INDEX
| SR.NO. TOPIC |
| 1 RESPONSIBILITY ACCOUNTING |
| 2 INVESTMENT |
| 3 CLASSIFICATION OF INVESTMENT |
| 4 INVESTMENT AVENUES |
| 5 VARIOUS INVESTMENT AVENUES |
| 6 FEATURES OF INVESTMENT AVENUES |
| 7 COMPARISON OF INVESTMENT AVENUES |
| 8 INVESTMENT CENTRES |
| 9 RETURN ON INVESTMENT |
| 10. RETURN ON EQUITY |
| 11. ECONOMIC VALUE ADDED |
| 12. IMPLEMENTATION |
| 13. INVESTMENT INSTITUTIONS |
| 14. THE UNIT TRUST OF |
| 15. INVESTMENT AND SPECULATION |
ACKNOWLEDGEMENT
It gives us a great pleasure while submitting this project on the topic
“Investment Centres.”
We thank Prof. Manish Sharma for guiding us throughout this project work and also for motivating us in different ways. He has been the tremendous helping hand in completing this difficult task, had an easy or any time access to such knowledgeable and guiding spirit.
We feel there is ample scope of improvement upon the work of this nature and shall be thankful if any suggestion is offered for its improvement.
We express our deep gratitude towards family members, who helped us in giving a final shape and structure to this project work.
We are also thankful to all those seen and unseen hands, which have been of direct or indirect help in completion of this project work
RESPONSIBILITY ACCOUNTING
Responsibility Accounting collects and reports planned and actual accounting information about the inputs and outputs of responsibility centres.
Responsibility Accounting must be so designed as to suit the existing structure of the organization. Responsibility should be coupled with authority. A person is obliged to perform his duties only when he is conferred with adequate powers to do so. A sound organization structure, with clear-cut assignment of authorities and responsibilities should exist for the successful functioning of the responsibility accounting system. When the organization is not in order, it will miserably fail to work. Responsibility accounting system mainly depends on the assigned responsibilities and authorities such that the performance of each manager is evaluated in terms of such factors.
Responsibility center within an organization has control over revenue, cost and investment funds. It is a profit center whose performance is evaluated on the basis of the return earned on invested capital. The corporate headquarters or division in a large decentralized organization would be an example of an investment center. Return on Investment and Residual Income are two key performance measures of an investment center
The main focus of responsibility accounting is on the responsibility centres. A responsibility centre is a sub-unit of an organization under the control of a manager who is held responsible for the activities of that centre. The responsibility centres, for control purposes, are generally classified into:
(1) Cost Centres (2) Profit Centres (3) Investment Centres (4) Revenue Centres
COST CENTRES:
When the manager is held accountable only for costs incurred in a responsibility centre, it is called a cost centre. More precisely, it is the inputs and not outputs that are measured in terms of money. In a cost centre of responsibility, the accounting system records only costs incurred by the centre/unit/division, but the revenues earned (output) are excluded from the purview. This only means that a cost centre is a segment whose financial performance is measured in terms of cost. The costs are the planning and control data in cost centres, since managers are not made responsible for profits and investments in assets. The performance of the managers is evaluated by comparing the costs incurred with the budgeted costs. The management focuses on the cost variances for ensuring proper control. The performance of a cost centre is measured by cost alone, without taking into consideration, its attainments in terms of “output”.
A cost centre does not serve the purpose of measuring the performance of the responsibility centre, since it ignores the output (revenues) measured in terms of money. A common feature of production departments is that they are usually multiple product units. There must be some common basis to aggregate the dissimilar products to arrive at the overall output of the responsibility centre. If this is not done, the efficiency and effectiveness of the responsibility centre cannot be measured.
PROFIT CENTRES:
When the manager is held responsible for both cost (inputs) and revenues (output) and thus, for profit of a responsibility centre, it is called a Profit Centre. In a Profit Centre, both inputs and outputs are measured in terms of money. The difference between revenues and costs represents profit where the former exceeds the latter and loss when it is vice versa. The term “revenue” with reference to responsibility accounting is used in a different sense altogether. According to generally accepted principles of accounting, revenues are recognized only when sales are made to external customers. For evaluating the performance of a profit centre, the revenue represents a monetary measure of output emanating from a profit centre during a given period, irrespective of whether the revenue is realized or not. The underlying principle is that a department has output representing goods and services which are capable of monetary measurement.
The relevant profit to facilitate the evaluation of performance measurement of a profit centre is the pre-tax profit of a responsibility centre. The profit of all the departments so calculated will not necessarily be equivalent to the profit of the entire organization. The variance will arise because costs which are not attributable to any single department are excluded from the computation of the department's profits and the same are adjusted while determining the profits of the whole organization. Hence, it is the divisional profit which is required for the purpose of managerial control.
As the profit provides more effective appraisal of the manager's performance, the manager of the profit centre is highly motivated in his decision-making relating to inputs and outputs so that profits can be maximized. In consonance with the above objective, by creating more profit centres in an organization, decentralization of activities can be easily effected.
The profit centre approach cannot be uniformly applied to all responsibility centres. The following are the criteria to be considered for making a responsibility centre into a profit centre. A profit centre must maintain additional record keeping to measure inputs and outputs in monetary terms. When a responsibility centre renders only services to other departments at the instance of the management, e.g., internal audit. It cannot be made a profit centre. A profit centre will gain more meaning and significance only when the divisional managers of responsibility centres have empowered adequately in their decision making relating to quality and quantity of outputs and also their relation to costs. If the output of a division is fairly homogeneous (e.g., cement), a profit centre will not prove to be more beneficial than a cost centre. Again, due to intense competition prevailing among different profit centres, there will be continuous friction among the centres arresting the growth and expansion of the whole organization. A profit centre will generate too much of interest in the short-run profit to the detriment of long-term results.
A
INVESTMENT CENTRES:
When the manager is held responsibility for costs and revenues as well as for the investment in assets of a responsibility centre, it is called an Investment Centre. In an investment centre, the performance is measured not by profit alone, but it is related to investments effected, since the manager of an investment centre is always interested to earn a satisfactory return. The return on investment which is usually referred to as ROI, serves as a criterion for the performance evaluation of the manager of an investment centre. Viewed from this angle, investment centres may be considered as separate entities wherein the managers are entrusted with the overall of managing inputs, outputs and investment. This only represents an extension of the responsibility idea.
INVESTMENT
Investment or investing is a term with several closely-related meanings in business management, finance and economics, related to saving or deferring consumption.
Investment is the choice by the individual to risk his savings with the hope of gain. Rather than store the good produced, or its money equivalent, the investor chooses to use that good either to create a durable consumer or producer good, or to lend the original saved good to another in exchange for either interest or a share of the profits.
In the first case, the individual creates durable consumer goods, hoping the services from the good will make his life better. In the second, the individual becomes an entrepreneur using the resource to produce goods and services for others in the hope of a profitable sale. The third case describes a lender, and the fourth describes an investor in a share of the business.
In each case, the consumer obtains a durable asset or investment, and accounts for that asset by recording an equivalent liability. As time passes, and both prices and interest rates change, the value of the asset and liability also change.
An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of getting a future return or interest from it. The word originates in the Latin "vestis", meaning garment, and refers to the act of putting things (money or other claims to resources) into others' pockets. See Invest. The basic meaning of the term being an asset held to have some recurring or capital gains. It is an asset that is expected to give returns without any work on the asset per se.
All investments are risky, as the investor parts with his money. An efficient investor with proper training can reduce the risk and maximize returns. He can avoid pitfalls and protect his interests.
Companies and govt. sell securities, either for equity capital or debt capital. These securities may be in the form of shares, debentures, bonds, etc. which are marketable. They have different degrees of risk and return, varying with the instrument. Some instruments of investment are non marketable and they are more risky and may become sometimes waste paper. The management of risk and return requires expertise. Investment is both art and science. The performance of companies and changes in share prices are all based on some fundamental principles, sentiment and psychological expectations. As such, investor has to use his discretion, which is an art to acquire by learning and experience. Principles of investment and the art of the management of investment are basic requirements for a successful investor.
Investors should be those who invest with the objective of receiving some income, share in the prosperity of the company and gain capital appreciation in a longer time span. Investors in the wider sense include speculators, institutions, companies and even banks.
OBJECTIVES OF INVESTOR
The investor has various alternative avenues of investment for his savings to flow in accordance with his preferences. Savings flow in to investment for a return, but savings kept as cash are barren and do not earn anything. Savings are invested in assets depending on their risk and return characteristics. But a minimum amount of cash is always kept in hand for transaction and contingencies. Any rational investor knows that money if loosing its value by the extent of the rise in prices. If money lent cannot earn as much as rise in prices or inflation, the real rate of return is negative. Thus, if inflation is at an average annual rate of 10%, then the return should be 10% or above to induce savings to flow in to investment. Thus, if an investment is made in short term deposits with banks or else securities of govt., then the rate of interest is around 8 to 10 %. As the risk of loss of money is almost negligible in such cases, this rate can be called as risk free returns. All investments involve some risk or uncertainty. The objective of investor is to minimize the risk involved in investment and maximize the return.
CLASSIFICATION OF INVESTMENT
There are different methods of classifying the investment avenues.
A major classification is:
1. Physical investments
2. Financial investments.
They are physical, if savings are used to acquire physical assets, useful for consumption or production. Some physical assets like ploughs, tractors or harvesters are useful in agricultural production. A few physical assets like lorries, cars, jeeps, etc. are useful in business. Many items of physical assets are not useful for further production of goods or create income as in the case of consumer durables, gold, silver, etc. But most of the financial assets, barring cash are used for production or consumption, or further creation of assets, useful for production of goods and services.
Among different types of investments, some are marketable and transferable and others are not. Eg of marketable assets are shares and debentures of public limited companies, particularly the listed companies on stock exchanges, bonds of P.S.Us, govt. securities, etc. Non marketable securities or investments are bank deposits, provident and pension funds, insurance certificates, post office deposits, national savings certificates, company deposits, private limited companies, shares, etc.
I. FINANCIAL ASSETS II. PHYSICAL ASSETS
SAVER
CASH BANKS DEPOSITS P.F., L.I.C. SCHEMES PENSION SCHEME P.O. CERTIFICATES AND DEPOSITS
INVESTOR
SHARES, BONDS, GOVT. SECURITIES, ETC. M.F.SCHEMES, UTI UNITS, ETC.
III. MARKETABLE ASSETS
STOCK & CAPITAL MARKETS
NEW ISSUES STOCK MARKETS
MODES OF INVESTMENT
There are different types of securities conferring different set of rights on the investors and different set of conditions under which these rights can be exercised. The various avenues for investment, ranging from riskless to high risk investment opportunities consist of both security and non- security forms of investment. All securitized forms given below are marketable.
- Security forms of investment
- corporate bonds/ debentures
a. convertible
b. non- convertible
- public sector bonds
a. taxable
b. tax free
- preference shares
- equity shares
a. new issue
b. rights issue
c. bonus issue
- Non- security forms of investment
- national savings schemes
- national savings certificates
- provident fund
a. statutory provident fund
b. recognized provident fund
c. unrecognized provident fund
d. public provident fund
- corporate fixed deposits
a. whole life policies
b. limited payment life policy
c. jeevan mitra
d. jeevan saathi
e. jeevan dhara
f. jeevan kishor
g. jeevan sarita
- post office savings bank account
a. recurring deposits
b. time deposits
c. monthly income scheme
d. senior citizens saving scheme
- others
a. RBI relief bonds phased out
b. Kisan vikas patra
c. Chit funds, nidhis, etc.
INVESTMENT AVENUES
Though investment opportunities abound all the time and in almost all situations, often they may not be very easy to identify. A shrewd and discerning investor will usually find opportunities for making money in places, and in situations, where a less discerning one will not. The best investment opportunities are often found in the most unlikely places and situations. For example, in the beginning of 1994 few could have predicted that the shares of the then relatively unknown company like Infosys Technologies, focusing primarily on Y2K software projects, would provide one of the best investment opportunities of the last decade.
VARIOUS INVESTMENT AVENUES:
There are a large number of investment instruments available today. To make our lives easier we would classify or group them under 4 main types of investment avenues. We shall name and briefly describe them.
1. FINANCIAL SECURITIES: These investment instruments are freely tradable and negotiable. These would include equity shares, preference shares, convertible debentures, non-convertible debentures, public sector bonds, savings certificates, gilt-edged securities and money market securities.
2. NON-SECURITIZED FINANCIAL SECURITIES: These investment instruments are not tradable, transferable nor negotiable. And would include bank deposits, post office deposits, company fixed deposits, provident fund schemes, national savings schemes and life insurance.
3. MUTUAL FUND SCHEMES: If an investor does not directly want to invest in the markets, he/she could buy units/shares in a mutual fund scheme. These schemes are mainly growth (or equity) oriented, income (or debt) oriented or balanced (i.e. both growth and debt) schemes.
4. REAL ASSETS: Real assets are physical investments, which would include real estate, gold & silver, precious stones, rare coins & stamps and art objects.
5. EMPLOYEES’ PROVIDENT FUND: This is one of the very safe investment avenues. The current interest rate of EPF is 8.5% per annum. However, this rate is not fixed and the government can modify the same from time to time. The best part of EPF is that the interest earned is exempt from tax under section 10 (12) of the Income Tax Act. That is the entire interest income earned by you goes into your pocket. The taxman gets nothing.
6. PUBLIC PROVIDENT FUND (PPF): PPF is considered yet another safe investment avenue. The current interest rate on PPF is 8% per annum. Again like EPF the rate of interest is not fixed. The government modifies the same from time to time.
7. LIFE INSURANCE POLICY (INCLUDING ULIP & PENSION PLAN): There are a variety of insurance products available. The traditional plans such as money back, cash back, endowment, whole life, children plans are considered relatively safe. However, the returns thereon vary between 4% per annum to 6% per annum. For most of these plans premium has to be paid monthly, quarterly, semi-annually or annually during the term of the policy.
8. NATIONAL SAVINGS CERTIFICATE (NSC): This is also a very safe investment avenue. The certificate has a maturity period of 6 years. The current interest rate is 8.16% per annum. The interest rate is fixed in a sense that subsequent changes to the interest rates do not affect you. That is, any increase/decrease in interest rates will not have any impact on your investment or interest earned.
The best part of PPF is that the interest thereon is exempt from tax under section 10(11) of the Income Tax Act. Tax deduction can be claimed on contribution made by an individual into his own PPF account or into the PPF account of his spouse or children
Before choosing the avenue for investment the investor would probably want to evaluate and compare them. This would also help him in creating a well diversified portfolio, which is both maintainable and manageable.
FEATURES OF INVESTMENT AVENUES
1. RISK: The risk depends on the following factors:
a. the longer the maturity period, the larger is the risk. Thus, deposits of two years carry a higher rate than one-year deposits.
b. The more the creditworthiness of the borrower or the agency issuing securities, the less is the risk. Thus, the risk of loss of interest and principal is less with the government or semi- government bodies than with the private corporate units.
c. The nature of instrument, namely, the debt instrument or fixed deposit or ownership instrument like equity or preference share, also determines risk. The risk of less in the case of debt instruments like debentures, as these are secured and fixed interest is payable on them. In the case of ownership instruments, the risk of loss is more due to their unsecured nature and variability of their return and ownership character which burdens them with all the risks connected with the enterprise.
2. RETURN: A major factor influencing the pattern of investment is its return, which is the yield plus capital appreciation, if any. The difference between the purchase price and the sale price is capital appreciation and the yield is the interest or dividend divided by its purchase price.
3. SAFETY: The safety of capital is the certainty of return on capital without loss of money or time involved. In the cases of money lent, some transaction costs and time are involved in getting the funds back. But leaving aside such general costs like stamp duty, postal charges, etc. the time involved is also an important factor. If money is returnable not on the same day but after a lapse of time, then the loss of liquidity is involved and if the time of return of funds is not certain and if cost of selling or realization of proceeds are involved, then the safety of funds is also not perfect. Thus, if safety of capital is to be assured then riskless return as in case of government bonds is to be chosen. If the return is higher as in case of private securities, then the degree of safety is less.
4. LIQUIDITY: If a capital asset is easily realizable, saleable or marketable, then it is said to be liquid. If an investment can be encashed with a time lag as in case of equity shares or with loss of money as in case of U.S.64 of UTI then they are less liquid. If, on the other hand there is a good market for the capital asset and no risk of loss of money or capital and no uncertainty of time involved, then the liquidity of asset is good. If liquidity is high, then the return may be low as in case of bank saving deposits.
An investor generally prefers liquidity for his investment, safety of his fund, a good return with a minimum risk or minimization of risk and maximization of return.
5. MARKETABILITY: This means easy and quick means of transferability of an asset.Thus asset of listed companies and shares of public limited companies are more easily transferable then those of non listed companies and private limited companies.
COMPARISON OF INVESTMENT AVENUES
| | Rate of return | Rate of return | | | |
|
|
| Annual Income | Capital Appreciation | Risk | Marketability | Tax Benefit | Convenience |
| Financial Securities |
|
|
|
|
|
|
| Equity | Low | High | High | High | Yes | High |
| Non-convertible Debentures | High | Low | Low | Average | Nil | High |
| Financial Securities (Non-securitized) |
|
|
|
|
|
|
| Bank deposits | Low | Nil | Low | High | Yes | High |
| Provident fund | Nil | High | Nil | Average | Yes | High |
| Life insurance | Nil | High | Nil | Average | Yes | High |
| Mutual funds |
|
|
|
|
|
|
| Growth/equity | Low | High | High | High | Yes | High |
| Income/debt | High | Low | Low | High | Yes | High |
| Real assets |
|
|
|
|
|
|
| Real estate | Low | High | Low | Low | Limited | Average |
| Gold/silver | Nil | Average | Average | Average | Nil | Average |
INVESTMENT CENTRES:
When the manager is held responsibility for costs and revenues as well as for the investment in assets of a responsibility centre, it is called an Investment Centre. In an investment centre, the performance is measured not by profit alone, but it is related to investments effected, since the manager of an investment centre is always interested to earn a satisfactory return. The return on investment which is usually referred to as ROI, serves as a criterion for the performance evaluation of the manager of an investment centre. Viewed from this angle, investment centres may be considered as separate entities wherein the managers are entrusted with the overall of managing inputs, outputs and investment. This only represents an extension of the responsibility idea.
An investment center is a classification used for business units within an enterprise. The essential element of an investment center is that it is treated as a unit which is measured against its use of capital, as opposed to a cost or profit center, which are measured against raw costs or profits.
The advantage of this form of measurement is that it tends to be more encompassing, since it accounts for all uses of capital. It is susceptible to manipulation by managers with a short term focus, or by manipulating the hurdle rate used to evaluate divisions
The purpose of this is to:
1) Discuss two common performance measurements for investment centres and the various relationships between these measurements,
2) Present some equations related to these measurements that can be used for planning purposes,
3) Discuss a number of issues related to how these measurements are calculated and
4) Discuss the transfer pricing problem that arises when investment centres sell products or services to each other.
Investment center is one of the breakdowns of responsibility centres in accounting. It is accountable for company's profit and also its assets. Both investment center and profit center are parallel each other hence they should not be regarded as separate category. The three measurements commonly used to evaluate investment centres are Return on Investment (ROI), Return on Equity (ROE) and Economic Value Added (EVA).The ROI measurement is discussed in the first section, followed by a discussion of ROE and finally the issues related to transfer pricing are discussed in the last section. An Appendix is also included related to the conflict between choosing investment projects and evaluating the subsequent results.
RETURN ON INVESTMENT
Return on Investment – (ROI) is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.
In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (realized or unrealized) on an investment relative to the amount of money invested.
The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment.
ROI is usually expressed as a percentage rather than a fraction.
Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.
The rate of return can take on any value greater than or equal to -100% -- a positive value corresponds to capital growth, a negative value corresponds to capital decay, and a value of 0% corresponds to no change.
To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.
For example, what is the ROI for a new marketing program that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in increased profits during the same time?
.
Return on investment (ROI) = Net operating income / Average operating income
ROI = (Net operating income / Sales) × (Sales / Average operating assets)
These two equations are equivalent because the sales terms cancel out in the second equation. The first term on the right hand side of the equation is margin, which is defined as follows:
Margin = Net operating income / Sales
Margin is a measure of management's ability to control operating expenses in relation to sales. The lower the operating expenses per dollar of sales, the higher the margin earned.
The second term on the right hand side of the equation is turnover, which is defined as follows:
Turnover = Sales / Average operating assets
Turnover is a measure of the sales that are generated for each dollar invested in operating assets.
The following alternative form of the ROI formula, which we will use here, combines margin and turnover.
ROI = Margin × Turnover
Both the formulas give same answer. However margin and turnover formulation provides some additional insights. Some managers tend to focus too much on margin and ignore turnover. To some degree the margin can be a valuable indicator of a manager's responsibility. Standing alone, however, it overlooks one very crucial area of manager's responsibility--the investment in operating assets. Excessive funds tied up in operating assets, which depresses turnover, can be just as much of a drag on profitability as excessive operating expenses, which depresses margin. One of the advantages of return on investment (ROI) as a performance measure is that it forces the manager to control the investment in operating assets as well as to control expenses and the margin.
RETURN ON INVESTMENT ANALYSIS
Return on Investment (ROI) analysis is one of several approaches to building a financial business case.
The term means that decision makers evaluate the investment by comparing the magnitude and timing of expected gains to the investment costs.
Decision makers will also look for ways to improve ROI by reducing costs, increasing gains, or accelerating gains.
In the last few decades, this approach has been applied to asset purchase decisions (computer systems or a fleet of vehicles, for example), "go/no-go" decisions for programs of all kinds (including marketing programs, recruiting programs, and training programs), and to more traditional investment decisions (such as the management of stock portfolios or the use of venture capital).
METHODS OF INCREASING ROI
Anything that causes one of the variables in the numerator to increase (relative to the denominator) or one of the variables in the denominator to decrease (relative to the size of the numerator), will increase ROI.
It is the relative state of an item that is important.
EXAMPLE: Regal Company reports the following data for last year’s operations:
| Rs30,000 | |
| Sales | Rs500,000 |
| Average operating assets | Rs200,000 |
To increase ROI, at least one of the following must occur:
1) Increase sales: If sales increase at a greater rate than the increase in operating assets, turnover will improve and ROI will increase. If sales increase at a slower rate than the increase in operating income(because expenses are increasing at a slower rate than the increase in sales) , then margin will improve and ROI will improve.
Example 1—Increase sales:
Assume that Regal Company is able to increase sales to Rs600,000 and net operating income increases to Rs42,000. Also assume that operating assets are not affected.
(Compared to 15% before)
2) Reduce expenses: Cutting expenses is the easiest way to improve ROI. Increasing sales (relative to operating income and operating assets) is the next best way to increase ROI.
Example 2—Reduce expenses:
Assume that Regal Company is able to reduce expenses by 10,000 per year, so that net operating income increases from Rs30,000 to Rs40,000. Also assume that sales and operating assets are not affected.
(Compared to 15% before)
3) Reduce operating assets: Reducing operating assets by reducing inventories (using JIT) or reducing the level of Accounts Receivable by using such thing as “lock boxes” (providing local post office boxes for customers to make payments) to reduce deposit in transit times, is the next best approach.
Example 3—Reduce assets:
Assume that Regal Company is able to reduce its average operating assets from Rs2,00,000 to Rs1,25,000. Also assume that sales and net operating income are not affected.
(Compared to 15% before)
ADVANTAGES OF ROI
There are several advantages in using ROI to measure divisional performance. They are as follows
1. It is generally accepted measure of overall performance. As a measure of divisional performance, it is consistent with a firm-wise rate of return analysis. It is also compatible with the common sense view that investments are made to achieve the goal of a desired rate of return.
2. ROI analysis is a relative and not absolute measure. It is, in fact, a ratio/percentage. It therefore, serves as a common denominator so that a comparison can be made between the performances of different divisions. Thus ROI is of great practical significance.
3. ROI is conceptually easy to understand and interpret.
4. It can provide an incentive for optimum utilization of the assets of the firm. In operational terms, it encourages divisional managers to obtain/retain assets that provide satisfactory ROI and to discard /dispose off assets that are not giving acceptable returns.
CRITICISM OF ROI
- Managers may not know how to increase ROI; they may increase ROI in a way that is inconsistent with the company's strategy; or they may take actions that increase ROI in the short run but harm company the long run (such as cutting back on the research and development). This is why ROI is best used as part of a balanced scorecard. A balanced scorecard can provide concrete guidance to managers, making it more likely that action taken are consistent with the company's strategy and reducing the likelihood that short-run performance will be enhanced at the expense of long-term performance.
- A manager may take over a segment in which there are many “committed” costs (e.g. rent) over which the manager has no control. These costs may be valid in determining the performance of the segment as an investment centre but should not be used to evaluate the performance of that manager relative to other managers.
- When Net operating assets are used, the manager who is evaluated on the basis of ROI may reject new investment opportunities involving plant and equipment because they will adversely affect his/her ROI.
4. In complex business settings, however, it is not always easy to match specific returns (such as increased profits) with the specific costs that bring them, and this makes ROI less trustworthy as a guide for decision support.
5. Simple ROI also becomes less trustworthy as a useful metric when the cost figures include allocated or indirect costs, which are probably not caused directly by the action or the investment.
6. Business investments typically involve financial consequences extending several years or more. In such cases, the metric has meaning only when the time period is clearly stated. Shorter or longer time periods may produce quite different ROI figures for the same investment. When financial impacts extend across several years, moreover, the analyst must decide whether to use discounted (net present value) figures or non discounted values.
Rate of Return and Return on Investment indicate cash flow from an investment to the investor over a specified period of time, usually a year.
ROI is a measure of investment profitability, not a measure of investment size. While compound interest and dividend reinvestment can increase the size of the investment (thus potentially yielding a higher dollar return to the investor), Return on Investment is a percentage return based on capital invested.
In general, the higher the investment risk, the greater the potential investment return, and the greater the potential investment loss.
RETURN ON EQUITY
Return on Equity (ROE, Return on average common equity, return on net worth) measures the rate of return on the ownership interest of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.
ROE = (Net income) / (Average total equity)
The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.
Return on Equity (ROE) measures how well a company uses the capital provided by its equity investors. Since equity investors are entitled to what profits remain after interest is paid to debt holders and taxes are paid to the government, net income is the appropriate measure of profit.
Return on equity is a critical weapon in the investor's arsenal, as long as it's properly understood for what it is. ROE encompasses the three pillars of corporate management -- profitability, asset management, and financial leverage. By seeing how well the executive team balances these components, investors can not only get an excellent sense of whether they will receive a decent return on equity but can also assess management's ability to get the job done.
If return on equity is simply:
ROE = one year's earnings / shareholder equity
ROE = (one year's earnings / one year's sales) x (one year's sales / assets) x (assets / shareholder equity)
Earnings over sales are profit margin, sales over assets are asset turnover, and assets over equity are the amount of leverage the company has.
ROE is presumably irrelevant if the earnings are not reinvested.
- The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
- The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).
- New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"
- Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always recalculate on a 'per share' basis, i.e., earnings per share/book value per share.
ROE encompasses the three pillars of corporate management -- profitability, asset management, and financial leverage. By seeing how well the executive team balances these components, investors can not only get an excellent sense of whether they will receive a decent return on equity but can also assess management's ability to get the job done.Return on equity is calculated by taking a year's worth of earnings and dividing them by the average shareholder equity for that year.
ECONOMIC VALUE ADDED
Economic Value Added or EVA is an estimate of true economic profit after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital.
EVA is the monetary value of an entity at the end of a time period minus the monetary value of that same entity at the beginning of that time period.
EVA is an incentive system so employees need a reward for - creating and sustaining it. Successful implementation requires a substantial commitment by managers and employees at all levels of an organization.
Economic value added (EVA) is the most misunderstood term among the practitioners of corporate finance. The proponents of EVA are presenting it as the wonder drug of the millennium in overcoming all corporate ills at one stroke and ultimately help in increasing the wealth of the shareholder, which is synonymous with the maximization of the firm value. The attractiveness of the EVA lies in its use of cash flow and cost of capital that are determinant of the value of the firm.
Technically speaking EVA is nothing but the residual income after factoring the cost of capital into net operating profit after tax.
In the process, EVA is being bandied about with utmost impunity by all and sundry,
which includes the popular press. The academic world in its turn has come up with
various empirical studies which either supports the superiority of EVA or questions the
claim of its proponents. Currently the empirical evidence is split almost half way.
EVA is nothing but a new version of the age-old residual income concept recognized by
economists since the 1770's. Both EVA and ‘residual income’ concepts are based on the
principle that a firm creates wealth for its owners only if it generates surplus over the cost
of the total invested capital. So what is new? Perhaps EVA could bring back the lost
focus on ‘economic surplus’ from the current emphasis on accounting profit. In a lighter
vein it can be said that in an era where commercial sponsorship is the ticket to the
popularity of even the concept of god, the concept of residual income has not found a
good sponsor until Stern Stewart and Company had adopted it and relaunched it with a
brand new name of EVA.
Examining EVA as a corporate philosophy we intend to look at the efficacy of EVA
when implemented at every level of managerial decision making process to encourage
managers to deploy resources only on value enhancing activities and to align the interests
of shareholders with managers. This involves two things, one is linking managerial
compensation package with EVA and second is to inculcate the culture of evaluating
every action from the viewpoint that it should generate EVA. The ultimate outcome
should be enhancement in the firm-value measured by the capital market. When EVA is
used as a management philosophy, it results in the enhancement of productivity by
continuously focusing on return vis-Ã -vis cost of capital. However as market discounts
expected long term performance of the firm, any compensation that motivates
enhancement of short term EVA, may not maximize the firm value.
However with EVA culture, the firm as a whole focuses on the economic surplus and that
definitely improves value enhancement process. Of course, this can be achieved even by
implementing the other practices but the simplicity of EVA in communicating the very
fundamental principle, that generation of surplus over cost of capital can only enhance
the firm value, makes it a management technique superior to other planning and control
techniques. We shall examine the appropriateness of this perception. The basic formula is:
EVA = ( r - c ) * K = NOPAT – c * K
Where r = NOPAT / K
r is Return on Invested Capital (ROIC) is the firm's return on capital, NOPAT is the Net Operating Profit After Tax, c is the Weighted Average Cost of Capital (WACC), K is capital employed. To calculate NOPAT, EVA starts with income before income taxes and minority interests. Then it adds interest expense to get earnings before interest and taxes (EBIT). Next, it makes two adjustments. First, it adds and subtracts non-cash items to put EBIT on a cash basis. An alternative would be to take the information from the firm’s cash flow statement, if available. Then, it capitalizes expenses which it believes should be treated as investments. The effect of this is to move certain expense items to the balance sheet.
Capital being used in EVA calculation is not the book capital, capital is defined as an
approximation of the economic book value of all cash invested in going-concern business
activities, capital are essentially a company’s net assets (total assets less non-interest bearing current liabilities), but with three adjustments:
1. Marketable securities and construction in progress are subtracted.
2. The present value of non capitalized leases is added to net property, plant, and
equipment
3. Certain equity equivalent reserves are added to assets:
* Bad debt reserve is added to receivables.
* LIFO reserve is added to inventories.
* The cumulative amortization of goodwill is added back to goodwill
* R&D expense is capitalized as a long-term asset and smoothly depreciated over 5
years (a period chosen to approximate the economic life typical of an investment in
R&D).
* Cumulative unusual losses (gains) after taxes are considered to be a long-term
investment.
A firm can motivate its managers to direct their effort towards maximizing the value of
the firm only by, first measuring the firm value correctly and secondly by providing
incentives to managers to create value. Both are interdependent and they complement
each other. Therefore the EVA concept from two perspectives, EVA as a performance measure and EVA as a corporate philosophy.
THE NEED FOR EVA
How relevant is EVA today? Responds Stern, “Some may say that EVA was a fad of the 1990s, but earning more than the cost of capital is not a fad. It is what all companies should do all of the time. That they do not is surprising. All of the talk on governance, also not a fad, never demanded this simple requirement. Until boards do, EVA will remain as relevant as it was in the 1990s.” There is a long history in economics of preferring “economic” over “accounting” profits. The difference is that the former subtracts opportunity costs, in particular, a “fair” rate of return on investment. Accounting profits do not.
In its basic form, EVA is the Net Operating Profit After Taxes (NOPAT) minus the money cost of capital. Money cost of capital means the dollar value of that cost rather than a rate of return. It adds back to the accounting profits the amortisation of goodwill or capitalization of brand advertising. There are other similar adjustments of intangibles which EVA considers important. Shareholders of the company receive positive value added when the return from the capital employed in the business operations is greater than the cost of that capital. The EVA concept believes that for every performance measure there is a corresponding wealth measure.
For example: The P/E ratio is the wealth measure that corresponds to return on equity. Market capitalization (price x number of shares) corresponds to free cash flow, while total shareholder return corresponds to cash flow return on investment.
Examples of converting accrual information to cash are adding increases in LIFO reserves. Another is adding increases in the allowance for bad debts. An example of capitalizing debt/equity equivalents is to convert operating to capital leases. It takes an off-balance sheet type of financing (the operating lease) and puts it back onto the converted balance sheet. The preferred way to do this is to take the present value of the lease payments for the period of the lease.
The interest rate for the discounting is usually available from the company – its ratio of lease payments for the year to total lease obligations. If not available, a reasonable discount rate can be estimated based on the firm’s cost of debt and equity capital. Next, in converting to a cash basis, the company subtracts cash taxes paid. One can do this by subtracting increases in deferred tax liability and adding tax subsidy on deductible expenses. The result is cash operating taxes. A key step is to determine the weighted average cost of capital and multiply it times the capital that the company uses. This is the “opportunity cost” concept that is at the heart of the economic profits approach. Estimating the cost of debt is relatively straight-forward. The exception is if the debt is not publicly traded and therefore hard to value (such as CDO debt). In the absence of such problems, the standard way is to look at debt costs on the income statement and divide by the total debt outstanding on the balance sheet. Another way is to estimate the cost of debt from the company’s debt rating from rating agencies such as Moody’s or Standard and Poor’s.
IMPLEMENTATION
The EVA concept is not a new one. It is a basic part of accounting and finance. The key to it all is successful implementation. That is, calculating the numbers and then committing management to act on them, such as to increase funding to divisions with positive EVA, and to harvest (sell) divisions with negative EVA. Another important implementation is to reward or punish managers for generating positive or negative EVA. Incentive schemes based on the EVA are shown to be more motivating than other company-wide or accrual-based incentives. According to Stern, “EVA attempts to bring the concept of the franchisee into the corporate world. Most franchises outperform company operated businesses. Ownership makes a difference. EVA-based compensation mimics the ownership mindset and encourages the company manager to take decisions as would the franchise owner.”
EVA AS A PERFORMANCE MEASURE
Proponents of EVA argue that EVA is a superior measure as compared to other
performance measures on four counts:
* It is nearer to the real cash flows of the business entity;
* It is easy to calculate and understand;
* It has a higher correlation to the market value of the firm and
* Its application to employee compensation leads to the alignment of managerial
interests with those of the shareholders, thus minimizing the supposedly
dysfunctional behavior of the management.
The last two merits can be considered as a reflection of the first two. If EVA truly
represents the real cash flows of a business entity and it is easy to calculate and
understand, then it automatically follows that it should be closely related to the market
valuation and it should minimize the dysfunctional behavior of the management when
used as an incentive measure. In other words, close relation to market valuation and
convergence of managerial interests with shareholders interests is a vindication of EVA
as a superior metric.
EVA as a performance measure looks into the efficacy of EVA both as an absolute
measure in comparison with net income, residual income and similar measures as well as
a ratio in relation with performance measures like ROE, ROA and Operating Profit
Margin, which are commonly used by both managers and equity analysts alike. These
measures are normally used internally by the management to evaluate employee
performance, incentive calculation and investment decisions and externally by equity
analysts to ascertain the performance and growth of the firm. Along with these measures
valuation models like NPV, IRR, Payback period and Book rate of return are used both
internally and externally by managers for investment decisions. The former measures are
backward looking measures which take into account past and current performance and
facilitates prediction of future performance, whereas latter measures are more forward
looking and discount the expected future cash flow streams associated with a given
investment or new investment to ascertain the economic viability of the same.
INVESTMENT INSTITUTIONS
INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OF
The industrial credit and investment corporation was sponsored by a mission from the World Bank for the purpose of developing small and medium industries in the private sector. It was registered in January, 1955 under the Indian Companies Act. Its issued capital was subscribed by Indian Banks, insurance companies and individuals and corporation of the
The aim of ICICI was to stimulate the promotion of new industries, to assist the expansion and modernization of existing industries and to furnish technical and managerial aid so as to increase production and afford employment opportunities.
The corporation granted:
A) Long term or medium term loans, both rupee loans and foreign currency loans.
B) Participated in equity capital and in debentures and underwrote new issues of shares and debentures,
C) Guaranteed loans from other private investment sources.
D) ICICI provide financial services such as deferred credit, leasing credit, installment sale , asset credit and venture capital.
ICICI assisted manufacturing industries in all sectors, that is , the private sector, the joint sector, the public sector and cooperative sector. ICICI’s assistance comprised of foreign currency loans, rupee loans, guarantees, and subscription of shares and debentures. The corporation showed increasing interest in the development of new industries in backward regions.
There was a remarkably significant increase in financial assistance by ICICI in recent years;
FINANCIAL ASSISTANCE BY ICICI;
( Rs Crores )
| Year | 1980-81 | 1990-91 | 2000-01 | 2007-08 |
| Loans sanctioned | 310 | 3,740 | 55,820 | 36,230 |
| Disbursements | 180 | 1,970 | 31,660 | 25,830 |
The corporation assisted industrial concerns with loans and guarantees either in rupees or in any foreign currency. Besides, it underwrote ordinary and preference shares and debentures and it also subscribed directly to ordinary and preference shares issues. A significant function performed by the corporation was the provision of foreign currency loans and advances to enable Indian Industrial concerns to secure essential capital goods from foreign countries.
ICICI commenced leasing operation in1983.it provided leasing assistance for computerization, modernization/replacement, equipment of energy conservation, export orientation, pollution control etc. the industries helped under leasing included textiles, engineering, chemicals, fertilizers, cement, sugar, etc.
ICICI had set up ICICI asset management Co Ltd in June 1993 to operate the schemes of the ICICI mutual fund- this was later called Prudential ICICI mutual fund. Yet another subsidiary called ICICI Investors Services Ltd and ICICI Banking Corporation Ltd.
Apart from these, ICICI had promoted the following companies and institutions in recent years:
A) Credit Rating Information Services of India Ltd. (CRISIL ), set up by ICICI in association with Unit Trust Of India to provide credit rating services to the corporate sector.
B) Technology development and Information Company of India Ltd. (TDICI ) promoted by ICICI , to finance the transfer and up gradation of technology and provide technology information –this was christened as ICICI venture Funds in 1998.
C) Programme for the Advancement of Commercial Technology (PACT ), set up with a grant of US$ 10 million provided by USAID to assist market oriented R&D activity, jointly undertaken by Indian and U.S companies ICICI was entrusted with the administration and management of PACT.
THE UNIT TRUST OF
The Unit Trust of India was formally established in February 1964. The initial capital of the Trust was Rs. 5 crores which was subscribed fully by the Reserve bank of
The primary objective of the Unit Trust is two fold:
(a) Stimulate and pool the savings of the middle and low income groups, and
(b) To enable them to share the benefits and prosperity of the rapidly growing industrialization in the country. These two fold objectives would be achieved through a three fold approach.
(i) By selling Units of the Trust among as many investors as possible in different part of the country.
(ii) By investing the sale proceeds of the units and also the initial capital fund of Rs. 5 crores in industrial and corporate securities; and
(iii) By paying dividends to those who have bought the Unit of the Trust.
OPERATION OF THE UNIT TRUST
After a sharp slump in the second year of its existence the operations of the Trust picked up conspicuously in the succeeding year. The total number of units holders registered with the Trust at one time exceeded 25 million with mobilized funds exceeding Rs. 73000 crores in June 2000.
The Trust had built up a portfolio of investments which was balanced between the fixed bearing securities and variable income bearing securities the main objective of the Trust was of maximize income consistent with safety of capital.
The Trust had invested in securities of about 300 sound concerns, which were on regular dividend paying basis. Barring investment in bonds of public corporations, the Trust funds were invested in financial, public utility and manufacturing enterprises.
Apart from subscribing to the shares and debentures of companies, UTI sanctioned loans to the corporate sectors.
ADVANTAGES OF THE UNITS
Initially, the Unit of the Trust had four distinct advantages:
(a) Investment in Unit was safe, since the risk was spread over a wide range of securities (fixed income bearing and variable income bearing).
(b) The unit holders received steady and decent income. Nine tenths of the income of the URI was distributed.
(c) Dividend income from the Unit Trust enjoyed various tax concessions in the hands of the unit holders.
(d) The units were highly liquid in the sense that an investor could cash them whenever he or she wanted. The units could be sold back to the Trust any time at prices fixed by the Trust.
AN ASSESSMENT OF THE UNIT TRUST
The commencement of sales of units by the Unit Trust from July 1964 was acclaimed as a landmark in the development of
The operation of the Unit trust during the first three decades showed that the returns for unit holders were reasonable. After a maiden dividend of 7.62 per cent per annum, UTI gradually raised the rate of dividend till it touched 26 per cent in 1993-94. During the next four year, the rate of dividend was maintained at 20 per cent. The response of investors especially of the small and medium income groups, to the Unit scheme was also very encouraging and it seemed that the Unit Trust had met the genuine needs of large number of investors by providing a form of investment which was safe, which brought in steady income and which was liquid enough.
The whole edifice of UT, however, crumbled in September-October 1998 when the prestigious Unit Scheme 1964 came under serious trouble. The plunge of 224 points in BSE sensex on
CAUSES FOR THE FAILURE OF UTI
UTI finally collapsed during 2001-02. An institution built on the confidence and faith of crores of savers from lower and middle income groups has been callously ruined by scheming and petty politicians colluding with incompetent and corrupt bureaucrats on the one side and unscrupulous business houses and stock exchange brokers on the other. There are many reasons for the failure and collapsed of UTI.
(a) UTI was forced-top officials of UTI and o the finance ministries were heavily bribed to invest in the shares of scheming business house and fly by night operators. These shares lost their value or, in some cases, they become worthless pieces of paper. UTI was made to lose thousands of crores of rupees in this way.
(b) The management of UTI was again bribed heavily by leading business houses to extend loans to them or to their subsidiaries; these loans were not repaid and became NPAs.
(c) While the basis purpose of UTI was to mobilize the savings of the poor and the middle classes, the Finance Ministry used in as an instrument to support and influence the stock exchange. The UTI funds were extensively borrowed by unscrupulous stock brokers-Ketan Parekh was one – to manipulate the stock exchange. Often against the interest of UTI itself.
(d) Finally, the former Finance Minister, Mr. Yashwant Sinha and Finance Ministry officials, killed public confidence in UTI through their wrong and misleading statement about the ownership and management of UTI. They allowed large corporate members to withdraw their investments in US 64 units at high price, when they had the secret information that UTI was about to collapse.
An Expert committee under the chairmanship of Mr. Deepak Parekh was set up to undertake a comprehensive review of the functioning of UTI and make recommendations to restore investor confidence. The Parekh Committee made as many as 19 recommendations which, among others, included suggestion for converting US-1964 into a net-asset-value drawn scheme over a period of three years.
The Govt of India repealed the UTI Act and created to entities – UTI-1 and UTI-2. UTI-1 was giving US-64 and all the assured returns schemes and is manages by an administrator appointed by the Government. The US-64 units had been converted into bonds carrying 6.75 per cent rate of interest as from May 2003.
UTI-2 is an unencumbered mutual fund with only NAV-based schemes did not present any difficulties. In January 2003, Uti-2 was handed over to a new set of owners consisting of SBI, Bank of Baroda,
OTHER INVESTMENT INSTITUTION – LIC AND GIC
Apart from the Unit Trust of India which mobilizes the savings of the public to specifically invest in the industrial securities, there are two other, investment institutions in the country The Life Insurance Corporation of India (LIC) and the General Insurance Corporation of India (GIC). These two institutions collect large amounts of funds from the general public to provide insurance cover but they use part of their funds to give long term loans to the corporate sectors or to acquire industrial securities (shares and debentures) from the market. Because of the large funds they are able to mobilize, these two institutions have become powerful operations in the stock exchange.
During 2003-04, LIC had sanctioned term finance and other financial assistance amounting to Rs. 27750 crores (Rs. 4340 in 2002-03) and disbursed Rs. 15750 crores (Rs. 6200 crores in 2002-03). During 2003-04, GIC and its subsidiaries sanctioned Rs. 1870 crores and disbursed Rs. 1620 crores to the industrial sector. The assistance of LIC and GIC and its subsidiaries to the industrial sector is in the form of loans, underwriting and direct subscription of equities, preference shares, debentures and bonds.
INVESTMENT AND SPECULATION
They are leading to claims on money, aim at maximization of return consistent with the risk taken. Motive is the determining factor, distinguishing between investment and speculation. In investment, the investor has long term and medium term objectives, takes delivery of securities and books profits as and when the returns are higher his target expectations. The speculation has a short term perspective and maximizes the returns through buying and selling and delivery of securities is least important in trade. Strakes of risk are higher and returns are higher in speculation than in investment. Both aim at capital gains or appreciation in share prices and maximization of returns. The difference is only in degree as between investment and speculation.
In the Indian stock markets, nearly, of trade is speculative in nature and do not involve deliveries of shares. Values of trade increase with increase in speculation, but the genuine investor takes the delivery and gets the securites transferred into his name in the companys registers, whether, it is an ownership or debt category. Speculation is increasing ingredient of the stock markets all over the world to impart liquidity and continuing trade and quotation.
SCOPE OF INVESTMENTS
The term "investment" is used differently in economics and in finance. Economists refer to a real investment (such as a machine or a house), while financial economists refer to a financial asset, such as money that is put into a bank or the market, which may then be used to buy a real asset.
BUSINESS MANAGEMENT
The investment decision (also known as capital budgeting) is one of the fundamental decisions of business management: Managers determine the investment value of the assets that a business enterprise has within its control or possession. These assets may be physical (such as buildings or machinery), intangible (such as patents, software, goodwill), or financial (see below). Assets are used to produce streams of revenue that often are associated with particular costs or outflows. All together, the manager must determine whether the net present value of the investment to the enterprise is positive using the marginal cost of capital that is associated with the particular area of business.
In terms of financial assets, these are often marketable securities such as a company stock (an equity investment) or bonds (a debt investment). At times the goal of the investment is for producing future cash flows, while at others it may be for purposes of gaining access to more assets by establishing control or influence over the operation of a second company (the investor).
ECONOMICS
In economics, investment is the production per unit time of goods which are not consumed but are to be used for future production. Examples include tangibles (such as building a railroad or factory) and intangibles (such as a year of schooling or on-the-job training). In measures of national income and output, gross investment (represented by the variable I) is also a component of Gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is consumption, G is government spending, and NX is net exports. Thus investment is everything that remains of production after consumption, government spending, and exports are subtracted.
Both non-residential investment (such as factories) and residential investment (new houses) combine to make up
Investment, as production over a period of time ("per year"), is not capital. The time dimension of investment makes it a flow. By contrast, capital is a stock, that is, an accumulation measurable at a point in time (say December 31st).
Investment is often modeled as a function of Income and Interest rates, given by the relation I = f(Y, r). An increase in income encourages higher investment, whereas a higher interest rate may discourage investment as it becomes more costly to borrow money. Even if a firm chooses to use its own funds in an investment, the interest rate represents an opportunity cost of investing those funds rather than loaning them out for interest.
FINANCE
In finance, investment is the buying securities or other monetary or paper (financial) assets in the money markets or capital markets, or in fairly liquid real assets, such as gold, real estate, or collectibles. Valuation is the method for assessing whether a potential investment is worth its price. Returns on investments will follow the risk-return spectrum.
Types of financial investments include shares, other equity investment, and bonds (including bonds denominated in foreign currencies). These financial assets are then expected to provide income or positive future cash flows, and may increase or decrease in value giving the investor capital gains or losses.
Trades in contingent claims or derivative securities do not necessarily have future positive expected cash flows, and so are not considered assets, or strictly speaking, securities or investments. Nevertheless, since their cash flows are closely related to (or derived from) those of specific securities, they are often studied as or treated as investments.
Investments are often made indirectly through intermediaries, such as banks, mutual funds, pension funds, insurance companies, collective investment schemes, and investment clubs. Though their legal and procedural details differ, an intermediary generally makes an investment using money from many individuals, each of whom receives a claim on the intermediary.
PERSONAL FINANCE
Within personal finance, money used to purchase shares, put in a collective investment scheme or used to buy any asset where there is an element of capital risk is deemed an investment. Saving within personal finance refers to money put aside, normally on a regular basis. This distinction is important, as investment risk can cause a capital loss when an investment is realized, unlike saving(s) where the more limited risk is cash devaluing due to inflation.
In many instances the terms saving and investment are used interchangeably, which confuses this distinction. For example many deposit accounts are labeled as investment accounts by banks for marketing purposes. Whether an asset is a saving(s) or an investment depends on where the money is invested: if it is cash then it is savings, if its value can fluctuate then it is investment.
REAL ESTATE
In real estate, investment money is used to purchase property for the purpose of holding or leasing for income and there is an element of capital risk.
RESIDENTIAL REAL ESTATE
The most common form of real estate investment as it includes property purchased as a primary residence. In many cases the buyer does not have the full purchase price for a property and must engage a lender such as a bank, finance company or private lender. Different countries have their individual normal lending levels, but usually they will fall into the range of 70-90% of the purchase price. Against other types of real estate, residential real estate is the least risky.
COMMERCIAL REAL ESTATE
Commercial real estate consists of multifamily apartments, office buildings, retail space, hotels and motels, warehouses, and other commercial properties. Due to the higher risk of commercial real estate, loan-to-value ratios allowed by banks and other lenders are lower and often fall in the range of 50-70%.
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