MBA Department

PPTs on
Financial Services and Systems

III SEMESTER
 UNIT-
I

INTRODUCTION TO
FINANCIAL
SYSTEM
Meaning of financial services

• In general, all types of activities, which are of a

financial nature could be brought under the term
'financial services'. The term financial services' in a
broad, sense means "mobilizing and allocating
savings". Thus it includes all activities involved in
the transformation of savings into investment.
• Financial services can also be called 'financial inter
mediation'. Financial intermediation is a process by
which funds are mobilizing from a large number of
savers and make them available to all those who are
in need of it and particularly to , corporate
customers.
• Thus, financial services sector is a key area and it is
very vital for industrial developments. A well
developed financial services industry is absolutely
necessary to mobilize the savings and to allocate
them to various invest able channels and thereby to
promote industrial development in a country.
 Classification of Financial Services
•Industry
The financial intermediaries in India can be traditionally
classified into two :
i. Capital Market intermediaries and
ii. Money market intermediaries.
• The capital market intermediaries consist of term
lending institutions and investing institutions which
mainly provide lung term funds. On the other hand,
money market consists of commercial banks, co-
operative banks and other agencies which supply only
short term funds. Hence, the term 'financial services
industry' includes all kinds of organizations which
intermediate .and facilitate financial transactions of both
individuals and corporate customers.
Scope of Financial Services

• Financial services cover a wide range of

activities. They can be broadly classified into two,
namely :
i. Traditional. Activities
ii. Modern activities.
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.
a. Fund based activities and
b. Non-fund based activities.
Fund based activities :
The traditional services which come under fund based
activities are the following :
i. Underwriting or investment in shares, debentures,
bonds, etc. of new issues (primary market
activities).
ii. Dealing in secondary market activities.
iii. Participating in money market instruments like
commercial papers, certificate of deposits,
treasury bills, discounting of bills etc .
iv. Involving in equipment leasing, hire purchase,
venture capital, seed capital, dealing in
foreign exchange market activities. Non fund
based activities
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 :
i. Managing die 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.

ii. Making arrangements for the placement of capital

and debt instruments with investment institutions.

Arrangement
iii. of funds from financial institutions for the
clients' project cost or his working capital requirements.

iv. Assisting in the processof getting all Government

and other clearances.
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 hereunder.
i. Rendering project advisory services right from
the preparation of the project report rill the
raising of funds for starting the project with
necessary Government approvals.
ii. Planning for M&A and assisting for their smooth
carry out.
iii. Guiding corporate customers in capital
restructuring
iv. Acting as trustees to the debenture holders.
v. Recommending suitable changes in the management
structure and management style with a view to
achieving better results.
vi. Structuring the financial collaborations / joint ventures
by identifying suitable joint venture partners and
preparing joint venture agreements,
vii. Rehabilitating and restructuring sick companies
through appropriate scheme of reconstruction and
facilitating the implementation of the scheme.
viii. Hedging of risks due to exchange rate risk,
interest rate risk, economic risk, and political
risk by using swaps and other derivative
products.

ix. Managing [In- portfolio of large Public

Sector Corporations.

x. Undertaking risk management services

like insurance services, buy-hack options
etc.
xi. 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.
xii.Guiding the clients in the minimization of the cost
of debt and in the determination of the optimum debt-
equity mix. Undertaking services relating to the
capital market, such as
a. Clearing services
b. Registration and transfers,
c. Safe custody of securities
d. Collection of income on securities
xiv. Promoting credit rating agencies for the purpose
of rating companies which want to go public by the
issue of debt instrument;*.
Sources of Revenue

There arc two categories of sources of income for

a financial services company, namely :

(i) Fund based and

(ii) Fee based.

Fund based income
• Fund based income comes mainly from interest
spread (the difference between the interest earned
and interest paid), lease rentals, income from
investments in capital market and real estate.
• On the other hand, fee based income has its sources
in merchant banking, advisory services, custodial
services, loan syndication, etc.
• In fact, a major part of the income is earned through
fund-based activities.
• At the same time, it involves a large share of
expenditure also in the form of interest and
brokerage.
• In recent times, a number of private financial
companies have started accepting deposits by
offering a very high rate of interest.
• When the cost of deposit resources goes up, tin"
(ending rate should also go up.
• It means that such companies have to compromise
the quality of its investments.
Fee based income

• Fee based income, on the other hand, does

not involve much risk.
• But, it requires a lot of expertise on the part of
a financial company to offer such fee-based
services.
Causes For Financial services Innovation
• Financial intermediaries have to perform the task of
financial innovation to meet the dynamically
changing needs of the economy and to help the
investors cope with the increasingly volatile and
uncertain market place.
• There is a dire necessity for the financial
intermediaries to go for innovation due to the
following reasons :
i.Low profitability : The profitability of the major
FI, namely (he banks has been very much affected in
recent times. There is a decline, in the profitability of
traditional banking products. So, (hey have been
compelled to seek out new products which may fetch
high returns.
ii.Keen competition : The entry of many FIs in the
financial sector has led to severe competition among
them. This keen competition has paved the way for
the entry of varied nature of innovative financial
products so ns to meet the varied requirements of the
investors.
iii. Economic Liberalization : Reform of the
Financial sector constitutes the most important
component of India's programme towards economic
liberalization. The recent economic liberalization
measures have opened the door foreign competitors
to enter into our domestic market. Deregulation in the
form of elimination of exchange controls and interest
rate ceilings have made the market more competitive.
Innovation has become a must for survival.
iv. Improved communication technology : The
communication technology has become so advanced
that even the world's issuers can be linked with the
investors i the global financial market without any
difficulty by mean of offering so many options and
opportunities.
v. Customer Service : Now a days, the customer's
expectations are very great. They want newer products at
lower cost or at lower credit risk to replace the existing one To
meet this increased customer sophistication, the financial
intermediaries are constantly undertaking research in order to
invent a new product which may suit to the requirement of the
investing public.
vi. Global impact : Many of the providers and users of capital
have changed their roles all over the world. FI have come out
of their traditional approach and they arc ready to assume
more credit risks.
vii. Investor Awareness: With a growing awareness
amongst the investing public, there has been a distinct
shift from investing the savings in physical assets like
gold, silver, land etc. to financial assets like shares,
debentures, mutual funds, etc.
• Again, within the financial assets, they go from 'risk free
bank deposits to risky investments in shares.
• To meet the growing awareness of the
public, innovations has become the need of the hour.
New Financial Products and Services
• In these days of complex finances, people expect a
financial service company to play a very dynamic role
not only as a provider of finance but also as a
departmental store of finance.

• With the opening of the economy to multinationals,

the free market concept has assumed much
significance.
• As a result, the clients both corporate and individuals are
exposed to the phenomena of volatility and uncertainty
and hence the)' expect the financial services company to
innovate new products and services so as to meet their
varied requirements.

• As a result of innovations, new instruments and new

products are emerging in the capital market. The capital
market and the money market are getting widened and
deepened.
• Moreover, there has been a structured change in the
international capital market with the emergence of new
products and innovative techniques of operation in the
capital market.
• Many financial intermediaries including banks have
already Started expanding [heir activities in the financial
services sector by offering a variety new products. As :t
result, sophistication and innovations have appeared in
the arena of financial intermediations. Some of them are
briefly explained hereunder :
Merchant Banking
• A merchant hanker is a financial intermediary who
helps to transfer capital from those who possess it to
those who need it.
• Merchant banking includes a wide range of activities
such as management of customer securities,
portfolio management, project counseling and
appraisal, underwriting of shares and debentures,
loan syndication, acting as banker for the refund
orders, handling interest and dividend warrants etc.
• Thus, a merchant hanker renders a host of services
lo corporate, and thus promote industrial
development in the country.
Loan Syndication
• This is more or less similar to consortium financing. But
this work is taken up by the merchant banker as a lead
manager.
• It refers to a loan arranged by a bank called lead
manager for a borrower who is usually a large corporate
customer or a government department.
• It also enables the members of the syndicate to share the
credit risk associated with a particular loan among
themselves.
Leasing
• A lease is an agreement under which a company or a
firm acquires a right to make use of a capital asset like
machinery, on payment of a prescribed fee called 'rental
charges'.
• In countries like USA, the UK and Japan, equipment
leasing is very popular and nearly 25% of plant and
equipment is being financed by leasing companies.
• In India also, many financial companies have started
equipment leasing business.
Mutual Funds
• A mutual fund refers to a fund raised by a financial
service company by pooling the savings of the public.

• It is invested in a diversified portfolio with a view to

spreading and minimizing the risk The fund provides
investment avenues for small investors who cannot
participate in the equities of big companies.

• It ensures low-risk, steady returns, high liquidity- and

better capitalization in the long run.
Factoring

• Factoring refers to the process of managing the sales

register of a client by a financial services company.

• The entire responsibility of collecting the book debts

passes on to the factor.
Forfaiting

• Forfaiting is a technique by which a forfaiter

(financing agency) discounts an export bill and pays
ready cash to the exporter who can concentrate on
the export front without bothering about collection
of export bills.
Venture Capital

• A venture capital is another method of financing in

form of equity participation.
Custodial Services

• Under this a financial intermediary mainly provides

services to clients, for a prescribed fee, like safe
keeping of financial securities and collection of
interest and dividends.
Corporate advisory services

• Financial intermediaries hanks have

particularly setup specialized

• branches for this. of finance like Euro loans, GDRs

As new avenues
etc. are available to corporate customers, this service
is of immense help to the customers.
Securitization
Securitization is a technique whereby a financial
company converts its ill-liquid, non-negotiable and
high value financial assets into securities of small
value which are made tradable and transferable.
Derivative Security

• A derivative security is a security whose value

depends upon the values of other basic variable
backing the security.

• In most cases, these variables are nothing but the

prices of traded securities.
New products in Forex Markets

• New products have also emerged in the forex

markets of developed countries. of these
Some products areyetto make full in Indian
entry markets. Among them are :
a. Forward contract: A forward transaction is one
where the delivery of foreign currency takes place at
a specified future date for a specified price. It may
have a fixed or flexible maturity date.
.
b. Options: As the very name implies, it is a contract
where in the buyer of option's has a right to buy or
sell a fixed amount of currency against another
currency at a fixed rate on a future date according to
his options.
c. Futures : It is a contract wherein there is an
agreement to buy or sell a stated quantity of foreign
currency at a future date at a price agreed to between
the parties on the stated exchange.
• d. Swaps : A swap refers to a transaction wherein a financial
intermediary buys and sells a specified foreign currency
simultaneously for different maturity dates.
Lines of Credit

• It is an innovative funding mechanism for the import

of goods and services on deferred payments terms.

• LOC is an arrangement of a financing institution of

one country with another to support the export of
goods and services to as to enable the importer to
import on deferred payment terms.
Challenges Facing the Financial Services Sector

• Though financial services sector is growing very

fast, it has its own set of problems and challenges.
• The financial sector has to face many challenges in
its attempt to fulfill the ever growing financial
demands of the economy.
• Some of the important challenges are briefly
explained hereunder
I. Lack of qualified personnel : The financial
services sector is fully geared to the task of
'financial creativity'. However, this sector has
to face many challenges. The dearth of
qualified and trained personnel is an important
impediment in its growth,
II. Lack of investor awareness : The
introduction of new financial products and
instruments will be of no use unless the
investor is aware of the advantages and uses
of the new and innovative products and
instruments,
• Lack of transparency : The whole financial
system is undergoing a phenomenal change in
accordance with the requirements of the national
global environments. It is high time that this
sector gave up their orthodox attitude of keeping
accounts in a highly secret manner.
• Lack of specialization: in the Indian sense, each
financial intermediary seems to deal in a
different financial service lines without
specializing in one or two areas. In other
countries , FI specialize in one or two areas only
and provide expert service.
• Lack of recent data: most of the fi do not spend
more on research. It is very vital that one should
build up a proper data base on the basis of which
one could embark upon financial creativity.
• Lack of efficient risk management system: with
the opening of the economy to multinationals
and exposure of Indian companies to
international competition, much importance is
given to foreign portfolio flows. It involves the
utilization of multi currency transactions which
exposes the client to exchange rate risk, interest
rate risk and economic and political risk.
• The above challenges are likely to increase in
number with the growing requirements of the
customers.
• The financial services sector should rise up to
the occasion to meet these challenges by
adopting new instruments and innovative
means of financing so that it could play a
very dynamic role in the economy.
Present Scenario

• The Indian economy is in the process of rapid

transformation. Reforms ate taking place in
every field / part of economy.
• Hence financial services sector is also
witnessing changes.
• The present scenario can be explained in
following terms
Conservatism to dynamism
• The main objective of the financial sector
reforms is to promote an efficient, competitive
and diversified financial system in the country.
• This is very essential to raise the allocate
efficiency of available savings, increase the
return on investment and thus to promote (he
accelerated growth of the economy as a whole.
• At present numerous new Fls have started
functioning with a view to extending
multifarious services to the investing public in
the area of financial services
Emergence of Primary Equity
Market
• The capital markets, which were very sluggish,
have become a very popular source of raising
finance.
• The number of stock exchanges in the country
has gone up from 9 in 1980 to 22 in 1994.
• After the lowering of bank interest rates, capital
markets have become a very popular mode of
channelizing the saving of medium class people.
Concept of credit rating

• The investment decisions of the investors have

been based on factors like name recognition of
the company, operations of the group, market
sentiments, reputation of the promoters etc. now
grading from an independent agency would help
the investors in his portfolio management and
thus, equity grading is going to play a significant
role in investment decision making.
Process of globalization
• The process of globalization has paved the way
for the entry of innovative and sophisticated
products into our country.
• Since the government is very keen in removing
all obstacles that stand in the way of inflow of
foreign capital, the potentialities for the
introduction of innovative, international
financial products in India are very great.
• Moreover, our country is likely to enter the full
convertibility era soon.
Process of liberalization
• Our government has initiated many steps to
reform the financial services industry.
• The government has already switched over to
free pricing of issues the interest have been
deregulated.
• The private sector has been permitted to
participate in banking and mutual funds and the
public sector undertakings are being privatized.
• SEBI has liberalized many stringent conditions
so as to boost the capital and money markets.
 Unit -2
Concept of Leasing
Lease - definition

• 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.

• A financing arrangement that provides a firm

with an advantage of using an asset, without
owning it, may be termed as ‗leasing‘.
Characteristics of lease

• The Parties
• The Asset
• The Term
• The Lease Rentals
PURPOSE OF LEASING ?
• The purpose of choosing a lease can be many.
Generally, a lease is structured for following
reasons.
• Benefits of Taxes: Tax benefit is availed to both the
parties, i.e. Lessor and Lessee.
• Lessor, being the owner of the asset, can claim
depreciation as an expense in his books and
therefore get the tax benefit.
• On the other hand, the lessee can claim the MLPs
i.e. lease rentals as an expense and achieve tax
benefit in a similar way.
Avoid Ownership and thereby
Risks of Ownership:Avoiding
• Ownership is avoided to avoid the
investment of money into the asset.
• It indirectly keeps the leverage low and hence
opportunities of borrowing money remain
open for the business.
• A Lease is an off balance sheet item.
ADVANTAGES OF LEASING
BALANCED CASH OUTFLOW
• The biggest advantage of leasing is that cash
outflow or payments related to leasing are spread
out over several years, hence saving the burden
of one-time significant cash payment.
• This helps a business to maintain a steady cash-
flow profile.
QUALITY ASSETS
• While leasing an asset, the ownership of the asset
still lies with the lessor whereas the lessee just pays
the rental expense.
• Given this agreement, it becomes plausible for a
business to invest in good quality assets which
might look unaffordable or expensive otherwise.
BETTER USAGE OF CAPITAL
• Given that a company chooses to lease over
investing in an asset by purchasing, it releases
capital for the business to fund its other capital
needs or to save money for a better capital
investment decision.
TAX BENEFIT
• Leasing expense or lease payments are considered as
operating expenses, and hence, of interest, are tax
deductible.
OFF-BALANCE SHEET DEBT
• Although lease expenses get the same treatment as
that of interest expense, the lease itself is treated
differently from debt.
• Leasing is classified as an off-balance sheet debt and
doesn‘t appear on company‘s balance sheet.
LOW CAPITAL EXPENDITURE
• Leasing is an ideal option for a newly set-up business
given that it means lower initial cost and lower
CapEx requirements.
BETTER PLANNING
• Lease expenses usually remain constant for over the
asset‘s life or lease tenor, or grow in line with inflation.
• This helps in planning expense or cash outflow when
undertaking a budgeting exercise.
NO RISK OF OBSOLESCENCE
• For businesses operating in the sector, where there is a
high risk of technology becoming obsolete, leasing
yields great returns and saves the business from the risk
of investing in a technology that might soon become
outdated.
• For example, it is ideal for the technology business
 Regulatory framework of leasing
• Provisions under Contract Act relating
to Bailment:
• two parties - lessor - bailor, lessee-bailee.
• Transfer of possession of goods from
bailor(lessor) to bailee(lessee), for a
purpose. specific
• As under bailment, on accomplishment of purpose
the goods transferred from lessee to lessor.
Regulatory framework of leasing….

• Not to set up an Adverse Title: must inform

the lessor of any adverse claim.
• Payment of Lease Rental:
• Insure and Repair the Goods:
• Liabilities of the Lessor(Bailor):
 Theoretical Framework of
Leasing
• Liabilities of Lessor (Bailor):
• Delivery of Goods:
- Ensure delivery of goods to the lessee, along with
documents for lawful use of asset. Lease
commences on delivery.
• Peaceful Possession:
- Lessor must ensure quite possession of the goods
during the lease term
• Fitness of Goods
• To Disclose All Defects: all known defects to be
disclosed. If not then the lessor has to compensate
the losses incurred by the lessee due to such defects.
Theoretical Framework of Leasing…
Remedies for Breach;
• Remedies to the Lessor:
-Forfeiture : forfeiture of all lease rentals paid up to
the date of termination, even if it exceeds the amt. of
benefit received by the lessee.
-Repossession : repossession of goods on breach of
lease through serving of a notice on lessee.
• For repossession of goods physical force can be
used by the lessor.
• Remedies to the lessee: may claim damages for loss
resulting from the termination.
• This includes increased lease rentals he has to pay
on new lease asset obtained + damages for not
allowing him to use the asset from termination date
to the date of expiry of the lease term.

Surabhi Lakshmi, Assistant Professor, IARE.

Theoretical Framework of Leasing…
• Insurance of the leased Asset ;
• Both lessor or lesse can obtain the insurance.
• Generally obtained by the lessee, covering loss due
damage by fire, riot, faulty handling, Act of God etc.
• Claims Proceeds : in case of asset being
fully
destroyed, the claims received , adjusted against the
lessor‘s dues. In case of partial damage, the
claim
proceeds to be adjusted against amount
financed, and then for balance lease rentals is
computed.
• Sub Lease by lessee : not allowed unless provided in
the lease agreement. Except for assets where
sub
lease is apparent. Sub lease becomes the lease of the
original lessor as well. If Main lease is
terminated then the sub lease gets automatically
Lease Documentation and Agreement

• Lease Approval Process:

• Appraisal of the Lease proposal. Sanctioning of
the credit amount.
• Letter of Offer, with stipulated time for
acceptance.
• Acceptance of Offer by lessee within stipulated
time, with Board Resolution for acceptance of
the offer.
• Documents required:
• Purchase Order, Invoice, Bill of Sale from supplier,
delivery note, insurance policies, import license,
copy of shops and establishments registration
certificate, copies of Audited balance Sheet and P&L
A/c. for 3yrs, M of A and Articles of Association,
Provisional results for the first 6 months, IT
returns/Salary certificate.

Surabhi Lakshmi, Assistant Professor, IARE.

Lease Documentation and Agreement…..

• All these documents to be obtained by the lessor

from the lessee.
• They are called ―Attendant Documents‖ as they help
in taking a decision for the lease proposal.
• Insurance Policy compulsory for the leased asset, in
the name of the lessor account lessee. Policy should
be in the custody of the lessor.
 Lease Agreements
• It specifies the legal rights and obligations of the
lessor and lessee.
• Usually a Master lease is signed containing the
qualitative terms in the main part, and the
equipment details, rentals, credit limits and
payment duration etc in attached schedules.
• Additional lease facilities are finalized under
supplemental lease agreements, with reference to
the Main Master Lease Agreement.
 Lease
Agreements...
• Clauses in Lease Agreement:
• Nature of the lease : financial lease, operating lease etc.
• Description : of the equipment, its actual condition, size, estimated useful life,
components etc.
• Delivery and Re-delivery : when and how the equipment would be delivered to
the lessee and redelivered by him.
• Lease Rentals ; procedure for payments of lease rentals with the rates. Besides,
the late payment charges.
• Repairs & Maintenance : responsibility of repairs, insurance etc.
• Title : identification and ownership of equipment.
• Events of default and Remedies : consequences of default and recourse
available to the lessor.
Tripartite Lease Agreement

• Three parties - Manufacturer, lessor(financier) and lessee.

• Guarantee Agreement : in addition to master lease agreement. Guarantor
liable for the due amt. of lessee. He signs the guarantee agreement. If Guarantor
is a company then Board Resoultion for the same is a must.
• Income and Address proof of Guarantor taken.
• Agreement on a stamp paper.
Tripartite Lease Agreement...

• Promissory Note:
• Lessee to execute an unconditional promissory note in favour of lessor for the
full amount of lease rentals payable, counter guaranteed by the guarantor.
• Beyond three years, a fresh promissory note to be executed.
• Receipt of Goods:
• In case of tripartite lease , the manufacturer/supplier/lessor, delivers the goods directly to
the lessee, so he has the execute the receipt for the goods.
Tripartite lease agreements...
• Collateral Security/Hypothecation Agreement:
• Sometimes required if financial position of the lessee is
weak.
• Collateral security may be a Promissory Note by lessee ,
insurance policies, shares etc.
• No Pledge Deed is required.
• A deed of Hypothecation may be executed on stamp
paper
of appropriate value.
Leasing -Tax Provisions

Lessor:

•The depreciation can be claimed by the lessor and not the lessee.
•Depreciation can be charged as a tax deductible expense item by lessor.
•The lease rentals received by lessor are taxable as profit & gain from business

Lessee:

•The lease rentals and Insurance, repairs, maintenance charges paid by lessee
are tax deductible items of expenses for the lessee
Financial evaluation of leasing

• Financial theorists and model builders have devoted a

substantial amount of time and effort to developing an
analytical framework within which the differential costs
associated with leasing versus buying can be compared.
• In spite of this abundance of models, the perplexed financial manager
can take some comfort in the fact that the practical effects resulting
from the differences in the models tend to be small because few real -
world decisions are changed as a result of which lease –buy model is
chosen.
Example of Lease–Buy
Analysis
Consider the following example to illustrate the lease –buy analysis procedure just
described. Suppose that the Alcoa Corporation is trying to decide whether it should
purchase or lease a new heavy -duty GMC truck. (The firm has already computed
the net present value of this proposed asset acquisition and found the project to be
acceptable.) The truck can be purchased for $50,000, including delivery.
Alternatively, the truck can be leased from General Motors Acceptance Corporation
for a 6-year period at a beginning -of -the -year lease payment of $10,000. If
purchased, Alcoa could borrow the needed funds from Mellon Bank at an annual
interest rate of 10 percent.
• If the truck is purchased, Alcoa estimates that it will
incur $750 per year of expenses to cover insurance
and a maintenance contract. These expenses would
not be incurred if the truck is leased. The truck will
be depreciated under MACRS guidelines as a 5-year
asset. Alcoa expects the actual salvage value to be
$20,000 at the end of six years. Alcoa‘s marginal tax
rate is 40 percent, and its weighted after-tax cost of
capital is 15 percent
 Net present value
• Net present value (NPV) of a project is the potential change
in an investor's wealth caused by that project while time
value of money is being accounted for. It equals the present
value of net cash inflows generated by a project less the
initial investment on the project.
• When cash inflows are even:
1 − (1 + i)-n
NPV = R × − Initial Investment
i
 In the above formula,
R is the net cash inflow expected to be received in each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to
operate
and generate cash inflows.
• When cash inflows are uneven:
R1 R2 R3
NPV = + + + ... − Initial Investment
(1 + i)1 (1 + i)2
(1 + i)3

Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...
• Decision Rule
• In case of standalone projects, accept a project only if its NPV is
positive, reject it if its NPV is negative and stay indifferent between
accepting or rejecting if NPV is zero.
• In case of mutually exclusive projects (i.e. competing projects),
accept the project with higher NPV.
 Internal rate of return

• The internal rate of return sometime known as yield on project is

the rate at which an investment project promises to generate a return
during its useful life. It is the discount rate at which the present
value of a project‘s net cash inflows becomes equal to the present
value of its net cash outflows. In other words, internal rate of return
is the discount rate at which a project‘s net present value becomes
equal to zero.
• Formula of internal rate of return factor:
 Hire purchase

Meaning:
Hire purchase is a method of financing of the fixed asset to be
purchased on future date. Under this method of financing, the
purchase price is paid in instalments. Ownership of the asset is
transferred after the payment of the last instalment.
 Features of Hire Purchase:

The main features of hire purchase finance are:

1.The hire purchaser becomes the owner of the asset after paying the
last installment.
2. Every installment is treated as hire charge for using the asset.
3.Hire purchaser can use the asset right after making the agreement
with the hire vendor.
4. The hire vendor has the right to repossess the asset in case of
difficulties in obtaining the payment of installment.
Advantages of Hire Purchase:

Hire purchase as a source of finance has the following advantages:

i. Financing of an asset through hire purchase is very easy.
ii. Hire purchaser becomes the owner of the asset in future.
iii.Hire purchaser gets the benefit of depreciation on asset hired by
him/her.
iv.Hire purchasers also enjoy the tax benefit on the interest payable by
them.
 Disadvantages of Hire Purchase:

Hire purchase financing suffers from following disadvantages:

• i. Ownership of asset is transferred only after the payment of the last
installment.
• ii. The magnitude of funds involved in hire purchase are very small
and only small types of assets like office equipment‘s,
automobiles, etc., are purchased through it.
• iii. The cost of financing through hire purchase is very high.
 Legal Framework

• There is no exclusive legislation dealing with hire purchase

transaction in India. The Hire purchase Act was passed in 1972.
An Amendment bill was introduced in 1989 to amend some of the
provisions of the act. However, the act has been enforced so far.
• 1. The format / contents of the hire-purchase agreement
• 2. Warrants and the conditions underlying the hire-purchase
agreement,
• 3. Ceiling on hire-purchase charges,
• 4. Rights and obligations of the hirer and the owner.
• In absence of any specific law, the hire purchase transactions are
governed bthe provisions of the Indian Contract Act and the
• Sale of Goods Act. In chapter relating to leasing we have discussed
the provisions related to Indian Contract Act, here we will discuss
the provisions of Sale of Goods Act.
 TAXATION ASPECTS

• There are three aspects of taxation of hire-purchase deals:

(i) income-tax,
(ii) sales tax and,
(iii) interest tax.

The hire-purchase transaction can be used as a tax planning device in

two ways: (i) by inflating the net income (finance income — interest on
borrowings by the finance company) at the rear-end of the deal and (ii)
by using hire-purchase as a bridge between the lessor and the lessee,
that is, introduction of an sales, are liable to sales tax.
Financial Evaluation of hire purchasing

• From the Point of View of the Hirer (Purchaser):

The tax treatment given to hire purchase is exactly the opposite of
that given to lease financing. It may be recalled that in lease
financing, the lessor is entitled to claim depreciation and other
deductions associated with the ownership of the equipment including
interest on the amount borrowed to purchase the asset, while the
lessee enjoys full deduction of lease rentals. In sharp contrast, in a
hire purchase deal, the hirer is entitled to claim depreciation and the
deduction for the finance charge (interest) component of the hire
instalment.
• Decision criterion: The decision criterion from the point of view
of hirer is the cost of hire purchase vis a vis the cost of leasing. If
the cost of hire purchase is less than the cost of leasing, the hirer
should prefer the hire purchase alternative and vice-versa.
• Cost of hire purchase: The cost of hire purchase to the
hirerconsists
of the following:
1. Down payment
2. + Service Charges
3. + Present value of hire purchase payments discounted by the cost
of
debt.
4.– Present value of depreciation tax shield discounted by cot of
capital.
5. – Present value of net salvage value discounted by cost of
capital.
• From the View Point of Vendor / Financer
Hire purchase and leasing represent two alternative investment
decisions of a finance company / financial intermediary / hire vendor.
The decision criterion therefore is based on a comparison of the net
present values of the two alternatives, namely, hire purchase and lease
financing. The alternative with a higher NPV would be selected and
the alternative having a lower NPV would be rejected.
• NPV of Hire purchase Plan: The NPV of HPP consist of
1. PV of hire purchase instalments
2. + Documentation and service fee.
3. + PV of tax shield on initial direct cost
4. – Loan amount
5. – Initial cost.
6. – PV of interest tax on finance income (interest)
7. – PV of income tax on finance income meted for interest tax
8. – PV of income tax on documentation and service fee.
 Hire purchase mathematics

Under a HIRE PURCHASE contract, a purchaser pays an initial deposit and

takes the item away. He or she then makes regular repayments (instalments).
The instalments include both repayment of the debt and the interest being
charged by the vendor. At the end of the period of the agreement, the purchaser
owns the item.
HIRE PURCHASE FORMULAS
TOTAL AMOUNT PAID = DEPOSIT + INSTALMENTS
TOTAL INTEREST PAID = TOTAL AMOUNT PAID – ORIGINAL PRICE
OF ITEM
The interest rate being charged under a Hire Purchase Agreement is calculated
using the SIMPLE INTEREST formula and is called the ANNUAL FLAT
RATE of interest:
rf = 100 I / Pt
Where:
• I = total interest paid under agreement
• P = amount owed (after deposit is deducted from original price)
• t = the number of years over which agreement runs
 Unit-3
Factoring
Meaning and Definition of Factoring

The word factor is derived from the Latin word facere. It

means to make or do or to get things done. Factoring simply refers to
selling the receivables by a firm to another party. The buyer of the
receivables is called the factor. Thus factoring refers to the agreement
in which the receivables are sold by a firm (client) to the factor
(financial intermediary).
 Objectives of Factoring
Factoring is a method of converting receivables into cash. There are
certain objectives of factoring. The important objectives are as
follows:
• 1. To relieve from the trouble of collecting receivables so as to
concentrate in sales and other major areas of business.
• 2. To minimize the risk of bad debts arising on account of non-
realisation of credit sales.
• 3. To adopt better credit control policy.
• 4. To carry on business smoothly and not to rely on external sources to
meet working capital requirements.
• 5. To get information about market, customers‘ credit worthiness etc. so
as to make necessary changes in the marketing policies or strategies.
 Types of Factoring

There are different types of factoring.

 Recourse Factoring
 Non-Recourse Factoring
 Maturity Factoring
 Advance Factoring
 Invoice Discounting
 Undisclosed Factoring
Advantages of Factoring

• Improves efficiency
• Higher credit standing
• Reduces cost
• Additional source
• Advisory service
• Acceleration of production cycle
• Adequate credit period for customers
• Competitive terms to offer
Limitations of Factoring

• 1. Factoring may lead to over-confidence in the behaviour of

the client. This results in overtrading or mismanagement.
• 2. There are chances of fraudulent acts on the part of the client.
Invoicing against non-existent goods, duplicate invoicing etc. are
some commonly found frauds. These would create problems to the
factors.
• 3. Lack of professionalism and competence, resistance to change
etc. are some of the problems which have made factoring services
unpopular.
• 4. Factoring is not suitable for small companies with lesser turnover,
companies with speculative business, companies having large number
of debtors for small amounts etc.
 Legal aspects of factoring

• 1. The sale is taking place on a credit basis and the factor takes the
responsibility for collecting payment from the buyer. For this purpose,
the agreement between the seller and the factor should clearly state
the role of each party involved in the sale.
• 2. The seller should give due authority to the factor for
collecting money from the buyer.
• 3. Legally, the claim on the buyer is assigned by the seller to the
factor.
For this, a letter of authority is given by the seller to the factor.
• 4. The buyer is also informed by the seller that he should
make payment only to the factor.
• 5. All the rights of the seller on the buyer now get transferred
to the
factor in his capacity as an assignee.
• 6. In case of default by the buyer, it is the factor who will take action
against the buyer in his capacity as an assignee.
• 7. No other creditor can have any claim settled with the buyer
towards the sale of goods except the factor.
• 8. The banker will be informed that he should not finance the seller
for any post sales requirements or accounts receivable discount, as it
is the factor who has been assigned with the bills.
• 9. Disputes arising between the seller and buyer should be settled
by the parties concerned and they should not affect the factor.
• 10. The factor must have the right to take legal action against the
buyer in the case of default.
Factoring scenario in India

Factoring service in India is of recent origin. It owes its genesis to the

recommendations of the Kalyanasundaram Study Group appointed by the RBI
in 1989. Pursuant to the acceptance of these recommendations, the RBI issued
guidelines for factoring services in 1990. The first factoring company – SBI
Factors and Commercial Ltd (SBI FACS) started operation in April 1991. This
article highlights the important aspects of the factoring services in India.
• The main recommendations of the Committee/Group are listed as follows:
• (1) Taking all the relevant facts into account, there is sufficient scope for
introduction factoring services in India which would be complementary to
the services provide by banks.
(2)The introduction of export factoring services would provide additional facility
to exporters.
(3)While quantification of the demand for factoring services has not been
possible, it is assessed that it would grow sufficiently so as to make factoring
business a commercially viable proposition within a period of two/three
years.
(4)On the export front, there would be a fairly good availment of various services
offered by export factors.
(5) With a view to attaining a balanced dispersal of risks, factors should offer
their services to all industries and all sectors in the economy.
(6) The pricing of various services by factors would essentially depend upon the cost of funds.

Factors should attempt a mix from among the various sources of funds to keep the cost of funds as

low as possible, in any case not exceeding 13.5 percent per annum, so that a reasonable spread is

available.

(7)The RBI could consider allowing factoring organizations to raise funds from the Discount and

Finance House of India Ltd, as also from other approved financial institutions, against their usance

promissory notes covering receivables factored by them, on the liens of revised procedure under bills

discounting scheme.

(8)The price for financing services would be around 16 per cent per annum and the aggregate price

for all other services may not exceed 2.5 percent to 3 percent of the debts services.

(9)In the beginning only select promoter institutions/groups of individuals with good track record in

financial services and competent management should be permitted to meter into this new field.
 Kalyanasundaram Standing Committee
Report Summary
• The Regulation of Factor (Assignment of Receivables) Bill, 2011
• The Standing Committee on Finance submitted its 39thReport on
‗The Regulation of Factor (Assignment of Receivables) Bill, 2011‘ on
August 30, 2011. The Chairperson was Shri Yashwant Sinha.
• The Bill seeks to provide for and regulate the assignment of
receivables by making provisions for registration of factoring
organisations and their regulation by the Reserve Bank of India (RBI).
In addition, the Bill provides for the rights and obligations of parties
to contract for the assignment of re.ceivables from one to another
• The Committee opined that there is a lack of clarity in the definitions and
title of the Bill, which gives the impression that a law to regulate factors
already exists. In addition, the Committee noted that the Hindi version of the
Bill translates ‗factor‘ to ‗adhatia‘. This may give the impression that factors
are to serve as intermediaries between enterprises and buyers of products,
which is prohibited by the Bill.
• The Report noted that the Ministry, in response to the Committee‘s
concerns, has stated its intention to replace the word ‗adhatia‘ in the Hindi
version with the word ‗factor‘ and to specifically exclude agents of
agricultural produce from the definition of ‗factor‘ in the Bill. In addition, the
Ministry has stated its intention to change the name of the Bill to ‗The
Factoring Regulation Bill, 2011‘. The Committee recommends that the
Ministry incorporate these modifications in to the Bill.
• The Committee noted that the 1988 report of an Expert Group headed
by C.S. Kalyansundaram, former chairman of State Bank of India,
recommended that assignment of receivables in favour of a factor be
exempt from stamp duty. The Committee stated that although it is in
agreement with the recommendation of the Expert Group, no such
provision is included in the Bill.
• The Report of the Committee states that the Ministry, in response to
the Committee‘s concerns, has agreed with its view and will bring an
amendment to the Indian Stamp Act, 1889 through a schedule to the
Bill. The Committee found this appropriate.
 BILL
DISCOUNTING
When the seller (drawer) deposits genuine commercial bills
and obtains financial accommodation from a bank or financial instit
instead of discounting the bill immediately may choose to wait till the
date of maturity.
When the seller (drawer) deposits genuine commercial bills
and obtains financial accommodation from a bank or financial
institution, it is known as 'bill discounting'. The seller, instead of
discounting the bill immediately may choose to wait till the date of
maturity. Commercial, the option of discounting will be advantageous
because the seller obtains ready cash, which can be used for meeting
immediate business requirements. However, in the process, the seller
may lose a little by way of discount charged by the discounting banker.
 Salient features

1. Discount charge:
The margin between advance granted by the bank and face value of the
bill is called the discount, and is calculated on the maturity value at
rate a certain percentage per annum.
2. Maturity:
Maturity date of a bill is defined as the date on which payment will fall
due. Normal maturity periods are 30, 60, 90 or 120 days. However, bills
maturing within 90 days are the most popular.
3. Ready finance:
Banks discount and purchase the bills of their customers so that the
customers get immediate finance from the bank. They need not wait till
the bank collects the payment of the bill.
4. Discounting and purchasing:
The term discounting of bills is used for demand bills, where the term
purchasing of bills is used for usance bills. In both cases, the bank
immediately credits the account of the customer with the amount of the
bill, less its charges. Charges are less in case of purchasing of bill
because the bank can collect the payment immediately by presenting
the bill to the drawee for payment. Charges are, however, higher in the
case of discounting of bill because the bank charges include not only
the charges for service rendered, but also the interest for the period
from the date of discounting the bill to the date of its maturity. In
addition, there are also charges when bills are dishonoured. In such
circumstances, the bank will debit the account of the customer with the
amount of the bill along with interest and other charges. Since the bank
is granting advance to the customers in both the discounting and
purchasing of bills, bills discounted and purchased are shown as
advances (Schedule 9) by a bank in its balance sheet.
 Parties involved in Bills of Exchange

Bills of exchange is used primarily in International trade, and is a written order

by one person to pay another a specific sum on a specific date sometime in the
future. It is known as ―Draft‖ in the United States. If the bill of exchange is
drawn on a bank, it is called a bank draft.
A bill of exchange may involve the following parties
1. Drawer This is the person who writes and signs the bill.
2. Drawee This is the person on whom the bill is drawn.
3.Acceptor This is the person who accepts the bill. In practice, the drawee is
the acceptor but a third person may accept a bill on behalf of the drawee.
4.Payee This is the person to whom the money stated in the bill is payable. He
may be the drawer or any other person to whom the bill has been endorsed.
5.Holder This is the person who is in the possession of the bill, after
being drawn. He /She may be the original payee, endorsee and bearer in
case of a bearer bill.
6. Endorser The person, either the drawer or holder, who endorses the
bill to any one by signing on the back of it is called an endorser.
7. Endorsee He/ She is the person in whose favour the bill is endorsed.
8.Drawee in case of need This is a person who is introduced at the
option of the drawer. Any endorser may insert the name of such person,
and the effect of it is that a resort may be had to him in case the bill is
dishonoured for non-acceptance or non-payment or in any other need.
9.Acceptor for honour The person who may voluntarily become a
party to a bill as acceptor in the event of the refusal by original drawee
to accept the bill if demanded by the notary. The acceptor for honour
offers to accept the bill supra protest* with a view to safeguard the
honour or prestige of the original drawer or any other endorser, as the
case may be.
 BILL DISCOUNTING PROCESS

The process of bill discounting is simple and logical.

• The seller sells the goods on credit and raises invoice on the buyer.
• The buyer accepts the invoice. By accepting, the buyer
acknowledges paying on the due date.
• Seller approaches the financing company to discount it.
• The financing company assures itself of the legitimacy of the bill and
creditworthiness of the buyer.
• The financing company avails the fund to the seller after
deducting appropriate margin, discount and fee as per the norms.
• The seller gets the funds and uses it for further business.
• On the due date of payment, the financial intermediary or the seller
collects the money from the buyer. ‗Who will collect the money‘
depends on the agreement between the seller and financing
company.
 ADVANTAGES OF BILL DISCOUNTING

The business gets the cash instantaneously giving business cycle a

better momentum. It allows an entrepreneur to do business without
funds. This works like a bank overdraft, the borrower pays the interest
only on the amount of money utilized. There is a tough competition in
the market to extend such credit and hence there are a plenty of
different products to suit the needs of the client. There are borrowers
who even cover the risk of bad debt along with the service. Obviously,
the charge may be little more.
 DISADVANTAGES OF BILL DISCOUNTING

• It can be an expensive form of financing compared to other modes of

financing such as bank overdraft etc. In many countries like India,
where the central bank encouraged the scheme of bill discounting and
allowed a lower percentage of interest. But, it was not successful due
to various misuses by financing brokers, banks etc.
• Note: Situation of invoice discounting is different in different
countries. The norms of financing differ in different countries and
they are different with different borrowers of the same countries as
well. This depends on the business policies of the banks and financial
institutions engaging in the discounting business.
 Unit - 4
Venture Capital Financing
 Meaning

It is a private or institutional investment made into early-stage / start-up

companies (new ventures). As defined, ventures involve risk (having
uncertain outcome) in the expectation of a sizeable gain. Venture
Capital is money invested in businesses that are small; or exist only as
an initiative, but have huge potential to grow. The people who invest
this money are called venture capitalists (VCs). The venture capital
investment is made when a venture capitalist buys shares of such a
company and becomes a financial partner in the business.
Features of Venture Capital investments

• High Risk
• Lack of Liquidity
• Long term horizon
• Equity participation and capital gains
• Venture capital investments are made in innovative projects
• Suppliers of venture capital participate in the management of
the company
Methods of Venture capital financing

• Equity
• participating debentures
• conditional loan
 FUNDING PROCESS

The venture capital funding process typically involves four phases

in the company's development:
• Idea generation
• Start-up
• Ramp up
• Exit
Step 1: Idea generation and submission of the Business Plan
• The initial step in approaching a Venture Capital is to submit a
business plan. The plan should include the below points:
• There should be an executive summary of the business
proposal
• Description of the opportunity and the market potential and
size
• Review on the existing and expected competitive scenario
• Detailed financial projections
• Details of the management of the company
• There is detailed analysis done of the submitted plan, by the Venture
Capital to decide whether to take up the project or no.
Step 2: Introductory Meeting
Once the preliminary study is done by the VC and they find the project
as per their preferences, there is a one-to-one meeting that is called for
discussing the project in detail. After the meeting the VC finally
decides whether or not to move forward to the due diligence stage of
the process.
Step 3: Due Diligence
The due diligence phase varies depending upon the nature of the
business proposal. This process involves solving of queries related to
customer references, product and business strategy evaluations,
management interviews, and other such exchanges of information
during this time period.
Step 4: Term Sheets and Funding
If the due diligence phase is satisfactory, the VC offers a term sheet,
which is a non-binding document explaining the basic terms and
conditions of the investment agreement. The term sheet is generally
negotiable and must be agreed upon by all parties, after which on
completion of legal documents and legal due diligence, funds are made
available.
 Types of Venture Capital funding
The various types of venture capital are classified as per their
applications at various stages of a business. The three principal types of
venture capital are early stage financing, expansion financing and
acquisition/buyout financing.
The venture capital funding procedure gets complete in six stages of
financing corresponding to the periods of a company's development
• Seed money: Low level financing for proving and fructifying a new
idea
• Start-up: New firms needing funds for expenses related
with marketingand product development
• First-Round: Manufacturing and early sales funding
• Second-Round: Operational capital given for early stage
companies which are selling products, but not returning a profit
• Third-Round: Also known as Mezzanine financing, this is the money
for expanding a newly beneficial company
 Advantages of Venture Capital

• They bring wealth and expertise to the company

• Large sum of equity finance can be provided
• The business does not stand the obligation to repay the money
• In addition to capital, it provides valuable information,
resources, technical assistance to make a business successful.
 Disadvantages of Venture Capital

• As the investors become part owners, the autonomy and control of the
founder is lost
• It is a lengthy and complex process
• It is an uncertain form of financing
• Benefit from such financing can be realized in long run only
 Exit route

There are various exit options for Venture Capital to cash out their
investment:
• IPO
• Promoter buyback
• Mergers and Acquisitions
• Sale to other strategic investor
Venture Fund Structure
 First Chicago method

This method is different from the previous conventional method of

evaluation, as it gives some discount to the starting point and the exit
point. There is more consideration given for the earnings during the
entire period. This scheme has the following aspects.
1. Three alternative positions are taken which are
• Success
• Sideways survival
• failure.
A probability rating is given to the three positions.
2.Through the discounted cash flow, the discounted present value is
assessed by giving a high discount rate to accommodate the risk factor.
3. The discounted value is multiplied by probability ratings which will
provide expected present value.
4.If the expected present value is Rs. 10 lakhs, and the fund required is
Rs. 5 lakhs, then the borrowing concern must have a minimum net
worth of 50%.
 Revenue Multiplier method

In this method, the value of the borrowing concern is based on an

estimated value. The estimated value is calculated on the basis of
1. Present value of the borrowing concern
2. Annual revenue
3. Expected rate of growth of revenue per year
4. Expected holding period ( number of years for the repayment)
5. Profit margin after tax
6. Expected P/E ratio at the time of quitting the borrowing concern.
This method will be useful for such concerns which have started
earning and where in the course of years their revenue will be
increasing. But this system is based on more data which may not
be available, especially in underdeveloped countries.
 Regulatory frame work of venture capital
financing

Venture Capital Fund: means a fund established in the form of a trust or

a company including a body corporate and registered under these
regulations which-
• has a dedicated pool of capital,
• raised in a manner specified in the regulations, and
• invests in accordance with the regulations.
Venture Capital Undertaking; means a domestic company :-
• whose shares are not listed on a recognized stock exchange in India;
• which is engaged in the business for providing services, production or
manufacture of article or things or does not include such activities or
sectors which are specified in the negative list by the Board with the
approval of the Central Government by notification in the Official
Gazette in this behalf.
Negative List
• Non-banking financial services excluding those Non-Banking
Financial companies which are registered with Reserve Bank of
India and have been categorized as Equipment Leasing or Hire
Purchase companies
• Gold Financing excluding those companies which are engaged in
gold financing for jewellery
• Activities not permitted under industrial policy of Government of
India.
• Any other activity which may be specified by the Board in
consultation with Government of India from time to
time."
Associate Company: means a company in which a director or trustee or
sponsor or settlor of the venture capital fund or asset management
company holds either individually or collectively, equity shares in
excess of 15% of its paid-up equity share capital of venture capital
undertaking".
Equity Linked Instruments: includes instruments convertible into equity
shares or share warrants, preference shares, debentures compulsorily or
optionally convertible into equity.
Investible Funds: means corpus of the fund net of expenditure for
administration and management of the fund.
Unit : means beneficial interest of the investors in the scheme or fund
floated by trust or shares issued by a company including a body
corporate
 Unit -5
Merchant banking
Meaning

• Merchant Banking is a combination of Banking and

consultancy services. It provides consultancy to its
clients for financial, marketing, managerial and legal
matters. Consultancy means to provide advice,
guidance and service for a fee. It helps a
businessman to start a business. It helps to raise
(collect) finance. It helps to expand and modernize
the business. It helps in restructuring of a business.
It helps to revive sick business units. It also helps
companies to register, buy and sell shares at
the stock exchange.
Functions of Merchant Banking

The functions of merchant banking are listed as follows:

• Raising Finance for Clients
• Broker in Stock Exchange
• Project Management
• Advice on Expansion and Modernization
• Managing Public Issue of Companies
• Handling Government Consent for Industrial Projects
• Special Assistance to Small Companies and Entrepreneurs
• Services to Public Sector Units
• Revival of Sick Industrial Units
• Portfolio Management
• Corporate Restructuring
• Money Market Operation
• Leasing Services
• Management of Interest and Dividend
Registration and Regulation of Working of
Intermediaries

SEBI regulates various intermediaries in the

primary and secondary markets through its
Regulations for these intermediaries. These
Regulations allow SEBI to inspect the functioning of
these intermediaries and to collect to fees from
them. Details of the registration and regulation of
the working of intermediaries are given in the
following sub-sections.
Primary Market Intermediaries
 Merchant bankers
 Registrars to an issue and share transfer agents
 Bankers to an issue
 Debenture trustees
 Underwriters
 Portfolio managers
Secondary Market Intermediaries
• Stock brokers
• Sub-brokers
Eligibility norms on Merchant Banking

Reforms for the merchant bankers

SEBI has made the following reforms for the merchant banker
1.Multiple categories of merchant banker will be abolished and there
will be only one equity merchant banker.
2.The merchant banker is allowed to perform underwriting activity. For
performing portfolio manager, the merchant banker has to seek
separate registration from SEBI.
3.A merchant banker cannot undertake the function of a non banking
financial company, such as accepting deposits, financing others‘
business, etc.
4.A merchant banker has to confine himself only to capital market
activities
Recognition by SEBI on merchant bankers
SEBI will grant recognition a merchant banker after taking into account
the following aspects
1. Considering how much the merchant are professionally competent.
2. Whether they have adequate capital
3. Track record, experience and general reputation of merchant bankers.
4.Quality of staff employed by merchant bankers, their adequacy and
available infrastructure are taken into account. After considering the
above aspects, SEBI will grant permission for the merchant banker to
start functioning.
Conditions by SEBI for merchant bankers
SEBI has laid the following conditions on the merchant bankers,
for conducting their operations. They are
1.SEBI will give authorization for a merchant banker to operate for 3
years only. Without SEBI‘s authorization, merchant bankers cannot
operate.
2. The minimum net worth of merchant banker should be Rs. 1 crore.
3.Merchant banker has to pay authorization fee, annual fee and
renewal fee.
4.All issue of shares must be managed by one authorized merchant
banker. It should be the lead manager.
5. The responsibility of the lead manager will be clearly indicated
by
SEBI.
Lead Manager

The commercial or investment bank which has primary responsibility

for organizing a given credit or bond issuance. This bank will find
other lending organizations or underwriters to create the syndicate,
negotiate terms with the issuer, and assess market conditions. Also
called syndicate manager, managing underwriter or lead
underwriter.
Responsibilities of Lead Managers

Every lead managers has to enter into an agreement with the issuing companies
setting out their mutual rights, liabilities and obligation relating to such issues
and in particular to disclosures, allotment and refund. A statement specifying
these is furnished to the SEBI at least one month before the opening of the issue
for subscription. In case of more than one lead manager, the statement has to
provide details about their respective responsibilities. A lead merchant banker
cannot manage an issue if the issuing company is his associate. He can also not
associate with a merchant banker who does not hold a certificate of registration
with the SEBI.
• Due Diligence Certificate
• Submission of Documents
• Acquisition of Shares
• Disclosure to SEBI
 UNDERWRITE
R
―Underwriter‖ has the meaning assigned to it in clause (f) of rule 2
of the Securities and Exchange Board of India (Underwriters)
Rules, 1993. According to SEBI Rules/Regulations on
underwriters, underwriter means a person who engages in the
business of underwriting of an issue of securities of a body
corporate.
Registration :To act as underwriter, a certificate of registration
must be obtained from SEBI. On application registration is
granted to eligible body corporate with adequate infrastructure
to support the business and with net worth not less than Rs. 20
lakhs.
Fee :Underwriters had to pay Rs. 5 lakh as registration fee and Rs. 2
lakh as renewal fee every three years from the fourth year from the
date of initial registration. Failure to pay renewal fee leads to
cancellation of certificate of registration.
General Obligations and responsibilities
• Code of conduct :Every underwriter has at all times to abide
by the code of conduct; he has to maintain a high standard of
integrity, dignity and fairness in all his dealings.
• He must not make any written or oral statement to
misrepresent (a) the services that he is capable of performing
for the issuer or has rendered to other issues or (b) his
underwriting commitment.
• Agreement with clients :Every underwriter has to enter into
an agreement with the issuing company.
• The agreement, among others, provides for the period during
which the agreement is in force, the amount of underwriting
obligations, the period within which the underwriter has to
subscribe to the issue after being intimated by/on behalf of
the issuer, the amount of Commission / brokerage, and
details of arrangements, if any, made by the underwriter for
fulfilling the underwriting obligations.
General responsibilities
• An underwriter cannot derive any direct or indirect benefit from
underwriting the issue other thanby the underwriting commission. The
maximum obligation under all underwriting agreements of an
underwriter cannot exceed twenty times his net worth. Underwriters
have to subscribe for securities under the agreement within 45 days of
the receipt of intimation from the issuers.
Brokers and bankers to issue
Bankers to an Issue
The bankers to an issue are engaged in activities such as
acceptance of applications along with application money
from the investor in respect of capital and refund of
application money.
Registration :To carry on activity as a banker to issue, a
person must obtain a certificate of registration from the
SEBI. The applicant should be a scheduled bank. Every
banker to an issue had to pay to the SEBI an annual free for
Rs. 5 lakh and renewal fee or Rs. 2.5 lakh every three years
from the fourth year from the date of initial registration. Non-
payment of the prescribed fee may lead to the suspension of
the registration certificate.
 Brokers to the Issue
• Brokers are persons mainly concerned with the procurement of
subscription to the issue from the prospective investors.
• The appointment of brokers is not compulsory and the
companies are free to appoint any number of brokers.
• The managers to the issue and the official brokers organize the
preliminary distribution of securities and procure direct
subscription from as large or as wide a circle of investors as
possible.
• A copy of the consent letter from all the brokers to the issue,
should be filed with the prospectus to the ROC.
• The brokerage applicable to all types of public issue of
industrial securities is fixed at 1.5%, whether the issue is
underwritten or not.
• The listed companies are allowed to pay a brokerage
on private placement of capital at a maximum rate of
0.5%.
• Brokerage is not allowed in respect of promoters‘
quota including the amounts taken up by the
directors, their friends and employees, and in respect
of the rights issues taken by or renounced by the
existing shareholders.
• Brokerage is not payable when the applications are
made by the institutions/ bankers against their
underwriting commitments or on the amounts
devolving on them as underwriters consequent to the
under subscription of the issues.

Surabhi Lakshmi, Assistant Professor, IARE.

Registrars to an Issue and Share Transfer
Agents
To carry on their business, the registrars must be registered with the
SEBI. They are divided into two categories:
(a) Category I, to carry on the activities as registrar to an issue and
share transfer Agent;
(b) Category II, to carry on the activity either as registrar or as a share
transfer agent. Category I registrars mush have minimum net worth
of Rs. 6 lakhs and Category II, Rs. 3. Category I is required to pay
a initial registration fee of Rs.50,000 and renewal fee of Rs.40,000
every three years, whereas Category II is required to pay Rs.30,000
and Rs. 25,000 respectively
 PORTFOLIO MANAGER
• Portfolio manager are defined as persons who in pursuance of a contract with
clients, advise, direct, undertake on their behalf the management/ administration
of portfolio of securities/ funds of clients.
• The term portfolio means the total holdings of securities belonging to any
person.
• The portfolio management can be (i) Discretionary or (ii) Non-discretionary.
• The first type of portfolio management permits the exercise of discretion in
regard to investment / management of the portfolio of the securities / funds.
• In order to carry on portfolio services, a certificate of registration from SEBI is
mandatory.
• The certificate of registration for portfolio management services is granted to
eligible applicants on payment of Rs.5 lakh as registration fee. Renewal may be
granted by SEBI on payment of Rs. 2.5 lakh as renewal fee (every three years).
Issue Management Process

• Issues Management is the process of identifying and resolving

issues in a project or organization.
• Using this Issue Management Process, you can identify and resolve
issues quickly, before they have an undesirable impact.
• Whether you experience staffing, supplier, equipment or other issues,
this process will guide you through the steps towards their speedy
resolution.
This Issue Management Process will help you to:
• Identify and record issues clearly
• Use Issue Forms to document issues properly
• Determine the impact of each issue
• Prioritize issues and report on their status
• Review all issues and decide on a course of
action
• Take the steps needed to resolve issues quickly
BOOK BUILDING

• Book building is a price discovery mechanism that is used in

the stock markets while pricing securities for the first time.
• When shares are being offered for sale in an IPO, it can either
be done at a fixed price.
• However, if the company is not sure about the exact price at
which to market its shares, it can decide a price range instead
of an exact figure.
• This process of discovering the price by providing the
investors with a price range and then asking them to bid on it
is called the book building process.
Book Building Process

• Appointment of Investment Banker

• Collecting Bids
• Price Discovery
• Publicizing
• Settlement
GREEN SHOE OPTION INITIAL PUBLIC
OFFERING PROMOTERS CONTRIBUTION

Green shoe option allows companies to intervene in the market to

stabilize share prices during the 30-day stabilization period
immediately after listing Most of us who invest in stocks of a
company know what is an IPO(initial public offering). An IPO is the
first sale of a stock or share by a company to the public. Companies
offering an IPO are sometimes new, young companies, or companies
which have been around for many years and have finally decided to
go public.
Let try to understand what does green shoe option mean.
Over-allotment option
• The green shoe option allows companies to intervene in the market
to stabilise share prices during the 30-day stabilization period
immediately after listing. This involves purchase of equity shares
from the market by the company-appointed agent in case the shares
fall below issue price.
• The green shoe option is exercised by a company making a public
issue. The issuer company uses green shoe option during IPO to
ensure that the shares price on the stock exchanges does not fall
below the issue price after issue of shares.
• Green shoe is a kind of option which is primarily used at the time of
IPO or listing of any stock to ensure a successful opening price. Any
company when decides to go public generally prefers the IPO route,
which it does with the help of big investment bankers also called
underwriters. These underwriters are responsible for making the
public issue successful and find the buyers for company‘s shares.
They are paid a certain amount of commission to do this work.
Origin of the Green shoe

• The term "green shoe" came from the Green Shoe Manufacturing
Company (now called Stride Rite Corporation), founded in 1919. It
was the first company to implement the greenshoe clause into their
underwriting agreement.
• In a company prospectus, the legal term for the green shoe is "over-
allotment option", because in addition to the shares originally offered,
shares are set aside for underwriters. This type of option is the only
means permitted by the US Securities and Exchange Commission
(SEC) for an underwriter to legally stabilize the price of a new issue
after the offering price has been determined. The SEC introduced this
option to enhance the efficiency and competitiveness of the fund
raising process for IPOs.
SEBI GUIDELINES RELATING TO NEW
ISSUES OF SECURITIES
SEBI advises certain guidelines in issue of fresh share capital, first
issue by new companies in Primary Market and functioning of
secondary markets in order to maintain quality standards. A few such
guidelines and objectives of the Securities and Exchange Board of India
(SEBI) are discussed here. SEBI Guidelines for issue of fresh share
capital

• 1. All applications should be submitted to SEBI in the prescribed

form.
• 2. Applications should be accompanied by true copies of industrial
license.
• 3. Cost of the project should be furnished with scheme of finance.
• 4. Company should have the shares issued to the public and listed in
one or more recognized stock exchanges.
5.Where the issue of equity share capital involves offer for
subscription by the public for the first time, the value of equity
capital, subscribed capital privately held by promoters, and their
friends shall be not less than 15% of the total issued equity capital.
6. An equity-preference ratio of 3:1 is allowed.
7.Capital cost of the projects should be as per the standard set with a
reasonable debt-equity ratio.
8. New company cannot issue shares at a premium. The dividend on
preference shares should be within the prescribed list.
9. All the details of the underwriting agreement.
10.Allotment of shares to NRIs is not allowed without the approval of
RBI.
11. Details of any firm allotment in favor of any financial institutions.
12. Declaration by secretary or director of the company.
CREDIT RATING

Credit rating is a mechanism by which the reliability and viability of a

credit instrument is brought out. When a company borrows or when a
businessman raises loan, the lenders are interested in knowing the
credit worthiness of the borrower not only in the present condition but
also in future. Hence, credit rating reveals the soundness of any credit
instruments issued by various business concerns for the purpose of
financing their business,. In credit rating, the investor is not only able to
know the soundness of the credit instrument, but be is also able to
analyze between different credit instruments and he can make a trade
off between risk and return.
Credit Rating Companies in India

Credit rating companies were started in India during the late 1980s.
• Credit Rating Information Services of India Ltd (CRISIL) was started
in 1988 as a subsidiary of ICICI.
• Information and Credit Rating Services Ltd., (ICRA) was started in
1990, which is a subsidiary of IDBI.
• In1993, Credit Analysis and Research Ltd. (CARE) was started
Grading System

Each of the rating agencies has different codes for expressing rating for
different instruments; however, the number of grades and sub-grades is
similar eg for long term debentures/bonds and fixed deposits, CRISIL
has 4 main grades and a host of sub-grades. In decreasing order of
quality, these are AAA,AA+, AA, AA-, A+, A, A-, BBB-, BBB, BBB+,
BB+, BB, BB-,B+, B, B-, C and D. ICRA, CARE and Duff and Phelps
have similar grading systems. The following table contains a key to the
codes used by CRISIL and ICRA.
Types of Credit Rating

1. Equity Rating
2. Bond Rating
3. Promissory Note Rating
4. Commercial Papers
5. Sovereign Rating
Advantages of Credit Rating

Different benefits accrue from use of rated instruments to different

class of investors or the company. These are explained as under:
A. Benefits to Investors
• Safety of investments
• Recognition of risk and returns
• Freedom of investment decisions
• Wider choice of investments
• Dependable credibility of issuer
• Relief from botheration to know company
Benefits to Intermediaries

Stock brokers have to make less efforts in persuading their clients to

select an investment proposal of making investment in highly rated
instruments. Thus rating enables brokers and other financial
intermediaries to save time, energy costs and manpower in convincing
their clients.