BA4003 - BANKING AND FINANCIAL SERVICES

UNIT IV

ASSET BASED FINANCIAL SERVICES

Introduction – Need for Financial Services – Financial Services Market in India – NBFC – RBI
framework and act for NBFC – Leasing and Hire Purchase – Financial evaluation – underwriting –
mutual funds.

1. FINANCIAL SERVICES

Financial services are a broad range of more specific activities such as banking, investing, and
insurance. Financial services are limited to the activity of financial services firms and their professionals,
while financial products are the actual goods, accounts, or investments they provide.

1.1 Objectives of Financial Services

The various objectives of financial services are as follows :

1) Fund Raising: The required funds can be raised by the help of financial services from the host of
investors, individuals, institutions and corporate.

2) Funds Deployment: There are various kinds of financial services present in the financial markets
which help the company in proper deployment of funds. It also helps in decision-making of financial mix.

3) Specialized Services: The various specialized services are being provided by financial service except
banking and insurance like credit rating, venture capital financing, lease financing, factoring, mutual
funds, merchant banking, stock lending, depository, credit cards, housing finance, book-building, etc.

4) Regulation: There are various kinds of regulatory bodies present in India like Securities and Exchange
Board of India (SEBI), Reserve Bank of India (RBI) and the Department of Banking and Insurance of the
Government of India

5) Economic Growth: The financial services help in increasing the economic growth and development of
country. It is done by the help of mobilizing the saving of the public by investing in productive
investments.

1.2 Scope of Financial Services

The scope / functions of financial service is as follows :

1) Gross Domestic Product (GDP): The gross domestic product refers to the financial value of all the
finished goods and services manufactured inside the country in a specific time period. The financial
service contributes to the GDP of the country.

2) Employment: The financial service requires various kinds of financial institutions which need different
kinds of skilled manpower which indirectly lead to increase in the employment of the country.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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3) Foreign Direct Investment (FDI): The financial service helps in increasing the foreign direct
investment in the country which helps in increasing the growth of the country.

4) Mobilizing of Funds: The financial service helps in increasing the investment opportunity among the
public leading to mobilizing the funds of the public.

5) Long-Term Loan: The long-term loan is basically required by the industries. The financial service helps
in providing cheap and long-term loan to industries.

6) Insurance: There are various types of financial services. Among them the most important is insurance.
The insurance financial protection to the consumers

1.3. Nature of Financial Services

The nature of financial services are given below :

1) Intangibility: The financial services are intangible in nature. The companies need to build goodwill
and confidence in the clients for producing better and efficient financial services. The quality and
innovations plays an important role for building reliability among the customers.

2) Customer Orientation: The financial institution selling financial services needs to study the demand of
the customers. By the help of various studies, the financial institutions makes different strategies
relating to the costs, liquidity and maturity consideration of the financial products.

3) Inseparability: The financial institutions and its customers cannot be separated from each other while
producing and supplying of financial services as both the functions of financial service is done at the
same time.

4) Perishability: Financial services cannot be stored as they need to be created and delivered to the
target customers as per their requirements. So, it is important for financial institutions to assure that
there is match of demand and supply of financial services.

5) Dynamism: The financial service should be dynamic so that they can be changed according to the
socio-economics changes in the economy like disposable income, standard of living, level of education,
etc.

6) Derivatives and Catalysts: The financial services are derivatives of financial market. So, they also act
as a catalyst in the market operation. It starts the market operations and help in increasing the
investment by increasing the saving for a high rate of capital formation.

7) Act as Link: The financial services bridge the gap between investors and borrowers. They give profit
bearing investment to the investors by which they can also minimize the risk. The investors have the
options of high risk and high profits, low risk and low profit or get a regular income on acceptable risk.

8) Distribution of Risks: The financial services distribute the funds in the profitable manner so that the
investors can diversify their risk in different financial services for getting maximum rate of return. The

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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various experts in the market help the investors for proper selection of the portfolio for getting
maximum return.

1.4 Types of Financial Services / Financial Service Market in India

The financial services are divided into wholesale financial service and retail financial services
according to the profile of users.

The wholesale financial services are the services which are used for converting into final retail
products. It is used by industry and business people. The retail financial services are given to the
individual for direct consumption. The Classification of Financial Services is as follows:

1.4.1 Modern Activities

The financial intermediaries also have other services besides the traditional services. These are
of non-fund based activity. These are classified under New Financial products and services. The different
services are as follows:

 It provides various project advisory services starting from the preparation of the project report
until raising of funds along with the various government approvals.
 The planning and implementing the process involved in for merger and acquisition.
 It assists the corporate customers in capital restructuring.
 It acts s the trustees to the debenture holders.
 It helps in achieving the better outcome by giving required changes in the management
structure and management style.
 It helps helps in finding the better joint venture partners and also making the joint venture
agreements which directly help in structuring the financial collaborations and joint ventures.
 It also helps the sick companies by rehabilitating and restructuring the proper plans in the
execution of the scheme.
 It helps in reducing risk by the help of exchange rate risk, interest rate risk, economic risk and
political risk by using swaps and other derivative products.
 It It helps in controlling the portfolio of large public sector company.
 It is involved in risk management service like insurance services, buy-back options etc.

1.4.2 Traditional Activities

The financial intermediaries from the past are providing various services including the money
and capital market activity. The traditional activities are classified into fund based activities and non-

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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fund based activities. These are also known as assets based financial services and fee based financial
services respectively.

1.4.2.1. Fund/Asset Based Financial Services

In this, the financial services are used for making assets or are backed by assets in which the
funds are changed to assets which are known as asset based financial services. It consists of the
following:

1) Lease Financing : A lease is known as the agreement between two parties known as lessor and lessee.
The lessor is the owner of the asset and lessee is the user of the asset. In this agreement, there is
transfer of asset from lessor to lesser for certain time period, in return the lessor receives the regular
rent.

2) Hire Purchase : The hire purchase refers to the hiring of an asset for certain time period and when the
time period gets over, there is purchase of same asset. At the time of sharing of asset, the person hiring
the asset gets the ownership and is allowed in use it..

3) Factoring : Factoring is done when the company requires immediate money. It is done by selling the
account receivable like invoices to a third party known as factor at certain discount for immediate cash.
This cash is required for continuous working of the business.

4) Forfeiting : Forfeiting is the way of financing of receivable related to international trade. It represents
to the purchase done by bank and financial institutions of trade bills/promissory notes instead of
recourse to the seller. The purchase is done by discounting the documents including the overall risk of
non-payment in collection.

5) Mutual Fund : Mutual fund is the type of investment in which the pool of funds is sourced from
various investors for investing in various securities like stocks, bonds, money market instruments and
similar assets. It is managed by the money managers who invest the fund capital and tries to get capital
gains and income for the investors of the fund.

6) Exchange Traded Funds (ETFs) : It is traded same like stocks in the stock exchange. It has the
following assets like stocks, commodities or bonds. They trade near to the net asset value according to
the working of the trading day. The ETFs also has a role to monitor various index like stock index or bond
index.

7) Consumer Credit/Consumer Finance : The term consumer credit means the activities related to giving
credit to the consumers for empowering them to acquire their own goods required for daily use.

8) Bill Discounting : The bill discounting or a bill of exchange is known as the short-term, negotiable and
can easily liquidates money market instrument. It is used for financing a transaction in goods which is
trade related instrument.

9) Housing Finance : The housing finance refers to the collection of all the financial arrangements which
are offered by the Housing Finance Companies (HFCs) for fulfilling the need of housing.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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10) Venture Capital : Venture capital includes two words i.e. venture and capital Venture refers to the
way of doing something whose result is not known as it is present with various kinds of loss while capital
refers to human and non-human resources required for starting the business.

1.4.2.2. Fee/Non-Fund Based Financial Services

The fee based financial does not provide instant fund but instead it allows for the creation of funds by
the fee charged service. It consists of the following :

1) Merchant Banking : The merchant banker can be individual or institutions like an underwriter or
agent for the companies and municipalities allocating securities. They are also involved in broker or
dealer functions, maintain the market for previously issued securities and also gives suggestion to the
investors on the advisory services.

2) Credit Rating : The credit rating is the process in which the symbol is assigned to the instrument for
some special work which is referred to as benchmark of present knowledge on related capacity on the
issuer to service its debt obligation on particular time. The symbols used in credit rating are basically
alphabetical or alphanumeric. The comparison of different instruments is easy by the help of credit
rating.

3) Stock Broking : The stock broking refers to the method of bringing together the buyers and sellers of
stock at the stock exchange. It is the function of financial service intermediary. It is done by brokers,
both main brokers and sub brokers who are allowed by the SEBI. The stock broker can be individual
broker, a firm of brokers or a corporatised broker.

4) Securitisation : The change of present or future cash inflow of an individual into trad-able security
which can be sold in the market is known as securitisation. These cash inflows can be from financial
assets like mortgage loans, automobile loans, trade receivables, credit card receivables, fare collections
will be security according to which borrowing can be raised.

5) Letters of Credit (LC) : A letter of credit is issued by the bank of the buyer to the seller which has a
written undertaking for repaying the cost of goods and services given by the seller to the buyer in place
of producing documents required within the precise time, place and to prescribed bank as stated in the
documents which is submitted according to the terms and conditions of the LC.

6) Bank Guarantees : The guarantee is the contract between the issuing bank and the client in which the
bank attempt to take the claims presented by the client on the customer on behalf of which the bank
had guarantee. The payment of default can be taken from the bank by the client in case the customers
do not fill the obligation.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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2. NBFC (Non-Banking Financial Companies)

NBFCs provide short-term funds to individuals and businesses for various purposes, such as
loans against gold, shares, and property, primarily for consumption needs. These loans cater to the
immediate financial requirements of borrowers and this forms one of the primary functions of NBFCs in
India.

2.1 What is difference between banks & NBFCs?

 NBFC cannot accept demand deposits;

 NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn
on itself;
 Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available
to depositors of NBFCs, unlike in case of banks.

2.2 FEATURES OF NBFCs

 The NBFCs are allowed to accept/renew public deposits for a minimum period of 12 months and
maximum period of 60 months. They cannot accept deposits repayable on demand.
 NBFCs cannot offer interest rates higher than the ceiling rate prescribed by RBI from time to
time. The present ceiling is 12.5 per cent per annum. The interest may be paid or compounded
at rests not shorter than monthly rests.
 NBFCs cannot offer gifts/incentives or any other additional benefit to the depositors.
 NBFCs (except certain AFCs) should have minimum investment grade credit rating.
 The deposits with NBFCs are not insured.
 The repayment of deposits by NBFCs is not guaranteed by RBI.
 There are certain mandatory disclosures about the company in the Application Form issued by
the company soliciting deposits.

2.3 TYPES OF NBFCs

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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2.4 Non-Banking Financial Companies (NBFC) vs. Banks

3. LEASING

According to the institute of chartered accounts of India, “a lease is an agreement whereby the
lessor conveys to the lessee, in return for rent, the right to use an asset for an agreed period of time.
Lessor is a person who conveys to another person (lessee) the right to use an asset in consideration of a
payment of periodical rental, under a lease agreement. Lessee is a person who obtains from the lessor
the right to use the asset for a periodical rental payment for an agreed period of time”.

3.1 Types of Lease

1. Financial lease
I. Full payout lease

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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II. True lease

2. Operating lease
3. Conveyance type lease
4. Leveraged lease
5. Sale and leaseback
6. Partial pay-out lease
7. Consumer leasing
8. Balloon lease
9. Close-end easing
10. Open-end leasing
11. Swap leasing
12. Wrap leasing
13. Import leasing
14. Cross border leasing
15. Japanese cross border leasing
16. International leasing

Financial Lease
A financial lease, also called ‘capital lease’, is a contract involving payment over an obligatory
period, of specified sums sufficient in total to amortize the capital outlay, besides giving some profit to
the lessor. According to the international Accounting Standard (IAS) no.17,”a financial lease is a lease
that transfers substantially all the risks and rewards incident to ownership of an asset. Title may not
eventually be transferred.

Full payout lease

In this type of lease, the lessor recovers the full value of the leasd asset, within the period of the
lease, by way of lease rentals and the residual value.

True lease
In this type of lease, the typical tax-related benefits, such as investment tax credit, depreciation
tax shields, etc. are offered to the lessor.

Operating lease
An operating lease is any other type of lease whereby the asset is not fully amortized during the
non-cancelable period of the lease, and where does not rely on the lease rentals for profits. It is basically
an economic service.

Conveyance-type lease
It is very long tenure lease applicable to immovable properties. The intention of the lease is to
convey title in property. Such leases are entered into for periods which may be as long as 99 years.

Leveraged lease
When a part or whole of the financial requirement involved in a lease are arranged with the help
of a financier, it takes the form of leveraged lease. This type of lease is resorted to in cases where the
value of the leased asset is very high.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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Sale and Leaseback

Under this type of lease, the owner of an asset sells it to the lessor, and gets the asset back
under the lease agreement. The ownership of the asset changes hands from the original owner to the
lessor, who in turn leases out the asset, back to in several leases. This the original owner.

Partial pay-out lease

It is a type of lease whereby the lessor obtains full payment of the lease in several leases. This
broadly falls under the category of operating lease.

Consumer leasing
Leasing of consumer durables such as televisions, refrigerators, etc. is called consumer leasing.

Balloon lease
A type of lease, which has zero residual value at the end of the lease period, is called ‘balloon
lease’.

Close-end leasing
A leasing arrangement whereby the asset leased out is reverted to the lessor is known as ‘close-
end leasing’. It is also called ‘walk-away’ lease.

Open-end leasing
A term commonly used in automobile leasing in the USA, it means a lease agreement where the
lease guarantees that the lessor will realize a minimum value from the sale of the asset at the end of the
lease period.

Swap leasing
In swap leasing, the lease is allowed to exchange equipment leased out whatever the original
asset has to be the lessor for some repair or maintenance.

Wrap leasing
When the lease further sub-leases the asset to the end-user, retaining a fee and a share of the
residual value, it is called wrap leasing.

Import leasing
The leasing of imported capital goods is known as ‘import leasing’. It is beneficial to the lessee
because arranging any other source of funding may take a long time, during which the prices of the
importable item, as also the rates of exchange, may change. Moreover, lenders don’t usually finance the
import duty, which forms a sizable part of the acquisition of such items.

Cross-border leasing
A type of lease where the lessor in one country leases out assets to a lessee to another country,
is known as cross-border leasing. The jurisdictions of lessors and lessees are in two different countries.

Double-dip
According to the concept of double-dip, it is possible to have the advantage of depreciation tax
benefits twice, depending on the prevalence of differing tax laws in two different countries.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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Triple-dip
Where the benefit of depreciation tax allowances is available in three different jurisdictions for a
single asset leased out, it is a case of triple-dip.

Japanese Cross-border leasing

The Japanese leasing falls broadly under three categories, namely samurai leasing, shogun
leasing and mushashi leasing, A ‘Smurai lease’ was encouraged by the government of japan with the
intention of reducing the huge surplus in the balance of payments enjoyed by japan.

International leasing

When a leasing company operates in different countries through its branches, it is case of
international leasing.

3.2 DIFFERENCE BETWEEN FINANCIAL LEASE & OPERATION LEASE

SI.No Characteristics Financial lease Operating lease

The asset leased out may be used
The asset leased out is use-specific for
1. Specificity commonly by a number of users in
the lessee
sequence
The risks and rewards associated
The lessee bears the risks and rewards
with the use of the leased is borne
associated with the use of the asset
2. Ownership by the lessor, and the lessee is
leased; the lessor is simply the legal
simply provided with the use of the
owner of the asset.
asset for a certain period time.
The lessee bears the risks of The lessor bears the risks of
3. Obsolescence risk
obsolescence obsolescence
The lease can be cancelled at the
The lease cannot be cancelled by either
option of the lessee and the lessor
of the parties. The lessor is rather
4. Cancelability does not have the difficulty of
interested in rentals and not in the
leasing the same asset to other
asset.
willing lessees.
The lease period usually coincides with Lease period is generally small, as
5. Lease period the life of the asset, and may be broken the lessor intends to lease the same
into primary and secondary period asset several times to various users
The cost of repairs and maintenance The cost of repairs and
6. Maintenance are borne by the lessee; the lessor is maintenance are borne by the
merely a financier in the deal lessor
As the lessor is just a financial
The lessor is specialized in handling
institution, it does not render any
7. Lessor’s service and operating the particular asset
specialized service in connection with
and, usually provides specialization
the lease
It is usually a non-pay out lease, as
It is a full pay-out lease, where a single
the lessor is in the business of
8. Pay-out lease repays the cost of the asset,
leasing the asset to various users
together with the interest
several times

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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3.3. LEASING PROCESS

1. Lease selection
The first step in a leasing transaction is the selection of the asset to be taken out on lease
basis. The lessee does this by giving due consideration to various requirement such as, lease payments
and other factors. The lessee then approaches the leasing company or the lease broking company for
the purpose of finalizing the lease deal.

2. Order and Delivery

Based on the selection made by the lessee, the lessor goes about placing an order for
manufacture of the asset to be leased. The manufacturer delivers the asset at the site of the lessee who,
in turn, gives a notice of acceptance to the lessor.

3. Lease Contract
Both the parties sign a lease agreement setting out the details of the terms of the lease
contract. Leases will normally be full payout, with varying terms and conditions. The usual lease period
ranges from 3 to 5 years.

4. Lease Period
During the currency of the lease period, the lessee will make lease payment at regular
intervals, as agreed upon between the parties. The lessee will ensure the proper upkeep and
maintenance of the asset leased.

3.4. ADVANTAGES OF LEASING

 Advantages of lessor
1) Stable business
2) Wider distribution
3) Sale of supplies
4) Second-hand market
5) Tax benefits
6) Absorbing obsolescence risks
7) Fillip to capital market
8) Easy finance
9) Other benefits
 Advantages of lessee
1) Efficient use of funds
2) Cheaper source
3) Flexible source
4) Enhanced borrowing capacity
5) Off-balance sheet financing
6) Tax benefits
7) Favorable terms
8) Guards against obsolescence
9) Avoidance of initial cash outlay

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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10) Better liquidity

11) Other benefits

3.5 LIMITATIONS OF LEASE FINANCING

1) Disguised Debt Financing

2) Costly option
3) Loss tax shield
4) Double sales-tax
5) Loss of residual value
6) Unfavorable gearing
7) No ownership
8) Risk of default
9) No working capital
10) Indiscriminate finance
11) Long-term venture

4. HIRE PURCHASE FINANCE

A transaction of finance whereby goods are bought and sold as per terms and conditions
specified below is known as ‘hire purchase finance’.
1) Payment of periodic instalments
2) Immediate possession of goods by the buyer
3) Ownership of goods remaining with the vendor until the payment of the last instalment
4) Vendor’s right to repossess the goods in the event of dedault committed by the buyer
5) Treatment of each instalment as hire charge till the payment of the last instalment

According to the Hire Purchase Act of 1972, the term ‘hire purchase’ is defined as, “an
agreement under which goods are let on hire and under which the hirer has an option to purchase them
in accordance with the terms of the agreement.

4.1 Difference between Leasing & Hire Purchasing

SI.No Characteristics Lease financing HP financing

Ownership of the property lies with the
1. Ownership finance company, the lessor, and it is never
transferred to the lessee, the user
Lessor, and not the lessee, is entitled to
2. Depreciation
claim depreciation tax shield
Capitalization of the asset is done in the
3. Capitalization
books of the lessor, the leasing company
The entire lease payments are eligible for
4. Payments
tax compution in the books of the lessee
The lessor, and not the lessee, has the right
5. Salvage value
to claim the benefit of salvage value
To of the property is transferred to
the hirer on the payment of the
last instalment
The hirer is entitled to claim of the
hirer
Capitalization of the asset is done
in the books of the hirer
The hirer can claim benefit of
salvage value as the prospective
owner of the asset
The hirer can claim benefit of
salvage value as the prospective
owner of the asset

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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Hire purchase is used as a source of

Leasing is used as a source of finance,
6. Magnitude usually for acquiring high cost assets such
as machinery, ships, airplanes, etc.
No down payment is required for acquiring
7. Down payment
the use of the leased assets
In the books of the lessee, leased assets
8. Reporting
are disclosed by way of a note only
Whereas the lessee has to maintain the
Maintenance of leased asset in the case of financial lease,
9.
asset upkeep is the responsibility of the lessor in
the case of operating lease
It is not suitable for the low-capital
10. Suitability enterprises which desire to show a strong
asset position in their balance sheets
An asset given on lease by a leasing
11. Nature of asset company is considered as the asset of the
lessor
All receipts from the lessee is taken into
12. Receipts
the lessor’s profit & loss account
Lessor’s income declines as the investment
13. Income
outstanding in the lease declines
finance, usually for acquiring low
cost assets such as automobiles,
office equipment, etc.
Down payment is required to be
made for acquiring the asset and
there is a margin maintained to the
extent of 20-25 percent
The asset bought on hire purchase
will be shown as an asset, and the
amount of instalmant payable to
the lessor as a liability
It is the hirer’s responsibility to
ensure the maintenance of the
asset bought
It is highly suitable for the low-
capital enterprises which need to
show a strong asset position in
their balance sheets
The hire vendor normally shows
the asset let under HP either as
stock in trade, or as receivables
Only the interest portion is taken
into the hire-vendor’s profit & loss
account
In the case HP transactions, finance
charges are allocated to the HP
period equally

5. FINANCIAL EVALUATION

It is an evaluation by the hirer of the desirability for lease and hire purchase. The hirer makes
decision based on the Present Value of Net Cash Outflow. The decision is considered favourable when
the PV of Net Cash Outflow under Hire Purchase is less than the PV of Net cash Outflow under leasing.
Following are the steps involved.

 Step 1 - Calculate annual interest amount

 Step 2 - Find the principal amount outstanding at the beginning of the each year = Total
outstanding principal – principal paid in the previous year.
 Step 3 - Find principal paid in the previous year = Annual installment amount – Annual Interest
 Step 4 - Find Annual ITS = Annual Interest x Tax rate
 Step 5 - Find Annual Depreciation
 Step 6 - Find Annual DTS = Annual depreciation x Tax rate
 Step 7 - Find Total TS = Step 4 + Step 6

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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 Step 8 - Find Annual installment amount = Total HP amount + (HP amount x flat rate of interest)
/ No. of HP years
 Step 9 - Find PV of salvage value of assets = SV x PVF
 Step 10 - Find Net Cash Outflow of HP = Step 8 – Step 7
 Step 11 - Find PV of net cash outflow of HP at the appropriate discount rate
 Step 12 - Find Total PV net cash outflow of HP = Step 11 – Step 9
 Step 13 - Find Tax shield on annual lease rentals = Annual Lease rental x Tax rate
 Step 14 - Find Net cash outflow of Leasing = Annual lease rental – Step 13
 Step 15 - Find Total PV of net cash outflow of Leasing at the approp. discount rate = Net cash
outflow of Leasing x PVAF
 Step 16 - Make a decision : HP is desirable if total PV of net cash flow of HP is Less than that of
leasing

6. UNDERWRITING

Underwriting is the process of evaluating risks to protect investors, banks, insurance agencies
and other financial institutions. Typically, an underwriter performs this risk analysis to make
recommendations for loans, investments and insurance policies.

Advantages of Underwriting

There are a few advantages of underwriting that make it a popular method for raising capital:

 Underwriting allows companies to avoid the costs associated with traditional fundraising
methods, such as issuing debt or equity.
 Underwriting allows companies to raise money without going through the lengthy and expensive
process of going public.
 Underwriting gives companies access to a larger pool of potential investors than they would have
if they relied on private equity or venture capital firms.

7. MUTUAL FUNDS

A mutual fund is a pool of money managed by a professional Fund Manager. It is a trust that
collects money from a number of investors who share a common investment objective and invests the
same in equities, bonds, money market instruments and/or other securities.

7.1 TYPES OF MUTUAL FUNDS

1. Mutual Funds Based On Asset Class

A. Equity Funds: These funds primarily invest in the equities or shares of various companies. Since, they
tend to reap high returns, they are generally considered to be high risk.

B. Debt Funds: These funds invest in multiple debt instruments including fixed income assets,
debentures, and government bonds. They are considered to be safe funds because, despite the market
fluctuations, their returns are set.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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C. Hybrid Funds: Also referred to as balanced funds, they usually invest in different asset classes,
irrespective of the proportion of debts and equities involved. This ensures that the risks and returns
remain in sync, thus striking a perfect balance.

D. Money Market Funds: These funds invest in short-term liquid instruments like Treasury bills. They are
considered to be risk-free as the returns, though moderate, are almost immediate.

E. Sectoral Funds: Just as the name suggests, sectoral funds make investments in well-defined market
sectors like infrastructure, real estate or finance. The returns on these funds are entirely dependent
upon the performance of that specific sector.

F. Index Funds: To simply put it, index funds are equivalent to buying shares from listed exchanges like
BSE or NSE. The returns vary with the movement of the index and are thus subject to market swings.

G. Tax-Saving Funds: The primary purpose of these funds is to enable an investor to claim tax
deductions specified under the Income Tax Act. With this in mind, they solely invest in tax-saving
schemes.

H. Funds of Funds: Instead of investing in bonds or securities, the funds of funds invest in other mutual
funds. The returns received depends upon the performance of the fund being invested in.

2. Mutual Funds Based On Structure

A. Open-Ended Funds: Open-ended funds are the type of mutual funds which are available to be bought
and redeemed across the year. They do not have a definite timeline after which they expire. However,
their purchase can be undertaken only at the prevailing net asset value (NAV). They are typically
preferred by investors because they offer instant liquidity.

B. Close-Ended Funds: In comparison, close-ended funds function according to a strict timeline. Their
purchase is often limited to a specific period, and their redemption can also be made only on a
predetermined maturity date. They are generally listed on the stock exchange and are preferred by
those investors who want to lock in their money for a fixed time interval.

3. Mutual Funds Based On Investment Objective

A. Income Funds: The basic aim of the income funds is to provide you with both, a regular income and
long-term capital growth. This is why they enable investors to place their money in fixed income
instruments like bonds and debentures.

B. Growth Funds: The fundamental objective of growth funds is to provide capital growth or
appreciation. They tend to invest in schemes where the possibility of the principal amount growing is
high. This makes them risky but capable of generating good returns.

C. Liquid Funds: The sole purpose of liquid funds is to provide a cover of liquidity to the investor. With
this as the goal, they invest in short-term investment instruments like treasury-bills or government
bonds. They are safer as compared to growth funds but can only generate moderate returns.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

7.2. Benefits of Mutual Funds

All the different types of mutual funds provide varied benefits. However, there are certain
elemental advantages shared by all of them. These are:

A. Diversification: Mutual funds allow you to invest in a diverse set of financial instruments, thus
minimizing your risk.

B. Management: The professional analyze the potential of various funds and help you figure out which
one would best meet your investment objectives.

C. Affordability: For those who prefer cost-effective and affordable investment alternatives, mutual
funds is an attractive option as one can invest with smaller amounts as well.

D. Flexibility: Mutual funds offer great flexibility to investors in terms of investment and withdrawal
options. Investors can choose various modes like lump sum, systematic transfer plans (STP), systematic
withdrawal (SWP) or systematic investment plans (SIP), depending upon their needs and requirements.

E. Transparency: All mutual funds are registered with and regulated by SEBI. This ensures that the
investors’ interests are safeguarded. Moreover, various rating agencies continuously review mutual fund
performance, strategy, and structure, thus bringing about transparency in operations.

7.3 Disadvantages of Mutual Funds In India

A drawback of investing in mutual funds in India is the higher cost associated with professional
management by experienced fund managers, resulting in various fees and expenses that are ultimately
borne by the investors.

A. Change in Fund Manager: The fund manager’s decision may not always be based on an analytical
decision but can be taken on personal bias. They can take a decision, which will only affect performance
in the short term and not in the long term.

B. Over-Diversification: Diversification is the most important benefit of a mutual fund, but there may be
over-diversification, which will increase the fund’s operating charges. This will reduce the chances of
earning a stable return from a single stock.

C. Exit Load: You have to pay a certain percentage as an exit load when redeeming the mutual funds
within the lock-in period. This is the biggest demotivator for investors who want to invest in mutual
funds because an amount goes toward the exit load.

D. No Promised Returns: Mutual funds do not promise any fixed returns and their price is reflected in
their NAV, which changes daily. If the NAV goes down after your investment, then you are at a
significant loss on your principal amount.

E. Lack of Control: The investors have zero control over where the fund manager invests the money. You
can view the disclosure norms and SID of the scheme, but the ultimate decision to invest in any
particular stock totally lies in the hands of the fund manager.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul