Tag: University of Mumbai BMS Notes

Cost of Preference Share Capital: An amount paid by company as dividend to preference shareholder is known as Cost of Preference Share Capital.

Preference share is a small unit of a company’s capital which bears fixed rate of dividend and holder of it gets dividend when company earn profit. Dividend payable is not a tax deductible amount. So, there is no tax adjustments required for comparing with cost of debt.

Formula for Cost of Preference Share:

Irredeemable Preference Share	Redeemable Preference Share
Kp = Dp/NP	Kp = Dp+((RV-NP)/n )/ (RV+NP)/2

Where,

K_p = Cost of Preference Share

D_p = Dividend on preference share

NP = Net proceeds from issue of preference share

(Issue price – Flotation cost)

RV = Redemption Value

N = Period of preference share

Example: A preference share issues at 12% worth Rs 60,000 at 5% discount and after 6 years it redeem at 10% premium. The flotation cost is 5% and tax rate is 20%. Find out the cost of preference share capital.

Solution:

Dividend on preference share (D_p) = 60,000*12/100 = Rs.7200

Discount = 60,000*5/100 = Rs.3000

Flotation Cost = 60,000*5/100 = Rs.3000

Net Proceeds (NP) = Rs. (60,000-3000-3000) = Rs. 54,000

Premium amount = 60,000*10/100 =Rs. 6000

Redemption Value = Rs. (60,000+6000) = Rs. 66,000

K_p = D_p+ ((RV-NP)/n)/ (RV+NP)/2

= 7200+ ((66,000-54,000)/6) / (66,000+54,000)/2

= 9200/60,000

= 15.33%

Cost of Equity is the rate of return a company pays out to equity investors. A firm uses cost of equity to assess the relative attractiveness of investments, including both internal projects and external acquisition opportunities. Companies typically use a combination of equity and debt financing, with equity capital being more expensive.

The cost of equity can be calculated by using the CAPM (Capital Asset Pricing Model) or Dividend Capitalization Model (for companies that pay out dividends).

CAPM (Capital Asset Pricing Model)

CAPM takes into account the riskiness of an investment relative to the market. The model is less exact due to the estimates made in the calculation (because it uses historical information).

CAPM Formula:

E(R_i) = R_f + β_i * [E(R_m) – R_f]

Where:

E(R_i) = Expected return on asset i

R_f = Risk-free rate of return

β_i = Beta of asset i

E(R_m) = Expected market return

Risk-Free Rate of Return

The return expected from a risk-free investment (if computing the expected return for a US company, the 10-year Treasury note could be used).

Beta

The measure of systematic risk (the volatility) of the asset relative to the market. Beta can be found online or calculated by using regression: dividing the covariance of the asset and market’s returns by the variance of the market.

β_i < 1: Asset i is less volatile (relative to the market)

β_i = 1: Asset i’s volatility is the same rate as the market

β_i > 1: Asset i is more volatile (relative to the market)

Expected Market Return

This value is typically the average return of the market (which the underlying security is a part of) over a specified period of time (five to ten years is an appropriate range) 

Dividend Capitalization Model

The Dividend Capitalization Model only applies to companies that pay dividends, and it also assumes that the dividends will grow at a constant rate. The model does not account for investment risk to the extent that CAPM does (since CAPM requires beta).

Dividend Capitalization Formula:

R_e = (D₁ / P₀) + g

Where:

R_e = Cost of Equity

D₁ = Dividends/share next year

P₀ = Current share price

g = Dividend growth rate

Dividends/Share Next Year

Companies usually announce dividends far in advance of the distribution. The information can be found in company filings (annual and quarterly reports or through press releases). If the information cannot be located, an assumption can be made (using historical information to dictate whether the next year’s dividend will be similar).

Current Share Price

The share price of a company can be found by searching the ticker or company name on the exchange that the stock is being traded on, or by simply using a credible search engine.

Dividend Growth Rate

The Dividend Growth Rate can be obtained by calculating the growth (each year) of the company’s past dividends and then taking the average of the values.

The growth rate for each year can be found by using the following equation:

Dividend Growth = (D_t/D_t-1) – 1

Where:

D_t = Dividend payment of year t

D_t-1 = Dividend payment of year t-1 (one year before year t)

The cost of retained earnings is the cost to a corporation of funds that it has generated internally. If the funds were not retained internally, they would be paid out to investors in the form of dividends. Therefore, the cost of retained earnings approximates the return that investors expect to earn on their equity investment in the company, which can be derived using the capital asset pricing model (CAPM). The CAPM combines the risk-free rate and a stock’s beta to arrive at the cost of equity capital.

Retained Earnings (RE) are the portion of a business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Normally, these funds are used for working capital and fixed asset purchases (capital expenditures) or allotted for paying off debt obligations.

The Purpose of Retained Earnings

Retained earnings represent a useful link between the income statement and the balance sheet, as they are recorded under shareholders’ equity, which connects the two statements. The purpose of retaining these earnings can be varied and includes buying new equipment and machines, spending on research and development, or other activities that could potentially generate growth for the company. This reinvestment into the company aims to achieve even more earnings in the future.

If a company does not believe it can earn a sufficient return on investment from those retained earnings (i.e., earn more than their cost of capital), then they will often distribute those earnings to shareholders as dividends or share buybacks.

Retained Earnings Formula

The RE formula is as follows:

RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends

Where RE = Retained Earnings

Beginning of Period Retained Earnings

At the end of each accounting period, retained earnings are reported on the balance sheet as the accumulated income from the prior year (including the current year’s income), minus dividends paid to shareholders. In the next accounting cycle, the RE ending balance from the previous accounting period will now become the retained earnings beginning balance.

The RE balance may not always be a positive number, as it may reflect that the current period’s net loss is greater than that of the RE beginning balance. Alternatively, a large distribution of dividends that exceed the retained earnings balance can cause it to go negative.

How Net Income Impacts Retained Earnings

Any changes or movement with net income will directly impact the RE balance. Factors such as an increase or decrease in net income and incurrence of net loss will pave the way to either business profitability or deficit. The Retained Earnings account can be negative due to large, cumulative net losses.  Naturally, the same items that affect net income affect RE.

How Dividends Impact Retained Earnings

Distribution of dividends to shareholders can be in the form of cash or stock. Both forms can reduce the value of RE for the business. Cash dividends represent a cash outflow and are recorded as reductions in the cash account. These reduce the size of a company’s balance sheet and asset value as the company no longer owns part of its liquid assets. Stock dividends, however, do not require a cash outflow. Instead, they reallocate a portion of the RE to common stock and additional paid-in capital accounts. This allocation does not impact the overall size of the company’s balance sheet, but it does decrease the value of stocks per share.

End of Period Retained Earnings

At the end of the period, you can calculate your final Retained Earnings balance for the balance sheet by taking the beginning period, adding any net income or net loss, and subtracting any dividends.

Example Calculation

In this example, the amount of dividends paid by XYZ is unknown to us, so using the information from the Balance Sheet and the Income Statement, we can derive it remembering the formula Beginning RE – Ending RE + Net income (-loss) = Dividends

Leverage, as a business term, refers to debt or to borrowing funds to finance the purchase of inventory, equipment and other company assets. Business owners can use either debt or equity to finance or buy the company’s assets. Using debt, or leverage, increases the company’s risk of bankruptcy but, it also can increase the company’s profits and returns; specifically its return on equity. This is true because if debt financing is used rather than equity financing then the owner’s equity is not diluted by issuing more shares of stock.

Borrowing in order to expand or invest is called leverage because the goal is to amplify the loan into a greater value for the firm or investors.

With debt financing, regardless if whether the interest charges are from a loan or line of credit, the interest payments are tax deductible. In addition, by making timely payments a company will establish a positive payment history and business credit rating.

Investors in a business prefer the business to use debt financing but only up to a point. Beyond a certain point, investors get nervous about too much debt financing as it drives up the company’s default risk.

Significance of Leverage

Leverage refers to the use of fixed costs in an attempt to increase the profitability. Leverage affects the level and variability of the firm’s after tax earnings and hence, the firm’s overall risk and return. The study of leverage is significant due to the following reasons.

(i) Measurement of Operating Risk

Operating risk refers to the risk of the firm not being able to cover its fixed operating costs. Since operating leverage depends on fixed operating costs, larger fixed operating costs indicates higher degree of operating leverage and thus, higher operating risk of the firm. High operating leverage is good when sales are rising but bad when they are falling.

(ii) Measurement of Financial Risk

Financial risk refers to the risk of the firm not being able to cover its fixed financial costs. Since financial leverage depends on fixed financial cost, high fixed financial costs indicates higher degree of operating leverage and thus, high financial risk. High financial leverage is good when operating profit is rising and bad when it is falling.

(iii) Managing Risk

Relationship between operating leverage and financial leverage is multiplicative rather than additive. Operating leverage and financial leverage can be combined in a number of different ways to obtain a desirable degree of total leverage and level of total firm risk.

(iv) Designing Appropriate Capital Structure Mix

To design an appropriate capital structure mix or financial plan, the amount of EBIT under various financial plans, should be related to earning per share. One widely used means of examining the effect of leverage to analyze the relationship between EBIT and earning per share.

(v) Increase Profitability

Leverage is an effort or attempt by which a firm tries to show high result or more benefit by using fixed costs assets and fixed return sources of capital. It insures maximum utilization of capital and fixed assets in order to increase the profitability of a firm, It helps to know the reasons not having more profit by a company.

Disability Insurance, often called DI or disability income insurance, or income protection, is a form of insurance that insures the beneficiary’s earned income against the risk that a disability creates a barrier for a worker to complete the core functions of their work. For example, the worker may suffer from an inability to maintain composure in the case of psychological disorders or an injury, illness or condition that causes physical impairment or incapacity to work. It encompasses paid sick leave, short-term disability benefits (STD), and long-term disability benefits (LTD). Statistics show that in the US a disabling accident occurs, on average, once every second. In fact, nearly 18.5% of Americans are currently living with a disability, and 1 out of every 4 persons in the US workforce will suffer a disabling injury before retirement.

Factors to consider while selecting a disability insurance coverage:

• Coverage amount: Be diligent in assessing your needs and select the plan, keeping in mind your income level and age. Choose the sum assured such that you and your family could continue to maintain your current lifestyle even if a contingency arises.
• Determine the disabilities covered: While buying health insurance for disabled, there are a wide variety of options available in the market. Compare the degree of disability (total or partial) and types of disabilities covered across various products and choose the one with the widest coverage.
• Refund feature: Some products provide the functionality of refund of a part of your premium amount if no claim is made within the specified period.
• Read the policy wording: For the different degree of disability, different percentages of the sum insured is paid. In the case of partial disability, the percentage may differ depending on the policy wording. So, read the policy document carefully.

There are various government-sponsored health insurance policies for the disabled:

1. Nirmalya Health Insurance: It is a government-sponsored health insurance scheme for people with mental disabilities. This scheme provides coverage of Rs. 1 Lakh at a low premium rate with benefits including pre and post hospitalisation expenses and OPD treatment.
2. Swavalamban Health Insurance: It is a custom-tailored insurance scheme to suit the needs of those with disabilities. This plan requires the insured to pay a single premium in one go and avail the coverage at any time of treatment. This policy can be availed only for those disabled individuals with a family income of Rs. 3 Lakh and below. No pre-medical test is required. There is no exclusion of pre-existing conditions. It aims in providing affordable insurance to people with blindness, vision problem, disability related to hearing and mental disabilities.

Health insurance is an insurance that covers the whole or a part of the risk of a person incurring medical expenses, spreading the risk over numerous persons. By estimating the overall risk of [health risk] and health system expenses over the risk pool, an insurer can develop a routine finance structure, such as a monthly premium or payroll tax, to provide the money to pay for the health care benefits specified in the insurance agreement. The benefit is administered by a central organization such as a government agency, private business, or not-for-profit entity.

According to the Health Insurance Association of America, health insurance is defined as “coverage that provides for the payments of benefits as a result of sickness or injury. It includes insurance for losses from accident, medical expense, disability, or accidental death and dismemberment”

In India, provision of health care services varies state-wise. Public health services are prominent in most of the states, but due to inadequate resources and management, major population opts for private health services.

To improve the awareness and better health care facilities, Insurance Regulatory and Development Authority of India and The General Corporation of India runs health care campaigns for the whole population. IN 2018, for under privileged citizens, Prime Minister Narendra Modi announced the launch of a new health insurance called Modicare and the government claims that the new system will try to reach more than 500 million people.

In India, Health insurance is offered mainly in two Types:

• Indemnity Plan basically covers the hospitalization expenses and has subtypes like Individual Insurance, Family Floater Insurance, Senior Citizen Insurance, Maternity Insurance, Group Medical Insurance.
• Fixed Benefit Plan pays a fixed amount for pre-decided diseases like critical illness, cancer, heart disease, etc. It has also its sub types like Preventive Insurance, Critical illness, Personal Accident.

Depending on the type of insurance and the company providing health insurance, coverage includes pre-and post-hospitalisation charges, ambulance charges, day care charges, Health Checkups, etc.

It is pivotal to know about the exclusions which are not covered under insurance schemes:

• Treatment related to dental disease or surgeries
• All kind of STD’s and AIDS
• Non-Allopathic Treatment

Few of the companies do provide insurance against such diseases or conditions, but that depends on the type and the insured amount.

Some important aspects to be considered before choosing the health insurance in India are Claim Settlement ratio, Insurance limits and Caps, Coverage and network hospitals.

Benefits of having a Health insurance Policy

1. Cashless Treatment: If you are insured, you can get cashless treatments as your insurance company would work in collaboration with various hospital networks.
2. Pre and post hospitalization cost coverage: Insurance policy also covers pre and post hospitalization charges up to the period of 60 days, depending on the insurance plans purchased.
3. Transportation Charges: Insurance policy also covers the amount paid to ambulance towards the transportation of insured.
4. No Claim Bonus (NCB): This is the bonus element which is paid to the insured if the insured does not file a claim for any treatment in the previous year.
5. Medical Checkup: Insurance policy also provide options for health checkups. Free health checkup is also provided by some insurers based on your previous NCBs.
6. Room Rent: Insurance policy also covers room expenses depending on the premium being paid by the insured.  
7. Tax Benefit: Premium paid on Health insurance is tax deductible under section 80D of the Income Tax Act.

Selection the Right Insurance Policy

It’s difficult to select the best insurance policies as all insurance company provides a similar type of insurance plan. Hence some of the important points that any Person should look before purchasing any plans are:

1. Sum Assured
2. Minimum Entry Age and renewability clause
3. Room Rent Capping
4. Inclusion and Exclusion
5. No Claim Bonus
6. Other Benefits

Long-term care insurance (LTC or LTCI) is an insurance product, sold in the United States, United Kingdom and Canada that helps pay for the costs associated with long-term care. Long-term care insurance covers care generally not covered by health insurance, Medicare, or Medicaid.

Individuals who require long-term care are generally not sick in the traditional sense but are unable to perform two of the six activities of daily living (ADLs) such as dressing, bathing, eating, toileting, continence, transferring (getting in and out of a bed or chair), and walking.

Age is not a determining factor in needing long-term care. About 70 percent of individuals over 65 will require at least some type of long-term care services during their lifetime. About 40% of those receiving long-term care today are between 18 and 64. Once a change of health occurs, long-term care insurance may not be available. Early onset (before 65) Alzheimer’s and Parkinson’s disease occur rarely.

Long-term care is an issue because people are living longer. As people age, many times they need help with everyday activities of daily living or require supervision due to severe cognitive impairment. That impacts women even more since they often live longer than men and, by default, become caregivers to others.

Vehicle insurance (also known as car insurance, motor insurance, or auto insurance) is insurance for cars, trucks, motorcycles, and other road vehicles. Its primary use is to provide financial protection against physical damage or bodily injury resulting from traffic collisions and against liability that could also arise from incidents in a vehicle. Vehicle insurance may additionally offer financial protection against theft of the vehicle, and against damage to the vehicle sustained from events other than traffic collisions, such as keying, weather or natural disasters, and damage sustained by colliding with stationary objects. The specific terms of vehicle insurance vary with legal regulations in each region.

Auto insurance in India deals with the insurance covers for the loss or damage caused to the automobile or its parts due to natural and man-made calamities. It provides accident cover for individual owners of the vehicle while driving and also for passengers and third-party legal liability. There are certain general insurance companies who also offer online insurance service for the vehicle.

Auto insurance in India is a compulsory requirement for all new vehicles used whether for commercial or personal use. The insurance companies have tie-ups with leading automobile manufacturers. They offer their customers instant auto quotes. Auto premium is determined by a number of factors and the amount of premium increases with the rise in the price of the vehicle. The claims of the auto insurance in India can be accidental, theft claims or third-party claims. Certain documents are required for claiming auto insurance in India, like duly signed claim form, RC copy of the vehicle, driving license copy, FIR copy, original estimate and policy copy.

There are different types of auto insurance in India:

Private Car Insurance: Private Car Insurance is the fastest growing sector in India as it is compulsory for all the new cars. The amount of premium depends on the make and value of the car, state where the car is registered and the year of manufacture. This amount can be reduced by asking the insurer for No Claim Bonus (NCB) if no claim is made for insurance in previous year.

Two Wheeler Insurance: The Two Wheeler Insurance in India covers accidental insurance for the drivers of the vehicle. The amount of premium depends on the current showroom price multiplied by the depreciation rate fixed by the Tariff Advisory Committee at the beginning of a policy period.

Commercial Vehicle Insurance: Commercial Vehicle Insurance in India provides cover for all the vehicles which are not used for personal purposes like trucks and HMVs. The amount of premium depends on the showroom price of the vehicle at the commencement of the insurance period, make of the vehicle and the place of registration of the vehicle. The auto insurance generally includes:

• Loss or damage by accident, fire, lightning, self-ignition, external explosion, burglary, housebreaking or theft, malicious act
• Liability for third party injury/death, third party property and liability to paid driver
• On payment of appropriate additional premium, loss/damage to electrical/electronic accessories

The auto insurance does not include:

• Consequential loss, depreciation, mechanical and electrical breakdown, failure or breakage
• When vehicle is used outside the geographical area
• War or nuclear perils and drunken driving

Third-party insurance

This cover is mandatory in India under the Motor Vehicles Act, 1988. This cover cannot be used for personal damages. This is offered at low premiums and allows for third party claims under “no fault liability. The premium is calculated through the rates provided by the Tariff Advisory Committee. This is branch of the IRDA (Insurance Regulatory and Development Authority of India). It covers bodily injury/accidental death and property damage.

Salient Features of Third Party Insurance

• Third party insurance is compulsory for all motor vehicles. In G. Govindan v. New India Assurance Co. Ltd., Third party risks insurance is mandatory under the statute. This provision cannot be overridden by any clause in the insurance policy.
• Third party insurance does not cover injuries to the insured himself but to the rest of the world who is injured by the insured.
• Beneficiary of third party insurance is the injured third party, the insured or the policy holder is only nominally the beneficiary of the policy. In practice the money is always paid direct by the insurance company to the third party (or his solicitor) and does not even pass through the hands of the insured person.
• In third party policies the premiums do not vary with the value of what is being insured because what is insured is the legal liability’ and it is not possible to know in advance what that liability will be.
• Third party insurance is almost entirely fault-based.(means you have to prove the fault of the insured first and also that injury occurred from the fault of the insured to claim damages from him)
• Third party insurance involves lawyers aid
• The third party insurance is unpopular with insurance companies as compared to first party insurance, because they never know the maximum amounts they will have to pay under third party policies.

Property insurance provides protection against most risks to property, such as fire, theft and some weather damage. This includes specialized forms of insurance such as fire insurance, flood insurance, earthquake insurance, home insurance, or boiler insurance. Property is insured in two main ways—open perils and named perils.

Open perils cover all the causes of loss not specifically excluded in the policy. Common exclusions on open peril policies include damage resulting from earthquakes, floods, nuclear incidents, acts of terrorism, and war. Named perils require the actual cause of loss to be listed in the policy for insurance to be provided. The more common named perils include such damage-causing events as fire, lightning, explosion, and theft.

Types of Coverage

There are three types of insurance coverage. Replacement cost coverage pays the cost of repairing or replacing your property with like kind & quality regardless of depreciation or appreciation. Premiums for this type of coverage are based on replacement cost values, and not based on actual cash value. [5] Actual cash value coverage provides for replacement cost minus depreciation. Extended replacement cost will pay over the coverage limit if the costs for construction have increased. This generally will not exceed 25% of the limit. When you obtain an insurance policy, the limit is the maximum amount of benefit the insurance company will pay for a given situation or occurrence. Limits also include the ages below or above what an insurance company will not issue a new policy or continue a policy.

This amount will need to fluctuate if the cost to replace homes in your neighborhood is rising; the amount needs to be in step with the actual reconstruction value of your home. In case of a fire, household content replacement is tabulated as a percentage of the value of the home. In case of high-value items, the insurance company may ask to specifically cover these items separate from the other household contents. One last coverage option is to have alternative living arrangements included in a policy. If property damage caused by a covered loss prevents you from living in your home, policies can pay the expenses of alternate living arrangements (e.g., hotels and restaurant costs) for a specified period of time to compensate for the “loss of use” of your home until you can return. The additional living expenses limit can vary, but is typically set at up to 20% of the dwelling coverage limit. You need to talk with your insurance company for advice about appropriate coverage and determine what type of limit may be appropriate for you.

Fire insurance in India

Fire insurance business in India is governed by the All India Fire Tariff that lays down the terms of coverage, the premium rates and the conditions of the fire policy. The fire insurance policy has been renamed as “Standard Fire and Special Perils Policy”. The risks covered are as follows:

• Dwellings, offices, shops, hospitals:
• Industrial, manufacturing risks
• Utilities located outside industrial/manufacturing risks
• Machinery and accessories
• Storage risks outside the compound of industrial risks
• Tank farms/gas holders located outside the compound of industrial risks

Importance

Protection Against Property Damage. Property insurance offers coverage against a lot of natural disasters including, but not limited to, monsoons and floods, fires, earthquakes, theft, and other weather-related damages. Regardless of your home’s size, location, and other security features that you may have added, no property is invulnerable to fires, floods, or burglaries. In some cases, the land your property is built in can also erode and send your home crashing down. Being a huge structure, homes have a lot of vulnerabilities; cover it with an earthquake or hurricane property insurance.

Protection Against Liability. A less known benefit of property insurance policies is its liability coverage clause. Many other forms of insurance policies including auto insurance include this provision. Sure, being a careful homeowner can help prevent a lot of accidents and injuries, but an incident could include your neighbors or your neighbor’s home. Liability coverage from your property insurance can help protect against these potentially costly incidents.

Protection Against Power Outages. Power outages were more frequent in the past, but still occur from time to time. If you run your computer or other electronics on a power cord, these outages can cause serious damage to your devices and shorten their lifespan significantly due to surges, Power outage can also cause food to spoil, which is why a lot of property insurance from homeowners include a refrigerator-restocking provision that can pay out up to $500.

Protection For Your Art And Jewelry. For homeowners who have expensive jewelry, art pieces, or other valuable possessions in their home, ask your insurance provider about adding a floater to your property insurance. This add-on feature will pay out for any damages to your personal items. Keep in mind, though, that these add-ons only usually have a fixed amount that will be paid.

Protection For Commercial Ventures. If you decide to rent your property out to a third-party, whether as a dorm room for college students, for families with kids, or for singles with pets, you are held responsible for any structural damages or personal injuries that they cause during the occupancy. In the event that your tenant gets hurt and files a law suit, the insurance may also offer some protection. Moreover, if you are caught in a situation wherein you need to file a lawsuit against your tenants for not paying rent or causing damage to your property, property insurance can also pay out for that.

Final Thoughts. These are just some of the many things that a property insurance can protect you from. Note that not all insurance policies are cut from the same cloth. You’ll want to sit down and discuss with a trusted insurance provider about specific coverage features that work best for your property and personal circumstances. For instance, if you live in a neighborhood that has historically withstood power outages, then tailoring your insurance policy to cut that feature from your coverage makes practical sense.

Exclusions

The following are excluded from insurance coverage:

• Loss or damage caused by war, civil war, and kindred perils
• Loss or damage caused by nuclear activity
• Loss or damage to the stocks in cold storage caused by change in temperature
• Loss or damage due to over-running of electric and/or electronic machines

Claims In the event of a fire loss covered under the fire insurance policy, the insured shall immediately give notice thereof to the insurance company. Within 15 days of the occurrence of such loss the insured should submit a claim in writing giving the details of damages and their estimated values. Details of other insurances on the same property should also be declared.

There are two reasons for it: (a) Government bonds are issued by the central government in India, (b) These bonds are regulated and managed by Reserve Bank of India (RBI).

What makes government bonds risk free is the security of the principal amount, and the certainty of the promised return. A person who wants to invest for long term, but wants to keep it risk-free, Government bonds are the best option.

Government Bonds

What are bonds and T-bills? These are Securities (G-secs) issued by the government of India to borrow money from investors. Who are investors?

• Big Investors: Banks, insurance companies, mutual funds, trusts, corporates etc. These are called big because their size of investment (in G-Secs) are large compared to small investors. Know more about mutual funds.
• Small Investors: HNI’s, NRIs, HUF members, individuals etc. In this group of people, ‘individual investors’ are the ones where we common men are placed. Read more about Peter Lynch a big HNI investor.

Government borrows money from these investors by offering them G-secs through “auctions“. How the auction is done? Through “competitive bidding” process. We will read more about it below.

In good old days, G-sec market was dominated by big players like banks, insurance companies, mutual funds etc. Small investors stood away from investing directly in bonds. Why? 

• First because of the difficult process of investing in bonds. A common man just did not knew how to buy government bonds. The ease with which they can buy stocks, mutual funds etc, Government bonds purchase was not as simple. Read more about how to buy stock online.
• Secondly, because the big players used to deal in much larger volumes, individuals just could not compete with them in the “auction” process. Know if small investors shall invest in debt funds.

Government Bonds – Process of Purchase

Before Nov’2017, Government Securities (G-Secs) like bonds and T-bills were virtually non-accessible for common men (small investors). But then RBI started the “Non-competitive Bidding Facility“. This made G-secs more accessible for common men.

Lets understand more about competitive and non-competitive bidding process:

• Competitive bidding: Example: Government issues a bond of Face Value of Rs.1,000, offering an interest @8.0% p.a. In the competitive bidding process (auction), “investors” will quote a price higher than the face value (Rs.1,000). Suppose based on all bids, RBI accepts a cut-off price as Rs.1,060. In this case everyone who has quoted Rs.1,060 or more will get their quoted lot of the bond. [Note: In this case, their yield will be lower than 8.0%. How much lower? 7.54% (=8.0% / 1,060 * 1000)].
• Non-competitive bidding: RBI’s “non-competitive bidding facility” for retail investors like me and you. Small investors just need to access the mobile and web app of NSE.

mall investors like me and you can buy government bonds in India using a mobile app or a web based app of National Stock Exchange (NSE). This app is called “NSE goBID“. Either of these two apps can be used to buy the following:

• Long-dated government bonds: holding time: 5 to 40 year.
• Treasury bills (T-bills): holding time less than 1 year.

Before one can go ahead and buy the government bonds using NSE goBID, the “process of registration” must be completed. But do not worry, everything is online. 

About NSE goBID APP

To get a better perspective of how/why a common man can invest in bonds, let’s understand why rich and wealthy like bonds.

Why wealthy prefer bonds?

The way high net worth investors think investment is slightly different than majority. They invest money in a backdrop of a condition where they have excess of it (money). How does it make a difference?

As they have money in excess, they can afford to buy bonds and not need it easily for next 10-15 years. This money can stay invested for prolonged period of time, and yield low returns (like 8% p.a.). Wealthy people do not mind it. They invest money mostly for wealth protection.

In the process of wealth protection, if their investment can yield even 8% p.a. odd returns, it is like icing on the cake. Moreover, the returns of the government bonds are almost guaranteed. How? Because they are backed by the Indian government. 

Whereas when we (common men) invest money for time horizons like 10-15 years, we think about growth. For such prolonged horizons we will instead invest in equity. Why? Because our objective is wealth creation. Read more about where to invest money for high returns.

So what does this tell us about bonds? It is only for rich and wealthy, right? But there are conditions where bonds may become good investment option for common men as well. Let’s see how…

When bonds are useful for common men…

Generally speaking, when common men invest money, they do it for wealth creation. Hence, they often invest with a long term perspective (5+ years). Equity based investment options can give much higher returns than bonds.

In India, a government bond will yield returns between 7-8% per annum even in long term. But a good equity based plan can easily give 14% p.a. in a time horizon of 5+ years. Read more about types of mutual funds and their potential returns.

Types of Government Bonds in India

The multiple variants of Government bonds are discussed below:

• Fixed-rate bonds

Government bonds of this nature come with a fixed rate of interest which remains constant throughout the tenure of investment irrespective of fluctuating market rates.

The coupon on a Government Bond is mentioned in nomenclature. For instance, 7% GOI 2021 means the following

Rate of interest on face value	7%
Issuer	Government of India
Maturity year	2021

• Floating Rate Bonds (FRBs)

As the name suggests, FRBs are subject to periodic changes in rate of returns. The change in rates is undertaken at intervals which are declared beforehand during the issuance of such bonds. For instance, an FRB could have a pre-announced interval of 6 months; which means interest rates on it would be re-set every six months throughout the tenure.

There is another variant to FRBs, wherein the rate of interest rate is bifurcated into two components: a base rate and a fixed spread. This spread is decided through auction and remains constant throughout the maturity tenure.

• Sovereign Gold Bonds (SGBs)

The Central Government issues sovereign Gold Bonds, wherein entities can invest in gold for an extended period through such bonds, without the burden of investing in physical gold. The interest earned on such bonds is exempted from tax.

Prices of such bonds are linked with gold’s prices. The nominal value of SGBs is reached by calculating the simple average of closing prices of 99.99% purity gold, three days preceding such bonds’ issuance. SGBs are also denominated in terms of one gram of gold.

As per RBI regulations, there are individual ceilings concerning SGB possession for different entities. Individuals and Hindu Undivided Families can only hold up to 4 kg of Sovereign Gold Bonds in a financial year. Trusts and other relevant entities can hold up to 20 kg if SGBs during a similar time frame. Interest at 2.50% is disbursed periodically on such SGBs and has a fixed maturity period of 8 years unless stated otherwise. Also, no tax is levied on interest earnings through such SGBs.

Investors seeking liquidity from such bonds shall need to wait for the first five years to redeem it. However, redemption shall only take effect on the date of subsequent interest disbursal.

Assuming that Mr A invested in an SGB on 1st April 2014, and interest disbursals are set on 1st May 2014 and every six months from thereon. In case he decides to withdraw it on 1st June 2019, he shall need to wait till 1st November 2019(interest disbursal date) to receive the redemption amount.

• Inflation-Indexed Bonds

It is a unique financial instrument, wherein the principal, as well as the interest earned on such bond, is accorded with inflation. Mainly issued for retail investors, these bonds are indexed as per the Consumer Price Index (CPI) or Wholesale Price Index (WPI). Such IIBs ensure real returns accrued with such investments remain constant, thereby allowing investors to safeguard their portfolio against inflation rates.

Another variant of such inflation-adjusted securities is Capital Indexed Bond. However, unlike IIBs, only the capital or principal proportion of balance is accorded with an inflation index.

• 7.75% GOI Savings Bond

This G-Sec was introduced as a replacement to the 8% Savings Bond in 2018. As noted from its nomenclature, the interest rate of such bonds is set at 7.75%. As per RBI regulations, these bonds can only be held by:

• An individual or individuals who are/are not NRI(s) in any capacity
• A minor with a legal guardian representative
• A Hindu Undivided Family

Interest earnings from such bonds are taxable under the Income Tax Act 1961 as per the investors’ applicable income tax slab. The minimum amount at which these bonds are issued is Rs. 1000 and in multiples of Rs. 1000 thereof.

• Bonds with Call or Put Option

The distinguishing feature of this type of bonds is the issuer enjoys the right to buy-back such bonds (call option) or the investor can exercise its right to sell (put option) them to such issuer. This transaction shall only take place on a date of interest disbursal.

Participating entities, i.e. the government and investor can only exercise their rights after the lapse of 5 years from its issuance date. This type of bonds might come with either:

• Call option only
• Put option only
• Both

In any case, the government can buy back its bonds at face value. Similarly, investors can sell such bonds to the issuer at face value. This ensures the preservation of the corpus invested in case of any downturn of the stock market.

• Zero-Coupon Bonds

As the name suggests, Zero-Coupon Bonds do not earn any interest. Earnings from Zero-Coupon Bonds arise from the difference in issuance price (at a discount) and redemption value (at par). This type of bonds are not issued through auction but rather created from existing securities.

Advantages of Investing in Government Bonds

• Sovereign Guarantee 

Government Bonds enjoy a premium status with respect to the stability of funds and promise of assured returns. As G-Secs are a form of a formal declaration of Government’s debt obligation, it implies the issuing governmental body’s liability to repay as per the stipulated terms.

• Inflation-adjusted 

Balances held in Inflation-Indexed Bonds are adjusted against increasing average price level. Other than that, the principal amount invested in Capital Indexed Bonds is also adjusted against inflation. This feature provides an edge to investors as they are less susceptible to be financially undermined as investing in such funds increase the real value of the deposited funds.

• Regular source of income

As per RBI regulations, interest earnings accrued on Government Bonds are supposed to be disbursed every six months to such debt holders. It provides investors with an opportunity to earn regular income by investing their idle funds.

Disadvantages of Investing in Government Bonds

• Low Income

Other than 7.75% GOI Savings Bond, interest earnings on other types of bonds are relatively lower.

• Loss of relevancy

As Government Bonds are long-term investment options with maturity tenure ranging from 5 – 40 years, it can lose relevancy over time. It means such bonds value loses relevance in the face of inflation, barring IIBs and Capital Indexed Bonds.