Professional Documents
Culture Documents
Fms Notes Full
Fms Notes Full
The institutional arrangements include all conditions and mechanisms governing the production,
distribution, exchange and holding of financial assets or instruments of all kinds and the organisations as
well as the manner of operations of financial markets and institutions of all descriptions.
With financial progress and innovations in financial technology, the scope of portfolio choice has also
improved. Therefore, it is widely held that the savings-income ratio is directly related to both financial
assets and financial institutions. That is, financial progress generally insures larger savings out of the same
level of real income.
As stores of value, financial assets command certain advantages over tangible assets (physical capital,
inventories of goods, etc.) they are convenient to hold, or easily storable, more liquid, that is more easily
encashable, more easily divisible, and less risky.
A very important property of financial assets is that they do not require regular management of the kind
most tangible assets do. The financial assets have made possible the separation of ultimate ownership and
management of tangible assets. The separation of savings from management has encouraged savings
greatly.
Other financial methods used are deductions at source of the contributions to provident fund and other
savings schemes. More generally, mobilisation of savings taken place when savers move into financial
assets, whether currency, bank deposits, post office savings deposits, life insurance policies, bill, bonds,
equity shares, etc.
(iii) Allocation of Funds:
Another important function of a financial system is to arrange smooth, efficient, and socially equitable
allocation of credit. With modem financial development and new financial assets, institutions and markets
have come to be organised, which are replaying an increasingly important role in the provision of credit.
In the allocative functions of financial institutions lies their main source of power. By granting easy and
cheap credit to particular firms, they can shift outward the resource constraint of these firms and make
them grow faster.
Money Market
Money market is a market for dealing with financial assets and securities which have a maturity period of
upto one year. In other words, it is a market for purely short term funds. The money market may be
subdivided into four. They are:
(i) Call money market
(ii) Commercial bills market
(iii) Treasury bills market
(iv) Short term loan market
Call MoneyMarket :The call money market is a market for extremely short period loans say one day to
fourteen days. So, it is highly liquid. The loans are repayable ondemand at the option of either the lender
or the borrower. In India, call money markets are associated with the presence of stock exchanges and
hence, they are located in major industrial towns like Bombay, Calcutta, Madras, Delhi, Ahmedabad etc.
The special feature of this market is that the interest rate varies from day to day and even from hour to
hour and centre to centre. It is very sensitive to changes in demand and supply of call loans.
Recent Trends :With a view to bringing the interest rates nearer to the free market rates, the Government
has taken the following steps:
(i) The interest rates on company deposits are freed.
(ii) The interest rates on 364 days Treasury Bills are determined by auctions and they are expected
to reflect the free market rates.
(iii) The coupon rates on Government loans have been revised upwards so as to be market
oriented.
(iv) The interest rates on debentures are allowed to be fixed by companies depending upon the
market rates.
(v) The maximum rates of interest payable on bank deposits (fixed) are freed for deposits of above one
year.
Financial Instruments
Financial instruments refer to those documents which represent financial claims on assets. As discussed
earlier, financial asset refers to a claim to the repayment of a certain sum of money at the end of a
specified period together with interest or dividend. Examples are Bill of exchange, Promissory Note,
Treasury Bill, Government Bond,
Deposit Receipt, Share, Debenture, etc. Financial instruments can also be called financial securities.
Financial securities can be classified into:
(i) Primary or direct securities.
(ii) Secondary or indirect securities.
Primary Securities :These are securities directly issued by the ultimate investors to the ultimate savers,
e.g. shares and debentures issued directly to the public.
Secondary Securities :These are securities issued by some intermediaries called financial intermediaries
to the ultimate savers, e.g. Unit Trust of India and mutual funds issue securities in the form of units to the
public and the money pooled is invested in companies.
Again these securities may be classified on the basis of duration as follows :
(i) Short-term securities
(ii) Medium-term securities
(iii) Long-term securities
Short-term securities are those which mature within a period of one year. For example, Bill of Exchange,
Treasury Bill, etc. Medium-term securities are those which have a maturity period ranging between one
and five years like Debentures maturing within a period of 5 years. Long-term securities are those which
have a maturity period of more than five years. For example, Government Bonds maturing after 10 years.
The company issuing securities for public subscription has to apply to a recognised stock exchange to get
its securities listed. If the permission is granted, then the securities are said to have been listed. Listing,
therefore, is a sort of sanction of the stock exchange permitting dealings in the specific securities. In
technical language, listed securities are also called ‘scrip’s’.
(b) Specimen copies of shares’ and debentures’ certificates, letters of allotment, etc.
(c) Particulars of bonuses and dividends declared during the last 10 years.
(d) Particulars of shares or debentures for which permission is sought.
(e) A statement showing the distribution of shares.
(f) A brief history of the company’s activities since its incorporation with reference to its assets, liabilities
and capital structure.
After a careful examination of the application, the stock exchange authorities may call upon the company
to execute a listing agreement. This contains the obligations and restrictions on the part of the company.
The company undertakes:
(a) That it would offer not less than 49 per cent of its issued capital for public subscription;
(b) That it would be fair to all applicants for shares while making allotments;
(c) That it would keep the stock exchange fully informed about vital matters affecting the company.
(d) That it would ensure equitable voting rights and dividend rights.
Challenges faced by the financial service sector.
Financial service sector has to face lot of challenges in its way to fulfil the ever growing financial demand
of the economy. Some of the important challenges are listed below:
1. Lack of qualified personnel in the financial service sector.
2. Lack of investor awareness about the various financial services.
3. Lack of transparency in the disclosure requirements and accounting practices relating to financial
services.
4. Lack of specialisation in different financial services (specialisation only in one or two services).
5. Lack of adequate data to take financial service related decisions.
6. Lack of efficient risk management system in the financial service sector.
The above challenges are likely to increase in number with the growing requirements of the customers.
However, the financial system in India at present is in a process of rapid transformation, particularly after
the introduction of new economic reforms
Unit 2
Financial services
Financial services refer to services provided by the finance industry. The finance industry encompasses a
broad range of organizations that deal with the management of money. Among these organizations are
banks, credit card companies, insurance companies, consumer finance companies, stock brokerages,
investment funds and some government sponsored enterprises.
1. Customer-Specific: Financial services are usually customer focused. The firms providing these
services, study the needs of their customers in detail before deciding their financial strategy, giving due
regard to costs, liquidity and maturity considerations. Financial services firms continuously remain in
touch with their customers, so that they can design products which can cater to the specific needs of
their customers. The providers of financial services constantly carry out market surveys, so they can
offer new products much ahead of need and impending legislation. Newer technologies are being used
to introduce innovative, customer friendly products and services which clearly indicate that the
concentration of the providers of financial services is on generating firm/customer specific services.
2. Intangibility: In a highly competitive global environment brand image is very crucial. Unless the
financial institutions providing financial products and services have good image, enjoying the
confidence of their clients, they may not be successful. Thus institutions have to focus on the quality
and innovativeness of their services to build up their credibility.
3. Concomitant: Production of financial services and supply of these services have to be concomitant.
Both these functions i.e. production of new and innovative financial services and supplying of these
services are to be performed simultaneously.
4. Tendency to Perish: Unlike any other service, financial services do tend to perish and hence cannot
be stored. They have to be supplied as required by the customers. Hence financial institutions have to
ensure a proper synchronization of demand and supply.
5. People Based Services: Marketing of financial services has to be people intensive and hence it’s
subjected to variability of performance or quality of service. The personnel in financial services
organisation need to be selected on the basis of their suitability and trained properly, so that they can
perform their activities efficiently and effectively.
6. Market Dynamics: The market dynamics depends to a great extent, on socioeconomic changes such
as disposable income, standard of living and educational changes related to the various classes of
customers. Therefore financial services have to be constantly redefined and refined taking into
consideration the market dynamics. The institutions providing financial services, while evolving new
services could be proactive in visualizing in advance what the market wants, or being reactive to the
needs and wants of their customers.
Financial services cover a wide range of activities. They can be broadly classified into two, namely:
1. Traditional Activities
Traditionally, the financial intermediaries have been rendering a wide range of services encompassing
both capital and money market activities. They can be grouped under two heads, viz.
Non fund based activities: Financial intermediaries provide services on the basis of non-fund activities
also. This can be called ‘fee based’ activity. Today customers, whether individual or corporate, are not
satisfied with mere provisions of finance. They expect more from financial services companies. Hence a
wide variety of services, are being provided under this head. They include:
Managing the capital issue i.e. management of pre-issue and post-issue activities relating to the
capital issue in accordance with the SEBI guidelines and thus enabling the promoters to market their
issue.
Making arrangements for the placement of capital and debt instruments with investment
institutions.
Arrangement of funds from financial institutions for the clients project cost or his working capital
requirements.
Assisting in the process of getting all Government and other clearances.
2. Modern Activities
Beside the above traditional services, the financial intermediaries render innumerable services in recent
times. Most of them are in the nature of non-fund based activity. In view of the importance, these
activities have been in brief under the head ‘New financial products and services’. However, some of the
modern services provided by them are given in brief here under.
Rendering project advisory services right from the preparation of the project report till the raising
of funds for starting the project with necessary Government approvals.
Planning for M&A and assisting for their smooth carry out.
Guiding corporate customers in capital restructuring.
Acting as trustees to the debenture holders.
Recommending suitable changes in the management structure and management style with a view
to achieving better results.
Structuring the financial collaborations/joint ventures by identifying suitable joint venture partners
and preparing joint venture agreements.
Rehabilitating and restructuring sick companies through appropriate scheme of reconstruction and
facilitating the implementation of the scheme.
Hedging of risks due to exchange rate risk, interest rate risk, economic risk, and political risk by
using swaps and other derivative products.
Managing in-portfolio of large Public Sector Corporations.
Undertaking risk management services like insurance services, buy-back options etc.
Advising the clients on the questions of selecting the best source of funds taking into
consideration the quantum of funds required, their cost, lending period etc.
Guiding the clients in the minimization of the cost of debt and in the determination of the optimum
debt-equity mix.
Promoting credit rating agencies for the purpose of rating companies which want to go public by
the issue of debt instrument.
Despite the fact that merchant banking is emerging as one of the prominent segment of financial service
sector, it is difficult to define what merchant banking is. The reason is very obvious as its limits
have never been adequately and strictly defined and it caters to wide variety of financial activities.
Dictionary of Banking and Finance explains merchant bank as an organisation that underwrites
securities for corporations, advisessuch clients on mergers and is involved in the ownership of
commercial ventures. Securities and Exchange Board of India (Merchant Bankers) Rules 1992
defines merchant bankers as “any person who is engaged in the business of issue management
either by making arrangement regarding selling, buying or subscribing to securities or acting as
manager, consultant, adviser or rendering corporate advisory services in relation to such issue
management. The Guidelines for Merchant Bankers (issued by Ministry of Finance, Deptt. of
Economic Affairs, Stock Exchange Division on 9-4-1990) instead of defining merchant banking
stated that these guidelines shall apply to those presently engaged in merchant banking activity
including as managers to issue and undertakes authorised activities. These activities interalia
include underwriting, portfolio management etc. Thus. to defines merchant bankers a definite
better approach is to include those agencies as merchant bankers which do what a merchant banker
does.
Normally every project has to raise debt funds for different sources as per need. Substantial debt raising
may be required for a new and capital intensive project. For such project merchant bankers may
undertake credit syndication. Credit syndication is credit procurement service. As per the
requirements, such syndication can be from national as well as international sources. Some of the
important credit syndication services offered are.
iii) Issue management
Traditionally this is one of the main functions of merchant banker. When ever an issue is made whether it
is public issue or private placement and further whether it is for equity shares, preference shares or
debentures, the merchant banker has a crucial role to play. Raising of funds from public has many
dimensions and formalities which are notpossible for the concerned. companies to comply with, where
merchant banker comes to their rescue. Marketing effort to convince the prospective investor needs
special attention. Here again merchant bankers are specialists. The specific important activities related to
issue management performed by merchant banks are mentioned here:
• Advise the company about the quantum and terms of raising funds.
• Advise as to what type of security may be acceptable in the market as well as to the
concerned lending institutions at the time of issue.
• Advise as to whether a fresh issue to be made or right issue to be made or if both, then in
what proportion, obtaining the desired consents, if any, from government or other
authorities
viii) Debenture trusteeship :-The merchant bankers can get themselves registered to act as trustee. These
trustees are to protect the interests of debenture holders as per the terms laid down in trust deed. They are,
as trustees, to undertake redressal of grievances of debenture holders. They are to ensure that refund
monies are paid and debenture certificates are dispatched in accordance with the Companies Act.
Debenture trustees are expected to observe high standards of integrity and fairness in discharging their
functions. They can call for periodical reports from the body corporate. They charge fee for such services.
Bill discunting
Bill discounting is a service against which merchant banker has to arrange funds against the bills which
have been discounted. This service is undertaken by merchant bankers generally if bill market is big as
well as mature. Otherwise bill discounting is undertaken by banks only. Depending on their credibility
they may also undertake the assignment of bill acceptance. These bills accepted and or discounted can be
foreign and merchant bankers can specify what types of bills they entertain. They charge commission for
these services.
(ii) Venture capital
Venture capital is the organized financing of relatively new enterprises to achieve substantial capital
gains. Such new companies are chosen because of their potential for considerable growth due to advance
technology, new products or services or other valuable innovations. A high risk is implied in the term and
is implicit in this type of investment. Since certain ingredients necessary for success of such projects are
missing in the begging but are added later on. Merchant bankers undertake to arrange and if necessary, to
provide such venture capital since traditional sources of finance like banks, financial institutions or public
issue etc. may not be available. Since expected returns on projects involving venture capital is high, these
are normally provided on soft terms. Such scheme is also popular as seed capital or risk capital scheme.
Merchant bankers deeply study such proposals before releasing the money. At opportune time such
investment can be disinvested to keep the cycle of venture capital more on.(iv) Lease financing and hire
purchase
Depending on the funds available, merchant bankers can also enter the field of lease or hire purchase
financing. Lease is an agreement where by the lessor (merchant banker in our case) conveys to the lessee
(the user), in return for rent, the right to use an asset for an agreed period of time. On the other hand in
hire purchase the user at the end of the agreed period has an option to purchase the asset which he has
used till date. The merchant bankers can advise the client to go in for leasing or hire purchase system of
financing an asset
(v) Factoring
Factoring is a novel financing innovation. It is a mixed service having financial as well as non financial
aspects. On one hand it involves management and collection of books debts which arise in process of
credit sale. The merchant bankers can take up this assignment and are required to perform activities like
sales ledger administration, credit collection, credit protection, evolving credit policy, arranging letter of
credit etc. On the other hand there is involvement of finance. Against factored debts the merchant banker
may provide advance with a certain margin
Make a systematic analysis of relevant information for credit monitoring and control.
• Provide full or partial protection against bad debts and accepting the risk of non realization.
• Provide financial assistance to the client.
• Provide information about prospective buyers.
• Provide financial counseling and assisting managing the liquidity.
vi) Underwriting
It refers to a contract by means of which merchant banker gives an assurance to the issuing company that
the former would subscribe to the securities offered in the event of non-subscription by the persons to
whom it was offered. The liability of merchant banker arises if the issue is not fully subscribed and this
liability is restricted to the commitment extended by him. The merchant bankers undertaking underwriting
make efforts on their own to induce the prospective investors to subscribe to the concerned issue. Such
assignment is accepted after evaluating viz :
• Company’s standing and its past record.
• Competence of the management.
• Purpose of the issue.
• Potentials
UNIT 3
The term venture capital comprises of two words, namely, ‘venture’ and ‘capital’. The term ‘venture’
literally means a ‘course’ or ‘proceeding’, the outcome of which is uncertain (i.e., involving risk). The
term capital refers to the resources to start the enterprise. Thus venture capital refers to capital investment
in a new and risky business enterprise. Money is invested in such enterprises because these have high
growth potential.
Venture capital is the money and resources made available to start up firms and small business with
exceptional growth potential (e.g., IT, infrastructure, real estate etc.). It is fundamentally along term risk
capital in the form of equity finance for the small new ventures which involve risk. But at the same time,
it a the strong potential for the growth. It thrives on the concept of high risk- high return. It is a means of
equity financing for rapidly growing private companies.
Venture capital is typically available in four forms in India: equity, conditional loan, income note and
conventional loan.
Equity: All VCFs in India provide equity but generally their contribution does not exceed 49 per cent of
the total equity capital. Thus, the effective control and majority ownership of the firm remain with the
entrepreneur. They buy shares of an enterprise with an intention to ultimately sell them off to make capital
gains.
Conditional loan: It is repayable in the form of a royalty after the venture is able to generate sales. No
interest is paid on such loans. In India, VCFs charge royalty ranging between 2 and 15 per cent; actual
rate depends on the other factors of the venture, such as gestation period, cost-flow patterns and riskiness.
Income note: It is a hybrid security which combines the features of both conventional loan and
conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at substantially low
rates.
Conventional loan: Under this form of assistance, the enterprise is assisted by way of loans. On the
loans, a lower fixed rate of interest is charged, till the unit becomes commercially operational. When the
company starts earning profits, normal or higher rate of interest will be charged on the loan. The loan has
to be repaid as per the terms of loan agreement.
Other financing methods: A few venture capitalists, particularly in the private sector, have started
introducing innovative financial securities like participating debentures introduced by TCFC.
The legal aspects relating to venture capital in India may be briefly explained as follows:
Regulatory Structure:
The SEBI regulates venture capital industry in India. It announced the regulations for the venture
capital funds in 1996, with the primary objective of protecting the interest of investors and providing
enough flexibility to the fund managers to make suitable investment decisions. Venture capital funds
appoint an asset management company to manage the portfolio of the fund. Any company proposing to
undertake venture capital investments is required to obtain certificate of registration from SEBI. Venture
capital fund can invest up to 40% of the paid up capital of the invested company or up to 20% of the
corpus of the fund in one undertaking. At least 80% of funds raised by VCF shall be invested in equity
shares or equity related securities issued by company whose shares are not listed on recognised stock
exchange. Venture capital investments are required to be restricted to domestic companies engaged in
business of software, information technology, biotechnology, agriculture, and allied sectors.
The Government of India has issued the following guidelines for various venture capital funds operating
in the country.
1. The financial institutions, State Bank of India, scheduled banks, and foreign banks are eligible to
establish venture capital companies or funds subject to the approval as may be required from the Reserve
Bank of India.
2. The venture capital funds have a minimum size of Rs. 10 crores and a debt equity ratio of 1:1.5. If
they desire to raise funds from the public, promoters will be required to contribute minimum of 40% of
the capital.
3. The guidelines also provide for NRI investment upto 74% on a non-repatriable basis.
4. The venture capital funds should be independent of the parent organisation.
5. The venture capital funds will be managed by professionals and can be set up as joint ventures even
with non-institutional promoters.
6. The venture capital funds will not be allowed to undertake activities such as trading, broking, and
money market operations but they will be allowed to invest in leasing to the extent of 15% of the total
funds deployed. The investment or revival of sick units will be treated as a part of venture capital activity.
7. A person holding a position of being a full time chairman, chief executive or managing director of a
company will not be allowed to hold the same position simultaneously in the venture capital
fund/company.
8. The venture capital assistance should be extended to the promoters who are now, and are
professionally or technically qualified with inadequate resources.
Meaning of leasing
Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a
series of contractual, periodic, tax deductible payments. The lessee is the receiver of the services or the
assets under the lease contract and the lessor is the owner of the assets. The relationship between the
tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called
the term of the lease). The consideration for the lease is called rent.
1. A contract by which one party (lessor) gives to another (lessee) the use and possession of equipment for
a specified time and for fixed payments.
2. The document in which this contract is written.
3. A great way companies can conserve capital.
4. An easy way vendors can increase sales.
A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer
conveys to the equipment user the right to use the equipment in return for a rental. In other words, lease is
a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to use the asset
during a specified period in return for a mutually agreed periodic payment (the lease rentals). The
important feature of a lease contract is separation of the ownership of the asset from its usage.
TYPES OF LEASE
1) Financial lease
Long-term, non-cancellable lease contracts are known as financial leases. The essential point of financial
lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at
the end of the lease period at a nominal cost. At lease it must give an option to the lessee to purchase the
asset he has used at the expiry of the lease. Under this lease the lessor recovers 90% of the fair value of
the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement
is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there
from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title
deeds remain with the lessor. Financial lease is also known as 'capital lease‘. In India, financial leases are
very popular with high-cost and high technology equipment.
2) Operational lease
An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement
gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and
maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease
period. Normally the lease is for a short period and even otherwise is revocable at a short notice. Mines,
Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of
obsolescence is very high in this kind of assets.
4) Leveraged leasing
Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The lessor
borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and the asset so
purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the
lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor, the owner of
the asset is entitled to depreciation allowance associated with the asset.
5) Direct leasing
Under direct leasing, a firm acquires the right to use an asset from the manufacture directly. The
ownership of the asset leased out remains with the manufacturer itself. The major types of direct lessor
include manufacturers, finance companies, independent lease companies, special purpose leasing
companies etc
Example
B-Tel, Inc. is a telecommunication services provider looking to expand to a new territory Z; it is analyzing
whether it should install its own telecom towers or lease them out from a prominent tower-sharing
company T-share, Inc.
Leasing out 100 towers would involve payment of $5,000,000 per year for 5 years.
Erecting 100 news towers would cost $18,000,000 including the cost of equipment and installation, etc.
The company has to obtain a long-term secured loan of $18 million at 5% per annum.
Owning a tower has some associated maintenance costs such as security, power and fueling, which
amounts to $10,000 per annum per tower.
The company’s tax rate is 40% while its long-term weighted average cost of debt is 6%. The tax laws
allow straight-line depreciation for 5 years.
Determine whether the company should erect its own towers or lease them out.
Solution
Annual cash out flows of leasing (Year 1 to Year 5) = $5,000,000 * (1 – 40%) = $3,000,000
Annual cash flows of purchasing have three components: the loan amount to be repaid in each period, the
maintenance costs to be borne each year, the tax shields associated with maintenance costs, depreciation
expense and interest expense. The following table summarizes the calculation of cash flows under this
alternative.
Period 1 2 3 4 5
Loan repayment A 4,157,546 4,157,546 4,157,546 4,157,546 4,157,546
Maintenance costs B 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Depreciation D 3,600,000 3,600,000 3,600,000 3,600,000 3,600,000
Interest expense I 900,000 737,123 566,101 386,529 197,978
Total tax T = 5,500,000 5,337,123 5,166,101 4,986,529 4,797,978
deductions B+D+I
Tax shield @ 40% t = 0.4×T 2,200,000 2,134,849 2,066,441 1,994,612 1,919,191
Net cash flows N = A+B–t 2,957,546 3,022,697 3,091,106 3,162,935 3,238,355
Annual loan repayment is based on present value calculation; it is the amount paid at the end of each year
for 5 years that would write off the loan completely. It is calculated using the following MS Excel
function: PMT (5%,5,-18000000).
Interest expense are calculated in the following debt amortization table:
Perio Opening Total Interest Principal Closing
d Principal Repayment Repayment Principal
0 18,000,000 - - - 18,000,000
1 18,000,000 4,157,546 900,00 3,257,546 14,742,454
0
2 14,742,454 4,157,546 737,12 3,420,424 11,322,030
3
3 11,322,030 4,157,546 566,10 3,591,445 7,730,585
1
4 7,730,585 4,157,546 386,52 3,771,017 3,959,568
9
5 3,959,568 4,157,546 197,97 3,959,568 -
8
It is necessary to prepare amortization table because tax laws do not allow deduction of total loan amount,
instead only interest expense is allowed as deduction.
Depreciation is calculated on straight-line basis using the 5-year useful life (i.e. $18,000,000/5 =
$3,600,000).
Tax shield is subtracted from loan repayments and maintenance costs while calculating the net cash
outflows because tax shield represents a cash inflow which arises due to tax deductibility of the expenses.
Now, we have to calculate the present value of cash outflows under both the options using the after-tax
cost of debt which is 3.6% (6% * (1-40%))
Present value of leasing at 3.6% = $13,545,157
Present value of purchasing at 3.6% = $13,950,176
Since leasing has a lower present value of cash outflows, it should be the preferred option.
UNIT 4
CREDIT RATING
Credit Rating is a symbolic indicator of the current objective assessment by a rating agency of the relative
capability and willingness of an issuer of a debt programmes to service the debt obligations as per the
terms of the contract. It may be referred as current opinion of a borrower’s credit quality in terms of
business and financial risk. On the basis of such evaluation the investors get some idea about the degree of
certainty of timely repayment of the principal amount of the debt instrument besides regular payment of
returns on it i.e. interest.
Rating is current opinion as to the relative safety of timely payment of interest and principal on a
debenture, structured obligation, preference shares, fixed deposits programme or shot term instruments.
Credit rating is an opinion on the relative ability and willingness of an issuer to make timely payment on
specific debt or related obligations over the life of the instrument.
1. Superior Information
Rating by an independent and professional firm offers a superior and more reliable source of information
on credit risk for three inter related risks:
(a) It provides unbiased opinion.
(b) Due to professional resources, a rating firm has greater ability to assess risks.
(c) It has access to lot of information which may not be publicly available.
A rating firm which gathers, analyses, interprets and summarizes complex information in a simple and
readily understood format for wide public consumption represents a cost effective arrange
Investment Grades
FAAA (F-Triple A) : Highest Safety
FAA (F-Double A) : High Safety
FA : Adequate Safety
Speculative Grades
FB : Inadequate Safety
FB : High Risk
(i) FC : Substantial
2. ICRA Ltd
The ICRA Ltd. has been promoted by the IFCI Ltd. as the main promoter to meet the requirements of the
companies based in the northern parts of the country. Apart from the main promoter, which holds 26 per
cent of the share capital, the other shareholders are the Unit Trust of India, banks, LIC, GIC, Exim Bank,
HDFC Ltd. and ILFS Ltd. It started operations in 1991. In order to bring international experience and
practices to the Indian capital markets, the ICRA has entered into a MOU with Moody’s Investors Service
to provide, through its company Financial Programmes Inc (FPI), credit education, risk management
software, credit research and consulting services to banks, financial/investment institutions, financial
services companies and mutual funds in India. As in the case of the CRISILICRA Rating Scale
Long Term including Debentures Medium Term including
Bonds and Preference Shares Deposits Fixed
Short Term Including Commercial Paper
Note : (i) The rating symbols group together similar (but not necessarily identical) concerns in terms of
their relative capability of timely servicing of a debts/obligations, as per terms of contracts, i.e.,
the relative degree of safety/risk.
(ii) The sign (+) or (-) may be used after the rating symbol to indicate the comparative
Factoring envisages the sale of trade debts to the factor by the company, i.e., the client. It is
where factoring differs from discounting. Under discounting, the financier simply
discounts the debts backed by account receivables of the client. He does so as an agent of
the client
Under this type, factor provides all kinds of services discussed above. Thus, a factor provides
finance, administers the sales ledger, collects the debts at his risk and renders consultancy
service. This type of factoring is a standard one. If the debtors fail to repay the debts, the
entire responsibility falls on the shoulders of the factor since the assumes the credit risk
also
(ii) With Recourse Factoring
As the very name suggest, under this type, the factor does not assume the credit risk. In other
words, if the debtors do not repay their dues in time and if their debts are outstanding beyond a
fixed period, say 60 to 90 days from the due date, such debts are automatically assigned back to
the client.
Under this, the factor does not provide immediate cash payment to the client at the time of
assignment of debts. He undertakes to pay cash as and when collections are made from
the debtors. The entire amount collected less factoring fees is paid to the client
immediately.
Under this type, the factor provides finance after disclosing the fact of assignment of debts to the
debtors concerned. This type of factoring is resorted to when the factor is not fully
satisfied with the financial condition of the client
Under this type, the services of a factor in a domestic business are simply extended to
international business. Factoring is done purely on the basis of the invoice prepared by
the exporter.
This type of factoring is suitable for business establishments which sell goods through
middlemen. Generally, goods are sold through wholesalers, retailers or through
middlemen. In such cases, the factor guarantees the supplier of goods against invoices
raised by the supplier upon another supplier.
FACTORING IN INDIA
In India, the idea of providing factoring services was first thought of by the Vaghul Working
Group. It had recommended that banks and private non-banking financial companies should be
encouraged to provide factoring services with a view to helping the industrialists and traders to
tide over their financial crunch arising out of delays in the realisation of their book debts. The
RBI subsequently constituted a study group in January 1988 under the chairmanship of Mr. C.S.
Kalyansundaram, former Managing Director of the SBI, to examine the feasibility of starting
factoring services. On the recommendation of the committee, the Banking Regulations Act was
amended in July 1990 with a view to enabling commercial banks to take up factoring services by
forming separate subsidiaries.
FORFEITING
The term ‘forfeit’ is a French word denoting ‘to give something’ or ‘give up one’s rights’ or
‘relinquish rights to something’. In fact, under forfeiting scheme, the exporter gives up his right
to receive payments in future under an export bill for immediate cash payments by the forfeitor.
This right to receive payment on the due date passes on to the forfeitor, since, the exporter has
already surrendered his right to the forfeitor. Thus, the exporter is able to get 100% of the
amount of the bill minus discount charges immediately and get the benefits of cash sale.
Bill discounting:
Discounting of bill is an attractive fund based financial service provided by the finance
companies. In the case of time bill (payable after a specified period), the holder need not wait till
maturity or due date. If he is in need of money, he can discount the bill with his banker. After
deducting a certain amount (discount), the banker credits the net amount in the customer’s
account. Thus, the bank purchases the bill and credits the customer’s account with the amount of
the bill less discount. On the due date, the drawee makes payment to the banker. If he fails to
make payment, the banker will recover the amount from the customer who has discounted the
bill. In short, discounting of bill means giving loans on the basis of the security of a bill of
exchange
UNIT 5
MUTUAL FUNDS
Mutual fund works on the principle of “small drops of water make a big ocean”. It is a form of
collective investment. To get the surplus funds from investors, it adopts a simple technique. Each
fund is divided into a small share called ‘units’ of equal value. Each investor is allocated units in
promotion to the size of his investment.
Mutual fund is a trust that pools the savings of investors. The money collected is then invested in
financial market instruments such as shares, debentures and other securities. The income earned
through these investments and the capital appreciations realized are shared by its unit holders in
proportion to the number of units owned by them. Thus mutual fund invests in a variety of
securities (called diversification). This reduces risk. Diversification reduces the risk because all
stock and/ or debt instruments may not move in the same direction.
In short, a mutual fund collects the savings from small investors, invests them in government and
other corporate securities and earns income through interest and dividends, besides capital gains.
Features of Mutual Funds
Mutual fund possesses the following features:
1. Mutual fund mobilizes funds from small as well as large investors by selling units.
2. Mutual fund provides an ideal opportunity to small investors an ideal avenue for investment.
3. Mutual fund enables the investors to enjoy the benefit of professional and expert management
of their funds.
4. Mutual fund invests the savings collected in a wide portfolio of securities in order to maximize
return and minimize risk for the benefit of investors.
5. Mutual fund provides switching facilities to investors who can switch from one scheme to
another.
6. Various schemes offered by mutual funds provide tax benefits to the investors.
7. In India mutual funds are regulated by agencies like SEBI.
8. The cost of purchase and sale of mutual fund units is low.
9. Mutual funds contribute to the economic development of a country.
Types of Mutual Funds (Classification of Mutual Funds)
Mutual funds (or mutual fund schemes) can be classified into many types. The following chart
shows the classification of mutual funds:
Taxation fund
Leveraged fund
1. Close ended funds: Under this type of fund, the size of the fund and its duration are fixed in
advance. Once the subscription reaches the predetermined level, the entry of investors will be
closed. After the expiry of the fixed period, the entire corpus is disinvested and the proceeds are
distributed to the unit holders in proportion to their holding.
Features of Close ended Funds
(a) The period and the target amount of the fund is fixed beforehand.
(b) Once the period is over and/ or the target is reached, the subscription will be closed (i.e.
investors cannot purchase any more units).
(c) The main objective is capital appreciation.
(d) At the time of redemption, the entire investment is liquidated and the proceeds are liquidated
and the proceeds are distributed among the unit holders.
(e) Units are listed and traded in stock exchanges.
(f) Generally the prices of units are quoted at a discount of upto 40% below their net asset value.
2. Open-ended funds: This is the just reverse of close-ended funds. Under this scheme the size
of the fund and / or the period of the fund is not fixed in advance. The investors are free to buy
and sell any number of units at any point of time.
(a) The investors are free to buy and sell units. There is no time limit.
1. Income fund: This scheme aims at generating regular and periodical income to the members.
Such funds are offered in two forms. The first scheme earns a target constant income at relatively
low risk. The second scheme offers the maximum possible income.
7. Index bonds: These are linked to a specific index of share prices. This means that the funds
mobilized under such schemes are invested principally in the securities of companies whose
securities are included in the index concerned and in the same proportion. The value of these
index linked funds will automatically go up whenever the market index goes up and vice versa.
8. Money market mutual funds: These funds are basically open ended mutual funds. They have
all the features of open ended mutual funds. But the investment is made is highly liquid and safe
securities like commercial paper, certificates of deposits, treasury bills etc. These are money
market instruments.
9. Off shore mutual funds: The sources of investments for these funds are from abroad.
10. Guilt funds: This is a type of mutual fund in which the funds are invested in guilt edged
securities like government securities. It means funds are not invested in corporate securities like
shares, bonds etc.
Establishment of a Mutual Fund: In India mutual fund play the role as investment with trust,
some of the formalities laid down by the SEBI to be establishment for setting up a mutual fund.
As the part of trustee sponsor the mutual fund, under the Indian Trust Act, 1882, under the
trustee company are represented by a board of directors. Board of Directors is appoints the AMC
and custodians. The board of trustees made relevant agreement with AMC and custodian. The
launch of each scheme involves inviting the public to invest in it, through an offer documents.
Depending on the particular objective of scheme, it may open for further sale and repurchase of
units, again in accordance with the particular of the scheme, the scheme may be wound up after
the particular time period.