Management of Financial Services

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

constructing a dss, role in business, group decision support system.
UNIT - II
Information system for strategic advantage, strategic role for information system,
breaking business barriers, reengineering business process, improving business
qualities.
UNIT - III
Information system analysis and design, information SDLC, hardware and software
acquisition, system testing, documentation and its tools, conversion methods.
UNIT - IV
Marketing IS, Manufacturing IS, Accounting IS, Financial IS.
MBA3rd 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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FINANCE : 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:
Financial
Services
Financial Institutions
Financial System
Financial Market
Financial
Instruments
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Bill Discounting
Factoring of Debtors
Parking of short term funds in the money market
Securitisation 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:
Size
Level of Output
Profits 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
Minimum capital,
Reserves and use of profits and reserves
Distribution of dividends
Maintenance of minimum cash reserve
Other 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 Services
Services
Banking Insurance Securities Contracts SEBI Regulations,
Regulation Act, 1938 Act, 1956 1992
Act, 1949 Companies Act, 1956
Indian Trust Act, 1882
Reserve Bank Insurance SEBI SEBI Rules for
of India Regulatory Registrar
Authority And Share
Transfer Agents
Notification, Regulations, SEBI Regulations,
Rules, Guildelines etc. 1994
Directions, 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:
Commercial Banks normally provide finance for short term needs of the
firms.
Term-lending institutions meet the long term funding needs of industries
which are commonly known as project financing.
Housing finance companies provide funds to individuals and some times
house-construction companies for acquisition of house property.
Venture capital provides funds in the form of equity to new projects which
involve some innovative ideas.
External Risk :
A 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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Another 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 :
An insurance company may fail to honour its obligation if the investments
they have been made poor.
Similarly, the quality of assets they have insured may also turn bad.
There 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:
First, in situation where the trades are not guaranteed by the stock
exchanges.
There 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 :
There 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 :
First 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.
They are also affected by the asset-liability mismatch and excessive
dealing in the security market.
Another 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
Receipt of the order from the clients
Execution of the order in the exchange
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Receipt of documents or cash from the clients and delivery of cash or
documents to the clients.
Internal Risk :
There are many fake documents in the market
Even if the stocks delivered are good and genuine, there is no guarantee
that they are good for delivery.
Many 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 :
First the credit rating information in India is relatively weak and published
accounts are not reliable to assess the credit worthiness of the borrowers.
Secondly, the competition in the industry allows very little time to take
decision on sanctioning the proposals, otherwise, the competitors will
take away your clients.
Another 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 :
The performance of mutual funds directly depends on the ability of the
fund managers in reading the market and making investments
accordingly.
On 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:
First things that need to be done is to check the assets, movable or
immovable, that are given as a security to avail the loan.
If 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. Thats 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) Investors 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 sponsors 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) Investors 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 their
money with
Fund
Manager
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:
Receiving and processing the application form of a mutual fund
Issuing of unit/share certificate on behalf of mutual fund
Maintain detailed records of unit holders transactions
Purchasing, selling, transferring and redeeming the Unit/Share certificate
Issuing of income /dividend, broker cheques etc.
(ii) Advertiser : Major responsibilities of an adviser include:
Helping mutual funds organizers to prepare a media plan for marketing
the fund.
Issuing/buying the space in newspapers and other electronic media for
advertising the various features of a fund.
Arranging or hoardings at public places.
(iii) Advisor/ Manager : It is generally a corporate entity that does the following
jobs:
Professional advice on the funds investments
Advice 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:
Holds Securities
Receives and delivers securities
Collects income/interest/dividends on the securities
Holds and processes cash
(vi) Other Players : Besides the above, other players are as under:
Fund Administrator
Fund Accounting Services
Legal Advisors.
Fund Officers
Underwriters/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 : Its easy to get your money out of a mutual fund. Write a cheques, make a
call and youve 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 funds
manager to make the right decisions regarding the funds 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 following
Dhansahyog, 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 clients 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--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) Promoters Contribution : A certificate to this effect that the required contribution of
the promoters 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:
Bipartite Lease : There are two parties in the lease transaction, namely (i) Asset
Supplier-cum-lessor and (ii) Lessee
Tripartite 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
Import 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.
Cross-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:
Executing the document should have the legal capacity to do
The 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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Nature of the Lease : This clause specifies whether the lease is an
operating lease, a financing lease or a leveraged lease.
Description : The clause specifies the detailed description of equipment,
its actual condition, size, components, estimated useful life, and so on.
Delivery 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.
Period : 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.
Lease 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.
Use : This clause enjoins upon the lessee the responsibility for proper and
lawful usage.
Title : identification and ownership of equipment.
Repairs and Maintenance: This clause specifies the responsibility for
repairs and maintenance, insurance and so on.
Alteration : It specifies that no alteration to the leased equipment may be
made without the written consent of the lessor.
Charges : This clause specifies clearly which party to the agreement
would bear the delivery, re-delivery, customs, income tax, sales tax and
clearance charges.
Inspection : 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.
Prohibition of Sub-leasing : This clause prohibits the lessee from the
sub-leasing or selling the equipment to third parties.
Events 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.
Applicable 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 :
Income from Salary ----------
Income from House Property ----------
Income from Business or Profession ----------
Income from Capital Gain ----------
Income 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:
Depreciation
Rent, taxes, repairs and insurance of the leased asset where such
expenditure is borne by the lessor.
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Amortisation of certain preliminary expenses, such as expenditure for
preparation of project report, market survey and so on.
Interest on borrowed Capital
Bad Debts
Entertainment expenses subject to prescribed limits.
Travel 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
Of Capital Nature
A 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 :
Central Sales Tax Act, 1957(CST): The CST deals with the levy and collection of
sales tax on the inter-state sale of goods only.
Sales 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:
Sales 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.
In 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 Service
Provider
Special Vehicle
Creit Rating
of Securities
Rating Agency
Structure
Issue of Securities
Investors
Subscription of
Securities
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, relatives
and 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 of
accumulated 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 16.5
cost of Improvement
4. Home Extensions 5,00,000 or 85% 16.5 --------
5 NRI Schemes 5,00,000 or 75% of cost 16.0 18.5
of 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 19.0
of 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 Rate
No. (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:
Industry Risk : It includes competitions from others, market factors,
demand and supply position and government policies, etc.
Marketing Risk : It covers competitive advantages or disadvantages,
market share, sales network, etc.
Operating Efficiency : It involves locational advantages, labour
cooperation, cost efficiency and operating margins, etc.,
Legal 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 :
Accounting 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.
Earning 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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Adequacy of Cash Flows : Cash flow adequacy as reflected in working
capital management, current ratio, quick ratio, etc. are examined by the
rating agencies.
Financial Flexibility : Financial flexibility of the firm in terms of capital
financing plans, ability to raise funds and so on.
Interest 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:
Track record of management: planning and control system, depth of
managerial talent, succession plan.
Evaluation of capacity to overcome adverse situations
Goals, 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:
Structure and regulatory framework of the financial system
Trends in regulation/deregulation and their impact on the company/institution
(ii) Fundamental Analysis : Fundamental analysis should include:
Capital Adequacy : Assessment of the true net worth of the issuer, its adequacy
to the volume of business and the risk profile of the assets.
Resources : Overview of funding sources, funding profile, cost and tenor of
various sources of funds.
Liquidity 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.
Profitability 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.
Interest 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:
Securitisation Transactions
Structuring Financial Instruments
Financing of Infrastructure projects
Municipal 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:
Rating Reckoner- an update on its accepted ratings and
CAREVIEW- a quarterly bulletin providing information on its ratings.
(vi) Other Services :
The CARE loan rating
Credit 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 post
investment 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:
The technology used in the project and possible threats of new technology
in the near future.
Different aspect of product life cycle.
The 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:
Greenfield based on a relatively new or high technology
New business in which the entrepreneur has good knowledge and
working experience.
New 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:
Expand the Market
Expand the Production
To establish warehouse.
Export 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 & Invoice
With Notice to pay Factor
BUYER
FACTOR
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The 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.
The 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.
The 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.
The 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 Forfaiting
No. 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:
Drawer
Drawee
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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Discount : 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.
Maturity : 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 :
Hire-purchase price of the goods,
Cash price of the goods,
Date of commencement of the hire-purchase agreement,
Number of installments and
Amount 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 due
Rebate = ----- 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 4
Rebate = ----- 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:-
Where the hire-purchase price is less than Rs. 15000, one half of the price
has been paid;
Where 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:
Borrower
Financier
(ii) A tripartite Arrangement : There are three parties:
Borrower
Dealer
Financier
(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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