Friday, April 6, 2012

Mrunal's Articles on UPSC: Economy

  1. How To get the cash to start my company?
  2. Problems in above options
  3. Financing my company: Debt OR Equity
  4. #1: Debt: Bonds
  5. #2: Equity –Shares
  6. Debt vs Equity : good and Bad things
  7. Upcoming articles
I want to start an Ice cream company, what will I need?
LandTo build a factory.
LaborWorkers to run the machines.
Capital Freezers, mixers and packing machines to make ice-cream.
EntrepreneurshipTo take the risk and do above three things.
  • These are called the four factors of production.
  • I already have the entrepreneurship in my heart and mind.
  • But it requires truckload of cash to arrange for the other three items: Land, Labour and Capital.

How To get the cash to start my company?

  • I can rob a bank
  • Or I can just start my own IIT Bombay, sell its application forms for 5,000 rupees and then declare cut off 99.99% and thus earning truckload of cash without actually wasting a single rupee in arranging the admission interviews.
  • Or I can join politics.

Problems in above options

  • Can't rob a rob a bank because this too requires Labour (gangsters) and Capital (guns, masks, vehicles) and Entrepreneurship (to take the risk of going to jail).
  • Can't start my own IIT Bombay would again require those four factors of production (Land, Labour, Capital, Entrepreneurship)+Permissions from UGC/AICTE.
  • Can't join politics because Only ministers can make huge money, MPs/MLAs don't. And Unfortunately I'm not a son or daughter of some big politician so I can't become minister @ young age (Agatha Sangma,  Sachin Pilot, Naveen Jindal et al) So even If I join politics right now, I'll have to do bootlicking of 'Party high command' until I get 60 years old, only then I can become minister and break the records set by A.Raja and Madhu Koda.
Now, There are two ways to (legally) arrange money for starting a company or to expand a company. First is Debt and Second Equity. See this chart

Financing my company: Debt OR Equity

#1: Debt- bond

  • The word debt is self-explanatory. You borrow money from someone: It can be a bank, it can be a friend, it can be a stranger.
  • I write on a piece of paper: "To whoever pays me Rs.1000, I'll pay annual 10% interest rate (Rs.100). And after 5 years, I'll also repay the principle amount Rs.1000. No "ifs" and "buts".
  • This is one type of security paper. We call it "BOND".
  • IF you hold my bonds, I'm liable to pay you money no matter what happens. Whether my ice-cream company actually makes profit or goes Kingfisher. I have to keep paying fixed money to you, every year.

Junk Bonds vs Gilt Edged Security

  • In above case I offered you 10% interest rate. But in real life, there are credit rating companies like CRISIL, S&P, Moody's etc. They'll give credit ratings to a bond. (i.e. Am I capable enough to actually pay you?).
  • Based on that, they give ratings example AA,A, BBB, BB,C,D etc.
  • I had talked about them in my previous article : Link between Credit Rating and Interest Rates

Junk Bonds

  • If my Bond gets "C" or "D" rating, it means I'm not creditworthy, I may default on this loan, I may run away. So my bond is as junk as Ra.One movie. A wise man will not invest in it.
  • So, how can I seduce you into purchasing my bonds?  How can I convenience you to take the higher risk, in buying my junk bond?
  • How about Free caller Tunes or a scratch-card that offers you a chance to dine with Sachin or Katrina?
  • Or How about Higher Interest rates: "If you give me Rs.1000, I'll give you 25% interest rate per year!"
  • This is also known as "High Yield Bond", because you're getting higher profit.

Gilt Edged Securities

  • Like an ice cream company, Government also needs finance- at times when tax collection is low and they need some temporary funds.
  • They issues treasury bonds. RBI sells these treasury bonds on Government's behalf.
  • But Governments generally have the "aukaat" to repay the principle and interest rates. Hence Government bonds have higher credit ratings (AA). So, they don't need to seduce you, they'll offer very low rate, say 4%.
  • Similarly, well known companies with high credit ratings (AA) also issue bonds but pay low  rates.
  • If you don't like to take risks, you'll invest in such bonds. These are called 'gilt-edged securities'.

Bearer Bonds (and Bad Guys)

  • In Bollywood movies, Kidnapper demands ransom of Rs.10 lakhs but he wants the money in the denomination of Rs.5/10/50 Rupee notes. Why? Because it is easy to circulate that money and harder for police or banks to keep track of it.
  • Same way, in Hollywood Spy-thriller movies, the Villain will ask you to pay 10 million dollars in Bearer bonds.
  • Bearer bonds are same as regular bonds, but they don't have 'holder's name' on it. These bearer bonds have coupons attached with them. So, if you don't want to withdraw the whole money, you can cut a few coupons and sell them to a broker to withdraw partial amount.
  • E.g. if Rs.100 interest is paid on 1st April 2012, But even on December-2011 you can sell the coupon to a Broker. Although he'll not give you Rs.100 but something like Rs.95 or 90. (Why so? Think about it!)
  • Anyways, the point is, Noone can keep a track of who withdrew the money, who's buying, who's selling Because there are no "names", addresses or records. Bad guys like it, because this ensures anonymity.
  • See the following example photograph of a Bearer bond of Government of Palestine. Notice that it doesn't have space for
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From: Mrunal Patel <>

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