(i)Transaction motive-hold money to meet regular commitments such as paying employees
(ii)Precautionary motive-hold money for emergency purpose such as demand from payables (iii)Speculative motive-hold money for investment purpose
Companies may invest surplus funds to earn return.Four factors need to be taken into account when deciding how a company should invest its surplus funds:
(i)Risk
(ii)Liquidity
(iii)Maturity
(iv)Return
When we talk about risk of an investment,we are really talking about the extent to which its value is likely to fluctuate.There is a strong link between risk and return:the higher the level of risk taken,the greater the return of the investment.The risk can be divided into two components:
(i)Systematic risk-risk that cannot be diversified away,variability of returns caused by factors affecting the whole market,eg.macroeconomics such as inflation.
(ii)Unsystematic risk-risk that can be diversified away,variability of returns caused by factors just affecting a specific market sector.This element of risk can be diversified by holding a well-diversified portfolio of investments(more than one investment).
Liquidity described how easily the money invested can be converted into cash.There is also a link between liquidity and return.An investment that is highly liquid will generally result in a lower return on the investment.On the other hand,an investment with a low level of liquidity will generally provide a higher return.If the amount and duration of surplus funds are subject to change,then only very liquid investments should be considered.
Maturity means the duration of investments.A company's investments should mature so that the surplus funds is available when the business needs it.This can be assessed by preparing a detailed cash budget to cover at least a six-month period into the future.There is also a link between maturity and return.A longer maturity will generally provide you with a higher return.On the other hand,an investment with a shorter maturity will result in a lower return.
The rate of return is the last factor to consider when investing surplus funds.This is because it is largely dictated by the three aforementioned factors-risk,liquidity and maturity.Once you have decided on the appropriate level of risk,liquidity and maturity,you have substantially narrowed down the types of investment that are appropriate.The market then dictates the rates of return on these investments to you.
There are numerous types of investment available for company with surplus funds.Surplus funds can be deposited in interest bearing accounts offered by banks,finance houses or buiding societies.Interest amount between such accounts can be compared by calculating the compound annual rate of interest(CAR):
(ii)Liquidity
(iii)Maturity
(iv)Return
When we talk about risk of an investment,we are really talking about the extent to which its value is likely to fluctuate.There is a strong link between risk and return:the higher the level of risk taken,the greater the return of the investment.The risk can be divided into two components:
(i)Systematic risk-risk that cannot be diversified away,variability of returns caused by factors affecting the whole market,eg.macroeconomics such as inflation.
(ii)Unsystematic risk-risk that can be diversified away,variability of returns caused by factors just affecting a specific market sector.This element of risk can be diversified by holding a well-diversified portfolio of investments(more than one investment).
Liquidity described how easily the money invested can be converted into cash.There is also a link between liquidity and return.An investment that is highly liquid will generally result in a lower return on the investment.On the other hand,an investment with a low level of liquidity will generally provide a higher return.If the amount and duration of surplus funds are subject to change,then only very liquid investments should be considered.
Maturity means the duration of investments.A company's investments should mature so that the surplus funds is available when the business needs it.This can be assessed by preparing a detailed cash budget to cover at least a six-month period into the future.There is also a link between maturity and return.A longer maturity will generally provide you with a higher return.On the other hand,an investment with a shorter maturity will result in a lower return.
The rate of return is the last factor to consider when investing surplus funds.This is because it is largely dictated by the three aforementioned factors-risk,liquidity and maturity.Once you have decided on the appropriate level of risk,liquidity and maturity,you have substantially narrowed down the types of investment that are appropriate.The market then dictates the rates of return on these investments to you.
There are numerous types of investment available for company with surplus funds.Surplus funds can be deposited in interest bearing accounts offered by banks,finance houses or buiding societies.Interest amount between such accounts can be compared by calculating the compound annual rate of interest(CAR):
CAR=[(1+x/n)^n-1] X 100%
x=% interest as in decimal figure
n=number of times interest paid per year
So let's understand this formula by looking at an example:nominal interest rate is 12% and is compounded quarterly.
nominal interest rate is the same meaning as interest rate per annum.In this example,it was received quarterly,so the n=4 meaning one year we received 4 time,then do as follow
CAR=[(1+0.12/4)^4-1] X 100%=12.6%
Other than this,we may also invest in the money market.Money market is a market for short-term debt securities.The yield(profitability) of a money market instrument depends on
(i)Its face value
(ii)interest rate or coupon rate offered
(iii)period of time before it is redeemed(ie.converted into cash) by the issuer
The interest yield=coupon rate/market price X 100%
let's see an example:On 5th january 2010 the market price of 5% treasury stock 2011 is $145.Calculate the interest yield.
So,the market price was given $145,but what about the coupon rate?You need a face value first but most of the time it is not given in exam,therefore always assumed it is $100.So the coupon rate=5% X $100=$5 and interest yield=$5/$145 X 100%=3.45%
Okay let's consider the securities in the money market.Gilts are one of them which are marketable British Government securities.The government issues them to finance its spending,but also uses them to control the money supply.Government promises to buy the gilt back on a specific date in the future.Gilts usually have fixed interest rates,although there are various index-linked gilts.If a company buys a gilt and holds it until it is repaid by the government,the return received will be fixed from the outset.As the government will not default on the debt and the interest to be earned is known in advance,this makes it a low-risk investment.
A certificate of deposit(CD) is a negotiable instrument issued by an institute(bank or buiding society) that indicate a sum of money deposited with a bank and will be repaid at a later specific date(as short as 7 days and as long as 5 years).CD is in bearer form which means title belongs to the holder and can be transferred by delivering the CD to the buyer.CDs can be bought and sold easily and offer attractive interest rates and low credit risk.They are useful for investing funds in the short-term since they can be sold at any time on the secondary market.They are liquid type of investment.
A bill of exchange is like a cheque.It is an unconditional order in writing from one person(the payee) to another,requiring the person to whom it is addressed(the drawee) to pay a specific sum of money on demand(sight bill) or at a future date(term bill).Bank and non-banking institutions are the main buyers of bills on the secondary market.The buyer makes a profit by purchasing the bill at a discount to its face value,then receiving the full value at maturity,or reselling it before this time.The level of risk attached to bills depends on the credit quality of the drawer.If the drawer is a large company or institution,the risk will be lower than if the drawer is relatively small and unknown.
Bonds are fixed interest security issued by government,company,a bank or other institution.May or may not be secured.
Commercial paper is a certificate issued by company promising to pay a fixed sum to the person bearing the note on a specific date.Commercial paper is an unsecured type of investment.
Loan stocks is issued by company in return for loans secured on a particular asset of the business.The loan is for long term.
Permanent interest bearing securities(PIBS) are securities created by building societies to raise funds and are quoted in the stock exchange.
Although there are more ways of investing surplus funds such as shares,high interest accounts,option deposits and more,but students are not required to know all,just some understanding of the investment options is sufficient.The important point to remember is that only after a company has assessed risk,liquidity and maturity,it is then in a position to consider the investment options available to it.I had provided a comprehensive explaination on different kinds on investment options above,it is up to you to decide how you are going to invest your surplus funds in future.Do not just hold the cash as you will suffer holding cost such as opportunity cost and theft of cash.Please have a throughout understanding on what this topic is trying to teach you.This article is applicable not only to CAT T10 students but also anyone who are doing business :)
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