Detailed report on INVESTMENT ON STOCK

INVESTMENTS

The dictionary meaning of investment is to commit money in order to earn a financial return or to make use of the money for future benefits or advantages. People commit money to investments with an expectation to increase their future wealth by investing money to spend in future years. For example, if you invest Rs. 1000 today and earn 10 %over the next year, you will have Rs.1100 one year from today.

An investment can be described as perfect if it satisfies all the needs of all investors. So, the starting point in searching for the perfect investment would be to examine investor needs. If all those needs are met by the investment, then that investment can be termed the perfect investment. Most investors and advisors spend a great deal of time understanding the merits of the thousands of investments available in India. Little time, however, is spent understanding the needs of the investor and ensuring that the most appropriate investments are selected for him.

The Investment Needs of an Investor

By and large, most investors have eight common needs from their investments:

 1. Security of Original Capital;

 2. Wealth Accumulation;

 3. Comfort Factor;

 4. Tax Efficiency;

 5. Life Cover;

 6. Income;

 7. Simplicity;

 8. Ease of Withdrawal;

 9. Communication.

Security of original capital: The chance of losing some capital has been a primary need. This is perhaps the strongest need among investors in India, who have suffered regularly due to failures of the financial system.

 Wealth accumulation: This is largely a factor of investment performance, including both short-term performance of an investment and long-term performance of a portfolio. Wealth accumulation is the ultimate measure of the success of an investment decision.

 Comfort factor: This refers to the peace of mind associated with an investment. Avoiding discomfort is probably a greater need than receiving comfort. Reputation plays an important part in delivering the comfort factor.

 Tax efficiency: Legitimate reduction in the amount of tax payable is an important part of the Indian psyche. Every rupee saved in taxes goes towards wealth accumulation.

 Life Cover: Many investors look for investments that offer good return with adequate life cover to manage the situations in case of any eventualities.

Income: This refers to money distributed at intervals by an investment, which are usually used by the investor for meeting regular expenses. Income needs tend to be fairly constant because they are related to lifestyle and are well understood by investors.

Simplicity: Investment instruments are complex, but investors need to understand what is being done with their money. A planner should also deliver simplicity to investors.

Ease of withdrawal: This refers to the ability to invest long term but withdraw funds when desired. This is strongly linked to a sense of ownership. It is normally triggered by a need to spend capital, change investments or cater to changes in other needs. Access to a long-term investment at short notice can only be had at a substantial cost.

Communication: This refers to informing and educating investors about the purpose and progress of their investments.  The need to communicate increases when investments are threatened.

• Security of original capital is more important when performance falls.
• Performance is more important when investments are performing well.
• Failures engender a desire for an increase in the comfort factor.

Perfect investment would have been achieved if all the above-mentioned needs had been met to satisfaction. But there is always a trade-off involved in making investments. As long as the investment strategy matches the needs of investor according to the priority assigned to them, he should be happy.

The Ideal Investment strategy should be a customized one for each investor depending on his risk-return profile, his satisfaction level, his income, and his expectations. Accurate planning gives accurate results. And for that there must be an efficient and trustworthy roadmap to achieve the ultimate goal of wealth maximization.

Choosing the Right Investment Options

After understanding the concept of investment, the investors would like to know how to go about the task of investment, how much to invest at any moment and when to buy or sell the securities, This depends on investment process as investment policy, investment analysis, valuation of securities, portfolio construction and portfolio evaluation and revision. Every investor tries to derive maximum economic advantage from his investment activity.

For evaluating an investment avenues are based upon the rate of return, risk and uncertainty, capital appreciation, marketability, tax advantage and convenience of investment. The following Table should give the clear picture relating to the investors’ investment decisions in various financial market instruments. The choice of the best investment options will depend on personal circumstances as well as general market conditions. For example, a good investment for a long-term retirement plan may not be a good investment for higher education expenses. In most cases, the right investment is a balance of three things: Liquidity, Safety and Return.

Stock Market – Indian stock markets particularly the BSE and the NSE, had been a preferred destination not only for the Indian investors but also for the Foreign investors. Although Indian Markets had been through tough times due to various scams, but history shows that they recovered very fast. Many types of scrip had been value creators for the investors. People have earned fortunes from the stock markets, but there are people who have lost everything due to incorrect timings or selection of fundamentally weak companies.

Mutual Funds - There is a collection of investors in Mutual funds that have professional fund managers that invest in the stock market collectively on behalf of investors. Mutual funds offer a better route to investing in equities for lay investors. A mutual fund acts like a professional fund manager, investing the money and passing the returns to its investors. All it deducts is a management fee and its expenses, which are declared in its offer document.

Unit Linked Insurance Plans - ULIPs are remarkably alike to mutual funds in terms of their structure and functioning; premium payments made are converted into units and a net asset value (NAV) is declared for the same. In traditional insurance products, the sum assured is the corner stone; in ULIPs premium payments is the key component.

Endowment Insurance – These policies are term policies. Investors have to pay the premiums for a particular term, and at maturity the accrued bonus and other benefits are returned to the policyholder if he survives at maturity.

Bullion Market – Precious metals like gold and silver had been a safe haven for Indian investors since ages. Besides jewellery these metals are used for investment purposes also. Since last 1 year, both Gold and Silver have highly appreciated in value both in the domestic as well as the international markets. In addition to its attributes as a store of value, the case for investing in gold revolves around the role it can play as a portfolio diversifier.

Real Estate- Returns are almost guaranteed because property values are always on the rise due to a growing world population. Residential real estate is more than just an investment. There are more ways than ever before to profit from real estate investment.

Advantages and disadvantages of holding stock

The basis of the theoretical calculations of an EOQ and an optimal ROL is that there are advantages and disadvantages of holding stock (of buying stock in large or small quantities). The advantages include:

• the need to meet customer demand
• taking advantage of bulk discounts
• Reducing total annual re-ordering cost.

The disadvantages include:

• storage costs
• cost of capital tied up in stock
• Deterioration, obsolescence, and theft.

The aim behind the calculations of EOQ and ROL is to weigh up these, and other advantages and disadvantages and to find a suitable compromise level.

EOQ

When determining how much to order at a time, an organisation will recognize that:

• as order quantity rises, average stock rises and the total annual cost of holding stock rises
• As order quantity rises, the number of orders decreases and the total annual re-order costs decrease.

The total of annual holding and re-order costs first decreases, then increases. The point at which cost is minimized is the EOQ. This cost behavior is illustrated by the graph in Figure 1.

Figure 1

The way in which this EOQ is calculated is based on certain assumptions, including:

• constant purchase price
• constant demand and constant lead-time
• holding-cost dependent on average stock
• Order costs independent of order quantity.

The assumptions result in a pattern of stock that can be illustrated graphically as shown in Figure 2.

Figure 2

The Formula
Using the standard ACCA notation in which:
CH = cost of holding a unit of stock for a year
CO = cost of placing an order
D = annual demand

Also:
TOC = total annual re-ordering cost
THC = total annual holding cost
x = order quantity

Then:
average stock = x/2

THC = x/2 × CH

And:
number of orders in a year = D/x

TOC = D/x × CO

The total annual cost (affected by order quantity) is:
C = THC + TOC = x/2 × CH + D/x × CO

This formula is not supplied in exams – it needs to be understood (and remembered).
The value of x, order quantity that minimizes this total cost is the EOQ, given by an easily remembered formula:

Use of EOQ Formula
you need to take care over which figures you put into the formula, particularly in multiple-choice questions. The areas to beware of fall into two categories:

1. Relevant costs – only include those costs affected by order quantity. Only include those holding costs which (in total in a year) will double if you order twice as much at a time. Only include those order costs which (in total in a year) will double if you order twice as often. (Thus, fixed salaries to storekeepers or buying department staff will be excluded.)
2. Consistent units – ensure that figures inserted have consistent units. Annual demand and cost of holding a unit for a year. Both holding costs and re-ordering costs should be in £, or both in pence.

Bulk Discounts
A common twist to exam questions is to ask students to evaluate whether bulk discounts are worth taking. While prices reduce, total annual holding costs will increase if more stock is ordered at a time, so the matter needs a little thought. The common approach is one of trial and error. This involves finding the total annual cost (holding cost, re-ordering cost and purchasing cost) at the level indicated by the EOQ and at the level(s) where discount first becomes available.
Figure 3 shows total costs (now including cost of purchasing the stock) plotted against order quantity with discount incorporated.

Figure 3

Point A represents the cost at the order quantity indicated by the EOQ. If stock is ordered in larger quantities, total costs will increase to point B1, at which stage bulk discounts are available, bringing the costs down to point B. Any calculations will involve finding which cost out of A, B or C is the lowest, as Example 1 will show.

Example 1
Moore Limited uses 5,000 units of its main raw material per month. The material costs £4 per unit to buy, supplier’s delivery costs are £25 per order and internal ordering costs are £2 per order. Total annual holding costs are £1 per unit. The supplier has offered a discount of 1% if 4,000 units of the material are bought at a time.

Required:

1. Establish the economic order quantity (EOQ) ignoring the discount opportunities.
2. Determine if the discount offer should be accepted.

Example 1 solutions

Re-order levels
As important as how much to order at a time is the question of when to order more stock. If an order is placed too late, when stocks have been allowed to run too low, a ‘stock-out’ will occur, resulting in either a loss of production or loss of sales, or possibly both.

If orders are placed too soon, when there are still substantial supplies in stock, then stock levels and holding costs will be unnecessarily high. The re-order level as explained below should not be confused with the stock control levels referred to in textbooks – this article ignores these. When it comes to calculating re-order levels, three sets of circumstances can be envisaged.

Lead-time is zero
‘Lead-time’ is the interval between placing an order with a supplier and that order arriving. It is unlikely that this could be reduced to zero – it would require astonishingly co-operative and efficient suppliers. If it were possible, a re-order level of zero could be adopted. An organisation could simply wait until it ran out of stock, click its corporate fingers, and stock would arrive instantaneously.

Constant demand, fixed finite lead-time
The assumption of constant demand is consistent with the assumptions underlying the EOQ formula. If suppliers take some time to provide goods, orders need to be placed in advance of running out. Figure 4 illustrates the problem and its solution.

Figure 4

If the lead-time is, say, 5 days, an order has to be placed before stocks have been exhausted. Specifically, the order should be placed when there is still sufficient stock to last 5 days, i.e:

Re-order level (ROL) = Demand in lead-time

So, if lead-time for a particular stock item is 5 days and daily demand is 30 units, the re-order level would be 5 days at 30 units per day, 150 units.

Variable demand in the lead-time

If demand in lead-time varied, it could be described by means of some form of probability distribution. Taking the previous example of the demand in lead-time being 150 units, we’re considering the possibility of demand being more than 150 or less than that. See Figure 5.

Note: This aspect of stock control produces a few problems. The EOQ formula requires that demand (and lead-time) for a stock item be constant. Here the possibility of demand varying or lead-time varying or both varying is introduced. Setting that problem aside, most ACCA syllabuses at the lower levels avoid any discussion of uncertainty or probability distributions. However, uncertainty in lead-time demand in stock control has featured in exams.
In these circumstances, a firm could place an order with a supplier when the stock fell to 150 units (the average demand in the lead-time). However, there’s a 33% chance (0.23 + 0.08 + 0.02 = 0.33) that demand would exceed this re-order level, and the organisation would be left with a problem. It is therefore advisable to increase the re-order level by an amount of ‘buffer stock’ (safety stock).

Buffer stock
Buffer stock is simply the amount by which ROL exceeds average demand in lead-time. It is needed when there is uncertainty in lead-time demand to reduce the chance of running out of stock and reduce the cost of such shortages.

If a ROL of 160 units was adopted, this would correspond to a buffer stock of 10 units (and reduce the chance of running out of stock to 0.08 + 0.02 = 0.1, or 10%). A ROL of 170 is equivalent to a buffer stock of 20 and reduces the chance of running out to 2%, and a ROL of 180 implies 30 units of buffer stock (and no chance of running short).

Optimal Re-order Levels

This leaves the problem of how to calculate the optimal ROL. There are two common ways in which one could determine a suitable re-order level (if the information was available):

1. A tabular approach – Calculate, for each possible ROL (each level of buffer stock) the cost of holding different levels of buffer stock and the cost incurred if the buffer is inadequate (‘stock-out’ costs). The optimal re-order level is that level at which the total of holding and stock-out costs are a minimum.
2. A ‘service level’ approach – An organisation has to determine a suitable level of service (an acceptably small probability that it would run out of stock), and would need to know the nature of the probability distribution for lead-time demand. These two would be used to find a suitable ROL.