Topic 5 Theory Questions Submitted to Naveen Rego Faculty for Special Study for Finance Submitted by Students of TYBMS

Mulund ollege of ommerce Nira! Biyani Roll No" #$%$ Shilpa Shete Roll No" #$$$ oncept No" & lassification of Merchant Ban'ing Fees Based Merchant Ban'ing( These banks dont take Balance Sheet Position i.e. these are only a service provider or in other words these are channel between two or more parties that comply with each others requirements. Fund Based Merchant Ban'ing( These banks take Balance Sheet Position. They initially provide funds to the client from their own resources in exchange of securities Bonds! "ebentures! #quity...$ and thereafter sell the same to others. These banks function mostly when funds requirement by client is urgent.

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%ssues raising over &s. '(( crore are mandatorily required to go in for book building. Book building is an auction process where the lead manager invites bids from potential subscribers in a price range. They must mention the price at which they are willing to buy! and also what quantity they are willing to buy at a given price. The Book running )anagers do complicated calculations to announce an acceptable price. The pricing is done at the price where the last share is sold and all subscribers pay that amount though they may have bid a higher price. %nvestors who dont want to miss the bus but cant predict the

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issue price can bid at cut,off price. There is also a part earmarked for small shareholders in the book built portion and also a public issue for the retail investors later. %t is the prospect of a better valuation and getting a good price for its share offer to the public and eventually getting shares listed on the stock market that attracts companies to the book building process. #arlier! the normal route of issuing shares was to quote a fixed offer price and throw open the issue to the public to subscribe. %f the public liked the price! they lapped the issue up. %f they did not the issue would be under subscribed and chances were that the issuing company would not be able to garner money to finance its plans. The book building exercise is basically a new method of pricing initial public issues above &s.'(( crore. Thus according to S#B% guidelines! Smaller si-ed issues! are not allowed to take the route. They will have to take the conventional route! as mentioned. Book Building is of two types . /+0 book building '((0 book building %n the /+0 book building exercise! /+0 of the %P1 will be through book building and *+0 will be through a separate issue. That is after the company completes raising /+0 of the initial public issue through the book,building route! it will come out with a separate issue for the remaining *+0. 2ccording to S#B% rules at least '+0 and *+0 of the issue must be offered to the non,institutional investors and retail investors respectively. Boo' Building Route
The company first appoints lead manager for the issue. 3ead managers are basically merchant bankers! who evaluate the issue and based on this they decide the likely price that the company will be able to fetch for each share from the primary market. The lead managers thus manage and market the issue for the company. 4urther they may also act as underwriters to the issue or they appoint underwriters institutions as

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underwriters to the issue. The function of underwriters is to give an undertaking to the company to take up all the un,subscribed shares of the public issue. %n return for their services and the risk they take they get a percentage of the proceeds of the issue. 4urther the lead manager has also to see that all the shares offered for the public issue are subscribed to as he has an undertaking to buy out those shares! which remain un,subscribed. The company in consortium with the lead manager prepares the offer document for the issue and gets it approved from S#B% Securities and #xchange Board of %ndia$. 2ny modification made by S#B% has to be incorporated by the lead manager in the draft prospectus. 2fter making the modifications in the prospectus if any directed by S#B% the company invites applications from the public. The company has to place advertisements for the issue in not less than three newspapers vi-.! a national #nglish daily! a national 6indi daily and in the regional language daily of the city or town where its registered office is situated. The advertisement should mention the bid opening and closing date. Bidding shall be permitted only if an electronically linked transparent facility is used. 2ll the S#B% guidelines have to be adhered to in case of inviting bids. Bids are accepted up to a minimum of five working days. 4urther the bidding centres are not less than the collection centres. The main difference between the conventional route of %P1 and the book,building route is the pricing of the issue. %n case of the conventional issue the price was fixed by the issuing company and the lead manager and than applications were invited on the basis of this price. %n other words the applicants to the public issue were required to pay the fixed price mentioned in the prospectus for each share. 1n the other side in the case of book building! applications are invited on the basis of the likely price decided upon by the company and lead manager. This likely price is 7ust an estimate of the share price from the issue. The price of the share is not fixed. 8o upper limit or lower limit is set. 6owever one factor that has to considered is that the issue price for the placement portion and offer to the public has to be the same. The price of each share is decided upon the bids received.

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The price at which all the shares open for issue are subscribed is decided as the issue price. The net offer to the public is to be made post book building within a maximum period of '+ days. %n the case of under subscription in the :net offer to the public! spill over from the :placement portion will be permitted. This will be entitled to only those who have opted for this facility in the bid offer form. Preference will be given to individual investors. The vice,versa case is also permissible. The applicants who have bid less than the issue price will be refunded their application money within '+ days from the bid closing date. 2lso bidders who have bid above the issue price will be refunded the surplus application money within the same period. Bidders who have quoted the issue price or a higher price will be allotted shares within the specified period. 2llotment of securities offered to the public shall be made within 5( days of the closure of public issue. The company has to pay at '+0 per annum interest if the allotment letters ; refund orders have not been despatched to the applicants within 5( days from the date of the closure of the issue. %n case of over subscription! allotment to non,institutional investors will be made on pro,rata basis. 6owever! for institutional investors the allotment will be on discretionary basis.

4inally! after complying with all the above formalities shares are listed on the stock exchange. 2t this point the underwriter or lead manager puts in an order on the stock exchange to buy back any amount of shares at the allotment price. This order stays open for normally a week. The idea behind this requirement is to force the lead manager to disclose the right price and set a benchmark price at which there are no sellers. 0dvantages The book,building route is favoured as compared to the conventional fixed price route by companies as they can get a better price for their issues by highlighting their earnings estimate. 2 company has the opportunity to base its price on its expected valuations. 6ere it en7oys the chance of getting a better

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than expected price for its shares. The lead manager will also try to get a better price for the shares as his earnings will be based on the price of the shares. 2ll said and done the price of the issue will be based mainly on the assumption that the shares will be traded in the secondary market at a price higher than the allotment price of the issue. Thus if the company is doing well presently and offers a 7ustifiable price earning ratio at the likely price of the issue! the turnout of the issue will be successful. The investors will only subscribe to the shares! if they expect the price of the shares to rise in the future so they can get good returns. %nvestors who are ready to pay a higher price for the issue expecting a higher return in the future en7oy an advantage in the book,building route. 6ere the chances of their getting the required number of share allotment are more as compared to the fixed price route. %n the fixed price route! as all share applicants quote the same price for shares! the above stated shareholders receive only a pro rata allotment that is 7ust a proportion of the shares they have applied. 6owever for companies! which are going through a slowdown phase or have no valued background to count on! the book,building route could be risky. %t may in most cases result in lower than expected price for its public issue. Thus the book building %P1 route with the passage of time should become the most sought after route for companies! which can 7ustify their issue prices with proper valuations. 2lso this will be favourable for investors with good pricing power. 6owever! this leaves small investors at a disadvantage with limited pricing power.

B)+/1T )+T .20-S

%t is a process by which an investor usually the investment banker$ buys out a significant portion of the equity of an unlisted company with a view to make it public within an agreed time frame. %n a bought,out deal! a promoter off loads

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the security! which is to be issued to the public to raise finance! to a )ember of 1T=#%. The )ember takes up this equity at the price fixed after a thorough appraisal of the company. 6e then offloads the equity! at a convenient time! to the public through an :1ffer for Sale.

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2 private placement is a private sale of unregistered securities by a public company to a select group of individuals or institutions. %t is a type of offering exempted from registration that allows the issuing company to avoid registration requirements and save underwriting fees by offering company shares directly to institutional and accredited investors. Because the securities sold in a private placement are not registered! they cannot be re,sold into the public market until a registration statement has been filed and declared effective. To compensate for the inability to sell the securities immediately! private placement securities are often issued at a discount or are structured to provide the investors certain protections against decreases in the common stock price. The distinctive features of a private placement are> '. There is no need for a formal prospectus and an underwriting arrangement. *. The terms of the issue are negotiated between the company and the investor. %n the private placement market in %ndia! securities are sold mainly to institutional investors like ?T%! )utual 4unds! 3%=! etc. 2ll available instruments like equity shares! preference shares! convertible debentures! etc may be privately placed. Private placements are sometimes seen as negative because of the price that the company pays to obtain the capital. The biggest concern with private placements is dilution. This concern is basically that the financing will cause

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too many shares of the company to be sold into the market relative to the current number of issued and outstanding shares. Some transactions are structured so that the investor may convert and sell his shares at a discount to the future market price of the common stock. @ith these transactions! the theoretical dilution is enormous because the investor can convert no matter how much the stock price decreases in the future. 2nother important concern is discounting. )any private placement investments provide the investor with a discounting feature! to compensate it for the temporary illiquidity of the private placement securities. 6owever! some discounts are simply too large relative to the holding period of the investment! leaving shareholders to wonder why they are holding stock at current prices when the private placement investors are able to buy the stock at lower levels. Types Private Placement securities can take many forms. The most basic is a =ommon Stock placement that is sold at some set discount or premium to the market price at closing. This type of structure may also include warrants that let the private placement investor purchase more stock at a set premium price for a period of time. 2nother basic structure is the 4ixed =onvertible security either Preferred Stock or "ebt$. These securities yield a current return through interest or dividends and can be converted by the investors into shares of the companys common stock at a set price usually at some premium to the market price at closing$. Private Placements structured in either of these basic structures are usually considered a good sign for the public company. They convey that the private placement investors believe in the companyAs prospects for the long term and are willing to take on market risk with their investment. riteria to be satisfied Some of the important conditions that a company should satisfy in order to be acceptable to institutional investors are . '. The net worth of the company should be at least &s. ' crore.

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*. The interest cover should be at least two times! as per the latest balance sheet. 5. The asset cover should be at least '.*+. 9. The company should have paid dividends for at least two years in the preceding three years. +. %n the case of a listed company! the stock price should be above par for six months prior to the issue. ,N,T,0- 3+B-, )FF2R
2n initial public offering %P1$ is the process through which a company makes the transition from a privately held entity to a public company with stock traded on one of the ma7or stock exchanges. %t is a source of collecting money from the public for the first time in the market to fund for its pro7ects. Typically! a company going through an %P1 is young and relatively unknownC therefore %P1s generally are considered riskier investments. 6owever! established private companies occasionally decide to :go public in order to raise more capital. The issuing company i.e.! the company going public$ needs the assistance of an investment bank ,, referred to as the :underwriter ,, to price and market its stock offering. Banks compete for the issuing companyAs business during a process known as the :beauty contest in which they present their credentials to the companyAs board of directors and assess a preliminary valuation of the company. %f the issuing company is new and relatively unknown! the banks often make valuations based on the companys competitors. The issuing company generally chooses an investment bank based on its underwriting experience! particularly with %P1s in the same industry. 2nother consideration for the issuing company is the credibility of the investment bankAs research analyst! who issues reports on the company throughout the year. The issuing company can give its business to more than one underwriter! in which case the bank that manages the %P1 becomes known as the :lead underwriter and the group of banks participating in the deal are called the :syndicate.

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2 prospectus has to be duly prepared. The prospectus includes the companys financial history and growth strategy! the details of its offering! and information on company management. %t also outlines industry competition and other risk factors that investors would want to know in advance. %n essence! the prospectus provides all of the information investors need to know in order to decide whether to participate in the %P1. The preliminary prospectus is also known as a :red herring because of the red ink used on the front page! which indicates that some information ,, including the price and si-e of the offering ,, is sub7ect to change. 2n essential part of the issuing companys marketing campaign is the :road show! which is a multi,city tour during which the company pitches its business plan to potential investors! usually institutional investors such as mutual funds! endowments! or pension funds. 2t these meetings! the underwriter attempts to gauge the level of interest in the %P1! which helps lead to a decision on how to price the stock offering. "uring and after the road show! in a process known as :book,building! the lead underwriter surveys potential investors and notes the interest in the stock so it can price the %P1 accordingly. The issuing company and the lead underwriter meet to set the :offering price and the number of shares to be issued at the offering! based on the expected demand for the stock. 4or the investment bank! the ob7ective is to balance the companys desire to price the stock so as to raise as much money as possible and the investors interest in gaining some financial reward for taking on the risk of investing in a company with an unproven public track record. #ach bank in the syndicate receives a certain number of shares to allocate to its clients.

,3) Terminologies
onditional )ffer( 2n offer to purchase securities depending upon the effectiveness of a registration statement and the pricing of an %P1. .irect 3ublic )ffer( 1ffering of securities directly by an issuer without the assistance of any %nvestment Banking firm.

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Minimum Subscription( The minimum shares the company needs to get from the public out of the total issue by the date of closure. Presently a company needs to raise D(0 of the issued amountC else! the company shall refund the whole amount received. 3rospectus( The official offer document included in the registration statement filed with S#B% in con7unction with a public offer. The prospectus contains information about the offer of securities and should be given to the original purchasers no later than the written confirmation of their purchase. +nder5riter( 2n investment banking firm! which enters into a contract with the issuer of new securities to distribute them to the investing public.

Theory Questions a6 7 b6 Functions and Services of Merchant ban's( '. onsultancy services( 1ffers valuable consultancy services to their clients on financial! managerial! technical! marketing and many other problems. *. /overnment consent( 6elp their clients in completing lengthy legal formalities for securing government consent or license for setting up a new venture or for expansion or moderni-ation of business. 5. 3ro!ect planning and feasibility study( =ollect necessary information about the pro7ect and prepares pro7ect report with the help of their expert staff. 9. Raising financial resources( Prepare financial plans on behalf of their clients and conduct negotiations with financial institutions and get loans approved on

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favorable terms and conditions. 2lso in a position to raise foreign currency for importing machinery and technical know how. +. ,ssue management( )anages capital issues on behalf of their clients and provide finance to them. This includes preparation and issue of prospectus! appointment of bankers! underwriting arrangement! press publicity etc. <. 3ortfolio management( 1ffer advice to their clients on investment in government securities! trust or charitable institution. ?ndertake purchase and sale of securities and management of individual investment portfolio of investors. /. 0dvice on e8pansion programme( 2ssistance offered in framing and executing expansion and diversification programmes systematically. B. -oan syndication( 4oreign currency loans have to be arranged from %ndian financing agencies and ; or foreign financial institutions. )erchant bankers help in co coordinating above! drafting agreements etc. D. orporate restructuring( 1ffer professional expertise in identifying the buyers;sellers! handling the negotiations! processing the documents etc. when a company plans to acquire a new company or when a group wants to disinvest and sell one of the units. '(. Revival pac'ages for sic' units( Provide for rehabilitation of sick units. Participate in negotiation with B%4& and consortium meetings of banks and financial institutions. S#B% has laid down following authori-ed activities of )erchant bankers> %ssue management =orporate advisor

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?nderwriting Portfolio management Services )anagers! consultants or advisors. ''. Miscellaneous Services( 2rrange finance for working capital need of business units. 2rrangement of lease finance. 2ssistance in securing foreign collaborations. 6elp in framing capital structure and financial plan.

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&ecruitment! selection and placement of managerial and technical staff. c6 .iscuss the role of a merchant ban'er in the follo5ing( ,nstrument designing and pricing( 2 cardinal principle of corporate finance is to maintain a proper proportion between public issue and loan capital to increase the rate of return on capital employed. %t is always a wise step to help the quantum of share capital higher than the loaned funds. The debt,equity ratio has to be considered for this purpose for having a balanced mixture of owned;and loaned capital. #xpert advice should be obtained from the auditors;financial controller;legal advisers and stockbrokers of the company. The norms fixed for this purpose by the stock exchange;controller of capital issues should also be taken into account. The proportion of various types of funds has! therefore! be in optimum mix. Right issue 9 Bonus issue The merchants bank work would also relate to advice to the companies on any right issue or bonus issue. They may advice on the documents needed! si-e of bonus issues or right issues! the need for underwriting E the institutions to underwrite! the terms E other necessary actions with regard to the issues of rights E bonus shares. 3rivate placement @hen the financial institutions directly subscribe to the equity;preference shares E;or debentures issued by the company the company is said to have privately

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placed these securities with the financial institutions. This does not require either a prospectus or letter of offer. The company could! if it so desires! approach! in the place of financial institutions! a well identifiable body of persons like merchant banks for private placement. )erchant banks help these companies to privately place their securities. -ead manager9lead ban' 3ead managers;merchant bankers would be responsible for ensuring timely refunds and allotment of securities to the investors. Management of 3ublic ,ssues( Same as theory no. d d6 :hat are the pre;issues and post issue functions< 3re issue functions are as follo5s( %. apital Mi8 Structure( 2 cardinal principle of corporate finance is to maintain a proper proportion between public issue and loan capital to increase the rate of return on capital employed. %t is always a wise step to help the quantum of share capital higher than the loaned funds. The debt,equity ratio has to be considered for this purpose for having a balanced mixture of owned;and loaned capital. #xpert advice should be obtained from the auditors;financial controller;legal advisers and stockbrokers of the company. The norms fixed for this purpose by the stock exchange;controller of capital issues should also be taken into account. The proportion of various types of funds has! therefore! be in optimum mix. %%. .eciding about type of securities to be issued( There are various types of shares and debentures! which can be issued by a company. %t is therefore! prudent to decide at first as to what type of shares;debentures the company would like to issue with special reference to the )emorandum;and 2rticle of 2ssociation of the company. %%%. 3ermission of S2B,( 2t this stage! necessary permission for issue of capital;exemption etc. has to be obtained from S#B%.

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%F. 3reparation and ,ssue of 3rospectus( The Board of "irectors is to decide through passing of resolution as to whether the work relating to the preparation and issue of prospectus is to be entrusted to some officers of the company or the services of some professional firms are to be availed of. )uch will depend on the si-e and nature of public offer. F. 3rinting and publicity of 3rospectus( @hen the prospectus is properly drafted and approved! then arrangement should be made for printing of required copies of it by entrusting the 7ob to a reputed firm of printers. 2fter getting the required copies of the prospectus printed! announcement of the public offer should be made in the leading newspapers at least seven days before the opening of subscription list. F%. 0ppointment9negotiations 5ith +nder5riters9Bro'ers and Ban'ers( 4or getting the issue underwritten! necessary negotiations should be held with banks and other financial institutions. %n this connection the services of stockbrokers may also be obtained as they can underwrite a substantial sum. The parties with whom negotiations are to be made must be supplied with the copies of the printed prospectus and their comments are obtained. @hen the things are settled with the underwriters;brokers;and the bankers then necessary agreements should be executed in between the parties and their consent letters be kept on records. F%%. Receipt of 0pplication from the Ban'ers( The &egistrars to the issue or the company as the case may be! will arrange for the scrutiny and proper classification of the applications before making allotment. %n case of under subscription! full allotment can be made only after the underwriters have subscribed upto the remaining extent. %n case of over subscription! the basis has to be got approved from the stock exchange. F%%%. 0rrangement for issue of shares( 2fter completing the process of allotment of shares arrangement has to be made for the issue of share certificates to the concerned allottees. 3ost issue functions(

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%. Proper scrutiny and segregation of share applications received!

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%%. 4urnishing of necessary information to the concerned stock exchange s$ and obtaining permission for basis of allotment. %%%. )aking out a list to be submitted to board of "irectors for allotment purpose! %F. Preparing share certificates in the names of the allottees and obtaining the signature of the authori-ed signatories on the certificates! and F. "ispatching of shares certificates to the allottees and preparation of the register of members.

f6 .iscuss the regulatory frame5or' for merchant ban'ing< The following are the S#B% guidelines for merchant bankers . '. 2uthorisation 2ny person or body proposing to engage in the business of merchant banking would need authorisation by the Securities and #xchange Board of %ndia S#B%$ in their prescribed format. This will also apply to those presently engaged in merchant banking activity! including as managers! consultants! or advisers to issues. *. 2uthorised activities a$ %ssue of management! which will inter-alia consist of preparation of prospectus E other information relating to the issues! determining financing structure! tie,up of financiers E final allotment E;or refund of subscription b$ =orporate advisory services relating to the issue c$ ?nderwriting d$ Portfolio management services e$ )anagers! consultant or adviser in the issue 5. 2uthorisation criteria 2ll merchant bankers are expected to perform with high standards of integrity E fairness in all their dealings. 2 code of conduct for merchant bankers will be

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prescribed by S#B%. @ithin this context! S#B%s authorisation criteria would take into account mainly the following, a$ Professional competence b$ Personnel! their adequacy E quality! E other infrastructure c$ =apital adequacy d$ Past track record! experience! general reputation E fairness in all their transaction 9. Terms of authorisation a$ 2ll merchant bankers! including the existing ones! must obtained the authorisation from S#B% within three months from the issue of these guidelines.S#B% may extend this period at its discretion by a maximum of three more months . b$ 2ll merchant bankers must have a minimum net worth of &S ' crore c$ The authorisation will be for a initial period of 5 years d$ S#B% may collect from the merchant bankers an initial authorisation fee! an annual fee E a renewal fee e$ 2ll issues must be managed by atleast one authorised banker functioning as the sole or lead manager. 1rdinarily not more than two merchant bankers should be associated as lead managers! advisers or consultants to a public issue f$ The specific responsibilities of each lead manager must be submitted to S#B% prior to the issue g$ @hile directors! promoters E every person who authorises the issue of prospectus shall bear full responsibility for the contents of the prospectus! merchant banker shall exercise due diligence independently verifying the contents of prospectus E reasonableness of the views expressed therein h$ To ensure a direct stake of merchant bankers in the issue managed by them! lead managers would be required to accept a minimum +0 underwriting obligation in the issue! sub7ect to a ceiling . i$ 3ead managers;merchant bankers would be responsible for ensuring timely refunds and allotment of securities to the investors .

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7$ The involvement of the merchant banker in an issue should continue atleast till the completion of essential follow, up steps! which must include the listing of the instrument! E dispatch of certificates k$ The merchant banker shall make available to S#B% such information! documents! returns E reports as may be prescribed E called for. l$ S#B% shall prepare E prescribe a code of conduct for merchant bankers which they should adhere to m$ S#B% may suspend;cancel the authorisation of merchant bankers for a suitable duration in case of violations of the guidelines