management of financial services

UNIT - IDecision Support System : Overview, components and classification, steps in

constructing a dss, role in business, group decision support system.

UNIT - IIInformation system for strategic advantage, strategic role for information system,

breaking business barriers, reengineering business process, improving business

qualities.

UNIT - IIIInformation system analysis and design, information SDLC, hardware and software

acquisition, system testing, documentation and its tools, conversion methods.

UNIT - IVMarketing IS, Manufacturing IS, Accounting IS, Financial IS.

MBA–3rd SEMESTER, M.D.U., ROHTAK

SYLLABUS

External Marks : 70 Time : 3 hrs.

Internal Marks : 30

67

MANAGEMENT OF FINANCIAL SERVICES

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UNIT – I

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MANAGEMENT OF FINANCIAL SERVICESFINANCE : SPECIALIZATION PAPERS

Q. Define Financial Services. Explain its nature and scope.

Ans. Introduction : Financial services are an important component of the financial system.

There are four components of financial system.

Diagram : Financial System

Meaning of Financial Services : The term financial services is broadly understood to

include banking, insurance, housing finance, stock broking and investment services. The

services include fund-based as well as fee-based services. Financial services cater to the

needs of financial institutions, financial markets and financial instruments geared to serve

individual and institutional investors.

Financial institutions and financial markets facilitate functioning of the financial system

through financial instruments. In order to fulfil the tasks assigned, they required a number of

services of financial nature. Financial services are, therefore regarded as the fourth element

of the financial system. An orderly functioning of the financial system depends to a great deal

on the range of financial services extended by the provider, and their efficiency and

effectiveness.

Financial services not only to help to raise the required funds but also ensure their efficient

deployment. They assist in deciding the financial mix and extend their services up to the

stage of servicing of lenders. In order to ensure an efficient management of funds, services

such as:

FinancialServices

Financial Institutions

Financial System

Financial Market

FinancialInstruments

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ØBill Discounting

ØFactoring of Debtors

ØParking of short term funds in the money market

ØSecuritisation of debts

Sources of Financial Services :

(i) Stock Exchanges

(ii) Specialised and General Institutions

(iii) Non-Banking Finance Companies

(iv) Subsidiaries of financial Institutions

(v) Bank Insurance Companies.

Nature of Financial Services :

Financial services differ in nature from other services. Some of the salient features of

financial services are discussed as follows:

(1) Customer-Oriented : Financial services are customer-oriented. The providers of

such services study the needs on the customers in detail to suggest financial

strategies which give due regard to costs, liquidity and maturity considerations. The

providers of financial services remain in constant touch with the market. They design

both universal and firm-specific projects. This is due to the fact that the present day

firms happen to be different in terms of:

ØSize

ØLevel of Output

ØProfits and Labour force.

(2) Intangibility : Financial services are intangible in nature. Unless the institutions

supplying them have a good image and confidence of the clients, they may not

succeed. Thus, they have to focus on quality and innovativeness of their services to

build their credibility and gain the trust of clients.

(3) Inseparability : the functions of producing and supplying financial services have to be

performed simultaneously. This needs a perfect understanding between the financial

services firms and their clients.

(4) Perishability : Financial services like any other services cannot be stored. They have

to be supplied as required by customers. The providers of financial services have to

ensure a match between demand and supply.

(5) People Based Service : Marketing of financial services is people-intensive and

therefore subject to variability of performance or quality of service. The personnel in

financial services organizations need to be selected on the basis of their suitability.

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(6) Dynamism : Financial services have to be constantly redefined on the basis of socio-

economic changes such as disposable income, standard of living and educational

changes related to the various classes of customers. Financial services institutions

while evolving new services could be proactive in visualizing in advance what the

markets want, or reactive to the needs and wants of customers.

Scope or Constituents of Financial Services : Financial services comprise four major

constituents:

(1) Instruments : These includes:

(i) Equity Instruments

(ii) Debt Instruments

(iii) Hybrid Instruments

(iv) Exotic Instruments.

(2) Market Players : These includes:

(i) Banks

(ii) Financing Institutions

(iii) Mutual Funds

(iv) Merchant Bankers

(v) Stock Brokers

(vi) Consultants

(vii) Underwriters

(viii) Market Makers etc.

(3) Specialised Institutions : These include:

(i) Discount Houses

(ii) Credit Rating Agencies

(iii) Venture Capital Institutions etc.

(4) Regulatory Bodies : These includes

(i) Department of Banking and Insurance of the Central Government.

(ii) Reserve Bank of India

(iii) Securities and the Exchange Board of India (SEBI)

(iv) Board for Industrial and Financial Reconstruction (BIFR)

Q. Explain the Regulatory Framework for Financial Services.

Ans. Meaning of Financial Services : Financial services cater to the needs of financial

institutions, financial markets and financial instruments geared to serve individual and

institutional investors.

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Financial institutions and financial markets facilitate functioning of the financial system

through financial instruments. In order to fulfil the tasks assigned, they required a number of

services of financial nature. Financial services are, therefore regarded as the fourth element

of the financial system. An orderly functioning of the financial system depends to a great deal

on the range of financial services extended by the provider, and their efficiency and

effectiveness.

Different Level of Regulation on Financial Services :

Level I Government of India

Appellate Authority and Regulator in Certain Cases

Level II Legislation Passed in the Parliament

Banking Regulation Act,

Insurance Act,

Indian Trust Act, etc.

Level III Institutions Under an Act of Parliament

UTI Act,

LIC Act,

GIC Act, etc.

Level IV Regulators

RBI

SEBI

IRA

Level V Regulations Given by the Regulators

RBI Directions to Commercial Banks

NBFC's Directions issued by the RBI

SEBI Regulations, Guidelines, Notifications, etc.

Level VI Self - Regulation

By-laws, Rules and Regulation and Code of Conduct

Issued by the various Financial Service Industry

Associations.

Regulatory Framework : For the purpose of studying regulatory framework which govern

the financial services, we can divide the financial services in four different categories:

(A) Banking and Financing Services

(B) Insurance Services

(C) Investment Services

(D) Merchant Banking and other services

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Regulations on all these services are :

(A) Regulations on Banking And Financing Services :

(1) Banking Institutions : In order to develop a sound banking system in the

country, the RBI regulates the commercial banking institutions in the following

ways:

(i) It is the licensing authority to sanction the establishment of new bank or

new branch.

(ii) It prescribe the

ØMinimum capital,

ØReserves and use of profits and reserves

ØDistribution of dividends

ØMaintenance of minimum cash reserve

ØOther liquid assets

(iii) It has the authority to inspect or conduct investigation on the working of the

banks; and

(iv) It has the power to control the appointment of Chairman and Chief

Executive Officer of the private Banks and nominate members in the

Board of Directors.

(2) Non-Banking Financial Companies (NBFCs) : The Banking Laws Act, 1963

was introduced to regulate the NBFCs. The RBI which derives powers under this

Act regulates the NBFCs as follows:

(i) It requires the NBFCs of certain categories to register with it and provide

periodical statements on their working.

(ii) It prescribes the types of companies which are eligible to raise funds from

public and its members.

(iii) It also prescribes the extent to which the funds could be raised and the

terms and condition thereof.

(iv) NBFCs are also required to invest certain percentage of the deposits in

the approved securities and maintain reserve fund.

(v) It also collects periodic reports and has the powers to collect information

on any aspect relating to the functioning of the NBFCs , conduct

inspection of the books of NBFCs and investigate on any aspects relating

to the activities of the NBFCs.

(vi) Finally, it has the powers to imposing penalties or suspending or canceling

the license or registration.

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Major Directions:

The RBI has issued three major directions to regulate different forms of Non-Banking

Financial Companies and other financial institutions. They are:

(i) Non-Banking Financial Companies Directions, 1977

(ii) Miscellaneous Non-Banking Financial Companies Directions, 1977

(iii) Residuary Non-Banking Financial Companies Directions, 1977

(B) Regulations on Insurance Services : With an objective of reforming the insurance

sector and allowing private entrants, the Government of India had set up an interim

Insurance Regulation Authority (IRA) in January, 1996 and introduced the Insurance

Regulatory Authority Bill, 1996 in December, 1996 to give statutory status. The duties,

powers and functions of the IRA as per the Act are:

(i) To regulate, promote and ensure orderly growth of the insurance business.

(ii) To protect the interest of the policyholders in matter concerning assigning of

policy nomination by policyholders, insurance interest, settlement of insurance

claims, surrender value of the policy and other terms and conditions of contract

insurance.

(iii) To promote efficiency in the conduct of insurance business

(iv) To call for information from, undertake inspection and conduct enquires and

investigation including audit of the insurers, insurance intermediaries and other

organization connected with the insurance business.

(v) To regulate investment of funds by insurance companies.

(vi) To adjudicate disputes between insurers and intermediaries.

(C) Regulations on Investment Services : Investment services are primarily fund based

activities. The mutual funds and venture capital funds are directly fall under the

investment services. SEBI is emerging as a powerful regulator of various financial

services.

Securities and Exchange Board of India (SEBI) : The SEBI Act, 1992 entrusts the

responsibility of protecting the interest of investors in securities. They are:

(i) Regulating the business of stock exchange and any other securities markets.

(ii) Registering and regulating the working of stock brokers.

(iii) Registering and regulating the working of collective investment schemes

including mutual funds.

(iv) Promoting investors education and training of intermediaries of securities

markets.

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(v) Calling for information from, undertaking inspection, conducting inquires and

audit of stock exchanges.

(vi) Conducting research for the above purpose

(vii) Performing some other functions as may be required.

(D) Merchant Banking and Other Services : There are several intermediaries

associated with management of public and rights issue of capital. While the merchant

bankers is the main intermediary others associated with the issue management are

Underwriters, Brokers, Advisors and Credit Rating Agencies. The SEBI has issued a

detailed guideline/regulation on many of these intermediaries. They are:

(i) SEBI ( Merchant Banker) Regulation, 1992

(ii) SEBI Rules for Underwriters

(iii) SEBI ( Brokers and Sub-brokers) Regulation 1992

(iv) SEBI Rules for Registrar to an Issue and Share Transfer Agents, 1993

(v) SEBI (Debentures Trustees ) Regulations, 1993

Graphic Presentation of Regulation on Financial Services :

Regulation on Financial Services Financial Services

Banking and Insurance Investment and Merchant Bankers Financing Services Fee-based Services and Other ServicesServices

Banking Insurance Securities Contracts SEBI Regulations,Regulation Act, 1938 Act, 1956 1992Act, 1949 Companies Act, 1956

Indian Trust Act, 1882

Reserve Bank Insurance SEBI SEBI Rules forof India Regulatory Registrar

Authority And ShareTransfer Agents

Notification, Regulations, SEBI Regulations,Rules, Guildelines etc. 1994Directions, etc.

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Q. Explain the risk involved in Financial Services.

Ans. Meaning of Financial Services : The term financial services is broadly understood to

include banking, insurance, housing finance, stock broking and investment services.

Classification of Financial Services:- Financial services include fund-based as well as fee-

based services.

(i) Fund-based Services: In fund based services, the firm raises equity, debt and deposits

and invests in securities or lends to those who are in need of capital.

(ii) Fee-based Services: In fee-based services, the financial service firms enable other to

raise capital from the market.

The financial sector is also known for its dynamic character and within a short period, it has

introduced several new products and services. Though the sector is growing rapidly all over

the world, the financial markets have seen a number of bank and insurance companies

failure and market crashes. The industry is operating in an environment where the risk is

very high.

Trading in Risk : There are two types of risk involved in financial services:

(1) External Risk

(2) Internal Risk.

(1) External Risk : It could be due to changes in interest rate in the market that reduces

the value of existing financial claims. As these are events arising outside the company,

they can be grouped under external sources. The following are few external sources of

risk:

(i) Institutions Providing Direct Finance : There are different types of institutions

available in the financial market providing finance for various requirements.

There are many examples:

ØCommercial Banks normally provide finance for short term needs of the

firms.

ØTerm-lending institutions meet the long term funding needs of industries

which are commonly known as project financing.

ØHousing finance companies provide funds to individuals and some times

house-construction companies for acquisition of house property.

ØVenture capital provides funds in the form of equity to new projects which

involve some innovative ideas.

External Risk :

ØA bank may fail to honour the deposit claims of the deposit holders if the

non-performing assets of the bank are above its net worth.

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ØAnother important external reason for the failure of these institutions in the

business of lending is the quality of other assets in their total assets. If the

investment is made in high-risk debt or equity securities, any adverse

development in the capital market or the issuing company or agency will

reduce the value of the investments and in this process it may affect the

bank's ability to meet the liability.

(ii) Insurance Services : Insurance services take the risk associated with the

assets of their clients. The premium collected for this service in turn is either

invested in securities or led to outsiders who are in need of money.

External Risk :

ØAn insurance company may fail to honour its obligation if the investments

they have been made poor.

ØSimilarly, the quality of assets they have insured may also turn bad.

ØThere are two common problems in insurance services namely :

(a) Moral Hazard : Moral hazard is the tendency of an insured to take greater

risk because she/he is insured. For example, a machine owner may run

the machine continuously ignoring the normal shut-down requirement to

complete an order in less time. Without insurance, the owner may not turn

the unit ignoring the normal shut-down requirement.

(b) Adverse Selection : The adverse selection is the tendency of insuring

the low quality asset and not insuring high quality assets.

(iii) Stock Broking Services : Stock Brokers but and sell on behalf of their clients.

They collect the securities from the sellers and collect money from the buyer and

hand over the funds to seller after deducting the brokerage for the service

rendered.

External Risk : Though the activity looks relatively simple, the risk from external

sources are very high:

ØFirst, in situation where the trades are not guaranteed by the stock

exchanges.

ØThere is always a possibility that the client may fail to honour the

commitment but the broker has to make good the loss.

(iv) Leasing and Hire Purchase : Leasing and Hire Purchase service is very close

to the banking service. These companies also raise money from the market

through deposits and other means and lend to industries. Of course, the lending

is done not in the form of term loan or working capital loan, but in the form of

assets.

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External Risk : Leasing and hire purchase companies are also affected by the

frequent changes in the regulations. The recent Reserve Bank of India

regulation is expected to wipe out many of these companies from the market as

RBI has put rigid norms in raising deposits from the public.

(v) Institutions Offering Fee Based Services : Merchant Banking, Mutual Funds,

Credit Rating , Merger and Acquisition are few examples of fee based services

offered by the financial services companies.

External Risk :

ØThere are major changes in the regulation of merchant banking and

mutual funds which will effectively reduce the number of players in their

respective industry.

(2) Internal Risk : Financial Services Company often fails due to their own mistakes.

There are several internal factors that contribute to the failure of the firms in the

financial services industry. Some of these internal sources of risk for different financial

services companies are discussed below:

(i) Institutions Providing Direct Finance : Banks, term lending institutions and

other companies providing direct finance are exposed to several internal source

of risk.

Internal Risks :

ØFirst and foremost among them is the quality of evaluation of the loan

proposals. Often, the appraising officers fail to consider vital issues that

affect the outcome of the project.

ØThey are also affected by the asset-liability mismatch and excessive

dealing in the security market.

ØAnother important source of internal risk is the policy of the institution in

using derivatives in managing their risk. If the bank fails to use the

derivatives products in hedging the risk, its performance may be affected if

the market moves against the position the bank is holding.

(ii) Insurance Services : As in case of financial services companies which are in

the business of direct lending, insurance companies are also affected by the

efficiency in assessing the insurance proposal.

Internal Risk : Unless, the internal system of evaluating the insurance proposal

is efficient, the company will end up in insuring bad assets.

(iii) Stock Broking Service : Though the stock broking is a fee based service, there

are many sources of risk attributable to internal factors. Stock broking activity

typically involves

ØReceipt of the order from the clients

ØExecution of the order in the exchange

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ØReceipt of documents or cash from the clients and delivery of cash or

documents to the clients.

Internal Risk :

ØThere are many fake documents in the market

ØEven if the stocks delivered are good and genuine, there is no guarantee

that they are good for delivery.

ØMany Indian stock brokers have also trade on their account and their

proximity with the trading system does not guarantee profit. On several

occasions, many big brokers have incurred huge losses on their trading.

(iv) Leasing and Hire Purchase : The business of leasing and hire purchase is

highly competitive with too many players in the market.

Internal Risk :

ØFirst the credit rating information in India is relatively weak and published

accounts are not reliable to assess the credit worthiness of the borrowers.

ØSecondly, the competition in the industry allows very little time to take

decision on sanctioning the proposals, otherwise, the competitors will

take away your clients.

ØAnother internal problem is on the asset-liability mismatch.

(v) Institutions Offering Fee Based Services : Institutions offering specialized

services are exposed to several internal risks.

Internal Risk :

ØThe performance of mutual funds directly depends on the ability of the

fund managers in reading the market and making investments

accordingly.

ØOn the other hands, if they freely use the information to their own benefit, it

hurts the performance of the funds.

Types of Risk : In the previous section, the different source of risk for various financial

services firms have discussed. They could now broadly be classified under the following six

heads:

1. Credit Risk : Many of the financial services firms like banking, credit cards, lease and

hire purchase are also involved in fund based business. The credit risk affects the fund

based activities of the financial services. The risk arises in evaluating the proposals for

lending. While credit rating, either by credit rating institutions or internally helps to

quantify the risk, the percentage of non-performing assets measurers the impact of

credit risks in the firms.

2. Asset-Liability Gap Risk : This risk also applies to firms doing fund based services.

Since funds raised from external sources play a major role in the fund based activities,

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the duration of the liability is an important variable which needs to be considered while

lending. For example, if a firm gives a five year loan against a deposit for two years,

there is a mismatch between the liability and asset.

3. Due-Diligence Risk : Merchant banking companies and other financial services firms

which are offering fee based services like merger and acquisition have to exercise due

diligence in their operations. This due diligence may have to be provided to the

regulatory agencies or to their clients. For example, the SEBI regulation on Merchant

Banking requires the lead manager to provide a due diligence certificate in the

prescribed form before the public or rights issue opens for subscriptions. In the event

of any lapse or mistake noticed in the due diligence subsequently, it will affect the

financial services firm which has provided the due-diligence certificate in different

ways.

4. Interest Rate Risk : This risk affects the firms which are in fund based activities. The

interest rate risk arises when there are frequent changes in the interest rates in the

market.

5. Market Risk : Financial services firms which are in the investment business or

investing a part of the funds in securities are exposed to the market risk. This risk

arises on account of changes in the economy and all securities are affected.

6. Currency Risk : Firms which are dealing in foreign exchange currencies are exposed

to this source of risk. Bank, financial institutions and money changers are few financial

services firms which are normally affected by this source of risk. This risk arises

because of changes in the currency values which in turn was determined by the

fundamental economic strength of the two countries and short run demand and supply

gap. These firms are affected by currency risk when they hold currencies or liabilities

in the form of either forward contract or interest/principal payment.

(i) When the Rupee depreciates, it affects those who are holding foreign currency

liabilities.

(ii) When the Rupee appreciates, if affects those who are holding foreign currency.

Q. Explain how you can manage the risk involved in Financial Services.

Ans. Introduction : It may not be feasible to start any venture without taking risk. Risk is an

integral part of any business and the reward or profit is directly proportional to the risk

undertaken. In the case of financial services industry, the firms deals with financial claims

which are by nature risk products. We will now discuss different strategies available to

manage these risks:

Management of Risk :

(1) Managing Credit Risk : The first step in the process of managing the credit risk is the

quantification of credit risk the firm is exposed. The quantification is done through

credit rating. The firm can adopt the following strategy in managing the credit risk. The

steps involved in this strategy are:

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(i) Desirable Loan Portfolio : The starting point could be to develop a desirable

loan mix which consists of different categories of the borrowers.

(ii) Continuous Monitoring : This is more important in managing the credit risk.

This continuous monitoring requires flow of information from the borrowers and

also from the market and the firm has to develop necessary mechanism to

collect such information from the borrowers and the market intelligence system.

Since the performance of the borrowers deteriorate over a period, the

monitoring system in force should give early warning and thus assumes a

crucial role in the credit risk management.

(iii) Action on Doubtful and Bad Debts : The moment the monitoring system

raises some doubts about the loan account, action need to be initiated to

recover the loans. The steps are:

ØFirst things that need to be done is to check the assets, movable or

immovable, that are given as a security to avail the loan.

ØIf the asset value is found is to be inadequate, then demand is to be made

for additional security. Along with this process, it is also useful to offer a

good discount to motivate the borrowers to prepay the loan.

(2) Managing Asset-Liability Gap Risk : This risk also applies to firms doing fund based

services. Since funds raised from external sources play a major role in the fund based

activities, the duration of the liability is an important variable which needs to be

considered while lending. For example, if a firm gives a five year loan against a

deposit for two years, there is a mismatch between the liability and asset. The

techniques of management are:

Gap Management: The first job in the ALM is to measure gap. There are two

ways in which the gap can be measured. If the gap is measured at a macro level,

it has limited use. It given an idea about the level of risk involved in the firm. The

second method which is useful in ALM is to get a detailed break up of 'Gap'. The

gap has to be necessarily closed or managed.

(3) Managing Due-Diligence Risk : The professional efficiency and ethics followed by

the firm determine this source of risk. Since the financial services firm is giving a

certification to either the regulating agencies or its client on the completion of required

formalities, they are expected to perform efficiently with thigh ethical standards. This

risk could be managed by bringing in more professional an creating right environment

within the organization.

(4) Managing Interest Rate Risk : Interest rates in the economy play a major role in the

financial markets. For managing interest rate risk interest rate swap is adopted.

Interest Rate Swap : Interest rate swap involves the exchange of interest payments.

It usually occurs when a person or a firm needs fixed rate funds but is only able to get

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floating rate funds. It finds another party who needs any floating rate loan but is able to

get fixed rate funds. The two, known as counter parties, exchange the interest

payments and the loans according to their own choice. It is the swap dealer, usually a

bank, that brings together the two counter-parties for the swap.

(5) Managing Market Risk : This is the minimum risk that investors in the market are

exposed. Firms which are investing in the securities have to manage the market risk.

There are several ways through which the market risk is managed. Some firms take a

view on the market and switch over the funds from one market to another in order to

minimize the risk.

(6) Managing Currency Risk : Firms dealing in foreign exchange are exposed to

currency risk. Non-banking entities, such as traders, that use the foreign exchange

market for the purpose of hedging their foreign exchange exposure on account of

changes in the exchange rate. They are known as hedgers.

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UNIT – II


Q. Explain the Operations of Indian Stock Market.

Ans. Meaning of Stock Exchange : Stock exchange means an organized market where

securities issued by companies, government organizations and semi-organizations are sold

and purchased. Securities include:

(i) Shares

(ii) Debentures

(iii) Bonds etc.

Definition of Stock Exchange :

According to Pyle :

“Stock Exchange are market places where securities that have been listed thereon,

may be bought and sold for either investment or speculation.”

Features of Stock Exchange : The main features of stock exchange are as follows:

(1) Organised Market : Stock Exchange is an organized market. Every stock exchange

has a management committee, which has all the rights related to management and

control of exchange. All the transactions taking place in the stock exchange are done

as per the prescribed procedure under the guidance of management committee.

(2) Dealing in Securities issued by various concerns : Only those securities are

traded in the stock exchanges which are listed there. After fulfilling certain terms and

conditions, a company gets it security listed on stock exchange.

(3) Dealing only through Authorized Members : Investors can sale and purchase

securities in stock exchange only through authorized members. Stock exchange is a

specified market place where only the authorized members can go. Investor has to

take their help to sale and purchase.

(4) Necessary to obey the Rules and Bye-Laws : While transacting in stock exchange,

it is necessary to obey the rules and bye-laws determined by stock exchange.

Functions of Stock Exchange : The main functions performed b stock exchange are as

follows:

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(1) Providing Liquidity and Marketability to existing securities : Stock exchange is a

market place where previously issued securities are traded. Various types of

securities are traded here on regular basis. Whenever required, investor can invest his

money through this market into securities and can reconvert this investment into cash.

(2) Pricing of Securities : A stock exchange provides platform to deal in securities. The

forces of demand and supply work freely in the stock exchange. In this way, prices of

securities are determined.

(3) Safety of Transactions : Stock exchanges are organized markets. The fully protect

the interest of investors. Each stock exchange has its own laws and be-laws. Each

member of stock exchange has to follow them and any member found violating them,

his membership is cancelled.

(4) Contributes to Economic Growth : Stock exchange provides liquidity to securities.

This gives the investor a double benefit-first, the benefit of the change in the market

price of securities and secondly, n case of need for money they can be sold at the

existing market price at any time.

(5) Spreading Equity Cult : Share market collects every types of information in respect

of the listed companies. Generally this information is published or otherwise n case of

need anybody can get it from the stock exchange free of any cost. In this way, the stock

exchange guides the investors by providing various types of information.]

(6) Providing Scope for Speculation : When securities are purchased with a view to

getting profit as a result of change in their market price, it s called speculation. It is

allowed or permitted under the provisions of the relevant Act. It is accepted that in

order to provide liquidity to securities, some scope for speculation must be allowed.

The share market provides this facility.

Stock Exchange in India : There are 24 stock exchanges functioning currently in India. The

names are given below:

1. Mumbai Stock Exchange OR 12. Bhubaneswar Stock Exchange

Bombay Stock Exchange-BSE 13. Cochin Stock Exchange

2 National Stock Exchange (NSE) 14. Coimbatore Stock Exchange

3. Over the Counter Exchange o 15. Guwahati Stock Exchange

India (OTCEI) 16. Jaipur Stock Exchange

4. Calcutta Stock Exchange(CSE) 17. Kanpur Stock Exchange

5. Delhi Stock Exchange (DSE) 18. Ludhiana Stock Exchange

6. Chennai Stock Exchange 19. Mangalore Stock Exchange

7. Ahmedabad Stock Exchange 20. Meerut Stock Exchange

8. Hyderabad Stock Exchange 21. Patna Stock Exchange

9. Bangalore Stock Exchange 22. Pune Stock Exchange

10. Indore Stock Exchange 23. Rajkot Stock Exchange

11. Baroda Stock Exchange 24. Capital Stock Exchange Kerala Ltd.

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Q. What are the main features of NSEI? Explain the trading process of NSEI

Ans. National Stock Exchange of India (NSEI) : The NSEI has been established in the form of a traditional competitor stock exchange. It is an exchange where business is carried on in the securities of the medium & large-sized companies & the government securities. This stock exchange is fully computerized.

The NSEI was established in the form of a public limited company in Nov., 1992. Its promoters are like this:

(i) The Industrial Development Bank of India (IDBI).

(ii) The Industrial Finance Corporation of India (IFCI).

(iii) The Industrial Credit & Investment Corporation of India (ICICI).

(iv) The Life Insurance Corporation of India (LIC).

(v) The General Insurance Corporation of India (GIC).

(vi) The SBI Capital Market Limited.

(vii) The Stock Holding Corporation of India Ltd.

(viii) The Infrastructure Leasing & Financial Services Ltd.

Features or Nature of NSEI : The Chief features of the NSEI are following:

1) Model Exchange : The NSEI is the first stock exchange of its kind. The system of transaction of securities is very efficient and transparent. It is, therefore called a model exchange.

2) Floorless : In the NSEI there is no special importance of trading. The terminals of the NSEI have been established almost throughout the country.

3) Two Segments : On the basis of the transactions of securities done on the NSEI, it can be divided into two parts:

(i) Wholesale Debt Market (WDM): This can be called money market segment. It mai9nly concerns the government securities, bonds of public sector undertakings, treasury bills, commercial papers, certificates of deposits, etc.

(ii) Capital Market Segment: Its concern is with the shares and debentures of companies.

4) Easy Access : It being a special floorless stock exchange, every big and small investor can easily approach it.

5) Transparency in Transactions : Anybody can visit the local terminal of the NSEI and have a look at various transactions of the securities. Therefore is no possibility of any fraud in transactions.

6) Competition : The NSEI has removed the shortcomings of the traditional share markets and it has attempted to provide better facilities to the investors. That’s why the remaining share markets are nervous at its success. Now, they are also trying to provide good facilitate to the investors. In this way, there is a competition between two kinds of share markets. The investors are getting the benefits of this competition.

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7) Same Price : Under the traditional system, the shares of a company could have

different rates in different share markets but at the NSEI all the shares have the same

value in all the towns.

8) Listing of other Stock Exchange : The securities of those companies which have not

been listed on other share markets can be traded on the NSEI.

9) Undisclosed Identity of Participants : Information about any individual trading on

any terminal of the NSEI cannot be passed on to any other person. In this way, the

secrecy about the identity of the investors is maintained.

10) Order Driven System : The NSEI is a stock exchange based on the order driven

system. It means that the sellers and buyers first place the order about the type of

security, its number, rate and time when they are ready to buy or sell them. On the

receipt of this order on the computer, the process of order matching starts. The

moment a good matching takes place, its information appears on the computer

screen.

Purposes of NSEI :

The chief aims of the establishment of the NSEI are the following:

1) Single Stock Exchange at National Level : It was decided by a Shri M.J. Pherwani

that there should be a single stock exchange at the National level so that the

confidence of the investors in the capital market increases.

2) Increasing Numbers of Transactions : For the last few decades, there has been an

increase in the numbers of investors while the stock exchange system continues to be

old. In such a situation the transactions cannot be settled easily. The purpose of the

establishment of the NSEI is to solve this problem.

3) Increasing Transaction Costs : The transaction costs increase because of the

distance between the stock exchange and the investors. Through the medium of

NSEI, an effort bas been made to reduce these costs.

4) Decreasing Liquidity : There is a decline in the liquidity of the securities under the

system of local stock exchange because the people doing transaction on a single

stock exchange are limited in number. On the contrary, through the medium of NSEI

the investors from the entire country can trade simultaneously at a single stock

exchange. This increase the liquidity of securities. Therefore, the purpose of the NSEI

is to check the decreasing liquidity of securities.

5) Developing a Debt Market : The purpose of the NSEI is to develop a debt Market. In

the traditional share market, transactions are mostly in shares and no attention is paid

to Debentures. Now the NSEI has divided the market in two parts-Debt market and

capital Market. Therefore, this division is helpful in the development of debt market.

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6) Conforming to International Standard : Many modern share markets are being

established at the International Level. In India also, there is a dire need of establishing

a stock exchange of international level. The NSEI is a modern stock exchange based

on the international standards.

7) Outdated Settlement System : In the traditional share markets, the system of

settlement of transactions had become old. It was getting difficult to control the ever

increasing number of transactions under this system. Under the NSEI, provision has

been made to settle the transaction very quickly.

Trading Process on NSEI : The selling and buying process of securities on the NSEI is as

under:

1) Placing the Order : First of all the person buying or selling securities places an order.

In this order, he tells the name of the company whose security he is ready to buy or sell

at what price, in what quantity and for what period of time.

2) Conveying the Message to Computer : The moment the terminal operator receives

the order from the customer, he feeds it in the computer.

3) Starting of Matching Process : The moment the computer receives orders, it starts

the process of matching. During the process of matching orders, the best matching of

the selling or buying order is sought to be found out.

4) Accepting the Order : As soon as the best matching of the buying and selling orders

is established during the process of matching orders, its list is immediately obtained on

the computer screen. This information tells us at what rate, time. All the terminals of the

NSEI established throughout the country go on feeding their computers continent with

what party your order has been transacted.

5) Delivery and Payment : After the transaction has been settled, the delivery and

payment are made according to the rules of the NSEI.

Q. What are the main features of OTCEI? Explain the trading process of OTCEI.

Ans. Over the Counter Exchange of India (OTCEI) : The OTCEI is a completely

computerized and special ringless stock exchange which is different from the traditional

stock exchange and on which the buying and selling of securities is absolutely transparent

and moves at a great speed. Its counters are spread all over the country where transactions

are made with the help of telephone.

The OTCEI was established under section 25 of the Companies Act, 1956 in October, 1990.

The promoters of the OTCEI are the following financial and other institutions:

(i) The Unit Trust of India

(ii) The Industrial Credit and Investment Corporation of India.

(iii) The Industrial Development Bank of India

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(iv) The Industrial Finance Corporation of India

(v) The Life Insurance Corporation of India

(vi) The General Insurance Corporation of India

(vii) The SBI Capital Market Limited

(viii) The Canbank Financial Services Limited.

Features or Nature of OTCEI : The main features of the OTCEI are the following:

(1) Ringless Trading : There s no particular place for transacting business in securities

under the OTCEI. This exchange has its counters/offices throughout the country. Any

buyer or seller of securities can go the counter/officer and have transaction through

the medium of the operator.

(2) Nation Network : The OTCEI has its network all over the country. All the counters are

linked with the central terminal through the medium of computers. Therefore, the

facility of nationwide listing is available here. In other words by listing on one

exchange, one can have transactions with all the counters in the whole country.

(3) Exclusive List of Companies : On the OTCEI only those companies are listed whose

issued capital is 30 lakhs or more. In the old share markets this amount used to be ten

crores on the BSE and three crores on the other exchanges and hence, listing was not

possible in case the issued capital was less than three crores. Those companies

which have been listed on the old share markets cannot be listed on the OTCEI.

(4) Fully Computerized : This exchange is fully computerized. It means that all the

transactions done on this exchange are done through the medium of computers.

(5) Sponsorship : In order to get listed on the OTCEI, a company has to find a member to

sponsor it. The main job of a sponsor is market making. T means a sponsor has to be

read to buy or sell the shares of that company at least for a period of 18 months. In this

way, a sponsor creates liquidity in securities.

(6) Investor’s Registration : All the investors doing transactions on the OTCEI have got

to register themselves compulsorily. Registration can be got done b giving an

application at an counter. The registration is called the INVESTOTC CARD. On the

basis of this card, one can do transactions of securities at any counter throughout the

country.

(7) Greater Liquidity : There is greater liquidity in securities because of the sponsor’s job

of market making.

(8) Transparency in Transactions : All the transactions are done in the presence of the

investor. The rates of buying and selling can be seen on the computer screen. The

operator cannot do any fraud or mischief with the transactions.

(9) Faster Delivery and Payment : On the OTCEI, delivery in case of buying and

payment in case of selling are both very fast. The work of delivery and payment in case

of listed securities and permitted securities is completed within seven days and 15

days respectively.

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(10) Two ways of Public Offer : A company listed on the OTCEI can issue security in two

ways. Firstly, the company can go directly to the public. This is called Direct Offer

System. Secondly, the company sells its securities to the sponsor at a particular price.

Then the sponsor sells them to the public. This is called Indirect Offer System.

(11) Easy Access : In the big cities the counters of the OTCEI can be seen like ordinary

shops. Any body can go the counter and do buying and selling of securities.

Trading Process : One can trade in securities b going to any counter of the OTCEI. All the

counters are linked with the central computer at the OTCEI headquarter. This office is in

Mumbai. There can be three types of trading on the OTCEI:

(1) Initial Allotment : When an investor is allotted shares through the medium of OTCEI,

he is given a receipt which is called counter receipt-CR. This receipt is just like the

share certificate. Selling and buying can be done through the medium of this receipt.

(2) Buying in the Secondary Market : For the purpose of buying shares listed on the

OTCEI, a person has to get himself registered (if he is not already registered). After

this, he informs the counter operator about the number of the shares to be purchased.

The counter operator displays the rates on the screen. After getting himself satisfied

with the rate, the investor hands over the cheque to the operator. On the encashment

of the cheque, the CR is handed over to the investor. This procedure takes about a

week.

(3) Selling in the Secondary Market : An investor who has purchased shares from the

OTCEI can sell his shares at any counter of the OTCEI. After getting himself satisfied

with the rate displayed on the screen, the investor hands over the Counter Receipt and

the Transfer Deed to the Operator. The operator prepares the Sales Confirmation Slip

(SCS) and a copy of it is handed over to the seller. The operator sends the CR, TD and

SCS to the Registrar for confirmation. After confirming every detail the Registrar sends

them back to the counter operator. In the end the operator issues a cheque to the seller

and receives back the SCS from the seller.

Purposes of OTCEI : The objects of the establishment of the OTCEI may be described as

under:

(1) Liquidity : The first object for the establishment of the OTCEI is o maintain liquidity in

the securities of the small companies. The sponsor has got to do the job of market

making.

(2) Transparency : The second aim of this share market is to maintain transparency of

transactions. Here all the transactions are made on the computer screen. This

eliminates any chance of fraud.

(3) Investor’s Grievances : An important aim of the establishment of the OTCEI is the

speed solution of the problems of the investors.

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(4) Quick Settlement : In the traditional share markets both the delivery and payment

take time. This problem has been overcome with the help of the OTCEI.

(5) Listing of Small Companies : Small companies remain deprived of being listed

because they are unable to fulfil the conditions laid down by the old share markets.

(6) Access : This stock exchange is of the ringless type and therefore, has its counters all

over the country.

Q. Write brief notes on the concept of mutual funds. Also explain the

organizational functions of mutual funds.

Ans. Meaning of Mutual Fund : A mutual fund is essentially a mechanism of pooling

together the savings of a large number of small investors for collective investment, with an

avowed objective of attractive yields and capital appreciation, holding the safety and liquidity

as prime parameters.

A mutual fund is a trust that pools the savings of a number of investors who share a common

financial goal. The money, thus, collected is then invested in capital market instruments such

as shares, debentures and other securities. The income earned through these investments

and the capital appreciation realized are share by its unit holders in proportion to the number

of units owned by them.

Working of a Mutual Fund : The flow chart below describes broadly the working of a

mutual fund :

Returns

Passed back to

Generates

Investors

Pool theirmoney with

FundManager

Invest in

Securities

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Mutual Fund – Organisation : There are many entities involved and the diagram below

illustrates the organization set up of a mutual fund:

Organisation of a Mutual Fund

A mutual fund can be constituted either as a corporate entity or as a trust. In India, UTI was

set up as a corporation under an Act of parliament in 1964. Indian banks when permitted to

operate mutual funds, were asked to create trusts to run these funds. A trust has to work on

behalf of its trustees. Indian banks operating mutual funds had made a convincing plea

before the government to allow their mutual funds to constitute them as ‘Asset Management

Companies’. The department of Company Affairs, Ministry of Law, Justice and Company

Affairs has issued guidelines in respect of registration of Assets Management Companies

(AMCs) in consultation with SEBI, as follows:

(1) Approval of AMC by SEBI : As per guidelines, AMC shall be authorized for business

by SEBI on the basis of certain criteria and the Memorandum and Articles of

Association of the AMC would have to be approved by SEBI.

(2) Authorised Capital of AMC : The primary objective of setting up of an AMC is to

manage the assets of the mutual funds and other activities, which it can carry out, such

as, financial services consultancy, which do not conflict with the fund management

activity and are only secondary and incidental. Many players who help in running a

mutual fund are as follows:

SEBI

Unit Holders

Sponsors

Trustees

The Mutual Fund

Custodian

AMC

Transer Agent

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(i) Registers and Transfer Agents : The major responsibilities are:

ØReceiving and processing the application form of a mutual fund

ØIssuing of unit/share certificate on behalf of mutual fund

ØMaintain detailed records of unit holders transactions

ØPurchasing, selling, transferring and redeeming the Unit/Share certificate

ØIssuing of income /dividend, broker cheques etc.

(ii) Advertiser : Major responsibilities of an adviser include:

ØHelping mutual funds organizers to prepare a media plan for marketing

the fund.

ØIssuing/buying the space in newspapers and other electronic media for

advertising the various features of a fund.

ØArranging or hoardings at public places.

(iii) Advisor/ Manager : It is generally a corporate entity that does the following

jobs:

ØProfessional advice on the fund’s investments

ØAdvice on asset management services.

(iv) Trustees : Trustees provide the overall management services and charge

management fee.

(v) Custodian : A custodian is again a corporate body that carries out the following

functions:

ØHolds Securities

ØReceives and delivers securities

ØCollects income/interest/dividends on the securities

ØHolds and processes cash

(vi) Other Players : Besides the above, other players are as under:

ØFund Administrator

ØFund Accounting Services

ØLegal Advisors.

ØFund Officers

ØUnderwriters/Distributors

Q. What are the advantages of investing in mutual funds? Also explain the

drawbacks of mutual funds.





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Advantages of Investing in Mutual Funds : The advantages of investing in mutual funds

are:

(1) Professional Management : Most mutual funds pay top-flight professionals to

manage their investments. These managers decide what securities the fund will buy

and sell.

(2) Regulatory Oversight : Mutual funds are subject to many government regulations

that protect investors from fraud.

(3) Liquidity : It’s easy to get your money out of a mutual fund. Write a cheques, make a

call and you’ve got the cash.

(4) Convenience : You can usually buy mutual fund shares by mail, phone or over the

Internet.

(5) Low Cost : Mutual fund expenses are often no more 1.5 % of your investment.

(6) Investment variety and spread in different industries.

(7) Capital Appreciation

(8) No impulsive decision-making regarding purchase or sale of share/securities, since

the funds are managed by expert, professional fund managers who have access to

the latest detailed information regarding the stock market.

(9) Even the smallest dividend or capital gain gets reinvested, thus enhancing the

effective return.

(10) Freedom from paperwork.

(11) Transparency

(12) Flexibility

(13) Choice of Schemes

(14) Tax benefits on invested amounts/returns/capital gains

(15) Well regulated

Drawbacks of Mutual Fund : Mutual funds have their drawbacks:

(1) No Guarantees : No investment is risk-free. If the entire stock market declines in

value, the value of mutual fund shares will go down as well.

(2) Fees and Commissions : All funds charge administrative fees to cover their day-to-

day expenses. Some funds also charge sales commissions or ‘loads’ to compensate

brokers, financial consultants, or financial planners.

(3) Taxes : During a typical year, most actively managed mutual funds sell anywhere from

20 to 70% of the securities in their portfolios. If your fund makes a profit on its sales,

you will pay taxes on the income you receive, even if you reinvest the money you

made.

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(4) Management Risk : When you invest in a mutual fund, you depend on the fund’s

manager to make the right decisions regarding the fund’s portfolio. If the manager

does not perform as well as you had hoped, you might not make as much money on

your investment as you expected.

Q. What are the different types of mutual funds schemes? Also explain the types of

mutual fund schemes in India.





Types of Mutual Fund Schemes : A wide variety of mutual fund schemes exists to cater to

the needs such as financial position, risk tolerance and return expectations etc.

Types of Mutual Fund Schemes

By Structure By Investment Other Schemes

Objectives

Open-ended Funds Growth Funds Tax Saving Funds

Close-ended Funds Income Funds Special Funds

Balanced Funds

Area Funds

(A) By Structure : On the basis of structure, there are two types of mutual fund schemes:

(1) Open-ended Funds : In open-ended funds, there is not limit to the size of funds.

Investors can invest as and when they like.

(2) Close-ended funds : These funds are fixed in size as regards the corpus of the

fund and the number of shares. In close-ended funds, no fresh units are created

after the original officer of the scheme expires.

(B) By Investment Objectives : On the basis of investment objectives there are four

types of mutual funds schemes:

(1) Growth Funds : These funds do not offer fixed regular returns but provide

substantial capital appreciation in the long run. The pattern of investment in

general is oriented towards shares of high growth companies.

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(2) Income Funds : These funds offer a return much higher than the bank deposits

but with less capital appreciation. The emphasis being on regular returns, the

pattern of investment in general is oriented towards fixed income-yielding

securities like non-convertible debentures of consistently good dividend paying

companies etc.

(3) Balance Schemes or Income and Growth-Oriented Funds : These offer a

blend of immediate average returns and reasonable capital appreciation in the

long run.

(4) Area Funds : These are funds that are raised on other countries for providing

access to foreign investors. The India Growth Fund and the India Fund raised in

the US and UK respectively are examples of area funds.

(C) Other Schemes :

(1) Tax Saving Funds : These funds are raised for providing tax relief to those

investors whose income comes under taxable limits.

(2) Special Funds : These funds are invested in a particular industry like cement,

steel, jute, power or textile etc. These funds carry high risks with them as the

entire fund is exposed to a particular industry.

Types of Mutual Fund Schemes in India :

(1) Growth Funds : There are the following features:

(i) Objective : Generating substantial capital appreciation

(ii) Investment Pattern : Nearly all in equity shares

(iii) Duration : Seven Years

(iv) Investment Risk : High risk in reinvestment schemes

(v) Returns : No assured return but high returns are expected

(vi) Liquidity : No repurchase facility except at the end of the scheme

(vii) Transfer of units is allowed

Some Examples of Growth Schemes : Schemes issued by

(a) Master Share, Master share plus, Master Gain, UGS-200 Unit Trust of India

(b) Magnum Express, Magnum Multiplier SBI Mutual Fund

(C) Canshare, Canstar Cap, Cangrowth, Canbonus Canbank Mutual Fund

(d) Ind Ratna, Ind Sagar, Ind Moti Indbank Mutual Fund

(2) Income Funds : The Income funds are the following features:

(i) Objective : Assured minimum income and safety of capital

(ii) Duration : 5-7 years

(iii) Investment Pattern : Bulk of funds invested in fixed income securities like

government bonds, company debentures, etc. and rest in equity shares.

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(iv) Investment Risk : Absolute Safety

(v) Return : 14.75% p.a. upwards-payable monthly or quarterly plus mid scheme

bonus and end of the scheme appreciation.

(vi) Liquidity : No listing on stock exchange and units are not transferable.

Some examples of Income Funds:

(a) Units Scheme of 1964, Growing Income Unit Scheme of 1987 Unit trust of India

(b) Magnum Monthly Income Schemes SBI Mutual Fund

(c) Rising Monthly Income Schemes BOI Mutual Fund

(3) Balance Funds : The main features are:

(i) Objective : Income and growth with reasonable safety

(ii) Duration : Seven Years

(iii) Investment pattern : About 50% in equity and the rest in debenture etc.

(iv) Returns : No assured returns, but steady income due to annual contribution of

minimum of 80% of the Trust’ income by way of dividends, interest etc.

(v) Liquidity : Repurchase facility after initial lock-in period of three years

(vi) No listing of stock exchange

(vii) Transfer of units permitted

(viii) Units can be pledged to banks for loans

(4) Tax Planning Schemes : The investment made under these schemes are deductible

from the taxable income up to certain limits, thus providing substantial tax relief to the

investors.

Examples of tax planning schemes:

(a) Can 80CC and Canstar 80L of Canbank Mutual Fund

(b) Ind 88A of Indbank Mutual Fund

(5) Other Schemes : These include schemes of 10-15 years duration, which offer

multiple benefits. For example:

Sr. No. Scheme Benefits

1. Unit Linked Insurance (i) Contribution eligible for tax deduction of Plan of UTI IT Act

(ii) Insurance cover up to target amount

(iii) Reasonable income by way of dividend

(iv) Liquidity

(v) Safety Of Capital

2. Dhanaraksha, These offer some or all of the followingDhansahyog, benefits :

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Dhanavridhi (i) Life Insurance cover

(ii) Accident Insurance Cover

Schemes of LIC (iii) Reinvestment of annual dividends of

Mutual Fund reasonable dividend

(iv) Safety of capital

(v) Reasonable capital appreciation

(vi) Liquidity

(vii) Units are not transferable, but bank

loan facility is available

(viii) Tax exemption on dividend

Q. Explain the Merchant Banking Services.

Ans. Merchant Bankers : A merchant banker is any person who is engaged in the business

of issue management either by making arrangements regarding selling, buying or

subscribing to securities or acting as manager/consultant/advisors or rendering corporate

advisory service in relation to such issue management. Issues mean an offer for

sale/purchase of securities by any body corporate/other person or group of persons through

a merchant banker. The importance of merchant bankers as sponsors of capital issues is

reflected in their major services such as, determining the composition of capital structure,

draft of prospects and application forms, listing of securities and so on. In view of the

importance of merchant bankers in the process of capital issues, it is now mandatory that all

public issues should be managed by merchant bankers functioning as the lead managers. In

the case of right issues not exceeding Rs. 50 lakh, such as appointments may not be

necessary.

Services provided by the Merchant Bankers :

(1) Project Management : Right from planning to commissioning of project, project

counseling and preparation of project reports, feasibility reports, preparation of loan

application form, government clearances for the project from various agencies,

foreign collaboration, etc.

(2) Issue Management :

(i) The evaluation of the client’s fund requirements and evolution of a suitable

finance package.

(ii) The design of instrument such as equity, convertible debentures, non-

convertible debentures etc.

(iii) Applications covering consents from institutions/banks and audited certificates,

etc.

(iv) Appointment of agencies such as printers, advertising agencies, registrars,

underwriters, and brokers to the issue.

(v) Preparation of prospectus

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(3) Portfolio Management Services : Portfolio management schemes are promoted by

merchant bankers and other finance companies to handle funds of investors at a fee.

(4) Counselling : Corporate counseling basically means the advice a merchant banker

gives to a corporate unit to ensure better performance in terms of growth and survival.

(5) Loan Syndication : Loan syndication refers to the services rendered by merchant

banker in arranging and procuring credit from financial institutions, banks and other

lending institutions.

Q. What is Issue Management. Explain various types of issues.

Ans. Issue Management : Issue management refers to management of securities

offerings of the corporate sector to public and existing shareholders on rights basis. Issue

managers in capital market are known as Merchant Banker or Lead Managers. Although the

term merchant banking, in generic terms, covers a wide range of services, but issue

management constitutes perhaps the most important function within it.

Under SEBI Guidelines, each public issue and rights issue of more than Rs. 50 lacs is

required to be managed by merchant banker, registered with SEBI.

Types of Issues : Existing as well as new companies raise funds through various sources

for implementing projects:

(1) Public Issue : The most common method of raising funds through issues is through

prospectus. Public issue is made by a company through prospectus for a fixed number

of shares at a stated price which may be at par or premium and any person can apply

for the shares of the company.

(2) Rights Issue : Right issues are issues of new shares in which existing shareholders

are given preemptive rights to subscribe to new issue of shares. Such further shares

are offered in proportion to the capital paid-up on the shares help by them at the date of

such offer. The shareholders to whom the offer is made are not under any legal

obligation to accept the offer.

(3) Private Placement : The direct sale of securities by a company to investors is called

private placement. In private placement, no prospectus is issued. Private placement

covers shares, preference, shares and debentures.

Q. Discuss briefly the pre-issue and post-issue obligations of merchant bankers.

Ans. Introduction : raising money from the capital market needs planning the activities and

chalking out a marketing strategy. It is, therefore, essential to make an nalaytical study of

various sources, the quantum, the appropriate time, the cost of raising capital and the

possible impact of such resources on the overall capital structure besides the low governing

the issue. There are various activities required for raising funds from the capital markets.

These can be broadly divided into pre-issue and post-issue activities.

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(A) Pre-issue Activities :

(1) Signing of MoU : Issue management activities begin with the signing of

Memorandum of Understanding between the client company and the Merchant

banker. The MoU clearly specifies the role and responsibility of the Merchant banker,

vis-à-vis, that of the Issuing Company.

(2) Obtaining Appraisal Note : After the contract is awarded, an appraisal note is

prepared either-in-house or is obtained from outside appraising agencies viz.,

financial institutions/banks etc. The appraisal not thus prepared throws light on the

proposed capital outlay on the project and the sources of funding it.

(3) Determination of Optimum Capital Structure : Optimum capital structure is

determined considering the nature and size of the project. If the project is capital

intensive, funding is generally biased in favour of equity funding.

(4) Appointment of Underwriters, Registrars etc. : For ensuring subscription to the

offer, underwriting arrangement are also made with various functionaries. This is

followed by appointment of registrars to an issue for handling share allotment related

work, appointment of Bankers to an issue for handling collection of application at

various centres, printers for bulk printing of issue related stationery, legal advisors and

advertising agency.

(5) Preparation of Documents : Thereafter, initial application are submitted to those

stock exchange where the listing company intends to get its securities listed. Lead

managers also prepares the list of material documents viz., MoU with Registrar, with

bankers to an issue, with advisor to the issue, co-managers to issue, agreement for

purchase of properties, etc., to be sent for inclusion of prospectus.

(6) Due Diligence : The lead manager while preparing the offer document is required to

exercise utmost due diligence and to ensure that the disclosures made in the draft

offer document are true, fair and adequate.

(7) Submission of Offer Document to SEBI : The draft document thus prepared is filed

with SEBI along with a due diligence certificate to obtain their observations. SEBI is

required to give its observations on the offer document within 21 days from the receipt

of the offer document.

(8) Finalisation of Collection Centres : Lead Manager finalises collection centres at

various places for collection of issue application from the prospective investors.

(9) Filing with RoC : After incorporating SEBI observations in the offer document, the

complete document is filed with Registrar of Companies to obtain their

acknowledgment.

(10) Launching of a Public Issue : The observation letter issued by SEBI is valid for a

period of 365 days from the date of its issuance within which the issue can open for

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subscription. Once the legal formalities and statutory permission for issue of capital

are complete, the process of marketing the issue starts. Lead manager has to arrange

for distribution of public issue stationery to various collecting banks, brokers, investor ,

etc. The announcement regarding opening of issue in the newspapers is alos required

to be made by advertising in newspapers 10 days before of the issue opens.

(11) Promoter’s Contribution : A certificate to this effect that the required contribution of

the promoter’s has been raised before opening of the issue obtained from a chartered

accountant is also required to be filed with SEBI.

(12) Closing of the Issue : During the currency of the issue, collection figures are also

obtained on daily basis from Bankers to the issue. These figures are to be filed in a 3

days report with SEBI. Another announcement through the newspapers is also made

regarding the closure of the issue.

(B) Post-Issue Activities : After the closures of the issue, lead manager has to manage

the post-issue activities pertaining to the issue. Certificate of 90% subscription from

Registrar as well as final collection certificate from Bankers are obtained.

(1) Finalisation of Basis of Allotment : In case of a public offering, if the issue is

subscribed more than five times, association of SEBI nominated public representative

is required to participate in the finalization of Basis of allotment (BoA).

(2) Despatch of Share Certificate : Then follows dispatch of share certificates to the

successful allotees and refund order to unsuccessful applicants.

(3) Issue of Advertisement in Newspapers : An announcement in the newspaper is

also made regarding BoA, no. of applications received and the date of despatch of

share certificates and refund orders etc.

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UNIT – III


Q. Define Leasing. What are its essential elements? Discuss briefly the

significance and limitations of leasing.

Ans. Meaning of Leasing : Conceptually, a lease may be defined as a contractual

arrangement in which a party owing an asset (lessor) provides the asset for use to another

(lessee) over a certain/for an agreed period of time for consideration in form of periodic

payment. At the end of the period of contract, the asset reverts back to the lessor unless

there is a provision for the renewal of the contract. Leasing is a process by which a firm

obtain the use of a certain fixed asset for which it must make a series of contractual periodic

tax-deductible payments (lease rentals).

Essential Elements : The essential elements of leasing are:

(1) Parties to the Contract : There are essentially two parties to a contract of lease

financing, namely:

(i) The Owner called the lessor

(ii) The User called the lessee

Lessors as well as lessees may be individuals, partnerships, joint stock companies,

corporations or financial institutions. Sometime there may be jointly lessors or joint

lessees. Besides, there may be a lease-broker who acts as an intermediary in

arranging lease deals. They charge certain percentage of fees for their services,

ranging between 0.5 to 1 percent.

(2) Asset : The asset, property or equipment to be leased is the subject matter of a

contract of lease financing. The asset may be an automobile, plant & machinery

equipment, land & building and so on. The asset must, however, be of the lessee's

choice suitable for his business needs.

(3) Ownership separated from User : The essence of a lease financing contract is that

during the lease-tenure, ownership of the asset vests with the lessor and its use is

allowed to the lessee. On the expiry of the lease tenure, the asset reverts to the lessor.

(4) Term of Lease : the term of lease is the period for which the agreement of lease

remains in operation. Each lease should have a definite period otherwise it will be

legally inoperative.

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(5) Lease Rentals : The consideration which the lessee pays to the lessor for the lease

transaction is the lease rental.

(6) Modes of Terminating Lease : The lease is terminated at the end of the lease period

and various courses are possible, namely,

(i) The lease is renewed on a perpetual basis for a definite period, or

(ii) The asset reverts to the lessor, or

(iii) The asset reverts to the lessor and the lessor sells it to a third party, or

(iv) The lessor sells the asset to the lessee.

Advantage/Significance of Leasing : The advantages are:

(A) Advantage to the Lessee : Lease financing has following advantage to the lessee:

(1) Financing of Capital Goods : Lease financing enables the lessee to have finance for

huge investments in land, building, plant, machinery, heavy equipments and so on,

upto 100 percent, without requiring any immediate down payment.

(2) Additional Source of Finance : leasing facilitates the acquisition of equipment, plant

& machinery without necessary capital outlay, and thus, has a competitive advantage

of mobilizing the scare financial resources of the business enterprise.

(3) Less Costly : Leasing, as a method of financing, is less costly than other alternatives

available.

(4) Ownership Preserved : Leasing provides finance without diluting the ownership or

control of the promoters.

(5) Flexibility in Structuring of Rentals : The lease rentals can be structured to

accommodate the cash flow position of the lessee, making the payment of rentals

convenient to him.

(6) Simplicity : A lease finance arrangement is simple to negotiate and free from

cumbersome procedure with faster and simple documentation.

(7) Tax Benefits : By suitable structuring of lease rentals, a lot of tax advantage can be

derived. If the lessee is in a tax paying position, the rental may be increased to lower

his taxable income. If the lessor is in tax paying position, the rentals may be lowered to

pass on a part of the tax benefit to the lessee. Thus, the rentals can be adjusted

suitably for postponement of taxes.

(8) Obsolescence Risk is averted : In a lease arrangement, the lessor being the owner

bears the risk of obsolescence and the lessee is always free to replace the asset with

latest technology.

(B) Advantage to the Lessor : A lessor has the following advantage:

(1) Full Security : The lessor's interest is fully secured since he is always the owner of the

leased asset and can take repossession of the asset if the lessee defaults.

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(2) Tax Benefit : The greatest advantage for the lessor is the tax relief by way of

depreciation. If the lessor is in high tax bracket, he can assets high depreciation rates

and , thus reduce his tax liability substantially.

(3) High Profitability : The leasing business is highly profitable since the rate of return is

more than what the lessor pays on his borrowings.

(4) High Growth Potential : The leasing industry has a high growth potential. Lease

financing enables the lessees to acquire equipment and machinery even during a

period of depression, since they do not have to invest any capital. Leasing, thus,

maintains the economic growth even during recessionary period.

Limitations of Leasing : Lease financing suffers from certain limitations too:

(1) Restrictions on Use of Equipment : A lease arrangement may impose certain

restrictions on use of the equipment, or require compulsory insurance, and so on.

Besides, the lessee is not free to make additions or alterations t the leased asset to suit

his requirement.

(2) Loss of Residual Value : The lessee never becomes the owner of the leased asset.

Thus, he is deprived of the residual value of the asset and is not even entitled to any

improvement done by the lessee or caused by inflation or otherwise, such as

appreciation in value of leasehold land.

(3) Consequences of Default : If the lessee defaults are complying with any terms and

conditions of the lease contract, the lessor may terminate the lease and take over the

possession of the leased asset.

(4) Understatement of Lessee's Asset : Since the leased assets do not form part of

lessee's assets, there is an effective understatement of his assets.

(5) Double Sales-tax : With the amendment of sale-tax law of various states, a lease

financing transaction may be charged to sales-tax twice- once when the lessor

purchases the equipment and again when it is leaded to the lessee.

Q. Define Lease. Give the Classification of Lease.

Ans : Meaning of Leasing : Conceptually, a lease may be defined as a contractual

arrangement in which a party owing an asset (lessor) provides the asset for use to another

(lessee) over a certain/for an agreed period of time for consideration in form of periodic

payment. At the end of the period of contract, the asset reverts back to the lessor unless

there is a provision for the renewal of the contract. Leasing is a process by which a firm

obtain the use of a certain fixed asset for which it must make a series of contractual periodic

tax-deductible payments (lease rentals).

Classification of Lease : Leasing can be classified into the following types:

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(A) Finance Lease and Operating Lease :

(1) Finance Lease : According to International Accounting Standards (IAS-17), in finance

lease the lessor transfers to the lessee, substantially all the risks and rewards

incidental to the ownership of the asset. It involves payment of rentals over an

obligatory non-cancellable lease period, sufficient in total to amortise the capital outlay

of the lessor and leave some profit. In such leases, the lessor is only a financier and is

usually not interested in the assets. Types of assets included, under such lease, are

ships, lands, buildings, heavy machinery diesel generating sets and so on.

(2) Operating Lease : According to the IAS-17, an operating lease is one which is not a

finance lease. In an operating lease, the lessor does not transfer all the risks and

rewards incidental to the ownership of the asset and the cost of the asset is not fully

amortised during primary lease period. The lessor provides services attached to the

leased asset, such as maintenance, repair and technical advice. Operating lease is

generally used for computers, office equipments, automobiles, trucks, some other

equipments, and so on.

(B) Sale and Lease Back and Direct Lease :

(1) Sale and Lease Back : In a way, it is an indirect form of leasing. The owner of an asset

sells it to a leasing company (lessor) which leases it back to the owner (lessee).

(2) Direct Lease : In direct lease, the lessee, and the owner of the asset are two different

entities. A direct lease can be of two types:

ØBipartite Lease : There are two parties in the lease transaction, namely (i) Asset

Supplier-cum-lessor and (ii) Lessee

ØTripartite Lease : Such type of lease involves three different parties in the lease

agreement: supplier, lessor and lessee.

(C) Single Investor Lease and Leveraged Lease :

(1) Single Investor Lease : There are only two parties to the lease transaction- the lessor

and the lessee. The leasing company (lessor) funds the entire investment by an

appropriate mix of debt and equity funds.

(2) Leveraged Lease : There are three parties to the transaction- (i) Lessor, (ii) Lender

(iii) Lessee. In such type of lease, the leasing company buys the asset through

substantial borrowing.

(D) Domestic Lease and International Lease :

(1) Domestic Lease : A lease transaction is classified as domestic if all parties to the

agreement, namely, equipment supplier, lessor and the lessee, are domiciled in the

same country.

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(2) International Lease : If the parties to the lease transaction are domiciled in different

countries, it is known as international lease. This type of lease if further sub-classified

into

ØImport Lease : In an import lease, the lessor and the lessee are domiciled in the

same country but the equipment supplier is located in a different country. The

lessor imports the asset and leases it to the lessee.

ØCross-border Lease : When the lessor and the lessee are domiciled in different

countries, the lease is classified as cross-border lease. The domicile of the

supplier is immaterial.

Q. What are the regulations and directions for lease?

Ans. RBI NBFCs Directions : With a view to coordinate, regulate and control the

functioning of all non-banking financial companies, the RBI issues directions from time to

time under the RBI Act. They apply to leasing and hire-purchase companies as well.

(1) Other Acts /Laws : The other acts/laws applicable to the NBFCs are:

(i) Motor Vehicles Act : the lessor is regarded as a dealer and although the legal

ownership vests in the lessor, the lessee is regarded as the owner for purposes

of registration of the vehicle under the Act and so on. In case of vehicle financed

under lease, the lessor is treated as a financier.

(ii) Indian Stamp Act : The Act requires payment of stamp duty on all

instruments/documents creating a right/liability in monetary terms. The

contracts for equipment leasing are subject to stamp duty which varies from

state to state.

(2) Lease Documentation and Agreement : Lease transactions involve a number of

formalities and various documents. The lease agreements have to be properly

documented to formalize the deal between the parties concerned and to bind them.

The purposes and essential requirements of lease documentations are:

(i) The documentation of lease agreements is significant as it provides evidence

availability and enforceability of security, brings to sharp focus the terms and

conditions agreed between the borrower and the lenders and enables the

leasing company to take appropriate legal action in case of default.

(ii) The essential requirements of documentation of lease agreements are that the

persons:

ØExecuting the document should have the legal capacity to do

ØThe documents should be in the prescribed format, should be properly

stamped, witnessed, and the duly executed and stamped documents

should be registered where necessary, with appropriate authorities.

(iii) Clauses in Lease Agreement : There is no standardized lease agreement. The

contents differ from case to case. A typical lease agreement has the following

clauses:

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ØNature of the Lease : This clause specifies whether the lease is an

operating lease, a financing lease or a leveraged lease.

ØDescription : The clause specifies the detailed description of equipment,

its actual condition, size, components, estimated useful life, and so on.

ØDelivery and Re-Delivery : The clause specifies when and how the

equipment would be delivered to the lessee and re-delivered to the lessor

or expiry of the lease contract.

ØPeriod : This clause specifies that the lessee has to take the equipment

for his use on lease on the terms specified in the schedule to the

agreement. It also includes an option clause to the lessee to renew the

lease of the equipment.

ØLease Rentals : This clause specifies the procedure for paying lease

rentals by the lessee to the lessor at the rates specified in the schedule to

the agreement.

ØUse : This clause enjoins upon the lessee the responsibility for proper and

lawful usage.

ØTitle : identification and ownership of equipment.

ØRepairs and Maintenance: This clause specifies the responsibility for

repairs and maintenance, insurance and so on.

ØAlteration : It specifies that no alteration to the leased equipment may be

made without the written consent of the lessor.

ØCharges : This clause specifies clearly which party to the agreement

would bear the delivery, re-delivery, customs, income tax, sales tax and

clearance charges.

ØInspection : It gives the lessor or his representative a right to enter the

lessee's premises for the purpose of confirming the existence, condition

and proper maintenance of the equipment.

ØProhibition of Sub-leasing : This clause prohibits the lessee from the

sub-leasing or selling the equipment to third parties.

ØEvents of default and remedies : This clause specifies the

consequences of defaults by the lessee and recourse available to the

lessor. This clause may also specify other remedies, if any.

ØApplicable Law : This clause specifies the country whose laws would

prevail in case of a dispute.

Q. Explain the accounting treatment for finance and operating leases by a lessor

and by a lessee and their disclosures in financial statements.

Ans. Accounting Treatment for Leasing : Accounting treatment for leasing is divided into

two parts:

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(A) Accounting for Leases by a Lessee

(B) Accounting for Leases by a Lessor

(A) Accounting for Leases by a Lessee : Accounting for finance and operating leases

by a lessee and disclosures in their financial statements are given below:

(1) Finance Lease : A finance lease should be reflected in the balance sheet of a lessee

by recording an asset and a liability at amount equal at the inception of the lease to the

fair value of the leased assets net of grants and tax credits receivable by the lessor; if

lower, at the present value of the minimum lease payments. In calculating the present

value of the minimum lease payments the lease factor is the interest implicit in the

lease, if this is practicable to determine.

A finance lease gives rise to a depreciation charge for the asset as well as finance

charge for each accounting period. The depreciation policy for leased assets should

be consistent with that for depreciable assets which are owned and the depreciation

charge should be calculated on the basis set out in the 'IAS-4:Depreciation

Accounting'.

(2) Operating Lease : The charge to income under an operating lease should be the

rental expenses for the accounting period, recognized on a systematic basis that is

representative of the time pattern of the user's benefit.

Disclosure in Financial Statements of Lessees: Disclosure should be made of the

amount of the assets that are subject to finance lease at each balance sheet date.

Liabilities related to these leased assets should be shown separately from other

liabilities, differentiating between the current and the long-term portions.

(B) Accounting for Leases by Lessors : Accounting for finance, and operating leases

by lessors and disclosure in their financial statements are given below:

(1) Finance Lease : An asset held under a finance lease should be recorded in the

balance sheet not as property, plant & equipment but as a receivable, at an anount

equal to the net investment in the lease.

(2) Operating Lease : Assets held for operating leases should be recorded as property,

plant & equipment in the balance sheet of the lessor.

The depreciation of leased assets should be on a basis consistent with the lessor's

normal depreciation policy for similar assets and the depreciation charge should be

calculated on the basis set out in IAS-4: Depreciation Accounting.

Disclosure in the Financial Statements of Lessors: Disclosures should be made at

each balance sheet date of the gross investment in leases reported as finance leases,

and the related unearned finance income and unguaranteed residual values of the

leased assets.

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Q. Explain the Tax aspects of Leasing.

Ans. Tax Aspects of Leasing : The tax aspects of leasing pertain to both income-tax and

sales tax.

(A) Income Tax Aspects

(B) Sales Tax Aspects

(A) Income Tax Aspects : Leasing , as a finance device, has tax implications for, and

offers tax benefits both to, the lessor and the lessee.

(1) For Lessor : The main attraction of leasing device to the lessor is the deduction of

depreciation from his taxable income. The relevant provisions applicable to the

computation of the lessor's income, the tax rates and so on are summarized as

follows:

(i) Taxability of Lease Rentals : the computation of taxable income of an

assessee under the provisions of the Income Tax Act, 1961 involves

computation under various heads of income which are aggregated and then

reduced by certain deductions. Calculation of Computation of Income are:

Computation of Total Income :

ØIncome from Salary ----------

ØIncome from House Property ----------

ØIncome from Business or Profession ----------

ØIncome from Capital Gain ----------

ØIncome from Other Sources ----------

____________

Gross Total Income -----------

Less: Deductions ----------

_____________

Taxable Income ------------

Where leasing constitutes the business/main activity of the assessee (lessor), income from

lease rental is taxable under the head Income from Business or Profession. In other cases,

the income from lease is taxed as Income from Other Sources.

(ii) Deductibility of Expenses : While computing the income of lessor from

leasing, certain expenses are allowed as a deduction to determine the taxable

income. These include:

ØDepreciation

ØRent, taxes, repairs and insurance of the leased asset where such

expenditure is borne by the lessor.

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ØAmortisation of certain preliminary expenses, such as expenditure for

preparation of project report, market survey and so on.

ØInterest on borrowed Capital

ØBad Debts

ØEntertainment expenses subject to prescribed limits.

ØTravel Expenses as per approved norms.

Among the allowable deductions, depreciation and interest are the most important

expenses for the lessor in the computation of his taxable income.

(2) For Lessee : The income tax considerations for the lessee are:

(i) Allowability of Lease Rentals : Lease rentals are allowed by the Income Tax

Act as a normal business expenditure of the lessee for assessment purpose

provided the expense is not

ØOf Capital Nature

ØA Personal Expense.

(ii) Deductibility of Incidental Expenses : The lessee is normally required to bear

expenses associated with the leased asset such as repairs and maintenance,

finance charge and so on. These incidental expenses to the lease are allowed

as a deduction by the Income Tax Act from taxable income of the lessee.

(B) Sales Tax Aspects : The legislative framework governing levy of sales tax consists of

the :

ØCentral Sales Tax Act, 1957(CST): The CST deals with the levy and collection of

sales tax on the inter-state sale of goods only.

ØSales Tax Acts: The tax on sale of goods within a state (Intra-state sale) is

governed by the provisions of the respective STAs.

A lease normally has three important elements from the viewpoint of sales tax:

(i) Purchase of Equipment : When purchase of an equipment by a lesser involves inter-

state sale, the transactions attracts the provisions of the CST according to which the

normal rate of sales tax (10 per cent) or the appropriate rate applicable to intra-state

purchase/sale of goods in the respective state, whichever is higher, is imposed.

(ii) Lease Rentals : Before 1982, there was no sales tax on lease rentals. The incidence

of sales tax on them was introduced by the Constitution Act, 1982. The provisions are:

ØSales tax is payable on the annual taxable turnover (aggregate lease rentals) of

the lessor. The rates of tax vary between a minimum and maximum; they also

vary from state to state.

ØIn addition, in several states, surcharge, additional surcharge, additional sales

tax on turnover exceeding a specified limit/turnover tax are also levied on the

lease rentals.

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(iii) Sale of Asset : Second sale exemptions available for the normal second sale

transaction within the state are usually not available for lease transaction. For

example, a leasing company buys and equipment from a supplier and lease it to a

lessee, both within the same state. The transaction between the leasing company and

the equipment supplier is called the first sale; it will attract local sales tax. The

transaction between the lessor and the lessee being a deemed sale is called second

sale. Normally second sale of some specified goods is exempted from levy of sales

tax. But thie exemption is usually not available in lease transactions.

Q. Define Debt Securitization. Explain its process.

Ans. Meaning of Debt Securitization : Securitization is the process of pooling and

repackaging of homogeneous illiquid financial assets into marketable securities that can be

sold to investors. In other words, securitization is the process of transforming assets into

securities. The process leads to the creation of financial instruments that represent

ownership interest in, or are secured by a segregated income producing asset or pool, of

assets. The pool of assets collateralizes securities. These assets are generally secured by

personal or real property such as automobiles, real estate, or equipment loans but in some

case are unsecured for example, credit card debt and consumer loans.

Securitization Process : The securitization process is listed below:

(1) Asset are originated through receivables, leases, housing loans or any other form of

debt by a company and funded on its balance sheet. The company is normally referred

to as the "originator".

(2) Once a suitably large portfolio of assets has been originated, the assets are analysed

as a portfolio and then sold or assigned to a third party, which is normally a special

purpose vehicle company ("SPV") formed for the specific purpose of funding the

assets. It issues debt and purchases receivables from the originator.

(3) The administration of the asset is then subcontracted back to the originator by the

SPV. It is responsible for collecting interest and principal payments on the loans in the

underlying poolt of assets and transfer to the SPV.

(4) The SPV issues tradable securities to fund the purchase of assets. The performance

of these securities is directly linked to the performance of the assets and there is no

resource back to the originator.

(5) The investors purchase the securities because they are satisfied that the securities

would be paid in full and on time from the cash flows available in the asset pool. The

proceeds from the sale of securities are used to pay the originator.

(6) The SPV agrees to pay any surpluses which, may arise during its funding of the

assets, back to the originator. Thus, the originator, for all practical purposes, retains its

existing relationship with the borrowers and all of the economies of funding the assets.

(7) As cash flow arise on the assets, these are used by the SPV to repay funds to the

investors in the securities.

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Graphic Presentation of Securitization Process :

Parties to a Securitization Transaction :

(1) Originator : This is the entity on whose books the assets to be securitized exist. It sells the assets on its books and receives the funds generated from such sale.

(2) SPV : An issuer, also known as the SPV, is the entity, which would typically buy the assets to be securitized from the originator.

(3) Investors : The investors may be in the form of individuals or institutional investors, and so on. They buy a participating interest in the total pool of receivables and receive their payment in the form of interest and principal as per agreed pattern.

(4) Obligors : the obligors are the original debtors. The amount outstanding from an obligor is the asset that is transferred to an SPV.

(5) Rating Agency : Since the investors take on the risk of the asset pool rather than the originator, an external credit rating plays an important role. The rating process would assess the strength of the cash flow and the mechanism designed to ensure full and timely payment by the process of selection of loans of appropriate credit quality, the extent of credit and liquidity support provided and the strength of the legal framework.

(6) Administrator or Servicer : It collects the payment due from the obligors and passes it to the SPV, follows up with delinquent borrowers and pursues legal remedies available against the defaulting borrowers. Since it receives the installment and pays it to the SPV, it is also called the Receiving and Paying Agent.

(7) Structure : Normally, an investment banker is responsible as structure for bringing together the originator, the credit enhancers, the investors and other partners to a securitization deal. It also works with the originator and helps in structuring deals.

Interest and Principal

Ancillary ServiceProvider

Special Vehicle

Creit Ratingof Securities

Rating Agency

Structure

Issue of Securities

Investors

Subscription ofSecurities

Obligor

Originator

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Q. Explain the System and Organisation of Housing Finance in India.

Ans. Introduction : Housing is one of the basic human need of the society. It is closely

linked with the process of overall socio-economic development of a country. India, being a

highly populated country there is a great need and scope for the development of Housing

Sector. Unfortunately, for some reasons or the other, the housing sector in India has

remained underdeveloped in the past, however, it is hoped that there would be improvement

in the near future.

Organisation or Structure of Housing Finance in India :

The setting up of the National Housing Bank marked the new era in housing finance as a new

fund-based financial service in the country. A large number of financial

institutions/companies in the public, private and joint sector entered in this field. For

example, Life Insurance Corporation of India and General Insurance Corporation came with

various schemes for finance the housing units. In 1970, Housing and Urban Development

Corporation (HUDCO) a wholly government owned enterprise, was set up with the objective

of housing and urban development as well as infrastructure development. The structure of

housing finance industry is presented in the following figure:

STRUCTURE OF HOUSE FINANCING INDUSTRY

Formal Sector Informal Sector

Household Savings

Disposal of Existing Properties

Borrowings from friends, relativesand money lenders, Etc.

Government

Central Govt.

State Govt.

Public Authorities

Banking

Commercial Banks

Cooperative Banks

Other Banks

Non-Banking

Non-Banking Finance Companies (NBFCs)

Housing Finance Companies (HFCs)

Non-Banking Housing Finance Companies (NBHFCs)

Insurance LIC/GIC

Specialised Institutions HDFC

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Q. Explain the Housing Finance Schemes in India.

Ans. Housing Finance Schemes : Various institutions provide financial assistance to the

needy persons. For this, they have come out with various financing schemes with different

features for meeting the diversified needs of this sector. The various housing finance

schemes are :

(A) Home Loan Account Scheme of NHB : Home Loan Account Scheme initiated by

National Housing Bank (NHB) with an objective of encouraging individual to save

specifically for housing. The basic features of this scheme are:

(i) Eligibility : Any Indian citizen who is not owing exclusively in his or her name, a

house/flat/apartment any where in India may open an account under this

scheme.

(ii) Contribution : The individual under this scheme is required to start a saving of a

minimum of Rs. 30 per month. The minimum period for which the savings must

be accumulated is five years to become eligible for loan under this scheme.

There is no upper limit on the amount to be saved under the scheme.

(iii) Interest on Deposit : The contribution under this scheme is entitled for interest

at the rate of 10 per cent per annum.

(iv) Default : If the contributor fails to deposit for a continuous period for 12 calendar

months, the original date of opening the home loan account is shifted forward by

the period of default.

(v) Withdrawals : Under this scheme the amount can be withdrawn only for

construction/buying a house or a flat only after the expiry of 5 years. The amount

can be withdrawn even if he/she does not avail of loan facility.

(vi) Eligibility of Loan : An account holder is eligible for housing loan on the

completion of the saving period. The quantum of the loan is based upon the built-

up area which is as under:

Built-up Area Quantum of loan in multiples ofaccumulated savings

Upto 430 square feet 4 times

Upto 860 square feet 3 times

Above 860 square feet 2 times

(vii) Interest on Loan

Loan Amount Interest per annum (%)

Up to 50,000 10.5

50,001-1,00,000 12.0

1,00,001-2,00,000 13.5

Above 2,00,000 14.5

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(B) HDFC Schemes for Individual Finance : Housing Development Finance

Corporation Ltd. is a leading private sector housing finance company in India. The

HDFC was set up in 1977 by the ICICI. Two important schemes offered by the HDFC

are:

(i) Home Saving Plan : This scheme is designed on the pattern of HLAS of NHB. The

basic objective of this scheme is to provide housing loan on the basis of savings of the

borrower. The scheme is open to individual as well as to individual jointly with a child or

spouse. In this scheme, the minimum savings period is 25 months, but a participant

can save up to a period of 7 years. The amount of loan granted would be equal to 70%

of the cost of the property and the balance 30% would be financed from the borrower's

savings. The maximum period of re-payment is normally 15 years. The basic feature

of this scheme is that whole amount collected through savings contributed by the

participant borrowers is kept separate and is not mixed with other funds raised by the

HDFC.

(ii) Home Loans (Individual) : Another important scheme of HDFC for providing

housing loans to individual in the country is Home Loan (Individual).

The amount of loan and rate of interest charged on some of the schemes offered by the

HDFC have been shown in the following table:

Sr. Scheme Amount of Loan Interest Rate in (%)No. (Maximum) in Rs.

Min. Max.

1. Home Saving Plan ------------------------- -------- --------

2. Home Loans (Individual) 5,00,000 10.5 16.5

3. Home Improvement Loan 5,00,000 or 70% of the 15.5 16.5cost of Improvement

4. Home Extensions 5,00,000 or 85% 16.5 --------

5 NRI Schemes 5,00,000 or 75% of cost 16.0 18.5of property

(C) Schemes of LIC Housing Finance Ltd. : Various housing finance schemes of LIC

Housing Finance Ltd. are:

Sr. Scheme Amount of Loan Interest Rate in (%)No. (Maximum)

Min. Max.

1. Griha Prakash 5,00,000 or 75% 12.5 16.5

2. GrIha Shubh 10,00,000 or 75% of the cost 12.5 19.0of property

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3. Griha Dhara 5,00,000 12.5 15.0

4. Griha Lakshmi 10,00,000 17.0 19.0

5. Griha Jyoti 10,00,000 or 85% of cost 12.5 15.0

of property

6. Jeewan Niwas 5,00,000 12.5 17.0

7. Jeewan Kutir 2,00,000 12.0 15.5

(D) GIC Housing Finance : The GIC Housing Finance Ltd. was set up in December 1989

by the General Insurance Corporation as its subsidiary company. The various

schemes are:

Sr. Scheme Amount of Loan Interest RateNo. (Maximum) in (%)

Min. Max.

1. Apna Ghar Yojna 5,00,000 12.0 18.5

2. Repairs/Renovation 10,00,000 or 75% of 14.0 19.0

the cost of property

3. Line of Credit to Company As per Company 13.0 16.5

4. Line of Credit through Company As per Company 13.0 16.5

5. Employees Housing Scheme 3,60,000 or 70% of cost 17.5 18.5

6. Construction Finance Scheme 50% of cost of property 21.0 19.0

(E) SBI Home Finance : The SBI Home Finance was established in 1988, as subsidiary

of the State Bank of India, to provide financial assistance for housing specifically in the

Eastern and North Eastern Regions of the country. Basic features are:

(i) The SBI HF grants the house loans to individuals for construction of houses,

purchase of house/flat, repairs renovation, extension, alteration of the existing

houses.

(ii) The quantum of loan is maximum 10 lakh

(iii) The re-payment period ranges 5-20 years.

(iv) The rates of interest are subject to changes from time to time. It varies with the

size of loan, term of loan and purpose of the loan.

Rate of Interest for a loan

Sr. No. Loan Amount Rate of Interest (%)

1. Up to 25,000 12.0

2. 25,001-1,00000 15.5

3. 1,00,001-5,00,000 16.0

4. 5,00,001 and above 16.5

5. Repairs loan upto 30,000 16.0

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(vii) House loans are secured by equitable mortgage of property to be financed on

the basis of first charge

Q. Explain the concept of Credit Rating. What are its functions and significance?

Also explain the process of Credit Rating.

Ans. Credit Rating : Credit rating is a grading service to investors which helps them in

reducing their risk. It provides a bird's eye-view on the credit quality or the instrument quality

of a particular credit instrument issued by a business house. It is a technique in which

relative ranking is provided to different instruments of a company on the basis of systematic

analysis of the strengths and weaknesses of them. This credit ranking is done on the basis

of:

(i) Analysis of Financial Statements

(ii) Project Analysis

(iii) Credit Worthiness factors

(iv) Future prospects of the concern project.

Definitions :

According to L.M. Bhole

"It can be defined as an act of assigning values to credit instruments by estimating or

assessing the solvency, i.e. the ability of the borrower to repay debt, and expressing them

through pre-determined symbols".

Significance of Credit Rating :

(i) It imposes a healthy discipline on borrowers.

(ii) It encourages greater information disclosures, better accounting standards and

improved financial information, which ultimately helps in investor protection.

(iii) It helps merchant bankers, brokers, regulatory authorities, etc. in discharging their

functions related to debt issues.

(iv) Ratings are very useful to investors especially when the regulatory authority takes no

responsibility for those who raise funds.

(v) The leading rating agencies play a vital role in evaluating sovereign ratings.

Functions of Credit Rating : The major functions of credit rating are as follows:

(i) To impose a healthy discipline on borrowers.

(ii) To facilitate formulation of public guidelines on institutional investment.

(iii) To help merchant banker, broker, regulatory authorities, etc. discharging their

functions related to debt issues.

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Types of Credit Rating : Credit rating are of different types:

(i) Bond Rating: Rating the bond or debt securities issued by a company, Governmental

or quasi-Governmental body is called bond. This type of rating occupies the major

share in the business of credit rating agencies.

(ii) Equity Rating: The rating of equity shares in the capital market is called equity rating

and it occupies the minimum share in the business of credit rating agencies.

(iii) Commercial Paper Rating: It is mandatory on the part of a corporate body to obtain the

rating from credit rating agency before issuing commercial paper in the market. This is

known as commercial paper rating

(iv) Borrowers Rating: This includes rating a borrower to whom a loan facility may be

sanctioned.

(v) Sovereign Rating: This includes rating a country as to its credit worthiness, probability

to risk etc.

Credit Rating Process : The steps involved in the credit rating process are as follows:

1. The rating process begins at the request of the company

2. A team is formed with professionally qualified analysts who are well-versed with the

working of the particular industry in which the requesting company operates. The team

visits the company and make inspections of the operations first hand.

3. The team conduct meetings with different levels of management including the chief

executive officer

4. The team consults with a back-up team which has collected company's information

from other sources and prepares the report.

5. The team forwards its reports to the internal committee consisting of senior executives

of credit rating agency.

6. An open discussion between the team members and the internal committee takes

place to arrive at a rating.

7. Then the ratings are placed before an external committee consisting of respected and

eminent people unconnected with credit rating agency to avoid any sort of biasness.

8. The decision of the external committee is communicated to the company as a final

decision.

9. The company may volunteer any further information at this point which could affect the

rating. This information is passed on to the external committee again for change or

affirmation of the previous ratings.

10. The company may request the agency for review of the rating.

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This process can also be presented through the following flow chart :

Request by the Company for Rating

Assigning the Work to a Team by Credit Rating Agency

Visit and Inspection of company by the Team

Receive Intial Information and Conducts Managerial Meetings

Interaction with Back-up Team and Preparation of Report

Forwading of Report to Senior Exective of Rating Agency

Arriving at a Rating after Discussins

Forwarding Rating to External Committee for Final Decision

Communicationg Rating to Company

Acceptance

Drawbacks of Credit Rating Process : Rating Process has certain advantage but

simultaneously suffers from drawbacks also. These are:

1. It does not take into account the factors, like market prices, personal risk or

reward preferences that might influence investment decisions.

2. It is based on certain primitives. The analysis is based on information provided

by the issuer and the rating agency does not take audit of that information.

Consequently the rating process is compromised on the information provided,

whether it is accurate pr inaccurate.

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3. Most of the rating agencies do not give rating to equity are supposed to take risk

4. The ratings are only the matters of opinion and not a recommendation to

purchase or sell or hold security.

5. Credit ratings depend on both expertise and honesty of credit rating agencies.

Therefore, credit ratings may also serve to misguide the investors.

Q. Explain briefly the credit rating methodology used by the rating agencies for

manufacturing and financial services companies.

Ans. Rating Methodology : The rating methodology involves an analysis of the industry

risk, issuer's business and financial risks. A rating is assigned after assessing all the factors

that could affect the credit worthiness of the entity. The rating methodology is illustrated

below with reference to

(1) For Manufacturing Companies : The main elements of the rating methodology for

manufacturing companies are given below:

(i) Business Risk Analysis : The rating analysis begins with an assessment of the

company's environment, focusing on the strength of the industry prospects,

pattern of business cycles as well as the competitive factors affecting the

industry. Business analysis is basically undertaken to analyse the risks involved

in the operations of the company. It includes:

ØIndustry Risk : It includes competitions from others, market factors,

demand and supply position and government policies, etc.

ØMarketing Risk : It covers competitive advantages or disadvantages,

market share, sales network, etc.

ØOperating Efficiency : It involves locational advantages, labour

cooperation, cost efficiency and operating margins, etc.,

ØLegal Position : Terms of the issue document/prospectus, trustees and

their responsibilities, systems for timely payment and for protection

against fraud and so on.

(ii) Financial Risk Analysis : After evaluating the issuer's competitive positions

and operating environment, the analysts proceed to analyse the financial

strength of the issuer. This analysis includes the examination of :

ØAccounting Quality : Overstatement/Understatement of profits, auditors

qualifications, method of income recognition, inventory valuation and

depreciation policies, contingent liabilities etc. are examined by the credit

rating agency.

ØEarning Prospects : The projection of future earnings, profitability ratios,

earning per share proportion of interest to gross profit and net profit, etc.

are analysed to check the truthfulness of the given data.

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ØAdequacy of Cash Flows : Cash flow adequacy as reflected in working

capital management, current ratio, quick ratio, etc. are examined by the

rating agencies.

ØFinancial Flexibility : Financial flexibility of the firm in terms of capital

financing plans, ability to raise funds and so on.

ØInterest and Tax Sensitivity : Exposure to interest rate changes, tax law

changes, hedging against interest rates and so on.

(iii) Management Risk : A proper assessment of debt protection levels requires an

evaluation of the management philosophies and its strategies. The analyst

compares the company's business strategies and financial plans to provide

insights into a management's abilities, with respect to forecasting and

implementing of plans. Specific areas reviewed include:

ØTrack record of management: planning and control system, depth of

managerial talent, succession plan.

ØEvaluation of capacity to overcome adverse situations

ØGoals, philosophy and strategies.

(2) For Financial Services Companies : When rating debt instruments of financial

institutions, banks and non-banking finance companies, in addition to the financial

analysis and management evaluation explained above, the assessment also lays

emphasis on the following factors:

(i) Regulatory and Competitive Environment : This includes:

ØStructure and regulatory framework of the financial system

ØTrends in regulation/deregulation and their impact on the company/institution

(ii) Fundamental Analysis : Fundamental analysis should include:

ØCapital Adequacy : Assessment of the true net worth of the issuer, its adequacy

to the volume of business and the risk profile of the assets.

ØResources : Overview of funding sources, funding profile, cost and tenor of

various sources of funds.

ØLiquidity Management : Capital structure, term matching of assets and

liabilities, policy on liquid assets in relation to financing commitments and

maturing deposits are also analysed by credit rating agencies.

ØProfitability and Financial Position : Credit rating agency also analyses the

profitability and financial position of the company. For this, the rating agency

analyses the past profit, revenues on non fund based services, accretion to

reserve and so on.

ØInterest and Tax Sensitivity : Exposure to interest rate changes, tax law

changes, hedging against interest rates and so on.

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Q. Explain the Credit Rating Agencies in India. Also explain the rating symbols

used by credit rating agencies.

Ans. Credit Rating Agencies in India : There are four credit rating agencies in India.

These are as follows:

1. CRISIL Ltd.

2. ICRA Ltd.

3. CARE Ltd.

4. FITCH Ltd.

1. Credit Rating Information Services of India Ltd. (CRISIL Ltd.) : As the first credit

rating agency in India, the CRISIL was promoted in 1987 jointly by the ICICIA Ltd. and

the Unit Trust of India. Other shareholders include:

(i) Asian Development Bank.

(ii) Life Insurance Corporation

(iii) HDFC Ltd

(iv) General Insurance Corporation

(v) Several Foreign and Indian Banks.

It commenced operation on January 1, 1988. It offered its share capital to the public in 1993.

Its objective is to rate the debentures, fixed deposits, short term borrowing instruments and

preference shares of the companies on request from them. The CRISIL ratings are now

required by the authorities, banks, UTI, merchant bankers, etc. in the due course of assisting

companies. CRISIL is also publishing the corporate news regularly, containing information

on their financial, business and technical aspects.

Objectives of CRISIL :

(i) To assist both individual and institutional investors in making investment decisions in

fixed interest securities.

(ii) To enable companies to mobilize funds in large amounts from a wide investor base, at

a fair cost.

(iii) To enable intermediaries to place debt instruments with investors by providing them

with an effective marketing tool.

(iv) To provide regulators with a market-driven system for bringing about discipline and a

healthy growth of capital markets.

To achieve these objectives, the functions performed by the CRISIL currently fall under four

broad categories:

(i) Credit Rating Services

(ii) Advisory Services

(iii) Credibility first rating and evaluation services

(iv) Training Services

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Rating Symbols and Investor Protection : Investors should also be familiar with the

ratings given by the CRISIL for protecting their interests. The CRISIL ratings are given only

for debt instruments of companies, commercial papers, debentures, bonds and fixed

deposits. The symbols and their implication used for ratings are as follows:

Debenture Ratings :

Debenture Ratings Implications

Triple A - AAA Highest Security

Double A -AA High Safety

Single A - (A) Adequate Safety

Triple B- BBB Moderate Safety

Double B - BB Inadequate Safety

B High Risk

C Substantial Risk

D Default

Fixed Deposit Ratings :

Fixed Deposit Ratings Implications

F -Triple A - (FAAA) Highest Safety

F -Double A -(FAA) High Safety

F -Single A - (FA) Adequate Safety

F- Single B ( FB) Inadequate Safety

F- Single C (FC) High Risk

F-Single D (FD) Default

Short-Term Instruments :

P-1 Highest Safety

P-2 High Safety

P-3 Adequate Safety

P-4 Inadequate Safety

P-5 Default

2. Investment Information and Credit Rating Agency of India Ltd. (ICRA Ltd.) : ICRA

was incorporated on January 16, 1991 and launched its service on August 31, 1991. It

was formerly known as Investment Information and Credit Rating Agency of India Ltd.

The ICRA Ltd. Has been promoted by the IFCI Ltd as the main promoter to meet the

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requirements of the companies based in the northern parts of the country. Apart from

the main promoter, which holds 26 percent of the share capital, the other shareholders

are:

(i) Unit Trust of India

(ii) Banks

(iii) Life Insurance Corporation

(iv) General Insurance Corporation

(v) Exim Bank

(vi) HDFC Ltd.

(vii) ILFS Ltd.

Objectives of ICRA :

(i) To assist investor, both individual and institution, in making well informed

decisions.

(ii) To assist issuers in raising funds, from a wider investor base, in large amounts

and at a lower cost for highly rated entities

(iii) To enable banks, investment bankers, brokers in placing debt with investors by

providing them with a marketing tool.

(iv) To provide regulators with market driven systems to encourage the healthy

growth of the capital markets in a disciplined manner, without additional burden

on the Government.

Services provided by ICRA : It presently offers its services under three banners:

(i) Rating Services

(ii) Information Services

(iii) Advisory Service

ICRA offers its rating services to a wide range of issuers including :

(i) Manufacturing Companies

(ii) Banks and Financial Institutions

(iii) Power Companies

(iv) Service Companies

(v) Construction Companies

(vi) Insurance Companies

(vii) Municipal and other local bodies

(viii) Non-banking financial service companies

(ix) Telecom Companies

(x) Infrastructure Companies, such as dams, roads and highways.

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Rating Symbols :

Long-Term Instruments Including Debentures, Bonds and Preference Shares :

LAAA Highest Safety

LAA+, LAA High Safety

LA+, LA Adequate Safety

LBBB Moderate Safety

LBB+, LBB Inadequate Safety

LB+, LB Risk Prone

LC+, LC Substantial Risk

LD Default Extremely Speculative

Medium Term Instruments, Including Fixed Deposit and Certificate of Deposits :

MAAA Highest Safety

MAA+, MAA High Safety

MA+, MA Adequate Safety

MB+, MB Inadequate Safety

MC+, MC Risk Prone

MD Default

Short-term Instruments, including Commercial Papers :

A1+, A1 Highest Safety

A2+, A2 High Safety

A3+, A3 Adequate Safety

A4+, A4 Risk Prone

A5 Default

3. Credit Analysis and Research Care (CARE Ltd.) : The CARE Ltd is a credit rating

and information services company promoted by the Industrial Development Bank of

India jointly with financial institutions, public/private sector banks and private finance

companies. It commenced its credit rating operations in October 1993 and offers a

wide range of products and services in the field of credit information and equity

research. Currently, it offers the following services:

(i) Credit Rating : The CARE undertakes credit rating of all types of debt

instruments, both short term and long term.

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(ii) Advisory Services : The CARE provides advisory services in the areas of:

ØSecuritisation Transactions

ØStructuring Financial Instruments

ØFinancing of Infrastructure projects

ØMunicipal Finances

(iii) Information Services : The broad objective of the information services is to

make available information on any company, industry or sector required by a

business enterprise.

(iv) Equity Research : Equity research involves an extensive study of the shares

listed/ to be listed in the major stock exchanges, and identification of the

potential winners and lowers among them, on the basis of the fundamentals

affecting the industry, market shares, management capabilities, international

competitiveness and other relevant factors.

(v) Publications : The CARE's publications include:

ØRating Reckoner- an update on its accepted ratings and

ØCAREVIEW- a quarterly bulletin providing information on its ratings.

(vi) Other Services :

ØThe CARE loan rating

ØCredit Analysis Rating

Rating Symbols : The CARE's ratings are as follows:

CAR -1 Excellent debt management capability

CAR-2 Very good management capability

CAR -3 Good Capability in debt management

CAR -4 Barely satisfactory capability for debt management

CAR -5 Poor capability for debt management

4. FITCH Ratings India Ltd. : FITCH ratings are an international rating agency that

provides global capital market investors with the highest quality ratings and research.

FITCH rates entities in 75 countries and has some 1100 employees in more than 40

local offices worldwide. FITCH ratings provides ratings for financial institutions,

insurance corporates, sovereigns and Public finance markets worldwide. FITCH India

is a 100% subsidiary of FITCH group. It is the only international rating agency with a

presence on the ground in India.

Benefits of a Rating from FITCH :

(i) It is the only rating agency in India with the ability to issue ratings on both

domestic and international debt issuances.

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(ii) FITCH ratings are quoted daily on the financial magazines in the public press

and in research publications.

Rating Symbols :

1. Long Term Investment ( 12 months and above) :

AAA (ind) Highest Credit Quality

AA (ind) High Credit Quality

A (ind) Adequate Credit Quality

BBB (ind) Moderate Credit Quality

BB (ind) Speculative

B ( ind) Highly speculative

C (ind) High Default Risk

D (ind) Default

2. Time Deposits ( Bank Deposits and Fixed Deposits) :

tAAA (ind) Highest Credit Quality

tAA+(ind) High Credit Quality

tA +(ind) Adequate Credit Quality

tB+(ind) Speculative

t C(ind) High Default Risk

t D(ind) Default

3. Short-Term ( Less than 1 Year) :

F 1+( Ind) Highest Credit Quality

F 2+( Ind) Good Credit Quality

F 3 ( Ind) Fair Credit Quality

F 4 ( Ind) Speculative

F 5 ( Ind) Default

Key Indian Clients : The key Indian Clients of FICTH rating are as follows:

1. Ashok Leyland Ltd. 2. Ambuja Cement Ltd.

3. Britannia Ltd. 4. Indo Gulf Fertilizers Ltd.

5. Ford Motor Company Ltd. 6. Reliance Industries Ltd.

7. Reliance Petroleum Ltd. 8. WIPRO Ltd.

9. State Bank of India 10. Kotak Mahindra.

11. ICICI Bank 12. IDBI.

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UNIT – IV


Q. Define Venture Capital. What are the regulations of venture capital funds by the

SEBI

Ans. Introduction : Venture capital implies long term investment generally in high risk

industrial projects with high reward possibilities. This investment may be at any stage of

implementation of the project between start-up and commencement production.

Expectation of higher gain motivates the investor to invest the funds in the risky venture

which generally utilize new technology with higher probability of failure than success. The

investor makes higher capital gains through appreciation in the value of such investment if

the new technology proves successful, leading the enterprise to grow.

Meaning of Venture Capital : Venture capital is equity, equity featured capital seeking

investment in new ideas, new companies, new products, new process or new services that

offer the potential of high returns on investment. It may also include investment in

turnaround situations.

Venture capital means start up and first stage financing and funding the expansion of

companies that have already demonstrated their business potential but do not have access

to the public securities markets or to credit oriented institutional funding sources.

Features of Venture Capital :

(i) Investments are made in equity or equity featured instruments of investment in high

tech industry and wait for 5-7 years to reap the benefit of capital gains.

(ii) Young companies that do not have access to public sources of equity or other forms of

capital can collect venture capital.

(iii) Investment are made in innovative projects with new technology with a view to

commercialize the know how through new products/services.

(iv) Industry, products or services that hold potential of better than normal.

(v) Add value to the company through active participation and take higher risks with the

expectation of higher rewards.

(vi) It is a long term investment in growth-oriented small/medium firms.

(vii) Turnaround Companies- When sick industries are revised by purchasing by any other,

then the face of this industry has turnaround.

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(viii) Venture capital investors are not directly involved in the management of the enterprise but manage their own portfolio of investments.

(ix) Venture capital investor does not interfere in the day-to-day business affairs but closely watches the performance of the business unit and keeps in close contact with the entrepreneur to protect and enhance his investment.

(x) Venture capital funds need not be repaid in the course of business units, but it is realized through the exit route.

SEBI Venture Capital Funds Regulations : According to these regulations, a VCF means a fund setup as a trust/company which has dedicated pool of capital raised in the specified manner and invests it in the specified manner. The main elements of the SEBI regulations are discussed below:

(1) All VCFs must be registered with SEBI and pay Rs. 1,00,000 as application fee and Rs. 10,00,000 as registration fee for grant of certificate.

(2) An applicant, whose application has been rejected by SEBI, would not carry on any activity as a VCF.

(3) In the interest of investors, SEBI can issue directions with regard to transfer of records/documents/securities/disposal of investment relating to is activities as a VCF.

(4) In order to protect the interest of the investors, it can also appoint any person to take charge of the records/documents/securities including the terms and conditions of such appointment.

(5) The VCF are authorized to raise funds/money from:

(i) Indian Investors

(ii) Foreign Investors

(iii) Non-Resident Indian Investors

(6) Venture capital funds must disclose the investment strategy at the time of their registration.

(7) They cannot invest more than 25 per cent corpus of the fund in one venture capital undertaking.

(8) A VCF is not permitted to issue any document/advertisement inviting offers from public for subscription/ purchase of any of its units.

(9) The VCFs must maintain for a period of eight years, books of accounts which give a true and fair picture of the state of their affairs.

(10) A VCF established as a company can be wound up in accordance with the provision of the Companies Act.

Q. Discuss the Process of Venture Capital Investment.

Ans. Venture Capital Investment Process : Financing of a high tech project under venture capital has following steps. They can be presented in the form of following diagram:

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Graphic Presentation of Venture Capital Investment Process :

Preparing a Project Report

Preliminary Evaluation

Detailed Approval

Sensitivity Analysis

Investment in the Project

Monitoring the project and postinvestment support

(1) Preparing a Project Report : The prospective entrepreneur, with his know-ho,

prepares a project report establishing therein the possibility of marketing a

commercial product. This can be done with the help of an auditor, professional or a

merchant banker. The business consists of five important feasibility reports namely:

(i) Technical Feasibility

(ii) Financial Feasibility

(iii) Managerial Feasibility

(iv) Marketing Feasibility

(v) Socio-economic Feasibility

(2) Preliminary Evaluation : After the first stage is completed, the venture capital

investor normally discusses the investment plan for the project with banker.

(3) Detailed Approval : In addition to the close discussion with the management team, a

detailed appraisal of project is undertaken. If required, they may even consult experts

in the similar field to take a decision.

(4) Sensitivity Analysis : The forecasted results of both sales and profits are tested and

analyzed. The risks and threats are evaluated by using sensitivity analysis, which

helps evaluate to predict the probable risks and returns associated wit the project.

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(5) Investment in the Project : The terms and conditions of venture capital assistance

are finalized according to the requirement of the project. The amount of funds

required, profit of the business, technology and the possible competition in the

business will also be looked into.

(6) Monitoring the project and post investment support : The venture capitalist role

begins with financing the project. It is a general practice of investor to appoint and

executive director to have closer look into the project. He assists the project in

developing strategies, decision making and planning.

Q. What are the stages of Venture Capital Financing.

Ans. Venture Capital Financing : The selection of investment is closely related to the

stages and type of investment. The stages of financing as differentiated in the venture

capital industry broadly fall into two categories :

Stages of Venture Capital Financing

Early Stage Financing Later Stage Financing

Seed Capital Expansion Finance

Start up stage Financing Turnarounds

Second Round Financing Management BuyOuts

(A) Early Stage Financing : This stage of financing is done to initiate the new project or

help the new technocrat who wishes to commercialize his research talents. The main

instruments used for such financial assistance would be in the form of equity

contribution, unsecured loans and optionally convertible securities. This stage of

venture capital financing consists of:

(i) Seed Capital : Relatively small amount of capital is provided to an entrepreneur

to prove his concept. Seed capital financing includes implementation of

research project, starting from the all initial conceptual stage. This stage

requires more time to complete the process because the entrepreneur has

madder an effort to the maximum to meet the market potentially. They key

factors that influence equity financing at this stage are:

ØThe technology used in the project and possible threats of new technology

in the near future.

ØDifferent aspect of product life cycle.

ØThe total investment required to commercialize the product and the time

required to get suitable returns etc.

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(ii) Start Up Stage Financing : This is the stage when commercial manufacturing

has to commence. Venture capital financing here is provided for product

development and initial marketing. It includes several types of new projects

such as:

ØGreenfield based on a relatively new or high technology

ØNew business in which the entrepreneur has good knowledge and

working experience.

ØNew projects by established companies

(iii) Second Round Financing : Start up stage is the stage of implementation of a

project The enterprise may need funds for further investment before completion

of the project. Such financing is called second round financing. This represents

the stage at which the product has already been launched in the market but the

business has not, yet, become profitable enough for public offering to attract

new investors. This type of financing is required when the project incurs loss or

shows inability to yield sufficient profits. The reason could be due to internal or

external factors.

(B) Later Stage Financing : This stage of venture capital financing involves established

business which required additional financial support but cannot take recourse to

public issues of capital. It includes:

(i) Expansion Finance : Expansion finance may be needed by the enterprise for

adding production capacity once it has successfully gained market share and

faces excess demand for the product. It is strategically executed to:

ØExpand the Market

ØExpand the Production

ØTo establish warehouse.

ØExport activities may also be considered for financing the proposed

project.

(ii) Turnaround : Venture capitalists make available finance for an enterprise which

has gone unprofitable after crossing the early stage and entering into

commercial production. Two kinds of inputs are required in a turnaround-

namely, money and management. The VCIs have to identify good management

and operations leadership. Such form of venture capital financing involves

medium to high risk and a time-frame to three to five years.

(iii) Management BuyOuts : VCIs provide funds to enable the current operating

management to acquire an existing product line.

Q. Explain the Financial Instruments of Venture Capital Financing.

Ans. Structuring the Deal/Financial Instruments : The structuring of the deal refers to

the financial instruments through which venture capital investment is made. There are many

instruments:

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(1) Equity Instruments : The following types of equity instruments are:

(i) Ordinary Equity Shares

(ii) Non-Voting Equity Shares

(iii) Preference Ordinary Shares

(iv) Cumulative Convertible Preference shares.

(v) Participating Preference Shares

(vi) Convertible cumulative redeemable preference shares

(2) Debt Instruments : To ensure that the entrepreneur retains managerial control, debt

instruments are issued. They Includes:

(i) Convertible Debt: This debt can be converted in to equity shares of the

company.

(ii) Non-Convertible Debt: This debt cannot be converted into equity shares of the

company.

(iii) Conditional Loan: This is a form of loan finance without any pre-determined

repayment schedule or interest rate. The suppliers of such loans recover a

specified percentage of sales towards the recovery of the principal as well as

revenue in a pre-determined ratio, usually 50:50. The charges on sales is known

as royalty.

(iv) Conventional Loans: These are modified to the requirements of venture capital

financing. They carry lower interest initially which increases after commercial

production commence. A small royalty is additionally charged to cover the

interest foregone during the initial years.

(v) Income Notes: These fall between the conventional and the conditional loans

and carry a uniform low rate of interest plus royalty on sales.

Q. What are the important channels for exit of investment in venture capital

financing?

Ans. Exit Routes : The main aim of the venture capitalist is to realize the investments with

huge profit after the completion of successful efforts with the promoter in launching or

commercializing the product. The exit route will be well thought by the investor at the stage of

making investments. There are four alternatives:

(1) Initial Public Offer : Most of the venture capital assisted firms prefer to go in for public

issues to recover their investments with profits. The public issues provide another

opportunity for the company to list its shares in the stock market. Once the shares are

listed, the image of the company increases and attracts efficient persons to work in the

organizations, In addition to this, commercial banks and financial institutors

strategically come forward to offer different types of loans. If the firm wishes to raise

additional capital for expansion and growth, it could be done easily through the public

issue.

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(2) Buy Back of Share by the Promoters : Sometimes, the promoter may prefer to have

exit route though Over The Counter Exchange Of India by entering into bought out

deals with the member of O.T.C. He may purchase the shares with a view to entering

into the primary market later.

(3) Sale of Enterprise to Another Company : Venture capitalist can recover its

investments by selling the holdings to outsider or some other company who is

interested in purchasing the entire enterprise from the entrepreneur.

(4) Liquidation : This is a lender of last resort, when a firm performs very badly, on other

words if it incurs continuous cash loss over the years, the venture capitalist and the

entrepreneur decides, to close down the operations. Hence, it takes the firm to

liquidation. The reason for such a excise would be many:

(i) Stiff Competition

(ii) Technological Failure

(iii) Poor management by the entrepreneur etc.

Q. Define Factoring. Explain briefly the Mechanism of Factoring

Ans. Factoring : Factoring is a financial service which is rendered by the specilaised

persons known as 'Factors" who deal in realizing the book debts, bills receivable, managing

sundry debtors and sales registers of the commercial and trading firms in the capacity of

agent for a commission. Such commission is known as 'commercial charge'. Factoring helps

in realization of credit sales of trading firms.

Definition of Factoring :

"Factoring means an arrangement between a factor and his client which includes at

least two of the following services to be provided by the factors:

(i) Finance

(ii) Maintenance of accounts

(iii) Collection of debts

(iv) Protection against credit risk".

Parties to Factoring Contract :

1. Buyer of goods who has to pay for goods bought in a factoring contract.

2. Seller of goods who has to realize credit sales from buyer

3. Factor who acts as agent in realizing credit sales from buyer and passes on the

realized sum to seller after deducting his commission.

Process OR Mechanism of Factoring : Credit sales generate the factoring business in

ordinary course of business dealings. Realisation of credit sales is the main function of

factoring services. Once sale transaction is completed, the factor steps in to realize the

sales. Thus, factor works between the seller and the buyer and sometimes with seller's

banks together. Mechanism of Factoring is:

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Mechanism of Factoring

Various activities undertaken by the three parties in a factoring transaction are listed here under:

(1) Buyer :

(i) Buyer negotiates terms of purchasing the material with the seller.

(ii) Buyer receives delivery of goods with invoice and instructions by the seller to make payment to the factor on due date.

(iii) Buyer makes payment to factor in time or gets extension of time or in the case of default is subject to legal process at the hands of factor.

(2) Seller :

(i) Memorandum of Understanding(MOU) with the buyer in the form of letter exchanged between them or agreement entered into between them.

(ii) Sells goods to the buyer as MOU.

(iii) Delivers copies of invoice, delivery challan, MOU, instruction to make payment to factor given to buyer.

(iv) Seller receives 80 per cent or more payment in advance from factor on selling the receivable from the buyer to him.

(v) Seller receives balance payment from factor after deduction of factor's service charges etc.

(3) Factor :

(i) The factor enters into agreement with seller for rendering factor services to it.

(ii) On receipt of copies of sale documents as referred to above makes payment to the seller of the 80 per cent of the price of the debt.

(iii) The factor receives payment from the buyer on due dates and remits the money to seller after usual deductions.

(iv) The factor also ensures that the following conditions should be met to give full effect to the factoring arrangements:

SELLER

Places Order

Delivery of Goods & InvoiceWith Notice to pay Factor

BUYER

FACTOR

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ØThe invoice, bills or other documents drawn by the seller should contain a

clause that these payments arising out of the transaction as referred to or

mentioned in might be factored.

ØThe seller should confirm in writing to the factor that all the payments

arising out of these bills are free from any charge, pledge, or mortgage etc.

ØThe seller should execute a deed of assignment in favour of the factor to

enable hime to recover the payment at the time or after default.

ØThe seller should confirm that all conditions to sell-buy contract between

him and the buyer have been complied with and the transactions

complete.

Q. Discuss briefly the various forms of factoring. Also explain the advantage and

disadvantage of Factoring.

Ans. Factoring : Factoring is a financial service which is rendered by the specilaised

persons known as 'Factors" who deal in realizing the book debts, bills receivable, managing

sundry debtors and sales registers of the commercial and trading firms in the capacity of

agent for a commission. Such commission is known as 'commercial charge'. Factoring helps

in realization of credit sales of trading firms.

Types /Forms of Factoring: Depending upon the features built into the factoring

arrangement to cater to the varying needs of trade/clients, there can be different types of

factoring. The important forms of factoring arrangements are briefly discussed below:

(1) Recourse Factoring : Under a recourse factoring arrangement, the factor has

recourse to the client (firm) if the debt purchased factored turns out to be irrecoverable.

In other words, the factor does assume credit risks associated with the receivables. If

the customer defaults in payment, the client has to make good the loss incurred by the

factor. The factor is entitled to recover from the client the amount paid in advance in

case the customer does not pay on maturity. The factor charges the client for

maintaining the sales ledger and debt collection services and also for the interest for

the period on the amount drawn by the client.

(2) Non-recourse Factoring : The factor does not have the right of recourse in case of

non-recourse factoring. The loss arising out of irrecoverable receivables is borne by

him, as a compensation for which he charges a higher commission. The additional

fess charged by him as a premium for risk-bearing is referred to as a del-credere

commission.

(3) Advance Factoring : The factor pays a pre-specified portion of the factored

receivables in advance, the balance being paid upon collection.

(4) Maturity Factoring : The maturity factoring is also known as collection factoring.

Under such arrangements, the factor does not make a pre-payment to the client. The

payment is made on the date of collection.

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(5) Disclosed Factoring : In disclosed factoring, the name of the factor is disclosed in the invoice by the supplier or manufacturer of the goods asking the buyer to make payment to the factor. The supplier may continue to bear the risk of non-payment by the buyer without passing it on to the factor.

(6) Undisclosed Factoring : The name of the factor is not disclosed in the invoice although factor maintains the sales ledger of the supplier or manufacturer. The entire realization of the business transaction is done in the name of the supplier company abut all control remains with the factor.

(7) Domestic Factoring : In the domestic factoring, the three parties involved, namely, buyer, seller and factor are domiciled in the same country.

(8) Export Factoring : The process of export factoring is almost similar to domestic factoring except in respect of the parties involved. While in domestic factoring three parties are involved, there are usually four parties to a cross-border factoring transaction. They are:

(i) exporter (Seller)

(ii) Importer ( Buyer)

(iii) Export Factor

(iv) Import Factor

Since two factors are involved in the deal, international factoring is also called Two-Factor System of Factoring.

Advantages of Factoring : Following are the advantage resulting from the factoring:

(1) Elimination of trade discounts.

(2) Prompt payments and credits

(3) Reduction in administrative cost and burden.

(4) Increase in return to the client

(5) Improvement in liquidity

(6) Provides insurance against bad debts

(7) It is not bank loan nor a deposit but facilitates liquidity

(8) It avoids increased debts

(9) Better credit discipline amongst customers by regular realization of dues, effective control of sales journal, reduced credit risk, better working capital requirement etc.

Disadvantages of Factoring :

(1) Image of the client may suffer as engaging a factoring agency is not considered a good sign of efficient management.

(2) Factoring may not be of much use where companies have nation-wide network of branches.

(3) Where goods are sold against advance payment, factoring may not be useful.

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Q. Write a note on Factoring in India.

Ans. Factoring in India : Some of the major factoring firms in India are:

(1) SBI Factors & Commercial Services Ltd. : SBI gas floated its subsidiary in March, 1991 as SBI Factors and Commercial Services Ltd. which commenced operations in April, 1991 starting with bill-discounting and other services. SBI FACS contemplated to undertake collection and credit services designed to improve cash flow of business concerns, by timely realization of debt or receivables. A seller can have his invoice converted into instant cash upto 80% without having to wait for 30, 60 or 90 days. SBI FACS takes the responsibility of collection of debts due from customers of the clients. It will also undertake the maintenance of client's sales ledger by using the computerised system. SBI FACS has paid up capital of Rs. 25 crores and had factored debt of Rs. 30 crores with gross profit of Rs. 2 crores during the year.

(2) Canara Banks Factors Ltd. : Canara Bank Factor Ltd, got approval and was simultaneously incorporated as subsidiary of Canara Bank in August 1991 and has been operating in south zone. It has paid up capital of Rs. 10 crores contributed by Canara Bank, Andhra Bank and Small Industrial Development Bank of India in the proportion of 60:20:20 and rendering same services as SBI FACS.

(3) Fairgrowth Factors Ltd. : It is the first company in private sector aloe\wed to operate as factors. It has started its functions in April, 1992 and has paid up capital of Rs.5 crores.

Q. Define Forfaiting. Explain briefly the Mechanism of Forfaiting.

Ans. Forfaiting : Forfaiting denotes the purchase of trade bills or promissory notes by a bank or financial institution without recourse to seller. This purchase is in the form of discounting the bills or notes covering the entire risk of non-payments in collection. Thus, all risks and collection problems are fully the forfaiter's responsibility who pays cash to seller after discounting the notes or bills. Forfaiting has been permitted to exporters in India since 1992.Forfaiting is a without recourse finance which converts a credit sale into a cash sale.

Mechanism of Forfaiting : The communication channels and module of transactions in forfeiting are shown in the following figure:

Diagram : Mechanism of Forfaiting

Exporter

Agreement

Delivery of goods - export

Delivery of Bills of Exchange

With bank/acceptance guarantor

Importer

Forfaiter

Presentation of bills on maturity

Payment on Maturity Bank

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Explanation :

(1) Commercial contract between the exporter and importer

(2) Delivery of goods from exporter to importer

(3) Acceptance and delivery of bills of exchange drawn on importer by exporter back to

exporter

(4) Forfaiting contract between the forfeiter and the exporter

(5) Delivery of bills of exchange by exporter to importer

(6) Cash payment by forfeiter to exporter of the face value of bill less discount.

(7) Presentation of bills of exchange on maturity for payment by forfeiter to importer bank.

(8) Payment of bills by importers bank to forfeiter.

Advantage of Forfaiting :

(i) Forfaiting enable a broad range of instrument in use like promissory notes, bills of

exchange etc.

(ii) It does not involve any risk on account of foreign exchange fluctuations to exporter

between the insurance date and maturity of paper.

(iii) Exporter faces no administration and collection problems

(iv) It provides finance for counter trade, etc.

Q. Distinguish between Factoring and Forfaiting.

Ans. Meaning of Factoring : Factoring is a financial service which is rendered by the

specilaised persons known as 'Factors" who deal in realizing the book debts, bills

receivable, managing sundry debtors and sales registers of the commercial and trading

firms in the capacity of agent for a commission. Such commission is known as 'commercial

charge'. Factoring helps in realization of credit sales of trading firms.

Forfaiting : Forfaiting denotes the purchase of trade bills or promissory notes by a bank or

financial institution without recourse to seller. This purchase is in the form of discounting the

bills or notes covering the entire risk of non-payments in collection. Thus, all risks and

collection problems are fully the forfaiter's responsibility who pays cash to seller after

discounting the notes or bills.

Distinguish Between Factoring and Forfaiting :

Sr. Basis Factoring ForfaitingNo. of Difference

1. Time Factoring is usually for trade Forfaiting is usually for

credit transactions of short credit transactions of long

term maturities not exceeding term maturity periods.

six months

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2. Recourse or Factoring can be with Forfaiting is without

without recourse recourse or without recourse recourse to the exporter.

depending upon the terms All risks are taken over

of transactions between the by the forfeiter

seller and factor.

3. Cost Cost of factoring is usually Cost of forfeiting is borne

borne by the seller. by the importer

Q. Briefly explain the features of a bill of exchange, its types and advantages.

Ans. Introduction : Bill discounting, as a fund based activity, emerged as a profitable business in the early nineties for finance companies. Bill discounting is a source of short-term trade finance. It is also known as acceptance credit where one party accepts the liability of trade towards third party. Bill discounting is used as a medium of financing the current trade and is not used for financing capital purposes.

The concept of bills discounting based upon the operation of bills of exchange.

Definition of Bill of Exchange (B/E) :

According to the Indian Negotiable Instruments Act, 1881

" The bill of exchange is an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person, or to the bearer of that instrument".

Creation of a B/E : Suppose a seller sells goods to a buyer. In most cases, the seller would like to be paid immediately but the buyer would like to pay only after some time, that is, the buyer would wish to purchase on credit. To solve this problem, the seller draws a B/E of a given maturity on the buyer. The seller has now assumed the role of a creditor and is called the drawer of the bill. The buyer, who is the debtor, is called the drawee. The seller then sends the bill to the buyer who acknowledges his responsibility for the payment of the amount on the terms mentioned on the bill by writing his acceptance on the bill. The acceptor could be the buyer himself or any third party willing to take on the credit risk of the buyer. Normally there are two parties involved in bill of exchange:

ØDrawer

ØDrawee

Discounting of a B/E : The seller, who is the holder of an accepted B/E has two options:

1. Hold on to the B/E till maturity and then take the payment from the buyer.

2. Discount the B/E with a discounting agency. This second options is by far more attractive to the seller. The seller can take over the accepted B/E to a discounting agency and obtain ready cash. The discounting agency may be a bank, NBFC or a company. The act of handing over an endorsed B/E for ready money is called discounting the B/E.

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ØDiscount : The margin between the ready money paid and the face value of the

bill is called the discount and is calculated at a rate percentage per annum on the

maturity value.

ØMaturity : The maturity a B/E is defined as the date in which payment will fall

due. Normal maturity periods are 30, 60, 90 or 120 days but bills maturing within

90 days seem to be the most popular.

Types of Bill : There are various types of bills.

(1) Demand Bill : This is payable immediately "at sight" or "on presentment" to the

drawee. A bill on which no time of payment is specified is also termed as demand bill.

(2) Usance Bill : This is also called time bill. Usance bill refers to the time period for

payment of bill.

(3) Documentary Bills : These are the B/Es that are accompanied by documents that

confirm that a trade has taken place between the buyer and the seller of goods. These

documents include the invoice and other documents.

(4) Clean Bills : These bills are not accompanied by any documents that show that a

trade has taken place between the buyer and the seller. Because of this, the interest

rate charged on such bill is higher than the rate charged on documentary bills.

Advantages of Bill Discounting : The advantages of bill discounting to investors and

banks and finance companies are as follows:

(A) To Investors :

(i) Short term sources of finance.

(ii) Flexibility, not only in the quantum of investment but also in the duration of

investments.

(B) To Banks :

(i) Safety of Funds : The greatest security for a banker is that a B/E is a negotiable

instrument bearing signatures of two parties considered good for the amount of

bill; so he can enforce his claim easily.

(ii) Certainty of Payment : A B/E is a self-liquidating assets with the banker

knowing in advance the date of its maturity

(iii) Profitability : Since the discount on a bill is front-ended, the yield is much higher

than on other loans and advances, where interest is paid quarterly or half yearly.

Q. What is Hire-purchase System? Also explain the Legal Provisions of Hire-

Purchase System.

Ans. Hire-Purchase System : Hire purchase means a transaction where goods are

delivered to the purchase immediately on signing the agreement and he is called upon to the

purchase price in periodic installments. These installments may be monthly, quarterly, half-

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yearly or yearly depending upon the terms of the agreement. Each instilment is treated as a

hire charge till the payment of the last installment when ownership or property in the goods

passes from seller to the buyer. In case the default is made in the payment of even the last

installment, the seller will be entitled to repossess the goods and forfeit the amount already

received treating it as a hire charge. As such, under this system, the purchaser is called 'Hire

Purchaser' and the seller is called 'Hire Vendor'.

Definitions :

According to J. R. Batliboi :

"Under the Hire Purchase System, goods are delivered to a person who agrees to pa

the owners by equal periodical installments, such installments are to be treated as hire of

these goods, until a certain fixed amount has been paid, when these goods become the

property of the hirer".

Characteristics of Legal Provisions of Hire-Purchase System :

(1) Right to use the goods : Possession of goods is delivered to the hire-purchaser

immediately on signing the agreement and he becomes entitled to use the goods.

(2) Payment in Installment : Under section 3 of the Act, it is compulsory that hire-

purchase agreement should be in writing and signed b the parties concerned. It must

state the following :

ØHire-purchase price of the goods,

ØCash price of the goods,

ØDate of commencement of the hire-purchase agreement,

ØNumber of installments and

ØAmount of each installment.

(3) Ownership of Goods : Although the possession of goods is delivered to the hire

purchaser immediately on signing the agreement, the ownership or property in the

goods does not pass to the purchaser or hirer till the final installment is paid.

(4) Right of the hirer to purchase with rebate : The Act confers on the hire purchaser

the right ot purchase the goods b giving 14 day's notice to the owner. In such a case the

hirer is entitled to a rebate calculated in the following formula:

2 Total Hire Purchase Charges x No. of installments not yet dueRebate = ----- X --------------------------------------------------------------------------------

3 Total No. of Installment

The hirer has to pa the balance of the installment amount less rebate calculated as above.

Example : From the following information, calculate the amount to be paid to the owner if the

hire purchaser intends to complete the purchase of goods:

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Hire Purchase Price Rs. 72,000

Cash Price Rs. 54,000

No. of Installments 12

Installments paid by the hire purchaser 8

Solution :

Hire purchase Charges = Hire purchase price - Cash price

= 72,000-54000

= 18000

Amount of each installment = 72000 /12 = 6000

Balance of Hire Purchase Price = 4 X 6000 = 24000

2 18000 x 4Rebate = ----- X ------------------- = 4,000

3 12

The hire purchaser may, therefore, complete the purchase of goods by paying a lump sum of

Rs. 20,000 (24,000-4,000).

(5) When default is made in the payment of any installment:

(i) Right of repossession of goods by the seller : IF default is made in the

payment of even the last installment, the seller will be entitled to take away the

goods because the ownership in the property remains with the seller till the

payment of final installment.

However, Section 20 of the Act provides that in the following cases, the hire

vendor cannot exercise his right of repossession of goods unless it is

sanctioned by the court:-

ØWhere the hire-purchase price is less than Rs. 15000, one half of the price

has been paid;

ØWhere the hire-purchase price is higher, three fourth of the hire-purchase

price has been paid.

(ii) Refund to the hire-purchaser: In case the hire vendor repossesses the goods,

he is not bound to return the amounts already received as they represent hire

charges but he will be required, under the Act, to refund to the hire-purchaser the

amount by which the total amount received from the hire-purchaser plus the

value of the goods on the date of repossession exceeds the hire purchase price.

(iii) Right to recover the arrears : In addition to the right to repossess the goods

and the right to retain the installments already paid as hire charges, the hire

vendor also has the right to recover the arrears of installments due on the date of

default.

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(6) Liability of hire-purchaser to keep the goods in good condition : The hire-

purchaser, during that period when he is in possession of goods, is supposed to take

all such care of goods a prudent person does in case of his own goods.

(7) Loss occurring to goods has to be borne by the seller : So long as the hire-

purchaser has taken reasonable care of the goods expected from a prudent person,

any loss occurring to goods has to be borne by the seller as the risk lies with the

ownership.

(8) No right to sell or pledge the goods : As the hire-purchaser is in the legal position of

bailee, he has no right to sell or pledge the goods till he becomes the owner.

Q. Discuss the main features of Consumer Credit

Ans. Consumer Credit : Consumer credit includes all asset-based financing plans offered

to primarily individuals to acquire consumer goods. Typically in a consumer credit

transaction the individual-buyer pays a fraction of the cash purchase price at the time of the

delivery of the asset and pays the balance with interest over a specified period of time. The

main suppliers of consumer credit are :

(i) Foreign/Multinational Banks

(ii) Commercial Banks

(iii) Finance Companies

And cover items such as cars, scooters, VCRs, TVs, refrigerators, washing machines, home

appliances and so on.

Salient Features : The salient features of consumer credit are:

(1) Parties to the Transaction : The parties to a consumer credit transaction depend

upon the nature of the transaction.

(i) A bipartite Arrangement : There are tow parties:

ØBorrower

ØFinancier

(ii) A tripartite Arrangement : There are three parties:

ØBorrower

ØDealer

ØFinancier

(2) Structure of the Transaction : A consumer credit arrangement can be structured in

three ways:

(i) Hire-Purchase : The customer has the option to purchase the assets. But he

may not exercise the option and return the goods according to the terms of the

agreement.

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(ii) Conditional Sale : The ownership is not transferred to the customer until the

total purchase price including the credit charge is paid. The customer cannot

terminate the agreement before the payment of the full price.

(iii) Credit Sale : The ownership is transferred to the customer on payment of the

first installment. He cannot cancel the agreement.

(3) Mode of Payment : From the point of view of payment, the consumer credit

arrangement fall into two groups:

(i) Down Payment Scheme : The down payment may range between 20-25 per

cent of the cost of asset.

(ii) Deposit-linked Scheme : The payment may vary between 15-25 per cent of the

amount financed.

(4) Payment Period and Rate of Interest : A wide range of options are available.

Typically, the repayment period ranges between 12-60 monthly installments. The rate

of interest is normally expressed at a flat rate.

(5) Security : Security is generally in the form of a first charge in the asset. The consumer

cannot sell the pledge asset.

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management of financial services

Documents

life insurance

general insurance

industrial

managing sundry

financial

financial

home saving

sbi home finance