Dostana Part II

Dostana Part II

Amol Rathod +91-9763852593 student of JICA
Pankaj Bhand +91-9405005540 student of JICA

Capital structure

Cost of debt

Tax is deductible expenses. The cost of capital is equivalent to debt burden on organization has to bear in terms of interest, tax or dividend etc. the formula for calculation is as below:

I (1-t) + (F-P/N)

Kd=       (P+F)/2

Kd – cost of debt, I- interest, t- taxation rate, F- face value of debenture, P- net amount realized, N- period of maturity.

Cost of preference capital

Cost of dividend + cost of actual additional liability in terms of tax+dividend payment expenses will result in cost of capital. The effective rate of interest which organization needs to bear is more than face value if tax and additional amounting expenses are high. The formula for the same is as below:

   PD+ (F-P)/N

Kp=        (F+P)/2

Kp- cost of preference shares, PD- preference dividend, F-repayable value, P- net amount realised, and N- maturity period

Cost of long term loan:

Long term loan is one of the sources for capital. When loan is repaid additional burden of interest to with of principle is to be bared by the firm as cost of capital. In this formula tax is value additional factor considered in calculating cost of capital. Formula for the same is as below:

Kd= interest (1- Tax Rate)

Cost of equity capital:

Different approaches towards cost of capital are as below:

Cost of equity capital

 

Dividend /Price     Dividend, Price          EPS to Price            Cost of Retained Earnings       Realised Yield

Approach                 and Growth                 Approach                      Approach                          Approach   

                                 Approach                                        

EPS to Price approach:

Comparison of price of share with earning per share is done as there is difference between face value and market value of share so in place of dividend importance is given to earnings per share. The formula for the same is as below:

Ke = EPS/P

EPS- earnings per share, P -price of share

Cost of retained earnings approach:

Cost of retained earnings is a kind of opportunity cost for investors. When company retains higher amount of earnings then it is indication of future gain in terms of value addition to price and asset charge of company. The formula for the same is as below:

Kr = cost of equity capital X (1-tp/ 1-tg)

Kr – cost of retained earnings, tp – ordinary personal income tax rate, tg – personal long term capital gains

Dividend /Price     :

In this approach dividend and market price of the shares is compared to analyse the cost of capital. This approach can also be termed as EPS approach based on market price of the share. Ion this approach what is current price and earnings for the same price in terms of dividend are measured and then the amount of cost of capital is calculated .formula for the same is as below:

Ke = D/MP

D- Dividend per share, MP- market price of share

Dividend, Price and Growth Approach:

In this approach with amount of dividend expected rate of growth of organization is also considered. The formula to calculate cost of capital for the same is as below

Ke = D/ MP+ G (growth)  

COMMODITY SWAPS

Producers need to manage their exposure to fluctuations in the prices for their commodities. They are primarily concerned with fixing prices on contracts to sell their produce. A gold producer wants to hedge his losses attributable to a fall in the price of gold for his current gold inventory. A cattle farmer wants to hedge his exposure to changes in the price of his livestock.

End-users need to hedge the prices at which they can purchase these commodities. A university might want to lock in the price at which it purchases electricity to supply its air conditioning units for the upcoming summer months. An airline wants to lock in the price of the jet fuel it needs to purchase in order to satisfy the peak in seasonal demand for travel.

Speculators are funds or individual investors who can either buy or sell commodities by participating in the global commodities market. While many may argue that their involvement is fundamentally destabilizing, it is the liquidity they provide in normal markets that facilitates the business of the producer and of the end-user.

Why would speculators look at the commodities markets? Traditionally, they may have wanted a hedge against inflation. If the general price level is going up, it is probably attributable to increases in input prices. Or, speculators may see tremendous opportunity in commodity markets. Some analysts argue that commodity markets are more technically-driven or more likely to show a persistent trend.

The futures markets have been the traditional vehicles for participating in the commodities markets. Indeed, derivatives markets started in the commodities field.

Types of commodity swaps

There are two types of commodity swaps: fixed-floating or commodity-for-interest.

Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the exception that both indices are commodity based indices.

General market indices in the commodities market with which many people would be familiar include the Goldman Sachs Commodities Index (GSCI) and the Commodities Research Board Index (CRB). These two indices place different weights on the various commodities so they will be used according to the swap agent's requirements.

Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity in question is exchanged for some money market rate (plus or minus a spread).

Valuing commodity swaps

In pricing commodity swaps, we can think of the swap as a strip of forwards each priced at inception with zero market value (in a present value sense). Thinking of a swap as a strip of at-the-money forwards is also a useful intuitive way of interpreting interest rate swaps or equity swaps.

Commodity swaps are characterized by some idiosyncratic peculiarities, though.

These include the following factors for which we must account (at a minimum):

1. The cost of hedging
2. The institutional structure of the particular commodity market in question
3. The liquidity of the underlying commodity market
4. Seasonality and its effects on the underlying commodity market
5. The variability of the futures bid/offer spread
6. Brokerage fees
7. Credit risk, capital costs and administrative costs

Some of these factors must be extended to the pricing and hedging of interest rate swaps, currency swaps and equity swaps as well. The idiosyncratic nature of the commodity markets refers more to the often limited number of participants in these markets (naturally begging questions of liquidity and market information), the unique factors driving these markets, the inter-relations with cognate markets and the individual participants in these markets. 

Crop Insurance History:

In our country crop production has been subjected to the vagaries of the climate. Some of the other problems that the Indian agriculture is constantly tackling with are the large-scale damages that are caused as a result of the attack of pests and diseases. It is in a scenario such as this in India that the issue of crop insurance assumes a vital role in the stable growth of the agricultural sector. Tracing the Crop Insurance History in India we see that it was started with the introduction of the All-Risk Comprehensive Crop Insurance Scheme (CCIS) that covered the major crops. This scheme was introduced in 1985. In fact this period of introduction also coincided with the introduction of the Seventh-Five-year plan. This initial scheme was of course later substituted and replaced by the National Agricultural Insurance Scheme. This substitution came into effect from 1999. These Schemes that have been introduced throughout the crop insurance history have been preceded by years of preparation, studies, planning, experiments and trials on a pilot basis.
In the crop insurance history, the question of introducing a crop insurance scheme was taken up for examination soon after the Indian independence. The first aspect that was examined related to the modalities of crop insurance. The issue under consideration was about whether the crop insurance should be offered under an Individual approach or on Homogenous area approach.

The Individual approach of the scheme indemnifies the farmer to the full extent of the losses. Also the premium that is to be paid by him is determined with reference to his own past yield and loss experience. The Individual approach for these schemes necessitates reliable and accurate data of crop yields of individual farmers for a sufficiently long period, for fixation of premium on actuarially sound basis.

The Homogenous area approach on the other hand was aimed at envisaging a homogeneous area from the point of view of crop production and similarity of annual variability of crop production. The homogenous area approach was found to be more favorable. This is because it would facilitate the provision of a single unit treatment to various agro-climatically homogenous areas and the individual farmers and allow them to pay the same rate of premium and receive the same benefits, irrespective of their individual fortunes. 

Agriculture Insurance

India is an agrarian society with 75% of the population depending on it, for their livelihood. Agriculture or crop insurance has assumed importance with large scale damage caused due to pest attacks, crop diseases and vagaries of weather. The objective is to provide insurance coverage and financial support to the farmers in the event of failure of any of the notified crop as a result of natural calamities, pests & diseases. The list of crops being covered for insurance differs from state to state. Generally quite a few Kharif and Rabi season crops are covered. These crops are insured at the community/block/gram panchayat levels. Agriculture insurance schemes are of immense help to farmers, providing them with financial security.

Comprehensive Crop Insurance Scheme (CCIS) has been in operation in the country since Kharif 1985 as an instrument of risk management in agriculture and as a measure of providing relief to farmers whose crops are damaged due to natural calamities. The sum insured is equal to crop loan disbursed subject to a maximum of Rs. 10,000 per farmer. The premium is charged at the rate of 2 per cent for rice, wheat and millets and 1 per cent for pulses and oilseeds. Since inception of the Scheme in 1985, about 6.45 crore farmers have been covered up to rabi 1997-98 season. The total amount of claims paid was Rs. 1623 crore as against a premium collection of about Rs. 313 crore up to rabi, 1997- 98 season. The Scheme is thus unviable. The losses incurred are met by the Government of India and the concerned state Governments in the ratio 2:1. The main drawback of the scheme is seen in the claims entertained for one single crop, namely, groundnut, because of which Gujarat state alone received Rs. 792 crores as claims compensation out of all India claims of Rs. 1623 crores. Thus one single crop (groundnut) in just one state (Gujarat) alone claimed 48.8 percent of total claims between 1985 to rabi 1997-98.

An Experimental Crop Insurance Scheme was introduced by the Government of India during rabi 1997-98 season covering non-loanee small and marginal farmers growing specified crops in selected districts. The scheme could be implemented only in 14 districts of 5 States. The premium was totally subsidised. Premium and claims both, were shared by Central and State Governments in the ratio of 4:1. About 4.78 lakh farmers were covered for a sum insured of Rs. 172 crore under the scheme during the rabi 1997-98 season. The total premium collected was Rs. 2.86 crore and against that, the claims amounted to around Rs.

39.78 crore. The Scheme has since been discontinued from kharif 1998 season. However, an expanded crop insurance scheme that will cover all farmers and more crops is under active consideration of the Government.

Economists have proven that farmers stand to benefit from crop insurance, even unsubsidized crop insurance. However, private markets for crop insurance worldwide are not highly developed, except for in a few cases. Skees (2000) documents several reasons for the underdevelopment of private crop insurance. Subsidized crop insurance crowds out private insurers and stifles innovation. Farmers are considered to know their risks better than the government or the private sector, so knowledge of agriculture is essential for insurers. The need for information increases the cost of insurance. Agricultural risk is unique—natural disasters can be widespread and are neither completely independent nor correlated. Studies have indicated that farmers/decision makers tend to underestimate the risk of damage by natural causes.

In the United States crop insurance is subsidized by the government but

administered through private companies. Hail insurance is not subsidized, so most insurers offer hail insurance along with the subsidized government policies. Rates are based upon the history of crop losses due to hail in the county and competition also plays a factor in keeping rates low. Adverse selection is not an issue because companies set rates higher for high-risk areas. Moral hazard is also less of a problem, as hail is a natural event. The multiple-peril insurance subsidized by the government is considered to be too expensive if offered without subsidies. A crop insurance agent from Midwest estimated that over half of the farmers who purchase subsidized multi-peril crop insurance also purchase hail insurance. The model used for hail insurance can also be used for other natural disasters, like drought, flood, and wind. The current subsidized insurance program administered

through private companies is relatively new. This program is considered to be a significant improvement over the previous unpopular programs administered by the government, although it is not flawless. An option for the Indian government is to administer its crop insurance program through private companies and gradually phase out the subsidy. This option could best be used for a “transition” period. Initially subsidizing premium rates for crop insurance offered through private companies would give the private sector incentive to enter the agricultural sector and time to gain experience before the withdrawal of subsidies. Crop insurance in South Africa was started in 1929 when a group of farmers started a pool scheme. Subsidized multi-peril insurance was offered for some time, but for the past fifteen years no subsidies have been given. Hail is the main peril covered and many other perils are also covered. Historical data and past claims play a role in determining the premiums and damage assessment is the biggest challenge for crop insurers. Crops at different stages are affected differently by hail, making knowledge essential for insurers. There are several players and new ones are

continuously targeting this market. Several crops are covered, including maize, wheat, sunflowers, and citrus fruits. The South Africa case illustrates how private individuals can offer crop insurance that is beneficial to farmers and how crop insurance can still exist after subsidies are withdrawn. In Canada crop insurance was administered through an area approach, similar to that of India. Research from 1995 by Turvey and Islam indicated that the area approach was not only inequitable but also inefficient. The empirical research from 537 farms confirmed the belief that individual crop insurance is better in terms of

risk reduction, but premiums would also be higher. The area approach in Canada was concluded to be inequitable, as benefits were not fairly distributed. The most benefits to be accrued would be by the farmers with yields closest to the average.

The crop insurance in Canada was voluntary at this time, unlike the NAIS. Adverse selection would be less of a problem at the individual level when insurance is mandatory. Cross-subsidization would be more of a problem, because the better farmers having to purchase insurance would indirectly subsidize the worse farmers. A 1997 study by Sakurai and Reardon indicated that there was an unmet demand for formal drought insurance in Burkina Faso. Burkina Faso is a part of the West African Semi-Arid Tropics (WASAT) and experiences frequent drought. Much of the farmland in India is in the semi-arid tropics. The demand for drought insurance was found to decrease in households with higher overall incomes or more self-insurance. The authors suggest that crop insurance alone is not sufficient; that policy and programs that supports self-insurance, such as micro credit or increase of off-farm employment, are also important. Perhaps in India public funds and government policy would be better aimed at strengthening self insurance mechanisms, while leaving crop insurance to the private sector.