Case Study for Istisna

Scenario
M/s. ABC Garments Ltd. Was incorporated in 1980 and is a part of BCG Group. The client is engaged in the manufacturing of Men formal and casual wear They sell its finished product to local and international buyers on credit wear. basis. Their export sale constitutes of more than 50% of their sale The company has a strong banking relationship with MBL and the owners are interested in Islamic banking. As the customer usually sell its goods on credit basis so there is always a short term requirement of funds for working capital needs. The owners of the company have approached the bank and informed about their working capital requirements (to manufacture the goods for the order). The customer has informed the bank that it has very sound relationships with its customers and till to date there is no default in payment and provides list of credible customers. Related RMs decided to offer Istisna Financing to the customer

Statistics
Upon inquiry of the RM customer informed that it has a confirmed order in place for the supply of 4000 units of Men sports Outfit to Faysal Agencies at Rs. 1.11 Mn for which he has not yet started the production. Following additional information was also obtained by the RM to determine the nature of the Istisna facility to the customer:
Market Price fluctuation: 5%
Zip Hoodie Sweat Shirt Mens Number of Units: 1000 Cost price per unit: Rs.274 Sale price per unit : Rs.338 Gross Margin: 19% Mens Short Number of Units: Cost price per unit: Sale price per unit : Gross Margin: 1000 Rs.254 Rs.318 20%

Cost Cushion: 5%

Credit Sale Period: 30 days

Round Neck Sweat Shirt Boys Number of Units: 1000 Cost price per unit: Rs.240 Sale price per unit : Rs.293 Gross Margin: 18% Mens Pique Shirt Number of Units: Cost price per unit: Sale price per unit : Gross Margin: 1000 Rs.130 Rs.156 17%

Delivery Date: After 120 Days of Disbursement

Istisna Pricing
1. Since the customer has a average gross margin of 19% for the four outfit products, p , so the R.M decided to g give order to the customer to manufacture 1000 units each at the following prices:
Zip Hoodie Sweat Shirt Mens Cost Price for Istisna/Unit: Rs.260 Market Selling Price/Unit: Rs.338 Target Selling Price/Unit: Rs.321 Mens Short Cost Price for Istisna/Unit: Market Selling Price/Unit: Target Selling Price/Unit: Rs.242 Rs.318 Rs.302 Round Neck Sweat Shirt Boys Cost Price for Istisna/Unit: Rs.228 Market Selling Price/Unit: Rs.293 Target Selling Price/Unit: Rs.278 Mens Pique Shirt Cost Price for Istisna/Unit: Market Selling Price/Unit: Target Selling Price/Unit: Rs.123 Rs.156 Rs.148

2. Customer intimate that it will deliver the manufactured goods to Bank after 120 days and before shipment.

Istisna Pricing

3 These Purchase prices of Rs.260/unit, 3. Rs 260/unit Rs.228/unit, Rs 228/unit Rs.242/unit, Rs 242/unit Rs.123/unit Rs 123/unit also gives a 5% cost cushion to RM to sell the goods in the market and to recover its principal and profit in case the customer fails to sell the goods to the ultimate purchaser as an agent of MBL (With confirmed order in place this risk is mitigated to a huge extent) 4. After 30 days, customer delivers the goods to MBL and ownership is transferred to MBL.

Istisna Pricing
MBL SELLING PRICE: 1) MBL, after purchase of goods would ask the customer to sell the goods, as MBLs agent to the ultimate purchase as per the purchase order at Rs. 1,049,988 (5% less than the normal order price of Rs, 1,105,250) to mitigate the risk of price fluctuation in the market. As per the terms of the order MBL the agent would be required to bring the sale proceeds to MBL within 30 days of the execution of sale. MBL will give a fixed agency fee to its agent @ 1% of the MBLs selling price i.e Rs.11,053

2) 3)

Istisna Pricing
4) Incentive fee: {Incentive fee = MBLs sale p { price - Agency g y fee - MBL Purchase p price MBLs profit margin {(MBL Purchase price x profit/365

x No. of days) }

Financing Period of 150 days= Istisna Delivery Period + Credit Sale Period) Incentive Fee = MBLs Sale Price MBL Purchase Price Agency Fee (1,049,988) (853,221) (11,053) MBLs Profit Margin (52,596) Incentive Fee = 133,118

Istisna Process Flow

Credit Approval Stage After necessary y Credit and Shariah approvals, pp , MBL & ABC (Manufacturer) will enter into Master Istisna Agreement to manufacture goods from time to time on agreed terms and conditions. The customer and MBL will also enter into an Agency Agreement to sell/export the goods to credible buyers Customer will also sign an independent corporate guarantee for the creditworthiness of its customer by listing out their names. U Upon the th requirement i t of f the th facility f ilit the th customer t f i h a Written furnishes W itt Offer Off (Appendix A) mentioning complete description of goods (Men sports outfit), quantity (4000 Units), delivery date(after 120 days) and Istisna price (Rs. 853,221) etc along with copy of valid confirmed order.

Istisna Process Flow

Transaction Stage U Upon acceptance t of f the th offer ff MBL disburses di b th fund the f d into i t the th account t of f the customer. Customer delivers the goods on 120th day of the acceptance of Written offer. MBLs representative inspects the goods to ensure existence of goods, its proper identification & separation from the customers owned stocks (i.e. goods not sold).

Istisna Process Flow

A Goods Receiving g Note ( (Appendix pp B) ) will be executed at this moment by y the Bank representative & Customer to evidence the delivery of the Finished Goods-Mens Sports Outfit (4000 units) to MBL. The risks and rewards associated with the Goods will be transferred to MBL at this stage.

Agency Stage As per the Agency Agreement MBL appoints the customer as his agent to sell the goods at Rs. 1,049,988 (accounting for price fluctuation of 5%) and bring the sale proceeds in 30 days as per the confirmed order.

Istisna Process Flow

Agency Stage On the basis of financing model following agency fee and incentive fee was agreed via schedule 2 of Agency Agreement: Agency fee: Rs. 11,053 (1% of Minimum selling price)
Days from the date of N ti Notice 145 150 155

Incentive Fee (R ) (Rs.) 134,871 133,118 131,365

Istisna Process Flow

As an Agent, ABC will sell the goods to Faysal Agencies on credit basis of 30 days which will be evidenced via Confirmation of Sale of Finished Goods (Schedule 3 of the Agency Agreement). As per the payment terms, the buyer will pay the selling price to the Agent. After receiving the payment, the Agent will pass on the proceeds i.e. Rs.1,105,250 (net of applicable Agency & Incentive fee) to MBL on due date. If the customer makes the payment on due date the following will be the net cash flow out of this transaction:
Outflow PKR 853,221 Inflow PKR 1,049,988 Agency fee PKR 11,053 Incentive fee PKR 133,188 Net inflow PKR 7,777,397 Margin PKR 15%

Istisna Process Flow

Following table debits different scenarios of early and late payment by the customer (Customers incentive fee will be reduced/increased to account for his performance)
S. No. 0 145 150 155 Bank outflow (853,221) 1,049,988 1,049,988 1,049,988 11,053 11,053 11,053 134,871 133,118 131,365 7,761,786 7,777,397 7,792,808 50,843 52,596 54,349 Inflow Agency Incentive Net flow fee Profit

Appendixes for Istisna Agreement

APPENDIX A WRITTEN OFFER [Date] To: [Insert name and address of the Bank] Dear Sirs, (1) Written offer for manufacture of Goods [insert description]

We (the Manufacturer) are pleased to confirm our willingness to manufacture the Goods subject to the following terms and conditions: (a) Description of the Goods: -----------------------------------------------------------------------------------------------------------------------------------------------------------Detail of Goods and Istisna Cost Price (cost of manufacture): Quantity 5000 6900 7200 Per Unit Istisna Price 158 285 352 Total Istisna Price 5,000,158 1,966,500 2,534,400 Delivery Date 14 Feb 2011 14 Feb 2011 14 Feb 2011

(b) S.no 1 2 3

Specification of Goods 100% Cotton Flannel Dyed 100% Cotton Flannel Dyed 100% Cotton Flannel Dyed (c) Point of Delivery:

(2) (3)

We also attach the original and valid [Letter of Credit][Purchase Order] (if available). All terms and conditions (including the definitions) of the Master Istisna Agreement shall apply to this Written Offer.

IN WITNESS WHEREOF, the Manufacturer has executed and delivered this Written Offer as of the date mentioned hereinabove. hereinabove Yours faithfully, For and on Behalf of the Manufacturer ______________________ WITNESSES: 1. __________________________ Acceptance of the above Written Offer We, Meezan Bank Limited accept the Written Offer of the Manufacturer dated ___ on the terms and conditions contained in the Master Istisna Agreement. ______________________ For and on Behalf of Meezan Bank Limited Dated: ________________ 2. __________________________

APPENDIX B
GOODS RECEIVING NOTE (for ISTISNA Transactions) [Date] To: [Insert name and address of the Manufacturer] Dear Sirs, Master Istisna Agreement dated [______] (Agreement) Goods Receiving Note (1) We confirm having received the Goods contracted to be delivered by you as per the following details: ) Date of Receipt: p a) b) Time: c) Address: d) Description of Goods received: The quantity, quality, and other specifications of the Goods have not been ascertained. e) Specification of Goods received: cription ow Case le Fitted Sheet uble Fitted Sheet f) Qty (Units) 5000 6900 7200 Specification 100% Cotton Flannel Dyed 100% Cotton Flannel Dyed 100% Cotton Flannel Dyed Value in PKR (Per unit) 158 285 352

Goods identification Method:

g) Date of Physical Inspection:

NOTE: The specifications of the Goods must match with the specifications mentioned in the Written Offer i i.e. e Appendix A of the Master Istisna Agreement (This text box is not a part of the agreement.)

h) Additional remarks: This receipt of Goods is subject to the Goods being inspected and found in order and Meezan Bank Limited reserves its rights to claim any remedies under the law and in terms of the aforementioned Agreement from the Manufacturer if the Goods are found not to be in order and as per the specifications agreed upon. Meezan Bank Limiteds acceptance of the Goods hereunder does not amount to a waiver of any of its rights under the law and/or under the Agreement. Yours faithfully, ______________________________________ For and on Behalf of Meezan Bank Limited

Appendixes for Agency Agreement

SCHEDULE 1 (Agency Agreement)

[Date] To, [Agent] [Address] Attention: From: Notice (for ISTISNA Transactions)

[ [

] ]

Re: Authorization to Sell the Goods as Undisclosed Agent We refer to the Agency Agreement between [ ] and us dated [ ](Agency Agreement)

In pursuance of Clause 3 of the Agency Agreement, we hereby authorize you to sell the following Goods (Sale Goods) on our behalf as our undisclosed agent and following the sale of the Sale Goods collect and pay us the Sale Price immedietaly upon receipt of the Sale price. We hereby advise and authorize you to take possession of the Sale Goods from [Point of Delivery] on [ ] so as to be able to execute the sale contemplated by this Notice and the Agency Agreement. Your Agency Fee and Incentive Fee shall be as per attached Schedule 2 Minimum Target Selling Price (PKR / Unit) 158 285 352

Description Pillow Case Single Fitted Sheet Double Fitted Sheet Total Buyer (If identified)

Qty (Units) 5000 6900 7200

Specification 100% Cotton Flannel Dyed 100% Cotton Flannel Dyed 100% Cotton Flannel Dyed

NOTE: The specification and quantity of the Goods must match with the specifications mentioned in the Goods Receiving Note. (This text box is not a part of the agreement.)

Terms: Advance ____ days before sale (advance payment to be received after Notice) Advance ___ days before sale (advance payment already received before Notice) Spot (Cash) Credit ____ days from Sale Sale Price Payment Date (If identified): [ ]

Payment Instructions: [to be credited to our account [ ] with [ ] Without limiting the applicability of any other provision of the Agency Agreement or any of the other related transaction documents) the provisions of the Agency Agreement shall apply (mutatis mutandis) to this Notice as if the same were herein set out in full. In addition to the terms of the Agency Agreement, the above authorization to sell as our undisclosed agent is subject to the following conditions: Examples of conditions include: a. b. c.
Sale price below Rs. 40 per unit not allowed

(This text box is not a part of the agreement.)

IN WITNESSES WHEREOF, the Principal has executed and delivered this Notice as of the [*] day of [*] For and on behalf of ______________________________________ For and on Behalf of Meezan Bank Limited WITNESSES: 1. _____________________ 2. _____________________

Schedule 2 A Agency F Fee

1. Agency Fee Rs.11,053 2. Incentive Fee as per following Schedule:
Days from the date of Notice 15 30 45 60 Incentive Fee (Rs.) 129,612 122,599 117,339 112,080

Risk Mitigation
RISK MITIGANTS Price Fluctuation Risk: This risk was covered by y asking g the customer to sell the apparel at minimum value of Rs.95/kg as against market value of Rs. 100/kg. . Ultimate Buyer Risk: This risk is covered by asking the customer to list down its 4 creditworthy customer and provide a corporate guarantee for these customers. Delay Payment risk: This risk is covered by linking incentive fee with the timely payment of the customer which reduces on daily basis for late payments.