correspond to unpredictable or unexpected events affecting the overall economy. UNDERSTANDING BCG MATRIX The Boston Consulting Group Matrix (also known as growth share matrix) enables companies to determine the various areas of their business that require additional investment as well as resources. This is a framework that was created by the Boston Consulting Group to help organizations analyse products as per the growth and market share. This model is along the lines of the product life cycle theory which can be utilized to identify the priorities that need to be given within the portfolio of products for a business unit. Every company aims for long-term value creation and for this purpose it needs a product portfolio comprising of low growth products which generate plenty of cash along with high growth products that require cash inputs. The objective behind this is faster the growth of a product’s market and bigger the market share a product possesses, the better it is for the organization. The BCG Matrix can be represented by a four-quadrant chart, where the relative market share position is along the X-axis, and business growth rate is along the Y-axis. The four quadrants refer to the Dogs (lower right), Cash Cows (lower left), Question Marks (upper right), and Stars (upper left). Relative Market Share HIGH LOW STARS QUESTION MARKS CASH COWS DOGS LOW Page | 29  IOV-Registered Valuers Foundation Stars These are the products that possess the best market share and produce the most cash. The products that come first-time to market as well as monopolies are considered as stars. They take up large amounts of cash because of the high levels of growth rate. Businesses can prefer to invest in stars. Cash Cows These are the business products that have higher market share, but lower market growth rate. They tend to consume less cash as compared to the cash they generate. Firms can prefer to invest in cash cows in order to maintain the existing level of productivity. Dogs These products have a low market growth rate and a low market share. They neither consume a lot of cash, nor do they earn a lot of cash. Companies can prefer to sell these off, as these business units generally do not bring back anything in return. Hence, these are considered as cash traps as companies have their money tied up in them. Question Marks These products have a low market share, against high market growth rate. They take up a lot of cash, but tend to generate little in return, and in fact, lead to loss of money. With their potential to grow at fast pace (because of the high growth prospects) and turn into stars, companies can prefer to invest in them if they spot the growth potential. In case of no growth potential, these can be sold off. Understanding GE McKinsey Matrix It is a nine-box matrix for analysis of product portfolio. Every product your business considers will have its own demands and requirements along with the limited resources available – some may require you to invest in them, some may require you to hold them, while may require you to let them go. Such level of decision making is done using the GE McKinsey Matrix. It is quite similar to the BCG Matrix, but, slightly more complex than it. In short, this model is helpful for evaluation of strategic business units for optimal allocation of company resources. This matrix is an improvement over BCG Matrix which only had 4 quadrants and focused only on business unit as well as market share. On the other hand, GE McKinsey Matrix also plots the real market situations / conditions against the company’s potential to stand in the existing market. This matrix does comparison of product groups in regards to market attractiveness as well as competitive strength. This 3x3 grid measures business strength on the X-axis, against the market attractiveness on the Y-axis. This comparison helps to evaluate the strategic business unit’s position in the market, as well as determine its category in terms of High, Medium or Low. Page | 30  S or FA /Chapter-1/Macroeconomics Business Unit Strength High Medium Low High Industry Attractiveness Medium Low The market / industry attractiveness dimension enables to analyze the advantages an organization is likely to get by making an entry and competing within the market. The various factors considered include size of the industry, growth rate, market profitability, pricing trends, and so on. The business strength dimension enables in understanding of whether a firm possesses the required competence to compete in a specific market by considering various factors like market share, assets, company profitability, brand position, environmental concerns, product differentiation, and more. Once every product is provided with its value with regards to industry attractiveness and business strength, than it gets plotted at the right place / spot in the graph (in either of the nine boxes of the matrix). Once the product is plotted in its place, the decision about it’s strategy can be taken – these strategies are broadly either of Grow, Hold and Harvest. Grow When the business unit is strong in terms of strong attractiveness, you can grow the business by taking the decision to invest more resources. The business units for which strategy ‘Grow’ is ideal are the ones that have high business unit strength and high market attractiveness. Hold When the business unit strength is average along with average market attractiveness, you need to adopt the ‘Hold’ strategy. For scenarios where the market is going downwards or Page | 31  IOV-Registered Valuers Foundation there is too much competition, the business unit may not yield good returns even after plenty of resources are invested. Hence, an appropriate solution would be to wait using the ‘Hold’ strategy for the business unit, to check if the business unit is able to rise above some of the competitors or the market environment improves. Harvest When the business unit strength is low along with unattractive market, you need to sell or liquidate the business or perhaps hold the business for particular residual value that it possesses. You need to harvest the weak businesses and ensure reinvestment of money into business units that are on the move towards growth. Page | 32  S or FA /Chapter-2/Statement Analysis FINANCE & FINANCIAL STATEMENT ANALYSIS I 02 1. Finance 2. Financial Statement Analysis Page | 33  IOV-Registered Valuers Foundation FINANCE AND FINANCIAL STATEMENT ANALYSIS I 02 1. FINANCE For a business, it becomes very important to determine the fair value of the financial assets from a strategic point of view. Appropriate valuation of the business would depend a great deal on the accurate valuation of its securities and financial assets, which could be investment and fund-raising avenues like stocks, bonds, bank deposits, and loans. A professional valuer will be able to do full justice to the valuation process of financial assets by getting complete clarity on the basic concepts of finance and corresponding decisions in finance. BASIC CONCEPTS OF FINANCE For sustainability and growth of a company, the business management team needs to focus on critical financial aspects like rising of capital (funds) as well as investment in the right projects to get more value of the money they possess. In this regards, it becomes critical to understand the various financial concepts related to capital structure for fund raising and capital budgeting for earning returns (in future) on the investment made at present (by effective consideration of Time Value of Money through understanding of parameters like Net Present Value, Internal Rate of Return, Risk-Return Trade-Off). 1. Time Value of money Consider a person having two options in front of him: a) To get INR 5,00,000 at present b) To get the same amount after a year Common sense would have the person choose the first option to receive the money in present. Why? Well, by doing so, and simply keeping the money in bank (in a savings account), the person would be able to earn slightly more money at the end of the year. So, it makes no sense for him to opt for the second option. This is clearly because of the earning capacity of the money that the person is bound to receive in present. This is the basis of Time Value of Money (TVM), one of the founding principles of finance - that money received at present is more valuable as compared to the same amount received at some future time, due to its potentially earning capability. This earning Page | 34  S or FA /Chapter-2/Statement Analysis capability refers to the possibility of the money being invested and earned interest upon.TVM is also known as ‘present discounted value’, which considers any particular amount of money as worth more when received as soon as possible, subject to the abilit y of that money to earn interest. 2. Why is the Time Value of Money or Time Preference Relevant?  Uncertainty Suppose a person chooses to receive money from a colleague / friend or an agency in future, instead of accepting the money at present. There is the risk of the money not coming to the person in future (uncertainty), if the financial situation of the colleague or agency changes drastically in future.  Preference for consumption A person is likely to accept receiving money in present so that he can start using the same for his daily consumption as well as for routine business expenses.  Available investment opportunities It is possible to earn some interest over the money invested in any bank or other investment avenues.  Inflation The money that is not in the hands of a person at present, carries the risk of losing value and purchasing power due to rise in inflation in the future. Basic Time Value of Money Formula One of the most basic TVM formula looks like under: (n x t) FV = PV x [ 1 + ( i / n) ] It considers following variables such as:  FV = Future value of money (after earning interest)  PV = Present value of money  i = interest rate  n = number of compounding periods per year (investment period / loan period)  t = number of years (the time period for which money is held) TVM Example Assume a person accepts INR 5,00,000 at present and invests it for a period of 1 year at 10% interest. In such a scenario, the Future Value of money is calculated as: FV = 5,00,000 x (1 + (10% / 1) ^ (1 x 1) = INR 5,50,000 3. Compounding and Discounting As seen with TVM, it is all about the present value and future value of money. The two different methods to ascertain the money’s worth at different points in time are compounding and discounting. Page | 35  IOV-Registered Valuers Foundation Compounding is used to compute the future value of current money (investment), to get clarity on the future values of cash flow at the end of a specific period, at a fixed (definite) rate. This method uses compound interest rates and helps to determine the amount you will get at a future date for some amount of money invested at present (today). Formula for Compounding (based on TVM formula discussed above): FV = PV (1+r)^n Where r = rate of interest on investment n = number of years On the other hand, discounting is used to know the current value of future money, to get clarity on the current value of future cash flow, at a specified rate. This method uses discount rates and helps to determine the amount you need to invest currently (today), to earn a particular amount in future. Formula for Discounting (based on TVM formula discussed above): PV = FV / (1+r)^n Where r = discount rate n = future years 4. Capital Structure This topic is covered in detail later during the chapter in the section on ‘Financial Statement Analysis’. 5. Capital Budgeting Capital budgeting plays a very important role in every business, especially with regards to investment decisions. It refers to the decisions on investment - which take its due course of time to mature and need to be based around the returns that investment is likely to give. Clearly, the investment decisions take into consideration the future value of invested money, or the time period it will take for the investment to give some returns. Page | 36  S or FA /Chapter-2/Statement Analysis Examples of investment decisions or capital expenditure decisions by firmscan be viewed below: Acquisition Expansion of Another of Existing Business Business Replacing Selling a Long Business Term Division Assets Change of Modifying Sales Advertise- Distribution ment Approach Campaign As a capital budget project will take some period of time to yield results (from the investment made), businesses approach this process using a systematic appro ach towards:  Identifying long term objectives  Detailed search and identification of fresh investment opportunities  Estimation as well as forecast of existing (current) and future cash flows  Establishment of control over expenses and effective monitoring of critical aspects of project execution  Having a stable administrative framework possessing the capability to transfer necessary information to the decision level Capital budgeting involves use of the concept of present value of future investment that needs to be done now. This refers to the TVM (Time Value of Money) concept that has been discussed earlier in this chapter. It basis this application on various techniques like Net Present Value, IRR (Internal Rate of Return), and Risk-Return Trade Off, which will be discussed later. 6. Portfolios and Diversification An investment portfolio comprises of a collection of investments, which are selected to achieve certain degree of diversification and help the investor fulfill its investment objectives. Typically, an investment portfolio represents a combination of various asset classes like bonds, stocks, as well as cash. These asset classes can be sub-divided as:  Stocks into international stocks, large cap stocks, mid cap stocks, and small cap stocks. Page | 37  IOV-Registered Valuers Foundation  Bonds into foreign bonds, short term bonds, intermediate term bonds, and tax- exempt municipal bonds. 7. Net Present Value (NPV) For any business, this value refers to the present (existing) value of all the cash flows that are bound to be incurred during the life span of a project. Net Present Value is the difference between present value of all cash inflows and present value of all cash outflows expected to occur over a period of time for a project. It is used during capital budgeting or taking investment decisions to be able to do effective analysis of the profitability of an investment project. NPV = Discounted Cash Inflows – Discounted Cash Outflows Positive NPV denotes the maximum possible amount a business would pay for making the investment or it represents the amount at which the business is ready to let go the investment, without actually being in a financially worse situation. Positive NPV highlights that the estimated (projected) earnings generated through a project (investment) is more than the estimated costs. Assumption is that any investment with positive NPV is a profitable preposition, while any investment (project) with a negative NPV is a loss-making preposition. This forms the basis of the NPV Rule (Net Present Value Rule) that states ‘to consider only investments with a positive Net Present Value’. Understanding NPV with an Example A business is likely to decide about an investment to be made, against the returns it expects to earn over a period of time. Suppose a company is confronted with a situatio n where it can invest INR 1,00,000 today and earn 10% over it after a year’s time, which equates to receiving an amount of INR 1,10,000 after 1 year. The business would decide to go ahead with this investment today if the investment avenue is reliable and if there is no other investment it can do with that amount (of INR 1,00,000) today that could fetch it more than 10% returns within the same time period of 1 year. This decision on the future capability of earning a particular percentage of returns is the key to any investments that a company makes. The percentage of returns (10% in this example) can be considered as the ‘discount rate’ that varies depending on the investor. For example, one business may find this 10% to be enough (and more than anything el se it could earn from the same investment amount), while some other business may feel that it could potentially earn say 12% from another reliable investment avenue within the same period of time. For the second business, the discount rate is 12%. Thus, the discount rate is determined by businesses considering the expected return of other possible investment projects carrying a similar risk level or the cost of borrowing Page | 38  S or FA /Chapter-2/Statement Analysis funds required for financing that project. So, a business may take the decision to not go for a project (investment) that is likely to return 10% over a 1 year time period if another project (investment opportunity) is expected to provide 12% returns in the same time period. At the same time, a business may also avoid the project (expected to give 10% return in 1 year) if the cost of borrowing money is equivalent to 11% for financing the project. Advantages of NPV as an Acceptable Investment Rule  Accounts for Time Value of Money  Measure of true Profitability  Shareholder Value Limitations of using NPV  Very difficult to estimate discount rate, cash flow and investment costs  Room for error / inaccuracy as it relies on several estimations and assumptions  Difficult to account for unforeseen expenses required by a project 8. Internal Rate of Return (IRR) IRR (Internal Rate of Return) is the discount rate which makes NPV = 0 for all the cash flows from a specific project. It is quite similar to NPV. IRR is used to estimate the profitability of possible investment opportunities in capital budgeting. In case of IRR, the discounted cash inflows are equal to the discounted cash outflows – thereby, making NPV = 0. Internal Rate of Return helps to compare projects (investments) with different life spans (time periods) as well as projects with different capital requirements for investment. So, IRR can be utilized to compare the expected profitability of a project spanning two years and which requires an investment of INR 1, 00,000 with a project spanning five years and that requires an investment of INR 75,000. As compared to NPV, IRR is considered to make way too many assumptions with regards to reinvestment risk as well as capital allocation. So, it is advisable to not use IRR alone and it should always be used in conjunction with Net Present Value (NPV). Key Differences Between NPV and IRR Net Present Value (NPV) Internal Rate of Return (IRR) Determines Surplus of the project Determines the break-even point with no profit and no loss Accept a project with positive NPV Accept a project with IRR greater than required rate of return (cut-off rate) Reject a project with negative NPV Reject a project with required rate of return (cut-off rate) higher than IRR Calculation of NPV is in absolute Calculation of IRR is in percentage terms terms Page | 39  IOV-Registered Valuers Foundation 9. Payback Period Payback period is one of the important techniques for implementation of capital budgeting. It refers to the time required for recovering the initial cost of an investment made – the number of years required to receive back the initial investment that an investor would have made. As a method for implementing capital budgeting, payback period helps to compare various projects, and determine the number of years it would take for each of them to get back the initial investment amount. This ultimately helps to select the project which takes minimum number of years to retrieve back the amount invested. It is the only capital budgeting technique that ignores the time value of money. It is very simple and its simplicity is one of the reasons why it is often used i n combination with other capital budgeting techniques for project selection. 10. Risk-Return Trade-off Any investment decision is based on the two major factors – risk and return. A higher risk is often associated with an investment expected to give higher returns, whereas a lower risk is associated with an investment expected to provide considerably lower returns. Such a trade-off between risk and return as faced by a business (or individual investor) while making investment decisions is referred to as the ‘risk-return trade-off’. It is the relationship between amount of risk taken for an investment and the amount of return gained on an investment and the amount of risk undertaken in that investment. As per this trade -off, the potential return increases or there is a probability of higher return with a rise in risk. It indicates that the investing business (or individual investor) should be ready to accept a higher probability of loss, if it is willing to earn higher profits. But, there is no guarantee here. So, higher risk doesn’t always equate to higher returns. It is just that it gives the investor a probability of earning higher returns in future. Page | 40  S or FA /Chapter-3/Professional Ethics and Standards PROFESSIONAL ETHICS & STANDARDS I 03 1. Model code of Conduct for Registered Valuers as notified by Ministry of Corporate Affairs (MCA) under the Companies (Registered Valuers and Valuation) Rules, 2017 2. Ethical Considerations under Terms of Engagements Page | 41  IOV-Registered Valuers Foundation PROFESSIONAL ETHICS AND STANDARDS I 03 1. MODEL CODE OF CONDUCT FOR REGISTERED VALUERS AS NOTIFIED BY MINISTRY OF CORPORATE AFFAIRS (MCA) UNDER THE COMPANIES (REGISTERED VALUERS AND VALUATION)