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Q1: there are two main regulators to regulate the Indian Financial System RBI and SEBI.

. Explain the role of SEBI in detail. Do you think that these two agencies can be merged to create a super regulatory body for an effective regulation of the financial system? Answer: (first part) As part of economic reforms programme started in June 1991, the Government of India initiated several capital market reforms, which included the abolition of the office of the Controller of Capital Issues (CCI) and granting statutory recognition to Securities Exchange Board of India (SEBI) in 1992 for: (a) Protecting the interest of investors in securities; (b) Promoting the development of securities market; (c) Regulating the securities market; and (d) Matters connected there with or incidental thereto. Role of SEBI: SEBI has been vested with necessary powers concerning various aspects of capital market such as: (i) Regulating the business in stock exchanges and any other securities market; (ii) Registering and regulating the working of various intermediaries and mutual funds; (iii) Promoting and regulating self regulatory organisations; (iv) Promoting investors education and training of intermediaries; (v) Prohibiting insider trading and unfair trade practices; (vi) Regulating substantial acquisition of shares and take over of companies; (vii) Calling for information, undertaking inspection, conducting inquiries and audit of stock exchanges, and intermediaries and self regulation organisations in the stock market; and (viii) Performing such functions and exercising such powers under the provisions of the Capital Issues (Control) Act, 1947 and the Securities Contracts (Regulation) Act, 1956 as may be delegated to it by the Central Government. (Further explanation, if required: As part of its efforts to protect investors interests, SEBI has initiated many primary market reforms, which include improved disclosure standards in public issue documents, introduction of prudential norms and simplification of issue procedures. Companies are now required to disclose all material facts and risk factors associated with their projects while making public issue. All issue documents are to be vetted by SEBI to ensure that the disclosures are not only adequate but also authentic and accurate. SEBI has also introduced a code of advertisement for public issues for ensuring fair and truthful disclosures. Merchant bankers and all mutual funds including UTI have been brought under the regulatory framework of SEBI.

A code of conduct has been issued specifying a high degree of responsibility towards investors in respect of pricing and premium fixation of issues. To reduce cost of issue, underwriting of issues has been made optional subject to the condition that the issue is not under-subscribed. In case the issue is under-subscribed i.e., it was not able to collect 90% of the amount offered to the public, the entire amount would be refunded to the investors. The practice of preferential allotment of shares to promoters at prices unrelated to the prevailing market prices has been stopped and private placements have been made more restrictive. All primary issues have now to be made through depository mode. The initial public offers (IPOs) can go for book building for which the price band and issue size have to be disclosed. Companies with dematerialised shares can alter the par value as and when they so desire. As for measures in the secondary market, it should be noted that all statutory powers to regulate stock exchanges under the Securities Contracts (Regulation) Act have now been vested with SEBI through the passage of securities law (Amendment) Act in 1995. SEBI has duly notified rules and a code of conduct to regulate the activities of intermediaries in the securities market and then registration in the securities market and then registration with SEBI is made compulsory. It has issued guidelines for composition of the governing bodies of stock exchanges so as to include more public representatives. Corporate membership has also been introduced at the stock exchanges. It has notified the regulations on insider trading to protect and preserve the integrity of stock markets and issued guidelines for mergers and acquisitions. SEBI has constantly reviewed the traditional trading systems of Indian stock exchanges and tried to simplify the procedure, achieve transparency in transactions and reduce their costs. To prevent excessive speculations and volatility in the market, it has done away with badla system, and introduced rolling settlement and trading in derivatives. All stock exchanges have been advised to set-up Clearing Corporation / settlement guarantee fund to ensure timely settlements. SEBI organises training programmes for intermediaries in the securities market and conferences for investor education all over the country from time to time.) Answer: (2nd part): Should SEBI and RBI be merged? In my opinion, they should not be merged and remain separate entities due to the following reasons: 1.) SEBI is the regulator of security and capital markets whereas RBI is the regulator of the banking industry and controls the monetary policy of India. Both these are different realms of the financial sector, and need to be handled independently. 2.) Officers are taken in both these institutions with specific credentials appropriate to the job and market. Combining both the organizations would lead to shuffling of employees and hence the candidate may not be qualified for the job allotted 3.) As keeping the institutions separate, would result in less bureaucracy and increased efficiency.

4.) As both RBI and SEBI are autonomous, they have separate heads and divisions. Merging, them would create less positions and could lead to internal politics resulting in decrease of efficiency. 5.) History has shown that there could be differences of opinion among the regulators: For example SEBI and IRDA had a spat over the ULIP issue. To avoid all these controversies, they should stay independent. Q2. a) Explain different ways in which a venture capitalist can finance an investment proposal? Answer: A) Equity instruments: 1. Ordinary equity shares 2. Non-voting equity shares: entitled for higher dividene but carry no voting right 3. Deferred ordinary shares 4. Preferred ordinary shares 5. Equity warrants 6. Preference shares 7. Cumulative convertible preference shares 8. Participating preference shares 9. Cumulative convertible participatory preferred ordinary shares 10. Convertible cumulative redeemable preference shares Of the types of equity-linked financial instruments, Equity warrants, Non-voting equity shares and Cumulative convertible participatory preferred ordinary shares can be used to structure a flexible venture capital deal. B) Debt instruments: To ensure that entrepreneur retains the control and venture capital investor (VCI) receives a running yield during the early years when the equity portion is unlikely to yield any return, debt instruments are also used by VCIs. They include, in addition to conventional loans, income notes, non-convertible debentures, partly convertible debentures, fully convertible debentures, zero interest bonds, secured premium notes and deep discount bonds.

1. Conditional loans: This is a form of loan finance without any predetermined repayment schedule or interest rate. The suppliers of such loans recover a specified percentage of sales towards the recovery of principal as well as revenue in a predetermined ratio, usually 50:50. The charge on sales is known as royalty. The investor stands to gain /lose depending on whether the actual sales are higher/lower than the projected sales. It is a quasi- equity instrument. 2. Conventional loans:

These are modified to the requirements of venture capital financing. They carry lower interest which increases after commercial production commences. A small royalty is additionally charged to cover interest forgone during the initial years. Although the repayment of principal is based on pre-stipulated schedule, VCIs usually do not insist upon mortgage/other security. 3. Income notes: These fall between the conventional loans and the conditional loans and carry a uniform low rate of interest plus a royalty on sales. The principal is repaid according to a stipulated schedule 4. Non-convertible debentures: These carry a fixed/variable rate of interest, are redeemable at par/premium, are secured, and can be cumulative/non- cumulative. 5. Partly convertible debentures: The convertible portion is converted into equity shares at par/premium. The nonconvertible portion earns interest till redemption generally at par. Such instruments are best suited for second round venture capital financing. 6. Zero interest/coupon bonds/debentures: These can be either convertible or non-convertible with no interest rate. The nonconvertible bonds are sold at discount from their maturity value while convertible ones are converted into equity shares at a stipulated price and time. They offer considerable flexibility and are an appropriate instrument for later stage venture capital financing. 7. Secured premium notes: These are secured, redeemable at premium in lump-sum /installment, have zero interest and carry a warrant against which equity shares can be acquired. It is useful for later stage financing. 8. Deep discount bonds: These are issued at large discount to their maturity value. As a long term instrument these are not suited to venture capital investment. Q# 2(b) What do you understand by financial derivatives? Explain in detail. A derivative is a financial instrument whose value depends on is derived from the value of some other financial instrument, called the underlying asset. Common examples of underlying assets are stocks, bonds, corn, pork, wheat, rainfall, etc. Basic purpose of derivatives In derivatives transactions, one partys loss is always another partys gain The main purpose of derivatives is to transfer risk from one person or firm to another, that is, to provide insurance

If a farmer before planting can guarantee a certain price he will receive, he is more likely to plant Derivatives improve overall performance of the economy

Major categories of derivatives Forwards and futures Options Swaps FORWARDS A forward, or a forward contract, is: An agreement between a buyer and a seller to exchange a commodity or a financial instrument for a prespecified amount of cash on a prearranged future date. Example: interest rate forwards. Forwards are highly customized, and are much less common than the futures. FUTURES A future is a forward contract that has been standardized and sold through an organized exchange. Structure of a futures contract: Seller (has short position) is obligated to deliver the commodity or a financial instrument to the buyer (has long position) on a specific date This date is called settlement, or delivery, date. OPTIONS A call option on a stock gives its holder the right to buy a fixed number of shares at a given price by some future date, while a put option gives its holder the right to sell a fixed number of shares on the same terms. The specified price is called the exercise price. The purchase price of an option the money that changes hands on day one is called the option premium. Options enable their holders to lever their resources, while at the same time limiting their risk. SWAPS A swap is a contract to exchange cash flows over a specific period. The principal used to compute the flows is the notional amount. Suppose you have an adjustable-rate mortgage with principal of $200,000 and current payments of $11,000 per year. So you can swap it for a fixed-rate mortgage for the same principal amount of $200,000. Q # 3(a) CREDIT RATING METHODOLOGY for a FINANCIAL INSTRUMENT A Rating agencys rating process usually includes fundamental analysis of public and private issuer-specific data, industry analysis, and presentations by the issuers senior executives, statistical classification models and judgement Typically, the rating agency is privy to the issuers short and long-range plans and budgets The rating methodology is divided into two independent segments:

The first segment deals with operational characteristics and the second one with the financial characteristics Also quantitative and objective factors; qualitative aspects, like assessment of management capabilities play a very important role in arriving at the rating of an instrument The relative importance of qualitative and quantitative components of the analysis varies with the type of issuer. Key areas considered in a rating include the following: o Business risk o Financial risk o Management evaluation o Business environment analysis Rating is not based on a predetermined formula, which specifies the relevant variables as well as weights attached to each one of them Broadly, the rating agency assures itself that there is a good congruence between assets and liabilities of a company and downgrades the rating if the quality of assets depreciates.

Q# 3(b) BOOK BUILDING PROCESS for IPO Book Building is essentially a process used by companies raising capital through Public Offerings-both Initial Public Offers (IPOs) and Follow-on Public Offers (FPOs) to aid price and demand discovery. It is a mechanism where, during the period for which the book for the offer is open, the bids are collected from investors at various prices, which are within the price band specified by the issuer. The process is directed towards both the institutional as well as the retail investors. The issue price is determined after the bid closure based on the demand generated in the process. The Process:

The Issuer who is planning an offer nominates lead merchant banker(s) as 'book runners'. The Issuer specifies the number of securities to be issued and the price band for the bids. The Issuer also appoints syndicate members with whom orders are to be placed by the investors. The syndicate members input the orders into an 'electronic book'. This process is called 'bidding' and is similar to open auction. The book normally remains open for a period of 5 days. Bids have to be entered within the specified price band. Bids can be revised by the bidders before the book closes. On the close of the book building period, the book runners evaluate the bids on the basis of the demand at various price levels. The book runners and the Issuer decide the final price at which the securities shall be issued.

Generally, the number of shares are fixed, the issue size gets frozen based on the final price per share. Allocation of securities is made to the successful bidders. The rest get refund orders.

Q3.c Revival Of Sick industrial unit:An industrial unit is considered sick when its financial position is not satisfactory and it becomes worse year after year. It incurs losses and its capital reserves may be stretched out in course of time. When its current liabilities are more than current assets, the organization may not be in a position to pay its liabilities. The increasing trend in industrial sickness touching all types of units including small, medium and large-scale industrial sectors is of considerable concern. In India, there were 2,52,947 units found sick and their credit outstanding was Rs.25,767 crore in large, medium and small-scale industries at the end of March 2001. Out of this, a large number of small-scale industrial units (2,49,630) were found sick and their outstanding bank credit was Rs.4,506 crore in the country. The problem is assuming titanic proportion and may have added repercussions in a country like India which cannot afford unemployment and loss of production. The small-scale industrial (SSI) sector is the worst hit. A number of small industries are either born sick or stay sick. It is disturbing to note that despite sound academic qualifications and initial zeal of the entrepreneurs and full initial backing by financial institutions, sickness still persists. By the end of March 2005, there were 1,688 number of SSI units found sick with outstanding bank credit blocked with them was R s . 1 7 0 . 1 3 c r o r e a n d 2 0 , 5 4 7 n um b e r o f employees were affected in Orissa. The reasons for sickness are of a varied nature. The more common are management failure, non-availability of raw materials, power cuts, labour unrest, marketing problems etc. Though the sickness develops gradually and not an overnight phenomenon, the financial institutions are taken into confidence at the critical stages. When the problems and difficulties arise, the diagnosis and treatment would certainly be much easier. However, when the sickness reaches an advanced stage, it becomes difficult and takes longer time to diagnose the reasons and makes it more costly and expensive to bring the units back to normal. So, there is need to identify sickness in the initial stages and to initiate the process of corrective measures and revival / rehabilitation before the sickness assumes a serious proportion.

Q 3.d Functions of Investment Bank Functions of Investment Banking: Investment banks carry out multilateral functions. Some of the most important functions of investment banking are as follows: Investment banking helps public and private corporations in issuance of securities in the primary market. They also act as intermediaries in tradingfor clients. Investment banking provides financial advice to investors and helps them by assisting in purchasing and trading securities as well as managing financial assets Investment banking differs from commercial banking as investment banks don't accept deposits neither do they grant retail loans. Small firms which provide services of investment banking are called boutiques. They mainly specialize in bond trading, providing technical analysis or program trading as well as advising for mergers and acquisitions Core activities of Investment Banking Investment banking: is the traditional aspect of investment banks that involves helping customers raise funds in the capital markets and advise them on mergers and acquisitions. Investment banking can also involve subscribing investors to a security issuance, negotiating with a merger target and coordinating with bidders. Sales and trading: Depending on the needs of the bank and its clients, the main function of a large investment bank is buying and selling products. In market making, the traders will buy and sell securities or financial products with the goal of earning an incremental amount of money on every trade. Sales is the term that is used for the sales force, whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas and take orders. Research: is the division of investment banks which reviews companies and makes reports about their prospects, often with "buy" or "sell" ratings. Although the research division generates no revenue, its resources can be used to assist traders in trading, can be used by the sales force in suggesting ideas to the customers, and by the investment bankers for covering their clients. Q. 3f) Sources of Foreign Currency Finance for a company Ans: Foreign Sources play an important part in meeting the long-term financial needs of the business in India. These usually take the form of (1) external borrowings; (2) foreign investments and; (3) deposits from NRIs. 1. External Borrowings: These include loans obtained at concessional rates of interest with long maturity period and commercial borrowings. The major sources of concessional loans have been the International Monetary Fund (IMF), Aid India Consortium (AIC), Asian Development Bank (ADB), World Bank (International Bank for Reconstruction and Development) and International Financial Corporation. The World Bank grants loans for specific industrial projects of high priority and given either directly to an industrial concern or through a government agency. The International Finance Corporation, an affiliate of the World Bank, grants loans to industrial units for a period of 8 to 10 years. Such loans do not require government guarantee. As for the external commercial borrowings, their major sources has been the export credit agencies

like US Exim Bank, the Japanese Exim Bank, Export Credit and Guarantee Corporation of U.K. and other government and multilateral agencies. The external commercial borrowings are permitted by the government as an important source of finance for Indian firms for the expansion investments. 2. Foreign Investments: The foreign investments in our country are generally done in the form of foreign direct investment (FDI) or through foreign collaborations. The foreign direct investment usually refers to the subscription by the foreigners to shares and debentures of the Indian Companies. This is also known as portfolio investment and covers their subscription to ADRs, GDRs and FCCBs (Foreign Currency Convertible Bonds). Alternatively, some companies are formed with the specified purpose of operating in India or the multinationals can set up their subsidiary or branch in India. As for the foreign collaborations, these can be of financial collaborations involving foreign companies participation in equity capital of an existing or new undertaking. The technical collaborations are by way of supply of technical knowledge, patents and machineries. To start with, the technical collaborations had been the more popular form in the past. But during the post liberalization phase, shift from technical collaborations to financial collaborations is noticed in our country. It may be noted that the government has been very successful in attracting more foreign investment in the post liberalisation era. It is because the Government of India now permits automatic approval of foreign investment upto 51% equity in 34 industries and a special board (Foreign Investment Promotion Board) has been set up to process cases not covered by automatic approvals. The main advantage of foreign investment is that generally the foreign investor also brings with him the technical expertise and the modern machinery. The disadvantage, however, is that a large part of profits are transferred to the foreign investors. 3. Non-resident Indians (NRIs): The persons of Indian origin (PIO) living abroad commonly known as Non-Resident Indians (NRIs) constitute an important source of long-term finance for industries in India. The most common form of their contribution is in the form of deposits under Foreign Currency Non-Resident Account (FCNRA) and Non-Resident (External) Rupee Account (NRERA). However, like external borrowing, NRI deposits are high cost source of external finance and are fair weather friends. Hence, too much dependence on NRI deposits is not a right policy. It may be noted that they are also permitted to subscribe to the shares and debentures of the companies in India, and have the option of selling them and take back the amount. This constitutes an integral part of foreign direct investment. Ans 4: Sales 500 Cost of RM 200 Labour cost for manufacturing 100 EBIT - 200 Interest on borrowings 60 Profit available to equity shareholders 140 a) Total market value of firm = EBIT/Ko = 200/0.125 = 1600 b) Total market value of the debt of the firm = Interest/Kd = 60/0.10 = 600

c) Total market value of the equity of the firm = Ko-Kd = 1600-600 = 1000 d) Equity capitalization rate (Ke) = Profit available to equity shareholders/Total market value of equity = 140/1000 = 0.14 or 14%

5. A firm has sales of Rs 1000000. Variable cost is 70%, total cost is Rs 900000 & debt of Rs 500000 at 10% rate of interest. If tax rate is 40% calculate(a) Operating Leverage (b) Financial Leverage (c) Combined Leverage (d) If the firm wants to double up its earnings before interest & tax (EBIT), how much of a raise in sales would be needed on a percentage basis? Variable Cost = 70% of Sales = 70% of 1000000 = 7, 00,000 Fixed Cost = Total Cost Variable = 900000 700000 = 2, 00,000 EBIT = Sales Variable Cost Fixed Cost = 10, 00,000 7, 00,000 2, 00,000 = 1, 00,000 Interest = 10% of Debt = 10% of 5, 00,000 = 50,000 (a) Operating Leverage = Sales Variable Cost EBIT = 10, 00,000 7, 00,000 1, 00,000 = 3.0 (b) Financial Leverage = = 1, 00,000 1, 00,000 50, 000 =2 (c) Combined Leverage = Sales Variable Cost EBIT - Interest = 10, 00,000 7, 00,000 1, 00,000 50, 000 =6 (d) For EBIT to be Rs 2, 00,000. Following calculation required Sales 13, 33,333 Less: Variable Cost 9, 33,333 Less: Fixed Cost 2, 00,000 EBIT 2, 00,000 If EBIT increases by 100% the Sales increases by 33.33% Percentage increase in Sales = 3, 33,333*100 EBIT EBIT Interest

10, 00,000 = 33.33% 6. (a) ABC company Ltd is expected 10% return on total assets on Rs. 50 lakh. The company has outstanding shares 20000. The directors of the company have decided to pay 40% of earning as dividend. The rate of return required by shareholders is 12.5%. Rate of return expected on investment is 15%. You are required to determine the price of the share using Walters Model. Earnings of Company = 50, 00,000 * 10% = 5, 00,000 Earnings per share = Earnings/Number of outstanding share = 5, 00,000/20, 000 = Rs 25 per share Dividend per share = Earnings per share*40% = Rs 10 per share Price of the share using Walter ModelP = [D + (r/ke)*(E-D)]/ ke P = [10 + (0.15/.125)*(25 10)]/0.125 P = 28/0.125 P = Rs. 224 per share (b) The current market price of a share of X ltd is Rs 120 per share. The company is considering Rs 6.4 per share as dividend. The company belongs to a risk class for which the capitalization rate is 9.6%. Based on the M &M approach calculate the market price of the share of the company when the dividend is declared & not declared. What is your learning out of it? Market price of the share at the end of year 1 (with dividend) Po = [1/ (1 + ke)]*(D1 +P1) 120 = [1/ (1 + .096)]*(6.4 + P1) 120 = 5.84 + 0.91P1 P1 = Rs. 125.45 per share Market price of the share at the end of year 1 (without dividend) Po = [1/ (1 + ke)]*(D1 +P1) 120 = [1/ (1 + .096)]*(0 + P1) 120 = 0 + 0.91P1 P1 = Rs. 131.87 per share Learnings: The market price of the share at the end of year 1 will always be higher, if the company does not payout dividends.

Q7 Income Statement of Modern Electronic

Net Sales COGS

3060 -2338

GP Selling Admin Deprication Operating Income Non operating Surplus EBIT Interest EBT Tax@35% EAT Dividends Retained Earnings

722 -223 -179 -180 140 34 174 -36 138 -48.3 89.7 -24 65.7

b) Formula for estimating external financing need= Growth in sales*Total assets Growth in sales* CL- Net profit margin *new sales* dividend = 595.8