Buddha Air Private Ltd: Financial Management Case Study
(a) Surplus Units, Deficit Units, and Sources of Short-Term Financing
A surplus unit is an individual or organization that has more funds available than it currently needs. A deficit unit needs additional financing because its planned expenditures exceed its available funds.
The Basnet family acted as a surplus unit when it invested its own equity capital to establish Buddha Air. The family had savings available and used those funds to finance the airline.
Buddha Air acts as a deficit unit when it needs to borrow money to purchase additional aircraft or expand its operations. For example, the company plans to purchase an ATR 42 costing Rs 500 million, financing 90% of the purchase through a bank loan.
The two sources available to satisfy the airline's immediate financing needs are:
- Bank line of credit: Buddha Air can borrow funds temporarily from its bank when unexpected cash shortages occur.
- Government securities: The airline can sell its holdings of government securities to obtain cash quickly when necessary.
These sources help the airline maintain sufficient liquidity for daily operations.
(b) Transfer of Capital and Primary Versus Secondary Markets
Capital can be transferred from savers to borrowers in three main ways.
1. Direct transfer: A business sells securities directly to investors without using a financial intermediary.
2. Transfer through an investment bank: An investment bank helps a company issue securities and distribute them to investors. Depending on the arrangement, it may underwrite the securities.
3. Transfer through financial intermediaries: Institutions such as commercial banks collect funds from savers and provide financing to borrowers.
Ram Panday's stock purchase
If Buddha Air issues new common shares and Ram purchases 100 newly issued shares through Siddhartha Capital Limited, the transaction takes place in the primary market.
This is because the shares are being issued for the first time, and the proceeds ultimately go to Buddha Air.
Siddhartha Capital Limited may act as an issue manager or intermediary, helping facilitate the issuance, distribution, and processing of the shares.
However, if Ram purchases previously issued Buddha Air shares from another investor, the transaction occurs in the secondary market.
In that case, the money goes to the selling investor rather than Buddha Air.
The same distinction applies if Ram purchases previously outstanding shares in a dealer market. A dealer may buy and sell securities from its own inventory, but the transaction remains a secondary market transaction.
The key difference is whether the shares are newly issued or already outstanding.
(c) Market Efficiency and the Importance of Financial Markets
A financial market is considered informationally efficient when security prices reflect available relevant information.
In an efficient market, new information is incorporated into prices quickly, making it difficult for investors to consistently earn abnormal risk-adjusted returns using information already reflected in prices.
Why are some stock prices more efficient than others?
Some stocks are traded more frequently, followed by more analysts, and covered more extensively by financial news organizations.
For example, a large publicly traded airline may have thousands of investors and extensive financial reporting. New information about its profits or operating performance can be reflected in its stock price relatively quickly.
A smaller company with limited trading activity and less publicly available information may have less efficient pricing.
Factors affecting market efficiency include:
- Availability and accuracy of information
- Trading volume and market liquidity
- Number of investors and analysts
- Transaction costs
- Competition among market participants
Why are financial markets important for economic growth?
Financial markets help transfer funds from people who have savings to businesses and individuals that need capital.
They support economic growth by allowing companies to finance new investments, expand operations, purchase equipment, and create jobs.
For Buddha Air, financial markets provide opportunities to raise funds for purchasing aircraft and expanding airline services.
Financial markets also provide liquidity, facilitate risk sharing, and help investors determine the value of financial assets.
Therefore, well-functioning financial markets contribute to investment, business expansion, and economic development.
(d) Advice to Ram Panday About Investing in an IPO
An Initial Public Offering (IPO) occurs when a company offers shares to the public for the first time.
Although IPOs can provide attractive investment opportunities, Ram should not assume that every IPO will generate a profit.
My advice would be to carefully evaluate the company before investing.
First, examine the company's financial condition.
Ram should review the airline's revenues, profits, debt obligations, cash flows, and future growth prospects.
Second, consider the offering price.
A successful airline is not automatically a good investment at every price. If the IPO shares are overpriced, investors may experience losses even if the company performs reasonably well.
Third, understand the allocation process.
Applying for a large number of shares does not guarantee receiving them. If the IPO is oversubscribed, shares may be allocated according to applicable securities regulations and the offering's allocation procedures.
Fourth, avoid purchasing shares immediately after the IPO simply because the price is rising.
IPO prices can be volatile, and enthusiasm surrounding a new listing may temporarily push prices above reasonable valuations.
Finally, diversify investments.
Ram should avoid putting all his savings into one airline because the aviation industry faces risks involving fuel prices, economic conditions, competition, operating costs, and regulatory changes.
Recommendation: Ram should invest only after evaluating the company's fundamentals, the offering price, and his own financial goals and risk tolerance.
(e) How Perfect Financial Markets Could Allow Buddha Air to Avoid Financial Institutions
In a perfect financial market, we generally assume that information is freely available, transaction costs are absent, and there are no market frictions that prevent savers and borrowers from dealing directly with one another.
Under these conditions, Buddha Air could raise funds directly from investors without relying on banks or other financial intermediaries.
For example, instead of borrowing Rs 450 million from Everest Bank to finance 90% of its ATR 42 purchase, Buddha Air could issue bonds directly to investors.
Investors with excess savings could purchase those bonds, providing the airline with the financing it needs.
Similarly, Buddha Air could raise additional equity capital by issuing common stock directly to investors.
Because a perfect financial market would eliminate the transaction costs and information problems that financial institutions often help address, there would be less need for intermediaries.
However, real financial markets are not perfect.
Financial institutions remain important because they provide services such as credit evaluation, risk management, payment processing, information gathering, and financial advice.
Final Conclusion
The Buddha Air case demonstrates how businesses use financial markets and financial institutions to finance operations and expansion.
The airline can obtain short-term liquidity through its credit line and government securities while raising long-term capital through bank loans, bonds, or equity issuance.
Understanding financial intermediaries, market efficiency, IPOs, and investment risks allows both businesses and investors to make better financial decisions.
