SOURCES OF FINANCE

Chapter objectives
This chapter is intended to provide: An introduction to the different sources of finance available to management, both internal and external An overview of the advantages and disadvantages of the different sources of funds An understanding of the factors governing the choice between different sources of funds.

SOURCES OF FINANCE
A company might raise new funds from the following internal and external sources
Own Funds * Equity Capital * Preference Capital * Retained Earnings Promoters Contribution Subsidy/Capital Borrowed Funds Debentures & Bonds Term Loans from Financial Institutions & Banks Unsecured Loans Leasing & Venture Capital Financing Bridge Finance Debt Securitisation Trade Credit & Advances from Customers Various Forms of Bank Finance Export Financing : Pre-Shipment, PostShipment, Others OTHER SOURCES Inter Corporate Deposits (ICD) Public Deposits (PD) Certificate of Deposits Commercial Papers Seed Capital Assistance Deferred Payment Guarantee Deep Discount Bonds Other Financial Instruments Long Term

9. Foreign Currency Funds, ADR, GDR, Etc.

EQUITY SHARE CAPITAL Companies may raise finance by way of Equity or Ordinary Capital, subject to the regulations laid down in the Companies Act, SEBI Guidelines and other related laws. Ordinary shares are issued to the

owners of a company. They have a nominal or 'face' value and a market value. The market value of a share bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares.
1. Features: (a) Risk: Generally, Equity Shares are to be paid off only upon liquidation. So risk is the least. (b) Cost: Equity Shareholders are entitled to Net Residual Income, i.e. Profit after Tax and Preference Dividend, and their expectations are high. Therefore, the Cost of Equity Capital is high. (c) Control: Equity Shareholders are Owners of the Company, and have control over the management of the Company. Advantages: (a) Equity Capital provides a security (Equity Base) to other suppliers of funds. So, a Company with a high PaidUp Equity Capital can raise further funds from other sources easily. (b) It is a permanent source of finance. Generally, it is to be repaid only in the event of liquidation. (c) There are no committed payments to holders of Equity Shares. Dividends are discretionary and are not mandatory like Interest on Debentures. Disadvantages: (a) Cost of Equity Shares is high, and also Floatation Costs (Issue Expenses) are higher. (b) Dividends are not taxdeductible, and hence there is no extra attraction for the Company,to issue Equity Shares. (c) Investors find Equity Shares riskier due to uncertainty of dividends and capital gains. (d) Issue of new Equity Capital will reduce the EPS of existing Shareholders, unless profits are proportionately higher. (e) Issue of new Equity Capital reduces the ownership and control of existing Shareholders.

2.

3.

PREFERENCE SHARE CAPITAL

Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. Preference Shareholders enjoy priority or preference over Equity Shareholders, as
regards (1) Payment of dividend at a fixed rate, and (2) Repayment of Capital on the winding up of the Company.

In case of cumulative preference shares where the right to an unpaid dividend is carried forward to later years, the arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders.
1. Features: (a) Cumulative Option: Preference Shares may be issued as cumulative, i.e. the dividend payable in a year of loss gets carried over to subsequent years till there are adequate profits to pay the accumulated dividends. (b) Redeemability & Convertibility: Generally, Preference Shares carry a stipulation of repayment at the end of a time period. Sometimes, they may also carry the option of conversion into Equity Capital. (c) Preference Dividend: Preference Dividend Rate is normally higher than the rate of interest on debentures, loans, etc. This is an appropriation of profits and not a charge against profits (d) Hybrid Form of financing: Preference Capital has features of both Debt and Equity. It can be compared with Debt since the rate of dividend is fixed and the Capital is repayable at the end of period. It can also be likened to Equity because dividend is not tax-deductible. Advantages: (a) There is no dilution of EPS on the enlarged capital base. Issue of further Equity Capital will reduce the EPS, arc therefore affect market perception about the Company. (b) There is leveraging / gearing advantage as Preference Capital bears a fixed charge. (c) There is no risk of takeover or loss of control. (d) Preference Capital can be redeemed after a specified period. Disadvantages: (a) Preference Dividend is an appropriation of Profit, and is not deductible for tax purposes. (b) Arrears of Fixed Cumulative Dividend may create a burden on the Company, when Equity Dividend is declared.

2.

3.

Retained Earnings 1. It is a general practice of Companies to accumulate profits and plough them back into business. Such accumulated profits are called Retained Earnings. They belong-to the Equity Shareholders, and increase the Net Worth of the Company. 2. Enterprises must hold back or retain a reasonable amount of profit every year for their expansion plans, and other legal requirements in this regard. 3. Profitmaking Companies that undertake an expansion / diversification programme should invest a part of their accumulated reserves or cash profits for creation of capital assets. In other words, the surplus generated from operations, after meeting all the contractual, statutory and working requirements of funds, is available for further capital expenditure. This constitutes the Internal Fund Generation of the Company. 4. Retained Earnings entail almost no risk. There is no dilution of control in retaining profits.

Promoters Contribution 1. Forms: The Promoter / Enterpreneur is required to provide his funds as initial contribution for any new project. Some forms of Promoters Contribution are

2.

3.

(a) Subscription to Equity or Preference Share Capital, (b) Rights Issue, (c) Fully Convertible Debentures issued as rights to existing Shareholders, (d) Unsecured Loans, (e) Seed Capital Assistance, (f) Venture Capital Assistance, or (g) Internal Cash Accruals. Features: Promoters Contribution is the basic source of Equity Fund since their interest in the project and its success should be backed by monetary investment. A project without Promoters Contribution is no project at all. Margin: Banks and Financial Institutions insist on Promoters Contribution as Margin before granting debt assistance. The required margin limit may vary from 10% to 25% depending upon various factors. The lenders insist that the margin should be contributed in full at the initial stages of the project, before loan assistance is provided. Subsidy / Capital Incentives source of financing.

1.

2.

3.

4.

Types of Incentives: In order to promote balanced regional and economic development, special incentives are provided to units set up in backward areas. Such incentives may either be (a) lumpsum subsidy or (b) deferment of sales tax and octroi duty, etc. Conditions: These incentives are sanctioned by the implementing agency as a percentage of the fixed capital investment subject to an overall ceiling. It forms part of the long-term means of finance for the project. These are sanctioned and released to the units only after they have complied with the requirements of the relevant scheme. The requirements may be classified into - (a) Initial Effective Steps, and (b) Final Effective Steps, under the Scheme. Project Viability: The viability of the project must not be dependent on the quantum and availability of incentives. During project appraisal, the impact of special capital incentives should not be considered for analysing cash flows and profitability. Bridge Finance against Incentives: The release of Special Capital Incentives by the concerned State Government generally takes one to two years. Hence, Bridge Finance may be availed against the Capital incentives. However, the Bridge Finance may not be fully available to the entire extent of the subsidy. Therefore, the balance margin may have to be brought in by the promoters from their own resources.

1.

Debentures and Bonds (Long Term) Features: (a) Public Limited Companies can raise funds from public by issuing debentures or bonds, by complying with legal requirements in this regard. Debentures are issued on the basis of a Debenture Trust Deed that lays down the terms and conditions of issue. (b) Issue of Debentures is governed by Companies Act, SEBI Regulations, and related Laws. (c) Debentures are normally secured against the assets of the Company. (d) Interest Rate on debentures is lower, compared to Preference Dividend rate or Cost of Equity Capital. (e) Debentures can also be issued with new inventive schemes like warrants, options, convertibility, etc.

(f) 2.

3.

Credit Rating is compulsory for public issue of debentures or private placement to Mutual Funds. Advantages: (a) Cost of Debt Capital is lower when compared to Equity or Preference Capital. Thus Gearing or Leverage effect is advantageous for Companies with good ROCE. (b) Debenture financing does not result in dilution of control. (c) In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo decreases in real terms as the price level increases. Disadvantages of debenture financing are (a) Debenture Interest and Capital repayment are obligatory payments. Interest is payable even in case of insufficient profits for the year. (b) There may be restrictive covenants (conditions) in a Debenture Trust Deed. (c) Debenture financing increases the financial risk associated with the Firm.

Long Term Loans from Financial Institutions & Commercial Banks Institutions: Specialised Public Financial Institutions and Commercial Banks provide longterm financial assistance to industry, e.g. the Industrial Finance Corporation of India (IFCI), the State Financial Corporations (SFC), the National Small Industries Corporation Limited (NSIC), etc. 2. Project Analysis: The applicant has to satisfy the lending institution as regards feasibility of the project in the following aspects (a) Technical, (b) Commercial, (c) Economic, (d) Financial and (e) Managerial. 3. Loan Terms: The rates of interest charged by the institutions differ under various schemes. These Secured Loans are to be repaid according to a given repayment schedule. long term financing, Unsecured Loans are relevant, Discuss. 1. 2. Unsecured Loans constitute a significant part of longterm finance available to an enterprise. These loans come to the rescue of the enterprise, in case the financial institution does not sanction the required funds in full. For example, if a term loan of 50 Lakhs is applied for, but only 40 Lakhs is sanctioned, the balance of 10 Lakhs may be raised as Unsecured Loans. Unsecured Loans are generally provided by promoters to meet the Promoters Contribution norm. Such Unsecured Loans are considered as part of the equity for calculating debt equity ratio. These loans are subordinate to institutional loans. Hence (a) Rate of interest on these loans should be less than or equal to the rate of interest on institutional loans. (b) Interest can be paid only after payment of institutional dues. (c) Repayment of unsecured loans is possible only with prior approval of the financial institutions.

3.

4.

Write short notes on Lease Financing.

1.

2. 3.

Meaning: Leasing is a contract where one party (Owner/ Lessor / Leasing Company) purchases the assets and permits its use by another party (Lessee) over a specified period of time. Thus, leasing Is an alternative to the purchase of an asset out of own or borrowed funds. Consideration: The Lessee pays a specified rent (Lease Rental Charges) at periodical intervals as consideration for the use of the asset. This constitutes the Income of the Lessor. Types: Lease may be classified into (a) Financial Lease, and (b) Operating Lease. (See Question 13 below.) Some other types of Leases are (a) Sale and Leaseback, (b) Sales Aid Lease, (c) Leveraged Lease, and (d) Openended and Closed-end Lease. (Refer Questions 14 to 16 below)

13.

Differentiate between Financial Lease and Operating Lease. Finance Lease Operating Lease A lease is classified as an

Particulars

1. Meaning A Finance Lease is an arrangement to finance the Operating Lease if it use of equipment for a major part of its useful life, recovery of It is also called Capital Lease, as it is nothing but funds a loan in disguise. 2. Term Compared to an Operating Lease, a Financial shorter than the Lease is longerterm in nature. 3. Risks and Rewards ownership Risks and Rewards incident to ownership are use of the asset passed on to the Lessee. The Lessor only remains the legal owner of the asset. 4.Obsolescence Lessee bears the risk of obsolescence. Risk) incidental Lessor. 5.Right to Lessor is interested in his rentals and not in difficulty in leasing cancel the asset. He must get his principal back along willing Lessor, the with interest. So, the lease is generally Lessor. non-cancellable by either party. 6. Cost of repairs, Repairs, etc. 7.Full pay-out since the Lessor enters into the transaction only as Financier. He does not bear the cost of repairs, maintenance or operations. The lease is usually full pay-out, that is, the

does not secure for the Lessor the capital outlay plus a return on the invested, during the lease term. The term of Operating Lease is assets economic life. The Lessee is only provided the for a certain time. Risk incident to belong wholly to the Lessor. All risks (including Obsolescence to ownership belong wholly to the As the Lessor does not have the same asset to any other lease is kept cancellable by the

Usually, the Lessor bears cost of maintenance or operations. The lease is usually non-payout,

single lease repays the cost of the asset together asset over with interest thereon.

Lessor expects to lease the same and over again to several users.

14.

Explain the concepts of - (1) Sale and Lease Back, and (2) Sales Aid Lease.

1.

Sales and Lease Back: (a) Here, the owner of an asset sells the asset to a party (Buyer), who in turn leases back the same asset to the owner in consideration of Lease Rentals. So, the asset is not physically exchanged, but is transferred by way of Book Entries only. In this transaction, the Seller assumes the role of Lessee and the Buyer assumes the role of a Lessor. The Seller gets the agreed Selling Price and the Buyer gets the Lease Rentals. The main advantage is that the Lessee can satisfy himself completely regarding the quality of the asset, and after possession of the asset, convert the sale into a lease agreement.

(b)

(c)

2.

SalesAid Lease: (a) Under this lease contract, the Lessor enters into a tie up with a Manufacturer (of Equipments / Assets) for marketing the latters product through his own leasing operations, it is called a SalesAidLease. In consideration of the aid in sales, Manufacturers may grant either credit, or a commission to the Lessor. Thus, the Lessor earns from both sources, i.e. from the Lessee and the Manufacturer.

(b)

15.

Explain the concept of Leveraged Lease. N 07 1. Under a Leveraged Lease arrangement, the Lessor borrows a substantial portion of the purchase price of the Asset from a Lender, i.e. a Commercial Bank or a Financial Institution, with full recourse to the Lessee without recourse to the Lessor. The Lease Agreement provides for the Lease Rentals to the paid b by the Lease and creation of mortgage/charge on the asset, in favor of the Lessor. The transaction is routed through a Trustee who looks after the interest of the Lessor and the Lender. The Trustee receives the rentals from the Lessee and passes on to the Lender, and the surplus left after satisfying the claims of the Lender, goes to the Lessor. As owner of the asset, the Lessor is entitled to tax benefits by claim of Depreciation Allowance.

2.

3.

4.

5.

16.

Explain the concepts of ClosedEnd and OpenLease M 08 Open Ended Lease Closed End Lease
It is a agreement that puts no obligation on the

1. It is a lease agreement that gives an option to the Lessee, Lessee to to purchase the Leased Asset at the end of the agreement. agreement. 2. It is a variation of called as Finance Lease. Lease. 3. Lessee bears the risk that the asset may depreciate more than what was expected, at the end of the ease. Lessee gains if the asset depreciates less than expected.

purchase the Leased Asset at the end of the

It is also called as True Lease or Walkaway

Lessee need not worry about rate of depreciation of the Leased Asset.

Write short notes on Venture Capital Financing. 1.

RTP, N 02, M 05, N 07, N 08, M 09, M10

Meaning: Venture Capital Financing refers to financing of high risk ventures promoted by new, qualified entrepreneurs who require funds to give shape to their ideas. Here, a financier (called Venture Capitalist) invests in the Equity or Debt of an Enterpreneur (Promoter / Venture Capital Undertaking) who has a potentially successful business idea, but does not have the desired track record or financial backing. Generally, venture capital funding is associated with (a) heavy initial investment businesses, e.g. energy conservation, quality upgradation, or (b) sunrise sectors like information technology.

Venture Capital Company (VCC) Undertaking (VCU) Investor

Venture Capital Assistance

Venture Capital

Promoter / Enterpreneur

2.

Methods of Venture Capital Financing: (a) Equity Financing: VCUs generally require funds for a longer period but may not be able to provide returns to the investors during initial stages. Hence, Equity Share Capital financing is advantageous. The Investors contribution does not exceed 49% of the total Equity Capital of the VCU. Hence, the effective control and ownership remains with the entrepreneur. Conditional Loan: A Conditional Loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. The rate of royalty (say 2% to 15%) may be based on factors like (i) gestation period, (ii) cash flow patterns, (iii) extent of risk,, etc. Sometimes, the VCU has a choice of paying a high rate of interest (say 20%) instead of royalty on sales once the activity becomes commercially sound.

(b)

(c)

Income Note: It is a hybrid type of finance, which combines the features of both conventional loan & conditional loan. The VCU has to pay both interest and royalty on sales but at substantially low rates. Participating Debentures: Interest on such debentures is payable at three different rates based on the phase of operations (i) Startup and commissioning phase NIL Interest, (ii) Initial Operations Stage Low rate of interest, and (iii) After a particular level of operations High rate of interest.

(d)

18. What are the factors that a Venture Capitalist should consider before financing any risky project? 1. Expertise of Companys Management: The success of a new project is highly dependent on the quality of the VCUs management team. VCCs expect that the VCU / Promoter / Entrepreneur should have a skilled team of Managers. Managements are also required to show a high level of commitments to the project. Expertise in production: The Venture Capitalist should ensure that the Entrepreneur and his team should have necessary technical ability to be able to develop and produce new product/service. Nature of new product / service: The Venture Capitalist should consider whether the development and production of new product / service is technically feasible. They should employ experts in their respective fields to examine the idea proposed by the entrepreneur. Future Prospects: Since the degree of risk involved in investing in the VCU is quite fairly high, the Venture Capital should seek to ensure that the prospects for future profits compensate for the risk. Therefore, they should see a detailed business plan setting out the future business strategy. Competition: The Venture Capitalist should seek assurance that there is actually a market for the new product. Further, the Venture Capitalist should review the Market Research work carried out by the Entrepreneur. Risk borne by Entrepreneur: The Venture Capitalist is expected to see that the Entrepreneur bears a high degree of risk. This will assure them that the Entrepreneur has the sufficient level of the commitment to project as they themselves will have a lot of loss, should the project fail. Exit Route: The Venture Capitalist should try to establish a number of exit routes. These may include a sale of shares to the public, sale of shares to another business, or sale of share of original owners, etc. Board Membership: In case of Companies, to ensure proper protection of their investment, the Venture Capitalist should require a place on the Board of Directors. This will enable them to have their say on all significant matters affecting the business.

2.

3.

4.

5.

6.

7.

8.

19. 08

What do you mean by Bridge Finance?

M 03, M 06, N

1. Meaning: Bridge Finance refers to loans taken by a Company usually from commercial banks, for a short period, pending disbursement of loans sanctioned by financial institutions.

2.

Sanction: (a) When a Promoter or an enterprise approaches a financial institut for a longterm loan, there may be some normal time delays in project evaluation, administrative & procedural formalities and final sanction. Since the project commencement cannot be delayed, the Promoter may start his activities after receiving in principle approval from the term lending institution. To meet his temporary fund requirements for starting the project, the Promoter may arrange shortterm loans from Commercial Banks or from the term lending institution Itself. Such temporary finance, pending sanction of the long term loan, is called as Bridge Finance. This Bridge Finance may be used for (i) paying advance for factory land / machinery acquisition, (ii) purchase of equipments, etc.

(b)

(c)

(d)

(e)

3.

Terms: (a) (b) Interest: The interest rate on Bridge Finance is higher when compared to term loans. Repayment: These are repaid or adjusted out of the term loans as and when disbursed by the concerned institutions. Security: These are secured by hypothecating movable assets, personal guarantees & promissory notes. RTP, M 03, M 04, N 04, M 06, M 07, M

(c)

20 What do you understand by Debt Securitisation? 08, M 11 1. Securitisation: (a)

Secuiitisation is the process by which financial assts (e.g. Loan Receivables, Mortgage backed receivables, Credit Card balances, Hire Purchase Debtors, Trade Debtors, etc.) are transformed into securities. Securitisation is different from Factoring since the latter involves transfer of debts without transformation thereof into securities. Securitisation is a mode of financing, wherein securities are issued on the basis of a package of assets (called Asset Pool). In this method of recycling funds, assets generating steady cash flows are packaged together and against this asset pool, market securities can be issued.

(b)

2.

Securitication Process:

(a)

Initial Lending / Origination Function: Originator gives various Loans to different Borrowers (Obligors). Borrowers have to repay the loans in EMIs (Interest + Principal). These EMIs constitute financial assets / receivables for the Originator. Securitisatlon Function: Financial Assets / Receivables or defined rights therein, are transferred, fully or partly, by the Originator to a SPE. SPE pays the Originator immediately in cash or in any other consideration for taking over the financial assets. The assets transferred are termed Securitised Assets and the assets or rights retained by the Originator are called Retained Assets. Financing Function: SPE finances the assets transferred to it by issue of securities such as Pass Through Certificates (PTCs) and/or debt securities to Investors. These are generally sold to Investors (Mutual Funds, LIC, etc), through Merchant Bankers.

(b)

(c)

Note: Special Purpose Entity (SPE) may also be called Special Purpose Vehicle (SPY). 21. Outline the features of Securitisation. M 07 Servicing: The Originator may continue to service the securitised assets, i.e. collect amounts due from Borrowers, etc.), with or without servicing fee for the same. Sometimes, the Servicer may be an entity other than the Originator. Spread: The Originator usually keeps the spread available (i.e. difference) between yield from secured assets (interest received from Borrowers) and interest paid to Investors (of securities). This constitutes the Originators income. Forms: In a simple Pass Through Structure, the Investor owns a proportionate share of the asset pool and the cash flows when generated are passed on directly to the Investor. This is done by issuing Pass Through Certificates (PTCs). However, in mortgage or assetbacked bonds, the Investor has a lien on the underlying asset pool. The SPE accumulates collections from borrowers

1.

2.

3.

from time to time, and makes payments to Investors at regular predetermined intervals. The SPE can invest the funds received in short term instruments and improve its yield, when there is time lag between receipt and payment. 4. Future Receivables: The Originator may securitise or agree to securitise future receivables, i.e, receivables that are not existing at the time of agreement but which would be arising in future. In case of such securitisation, the future receivables are estimated at the time of entering into the transaction and the purchase consideration for the same is received by the Originator in advance. Revolving Period Securitisation: Future Receivables can be transferred, as and when they arise, or at specified intervals, the transfers being on prearranged terms. Recourse: The securitisation process is generally without recourse, i.e. the Investor bears the credit risk or risk of default, and the Issuer is under an obligation to pay to Investors, only if the cash flows are received by him from the Asset Pool. However, the Originator has a right to legal recourse against the Borrower in the event of default. CredIt Enhancement: It is an arrangement designed to protect the Investors (i.e. holders of the securities issued by an SPE) from losses and / or cash flow mismatches arising from shortfall or delays in collections from the securitised assets. The arrangement often involves one or more of the following (a) Cash Collateral: Deposit of cash which can be used by the SPE, in specified circumstances, fbr discharging its financial obligation on its securities held by the investors. Over Collaterisatlon: Assets in excess of the securitised assets are made available to the SPE, so that their realisation can be used to fund the shortfalls and / or mismatches in fulfilment of SPEs financial obligations. Recourse Obligation: Obligation accepted by the Originator of the Securitisation Process. Third Party Guarantee: Guarantee given by any Third Party, to meet any shortfall on the part of the SPE in meeting its financial obligations in respect of the securitisation transaction. Structuring of Instruments: Instruments issued by an SPE are structured into Senior Securities (issued to investors) and Subordinate Securities (issued to Originators). Payments on subordinated securities are due only after the amounts due on the senior securities are discharged.

5.

6.

7.

(b)

(c) (d)

(e)

Note: Credit Enhancement facility can be provided either by the Originator himself or by any Third Party.

22. List the advantages of Securitisation. M 09 To the Originator

07,

To the Investor

1. The assets are shifted off the Balance Sheet, thus giving the Originator recourse to 1. Securities are tied up to

offBalance Sheet funding. (Asset 2. It converts illiquid assets to liquid portfolio. 3. It facilitates better Balance Sheet management as assets are transferred off Balance investment avenues Sheet facilitating satisfaction of capital adequacy norms. 4. The Originators credit rating enhances.

definite assets

Pool). 2. New

are opened up.

23 Briefly describe Trade Credit, Accruals and Advances as sources of Short Term Finance. M 03 1. TRADE CREDIT: (a) Meaning: It represents credit granted by suppliers of goods, in the normal course of business. It is common to almost all business operations. Forms: It can be in the form of an Open Account, i.e. running / continuous account basis, or Bills Payable, i.e. billbybill settlement basis. Duration: The duration of such trade credit is based on various factors including prevailing practices, and is usually between 15 to 90 days. Advantages: There is no explicit cost associated with Credit Period availed. It is available and keeps on rotating as long as the business is a going concern.

(b)

(c)

(d)

2.

It enhances automatically with the increase in the volume of business. ACCRUED EXPENSES AND DEFERRED INCOME: (a) Accrued Expenses represent liabilities which a Firm has to pay for the services which it has already received. Such expenses arise out of the day-to-day activities of the Firm, and represent a spontaneous source of finance. (b) Deferred Income reflects the amount of funds received by a Firm in lieu of goods and services to be provided in the future. These receipts increase the Firms liquidity, and are also considered to be an important source of spontaneous finance. ADVANCES FROM CUSTOMERS: (a) When the goods are costly or when considerable time period is involved, it is usual business practice to obtain advance money from customers, e.g. Construction of a bridge / building, Manufacture of a specialised equipment involving heavy cost based on customers requirements (b) This is a cost-free source of finance and hence substantially useful.

3.

24.

What are the various forms of Bank Credit towards Working Capital needs of a Business? RTP Bank Credit towards Working Capital may be in the following forms 1. Cash Credit: This facility will be given by the Bank to the customer by giving certain amount of credit facility on continuous basis. The Borrower will not be allowed to exceed the limits sanctioned by the Bank. Cash Credit facility is generally granted against primary security of pledging of Stocks. 2. Bank Overdraft: It is a short-term borrowing facility made available to the Companies in case of urgent need of funds. Banks will impose limits on the amount lent. When the borrowed funds are no longer required, they can quickly and easily be repaid. Banks grant overdrafts with a right to call them in at short notice. 3. Bills Acceptance: To obtain finance under this type of arrangement, a Company draws a Bill of Exchange on the Bank. The Bank accepts the bill thereby promising to pay out the amount of the bill at some specified future date. 4. Line of Credit: Line of Credit is a commitment by a Bank to lend a certain amount of funds on demand specifying the maximum amount. 5. Letter of Credit: It is an arrangement by which the Issuing Bank on the instructions of a customer or on its own behalf undertakes to pay or accept or negotiate or authorizes another Bank to do so against stipulated documents subject to compliance with specified terms and conditions. 6. Bank Guarantees: Bank Guarantees may be provided by Commercial Banks on behalf of their clients / Borrowers in favour of third parties, who will be the beneficiaries of the guarantees. 25. What are various forms in which Short Term Finance can be obtained from Banks? M 10 GENERAL FEATURES OF BANK FINANCE (a) Bank Advances are in the form of Loan, Overdraft, Cash Credit and Bills Purchased / Discounted, etc. (b) The terms, conditions and norms for lending are based on the general policy guidelines laid down by the RBI and also by the schemes of the concerned Bank. (c) Advances are granted against securities which can be classified as Primary Security: Hypothecation of Stocks, Book Debts, Equitable Mortgage of Fixed Assets, Pro-notes, etc. Collateral Security: Equitable Mortgage of Land, Buildings or other property belonging to the Firm or its Promoters. Guarantees: Personal Guarantees of the concerned Promoters, Partners or Directors. 1. Loans: (a) It is a single advance, wherein the entire amount of loan is disbursed at one time by transfer to the current account of the borrower. (b) Interest and other charges like inspection, insurance, processing charges, etc. are charged to this account. (c) Repayment of installments by the borrower as per the agreed schedule is credited to this account. (d) Loan Accounts are not running accounts like Overdraft and Cash Credit accounts.

2.

Overdraft: (a) Under this facility, a fixed limit is granted within which the borrower is allowed to overdraw from his account, e.g. `10 Lakhs Credit. Technically, Overdrafts are repayable on demand, but they generally continue for longer periods by annual renewal of limits, and constitute Working Capital financing. The borrower can use and draw upto the extent of limit sanctioned, according to his requirements. Interest is charged on daily balances basis, on the actual amount of Overdraft used. These accounts are running or operative like Cash Credit and Current Accounts, and hence cheque books are provided to operate these accounts.

(b)

(c)

(d)

3.

Clean Overdrafts: (a) A Clean OD refers to an advance by way of overdraft facility, but not backed by any tangible security. Clean Advances may be given only to reputed and financially sound parties. The Bank has to rely upon the personal security of the Borrowers. Banks take guarantees from other related persons who are creditworthy, before granting this facility. Some factors considered by the Bank before granting Clean ODs are (i) Past operations of the party, (ii) Turnover / operations in the account, (iii) Satisfactory dealings for considerable period and (iv) Reputation in the market. A Clean Advance is generally granted for a short period and must not be continued for long.

(b)

(c)

(d)

4. Cash Credits: (a) It is an arrangement under which a customer is allowed an advance up to certain limit against credit granted by Bank, e.g. `25 Lakhs Cash Credit facility. Generally, Cash Credit limit are sanctioned against pledge or hypothecation of goods / stocks. The customer need not borrow the entire amount of advance at one time, he can only draw to the extent of his requirements and deposit surplus funds in his account. Interest is charged only on the amount actually availed of by the customer and not on the full amount. Technically, Cash Credit Advances are repayable on demand, but these are continued and also enhanced from time-to-time by the borrower and the bank as part of working capital financing. These accounts are running or operative accounts like Overdrafts and Current Accounts and hence cheque books are provided to operate these accounts.

(b)

(c)

(d)

5.

Advances against Goods: (a) Under this arrangement, the Bank grants advance as a percentage of value of goods offered as security. Goods includes all forms of movables which are offered to the Bank as security, including agricultural commodities, industrial rawmaterials, or partly finished goods. Generally, the goods are offered as security / charge to the Bank by way of pledge or hypothecation. For calculation of drawing limits, valuation of the goods Is made from time to time. The Bank also obtains periodical statements of stocks from the Borrower.

(b)

(c)

(d)

6.

Bills Purchased I Discounted:

(a) These advances are allowed against the security of bills, which may be clean or documentary. (b) This arrangement operates as under Borrower (Manufacturer) supplies goods to his customers and raises supply bills (invoices) on them, falling due for payment on a future date, e.g. 45 days credit. The Bank discounts supply bills (invoices) by paying the amount of the bill after deducting a margin /.reserve and discounting charges. For example, for a bill of `1,000, the Bank may advance ` 870 (`1,000 less 10% margin `100 less discounting charges 30). Upon collection of amount due from the customer (after 45 days), the Bank takes the full amount of the bill and credits the balance amount earlier withheld as margin. In the above case, the Bank may credit `92 (`100 margin less Charges `8). The difference between the amounts collected (`1,000) and the amounts credited (`870 + `92) represents earnings of the Bankers for the period. This item of income is called Discount.

(c)

Although the term Bills Purchased gives the impression that the Bank becomes the Owner or Purchaser of such bills, in actual practice, the Bank holds bills only as security for advance. The Borrower is ultimately liable on the advance, in case of default by the customer. The Bank, in addition to the rights against the parties liable, can also exercise a Pledgees rights over goods covered by the documents. Sometimes, Overdraft or Cash Credit limits may also be allowed against the security of bills, after maintaining a suitable margin. Here, the Bill is not a primary security but only a collateral security. In such case, the Banker does not become a party to the bill, but merely collects it as an agent for its customer.

(d)

7.

Advance against Documents of Title to goods:

(a) (b) (c)

A document becomes a document of title to goods when its possession is considered possession of goods itself and granted such recognition by law or business custom. A person in possession of a document to goods can enable another person to take delivery of the goods in his right, by endorsement or delivery (or both) of the document. Advance against the pledge of such documents is equivalent to an advance against the pledge of goods themselves.

8.

Advance against Bills on Government: (a) Banks may also provide advances against bills raised on Government or SemiGovernment Departments. Some types of bills are (i) Bills for supply of goods against firm orders after acceptance of tender, or (ii) Bills from contractors for work executed either wholly or partially under firm contracts. (b) Generally, these bills are accompanied by inspection notes from representatives of Government Agencies for having inspected the goods before they are despatched. If bills are without the inspection report, banks examine them with the accepted tender or contract, to verify that the goods supplied under the bills strictly conform to the terms and conditions. (c) These bills represent a debt in favour of suppliers/contractors, due from the Government Agency. This debt is assigned to the bank by endorsement of supply bills and executing a irrevocable Power of Attorney in favour of the banks for receiving the amount due from the Government Departments. The Power of Attorney has to be registered with the Government Department concerned. (d) The banks also take a separate letter from the suppliers/contractors instructing the Government Body to pay the amount of bills direct to the bank. (e) Supply Bills are not negotiable instruments because they are not Bills of Exchange. The security available to a Banker Is by way of assignment of debts represented by the Supply Bills. Term Loans by Banks: (a) Commercial Banks grant term loans for small projects falling under priority sector, small scale sector, etc. (b) Term Loans are granted after careful project analysis and evaluation of credit worthiness of the borrower. (c) The loan period is determined on a case-to-case basis, normally 3 to 7 years. The loans shall be repayable over a period of time in monthly / quarterly / half-yearly or yearly installments. (d) The loans are granted on the security of Fixed Assets, and other suitable collateral securities. Write short notes on pre-shipment finance for export, i.e. Packing Credit Facility.

9.

26.

1. Meaning: Packing Credit is an advance extended by Banks to an Exporter, for the purpose of buying, manufacturing, processing, packing and shipping goods to overseas buyers. 2. Applicability: (a) Packing Credit facility is offered on the basis of firm export order placed with the Exporter, by his foreign customer (buyer) or an irrevocable Letter of Credit (LC) opened in favour of the Exporter.

(b)

An advance so taken by an Exporter should be settled within 180 days, by negotiation of export bills or receipt of export proceeds in an approved manner. Thus, Packing Credit is essentially a shortterm advance.

3.

Types of Packing Credit: (a) Clean Packing Credit: There is no charge or control over Raw Materials or Finished Goods that constitute the supply. The Bank takes into consideration trade requirements, credit worthiness of exporter and its margin. The Bank should obtain Export Credit Guarantee Corporation (ECGC) Insurance Cover. (b) Packing Credit against hypothecation of goods: Goods which constitute the supply are hypothecated to the Bank as security, with the stipulated margin. The goods are exported by the Borrower. The Bank does not have any effective possession of the same. The Exporter has to submit Stock Statements at the time of sanction, and also periodically and / or whenever there is any movement in stocks. (c) Packing Credit against pledge of goods: Goods which constitute the supply are pledged to the Bank as security, with the stipulated margin. Goods shall be handed over to approved Clearing Agents, who ship the same from time to time as required by the Exporter. The effective possession of the goods so pledged lies with the Bank, and are kept under its lock and key. Formalities and Requirements: (a) ECGC Guarantee: Export Credit Guarantee Corporation (ECGC) guarantees the recovery of advance granted to an exporter, against payment of insurance premium. The Bank arranges for this insurance cover by recovering the same from the Exporter (Borrowers) account. (b) Forward Exchange Contract: If the export bill is drawn in a foreign currency, the exporter should enter into a forward exchange contract with the bank, thereby avoiding risk involved in fluctuations of exchange rates. (c) Documents: The documentary formalities specified by the Banker should be complied with.

4.

27. What are the various modes in which Post-Shipment Finance can be given for export trade? Post-Shipment Finance, i.e. after shipment of goods, can be in the following forms 1. Purchase / discounting of documentary export bills: (a) Just like discounting / purchasing of local supply bills, Banks provide finance to exporters by purchasing export bills drawn payable at sight or by discounting usance export bills. (b) The documents to be obtained in this regard are (i) Letter of Hypothecation covering the goods, and (ii) General guarantee of Directors or Partners of the Firm / Company, (iii) Documentary evidence for actual export like Export Bill, Packing List, Bill of Lading, Post Parcel Receipts, or Air Consignment Notes.

(c)

ECGC Guarantee must be obtained against risks by a contract shipment (comprehensive risks) policy covering both political and commercial risks. ECGCs liability is restricted to the credit limit fixed for the individual exporter irrespective of the policy amount.

2.

3.

Advance against export bills sent for collection: (a) Banks also provide advance to Exporters, against export bills forwarded through them for collection. (b) The evaluation factors include the creditworthiness of the party, nature of goods exported, usance, standing of drawee, margin, etc. (c) The documents to be obtained are: (i) Demand Promissory Note, (ii) Letter of Continuity, (iii) Letter of Hypothecation covering bills, (iv) General Guarantee of Directors or Partners. Advance against Duty Drawback, Cash Subsidy, etc. (a) Banks also provide advance against Duty Drawback, Cash Subsidy, etc. receivable by Exporters against export performance. Such advances are of clean nature hence necessary precaution should be-exercised. (b) It is insisted that the export bills are either negotiated or forwarded for collection through the Bank, so that the Bank Is in a position to verify the Exporters claims for Duty Drawback, Cash Subsidy, etc. An advance so availed of by an Exporter should be settled within 180 days from the date of shipment of the goods. The documents to be obtained are (i) Demand Promissory Note, (ii) Letter of Continuity, (iii) General Guarantee of Directors or Partners, (iv) Undertaking from the Borrowers that they will deposit the cheques / payments received from the appropriate authorities immediately with the Bank and not use them in any other manner.

(c)

(d)

28.

List the facilities extended by Banks to exporters, In addition to pro & post-shipment finance. 1. Letters of Credit: On behalf of approved exporters, Banks establish Letters of Credit on their overseas or up-country suppliers. Guarantees: Guarantees for waiver of excise duty, due performance of contracts, bond in lieu of cash security deposit, guarantees for advance payments, etc. are also issued by Banks to approved clients. Deferred Payment: Banks provide finance to approved clients undertaking exports On deferred payment terms. Credit Reports: Banks also try to secure for their exporter-customers, status reports of their buyers and trade information on various commodities through their correspondents. General Information: Banks may also provide economic intelligence on various counties, currencies, etc. to their exporter clients, on need basis.

2.

3.

4.

5.

3. SPECIAL ITEMS
29. 1. Write short notes on Inter Corporate Deposits & Public Deposits INTER CORPORATE DEPOSITS: (ICDs) (a) Companies can borrow funds for a short period, for example 6 months or Less, from other Companies which have surplus liquidity. Such deposits made by one Company in another are called Inter-Corporate Deposits ( and are subject to the provisions of the Companies Act, 1956. The rate of interest on lCDs varies depending upon the amount involved and time period.

(b)

(c)

2.

PUBLIC DEPOSITS: (a) (b) Public Deposits are a very important source for short-term and medium term finance. A Company can accept public deposits from members of the public and shareholders, subject to the stipulations laid down by RBI from time to time. The maximum amount that can be raised by Way of Public Deposits, maturity period, procedural compliance, etc. are laid down by RBI, from time to time. These deposits are unsecured loans and are used for working capital requirements. They should not be used for acquiring fixed assets since they are to be repaid within a period of 3 years.

(c)

(d)

30.

Write short notes on Certificate of Deposit (CD).

CD is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a Bank or other eligible Financial Institution for a specified time period. 1. Eligible issuers of CD: CDs can be issued by (a) Scheduled Commercial Banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs), and (b) select All-India Financial Institution that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Investors in CD: CDs can be issued to Individuals, Corporations, Companies, Trusts, Funds, Associations,, etc. Non Resident Indians (NRIs) may subscribe to CDs, but only on non-repatriable basis. Maturity Period: The maturity period shall be as under CDs issued by Banks: issue. CDs issued by FIs: Not less than 15 days and not more than one year from the date of

2.

3.

Not less than 1 year and not exceeding 3 years from the date of issue.

4.

Repayment: There will be no grace period for repayment of CDs. If the maturity date happens to be holiday, the issuing bank should make payment on the immediate preceding working day. Minimum Size of Issue and Denominations: Minimum amount of a CD should be `1 Lakh or multiples thereof. Minimum Deposit that could be accepted from a single subscriber should not be less than `1 Lakh. Fractions are not permitted. Aggregate Amount of CD: Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e, issue of CD together with Term Money Borrowings (TMB), Term Deposits (TD), Commercial Papers (CP) and Inter-Corporate Deposits should not exceed 100% of its Net Owned Funds, as per the latest audited Balance Sheet. Format of CDs: Issuance of CD will attract stamp duty. Banks / FIs should issue CDs only in dematerialised form. However, under the Depositories Act, 1996, investors have the option to seek certificate in physical form. Such requests should be reported to RBI separately. Transferability: Physical CDs are freely transferable by endorsement and delivery. Dematted CDs can be transferred as per the procedure applicable to other demat securities. There is no lockin period for CDs. Security Aspect: Physical CDs are freely transferable by endorsement and delivery. So, the CD certificates should be printed on good quality security paper, and necessary precautions are taken to guard against tampering with the document. The CD should be signed by two or more authorized signatories. Duplicate Certificates: In case of the loss of physical CD certificates, duplicate certificates can be issued after compliance of the following: (a) Public Notice in at least one local newspaper, (b) Lapse of a reasonable period (say 15 days) from the date of the notice in newspaper, and (c) Execution of an Indemnity Bond by the Investor to the satisfaction of the issuer of CD. Duplicate Certificate should state so and should only be issued in physical form. No fresh stamping is required. Discount / Coupon Rate: CDs may be issued at a discount on face value. Banks/FIs are also allowed to issue CDs on floating rate basis, provided the methodology of compiling the floating rate is objective, transparent and market based. The issuing bank/Fl is free to determine the discount / coupon rate. The Interest Rate on floating rate CDs would have to be re-set periodically in accordance with a pre-determined formula that indicates the spread over a transparent benchmark. Reserve Requirements: Banks have to maintain the appropriate reserve requirements, i.e. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), on the issue price of the CDs. Loans/Buybacks: Banks / FIs cannot grant loans against CDs. They cannot buy-back their own CDs before maturity. Payment of Certificate: Since CDs are transferable, the physical certificate may be presented for payment by the last holder and payment shall be made only by a crossed cheque. The holders of dematted CDs will claim the payment through their respective Depository Participants (DPs) and give transfer/delivery instructions to transfer the demat security. The holder should also communicate to the issuer by a letter/fax enclosing the copy of the delivery instruction it had given to its DP, and intimate the place at which the payment is requested to facilitate prompt payment.

5.

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

Accounting: Banks/FIs may account the Issue Price under the Head CDs issued and show it under Deposits. Accounting entries towards discount will be made as in the case of Cash Certificates. Banks/FIs should maintain a Register of CDs issued with complete particulars. Standardised Market Practices and Documentation: Fixed Income Money Market and Derivatives Association of India (FIMMDA) may prescribe, in consultation with the RBI, for operational flexibility and smooth functioning of CD market, any standardised procedure and documentation that are to be followed by the participants, in consonance with the international best practices. Reporting: Banks should include the amount of CDs in the fortnightly return u/s 42 of RB Act and also separately indicate the amount so included by way of a footnote in the return. A further fortnightly return is required to be submitted to the RBI within 10 days from the end of the fortnight date.

16.

17.

31.

Prabhat Co. has to make a payment of `20 Laths on 16th April. It has surplus money today (15th January) and the Company has decided to Invest in Certificate of Oeposit (CDs) of a leading Nationalised Bank at 8.00% p.a. What money is required to be Invested now? (1 year = 365 days)

Number of Days for CD=15th Jan to 16th April = 91 days. So, Interest Rate for 91 days= = 1.9945% Let Initial Investment be `M. Hence, amount received on maturity of CD is computed below Initial Investment ` M + Interest thereon at 1.9945% = M 1.9945%M = 101.9945%M Since the Company requires `20 lakhs on maturity, 101.9945% M = `20,00,000 So, Initial Investment M =
` 20, 00, 000 101.9945%

=`19,60,890.

Note: Interest calculations on CP and CD are on similar lines.

32. What do you understand by Commercial Paper? 07, M 08

RTP, N 03, M 05, M

Commercial Paper is a short- unsecured, usance promissory note issued by a Company, negotiable by endorsement and delivery, issued at a discount on face value, and redeemable at its face value. The difference between the initial investment and the maturity value, constitutes the income of the investor. Example: A Company issues a Commercial Paper each having maturity value of `5,00,000. The Investor pays (say) 4,82,850 at the time of his investment. On maturity, the Company pays `5,00,000 (maturity value or redemption value) to the Investor. The Commercial Paper is said to be issued at a discount of `5,00,000`4,82,850 = `17450. This constitutes the interest income of the investor.

33. List the RBl Guidelines in respect of issue of Commercial Paper 07, M 08

RTP, N 03, M 05, M

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. 1. Eligible Issuers of CP: (a) Corporates, (b) Primary Dealers (PDs), and (c) All-India Financial Institutions (FIs) that have been permitted to raise short-term resources under the umbrella limit fixed by RBI are eligible to issue CP. All-India Financial Institutions (FIs) mean those financial institutions which have been permitted specifically by the RBI to raise resources by way of Term Money, Term Deposits, Certificates of Deposit, Commercial Paper and Inter-Corporate Deposits, where applicable, within umbrella limit. Primary Dealer means a Non-Banking Financial Company (NBFC) which holds a valid letter of authorisation as a Primary Dealer issued by the RBI. Satellite Dealers are not eligible to issue CP, w.e.f 1-6-02.

2.

Investors for CP: CP may be issued to and held by (a) Individuals, (b) Banking Companies, (c) Other Corporate Bodies registered or incorporated in India, (d) Unincorporated Bodies, (e) NonResident Indians (NRIs), and (f) Foreign Institutional Investors (FIIs). Investment by FIIs should be within the limits set for their investments by SEBI. Maturity: CP can be issued for maturities between a minimum of 7 days and a maximum up to one year from the date of issue. Maturity Date of the CP should not go beyond the date up to which the credit rating of the issuer is valid. Denominations: CP can be issued in denominations of `5 Lakh or multiples thereof. Amount invested by a single investor should not be less than ` 5 Lakh (Face Value). Basic issue conditions for a Corporate: A Corporate would be eligible to issue CP provided (a) (b) (c) Its tangible Net Worth, as per the latest audited Balance Sheet, is not less than ` 4 Crores, It has been sanctioned Working Capital limit by Bank/s or all-India Financial Institution/s, Its borrowal account is classified as a Standard Asset by the Financing Bank/s/ Institution/s.

3.

5.

Note: Working Capital Limit means the aggregate limits, including those by way of purchase/discount of bills sanctioned by one or more Banks/FIs for meeting the working capital requirements. Tangible Net Worth = Paid Up Capital + Free Reserves + Share Premium Account + Capital Redemption Reserves + Debenture Redemption Reserves + Any other reserve not being created for repayment of any future liability or for depreciation in assets or for bad debts or reserve created by revaluation of assets Less: Accumulated Balance of Loss in P&L A/c Less: Deferred Revenue Expenditure Less: Intangible Assets

6.

Credit Rating: All eligible participants shall obtain the credit rating for issuance of CP from (a) (b) (c) (d) (e) Credit Rating Information Services of India Limited (CRISIL), or Investment Information and Credit Rating Agency of India Limited (ICRA), or Credit Analysis and Research Limited (CARE), or FITCH Ratings India Private Limited, or Such other credit rating agencies as may be specified by the RBI.

Minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. At the time of issuance of CP, the rating so obtained should be current and not fallen due for review.

7.

Amount of CP: (a) The aggregate amount of CP from an issuer shall be the least of - (a) limit as approved by its Board of Directors, or (b) quantum indicated by the Credit Rating Agency for the specified rating. An FI can issue CP within the overall umbrella limit fixed by the RBI, i.e. issue of CP together with Term Money Borrowings (TMB), Term Deposits (TD), Certificates of Deposit (CD) and Inter-Corporate Deposits (ICD) should not exceed 100% of its Net Owned Funds, as per the latest audited Balance Sheet.

(b)

8.

Time Period: The total amount of CP proposed to be issued should be raised within two weeks from the date on which the issue is open for subscription. Every CP issue shall be reported to the RBI, through the Issuing and Paying Agent (IPA) within three days from the date of completion of the issue. Mode of Issuance: The following points are relevant (a) CP can be issued either in the form of a promissory note (physical form) or in a dematerialised form (demat form). (FTs and PDS can invest I hold CPs only in demat form. CP will be issued at a discount to face value as may be determined by the issuer. No Issuer shall have the issue of CP underwritten or co-accepted.

9.

(b) (c) 10.

Issuing and Paying Agent (IPA): Only a Scheduled Bank can act as an WA for issuance of CP. Every Issuer must appoint an IPA for issuance of CP. Procedure for Issuance: The Issuer should disclose to the potential investors its financial position as per the standard market practice. After the exchange of deal confirmation between the Investor and the issuer, the Issuing Company shall issue physical certificates to the Investor, or arrange for crediting the CP to the Investors account with a depository. Investors shall be given a copy of IPA Certificate to the effect that the Issuer has a valid agreement with the IPA and documents are in order.

11.

12.

Mode of Investment in CP: The Investor in CP shall pay the discounted value (Issue Price) of the CP by means of a crossed account payee cheque to the account of the Issuer, through the IPA. Repayment of CP on maturity: On maturity of CP, when the CP is held in physical form, the holder of the CP shall present the instrument for payment to the Issuer, through the IPA. When the CP is held in demat form, the holder of the CP will get it redeemed through the depository and receive payment from the IPA. Defaults in CP market: In order to monitor defaults in redemption of CP, Scheduled Banks which act as IPAs, shall immediately report, on occurrence, full particulars of defaults in repayment of CPs to the RBI. Stand-by Facility: Non-Bank Entities including Corporates may provide unconditional and irrevocable guarantee for credit enhancement for CP issue provided (a) (b) the issuer fulfils the eligibility criteria prescribed for issuance of CP, the guarantor has a credit rating at least one notch higher than the issuer given by an approved credit rating agency, and the offer document for CP properly discloses the net worth of the guarantor Company, the names of the Companies to which the guarantor has issued similar guarantees, the extent of the guarantees offered by the guarantor Company, and the conditions under which the guarantee will be invoked.

13.

14.

15.

(c)

34. What are the advantages of Commercial Paper? 07, M 08 1. 2. SImplicity: Documentation involved in issue of Commercial Paper is simple and minimum.

Cash Flow Management: The Issuer Company can issue Commercial Paper with suitable maturity periods (not exceeding one year), tailored to match the cash flows of the Company. Alternative for bank finance: A well-rated Company can diversify its sources of finance from Banks, to short-term money markets, at relatively cheaper cost. Returns to Investors: CPs provide investors with higher returns than the banking system. Incentive for financial strength: Companies which raise funds through CP become well-known in the financial world for their strengths. They are placed in a more favourable position for raising long-term capital also. So, there is an inbuilt Incentive for Companies to remain financially strong. Prithvi Ltd. issued a CP as per the following details - (a) Date of Issue - 17th January, (b) Date of Maturity - 17th April, (c) Interest Rate - 11.25% p.a. What was the net amount received by the Company for every CP of `5,00,000? Number of Days for CP = 17th Jan to 17th April = 90 days. So, Interest for 90 days=
90 365

3. 4. 5.

35.

11.25%

= 2.774% Let Initial Investment be ` M. Hence, Maturity Value of every CP of `5,00,000 is computed

below

Initial Investment `M + Interest thereon at 2.774% = M 2.774%M = 102.774%M. Since the Face Value (i.e. Maturity Value) of each CP is `5 Lakhs, 102.774% M = `5,00,000 Hence, Initial Investment (Issue Price) = `M = 36.
` 5, 00, 000 102.774%

= `4,86,504

Agni Ltd Issued a CP at ` 4,80,30, for a maturity period of 91 days. What is the Annual Financing cost of this CP? Annual Financing Cost of CP =
Face Value - issue Price Math Issue Price 365 Maturity Period

Here, Face Value = ` 5,00,000 (basic), Issue Price = `4,80,300, Maturity Period = 91 days. Hence, Annual Financing Cost of CP = 37. 1.
5,00,000 - 4,80,300 365 = 0.1645 =16.45% 4,80,300 91

2.

3.

4. 5.

What do you understand by Seed Capital Assistance? RTP, M 05, N 08, M 10 Applicability: Seed Capital Assistance Scheme is designed by IDBI for professionally or technically qualified entrepreneurs and / or persons possessing relevant experience, skills and entrepreneurial traits. All the projects eligible for financial assistance from IDBI directly or indirectly through refinance are eligible under the scheme. Amount of Finance: The project cost should not exceed `2Crores. The maximum assistance under the scheme will be (a) 50% of the required Promoters Contribution, or (b) `15 Laths, whichever is lower. Interest and Charges: The assistance is initially interest- free, but carries a service charge of 1% p.a. for the first five years and at increasing rate thereafter. When the financial position and profitability is favourable, IDBI may charge interest at a suitable rate even during the currency of the loan. Repayment: Repayment Schedule is based on the repaying capacity of the unit. Initial Moratorium = Upto five years. Other Agencies: For projects with a Project Cost exceeding `2 Crores, Seed Capital may be obtained from the Risk Capital and Technology Corporation Limited (RCTC). For small projects costing upto `5 Lakhs, assistance under the National Equity Fund of the SIDBI may be availed. What do you understand by Deferred Payment Guarantee in case of Fixed Assets? Suppliers of Machinery may provide Deferred Credit Facility under which payment for the purchase of machinery can be made over a period of time. Sometimes, an initial down payment is made and the balance paid in suitable installments. In some other cases, the entire cost of the machinery is financed and the Company is not required to contribute any amount initially towards acquisition of the machinery. Normally, the Supplier of Machinery insists that a Bank Guarantee should be furnished by the Buyer. Deferred Payment Guarantee does not have a moratorium period for repayment. Hence, it is advisable only for an existing profit making Company. RTP, M 04, N 07, N 08,

38. 1. 2.

3. 4.

39. What do you mean by Deep Discount Bonds (DDBs)? N 09 1.

Deep Discount Bonds is a form of zero-interest bonds, which are sold at a discounted value (i.e. below par) and on maturity, the Face Value is paid to investors.

2.

For example, a Bond of a face value of `1 Lakh may be issued for ` 2,700 initially. The Investor pays ` 2,700 at first. He gets the maturity value of `1 Lakh at the end of the holding period, say 25 years. Sometimes, the Issuing Company may give options for redemption at periodical intervals say, after 5 years, 10 years, 15 years, 20 years, etc. There is no interest payment during the lock-in / holding period. These bonds can be traded in the market. Hence, the Investor can also sell the bonds in stock market and realise the difference between his Initial Investment and the Current Market Price. Write a brief note on some new financial instruments, in addition to DDBs and CPs. Secured Premium Notes (SPNs): Secured Premium Notes is issued along with a detachable warrant and is redeemable after a specified period, say 4 to 7 years. There is an option to convert the SPNs into Equity Shares, within the time period specified by the Company. (M 08) Zero interest Fully Convertible Debentures: (a) (b) These are fully-convertible debentures, which do not carry any interest. The Debentures are compulsorily and automatically converted after a specified period of time, and its holders are entitled to new Equity Shares of the Company at a pre-determined price. The Company is benefitted since no interest is to be paid on it. The Investor is benefited if the Market Price of the Companys Shares is very high, since he tends to get Equity Shares of the Company at an agreed lower rate.

3.

4.

40. 1.

2.

(c)

3.

Zero Coupon Bonds: Zero Coupon Bonds do not carry any interest. It is sold by the issuing Company at a discount. The difference between the discounted value and maturing or face value represents the interest to be earned by the investor on such bonds. It operates in the same manner as a DDB, but the lock-in period is comparatively less. (M 04) Double Option Bonds: (a) (b) (c) This Bond has two parts in the form of two separate certificates, one for principal say `5,000 and other for interest (including Redemption Premium) say `16,500. Both these certificates are listed on all major Stock Exchanges. The Investor has the facility of selling either one or both parts at anytime he wishes so. These Bonds were first issued by the IDBI, with Face Value ` 5,000, Interest at 15% p.a. compounded half-yearly, and Maturity Period of 10 years.

4.

5.

Option Bonds: These are cumulative and noncumulative bonds, where interest is payable on maturity or periodically. Redemption Premium is also offered to attract Investors. These were issued by PFIs like IDBI, ICICI, etc. Inflation Bonds: Inflation Bonds are bonds in which interest rate is adjusted for inflation. Thus, the Investor gets an interest free from the effects of inflation, For example, if the interest rate is 11% and the inflation is 3% the Investor will earn 14%, thereby the Investor is protected against inflation. Floating Rate Bonds: In this type of bond, the interest rate is not fixed and is allowed to float depending upon the market conditions. This is an instrument used by the issuing Companies to hedge themselves against the volatility in the interest rates. Financial Institutions like IDBI] ICICI, etc. have raised funds from these bonds.

6.

7.

(N 09) 41. What are the major sources of Foreign Currency

The major sources of Foreign Currency funds are 1. Commercial Banks: Commercial Banks extend foreign currency loans for international operations, just like Rupee Loans (Domestic Loans). Banks also provide facilities for overdraft. Development Banks: Development Banks (e.g. EXIM Bank) offer long and medium term loans including foreign currency loans. These are national level agencies and offer a number of concessions to foreign Companies to invest within their country and to finance exports from their countries. International Agencies: International agencies like International Finance Corporation (IFC), International Bank for Reconstruction & Development (IBRD), Asian Development Bank (ADB), International Monetary Fund (IMF), etc. provide indirect assistance for obtaining foreign currency. International Capital Markets: Savings of individual investors can be effectively tapped by issue of Shares or Debentures in the world market. International Capital Markets in Tokyo, London, Luxembourg, New York, etc. cater to the needs of MultiNational Corporations raise substantial sums from investors spread across the globe. In the International Market, the availability of foreign currency is ensured through (a) EuroCurrency Market, (b) Export Credit Facilities, (c) Bonds Issues and (d) Financial Instruments.

2.

3.

4.

42.

Explain briefly the features of External Commercial Borrowings. (ECB) M 08 External Commercial Borrowings (ECB) refer to Commercial Loans, which may be in the form of Bank Loans, Buyers Credit, Suppliers Credit, Securitised Instruments (e.g. Floating Rate Notes or Fixed Rate Bonds), availed from Non Resident Lenders, with minimum average maturity of 3 years. Borrowers can raise ECBs through Internationally recognised sources like (a) International Banks, (b) International Capital Markets, (c) Multilateral Financial Institutions e.g. ADB, (d) Export Credit Agencies, (e) Suppliers of Equipment, (f) Foreign Collaborators, and (g) Foreign Equity Holders. ECBs can be accessed through (a) Automatic Route (for Companies registered under the Companies Act, and NGOs engaged in micro-finance activities), or (b) Approval Route (i.e. after obtaining RBI / Government Approval).

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List out a few financial instruments in the international market.

N 08, M

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Euro Bonds: Euro Bonds are debt instruments denominated in a currency issued outside the country of that currency. Example: A Rupee Bond floated in France, a Yen Bond floated in Germany. Foreign Bonds: These are debt instruments denominated in a currency which is foreign to the borrower and is sold in the country of that currency. Example: A British Firm / Company placing Dollar denominated bonds in USA. Fully Hedged Bonds: In Foreign Bonds, the risk of currency fluctuations exists. Fully hedged Bonds eliminate the risk by selling the entire stream of principal and interest payments in forward markets. Floating Rate Notes: These are issued up to 7 years maturity. Interest rates are adjusted to reflect the prevailing exchange rates. They provide cheaper money than Foreign Loans. Euro Commercial Papers: ECPs are shortterm money market instruments with a maturity period of less than one year. They are usually designated in US Dollars. Foreign Currency Options: A Foreign Currency Option is the right to buy or sell, spot, future or forward, a specified foreign currency. It provides a hedge against financial and economic risks. Foreign Currency Futures: These are obligations to buy or sell a specified currency in the present, for settlement at a future date.

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What do you understand by Euro Issues? Explain the operation of Global Depository Receipts, American Depository Receipts, etc. M 06, M 08, N 10 Write short not on Global Depository Receipts and American Depository Receipts. RTP, M 03, M 04, M 07, M 09

In the Indian context, Euro Issue means that the issue is listed on a European / US Stock Exchange. The subscription can come from any part of the world, except India. Finance can be raised by (1) Global Depository Receipts (GDRs), (2) Foreign Currency Convertible Bonds (FCCBs), or (3) Pure Debt Bonds. GDRs and FCCBs are more popular. GDRs do not carry voting rights and hence there is no dilution of control. 1. Global Depository Receipts: (GDRs): (a) A Depository Receipt (DR) is basically a negotiable certificate, denominated in US Dollars that represents a nonUS Companys publicly traded local currency (say, Indian Rupee) Equity Shares. DRS are created when the local currency shares of an Indian Company are delivered to the depositorys local custodian bank, against which the Depository Bank issues DRs in US Dollars. These DRs may be freely traded in the overseas markets like any other dollar denominated security through either a foreign Stock Exchange or through Over The Counter (OTC) market or among a restricted group like Qualified Institutional Buyers (QIBs).

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GDR with Warrants are more attractive than plain GDRs due to additional value of attached warrants.

American Depository Receipts: (ADRs): Depository Receipts issued by a Company in the USA are known as ADRs. Such receipts have to be issued in accordance with the provisions stipulated by the Securities Exchange Commission (SEC) of the USA, which is a regulatory body like the SEBI in India. List a few types of international issues. RTP Foreign Euro Bonds: In domestic capital markets of various countries the Bond Issues referred above are known by different names, e.g. Yankee Bonds in US, Swiss Frances in Switzerland Samurai Bonds in Tokyo and Bulldogs in UK. Euro Convertible Bonds: It is a Euro-Bond, a debt instrument which gives the bondholders an option to convert them into a pre-determined number of Equity Shares of the Company. Usually the price of the Equity Shares at the time of conversion will have a premium element. These bonds carry a fixed rate of interest. These bonds may include a Call Option (where the issuer Company has the option of calling/buying the bonds for redemption prior to the maturity date) or a Put Option (which gives the holder the option to put / sell his bonds to the issuer Company at a pre-determined date and price). (RTP) Plain Euro Bonds: Plain Euro Bonds are mere Debt Instruments. These are not very attractive for an Investor who desires to have valuable additions to his investment. Euro Convertible Zero Bonds: These bonds are structured as a convertible bond. No interest is payable on the bonds. But conversion of bonds takes place on maturity at a predetermined price. Usually there is a five years maturity period and they are treated as a deferred equity issue. Euro Bonds with Equity Warrants: These bonds carry a coupon rate determined by market rates. The warrants are detachable. Pure bonds are traded at a discount. Fixed Income Funds may like to invest for the purposes of earning regular income / cash flow. Explain the concept of Indian Depository Receipts (IDRs) N 07 The concept of Depository Receipt Mechanism, which is used to raise funds in foreign currency has been applied i the Indian Capital Market through the issue of IDRs. Foreign Companies can issue IDRs, to raise funds from the Indian Capital Market, in the same way as Indian Companies uses ADRS / GDRs to raise foreign capital. IDRs are listed and traded in India, in the same manner as other Indian Securities.

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