Assignment Code: MCO-07/TMA/2021-22

Course Code: MCO-07

Assignment Name: Financial Management

Year: 2021-2022

Verification Status: Verified by Professor

Attempt all the questions:

Q1. (a) Why is cost of capital taken as minimum acceptable rate of return on an investment by the firms? Discuss. (10)

Ans) The cost of capital is a crucial issue in finance. It connects the company's long-term actions to the shareholders' wealth as assessed by the market. When a corporate group raises funds, it must consider the expense of doing so. As a result, calculating the cost of capital is crucial, and finance managers must pay special attention to it.

The cost of capital is the lowest rate of return on new investments that is acceptable. The degree of risk connected with the firm, the taxes it must pay, and the supply and demand of various sources of financing are the primary elements driving the cost of capital for a firm. The term "cost of capital" refers to the minimal rate of return a company must achieve on its investments in order for its equity shares to maintain their market value.

The following assumptions are made when calculating the cost of capital: corporations acquire assets that do not modify their business risk, and these acquisitions are financed in such a way that the financial risk remains unchanged. We must estimate the rates of return demanded by investors in the firm's securities, including borrowings, and average those rates based on the market prices of the various securities now outstanding in order to assess the cost of capital.

While the contractual interest / dividend rate (adjusted for taxes) represents the cost of debt and preference capital, the cost of equity capital is difficult to determine. The E / P method, E / P + Growth method, D / P method, D / P + Growth method, Realised yield technique, and using the Beta co-efficient of the share are the six approaches to estimating the cost of equity. The weighted cost of capital is calculated by assigning book or market weights to assets.

For a business, there are four key sources of long-term funds:

1. Retained Earnings,

2. Long-Term Debt and Debentures,

3. Preferences share capital,

4. Equity share capital

While not all of these sources will be used to fund the firm's activities, each firm will have some of them in its capital structure. The after-tax cost of financing is the precise cost of each source of funding. It can be pre-tax, as long as the basis is the same for all of the sources of capital used to calculate the cost of capital.

(b) How will you calculate the cost of debt capital? Explain with example. (10)

Ans) In case the debentures are issued at premium or discount, the cost of debt should be calculated based on net proceeds realised. The formula will be as follows:

where

Kd = Cost of debt after tax

I = Annual Interest Payment

NP = Net Proceeds of Loans

T = Tax Rate

Illustration No. 1:

A company issue 10% irredeemable debentures of Rs. 10,000. The company is in 50% tax bracket. Calculate cost of debt capital at par, at 10% discount and at 10% premium

Solution:

For computing cost of redeemable debts, the period of redemption is considered. The cost of long-term debt is the investor’s yield to maturity adjusted by the firm’s tax rate plus distribution cost. The question of yield to maturity arises only when the loan is taken either at discount or at premium. The formula for cost of debt will be:

Where

mp = maturity period

p = nominal or par value

np = net proceeds i.e. (Par value – Discount + Premium)

Illustration No. 2:

A firm issued 100 10% debentures, each of Rs. 100 at 5% discount. The debentures are to be redeemed at the end of 10th year. The tax rate is 50%. Calculate

cost of debt capital.

Solution:

Q2. (a) Explain and illustrate net present value method and internal rate of return method. What are the limitations of using these methods? (12)

Ans) The net present value method and internal rate of return method concepts are given below:

Net Present Value

It is the net present value of all cash flows that occur throughout the course of a project's life cycle: outflows will be negative, while inflows will be positive. Obviously, a positive NPV is obtained when the present value of inflows exceeds the present value of outflows, and a negative NPV is obtained when the present value of outflows exceeds the present value of inflows. A positive NPV indicates a net gain in value maximisation, hence any project with a positive NPV is acceptable; however, if the project has a negative NPV, it should not be accepted. The NPV can be written as follows:

Illustration:

A firm is considering an investment proposal  worth Rs.80,000. The CFATs (cash flows after tax) are expected to be as follows. The rate of discount is 10%. Find out whether the  project is worthwhile or not.

Year                                                                       CFATs

                                                                            (Rs.)

                                                                                         1 15,000

                                                                                         2 22,000

                                                                                         3 27,000

                                                                                         4 29,000

                                                                                         5 21,000

Solution:

In this project the PV of inflows is Rs. 84950.50  while the PV of outflows is Rs. 80,000. Hence the NPV is Rs.  4950.50 which makes the project an acceptable project because  NPV is positive.

Limitations of NPV

It delivers the absolute value, therefore comparing two distinct projects, especially when they are of different sizes, is difficult.

1. It is frequently impossible to predict the rate of interest at which discounting will be performed in advance. Similarly, if the rate of interest has changed, a certain NPV may no longer be applicable.

2. It may lead to poor decision-making, particularly when money are limited and we must select between several possibilities.

Internal Rate of Return

The internal rate of return is a good indicator of a project's profitability. It does, however, have a significant flaw. It is assumed that the cash inflows from a project are reinvested at the project's IRR. This might not be the case. It is more acceptable to assume that a project's cash flows be reinvested at the cost of capital or at any other rate where investment opportunities exist (which is usually lower than the IRR).

With this assumption, a modification to the IRR is frequently suggested, and this rate is known as the Modified Internal Rate of Return or MIRR; in this method, we first calculate the terminal value of cash inflows at the cost of capital (or another more realistic rate), and then discount it at a rate that equalises its value with the present value of initial investment.

Illustration:

Year                                                                       CFATs

0                                                                                        - 1200

1                                                                                        300

2                                                                                        350

3                                                                                        450

4                                                                                       500

Assuming the cost of capital at 10%

The NPV of the proposal

The Modified Internal Rate of Return (MIRR) is calculated as follows:

Terminal values of inflows

= 300(1.1)³ + 350(1.1)² + 450(1.1) + 500

= 1817.80

Discounted at 10%, its present value is 1241.58

Discounted at 11%, its present value is 1197.44

Limitations of Internal Rate of Return

Disadvantage: Ignores Future Costs:

The IRR method only concerns itself with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profit. If you are considering an investment in trucks, for example, future fuel and maintenance costs might affect profit as fuel prices fluctuate and maintenance requirements change. A dependent project may be the necessity to purchase vacant land on which to park a fleet of trucks, and such cost would not factor in the IRR calculation of the cash flows generated by the operation of the fleet.

Disadvantage: Ignores Reinvestment Rates:

Although the IRR allows you to calculate the value of future cash flows, it makes an implicit assumption that those cash flows can be reinvested at the same rate as the IRR. That assumption is not practical as the IRR is sometimes a very high number and opportunities that yield such a return are generally not available or significantly limited.

(b) A company’s earnings before interest and tax is Rs. 5,00,000. The capital structure is as given below:

                                                                                          Rs.

10% debentures                                                                  15,00,000

12% preference shares                                                       3,00,000

Equity shares of 100 each                                                  10,00,000

The company is in the bracket of 40% tax bracket. Calculate the earnings per share and degree of financial leverage of the company. (8)

Ans) The company is in the bracket of 40% tax bracket. Calculate the earnings per share and degree of financial leverage of the company. (8)

Ans) Earning before interest and tax                                      Rs.5,00,000

Less: Interest on Debenture @10%                                        (-)1,50,000

Profit before Tax(PBT)                                                           3,50,000

Number of equity Share:                                                      Rs. 10,00,000/100

                                                                                         = 10,000

                                          Profit after tax – preferred Divident

Earnings Per Share (EPS) = --------------------------------

                                                         No. of Shares

Profit after Tax = PBT-Tax

(PAT) = 35,5000 – 40% (35,000)

         = 3,50,000 – 1,40,000

         = Rs. 210000

Preferred Divident = 12% of Rs. 3,00,000

                             = Rs. 36,000.

EPS =  210000 -36000/10000 = 17.40

                                   PBT ( Profit Debate Tax)

Financial Coverage = ----------------------------

                                   Profit After Tax (PAT)

                                =3,50,000/21,0000

                                = 1.87

Q3. (a) What are dividends? Are dividends irrelevant? (10)

Ans) A dividend is a monetary or stock payment made by a public firm to its shareholders. Rather of selling stock, dividend investors seek a steady stream of income via dividends.

Dividends are a way for companies to distribute their profits to their shareholders. Each share of stock you own entitles you to a specified amount of money when a firm pays a dividend. Dividends can be paid in cash, additional stock shares, or even stock warrants. Dividends are paid by both private and public companies, but not all of them do so, and there are no regulations requiring them to. If a corporation chooses, dividends can be paid monthly, quarterly, or annually. Special dividends are paid on an irregular basis.

Even in companies that pay dividends, not every shareholder gets the same amount. Dividends are paid in varying quantities or none at all on preferred and common shares, as well as other types of stock. For example, preferred stock has a stronger claim to dividends than common stock. In theory, dividends are used to value stocks, with the assumption that a stock is worth the present value of all expected future dividends. That notion must be adapted to real-world circumstances for a variety of reasons, including the fact that many shares do not pay dividends. Rather than battling, theorists have gone so far in some situations that adaptations have completely absorbed the original theory, leading to the conclusion that pay-outs are actually harmful.

W.I.N. Buttons, Maxi Skirts, Disco, and Dividend Irrelevance

As with any era, there was a lot about the 1970s that seemed thrilling at the time but didn't always hold up over time. The Effects of Dividend Yield and Dividend Policy on Common Stock Prices and Returns, a 1974 Journal of Financial Economics paper by Fischer Black and Myron Scholes (the same Black and Scholes whose names are on the famous option pricing model) went a long way toward fostering intellectual animosity between income seekers and theoreticians.

For openers, we must examine the continuous relevance of any research based on data from 1926 to 1966, given the tremendous changes in the global economy, our local economy, the structure of our financial system, the political backdrop of market economics, the cost and flow of information, and so on. Much has been constant throughout history, but certain parts have not, such as how regular investors see dividends in this example.

There's also the notion of ex dividend, which holds that when the deadline for new buyers to be eligible for a newly declared dividend has passed, a stock's price should decline by the amount of the dividend (analogous to the way bonds regularly trade subject to interest accrued from the last semi-annual payment date through the date of the transaction). In previous generations, when yield-oriented equities investing was the norm rather than the exception, the ex-dividend issue was a big deal. The ex-dividend phenomenon is likely to have aged similarly to my knees, with so many additional factors influencing stock returns and dividends now (factors that are more quantitative and recognised than ever).

(b) Why is stock exchange an important institution of the capital market? (10)

Ans) A stock exchange, also known as a securities exchange or bourse, is a marketplace where stockbrokers and traders can buy and sell securities such as stocks, bonds, and other financial instruments. Stock exchanges may also offer services such as the issue and redemption of such securities and instruments, as well as capital events such as income and dividend payments. [requires citation] Stocks issued by publicly traded firms, unit trusts, derivatives, pooled investment products, and bonds are all examples of securities traded on a stock market. Buyers and sellers complete deals by open outcry at a central location such as the exchange floor or via an electronic trading platform on stock exchanges that operate as "continuous auction" marketplaces.

A securities must be listed on a particular stock exchange in order to be traded there. There is usually a central site, at least for record keeping, although trading is becoming less tied to a physical location as modern markets employ electronic communication networks to benefit from higher speed and lower transaction costs. The only brokers who can trade on an exchange are those who are members of the exchange. Other trading venues, such as electronic communication networks, alternative trading platforms, and "dark pools," have displaced traditional stock exchanges as a source of trading activity in recent years.

The primary market is where stocks and bonds are first offered to the public, and the secondary market is where they are traded after that. The most significant component of a stock market is frequently the stock exchange. Supply and demand in stock markets are influenced by a variety of factors that affect stock prices, as they do in all free markets.

Stock does not have to be issued through a stock exchange and does not have to be traded on a stock exchange after it is issued. Trading might take place off-exchange or over-the-counter. Derivatives and bonds are typically exchanged in this manner. Stock markets are becoming more and more integrated with the global securities market. Stock exchanges also serve an economic purpose by providing liquidity to shareholders and facilitating the sale of shares.

A capital market is a financial market that buys and sells long-term debt (over a year) or equity-backed securities, as opposed to a money market, which buys and sells short-term debt. Savers' money is channelled through capital markets to those who can put it to good use over time, such as businesses or governments making long-term investments. [a] Financial regulators such as the Securities and Exchange Board of India (SEBI), the Bank of England (BoE), and the Securities and Exchange Commission of the United States (SEC) regulate capital markets, among other things, to protect investors against fraud.

The majority of capital market transactions are administered by financial institutions or government and corporate treasury departments, however some can be accessed directly by the general people. In the United States, for example, any American citizen with an internet connection can open an account with Treasury Direct and utilise it to buy bonds in the primary market, even though individual sales represent for a small percentage of overall bond sales. Various private companies offer browser-based services that allow users to purchase shares and, in some cases, bonds on secondary markets. There are thousands of these systems, the majority of which serve only a small portion of the entire capital markets. Stock exchanges, investment banks, and government offices are among the organisations that host the systems. The systems are physically located all over the world, but they are concentrated in financial centres such as London, New York, and Hong Kong.

Q4. (a) Explain the different approaches of working capital policy. (10)

Ans) Working capital requirements and the value of various current assets are calculated using sales forecasts for products and services. Working capital management that is effective enhances a company's liquidity and profitability. Forecasting sales is difficult, and forecasting current assets is even more difficult. To deal with this ambiguity, the financial management must maintain a minimum level as well as a safety level for each of the current assets at various sales levels. The level of safety is a key aspect of working capital policy. Working capital policy can be determined in one of three ways: The three approaches are (a) conservative, (b) aggressive, and (c) moderate. The firm does not want to take a risk when it has a conservative working capital policy. The level of current assets will increase more than the proportion for every increase in sales. By enhancing the safety component of current assets, this policy aims to lessen the danger of a working capital deficit. Furthermore, such an insurance helps to limit the risk of liability non-payment.

Increased sales do not result in a corresponding growth in current assets in the case of an aggressive working capital programme. Because of the inadequate liquidity, such policies may lead to the firm's insolvency. The firm's profitability will continue to decline. A moderate working capital path is preferable. As a result of this programme, the level of current assets will rise in proportion to the increase in sales. To put it another way, if sales are predicted to increase by 10%, the present asset level must be increased by 10%. It is a conservative method to expand current asset levels by 15%, while it is an ambitious approach to increase current asset levels by 8%.

Working capital finance can be done in one of three ways. These are the following:

Hedging Approach

The matching technique is another name for the hedging strategy. Long-term funds should be utilised to acquire fixed assets and permanent current, whereas short-term funds should be used to acquire temporary working capital in this method.

A Moderate Approach

This strategy implies that, in addition to fixed assets and long-term current assets, a portion of variable current assets should be financed with long-term funds. Short-term resources are only employed to fulfil peak seasonal demands. The surplus fund is kept invested in marketable securities during the off-season. Surplus current assets allow the company to absorb unexpected changes in sales, production plans, and procurement time without disrupting operations. Furthermore, the increased cash minimises the chance of insolvency. However, decreased risk equates to fewer profits. Large investments in current assets result in increased interest rates and carrying costs, as well as an incentive to be more efficient. However, the firm's conservative stance will allow it to absorb day-to-day risk. It ensures that operations run smoothly and removes any concerns about recurrent obligations. Long-term finance is used to cover more than the overall capital requirement in this method. Excess cash is placed in short-term marketable securities, which are then sold in the market as needed to cover a pressing demand for working capital.

Taking an Aggressive Stance

This strategy is more reliant on short-term financing. Short-term funds are employed more frequently, especially for variable current assets and even a portion of permanent current assets, when the funds are raised from short-term sources. Current assets are only kept to cover current liabilities under this method, with no buffers for variations in working capital requirements. Long-term sources of capital are used to fund the company's working capital, while seasonal variations are covered by short-term borrowing. This method reduces the amount of money spent on net working capital and, as a result, lowers the cost of financing working capital needs. The biggest disadvantage of this method is that it demands constant financing and also growth, because the organisation is susceptible to unexpected shocks.

The approach to be taken will be determined by management's risk preferences. The risk neutral will take a hedging approach, the risk averse will take a conservative approach, and the risk takers will take an aggressive approach.

(b) Discuss the different criteria for the selection of proper marketable securities. (10)

Ans) Other types of tradable assets exist, but stocks are the most prevalent. Bonds and bills are the most typical debt securities.

Investing in Stocks

Stock is referred to as an equity investment since shareholders own a portion of the company in which they invest. The money raised from shareholders can be used as equity capital to fund operations and expansion. In exchange for their investment, the shareholder obtains voting rights and periodic dividends based on the company's performance. Investing in the stock market can be risky because the stock value of a firm can change dramatically depending on the industry and the specific business. On the other hand, many people make a career by investing in stocks.

Bonds as a Form of Investment

Bonds are the most common sort of marketable debt security, and they can be an excellent source of capital for small businesses. Bonds are a type of financial instrument that allows a company or government to borrow money from investors. A bond, like a bank loan, guarantees a predetermined rate of return in exchange for the use of the invested funds, known as the coupon rate. The face value of a bond is its par value. Each bond's par value, coupon rate, and maturity date are all specified. The maturity date is when the issuing entity is required to return the bond's full par value.

Because bonds are traded on the open market, they can be purchased for less than par value. These bonds are available at a lesser cost. Depending on market conditions, bonds may trade for more than par value. When this happens, bonds trade at a premium. Coupon payments are calculated using the bond's par value rather than its market value or purchase price. As a result, an investor purchasing a bond at a discount receives the same interest payments as someone purchasing the bond at face value. Bond interest payments that are discounted provide a higher return on investment than the advertised coupon rate. Bonds bought at a premium, on the other hand, have a lower rate of return than those bought at a discount.

Stock with Preferred Status

A marketable asset that includes some of the features of both equity and debt is referred to as a hybrid asset. Preferred shares are comparable to bonds in that they have fixed payments that are paid before dividends to common shareholders. Bondholders, on the other hand, are given precedence over preferred stockholders. Even if preferred share dividends are not paid in the event of financial trouble, bonds may continue to receive interest payments. Unlike a bond, the shareholder's initial investment is never repaid, making it a hybrid security.

In addition to the fixed dividend, preferred shareholders are entitled to a higher share of the company's cash in the event of bankruptcy. In exchange for the benefits of ordinary shareholders, preferred shareholders give up their voting rights. Some investors prefer preferred shares because of the guaranteed dividend and insolvency protection. Preferred shares appeal to those who find common equities too risky yet don't want to wait for bonds to mature.

Exchange-Traded Funds

ETFs are a type of mutual fund that allows investors to buy and sell a variety of assets such as stocks, bonds, and commodities. ETFs are considered marketable securities because they are traded on public exchanges. Marketable securities such as Dow Jones stocks could be among the assets held by exchange-traded funds. ETFs, on the other hand, can hold assets that aren't marketable securities, such as gold and other precious metals.

Other Assets That Can Be Invested In

Marketable securities include money market instruments, derivatives, and indirect investments. There are a variety of securities in each of these categories.

Characteristics of Marketable Securities

The most crucial feature of marketable securities is liquidity. Liquidity refers to the ability to convert assets into cash and use them as a means of exchange in other economic activities. Because of the market's proportional supply and demand, the security is even more liquid. The volume of transactions has an impact on liquidity. Because marketable securities may be sold quickly and price quotes are readily available, they have a lower rate of return than less liquid assets. They are, however, generally seen as posing a lower risk.

There are liquid assets that aren't marketable securities and liquid assets that are. When it comes to liquidity, investments that can be bought and sold quickly are marketable. If an investor or a company needs cash quickly, it is much easier to enter the market and sell marketable securities. For example, selling a non-negotiable certificate of deposit is much more complicated than selling common shares (CD).

As a result, the quality of intent is now considered a "marketability" factor. In truth, many financial professionals and accounting textbooks state that the purpose of a security distinguishes it from non-marketable securities. To be categorised as marketable securities, they must meet two conditions. The first is the capacity to transform funds into cash fast. The second criterion is that people who buy marketable securities intend to sell them when they run out of money. To put it another way, a note bought with short-term objectives in mind is significantly more marketable than one bought with long-term objectives in mind.

Marketable Securities Accounting

In accounting terms, marketable securities are current assets. As a result, they're usually reflected into working capital calculations on a company's balance sheet. It is usually mentioned if marketable securities are not included in working capital. In the idea of adjusted working capital, for example, only operating assets and liabilities are taken into account. Any financing-related items are excluded, such as short-term debt and marketable securities.

Short-term marketable securities are more likely to be invested in by companies with rigorous cash management policies. Longer-term or riskier investments, such as stocks and fixed-income assets with maturities longer than a year, are avoided. Marketable securities are typically included in a company's current assets section under the cash and cash equivalents item.

When doing research on a company, an investor should pay particular attention to the company's announcements. Some announcements, such as dividend payments, establish explicit cash commitments before they are made public. Assume a company is short on cash and has put all of its assets into marketable securities. Management's cash commitments can then be deducted from an investor's marketable securities. This amount of marketable securities is set aside for reasons other than servicing current liabilities.

Last Thoughts

There are liquid assets that aren't marketable securities and liquid assets that are. For example, a newly minted American Eagle Gold Coin is a liquid asset but not a marketable security. 1 In contrast, a hedge fund is a marketable security but not a liquid asset. Regardless, every marketable asset must meet the criteria for classification as a financial security. It must represent the interest of an owner or creditor, have a monetary worth, and provide a profit potential for the buyer.

Q5. (a) Discuss the objectives of inventory management. (8)

Ans) The operational and financial goals of inventory management are the most important. Supplies and spares must be delivered in adequate numbers to avoid work from being suspended owing to a lack of inventory, according to the operational objectives. The financial goal indicates that inventory should not be sitting idle and that only the most basic operating capital should be invested. The inventory management goals are as follows:

1. Taking Orders and Fulfilling Them: You won't be able to meet a received order if you don't know how many of those items you have on hand. You must have the proper products on hand at all times in order to fulfil orders. Otherwise, directives may cause you to become disorganised.

2. Having a Sufficient Supply: From raw materials to finished goods, inventory should be readily supplied in advance. You should have enough of the necessary materials on hand to ensure that products are not damaged when a consumer requests them. Supply tracking ensures that supplies are on hand to meet customer needs. It also enables demand to be shaped based on available supply. You can only set precise targets based on consumer demand once you have enough supply to meet demand.

3. Maintaining Stock Control: You'll need a complete inventory record to make things go more smoothly. This method allows you to keep track of your inventory and prevents errors such as duplicate orders or keeping the wrong amount of goods on hand. Overstock and understock situations should always be considered.

4. Keeping Expenses Low: Inventory management's primary purpose is to reduce costs as much as feasible. You should eliminate unnecessary capital in order to be financially secure. Money is, after all, a major constraint. To cut production expenses, keep your investment to a bare minimum and keep material costs in check. Your assets could become liabilities suddenly if they don't sell. As a result, one of the objectives of inventory management is to avoid losing money as a result of holding inventory.

5. Wastes and losses must be kept to a bare minimum. Having a record on hand reduces waste and protects your company from theft. When vast numbers of products must be handled, the risks are magnified. As a result, when it comes to keeping track of everything and minimising potential losses, an inventory management system is a lifesaver.

6. Inventory management improves overall productivity on a multitude of levels. When you need to update something in the manufacturing process, having an inventory system makes it easier. The first step in increasing or decreasing your productivity is to examine your tracking system and determine how to improve it.

7. Optimizing Product Sales: Another thing you can do with inventory management is analyse product sales patterns. The sales phase is critical to the overall organisation. It assists in gaining a better understanding of the current situation and formulating future assumptions based on the analysis.

8. Maintain a steady supply of materials, replacement components, and finished goods so that production does not suffer at any time and customer needs are met.

9. To avoid both overstocking and understocking of inventory.

10. Maintain an optimal inventory investment level based on operational and sales activity.

11. To keep material costs under control so that production expenses and total costs can be reduced.

12. Duplicate ordering or stock replenishment should be avoided. This can be done by consolidating purchases.

13. Deterioration, pilferage, wastages, and damages must all be reduced to a bare minimum.

14. To set up an effective inventory management system. Clear accountability should be established at all levels of the organisation.

15. To keep constant inventory control and ensure that the materials stated in stock ledgers are actually in the stores.

16. To make sure that high-quality goods are provided at a fair price. Quality stocks will be guaranteed by acceptable quality standards. The correct prices will be paid thanks to pricing analysis, cost analysis, and value analysis.

17. 1To make it easy to give data for both short- and long-term inventory planning and control.

(b) What is securitization? Explain its merits, demerits and process. (12)

Ans) Securitization is the process of transforming a financial institution's receivables, such as loans and advances, into bonds that are subsequently sold to investors. In simple terms, it is a method of converting illiquid assets into liquid assets in order to free up capital that has been stopped.

Merits

Borrowers, originators, special purpose vehicles, merchant banks, and investors are all involved in the securitization process. As a result, each of these parties benefits from the process, with the following advantages for the originator and investor:

To the Originator:

The originator reaps the greatest advantage from securitization because the goal is to free up the blocked money so that they can pursue other appealing alternatives. Let's take a look at each of these:

1. Unblocks Capital: Securitization allows the originator to recoup the amount lent far sooner than the time period specified.

2. Liquidity is provided by converting illiquid assets, such as receivables on bank-approved loans, into liquid assets.

3. Lowers Funding Costs: Through securitization, even BB-grade enterprises can profit from AAA rates provided their cash flow is AAA-rated.

4. Risk Management: By securitizing its receivables, the financial institution granting the cash can transfer the risk of bad debts.

5. Overcoming Profit Uncertainty: When debt recovery is unclear, the long-term profitability of the business is also questionable. As a result, securitization of such obligations is a viable tool for protecting against loss.

6. Reduces the Need for Financial Leverage: Because securitization releases blocked money to maintain liquidity, the originator does not need to seek financial leverage in the event of an emergency.

To the Investor:

The goal of the investor is to increase the rate of return on investment. The following are some of the reasons why securitization is a good investment:

1. MBS and ABS are considered to be a wise investment option because of their feasibility and trustworthiness.

2. Less Credit Risk: Because securitized assets are treated apart from their parent corporation, they have a greater creditworthiness.

3. Better Returns: Securitization allows investors to get a higher return on their investment; nevertheless, it is more dependent on the risk-taking ability of the investor.

4. Diversified Portfolio: By integrating securitized bonds in a well-diversified portfolio, the investor can achieve a well-diversified portfolio that is distinct from other securities.

5. Small Investors Can Earn From Securitized Bonds: Investors with a small amount of money to invest can profit from securitized bonds.

Demerits

Securitization necessitates thorough research and experience; else, it may prove to be risky for investors.

1. Investors may not receive complete information on the assets included in a securitized bond due to a lack of transparency on the part of the SPV.

2. Complex to Manage: The entire securitization process is highly complex, involving several parties, and the assets must be blended carefully.

3. Rather Expensive: When compared to the cost of a stock IPO, the cost of a securitized bond, including underwriting, legal, administration, and rating fees, is usually quite high.

4. Risk is taken by the investor: The failure of the borrower to repay his loans would result in a loss for the investors. As a result, the investor is the single bearer of risk in the process.

5. Inaccurate Risk Assessment: Even the originator can miss the value of underlying assets or the credit risk linked with them.

6. Prepayment Loss: If the borrower repays the loan earlier than the agreed-upon time, the investors will lose money on their investment.

Process

Securitization is a complicated and time-consuming procedure that involves numerous parties and involves the conversion of receivables into bonds. The following are the steps involved in the securitization process:

1. The borrower approaches a bank or other financial institution (originator) to obtain a loan. In exchange for any collateral, the financial institution permits a set amount to be used as debt.

2. Pooling Function: The originator then sells its receivables to the special purpose entity via pledge receipts.

3. The SPV securitizes these receivables by converting them into marketable securities, such as Pay Through Certificates or PTCs (Pass-Through Certificate). These products are then delivered to merchant banks, who will sell them to investors. These instruments are purchased by investors with the intention of profiting in the long run.

The investors are entitled to a return on their investment because they extended the loan. The borrowers are completely unaware of the securitization and pay their monthly payments on schedule. The originator receives a lump sum payment from the SPV, but at a discounted rate. For its services, the merchant bank charges a fee.