Basics of An MBA

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Basics of MBA-----A route to success
"In the name of ALLAH, the Most Merciful and Gracious"

WHAT IS AN MBA?
M.B.A these three letters spell success in business, and for good reason. Now in reality, just having a Master
of Business Administration degree does not make anyone a master of business administration that takes years
of on-the-job experience. But the course of study that leads to an MBA prepares you extremely well for a
business career.
How? By giving you several reasons.
First, an MBA gives you the key principles of how to manage a business. A business can be manage either
by the Seat of the Pants or professionally, and business institutions teaches you the professional way.
Professional management calls for setting goals that motivates people, allocating resources to activities that
move the company towards those goals, monitoring progress and making any necessary adjustments. These
principles & other taught in an MBA program, usually leads to success.
Second, an MBA gives you exposure (at least classroom exposure) to the department. The function that you
will find in most business. These include management & operations, finance & accounting & sales &
marketing etc.
You learn about the rules these functions play in a business & how to get these areas to work together. All of
this prepares you to deals effectively with the various people working in a company.
Third, an MBA programs gives you sophisticated ways of approaching methods, which often involves
simple calculations or diagram, so you can clearly see the parts of the problem, develop potential solutions,
choose the best course of action, and present your case to others in a winning way.
Finally, MBA know the language of the business like any profession; business has its own lingo & special
words. If you understand the words, you understand the concept. If you understand the concept you can easily
apply them in your business.
Before going to proceed to the next topic I want to share some words about business & specifically about
accounting & finance. Some people find accounting confusing & finance frustrating, but Im not sure why. It
cant be the arithmetic, because if you can add, subtract, multiply, & divide-or can use a calculator-than you
can deal with the numbers in everything from basic budgets to major investments.
Of course, if the number doesnt give you trouble, and then the words might. If you find terms like
deprecation, present value & shareholders equity mysterious, dont worry. They are just words. And
they have straightforward meanings, once they have been explained.
The upcoming part of these notes explains all these and more, including how these topics are important, and
why we use these words in business & where it can apply etc.
HIDAYAT ULLAH KHAN WAZIR

Planning Officer
Elementary & Secondary Education Department,
Civil Secretariat Peshawar KPK.
Cell # 03339668669
Wazir222@yahoo.com
For suggestion wazir222@yahoo.com | cell # 03339668669
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INTRODUCTION TO BUSINESS:
What is business?
The term Business means all those legal human activities which are related to the production & distribution
of goods & services with the object of earning profit.
OR
All those economic activities whose aim is to earn profit is called Business.
Components of business
BUSINESS
INDUSTRY
COMMERCE
Industry
Industry means that part of business activity, which is concerned with the extraction, production and
fabrication of products.
It is a place where raw material is converted into finished or semi-finished goods, which have the ability to
satisfy human needs or can be used in another industry as a base material.
Kinds of industry
1. Primary industry
Primary industry is engaged in the production or extraction of raw materials, which are used in the secondary
industry. It has two parts:
(a) Extractive Industry
Extractive industries are those industries, which extract, raise or produce raw material from below or above the
surface of the earth. For example, fishery, extraction of oil, gas and coal etc.
(b) Genetic Industry
Genetic industries are those, which are engaged in reproducing and multiplying certain species of animals and
plants. For example, poultry farm, fishing farm, diary farm, plant nurseries etc.
2. Secondary industry
These industries use raw materials and make useful goods. Raw material of these industries is obtained from
primary industry. Secondary industry can be divided into three parts:
(a) Constructive Industry
All kinds of constructions are included in this industry. For example, buildings, canals, roads, bridges etc.
(b) Manufacturing Industry
In this industry, material is converted into some finished goods or semi-finished goods. For example, textile
mills, sugar mills etc.
(c) Services Industry
These industries include those industries, which are engaged in providing services of professionals such as
lawyers, doctors, teacher etc.
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Commerce
The term commerce includes all activities, functions and institutions, which are involved in transferring
goods, produced in various industries, from their place of production to ultimate consumers.
In simple words, trade and aids to trade is called commerce.
Scope of commerce
The scope of commerce can be explained as:
1. Trade
Trade is the whole procedure of transferring or distributing the goods produced by different persons or
industries to their ultimate consumers. In other words, the system or channel, which helps the exchange of
goods, is called trade.
Types of trade
(a) Home Trade
The purchase and sale of goods inside the country is called home trade. It is also known as domestic, local
or internal trade. It has two types:
(i) Wholesale Trade
It involves selling of goods in large quantities to shopkeepers, in order to resale them to the consumers. A
wholesaler is like a bridge between the producers and retailers.
(ii) Retail Trade
Retailing means selling the goods in small quantities to the ultimate consumers. Retailer is a middleman, who
purchase goods from manufacturers or wholesalers and provide these goods to the consumers near their
houses.
(b) Foreign Trade
Exchange of goods and services between two or more independent countries for their mutual advantages is
called foreign trade. It is also called international trade.
(i) Import Trade
When goods or services are purchased from other country it is called import trade.
(ii) Export Trade
When goods or services are sold to any other country it is called export trade.
2. Aids to trade
Trade means buying and selling of goods, whereas, aids to trade mean all those things which are helpful in
trade.
(a) Banking (b) Transportation (c) Insurance (d) Warehousing (e) Agents
(f) Finance (g) Advertising
(h) Communication
Difference between business & profession
Business
A Business is organized to produce goods & services to society in order to earn profit.
Profession
It refers to a vocation after getting specialized training. The professional man provides services of specialized
nature to the community.
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Different Types of Business Organizations:

1. Sole Proprietorship
Sole proprietorship is the Simplest, oldest, and most common form of business ownership which is owned and
controlled by one person. In this business, one man invests his capital himself. He is all in all in doing his
business. He enjoys the whole of the profit.
Advantages:
It is easily & inexpensively formed.
It is subject to few government regulations.
The business pays no corporate income tax; only personal income tax is paid by the proprietor.
Limitations:
It is difficult for a proprietorship to obtain large sums of capital.
The proprietor has unlimited personal liability for the business debts, which can result in losses that
exceed the money invested by him in the business.
The life of the business organized as proprietorship is limited to the life of the individual who created
it.
2. Partnership
Partnership means a lawful business owned by two or more persons. The profit of the business shared by the
partners in agreed ratio. The liability of each partner is unlimited. Small and medium size business activities
are performed under this organization.
Advantages:
Low cost involved
Ease of formation.
Limitations:
Unlimited Liability.
Limited life of the organization.
Difficulty of transferring ownership.
Difficulty of raising large amounts of capital.
3. Joint Stock Company
A joint stock company is a voluntary association formed by people to carry on a certain business for profit.
People contribute their capital in the forms of shares in the company. Company works in its own name under
common seal. It has a separate legal entity apart from its members. It can sue and be sued in its name. In the
joint stock company, the work of organization begins before its incorporation by promoters and it continues
after incorporation.
Advantages:
Unlimited life:
A corporation can continue even after the death of its original owners.
Easy transferability of ownership interest:
Ownership interests can be divided into shares of stock, which in turn can be transferred far more easily than
can proprietorship & partnership interests.
Limited Liability:
The liability of the shareholders is limited up to the extent of nominal value of shares held by them. Creditors
and banks cannot confiscate personal properties of director & shareholders in case of its bankruptcy.
Common Seal:
The company is an artificial person created by law; it therefore cannot sign documents for itself. The law has
provided the use of seal with the name of the company engraved on it. This seal have the effect of a signature
of a real person.
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Limitations:
Double Taxation:
Corporate earnings may be subject to double taxation the earnings of the corporation are taxed at corporate
level, and then any earnings paid out as dividends are taxed again as income to the stockholders.
Legal Formalities:
Setting up a corporation, and filing many official documents, is more complex and time consuming than for a
proprietorship or a partnership.
Classification of company
1.
Statutory Company:
A company which is incorporated by a special act of legislative or under ordinance is called statutory company
e.g. SBP, NBP & WAPDA etc.
2.
Registered Company:
A company which is formed & registered under the companies ordinance 1984 is known as a registered
company.
Companies limited by shares:
1. Private limited companies
2. Public limited companies
Private Limited Companies:
Following are the main characteristics of private limited companies:
Number of members in a private limited company ranges from two to fifty (50)
Words and parentheses (Private) Limited are added at the end of the name of a private limited
company. Example: ABC (Private) Limited.
Private limited company can not offer its shares to general public at large.
In case a shareholder decides to sell his shares, his shares are first offered to existing shareholders. If
all existing shareholders decide not to purchase these shares, only then, an outsider can buy them.
The shareholders of the private limited company elect two members of the company as Directors.
These directors form a board of directors to run the affairs of the company.
The head of board of directors is called chief executive.
Public Limited Company:
Following are the main characteristics of public limited companies:
Minimum number of members in a public limited company is seven (7)

There is no restriction on the maximum number of members in a public limited company.
Word Limited is added at the end of the name of a public limited company. Example: ABC Limited.
Public limited company can offer its shares to general public at large.
The shareholders of the public limited company elect seven members of the company as Directors.
These directors form a board of directors to run the affairs of the company.
The head of board of directors is called chief executive.
There are two types of public limited company:

1.
Listed Company
2.
Non Listed Company
Listed Company (quoted company)
Listed company is that company whose shares are quoted on stock exchange i.e. whose shares are traded in
stock exchange. It is also called quoted company.
Non Listed Company
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Non listed company is that company whose shares are not quoted on stock exchange i.e. whose shares are not
traded in stock exchange.
Hybrids (Mixed):
Hybrid organizations are specialized types of partnerships, which combine the limited liability advantage of a
corporation with the tax advantages of a partnership.
S-Type Corporation:
S- Type corporations are Limited Liability Corporations without double taxation. In a regular corporation, the
company itself is taxed on business profits. In addition, the owners pay individual income tax on money that
they draw from the corporation as salaries, bonuses, or dividends. In contrast, in an S-corporation, all business
profits "pass through" to the owners, who report them on their personal tax returns (as in sole proprietorships,
partnerships, and Limited Liability Companies). The S-corporation itself does not pay any income tax,
although a co-owned S-corporation must file an informational tax return like a partnership or Limited Liability
Companies to tell the tax authorities what each shareholder's portion of the corporate income is.
LLP:
Limited Liability Partnership (LLP) is also a form of partnership which allows limited liability to the owners
and avoids double taxation. These organizations are similar in many ways to the S Corporations; however,
LLPs offer more flexibility and benefits to the owners.
PC:
Personal Corporations (PC) or Professional Corporations are generally formed by professionals to protect them
against litigations. Professionals like doctors, lawyers and accountants prefer to register their business as
Professional Corporations.
Formation of joint stock company
Stages in formation of a joint stock company
Promotion Stage
Incorporation Stage
Capital Certificate
Subscription Commencement
1.
Promotion stage
The promoters do the basic work for the start of a commercial or an industrial business on corporate basis.
Promotion is the discovery of ideas and organization of funds, property and skill, to run the business for the
purpose of earning income. Following steps are involved in the stage of promotion.
1. Discovering of business opportunity. 2. Investigation 3. Assembling various Factors 4. Financial Sources
5. Preparation of Essential Documents
The promoters carrying out these various activities give the company its physical form in the shape of:
Giving a name to the company
Sanctioning of Capital Issue
The persons who make all investigations, preparation and arrangements for incorporating are called promoters.
2.
Incorporation stage
The second stage for establishment of a company is to get it incorporated.

i.
Filling of Document
Following documents are to be submitted by the promoters in the Registrars office
(a) Memorandum of Association (b) Articles of Association (c) List of Directors (d) Written Consent of
Directors (e) Declaration of Qualifying Shares (f) Prospectus (g) Statutory Declaration
ii.
Payment of Registration Fee
For the registration of company, the registration fee is also paid to the Registrar. For example
Application and documents filing fee
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Registration fee
Stamp fee on Memorandum and Articles
iii.
Certificate of Incorporation
If the registrar finds all the documents right and thinks that all formalities have been fulfilled then he issues the
certificate of incorporation to promoters.
3.
Capital subscription stage
After getting certificate of incorporation, the next stage is to make arrangement for raising capital. For any
kind of business, the company raises its capital through following sources:
By Issuing Shares
By Issuing Debentures/bonds
By Savings
A private company can commence business on receipt of certificate of incorporation. However a public
company has to fulfill another requirement of subscription to obtain the certificate of commencement of
business.
4.
Certificate of commencement
For the commencement of business, every public company has to obtain the certificate of commencement,
which requires the fulfillment of following conditions:
i.
Issue of Prospectus
A company has to issue prospectus for selling shares and debentures to public.
ii.
Allotment of Shares
The shares and debentures are allotted according to the pro visions of memorandum, when applications are
received from the public.
iii.
Minimum Subscription
It is also certified that the shares have been allotted up to an amount, not less than the minimum subscription.
After verifying the foregoing documents, the registrar issues a certificate of commencement of business to
public company.
Legal Formalities /Basic legal documents of Public Limited Company:
1.
Memorandum of association:
Memorandum of association is known as Charter of Company, as it sets the limits, which the company
cannot go out of. Through this, the shareholders and creditors can know about the range of business activities
of the company. Any work or business not stated in the memorandum cannot be carried out by the
management.
2.
Articles of association:
Articles of association are the by-laws of a company. It includes the rules and regulations, necessary to
manage the internal affairs of the company and to achieve the objectives stated in the memorandum. Articles
are responsible for the good conduct of the whole management.
3.
Prospectus:
A prospectus is a notice to general public about the formation of new company. The company tries to attract
the public to purchase its shares through the prospectus, as the terms and conditions for the purchase of shares
and debentures are written in it. There is an application form in every copy of a prospectus. Only the public
company is required to issue the prospectus.
The Memorandum of Association is the constitution of a company. The Articles of Association are the
basic rules to run the business and the Prospectus is a notice to the public for the purchase of securities of
the company.
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Share capital:
In company, share capital means the amount contributed by the shareholders.
Authorized Capital:
This is maximum amount of capital with which a company is registered or authorized to issue. It is divided
into shares of small value. For example, the authorized capital of the company Rs. 1,000,000 divided into
100,000 shares of Rs. 10 each.
Issued Capital:
It is a part of authorized capital which is offered to the general public for sale.
For example, a company has an authorized capital of Rs. 1,000,000 dividend into 100,000 shares of Rs. 10
each. It offers 20,000 shares of Rs. 10 each to general public. So it means issued capital is Rs. 200,000.
Un-Issued Capital:
It is a part of authorized capital which is not offered to the general public for sale.
For example, a company has an authorized capital of Rs. 1,000,000 divided into 100,000 shares of Rs. 10 each.
It offers 20,000 shares of Rs. 10 each to general public. So it means un-issued capital is Rs. 800,000 consisting
of 80,000 shares of Rs. 10 each.
Subscribed Capital:
That part of issued capital for which applications are sent by the public and which are accepted is called
subscribed capital. For example, out of 20,000 shares offered by the company, the general public takes up only
10,000 shares. So subscribed capital, is Rs. 100,000.
Called up Capital:
A company may require payment of the par value either in installments or in lump sum. So amount of shares
demanded by company is known as called up capital. For example, out of 10,000 shares taken by public,
company requires a payment of 6 per share. So called up capital of the company is Rs. 60,000 (10,000 share
@ Rs. 6).
Paid up Capital:
It is that part of called up capital which is actually received by the company. If some shareholders could not
pay all the money of called up capital, such money is called as calls in arrears or calls unpaid.
Reserve Capital:
The capital which is reserved for unexpected events or for future needs is called reserve capital. Company
decides not to call up some part of uncalled up capital until winding up. It is normally kept for the payment of
debts at the time of winding up.
Redeemable Capital:
A company can obtain redeemable capital by issue of:
(a) Participation Term Certificates (b) Musharika Certificate (c) Term Finance Certificate
Entrepreneurship:
Management ability of the people who are running the business
Enterprise Resource Planning (ERP):
Large-scale information system for organizing and managing a firms processes across product lines,
departments, and geographic locations
Partnership agreement/ Deed:
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Partnership deed or agreement is a document which includes the terms and conditions related to the
partnership; and regulations governing its internal management and organization.
Ethics in the workplace:

Ethicsbeliefs about what is right and wrong or good and bad in actions that affect others.
Ethical Behaviorbehavior conforming to generally accepted social norms concerning beneficial
and harmful actions.
Unethical Behaviorbehavior that does not conform to generally accepted social norms concerning
beneficial and harmful actions.
Business Ethicsethical or unethical behaviors by a manager or employer of an organization.
Merger/Amalgamation:
The combining together of two or more firms into a single business on a basis that is mutually agreed by the
firms management & approved by their shareholders
Acquisition/takeover:
To acquire one firm by another is called acquisition.
Joint Venture:
A business owned jointly by two independent firms who continue to function separately in all other respects
but pool together their resources in a particular line of activity.

MBA FINANCE
Cell # 03339668669
khan11151@yahoo.com
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MANAGEMENT
What is an Organization?
An entity/unit where two or more persons work together to achieve a goal or a common purpose is called
Organization
Organization depends upon the following important concept:
People
Purpose
Process
POLCA
If there is an organization, then there must be some people. They work as whole for a common purpose, so
there must be a defined purpose. If an organization doesnt have any purpose, it will not survive for long run.
To achieve the purposes by using people, the processes are needed. Without any process, you cannot achieve
any type of purpose or goal. If we see in our daily life, we have some goals. For achieving these goals, we use
some processes. So that process is also obvious and important for an organization. The last important thing for
any organization is that it requires main pillars of management i.e. POLCA:
Planning
Organizing
Leading
Controlling
A manager must perform all theses management functions with Assurance!
What is Management?
Management is the process of designing an environment & maintaining it where individuals in form of
groups can carry out activities to accomplish their selected goals & objectives.
OR
Management is generally defined as the art & science of getting things done through others
OR
Organizing & directing the work of others is known as administration. In a business it is called business
administration. In hospital, it is called health-care administration. In a government organization it is called
public administration.
We define management as the process of coordinating and integrating work activities so that they are
completed efficiently and effectively with and through other people. Lets look at some specific parts of this
definition.
The process represents the ongoing functions of primary activities engaged in by managers. These functions
are typically labeled planning, organizing, leading, and controlling. Let us remember it by POLCA as
functions.
Managerial functions i.e. POLCA

POLCA as functions:
Planning:
Planning is the 1st function of management. Planning is a pre-determined course of action, with selection of
objectives, goals & guidelines of action to achieve those goals.
Planning is the function that involves the process of defining goals, establishing strategies for achieving those
goals. And developing plans to integrate and coordinate activities.
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Organizing:
Organizing is the 2nd function of management that involves the process of determining what tasks are to be
done. Who is to do them, how the tasks are to be grouped, who reports to whom, and where decisions are to be
made.
Leading:
Leading is the 3rd function of management that involves motivating subordinates, influencing individuals or
teams as they work, selecting the most effective communication channels, or dealing in any way with
employee behavior issues.
Controlling:
Controlling is the process of measuring performance and taking actions to ensure desired results in the
organization. It involves measuring and correcting individual as well as organizational performance to ensure
that events conform to plans. Controlling facilitates accomplishment of plans.
Assurance:
Quality function which demands from every manager that he ensures that prior management support and
management processes are in place before POLC management functions are executed.
Management process:
It is the set of ongoing decisions and work activities in which managers engage as they plan, organize, lead,
and control. The management process includes more than the four management functions.
1. The process also includes work methods, managerial roles, and managerial work agendas.
2. The management process applies to both profit-making and not-for-profit organizations.
a. A not-for-profit organization is an organization whose main purposes center on issues other than
making profits.
Examples of not-for-profit organizational include government organizations, cultural institutions,
charitable institutions, and some health-care facilities.
Management Process:
Planning
Defining goals,
Organizing
Leading
establishing
Determining what
strategy, and
needs to be done
Directing and
motivating all
developing sub
how it will be
done
involved parties
and who is to do it
conflicts
plans to
coordinate
activities
and resolving
Controlling
Monitoring
activities to
ensure
that they are
accomplished as
Lead to
Achieving the
organizations
stated purpose
planned
Efficiency refers to getting the most output from the least amount of inputs.
Effectiveness is often described as doing the right things that is, those work activities that will help the
organization reach its goals.
We have learnt that; a manager is someone who works with and through other people by coordinating their
work activities in order to accomplish organizational goals. While performing, the manager has to keep in
mind that he has to deal workers and other people around him in variety of situations.
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Management Skills, Knowledge and Performance:

Managers need a knowledge base. This knowledge base provides a context for the managers
activities. It can include information about an industry and its technology, company policies and
practices, company goals and plans, company culture, the personalities of key organization members,
and important suppliers and customers.
Managers need three types of key skills to perform the duties and activities associated with being a
manager.
1. Technical skills are skills that reflect both an understanding of and a proficiency in a specialized field.
Technical skills include knowledge of and proficiency in a certain specialized field, such as engineering,
computers, accounting, or manufacturing. These skills are more important at lower levels of management since
these managers are dealing directly with employees doing the organizations work.
2. Human skills are associated with a managers ability to work well
with others both as a member of a
group and as a leader who gets things done through others. Because managers deal directly with people, this
skill is crucial! Managers with good human skills are able to get the best out of their people. They know how
to communicate, motivate, lead, and inspire enthusiasm and trust. These skills are equally important at all
levels of management.
3. Conceptual skills are skills related to the ability to visualize the organization as a whole, discern
interrelationships among organizational parts, and understand how the organization fit into the wider context
of the industry, community, and world. Conceptual skills are the skills managers must have to think and to
conceptualize about abstract and complex situations. Using these skills, managers must be able to see the
organization as a whole, understand the relationships among various submits, and visualize how the
organization fits into its broader environment.
Managerial roles in organizations:

A role is an organized set of behaviors that is associated with a particular office or position.
Dr. Henry Minzberg, a prominent management researcher, says that what managers do can best be described
by looking at the roles they play at work. The term management role refers to specific categories of managerial
behavior. There are three types of roles which a manager usually does in any organization.
Interpersonal roles are roles that involve people (subordinates and persons outside the organization) and
other duties that are ceremonial and symbolic in nature. The three interpersonal roles include being a
figurehead, leader, and liaison.
Informational roles involve receiving, collecting, and disseminating information. The three informational
roles include a monitor, disseminator, and spokesperson.
Decisional roles revolved around making choices. The four decisional roles include entrepreneur, disturbance
handler, resource allocator, and negotiator.
Coordination:
Coordination means to ensure that the organization works well & there are no conflicts or overlapping or
duplication of works. It attempts to bring about cooperation and team work among the employees of an
organization.
Cooperation:
Cooperation is the collective action of one person with another or others toward a common goal, whereas in
coordination it is needed not only to ensure team work & cooperation but also to prevent conflicts that may
arise in the work of an organization.
Crisis management:
A process which describes an organizations methods for dealing with emergencies is called crisis
management.
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Risk management:
Risk management is the act or practice of dealing with risk. It includes planning for risk, assessing (identifying
and analyzing) risk issues, developing risk handling options, and monitoring risks to determine how risks have
changed.
Proper risk management is proactive rather than reactive
Risk Management Process:
It is important that a risk management strategy is established early in a project and that risk is continually
addressed throughout the project life cycle. Risk management includes several related actions involving risk:
planning, assessment (identification and analysis), handling, and monitoring:
Risk planning: This is the process of developing and documenting an organized, comprehensive, and
interactive strategy and methods for identifying and tracking risk issues, developing risk handling
plans, performing continuous risk assessments to determine how risks have changed, and assigning
adequate resources.
Risk assessment: This process involves identifying and analyzing program areas and critical technical
process risks to increase the likelihood of meeting cost, performance, and schedule objectives.
Risk identification is the process of examining the program areas and each critical technical process
to identify and document the associated risk. Risk analysis is the process of examining each identified
risk issue or process to refine the description of the risk, isolate the cause, and determine the effects.
Risk handling: This is the process that identifies, evaluates, selects, and implements options in order
to set risk at acceptable levels given program constraints and objectives. This includes the specifics on
what should be done, when it should be accomplished, who is responsible, and associated cost and
schedule. Risk handling options include assumption, avoidance, control (also known as mitigation),
and transfer. The most desirable handling option is selected, and a specific approach is then developed
for this option.
Risk monitoring: This is the process that systematically tracks and evaluates the performance of risk
handling actions against established metrics throughout the acquisition process and provides inputs to
updating risk handling strategies, as appropriate.
Total quality management (TQM):
The term total quality management (TQM) is an approach in which all the companys people are involved in
constantly improving the quality of products, services, and marketing processes.
In the narrowest sense, quality can be defined as freedom from defects.
Quality has a direct impact on product or service performance. Quality is defined in terms of customer
satisfaction.
The fundamental aim of todays total quality management has become total customer satisfaction.
Contingency Plan: a plan B or a backup plan you can adopt if plan A fails or condition change.
Infrastructure: A basic structural foundations of a society .i.e. road, bridge, severs etc.
Structure: refers to the way a company or department is organized. A companys structure includes elements
such as the corporate hierarchy, the number & kinds of department, number of locations & the scope of
operations.
Delegation: delegation means passing responsibility for performing a task along to a subordinate that is to
someone who reports to you, the manager.
Responsibility: it refers to the work that a member of an organization is supposed to do & the standards for
that work to be considered properly accomplished.
Area of responsibility: it refers to the scope of someones job.
Authority: it is the power to do something. The organization gives the president of the organization the power
to run the organization, he shares out that power to other managers in the organization.
Accountability: it refers to the fact that people with certain responsibilities are held to account for performing
them. Their superior will make certain that those responsibilities are properly handled.
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ACCOUNTING
Accounting is the language of the business.
Accounting is the art of recording, classifying, summarizing & interpreting result of the business activities
(transaction) for a specific period.
Recording:
It is the basic function of accounting. Recording means to put the transaction in written form into the books of
accounts. Recording is done in the book which is called Journal. It is further sub-divided into various sub
diary books such as cash-journal, purchase-journal and sales-journal etc.
Classifying:
Classification is the process of grouping of transaction, or entries of one nature at one place. The work of
classification is done in the book termed as Ledger.
Summarizing:
Summarizing involves presenting the classified data in a manner which is understandable & useful to
management & other interested parties. It involves the preparation of financial statements.
Purpose of accounting:
Accounting provides decision-makers with sufficient, relevant information to make prudent and intelligent
business decisions. This information is provided through accounting reports called financial statements. The
whole process is called financial reporting
The purpose of accounting is to organize the financial details of business.
To identify the financial transactions.
To organize the financial data into useful information
To measure the value of these information in terms of money
To analyze, interpret, and communicate the information to persons or groups, both inside or outside
the business.
Event:
Event is the happening of any thing but in accounting we discuss monetary events
Monetary Events:
If the financial position of a business is change due to the happening of event that Event is called Monetary
Event.
Transaction:
In accounting or business terms, any dealing between two persons involving money or a valuable thing is
called transaction.
OR
Any business activity in which money is involved is called transaction.
Voucher:
Voucher is documentary evidence in a specific format that records the details of a transaction. It is
accompanied by the evidence of transaction. Normally three types of vouchers are used:
(a)
(b)
Receipt voucher is used to record cash or bank receipt.

Payment Voucher is used to record a payment of cash or cheque.
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Journal voucher is used to record transactions that do not affect cash or bank
Book keeping:
The art of recording business transactions in books in a regular & systematic manner is called book keeping.
Single entry accounting/Cash accounting.
This system records only cash movement of transactions and that too up to the extent of recording one aspect
of the transactions.
This means that only receipt or payment of cash is recorded and no separate record is maintained (about the
source of receipt and payment) as to from whom the cash was received or to whom it was paid.
Double entry book keeping/Commercial accounting.
Double entry or commercial accounting system records both aspects of transaction i.e. receipt or payment and
source of receipt or payment. It also records credit transactions i.e. recording of Electricity Bill or accruals of
Salary payment etc.
It should be noted that in cash accounting date of receipt / payment of actual cash is important while in
commercial accounting the date on which the expense is caused (whether paid or not) as well as the spreading
of the cost of certain items over their useful life becomes important.
Cash accounting and accrual accounting:
Cash Accounting:
It is the accounting system in which transactions are recorded when actual cash / cheque is received or paid.
Lets take the example of utility bills like electricity, telephone etc. The bill of January is received on 15th
February and paid on 25th February. If the organization is following cash accounting practice it will record the
expense of electricity / telephone on 25th February because the actual payment is made on that day. The same
principle applies for income and other transactions as well i.e. income is recorded when cash is actually
received instead recording when it is earned & expenses are recorded when paid.
Accrual Accounting:
It is the accounting system in which events are recorded as and when they occur.
This means that income is recorded when it is earned and expense is recorded when incurred i.e. the
organization has obtained the benefit from it. Consider the above example. The electricity is utilized in the
month of January so the expense should be recorded in the month of January. Similarly the company that is
providing the electricity should record the income in the month of January.
Account:
An accounting system keeps separate record of each item like assets, liabilities, etc. For example, a separate
record is kept for cash that shows increase and decrease in it.
This record that summarizes movement in an individual item is called an Account.
Each element/sub-element of the balance sheet is named as Account, Technically, these are also called
Ledger Accounts.
Classification of Accounts:
The accounts are classified into following heads it is also called chart of accounts:
Assets
Liabilities
Income
Expenses (further divided into capital and revenue expenses)
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Assets:
Assets are economic resources that are owned by a business and are expected to benefit future operations.
There are two types of assets:
1. Tangible Assets which have physical existence and can be seen or touched. It includes Fixed as well as
Current assets.
Fixed Assets Are the assets of permanent nature that a business acquires, such as plant, machinery,
building, furniture, vehicles etc. Fixed assets are subject to depreciation.
Long Term Assets These are the assets of the business that are receivable after twelve months of the
balance sheet date. For example, if business has invested some money for two years in any saving
scheme or has purchased saving certificates for more than one year, it is a long term asset.
Current Assets Current Assets includes cash in hand & in bank account & the receivables that are
expected to be received within one year of the balance sheet date. Closing stock & all accrued incomes
are the examples of Current Assets because these are expected to be received within one accounting
period from the balance sheet date.
2. Intangible assets which have no physical existence like, trademark, patents/ copyright and goodwill etc.
A Trademark is a legally protected brand name, slogan or design of a product or firm. A registered
trademark cannot be used by another company, because the firm that owns it used its resources to
develop & establish that trademark.
Patents give an exclusive right to a product or process to the holder of the patent. Like a trademark,
this protects the company or person who developed the product or process from having their work
exploited by others.
Goodwill- This is simply the value attached to the good reputation earned through good and clean
conduct of business over a number of years. This good reputation also has a value and becomes part of
investment in business.
Stock:
Stock is the quantity of unsold goods lying with the organization.
Stock is termed as the value of goods available to the business that are ready for sale. For accounting
purposes, stock is of two types:
1.
2.
In trading concern, Stock consists of goods that are purchased for the purpose of resale, but not sold
in that accounting period. Trading concern is that organization, which purchases items for resale
purposes.
In manufacturing concern, (an organization that converts raw material into finished product by
putting it in a process) stock consists of:
Raw material is the basic part of an item, which is processed to make a complete item.
Work in Process: In manufacturing concern, raw material is put into process to convert it into
finished goods. At the end of the year, some part of raw material remains under process. It is neither in
shape of raw material nor in shape of finished goods. Such items are taken in stock as work in process.
Finished goods contain items that are ready for sale, but could not be sold at the end of accounting
period.
Opening stock is the value of goods available for sale in the beginning of an accounting year. Closing Stock
of previous year is the opening stock in present year (current year).
Closing stock is the value of goods unsold at the end of accounting period. For purposes of making financial
statements, it is deducted from cost of goods sold & is shown as a current asset in the Balance Sheet.
As this is the value of goods that are yet to be sold, so it cannot be included in cost of goods sold. That is why
it is deducted from cost of good sold. On the other hand, its benefit will be received in the next accounting
year, so it is shown as an asset in the balance sheet.
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Liabilities:
Liabilities are debts and obligations of the business.
Classification of Liabilities:
Long Term Liabilities These are the liabilities that will become payable after a period of more than one
year of the balance sheet date. For example, if business has taken a loan from bank or any third person and it is
payable after three years, it will be treated as a long term liability for the business.
Current Liabilities These are the obligations of the business that are payable within twelve months of the
balance sheet date.
Accrued Expenses Payable :( Current Liabilities)
Accrued means recorded but not paid, collected or allocated.
The accrued expenses account sums up all of the other money that the company owes to companies and
individuals it does business with, including employees and independent contractors, attorneys and other
outside professionals, & utilities such as the electric & telephone companies who have not been paid for
services rendered on the date of the balance sheet.
Asset is a right to receive and liability is an obligation to pay, therefore, these are opposite to
each other.
Account Payable:
An amount owed to a supplier for good or services purchased on credit; payment is due within a short time
period, usually 30 days or less.
Notes Payable:
A liability expressed by a written promise to make a future payment at a specific time,
Income, Expenditure, and Profit & Loss
Income/Revenue is the value of goods and services earned from the operation of the business. It
includes both cash & credit. For example, if a business entity deals in garments. What it earns from the
sale of garments, is its income. If somebody is rendering services, what he earned from rendering
services is his income.
Expenses are the cost and the efforts made to earn the income, translated in monetary terms. It
includes both expenses, i.e., paid and to be paid (payable). Consider the above mentioned example, if
any sum is spent in running the garments business effectively or in provision of services, is termed as
expense.
Profit is the excess of income over expenses in a specified accounting period.
Expenditure Vs Expenses
Expenditure: It is the cost spreading over two or more accounting periods. Expense is the portion of
Expenditure for one accounting period only.
Capital Expenditure
Capital Expenditure is the amount of cost used during a particular period to acquire or improve long-term
assets such as property, plant or equipment.
Revenue Expenditure
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Revenue Expenditure is the cost of resources consumed or used up in the process of generating revenue,
generally referred to as expenses. For example, salary of the employee, rent of the building, etc.
Difference between expenses & Purchases

If business purchases items for its own use (items that are not meant to be resold) such items are
charged to expense account.
If business purchases items for resale purposes, such items are charged to purchases account.
Preliminary Expenses:
All expenses incurred up to the stage of incorporation of the company are called Preliminary Expenses.
All these expenses are incurred by subscribers of the company.
The accounting equation:
Resources in the business = Resources supplied by the owner
In accounting, terms are used to describe things. The amount of resources supplied by the owner is called
Equities. The actual resources which are in the business are called assets. This means that the accounting
equation above, when the owner has supplied all the resources, can be shown as:
Assets = Equities
Usually, people, other than the owner has supplied some of the assets. Liabilities are the name given to the
amounts owing to these people for these assets. The equation has now changed to:
Assets = Owners Equity + Liabilities
It can be seen that two sides of the equation will have the same totals. This is because we are dealing with the
same thing with two different points of view. It is:
Resources in the business = Resources: who supplied them
Assets = Owners Equity + Liabilities
It is a fact that total of each side will always equal one another, and this will always be true no matter how
many transactions there may be. The actual assets, Owners Equity and liabilities may change, but the total of
the assets will always equal to the total of Owners Equity and liabilities.
Owners Equity:
Owners equity means owners rights in the business & it includes capital of the owner & his drawing in the
business.
A corporation will always have an account for stock on the balance sheet, although a
proprietorship/partnership will not have accounts for stock but will show the owners equity in the form of
capital contributions and retained earnings.
A company may issue several classes of stock, each with different features such as dividend policies and
voting rights.
This simply means that the shareholders own the assets & owe the liabilities. After you subtract what
is owed from what is owned, you have the actual stake the owners have in the company, & the actual
value of the company. Owners equity is also called net worth.
Equity:
Equity is the total of capital, reserves and undistributed profit. That means the amount contributed by share
holders plus accumulated profits of the company. Equity, therefore, represents the total of shareholders fund in
the company.
Capital:
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Whatever money or resources from ones own pocket are put in a business is referred to as CAPITAL.
Capital is the investment of the Owner in the business. This capital or investment must earn a return or profit
on its use even if it is coming out of ones pocket. This return is also known as PROFIT. Capital is often called
the owners net worth.
Additional Paid-in-Capital:
When a company issued its stock. The stock has a par value, a value assigned to a share of stock by the
organization ($1, or $5, or $10 a share). This value does not determine the selling price (that is market value)
of the stock. The selling price is the price the investor actually pays per share is determined in the market.
The amount paid to the company in excess of the par value of the stock is counted as additional paid-incapital.
It is capital paid into the company in addition to the stocks par value.
Additional paid-in-capital is also known as paid-in-surplus.
Retained Earnings:
When the organization earns a profit for a period, it can only do one of two things with the money (profit).
Distribute it in the form of dividends or retain it in the organization to finance more assets.
Any income not distributed as dividends goes into retained earnings. It is thus reinvested in the organization &
becomes part of the capital that finances the organization.
Drawing:
Whenever the owner wants to take cash or goods out of the business for personal use. This is known as
drawing.
Any money taken out as drawings will reduce capital.
Sometimes goods are also taken by the owner of the business. These are also known as drawings.
Debit and Credit:
Debit and Credit are two Latin words and as such it is difficult to say what do these mean. But we can develop
an understanding as to what does these terms stand for.
Debit
It signifies the receiving of benefit. In simple words it is the left hand side. DEBIT is a record of an
indebtedness; specifically an entry on the left-hand side of an account constituting an addition to an expense or
asset account or a deduction from a revenue, net worth, or liability account.
Credit
It signifies the providing of a benefit. In simple words it is the right hand side. CREDIT, in accounting, is an
accounting entry system that either decreases assets or increases liabilities or owners equity.
Rules of Debit and Credit:
For Debit,
Any account that obtains a benefit is Debit.
OR
Anything that will provide benefit to the business is Debit.
Both these statements may look different but in fact if we consider that whenever an account benefits as a
result of a transaction, it will have to return that benefit to the business then both the statements will look like
different sides of the same picture.
For credit,
Any account that provides a benefit is Credit.
OR
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Anything to which the business has a responsibility to return a benefit in future is Credit
Rules of Debit and Credit for Assets
Similarly we have established that whenever a business transfers a value / benefit to an account and as a result
creates some thing that will provide future benefit; the thing is termed as Asset. By combining both these
rules we can devise following rules of Debit and Credit for Assets:
When an asset is created or purchased, value / benefit is transferred to that account, so it is Debited
i. Increase in Asset is Debit
Reversing the above situation if the asset is sold, which is termed as disposing off, for say cash, the
asset account provides benefit to the cash account. Therefore, the asset account is credited.
ii. Decrease in Asset is Credit
Rules of Debit and Credit for Liabilities
Anything that transfers value to the business, and in turn creates a responsibility on part of the business to
return a benefit, is a Liability. Therefore, liabilities are the exact opposite of the assets.
When a liability is created the benefit is provided to business by that account so it is Credited
iii. Increase in Liability is Credit
When the business returns the benefit or repays the liability, the liability account benefits from the business.
So it is debited
iv. Decrease in Liability is Debit
Rules of Debit and Credit for Expenses
Just like assets, we have to pay for expenses. From assets, we draw benefit for a long time whereas the benefit
from expenses is for a short run. Therefore, Expenditure is just like Asset but for a short run.
Using our rule for Debit and Credit, when we pay cash for any expense that expense account benefits from
cash, therefore, it is debited.
Now we can lay down our rule for Expenditure:
v. Increase in Expenditure is Debit
Reversing the above situation, if we return any item that we had purchased, we will receive cash in
return. Cash account will receive benefit from that Expenditure account. Therefore, Expenditure
account will be credited
vi. Decrease in Expenditure is Credit
Rules of Debit and Credit for Income
Income accounts are exactly opposite to expense accounts just as liabilities are opposite to that of assets.
Therefore, using the same principle we can draw our rules of Debit and Credit for Income
vii.
viii.
Increase in Income is Credit

Decrease in Income is Debit
How to Carry Forward a Balance?

It is clear that in T account, at the end of accounting period, if one side is greater than the other side,
balancing figure will be written on the lesser side as balance. For instance, if amount on debit side is greater
than the amount on credit side, the balancing figure is written on the credit side as balance & it is known as
Debit Balance. On the other hand, if amount on the credit side is greater than that of amount on the debit side,
the balance is shown on the debit side. It is called the Credit Balance.
Depreciation:
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Depreciation means the reduction in the values of fixed assets e.g building, office equipment etc. Depreciation
is a way of allocating the cost of a fixed asset with a life of more than one year. The cost of the asset is charged
against income/return over the life of the asset, rather than all in one year.
When an expense is incurred, it is charged to profit & loss account of the same accounting period in which it
has incurred. Fixed assets are used for longer period of time. Now, the question is how to charge a fixed asset
to profit & loss account. For this purpose, estimated life of the asset is determined.
Estimated life is the number of years in which a fixed asset is expected to be used. Then, total cost of the asset
is divided by total number of estimated years. The value, so determined, is called depreciation for that year
and is charged to profit & loss account. The same amount is deducted from total cost of fixed asset. The net
amount (after deducting depreciation) is called Written down Value. Example: An asset has a cost of Rs.
150,000. It is expected to be used for ten years. Depreciation to be charged to profit & loss account is Rs.
15,000 (Cost of asset/estimated life). In this case, it will be 150,000/10 = 15,000.
That is why depreciation is called an accounting estimate.
Methods of calculating Depreciation
There are several methods for calculating depreciation. At this stage, we will discuss only two of them namely:
Straight line method or Original cost method or Fixed installment method
Reducing balance method or Diminishing balance method or written down method.
Straight Line Method:
Under this method, a fixed amount is calculated by a formula. That fixed amount is charged every year
irrespective of the written down value of the asset. The formula for calculating the depreciation is given
below:
Depreciation = (cost Residual value) / Expected useful life of the asset
Residual value is the cost of the asset after the expiry of its useful life.
Under this method, at the expiry of assets useful life, its written down value will become zero. Consider the
following example:
Cost of the Asset = Rs.100,000

Life of the Asset = 5 years
Annual Depreciation = 20 % of cost or Rs.20, 000
Written down value method
Cost of the Asset
= Rs. 100,000
Annual Depreciation = 20%
Year 1 Depreciation = 20 % of 100,000
Year 1 WDV
= 100,000 20,000
Year 2 Depreciation = 20 % of 80,000
Year 2 WDV
= 80,000 16,000
= 20,000
= 80,000
= 16,000
= 64,000
Depreciation expense account contains the depreciation of the current year.

Depreciation account is charged to profit & loss account under the heading of Administrative Expenses.
In the balance sheet, fixed assets are presented at written down value i.e. WDV
WDV = Actual cost of fixed asset Accumulated Depreciation.
Fixed assets are also called Depreciable Assets.
Useful Life:
Useful Life or Economic Life is the time period for machine is expected to operate efficiently.
It is the life for which a machine is estimated to provide more benefit than the cost to run it.
Accumulated Depreciation:
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Accumulated Depreciation is the depreciation that has been charged on a particular asset from the time of
purchase of the asset to the present time. This is the amount that has been charged to profit and loss account
from the year of purchase to the present year. In other words, Accumulated Depreciation shows the cost of
usage of the asset up to the current year. Depreciation of the following years in which asset was used is added
up in this account
Once an asset has been fully depreciated, no more depreciation should be recorded on it, even though
the property may be in good condition and may be in use.
The objective of depreciation is to spread the cost of an asset over the periods of its usefulness; in no
case can depreciation be greater than the amount paid for the asset. When a fully depreciated asset is in
use beyond the original estimate of useful life, the asset account and the accumulated depreciation
account should remain in the accounting records without further entries until the asset is retired.
No depreciation is charged for Land. In case of Leased Asset/Lease Hold Land the amount paid for it
is charged over the life of the lease and is called Amortization.
Characteristics of Deprecation:
(1) The depreciation, in the case of fixed assets are charged only as buildings, plant and machinery, furniture,
'etc. There is no question of attribution in the case of current assets, such as stock, accounts receivable, change
in ownership, etc.
(2) Depreciation causes permanent, gradual and continuous decline in the value of the asset.
(3) Depreciation is computed until the last day of the estimated working time Life of asset.
(4) Depreciation is the account of the use of asset, in some cases; however, the depreciation can occur even if
the assets that are not used, for example, leasehold property, patents, copyrights, etc.
(5) Depreciation is a charge against the revenue of an accounting period.
(6) Depreciation does not depend on fluctuations in the market value of the asset.
(7) The amount of the depreciation of an accounting year can not be accurately determined, it must be
estimated. In certain cases, however, it can be determined accurately, e.g. leasehold property, patents,
copyrights, etc
Accounting cycle /process:

It refers to a complete sequence of accounting procedures which are required to be repeated in same order
during each accounting period.
Analyzing financial transaction.
The purpose is to see which two (or more) Accounts (or sub-Accounts) are affected by a particular financial
transaction.
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(1)
General
Journal
(8)
(2)
Prepare an
After Closing
Trial Balance
(7)
Posting in
ledger
(3)
Accounting
Cycle
Journalize and
Post Closing
Entries
(6)
Preparing trial
balance
(4)
Prepare
Financial
statements
(5)
Making
adjusting Entries
Prepare an
Adjusted Trial
Balance
(1)
General Journal:
General journal means chronological records of business transactions.

In actual accounting system, the information about business transaction is initially recorded in journal. since
it is the accounting record in which transactions are first recorded, so sometime it is also called the book of
original entry, and it is also known as a day book because it contains the account of every days
transactions.
As journal contains chronological record of business transaction, it uses the double-entry system of
accounting, thus act of debiting one account & crediting the other account of the business transaction is also
called the journal.
(2)
General Ledger The T Account
A classified record of the business transactions after journalizing them grouping separate but similar
transactions together is called ledger. Ledger is a book that keeps separate classified record for each account
(Book of Accounts).
The Ledger Balance
The total of all balances on the Debit side is ALWAYS equal to the total of all balances on the Credit side.
This is called the balancing of books of accounts.
The balance may be written out after every transaction in a third column or calculated at the end of a specific
time period (an accounting period).
A Debit balance is shown without brackets and a Credit balance is shown in brackets (XYZ).
Cash Book & Bank Book
Cash book and bank book are part of general ledger.
Cash Book
All cash transactions (receipts and payments) are recorded in the cash book. Cash book balance shows the
amount of cash in hand at a particular time.
Bank Book
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All bank transactions (receipts & payments) are recorded in the bank book. The balance of bank book reflects
the cash available at bank at a particular time.
(3)
Trial Balance:
Trial balance is a three-column schedule listing the names & the balances of all the accounts in order in which
they appear in the general ledger and their balances as of a specified date.
A trial balance is usually prepared at the end of an accounting period and is used to see if additional
adjustments are required to any of the balances. Since the basic accounting system relies on double-entry
bookkeeping, a trial balance will have the same total debit amount as it has total credit amounts.
Both sides of trial balance i.e. Debit side and credit side must be equal. If both sides are not equal,
there are some errors in the books of accounts.
Trial balance shows the mathematical accuracy of the books of accounts.
Limitations of Trial Balance
Trial balance only shows the mathematical accuracy of the accounts.
If both sides of trial balance are equal, books of accounts are considered to be correct. But this might
not be true in all the cases.
If any transaction is not recorded at all, trial balance can not detect the omitted transaction.
If any transaction is recorded in the wrong head e.g. if an expense is debited to an assets account. Trial
balance will not be able to detect that mistake too
(4)
Making adjusting entries:
These are the Entries required for those transactions which affect revenues or expenses of more than one
accounting period.
Immediate recording of every event in some cases is not practical e.g. raw material, office supplies,
depreciation. Journal entries of such expenses are recorded at the end of accounting period and are called
adjusting entries. Regular journal entries (chronological) are recorded in blue and adjusting entries are
recorded in red.
Adjusting Entry to record Expenses on Fixed Assets
The expenditure use to acquire Fixed Assets is spread over a number of Accounting periods.
The spreading of that expenditure over a number of Accounting periods is called Expense for that
period.
Adjusting entry is also required to record Prepaid Costs.
Expenses are the expired portion of Assets.
Office supplies and Raw material are treated at the end of Accounting period. The balance of Office
supplies & Raw materials is calculated as follows:
Opening balance
Add: Purchases
Less: Closing balance
Prepaid Costs/expenses are initially taken as an Asset. Pre paid costs, if consumed entirely during
Accounting period are charged directly to expense
Types of Adjusting Entries
a) Entries to distribute expenditure benefiting more than one accounting period e.g. fixed assets, pre-paid
costs (if for more than one year). Pre-paid costs are initially taken as Asset and corresponding portion for an
accounting period is reduced there from. In the case of office supplies, raw materials, the formula is: - opening
balance + purchases-closing balance. This would give the amount/extent of official supplies, raw materials
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consumed during the accounting period. It must also be noted that pre paid costs, if consumed entirely during
accounting period, are charged directly to expense.
b) Entries to distribute un-earned revenue i.e. revenue collected in advance (deferred revenue). It is first
recorded as liability, and is gradually reduced in the subsequent accounting period.
c) Entries to record accrued expenses e.g. unpaid salaries, interest payable, to be paid in the subsequent
accounting period.
d) Entries to record accrued revenues. These are first recorded as Assets i.e. Revenue Receivable. For
example if rendering of services/delivery of goods is spread over a number of accounting periods, and billing
is to be done at the completion of rendering services or delivering goods, then corresponding adjusting entry
for each accounting period is made for Revenue Receivable, but not yet earned.
(5)
Preparing adjusted trial balance:
This is the fifth step in Accounting Cycle. In this, we take into account the adjusting entries made earlier in
step 4. Adjusting entries are journalized and posted, i.e. recorded in journal and posted in ledger.
In this both accumulated depreciation & deprecation expenses are recorded, accumulated depreciation after
fixed assets credited while deprecation expenses at end of trial balance & is debited.
(6)
Preparing Financial Statements:
Now we come to the all-important step of preparing Financial Statements from Accounting Records.
Income Statement/Profit & Loss account is prepared from Adjusted Trial Balance, first. Then Statement of
Owners equity between Income Statement and Balance Sheet is prepared. For this, Net profit/loss in Income
Statement is added to/ subtracted from owners equity in Owners equity Statement, and the total/net is then
transferred to Balance Sheet. After the preparation of Balance Sheet, the fourth Financial Statement i.e. Cash
flow Statement is prepared separately.
Financial Statements
Different reports generated from the books of accounts to provide information to the relevant persons.
Every business is carried out to make profit. If it is not run successfully, it will sustain loss. The
calculation of such profit & loss is probably the most important objective of the accounting function.
Such information is acquired from Financial Statements.
Financial Statements are the end product of the whole accounting process. These show us the
profitability of the business concern and the financial position of the entity at a specified date.
(a)
Profit & Loss Account (income statement):
Profit & Loss account is an account that summarizes the profitability of the organization for a specific
accounting period.
An income statement is a flow statement over a period of time matching the operating cycle of the business,
which reports the income of the firm.
Generally,
Revenue Expense = Income
In The Red- people say a company with a loss for a period is in the red because losses used to be
written in the books in red ink.
You will also hear the expression red ink, as in, if this new product fails, we will be swimming in red
ink.
(b)
Statement of Changes in Equity:
The statement of changes in equity shows the movement in the shareholders equity (capital and reserves)
during the year. We can say that it replaces profit and loss appropriation account of partnership business.
(c)
Balance Sheet:
Balance sheet is usually described as snapshot of an organization that shows us assets, liabilities & owners
equity at a certain time. Assets are financed by liabilities & owners equity. Liabilities & equity exist to
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finance assets. Assets exist to generate cash to pay off the liabilities, with enough left over to give the owners a
profit. This simply means that the shareholders own the assets & owe the liabilities. After we subtract what is
owed from what is owned, we have the actual stake the owners have in the company & the actual value of the
company. Balance sheet is the summarized analysis in a T form of all assets, liabilities & owners equity of
the entity, with assets listed on left hand side and liabilities & owners equity on right hand side or in report
form Assets on top & liabilities & owners equity below assets.
(c)
Cash Flow Statement
Cash flow Statement giving a picture of cash inflows (receipts) and cash outflows (payments) during the
accounting period. A cash flow statement shows the cash position of the firm and the way cash has been
acquired or utilized in an accounting period. A cash flow statement separates the activities of the firm into
three categories, which are operating activities, investing activities and financing activities. A cash flow
statement can be derived from P/L or Income Statement and two consecutive year Balance Sheets. A cash flow
statement is not prepared on accrual basis but rather on cash basis: Actual cash receipts and cash payments.
Notes to Financial Statements:
In addition to above, notes containing additional information (financial & non-financial) about the business are
also attached to financial statements.
(7) Closing entries:
The owners capital account and other balance sheets accounts are called permanent or real accounts, because
their balances continue to exist beyond the current accounting period. The process of transferring the balances
of the temporary account into the owners capital account is called closing the accounts. The journal entries
made for the purpose of closing the temporary accounts are called closing entries.
The revenue, expense, and drawing accounts are called temporary accounts, or nominal accounts, because they
accumulate the transactions of only one accounting period. At the end of this accounting period the changes in
owners equity accumulated in these temporary accounts are transferred into the owners capital account. This
process serves two purposes. First it updates the balance of the owners capital account for changes in owners
equity account occurring during the accounting period. Second, it returns the balances of the temporary
accounts to zero, so that they are ready for measuring the revenue, expenses, and drawings of the next
accounting period.
Revenue and expense accounts are closed at the end of each accounting period by transferring their balances to
a summary account called income summary. When the credit balance of the revenue accounts and the debit
balances of expense accounts have been transferred into one summary account, the balance of this income
summary will be the net income or net loss for the period. If the revenue (credit balances) exceeds the
expenses (debit balances), the income summary account will have a credit balance representing net income.
Conversely, if expenses exceed revenue, the Income Summary will have a debit balance representing net loss.
This is consistent with the rule that increases in owners equity are recorded by credits and decreases are
recorded by debits.
Closing Entries for Revenue Accounts
Revenue accounts have credit balances. Therefore, closing a revenue account means transferring its credit
balance to the Income Summary account. This transfer is accomplished by a journal entry debiting the revenue
account an amount equal to its credit balance, with an offsetting credit to the Income Summary account. The
debit portion of this closing entry returns the balance of the revenue account to zero; the credit portion
transfers the former balance of the revenue account into the Income Summary account.
Closing Entries for Expense Accounts
Expense accounts have debit balances. Closing an expense account means transferring its debit balance to the
Income Summary account. The journal entry to close an expense account, therefore, consists of a credit to the
expense account in an amount equal to its debit balance, with an offsetting debit to the Income Summary
account.
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Closing the Income Summary Account

Due to increase in net income owners equity increases. The credit balance of Income Summary account is,
therefore transferred to the owners equity account. Conversely if the expenses of a business are larger than its
revenue, the Income Summary account will have a debit balance, representing a net loss for the accounting
period .In this case, the closing of the Income Summary account requires a debit to the owners capital account
and an offsetting credit to the Income Summary account. The owners equity will, of course, be reduced by the
amount of the loss debited to the capital account.
Note that the Income Summary account is used only at the end of the period when the accounts are being
closed. The Income Summary account has no entries and no balance except during the process of closing the
accounts at the end of accounting period.
Closing the Owners Drawing Account
Withdrawals of cash or other assets by the owner are not considered an expense of the business and, therefore,
are not a factor in determining the net income for the period. Since drawings by the owner do not constitute an
expense, the owners drawing account is closed not into the Income Summary account but directly to the
owners capital account.
Revenue, Expense and Drawing (by owner) change owners equity. These are temporary capital accounts. To
make these Accounts ready for recording events of next accounting periods, we take the following steps: Close (transfer) Revenue Accounts to Income Summary Account.
Close (transfer) Expense Accounts to Income Summary Account.
Close (transfer) Income Summary Account to Owners Equity Account or Capital Account.
Close Drawing Account directly to Capital Account.
Debit and credit entries of course are involved in journal and ledger.
(8)
After-closing trial balance:
The final step in accounting cycle is preparation of after-closing trial balance. In many cases, another trial
balance is prepared after closing entries have been recorded in journal and posted in ledger.
Valuation of Stock:
Any manufacturing organization purchases different material through out the year. The prices of purchases
may be different due to inflationary conditions of the economy. The question is, what item should be issued
first & what item should be issued later for manufacturing. For this purpose, the organization has to make a
policy for issue of stock. All the issues for manufacturing and valuation of stock are recorded according to the
policy of the organization. Mostly these three methods are used for the valuation of stock:
Methods of Stock valuation
First in first out (FIFO)
Last in first out (LIFO)
Weighted average
First in first out (FIFO)
The FIFO method is based on the assumption that the first merchandise purchased is the first merchandised
issued. The FIFO uses actual purchase cost. Thus, if merchandise has been purchased at several different costs,
the inventory (stock) will have several different cost prices. The cost of goods sold for a given sales
transaction may involve several different cost prices.
Last in first out (LIFO)
As the name suggests, the LIFO method is based on the assumption that the recently purchased merchandise is
issued first. The LIFO uses actual purchase cost.
Weighted average method
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When weighted average method is in use, the average cost of all units in inventory, is computed after every
purchase. This average cost is computed by dividing the total cost of goods available for sale by the number of
units in inventory. Under the average cost assumption, all items in inventory are assigned the same per unit
cost. Hence, it does not matter which units are sold; the cost of goods sold is always based on current average
unit cost.
Bank Reconciliation Statements:
The process of reconciling business cash account records of receipts & payments with the bank statement
records of receipts & payments.
Petty Cash Book:
In almost all business it is found necessary to keep small sums of ready money in cash with the cashier for the
purpose of meeting small expenses such as postage, telegrams, etc.
The sum of money so kept in hand is generally termed as the petty cash and the book in which the petty cash
expenses are recorded is called petty cash book.
The Imprest System/Account:
The more scientific method of maintain petty cash so for introduced into practice is the imprest system. Under
this system a fixed sum of money is given in advance to the petty cahier to cover the petty expenses for the
month.
At the end of the month the petty cashier submits his statements of petty expenses to the chief cashier. The
chief cahier on the receipts of such statements refunds to the petty cashier the exact amount spent by him
during the month. Thus making the imprest for the next month the same as it was at the beginning of the
current month.
Final Account:
The term final accounts means statements which are finally prepared to show the profit earned or loss suffered
by the firm & financial state of affairs of the firms at the end of the period concerned.
1- Income Statements/The profit & loss Account/Statements of operations
2- Balance Sheet/ Position Statements/ State of Financial Condition
Work Sheet:
The work sheet is an analytical device which accumulate data for the adjusting * closing entries & working
paper for the accountant & for analyzing the trial balance in order to prepare the financial statements.
It should be noted that it is not a part of the accounting records.

It is simply a working paper which is prepared by the accountant for his own convenience.
It makes the construction of financial statements easy, convenient and accurate at the end of the year.
It is usually prepared in pencil
Fluctuation:
Fluctuation is the increase & decrease in market value of an asset.
Amortization:
The reduction in the value of an intangible asset taken as an expense written off in each accounting period.
Depletion:
The reduction in the value of a natural resource asset due to using up the natural resources.
Example:
Using up (depletion) of gravel deposits petroleum resources, or other natural resources properly/timber trees
etc.
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Reserves:
Reserve means an amount set aside out of profits or other surpluses either for the purpose of retaining profit in
the business as additional working capital or to provide for some anticipated loss/liability.
Capital Reserve and Fixed Asset Replacement Reserve are used for specific purpose. These are not distributed
among share holders. General Reserve and undistributed profit` can be distributed among share holders.
Revaluation Reserve is created when an asset is re-valued from cost to market value.
Revaluation Reserve can not be distributed among the share holders. It can be utilized for:
Setting off any loss on revaluation
At the time of disposal of asset, the reserve relating to that asset is transferred to profit & loss account.
Reserves Fund:
If the amount of reserve is invested outside the business in Govt: papers or in securities, then it is called
reserve funds.
Term Finance Certificate:
Term Finance Certificates are issued for a defined period. These are also issued to obtain loan from public at
large. Both Debentures and Term Finance Certificates are usually issued by Public Companies.
Marketable Securities:
Marketable securities are short-term investments, usually in U.S govt. securities or the commercial paper of
other firms. Securities have short maturities and stable prices, because of their liquidity these securities are
referred to as Near-Cash-Assets.
Commercial paper is the name for short-term promissory notes issued by large banks and corporations.
Account Receivables (Debtors):
Account receivables are amounts owned to customer who have purchased goods or services from the company
on credit.
Bad Debts:
When goods are sold on credit the business takes the risk that some of the customers may never pay for the
goods sold to them. When a debtor does not pay the amount due to him, it is said to be a bad debt.
This is a loss sustained as a result of a risk taken in the normal course of business. It is charged to Profit and
Loss Account in the period in which it is sustained.
Prepayments & Deferred charges:
Prepayment is insurance premiums paid in advance. The company has paid the bill, say for five years of
insurance coverage in advance. That prepayment creates an asset that will be used up over five-year period. So
it is carried as a long-term asset.
Deferred charges are similar. They represent money already spent that will yield a benefit in the coming years.
For example, research and development expenses for a new product may be allocated over the life of that
product. The company sets up an asset account for that amount so it can make that allocation.
Scrap Value/Residual Value:
The price/value at which an asset may sold at the end of its useful life.
Service:
A service is an activity or benefit offered for sale that is essentially intangible and does not result in the
ownership of anything.
Accounting principles
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Accounting principles may be defined as those rules of action or conduct which derived from experiences &
practices & when they prove useful, they become accepted as a principle of accounting. In the absence of
common principles there will be a chaotic situation and every accountant will have his own principles. Not
only the utility of accounts will be less but these will not be comparable even in the same business. Therefore,
it becomes essential that common principles should be followed for measuring business revenues and
expenses.
Essential Features of Accounting Principles:
Accounting principles are accepted if they satisfy the following norms:
Usefulness:
A principle will be relevant only if it satisfies the needs of those who use it. The accounting principles should
be able to provide useful information to its users otherwise it will not serve the purpose.
Objectivity:
A principle will be said to be objective if it is based on facts and figures. There should not be a scope for
personal bias. If the principle can be influenced by the personal bias of users, it will not be objective and its
usefulness will be limited.
Feasibility:
The accounting principle should be practicable. The principles should be easy to use otherwise their utility will
be limited.
Classification of accounting principles:

Accounting principles can be classified into two kinds:
1.
Accounting Concepts:
The term concepts include those basic assumptions or conditions upon which accounting is based. The
following are the important accounting concepts:
1. Business Entity Concept
2. Going Concern Concept
3. Money Measurement Concept
4. Cost Concept
5. Duel Aspect Concept
6. Accounting Period Concept
7. Matching Concept
8. Realisation / Realization Concepts
Business Entity Concept:
In accounting, business is treated as separate entity from its owners. Accounts are prepared to give information
about the business and not about those who own it. a distinction is made between business transactions and
personal transactions. Without such a distinction, the affairs of the business will be mixed up with the private
affairs of the proprietor and the true picture of the firm will not be available. The 'Business' and 'owner' are
taken as two separate entities. The accountant is interested to record transactions relating to business only. The
private transactions of the owner will be recorded separately and will have no bearing on the business
transactions. All the transactions of the business are recorded in the books of the business from the point of
view of the business as an entity and even the proprietor is treated as a creditor to the extent of his capital.
The concept of separate entity is applicable to all of business organizations. For example, in case of a sole
proprietorship business or partnership business, though the sole proprietor or partners are not considered as
separate entities in the eyes of law, but for accounting purposes they will be considered as separate entities. In
the case of joint stock Company, the business has a separate legal entity than the shareholders. The coming and
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going shareholders don not affect the entity of the business. Thus, the distinction between owner and the
business unit has helped accounting in reporting profitability more objectively and fairly. It has also led to the
development of 'responsibility accounting' which enables us to find out the profitability of even the different
sub-units of the main business.
Going Concern Concept:
According to going concern concept it is assumed that the business will exist for a long time to come.
Transactions are recorded in the books keeping in view the going concern aspect of the business unit. A firm is
said to be going concern when there is neither the intention nor necessary to wind up its affairs. In other words,
it should continue to operate at its present scale in the future. On account of this concept the fixed assets are
shown in the balance sheet at a diminishing balance method i.e., going concern value. There is no need to
show assets at market value because these have been purchased for use in future and earn revenues and not for
sale purpose. The concept also necessitates distinction between expenditure that will render benefit over a long
period and that whose benefit will be exhausted quickly, say within one year. The going concern concept also
implies that existing liabilities will be paid at maturity.
Money Measurement Concept:
Accounting is to records only those transactions which can be expressed in terms of money. Transactions or
events which cannot be expressed in money do not find place in the books of accounts though they may be
very useful for the business. For example, if a business has got a team of dedicated and trusted employees, it is
definitely an asset to the business, but since their monetary measurement is not possible, they are not shown in
the books of business. It should be remembered that money enables various things of diverse nature to be
added up together and dealt with. The use of a building and the use of clerical service can be aggregated only
through money values and not otherwise.
Cost Concept:
This concept is closely related to the going concern concept. According to this concept, an asset is ordinarily
recorded in the books at the price at which it was acquired i.e. at its cost price. This cost serves the basis for
the accounting of this asset during the subsequent period. The 'cost' should not be confused with 'value'. It
must be remembered that as the real worth of the assets changes from time to time, it does not mean that the
value of such an asset is wrongly recorded in the books. The book values of the assets as recorded do not
reflect their real value. They do not signify that values noted therein are the values for which they can be sold.
Though the assets are recorded in the books at cost, in course of time, they are reduced in value on account of
depreciation charges. The idea that the transactions should be recorded at cost rather than at a subjective or
arbitrary value is known as cost concept. With the passage of time, the market value of fixed assets like land
and buildings vary greatly from their cost. These changes in the value are generally ignored by the accountants
and they continue to value them in the balance sheet at historical cost. The principle of valuing the fixed assets
at cost and not at market value is the underlying principle in cost concept. According to them the current
values alone will fairly represent the cost to the entity. The cost principle is based on the principle of
objectivity. There is no room for personal assessment in showing the figures in accounting records. If
subjectivity is flowed in records the same assets will be valued at different figures by different individual.
Every body will have his own views about various assets. The cost concept is helpful in making truthful
records. The records become more reliable and comparable.
Dual Aspect Concept:
This is the basic concept of accounting. Modern accounting system is based on dual aspect concept. Dual
concept may be stated as "for every debit, there is a credit". Every transaction should have two sided effect to
the extent of same amount. For example, if A starts a business with a capital of $10,000. There are two aspects
of the transaction. On the one hand the business has assets of $10,000 while on the other hand the business has
to pay to the proprietor a sum of $10,000 which is taken as proprietor's capital. This expression can be shown
in the form of following equation:
Capital (Equities)
=
Cash (Assets)
10,000
=
10,000
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Accounting period concept:

According to this concept, the life of the business is divided into appropriate segments for studying the results
shown by the business after each segment. Since the life of the business is considered to be indefinite
(according to going concern concept) the measurement of income and studying financial position of the
business according to the above concept, after a very long period would not be helpful in taking proper
corrective steps at the appropriate time. It is, therefore, absolutely necessary that after each segment or time
interval the businessman must stop and see, how things are going on. In accounting such a segment or time
interval is called accounting period. It is usually of a year. At the end of each accounting period and income
statement/profit & loss Account and a Balance Sheet are prepared.
Matching concept:
The aim of business is to earn profit. In order to ascertain the profit the costs (expenses) are matched to
revenue. The difference between income from sales and costs of producing the goods will be the profit. When
business is taken as a going concern then it becomes necessary to evaluate the performance periodically. A
correct statement of income requires a distinction between past, present and future expenditures. A distinction
between capital and revenue expenditure is also necessary. The revenues and costs of same period are
matched. In other words, income made by the business during a period can be measured only when the
revenue earned during a period is compared with the expenditure incurred for earning that revenue. The
question when the payment was received or made is irrelevant.
Realization Concept:
This concept emphasizes that profit should be considered only when realized. The question is at what stage
profit should be deemed to have accrued? Whether at the time of receiving the order or at the time of execution
of the order or at the time of receiving the cash? For answering this question the accounting is in conformity
with the law and Recognizes the principle of law i.e., the revenue is earned only when the goods are
transferred. It means that profit is deemed to have accrued when property in goods passes to the buyer, viz.,
when sales are made.
2.
Accounting Conventions:
The term "conventions" includes those customs or traditions which guide the accountants while preparing the
accounting statements. The following are the important accounting conventions.
1.
2.
3.
4.
Convention of Disclosure
Convention of Materiality
Convention of Consistency
Convention of Conservatism
Convention of Disclosure:
The disclosure of all significant information is one of the important accounting conventions. It implies that
accounts should be prepared in such a way that all material information is clearly disclosed to the reader. The
term disclosure does not imply that all information that any one could desire is to be included in accounting
statements. The term only implies that there is to a sufficient disclosure of information which is of material in
trust to proprietors, present and potential creditors and investors. The idea behind this convention is that any
body who want to study the financial statements should not be mislead. He should be able to make a free
judgment. The disclosures can be in the way of foot notes. Within the body of financial statements, in the
minutes of meeting of directors etc.
Convention of Materiality:
It refers to the relative importance of an item or even. According to this convention only those events or items
should be recorded which have a significant bearing and insignificant things should be ignored. This is
because otherwise accounting will be unnecessarily over burden with minute details. There is no formula in
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making a distinction between material and immaterial events. It is a matter of judgment and it is left to the
accountant for taking a decision. It should be noted that an item material for one concern may be immaterial
for another. Similarly, an item material in one year may not be material in the next year.
Convention of Consistency:
This convention means that accounting practices should remain unchanged from one period to another. For
example, if stock is valued at cost or market price whichever is less; this principle should be followed year
after year. Similarly, if depreciation is charged on fixed assets according to diminishing balance method, it
should be done year after year. This is necessary for the purpose of comparison. However, consistency does
not mean inflexibility. It does not forbid introduction of improved accounting techniques. If a change becomes
necessary, the change and its effect should be stated clearly.
Convention of Conservatism:
This convention means a caution approach or policy of "play safe". This convention ensures that uncertainties
and risks inherent in business transactions should be given a proper consideration. If there is a possibility of
loss, it should be taken into account at the earliest. On the other hand, a prospect of profit should be ignored up
to the time it does not materialise. On account of this reason, the accountants follow the rule 'anticipate no
profit but provide for all possible losses'. On account of this convention, the inventory is valued 'at cost or
market price whichever is less.' The effect of the above is that in case market prices has gone down then
provide for the 'anticipated loss' but if the market price has gone up then ignore the 'anticipated profits.'
Similarly a provision is made for possible bad and doubtful debt out of current year's profits.
Critics point out that conservatism to an excess degree will result in the creation of secrets reserves. This will
be quite contrary to the doctrine of disclosure.
Letter of credit
L/C is a binding document that a buyer can request from his bank in order to guarantee that the payment for
goods will be transferred to the seller. Basically, a letter of credit gives the seller reassurance that he will
receive the payment for the goods. In order for the payment to occur, the seller has to present the bank with the
necessary shipping documents confirming the shipment of goods within a given time frame. It is often used in
international trade to eliminate risks such as unfamiliarity with the foreign country, customs, or political
instability.
Bill of exchange
An unconditional order issued by a person or business which directs the recipient to pay a fixed sum of money
to a third party at a future date. The future date may be either fixed or negotiable. A bill of exchange must be
in writing and signed and dated. It is also called draft.
MBA FINANCE
Cell # 03339668669
Wazir222@yahoo.com
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INTRODUCTION TO FINANCIAL MANAGEMENT

What is Financial Management?
FM is the procedure of managing financial resources as well as how to find and use best way of investments
and financing opportunities in an ever-changing and increasingly complex environment.
OR
Financial Management is concerned with the acquisition, financing, and management of assets with some
overall goal in mind.
Finance:
Finance is the art & science of managing financial resources in an optimal pattern i.e. the best use of available
financial sources
Financing:
The way in which a proposed purchaser intends to make up the difference between cash on hand and the
purchase price.
Financial Services:
The part of finance concerned with design & delivery of advice & financial products to individuals, business &
government.
Why should we study FM?
First of all, financial management is a core life skill; almost every one needs to understand some concepts of
finance to manage his business & personal finances.
It is generally and quite rightfully said, Money makes the world go round. Finance is like a life-blood for a
company. Even the best of the companies and CEOs go out of the business because of poor financial
management policies.
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Major Areas & Concepts of Financial Management

Following are some of the important areas and concepts of financial management,
(1)
Analysis of Financial Statements:
Analysis of financial statement is one of the most common techniques of financial management, in which the
financial performance and financial health of a company are analyzed based on its past performance. `
The following financial statements are used in the analysis process.
Profit & Loss Statement/Income Statement

Balance Sheet
Statement of Shareholders equity
Statement of Cash Flows
Taken together, these statements give an accounting picture of the firms operations and financial position.
Financial statements report what has actually happened to the assets, earnings, and dividends over the years.
The analysis of the information contained in these statements help management of the organization to evaluate
the performance and activities of the concern; it also helps the investors and creditors to have an idea of the
profitability potential and creditworthiness of the business.
(2)
Investment Decisions & Capital Budgeting:
Investment decisions are the most critical as they usually involve huge sums of money and these decisions are
likely to bring prosperity or doom to a business. A companys future income depends on how much investment
is made, in what type of assets, and how these assets add to the overall value of the company.
Capital Budgeting is the planning process used to determine a firm's long term investments such as new
machinery, replacement machinery, new plants, new products, and research and development projects.
Capital budgeting process is carried out for projects involving heavy initial upfront cost. Capital budgeting is a
term strictly related to investment in fixed assets; here, the term capital refers to the fixed assets that are used
in production, while budget is a plan which details projected cash inflows and outflows over some future
period. These projects can take any of the following forms: New project, Expansion project, Modernization /
Replacement, Research & development, Exploration, Other / social responsibility Pollution control etc.
The following concepts and techniques are employed while analyzing investment decisions.
Interest rate formulas
Time Value of Money
Discounted Cash Flows
Net Present Value
Internal Rate of Return
(3)
Risk & Return:
Investors, individual or institutional, invest their money with the expectations of earning a return on their
investment. While investors wish and attempt to earn maximum return, they are constrained by risk. How the
risks and returns are related and how do investors make a choice of their portfolios is important for investment
decision making. Following concepts and theories would be discussed while discussing the risk-return choices
of the investor:
(4)
Uncertainty
Risk
Portfolio Theory
Capital Asset Pricing Model
Corporate Financing & Capital Structure:
When a firm plans to expand, it needs capital or funds. Acquisition of funds is considered to be a primary
responsibility of a finance department in an organization. There are numerous ways to acquire funds, i.e.,
finances can be raised in the form of debt or equity. The proportion of debt and equity constitutes the capital
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structure of the firm. Financial experts attempt to find a combination of debt and equity that could increase the
overall value of the company, i.e., they try to find the optimal capital structure. The following concepts would
be used to understand how an optimal capital structure could be attained.
(5)
Cost of Capital
Leverage
Dividend Policy
Debt Instruments
Valuation:
Asset or company valuation is important not only for financial managers, but also for creditors and investors.
It is important to know the value of the company or its assets to make important financing and investment
choices. Different valuation techniques and factors that influence the value of a company or its financial
instruments would be discussed in this section.
Share
Bond
Option
Corporate
(6)
Working Capital & Inventory Management:
Working capital and inventory management pertains to the effective management of current assets. As we will
see, an optimal and effective utilization of working capital and inventory increases the operating efficiency of
the firm.
(7)
International Finance & Foreign Exchange:
With the increasing importance of international trade and global markets, the role of international finance has
increased manifold. In a global environment, the finance managers have more choices pertaining to investing
and financing than ever before. However, it is important to understand the implications of working in a global
environment, since fluctuations in the currency rates can convert a good financing or investment decision into
a bad one.
Internal Business Environment:
Internal environment of business normally consists of the following.
Finance
Marketing
Human Resources
Operations (Production, Manufacturing)
Technology
Other Functions (Logistics, Communications)
External Business Environment:
The following business environment factors outside an organization have a profound effect on the functions
and operations of an organization.
Customers
Suppliers
Competitors
Government/Legal Agencies & Regulations
Macro Economy/Markets:
Technological Revolution
SWOT Analysis
An analysis which is used in a business is called SWOT Analysis. SWOT is an acronym where
S stands for Strengths
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W stands for Weaknesses

O stands for Opportunities
T stands for Threats
Strengths and weaknesses are within an organization, i.e., they pertain to the internal environment of the
organization. Opportunities and threats, on the other hand, pertain to the external environment, i.e., outside the
organization.
OBJECTIVES OF FINANCIAL MANAGEMENT AS COMPARED TO ECONOMICS AND
FINANCIAL ACCOUNTING
Objective of Economics:
The objective of economics, as a subject, is profit maximization; however, the scope of economic profit
maximization is vast and loosely defined. In economics, we can talk about profit maximization for an
individual, the whole society, or a particular class or group. We can also talk about profit maximization for the
whole world in global terms. In social economics, we may study the social profit maximization for the
societies, whereas, in capitalistic economics we may study individual or companys profit.
Objective of Financial Management (FM):
In comparison, financial management is more focused. The objective of financial management, specifically, is
to maximize the shareholders wealth in the present terms. Financial practitioners usually use the discounting
and the net present value techniques while calculating the increase in the wealth of shareholders.
Objective of Financial Accounting (FA):

The objective of financial accounting is to collect accurate, systematic, and timely financial data and other
financial information, and to compile and consolidate it in an organized and systematic way, according to the
principles and rules of accounting, for reporting purpose.
The financial managers use these reports to assess the financial position of the company through various
financial management tools and then the financial position can be compared to, or benchmarked against, the
industry norms. The four different financial statements used for the purpose of reporting and analysis are
1. Balance Sheet
2. P/L or Income Statement
3. Cash Flow Statement
4. Statement of Retained Earnings (or Shareholders Equity Statement)
In financial accounting, assets are recorded on the basis of historical costs in the balance sheet, i.e., the assets
are recorded at their original purchase price. Of course, the depreciation on the asset is duly subtracted from its
original value as the asset remains in use of the business. However, in financial management, book value is
seldom used and financial managers consider the market value and the intrinsic value of assets.
FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is the process of examining relationships among financial statement elements and
making comparisons with relevant information. It is a valuable tool used by investors and creditors, financial
analysts, and others in their decision-making processes related to stocks, bonds, and other financial
instruments.
The goal in analyzing financial statements is to assess past performance and current financial position and to
make predictions about the future performance of a company.
Investors who buy stock are primarily interested in a company's profitability and their prospects for earning a
return on their investment by receiving dividends and/or increasing the market value of their stock holdings.
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Creditors and investors who buy debt securities, such as bonds, are more interested in liquidity and solvency:
the company's short-and long-run ability to pay its debts.
Financial analysts, who frequently specialize in following certain industries, routinely assess the profitability,
liquidity, and solvency of companies in order to make recommendations about the purchase or sale of
securities, such as stocks and bonds.
Three primary types of financial statement analysis are commonly known as horizontal analysis, vertical
analysis, and ratio analysis.
Fundamental Analysis:
Fundamental analysis at company level involves analyzing basic financial variables in order to estimate
intrinsic value. These variables include sales, profit margins, depreciation, the tax rate, sources of financing,
asset utilization, and other factors. The end result of fundamental analysis at the company level is an estimate
of the two factors that determine a securitys value: cash flow stream and a required rate of return
(alternatively, a P/E ratio)
Industry analysis
Industries as well as the market and companies, are analyzed through the study of a wide range of data,
including sales, earnings, dividends, capital structure, product lines, regulations, innovations, and so on.
Such analysis requires considerable expertise and is usually performed by industry analysts employed by
brokerage firms and other institutional investors.
Uses of financial analysis

Ratio analysis is used by three main groups:
Managers, who employ ratios to help analyze, control, and thus improve their firms operations;
Credit analyst, including bank loan officers and bond rating analysts, who analyze ratios to help
ascertain a companys ability to pay its debts; and
Stock analyst, who are interested in a companys efficiency, risk, and growth prospects.
Trend percentages/ Horizontal Analysis/ Index Analysis:
This type of analysis is directed at the comparison of figures of two or more accounting periods. It is done in
two steps.
As a 1 st step total difference between figures of the current year & previous year(s) is calculated.
In the 2nd step %age changes are worked out using previous year as a base year.
Common- Size Analysis/ Vertical Analysis/ Component percentages:
In this type of analysis all figures in the financial statements are converted to a common unit by expressing
them as %age of a key figure in the statement generally, total sales in the income statement & total assets in
the balance sheet are taken as a key figures. After these figures have been converted into %age they are 1 st
looked at vertically for each period to find out any unusual item & then they are compared with the %age
figures of other periods.
RATIOS ANALYSIS:
A ratio is a calculation that shows the relationship between two values. A financial ratio shows the relationship
between too financial statement accounts. Financial Ratios are like financial temperatures, which give the state
of the health of a business.
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This analysis technique is most widely used. In these inter-linkages of Income Statement and Balance Sheet
items are established and inferences are drawn there from.
Ratio analysis is the most common form of financial analysis. It provides relative measures of the firm's
conditions and performance. Ratios help us to compare different businesses in the same industry and of a
similar size.
Classification of Ratios:
Working capital
Working capital of the business is the net value of current assets & current liabilities.
Working Capital = Current Assets Current Liabilities
(a)
Liquidity ratios
Liquidity Ratios are used to measure a firms ability to meet short-term obligations.
They compare short-term obligations to short-term (or current) resources available to meet these obligations.
I.
Current Ratio:
Current ratio is a ratio between current assets and liabilities, which tells that for every rupee in current
liabilities, how many current assets do the company possess.
Generally, the higher the ratio, the better it is considered, but too high a ratio may imply less productive use of
current assets. A ratio of two to one (2:1) is considered ideal.
= Current Assets / Current Liabilities
Current assets should be twice the current liabilities. It should however be noted that too high ratio may
indicate that capital is not being used productively and efficiently. Such a situation calls for financial
reorganization.
II.
Quick ratio:
This is also called acid-test ratio. In this, inventories and pre-paid expenses are excluded from current assets.
Only cash, marketable securities and Receivables (called Quick Assets) are considered. For Quick Ratio, the
normal ratio is 1:1 i.e. quick assets should be equal to current liabilities. It should be noted that current ratio
measures general liquidity, whereas quick ratio measures immediate liquidity.
= (Current Assets Inventory- pre-paid expenses)/ Current Liabilities
IV.
Cash Ratio
= Cash Equivalents + Marketable Securities/ Current Liabilities
The cash ratio indicates the most immediate liquidity of the firm. A high cash ratio indicates that the firm is
not using its cash to its best advantages; cash should be put to work in the operations of the company.
(b)
Profitability ratios:
Profitability ratios measures the companys earning power & managements effectiveness in running
operations.
The profitability ratios show the combine effects of liquidity, asset management, and debt management on
operating result.
I.
Gross Profit Margin (on sales):
One of the most commonly used ratios is G.profit margin on sales. This ratio tells the percentage of profit for
every dollar of revenue earned. This ratio is usually expressed in terms of percentage and the general rule is,
the higher the ratio, the better it is.
= [Net Profit / Sales] X 100
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Operating Margin (on sales):
The operating margin measures operating income as a percentage of sales.

In contrast to the gross margin the operating margin measures managements effectiveness in the nonproduction areas of the company. It measures the contribution (or lack of contribution) of sales, administrative
and other non-production function.
= [Operating Profit / Sales] X 100
III.
Net Margin (on sales):
The net margin measures the bottom-line-net income-as a percentage of sales. This shows the percentage of
each sales dollar that the company manages to hang on to after production & operating expenses, after interest
& other expenses & after taxes.
= [Net Profit / Sales] X 100
IV.
Return on Assets (ROA):
It shows the profitability of the company against each dollar invested in total assets. We can obtain this figure
by simply dividing the net profit with total assets. Since the assets are economic resources that are used to earn
profit, it is logical to assess if the assets have been used efficiently enough to generate profits. This ratio is also
expressed in percentage terms.
= [Net Profit / Total Assets] X 100
V.
Return on Equity (ROE/ROI):
Return on equity is of special interest to the shareholders, since equity represents the owners share in the
business. Return on equity can be obtained by dividing the net income with the total equity. This ratio shows
that for each dollar in equity how much profit is generated by the company.
= [Net Profit /Common Equity] X 100
(c)
Asset management ratios:
These ratios measures show how effectively the firm has been managing its assets.
I.
Inventory Turnover:
Inventory turnover shows the number of times the inventories are replenished within one accounting cycle.
The ratio can be obtained by dividing the sales by inventory. The inventory turnover confirms whether or not
the major portions of the current assets of the firm are tied up in inventory. A higher turnover is desirable as it
reflects the liquidity of the inventories.
= Sales / inventories
II.
Total Assets Turnover:
An effective use of total assets held by a company ensures greater revenue to the firm. In order to measure
how effectively a company has used its total assets to generate revenues, we compute the total assets turnover
ratios, dividing the sales by total assets.
= Sales / Total Assets
(d)
Debt/solvency ratios (or capital structure):
Solvency is the capability of a company to pay its bills on time.

Long term solvency examine two elements
The first is the proportion of debts the company uses in its financial structure.
The second is its capability to pay the interest on the debt (that is to service the debt).
I.
Debt-to-Assets Ratio:
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A commonly used ratio to measure the capital structure of the firm is debt to assets ratio. Capital structure
refers to the financing mix (proportion of debt and equity) of a firm. The greater the proportion of debt in the
financing mix, the less willing creditors, and investors would be to provide more finances to the company. In
Pakistan, the debt to assets ratio is prescribed in prudential regulations by the State Bank of Pakistan as a
guideline for the banks (creditors). A ratio greater than 0.66 to 1 is considered alarming for the providers of
funds.
= Total Debt / Total Assets
II.
Debt-to-Equity Ratio:
It shows the proportion of debt to equity. The debt-to-equity ratio measures the extent to which the owners
are using debt-that is, trade credit, liabilities, & borrowings-rather than their own funds to finance the
company. Many analysts look for debt-to-equity of 1.0 or less. That means that half of the company financing
or less comes from debt. A ratio of 60 to 40 is used for new projects, i.e., for a project it is permitted to raise
its finances 60 percent from the debt and 40 percent from equity. Debt to equity is computed by the following
formula.
= Total Debt / Total Equity
III. Times-Interest-Earned:
Times-interest-earned reflects the ability of a company to pay its financial charges (interest). This ratio is
obtained by dividing the operating profit by the interest charges.
Conceptually, the interest charges are to be paid from the earnings before interest and taxes. A ratio of 4 to 1
shows that the company covers the interest charges 4 times, which is generally considered satisfactory by the
management, however, a ratio higher than that, may be more desirable. A high time-interest-earned ratio is a
good sign, especially for the creditors.
= EBIT / Interest Charges
IV.
Market Value Ratios:
Market value ratios relate the firms stock price to its earnings & book value per share. These ratios give
management an indication of what equity investors think of the companys past performance & future
prospects.
V.
Price Earning Ratio:
It shows how much investors are willing to pay per rupee of reported profits. This ratio reflects the optimism,
or lack thereof, investors have about the future performance of the company.
= Market Price per share / *Earnings per share
VI.
*Earning Per Share (EPS):

= Net Income / Average Number of Common Shares Outstanding
(e)
Activity ratios
Activity Ratios also known as efficiency or turn over ratios, measure how effectively the firm is using its
assets. Our focus is to attention on how effectively the firm is managing two specific asset groups-receivables
and inventories- and its total assets in general.
I.
A/C Receivables Turnover (RTO):
It shows have quickly Accounts Receivables are collected i.e. converted into cash. It is determined by
Receivable Turnover Ratio (RTO). It is number of times Receivables are converted into cash during the
year.
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= net sale for the year/ Average Receivables during the year.
II.
Average Collection Period:
Also known as Days Sales Outstanding, average collection period shows in how many days the Accounts
receivables of the company are converted into cash. Most of the companies sell most of their products/services
on credit basis, hence it is critical for the company to know in how much time these receivables could be
converted to cash in order to ensure liquidity at all times. Average collection period is calculated using the
following formula
= Average Accounts Receivable / (Annual Sales/360)
Note: Average collection period is usually expressed in terms of days. If you find a decimalized answer, you
should round it off to the next integer.
Limitations of Financial Statement Analysis:
Despite the fact that ratios are a useful analysis tool, there are certain limitations, which are important for an
analyst to understand before applying this tool, in order to make his analysis more meaningful.
FSA is generally an outdated (because of Historical Cost Basis) post-mortem of what has already
happened. It is simply a common starting point for comparison. Use Constant Rupee / Dollar analysis
to account for inflation.
FSA is limited by the fact that financial statements are window dressed by creative accountants.
Window dressing refers to the understatement or overstatement of financial facts.
Different companies use different accounting standards for Inventory, Depreciation, etc. therefore
comparing their financial ratios can be misleading
FSA just presents a few static snapshots of a business financial health but not the complete moving
picture.
Its difficult to say based on Financial Ratios whether a company is healthy or not because that
depends on the size and nature of the business.
FM Measures of Financial Health:

The financial management measures that are used for assessing the financial health of a company primarily
focus on the basic objective of financial management, i.e., to increase the wealth of the shareholders. Given
below are the two important measures of financial health.
Difference in Focus:
Financial Statements are prepared by financial accountants with a certain perspective, however the financial
managersthe end users of these financial statements, have a different focus to draw meaningful conclusions
out of these statements. These differences are listed below
Financial Accounting (FA) Focus:
Use Historical Value (assets are booked at original purchase price)
Follow Accrual Principle (calculate Net Income based on accrued expense and accrued
revenue)
How to most logically, clearly, and completely represent the financial data.
Financial Management (FM) Focus:
Use Market Value (assets are valued at current market price)
Follow Incremental Cash Flows because an Assets (and a Companys) Value is determined
by the cash flows that it generates.
How to pick the best assets and liabilities portfolios in order to maximize shareholder wealth.
M.V.A (Market Value Added):
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Market Value Added is a measure of wealth added to the amount of equity capital provided by the
shareholders. It can be determined by the following equation
MVA (Rupees) = Market Value of Equity Book Value of Equity Capital
Following are the characteristics of MVA
It is a cumulative measure, i.e., it is measured from the inception of the company to date. Market
Value is based on market price of shares.
It shows how much more (or less) value the management has succeeded in adding (or reducing) to the
company in the eyes of the general public / market.
It is used for incentive compensation packages for CEOs and higher level management.
E.V.A (Economic Value Added):
Economic Value Added, on the other hand, focuses on the managerial effectiveness in a given year. It can be
obtained by subtracting the cost of total capital from the operating profits of a company
EVA (Rupees) = EBIT (or Operating Profit) Cost of Total Capital
EVA has the following characteristics
It is measured for any one year.
It is relatively difficult to calculate because Operating Profit depends on Depreciation Method,
Inventory Valuation, and Leasing Treatment, etc. Also, a combined Cost of Total Capital (Debt and
Equity) is difficult to compute.
TIME VALUE OF MONEY:

FM Concepts:
There are certain financial management concepts that should be kept in mind, while making an analysis of a
financial decision. The one-liners given here would help you in committing these concepts to your memory.
A rupee today is worth more than a rupee tomorrow.

Time Value of Money & Interest
A safe rupee is worth more than a risky rupee.
Risk and Return
Dont compare apples to oranges.
Discounting & NPV
Dont put all your eggs in one basket.
Portfolio Diversification
Get insurance because you will break some eggs.
Hedging & Risk Management
Time Value of Money:
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The first concept, time value of money, says that a rupee in your hand today is worth more than the rupee that
you are going to get tomorrow or the day after. This is because if you have a rupee in hand, you can put it into
a bank (invest it) and can earn interest (return) on it, and tomorrow you are going to have more than rupee one,
which of course, is more desirable than having just one rupee.
Risk and Return:
Investors want to earn maximum return on their investment; however, risk is a constraint to this objective.
Investors dislike risk-bearing, unless they are adequately compensated for that. Now the risk and return
concept states that a safe rupee in your hand is better than a risky rupee which is not in your hand. This may
imply that the investors would be willing to bear risk if they are offered more than a rupee i.e., a certain
premium for risk bearing. However, in the absence of this additional compensation, a safe rupee is better than
a risky rupee.
Discounting & Net Present Value (NPV):
The third concept is of discounting and net present value of money. This is a fundamental mathematical
concept. Whether discounting for an asset or a company, we have to see what cash flow would it generate
during its future life and then we bring back those future cash flow to the present, i.e., we discount the future
cash flows to obtain their present value. This exercise is done to make comparison of cash flows occurring in
different time periods, i.e., comparing apples to apples, rather than oranges.
Portfolio Diversification:
The fourth concept is of portfolio diversification i.e. how to select different investment options so as to reduce
risk of losing the invested money. For instance if an investor has a million rupees and he invests his total
wealth in a single companys share, he would be exposed to greater risk. If the company goes out of business
or faces serious loss, the investor is likely to lose all his investment. However, if that investor puts his total
wealth into shares of ten different companies, the chances that all the ten companies would face loss is
comparatively lesser and hence the risk for the investor is diversified and reduced. The rule of finance says do
not put all your eggs in one basket, because if you drop the basket accidentally, you are likely to lose all the
eggs.
Hedging & Risk Management:
Finally, there is this fifth concept of hedging and risk management. Hedging is a strategy of risk management
that is employed by investors to reduce or minimize the chances of loss. Insurance is said to be an effective
tools used to manage risk. The concept of hedging and risk management says that whether you put your eggs
in one basket or in different baskets, chances are there that you will break your eggs so it is better to get the
eggs insured Insurance is the best way to avoid loss so that even if the loss occurs you may get a claim on your
damages.
Now, lets discuss the concept of interest in detail, first major & technical area in financial management.
Remember, that the basic objective in financial management is to maximize shareholders wealth.
Interest Theory:
Economic Theory:
Interest rate is an equilibrium price, expressed in percentage terms, at which demand and supply of funds (or
capital) meet, i.e., the rate at which the lenders are ready to lend and buyers are ready to buy. But equilibrium
price (Interest rate) varies from one market to another. For example, the price of capital in the property
market is different from the price of capital in the cotton market. Markets have different interest rates guided
by the supply & demand of funds in that market.
Although the interest rates in different markets may differ, however, all the markets in the country and the
interest rates prevailing there are interlinked.
Now, we come to the factors that determine the interest rates. It is important to understand the factors that
make up an interest rate in the present day business environment. In business when we talk about the interest,
we usually refer to nominal rate of interest which is determined with the help of following factors.
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Factors
i = iRF + g + DR + MR + LP + SR
i is the nominal interest rate generally quoted in papers. The real interest rate = i g , Here
i = market interest rate
g = rate of inflation
DR = Default risk premium
MR = Maturity risk premium
LP = Liquidity preference
SR = Sovereign Risk
The explanation of these determinants of interest rates is given as under:
Risk Free Interest Rate (IRF):
Factually speaking, there is no such thing as a risk-free rate of return because no investment can be entirely
risk-free. All the investments and securities include a certain amount of risk. A company may go bankrupt or
close down. However, if we talk about the relevant risk involved in different securities, the government-issued
securities are considered as risk-free, since the chances of default of a government are minimal. These
government issued securities provide a benchmark for the determination of interest rates. Internationally the
US T-Bills are considered as risk free rate of return.
In Pakistan, Government of Pakistan T-Bills can be used as a proxy for risk free rate of return, however, since
Pakistan faces some sovereign risk, the T-bills would not be considered entirely risk-free in the true sense.
Inflation (g):
The expected average inflation over the life of the investment or security is usually inculcated in the nominal
interest rate by the issuer of security to cover the inflation risk. For instance, consider a bond with a maturity
of 5 years. If the inflation rate in Pakistan is 8 % and the bond is also offering 8% percent interest rate, the
investors would not be willing to invest in the bond since the gains from the interest rate would be exactly
offset by the inflation rate which is actually eroding the wealth of the investor. To secure the investor against
inflation the issuers, while quoting nominal interest rates, add the rate of inflation to the real interest rate.
Default Risk Premium (DR):
Default risk refers to the risk that the company might go bankrupt or close down & bonds, or shares issued by
the company may collapse. Default Risk Premium is charged by the investor, as compensation, against the risk
that the company might goes bankrupt. Companies may also default on interest payments, something not very
unusual in the corporate world. In USA, rating agencies like Moodys and S&P grade securities (debt and
equity instruments) according to their financial health and thus identify those companies which have a good
ability to pay off their principal lending and interest charges and those which might default on the payments.
Maturity Risk Premium (MR):
The maturity risk premium is linked to the life of that security. For example, if you purchase the long term
Federal Investment Bonds issued by the government of Pakistan, you are assuming certain risk, because
changes in the rates of inflation or interest rates would depreciate the value of your investment. These changes
are more likely in the long term and less likely in the short term. Maturity Risk Premium is linked to life of the
investment. The longer the maturity period, the higher the maturity risk premium.
Sovereign Risk Premium (SR):
Sovereign Risk refers to the risk of government default on debt because of political or economic turmoil, war,
prolonged budget and trade deficits. This risk is also linked to foreign exchange (F/x), depreciation, and
devaluation. Now-a-days the individuals as well as institutions are investing billions of rupees globally. If a
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bank wants to invest in Pakistan, it will have to take view of Pakistans political, economic, and financial
environment. If the bank sees some risk involved it would be willing to lend at a higher interest rate. The
interest rate would be high since the bank would add sovereign risk premium to the interest rate. Here it may
be clarified that Pakistan is not considered as risky as many other countries of Africa and South America.
Liquidity Preference (LP):
Investor psychology is such that they prefer easily encashable securities. Moreover, they charge the borrower
for forgoing their liquidity. A higher liquidity preference would always push the interest rates upwards.
YIELD CURVE THEORY:
Term Structure and Yield Curve:
Interest rates for any security vary across time horizon. The supply & demand for funds vary depending on
how long the funds are required. Normally, short term interest rates are lower than long term rates, or we can
say that the interest rates depend on their term structure. Based on the maturity, the securities can be classified
into three categories.
Short Term: Short term means for the period of one year or less.
Medium Term: For the period of any where between one year to five years.
Long Term: Any where between 15 years to 20 years some people say that medium term is from 5
year to ten years and long term from 10 years to 20 years and plus.
Nominal or upward sloping yield curve:
The supply & demand of funds or capital varies depending upon how long funds are required. For example,
today the supply and demand for short term money might be different from supply and demand of the long
term money. In another words, the number of borrowers to take loan for one week may be different from the
borrowers of loan for one year. Short term interest may be different than the long term interest; normally, short
term interest rates are lower than long term than interest rates because investors think that inflation is going to
increase. This phenomenon results in nominal or upward sloping yield curve.
Abnormal or downward sloping yield curve:
Sometimes, the reverse is true. This is known as the Abnormal (or Downward Sloping) Yield Curve. It is the
case where the short term rates are higher than long term interest rates. You can also have a mixed or Humped
Back Curve.
Expectations Theory:
Investors normally expect inflation (and interest) to rise with time thereby giving rise to a normal shaped yield
curve.
Liquidity Preference Theory:
Investors prefer easily encashable securities with short maturities. The only problem is that short term
securities are easy to encash but at maturity there is no guarantee that you can renew it. so, you can find a
security today which will give you 25% or 30% per annum they are not always renewable hence
unpredictable.
Market Segmentation:
The demand/supply for Short Term securities is different from that of Long Term securities.
This can easily give rise to an Abnormal Yield Curve.
Now lets talk about the practical types of interest there are three kinds of interest we will talk about
1. Simple Interest (or Straight Line):
Simple interest incurs only on the principal. While calculating simple interest we keep the interest and
principal separately, i.e., the interest incurred in one year is not added to the principal while calculating interest
of the next period.
F V = PV + (PV x i x n)
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Example: Assume that you have Rs 100 today and you want to invest the amount with a bank for five years.
The bank is offering an interest rate of 7 percent. We can obtain the simple interest on the investment using the
aforementioned formula
F V = PV + (PV x i x n)
Here FV is the simple interest accrued for the term of the investment
PV is the amount invested, i.e., Rs 100 in our example
i stands for the interest rate offered by the bank, i.e., 7 % = 0.07
n is the term of the investment, which is assumed to be 5 years
Putting these values in the formula, we get
FV = 100 + (100 x 0.07 x 5)
FV = 100 + (7 x 5)
FV = 100 + (35)
FV = Rs 135
Here Rs 135 is the future value of investment after five years and Rs 35 is the interest accrued during five
years on the initial investment of Rs 100.
2. Discrete Compound Interest:
Discrete compound interest is the most commonly used tool in Financial Management Discounting and NPV
calculations. Unlike simple interest, compound interest takes into account the principal as well as interest
accrued for a term, while calculating interest incurred during the next term. i.e., interest incurred for one year
would be added to the principal to calculate the interest for the next period. However, this compounding of
interest takes place in a discrete manner, i.e., the compounding takes place yearly, semi-annually, quarterly, or
monthly.
Annual (yearly) compounding:
F V = PV x (1 + )
However, a slight modification in the formula is need if the compounding takes place monthly.
Such a compounding would be calculated using the following formula.
F V = PV x (1 + / m)
Here m refers to the compounding intervals during the term of the investment. In order to calculate monthly
compounding, the value of m would be 12; however, for quarterly compounding calculation m would be
equal to 4
Example:
Assume that the investor in our previous example is offered a compound return (interest) on his same
investment, at the same interest rate and term. The future value of the investment is given as under
FV = PV x (1 + )
FV = 100 x (1 + 0.07)
FV = 100 x (1.07)
FV = 100 x (1.40255)
FV = 140.255
Here the interest accrued on the five year investment is more than what we found out in simple interest.
However if the compounding is done every month the future value of investment would be
F V = PV x (1 + ( / m)
F V = PV x (1 + (0.07/12)
F V = PV x (1 + (0.005833)
F V = PV x (1.005833)
FV = 100 x 1.4176
FV = 141.76
With more frequent compounding, the wealth of the investor increases to a greater degree.
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3. Continuous (or Exponential) Compound Interest:

The other type of compound interest is exponential compound interest. In this compound interest an infinite
number of times per year at intervals of microseconds.
F V (Continuous compounding) = PV x
Here e is a constant the derived value of which is 2.718
Example:
Assume that the same investor has now the opportunity of investing at continuous compounding with the same
term and interest rate. His future wealth after five years is given as under
F V = PV x
F V = 100 x 2.718 ( . )
FV = 100 x 1.419
FV = 141.9
We can see that the wealth of the investor is the highest, when he decided to invest in a scheme which offers
continuous compounding.
The difference between simple and compound interest can increase manifold if the term of the investment is
increased. As we see in the following example
Example:
Suppose you deposit Rs 10 in a bank today. The bank offers you 10% per annum (or per year) interest. How
much money will you have in the bank after 15 years?
If the bank is offering simple interest:
FV = PV + (PV x i x n) = 10+ (10x0.10x15) = Rs. 25
If the bank is offering discrete compounding:
FV = PV x (1 + )
= 10 x (1 + 0.10)
= Rs. 42 approx.
Banks do not offer continuous compounding but if they did:
FV = PV x = 10 x (2.718) . = Rs. 45 approx
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FINANCIAL FORECASTING AND FINANCIAL PLANNING

Objectives of Financial Forecasting:
Although, financial planning and forecasting cannot reduce the uncertainty in our lives, the idea is simply to
acknowledge and identify different points in time, where we expect some future occurrences, and to prepare
plans and contingencies in the light of those forecasted happenings. Of course, we cannot be certain about the
future, but we can always plan and arrange for it.
1)
2)
3)
4)
Reduce cost of responding to emergencies by anticipating the future occurrences

Prepare to take advantage of future opportunities
Prepare contingency and emergency plans
Prepare to deal with possible outcomes
Planning Documents:
There are three types of documents that are to be prepared while making a financial plan. These are
1) Cash Budget
2) Pro Forma Balance Sheet
3) Pro Forma Income Statement
Here, the term pro forma refers to forecasting. These pro forma statements are prepared on the basis of
certain estimates.
Methods of forecasting
In order to prepare pro forma statements, two methods are commonly practiced, which are given as under
Percentage of Sales:
Simple
Cash Budget:
Detailed, more complicated
Percentage of sales:
Step 1: Estimate year-by-year Sales Revenue and Expenses
Step 2: Estimate Levels of Investment Needs (in Assets) required meeting estimated sales (using Financial
Ratios). That how the Assets of the company changes with the change in
Step 3: Estimate the Financing Needs (Liabilities)
Explanation:
While employing percentage of sales method, we would estimate the cash flows based on the sales revenue.
The first step is to forecast the changes in the sales revenue in the successive years.
Expenses incurring in successive period would also be estimated. These expenses include cost of goods sold
expense, administrative, expense, marketing expense, depreciation expense, and other expenses.
However, these revenues and expenses would be estimated on cash, rather than accrual basis.
After estimating the revenues and expenses, we need to forecast the anticipated changes in assets and liabilities
as a result of changes in sales. Having forecasted the assets and liabilities as a result of changes in sale, we
would be able to identify how much capital the firm has to invest in assets and how much the company needs
to borrow as a result of any shortfall. Here, we would examine the various heads of assets and liabilities and
their relationship with sales. We can establish these relations by identifying the changes in assets and liabilities
as a result of change in sales, and to do that certain assumptions need to be considered.
General assumptions
Current Assets:
Generally grow in proportion to Sales.
Fixed Assets:
Do not always grow in proportion to Sales. Ask if you need to expand property, office
or factory space, machinery in order to achieve your Sales target.
Current Liabilities:
Also called Spontaneous Financing. Generally grow in proportion to Sale
Long Term Liabilities: Also, called Discretionary Financing does not grow in proportion to Sales
Explanation:
Current assets include cash, marketable securities, accounts receivable, inventory, and prepaid expenses. Out
of these current assets, changes in cash, accounts receivable and inventory can be directly linked to changes in
sales. However, marketable securities and prepaid expenses are independent of sales, i.e., changes in sales may
not affect these two heads. It is also important to note that the current assets do not change exactly in the same
proportion as the sales in real life situation, i.e., an increase of 10 percent in sales may not necessarily
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guarantee that the current assets would also increase by 10 percent. However, for the sake of simplicity we
would assume that the current assets change proportionally as the sales change.
On the other hand, fixed assets do not change directly with a change in sales. For example, if you plan to
increase the sales revenue by 20% then it is not necessary to increase the fixed assets by 20%. But, if a
company plans to double its sales in the next three years, the company might have to increase its fixed assets;
however, small year-to-year changes in sales do not affect the fixed assets.
Current liabilities include accounts payable, short term portion of long term liabilities and accrued expenses.
Current liabilities like current assets are assumed to grow proportionally with any growth in sales. If the sales
of a company increase by 30 percent, its current liabilities would also increase by 30 percent. Current
liabilities are also called spontaneous financing since they move in direct relation with changes in sales.
However, the long term liabilities, also known as discretionary financing, do not directly change in proportion
to the changes in sales revenue.
In order to have a better understanding of the aforementioned concepts, let us take into consideration a
numerical example.
Example:
Assume that you are establishing cafeteria as a new business venture. In order to get your project funded you
would be needing capital. In addition, you would also need to forecast how your business would generate
revenues and incur expenses in the coming years.
Suppose you expect the Sales Revenue from your Caf (or Canteen) business to grow from Rs 200,000 to Rs
300,000 and your Expenses to grow from Rs 50,000 to Rs 70,000 after 1 year. These forecasts can be based on
the business environment in which the business operates, competition faced by the business, marketing efforts
and activities of the business and the target market.
The first thing we need to calculate here is the sales growth rate. The increase in the sales in Rupee terms is
300,000-200,000=Rs.100, 000. The sales revenue has increased up to rupees 100,000 rate of increase is 50%
as present sales were Rs.200, 000.
This means that the Sales Revenue growth rate is:
(300,000-200,000) / 200,000 = 0.5 = 50%
Similarly an increase in expenses of Rs 20,000 shows that the rate of increase in expense is 40% (i.e., increase
of Rs 20,000 in expenses divided by the expenses in year one).
After forecasting the growth rate in revenues and expenses, the next step is to estimate the changes in
investment and financing (i.e., changes in assets and liabilities).
In order to estimate these changes, we would need to calculate a few ratios.
In order to estimate the current assets for the next year, we need to calculate the ratio current asset to sales for
the current year. In order to arrive at the estimate of current assets for the next year we would simply multiply
the estimated sales for the next year with the ratio.
Estimated current assets for the next year
= [Current assets for the current year/Current sales] x Estimated sales for the next year
If we assume the current assets/sales ratio to be 20 percent, putting in the values in the aforementioned
equation, we get
Current assets for the next year = 300,000 x (0.2) = 60,000
This shows that with an increase in sales of Rs 100,000, the current assets of the cafeteria are likely to increase
as 20 percent of the sales.
We will assume here that there is no change in the fixed assets. As mentioned earlier, fixed assets do not
change with year-to-year changes in sales, however, over a period of time, the fixed assets may be increased as
the business requires expansion.
The next step is to forecast the retained earningsthe amount of profit which would be reinvested in the
business. Retained earning forecasting is important so that any shortfall in cash could be identified and the
amount of external financing necessary for the business could also be assessed.
Retained earnings can be estimated using the following formula
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Expected Estimated retained earnings

= estimated sales x profit margin x plowback ratio
Plow back ratio=1-pay out ratio
Pay out ratio=dividend/net income
Profit margin=net income/sales
Here, we assume that the profit margin ratio is 25 percent, whereas payout ratio of the cafeteria is 50 percent
Estimated retained earnings = 300,000 x 0.25 x (1-0.5)
=75,000*(1-0.5) =Rs.37, 500
Rs 37,500/- is predicted retained earnings amount which should appear in the pro forma balance sheet. It shoes
that half of the income will be distributed among the owners & the other half will be reinvested.
Now lets forecast the external or discretionary financing (external financing), since we have estimated the
revenues and expenses of the business, the changes in assets and the part of the net income that is to be
reinvested in the business.
The formula will be used:
Estimated discretionary financing
= estimated total assets estimated total liabilities estimated total equity
Estimated total equity can be found out by adding the retained earnings plus initial investment. The business
was started with an initial investment of Rs 100,000 and then after one year of operations the earnings retained
out of the profit, i.e., Rs 37,500 would be added to the equity. Hence the total equity is Rs 137,500.
Now we can easily solve the above given equation
Estimated discretionary financing
= estimated total assets estimated total liabilities- estimated total equity
=160,000-0-137,500= Rs.22, 500
This is the borrowing that we need to raise in form of loan or the equity, as a result of growth in sales.
After calculating the estimated revenues, expenses, assets and liabilities, we are in a position to prepare the pro
forma cash flow statement. The owners like to see the company to grow at a steady rate rather then high
growth & slump scenario. The shareholders prefer those companies where growth rate is steady and consistent
& the mangers need to make sure that the growth rate remains steady.
If you want to maintain the forecasted financial ratios that you have calculated and along with this we do not
want additional personal capital to be invested in the business, then at what rate the business is growing can be
calculated by the following formula
G (Desired Growth Rate) = return on equity x (1- pay out ratio)
Pay out ratio as defined above equals, dividends/net income.
Return on equity is net income/ total equity.
Drawback of Percent of Sales Method:
Despite the fact that percentage of sales method is widely used method for forecasting, it has certain
disadvantages.
The first and the foremost problem with this method is that it is only a rough approximation and is not very
detailed. The other problem is that if there is a change in fixed assets during the forecasted period the
percentage of sales method would not yield a very accurate answer. The third problem is that the lumpy assets
are not taken into account while using the percentage of sales method. Here, lumpy assets refer to those assets
which can only be acquired in large discrete units.
Summarizing the above discussion, we can say that in percentage of sales method of forecasting pro forma
cash flow statement most of the heads in the balance sheet are linked to the sales growth of the business. First
of all, we need to know the ratios of assets and liabilities to sales for the current period. These ratios are then
applied to the estimated sales for the next period to get a forecast of assets and liabilities for the next period.
After understanding the dynamics of percentage of sales method, and having prepared the pro forma income
statement and pro forma balance sheet, we are in a position to discuss the forecasted or pro forma cash flow
statement. A pro forma cash flow statement is just like an ordinary cash flow statement; the only difference is
that the figures in a pro forma cash flow statement are estimated figures rather than actual ones. The estimated
statement is later compared to the real after-effect cash flow statement to assess the quality of the estimate.
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After calculating the estimated sales revenue, we have already calculated the estimated net income of the
business, multiplying the estimated figure of sales for the next year with the profit margin ratio. Forecasted net
income gives the starting point for an estimated cash flow statement. If the assets are 20% of sales and
depreciation is10% of the assets then the depreciation is 10% multiply 20% which is equal to 2% of sales.
After calculating depreciation at 2%, you can calculate the forecasted depreciation this will appear in our
forecasted cash flow statement. Afterwards we would see the increases and decreases in current assets and
current liabilities. An increases in current assets and increase in current liabilities can be calculated using
constant percentage of sales approach. We can compare the forecasted cash flow with the actual cash flow
statement to know how much accurate our estimates are. If we use indirect cash flow then the first thing is our
net income plus depreciation, minus increase in current assets, plus decrease in current liabilities, would
provide us with cash flows from operations.
Present value and discounting:
Objectives of present value:
Present value is the current value of one or more future cash payments, discounted at some appropriate
interest rate.
The objective of calculating the present value is to translate the future cash flows in to present terms. The basic
principle is to compare apples with apples. For instance, if you have Rs.10 in your pocket today and then you
have may as many rupees ten years after, how can you compare the two. You can do it only by comparing both
amounts at the Present time.
We choose the present (today) as the most convenient point in time where we could compare all the cash flows
taking place at various points in time in future. We must compare everything at the SAME point in time
otherwise; we would be neglecting the Time Value of money concept.
For example, Rs 105 is more than Rs 100 BUT; Rs 105 after 1 year may not necessarily be more than Rs 100
today! We first have to first bring all cash flows to the Present, or Discount them, and then compare them. The
concept of present value says that we can compare both the amounts in the date of today we will bring back
future cash flows to the present.
Discounting:
Discounting is defined as bringing the future cash flow to the present time.
Before answering which amount is greater in the aforementioned example, we need to have some concept of
interest rates or the cost of money. An interest rate can also be understood as an opportunity cost.
One of the simple ways of estimating what opportunity cost or interest rate should be for our discounting
calculations, we can use interest rate given on the PLS accounts by the banks. For example, if money is
deposited in a bank and getting 10% per annum then it is interest or opportunity cost for you. This interest on
PLS account becomes minimum rate of return which any investment should be able to generate. Therefore, the
investment project should offer higher rate of return than the returns on the PLS account.
Now lets see the answer of the question that Rs.105 will be more one year later or Rs.100 today, and for this,
we need interest or opportunity cost. It is important to understand why interest rate is called opportunity cost?
Because, opportunity cost essentially means the cost of taking up one option while sacrificing the other. For
instance, when you deposit your money in the bank and get interest, you are sacrificing by
1) Not consuming the money to buy something for yourself and
2) Not investing your money elsewhere at a higher return than the bank interest.
Usually when an investment option is taken up, investors forgo the option of depositing the money in a bank
account and earn interest on that. The opportunity lost in this case is the opportunity cost. Now the question is
that what kind of interest rate should we use? There are many interest rates quoted in the schedules of the bank
but for discounting, the most commonly used rate is the nominal interest rate, or APR.
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Interest Rates for Discounting Calculations

Nominal (or APR) Interest Rate = i nom
It is usually published in newspapers .Annual Nominal Interest Rate is quoted for 1 year by Credit Card
Companies and Leasing Companies because it understates the actual (or Effective) interest you have to pay,
these companies want to create an impression that the interest charged by them is the minimum in the market.
Periodic Interest Rate = i per
Periodic interest rate is used in FM for Discounting and Present Value (PV) calculations.
It is defined as
i per = ( i nominal Interest rate) / m
Where
m = no. of times compounding takes place in 1 year i.e.
If semi-annual compounding then m = 2
Effective Interest Rate = i eff
It is very useful to compare securities and investments with different life or compounding cycles but not used
for Discounting and PV.
i eff = (1 + (
/ )) 1
Where m = no. of times compounding takes place in 1 year, the compounding cycle. The shorter the
compounding cycle more frequently money compounded & faster the money grows.
Coming back to our earlier example where we were trying to figure out whether or not Rs 100 of today are
worth more than Rs 105 a year after, while the periodic interest rate is 10 percent per annum. The interest rate
used here would be the nominal interest rate, i.e., 10 percent. When we are going to solve for the present value
we are discounting from the future to the present
PV = FV/ (1 + )
Where, i=interest rate
N=no. of years if we plug in the values
PV = 105/ (1 + 0.10) = Rs.95.45
Now we can see that if we discount Rs.105 from future to the present that is only the worth of Rs.95.45 which
is less than Rs.100. The amount offered in the future is seemingly more but when converted to present value,
the worth it has today, it come out to be less than Rs 100. Thus, it is clear that Rs100 today worth more to Rs.
105 one year later. This conclusion is drawn on the assumption that interest rate is 10%, but if we change the
interest rate, the answer might be different.
Now the point to understand is that if we discount back this money from 2 years back we would have only
approximate Rs.87 in other words if Rs 105 are to be received after two years, the present value of would be
even lesser.
If you discount Rs 105 two years from now, you will have lesser amount than you have one year from today.
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Cafe Case Study:

Suppose you are thinking about starting a small caf or canteen inside a university campus. You make a simple
feasibility report showing the estimated initial investment and the forecasted cash flows for the first Year
(based on expected cash receipts from sales and cash payments for expenses).
The Key Financial Data is as follows:
Initial Investment = Rs 100,000

Forecasted Cash Receipts (end Year 1) = Rs 200,000
Forecasted Cash Payments (end Year 1) = Rs 50,000
Forecasted Future Investment (end Year 1)=Rs30,000
Periodic Interest Rate (Opportunity Cost) = 10% p.a.
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First step is to represent the phenomenon through a diagram in the form of cash out flows.
First of all, we can see the initial investment represented by the downward arrow. We have also forecasted the
sales one year from now that is Rs.200, 000. This is a cash inflow for the business and is represented by an
upward arrow; similarly, the expenses and investments (cash outflows) that we expect in future, will be shown
by the downward arrows. In the diagram there are three arrows, the upward one is showing forecasted sales
(cash inflow) and two arrows downward show expenses of Rs.50, 000 and invest outlay of Rs.30, 000
respectively. Now the combined effect of the three arrows can be represented by a single arrow. We can see
that cash inflow of Rs.200,000 is having a +ve sign and expenses of Rs.50,000 and investment out lay of
Rs.30,000 have ve signs and finally, by deducting the negative signed figures from the positive one we can
arrive at the net effect of the cash inflows and outflows, which is given as under
200,000-50,000-30,000 =Rs 120,000.
These different arrows can be added or subtracted because they are occurring at the same point of time and
Rs.120, 000 can be shown by one arrow sign. In order to calculate the present value of Rs.120, 000, rate of
interest as discount factor should be 10% per year.
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Calculating the NPV of the Caf Business for 1st Year:

NPV = Net Present Value (taking Investment outflows into account)
NPV = -Initial Investment + Sum of Net Cash Flows from Each Future Year.
NPV = - Io +PV (CF1) + PV (CF2) + PV (CF3) + PV (CF4) + ...+ 8
Note that PV (CF1) means the Present Value of Future Net Cash Flow (CF) taking place at the end of Year 1.
CF is like the FV in our interest formulas. Our compounding cycle is 1 year so the Periodic Interest Rate is
10%.
Present Value of Net Cash Flow from Year 1 =
PV (CF1) = CF1/ (1 + ) = 120,000/ (1 + 0.1) = Rs 109,000
The value of money has shrink from Rs.120, 000 to 109,000 as the concept of time value of the money
suggests and now we are in position to calculate the net present value of the money:
NPV = - Io + PV (CF1) = -100,000 + 109,000 = + Rs 9,000
The NPV of our Business after 1 Year is Positive Rs 9,000 which is a good sign. We will discuss this topic in
more detail in capital budgeting.
Discounting cash flow analysis, annuities and perpetuities
This lecture is continuation of the previous lectures topics. In the previous lecture, we had discussed the
calculation of the Net Present Value (NPV) and the use of the value of interest rate or Opportunity cost in the
process. Bank Interest on the PLS Account represents the Minimum Opportunity Cost of our investment. A
good investment opportunity should, however, offer a higher return than the Bank Interest rate. We also used
the time & arrow diagram to show the cash flows forecast. In the diagram, we used upward pointing arrow to
represent the cash inflows & downward pointing arrow are used to represent the cash outflows. You can
simplify that diagram by arithmetically solving the upward & down ward pointing arrows at same point in
time by showing it with one arrow. (see Fig)
Use Downward Pointing Arrows to show Cash Outflows (Cash Payments or Expenses or Investments). Use
Upward Pointing Arrows to show Cash Inflows (Cash Receipts ie. Cash Revenue or Income)
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The arrows in time-and-arrow diagram can be added and subtracted when they are on same point in time but
when these arrows are at the different point of time these cannot be added or subtracted.
Now, lets talk about some common cash flow patterns the most common is called annuity.
Annuity:
An annuity is a series of fixed payments, which might be over a fixed number of years, or over the lifetime of
an individual, or both. The commonly known types of annuities we see are the monthly rent, and monthly
mortgage payments, or insurance premiums.
There are two types of annuities
1. Ordinary Annuity
An ordinary annuity, also known as deferred annuity, consists of a series of equal payments at the end of each
period.
2. Annuity Due
An annuity due consists of a series of equal payments at the beginning of each period.
Value of Annuity depends on the Constant Cash Flows (CCF) (over a limited or finite period of time) and the
Discount Factor (which is different for Annual or Multiple Compounding)
Annual Compounding (at end of every year):

FV = CCF (1 + ) -1
For example, the payment of Rs.10,000 as monthly rental to the land lord is an annuity which gives birth to an
annuity stream. Future value of an annuity can be seen as follows:
Future value of annuity =constant cash flows x ( + ) -1/i
Where, i=interest rate
n=no. of years
We can write this formula in smaller compounded form which describes a compounding cycle given as under:
Multiple Compounding:
Future Value of annuity =CCF (constant cash flow) x ( + / ) -1/i/n
Once we have calculated the
future value of the annuity, it is very easy to calculate the present value using the well-known interest rate
formula.
Annual Compounding (at end of every year)
PV =FV / (1 + i) . n = life of Annuity in number of years
Multiple Compounding:
PV =FV / [1 + (i/m)]( + ( / )
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i = % interest per year

More than once per year i.e. Monthly (m =12), Quarterly (m=4), Six-monthly (m=2).
n = number of years
Now lets talk about another kind of cash flow pattern called perpetuity.
The difference between Annuity and Perpetuity is that the Perpetuity is an ongoing concern, it is never ending
stream of annuities, whereas an annuity is for a limited period.
Perpetuity:
It is defined as an annuity with an infinite life making continual payments.
In real life, we see the example of perpetuity in the retirement plan. For Example, you might plan to save a
sufficient amount of money & invested in a particular security or investment that will give you steady &
consistent rate of return on every month or quarter and this represents a constant cash flow amount that we can
assume to go as long as you live. Since we are not sure how far we are going to live and we make an infinite
series of annuities the formula of Future value of Perpetuity is simpler than that of annuity:
Future value of perpetuity=constant cash flow/interest rate
As we assume that, it is never ending and on going so time is irrelevant and is simply dropped out of the
equation.
Lets do a simple numerical example which will help us what an annuity calculation is like
Example:
Assume that we need to make a basic financial decision, whether to purchase a particular asset or to get it on
lease (installments).
A car has a Market Value today of Rs 150,000. If you get the car on Lease Financing, then you are required to
pay a fixed regular rental at a fixed interest rate to the Leasing Company. You are allowed to use the car but
the ownership of the car stays in the name of the Leasing Company until you complete all your rental
payments. The question is whether you should Lease the car or Buy it?
The Leasing Company quotes Rs 120,000 every year for 2 years in the form of Car Lease Rental at a Nominal
rate of interest (APR interest rate) of 20% pa. Then what is the total Future Value you would have paid after 2
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years? You would be paying approximately Rs 240,000 if you do not take into account the time value of
money.
Now we calculate the present value of the investment by using Time value of money concept.
First, we need to calculate the future value by using annuity formula
FV =CCF (1 + ) - 1]/ i
=120,000[ (1 + 0.2) -1]/0.2
= Rs 264,000 (yearly compounding)
If we deposit the amount annually in a bank at the rate of 20 percent, we would be able to get Rs 264,000 at
the end of the second year. Now we will calculate what the present value of this future value is going to be,
and for this, we will use the old interest rate formula
PV = FV/ (1 + )
= 264,000 / (1 + 0.2)
= Rs 183,333
The resulting amount is about Rs 33,000 more than what we would have originally paid if we had bought the
car rather than lease it
The above calculation, however, was not based on realistic assumptions because car lease rentals are generally
paid monthly, rather than annual payments. In fact, you pay Rs 10,000 per month for 2 years. We use periodic
interest rate (i/m). Now, what is the future value after 2 years? Our cash flow diagram should present the
monthly installments & not annual Payments.
It can be argued that by paying a rental of 10,000 monthly, we are actually paying Rs 120,000 in a year, so
there hardly any difference. But, by not realizing the difference, one is violating the time value of money
because cash flows occurring at different points of time cannot be subtracted or added.
It is the cardinal principle of Time value of money.
If we have to calculate the future value of the annuity on a monthly basis, we would use the following formula.
= CCF X {( + ( / ) -1}/i/m}
Now the m= 12 compounding cycle in a year
Putting the values in the formula, we obtain the result as under.
FV2=Rs 292,150
Now, we can calculate the present value of the future value of annuity
PV = FV / (1+i) n
=292150/(1+.2/12)2x12
=196,481
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The present value of annuity can also be called the intrinsic value of the annuity.
The aforementioned technique allows us to compare the amount of money we are paying to leasing company
with the market value of car. It helps you to decide whether you should buy the car on market price or to get it
leased. The cost of leasing at 20% p.a. tell us that you have to pay 20% interest & you have to pay more
money in leasing as compare to the decision if you buy it .
Perpetuity Example - Retirement Planning
You would like to retire at the age of 60 and receive an income of Rs. 200,000 every year from your Bank
Account for as long as you live. How much money do you need to deposit in the Bank Account offering 10%
pa so that the Account will pay you Rs 200,000 of interest income every year forever (even though you will
not live forever)!
PV = CCF / i = 200,000 / 0.10 = Rs 2,000,000
This also implies that you would be receiving Rs 200,000 every year for the rest of your life and the money
would neither finish nor decrease in amount. This would happen so, because what you would be receiving at
the end each year would be interest accrued on the investment that you have made. The money that you are
getting is not a part of the investment; instead, it is the yield on your investment.
This may sound like a big idea for making money, but in fact, it is not so. Inflation, a macroeconomic
syndrome erodes the value of money constantly. If the prevailing inflation rate is 5 percent, then your real
return on investment is not 10 percent. If we consider the real rate of return, which is interest rate rate of
inflation, you would see that you need to invest twice as much to guard yourself against inflation.
Another example for perpetuity is Consol Bonds. Consol Bonds were issued by the British Government in
18th century to pay off the smaller bonds that were issued to fund the wars against France. Since the purpose
of the bond was to consolidate the past debts, it was named as Consol. These bonds were just like other bonds
issued by the government, with the difference that it had no maturity. It implies that the holder of the bond was
to receive regular interest payments for an endless period.
Now if we have to invest in such a bond we need to know the price or the present value of the bond. Dividing
the interest payment that a Consol bondholder would receive, by the interest rate, we can find the present value
of a Consol bond. Suppose that the interest rate is at 10 percent and the promised interest payments to be
received are 1,000 every year, the price of the bond can be calculated as under
PV = CCF / i = 1,000/ 0.10 = 10,000
With this example, the discussion on discounted cash flows, annuities, and perpetuities is concluded.
Capital budgeting and capital budgeting techniques:
The procedure of managing capital assets by means of a capital budget. This may cover a yearly or longer
period.
OR
Capital budgeting is about investment in fixed assets. Fixed assets are the part of long-term assets in the
balance sheet.
We need to understand why capital budgeting is so important and why do we have to invest in fixed assets?
The answer is simple; the equipment or machinery and other fixed assets depreciate over a period, they lose
their productivity and get obsolete after sometime. These assets need to be replaced with new assets. This
replacement involves investment in fixed assets.
Moreover, if a company intends to start a new project, Capital Budgeting techniques are employed to assess
the financial viability of the project. Suppose, for instance, a company wants to introduce a new soap and
launching of the new product demands changes in the manufacturing process, the company will have to
purchase new equipment in the form of fixed assets. Capital budgeting is a technique used to evaluate the
value of investment and projects in fixed assets. It is also used to assess the working capital requirements.
Combined together it helps the company management to decide whether the new venture should be taken up or
not.
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Capital budgeting is a decentralized function. In big corporations, this function is not an individuals job,
rather, different departments and teams are assigned to work on different aspects of capital budgeting.
Department managers prepare the budget for fixed assets in coming years, which is quite helpful in capital
budgeting. Besides, there are project managers who make the budget for a new project; the cost accountants
count the cost and assess the expenses to be incurred; the market researches provide their input about the
consumer psychology and sales potential. There may be as many departments involved in capital budgeting, as
there are present in an organization.
The biggest challenge in capital budgeting is to keep finding the valuable projects, i.e., projects that may add
to the value of the firm. You must be familiar with the basic objective of financial management by now, which
is to maximize shareholders wealth. This is possible only by investing in the projects, which have positive net
present value, which in effect will increase the shareholders wealth.
Techniques of capital budgeting:
Capital budgeting is a mathematical concept in the sense that we have to use different quantitative investments
criteria to evaluate whether an opportunity is worth investing in or not.
Some of these techniques of capital budgeting are as under
1. Pay back period
2. Return on investment (ROI)
3. Net Present Value (NPV)
4. Profitability Index (PI)
5. Internal Rate of Return (IRR)
We will assume that the interest rate, or the discount rate, or the required of return, which we use in calculating
the net present value is given, later on, when we will discuss the concept of risk, we would see how the
discount rate is calculated .
For now, let us talk about the pay back period.
Pay back period:
In this technique, we try to figure out how long it would take to recover the invested capital through positive
cash flows of the business.
Reverting back to the cafe example, an initial investment of Rs. 200,000 is required to start the business; Rs
10,000 per month are expected to be earned for the first year, and Rs 20,000 would be earned every month in
the second year.
Now according to the aforementioned assumptions, in the first year, you earn Rs.10, 000 per month, which
make Rs. 120,000 for the year (twelve months). Since you had invested Rs. 200,000 initially of which Rs.
120,000 have been recovered in the first year, you are still Rs.80, 000 short of recovering your initial
investment. In the second year, you would be earning Rs. 20,000 per month, so the remaining Rs. 80,000 can
be recovered in the next four months. We can say that the initial invested capital can be recovered in 16
months, or the payback period for this investment is 16 months. The shorter the payback period of a project,
the more an investor would be willing to invest his money in the project.
While the payback period is a simple and straightforward method for analyzing a capital budgeting proposal, it
has certain limitations. First and the foremost problem is that it does not take into account the concept of time
value of money. The cash flows are considered regardless of the time in which they are occurring. You must
have noticed that we have not used any interest rate while making calculation.
Now, let us talk about the next budgeting criteria called return on investment.
Return on Investments:
The concept of return on investment loosely defined, as there are a number of ratios that can be used to
analyze return on investment. However, in capital budgeting it implies the annual average cash flow a business
is making as a percentage of investment. In other words, it is an average percentage of investment recovered in
cash every year.
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The formula for return on investment is as follows:

ROI= (CF/n)/ Io
Dividing the average annual cash flow by the initial investment, we can calculate the return on investment.
Example:
Taking the same example of a caf, the initial investment of Rs.200,000, Rs 10,000 per month profit in the 1st
year in Rs 20,000 per month profit for the second year, we can easily calculate the ROI.
ROI= ((120,000+240,000)/2)/200,000= 0.90 = 90%
Where, Rs 120,000=cash flow for 1st year at Rs 10,000 per month
Rs 240,000=cash flow for the 2nd year at Rs 20,000 per month.
n=2 years
Return on Investment is also very easy to calculate, but like payback period, it does not take into account the
time value of money concept.
A high ROI ratio is considered better and 90% is a very good rate of return but before deciding whether or not
this project should be taken up, we should compare this project with the alternative opportunities on hand. It is
also important to take into consideration the prevailing rate of inflation in the country so that the returns could
be adjusted accordingly.
The next and the most important criteria for evaluating a capital budgeting proposal is net present value.
Net Present Value (NPV):
NPV is a mathematical tool which uses the discounting process, something that we have found missing in the
aforementioned capital budgeting techniques. Net Present Value is defined as the value today of the Future
Incremental After-tax Net Cash Flows less the initial investment.
NPV=-IO+CFt/(1 + )
Where,
CFt=cash flows occurring in different time periods
-IO= Initial cash outflow
i=discount /interest rate
t=year in which the cash flow takes place
Initial cash outflow, being an outflow, is always expressed as a negative figure.
NPV is considered one of the most popular capital budgeting criteria. The disadvantage with the NPV is that it
is difficult to calculate since these calculations are based on too many estimates.
In order to calculate the NPV we need to forecast the future cash flows and sales; the discount factor is also an
estimate. If the NPV of a project is more than zero, it should be accepted. If two or more projects under
contemplation, then the one with the higher NPV, should be accepted. When a company invests in projects
with positive NPV, they raise the shareholders wealth or companys value. This would also increase the
market value added and the economic value added for the firm.
Example:
Taking the same example of a caf, an initial investment of Rs.200,000, Rs 10,000 per month profit in the 1st
year & Rs 20,000 per month profit for the second year. However, for the calculation of the NPV we would be
requiring another important inputthe discount rate. Assume the discount rate is 10 percent. Ten percent is
what you at least expect to earn from the business. This is the rate of return, which you can get by simply
putting your money with a bank. If the business cannot yield more than 10 percent, then it is pointless to take
unnecessary headache of setting up a business and running it, since ten percent can be earned with a no-sweateffort of placing the money with a bank.
Where,
CFt=cash flows occurring in different time periods, i.e., Rs 120,000 in the first year and Rs
240,000 in the second year
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-IO= Initial cash outflow = -200,000

i=discount /interest rate = 10 percent
t= 2 years
Putting in the values in the formula
NPV=-IO+CF/i
=-200,000+120,000/ (1+0.10)+240,000 (1 + 0.10)
= -200,000 +109,091+198,347
=+Rs.107438
At the end of 2nd year, the NPV is +ve, you can also solve this example by monthly compounding if you want
to have a more precise answer.
The cash flows at the end of the first year and second year will have to be brought back to the present.
The present value of the cash flows occurring at the end of the first year can be calculated by dividing the cash
flows by 1 plus discount factor as under.
120000/ (1+0.10) = 109,091
The cash flow occurring at the end of the second year can be calculated by dividing the cash flow by one plus
discount factor squared.
240,000/(1 + 0.10) = 198,347
NPV=-2000000+120000/(1+0.10)+240000/(1+0.10)2
=-200000+109091+198347
=+Rs.107438 at the end of second year NPV is +ve
In other words, according to your cash flow forecast and required return, two years of running this business is
worth Rs 107,438 in cash to you today. The following diagram can explain the point further.
The next criterion that we would talk about here is the profitability index, or the cost-benefit ratio.
Probability Index:
It is quite similar to the NPV in terms of concept and calculation. Profitability index may be defined as the
ratio of the present value of future cash flows to the initial investment.
The profitability index can be calculated using the following formula.
PI={CFt/( + ) } / IO
Those projects with a profitability index ratio of more than one (PI >= 1.0) are considered acceptable. Here it
is important to mention that those projects, which are ranked as acceptable using the NPV method, would also
be acceptable on the profitability index criteria.
Example: The profitability index for the caf example can be calculated as under.
PI = [120,000]/ (1+ 0.1) + [240,000 /(1 + 0.1) ]/200,000
= (109,091 + 198,347) / 200,000 = 1. 54
PI = 1.54 > 1.0
Therefore, the project is acceptable. Notice that we have taken into consideration the annualized return. The
same can be calculated using the monthly returns with a slight adjustment in the formula as we have studied in
the previous lectures. If there were two or more projects that need ranking, the one with the highest
profitability index would be acceptable.
Let us now talk about the fifth and the final capital budgeting criteria, known as Internal Rate of Return (IRR).
Internal Rate of Return (IRR):
IRR is a widely used and an important measure, which is more common in practice than the NPV. IRR, unlike
NPV that is expressed in dollar amounts, is always quoted in terms of percentage, which makes it comparable
to the other market interest rates or the inflation rate.
IRR calculation involves the same equation that we have earlier used for the calculation of NPV.
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The only difference is that while calculating IRR we would set the value of NPV equal to zero and then solve
the equation for the value of i. In other words, the value of i, at which the net present value of the project
equals zero would be considered as the internal rate of return of the project.
This is important to remember that unlike NPV calculation, the value of IRR is constant in every year for the
life of the project. While working out the NPV, we can change the discount rate for every single, but for IRR
you would come up with a rate that is constant and fixed for every single year in the life of the project.
Another simplistic explanation of IRR can be that it is the break-even rate of return.
In other words, at this rate of return, we would be able to recover the initial investment in projects lifetime.
IRR is calculated by a trial and error method or iteration. Finding the value of an unknown variable may
involve solving of higher degree polynomial equations and the easiest way to go about it is to use trial and
error method.
In a trial-and-error method, we tryout a value of i, and see if the equation comes to the value of zero; if it
does not, try another value, even if the second value does not bring the equation down to zero and so on. The
higher the IRR, the better it is considered, however, which value of the IRR can be considered as acceptable is
difficult to measure.
Another important distinction needs to clarification here is that the internal rate of return is different from the
discounting rate that we use in the calculation of the NPV. In the NPV formula, we used the discount rate as
the required rate of return that we expected the project to generate. In case of IRR, we used the existing cash
flows to find the forecasted return. These two different interpretations of
i should be kept in mind while calculating NPV and IRR.
We can calculate the IRR for the caf project in the following manner. Using the same formula of NPV, we
can put the values in the formula
IRR Equation:
NPV= -IO +CF1/ (1+IRR) + CF2/ (1 + IRR)
= 0= -200,000 + 120,000/ (1+0.1) + 240,000/ (1 + 0.1)
Solving the equation assuming IRR to be 10 percent, we have obtained a figure of 107,483, which was
calculated as our NPV for the caf project. However, in order to bring the NPV down to zero, we need
to
apply a higher rate as an assumed IRR. If we assume IRR to be 50 percent the equation can be solved as
follows.
NPV= -IO +CF1/ (1+IRR) + CF2/ (1+IRR)/(1 + IRR)
= 0= -200,000 + 120,000/(1+0.5) + 240,000/(1 + 0.5)
The calculation gives us a figure of -13,333, which is lesser than zero. In order to bring the value equal to zero
we would use a rate lesser than 50 percent.
Trying out various IRR rates, we can finally reach a rate of 43.6 percent at which the value of NPV would
come down to -48 which is close to zero. If we try out IRR with more decimal places, we can bring the value
of NPV equal to zero. However, with approximation, 43.6 percent is the actual IRR of the project.
Risk and Return
The chance of financial loss or, more formally, the variability of returns associated with a given asset.
When we talk about risk with the reference to the investment we are talking about risk in term of the
uncertainty in outcome of our investment. We are talking about the variability, spread, or volatility that can
take place in the expected future Value (Cash Flows) or Returns. For example, we are asking ourselves if we
invest Rs 1,000 for buying a share today then what will be the price of the share one year from now. There is
no guarantee about the price of the share after one year therefore there is an uncertainty or risk we are taking
because we do not know the final outcome. So, the difference or variation in the possible outcomes of a
particular investment also represents the riskiness of a particular investment.
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Risk can be understood with reference to the uncertainty of Future Cash Flows produced by Assets (Physical
& Financial Securities). Businesses make forecasts based on certain assumptions. These forecasts are not
100% accurate and there is uncertainty in the possible outcome. The actual cash flows one or five years from
now may be very different from the forecasted and this to represent risk. When we talk about risk in investing
in direct claim securities then we need to keep in mind the distinction between Stand Alone Risk (or Single
Investment Risk) as oppose to market or Portfolio Risk (or Collection of Investments Risk)which is a risk of
particular investment compare to other investments you have made. In Portfolio risk we are interested in
overall risk of entire collection of investments that made by the company.
In case of portfolio risk we can further made distinction between Diversifiable Risk and Market risk
Diversifiable Risk: random risk specific to one company, can be virtually eliminated.
Market Risk: It is defined as uncertainty caused by broad movement in market or economy. More significant
Causes of Risk:
These can be Company-Specific or General. It may be because of Cash Losses from operations or poor
financial management of the company. This is one possibility but the real question is that why these losses
occurred. One of the reasons for the losses might be the companys Debt, Inflation, Economy, Politics, War or
Fate. Final analysis of risk is that it is a game of fate or chance.
Measurement of Risk:
It is important to attach different numbers to the risk so that we can rank different investments.
Risk is measured in terms of the standard deviation or variance. You have studied these terms in the statistics.
Risk is still quite subjective even after the numbers you have calculated after standard deviation. The reason is
that you have to keep in mind what kind of risk you are talking about. Are you
Stand Alone Risk or Portfolio Risk?
Market Risk or Diversifiable Risk?
Stock Price Risk or Earnings Risk?
Another important thing is Time Horizon for which you are measuring the risk. Are you investing in Stocks
over 1 Year or over 30 Years? The level of risk might change as time period of the investment change.
Fundamental Rule of Risk & Return:
This rule can be summed up in saying that No Pain - No Gain. Investors will not take on additional Market
Risk unless they expect to receive additional Return which is common sense and quite logical. Most investors
are Risk Averse. Another important principle that one should to keep in mind is Diversification.
Diversification:
It states that dont put all your eggs in one basket. Diversification can reduce risk. By spreading your money
across many different Investments, Markets, Industries, Countries you can avoid the weakness of each. Make
sure that they are Uncorrelated so that they dont suffer from the same bad news. Due to certain change in the
interest rates some of the investments in your portfolio may go up and the others go downward.
Before taking about the risk we first see the different possible outcomes of a particular investment by
analyzing the expected return. It is mentioned earlier that once we have an idea of the variation then we can
measure the risk of that investment.
Range of Possible Outcomes, Expected Return:
Overall Return on Stock = Dividend Yield + Capital Gains Yield (Gordons Formula) Simply, Return is
proportional to Capital Gain which is proportional to Selling Price. We can use Forecasted Selling Price as
measure of Return. The wider the range of Possible Outcomes that can occur, the greater the Risk
The chance that a future event will actually occur is measured using Probability
Expected ROR = < r > =
pi ri
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Where pi represents the Probability of Outcome i taking place and ri represents the Rate of Return (ROR) if
Outcome i takes place. The Probability gives weight age to the return. The Expected or Most Likely ROR is
the SUM of the weighted returns for ALL possible Outcomes.
Now let us take a look of case of investing in the share of the particular company.
Suppose you are deciding whether to invest in the Stock of Company ABC. Youre not sure because the
Future or Forecasted Price of the Stock after 1 year could reach any one of 3 Possible Values (or Outcomes).
Before you can estimate the most likely or Mean or Expected Future Price, you need to guess the Probability
of Each Possible Outcome.
Capital Asset Pricing Model (CAPM):
CAPM is the basic theory that links risk & return for all assets.
A model that allows investors to price securities, such as stocks, based on the risk-free rate, market returns,
and the security's volatility.
CAPM = Rf + Beta of Stock x (Rm RF)
Where
Rf = Risk free rate
Rm = Return on the Market
Rf = Risk free rate
Weighted Average Cost of Capital (WACC)
The weighted average cost of capital is the cost linked with a firm's capital structure.
Securities:
Security, also known as a financial asset, is a piece of paper representing a claim on an asset.
Securities can be classified into two categories.
Direct Securities: Direct securities include stocks and bonds. While valuing direct securities we take
into account the cash flows generated by the underlying assets.
Discounted Cash Flow (DCF) technique is often used to determine the value of a stock or bond.
Indirect Securities: Indirect securities include derivatives, Futures and Options
The securities do not generate any cash flow; however, its value depends on the value of the underlying asset.
Stocks (or Shares):
Stocks (or Shares) are paper certificates representing ownership in a business. Therefore, if a company has
issued 1 million shares and an investor owns 1 share only, he is a part owner (or shareholder) of the company.
Stocks or shares are represented in the equity section of the balance sheet. A stock certificate is perpetuity, i.e.,
it lasts as long as the company does. Shareholders have a residual claim (last claim) on whatever net income
(or profit) and assets are left over after the bondholders have been fully paid off. It is the most common source
of raising funds under Islamic Shariah. Shares are traded in Stock market e.g. Karachi Stock Exchange (KSE),
Lahore Stock Exchange (LSE) & Islamabad Stock Exchange (ISE).
Types of Stocks
Common stock represents the basic equity ownership in a corporation Common shareholders receive
dividends, or portion of the net income which the management decides, NOT to reinvest into the
company in the form of retained earnings.
Dividends are paid in proportion to the number of shares the stockholders own and are announced by
the board of directors, who may opt not to announce a dividend in a particular year. Common
Stockholders have voting rights to elect the board of directors.
Preferred stock is an equity which has characteristics of both bonds and common stock. It is the stock
with a predetermined or fixed dividend. In case, the board of directors announces dividends, the
preferred stockholders would have a priority claim on them, i.e., they would be paid dividends before
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any dividends are paid to the common stockholders. However, if the board opts to retain earnings, the
preferred stock would not yield a dividend, and thus cash flows from a preferred dividend are not as
certain as income of the bondholders.
Dividends are paid out of net income. Shareholders get a part of the net profit of the company during the year,
proportional to their shareholdings, and it is for the management to decide how much of the profit is to be
distributed among the shareholders.
Blue chip stocks are stocks of well-established companies that have stable earnings and no extensive
liabilities.
Penny stocks are low-priced, speculative and risky securities which are traded over-the-counter
(OTC); i.e. outside of one of the major exchanges.
Income stocks offer a higher dividend in relation to their market price. They are especially attractive
to investors who are looking for current income that will gradually grow over the years as a way to
offset inflation.
Growth stocks are securities which appreciate in value and yield a high return. Their profits are
typically re-invested to expand the business. Investors gain because the stock prices increase as the
business grows, thus increasing the value of the investment.
Value stocks are securities which investors consider to be undervalued. They feel that the stock is
being traded below market value, and they believe in the long-term growth of the issuing company.
Bonds and classification of bonds:
Bonds:
It is a debt paper representing loan or borrowing. These are long term debt instruments.
OR
A certificate of debt (usually interest-bearing or discounted) that is issued by a government or company in
order to raise money; the issuer is required to pay a fixed sum yearly until maturity and then a fixed sum to
repay the principal.
Bonds: Numerical Features
Maturity or Tenure or Life: Measured in years. On the Maturity Date when the bond expires, the
Issuer returns all the money (Principal/par and Interest/coupon) to the Investor (thereby terminating or
Redeeming the bond) ie. 6 months, 1 year, 3 years, 5 years, 10 years,
Par Value or Face Value: Principal Amount (generally printed on the bond paper) returned at
maturity ie. Rs 1,000 or Rs. 10,000. Contrast this to Market Value (or Actual Price based on
Supply/Demand) and Intrinsic or Fair Value (estimated using Bond Pricing or Present Value Formula)
Coupon Interest Rate: percentage of Par Value paid out as interest irrespective of changes in Market
Value ie. 5 % pa, 10 % pa, 15% pa, etc. Coupon Receipt = Coupon Rate x Par Value. Coupon
Receipts can be paid out monthly, quarterly, six-monthly, annuallyetc. Contrast to Market Interest
Rate (macro-economic).
Bonds: Characteristics & Legal Points
Indenture: Long Legal Agreement between the Issuer (or Borrower) and the Bond Trustee
(generally a bank or financial institution that acts as the representative for all Bondholders). Basically
protects Bondholders from mis-management by the bond issuer, default, other security holders, etc.
Claims on Assets & Income:
Bondholders have the First Claim on Assets in case the company closes down (Before Shareholders). The
Financial Charges due to Bond Holders must be paid out from the Income before any Net Income can be
distributed to Stockholders in the form of Dividends. If Issuer (or Borrower) does not pay the interest to the
Bondholder (i.e. Default), then the firm can be legally declared Insolvent, Bankrupt, and forced to close down.
Bonds Security:
Mortgage Bonds are backed by real property (i.e. Land, building, machinery, inventory) whose value is
generally higher than that of the value of the bonds issued. Debentures and Subordinated Bonds are not
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secured by real property but they are backed by personal and corporate guarantees and their security and value
is tied to the anticipated future cash in-flows of the business.
Call Provision:
The right (or option) of the Issuer to call back (redeem) or retire the bond by paying-off the Bondholders
before the Maturity Date. When market interest rates drop, Issuers (or Borrowers) often call back the old
bonds and issue new ones at lower interest rates.
Bond Ratings & Risk:
Bonds are rated by various Rating Agencies:
Internationally: Moodys, S&P.
In Pakistan: PACRA, VIS.
International Bond Rating Scale (starting from the best or least risky): AAA, AA, A, BBB, BB, B, CCC, CC,
C, D. Also + is better and - is worse. So A+ is better than A. A- is worse than A. In Pakistan, Pakistan Credit
Rating Agency (PACRA) and Vital Information Services (VIS) are actively conducting analysis of corporate
securities and grading them.
Based on future Risk Potential of the company that is the Issuer of the bond.
Bond risk increases with:
Operating losses (check Cash Flow Statement and P/L)
Excessive borrowings or debt (check Balance Sheet)
Large variations in income
Small size of business
Country and foreign exchange rate risk
Types of Bonds:
Mortgage Bonds: backed & secured by real assets
Subordinated Debt and General Credit: lower rank and claim than Mortgage Bonds.
Debentures: Debentures are the most general corporate bonds. They're backed by the credit of the
issuer, rather than by any specific assets. These are not secured by real property, risky
Floating Rate Bond: It is defined as a type of bond bearing a yield that may rise and fall within a
specified range according to fluctuations in the market. The bond has been used in the housing bond
market
Eurobonds: it issued from a foreign country
Zero Bonds & Low Coupon Bonds: no regular interest payments (+ for lender), not callable (+ for
investor)
Junk Bonds & High Yield Bonds: Corporations that are small in size, or lack an established
operating track record are also likely to be considered speculative grade. Junk bonds are most
commonly associated with corporate issuers. They are high-risk debt with rating below BB by S&P.
Convertible Bonds:
A convertible bond is a bond which can be converted into the company's common stock. You can exercise the
convertible bond and exchange the bond into a predetermined amount of shares in the company. The
conversion ratio can vary from bond to bond. You can find the terms of the convertible, such as the exact
number of shares or the method of determining how many shares the bond is converted into, in the indenture.
For example a conversion ratio of 40:1 means that for every bond (with Rs.1,000 par value) you hold you can
exchange for 40 shares of stock. Occasionally, the indenture might have a provision that states the conversion
ratio will change through the years, but this is rare. Convertibles typically offer a lower yield than a regular
bond because there is the option to convert the shares into stock and collect the capital gain. But, should the
company go bankrupt, convertibles are ranked the same as regular bonds so you have a better chance of
getting some of your money back
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Classification of bonds on Balance sheet:

One should be very careful regarding the classifications of bonds on the balance sheet. Because, when you are
Issuing Bonds (i.e. borrowing money) then the Value of Bonds appears under Liabilities side (as Long Term
Debt) of Balance Sheet. If you are Investing (or buying) Bonds of other companies then their Value appears
under Assets side (as Marketable Securities) of Balance Sheet.
The Important thing to remember is that the stocks represent the ownership and bonds represent the
debt.
Both are the direct claim securities.
Share vs Bonds
The main difference between shares and bonds is that
Shares are representation of ownership in a company while bonds are not representative of ownership.
The second difference is that shares last as long as the company lasts where as bonds have limited life.
Another difference is that the return on a bond is predetermined, i.e., the investor knows in advance
how much return he would get from a bond. However, a stockholder cannot be certain about the return
on a stock investment, since the dividends may or may not be paid in a certain year or the percentage
of dividends announced may vary.
Financial Markets:
Financial market is a market for the exchange of capital and credit, including the money markets and the
capital markets.
Capital Markets:
These are the markets for the long term debt & corporate stocks.
Stock Exchange: A stock exchange is a place where the listed shares, Term finance certificates (TFC)
and national investment trust units (NIT) are exchanged and traded between buyers and sellers.
Long term government & corporate bonds are also traded in capital markets.
Money Markets
Money market generally is a market where there is buying and selling of short term liquid debt instruments.
(Short term means one year or less). Liquid means something which is easily en-cashable; an instrument that
can be easily exchanged for cash.
Real Assets or Physical Asset Markets
Following are the active markets of real and physical assets in Pakistan
Cotton Exchange, Gold Market, Kapra Market
Property (land, house, apartment, warehouse)
Computer hardware, Used Cars, Wheat, Sugar, Vegetables, etc.
Financial institution:
Those Institution which collects funds from the public and places them in financial assets, such as deposits,
loans, and bonds, rather than tangible property.
Real Assets:
Real assets are tangible assets that have physical characteristics. For instance, land, house, equipment, car,
wheat, fruits, cotton, computers, etc., are different kinds of real assets.
Value:
In financial terms, there are different types of values, which are given as under.
Book Value:
Book Value is the value of an asset as shown on the Balance Sheet. It is based on historical cost (or
purchase price) and accumulated depreciation.
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Market Value:
Market value of an asset is as quoted in the market, which basically depends on the supply & demand
of the asset and the negotiations between buyers & sellers.
Liquidation Value:
The liquidation value is the value of an asset in a particular situation, where the company is in the
process of wrapping up the business and its assets are valued and sold individually.
Fair Value or Intrinsic Value:
The most important value concept in this course is of fair value or the intrinsic value. In order to find the
intrinsic value of an asset, the present value of the working assets future cash flows is calculated and summed
up. If the intrinsic value of an asset is less than its market value, the asset among investors is perceived as
undervalued. Intrinsic value or the fair value is calculated by summing up the discounted future cash flows.
In Financial accounting, we followed the principle of accrual accounting in which expenses & incomes are
rerecorded when they incur. In Financial management, we will primarily be interested in cash & cash flows. In
Financial management, we will use cash as primary source for calculating value, although the accrual data
would also be useful for analyzing a firms financial position.
Who are Shareholders?
Shareholder is any possessor of one or more shares in a corporation. A shareholder usually has proof that they
are a shareholder; this evidence is represented by a stock certificate.
Who are Stakeholders?
Stakeholders are the particular people or groups who have a stake, or an interest, in the conclusion of the
project. Usually stakeholders are from within the company, and could include internal clients, management,
employees, administrators... etc
What is Investment?
Money put in property or other projects with the hope of making a profit, with enough security to return and
protect the capital; not speculation.
Define Asset Management?
Careful administration of investable (liquid) assets, aimed at achieving an optimum risk-reward ratio.
What is Capital Structure?
The capital structure of a company is the particular mixture of debt, equity and other sources of finance that it
uses to fund its long term financing. The key division in capital structure is between debt and equity. The
amount of debt funding is measured by gearing.
OR
A mix of a company's long-term debt, detailed short-term debt, common equity and preferred equity. The
capital structure is how a firm finances its overall operations and growth by using different sources of funds.
Loan amortization:
The schedule of payments to be made in repaying a debt. With level-payment amortization, the payment
amount is constant through out the repayment period. With constant-principal payment amortization, the
amount of principal repaid in each payment is constant but the interest amount and the total payment amount
decline as the principal balance of the loan is reduced.
Debt Financing
Debt financing is basically money that you borrow to run your business with the promise to return the
principal in addition to an agreed-upon level of interest. Although the term tends to have a negative
connotation, startup companies often turn to debt to finance their operations. In fact, even the healthiest of
corporate balance sheets will include some level of debt. In finance, debt is also referred to as leverage. The
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most popular source for debt financing is the bank, but debt can also be issued by a private company or even a
friend or family member. Debt financing is being divided into two categories, based on the type of loan you
are seeking: short term debt financing and long term debt financing
Short Term Debt Financing usually applies to money needed for the day-to-day operations of the business,
such as purchasing inventory, supplies, or paying the wages of employees. Short term financing is referred to
as an operating loan or short term loan because scheduled repayment takes place in less than one year. There
are many ways for which a firm can look for short terms financing some of these include: Overdrafts, Shortterm loans, Bills of exchange, Promissory notes/commercial paper, Inventory loan, Letters of credit, etc.
Long Term Debt Financing usually applies to assets your business is purchasing, such as equipment,
buildings, land, or machinery. With long term debt financing, the scheduled repayment of the loan and the
estimated useful life of the assets extends over more than one year.
Short term financing is normally used to provide money that has to be paid back within a year. The period may
be shorter than one year as well.
Cross-Sectional Analysis:
Comparison of different firms financial ratios at the same point in time; involves comparing the firms ratios
to those of other firms in its industry or to industry averages.
Benchmarking:
A type of cross-sectional analysis in which the firms ratio values are compared to those of a key competitor or
group of competitors that it wishes to emulate.
Leverage: result from the use of fixed-cost assets or funds to magnify returns to the firms owners. It is the
degree to which an investor or business is utilizing borrowed money..
Operating Leverage: The percentage of fixed costs in a company's cost structure. Generally, the higher the
operating leverage, the more a company's income is affected by fluctuation in sales volume. The higher
income vs. sales ratio results from a smaller portion of variable costs, which means the company does not have
to pay as much additional money for each unit produced or sold. The more significant the volume of sales, the
more beneficial the investment in fixed costs becomes.
Financial leverage: The potential use of fixed financial costs to magnify the effects of changes in earnings
before interest & taxes on the firms earnings per share. The degree to which an investor or business is
utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable
to make payments on their debt; they may also be unable to find new lenders in the future. Financial leverage
is not always bad, however; it can increase the shareholders' return on their investment and often there are tax
advantages associated with borrowing. It is the debt/equity ratio measures.
Portfolio: A collection, or group of assets.
Leasing:
The process by which a firm can obtain the uses of certain fixed assets for which it must make a series of
contractual, periodic, tax-deductible payments.
Lease: The receiver of the services of the assets under a lease contract.
Lessor: the owner of assets that are being leased.
Cash: Currency and coins on hand, bank balances, and negotiable money orders and checks.
Investment
In finance, the purchase of a financial product or other item of value with an expectation of favorable future
returns. In general terms, investment means the use money in the hope of making more money. OR
In business, the purchase by a producer of a physical good, such as durable equipment or inventory, in the
hope of improving future business.
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Corporate finance:
Corporate finance is the study of planning, evaluating and drawing decisions in the course of business. In most
businesses, corporate finance focuses on raising money for various projects or ventures. For investment banks
and similar corporations, corporate finance focuses on the analysis of corporate acquisitions and other
decisions.
Speculation:
Speculation means taking large risks, especially with respect to trying to predict the future; gambling, in the
hopes of making quick, large gains.
Option
The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given
stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of
time. For stock options, the amount is usually 100 shares. Each option has a buyer, called the holder, and a
seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms
of the contract by delivering the shares to the appropriate party. In the case of a security that cannot be
delivered such as an index, the contract is settled in cash. For the holder, the potential loss is limited to the
price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the
money spent to purchase the option is lost. For the buyer, the upside is unlimited. Options, like stocks, are
therefore said to have an asymmetrical payoff pattern. For the writer, the potential loss is unlimited unless the
contract is covered, meaning that the writer already owns the security underlying the option. Options are most
frequently as either leverage or protection. As leverage, options allow the holder to control equity in a limited
capacity for a fraction of what the shares would cost. The difference can be invested elsewhere until the option
is exercised. As protection, options can guard against price fluctuations in the near term because they provide
the right acquire the underlying stock at a fixed price for a limited time. risk is limited to the option premium
(except when writing options for a security that is not already owned). However, the costs of trading options
(including both commissions and the bid/ask spread) is higher on a percentage basis than trading the
underlying stock. In addition, options are very complex and require a great deal of observation and
maintenance. It is also called option contract.
Call option
An option contract that gives the holder the right to buy a certain quantity (usually 100 shares) of an
underlying security from the writer of the option, at a specified price (the strike price) up to a specified date
(the expiration date). It is also called call.
Put option
An option contract that gives the holder the right to sell a certain quantity of an underlying security to the
writer of the option, at a specified price (strike price) up to a specified date (expiration date); here also called
put.

MBA FINANCE
Cell # 03339668669
Wazir222@yahoo.com
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INTRODUCTION TO ECONOMICS
What is economics?
Economics is the study of how we the people engage ourselves in production, distribution and consumption
of goods and services in a society.
OR
Economics is a social science which deals with ways through which we can best utilize the scarce resources
to satisfy unlimited wants in efficient & effective way.
The term economics came from the Greek for oikos (house) and nomos (custom or law), hence "rules of the
household.
Branches of economics
Normative economics:
Normative economics is the branch of economics that incorporates value judgments about what the economy
should be like or what particular policy actions should be recommended to achieve a desirable goal. Normative
economics looks at the desirability of certain aspects of the economy. It underlies expressions of support for
particular economic policies. Normative economics is known as statements of opinion which cannot be proved
or disproved, and suggests what should be done to solve economic problems, i-e unemployment should be
reduced. Normative economics discusses "what ought to be".
Examples:
1- A normative economic theory not only describes how money-supply growth affects inflation, but it also
provides instructions that what policy should be followed.
2- A normative economic theory not only describes how interest rate affects inflation but it also provides
guidance that what policy should be followed.
Positive economics:
Positive economics, by contrast, is the analysis of facts and behavior in an economy or the way things are.
Positive statements can be proved or disproved, and which concern how an economy works, i-e unemployment
is increasing in our economy. Positive economics is sometimes defined as the economics of "what is"
Examples:
1- A positive economic theory might describe how money-supply growth affects inflation, but it does not
provide any instruction on what policy should be followed.
2- A positive economic theory might describe how interest rate affects inflation but it does not provide any
guidance on whether what policy should be followed.
We the people: includes firms, households and the government.
Goods are the things which are produced to be sold.
Services involve doing something for the customers but not producing goods.
Factors of production
Factors of production are inputs into the production process. These are the resources needed to produce goods
and services. The factors of production are:
Land includes the land used for agriculture or industrial purposes as well as natural resources taken
from above or below the soil.
Capital consists of durable producer goods (machines, plants etc.) that are in turn used for production
of other goods.
Labor consists of the manpower used in the process of production.
Entrepreneurship includes the managerial abilities that a person brings to the organization.
Entrepreneurs can be owners or managers of firms.
Scarcity:
Scarcity does not mean that a good is rare; scarcity exists because economic resources are unable to supply all
the goods demanded. It is a pervasive condition of human existence that exists because society has unlimited
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wants and needs, but limited resources used for their satisfaction. In other words, while we all want a bunch of
stuff, we can't have everything that we want.
Rationing:
Rationing is a process by which we limit the supply or amount of some economic factor which is scarcely
available. It is the distribution or allocation of a limited commodity, usually accomplished based on a standard
or criterion. The two primary methods of rationing are markets and governments. Rationing is needed due to
the scarcity problem. Because wants and needs are unlimited, but resources are limited, available commodities
must be rationed out to competing uses.
Economic systems:
There are different types of economic systems prevailing in the world.
Dictatorship:
Dictatorship is a system in which economic decisions are taken by the dictator which may be an individual or a
group of selected people.
Command or planned economy:
A command or planned economy is a mode of economic organization in which the key economic functions
for whom, what, how to produce are principally determined by government directive. In a planned economy, a
planning committee usually government or some group determines the economys output of goods and
services. They decide about the optimal mix of resources in the economy. They also decide how the factor of
production needs to be employed to get optimal mix.
Free market/capitalist economy:
A free market/capitalist economy is a system in which the questions about what to produce, how to produce
and for whom to produce are decided primarily by the demand and supply interactions in the market. In this
economy what to produce is thereby determined by the market price of each good and service in relation to the
cost of producing each good and service.
In a free economy the only goods and services produced are those whose price in the market is at least equal to
the producers cost of producing output. When a price greater than the cost of producing that good or service
prevails, producers are induced to increase the production. If the products price falls below the cost of
production, producers reduce supply.
Islamic economic system:
This system is based on Islamic values and Islamic rules i-e zakat, ushr, etc. Islam forbids both the taking and
giving of interest. Modern economists, too, have slowly begun to realize the futility of interest. The Islamic
economic principles if strictly followed would eliminate the possibility of accumulation of wealth in the hands
of a few and would ensure the greater circulation of money as well as a wider distribution of wealth. Broadly
speaking these principles are (1) Zakat or compulsory alms giving
(2) The Islamic law of inheritance which splits the property of an individual into a number of shares given to
his relations
(3) The forbiddance of interest which checks accumulation of wealth and this strike at the root of capitalism.
Pakistan case: A mixed economy:
In Pakistan, there is mixed economic system. Resources are governed by both government and individuals.
Some resources are in the hand of government and some are in the hand of public. Optimal mix of resources is
decided by the price mechanism i-e by the market forces of demand and supply.
Pakistan economy thus consists of the characteristics of both planned economy and free market economy.
People are free to make their decisions. They can make their properties. Government controls the Defense.
Circular flow of goods & income:
There are two sectors in the circular flow of goods & services. One is household sector and the other is the
business sector which includes firms. Households demands goods & services, Firms supply goods & services.
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An exchange takes place in an economy. In monetary economy, firms exchange goods & services for money.
Firms demands factors of production and households supply factors of production.
Firms pay the payment in terms of wages, rent, etc. This is circular flow of goods. On the other hand,
household gives money to firms to purchase the goods & services from firms, and firms gives money to
households in return for factors of production.
Distinction between Micro & Macro economics:
Micro Economics:
The branch of economics that studies the parts of the economy, especially such topics as markets, prices,
industries, demand, and supply. It can be thought of as the study of the economic trees, as compared to
macroeconomics, which is study of the entire economic forest. Microeconomics is a branch of economics that
studies how individuals, households, and firms make decisions to allocate limited resources typically in
markets where goods or services are being bought and sold. It also examines how these decisions and
behaviors affect the supply and demand for goods and services, which determines prices, and how prices, in
turn, determine the supply and demand of goods and services.
Macro Economics:
The branch of economics that studies the entire economy, especially such topics as aggregate production,
unemployment, inflation, and business cycles. It can be thought of as the study of the economic forest, as
compared to microeconomics, which is study of the economic trees.
Macroeconomics, involves the "sum total of economic activity, dealing with the issues of growth, inflation,
and unemployment and with national economic policies relating to these issues and the effects of government
actions (e.g., changing taxation levels) on them.
Microeconomics vs. Macroeconomics:
Microeconomics deals with behavior of individual units.
When Consuming; How we choose what to buy
When Producing; How we choose what to produce
Markets: The interaction of consumers and producers.
Macroeconomics deals with analysis of aggregate issues:
Economic growth Inflation Unemployment
Microeconomics is the foundation of macroeconomic analysis.
Rational choice is the choice based on pure reason and without succumbing to ones emotions or whims.
Consumers can decide about the rational decision by using cost and benefit analysis. Rational choice is a
general theory of human behavior that assumes individuals try to make the most efficient decisions possible in
an environment of scarce resources. By "efficient" it is meant that humans are "utility maximizes" - for any
given choice a person seeks the most benefit relative to costs. Consumers can make about the rational decision
by using cost and benefit analysis. Consumers want to maximize their level of satisfaction relative to their
cost. Rational choice is also the optimal choice.
Optimum means producing the best possible results (also optimal).
Equity in economics means a situation in which every thing is treated fairly or equally, i.e. according to its
due share. So if the lives of all individuals are deemed to have equal value, equity would demand that all of
them have equal financial net worth.
Nepotism means doing unfair favors for near ones when in power.
Barter trade is a non-monetary system of trade in which goods not money is exchanged. This was the
system used in the world before the advent of coins and currency.
Marginal cost is the increment to total costs of producing an additional unit of some good or service.
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Marginal benefit is the increment to total benefit derived from consuming an additional unit of good or
service.
Economic growth is an increase in the total output of a country over time. It is the long-run expansion of the
economy's ability to produce output. When GDP of a country is increasing it means that country is growing
economically. Economic growth is made possible by increasing the quantity or quality of the economy's
resources (labor, capital, land, and entrepreneurship).
Shortage:
A shortage is a situation in which demand exceeds supply, i.e. producers are unable to meet market demand
for the product. Shortages cause prices to raise prompting producers to produce more and consumers to
demand less.
Surplus:
A surplus is a situation of excess supply, in which market demand falls short of the quantity supplied; i.e. the
producers are unable to sell all the produced goods in the market. Surpluses cause prices to fall prompting
producers to supply less and consumers to demand more.
Price Mechanism:
The price mechanism is a signaling and rationing device which prompts consumers and producers to adjust
their demand and supply, respectively, in response to a shortage or surplus. Shortages cause prices to rise,
prompting producers to produce more and consumers to demand less. Surpluses cause prices to fall prompting
producers to supply less and consumers to demand more. In either case, the price mechanism attempts to clear
the shortage or surplus in the market.
Normal goods are goods whose quantity demanded goes up as consumer income increases.
Inferior goods are goods whose quantity demanded goes down as consumer income increases.
Giffen goods are the sub category of inferior good. It is a rare type of good seldom seen in the real world, in
which a change in price causes quantity demanded to change in the same direction (in violation of the law of
demand). In other words, an increase in the price of Giffen good results in an increase in the quantity
demanded. The existence of a Giffen good requires the existence of special circumstances. First, the good must
be an inferior good. Second, the income effect is greater than the substitution effect. A Giffen good is most
likely to result when the good is a significant share of the consumer's budget. Margarine is a Giffen good as
compared to butter.
Substitution effect:
It is one of two reasons for law of demand and the negative slope of the market demand curve. The
substitution effect occurs because a change in the price of a good makes it relatively higher or lower than the
prices of other goods that might act as substitutes. A higher price means that a good is more expensive relative
to other goods, while a lower price means it's less expensive.
Or more simply we can say that if price of any good increases, people reduce its consumption and substitute
any other good whose price is not increased. This is substitution effect.
Income effect:
It is also one of two reasons for the law of demand and the negative slope of the market demand curve. The
income effect results because a change in price gives buyers more real income, or the purchasing ower of the
income, even though money or nominal income remains the same. This causes changes in the quantity
demanded of the good.
Or more simply we can say that when price of any good increases, consumers real income falls and its
purchasing power also decreases. This is income effect.
Price effect:
Price effect is the addition of income and substitution effect.
Price effect = Income effect + Substitution effect
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Substitutes are goods that compete with one another or can be substituted for one another, like butter and
margarine.
Compliments goods are goods that go hand in hand with each another. Examples are left shoe and right shoe,
or bread and butter
Cash crops are the crops which are not used as food but as a raw material in factories e.g. cotton.
Paradox of value:
Observation that articles or goods critical to life (such as water) are very cheap, whereas others which have no
bearing on human existence (such as diamonds) are very expensive. This paradox is explained by the law of
supply and demand.
Demand
Demand refers to such a desire which is backed by the power to purchase & the desire to purchase.
A desire becomes demand only when it is supported by the willingness & power to purchase.
Law of demand:
The law of demand states that if the price of a certain commodity rises, its quantity demanded will go down,
and vice-versa.
Demand schedule:
A demand schedule is a table (sometimes also referred to as a graph) which shows various combinations of
quantity demanded and price.
Demand curve:
Graphical presentation of demand schedule gives us demand curve.
Demand function:
A demand function is an equational representation of demand as a function of its many determinants.
Qd = f ( Pg , T , Psi Psn , Pci Pcm , Y , B , Pge t+1 )
Where,
Pg = Price of the good, T = Tastes, Psi Psn = Prices of substitute goods, Pci Pcm = Prices of
complimentary goods, Y = Income, B = Income Distribution, Pge t+1 = Future prices
Equation of demand function is Qd= a b P
Shifts in the demand curve:
Shifts in the demand curve plotted in P-Qd space are caused by changes in any determinant of demand other
than the price of the good itself. Movements along the curve correspond to the changes in the variable on the
vertical axis.
Market demand curve
Market demand curve is a graphic representation of a market demand which shows the quantities of a
commodity that consumers are willing able to purchase during a period of time at various alternative prices,
while holding constant everything else that effects demand. The market demand curve for a commodity is
negatively sloped, indicating that more of a commodity is purchased at a lower price.
Supply
Supply is the quantity of a good that sellers wish to sell at each conceivable price.
Law of supply:
The law of supply states that the quantity supplied will go up as the price goes up and vice versa. As output
increases, cost will also increase. Higher prices means more profit so firms will produce more of that product
whose price has increased. New producers will also emerge in the market. And total supply will also increase.
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Supply schedule:
A supply schedule is a table (sometimes also referred to as a graph) which shows various combinations of
quantity supplied and price.
Supply curve:
Graphical illustration of the table/schedule gives us the supply curve.
Supply function:
A supply function is an equational representation of supply as a function of all its determinants.
Quantity Supplied = f (Price)
QS = f (Pg, Cg, a1 an, j1 jm, R, A, Pge t+1)
Where,
Quantity Supplied = Qs, Price of the goods = Pg, Profitability of alternative goods = a1..an,
Profitability of the goods jointly supplied = j1.jm, Nature and Other Random Shocks = R, Aims of
Producers = A, Expected Price of good = Pge at some future time = t+1
A supply equation is QS = c + d P
Equilibrium:
Equilibrium is a state in which there are no shortages and surpluses; in other words the quantity demanded is
equal to the quantity supplied.
Equilibrium price is the price prevailing at the point of intersection of the demand and supply curves; in other
words, it is the price at which the quantity demanded is equal to the quantity supplied.
Equilibrium quantity is the quantity at which the quantity demand is equal to the quantity supplied.
Price ceiling:
A price ceiling is the maximum price limit that the government sets to ensure that prices dont rise above that
limit (e.g. medicines).
Price floor:
A price floor is the minimum price that a Government sets to support a desired commodity or service in a
society (e.g. wages).
Social cost
Social cost is the cost of an economic decision, whether private or public, borne by the society as a whole.
Marginal social cost
Marginal social cost is the change in social costs caused by a unit change in output.
Elasticity
Elasticity is a term widely used in economics to denote the responsiveness of one variable to changes in
another. In proper words, it is the relative response of one variable to changes in another variable.
Types of elasticity
There are four major types of elasticity:
Price Elasticity of Demand
Price Elasticity of Supply
Income Elasticity of Demand
Cross-Price Elasticity of Demand
Price Elasticity of Demand:
Price elasticity of demand is the percentage change in quantity demanded with respect to the percentage
change in price. Formula:
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Pd = Percentage change in Quantity demanded/Percentage change in Price

Where = Epsilon; universal notation for elasticity.
If, for example, a 20% increase in the price of a product causes a 10% fall in the Quantity demanded, the price
elasticity of demand will be:
Pd = - 10%/20% = - 0.5
Price Elasticity of Supply:
Price elasticity of supply is the percentage change in quantity supplied with respect to the percentage change in
price. Formula:
Ps = Percentage change in Quantity Supplied/Percentage change in Price
If a 15% rise in the price of a product causes a 15% rise in the quantity supplied, the price elasticity of supply
will be:
Ps = 15%/15% = 1
Income Elasticity of Demand:
Income elasticity of demand is the percentage change in quantity demanded with respect to the percentage
change in income of the consumer. Formula:
Yd = Percentage change in Quantity demanded/Percentage change in Income
If a 2% rise in the consumers incomes causes an 8% rise in products demand, then the income elasticity of
demand for the product will be:
Yd = 8%/2% =4
Cross-Price Elasticity of Demand:
Cross price elasticity of demand is the percentage change in quantity demanded of a specific good, with
respect to the percentage change in the price of another related good.
Pbda= Percentage change in Demand for a good/Percentage change in Price of good b
If, for example, the demand for butter rose by 2% when the price of margarine rose by 8%, then the cross price
elasticity of demand of butter with respect to the price of margarine will be.
Pbda = 2%/8% = 0.25
If, on the other hand, the price of bread (a compliment) rose, the demand for butter would fall. If a 4% rise in
the price of bread led to a 3% fall in the demand for butter, the cross-price elasticity of demand for butter with
respect to bread would be:
Pbda = - 3%/4% = - 0.75
Elastic and inelastic demand
Slope and elasticity of demand have an inverse relationship. When slope is high elasticity of demand is low
and vice versa.
When the slope of a demand curve is infinity, elasticity is zero (perfectly inelastic demand); and when the
slope of a demand curve is zero, elasticity is infinite (perfectly elastic demand).
Unit elasticity means that a 1% change in price will result in an exact 1% change in quantity demanded.
Thus elasticity will be equal to one. A unit elastic demand curve plots as a rectangular hyperbola. Note that a
straight line demand curve cannot have unit elasticity as the value of elasticity changes along the straight line
demand curve.
Elastic demand means when price of any product increases, its demand also increases more than the increase
in price. As price increases total revenue decreases in case of elastic demand.
Inelastic demand of any product means that if price of that product increases there is very small effect on its
quantity demanded. As price increases, total revenue also increases in case of inelastic demand.
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For example, flour is the basic necessity of life for all people. Its demand is inelastic. As the price of flour
increases, its quantity demanded does not decrease much because people have to use flour in all situations
whether its price is high or low.
Arc Elasticity
Arc elasticity measures the average elasticity between two points on the demand curve. The formula is
simply (change in quantity/change in price)*(average price/average quantity).
To measure arc elasticity we take average values for Q and P respectively.
Point Elasticity
Point elasticity is used when the change in price is very small, i.e. the two points between which elasticity is
being measured essentially collapse on each other. Differential calculus is used to calculate the instantaneous
rate of change of quantity with respect to changes in price (dQ/dP) and then this is multiplied by P/Q, where P
and Q are the price and quantity obtaining at the point of interest. The formula for point elasticity can be
illustrated as:
= Q/P x P/ Q OR = dQ/P x P/Q
Where d = infinitely small change in price.
If elasticity = zero then demand curve will be vertical. If elasticity is infinity then the demand curve will be
horizontal.
Consumer behavior:
Consumer behavior is the behavior of the people with regards to selection, purchase & consumption of goods
& services for satisfaction of their wants.
Utility:
Utility is the satisfaction/pleasure/usefulness that a person gets from consumption of goods & services.
Cardinal vs. ordinal approach
There are two approaches to analyzing consumer behavior;
Marginal utility analysis (Cardinal approach)
Indifference curve approach (Ordinal approach)
Marginal utility analysis or cardinal approach
Marginal utility approach involves cardinal measurement of utility, i.e., you assign exact values or you
measure utility in exact units, while the indifference curve approach is an ordinal approach, i.e., you rank
possibilities or outcomes in an order of preferences, without assigning them exact utility values.
Total utility (TU) is the entire satisfaction one derives from consuming a good or service.
Marginal utility (MU) is the additional utility derived from the consumption of one or more unit of the good.
The law of diminishing marginal utility
If other things do not change & a consumer increase the use of a commodity, the utility of every new unit of
the commodity will be less than the utility of the previous unit.
The indifference curve approach or ordinal approach
This ordinal approach to utility consists in asking the question as to whether the consumer prefers one
combination or bundle of goods to another combination or bundle of goods. Ordinal approaches do not require
a measurement of the utility a person gains, rather, only a ranking of the various bundles in order of
preference.
An indifference curve is a line which charts out all the different points on which the consumer is indifferent
with respect to the utility he derives (in other words it is a combination of all equi-utility points). It is drawn in
goods space, i.e. a good Y on the vertical axis and a good X on the horizontal axis. Indifference curves are
bowed in towards the origin. In other words its slope decreases (in absolute terms) as we move down along the
curve from left to right.
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Marginal rate of substitution

The average slope of the indifference curve between any two points is given by the change in the quantity of
good Y divided by change in the quantity of good X. This is called the marginal rate of substitution (MRS).
MRS states how much unit of a good you have to give up in order get an additional unit of another good.
A diminishing marginal rate of substitution (MRS) is related to the principle of diminishing marginal utility.
MRS is equal to the ratio of the marginal utility of X to the marginal utility of Y.
dY/dX = MUX/ MUY = MRS
The indifference curve for perfect substitutes is a straight line, while it is L-shaped for perfect compliments.
An indifference map shows a number of indifference curves corresponding to different levels of utility.
A higher indifference curve corresponds to a higher level of utility. Indifference curves never intersect.
The Budget Line and Indifference curves:
The budget line shows various combinations of 2 goods X & Y that can be purchased. Its slope Px/PY is
called input price ratio.
The budget line can shift due to changes in total budget and the relative price ratio Px/PY. If money income
rises, the budget line will shift outwards (parallel to the initial budget line). If the relative price ratio changes,
the slope of the budget line changes.
Short run:
In terms of the macroeconomic analysis of the aggregate market, a period of time in which some prices,
especially wages, are rigid, inflexible, or otherwise in the process of adjusting. Short-run wage and price
rigidity prevents some markets, especially resources markets and most notably labor markets, from achieving
equilibrium. In terms of the microeconomic analysis of production and supply, a period of time in which at
least one input in the production process is variable and one is fixed. In the microeconomic analysis, the short
run is primarily used to analyze production decisions for a firm.
Long run:
In terms of the macroeconomic analysis of the aggregate market, a period of time in which all prices,
especially wages, are flexible, and have achieved their equilibrium levels. In terms of the microeconomic
analysis of production and supply, a period of time in which all inputs in the production process is variable.
The actual length of the short run and long run can vary considerably from industry to industry.
The law of diminishing marginal returns
The law of diminishing marginal returns states that as you increase the quantity of a variable factor together
with a fixed factor, the returns (in terms of output) become less and less. Thus if we are using labor in the
production of wheat given a fixed amount of land, after a certain point the increase in the output of wheat will
become less and less until it starts reducing the total output of wheat.
The total physical product (TPP) of a factor (F) is the latters total contribution to output measured in units
of output produced.
Average physical product (APP) is TPP per unit of the variable factor. APP can be represented by the
following formula,
APP = TPPF/QF
Marginal physical product (MPP) is the addition to TPP brought by employing an extra unit of the variable
factor. More generally,
MPPF = TPPF/QF
Relationship between APP and MPP
If the marginal physical product equals the average physical product, the average physical product will
not change.
If the marginal physical product is above the average physical product, the average physical product
will rise.
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If the marginal physical product is below the average physical product, the average physical product
will fall.
The scale of production
Returns to scale refers to a technical property of production that examines changes in output subsequent to a
proportional change in all inputs (where all inputs increase by a constant). If output increases by that same
proportional change then there are constant returns to scale (CRTS) sometimes referred to simply as returns to
scale.
The scale of production (returns to scale) can be increasing, decreasing or constant. Increasing (decreasing)
returns to scale arise when a 1% increase in the amount of all the factors employed causes a
>1% (<1%) increase in output. Constant returns arise when a 1% increase in all the factors causes a 1%
increase in output.
Returns to scale and returns to factor are two different concepts, the latter related to the short-term, the
former to the long-term.
Increasing returns to scale or (economies of scale) arise if, as firms become bigger and bigger, their costs per
unit of output fall. This could be because of larger more efficient plants, financial economies, more efficient
specialized labor, bulk discounts on purchases etc.
Economies of scale:
The increase in efficiency of production as the number of goods being produced increases. Typically, a
company that achieves economies of scale lowers the average cost per unit through increased production since
fixed costs are shared over an increased number of goods.
There are two types of economies of scale:
External economies - the cost per unit depends on the size of the industry, not the firm.
Internal economies - the cost per unit depends on size of the individual firm.
External economies and diseconomies of scale
External economies are benefits accruing to any one firm due to actions or the presence of other firms.
For example, advertising by a rival industry, setting up of credit information bureaus by banks.
An example of external diseconomies of scale arising is when, as an industry grows larger, a shortage of
specific raw materials or skilled labor occurs, adversely affecting the costs and prospects of all firms in the
industry.
Diseconomies of scale
Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased perunit costs. They are less well known than what economists have long understood as "economies of scale", the
forces which enable larger firms to produce goods and services at reduced per-unit costs.
The optimum combination of factors
The optimum combination of factors will obtain at the point where the marginal physical product of the last
dollar spent on all inputs is equal,
ISOQUANT
An isoquant represents different combinations of factors of production that a firm can employ to produce the
same level of output. Isoquant can be used to illustrate the concepts of returns to scale and returns to factor.
Isoquant Map:
Like an indifference map, an isoquant map consists of parallel isoquants that do not intersect. The higher the
output level the further to the right an isoquant will be.
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Marginal rate of technical substitution (MRTS)

The slope of an isoquant is called marginal rate of technical substitution (MRTS). It is analogous to the term
marginal rate of substitution (MRS) in consumer analysis. MRTS is the amount of one factor, e.g. capital, that
can be replaced by a one unit increase in the other factor e.g. labor, if output is to be held constant.
The principle of diminishing MRTS is related to the law of diminishing returns. As one moves down along an
isoquant drawn in K-L space, increasing amounts of labor are used relative to capital. Now, given diminishing
returns, the MPP of labor will fall relative to the MPP of capital.
isocost or budget line
The concept of isocost is similar to the budget line developed in indifference curve analysis. It is a line, which
captures all the different combinations of inputs that the firm can afford to hire.
If price of both inputs increases, the isocost line shifts inwards.
If price of one input increases, it pivots out.
The slope of isocost is PL/PK.
The isoquant-isocost combination can help answer:
What is the least cost way of producing a particular level of output?
What the highest level of output the firm can produce given a certain budget.
Sunk cost
In economics and in business decision-making, sunk costs are costs that have already been incurred and which
cannot be recovered to any significant degree. Sunk costs are sometimes contrasted with variable costs, which
are the costs that will change due to the proposed course of action.
Variable cost (VC)
Costs, which vary with the level of activity (or output), are called variable costs. Variable cost is a cost of
labor, material or overhead that changes according to the change in the volume of production units.
Combined with fixed costs, variable costs make up the total cost of production. While the total variable cost
changes with increased production, the total fixed cost stays the same.
Fixed Cost (FC)
Costs, which do not vary with the level of activity or output, are called fixed costs. In long run, there are no
fixed costs. Fixed cost does not vary depending on production or sales levels, such as rent, property tax,
insurance, or interest expense.
Total Cost (TC)
Total cost (TC) is the sum of all fixed and variable costs. It plot as a vertical summation of the horizontal line
total fixed cost (TFC) curve and the upward sloping total variable cost (TVC) curve.
TC = FC + VC
Average Cost or Average total cost (AC or ATC)
Total cost per unit of output, found by dividing total cost by the quantity of output. Average total cost, usually
abbreviated ATC, can be found in two ways. Because average total cost is total cost per unit of output, it can
be found by dividing total cost by the quantity of output. Alternatively, because total cost is the sum of total
variable cost and total fixed cost, average total cost can be derived by summing average variable cost and
average fixed cost. Average cost (AC) is the vertical summation of the AFC & AVC. Average variable cost
plus average fixed cost equals average total cost.
AVC + AFC = ATC or AC
Average variable cost (AVC)
AVC is an economics term to describe the total cost a firm can vary (labor, etc.) divided by the total units of
output.
AVC = TVC/Q
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Average fixed cost (AFC)

AFC is total fixed cost divided by the total units of output.
AFC = TFC/Q
AC = AFC + AVC, where average fixed cost (AFC) is a downward sloping line as you are dividing a fixed
number by an increasing number of output units. By contrast, average variable cost (AVC) first falls as output
increases and then rises.
Study of AC is necessary for firms to be able to set the price or (average revenue) at which they will sell. Also
they will be interested in knowing how AC is broken down into AFC & AVC.
Marginal cost (MC)
The change in total cost (or total variable cost) resulting from a change in the quantity of output produced by a
firm in the short run. Marginal cost indicates how much total cost changes for a give change in the quantity of
output. Because changes in total cost are matched by changes in total variable cost in the short run (remember
total fixed cost is fixed), marginal cost is the change in either total cost or total variable cost. Marginal cost,
usually abbreviated MC, is found by dividing the change in total cost (or total variable cost) by the change in
output.
Marginal cost is the addition to TC caused by a unit increase in output. More generally: MC = TC/Q
The secret of the shape of the MC curve lies in the law of diminishing marginal returns. The relationship
between MC and AC is a reflection of the relationship between MPP & APP. That is: both MC and AC fall in
the beginning, then MC starts to rise, cutting AC from below at the latters turning point (minima).
Profit maximization
Firms are interested in profit maximization. Profit is the difference between total revenue & total cost.
Higher the difference, higher is the level of profit. Economists say that when firms earn zero accounting
profits, they actually earn normal economic profits because TC already includes the normal profits that owners
of the firms need for themselves to stay in the business. Positive profits are, for this reason, called supernormal
profits as they are over and above what the owners normally require as a return for their entrepreneurship.
MARKET STRUCTURES
Perfect competition
Perfect competition is such type of market situation where a large number of firms produce & sell a
homogeneous product at a single per unit of time.
Everybody has to accept the current market price.
They may sell any quantity/buy any quantity.
The price is to effected by quantity, e.g whole-sale market, money market.
Imperfect Competition:
A market situation where competition is neither free nor perfect. The number of firms is not large & different
prices prevail for the same commodity per unit of time. Labour market, retail market etc. in Pakistan
agricultural markets are also imperfect markets.
The numbers of firms are small.

Competition is neither free nor perfect.
Mobility of factors of production is imperfect.
A restriction exists on entry of new firms in market.
Different prices prevail in market for the same product per unit of time.
Economists have identified four broad Imperfect Competition market structures:

Monopoly
Monopsony
Oligopoly
Duopoly
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(i)
Monopoly
Monopoly refers to a situation where there is a single producer in the market. However, it actually depends
upon how narrowly you define the industry.
Monopoly power
Economists are often interested in how much monopoly power any firm (not necessarily a monopoly) has.
Here monopoly stands for the extent to which the firm can raise prices without driving away all it customers.
In other words, monopoly power and price elasticity of demand are inversely related.
Firms whose customers are more have more monopoly power. A monopolistic firm faces inelastic demand of
the product & its demand curve is negatively sloped. While in perfect competition, demand curve has infinitely
elasticity.
Type of
Number Freedom of
Nature of
Examples
Implication
market
of firms
entry
product
for demand
curve
of firm
Perfect
competition
Very
many
Unrestricted
Homogenous
(undifferentiated)
Grains (wheat)
or vegetables
Horizontal;
firm is a price
taker
Monopolistic
competition
Many/
Several
Unrestricted
Differentiated
Plumbers,
restaurants
Few
Restricted
1.
Undifferentiated
or 2.
Differentiated
Cement, cars,
electrical
appliance, oil
One
Restricted
or
completely
blocked
Unique
WAPDA, or
KESC
Downward
sloping but
elastic;
firm
has
some
control
over
prices.
Downward
sloping
relatively
inelastic but
depends on
reactions
of
rivals to
a
price
change
Downward
sloping more
inelastic than
oligopoly; firm
has
considerable
control
over
price
Oligopoly
Cartel
Monopoly
or
Price discrimination (PD) happens when a producer charges different prices for the same product to different
customers. A seller with a degree of monopoly power has the ability to price discriminate. This means being
able to charge a different price to different customers.
(ii)
Monopsony
A monopsony is a market in which there is a single buyer. Monopsony power is the ability of the buyer to
affect the price of the good and pay less than the price that would exist in a competitive market.
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(iii)
Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers
(oligopolists). The word is derived from the Greek for few sellers.
Because there are few participants in this type of market, each oligopolist is aware of the actions of the
others. The decisions of one firm influence, and are influenced by the decisions of other firms.
Strategic planning by oligopolists always involves taking into account the likely responses of the other
market participants. This causes oligopolistic markets and industries to be at the highest risk for
collusion.
It is not possible to identify any single equilibrium in oligopoly. Theory of firm is not clearly
discussed & established as the theory of firm in the other three market structures. Reason for that is the
firms are interdependent.
Two possible scenarios of oligopoly
This tension between collusion & competition give rise to two possible scenarios that the oligopolist firms can
have:
1. Collusive oligopoly
2. Non-collusive oligopoly
1- Collusive oligopoly (CARTEL):
A collusive oligopoly (or cartel) is an agreement can be formed by deciding upon market shares, advertising
expenses, prices to be charged (identical or different) or production quotas, such as OPEC, are collusive
oligopolies. A firm can collude in many different ways. For example, they can collude on the market share in
total profits. Collusion can also be done in terms of how much advertising expenditures each firm would have
to put. They can also set the prices and quotas. If firms are not of equal size, then quotas can be allocated
according to the MC of each firm. Cost of the cartel firm is minimized if the MC of each of the firm is equal.
But the problem with this quota system is that firms which have higher MC will get lower quotas and the firms
which have lower MC will get higher quotas.
2- Non- collusive oligopoly
If different firms in the oligopolistic structures do not cooperate with each other is known as non collusive
oligopoly. In this case, collusion breaks down because the incentive to cheat is very high. This can arise, for
instance, in a situation where there is a lure of very high profits so that individual firms cheat on their quota
and try to increase output and profits. But this causes everyone else to do the same and therefore supply soars
and prices tumble producing in effect a non-collusive oligopoly.
The incentive to collude becomes strong for members of a non-collusive oligopoly when firms are not making
good profits. Thus oligopolies usually oscillate between collusive and non-collusive equilibria.
Merit good
Merit good is a good which Govt like people to consume more. A merit good in economics is a commodity
which is judged that an individual or society should have on the basis of a norm other than respecting
consumer preferences. Examples include food stamps, health care, and subsidized housing. If Govt found
positive consumption externality then there would be the case of subsidy. For example, Govt wants to
encourage people for more education and it thinks that marginal social benefit of education is higher than the
marginal private benefit so it gives scholarships and subsidies to the students and education sector.
Public good
In economics, a public good is a good that is non-rival and non-excludable. This means that consumption of
the good by one individual does not reduce the amount of the good available for consumption by others; and
no one can be effectively excluded from using that good. Common examples of public goods include: defense
and law enforcement (including the system of property rights), public fireworks, lighthouses, clean air and
other environmental goods, and information goods, such as software development, authorship, and invention.
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Experience goods are goods that people must get a flavor of before they can consider buying them. In
economics, an experience good is a product or service where product characteristics such as quality or price
are difficult to observe in advance, but these characteristics can be ascertained upon consumption.
Structure of National Economy:
The national economy is the total of all the financial transactions that go on in the nation. This includes
everything: a kid buying candy with a rupee in his hand, one mega corporation acquiring another in an
international transaction, the government opening (or closing) a military base.
An economy includes every exchange of money that takes place in a city, province or nation/region.
National economy/income has different concept which used in theory as well as in the analysis.
Gross Domestic Product (GDP):
Gross Domestic Product is the total market value of all goods and services produced within the political
boundaries of an economy during a given period of time, usually one year.
This is the government's official measure of how much output our economy produces.
GDP = C+I+G+NX(X-M)
GDP at factor and market prices:
Factor price is the price at which firm sells its final output to the consumers. While market price includes
factor price plus the indirect taxes imposed by the government. GDP at market price is higher than the GDP at
factor price.
GDP at factor cost = GDP at market price Indirect taxes
Gross National Product (GNP):
Gross national product (GNP) is the value, at current market prices, of all final goods and services produced
during a year by the factors owned by the citizens of a country. Thus the income earned by Pakistani citizens
working in the US would be included in Pakistans GNP but excluded from Pakistans GDP. Conversely, the
income earned by a US citizen (individual or corporate) in Pakistan would be included in Pakistans GDP but
excluded from Pakistans GNP. Generally, GNP = GDP + net factor income from abroad.
Net National Product (NNP):
Mathematically, national income is net national product (NNP). It is GNP adjusted for depreciation. In words,
it is the net output of commodities and services flowing during the year from the countrys production system
in the hands of ultimate consumers. The total market value of all final goods and services produced by citizens
of an economy during a given period of time, usually a year, after adjusting for the depreciation of capital.
Like NDP, NNP is a measure of the net production in the economy.
NNP = GNP Depreciation allowance
Depreciation:
The wearing out, breaking down, or technological obsolescence of physical capital that results from use in the
production of goods and services. To paraphrase an old saying, "You can't make a car without breaking a few
socket wrenches." In other words, when capital is used over and over again to produce goods and services, it
wears down from such use.
National income at factor cost (NI)/NNP at Factor Cost:
NNP is often referred to as national income. The sum of all factor incomes earned by the residents of a country
both from within the country as well as abroad. It is in fact the alternative name NNP and factor cost. NI at
factor coat or NNP at cost is the total income earned by a nations residents in the production of goods &
services. It is inclusive of net factor income earned from abroad. The main components of national income at
factor cost (i) wages & salaries paid by the firms to the employees (ii) interest which is the payment for the use
of funds (iii) rent & (iv) profit.
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Per Capita Income, Personal Income and Disposable Income:

Per capita income is obtained by dividing the national income by the total number of population. It is the
average annual income per head for all the inhabitants of the country; it is used to represent the standard of
living of the people.
Personal income of an individual is the total amount of income he receives from deploying all the different
factors of production he owns. Aggregate personal income is just the above definition aggregated for the
whole of the economy. The total income received by the members of the domestic household sector, which
may or may not be earned from productive activities during a given period of time, usually one year. The
primary use of personal income is to measure the income actually paid out to the household sector. After
adjusting for income taxes, personal income forms the basis for consumption expenditures on gross domestic
product.
Disposable income is obtained by subtracting the amount of direct taxes from the personal income of the
person. Aggregate holds as above as well. The total income that can be used by the household sector for either
consumption or saving during a given period of time, usually one year. This is the income left over after
income taxes and social security taxes are removed and government transfer payments, like welfare, social
security benefits, or unemployment compensation are added.
Real GDP:
The total market value, measured in constant prices, of all goods and services produced within the political
boundaries of an economy during a given period of time, usually one year. The key is that real gross domestic
product is measured in constant prices, the prices for a specific base year.
Real gross domestic product, also termed constant gross domestic product, adjusts gross domestic product for
inflation. You might want to compare real gross domestic product with the related term nominal GDP.
Nominal GDP:
The total market value, measured in current prices, of all goods and services produced within the political
boundaries of an economy during a given period of time, usually one year. The key is that nominal gross
domestic product is measured in current or actual prices; the prices buyers actually pay for goods and services
purchased. Nominal gross domestic product is also termed current gross domestic product.
Real flow includes services of land labor and capital going from households to firms, and products of firms as
physical goods of services flowing to households. Real GDP therefore excludes the effect of prices and
focuses entirely on the volume (or quantity) of goods and services produced.
Money (or nominal) flow includes the payments firms make to households for factor services and also it
includes the household spending money to buy goods from firms. Nominal GDP would therefore include the
effect of changes in the price level, as it is a measure of the money value of goods and services produced.
GDP deflator/price deflator
The process of converting nominal GDP into real GDP is known as deflation. A price index calculated as the
ratio nominal gross domestic product to real gross domestic product. Also commonly referred to as the implicit
price deflator, the GDP price deflator is used as an indicator of the economy's average price level.
GDP Deflator = Nominal GDP / Real GDP
It is the price deflator (see price\ratio expression in brackets below) which enables us to move from nominal to
real GDP. It provides a measure of the change in prices from the base (or benchmark) year to year a, given
values for some aggregate price index for the two years:
Real GDP year a = Nominal GDP year a X (Price Index base year / Price Index year a) Using a similar
formula and the same base year, Real GDP year b can be calculated and then year b compared with Real
GDP year a to get an idea of real GDP growth over the a to b period.
Example:
Nominal GDP was $150 billion in 1985
& $300 billion in 1994
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ASSUME that prices have risen by 50% over the period.
Real GDP in 1994 measured in 1985 prices:
= $300 billion x 100/150 = $200billion
Hypothetical economy
Year 1
Apples produced
100
Chicken produced
100
Cost per apple Rs
Year 2
150
140
4
Cost per chicken Rs

4
6
Nominal GDP in year1 = (100 x 2) + (100 x 4) = 600
Nominal GDP in year2 = (150 x 4) + (140 x 6) = 1440
Growth rate in nominal GDP = 1440 600/600 = 140%
Year2 price index at year 1 prices = 150 x 2 + 140 x 4/ 290 = 2.966
Year2 price index at year 2 prices = 150 x 4 + 140 x 6/290
= 4.966
Current year price index
GDP Deflator:
2.966X = 4.966 x100
X = 167.4%
This is the price level in percentage terms prevailing in the current year (Year2) relative to the price level of
Year1.
Real GDP = 1440 x 100/167.4 = 860
Growth rate = 860 600/600 = 43%
Per Capita GDP:
Per capita GDP is simply the total GDP of the economy divided by the no. of people in the economy.
The GDP of China might be bigger than the GDP of Switzerland but in average per capita terms, Switzerlands
income might be several times that of Chinas; the figure given in the lectures was 160.
Stocks vs. flows
Stock: A variable or measurement that is defined for an instant in time (as opposed to a period of time). A
stock can only be measured at a specific point in time. For example, money is the stock of production that
exists right now. Other important stock measures are population, employment, capital, and business
inventories. More examples include a persons wealth, number of people with college degrees and the govt.
debt.
Flow: A variable or measurement that is defined for a period of time (as opposed to an instant in time). A flow
can only be measured over a period. For example, GDP is the flow of production during a given year. Income
is another flow measures important to the study of economics. More examples include a persons saving,
number of new college graduates and the govt. budget deficit.
Methods of measuring GDP
There are three equivalent ways of measuring GDP:
i. The product or value added method which sums the value added by all the productive entities in the
economy;
ii. The expenditure method which sums up the value of all the final goods transactions taking place in the
economy;
iii. The factor income method which sums up all the incomes earned by all the factors of production in the
economy (rent for land, wages for labour, interest for capital, and equity returns for entrepreneurship).
The three methods are equivalent. One way to see why this must be so is because in an ex-post sense,
aggregate supply (i) = aggregate demand (ii) = national income (iii).
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Value added is the increase in the value of a good at each stage of the production process. The value that's
being increased is specifically the ability of a good to satisfy wants and needs either directly as consumption
good or indirectly as a capital good. A good that provides greater satisfaction has greater value. In essence, the
whole purpose of production is to transform raw materials and natural resources that have relatively little value
into goods and services that have greater value.
Final and Intermediate Goods:
GDP might be calculated at market prices (includes sales tax paid by consumer as part of the final price) or at
factor cost (excludes sales tax). If there is no sales tax, the two measures collapse to the same thing.
Final good:
A good (or service) that is available for purchase by the ultimate or intended user with no plans for further
physical transformation or as an input in the production of other goods that will be resold. Gross domestic
product seeks to measure the market value of final goods. Final goods are purchased through product markets
by the four basic macroeconomic sectors (household, business, government, and foreign) as consumption
expenditures, investment expenditures, government purchases, and exports.
Intermediate good:
A good (or service) that is used as an input or component in the production of another good. Intermediate
goods are combined into the production of finished products, or what are termed final goods. Intermediate
goods will be further processed before sold as final goods. Because gross domestic product seeks to measure
the market value of final goods, and because the value of intermediate goods are included in the value of final
goods, market transactions that capture the value of intermediate goods are not included separately in gross
domestic product. To do so would create the problem of double counting.
Difference between total value and value added:
Firm A:
Produces steel from raw iron and sells it for Rs 100,000 to firm B.
Firm B:
Buys steel worth Rs 100,000 then processes it to produce a car body worth Rs 200,000.
Firm C:
Buys the car body, adds the other parts etc. and sells complete car for Rs 450,000.
Value added or GDP:
Value of transactions: 100,000 + 200,000 + 450,000 = 750,000
GDP = Sum of the value added by each of the firms:
= 100,000 + (200,000 100,000) + (450,000 200,000)
= 100,000 + 100,000 + 250,000 = 450,000 GDP.
Also total expenditure of consumer on car = 450,000
The purchasing parity (PPP)
The purchasing power parity (PPP) is a measure of GDP recognizes the fact that a given amount of income in
one country might not be able to purchase the same quantity of goods and services in another country.
So, e.g. if China per capita income is 1/160th of Switzerlands per capital income, it might be that goods and
services in China are much cheaper and therefore Chinas per capita income does not need to grow 160 times
in order to deliver the same standard of living as in Switzerland. The PPP GDP per capita is therefore a more
sensible measure to use for comparison across countries at different levels of development. This is indeed the
reason why many international development organizations prefer this over simple GDP per capital.
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Business Cycle:
Predictable long-term pattern changes in national income. Traditional business cycles undergo four stages:
boom (prosperity), recession, depression, and recovery. After a recessionary phase, the expansionary phase
can start again. The phases of the business cycle are characterized by changing employment, industrial
productivity, and interest rates. Some economists believe that stock price trends precede business cycle stages.
Boom (prosperity): Boom is a period of rapid economic expansion.
Recession: A period of general economic decline; typically defined as a decline in GDP for two or more
consecutive quarters. A recession is typically accompanied by a drop in the stock market, an increase in
unemployment, and a decline in the housing market. A recession is generally considered less severe than a
depression, and if a recession continues long enough it is often then classified as a depression
Depression: A period during which business activity drops significantly. High unemployment rates and
deflation often accompany a depression.
Recovery: A period in a business cycle following a recession, during which the GDP rises.
Unemployment
Unemployment is the state in which a person is without work, available & willing to work, but is currently
unable to find a payable job.
The unemployment rate is defined as the ratio of the no. of unemployed people divided by the sum of the
employed and unemployed people. A rate of 3-4% is usually considered low, 10-15% considered high, and
over 20% considered extremely high.
Types of Unemployment:
There are several types of unemployment.
Frictional unemployment occurs when a worker moves from one job to another. While he searches for a job
he is experiencing frictional unemployment.
Structural unemployment is caused by a mismatch between the location of jobs and the location of jobseekers. "Location" may be geographical, or in terms of skills. The mismatch comes because unemployed are
unwilling or unable to change geography or skills.
Cyclical unemployment, also known as demand deficient unemployment, occurs when there is not enough
aggregate demand for the labor. This is caused by a business cycle recession.
Technological unemployment is caused by the replacement of workers by machines or other advanced
technology.
Classical or real-wage unemployment occurs when real wages for a job are set above the market-clearing
level. This is often as a result of government intervention, as with the minimum wage, or unions.
Seasonal unemployment relates to certain types of workers going out of job due to seasonal factors. Thus
crop producers in cold countries would have little to do when the fields are covered with snow from December
till March. The policies that could address this problem would be to facilitate labour migration in winter
months, or to develop alternative tasks for the winter (holding winter games in the region and developing it as
a tourist spot for e.g.!)
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Inflation:
The overall general upward price movement of goods and services in an economy (often caused by an increase
in the supply of money). when, the cost of goods and services increase, the value of a rupee is going to fall
because a person won't be able to purchase as much with that rupee as he previously could. Inflation is a
situation in which there is a continuous rise in the general price level. The rate of inflation is the percentage
annual increase in average price level.
Causes of Inflation:
Demand Pull Inflation
The process of excess demand beyond the output capacity of the economy to supply goods & services which
pulls up prices. Demand-pull inflation is likely when there is full employment of resources and when SRAS
is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a
number of reasons some of which occur together at the same moment of the economic cycle
A depreciation of the exchange rate, which has the effect of increasing the price of imports and
reduces the foreign price of Pakistan exports. If consumers buy fewer imports, while foreigners buy
more exports, AD will rise. If the economy is already at full employment, prices are pulled upwards.
A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real
disposable income causing demand to rise. A reduction in indirect taxes will mean that a given
amount of income will now buy a greater real volume of goods and services. Both factors can take
aggregate demand and real GDP higher and beyond potential GDP.
The rapid growth of the money supply perhaps as a consequence of increased bank and building
society borrowing if interest rates are low. Monetarist economists believe that the root causes of
inflation are monetary in particular when the monetary authorities permit an excessive growth of the
supply of money in circulation beyond that needed to finance the volume of transactions produced in
the economy.
Rising consumer confidence and an increase in the rate of growth of house prices both of which
would lead to an increase in total household demand for goods and services
Faster economic growth in other countries providing a boost to Pakistan exports overseas.
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The effects of an increase in AD on the price level can be shown in the next two diagrams. Higher prices
following an increase in demand lead to higher output and profits for those businesses where demand is
growing. The impact on prices is greatest when SRAS is inelastic.
In the first diagram the SRAS curve is drawn as non-linear. In the second, the macroeconomic equilibrium
following an outward shift of AD takes the economy beyond the equilibrium at potential GDP. This causes an
inflationary gap to appear which then triggers higher wage and other factor costs. The effect of this is to
cause an inward shift of SRAS taking real national output back towards a macroeconomic equilibrium at Yfc
but with the general price level higher than it was before.
The wage price spiral expectations-induced inflation

Rising expectations of inflation can often be self-fulfilling. If people expect prices to continue rising, they are
unlikely to accept pay rises less than their expected inflation rate because they want to protect the real
purchasing power of their incomes. For example a booming economy might see a rise in inflation from 3% to
5% due to an excess of AD. Workers will seek to negotiate higher wages and there is then a danger that this
will trigger a wage-price spiral that then requires the introduction of deflationary policies such as higher
interest rates or an increase in direct taxation.
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Inflation influences in the Pakistan economy
The diagram summarizes some of the key influences on inflation. Reading from left to right:
Average earnings comprise basic pay + income from overtime payments, productivity bonuses,
profit-related pay and other supplements to earned income

Productivity measures output per person employed, or output per person hour. A rise in productivity
helps to keep unit costs down. However, if earnings to people in work are rising faster than
productivity, then unit labor costs will increase
The growth of unit labor costs is a key determinant of inflation in the medium term. Additional
pressure on prices comes from higher import prices, commodity prices (e.g. oil, copper and aluminum)
and also the impact of indirect taxes such as VAT and excise duties.
Prices also increase when businesses decide to increase their profit margins. They are more likely to
do this during the upswing phase of the economic cycle.

Cost Push Inflation
Cost-push inflation is an increase in input costs-wages, raw material & components which push up final
prices. Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in
order to maintain their profit margins. There are many reasons why costs might rise:
Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on
exports of these commodities or alternatively by a fall in the value of the rupee in the foreign exchange
markets which increases the Pakistan price of imported inputs. A good example of cost push inflation was the
decision by Pakistan Gas and other energy suppliers to raise substantially the prices for gas and electricity that
it charges to domestic and industrial consumers at various points.
Rising labor costs - caused by wage increases which exceed any improvement in productivity. This cause is
important in those industries which are labor-intensive. Firms may decide not to pass these higher costs onto
their customers (they may be able to achieve some cost savings in other areas of the business) but in the long
run, wage inflation tends to move closely with price inflation because there are limits to the extent to which
any business can absorb higher wage expenses.
Higher indirect taxes imposed by the government for example a rise in the rate of excise duty on alcohol
and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an
extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers)
who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden
of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel,
then this would contribute to a rise in cost-push inflation.
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Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. This is shown
in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of real national output together with
a rise in the general level of prices.
Pure inflation is a special case of inflation in which the prices of all the goods and services in the
economy are rising at the same rate. So if an economy produces three goods: apples, shirts and cars,
and they cost Rs. 5, Rs. 100 and Rs. 400,000 respectively in 1992, while the prices in 1993 are Rs. 6,
Rs. 120 and Rs. 480,000, and the prices in 1994 are Rs. 9, Rs. 180 and Rs. 720,000, respectively, then
we can say that there was pure inflation of 20% in 1993 (over 1992) and pure inflation of 50% in
1994 (Over 1993).
Measurement of inflation:
More generally, inflation (in % p.a.) is measured as
[(Pt - Pt-1)/Pt-1]*100
Where Pt refers to the average price level prevailing in year t, and Pt-1 is the average price level prevailing in
period t-1. The term average price level usually refers to the value of an index, like consumer price index or
producer price index etc., which weights the prices of goods according to their share in the total nominal GDP.
Dates
Price level
Inflation (%)
30th June 2000
100
-----30th June 2001
105
5%
30th June 2002
107
1.9%
30th June 2003
120
12.1%
Ideal Inflation Rate for an Economy:
It is difficult to say what the ideal inflation rate for an economy is. But it is not usually zero. A small positive
inflation rate of about 3% is considered healthy for mature HICs while 7% is quite acceptable for fast growing
emerging economies. Inflation rates above 10% are generally considered undesirable.
Some countries, esp. in Latin America, have recorded inflation rates in 100s and 1000s of percentage p.a.
these episodes were known as hyper inflation episodes. The first country to suffer hyperinflation, and perhaps
in its severest form, was Germany in the 1920s. The country was burdened with very high debt linked to
obligations taken on as a result of being defeated by the allies in the 1st World War. The German government
could not find the resources to pay off the debt or the interest thereon and resorted to printing money. This,
however, plunged the local economy into hyperinflation.
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The Choice of price Index:

There are important statistical challenges to resolve in the definition of inflation. The choice of price index
often affects what one can say about inflation. Thus it might be that overall inflation is high, but food inflation
is low. Similarly, there can be a price index for students, the health sector, housing and each has a different
meaning attached to it. When talking about inflation, it should be clear which index is being referred to. The
most commonly used index when referring to overall inflation in the economy is the retail or consumer price
index (CPI).
The CPI and PPI:
Consumer Price Index an inflationary indicator that measures the change in the cost of a fixed basket of
products and services, including housing, electricity, food, and transportation. The CPI is published
monthly.CPI is measure estimating the average price of consumer goods & services purchased by households.
It is also called cost-of-living index.
Producer Price Index an inflationary indicator published by the U.S. Bureau of Labor Statistics to evaluate
wholesale price levels in the economy. The producer price index (PPI) is the price index of goods and raw
materials sold at the wholesale level to producers: examples of goods in the wholesale basket are steel, wheat,
cotton etc. at first it was used as a Wholesale Price Index (WPI). Retail Price Index an inflationary indicator
that measures the change in the cost of a fixed basket of retail goods.
However, all these indices are measures of price inflation. A slightly different but related concept is that of
wage inflation, which measures the rate of increase of average wages in the economy. Since real wages are
nominal wages adjusted for prices, it is straightforward to see that if wage inflation is greater than price
inflation, real wages are rising, and vice versa. Countries where price inflation is very high often keep track of
wage inflation rates to ensure that the real wage (which measures the purchasing power of workers) remains
constant. The practice of linking wages to prices is called index-linking and is the norm in many Latin
American countries.
Hyperinflation
Hyperinflation is a period of rapid inflation that leaves a country's currency virtually worthless.
Stagflation
Stagflation is a situation in which inflation and economic stagnation (high unemployment) occur
simultaneously and remain unchecked for a period of time. In economics, the term stagflation refers to the
situation when both the inflation rate and the unemployment rate are high. It is a difficult economic condition
for a country, as both inflation and economic stagnation occur simultaneously and no macroeconomic policy
can address both of these problems at the same time
Money:
Any medium of exchange which is fully backed by the government of a country is called money. Real money
is that money which is fully backed by some precious thing or gold. Fiat money is not actually backed by the
government but the government just gives the warrantee that money can be converted into gold at any time.
Functions:
Medium of exchange: we use it to buy stuff..
Unit of account: the common unit by which everyone measures prices and values.
Store of value: transfers purchasing power from the present to the future.
Bank:
A bank is an institution which deals with money basically & may be even property on the country. An
organization, usually a corporation, chartered by a state or federal government, which does most or all of the
following: receives demand deposits and time deposits, honors instruments drawn on them, and pays interest
on them; discounts notes, makes loans, and invests in securities; collects checks, drafts, and notes; certifies
depositor's checks; and issues drafts and cashier's checks.
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Central Bank:
The generic name given to a country's primary monetary authority, such as the State Bank of Pakistan. Usually
has responsibility for issuing currency, administering monetary policy, holding member banks' deposits, and
facilitating the nation's banking industry.
The Balance of Payments (BOP):
BOP is an accounting record of a countrys transactions with the rest of the world.
Balance of trade means a statement that takes into account the total value of exports and imports of visible
commodities of a country during a year. On the other hand Balance of payments is a statistical statement of
income and expenditure both of the visible & invisible items of trade on international account during a
calendar year. Here a visible commodity is meant the commodities which when export or import are recorded
to the trade accounts at the ports. Invisible items are those items which are not shown in the trade accounts at
the time of their import such as services of banking, Shipping, insurance etc.
The balance of payments (or BOP) measures the payments that flow between any individual country and all
other countries. It is used to summarize all international economic transactions for that country during a
specific time period, usually a year. The BOP is determined by the country's exports and imports of goods,
services, and financial capital, as well as financial transfers. It reflects all payments and liabilities to foreigners
(debits) and all payments and obligations received from foreigners (credits).
Balance of payments is one of the major indicators of a country's status in international trade, with net capital
outflow.
International Monetary System:
There is a marked difference between domestic trade & international trade. In international trade , the goods
are not exchange by barter (Pakistans cotton for japans cars for instance) but through the medium of money.
For example, if a Pakistani imports machinery from England, the English seller wants pounds and not
Pakistani rupees. How will you convert and at what rate the Pakistani currency with the British pound. The
government of each country here comes to their rescue and introduces a new element, the foreign exchange
rate. The foreign exchange rate determines the prices of foreign countries currency in terms of our own.
Exchange rate:
Exchange rate is that rate at which one currency may be converted into another. The exchange rate is used
when simply converting one currency to another (such as for the purposes of travel to another country), or for
engaging in speculation or trading in the foreign exchange market. There are a wide variety of factors which
influence the exchange rate, such as interest rates, inflation, and the state of politics and the economy in each
country.
The exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies
specifies how much one currency is worth in terms of the other. For example an exchange rate of 86.70
Pakistani rupees (PKR) to the United States dollar (USD) means that PKR 86.70 is worth the same as US $ 1.
There are three majors exchange rate systems.
1.
Fixed exchange rate system:
Fixed exchange rate system is one in which the exchange rate between two or more countries is set by the
government of a country. The fixed exchange rate remained operative under the gold standard from, 1880 to
1913. In this system, the countries define their currencies in terms of fixed amount of gold. This establishes the
exchange rates among the country on gold standard. For example, the price of gold was fixed at $ 20 per ounce
in USA up to 1933 & in England the price was 5 per ounce of gold. The rate of exchange between the two
countries was $5 to 1.
The gold standard was abandoned before the Second World War. Under the Bretton Woods Agreement in
1944, a new system of fixed exchange rate was established. There is less emphasis on gold as backing for the
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system. Under the new system, the value of currency of each country is to be fixed relatively to other
currencies by the government and the central bank of the country.
2.
Flexible/Floating Exchange Rates System:
Flexible/Floating Exchange Rates System is one in which a foreign exchange rate is determined by the market
forces of supply & demand for foreign exchange. In the freely floating exchange rates system, there is no
intervention on the part of the government of the country to determine the exchange rate. The government is
on the sideline. Its allow the foreign exchange markets to determine the exchange rates by the forces of supply
& demand for the foreign currency. We can say that the flexible exchange rates system, the exchange rates
fluctuates in response to market forces.
The disequilibrium in the balance of payments is automatically adjusted in the freely floating exchange rates.
For example, Pakistan has an excess of imports from France. Pakistani importers will naturally buy francs to
pay for their imports. The price of francs will be driven up in terms of pak rupee. The French goods become
more expensive to Pakistanis. The goods produced in Pakistan become cheaper to France. The exports from
Pakistan to France began to rise. The French purchases will continue till the exports & imports between the
two countries are restored to balance. We, thus, find that freely floating exchange rates tends to automatically
correct disequilibrium in the balance of payments at the international level.
A floating exchange rates system has the advantage of being self regulating. It automatically removes the
disequilibrium in the balance of payment of a country. The difficulty with this system is that it is
unpredictable. A fluctuation in exchange rates makes international trade riskier. If increases the cost of doing
business with other countries.
3.
Managed Float System:
The system of managed floating rates has been adopted in all most all the countries of the world since 1971.
Under this system, the currency of a country is allowed to float on foreign exchange market and determined its
exchange rates according to market forces. The government or the central bank of a country may intervene
from time to time in the currency market in order to lower or raise the price of its currency. The main purpose
of such intervention is to prevent sudden large swings in the value of a nations currency.
The policy of managed floating exchange rate was introduced in Pakistan in January, 1982. The state bank of
Pakistan influences the exchange rate of Pakistani currency with the major trading currencies of the world.
The countries having a managed floating enjoy the benefit of flexible rate i.e. automatic adjustment of balance
of payment. It also reduces uncertainty & speculation in the exchange rates. More over, it provides stable
terms of trade.
Pakistan, since July 1998, has moved to a dual exchange rates system. Under the new system there exists two
exchange rates namely managed float rate determined by the State Bank of Pakistan & the inter Bank Rate.
The Inter Bank Rate is determining by market force of demand & supply.
Foreign Exchange Market:
It is a place in which foreign exchange transactions take place. It is a part of money market in the financial
centers. In Pakistan there is no foreign exchange market as defined above. Here the most important component
of foreign exchange market is the central bank of the country or its authorized dealers.
Demand for Foreign Exchange:
Demand for foreign currency is the amount of foreign exchange, that people and firms of a country need to pay
for goods & services they purchased from another country. The greater the amount of goods & services
purchased by one country from the other, the greater is its demand for the foreign currency to pay for them &
vice versa. Let us assume there are two countries Pakistan and USA which trades with each other. The demand
for dollars by the people & firms in Pakistan arises due to the following factors.
Pakistan individuals, firms or government imports goods from USA.
The Pakistani travelling & studying in USA need dollars to meet traveling & educational expenses.
The Pakistani who want to invest in equity shares & bonds of the US companies.
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The Pakistani who want foreign exchange for investment in factories oil & gas exploration in USA
etc. & for sending gifts to relatives in USA.
Exchange rate in Pakistan:
Now, Pakistan is maintaining a floating rate. Under this exchange rate system, each bank quotes its own rate
depending on its short and long positions. Strong competition, however, means the exchange rates vary little
among the banks. Under the prevailing Exchange Control Act, the State Bank of Pakistan on application may
authorize any person or institution to deal in the foreign exchange market. By virtue of this vested authority,
the SBP may determine the extent to which a Bank would be authorized to deal in various currencies.
International Monetary Institutions:
During the inter-war years, all the countries of the world were forced off the gold standard. It was a period of
fluctuating exchange rates, blocked accounts, high tariffs, competitive exchange depreciation and quota
system, world specialization and productivity was continuously declining. When the 2nd world war was still
going on, the Great Britain and North America were giving serious thought to the problem of post-war
international exchange. The object was to increase international trading by promoting international monetary
co-operation. In order to achieve this objective, the return to gold standard was considered difficult because
that system proved too rigid. It made each country a slave rather than a master of its economic destiny. The
return of free exchange rates, the other extreme, was also not agreed upon, because it increases the risk in
international trading & thus reduces total volume of trade. The desire was to secure the advantages of both
system i.e. gold standard & free exchange rates system without their disadvantages.
In 1943 UK & USA submitted two plans fostering international trade thorough stable exchange rates. In July,
1944, the United Nations monetary currency plans known as the Keynes plan & the white plan put forward by
the economic experts of the Great Britain & USA. Following discussions of the two plans, a concrete program
of monetary & financial co-operation including stability of exchange was worked out. The Bretton Wood
Conference was attended by 44 representatives of different nations and there an agreement was signed to
establish the International Monetary Fund (IMF) and the International Bank for Reconstruction and
Development (IBRD), which today is part of the World Bank Group.
International Monetary Fund (IMF):
Establishment: The international Monetary Fund (IMF) was the outcome of Bretton Wood Agreement signed
by 44 major countries of the world in July 1944 in USA.
Organization: IMF is an autonomous organization & is affiliated to UNO. The management of the Fund is
under the control of two bodies (a) Board of Governors & (b) Board of Executive Directors. The Board of
Governor is the general body of management. It has the responsibility of formulating the general policies of
the Fund. The Board of Executive Directors is responsible for the day to day business of the Fund.
Quotas: Each of the members of IMF is required to contribute a quota to the Fund. The size of quota depends
upon the national income of the country & upon its share in international trade. The quota is made up of 75%
in the countrys own currency & 25% in gold. Members quotas are now supplemented by an allocation of
Special Drawing Rights (SDRs).
Functions of IMF:
1)
Maintaining exchange stability: one of the basic objectives of the IMF is to establish reasonable
exchange stability among the member countries. It keeps a strict watch over the exchange rate policies
of members countries & advises them as & when need arises.
2)
Borrowing: Originally each member could borrow in trenches (slices) equal to 25% of its quota in a
year. In addition to this, a member has the basic credit facility of 5 trenches (125% of its quota) from
the Fund. Now the credit facility has been raised upto 45% of ones quota over a three years period.
3)
Balancing demand & supply of currencies: The IMF also helps in maintaining balance between
demand & supply of various currencies. It purchases the currency of a country which is in great
demand (scarce currency) and rations its supply among the buyer countries.
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4)
Interest charges: The IMF charges interest on the credit provided to the countries. The interest on 1st
trench is nominal but it increases as the amount of loan increases.
5)
Technical assistance: The IMF also provides technical assistance, through the services of specialists
& experts, to member countries.
Methods of Borrowing:
1)
Standby Arrangement: this method of providing credit was introduced in 1952. According to this
method, the resources are made available to a member which may draw as & when it wishes.
2)
General Agreement to Borrow: In 1962, the leading 10 industrialized nations made a pool o 6 billion
dollars for helping each other through the IMF. The size of the pool has been increased to 17 billion
SDRs & less developed countries have also been included for financial help.
3)
Compensatory Finance Scheme: Under this method, which was started in 1963, if a member is
experiencing difficulty in the receipt of export credit, the IMF can give loan to a member with a fewer
conditions.
4)
Buffer Stock Facility: This scheme was introduced in 1969. The purpose of this scheme was to help
the primary producing countries to pay their subscription of primary product prices.
5)
The Extended Fund Facility: This scheme was introduced in 1974. The purpose of this scheme was
to provide long term assistance to member countries experiencing balance of payments difficulties.
6)
The supplementary Financing Facility: This scheme was started in 1979. Its purpose was to give
long term loans to less developed countries. It has a special fun of SDR 7.8 billion available by 14 of
the rich countries.
Special Drawing Rights:

The IMF, for the first time in 1967, issued special drawing rights (SDRs) to governments to settle
international debts. They have now replaced gold in international markets. They are thus paper substitutes for
the gold & function as international reserves. When they were initially introduced, they were linked to
dollar=SDR1=$1. Now the value of one unit of SDR is calculated by combining the value of leading five
currencies of the world. They are the new type of international money.
Functions of SDRs:
1)
A means of exchange: The SDRs with the consent of IMF are used to settle indebtedness between
nations. Thus they serve as means of exchange.
2)
A unit of value: All international transactions are now denominated in SDRs several other
institutions also use the SDRs as the unit of account.
3)
A store of value: With the introduction of SDRs, the role of gold has been reduced. The SDRs are
now the principal asset of the IMF.
There is no doubt that IMF is helping the developing countries in the correction of their balance of payments
deficits, maintaining monetary stability, giving technical assistance. However, the Fund has now become a
Rich Mens Club. The IMF is too much interfering in the economic policies of the less developed countries
including Pakistan by imposing various restrictions. For instance, it is dictating the fiscal policy in detail. It is
telling which commodities & services are to be taxed & also the scale of taxes. It is also scrutinizing the
expenditures of the Govt: of Pakistan. It is advising on phasing out subsidies & adjustments in utility prices
without realizing their impact on the poorer section of the society & the cost of production of goods. Pakistan
is hoping that after the conclusion of the current three years Poverty Reduction & Growth Facility (PRGF) it
will be in a position to live without IMF.
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WORLD BANK:
The World Bank or the international bank for reconstruction and development (IBRD) was set up in 1947 as
the sister organization to IMF.
Objective of World Bank:
1.
The original objective of establishing World Bank was to make loans to develop war shattered
economies of Europe in the Second World War.
2.
The bank also promotes investment by means of guarantee or participation in loans and other
investments made by private investors.
3.
It also supplements private investment by providing finance for productive purposes out of its own
capital funds.
4.
The World Bank helps now the poorer countries of the world. It provides source of advice and
information besides making loans.
Sources of world bank Funds:
There are three main sources of World Bank funds. They are:
(a)
Quotas: The membership of the World Bank is the same as that of IMF .Members makes
contributions in relation to their IMF Quota.
(b)
Bonds: The World Bank sells bonds in the capital markets of the world to raise funds.
(c)
Income: A very small proportion of the World Bank funds come from the interest on the loans
advanced.
New Organization of World Bank:
The World Bank has increased its operations by forming following three organizations.
The International Finance Corporation (IFC)
The International Development Association (IDA)
The Multilateral Investment Guarantee Agency (MIGA)
The World secures outside assistance from developed countries for poorer nations of the world. It is due to the
efforts of World Bank that Help Pakistan Club was formed of the rich nations to raise funds for Pakistan
development projects.
Criticism:
The working of the World Bank is criticized on the following grounds.
(1)
The Bank charges a very high rate of interest on loans.
(2)
The Bank harshly insists on the presence of repaying capacity of the borrowing country.
(3)
There are discriminations in advancing loans to members. Europe and western Hemisphere are smaller
both in area and population. They have received large amounts of loans. Whereas Asia and Africa both
rich in natural resources are being given step motherly treatment.
(4)
The loans given by World Bank to the developing countries are too small to play an effective role in
developing their economies
Evaluation:
The World Bank, on the whole, has helped in increasing the pace of economics development of different
countries of the world. The Bank as a mediator has played a significant role in solving major knotty issues e.g.
United Kingdom and United Arab Republic on the nationalization of the Suez Canal, between India and
Pakistan in resolving the Indus Basin water Dispute. Etc.
Devaluation:
This is the act of reducing the price (exchange rate) of one nation's currency in terms of other currencies. This
is usually done by a government to lower the price of the country's exports and raise the price of foreign
imports, which ultimately results in greater domestic production. A government devalues its currency by
actively selling it and buying foreign currencies through the foreign exchange market.
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Revaluation:
This is the act of increasing the price (exchange rate) of one nation's currency in terms of other currencies.
This is done by the government if it wants to raise the price of the country's exports and lower the price of
foreign imports. This is an appropriate action if the country is running an undesired trade surplus with other
countries. The procedure for revaluation is for the government to buy the nation's currency and/or sell foreign
currencies through the foreign exchange market.
Appreciation:
This is a more or less permanent increase in value or price. "More or less permanent" doesn't include
temporary, short-term jumps in price that are common in many markets. Appreciation is only those price
increases that reflect greater consumer satisfaction and thus value. While all sorts of stuff can appreciate in
value, some of the more common ones are real estate, works of art, corporate stock, and money. In particular,
the appreciation of a nation's money is seen by an increase in the exchange rate caused by a growing,
expanding, and healthy economy.
Depreciation:
A decline in the value of a given currency in comparison with other currencies. For instance, if the Pakistani
Rupees depreciates against the Dollar, buyers would have to pay more rupees in order to obtain the original
amount of Dollar before depreciation occurred.
The depreciation of a nation's money is seen as an increase in the exchange rate.
Public Finance:
Public Finance is that branch of economics which deals with the revenue & expenditure of a
government. The investment into the nature & principle of state expenditure & state revenue is
called public finance (Adam Smith).
The study of P.F split into four parts
1.
Public Expenditure
2.
Public Revenue
3.
Public Debt & its Management.
4.
Budgeting
The difference between public finance & private finance is that an individual adjusts his expenditure
in accordance with the given income. On the other hand, the Govt: relatively speaking adjusts its
income in accordance with its expenditure. Govt: prepare its expenditure/estimate expenditure and
only then devises ways & means to obtain the amount required.
Economic Policy:
The strategies & measures adopted by the Govt. to manage the economy as means of achieving its economic
objectives
In general terms Govt. are concerned with full employment, price stability, economic growth, & balance of
payment & efficient use of resources.
Economic policy is the means by which the Govt. stimulates or reigns in economic growth
There are two kinds of economic policy.
1)
Fiscal policy
The Govts income and expenditures policy is known as fiscal policy. Use of the federal government's powers
of spending and taxation to stabilize the business cycle. If the economy is mired in a recession, then the
appropriate fiscal policy is to increase spending or reduce taxes--termed expansionary policy. During periods
of high inflation, the opposite actions are needed--contractionary policy. The consequences of fiscal policy are
typically observed in terms of the federal deficit.
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Government purchases:
Expenditures on final goods and services (that is, gross domestic product) undertaken by the government
sector. Government purchases are used to operate the government (administrative salaries, etc.) and to provide
public goods (national defense, highways, etc.). Government purchases do not include other government
spending for transfer payments. These are expenditures on final goods by all three levels of government:
federal, state, and local governments. Government purchases are financed by a mix of taxes and borrowing.
Taxes:
Any sort of forced or coerced payments to government. The primary reason government collects taxes is to get
the revenue needed to finance public goods and pay administrative expenses. However, the more astute leaders
of the first estate have recognized over the years that taxes have other effects, including-(1) Redirecting resources from one good to another and (2) altering the total amount of production in the
economy. As such, taxes have been used to correct market failures, equalize the income distribution, achieve
efficiency, stabilize business cycles, and promote economic growth.
Fiscal policy is the governments program with respect to the amount and composition of (i) expenditure: the
purchase of goods and services, and spending in the form of subsidies, interest payments on debt,
unemployment benefit, pension and other payments, (ii) revenues, i.e. taxes and non-tax fees (such as license
fees etc.) and (iii) public debt: borrowing to cover the excess of expenditure over revenues. Borrowing can be
done from three sources: domestic banks and the general public, the central bank (e.g. State Bank of Pakistan),
and foreign creditors.
Budget Deficit, Budget Surplus and Balanced Budget:
If i>ii: the government is said to be running a fiscal or budget deficit and so the government must borrow (or
raise debt) to cover the deficit; if i<ii: the government is said to be running a fiscal or budget surplus and so the
government can pay-off or reduce its debt; if i=ii: the government is said to be running a balanced budget and
the governments net debt may remain constant.
Fiscal deficits and debt are often reported as a ratio of GDP. Although, there is no theoretical benchmark for
what constitutes a sustainable fiscal deficit or public debt ratio, the Maastricht criteria (for countries in the
European Union) is an important practical guide. It stipulates that fiscal deficit to GDP should be less than 3%
while public debt to GDP should be less than 60%.
Monetary policy: (money makes the world go round)
Monitory policy is the deliberate exercise of the monetary authoritys power to induce expansion or
contraction in the money supply.
Monetary policy is the process by which the government, central bank, or monetary authority manages the
supply of money, or trading in foreign exchange markets. Monetary policy is generally referred to as either
being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total
supply of money in the economy, and a contractionary policy decreases the total money supply.
Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates,
while contractionary policy has the goal of raising interest rates to combat inflation (or cool and otherwise
overheated economy). Monetary policy should be contrasted with fiscal policy, which refers to government
borrowing, spending and taxation.
Tools / instruments of monetary policy
Monetary policy can be defined as the central banks Programme, often changing on a daily basis, regarding
the direct or indirect control (through interest rates) of monetary conditions in the economy with a view to
managing aggregate demand and inflation. There are four major instruments of monetary policy:
I.
Reserve ratio and SLRs: the central bank can impose and alter a mandatory reserve ratio for
commercial banks, and through that, affect the money multiplier. By extension, the central bank can force
commercial banks to comply with additional statutory liquidity requirements (SLRs) that work similarly to a
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the reserve ratio. SLRs require commercial banks to invest in a certain quantity of T-bills and T-bonds. Since a
large stock of these is often held by the central bank as assets (credit to government), the central bank can use
SLRs to increase or run-down its holding of this stock, and thus cause M0 to increase or decrease directly.
II.
Discount rate: the central bank sometimes extends credit to commercial banks on their request to
meet their exigent liquidity needs. Such borrowing is called borrowing from the discount window and the rate
the central bank lends at the discount window is called the discount rate. If the central bank increases this rate,
banks would be inclined not to borrow from the central bank and instead keep a large reserve ratio as a cushion
against a possible liquidity crunch. A higher discount rate thus causes banks voluntary reserve ratio to
increase and the size of the money multiplier to reduce.
III.
Open market operations (OMOs): Central banks conduct OMOs on a frequent basis. An OMO
typically involves the central bank buying or selling government securities (T-bills and bonds) to commercial
banks. As mentioned in i) above, the central bank can build or run-down its stock of government securities and
affect M0. In contrast to i, however, it is not implemented as a mandatory requirement, rather the central bank
conducts an OMO in auction style in which all banks are free to bid. The price of the securities (and therefore
the yield or interest rate they offer) is determined by the degree of interest in the auction. If for instance, the
central bank wants to buy securities and there are very few willing sellers, then the sellers will demand a
higher price for the securities. This will push the yield (or return) on the securities down. By contrast, if there
were a large number of willing sellers, they would compete ferociously with each other to sell their stock to
the central bank. In this case, the securities prices are likely to be bid down, to the advantage of the central
bank. In both cases, however, the money supply will expand, as the central bank injects new currency into the
economy in exchange for the securities. In the reverse case, when the central bank sells securities in the
market, the money supply contracts.
IV.
Foreign exchange market interventions: A purchase or sale of foreign exchange by the central bank
has an ipso facto effect on the money supply because the central bank has to pay local currency in order to
buy the foreign currency. In balance sheet language, it can be seen that a central bank purchase of foreign
exchange, will cause the banks foreign exchange reserves (item 1 on the balance sheet) to increase. Unless
sterilized (by issuing central bank liquidity paper or OMOs) such an increase will cause an increase in M0,
which through a multiplier effect causes M2 (or money supply) to increase.
The concept of taxation
A levy imposed by the Govt. on goods & services.
Taxes are general purpose, compulsory contributions by the people to the public treasury (or national
exchequer) to meet the expenditure needs of the government. Without taxes, the government would not be able
to deliver services like law and order, public administration, national defense, free or subsidized health and
education etc.
Types of taxes
Direct tax
A tax imposed by the Govt. directly on individual income & also pays directly by those individual, like
personal income tax, corporation tax, wealth tax etc.
Personal income tax:
A tax on individuals income. This is the primary source of revenue for the federal government, a big source
for many state and local governments. In principle, personal income taxes are progressive, based on a
graduated tax scale. However, it's much more proportional today than it was several decades ago.
Corporate income tax:
A tax on the accounting profits of corporations. This tax is only levied on corporations, and excludes
businesses that are proprietorships or partnerships.
Indirect tax
Those kinds of tax imposed on producer but whose incidence is actually being shifted to the ultimate
consumer.
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Sales tax:
A tax on retail sales. This is major source of revenue for many state and local governments. Because poorer
people tend to spend a larger share of their income on stuff covered by sales taxes, it tends to be a regressive
tax. To reduce this repressiveness, some state and local governments excluded items like food and medicine.
Excise tax:
A tax on a specific good. This should be compared with a general sales tax, which is a tax on all (or nearly all)
goods sold. The most common excise taxes are on alcohol, tobacco, and gasoline. Excise taxes are used either
to discourage consumption of socially undesirable stuff (like alcohol and tobacco) or to raise some easy
revenue because the government knows buyers will keep buying regardless of the tax (like alcohol and
tobacco).
Value-added tax:
A tax on the extra value added during each stage in the production of a good. Most of the stuff or our economy
produces goes through several "stages," usually with different businesses. In each stage, resources do their
thing to the good to make it a little more valuable. For example, an ice cream store can take 50 cents worth of
ice cream, fudge, and whipped topping and turn it into a hot fudge sundae that's valued at $1.50. The efforts of
the ice cream resources thus add $1 in value. A value-added tax is based on this extra value.
Regressive tax
A tax in which people with more income pay a smaller percentage in taxes. For example, you earn $10,000 a
year and your boss gets $20,000. You pay $2,000 in taxes (20 percent) while your boss also pays $2,000 in
taxes (10 percent). Examples of regressive taxes abound including sales tax, excise tax, and Social Security
tax.
Proportional tax
A tax in which people pay the same percentage of income in taxes regardless of their incomes. For example,
you earn $10,000 a year and your boss gets $20,000. You pay $1,000 in taxes (10 percent) and your boss pays
$2,000 in taxes (10 percent). While a proportional tax would seem to make a lot of sense, very few taxes are
designed to be proportional and even fewer come out that way in practice.
Progressive tax
A tax in which people with more income pay a larger percentage in taxes. For example, you earn $10,000 a
year and your boss gets $20,000. You pay $1,000 in taxes (10 percent) and your boss pays$4,000 in taxes (20
percent). Our income tax system is designed to be progressive, but assorted loopholes and deductions keep it
from being as progressive in practice as it is on paper.
For LICs, income tax collection is very low and indirect taxes often account for more than 2/3rd of total
revenue as citizens often under-report their incomes in these countries, there is no voluntary tax payment
culture, and income tax collection agencies are weak and/or corrupt. By contrast, for HICs, income taxes are
much more important, accounting for over 2/3rd of total tax revenue.
Disposable income is obtained by subtracting income tax from total income. At the national level, disposable
income Yd is calculated as Y-T, or Y-tY, where t is the net income tax rate.
One important question before governments is determining the optimal tax rate, t, for the average citizen. If t is
too low, not enough taxes might be collected to enable the government to run and provide proper services. If t
becomes too high, the incentive for citizens to work will be reduced, meaning national income will go down
and tax collection will fall. Also at very high levels of t, the incentive to cheat and evade taxes increases and
the government, therefore, might face serious enforcement problems.
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National DebtAmount of money that a government owes its creditors. The U.S. national debt is over $6
trillion.
Economic Stability
Condition in an economic system in which the amount of money available and the quantity of goods and
services produced are growing at about the same rate.
Stabilization policyGovernment policy, embracing both fiscal and monetary policies, whose goal is to
smooth out fluctuations in output and unemployment and to stabilize prices
Period of gestation
The period between the start of an investment project and the time when production can start. Because this
period is usually quite long, particularly for major investment projects, expectations about market conditions
when the project is complete are necessarily very uncertain; long gestation periods make investment both more
risky and more difficult to predict.
Planning Officer
Elementary & Secondary Education Department
Cell # 03339668669
Wazir222@yahoo.com
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MANAGERIAL ECONOMICS
Managerial economics refers to the application of economic theory and the tools of analysis of decision
science to examine how an organization can achieve its aims or objectives most efficient
This can explained with the following Fig.
Management decision problems
Economic Theory:
Microeconomics
Macroeconomics
Decision sciences:
Mathematical economics
Econometrics
Managerial Economics:
Application of economic &
Decision science tools to solve
Managerial decision problems
Optimal solution to managerial

decision problems
Fig. 1.
The Nature of Managerial economics
Management decision problems (see the top of Fig) arise in any organization be it a firm, a nonprofit
organization (such as a hospital or a university), or a government agency- when it seeks to achieve some goal
or objective subject to some constraints. For example, a firm may seek to maximize profits subject to
limitations on the availability of essential inputs and in the face of legal constraints.
In all these cases, the organization faces management decision problems as it seeks to achieve its goal or
objective, subject to the constraints it faces. The goals and constraints may differ from case to case, but the
basic decision- making process is the same.
Relationship to Economic Theory:
The organization can solve its management decision problems by the application of economic theory and the
tools of decision science. Economic theory refers to microeconomics and macroeconomics.
Microeconomics is the study of the economic behavior of individual decision-making units, such as individual
consumers, resource owners, and business firms, in a free-enterprise system. Macroeconomics, on the other
hand, is the study of the total or aggregate level of output, income, employment, consumption, investment, and
prices for the economy viewed as a whole. Economic theories, which usually begin with a model, seek to
predict and explain economic behavior.
Relationship to the Decision Sciences:
Managerial economics is also closely related to the decision sciences. These use the tools of mathematical
economics and econometrics (see Fig.1) to construct and estimate decision models aimed at determining the
optimal behavior of the firm. Specifically, mathematical economics is used to formalize the economic models
postulated by economic theory. Econometrics then applies statistical tools (particularly regression analysis) to
real-world data to estimate the models postulated by economic theory and for forecasting.
Q = f(P,Y,Pc)
By collecting data on Q, P, Y and Pc for a particular commodity, we can then estimate the empirical
relationship. We will be able to know that how much in Q will occur by a change in P, Y and Pc. Also
forecasting is made possible
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Relationship to the Functional areas of Business Administration Studies

The relationship between managerial economics and the functional areas of business administration studies,
the latter include accounting, finance, marketing, personnel or human resource management, and production.
These disciplines study the business environment in which the firm operates and, as such, they provide the
background for managerial decision-making. Thus, managerial economics can be regarded as an overview
course that integrates economic theory, decision sciences, and the functional areas of business administration
studies; and it examines how they interact with one another as the firm attempts to achieve its goal most
efficiently.
Managerial economics is the use of economic theory and management science tools to examine how a firm can
achieve its objective most efficiently within the business environment in which it operates.
The Theory of the Firm
A firm is an organization that combines and organizes resources for the purpose of producing goods and / or
services for sale. These include proprietorships (firms owned by one individual), partnerships (firms owned by
two or more individuals), and corporations (owned by stockholders).
The functions of firms, therefore, is to purchase resources or inputs of labor services, capital, and raw
materials in order to transform them into goods and services for sale. Resources owners (workers and owners
of capital, land and raw materials) then use the income generated from the sale of their services or other
resources to firms to purchase the goods and services produced by firms. The circular flow of economic
activity is thus complete
The Objective and Value of the Firm:
Originally, the theory of the firm was based on the assumption that the goal or objective of the firm was to
maximize current or short-term profits. Since both short-term as well as long-term profits are clearly
important, the theory of the firm now postulates that the primary goal or objective of the firm is to maximize
the wealth or value of the firm. This is given by the present value of all expected future profits of the firm.
Future profits must be discounted to the present because a dollar of profit in the future is worth less than a
dollar of profit today.
Where PV is the present value of all expected future profits of the firm, represent the expected profits in each
of the n years considered, and r is the appropriate discount rate used to find the present value of future profits.
The Nature and Function of Profits:
Business versus economic profit:
To the general public and the business community, profit or business profit refers to the revenue of the firm
minus the explicit or accounting costs of the firm. Explicit costs are the actual out-of-pocket expenditures of
the firm to purchase or hire the inputs it requires in production. To the economist, however, economic profit
equals the revenue of the firm minus its explicit costs and implicit costs.
Implicit costs refer to the value of the inputs owned and used by the firm in its own production processes.
Specifically, implicit costs include the salary that the entrepreneur could earn from working for someone else
in a similar capacity (say, as the manager of another firm) and the return that the firm could earn from
investing its capital and renting its land and other inputs to other firms. Accordingly, economists include both
explicit and implicit costs in their definition of costs. That is, they include a normal return on owned resources
as part of costs, so that economic profit is revenue minus explicit and implicit costs. While the concepts of
business profit may be useful for accounting and tax purposes, it is the concept of economic profit that must be
used in order to reach correct investment decisions.
For example, suppose that a firm reports a business profit of $30,000 during a year, but the entrepreneur could
have earned $35,000 by managing another firm and $10000 by lending out his capital to another firm facing
similar risks. To the economists this entrepreneur is actually incurring an economic loss of $15,000 because,
from the business profit of $30,000 he would have to subtract the implicit or opportunity cost of $35,000 for
his wages and $10,000 for his capital.
Theories of Profit:
Marginal Efficiency Theory of Profit:
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Walker regards profits as rent of ability. Just as there are different grades of land, efficient entrepreneur, who
must remain in the field of production to meet the current demand, just recovers his cost of production. Above
him are entrepreneurs of superior ability. Just as rent arises because of the differential advantages enjoyed by a
superior land over the marginal land, profit also is the reward for differential ability of the entrepreneur over
the marginal entrepreneur or the no-profit entrepreneur.
Innovations Theory of Profits
According to Schumpeter, the principal function of the entrepreneur is to make innovations and profits are a
reward for performing this important function.
Innovations may be of two types: those which change the production function and reduce the cost of
production, and those innovations which stimulate the demand for the product, i.e., which change the
demand or utility function.
In the first type are included the introduction of new machinery, improved production techniques or processes,
exploitation of a new source of raw material or a new or better organizational pattern for the firm. The second
type of innovation are those which are calculated to increase the demand for the product by introducing a new
product or a new variety of an old product, new and more effective mode of advertisement, discovery of new
markets etc.
It may be pointed out, however, that profits owing to innovations are only temporary and tend to be competed
away. Soon the innovations come to be imitated by the rivals and they cease to be innovations or lose their
novelty. But in a dynamic world and progressive economy, the superior entrepreneurs continue to make
innovations and enjoy the profits thereof.
Risk-Bearing Theory of Profit:
As risk acts as a great deterrent, the supply of entrepreneurs is kept down, and those who do take the risk earn
much more than the normal return on the capital. Hence, profits are regarded as a reward for the risk taking or
risk-bearing.
This theory of profits is associated with F.B. Hawley`s name. Drucker mentions four kinds of risks:
replacement, risk proper, uncertainty and obsolescence. Replacement, generally known as depreciation, is
calculable and is counted as cost. Obsolescence is the least calculable but is also an item in the cost. Risk
proper (i.e. risk of marketability of the product) and uncertainty are not costs in the conventional sense, but are
charges against profits. They must be called costs of staying in business.
Function of Profit:
Profit serves a crucial function in a free-enterprise economy, high profits are the signal that consumers want
more of the output of the industry. High profits provide the incentive for firms to expand output and for more
firms to enter the industry in the long run. For a firm of above-average efficiency, profits represent the reward
for greater efficiency. On the other hand, lower profits or losses are the signal that consumers want less of the
commodity and/or that production methods are not efficient. Thus, profits provide the incentive for firms to
increase their efficiency and/or produce less of the commodity, and for some firms to leave the industry for
more profitable ones. Profits, therefore, provide the crucial signal for the reallocation of societys resources to
reflect changes in consumers tastes and demand over time.
The profit system is not perfect, and governments in free-enterprise economies often step in to modify the
operation of the profit system to make it more nearly consistent with broad societal goals. For example,
governments invariably regulate the prices charged for electricity by public utility companies to provide
shareholders with only a normal return on their investment. Governments also pass minimum wage legislation.
While not perfect, the profit system is the most efficient form of resource allocation available.

Planning Officer
Cell # 03339668669
Wazir222@yahoo.com
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MARKETING
Marketing: It is the process of creating consumer value in the form of goods, services, or ideas that can
improve the consumers life.
Marketing is the organizational function charged with defining customer targets and the best way to satisfy
needs and wants competitively and profitably. Since consumers and business buyers face an abundance of
suppliers seeking to satisfy their everyday need, companies and nonprofit organizations cannot survive today
by simply doing a good job. They must do an excellent job if they are to remain in the increasingly
competitive global marketplace. This is what we say that survival of the fittest. Many studies have
demonstrated that the key to profitable performance is to know and satisfy target customers with competitively
superior offers. This process takes place today in an increasingly global, technical, and competitive
environment.
What is marketing?
Marketing is not only restricted to selling and advertising as is perceived but is More than it advertising it
identifies and satisfies customers needs. It functions revolve around wide relation variety and range of tasks
and activities mostly termed as functions related to 4ps i.e. Product, price, place and promotion. Marketing is
creating customer value and satisfaction is at the very heart of modern marketing thinking and practice.
b. A very simple definition of marketing is that it is the delivery of customer satisfaction at a profit.
c. Sound marketing is critical to the success of every organization.
Marketing is a process of planning and executing the conception, pricing, promotion, and distribution of
ideas, goods, and services to create exchanges that satisfy individual and organizational objectives.
OR
Marketing is a social and managerial process by which, individuals and groups obtain what they need and
want through creating and exchanging products and value with others.
Understanding Marketing and Marketing Process
Process by which individuals and groups obtain what they need and want through creating and exchanging
products and value with others is termed as marketing process. The marketing process consists of four steps:
analyzing market opportunities; developing marketing strategies; planning marketing programs, which entails
choosing the marketing mix (the four Ps of product, price, place, and promotion); and organizing,
implementing, and controlling the marketing effort.
Marketing is the organizational function charged with defining customer targets and the best way to satisfy
needs and wants competitively and profitably. Since consumers and business buyers face an abundance of
suppliers seeking to satisfy their every need, companies and nonprofit organizations cannot survive today by
simply doing a good job. They must do an excellent job if they are to remain in the increasingly competitive
global marketplace. Many studies have demonstrated that the key to profitable performance is to know and
satisfy target customers with competitively superior offers. This process takes place today in an increasingly
global, technical, and competitive environment.
The marketing mix
A firms marketing mix (often called the four Ps) consists of product, place (or distribution), price, and
promotion. And some times even 6 or 7ps (Product, price, place promotion, position, personal relations, people
and profit)
Productwhat are you selling? (It might be a product or a service.)
Pricewhat is your pricing strategy?
Place or distributionhow are you distributing your product to get it into the Customers
marketplace?
Promotionhow are you telling consumers in your target group about your product?
Positioningwhat place do you want your product to hold in the consumers mind?
Personal relationshipshow are you building relationships with your target consumers?
People: public who can have impact on organization or can be affected by organization.
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Profits: the basic objective of organization that to have something valuable in return of product or
service mostly it is in form of money.
Marketing assumes that it will proceed in accordance with ethical actives. It Identifies the 4 marketing
variables i.e. product, price, promotion, and distribution it also states that the public, the customer, and the
client determine the marketing program. Marketing mainly emphasizes on creating and maintaining
relationships and applies for both non-profit organizations and profit-oriented businesses.
Marketing Management:
Marketing management is the art and science of choosing target markets and building profitable relationships
with them. Creating, delivering and communicating superior customer value is key.
Marketing management is the conscious effort to achieve desired exchange outcomes with target markets. The
marketers basic skill lies in influencing the level, timing, and composition of demand for a product, service,
organization, place, person, idea, or some form of information.
Marketing Management is defined as the analysis, planning, implementation, and control of programs
designed to create, build, and maintain beneficial exchanges with target buyers for the purpose of achieving
organizational objectives.
Customer relationship management (CRM)
CRM is the overall process of building and maintaining profitable customer relationships by delivering
superior customer value and satisfaction. CRM can be defined: as strategies focused on increasing customer
satisfaction, loyalty, and profitability by leveraging superior customer knowledge acquired, stored, and acted
upon with the aid of information technology.
Consumer
In business field we use this term that individual who derives direct utility of the product. Consumer has his
budget, and he tends to derive maximum utility within that budget. That is why we are keen to study his
preferences, choices, sensitivity and interests with a view to maximizing his utility.
Customer
This term connotes that individual who actually makes a decision in selecting a certain product. He may and
may not directly consume the product. But he takes a buying decision. A housewife for example buys cooking
oil for her household- she is a customer. The entire family is a consumer.
Two kinds of customers: Internal and External.
Internal are those, who work in the organization.
External are those who are individuals, business people and groups outside.
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STRATEGIC MANAGEMENT
What is strategic management?
Strategic Management can be defined as the art and science of formulating, implementing and evaluating
cross-functional decisions that enable an organization to achieve its objective.
OR
The on-going process of formulating, implementing and controlling broad plans that guide the organization in
achieving the strategic goals given its internal and external environment.
Interpretation:
1. On-going process:
Strategic management is a on-going process which is in existence through out the life of organization.
2. Shaping broad plans:
First, it is an on-going process in which broad plans are firstly formulated than implementing and finally
controlled.
3. Strategic goals:
Strategic goals are those which are set by top management. The broad plans are made in achieving the goals.
4. Internal and external environment:
Internal and external environment generally set the goals. Simply external environment forced internal
environment to set the goals and guide them that how to achieve these goals?
On-going
Process
Shaping & achieving

broad plans
Broad plans are for
achieving strategic
Influenced
External Environment
Forced
Top management or
Internal Environment to
achieve
Environment Scanning
Evaluation
Strategy Fermentation
Control
Strategy
Implication
Strategic management A route to success:

The study of strategic management integrates different topics. Different courses are integrated due to the study
of this course so that businesses become successful in every sector. It integrates the following:
Marketing
Management
Finance
Research and development
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The management and marketing are essential part of a business sectors. They should be integrated. Just like
other sections of the business are integrated under this study. This term is mostly used by academia but this is
also used in media.
Stages of Strategic management:
The strategic management process consists of three stages:
Strategy Formulation (strategy planning)
Strategy Implementations
Strategy Evaluation
Environment
Strategic Fermentation Most
Scanning
External
environment
Mission
Task
Environment
Social
Object
Environment
Internal
Environment
Strategic
Structure
Structure
Resource
Tact
Strategic Implication
Evaluation &
Control
Programme
Budget
Performance
& Evaluation
Procedure
Strategy Formulation:
Strategy formulation means a strategy formulate to execute the business activities. Strategy formulation
includes developing: Vision and Mission (The target of the business)
Strength and weakness (Strong points of business and also weaknesses)
Opportunities and threats (These are related with external environment for the business)
Strategy formulation is also concerned with setting long term goals and objectives, generating alternative
strategies to achieve that long term goals and choosing particular strategy to pursue.
The considerations for the best strategy formulation should be as follows:
Allocation of resources
Business to enter or retain
Business to divest or liquidate
Joint ventures or mergers
Whether to expand or not
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Moving into foreign markets

Trying to avoid take over
Strategy Implementation:
Strategy implementation is often called the action stage of strategic management. Implementing means
mobilizing employees and managers in order to put formulated strategies into action. It is often considered to
be most difficult stage of strategic management. It requires personal discipline, commitment and sacrifice.
Strategy formulated but not implemented serve no useful purpose.
Strategy evaluation:
Strategy evaluation is the final stage in the strategic management process. Management desperately needs to
know when particular strategies are not working well; strategy evaluation is the primary means for obtaining
this information. All strategies are subject to future modification because external and internal forces are
constantly changing.
Nature of Strategic Management:
The strategic-management process does not end when the firm decides what strategy or strategies to pursue.
There must be a translation of strategic thought into strategic action. This translation is much easier if
managers and employees of the firm understand the business, feel a part of the company, and through
involvement in strategy-formulation activities have become committed to helping the organization succeed.
Without understanding and commitment, strategy-implementation efforts face major problems.
Implementing strategy affects an organization from top to bottom; it impacts all the functional and divisional
areas of a business. It is beyond the purpose and scope of this text to examine all the business administration
concepts and tools important in strategy implementation.
Prime task:
Peter Drucker says:
The prime task is to think through the overall mission of a business.
Key Terms in Strategic Management
Strategy:
Strategies are the means by which long-term objectives will be achieved.
Strategy means long-term action plan to achieve basic long term goals & objectives of an
organization.
Action plan are Steps that must be taken, or activities that must be performed well, for a strategy to succeed.
An action plan has three major elements (1) Specific tasks: what will be done and by whom. (2) Time horizon:
when will it be done? (3) Resource allocation: what specific funds are available for specific activities? It is
also called action program.
Strategies are potential actions that require top management decisions and large amounts of the firm's
resources. In addition, strategies affect an organization's long-term prosperity, typically for at least five years,
and thus are future-oriented. Strategies have multifunctional or multidivisional consequences and require
consideration of both external and internal factors facing the firm.
Strategists
Strategists are individuals who are most responsible for the success or failure of an organization. Strategists
are individuals who form strategies. Strategists have various job titles, such as chief executive officer,
president, and owner, chair of the board, executive director, chancellor, dean, or entrepreneur.
Vision Statements
Many organizations today develop a "vision statement" which answers the question, what do we want to
become? Developing a vision statement is often considered the first step in strategic planning, preceding even
development of a mission statement. Many vision statements are a single sentence. For example the vision
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statement of Stokes Eye Clinic in Florence, South Carolina, is "Our vision is to take care of your vision." The
vision of the Institute of Management Accountants is "Global leadership in education, certification, and
practice of management accounting and financial management."
Mission Statements
Mission statements are "enduring statements of purpose that distinguish one business from other similar firms.
A mission statement identifies the scope of a firm's operations in product and market terms. It addresses the
basic question that faces all strategists: What is our business? A clear mission statement describes the values
and priorities of an organization. Developing a mission statement compels strategists to think about the nature
and scope of present operations and to assess the potential attractiveness of future markets and activities. A
mission statement broadly charts the future direction of an organization. An example mission statement is
provided below for Microsoft.
Microsoft's mission is to create software for the personal computer that empowers and enriches people in the
workplace, at school and at home. Microsoft's early vision of a computer on every desk and in every home is
coupled today with a strong commitment to Internet-related technologies that expand the power and reach of
the PC and its users. As the world's leading software provider, Microsoft strives to produce innovative
products that meet our customers' evolving needs.
External Opportunities and Threats
External opportunities and external threats refer to economic, social, cultural, demographic, environmental,
political, legal, governmental, technological, and competitive trends and events that could significantly benefit
or harm an organization in the future. Opportunities and threats are largely beyond the control of a single
organization, thus the term external. The computer revolution, biotechnology, population shifts, changing
work values and attitudes, space exploration, recyclable packages, and increased competition from foreign
companies are examples of opportunities or threats for companies. These types of changes are creating a
different type of consumer and consequently a need for different types of products, services, and strategies.
Other opportunities and threats may include the passage of a law, the introduction of a new product by a
competitor, a national catastrophe, or the declining value of the dollar. A competitor's strength could be a
threat. Unrest in the Balkans, rising interest rates, or the war against drugs could represent an opportunity or a
threat. A basic tenet of strategic management is that firms need to formulate strategies to take advantage of
external opportunities and to avoid or reduce the impact of external threats. For this reason, identifying,
monitoring, and evaluating external opportunities and threats are essential for success.
Environmental Scanning:
The process of conducting research and gathering and assimilating external information is sometimes called
environmental scanning or industry analysis. Lobbying is one activity that some organizations utilize to
influence external opportunities and threats.
Environment scanning has the management scan external environment for opportunities and threats and
internal environment for strengths and weaknesses. The factor which are most important for corporation factor
are referred as a strategic factor and summarized as SWOT standing for strength, weaknesses, opportunities
and threats.
Environmental Scanning
Internal Analysis
External Analysis
The external environment consist of opportunities and threats variables that outside the organization.
External environment has two parts:
Task environment includes all those factors which affect the organization and itself affected by the
organization. These factor effects the specific related organizations. These factors are shareholders
community, labor unions, creditor, customers, competitors, trade associations.
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Social environment is an environment which includes those forces effect does not the short run
activities of the organization but it influenced the long run activities or decisions. PEST analysis are
taken for social environment PEST analysis stands for political and legal economic socio cultural
logical and technological.
Internal Strengths and Weaknesses/Internal assessments
Internal strengths and internal weaknesses are an organization's controllable activities that are performed
especially well or poorly. They arise in the management, marketing, finance/accounting,
production/operations, research and development, and computer information systems activities of a business.
Identifying and evaluating organizational strengths and weaknesses in the functional areas of a business is an
essential strategic-management activity. Organizations strive to pursue strategies that capitalize on internal
strengths and improve on internal weaknesses.
Strengths and weaknesses are determined relative to competitors. Relative deficiency or superiority is
important information. Also, strengths and weaknesses can be determined by elements of being rather than
performance. For example, strength may involve ownership of natural resources or an historic reputation for
quality. Strengths and weaknesses may be determined relative to a firm's own objectives. For example, high
levels of inventory turnover may not be strength to a firm that seeks never to stock-out.
Internal factors can be determined in a number of ways that include computing ratios, measuring performance,
and comparing to past periods and industry averages. Various types of surveys also can be developed and
administered to examine internal factors such as employee morale, production efficiency, advertising
effectiveness, and customer loyalty.
Objectives
Objectives can be defined as specific results that an organization seeks to achieve in pursuing its basic mission.
Long-Term Objectives
Long-term objectives represent the results expected from pursuing certain strategies. Strategies represent the
actions to be taken to accomplish long-term objectives. The time frame for objectives and strategies should be
consistent, usually from two to five years.
Objectives are essential for organizational success because they state direction; aid in evaluation; create
synergy; reveal priorities; focus coordination; and provide a basis for effective planning, organizing,
motivating and controlling activities. Objectives should be challenging, measurable, consistent, reasonable,
and clear. In a multidimensional firm, objectives should be established for the overall company and for each
division.
Goal: a desired future condition that the organization seeks to achieve in pursuing its resources.
Annual Objectives
Annual objectives are short-term milestones that organizations must achieve to reach long-term objectives.
Like long-term objectives, annual objectives should be measurable, quantitative, challenging, realistic,
consistent, and prioritized. They should be established at the corporate, divisional, and functional levels in a
large organization.
Annual objectives should be stated in terms of management, marketing, finance/accounting,
production/operations, research and development, and information systems accomplishments. A set of annual
objectives is needed for each long-term objective.
Annual objectives are especially important in strategy implementation, whereas long-term objectives are
particularly important in strategy formulation. Annual objectives represent the basis for allocating resources.
Policies
Policies are the means by which annual objectives will be achieved. Policies include guidelines, rules, and
procedures established to support efforts to achieve stated objectives. Policies are guides to decision making
and address repetitive or recurring situations.
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Benefits of Strategic management
Following are the major benefits of Strategic management:
Proactive in shaping firms future
Initiate and influence actions
Formulate better strategies (Systematic, logical, rational approach)
Financial benefits:
Improved productivity
Improved sales
Improved profitability
Non-Financial benefits:
Increased employee productivity
Improved understanding of competitors strategies
Greater awareness of external threats
Understanding of performance reward relationships
Better problem-avoidance
Lesser resistance to change

Planning Officer
Cell # 03339668669
Wazir222@yahoo.com
wazir
PROJECT MANAGEMENT
What is a Project?
To achieve a single purpose with in bound of time, cost & required performance is called project.
Projects are a group of activities that have to be performed with limited resources to yield specific objectives,
in a specific time, and in a specific locality. Thus, a project is a temporary endeavor employed to create a
unique product, service or results. Projects are an investment on which resources are used to create assets that
will produce benefits over an expanded period of time. It is a unique process, consisting of a set of coordinated
and controlled activities with start and finish dates, undertaken to achieve an objective conforming to specific
requirements, including the constraints of time, cost and resources.
Short Range Projects:
They are completed within one year, and are focused towards achieving the tactical objectives. They are less
rigorous; require less or no risk. They are not cross functional.
These projects require limited Project Management tools, and have low level of sophistication. It is easy to
obtain approval, funding and organizational support for short range projects. For example, reduce defect in
shop number two from 6 to 4 percent.
Long Range Projects:
These projects involve higher risk and a proper feasibility analysis is essential before starting such projects.
They are most often cross functional. Their major impact is over long period of time, on internal as well as
external organization. Large numbers of resources are required to undertake long range projects and they
require breakthrough initiatives from the members.
Why Projects are initiated?
Projects are initiated in the following scenarios:
When starting a new business.

In order to develop/ modify a product or service.
For relocating and/or closing a facility.
For regulatory mandate.
For some community issues.
In order to re-engineer the process so as to reduce complaints, reduce cycle time, and eliminate errors.
For implementing a new system or process.
To introduce new equipment, tools or techniques.
Attributes of a Project:
Projects focus on a single goal as compared to a program. They have customers who are affected by the end
results. They have to be completed within specified time frame (completion date), within budget (limited
resources including, people, money, machines) and should be according to the specifications (with a certain
level of functionality and quality).
In brief projects are:
Directed towards achieving a specific result.

Coordination of undertaking of interrelated activities.
Of limited duration, a beginning and an end.
Prone to risks, that is, every project has a certain amount of risk.
Characteristics of Projects:
As already mentioned projects are temporary with a definite beginning and a definite end.
They also have temporary opportunities and temporary teams.
Projects are terminated when the objectives are achieved, or conversely, if the objectives cannot be
met.
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Most of the projects last for several years. However, they have a finite duration.
They involve multiple resources (human and non-human) and require close coordination.
They are composed of interdependent activities.
At the end of the project, a unique product, service or result is created. Some degree of customization
is also a characteristic of projects.
Projects encompass complex activities that are not simple, and may require repetitive acts.
They also include some connected activities. Some order and sequence is required in project activities.
The output from one activity is an input to another.
Project Management lives in the world of conflict. The management has to compete with functional
departments for resources and personnel.
There exists a constant conflict for project resources and for leadership roles in solving project
problems.
In every project, clients want changes, and the parent organization aims at maximization of profits.
Project Environment:
All projects are planned and implemented in a social, economic, environmental, political and international
context.
Cultural and Social Environment is that how a project affects the people and how they affect the
project. This requires understanding of economic, demographic, ethical, ethnic, religious and cultural
sensitivity issues.
International and Political Environment refers to the knowledge of international, national, regional or
local laws and customs, time zone differences, teleconferencing facilities, level of use of technology,
national holidays, travel means and logistic requirements.
Physical Environment is the knowledge about local ecology and physical geography that could affect
the project, or be affected by the project.
There can be two bosses at a time and that too with different priorities and objectives.
Project Participants:
Stakeholders are the ones who have a share, or an interest in an enterprise.
Key Stakeholders:
Project Manager:
Customers, End Users: The person or organization that will use the projects product. These may be
multiple layers of customers.
Performing Organization: The enterprise whose employees are most directly involved in doing the
work of project.
Project Management Working on the Project: The members of the team who are directly involved
in project management activities.
Project Team Members: The group that is performing the work of the project. It includes the
members who are directly involved in the project activities.
Sponsors: The person or group that provides financial resources, in cash, or kind, for the project.
Influencers: People or groups that are not directly related to the acquisition or use of the projects
product, but due to an individuals position in the customer organization or performing organization,
can influence, positively or negatively, the course of the project.
Project Management Organization: If it exists in performing organization, the Project Management
Organization can be a stakeholder if it has direct responsibility for the outcomes of the project.
Project Types:
Type I Projects Large Engineering Projects:
They have well defined project methods and end project requirements, such as construction projects.
Type II Projects Product Development Projects, Early Space Projects:
They have poorly defined project methods but have well defined project end requirements.
Type III Projects Software Development Projects:
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In these, the shape of end product proceeds. They have well defined project methods, but poorly defined
project end requirements.
Type IV Projects Organizational Development Projects, Vision Definition, Assessment of Impact
of Trainings:
They have both poorly defined project methods as well as project end requirements.
What is Project Management?
Project Management is the discipline of organizing and managing resources in such a way that these resources
deliver all the work required to complete a project within defined scope, time, and cost constraints. It is
important to note here that a project is a temporary and one-time endeavor undertaken to create a unique
product or service that brings about beneficial change or added value. This property of being a temporary and
one-time undertaking contrasts with processes, or operations, which are permanent or semi-permanent ongoing
functional work to create the same product or service over and over again. The management of these two
systems is often very different and requires varying technical skills and philosophy, hence requiring the
development of project management.
Systems:
In the preceding sections the word "systems" has been used rather loosely. The exact definition of a system
depends on the users, environment, and ultimate goal. Modern business practitioners define a system as:
A group of elements, either human or nonhuman, that is organized and arranged in such a way that the
elements can act as a whole toward achieving some common goal, objective, or end.
Programs:
Programs can be explained as the necessary first-level elements of a system. Program is longer in time horizon
then project. Program carries various sequential & support work factor hence program carrying more than one
project.
Project Proposal:
Project proposal is a document that presents a plan for a project to review for evaluation. It has a plan for data
collection, includes a schedule of the steps to be undertaken & an estimate of the time required for each step &
a budget.
Feasibility Analysis:
A feasibility study is an analytical tool used during the project planning process, shows how a business would
operate under an explicitly stated set of assumptions. These assumptions include the technology used (the
facilities, types of equipment, manufacturing process, etc.) and the financial aspects of the project (capital
needs, volume, cost of goods, wages etc.).
What is Feasibility Assessment?
As the name implies, a feasibility study is an analysis of the viability of an idea. The feasibility study focuses
on helping answer the essential question of should we proceed with the proposed project idea? All activities
of the study are directed toward helping answer this question.
Feasibility studies can be used in many ways but primarily focus on proposed business ventures.
Farmers and others with a business idea should conduct a feasibility study to determine the viability of their
idea before proceeding with the development of the business. Determining early on that a business idea will
not work saves time, money and heartache later.
A feasible business venture is one where the business will generate adequate cash flow and profits, withstand
the risks it will encounter, remain viable in the long-term and meet the goals of the founders. The venture can
be a new start-up business, the purchase of an existing business, an expansion of current business operations or
a new enterprise for an existing business. Information file, a feasibility study outline is provided to give
guidance on how to proceed with the study and what to include. Also, information file, how to use and when to
do a feasibility study helps through the process and also to get the most out of the study.
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A feasibility study is only one step in the business idea assessment and business development process.
Reviewing this process and reading the information below will help put the role of the feasibility study in
perspective.
A feasibility study is usually conducted after producers have discussed a series of business ideas or scenarios.
The feasibility study helps to frame and flesh-out specific business alternatives so they can be studied indepth. During this process the number of business alternatives under consideration is usually quickly reduced.
During the feasibility process you may investigate a variety of ways of organizing the business and positioning
your product in the marketplace. It is like an exploratory journey and you may take several paths before you
reach your destination. Just because the initial analysis is negative does not mean that the proposal does not
have merit if organized in a different fashion or if there are market conditions that need to change for the idea
to be viable. Sometimes limitations or flaws in the proposal can be corrected.
A pre-feasibility study may be conducted first to help sort out relevant alternatives. Before proceeding with a
full-blown feasibility study, you may want to do some pre-feasibility analysis of your own. If you find out
early on that the proposed business idea is not feasible, it will save you time and money.
Types of Feasibility:
Technical Feasibility:
This area reviews the engineering feasibility of the project, including structural, civil and other relevant
engineering aspects necessitated by the project design. The technical capabilities of the personnel as well as
the capability of the projected technologies to be used in the project are considered.
Managerial Feasibility:
Demonstrated management capability and availability, employee involvement, and commitment are key
elements required to ascertain managerial feasibility. This addresses the management and organizational
structure of the project, ensuring that the proponents structure is as described in the submittal and is well
suited to the type of operation undertaken.
Economic Feasibility:
This involves the feasibility of the proposed project to generate economic benefits. A benefit-cost analysis
(addressing a problem or need in the manner proposed by the project compared to other, the cost of other
approaches to the same or similar problem) is required. A breakeven analysis when appropriate is also a
required aspect of evaluating the economic feasibility of a project. (This addresses fixed and variable costs and
utilization/sales forecasts). The tangible and intangible aspects of a project should be translated into economic
terms to facilitate a consistent basis for evaluation. Even when a project is non-profit in nature, economic
feasibility is critical.
Financial Feasibility:
Financial feasibility should be distinguished from economic feasibility. Financial feasibility involves the
capability of the project organization to raise the appropriate funds needed to implement the proposed project.
In many instances, project proponents choose to have additional investors or other sources of funds for their
projects. In these cases, the feasibility, soundness, sources and applications of these project funds can be an
obstacle. As appropriate, loan availability, credit worthiness, equity, and loan schedule still be reviewed as
aspects of financial feasibility analysis.
Also included in this area are the review of implications of land purchases, leases and other estates in land.
Cultural Feasibility: Social Feasibility: Safety Feasibility: Political Feasibility: Environmental
Feasibility: Market Feasibility:
PC-I
(Planning Commission Pro forma-I --the pro forma statements are prepared on certain estimate, and
pro forma refers to forecasting)
PC-I It means to prepare a pro forma for development project.
PC-II it is used for putting up a proposal for the preparation of a feasibility study/report.
PC-III it is for monitoring the progress of developmental project both from financial & physical aspects.
PC-IV it is used to carry the evaluation of development work/project.
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PC-V it is the post completion report of a project.
Project Charter:
Why?-What?-When?-Whom?-How?
Why?
Objective of project
Scope of the project-scope statement, here is the standard
Steps of project planning
When you answered this than next
What?
We make a medical college
There will be 100 classrooms
There will be 1000 employees of all categories
The description of project
When?
When it will complete
Time boundsometime
It is a simple description
Whom?
Who will perform these activities?
Who will subscribe the project management?
Why it is necessary-Its criteria
Management hierarchy-it may be a matrix or expeditor management
How?
How can it will be finalize, by yourself or through other contractor
What is the name of the contractors company?
What are his major activities in past & how can he complete the project
When all these steps are in written form then it is called project charter.
Planning & Scheduling Tools:
In project managementplanning, launching & controlling a project requires special tool, one somewhat
different from those needed when managing an ongoing operation. A project has a beginning, middle & an
end. The project manager must plan & coordinate numerous activities, & keep them on track so that the project
achieves its goal, on time & on budget.
Critical Path Method (CPM)
CPM is a visual tool that will help you plan & control the tasks & activities in a project. The CPM was
developed by the chemical giant DuPont in the late 1950s for managing large projects, such as the
construction of huge production facilities.
Lets say you are planning to open a restaurant & have identified the following major tasks as the key ones in
the project:
Task Code
Task Description
Predecessors
Time (Weeks)
Find location
None
Negotiate lease
Do renovations
A,B
Hire chef
None
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Purchase fixtures
A,B
Plan menu
Hire & train crew
D,F
Install & test fixture
A,B,F
Conduct a dry run
All
Total Time
41
Notice that in addition to identifying the tasks, you must put them in order. You must identify predecessor
tasks, that is, tasks that must be completed before others can begin. You must estimate the time each task will
consume.
Notice also that nine tasks in our restaurant example are not exhaustive. For simplicity we have left out
advertising, food purchasing, and so on.
Getting the picture:
The first step in CPM analysis is to chart the tasks visually in order to see the relationship among them.
Once you see the relationships, you realize that you can do certain tasks concurrently. In this example, you
might think of the project as having two tracks: a Facilities Track and a Food Track. The Facilities Track
(Tasks A, B, C, & E) involves getting the restaurant space ready. The Food Track (Tasks D, F, & G) involves
hiring the chef & crew & getting the menu squared away.
CPM helps you see how to collapse the project & get it finished in less elapsed time than the total project
will require. Heres how to set it up with estimated times included.
The longest path through the project is called the Critical Path. In our example, that path extends from point
A to point I, and it will take a total of 23 weeks. This means that the total elapsed time of the project will be 23
weeks, even though the total project time is 41 weeks. Thats because the Facilities Track will take 18 weeks,
but the 16-week Food Track can be completed concurrently.
Note that the Food Track itself can be collapsed from 18 weeks to 16 weeks by planning the menu with the
chef while also hiring the crew. This does not improve the total elapsed time, but there is no reason not to get
whatever you can do in the most efficient way possible.
PERT:
PERT which stand for Program Evaluation and Review Technique, resembles Critical Path Method? PERT
was developed by the US Navy and the Lockheed Corporation for the Polaris missile system project in the late
1950s.
The major difference between PERT and CPM is that PERT enables you to make optimistic, pessimistic, and
best guess estimate of the time it will take to complete each task and the entire project. Then you calculate a
weighted average by assigning a value of 1 to the pessimistic and optimistic estimates, and a value of 4 to the
best guess. Then you plug the values into the following formula:
Estimated time = (Optimistic x 1) + (Best Guess x 4) + (Pessimistic x 1) / 6
(You divide by 6 because 1+4+1=6, and you are calculating a weighted average of the time estimates.)
Lets say the guess estimate of a tasks duration is 10 weeks, the pessimistic estimate is 14 weeks, and the
optimistic estimate is 8 weeks. The PERT formula would calculate the estimated time as follows:
Estimated time = 8+ (10x4) + 14 /6
Estimated time = 62/6
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Estimated time = 10.3 weeks

It is a simplified version of PERT. The actual system can incorporate very sophisticated statistical techniques.
For your planning purpose, the real value of PERT is the idea of coming up with the optimistic & pessimistic
estimates & then seeing which way any deviation from the best guess would be likely to go. In case, since 10.3
is greater than 10, the likelihood is that if you vary from the best guess, it is likely to be in the pessimistic
direction.
In my own version of PERT, I figure pessimistic estimates for the large task that I cant directly control.
When telling senior management about a project, I give them only the pessimistic estimates for these tasks
(and thus the project) and pretend they are best guesses.
On a product-development project with a major company, I brought the project in eight weeks late from the
best guess (due to programming problem beyond my control). But it was only two weeks late from the
pessimistic estimate, which was the only one I gave management. And I had doubled the programming time
estimate that Management Information System had given me.

Planning Officer
Cell # 03339668669
Wazir222@yahoo.com
wazir
FUNDAMENTALS OF AUDITING
What is an Audit?
Audit is an independent examination of financial statements of an entity that enables an auditor to express an
opinion whether the financial statements are prepared (in all material respects) in accordance with an identified
and acceptable financial reporting framework (e.g. international or local accounting standards and national
legislations)
The phrases used; to express the auditors opinion means that the financial statements give a true and fair
view or have been presented fairly in all material respects.
True and fair presentation means that the financial statement are prepared and presented in accordance with the
requirements of the applicable International Financial Reporting Standards (IFRS) and local
pronouncements/legislations.
What we can understand as the essential features of an audit from the above definition and explanation are as
under:
An auditor involves in examination of financial statements, the auditor is not responsible for the
preparation of the financial statements.
The end result of an audit is an opinion to assist the user of the financial statements. Auditing therefore
relies heavily on professional judgment, not merely on the facts.
The auditors opinion makes reference to true and fair or fair presentations but true and fair is
again a matter of judgment. It is not precisely defined for the auditor.
In order to make the user of the auditors report able to feel confident in relying on such report, the
auditor should be independent of the entity. Independent essentially means that the auditor has no
significant personal interest in the entity. This allows an objective, professional view to be taken.
You will note that this is a wide concept of an audit which can be applied to any entity, not just to limited
companies.
Why is there a need for an audit?
The problem that has always existed at the time when the manager reports to the owners is that: whether the
owners will believe the report or not? This is because the reports may:
Contain errors
Not disclose fraud
Be inadvertently misleading
Be deliberately misleading
Fail to disclose relevant information
Fail to conform to regulations
The solution to this problem of credibility in reports and accounts lies in appointing an independent person
called an auditor to examine the financial statements and report on his findings.
Many financial statements must conform to statutory or other requirements. The most notable is that all
company accounts have to conform to the requirements of the Companies Ordinance 1984 but many other
bodies (like: Charities, Building Societies, Financial Services business etc) have detailed accounting
requirements as required by the relevant legislations. In addition all accounts should conform to the
requirements of International Financial Reporting Standards (IFRSs).
It is essential that an audit of financial statements should be carried out to ensure that they conform to these
requirements.
What is the distinction between auditing and accounting?
Relationship between auditing and accounting
Auditing and accounting are closely connected but both are separate activities. The directors of a company are
responsible for establishing books of accounts that will accurately record financial information and that are
used for preparing the annual financial statements. It is similarly the responsibility of the directors to adopt
consistent and appropriate accounting policies in order to prepare and present the financial statements. The
financial statements have to comply with national legislative requirements and International Financial
Reporting Standards (IFRSs).
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Accounting is the process of recording, classifying, summarizing and reporting financial information in a
logical/systematic manner for the purpose of decision making. To provide relevant & reliable information,
accountants must have a thorough understanding of the principles and rules that provide the basis for preparing
the financial statements.
In auditing the financial statements, the concern is with determining whether the presented financial statements
properly (true and fair) reflect the financial information that occurred during the accounting period. Since
auditors are primarily concerned with the end result of this work i.e. do the financial statements show a true
and fair view? In order to arrive at their conclusion the auditors must have a deep knowledge and
understanding of accounting (including applicable accounting standards) and in practice, the directors will
consult with the auditors as to appropriate accounting policies to follow.
Many financial statement users and members of the general public confuse auditing with accounting. The
confusion results because most auditing is concerned with accounting information, and many auditors have
considerable expertise in accounting matters. The confusion is increased by giving the title Chartered
Accountant to individuals performing a major portion of the audit function.
Who can be an auditor?
For appointment as auditor of:
A Public Company or
A Private Company which is a subsidiary of a Public Company.
A Private Company having paid up capital of three million rupees or more.
The person must be a Chartered Accountant within the meaning of the Chartered Accountants Ordinance,
1961. For listed companies an auditor must have a satisfactory QCR (quality control review) rating issued by
ICAP.
What is an auditors report?
The primary aim of an audit is to enable the auditor to say these accounts show a true and fair view or, of
course, to say that they do not show a true and fair view.
At the end of his audit, when he has examined the entity, its record, and its financial statements, the auditor
produces a report addressed to the owners/stake holders in which he expresses his opinion of the truth and
fairness, and sometimes other aspects, of the financial statements.
Different types of audit?
1.
Authority Basis:
a)
Statutory Audit:
Independent persons conduct the statutory audit, it is compulsory for limited companies to get their accounts
audited by a chartered accountant, under the companies ordinance 1984, banking companies ordinance 1962,
insurance act 1938, and cooperative societys rules 1927.
b)
Private Audit:
it is concerned with sole proprietors & partnership.
c)
Internal Audit:
d)
Government Audit: Post audit is the audit or review of Govt: finances after they have been
expended. The scope of post audit includes audit or review of transactions pertaining to the financial
operation of the various agencies of Govt: on the state levels, with verification of state revenues at the
source and audit of expenditure all the way through work to the recipient or beneficiary of the
services.
2)
Scope Basis:
Complete Audit, Partial Audit.
3)
Purpose Basis:
Management Audit, Cost Audit, Special Audit
4)
Time Basis:
Continuous Audit, Final Audit.
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Different stages of audit:

Auditing is essentially a practical task. The auditor always needs to reflect the nature of the circumstances of
the entity under audit. It is unlikely that any two audit assignments will ever identical. It is however possible to
identify a number of standard stages in a typical external audit. These are as follows:
Audit appointment
Engagement letter
Initial planning
Knowledge of the business
Risk Assessment
Internal control review (procedures)
Control procedures (authorities/approvals/segregation of duties)
Preparation of the audit plan
Accounting system review
Analytical review techniques (Compliance procedures-Application of control test procedures) like
purchasing are according to the controls established.
Considering the ways in which audit evidence can be sought
Substantive testing (transaction level procedures)
Reasonable assurance
Review of the financial statements (compliance with the standards/material misstatement etc.)
Preparation and signing of report
At the stage of considering the ways of seeking audit evidence the auditor will make a preliminary evaluation
of the entitys control system:
If the controls are likely to lead to a true and fair set of financial statements the auditor will test those
controls.
If they appear weak he will not rely on the controls but carry out extensive testing of the transactions
and balances which appear in the financial statements by means of substantive procedures.
If the controls are operating effectively, the auditor can reduce the amount of substantive testing
described above and adopt a reliance approach.
If not then the auditor will be forced into a extensive substantive approach
General Principles of an Audit:
a) Independence: Auditor is independent of management i.e. he is not under the control or influence of
management.
b) Integrity: Auditor is honest and is not corrupt. He is straight forward in performing his professional work.
c) Objectivity: He obtains the evidence needed to form an opinion and his opinion is based on that evidence
alone. He is not subjective in forming his opinion.
d) Professional Competence and Due Care: Auditor has attained certain professional qualification, has
acquired the requisite skill and has attained the experience necessary for the audit and performs his work with
planning and due diligence.
e) Confidentiality: Auditor neither discloses the information obtained during the course of his audit without
permission of his client (except when required in a court of law) nor uses that information himself.
f) Professional Behavior: He should not only act in a professional manner but should also appear to be a
professional. He should maintain his professional knowledge and skill at a level required to ensure that a client
or employer receives the benefit of competent professional service based on up-to-date developments in
auditing practice and relevant legislation.
g) Technical Standards: Audit should be performed by following certain standards, international or
national.
Scope of an audit:
The term scope of an audit refers to the audit procedures that, in the auditors judgment and based on the
ISAs, are deemed appropriate in the circumstances to achieve the objective of the audit.
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Features of auditing profession:

In Pakistan auditing profession is allied with the Institute of Chartered Accountants of Pakistan (ICAP). It is an
autonomous body incorporated under the Chartered Accountants Ordinance 1961. ICAP is a regulatory body
that enjoys a self regulatory status. Its affairs are run by a council which is elected by its member (Chartered
Accountants). Only those members of the ICAP are eligible of doing audit who have obtained license for the
purpose, these are known are practicing members.
Objectives of Auditing:
Primary Objectives
a)
Fairness of Statements: fairness of statements can shows true & fair view after auditing.
b)
Prescribed Laws: to check that prescribed laws have been followed in preparation of fairness of
statements.
c)
Accounting Policies: the objective of auditing is to examine the accounting policies.
d)
Independent Opinions: to express an independent opinion, auditor must be honest in his work & the
other person must not influence him.
Secondary Objectives:
a)
Detection of Errors: the auditor can use ways & means to find out errors in accounting records.
b)
Detection of Frauds: the auditor can use ways & means to find out frauds in accounting records.
c)
Prevention of Errors: the error can be prevented through effective internal check. The mistake can
occur due to heavy work load or carelessness on the part of employees.
d)
Prevention of Frauds: In accounting frauds includes manipulation or alteration of records &

documents, misappropriation of assets, omission of the effects of transaction from records of
documents, these all can prevent through auditing.
Auditors Liabilities
The liabilities of auditors of a company can be studied under following heads:
a) Civil Liabilities.
Civil liabilities mean the disputes over losses caused to one party by acts of another. The civil liabilities of an
auditor can be for:- (i) Negligence (ii) Misfeasance
i) Liability for Negligence (under law of agency)
Auditor being agent of the Shareholders is required to carry out his duties with reasonable care and skill. If the
auditor is found to have neglect certain aspects of accounts. He may be sued in court of law. This liability
arises when an auditor has been fails to find out errors & frauds. Auditor is liable to pay losses which company
suffered due to negligence.
ii) Liability for Misfeasance
The term misfeasance means breach of duty. If auditor does something wrong in the performance of his duties
resulting in a financial loss to the company, he is guilty of misfeasance. For example auditors duties are laid
down in section 255 of the Companies Ordinance, 1984. If auditor does not perform his duties properly and the
company suffers loss or winding up the company he is liable for misfeasance.
b) Criminal Liabilities.
If auditor fails to comply with the requirements of Sections 157, 255 or 257, he shall be punishable with fine
up to Rs. 100,000/-. If he knowingly makes a false report for profit to himself or to put another person to a
disadvantage or loss for a material consideration, he shall also be punishable with imprisonment for a period of
one year. If charges of forgery are brought against an auditor, he may be liable to imprisonment for a term
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which may be extended to 2 years or fine up to Rs. 20,000 or both. If in any report the auditor makes a false
statement he shall be liable to imprisonment for a term up to 3 years and a fine not exceeding Rs. 20,000.
Civil Liabilities
Civil liabilities arise in the situation when there is absence of reasonable care and skill that can be expected of
a person in a set of circumstances. When negligence of an auditor is being evaluated, it is in terms of what
other competent auditors would have done in the same situation.
Liabilities to Liable:
If an auditor in his audit report namely point out a person liable in certain circumstances then the person
blamed has the right to see the auditor in court of law under liability to liable.
Liability to third party:
In the audit report of a company a third party is also interested which might not have direct relation with the
company but have indirect interest. Such as investors, creditors Govt: departments (taxation), Banks etc. For
example banks usually forward loans to companies on the basis of their audit report about financial statements,
if the auditor gives a false statements about these financial statements and in future the company goes bankrupt
then the auditor will liable to these third party.
COST ACCOUNTING:
Cost accounting is classifying, recording & appropriate allocation for the determination of cost of
products/services, the relation of these cost to sales values & ascertainment (to make clear) of profitability.
Cost accounting aim is systematic record of expenses & analysis of sales so as to ascertain cost of each
product manufactured of services rendered by the business.
The information of the cost of each unit produced or services rendered would enable the business man to
know;
Where to economize the cost
How to fix price
How to maximize the profit & so on.
So cost accounting main objective is minimization of cost & maximization of profit.
Purpose of Cost Accounting: One of the main purposes of cost accounting is to find out per unit of cost so to
set a selling price of that unit.
Elements of Cost:
Any product that is manufactured is the result of consumption of some resources. The management, for its
planning and controlling functions, must know the cost of using these resources. The constituent elements of
cost are broadly classified into three distinct elements:
Material Cost
Labor Cost
Overhead Cost
Direct Material Cost:
Those materials which can be conveniently identified & measured in the product. These materials directly
entered in the product & a part of directly finished goods/products. Such as timber in furniture, cloth in
shirt/dress making, bricks in building a house. Direct material costs are the costs of materials that are known to
have been used in producing and selling a product or rendering a service.
Indirect Material Cost:
Those material which are partially a part of finished goods/products such as nail in furniture making, thread in
dress making etc.
Direct Labor Cost:
Direct labor can be conveniently identified or attributed wholly to a product/job. Direct labor costs are the
specific costs of the workforce used to produce a product or rendering a service.
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Indirect Labor Cost:

That part of the labor force in a factory which is not directly concerned with the manufacturing of a goods or
the provision of services. Such as supervision, tools setters, clerical work, security guard, sweeper etc.
Overhead Cost:
It is generally defined as indirect material/labor & all other factory expenses that cannot be conveniently
identified & charged to specific job or product.
Manufacturing Overhead: Indirect material like lubricants, indirect labor, rent of factory building, repair,
depreciation, utilities bills,
Marketing/Selling Overheads: Advertisement cost, salesmen salary, commission on sales, market research
etc
Admin Overhead: Admin salaries, Admin office Utilities bills, Admin office rent, Stationary & postage
expenses, Board of director meeting expenses.
Distribution Overhead: expenditure from the time product is completed till it reaches its distribution/
consumers & includes expense of warehousing of finished goods, cost of transportation etc.
Cost Unit
It is a unit of a product or service in relation to which the cost is ascertained, i.e. it is the unit of the out put or
product of the business. In simple words the unit for which cost of producing the units is identified /allocated.
Example: Ball point for a Ball point manufacturing entity, Bottle for Beverage producing entity, Fan for a Fan
manufacturing entity
Cost Center
Cost centre is a location where costs are incurred and may or may not be attributed to cost units.
Examples: Workshop in a manufacturing concern, Auto service department, Electrical service department,
Packaging department, Janitorial service department
Revenue Centre
It is part of the entity that earns sales revenue. Its manager is responsible for the revenue earned not for the
cost of operations.
Examples: Sales department, Factory outlet
Profit Centre
Profit centre is a section of an organization that is responsible for producing profit.
Examples: A branch, A division
Investment Centre
An investment centre is a segment or a profit centre where the manager has significant degree of control over
his divisions investment policies.
Examples: a branch, a division
Relevant Cost
Relevant cost is a cost which changes with a change in decision. These are future costs that effect the current
management decision.
Examples: Variable cost, fixed cost which changes with in an alternative, Opportunity cost
Irrelevant Cost
Irrelevant costs are those costs that would not affect the current management decision.
Example: A building purchased in last year, its cost is irrelevant to affect management decisions.
Sunk Cost
Sunk cost is the cost expended in the past that cannot be retrieved on product or service.
Example: The entity purchase stationary in bulk last moth. This expense has been incurred and hence will not
be relevant to the management decisions to be taken subsequent to the purchase.
Opportunity Cost:
Opportunity cost is the value of a benefit sacrificed in favor of an alternative.
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Example An investor invests in stock exchange he foregoes the opportunity to invest further in his hotel. The
profit which the investor will be getting from the hotel is opportunity cost.
Product Cost
Product cost is a cost that is incurred in producing goods and services. This cost becomes part of inventory.
Example Direct material, direct labor and factory overhead.
Period Cost
The cost is not related to production and is matched against on a time period basis. This cost is considered to
be expired during the accounting period and is charged to the profit & loss account.
Example Selling and administrative expenses
Historical Cost
It is the cost which is incurred at the time of entering into the transaction. This cost is verifiable through
invoices/agreements. Historical cost is an actual cost that is borne at the time of purchase.
Example: A building purchased for Rs 400,000, has market value of Rs. 1,000,000. Its historical cost is Rs.
400,000.
Standard Cost
Standard cost is a Predetermine cost of the units.
Example: Standard cost for a unit of product A is set at Rs 30. It is compared with actual cost incurred for
control purposes.
Implicit Cost
Implicit cost imposed on a firm includes cost when it foregoes an alternative action but doesn't make a
physical payment. Such costs are related to forgone benefits of any single transaction, and occur when a firm:
Example: Uses its own capital or Uses its owner's time and/or financial resources
Explicit Cost
Explicit cost is the cost that is subject to actual payment or will be paid for in future.
Example: Wage, Rent, Materials
Differential Cost or Incremental cost
It is the difference of the costs of two or more alternatives.
Example: Difference between costs of raw material of two categories or quality.
Costing:
The measurement of cost of a product or service is called costing; however, it is not a recommended
terminology.
Prime Cost:
The total costs which can be directly identified with a job, a product or service is known as Prime cost. Thus
prime cost = direct materials + direct labor + other direct expenses.
Direct Material
+Direct Labor
+Other direct production cost
Prime cost
Conversion Cost:
This is the total cost of converting the raw materials into finished products. The total of direct labor other
direct expenses and factory overhead cost is known as conversion cost.
Direct labor cost
+Factory overhead cost
Conversion cost
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Total Production Cost:

Prime Cost
+Factory overhead cost
Total production cost
Cost Accumulation:
Cost accumulations are the various ways in which the entries in a set of cost accounts (costs incurred) may be
aggregated to provide different perspectives on the information.
Methods of cost accumulation:
Process costing:
It is a method of cost accounting applied to production carried out by a series of operational stages or
processes.
Job order costing
Generally, it is the allocation of all time, material and expenses to an individual project or job.
Cost of Goods Sold:
Cost of goods sold statement is a financial statement that contains information about cost of all those goods
that have been sold. Cost of goods sold is calculated by summing up elements of cost. This statement has five
parts/sections.
Difference between FA & CA:
1
1
4
5
6
7
8
Financial Accounting
Purpose to serve:
Financial Accounting provides information in
generals, shows financial status to owners &
outside parties.
Compulsion of Accounts:
Income tax law make it compulsory , companies
ordinance requires to maintain proper account
Nature of transaction:
FA relates to commercial transaction including
cash i.e. external transaction (mainly)
Information:
Monetary information only used.
Figures:
FA deals with actual facts & figures.
Reports:
It reports result after the end of accounting
period.
Control:
It lacks control over cost.
Stock Valuation:
Stocks are valued at cost or market price
whichever less is.
Efficiency:
FA gives no idea of relative efficiency of various
workers, plants & machinery.
Cost Accounting
Cost accounting provides information in particular
to management for proper planning & control for
decisions making.
No compulsion but kept voluntarily to fulfill
management requirements.
CA relates to transaction connected both
manufacturing of goods & products, so concerned
mainly with internal transaction which does not
involve cash
Monetary + non monetary information like units
CA partly deals with facts & figures & also deals
with estimates.
It gives reports to management as & when needed.
It emphasis is on control over cost by controlling

material cost, labor cost etc.
Stocks are valued at cost.
CA provides valuable information or relative

efficiency of labor, plants & machinery.
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What is Human Resource Management?

As we said that HRM is the management of people working in an organization, it is a subject related to human.
For simplicity, we can say that it is the management of humans or people. HRM is a managerial function that
tries to match an organizations needs to the skills and abilities of its employees. Human Resource
Management is responsible for how people are managed in the organizations. It is responsible for bringing
people in organization helping them perform their work, compensating them for their work and solving
problems that arise.
Functions of HRM
Basic functions that all managers perform: planning, organizing, staffing, leading, and controlling. HR
management involves the policies and practices needed to carry out the staffing (or people) function of
management.
HRM department regardless of the organizations size must perform following human resource management
functions
Staffing (HR planning, recruitment and selection)
Human resource development
Compensation and benefits
Safety and health
Employee and labor relations
Records maintaining, etc.
HR research (providing a HR information base, designing and implementing employee
communication system).
Interrelationship of HR function
Job: A group of tasks that must be performed in an organization to achieve its goals.
Position: The tasks and responsibilities performed by one person; there is a position for every individual in an
organization.
Task: A distinct, identifiable work activity composed of motions
Duty: A larger work segment composed of several tasks that are performed by an individual.
Responsibility: An obligation to perform certain tasks and duties.
Job Description: A job description is a written statement of what the jobholder actually does, how he does it,
and under what conditions the job is performed.
Job Specification: is information about physical working condition, work schedule & the organizational &
social context of the job.
Job Analysis: is the process of recording information about the work performed by an employee. Job Analysis
is the systematic process of collecting and making judgments about all the important information related to a
job. Job analysis is the procedure through which you determine the duties and nature of the jobs and the kinds
of people who should be hired for them.
Job Evaluation: is a comparison of job in order to determine compensation.
Job Satisfaction: is the degree to which individual feel positively or negatively about their jobs.
Job Enrichment: Job enrichment means building motivators like opportunities for achievement into the job
by making it more interesting and challenging. Forming natural work groups, combining tasks, establishing
client relationships, vertically loading the job, and having open feedback channels may implement Job
enrichment.
Job Enlargement: means building up the job so as to make it more satisfying to the worker.
Job Encroachment: means horizontal locality of job tasks.
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What Is Organizational Behavior?

Organizational Behavior is a field of study that investigates the impact that individuals, groups and structure
have on behavior within organizations, for the purpose of applying such knowledge toward improving an
organizations effectiveness:.
Organizational behavior is the study of the many factors that have an impact on how individuals and groups
respond to and act in organizations and how organizations manage their environments.
Why Do We Study OB?
Following are the reasons to study organizational behavior:
To learn about yourself and how to deal with others
You are part of an organization now, and will continue to be a part of various organizations
Organizations are increasingly expecting individuals to be able to work in teams, at least some of the
time
Some of you may want to be managers or entrepreneurs
The importance of studying organizational behavior (OB)
OB applies the knowledge gained about individuals, groups, and the effect of structure on behavior in order to
make organizations work more effectively. It is concerned with the study of what people do in an organization
and how that behavior affects the performance of the organization. There is increasing agreement as to the
components of OB, but there is still considerable debate as to the relative importance of each: motivation,
leader behavior and power, interpersonal communication, group structure and processes, learning, attitude
development and perception, change processes, conflict, work design, and work stress. It is also important
because it focus on the following areas.
OB is a way of thinking.
OB is multidisciplinary.
There is a distinctly humanistic orientation with OB.
The field of OB is performance oriented.
The external environment is seen as having significant impact on OB.
Communication
The word communication means the act or process of giving or exchanging of information, signals, or
messages as by talk, gestures, or writing. Technically speaking, in the act of communication, we make
opinions, feelings, information, etc known or understood by others through speech, writing or bodily
movement.
Communication is an important part of our world today. The ability to communicate effectively with others is
considered a prized quality of the successful business people. To communicate easily and effectively with your
readers, you should apply the following Seven C principles:
Completeness:
Provide all necessary information
Answer All questions asked
Give something extra, when desirable
Conciseness:
Eliminate wordy expressions-to the point.
Include only relevant material
Avoid unnecessary repetition
Consideration:
Focus on you instead of I and we
Show audience benefit or interest in the receiver
Emphasize positive, pleasant facts
Concreteness:
Use specific facts & figures
Put action in your verbs
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Choose vivid, image-building words

Clarity:
Choose precise, concrete & familiar words
Construct effective sentences & paragraphs
Courtesy:
Be sincerely tactful, thoughtful, and appreciative
Use expressions that show respect
Choose nondiscriminatory expression
Correctness:
Use the right level of language
Check accuracy of figures, facts & words
Maintain acceptable writing mechanics
WHAT IS STATISTICS?
That science which enables us to draw conclusions about various phenomena on the basis of real data collected
on sample-basis.
It is defined as the science of collection, presentation, analysis & interpretation of numerical data.
Descriptive statistics:
The branch of statistics that deals with collection presentation and analysis of numerical data is called
descriptive statistics.
Pure statistics:
Pure statistics/theoretical statistics is mathematical & deals with general theories, formulae, equation & their
derivations.
Applied statistics deals with the application of statistical methods to concrete subject matter, such as
measurement of economic, commercial, social, agricultural, industrial, scientific and mental phenomena,
measurement of living organism, study of vital & population movements & actuarial principles.
Population consists of the totality of the observation with which we are concerned.
Data is a collection of any number of related observations.
Variables
A characteristic that varies with an individual or an object is called a variable. A variable is called a
quantitative variable when a characteristic can be expressed numerically such as age, weight, income or
number of children. On the other hand, if the characteristic is non-numerical such as education, sex, eye
colour, quality, intelligence, poverty, satisfaction, etc. the variable is referred to as a qualitative variable.
Primary data is the most original data and has not undergone any statistical treatment.
Secondary data is that data which has undergone the statistical treatment at least once.
Sample is the representative part of the population.
Parameter is numerical value calculated from population.
Statistic: is a numerical value calculated from sample
Frequency Distribution: A tabular arrangement of data in which various items are arranged into classes in a
group of data is called F.D.
Central Tendency: the value of average which is tend to lie in the center of distribution is called central
tendency.
Average: A value which is used in this way to represent the distribution.
Arithmetic Mean: A value that is obtained by summing all the value dividing by their number.
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Median: an arrangement of data in ascending or descending. If the number of value are odd then the middle
value of data are Median & if value are even then is the two middle.
Mode: Values of data are mode which is more frequently in data or which is repeated more time in the data.
Geometric Mean: A group of a positive value X1, X2.Xn is the root of the product of the values.
Harmonic Mean: A set of n values X1, X2Xn is the reciprocal of the A.M of the reciprocals of
the values.
Weighted Arithmetic Mean: The numerical value of the relative values with respective weight is called
weighted arithmetic Mean.
Index Number: An index number is device which shows by its variation the changes in a magnitude which is
not capable of accurate measurement.
Probability: The ratio between favorable outcome and total outcome is called probability. OR. The chance
that a given outcome will occur.
References:
The Complete Idiots Guide to MBA Basics
By Tom Gorman
Principles of Accounting
By M.A. Ghani
Introduction to Business
By Professor M. Saeed Nasir
http://vustudents.ning.com/page/lecture-handouts
http://www.investorwords.com/
http://www.investorwords.com/term-of-the-day.html
http://www.investorguide.com/newsletters.php
http://www.google.com

Planning Officer
Cell # 03339668669
Wazir222@yahoo.com

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wazir

Basics of MBA-----A route to success

"In the name of ALLAH, the Most Merciful and Gracious"

HIDAYAT ULLAH KHAN WAZIR

Basics of MBA-----A route to success

Basics of MBA-----A route to success

Basics of MBA-----A route to success

Different Types of Business Organizations:

Basics of MBA-----A route to success

Minimum number of members in a public limited company is seven (7)

There are two types of public limited company:

Basics of MBA-----A route to success

The second stage for establishment of a company is to get it incorporated.

Basics of MBA-----A route to success

Capital subscription stage

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Basics of MBA-----A route to success

Basics of MBA-----A route to success

Ethics in the workplace:

HIDAYAT ULLAH KHAN WAZIR

For suggestion wazir222@yahoo.com | cell # 03339668669

Basics of MBA-----A route to success

Managerial functions i.e. POLCA

Basics of MBA-----A route to success

Basics of MBA-----A route to success

Management Skills, Knowledge and Performance:

Managerial roles in organizations:

Basics of MBA-----A route to success

Basics of MBA-----A route to success

Receipt voucher is used to record cash or bank receipt.

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Basics of MBA-----A route to success

Basics of MBA-----A route to success

For suggestion wazir222@yahoo.com | cell # 03339668669

Basics of MBA-----A route to success

Basics of MBA-----A route to success

Difference between expenses & Purchases

Basics of MBA-----A route to success

Basics of MBA-----A route to success

Increase in Income is Credit

How to Carry Forward a Balance?

Basics of MBA-----A route to success

Cost of the Asset = Rs.100,000

Depreciation expense account contains the depreciation of the current year.

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Basics of MBA-----A route to success

Accounting cycle /process:

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General journal means chronological records of business transactions.

General Ledger The T Account

Basics of MBA-----A route to success

Making adjusting entries:

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Basics of MBA-----A route to success

Preparing adjusted trial balance:

Preparing Financial Statements:

Profit & Loss Account (income statement):

Statement of Changes in Equity:

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Cash Flow Statement

Basics of MBA-----A route to success

Closing the Income Summary Account