1.

Finance vs Accounting

Ans: The difference between Finance and Accounting is:

a. Finance is fully cash based while accounting is cash and accrual based.

b. Accounting is mainly concerned with day to day transaction while finance is

focused on management of asset and future growth.

c. Time value of money is considered in finance but not considered in

accounting.

d. The clients for accounting and finance are individuals, companies and
governments

e. Accounting is mainly responsible for preparing the financial statement but the
finance is mainly concern with analyzing the financial statements.

f. Accounting is backward looking and finance is forward looking.

g. Accounting mainly focuses on reliability and accuracy while finance mainly

focuses on insights and analysis

h. The purpose of accounting is to provide information to the relevant users

while the purpose of the finance is to add value to the business.

i. Accounting is rule based but finance is analysis based.

2. Asset

a. Real asset: Real asset is a physical asset which has an inner or intrinsic
value due to their properties. Examples of real assets are real estate, land,
equipment etc.

b. Financial asset: Financial asset is a non-physical asset whose value is

derived from a contractual claim such as share or bonds. It is usually more
liquid than other physical asset (like real asset) and it is traded in a standardized
market. According to the International Financial Reporting Standard (IFRS),
financial assets can be:

1. Cash or cash equivalent.

2. Equity instrument

3. Contractual right to receive cash or other financial asset

4. A contractual right that will settle in company’s own equity instrument. It
may be derivative or non-derivative.

Classification:

i. Money market financial asset-short term: Money market financial assets

are short term securities which provide low-cost capital to businesses, banks and
government. The time duration is over night, few days, weeks or even months
but always less than a year. Examples are treasury bills, commercial papers,
repurchase agreement etc.

Money market serves five crucial functions. They are,

1. Trade: The money market plays crucial role in financing the domestic and
international trade. Commercial funds are made to traders through the bill of
exchange.

2. Industry finance: Money market helps industry in two ways:

a. It helps the industry to secure the loan which helps them to meet their
working capital requirements

b. Company sometimes need long term loans which they get from the capital
market, but sometimes the capital market depends on the condition of the
money market.

3. Profitable investment: This market helps the commercial banks to invest their
excess money to the profitable investment. Money market enables the
commercial banks to invest their excess money to the liquid asset which can
also be converted into cash in a quick possible of time.

4. Helping the commercial bank: A good money market helps the commercial
bank to become self-sufficient. When the commercial bank is in liquidity crisis,
instead of taking loans from central bank at a higher interest, they can all off
their short term loan from the money market.

5. Helping central bank: Though central bank can perform and function without
the money market, a strong money market can smooth the functions of the
central bank.
ii. Capital market financial asset-Long term: Capital market instrument are
long term securities like shares and bonds etc which are used by companies to
raise capital.

Capital market can either be primary market or secondary market. In primary

market, new issued share are traded for the first time and in secondary market,
existing stocks are traded.

iii. Fixed income financial assets: Fixed income financial assets are basically
debt instrument which provide fixed interest rate in the form of cupon payments
to the investors. The most common type of fixed income financial asset is cupon
bond.

There are four types of risk is associated with the fixed income asset. They are,

1. Interest rate risk, when the interest rises, bond prices fall, means that the
bonds rises value

2. Inflation risk, inflation is another risk for bond or fixed income investors.
When the inflation rate become more than the fixed income rate, the investor
lose their purchasing power.

3. Credit risk, when any investors invest in bonds, they take credit risk with
other kind of risk. It is the risk of becoming default.

4. Liquidity risk, when an investor wants to liquidate or sell the income asset
but they are unable to buy the buyer.

iv. Variable income financial asset: Variable income financial assets refer to
the investments that provide the investors a rate of return that varies from time
to time due to various factors like market conditions or economic conditions. It
provides both greater risk and rewards.

These assets are type of financial instrument whose future return is related to
the economic performance of the entity, and underlying measure such as short
term interest rates and contingency plans for the contracts. But it provides
higher income than fixed income asset. The very common variable income asset
is common stock. Common stock gives investor more income and growth than
fixed income asset but also the risk of losing the principal.
v. Derivatives: Derivatives is contract that derives its value form the condition
and performance of the underlying asset. The underlying asset can be
commodities, currencies, stocks, bonds, precious metals, stock indices etc.
Example: If a company is involved in a agro-product processing business.
Suppose they process only one item that is flour. They are a large consumer of
flour. In order for this company to be assured for the consistent price of the
flour, they have to buy a fixed or at least a predictable rate. To do this, the
company has to enter into a contract with the wheat producer to buy a certain
amount of wheat at a certain price within a certain period of time. It the price of
wheat goes above the expected price, then the company can exercise the option
and purchase the wheat at the strike price. The company has to pay a premium
for this privilege but get protection against one of their major production cost. If
the company decides not to exercise the option, then the producer can sell the
wheat to another buyer at a market price. In the end, the company is getting
assurance for competitive price of their commodity while the producer is getting
the fair value of the wheat. In this example, the value of the option is derived
from another underlying asset or in this example, particularly, a certain number
of bushel of wheat. Other common derivatives includes forward, futures and
swap.

Classification:

1. Forward: Forward derivatives are specified contracts between two parties to

buy or sell any specific asset at a specific price on a future date. The main
feature of the forward is:

a. They are bilateral contract so they are exposed to counter-party risk

b. Each contract is custom designed, hence every contract has separate size,
expiration date, asset type and quality.

c. The contract price is not generally in the public domain.

d. The contract has to be settle by the delivery of the asset

e. If one party wants to revere the contract, the other party is in monopoly to
command the price it wants.

Example of forward: Let’s assume a corn cultivator situation. The price

fluctuates very much and the farmer faces difficulty due to weather conditions,
insects, price market fluctuations and so on. For his protection the farmer may
enter into a forward contract with a private buyer. Many large food
manufacturer purchases these kinds of crop. From this forward contract the
farmer gets assurance that his product has a buyer. He will also have an agreed
upon price which he will get from delivering the required amount of corn.

2. Future: A future contract is a standardized contract which is traded in

regulated exchange. In future contract, prices are settled on a daily basis until
the day of the end of the contract. This prevents the accumulation of large profit
or losses.

The merits and demerits of the futures:

Merits:

1. Investors can use the futures to estimate the price of the underlying asset

2. Companies can hedge the price of the product

3. Futures need only a part of the amount to be deposited to the broker.

Demerits:

1. Investors have risk of losing more than the initial margin

2. Sometimes hedging with futures can cause the loose of favorable price
movement

3. Margin can be double-hedged means profit can increases as well as losses

Example of Future: Let’s assume, an investor enters into an oil market to buy a
future contract. He bought the futures in April with the expectation that the
price of the oil will be higher at the end of the year than the April price. The
December oil future is trading currently at a price of $50. However, the investor
has to pay a portion of the amount upfront with the broker. From April to
December, the price of the oil fluctuates as does the value of the future. If the
price fluctuates too much, the broker may ask another portion of the price to be
deposited. At the end of the year, if the price of the oil is $65, then the trader
sell the future contract and close the position. Then the earning of the trader is
(65-50)= 15 dollar minus any fees and commission. And if the price fall below
50, say 40, the loss of the trader is $10 in the future.

The difference between futures and forward contracts:

1. Futures are always traded in centralized exchange whereas the forward is
traded in OTC.

2. As futures are traded in exchange, it is highly standardized while the forward

is private agreement so they are not as rigid as futures

3. Futures have clearing houses, so the probability of default is very low but in
forward the chances of default is high.

4. Futures contracts are market to market daily, which means the profit and
losses are settled daily until the end of the contract whereas settlement of
forward occurs at the end of the contract.

5. Future contract settlement can occur within a range of date whereas the
settlements of the forward occur only a particular date.

6. Futures are mostly used by the speculator and futures are mostly used by the
hedger.

7. Futures are closed prior to the maturity and the transfer of the physical
commodity usually never occurs. But is forwards, as it is used by the hedgers
mostly, they want to eliminate the volatility of the asset price and delivery of
the asset usually take place.

8. In at any time the holder of the future want to transfer the obligation to any
party, he can easily sell the future to other parties. But there is no secondary
market of the forwards

9. In futures, both parties needs to deposit any initial deposits with the broker
but for forwards, as it is customized, no party has to deposit any amount of
money.

3. Options: Options are financial instrument that are derivatives based on the
values of underlying securities. The most two common options are call options
and put options.

a. Call option: Call option is a financial contract that gives the option buyer the
right to, not the obligation, to buy the stock, bond or other financial asset at a
specified price within a specified time period. For example, call option contract
may give a holder the right to buy 100 shares of any stock at TK100 up until the
expiry date in three months.
b. Put Option: Put option is a financial contract that gives the holder the right
to sell a specified asset at a specified price on or before expiration. Like the call
option example, a put option can give the holder the right to sell 100 shares of
any particular stock at TK100 until the expiry date of three months.

The main differences between call options and put options:

1. Call option gives the buyer the right to buy shares at pre-defined price
whereas the put option gives the seller the right to sell the share at pre-defined
price.

2. Call option is exercise when the price of the underlying asset increases. Put
option is exercise when the prices of the underlying asset price decreases.

3. Seller has asset or required amount of cash to buy the asset in call option. In
put option, the buyer has the required amount of asset or cash to buy the asset
prior to the exercise of the option.

4. In call option, Profit= market price - strike price – premium. In put option,
profit=strike price – market price - premium

3. Financial Markets: Financial markets are any market place where the
trading of securities occurs including the stock market, bond market, foreign
exchange market, derivatives market and others.

Feature of the financial market:

1. Financial market links investors and borrower and bridge the gap between
them

2. Financial market is easily available to the investors and borrowers for their
transactions.

3. Financial market creates a platform for buying and selling the marketable and
non-marketable securities. Marketable securities include shares, bonds,
debenture etc. Non-marketable securities include bank deposits, post office
deposits and other loan and advances.

4. The government controls the financial market by imposing many kinds of

rules and regulation.
5. Different types of financial intermediaries are involve in financial market
like, banks, non-banking financial instruments, stock exchanges, mutual fund
companies, brokers etc.

6. For investors, financial market provides different type of schemes either short
term or long term.

Types of financial market:

a. Money market short term: Money market is a short term securities market
where securities having maturities like overnight, day, week or even months but
must be less than one year, are traded.

The main features of the money market are:

1. It is for short term securities

2. No fixed geographical location

3. Institution involved in money market are commercial banks, insurance

corporations etc.

The major instruments of money markets are:

1. Call money

2. Treasury bill

3. Commercial bills

4. Commercial paper

5. Certificate of deposits

b. Capital market long term: Capital market is financial market where long
term bonds and equity securities are bought and sold.

Feature of capital market:

1. It connects the investors and entrepreneurial borrowers

2. It deals with long term securities

3. The intermediaries are brokers, underwriters, merchant bankers, sub brokers

etc.
4. Capital market is the determinant of the capital formation. Capital formation I
the net increase in the county’s economy

5. Capital markets are regulated by government and regulatory authorities.

6. Capital market deals with marketable and non-marketable securities.

Marketable securities includes shares, debentures and so on.

Instrument of capital market:

1. Share

2. Preferred share

3. Bonds

4. Debenture

5. Mutual funds

6. Public deposits

7. Derivatives

c. Primary market: Primary market is a market where companies sell their

securities to the public for the first time. IPO is an example of primary market

d. Secondary market: Secondary market is where the previously issued stocks,

bonds, futures, options are traded. Dhaka stock exchange is an example of
secondary market.

e. OTC market: OTC or over-the-counter market is a decentralized market in

which participants trade stock commodities and other securities directly
between two parties and without a central exchange or broker.

f. PP or DS market: A private placement is a sale of shares and bonds to a pre-

listed investor and institution rather than on the open market.

4. Decision in CF: Classification:

a. Investment decision: Investment decision are the financial decision that is

taken by management to invest funds in different asset with an aim to earn the
highest possible return.
b. Financing decision: Financing decision are the financial decisions that is
related to raising finance. It includes the sources of the finance and also the cost
and availability if the funds to invest.

c. Profit distribution decision: Profit distribution is a financial decision

relating to the proportion of the earned profit which will be retained for the
future development and growth and which portion of the profit will be delivered
to the investors to meet their expectation.

5. Time value of money:

a. PV vs FV: Present value is the current value of a future sum of money given
a specified rate of interest. Future value is the value of an asset at a future date
given a specific rate of interest.
FV
PV= n
(1+i)

FV=PV(1+i)n

b. Discounting and compounding: Discounting is the process of determining

the present value of a cash flow or stream that is to be received to the future
date.

Compounding means the ability of a sum to grow exponentially over a time

period by the repeated addition of earning to the principal invested.

b. Annuity: There are 4 conditions to be met for an annuity. They are:

1. Equal amount of cash flow

2. Specific time period

3. Equal time interval

4. Series of payment (More than one cash flow)

Classification:

i. Ordinary annuity: When the stream of cash flow is at the end of consecutive
period then it is an ordinary annuity.
1

[ ]
1− n
(1+i)
Formula: PVA= A
i
Formula: FVA=A [ (1+i)n −1
i ]
ii. Annuity Due: When the streak of cash flow is at the beginning of the
consecutive period then it is an annuity due.
1

[ ]
1−
(1+i)n
Formula: PVA= A (1+i)
i

Formula: FVA= A [ (1+i)n −1

i ] (1+i)

d. Growing annuity: Growing annuity is a series of cash flow for a fixed

amount of time where the cash flow is growing at a fixed rate.

Formula: PV= A[1/(i-g)-(1/(i-g))*((1+g)/(1+i) ¿ ¿t ¿

Where g is the growth rate.

Formula: FV=A [ (1+i)n −(1+ g)n

i−g ]
Where g is the growth rate

e. perpetuity: Perpetuity is the series or stream of payment which continues for

ever.
Payment
Formula: Perpetuity = i

f. Growing perpetuity: A growing is perpetuity is a stream of cash flow that is

expected to be received every year for ever but also grow at the same growth
rate forever.
payment
Formula: Growing perpetuity = i−g

g. NIR vs EIR: Nominal interest refers to the interest before adjusting the
inflation. It is also refer the stated rate.
1
Formula: nominal interest rate r=m*[(1+i) m – 1]
Where i= effective interest rate

r=stated rate

m=number of compounding periods

EIR: Effective interest rate is the real return on investment.

i n
Formula: effective interest rate = (1+ n ¿ ¿ -1

Where i is the nominal interest rate

The relation between real interest rate and nominal interest rate is, real interest
rate takes into account the inflation rate.

So the formula stands for,

Real interest rate = Nominal Interest rate- Inflation rate

6. Valuation concept: (Investment decision)

a. Total value of the company (Macro concept): Economic value is a measure

of company’s total value, often used as a more comprehensive alternative to
equity capitalization. EV includes in its calculation the market capitalization of
a company but also short term and long term debt as well as any cash on the
company’s balance sheet.

b. Value of debt or bond: The value of debt refers to the market price the
investors are willing to buy a company’s debt for, which differs from the book
value of the balance sheet.

Formula: V= ΣPV= [Interest rate* PVIFA]+[FV*PVIF]

c. value of equity: Value of equity is the total value of the company’s equity
and also known as the market capitalization.
D
Formula: P0 = Ke−g

d. Value of preferred Share: The value of preferred stock is the present value
of its future dividend discounted at the required rate of return of the stock.
Dp
Formula: Vp= kd
e. Valuation model: Classification:

i. DD model or DG model or Gordon’s model: The dividend discount model

or Gordon’s model is a valuation model of the company’s stock using the
assumption of constant growth in dividend. The model takes the series of
dividend per share and discounts them back to the present value using the
required rate of return.
n
Dn
Formula: DD= ∑
i=1 (1+ r)n

ii. DCF model: Discounted cash flow model is used to determine the value of
investment using the concept of the time value of money.
CF
Formula: DCF=
(1+r )n

iii. FCF model: Free cash flow represents how much the cash is available to
shareholder after the all the expense, reinvestment and debt are paid.

Free cash flow= cash flow from operation- capital expenditure.

Classification:

1. OFCF model: Operating free cash flow refers to the amount of cash
company generates from the revenue it brings deducts the cost of long term
investment on capital items or investment on capital securities.

2. FCFE model: Free cash flow to equity is the amount of cash the company
generates that is available for potential distribution to the shareholder.

FCFE= Cash from operation - Capital expenditure + Net debt issues

iv. Market value model: Market value is the value of an asset which is set in a
competitive auction setting. In other word, it is a method of determining the
value of an asset based on the similar asset in the market.

Classification:

1. MVA model: Market value added is the difference between the

market value of a company and the capital contribution of the investors. In other
words, it is the capital claim of the company plus the market value of the debt
and equity.
Formula: MVA= V - K

Where V is the market value of the firm and K is the total amount of the capital
invested in the firm.

2. EVA model: Economic value added is the measure of company’s financial

performance calculated by deducting its cost of capital from its operating profit
adjusted for taxes on a cash basis.

Formula: EVA= NOPAT – (WACC* Capital invested)

v. Comparative valuation model: Three classifications:

1. P/E multiples: P/E or price-earnings ratio is the ratio that measures the
company’s current share price compared to its earnings per share.
Share price
Formula: P/E ratio: Earning per share

2. P/BV multiples: The price-to-book ratio measures the company’s market

value relative to its book value.
Price per share
Formula: P/BV ratio = Book value per share

3. Others: There are other rations like

P/EG= Price to earning to growth ratio, which is the comparison between the
price of the share and the growth of the profit.
Price earning ratio
Formula: P/EG= Earning growthrate

P/CF= Price to cash flow, which compares the price of the share to the cash
flow per share.
Share price
Formula: Cash flow per share

P/S= price to sale ratio, it compares the stock price with the company’s sale.
Share Price
Formula: P/S= total sales

E/P= Earning yield, which is the inverse of the earning per share

7. Cost of capital concepts: (Financing Decision)

a. kd or YTM and kd(AT): Yield to maturity is the internal rate of return
earned by the investor if he buys any bond today at market price.

kd, Cost of debt, which is the effective interest rate a company pays on its debt.

kd(AT), cost of debt after tax, is the same as kd but it is after tax cost.
FV −MV
Annual interest rate+
Formula: ytm=kd(Before tax)= n
0.6× MV +0.4 × FV

kd(After tax)= kdBT(1 – Tax rate)

b. Ke(new): Cost of new equity is the cost of newly issued stock which takes
into account of flotation cost.
D
Formula: Cost of new equity = P 0−F +g

c. Kr or ke= Cost of equity or existing equity or cost of retained earning, is the

return a firm theoretically pays to the investors to compensate for the risk they
undertake by investing their capital.
D1
Formula: ke= P 0 +¿g

d. kp= Cost of preferred stock is the return rate needed by the holders of a
company’s preferred stock. It is calculated by dividing the annual preferred
dividend payment by the preferred stock market price.
D
Formula: kp(existing)= P

D
kp(New)= P−F

e. WACC or Kw: the weighted average cost of capital is the rate that a
company is expected to pay on its security holders. It is commonly referred as
the firm’s cost of capital.

kw=kd × wd+kp × ℘+ke ×we