UNIT I

Financial System

Financial System
A system that aims at establishing and providing a regular, smooth, efficient and cost
effective linkage between depositors and investors is known as financial system.
Features of a Financial System
1. Provides an ideal linkage between depositors and investors encouraging both
savings and investments
2. Facilitates expansion of financial markets over space and time
3. Promotes efficient allocation of financial resources for socially desirable and
economically productive purposes
4. Influences both quality and pace of economic development.
Constituents of Financial System

 FINANCIAL INSTITUTIONS
 FINANCIAL SERVICES
 FINANCIAL MARKETS
 FINANCIAL INSTRUMENTS
FINANCIAL INSTITUTIONS
Institutions that provide credit and credit related services are called Financial
Institutions
Characteristics of Financial Institutions
 Savings mobiliser
 Participants
 Dealers
 Generators
 Regulation
 Types
 Special Institutions
eg: Banks ,Insurance companies ect
Financial Services
Financial services comprise of various functions and services that are provided by
financial systems in a Financial system eg: Leasing, Hire purchase, credit cards e-
commerce etc.
Financial Markets
Financial markets include:
1.Organised and unorganized markets
2.Primary market and secondary market
3.Money market and Capital market.

Characteristics of Financial markets

 Facilitates buying and selling of financial claims.
 Funds are transferred from surplus units to deficit units
  Exists wherever financial transaction takes place
Characteristics of Financial Instruments
 Liquidity
 Collateral value
 Marketability
 Transferability
 Maturity period
 Transaction cost
 Risk and uncertainty
 Provision of option
 Tax status

Functions of good financial system

1. Regulation of currency
2. Banking Functions
3. Performance of agency services and custody of cash reserves
4. Management of national reserves of international currency
5. Credit control
6. Administering national fiscal and monetary policy to ensure stability of the
economy
7. Supply and development of funds for productive use
8. Maintaining liquidity
MERCHANT BANKING

• Merchant Banker is one who underwrites corporate securities and advises clients
on issues like corporate mergers. The Merchant banker may be in the form of a
company, firm or even a proprietory concern.It is basically service banking which
provides non-financial services such as arranging for funds rather than providing
them.
The merchant banker understands the requirements of the business concerns and
arranges finance with the help of financial institutions, banks, stock exchanges and
money market. Ist M.banker in India Grindlays Bank-1969 IInd SBI in 1973 followed
by ICICI.

According to SEBI (Merchant bankers) rules 1992, “A Merchant banker has been
defined as 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,advisor or rendering corporate advisory services in relation to
such issue management
Functions of Merchant Bankers
• Corporate counselling
• Project counselling
• Working capital
• Pre-investment studies
• Capital restructuring services
• Credit syndication
• Issue management
• Foreign currency financing
• Underwriting
• Portfolio management
• Working capital
• Acceptance credit
• Merger&Acquisation
• Venture Financing
• Lease Financing
• Mutual Funds
• Relief to sick Industries
• Corporate counselling: with regard to their timing of issue of shares, capital
structure& other promotional aspects with regard to company
• Project Counselling: with regard to conception of ideas, identification of various
projects, preparation of projects,feasibility reports,location of factory,obtaining funds,
approval from govts.,
• Working capital: Assessment of W.C.requirements, assistance in negotiation with
banks & co-ordinating in documentation & advicing on issue of debentures (L.term
working capital requirement).
4.Pre-investment studies: With regards to carrying out an in-depth investigation in order
to assess the financial& economic viability of a project, identifying the strength of the
client for growth in long run.
5. Capital restructuring services: To assist projects in achieving their maximum potential
through effective capital structuring(Widening capital base) by implementing schemes of
amalgamations, merger or change in business status.
6.Credit syndication: Activities connected with credit procurement and project financing,
aimed at raising Indian & foreign currency loans from financial institutions for long term
& short term requirements are collectively called as ‘credit syndication’ or ‘consortium
finance’.
7.Issue Management& Underwriting: deals with obtaining clearances, drafting
prospectus, underwriting, liasioning with brokers & bankers and keeping constant
communication with investors with regard to public issue of corporate securities.
8.Foreign currency financing: Finance provided to fund foreign trade transaction is called
‘foreign currency finance’.The provision of foreign currency finance takes the form of
export-import trade finance, euro currency loans, Indian joint ventures abroad and foreign
collaborations. The M.B assists in making study of the projects, assists in liaison with
RBI and other institutions, getting foreign currency loans etc.
9.Portfolio management: Making decision relating to investment of cash resources of a
corporate enterprise in marketable securities by deciding the quantum,timing and the type
of security to be bought.
Acceptance & Bill discounting: Activities relating to acceptance and discounting of bills
of exchange, besides advancement of loans to business concerns on the strength of such
instruments are collectively known as acceptance credit and bills discounting.
11.Merger&acquisition: M.B renders specialised services of mergers & acquisition by
offering expert valuation regarding the quantum and the nature of consideration and other
related matters (formulating schemes for financial reconstruction, getting approval from
shareholders, implementing mergers & acquisition)
12.Venture financing: A specially designed capital, as a form of equity financing for
funding high-risk and high-reward projects is known as ‘venture capital’.
13.Lease financing: Leasing involves letting out assets on lease for a particular time
period for use by the lessee. leasing provides an important alternative source of financing
capital outlay. M.Banker advices on choice of favourable rental structure for acquring
capital asset etc.,
14.Mutual Funds: Institutions or agencies engaged in the mobilisation of savings of
innumerable investors for the purpose of channeling them into productive investments of
a wide variety of corporate and other securities are called ‘mutual Funds’.
15.Relief to sick industries:Merchant bankers extend their support by providing relief to
sick industries
a) by assessing their requirements and restructuring their capital base
b) Evolving rehabilitation packages acceptable to financial institutions and banks &
obtaining approvals from BIFR .
c) Other services of merchant bankers include management of cash and short term
funds required by client companies, stock broking, servicing of issue by
maintaining of registers of share holders and debenture holders of ,client
companies, small scale industry counselling, equity research and investment
counselling to investors, assistance to NRI.

Regulations by SEBI
• Sebi has made following reforms for M.B .:
1.Multiple categories of M.B. will be abolished & there will be only one equity M.B.
2. A M.B. will have to seek separate registration from SEBI to do different functions like
underwriting portfolio management.
3. Should not undertake the function of banking company like accepting deposits,
financing etc.
4. A M.B. has to confine himself to capital market activities.
Recognition by SEBI ON MERCHANT BANKERS

• Professional competence of merchant bankers

• Their capital adequacy
• Track record, experience & general reputation of merchant bankers.
• Adequacy and quality of personnel employed by them and also the available
infrastructure.
Conditions by SEBI for Merchant Bankers
• SEBI will give authorisation for a m.b to operate only for 3 years.
• The minimum net worth of M.B should be Rs.5 crore.
• M.B. has to pay authorisation fee, annual fee& renewal fee
• All issues should be managed by a lead merchant banker.
• Lead M.B. is responsible for allotment of securities, refunds etc.
• M.B. will submit to SEBI all returns & send reports regarding the issue.
• Code of conduct for M.B. is given by SEBI
• Any violation by M.B will lead to revocation of authorisation by SEBI.
Conditions by SEBI Pertaining to pre-issue obligations
• Registration
• Capital structure
• Public issue
• Rights issue
• Prospectus, etc.
•
Registration: All M.B’s should register with SEBI. SEBI has classified M.B’s
under 4 categories

• Issue Mgt underwriting consultants mobilisation

• to issue of foreign
• Prospectus advisory funds
• Financial consultancy
• Structure co-managers
• Allotment of - Portfolio
• Securities manager
• Refund of
• subscription

SEBI
After the abolishing of CCI , SEBI has become an apex body in controlling the stock
exchange and also regulates the different types of securities in the stock exchange.
Functions of SEBI are:
1. Regulating and controlling the stock-exchanges in the country
2. Regulating the different kinds of securities by companies
3. Acts as a circuit breaker or cut-off switch when there are abnormal
fluctuations in the stock exchange.
4. Protecting the investors.
SEBI as a part of general obligation of merchant banker.
A merchant banker has to disclose the SEBI to following:-
1. His responsibility with regards to the issue
2. Any change in the information which has been already furnished.
3. Names of companies of which merchant bankers is associated as the lead
manager.
Any breach in the capital adequacy requirements
Merchant bankers are required for an issue
All public issues should be managed by atleast one merchant banker functioning as the
lead merchant banker. In case of issue of right shares to the existing member with or
without the right of renunciation, the amount of the issue of the body corporate does not
exceed Rs. 50 lakhs, the appointment of lead merchant banker shall not be issued upon

Securities contracts regulation Act

Through this act Government regulates the activities of stock-exchanges in the country.
This act tells about the trading of securities in the stock exchange and the conditionsto
companies for listing their shares in the stock market.
FERA
FERA has been replaced by FEMA. Far-reaching amendments were made in the Indian
companies act, Income-tax act, etc. to facilitate safe and orderly trading, and the
settlement of transaction as FERA was concerned only with regulation.

Also the aim of FEMA is facilitating trade as against that of FERA, which was to
prevent misuse. In other words, the theme of FERA was: ‘everything that is specified is
under control’. While the theme of FEMA is: ‘everything other than what is expressly
covered is not controlled’. Thus there is a lot of deregulation.

Difference between FERA and FEMA

Important FERA and FEMA have been summed up as follows:
1. In FEMA, only the specified acts relating to foreign exchange are
regulated, while in FERA, anything and everything that has to do with foreign exchange
was controlled.
Also the aim of FEMA is facilitating trade as against that of FERA, which was to
prevent misuse. In other words, the theme of FERA was: ‘everything that is specified is
under control’. While the theme of FEMA is: ‘everything other than what is expressly
covered is not controlled’. Thus there is a lot of deregulation.
 2. FEMA is a much enactment- only 49 sections as against 81 sections of
FERA.
3. In the process of simplification, many of the ‘laid downs’ of the erstwhile
FERA have been withdrawn.
4. Many provisions of FERA like the ones relating to blocked accounts,
Indians taking up employment abroad, employment of foreign technicians in India,
contracts in evasion of the act, vexatious search, culpable mental state, etc. have no
appearance in FEMA.

OTCEI market
The OTCEI was started with the objective of providing a market for the smaller
companies that could not afford the listing fees of the large exchange and did not fulfill
the minimum capital requirement for listing. It aimed at creating a fully decentralized
and transparent market. Over the counter means trading across the counter in scrip’s. The
counter refers to the location of the member or dealer of the OTCEI where the deal or
trade takes place. Every counter is treated as the trading floor for the OTCEI where the
investors can buy and sell.

Functions of stock exchange

The functions of Stock exchanges are,
a. Common , trading platform
b. Mobilization of savings
c. Safety to invaders
d. Distribution of new securities
e. Ready market
f. Liquidity
g. Capital formation
h. Speculative trading
i. Sound price setting
j. Economic barometer
k. True market mechanism. Etc
Money market
Money market is a collective name given to all the institution that are dealing in short-
term funds. It does not refer to a particular place. Dealers in the money market are spread
through out the country. Short-term funds are required for working capital requirements,
both in agricultural as well as in the industry.

Difference between primary market and secondary market.

SI.NO Primary Market Secondary Market

1 It deals only with new or fresh issue Deals in existing security
of security
2. No fixed geographical location Need a fixed place to house the
needed secondary market activities, viz., trading.
3. Creating long-term instrument for Providing liquidity through marketability
borrowings. to those instruments

Difference between OTCEI and conventional stock exchange

SI.N Conventional stock exchange OTCEI
O
1. Trading is done on floor Trading is done through network or
computer system
2. Membership is restricted to region Membership is spread throughout the
or location. country.
3. Need for market marker depends Market marker is a must for securities of
upon the exchange each company.
4. Settlement of transactions on the Settlement as per the OTCEI
basis of T+5
5. Minimum paid up capital is Rs.5 Minimum paid up capital is Rs.2crores
crores

UNIT II
ISSUE MANAGEMENT
 PROJECT FINANCING
Scheme of financing a particular economic unit in which a lender is satisfied in
looking at the cash flows and the earnings of that economic unit as a source of funds,
from which a loan can be repaid and to the assets of the economic unit as a collateral
for the loan.
It is different from the traditional form of financing, i.e., the corporate financing or
the balance sheet financing.
CHARACTERSTICS OF PROJECT FINANCING

1.A separate project entity is created that receives loans from lenders and equity from
sponsors.
2.The component of debt is very high in project financing.
3.The project funding and all its other cash flows are separated from the parent
company’s balance sheet.
4.Debt services and repayments entirely depends on the project’s cash flows. Project
assets are used as collateral for loan repayments.
5.Project financer’s risk are not entirely covered by the sponsors guarantees.
6.Third Parties like suppliers, customers, government and sponsors commit to share
the risk of the project.
Project Financing Arrangements

 The Build Own Operate Transfer Structure.

 The Build Own Operate Structure.
 The Build Lease Transfer Structure
Project Financing Risk and their Allocation
1.Risks
1. Project Completion Risk
2. Market Risk
3. Foreign Currency Risk
4. Inputs Supply Risk
2.Risk Mitigation
5. By Government
1. Country Risk
2. Sector Policy Risk
6. By Others
1. Commercial Risk

Optimal capital structure

An ideal mix of various sources of long-term funds that aims at minimizing the
overall cost of capital of the firm, and maximizes the market value of shares of a firm
is known “optimal capital structure”.

Financing capital structure

 Debt and equity are the sources of financing capital structure, which can be issued in
four patterns; they are Exclusive equity, Equity and preference stock, Equity and bonds
or debentures and Equity, preference and
shares and debentures.
Shares are different from debentures in the following manner:
1. Shareholders have proprietary interest in the company where as debenture holders
are only the creditors of the company.
2. Debentures holders are entitled to a fixed rate of interest, whereas the
shareholders are entitled to dividend depending on and varying with the profits.
3. Shareholders have voting rights where as debenture holders do not have voting
rights.
4. Debentures are redeemable where as shares except preference shares are not
redeemable.

Relationship between equity shares and preference shares;

Preference shareholders have a preferential right in receiving
dividends unlike the equity shareholders who are paid last. Preference shares are
redeemable whereas equity shares are not redeemable. Even in case of winding up of
company preference shareholders have a preferential right in repayment of capital.

Types of pricing of issues

While fixing the price of issues the qualitative and quantitative factor are to be
considered. The controller of capital issues have allowed the companies to adopt free
pricing. The fair value of shares are calculated on the basis of net asset value of the share,
profit earning capacity value and average market price.

Modes of making public issue

The different modes by which a public issue can be made by issue of prospectus,
offer for sale, private placement, rights issue bonus shares and book building.
Prospectus
Information memorandum
Information memorandum is defined as ‘ a process undertaken prior to the
filing of a prospectus by which a demand for the securities proposed to be issued
by a company is elicited, and the price and the terms of issue for such securities is
assessed by means of a notice, circular, advertisement or document’.

Deemed prospectus.
Deemed prospectus refers to the offer document issued by the ‘Issue House’,
which make an invitation on behalf of to the public to subscribe to the shares.
Thus the company makes an attempt to raise capital from the public without an
offer document or prospectus.

Red-herring prospectus
 According to sub-section (2) (3) & (4) of section 60B of the Companies Act, 1956, a
prospectus which does not have complete particulars on the price of securities offered
and the quantum of securities offered is known as Red-herring prospectus. Such a
prospectus is issued where a company offers its securities through the “book building
mode”.

shelf prospectus
Information about issue of shares contained in a file lying on the shelf is called
“Shelf prospectus”. Financial institutions and banks issue this type of prospectus. A
company filing such a prospectus is also required to file an information memorandum on
all material facts relating to new charges created, changes occurring in the financial
position in the period from the first offer, previous offer of securities within such time as
may be prescribed by the central government prior to making of a second or subsequent
offer of securities under the shelf prospectus.
Golden rule of prospectus.
The golden rule as regards drafting of prospectus was laid down in the leading case: New
Brunswick& Canda Rly. & Land Co., Vs. Muggeridge Aacordingly:
1.Only true nature of company’s venture shall be disclosed
2. Strict and scrupulous accuracy shall be maintained in drafting prospectus as it invites
the public to take shares on the faith of the representations contained in the prospectus.

Bought out deals

Bought out deal is an arrangement where the entire equity or related security is
bought in full or in lots, with the intention of off-loading it later in the market. This
arrangement is made by the merchant banker/ sponsor and the company, where the
sponsor takes the shares in lots and holds it till it is ready for public participation. This is
the cheapest and quickest source of finance for small and medium sized companies.
Private placement
A method of marketing of securities whereby the issuer makes the offer of sale to
individuals and institutions privately without the issue of a prospectus is known as private
placement method

Rights issue
In case of subsequent issue of shares, the shares of a company are first offered to the
existing shareholders of the company and in case they are not interested in taking up
these shares, then these shares are issued to the public. These shares may be renounced
by the share holders. Incase of right shares the company need not issue prospectus.
Bonus shares
The accumulated reserves and surplus of profits of a company are converted into
paid up capital, in the form of bonus shares to the existing share holders. It implies
capitalization of existing reserves and surplus of a company. The company while issuing
this type of shares to the existing shareholders will fix a proportion. Thus it is bonus or
additional share received by the existing shareholders.

underwriting
 When a company fails to raise the minimum capital through the issue, then it has to
be refunded to the subscribers as a result the need for underwriters were felt.
Underwriters enter into an agreement with the company for the sale of certain minimum
quantity of shares and debentures to the public for which they are entitles for a
commission called underwriting commission
How is a broker different from an underwriter ?
a)Broker enters into an agreement to sell shares & securities on behalf of the
company, an underwriter gives an undertaking to sell the shares or take up the shares
incase the shares are not subscribed by the public.
b) The broker will get commission for the shares he sells but an underwriter will get an
additional commission for taking up the shares.
c) The brokers risk is comparatively less when compared to that of the under writers
risk in case the shares allotted to him are not subscribed for.

Book-building.
A company, instead of offering shares directly to the public, invites bids from the
merchant bankers for the sale of shares, it is called book building.The entire procedure of
the allotment of listing of share will be undertaken by the merchant bankers. The share
price depends on the demand for the shares in the market. The book runner or the
merchant banker will select any stock exchange and register the shares for issue.
Depending on the demand for shares, the price of shares will be fixed and then allotment
will be made.

Green shoe option

A company making a public offer of equity shares by book building can avail green
shoe option for stabilizing the post listing price of its shares .The company shall appoint
one of the merchant bankers or book runners as stabilizing agent who is responsible for
price stabilizing. The stabilizing agent shall enter into agreement with the promoter or pre
issue shareholder to lend their shares for additional public issue. The size of these shares
shall not be more than 15% of the total issue size.
E-IOP
When a company goes into public issue of securities, it can resort to different
methods of raising money. When securities or shares are issued using electronic media
i.e., through internet then we call the issue as E-IPO. In the current day this is the
quickest and easy way of raising initial offer. A company before making
E-IPO should follow guidelines prescribed by SEBI.
ESOP
A method of marketing the securities of a company whereby its employees are
encouraged to take up shares and subscribe to it is known as stock option. It is a
voluntary scheme on the part of company to encourage employee’s participation in the
company. The scheme offers an incentive to employees to stay in the company.
 Role of Registrars to an issue.
Registrar to issue play a major role in the post-issue management. The work is in
close collaboration with bankers to issue. The task of getting application together sorting
them and arranging in an order is undertaken by registrar to issue Registrar should also
reconcile the total application collected by the banker to issue on behalf of the company.

Role of Bankers to an issue.

Banker to the issue accept application along with the subscription tendered at their
designated branches and forward them to the registrar or issue houses in accordance with
instruction issued to them. Banker to issue also undertake publicity to the issue by issuing
publicity material
Guidelines on initial public offers through the stock exchange
on-line system (e-IPO)

11A.1 A company proposing to issue capital to public through the on-line system of the
stock exchange for offer of securities shall comply with the requirements as
contained in this Chapter in addition to other requirements for public issues as
given in these Guidelines, wherever applicable.
11A.2 Agreement with the Stock exchange
11A.2.1 The company shall enter into an agreement with the Stock Exchange(s) which
have the requisite system of on-line offer of securities.
#01[* * *]
11A.2.2 The agreement mentioned in the above clause shall specify inter alia, the rights,
duties, responsibilities and obligations of the company and stock exchange(s)
inter se. The agreement may also provide for a dispute resolution mechanism
between the company and the stock exchange.
11A.3 Appointment of Brokers
11A.3.1 The stock exchange, shall appoint brokers of the exchange, who are registered
with SEBI, for the purpose of accepting applications and placing orders with the
company.
11A.3.2 For the purposes of this Chapter, the brokers, so appointed accepting
applications and application monies, shall be considered as 'collection centres'.
11A.3.3 The brokers so appointed, shall collect the money from his/their client for every
order placed by him/them and in case the client fails to pay for shares allocated as
per the Guidelines, the broker shall pay such amount.
11A.3.4 The company/lead manager shall ensure that the brokers having terminals are
appointed in compliance with the requirement of mandatory collection centres, as
specified in clause 5.9 of Chapter V of the Guidelines.
11A.3.5 The company/lead manager shall ensure that the brokers so appointed are
financially capable of honouring their commitments arising out of defaults of their
clients.
11A.3.6 The company shall pay to the broker/s a commission/fee for the services
rendered by him/them. The exchange shall ensure that the broker does not levy a
service fee on his clients in lieu of his services.
11A.4 Appointment of Registrar to the Issue
11A.4.1 The company shall appoint a Registrar to the Issue having electronic
connectivity with the Stock Exchange/s through which the securities are offered
under the system.
11A.5 Listing
#02[11A.5.1 The company may apply for listing of its securities on an exchange other
than the exchange through which it offers its securities to public through the on-
line system.]
11A.6 Responsibility of the Lead Manager
11A.6.1 The Lead Manager shall be responsible for co-ordination of all the activities
amongst various intermediaries connected in the issue/system.
11A.6.2 The names of brokers appointed by the issuer company alongwith the names of
the other intermediaries namely Lead managers to the issue and Registrars to the
Issue shall be disclosed in the prospectus and application form.
11A.7 Mode of operation
11A.7.1 The company shall, after filing the offer document with ROC and before opening
of the issue, make an issue advertisement in one English and one Hindi daily with
nationwide circulation, and one regional daily with wide circulation at the place
where the registered office of the issuer company is situated.
11A.7.2 The advertisement shall contain the salient features of the offer document as
specified in Form 2A of the Companies (Central Government's) General Rules
and Forms, 1956. The advertisement in addition to other required information,
shall also contain the following:
(i) the date of opening and closing of the issue;
(ii) the method and process of application and allotment;
(iii) the names, addresses and the telephone numbers of the stock brokers and
centres for accepting the applications.
11A.7.3 During the period the issue is open to the public for subscription, the applicants
may-
(a) approach the brokers of the stock exchange/s through which the securities
are offered under on-line system, to place an order for subscribing to the
securities. Every broker shall accept orders from all clients who place order
through him;
(b) directly send the application form alongwith the cheque/Demand Draft for
the sum payable towards application money to the Registrar to the Issue or place
the order to subscribe through a stock-broker under the on-line system.
11A.7.4 In case of issue of capital of Rs. 10 crores or above the Registrar to the Issue
shall open centres for collection of direct applications at the four metropolitan
centres situated at Delhi, Chennai, Calcutta and Mumbai.
11A.7.5 The broker shall collect the client registration form duly filled up and signed
from the applicants before placing the order in the system as per "Know your
client rule" as specified by SEBI and as may be modified from time to time.
11A.7.6 The broker shall, thereafter, enter the buy order in the system, on behalf of the
clients and enter details including the name, address, telephone number and
category of the applicant, the number of shares applied for, beneficiary ID, DP
code, etc. and give an order number/order confirmation slip to the applicant.
11A.7.7 The applicant may withdraw applications in terms of the Companies Act, 1956.
11A.7.8 The broker may collect an amount to the extent of 100% of the application
money as margin money from the clients before he places an order on their
behalf.
11A.7.9 The broker shall open a separate bank account [Escrow Account] with the
clearing house bank for primary market issues and the amount collected by the
broker from his clients as margin money shall be deposited in this account.
11A.7.10 The broker shall, at the end of each day while the issue is open for subscription,
download/forward the order data to the Registrar to the Issue on a daily basis.
This data shall consist of only valid orders (excluding those that are cancelled).
On the date of closure of the issue, the final status of orders received shall be sent
to the Registrar to the issue/company.
#03[11A.7.11 On the closure of the issue, the Designated Stock Exchange, alongwith the
Lead merchant banker and Registrars to the Issue shall ensure that the basis of
allocation is finalised in fair and proper manner on the lines of the norms with
respect to basis of allotment as specified in Chapter VII of the Guidelines, as may
be modified from time to time.]
11A.7.12 After finalisation of basis of allocation, the Registrar to the Issue/company shall
send the computer file containing the allocation details i.e. the allocation numbers,
allocated quantity, etc., of successful applicants to the Exchange. The Exchange
shall process and generate the broker-wise funds pay-in obligation and shall send
the file containing the allocation details to member brokers.
11A.7.13 On receipt of the basis of allocation data, the brokers shall immediately
intimate the fact of allocation to their client/applicant. The broker shall ensure that
each successful client/applicant submits the duly filled-in and signed application
form to him along with the amount payable towards the application money.
Amount already paid by the applicant as margin money shall be adjusted towards
the total allocation money payable. The broker shall, thereafter, hand over the
application forms of the successful applicants who have paid the application
money, to the exchange, which shall submit the same to the Registrar to
Issue/company for their records.
11A.7.14 The broker shall refund the margin money collected earlier, within 3 days of
receipt of basis of allocation, to the applicants who did not receive allocation.
11A.7.15 The brokers shall give details of the amount received from each client and the
names of clients who have not paid the application money to the exchange. The
brokers shall also give soft copy of this data of the exchange.
11A.7.16 On the pay-in day, the broker shall deposit the amount collected from the
clients in the separate bank account opened for primary issues with the clearing
house/bank. The clearing house shall debit the primary issue account of each
broker and credit the amount so collected from each broker to the "Issue
Account".
11A.7.17 In the event of the successful applicants failing to pay the application money,
the broker through whom such client placed orders, shall bring in the funds to the
extent of the client's default. If the broker does not bring in the funds, he shall be
declared as a defaulter by the exchange and action as prescribed under the Bye-
Laws of the Stock Exchange shall be initiated against him. In such a case, if the
 minimum subscription as disclosed in the prospectus is not received, the issue
proceeds shall be refunded to the applicants.
11A.7.18 The subscriber shall have an option to receive the security certificates or hold
the securities in dematerialised form as specified in the Guidelines.
11A.7.19 The concerned exchange shall not use the Settlement/Trade Guarantee Fund of
the Exchange for honoring brokers commitments in case of failure of broker to
bring in the funds.
11A.7.20 On payment and receipt of the sum payable on application for the amount
towards minimum subscription, the company shall allot the shares to the
applicants as per these Guidelines. The Registrar to the issue shall post the share
certificates to the investors or, instruct the depository to credit the depository
account of each investor, as the case may be.
11A.7.21 Allotment of securities shall be made not later than 15 days from the closure of
the issue failing which interest at the rate of 15% shall be paid to the investors.
11A.7.22 In cases of applicants who have applied directly or by post to the Registrar to
the issue, and have not received allocation, the Registrar to the issue shall arrange
to refund the application monies paid by them within the time prescribed.
11A.7.23 The brokers and other intermediaries engaged in the process of offering shares
through the on-line system shall maintain the following records for a period of 5
years:
(i) orders received;
(ii) applications received;
(iii) details of allocation and allotment;
(iv) details of margin collected and refunded;
(v) details of refund of application money.
11A.7.24 SEBI shall have the right to carry out an inspection of the records,
books and documents relating to the above, of any intermediary connected with
this system and every intermediary in the system shall at all times co-operate with
the inspection by SEBI. In addition the stock exchange have the right of
supervision and inspection of the activities of its member brokers connected with
the system
Guidelines on Advertisement

9.0 The Lead Merchant Banker shall ensure compliance with the guidelines on
Advertisement by the issuer company.

9.1 Guidelines on Advertisements

9.1.1 An issue advertisement shall be truthful, fair and clear and shall not
contain any statement which is untrue or misleading.
9.1.2 Any advertisement reproducing or purporting to reproduce any
information contained in a offer document shall reproduce such
information in full and disclose all relevant facts and not be restricted to
select extracts relating to that item.
9.1.3 An issue advertisement shall be considered to be misleading, if it contains-
(a) Statements made about the performance or activities of the
company in the absence of necessary explanatory or qualifying statements,
 which may give an exaggerated picture of the performance or activities,
than what it really is.
(b) An inaccurate portrayal of past performance or its portrayal in a
manner which implies that past gains or income will be repeated in the
future.
9.1.4 (a) An advertisement shall be set forth in a clear, concise and
understandable language.
(b) Extensive use of technical, legal terminology or complex language and
the inclusion of excessive details which may distract the investor, shall be
avoided.
9.1.5 An issue advertisement shall not contain statements which promise or
guarantee rapid increase in profits.
9.1.6 An issue advertisement shall not contain any information that is not
contained in the offer document.
9.1.7 No models, celebrities, fictional characters, landmarks or caricatures or the
likes shall be displayed on or form part of the offer documents or issue
advertisements.
#01[9.1.8] Issue advertisements shall not appear in the form of crawlers (the
advertisements which run simultaneously with the programme in a narrow
strip at the bottom of the television screen) on television.
#02[9.1.8A In case of issue of advertisement on television screen:
(a) the risk factors shall not be scrolled on the screen; and
(b) the advertisement shall advise the viewers to refer to the red
herring prospectus or other offer document for details.]
9.1.9 No advertisement shall include any issue slogans or brand names for the
issue except the normal commercial name of the company or commercial
brand names of its products already in use.
9.1.10 No slogans, expletives or non-factual and unsubstantiated titles shall
appear in the issue advertisements or offer documents.
9.1.11 If any advertisement carries any financial data, it shall also contain data
for the past three years and shall include particulars relating to sales, gross
profit, net profit, share capital, reserves, earnings per share, dividends and
the book values.
9.1.12 (a) All issue advertisements in newspapers, Magazines, brochures,
pamphlets containing highlights relating to any issue shall also contain
risk factors given equal importance in all respects including the print size.
(b) The print size of highlights and risk factors in issue advertisements
shall not be less than point #03[7] size.
#04[(c) Subject to section 66 of the Companies Act, 1956, any
advertisement made by an issuer in respect of opening or closure of the
issue shall be in the format and contain the minimum disclosures as given
in the relevant part of Schedule XX-A.
(d) Any pre-issue advertisement made under clause 5.6A or advertisement
made in connection with opening or closing of an issue by the issuer,
which is displayed in a billboard shall not contain any information apart
from that mentioned in the relevant part of Schedule XX-A.]
 9.1.13 No issue advertisement shall be released without giving "Risk Factors" in
respect of the concerned issue:
Provided that an issue opening/closing advertisement which does not
contain the highlights need not contain risk factors.
9.1.14 No corporate advertisement of issuer company shall be issued after 21
days of the filing of the offer document with the Board till the closure of
the issue unless the risk factors as are required to be mentioned in the offer
document, are mentioned in such advertisement.
9.1.15 No product advertisement of such company shall contain any reference
directly or indirectly to the performance of the company during the period
mentioned in clause 9.1.14.
9.1.16 (a) No advertisement shall be issued stating that the issue has been fully
subscribed or oversubscribed during the period the issue is open for
subscription, except to the effect that the issue is open or closed.
(b) No announcement regarding closure of the issue shall be made except
on the last closing date.
(c) If the issue is fully subscribed before the last closing date as stated in
the offer document, the announcement should be made only after the issue
is fully subscribed and such announcement is made on the date on which
the issued is to be closed.
9.1.17 Announcement regarding closure of issue shall be made only after the
Lead Merchant Banker is satisfied that at least 90% of the issue has been
subscribed and a certificate has been obtained to that effect from the
Registrar to the Issue.
9.1.18 No incentives, apart from the permissible underwriting commission and
brokerage, shall be offered through any advertisements to anyone
associated with marketing the issue.
9.1.19 In case there is a reservation for the NRIs, the issue advertisement shall
specify the same and indicate the place in India from where the individual
NRI applicant can procure application forms.

9.2 The Lead Merchant Banker shall also comply with the following:
(a) to obtain undertaking from the issuer as part of Memorandum of
Understanding to be entered into by the Lead Merchant Banker with the
issuer company to the effect that the issuer company shall not directly or
indirectly release, during any conference or at any other time, any material
or information which is not contained in the offer documents;
(b) to ensure that the issuer company obtains approval in respect of all issue
advertisements and publicity materials from the Lead Merchant Banker
responsible for marketing the issue and also ensure availability of copies
of all issue related materials with the Lead Merchant banker at least till the
allotment is completed.

#05[9.3 Research reports

9.3.1 The lead merchant banker shall ensure that the following are complied
with in respect of research reports:-
 (i) The research report is prepared only on the basis of published
information as contained in the offer documents.
#06[(ii) No selective or additional information or information
extraneous to the offer document shall be made available by the issuer or
any member of the issue management team/syndicate to any particular
section of the investors or to any research analyst in any manner
whatsoever including at road shows, presentations, in research or sales
reports or at bidding centres, etc.]
#07[(iii) No research report shall be circulated by the issuer or any
member of the issue management team/syndicate or their associates,
commencing from a date 45 days immediately preceding the filing of draft
offer document with SEBI and till 45 days after commencement of trading
in the relevant securities.]
(iv) The advertisement code is observed while circulating the research reports,
and that the risk factors are reproduced wherever highlights are given, as in case of an
advertisement.]
Green Shoe Option

8A.1 #01[(a) An issuer company making a public offer of equity shares can avail of the
Green Shoe Option (GSO) for stabilizing the post listing price of its shares,
subject to the provisions of this Chapter.]
(b) A company desirous of availing the option granted by this Chapter, shall in the
resolution of the general meeting authorizing the public issue, seek authorization
also for the possibility of allotment of further shares to the 'stabilizing agent' (SA)
at the end of the stabilization period in terms of clause 8A.15.
8A.2 The company shall appoint one of the #02[merchant bankers or Book Runners, as
the case may be, from amongst] the issue management team, as the "stabilizing
agent" (SA), who will be responsible for the price stabilization process, if
required. The SA shall enter into an agreement with the issuer company, prior to
filing of offer document with SEBI, clearly stating all the terms and conditions
relating to this option including fees charged/expenses to be incurred by SA for
this purpose.
#03[8A.3(a) The SA shall also enter into an agreement with the promoter(s) or pre-issue
shareholders who will lend their shares under the provisions of this Chapter,
specifying the maximum number of shares that may be borrowed from the
promoters or the shareholders, which shall not be in excess of 15% of the total
issue size.]
8A.4 The details of the agreements mentioned in clauses 8A.2 and 8A.3 shall be
disclosed in #04[the draft prospectus,] the draft Red Herring prospectus, Red
Herring prospectus and the final prospectus. The agreements shall also be
included as material documents for public inspection in terms of #05[clause
6.15.1].
8A.5 The #06[lead merchant banker or the] Lead Book Runner, in consultation with the
SA, shall determine the amount of shares to be overallotted with the public issue,
subject to the maximum number specified in clause 8A.3.
8A.6 The #07[draft prospectus, the] draft Red Herring prospectus, the Red Herring
prospectus and the final prospectus shall contain the following additional
disclosures:
(a) Name of the SA.
(b) The maximum number of shares (as also the percentage vis a vis the
proposed issue size) proposed to be over-allotted by the company.
(c) The period, for which the company proposes to avail of the stabilization
mechanism.
(d) The maximum increase in the capital of the company and the shareholding
pattern post issue, in case the company is required to allot further shares to the
extent of over-allotment in the issue.
(e) The maximum amount of funds to be received by the company in case of
further allotment and the use of these additional funds, in final document to be
filed with RoC
(f) Details of the agreement/arrangement entered in to by SA with the
promoters to borrow shares from the latter which inter-alia shall include name of
the promoters, their existing shareholding, number and percentage of shares to be
lent by them and other important terms and conditions including the rights and
obligations of each party.
(g) The final prospectus shall additionally disclose the exact number of shares
to be allotted pursuant to the public issue, stating separately therein the number of
shares to be borrowed from the promoters and overallotted by the SA, and the
percentage of such shares in relation to the total issue size.
#08[8A.7(a) In case of an initial public offer by a unlisted company, the promoters and
pre-issue shareholders and in case of public issue by a listed company, the
promoters and pre- issue shareholders holding more than 5% shares, may lend the
shares subject to the provisions of this Chapter.
(b) The SA shall borrow shares from the promoters or the pre-issue shareholders of the
issuer company or both, to the extent of the proposed over-allotment:
Provided that the shares referred to in this clause shall be in dematerialized form only.]
8A.8 The allocation of these shares shall be pro-rata to all the applicants.
8A.9 The stabilization mechanism shall be available for the period disclosed by the
company in the prospectus, which shall not exceed 30 days from the date when
trading permission was given by the exchange(s).
8A.10 The SA shall open a special account with a bank to be called the "Special Account
for GSO proceeds of ............. company" (hereinafter referred to as the GSO Bank
account) and a special account for securities with a depository participant to be
called the "Special Account for GSO shares of ............ company" (hereinafter
referred to as the GSO Demat Account).
8A.11 The money received from the applicants against the overallotment in the green
shoe option shall be kept in the GSO Bank Account, distinct from the issue
account and shall be used for the purpose of buying shares from the market,
during the stabilization period.
8A.12 The shares bought from the market by the SA, if any during the stabilization
period, shall be credited to the GSO Demat Account.
8A.13 The shares bought from the market and lying in the GSO Demat Account shall be
returned to the promoters immediately, in any case not later than 2 working days
after the close of the stabilization period.
8A.14 The prime responsibility of the SA shall be to stabilize post listing price of the
shares. To this end, the SA shall determine the timing of buying the shares, the
quantity to be bought, the price at which the shares are to be bought etc.
8A.15 On expiry of the stabilization period, in case the SA does not buy shares to the
extent of shares over-allotted by the company from the market, the issuer
company shall allot shares to the extent of the shortfall in dematerialized form to
the GSO Demat Account, within five days of the closure of the stabilization
period. These shares shall be returned to the promoters by the SA in lieu of the
shares borrowed from them and the GSO Demat Account shall be closed
thereafter. The company shall make a final listing application in respect of these
shares to all the Exchanges where the shares allotted in the public issue are listed.
The provisions of Chapter XIII shall not be applicable to such allotment.
8A.16 The shares returned to the promoters under clause 8A.13 or 8A.15, as the case may
be, shall be subject to the remaining lock in period as provided in the proviso the
clause 4.14.1.
8A.17 The SA shall remit an amount equal to (further shares allotted by the issuer
company to the GSO Demat Account)* (issue price) to the issuer company from
the GSO Bank Account. The amount left in this account, if any, after this
remittance and deduction of expenses incurred by the SA for the stabilization
mechanism, shall be transferred to the investor protection fund(s) of the stock
exchange(s) where the shares of issuer company are listed, in equal parts if the
shares are listed in more than one exchanges. The GSO Bank Account shall be
closed soon thereafter.
8A.18 The SA shall submit a report to the stock exchange(s) on a daily basis during the
stabilization period. The SA shall also submit a final report to SEBI in the format
specified in Schedule XXIX. (Flag B)This report shall be signed by the SA and
the company. This report shall be accompanied with a depository statement for
the "GSO Demat Account" for the stabilization period, indicating the flow of the
shares into and from the account. The report shall also be accompanied by an
undertaking given by the SA and countersigned by the depository(ies) regarding
confirmation of lock-in on the shares returned to the promoters in lieu of the
shares borrowed from them for the purpose of the stabilization, as per the
requirement specified in 8A.16.
8A.19 The SA shall maintain a register in respect of each issue having the green shoe
option in which he acts as a SA. The register shall contain the following details
of:
#09[(a)] in respect of each transaction effected in the course of the stabilizing
action, the price, date and time,
#10[(b)] the details of the promoters from whom the shares are borrowed and the
number of shares borrowed from each; and,
#11[(c)] details of allotments made under clause 8A.15.
8A.20 The register must be retained for a period of at least three years from the date of
the end of the stabilizing period.
 #12[8A.21 For the purpose of the Chapter VIII-A,-
(a) promoter means a promoter as defined in Explanation I to clause 6.4.2.1 of
these guidelines.
(b) Over allotment shall mean as an allotment or allocation of shares in excess
of the size of a public issue, made by the SA out of shares borrowed from the promoters
or the pre-issue shareholders or both, in pursuance of a green shoe option exercised by
the company in accordance with the provisions of this Chapter.]]
Offshore issue
Issue of shares & securities made beyond the boarders of a country are called as
offshore issues. Off shore issues are a source of raising capital and it may be in the form of
Foreign direct investment or indirect investment by institutional investors or by individuals
or any other form.
FDI
Foreign Direct Investment enables MNC or TNC to open up new investments in other
countries, particularly in developing countries
Issue management & SEBI Guidelines
Lesson Objectives
· To understand the process of issue management and SEBIguidelines related to issue
management activity.
Introduction
Issue management, now days, is one of the very important feebased services provided by
the financial institutions. In recent past various companies have entered into issue
management activities. Still there are very few large scale and specialized issue
management agencies in the country. With the growth of stock market and opening up of
economy, the scope for issue management activity is widening day by day. To protect the
investors’ interest and for orderly growth and development of market, SEBI has put in
place guidelines as ground rules relating to new issue management activities. These
guidelines are in addition to the company law requirements in relation to
issues of capital / securities.
Financial instruments can be classified into two main groups –
share capital and
debt capital.
There are various other classifications in each of the two categories. Also, there are
various types of company’s i.e. listed, unlisted, public, private etc. For each of
them SEBI has issued comprehensive guidelines, related to issue of financial instruments.
Let us discuss all these issue management activities in detail, one by one.
Eligibility Norms
To make an issue, the company must fulfill the eligibility norms specified by SEBI and
Companies Act. The companies issuing securities through an offer document, that is (a)
prospectus in case of public issue or offer for sale and (b) letter of offer in case
of right issue, should satisfy the eligibility norms as specified by SEBI, below:
Filing of Offer Document: In the case of a public issue of securities, as well as any issue
of security, by a listed company through rights issue in excess of Rs. 50 lakh, a draft
prospectus should be filed with SEBI through an eligible registered merchant banker at
least 21 days prior to filing it with ROC. Companies prohibited by SEBI, under any
order/direction, from accessing the capital market cannot issue any security.
The companies intending to issue securities to public should apply for listing them in
recognized stock exchange(s). Also, all the issuing companies must (a) enter into an
agreement with a depository registered with SEBI for dematerialization of securities
already issued / proposed to be issued and (b) give an option to subscribers / shareholder /
investors to receive security certificates or hold securities in a dematerialized form
with a depository.
Public issue / Offer for sale by Unlisted Companies: An unlisted company can make a
public issue / offer for sale of equity shares / security convertible into equity shares on a
late date if it has in three out of preceding five years (a) a pre issue net worth of Rs. 1
crore (b) a track record of distributable profit in terms of Sec. 205 of the Companies Act.
The size of the issue should not exceed five times of the pre-issue net worth as per last
available audited accounts either at the time of filing of offer or at the time of opening of
issue.
There are separate norms for companies in the information technology sector and
partnership firms converted into companies or companies formed out of a division on an
existing company. If the unlisted company does not comply with the aforesaid
requirement of minimum pre-issue net worth and track record of distributable profits or
its proposed size exceeds five times its pre-issue net worth, it can issue shares /
convertible security only through book building process on the condition that 60%
of the issue size would be allotted to qualified institutional buyers (QIB) failing which the
full subscription should be refunded.

Public issue by listed companies: All listed companies are eligible to make a public
issue of equity shares/ convertible securities if the issue size does not exceed five times
its preissue net worth as per the last available audited accounts at the time of either filing
of documents with SEBI or opening of the issue. A listed company which does not satisfy
this condition would be eligible to make issue only through book building process on the
condition that 60% of the issue size would be allotted to QIBs, failing which full
subscription money would be refunded.

Exemption: The eligibility norms specified above are not applicable in the following
cases:
· Private sector banks
· Infrastructure companies, wholly engaged in the business of developing, maintaining
and operating infrastructure facility within the meaning of Sec. 10(23-G) of the Income
Tax Act (a) whose project has been appraised by a public financial institution /
IDFC/ILFS and (b) not less than 5% of the project cost has been financed by any of the
appraising institutions jointly / severally by way of loan / subscription to equity or
combination of both and · Rights issue by a listed company.

Credit Rating for Debt Instruments: A debt instrument means an instrument / security
which creates / acknowledges indebtedness and includes debentures, bonds and such
other securities of a company whether constituting charge on its assets or not. For issue,
both public and rights, of a debt instrument, including convertibles, credit rating –
irrespective of the maturity or conversion period – is mandatory and should
be disclosed. The disclosure should also include the unaccepted credit rating. Two ratings
from two different credit rating agencies registered with SEBI should be obtained in case
of public/rights issue of Rs.100 crore and more. All credit ratings obtained during the
three years preceding the public/rights issue for any listed security of the issuing
company should also be disclosed in the offer document.
Outstanding Warrants / Financial Instruments: An unlisted company is prohibited
from making a public issue of shares /convertible securities in case there are any
outstanding financial instruments / any other rights entitling the existing promoters
/ shareholders any option to receive equity share capital after the initial public offering.

Partly Paid-up Shares: Before making a public / rights issued of equity shares /
convertible securities, all the existing partly paid up shares should be made fully paid up
or forfeited if the investor fails to pay call money within 12 months.

Pricing of Issues
A listed company can freely price shares/convertible securities through a public/ rights
issue. An unlisted company eligible to make a public issue and desirous of getting its
securities listed on a recognized stock exchange can also freely price shares and
convertible securities. The free pricing of equity shares by an infrastructure company is
subject to the compliance with disclosure norms as specified by SEBI from time to time.
While freely pricing their initial public issue of shares/ convertible, all banks require
approval by the RBI.
Differential Pricing: Listed/unlisted companies may issue shares/convertible securities
to applicants in the firm allotment category at a price different from the price at which the
net offer to the public is made, provided the price at which the securities are offered to
public.A listed company making a composite issue of capital may issue securities at
differential prices in its public and rights issue. In the public issue, which is a part of a
composite issue, differential pricing in firm allotment category vis-à-vis the net offer to
the public is also permissible. However, justification for the price differential should be
given in the offer document in case of firm allotment category as well as in all composite
issues.
Price Band: The issuer / issuing company can mention a price band of 20% (cap in the
price band should not exceed 20% of the floor price) in the offer document filed with
SEBI and the actual price can be determined at a later date before filing it with
the ROC. If the BOD of the issuing company has been authorized to determine the offer
price within a specified price band, a resolution would have to be passed by them to
determine such a price. The lead merchant banker should ensure that in case of listed
companies, a 48 hours notice of the meeting of BOD for passing the resolution for
determination of price is given to the regional stock exchange. The final offer document
should contain only one price and one set of financial projections, if applicable.
Payment of Discount / Commissions: Any direct or indirect payment in the nature of
discount / commission / allowance or otherwise cannot be made by the issuer company /
promoter to any firm allottee in a public issue.
Denomination of Shares: Public / rights issue of equity shares can be made in any
denomination in accordance with Sec 13(4) of the Companies Act and in compliance
with norms specified by SEBI from time to time. The companies which have already
issued shares in the denominations of Rs. 10 or Rs. 100 may change their standard
denomination by splitting / consolidating them. Promoters’ Contribution and Lock-in
Requirements Regulations regarding promoters’ contribution are discussed as
under:
Public issue by unlisted companies: The promoters should contribute at least 20% and
50% of the post issue capital in public issue at par and premium respectively. In case the
issue size exceeds Rs. 100 crores, their contribution would be computed on the basis of
total equity to be issued, including premium at present and in the future, upon conversion
of optionally convertible instruments, including warrants. Such contribution may be
computed by applying the slab rated mentioned below:
Size of Capital Issue Percentage of contribution (including premium)
On first Rs. 100 crores 50
On next Rs. 200 crores 40
On next Rs. 300 crores 30
On balance 15
While computing the extent of contribution, the amount against the last slab should be so
adjusted that on an average the promoters’ contribution is not less than 20% of post issue
capital after conversion.
Offer for sale by unlisted companies: The promoters’shareholding, after offer for sale,
should at least 20% of the post issue capital.
Public issue by listed companies: The participation of the promoters should either be (i)
to the extent of 20% of the proposed issue or (ii) to ensure shareholding to the extent of
20% of the post-issue capital.
Composite issue by Listed Companies: At the option of the promoters, the contribution
would be either 20% of the proposed public issue or 20% of the post-issue capital,
excluding rights issue component of the composite issue.
Public Issue by unlisted infrastructure companies at premium: The promoters
contribution, including contribution by equipment suppliers and other strategic investors,
should be at least 50% of the post-issue capital at the same or a price higher than the one
at which the securities are being offered to public.
Securities Ineligible for computation of promoters contribution: The securities
specified below acquired by / allotted to promoters would not be considered for
computation of promoters’ contribution: · Where before filing the offer document with
SEBI, equity shares were acquired during the preceding three years (a) for consideration
other than cash and revaluation of assets / capitalization of intangible assets is involved in
such transactions and (b) from a bonus issue out of revaluation reserves or reserves
without accrual of cash revenues;
 In
 the case of a public issue by unlisted companies, securities issued to promoters
during the preceding one year at a price lower than the price at which equity is offered to
the public.
The
 shares allotted to promoters during the previous year out of funds brought in
during that period in respect of companies formed by conversion of partnership firms
where the partners of the firm and the promoters of the converted company are the same
and there is no change in management unless such shares have been issued at the same
price at which the public offer is made. However, if partners’ capital existed in the firm
for a period exceeding one year on a continuous basis, the shares allotted to promoters
against such capital would be eligible.The ineligible shares specified in the above three
categories
would, be eligible for computation of promoters contribution if they are acquired in
pursuance of a scheme of merger/ amalgamation approved by a high court.
Securities
 of any private placement made by solicitation of subscription from unrelated
persons either directly or through an intermediary; and
Securities
 for which a specific written consent has not been obtained from the
respective shareholders for inclusion of their subscription in the minimum promoters
contribution.
Issue of convertible security: In the case of issue of convertible security, promoters
have an option to bring in their subscription by way of equity or subscription to the
convertible security being offered so that their total contribution would not
be less than the required minimum in cases of (a) par/ premium issue by unlisted
companies (b) offer for sale, (c) issues/ composite issue by listed companies and (d)
public issue at premium by infrastructure companies.

Promoters Participation in Excess of Required Minimum:

In a listed company participation by promoters in excess of the required minimum
percentage in public/ composite issues would be subject to pricing of preferential
allotment, if the issue price is lower than the price as determined on the basis of
preferential allotment pricing.
Promoters’ contribution before public issue: Promoters should bring in the full amount
of their contribution, including premium, at least one day before the public issue opens/
issue opening date which would be kept in an escrow account with a bank and would be
released to the company along with the public issue proceed.
Exemption from Requirement of Promoters’ Contribution:
The requirement of promoters contribution is not applicable in the following three cases,
although in all the cases, the shareholders should disclose in the offer document their
existing shareholding and the extent to which they are participating in the proposed issue:
a. Public issue by a company listed on a stock exchange for at least three years and
having a track record of dividend payment for at least three immediately preceding years.
However, if the promoters’ participate in the proposed issue to the extent greater than
higher of the two options available, namely, 20% of the issue or 20% of the
postissuecapital, the excess contribution would attract pricing guidelines on preferential
issues if the issue price is lower than the price as determined on the basis of the
guidelines on preferential issue.
b. Where no identifiable promoter / promoter group exists.
c. Rights issue.
Lock-in requirements of Promoters’ contribution: Promoters’contribution is subject to
a lock-in period as detailed below:
Lock-n of Minimum Required Contribution: In case of any (all) issues of capital to the
public, the minimum promoters’contribution would be locked in for a period of three
years. The lock-in period would start from the date of allotment in the proposed issue and
the last date of the lock-in period would be reckoned as three years from the date of
commencement of commercial production or the date of allotment in the public
issue, or whichever is later.
Lock-in excess promoters contribution: In the case of public issue by an unlisted
company, excess promoters’ contribution would be locked in for a period of one year.
The excess contribution in a public issue by a listed company would also be locked in for
a period of one year as per the lock-in provisions.
Securities issued last to be locked in first: The securities, forming part of the
promoters’ contribution issued last to them, would be locked in first for the specified
period. However, if securities were issued last to financial institutions as promoters, these
would not be locked in before the shares allotted to other promoters.
Lock-in of Pre-issue share capital of an unlisted company:
The entire pre-issue share capital, other than locked in as promoters’ contribution, would
be locked-in for one year from the date of commencement of commercial production or
the date of allotment in the public offer whichever is later.

Lock-in of securities issued on firm allotment basis:

Securities issued on firm allotment basis would be locked in for one year from the date of
commencement of commercial production, or date of allotment in public issue,
whichever is later.
Other requirements in respect of Lock-in: The other requirements relating to the lock-
in of promoters’ contribution is discussed hereunder:
Pledge of securities: Locked-in securities held by the promoters may be pledged only
with banks/financial institutions, as collateral security for loans granted by them provided
the pledge of shares is one the terms of the sanction of the loan.
Inter-se transfer of Securities: Transfer of locked in securities amongst promoters as
named in the offer document can be made subject to lock-in being applicable to the
transferees for the remaining lock-in period.
Inscription of Non-transferability: The securities, which are subject to a lock-in period,
should carry inscription ‘nontransferable’,along with duration of specified non-
transferable period mentioned in the face of the security certificate.

Issue Advertisement
The term advertisement is defined to include notices, brochures, pamphlets, circulars,
show cards, catalogues, placards, posters, insertions in newspapers, pictures, films, cover
pages of offer documents or any other print medium, radio, television programs through
any electronic media. The lead merchant banker should ensure compliance with the
guidelines on issue advertisement by the issuing companies.

Issue of Debt Instruments

A company offering convertible/non-convertible debt instruments through an offer
document should, in addition to the other relevant provisions of these guidelines,
complies with the following provisions:
Requirement of credit rating: A public or rights issue of debt instruments (including
convertible instruments) in respect of their maturity or conversion period can be made
only if the credit rating has been obtained and disclosed in the offer document. For all
issues greater than or equal to Rs.100 crore, two ratings from two different credit rating
agencies should be obtained.
Requirements in Respect of Debenture Trustees: In the case of issue of debentures
with maturity of more than 18 months, the issuer should appoint debenture trustees whose
name must be stated in the offer document. The issuer company in favor of the debenture
trustees should execute a trust deed within six months of the closure of the issue.
Creation of Debenture Redemption Reserves (DRR): A company has to create DRR in
the case of the issue of debentures with maturity of more than 18 months.
Distribution of Dividends: In the case of new companies, distribution of dividends
would require the approval of the trustees to the issue and the lead institution, if any. In
case of existing companies, prior permission of the lead institution for declaring dividend,
exceeding 20% as per the loan covenants, is necessary if the company does not comply
with institutional condition regarding interest and debt service coverage ratio.
Redemption: The issuer company should redeem the debentures as per the offer
documents.
Disclosure and Creation of Charge: The offer document should specifically state the
assets on which the security would be created as also the ranking of the charge(s). In the
case of second/residual charge or subordinated obligation, the risks associated with
should clearly be stated.
Filing of Letter of Option: A letter of option containing disclosures with regards to
credit rating, debentures holders resolution, option for conversion, justification for
conversion price and such other terms which SEBI may prescribe from time to time
should be filed with SEBI through an eligible merchant banker, in case of a roll over of
non-convertible portions of PCD/NCDs, etc.
Book Building
Book-building means a process by which a demand for the securities proposed to be
issued by a body corporate is elicited and built up and the price for such securities is
assessed for the determination of the quantum of such securities to be issued by means of
notice/ circular / advertisement/ document or information memoranda or offer document.
A company proposing to issue capital through book-building has to comply with the
requirements of SEBI in this regard. These are discussed here.
75% Book Building Process: The option of book-building is available to all body
corporate which are eligible to make an issue of capital to the public as an alternative to
and to the extent of the percentage of the issue, which can be reserved for firm allotment.
The issuer company can either reserve the securities for firm allotment or issue them
through bookbuilding process. The issue of securities though book-building route should
be separately identified/indicated as ‘placement portion category’ in the prospectus. The
securities available to the public should be separately identified as ‘net offer to the
public’. The requirement of minimum 25% of the securities to be offered to the public is
also applicable. Underwriting is mandatory to the extent of the net offer to the public.
The draft prospectus containing all the details except the price at which the securities are
offered should be filed with SEBI. The issuer company should nominate one of the lead
merchant bankers to the issue as book runner, and his name should be mentioned in the
prospectus. The copy of the draft prospectus, filed with SEBI, should be circulated by the
book runner to the institutional buyers, who are eligible for firm allotment, and to the
intermediaries, eligible to act as underwriters inviting offers for subscription to the
securities.
100% Book Building Process: In an issue of securities to the public through a
prospectus, the option for 100% book building is available to any issuer company. The
issue of capital should be Rs. 25 crore and above. Reservation for firm allotment to the
extent of the percentage specified in the relevant SEBI guidelines can be made only to
promoters, ‘permanent employees of the issuer company and in the case of new company
to the permanent employees of the promoting company’. It can also be made to
shareholders of the promoting companies, in the case of new company and shareholders
of group companies in the case of existing company either on a competitive basis or on a
firm allotment basis. The issuer company should appoint eligible merchant bankers as
book runner(s) and their names should be mentioned in the draft prospectus. The lead
merchant banker should act as the lead book runner and the other eligible merchant
bankers are termed as co-book runner. The issuer company should compulsorily
offer an additional 10% of the issue size offered to the public through the prospectus.
IPO Through Stock Exchange On-line System (E-IPO) In addition to other requirements
for public issue as given in SEBI guidelines wherever applicable, a company proposing to
issue capital to public through the on-line system of the stock exchange for offer of
securities has to comply with the additional requirements in this regard. They are
applicable to the fixed price issue as well as for the fixed price portion of the book-built
issues. The issuing company would have the option to issue securities to public either
through the on-line system of the stock-exchange or through the existing banking
channel. For E-IPO the company should enter into agreement with the
stock-exchange(s) and the stock-exchange would appoint SEBI registered stockbrokers of
the stock exchange to accept applications. The brokers and other intermediaries are
required to maintain records of (a) orders received, (b) applications received,
(c) details of allocation and allotment, (d) details of margin collected and refunded and
(e) details of refund of application money.
Issue of Capital by Designated Financial Institutions Designated financial institutions
(DFI), approaching the capital market for fund though an offer document, have to follow
following guidelines.
Promoters’ contributions: There is no requirement of minimum promoters’ contribution
in the case of any issue by DFIs. If any DFI proposes to make a reservation for
promoters, such contribution should come only from actual promoters and not from
directors, friends, relatives and associates, etc.
Reservation for employees: The DFIs may reserve out of the proposed issues for
allotment only to their permanent employees, including their MD or any fulltime director.
Such reservations should be restricted to Rs. 2000 per employee, subject to five percent
of the issue size. The shares allotted under the reserved category are subject to a lock-in
for a period of three years.
Pricing of the issue: The DFIs, may freely price the issues in consultation with the lead
managers, if the DFIs have a three years track record of consistent profitability out of
immediately preceding five years, with profit during last two years prior to the issue.
Preferential Issue
The preferential issue of equity shares/ fully convertible debentures (FCD)/ partly
convertible debentures (PCDs) or any other financial instruments, which would be
converted into or exchanged with equity shares at a later date by listed companies
to any select group of persons under section 81(1A) of the Companies Act, 1956 on a
private placement basis, are governed by the following guidelines:
Pricing of issue: The issue of shares on a preferential basis can be made at a price not
less than the higher of the following: (i) The average of the weekly high and low of the
closing prices of the related shares quoted on the stock exchange and
(ii) The average of the weekly high and low of the closing prices of the related shares
quoted on a stock exchange during the two weeks preceding the relevant date.
Pricing of Shares arising out of warrants: Where warrants are issued on a preferential
basis with an option to apply for and be allotted shares, the issuer company should
determine the price of the resultant shares in accordance with the provisions discussed in
the above point.
Pricing of shares on Conversion: Where PCDs/FCDs/ other convertible instruments are
issued on a preferential basis, providing for the issuer to allot shares at a future date, the
issuer should determine the price at which the shares could be allotted in the same
manner as specified for pricing of shares allotted in lieu of warrants.
Currency of Financial Instruments: In the case of warrants / PCDs / FCDs / or any
other financial instruments with a provision for the allotment of equity shares at a future
date, either through conversion or otherwise, the currency of the instruments cannot
exceed beyond 18 months from the date of issue of the relevant instruments.
Non-transferability of Financial Instruments: The instruments allotted on a
preferential basis to the promoters / promoter groups are subject to a lock-in period of
three years from the date of allotment. In any case, not more than 20% of
the total capital of the company, including the one brought in by way of preferential issue
would be subject to a lock-in period of three years from the date of allotment.
Currency of Shareholders’ Resolutions: Any allotment pursuant to any resolution
passed at a meeting of shareholders of a company granting consent for preferential issues
of any financial instrument, should be completed within a period of three months from
the date of passing of the resolution.
Certificate from Auditors: In case every issue of shares/ FCDs/PCDs/ or other financial
instruments has the conversion option, the statutory auditors of the issuer company
should certify that the issue of said instruments is being made in accordance with the
requirements contained in these guidelines.
OTCEI Issues
A company making an initial public offer of equity shares / convertible securities and
proposing to list them on the Over The Counter Exchange of India (OTCEI) has to
comply with following requirements:
Eligibility Norms: Such a company is exempted from the eligibility norms applicable to
unlisted companies, provided
(i) it is sponsored by a member of the OTCEI and
(ii) has appointed at least two market makers. Any offer of sale of equity shares /
convertible securities resulting from a bought out deal registered with OTCEI is also
exempted from the eligibility norms subject to the fulfillment of the listing criteria
 laid down by the OTCEI.
Pricing norms: Any offer for sale of equity shares or any other convertible security
resulting from a bought out deal registered with OTCEI is exempted from the pricing
norms specified for unlisted companies, subject to following conditions: (a) The
promoters after such issue would retain at least 20% of the total issued capital with a
lock-in of three years from the date of the allotment of securities in the proposed issue
and (b) at least two market makers are appointed in accordance with the market
making guidelines stipulated by the OTCEI.
Projection: In case of securities proposed to be listed on the OTCEI, projections based
on the appraisal done by the sponsor who undertakes to do market-making activity can be
included in the offer document subject to compliance with the other conditions relating to
the contents of offer documents.
 UNIT III
OTHER FEE BASED MANAGEMENT

Corporate restructuring includes mergers and acquisitions (M&As), amalgamation,

takeovers, spin-offs, leveraged buy-outs, buyback of shares, capital reorganisation etc.
 M&As are the most popular means of corporate restructuring or business
combinations.
 Merger or Amalgamation
 Merger or amalgamation may take two forms:
 Absorption is a combination of two or more companies into an
existing company.
 Consolidation is a combination of two or more companies into a
new company.
 In merger, there is complete amalgamation of the assets and liabilities as
well as shareholders’ interests and businesses of the merging companies.
There is yet another mode of merger. Here one company may purchase
another company without giving proportionate ownership to the
shareholders’ of the acquired company or without continuing the business
of the acquired company.
 Forms of Merger:
 Horizontal merger
 Vertical merger
 Conglomerate merger
 Acquisition may be defined as an act of acquiring effective control over assets or
management of a company by another company without any combination of
businesses or companies. A substantial acquisition occurs when an acquiring
firm acquires substantial quantity of shares or voting rights of the target company.
 Takeover – The term takeover is understood to connote hostility. When an
acquisition is a ‘forced’ or ‘unwilling’ acquisition, it is called a takeover.
 A holding company is a company that holds more than half of the nominal value
of the equity capital of another company, called a subsidiary company, or
controls the composition of its Board of Directors. Both holding and subsidiary
companies retain their separate legal entities and maintain their separate books of
accounts.
PURPOSE OF MERGERS & ACQUISITION
 Mergers and Acquisition are intended to:
 Limit competition.
 Utilise under-utilised market power.
 Overcome the problem of slow growth and profitability in one’s own
industry.
 Achieve diversification.
 Gain economies of scale and increase income with proportionately less
investment.
  Establish a transnational bridgehead without excessive start-up costs to
gain access to a foreign market.
 Utilise under-utilised resources–human and physical and managerial skills.
 Displace existing management.
 Circumvent government regulations.
 Reap speculative gains attendant upon new security issue or change in P/E
ratio.
 Create an image of aggressiveness and strategic opportunism, empire
building and to amass vast economic powers of the company.
Advantages of M&A are
The most common advantages of M&A are:
 Accelerated Growth
 Enhanced Profitability
 Economies of scale
 Operating economies
 Synergy
 Diversification of Risk
 Reduction in Tax Liability
 Financial Benefits
 Financing constraint
 Surplus cash
 Debt capacity
 Financing cost
 Increased Market Power

Steps involved in the analysis of mergers or acquisitions:

There are three important steps involved in the analysis of mergers or

acquisitions:

Planning
 Search and screening
 Financial evaluation
Value Creation Through Mergers and Acquisitions
Merger will create an economic advantage (EA) when the combined present value of
the merged firms is greater than the sum of their individual present values as separate
entities.
Valuation under Mergers and Acquisitions: DCF Approach
 In order to apply DCF technique, the following information is required:
 Estimating Free Cash Flows
 Revenues and expenses
 Capex and depreciation:
 Working capital changes
 Estimating the Cost of Capital
  Terminal Value
Financing a Merger
 Cash Offer:
A cash offer is a straightforward means of financing a merger. It does not
cause any dilution in the earnings per share and the ownership of the existing
shareholders of the acquiring company.
 Share Exchange:
 A share exchange offer will result into the sharing of ownership of the
acquiring company between its existing shareholders and new
shareholders (that is, shareholders of the acquired company). The earnings
and benefits would also be shared between these two groups of
shareholders. The precise extent of net benefits that accrue to each group
depends on the exchange ratio in terms of the market prices of the shares
of the acquiring and the acquired companies.
 The bootstrapping phenomenon.

Merger Negotiations: Significance of P/E Ratio and EPS Analysis

 The mergers and acquisitions decisions are also evaluated in terms of EPS, P/E
ratio, book value etc.
 Share Exchange Ratio
 The share exchange ratio (SER) would be as follows:

 The exchange ratio in terms of the market value of shares will keep the position of
the shareholders in value terms unchanged after the merger since their
proportionate wealth would remain at the pre-merger level.
 Post-merger weighted P/E ratio:
 (Pre-merger P/E ratio of the acquiring firm) × (Acquiring firm’s pre-merger
earnings × Post-merger combined earnings) + (Pre-merger P/E ratio of the
acquired firm) × (Acquired firm’s pre-merger earnings × Post-merger combined
earnings)

Factors Influencing the Earnings Growth

The important factors influencing the earnings growth of the acquiring firm in future
are:
 The price–earnings ratios of the acquiring and the acquired companies.
 The ratio of share exchanged by the acquiring company for one share of the acquired
company.
 The pre-merger earnings growth rates of acquiring and the acquired companies.
 The level of profit after tax of the merging companies.
 The weighted average of the earnings growth rates of the merging companies.

Leveraged Buy-outs
  A leveraged buy-out (LBO) is an acquisition of a company in which the
acquisition is substantially financed through debt. When the managers buy their
company from its owners employing debt, the leveraged buy-out is called
management buy-out (MBO).
 The following firms are generally the targets for LBOs:
 High growth, high market share firms
 High profit potential firms
 High liquidity and high debt capacity firms
 Low operating risk firms

 The evaluation of LBO transactions involves the same analysis as for mergers and
acquisitions. The DCF approach is used to value an LBO.
 A tender offer is a formal offer to purchase a given number of a company’s
shares at a specific price.
Tender Offer and Hostile Takeover
 Tender offer can be used in two situations.
 First, the acquiring company may directly approach the target company for
its takeover. If the target company does not agree, then the acquiring company may
directly approach the shareholders by means of a tender offer.
 Second, the tender offer may be used without any negotiations, and it may
be tantamount to a hostile takeover.

Defensive Tactics
 Divestiture
 Crown jewels
 Poison pill
 Greenmail
 White knight
 Golden parachutes
Regulation of Mergers and Takeovers in India
In India, mergers and acquisitions are regulated through:
 The provision of the Companies Act, 1956,
 The Monopolies and Restrictive Trade Practice (MRTP) Act, 1969,
 The Foreign Exchange Regulation Act (FERA), 1973,
 The Income Tax Act, 1961, and
 The Securities and Controls (Regulations) Act, 1956.
 The Securities and Exchange Board of India (SEBI) has issued guidelines to
regulate mergers, acquisitions and takeovers.
Legal Measures against Takeovers
 Refusal to Register the Transfer of Shares:
 a legal requirement relating to the transfer of shares have not be complied
with; or
 the transfer is in contravention of the law; or
 the transfer is prohibited by a court order; or
  the transfer is not in the interests of the company and the public.
 Protection of Minority Shareholders’ Interests
 SEBI Guidelines for Takeovers:
 Disclosure of share acquisition/holding
 Public announcement and open offer
 Offer price
 Disclosure
 Offer document
Legal Procedures

 Permission for merger

 Information to the stock exchange
 Approval of board of directors
 Application in the High Court
 Shareholders’ and creditors’ meetings
 Sanction by the High Court
 Filing of the Court order
 Transfer of assets and liabilities
 Payment by cash or securities
 Pooling of Interests Method
Accounting for Mergers and Acquisitions
 In the pooling of interests method of accounting, the balance sheet items and the
profit and loss items of the merged firms are combined without recording the
effects of merger. This implies that asset, liabilities and other items of the
acquiring and the acquired firms are simply added at the book values without
making any adjustments.
 Purchase Method
 Under the purchase method, the assets and liabilities of the acquiring firm after
the acquisition of the target firm may be stated at their exiting carrying amounts
or at the amounts adjusted for the purchase price paid to the target company.
PORTFOLIO MANAGEMENT
Introduction
In India, Portfolio Management is still in its infancy. Barring a few Indian banks, and
foreign banks and UTI, no other agency had professional Portfolio management until
1987. After the success of Mutual Funds in Mutual Funds, since /’ 1987, Professional
Portfolio Management, backed by competent
research staff became the order of the day. After the success of Mutual Funds in Portfolio
Management, a number of brokers and Investment Consultants some of whom are also
professionally qualified have become Portfolio Managers. They have managed the funds
of clients on both discretionary and nondiscretionary basis. It was fou:1d that many of
them, including
Mutual Funds have guaranteed a minimum return or capital appreciation and adopted all
kinds of incentives which are now prohibited by SEB!. They resorted to speculative over
trading and insider trading, discounts, etc., to achieve their targeted returns to the clients,
which are also prohibited by SEBI.
The recent CBI probe into the operations of many market dealers has revealed the
unscrupulous practices by banks, dealers and brokers in their Portfolio Operations. The
SEBI has then imposed stricter rules, which included their registration, a code of conduct
and minimum infrastructure, experience and
expertise etc. It is no longer possible for. any unemployed youth, or retired person or self-
styled consultant to engage in Portfolio Management without the SEBI’s licence. The
guidelines of SEBI are in the direction of making Portfolio
Manage-ment a responsible professional service to be rendered by experts in the field.
Basically Portfolio Management involves
a. A proper investment decision-making of what to buy and sell;
b. Proper money management in terms of investment in a basket of assets so as to satisfy
the asset preferences of investors;
c. Reduce the risk and increase returns.
Investment Strategy
In India, there are a large number of savers, barring the population who are below the
poverty line. In a poor country like this, it is surprising that its saving rate is as high as
27% of GDP per annum and investment at 28% of GDP. But the return in the form of
output growth is 3!: low as 5 to 7% per annum. One may ask why is it that high levels of
investment could not generate, comparable rates of growth of output? The answer is poor
investment strategy, involving high capital output ratios, low productivity of capital and
high rates of
obsolescence of capital. What is true of the nation at that Macro level is also true at Micro
level of individuals and institutions. The use of capital in India is wasteful and inefficient,
despite the fact that India is labour rich and capital poor. Thus, the Portfolio Managers in
India lack the expertise and experience,
which will enable them to have proper strategy for investment
management. Secondly, the average Indian Household saves around 60% in
financial form and 40% in physical form. Of those in financial form, nearly 42% is held
in cash and bank deposits, as per the latest RBI data and they have negative real returns
or return less than the inflation rates. Besides, a proportion of35% of financial savings is
held in form of Insurance, P.F., Pension Funds etc., while another l2% is in government
instruments and Certificates like Post Office Deposits, N.S. Certificates, Public Provident
Funds, National Saving Scheme etc. The real returns on Insurance, P.F., etc., are low and
many times lower than the average inflation rates. With the removal of many tax
concessions for investments in P.O. Savings instruments,
Certificates, etc., they also become less attractive to small and medium investors. The
only investments, statisfying all their objectives are capital market instruments. These
objectives are income, capital appreciation, safety, marketability, Liquidity and hedge
against inflation, and investment by average household in shares and deben-tures is only
around 5% of the total
financial savings.
Objectives of Investors: The return on equity investments in the capital market
particularly if proper investment strategy is adopted would satisfy the above objectives
and the real returns would be higher than any other saving instruments. It is in this
context, the art and science of investment and of Portfolio Management became the sine-
qua-non of success.All investments involve risk taking. However, some risk free
investments are available like bank deposits or P.O. Deposits whose returns are called
risk free returns of about 5-12%. So the returns on more risky investments are higher than
that, having
risk premium. Risk is variability of return and uncertainty of payment of interest and
repayment of principal. Risk is measured by standard deviation of the returns over the
mean for a given period. Risk varies directly with return. The higher the risk taken, the
higher is the return, under normal market conditions.
Although Indian markets are imperfect and are developing, “all the basic principles and
theory of portfolio management would apply and these are recapitu-lated below.
Risk and Beta
Risk is of two components - systematic market related risk and
unsystematic risk or company specific risk. The former cannot
be eliminated but managed with the help of Beta (b), which is
explained as follows:
 %
 age change of Scrip return
% age change of Market return
If = 1, the risk ,of the company is the same as that of the market and if > 1, the
company’s risk is more than the market
risk. If < 1, the reverse is the position. “
Specific Risk: If risk is company specific risk it can be reduced by diversifica-tion into
different industries and companies of different types and nature and whose covariance’s
are different and whose performances are disparate.
Types of Risk
Unsystematic Risk Systematic Risk
Company related risks due to higher costs, mismanagement, defective sales or inventory
strategy, insolvency, fall in demand and company specific recession, labour problems
etc.Market related risk due to demand problems, interest rates, inflation, raw materials,
import and export policy, Tax policy etc., Business Risk, Market Risk, Financial
Risk,Interest Rate Risk, Inflation Risk etc.
Modem Portfolio Theory (MPT): This postulates that public generally are risk averse.
In a perfect market, information is free and quickly absorbed by the market. Given the
return, risk can be reduced by diversification of investment into a number of Scrip’s.
Each Scrip has its own risk profile. The risks of any two Scrips are different from the risk
of a group of two companies together. Thus, if the risk of Reliance (b) is say 1.90 and
that of Dr. Beck is 0.70, the total of these two units is 1.30 as the average. But the actual
‘b’ may be less at say 1.00, reason being that the covariance of these two may be zero or
negative (lessthan 1).
CAPM & SML: (Capital Asset Pricing Model and
Security Market Line)
CAPM postulates that in a perfect market, where shares are correctly priced, every
security will give a return commensurate with its risk. “b” is a measure of the risk. The
market risk is different from the risks of individual Scrips comprising the market. CML
relates to the total risk of the market. But SML
refers to the risk, which is undiversifiable market related risk. Total risk is measured by
the standard devia-tion, while the undiversifiable risk is measured by Beta (13). CML, is
Capital Market Line and SML is Security Market Line.
Risk premium of portfolio is the excess of the expected portfolio return over the risk free
return. Similar is the definition in respect of risk premium of the market, namely,
expected Market Return minus Risk Free Return. CML passes through the risk free rate,
which represents the true time value of money
or the reward for waiting by savers.In portfolio management and investment decision-
making, time element and time value of money are very relevant. Savings are automatic
or induced. If induced, it requires a return enough
to induce them to part with liquidity. Thus, savings and liquidity will be parted by the
investors if only their time preference is satisfied by proper return.
Why time preference? Why savers prefer today’s return toomorrows return?
“A bird in hand is worth two in me bush”, as the adage goes.
1. More money is to be received after a year, if he has to lend to the user of funds today.
He forgoes consumption which has to be compensated.
2. Money lent today can produce something more than before and hence present money is
more valuable than money tomorrow. This premium is needed for waiting.
3. Money is losing in value due to rise in prices. Hence, moneylenders lose
and borrowers gain in times of inflation. Premium given is to compensate the lenders
against loss due to fall in value of money.
Compounding
Future Value Factor (FVF) is (1+ r)” is the rate of interest
required and (n) is the period of years of waiting.
Fn = P (1+ r)”, or
Future Value = Present Value x (Future Value Factor )
So the return required by savers is related to the waiting period, loss of consumption at
present, or liquidity and risk of loss of money or variance of returns.
Discounting
If the future flow of money is known as C1, C2, C3, etc. What is the present value of
them and how much is he prepared to pay for them. If he deposits today Rs. 100 he gets
Rs. 110 at the end of 1 year and Rs. 121 at the end of 2 years, the interest rate is 10%.
This process of finding the present value for future money flows is called discounting.
Present value of future
amounts is :
The multiplier is called PVF or Present Value Factor. We should know the amounts of
cash flows, (Fn) number of
years (n) are the required rate of return (r).
Perpetuity
When we receive a fixed sum of money every year upto infinity, it is called perpetuity.
Suppose we want to receive Rs. 100 every year for infinity and interest rate is 10%, we
have to deposit Rs.1,000 and the equation is PV = where PV is present value of
perpetuity, fixed periodic cash flow and r is rate of interests.
Annuity
Annuity is a constant cash flow for a finite time period of say 5 years (n). Examples of
annuity are found in the case of lease rentals, loan repayments, Recurring deposits, etc.

Application to Portfolio Management

Portfolio Management involves time element and time horizon. The present value of
future returns /cash flows by discounting is useful for share valuation and bond
valuation.The investment strategy in portfolio construction should have a time horizon,
say 3 to 5 years, to produce the desired results of say 20-30% return per annum. Besides
Portfolio Management should also take into account tax benefits and investment
incentives. As the returns are taken by investors net of tax payments, and there is always
an element of inflation, returns net of taxation and inflation are more relevant to tax
paying investors. These are called net real rates of
returns, which should be more than other returns. The should encompass risk free return
plus a reasonable risk premium, depending upon the risk taken, on the instru-ments/assets
invested.
Portfolio Construction, Revision and Evaluation
Portfolio Manager has to use all the tools of research like fundamental analysis and
technical analysis in addition to Risk -Return analysis to decide on the investment,
buying and selling etc. After the design of the Portfolio Strategy, the construction and
allocation of funds will lead to the building up of the portfolio. Thereafter the portfolio
thus built requires a constant
review and revision with the result that operations on it arc a continuous process. This is
also called Monitoring. Finally, once in a quarter or half year, the portfolio performance
is evaluated, for its success by comparing die actual achievements with the targets fixed.
This throws light on the efficiency of the investment strategy of Portfolio Manager and
helps the revision of portfolio.
MPT and Dominance Concept
The Modern Portfolio Theory (MPT) is based on assumptions of free” and perfect
information flow and the notion of dominance. This means that if the market is able to
absorb the information, fully and efficiently, price reflects the risks involved given the
same return, the investor can choose the scrips with the lowest possible risk. This is
possible by diversification into a
number of companies of say 10 to 15, which have diverse characteristics of risk. Thus,
when any two Scrips behave differently to given changes in the economy and industry
and when the co- efficient of correlation between them is less than 1, such scrips can be
joined in a portfolio so as to reduce the combined risk of the portfolio. The notion of
dominance tells us that no investor should invest in one company alone and if there are
two or more
companies with the same risk, then he has to choose the one with higher return and if
both have the same return he has to choose the One with lower risk. The investor can
reduce the risk by distributing his funds in a diverse variety of companies with varying
risks and returns which do not have much autocorrelation. Thus, the investor has not only
to make proper investment decision of what to buy and when to buy, but has a proper
investment strategy through diversification and choice of a proper ‘B’ for the scrips
selected so that the total risk of portfolio is the lowest possible.
Diversification Process
The process of diversification has various phases involving investment into various
classes of assets like equity, preference shares, CDs, NCDs, P.S.U. Bonds and Shares,
Money market instruments like commercial paper, inter-corporate investments, deposits
etc. Within each class of assets, there is further possibility of diversification into various
industries, different
companies etc. The proportion of funds invested into various classes of assets,
instruments, industries and compa-nies,would depend upon the objectives of investor,
under portfolio management and his asset preferences, income and asset requirements.A
portfolio with the objective of regular income would invest a proportion of funds in
bonds, debentures and Fixed Deposits.For such investments, duration of the life of the
bond/debenture, quality of the asset as judged by the credit rating and the expected yield
are the relevant variables.Bond market is not well developed in India but debentures,
partly or fully convertible into equity are in good demand both from individuals and
Mutual Funds. The Portfolio Manager
has to use his analytical power and discretion to choose the right debentures with the
required duration, yield and quality. The duration and immunisation of expected inflows
of funds to the required quantum of funds have to be well planned by the Portfolio
Manager. Research and high degree of analytical power in investment management and
bond portfolio management are necessary.The bond investments are thus equally
challenging as equity
investments and more so in respect of money market instruments.All these facts bring out
clearly the needed analytical powers and expertise of Portfolio Manager.

SEBI Guidelines for Portfolio Managers

It will thus be seen that Portfolio Management is an art and requires high degree of
expertise. The merchant banker has been authorised to do Portfolio Management
Services, if they belong to Categories I and II as licensed by the SEBI. This classification
of merchant bankers was dropped in 1996 and only the category I merchant bankers is
allowed to operate in India. Others who want to provide such services should have a
minimum net worth of Rs. 50 lakhs and expertise, as laid down or changed from time-to-
time by the SEBI and would have to register with the SEBI. The SEBI have set out the
guidelines in this regard, in which the relations of the client vis-a-vis the Portfolio
Manager and the respective rights and duties of both have been
set out. The code of conduct for Portfolio Managers has been laid down by the SEBI. The
job of Portfolio Manager in managing the client’s funds, either on discretionary or
nondiscretionary basis has thus become challenging and difficult due to the multitude of
obligations laid on his shoulders by the SEBI, in respect of their operations, accounts,
audit etc.
It is thus clear that Portfolio Management has become, a complex and respon-sible job
which requires an in-depth training and expertise. It is in this context that the regulations
of SEBI on Portfolio Management become necessary so that the minimum qualifications
and experience are also ensured for those who are registered with SEBI. Nobody can do
Portfolio
Management without SEBI registration and licence.The SEBI has given permission to
Merchant Bankers to do Portfolio Manage-ment. As per the guidelines of September,
1991 a separate category of Portfolio Managers is also licensed by SEBI for which
guidelines were given in January 1993. A
code of conduct was also laid down for this category, as is the case with all categories of
capital market players and intermediates.
 Portfolio Management Service
As per the SEBI norms, it refers to professional services rendered for manage-ment of
Portfolio of others, namely,clients or customers with the help of experts in Invesment
Advisory Services. The latter involves the advice regarding the worthwhileness of any
particular investment or advice of what to .buy and sell. investment management on the
other hand involves continuing relationship with client to manage investments with or
without discretion for the client as per his requirements.

Who can be a Portfolio Manager?

Only those who arc registered and pay the required licence fee are eligible to operate as
Portfolio Man.1gers. An applicai1t for this purpose should have necessary infrastructure
with professionally qualified persons and with a minimum of two persons with
experience in this business and a minimum networth of Rs. 50 lakhs. The Certificate once
granted is valid for three years.Fees payable for registration are Rs. 2.5 lakhs every year
for two
years and Rs. 1 lakh for the third year. From the fourth year onwards, renewal fees per
annum arc Rs. 75,000. These are subject to change by the SEBI.

Obligations and a code of conduct for Portfolio Manager

The SEBI has imposed a number of obligations and a code of conduct on them. The
Portfolio Manager should have a high standard of integrity, honesty and should not have
been convicted of any economic offence or moral turpitude. He should not resort to
rigging up of prices, insider trading or creating false markets,’ etc. Their books of
accounts, are subject
to inspection and audit by SEBI. The observance of the code of conduct and guidelines
given by the SEBI are subject to inspection and penalties for violation are imposed. The
Manager has to submit periodical returns and documents as may be required by the SEBI
from time-to-time.
Method of Operation
The Professional Portfolio Manager can be approached by any individual or organisation
with a minimum amount of investible funds of Rs. 1 lakh or Rs. 2 lakhs. If the Manager
is willing to accept him as his client, a contract is entered into for management of his
funds either on discretionary basis or nondiscretionary basis, specifying the objectives,
risk to be tolerated,
composition of assets / securities in the Portfolio and their relative proportion, fees
payable and time period of management, as per the preference of the client etc. The
client’s data base is collected, namely, his available income and assets, his needs, his risk
preferences, his choice for income or growth or both and host of personal details of the
client so as to enable the Manager to design a Proper Invesm1ent Strategy for him.
SEBI Norms
SEBI has prohibited the Portfolio Manager to assume any risk on behalf of the client.
Portfolio Manager cannot also assure any fixed return to the client. The investments made
or advised by him arc subject to risk which the client has to bear. The investment
consultancy and management has to be charged at rates which arc fixed at the beginning
and transparent as per the
contract. No sharing of profits or discounts or cash incentives to client are permitted. The
Portfolio Manager is prohibited to do lending, badla financing and bills discounting as
per SEBI norms. He cannot put the clients’ funds in any investment, not permitted by the
contract, entered into with the client. Normally investments can be made in both capital
market and money market instruments.Client’s money has to be kept in a separate
account with the public sector bank and cannot be mixed up with his own funds or
investments. All the deals done for a client’s account are to be
entered in his name and Contract Notes; Bills etc. are all passed in his name. A separate
ledger account is maintained for all purchases/sales on client’s behalf, which should be
done at the market price. Final settlement and termination of contract is as per the
contract and for the time period agreed upon. Notice of termination of contract is also as
per the contract. During the
period of contract, Portfolio Manager is only acting on a contractual basis and on a
fiduciary basis. No contract for less than a year is permitted by the SEBI.

CREDIT SYNDICATION
When more funds are required, different financial institutions are approached for
contributing working capital and fixed capital requirements. The financial institutions,
joining together for providing finance to a needy company is credit syndication.

TYPES OF SYNDICATED LOANS

1. Loans for setting up new projects
2. Loans for expansion, modernization, diversification, rehabilitation of projects.
3. Participatory loans
4. Loans for making investment in corporate securities (subscribing to public issues,
private placement)
5. Consortium loans
6. Refinancing loans (IDBI)
7. Rediscounting loans (IDBI)

CREDIT SYNDICATION SERVICES

Merchant Bankers provide various services towards syndication of loan. The services
vary depending up on the type of loan. Following are some of the services rendered by
merchant bankers:
1. Ascertaining promoter details
2. Ascertainment of cost details
3. Comparison of cost details
4. Identification of funding sources
5. Ascertainment of loan details
6. Furnishing beneficiary details
7. Making application
8. Project appraisal
9. Compliance for loan disbursement
10. Documentation and creation of security
11. Pre-disbursement compliance
SYNDICATION FOR WORKING CAPITAL LOANS
Arrangement for working capital loans are made by merchant bankers in the form of :
1. Cash credit
2. Overdraft
3. Demand loans
4. Bill financing
5 .Letter of guarantee
6. Letter of credit
CREDIT RATING
Credit rating

The process of assigning a symbol with reference to the instrument being rated,
that acts as an indicator of the current opinion on relative capability on the issuer to
service its debt obligation in a timely fashion, is known as credit rating. Rating are
usually expressed with alphabetical or alphanumeric symbols
Basis for Credit rating:
1. Business Analysis
2. Evaluation of industrial risk
3. Market position of company
4. operating efficiency of company
5. alegal position of company
6. Financial analysis
7. Statement of profits
8. Earning protection
9. Financial flexibility
10. Cash flow
11. Track record of management
12. Capacity to overcome adverse situation
13. Labour turnover
14. Asset quality
15. Financial position
Draw backs experienced in credit rating
a) Guidance, not recommendation
b) Based on assumptions
c) Competitive ratings
Rating agencies in India are
CRISIL : Credit rating and Information services of India Ltd.
ICRA : Investment information and credit.
CARE:

Equity grading
The rating of equity issues of companies is known as ‘equity grading’. It is aimed
at contributing towards enhancement of the capital mobilizing process by providing
authentic information, particularly when the dominant fund raising option is through
equity
Need for equity grading

a) Quality of information
b) Wiser choice
c) Lesser-known entrepreneurs
d) Availability of international rating agencies
e) Lack of benchmark .

MUTUAL FUNDS
Mutual fund

A trust that pools the savings of investors, who share a common financial
goal, is known as a mutual fund. The money thus collected is then invested in
financial market instruments such as shares, debentures and other securities
like government paper etc. The income earned through these investments, and
the capital appreciation realized, are shared by its unit holders in proportion
to the number of units owned by them.
open-ended mutual fund

When a fund is accepted and liquidated on a continuous basis by a mutual

fund manager, it is called a open ended scheme. The fund manager buys and
sells units constantly on demand by the investors. Under this scheme, the
capitalization of the fund will constantly change, since it is always open for
the investors to sell or buy their share units

Growth fund

It is a mutual fund scheme that offers the advantages of capital

appreciation of the underlying investment. For such funds, investment is
made in growth-oriented securities that are capable of appreciating in the long
run. Growth funds also known as nest eggs or long haul investments

Benefits of mutual fund from the point of view of investor and promoter

The following points are the benefits of mutual fund for both the investors
and the promoter

a) Mobilizing small saving

b) Investment avenue
c) Professional management
 d) Diversified investment
e) Better liquidity
f) Reduced risks
g) Investment protection
h) Switching facility
i) Tax benefits
j) Low transaction costs
k) Economic development
l) Convenience
m) Other benefits

Business valuation
Business valuation is a process and a set of procedures used to estimate the economic
value of an owner’s interest in a business. Valuation is used by financial market
participants to determine the price they are willing to pay or receive to consummate a sale
of a business. In addition to estimating the selling price of a business, the same valuation
tools are often used by business appraisers to resolve disputes related to estate and gift
taxation, divorce litigation, allocate business purchase price among business assets,
establish a formula for estimating the value of partners' ownership interest for buy-sell
agreements, and many other business and legal purposes

Standard and Premise of Business Value

Before the value of a business can be measured, the valuation assignment must specify
the reason for and circumstances surrounding the business valuation. These are formally
known as the business value standard and premise of value.

Business valuation results can vary considerably depending upon the choice of both the
standard and premise of value. In an actual business sale, it would be expected that the
buyer and seller, each with an incentive to achieve an optimal outcome, would determine
the fair market value of a business asset. The value conclusions based on a going concern
premise and that of sum of the parts or assemblage of business assets approach may
differ substantially for the same company.

Fair market value

“Fair market value” (or FMV) is a central standard of measuring business value. It is
defined differently by a number of sources.

The Internal Revenue Service defines FMV as the price at which property would change
hands between a willing buyer and a willing seller when the former is not under any
compulsion to buy and the latter is not under any compulsion to sell, both parties having
reasonable knowledge of relevant facts. This continues to be the prevailing definition of
the fair market value.
The Federal Accounting Standards Board utilizes the term "Fair value" (or FV). FASB
revised its definition of FV in 2006 to reflect the price that would be achieved in an
orderly transaction between market participants in the most advantageous market for the
asset.

The fair market value standard incorporates certain assumptions, including the
assumptions that the hypothetical purchaser is reasonably prudent and rational but is not
motivated by any synergistic or strategic influences; that the business will continue as a
going concern and not be liquidated; that the hypothetical transaction will be conducted
in cash or equivalents; and that the parties are willing and able to consummate the
transaction.

Note, however, that it is possible to achieve the fair market value for a business asset that
is being liquidated in its secondary market. This underscores the difference between the
standard and premise of value.

These assumptions might not, and probably do not, reflect the actual conditions of the
market in which the subject business might be sold. However, these conditions are
assumed because they yield a uniform standard of value, after applying generally-
accepted valuation techniques, which allows meaningful comparison between businesses
which are similarly situated.

Elements of business valuation

Economic conditions

A business valuation report generally begins with a description of national, regional and
local economic conditions existing as of the valuation date, as well as the conditions of
the industry in which the subject business operates.

] Financial Analysis

The financial statement analysis generally involves common size analysis, ratio analysis
(liquidity, turnover, profitability, etc.), trend analysis and industry comparative analysis.
This permits the valuation analyst to compare the subject company to other businesses in
the same or similar industry, and to discover trends affecting the company and/or the
industry over time. By comparing a company’s financial statements in different time
periods, the valuation expert can view growth or decline in revenues or expenses,
changes in capital structure, or other financial trends. How the subject company compares
to the industry will help with the risk assessment and ultimately help determine the
discount rate and the selection of market multiples.

Normalization of financial statements

The most common normalization adjustments fall into the following four categories:
 • Comparability Adjustments. The valuator may adjust the subject company’s
financial statements to facilitate a comparison between the subject company and
other businesses in the same industry or geographic location. These adjustments
are intended to eliminate differences between the way that published industry data
is presented and the way that the subject company’s data is presented in its
financial statements.

• Non-operating Adjustments. It is reasonable to assume that if a business were sold

in a hypothetical sales transaction (which is the underlying premise of the fair
market value standard), the seller would retain any assets which were not related
to the production of earnings or price those non-operating assets separately. For
this reason, non-operating assets (such as excess cash) are usually eliminated from
the balance sheet.

• Non-recurring Adjustments. The subject company’s financial statements may be

affected by events that are not expected to recur, such as the purchase or sale of
assets, a lawsuit, or an unusually large revenue or expense. These non-recurring
items are adjusted so that the financial statements will better reflect the
management’s expectations of future performance.

• Discretionary Adjustments. The owners of private companies may be paid at

variance from the market level of compensation that similar executives in the
industry might command. In order to determine fair market value, the owner’s
compensation, benefits, perquisites and distributions must be adjusted to industry
standards. Similarly, the rent paid by the subject business for the use of property
owned by the company’s owners individually may be scrutinized.

Income, Asset and Market Approaches

Three different approaches are commonly used in business valuation: the income
approach, the asset-based approach, and the market approach. Within each of these
approaches, there are various techniques for determining the value of a business using the
definition of value appropriate for the appraisal assignment. Generally, the income
approaches determine value by calculating the net present value of the benefit stream
generated by the business (discounted cash flow); the asset-based approaches determine
value by adding the sum of the parts of the business (net asset value); and the market
approaches determine value by comparing the subject company to other companies in the
same industry, of the same size, and/or within the same region.

A number of business valuation models can be constructed that utilize various methods
under the three business valuation approaches. Venture Capitalists and Private Equity
professionals have long used the First chicago method which essentially combines the
income approach with the market approach.

In determining which of these approaches to use, the valuation professional must exercise
discretion. Each technique has advantages and drawbacks, which must be considered
when applying those techniques to a particular subject company. Most treatises and court
decisions encourage the valuator to consider more than one technique, which must be
reconciled with each other to arrive at a value conclusion. A measure of common sense
and a good grasp of mathematics is helpful.

Income approaches

The income approaches determine fair market value by multiplying the benefit stream
generated by the subject company times a discount or capitalization rate. The discount or
capitalization rate converts the stream of benefits into present value. There are several
different income approaches, including capitalization of earnings or cash flows,
discounted future cash flows (“DCF”), and the excess earnings method (which is a hybrid
of asset and income approaches). Most of the income approaches consider the subject
company’s historical financial data; only the DCF method requires the subject company
to provide projected financial data. Most of the income approaches look to the company’s
adjusted historical financial data for a single period; only DCF requires data for multiple
future periods. The discount or capitalization rate must be matched to the type of benefit
stream to which it is applied. The result of a value calculation under the income approach
is generally the fair market value of a controlling, marketable interest in the subject
company, since the entire benefit stream of the subject company is most often valued, and
the capitalization and discount rates are derived from statistics concerning public
companies.

Discount or capitalization rates

A discount rate or capitalization rate is used to determine the present value of the
expected returns of a business. The discount rate and capitalization rate are closely
related to each other, but distinguishable. Generally speaking, the discount rate or
capitalization rate may be defined as the yield necessary to attract investors to a particular
investment, given the risks associated with that investment.

• In DCF valuations, the discount rate, often an estimate of the cost of capital for
the business are used to calculate the net present value of a series of projected
cash flows.

• On the other hand, a capitalization rate is applied in methods of business valuation

that are based on business data for a single period of time. For example, in real
estate valuations for properties that generate cash flows, a capitalization rate may
be applied to the net operating income (NOI) (i.e., income before depreciation and
interest expenses) of the property for the trailing twelve months.

There are several different methods of determining the appropriate discount rates. The
discount rate is composed of two elements: (1) the risk-free rate, which is the return that
an investor would expect from a secure, practically risk-free investment, such as a high
quality government bond; plus (2) a risk premium that compensates an investor for the
relative level of risk associated with a particular investment in excess of the risk-free rate.
Most importantly, the selected discount or capitalization rate must be consistent with
stream of benefits to which it is to be applied.

Capital Asset Pricing Model (“CAPM”)

The Capital Asset Pricing Model ( CAPM) is another method of determining the
appropriate discount rate in business valuations. The CAPM method originated from the
Nobel Prize winning studies of Harry Markowitz, James Tobin and William Sharpe. Like
the Ibbotson Build-Up method, the CAPM method derives the discount rate by adding a
risk premium to the risk-free rate. In this instance, however, the risk premium is derived
by multiplying the equity risk premium times “beta,” which is a measure of stock price
volatility. Beta is published by various sources (including Ibbotson Associates, which
was used in this valuation) for particular industries and companies. Beta is associated
with the systematic risks of an investment.

One of the criticisms of the CAPM method is that beta is derived from the volatility of
prices of publicly-traded companies, which are likely to differ from private companies in
their capital structures, diversification of products and markets, access to credit markets,
size, management depth, and many other respects. Where private companies can be
shown to be sufficiently similar to public companies, however, the CAPM method may
be appropriate.

Weighted Average Cost of Capital (“WACC”)

The weighted average cost of capital is an approach to determining a discount rate. The
WACC method determines the subject company’s actual cost of capital by calculating the
weighted average of the company’s cost of debt and cost of equity. The WACC must be
applied to the subject company’s net cash flow to total invested capital.

One of the problems with this method is that the valuator may elect to calculate WACC
according to the subject company’s existing capital structure, the average industry capital
structure, or the optimal capital structure. Such discretion detracts from the objectivity of
this approach, in the minds of some critics.

Indeed, since the WACC captures the risk of the subject business itself, the existing or
contemplated capital structures, rather than industry averages, are the appropriate choices
for business valuation.

Once the capitalization rate or discount rate is determined, it must be applied to an

appropriate economic income streams: pretax cash flow, aftertax cash flow, pretax net
income, after tax net income, excess earnings, projected cash flow, etc. The result of this
formula is the indicated value before discounts. Before moving on to calculate discounts,
however, the valuation professional must consider the indicated value under the asset and
market approaches.
Careful matching of the discount rate to the appropriate measure of economic income is
critical to the accuracy of the business valuation results. Net cash flow is a frequent
choice in professionally conducted business appraisals. The rationale behind this choice
is that this earnings basis corresponds to the equity discount rate derived from the Build-
Up or CAPM models: the returns obtained from investments in publicly traded
companies can easily be represented in terms of net cash flows. At the same time, the
discount rates are generally also derived from the public capital markets data.

Build-Up Method

The Build-Up Method is a widely-recognized method of determining the after-tax net

cash flow discount rate, which in turn yields the capitalization rate. The figures used in
the Build-Up Method are derived from various sources. This method is called a “build-
up” method because it is the sum of risks associated with various classes of assets. It is
based on the principle that investors would require a greater return on classes of assets
that are more risky. The first element of a Build-Up capitalization rate is the risk-free
rate, which is the rate of return for long-term government bonds. Investors who buy
large-cap equity stocks, which are inherently more risky than long-term government
bonds, require a greater return, so the next element of the Build-Up method is the equity
risk premium. In determining a company’s value, the long-horizon equity risk premium is
used because the Company’s life is assumed to be infinite. The sum of the risk-free rate
and the equity risk premium yields the long-term average market rate of return on large
public company stocks.

Similarly, investors who invest in small cap stocks, which are riskier than blue-chip
stocks, require a greater return, called the “size premium.” Size premium data is generally
available from two sources: Morningstars' (formerly Ibbotson & Associates') Stocks,
Bonds, Bills & Inflation and Duff & Phelps' Risk Premium Report.

By adding the first three elements of a Build-Up discount rate, we can determine the rate
of return that investors would require on their investments in small public company
stocks. These three elements of the Build-Up discount rate are known collectively as the
“systematic risks.”

In addition to systematic risks, the discount rate must include “unsystematic risks,” which
fall into two categories. One of those categories is the “industry risk premium.”
Morningstar’s yearbooks contain empirical data to quantify the risks associated with
various industries, grouped by SIC industry code.

The other category of unsystematic risk is referred to as “specific company risk.”

Historically, no published data has been available to quantify specific company risks.
However as of late 2006, new research has been able to quantify, or isolate, this risk for
publicly-traded stocks through the use of Total Beta calculations. P. Butler and K.
Pinkerton have outlined a procedure using a modified Capital Asset Pricing Model (
CAPM) to calculate the company specific risk premium. The model uses an equality
between the standard CAPM which relies on the total beta on one side of the equation;
and the firm's beta, size premium and company specific risk premium on the other. The
equality is then solved for the company specific risk premium as the only unknown.
While this is ground-breaking research, it has yet to be adopted and used by the valuation
community at large.

It is important to understand why this capitalization rate for small, privately-held

companies is significantly higher than the return that an investor might expect to receive
from other common types of investments, such as money market accounts, mutual funds,
or even real estate. Those investments involve substantially lower levels of risk than an
investment in a closely-held company. Depository accounts are insured by the federal
government (up to certain limits); mutual funds are composed of publicly-traded stocks,
for which risk can be substantially minimized through portfolio diversification; and real
estate almost invariably appreciates in value of long time horizons.

Closely-held companies, on the other hand, frequently fail for a variety of reasons too
numerous to name. Examples of the risk can be witnessed in the storefronts on every
Main Street in America. There are no federal guarantees. The risk of investing in a
private company cannot be reduced through diversification, and most businesses do not
own the type of hard assets that can ensure capital appreciation over time. This is why
investors demand a much higher return on their investment in closely-held businesses;
such investments are inherently much more risky.

Asset-based approaches

The value of asset-based analysis a business is equal to the sum of its parts. That is the
theory underlying the asset-based approaches to business valuation. The asset approach to
business valuation is based on the principle of substitution: no rational investor will pay
more for the business assets than the cost of procuring assets of similar economic utility.
In contrast to the income-based approaches, which require the valuation professional to
make subjective judgments about capitalization or discount rates, the adjusted net book
value method is relatively objective. Pursuant to accounting convention, most assets are
reported on the books of the subject company at their acquisition value, net of
depreciation where applicable. These values must be adjusted to fair market value
wherever possible. The value of a company’s intangible assets, such as goodwill, is
generally impossible to determine apart from the company’s overall enterprise value. For
this reason, the asset-based approach is not the most probative method of determining the
value of going business concerns. In these cases, the asset-based approach yields a result
that is probably lesser than the fair market value of the business. In considering an asset-
based approach, the valuation professional must consider whether the shareholder whose
interest is being valued would have any authority to access the value of the assets
directly. Shareholders own shares in a corporation, but not its assets, which are owned by
the corporation. A controlling shareholder may have the authority to direct the
corporation to sell all or part of the assets it owns and to distribute the proceeds to the
shareholder(s). The non-controlling shareholder, however, lacks this authority and cannot
access the value of the assets. As a result, the value of a corporation's assets is rarely the
most relevant indicator of value to a shareholder who cannot avail himself of that value.
Adjusted net book value may be the most relevant standard of value where liquidation is
imminent or ongoing; where a company earnings or cash flow are nominal, negative or
worth less than its assets; or where net book value is standard in the industry in which the
company operates. None of these situations applies to the Company which is the subject
of this valuation report. However, the adjusted net book value may be used as a “sanity
check” when compared to other methods of valuation, such as the income and market
approaches.

Market approaches

The market approach to business valuation is rooted in the economic principle of

competition: that in a free market the supply and demand forces will drive the price of
business assets to a certain equilibrium. Buyers would not pay more for the business, and
the sellers will not accept less, than the price of a comparable business enterprise. It is
similar in many respects to the “comparable sales” method that is commonly used in real
estate appraisal. The market price of the stocks of publicly traded companies engaged in
the same or a similar line of business, whose shares are actively traded in a free and open
market, can be a valid indicator of value when the transactions in which stocks are traded
are sufficiently similar to permit meaningful comparison.

The difficulty lies in identifying public companies that are sufficiently comparable to the
subject company for this purpose. Also, as for a private company, the equity is less liquid
(in other words its stocks are less easy to buy or sell) than for a public company, its value
is considered to be slightly lower than such a market-based valuation would giv
Guideline Public Company method

The Guideline Public Company method entails a comparison of the subject company to
publicly traded companies. The comparison is generally based on published data
regarding the public companies’ stock price and earnings, sales, or revenues, which is
expressed as a fraction known as a “multiple.” If the guideline public companies are
sufficiently similar to each other and the subject company to permit a meaningful
comparison, then their multiples should be nearly equal. The public companies identified
for comparison purposes should be similar to the subject company in terms of industry,
product lines, market, growth, and risk.

Transaction Method or Direct Market Data Method

Using this method, the valuation analyst may determine market multiples by reviewing
published data regarding actual transactions involving either minority or controlling
interests in either publicly traded or closely held companies. In judging whether a
reasonable basis for comparison exists, the valuation analysis must consider: (1) the
similarity of qualitative and quantitative investment and investor characteristics; (2) the
extent to which reliable data is known about the transactions in which interests in the
guideline companies were bought and sold; and (3) whether or not the price paid for the
guideline companies was in an arms-length transaction, or a forced or distressed sale.
 Discounts and premiums

The valuation approaches yield the fair market value of the Company as a whole. In
valuing a minority, non-controlling interest in a business, however, the valuation
professional must consider the applicability of discounts that affect such interests.
Discussions of discounts and premiums frequently begin with a review of the “levels of
value.” There are three common levels of value: controlling interest, marketable minority,
and non-marketable minority. The intermediate level, marketable minority interest, is
lesser than the controlling interest level and higher than the non-marketable minority
interest level. The marketable minority interest level represents the perceived value of
equity interests that are freely traded without any restrictions. These interests are
generally traded on the New York Stock Exchange, AMEX, NASDAQ, and other
exchanges where there is a ready market for equity securities. These values represent a
minority interest in the subject companies – small blocks of stock that represent less than
50% of the company’s equity, and usually much less than 50%. Controlling interest level
is the value that an investor would be willing to pay to acquire more than 50% of a
company’s stock, thereby gaining the attendant prerogatives of control. Some of the
prerogatives of control include: electing directors, hiring and firing the company’s
management and determining their compensation; declaring dividends and distributions,
determining the company’s strategy and line of business, and acquiring, selling or
liquidating the business. This level of value generally contains a control premium over
the intermediate level of value, which typically ranges from 25% to 50%. An additional
premium may be paid by strategic investors who are motivated by synergistic motives.
Non-marketable, minority level is the lowest level on the chart, representing the level at
which non-controlling equity interests in private companies are generally valued or
traded. This level of value is discounted because no ready market exists in which to
purchase or sell interests. Private companies are less “liquid” than publicly-traded
companies, and transactions in private companies take longer and are more uncertain.
Between the intermediate and lowest levels of the chart, there are restricted shares of
publicly-traded companies. Despite a growing inclination of the IRS and Tax Courts to
challenge valuation discounts , Shannon Pratt suggested in a scholarly presentation
recently that valuation discounts are actually increasing as the differences between public
and private companies is widening . Publicly-traded stocks have grown more liquid in the
past decade due to rapid electronic trading, reduced commissions, and governmental
deregulation. These developments have not improved the liquidity of interests in private
companies, however. Valuation discounts are multiplicative, so they must be considered
in order. Control premiums and their inverse, minority interest discounts, are considered
before marketability discounts are applied.

Discount for lack of control

The first discount that must be considered is the discount for lack of control, which in this
instance is also a minority interest discount. Minority interest discounts are the inverse of
control premiums, to which the following mathematical relationship exists: MID = 1 –
[1 / (1 + CP)] The most common source of data regarding control premiums is the
Control Premium Study, published annually by Mergerstat since 1972. Mergerstat
compiles data regarding publicly announced mergers, acquisitions and divestitures
involving 10% or more of the equity interests in public companies, where the purchase
price is $1 million or more and at least one of the parties to the transaction is a U.S.
entity. Mergerstat defines the “control premium” as the percentage difference between
the acquisition price and the share price of the freely-traded public shares five days prior
to the announcement of the M&A transaction. While it is not without valid criticism,
Mergerstat control premium data (and the minority interest discount derived therefrom) is
widely accepted within the valuation profession.

Discount for lack of marketability

Another factor to be considered in valuing closely held companies is the marketability of

an interest in such businesses. Marketability is defined as the ability to convert the
business interest into cash quickly, with minimum transaction and administrative costs,
and with a high degree of certainty as to the amount of net proceeds. There is usually a
cost and a time lag associated with locating interested and capable buyers of interests in
privately-held companies, because there is no established market of readily-available
buyers and sellers. All other factors being equal, an interest in a publicly traded company
is worth more because it is readily marketable. Conversely, an interest in a private-held
company is worth less because no established market exists. The IRS Valuation Guide for
Income, Estate and Gift Taxes, Valuation Training for Appeals Officers acknowledges
the relationship between value and marketability, stating: “Investors prefer an asset which
is easy to sell, that is, liquid.” The discount for lack of control is separate and
distinguishable from the discount for lack of marketability. It is the valuation
professional’s task to quantify the lack of marketability of an interest in a privately-held
company. Because, in this case, the subject interest is not a controlling interest in the
Company, and the owner of that interest cannot compel liquidation to convert the subject
interest to cash quickly, and no established market exists on which that interest could be
sold, the discount for lack of marketability is appropriate. Several empirical studies have
been published that attempt to quantify the discount for lack of marketability. These
studies include the restricted stock studies and the pre-IPO studies. The aggregate of
these studies indicate average discounts of 35% and 50%, respectively. Some experts
believe the Lack of Control and Marketability discounts can aggregate discounts for as
much as ninety percent of a Company's fair market value, specifically with family owned
companies.

Restricted stock studies

Restricted stocks are equity securities of public companies that are similar in all respects
to the freely traded stocks of those companies except that they carry a restriction that
prevents them from being traded on the open market for a certain period of time, which is
usually one year (two years prior to 1990). This restriction from active trading, which
amounts to a lack of marketability, is the only distinction between the restricted stock and
its freely-traded counterpart. Restricted stock can be traded in private transactions and
usually do so at a discount. The restricted stock studies attempt to verify the difference in
price at which the restricted shares trade versus the price at which the same unrestricted
securities trade in the open market as of the same date. The underlying data by which
these studies arrived at their conclusions has not been made public. Consequently, it is
not possible when valuing a particular company to compare the characteristics of that
company to the study data. Still, the existence of a marketability discount has been
recognized by valuation professionals and the Courts, and the restricted stock studies are
frequently cited as empirical evidence. Notably, the lowest average discount reported by
these studies was 26% and the highest average discount was 45%.

Option pricing

.Studies based on the prices paid for options have also confirmed discounts. If one holds
restricted stock and purchases an option to sell that stock at the market price (a put), the
holder has, in effect, purchased marketability for the shares. The price of the put is equal
to the marketability discount. The range of marketability discounts derived by this study
was 32% to 49%.
 UNIT IV
LEASING & HIRE PURCHASE
Lease Defined
Lease is a contract under which a lessor, the owner of the assets, gives right to use the
asset to a lessee, the user of the assets, for an agreed period of time for a consideration
called the lease rentals.
In up-fronted leases, more rentals are charged in the initial years and less in the later
years of the contract. The opposite happens in back ended leases.
Primary lease provides for the recovery of the cost of the assets and profit through lease
rentals during a period of about 4 or 5 years. It may be followed by a perpetual,
secondary lease on nominal lease rentals.
Types of Leases
Operating Lease
Financing Lease
Sale and Lease Back
Operating Lease
Shot-term, cancelable lease agreements are called operating lease.
Tourist renting a car, lease contracts for computers, office equipments and hotel rooms.
The Lessor is generally responsible for maintenance and insurance.
Risk of obsolescence remains with the lessor.

Financial Lease
Long-term, non-cancelable lease contracts are known as financial lease.
Examples are plant, machinery, land, building, ships and aircrafts.
Amortise the cost of the asset over the terms of the lease–Capital or Full pay-out leases.
Cash Flow Consequences of a Financial Lease
Avoidance of the purchase price.
Loss of depreciation tax shield.
After–tax payments of lease rentals.
Sale and Lease Back
Sometimes, a user may sell an (existing) asset owned by him to the lessor (leasing
company) and lease it back from him. Such sale and lease back arrangements may
provide substantial tax benefits.
In April 1989, Shipping Credit and Investment Corporation of India purchased Great
Eastern Shipping Company bulk carrier, Jag Lata, for Rs 12.5 Cr and then leased it
back to GESC on a 5 years lease, the rentals being Rs 28.13 Lakh per month. The
ships WDV was Rs 2.5 Cr.
 Commonly Used Lease Terminology
Leveraged Lease.
Cross-border lease.
Closed and open ended lease.
Direct lease.
Master lease.
Percentage lease.
Wet and dry lease.
Net net net lease.
Update lease.

Myths about Leasing

Leasing Provides 100% Financing
Leasing Provides Off-the-Balance-Sheet Financing.
Leasing Improves Performance.
Leasing Avoids Control of Capital Spending.

Advantages of Leasing
Convenience and Flexibility.
Shifting of Risk of Obsolescence.
Maintenance and Specialized Services.
Evaluating a Lease
Equivalent Loan Method.
Net Advantage of a Lease Method.
IRR Approach.

Equivalent Loan Method

EL is that amount of loan which commits a firm to exactly the same stream of fixed
obligations as does the lease liability.
Method—
Find out incremental cash flows from leasing.
Determine the amount of equivalent loan such cash flow can service.
Compare the equivalent loan so found with lease finance.

Net Advantage of a Lease Method

The direct cash flow consequences are:

The purchase price of the asset is avoided.
The depreciation tax shield Is lost.
The after tax lease rentals are paid.
The net present value of these cash flows at after tax cost of debt should be calculated. If
it is positive lease is beneficial.
Combination of Net Present Value of Investment and Net Advantage of Leasing

Lease Benefits to Lessor and Lessee

A lease can benefit both when their tax rate differs.
Leasing pays if the lessee’s marginal tax rate is less than that of the lessor. In fact in a
lease, the lessee sells his depreciation tax shield to the lessor.
In the absence of taxes it is hard to believe that leasing would be advantageous if the
capital markets are reasonably well functioning.
Gain of both is loss to the government in form of taxes.

Internal Rate of Return Approach

IRR of a lease is that rate which makes NAL equal to zero.
Ao = Purchase Price.
L = Lease Rentals.
DEP = Depreciation
T = Tax Rate
OC = Operating Cost
SV = Salvage Value
According to the Hire purchase Act of 1972, the term “ hire purchase” is
defined as “an agreement under which goods are let on hire and under which the hirer
has an option to purchase them in accordance with the terms of the agreement, and
includes an agreement under which:
• Possession of the goods is delivered by the owner thereof to a person on the
condition that such person pays the agreed amount in periodic payment.
• The property of the goods is to pass to such a person on the payment of last
installment.

Hire Purchase–Conditions
The owner of the asset (the Hirer or the manufacturer) gives the possession of the asset to
the Hirer with an understanding that the Hirer will pay agreed instalments over a
specified period of time.
The ownership of the asset will transfer to the hirer on the payment of all instalments.
The Hirer will have the option of terminating the agreement any time before the transfer
of ownership of assets. ( Cancellable Lease)
Leasing different from Hire purchase

Hire purchase Leasing

The agreement is entrusted for the transfer It is only in financial lease, the owner ship will get
of owner ship after a fixed period transferred while in operating lease, it is not so.

Depreciation is claimed by the lessor in the lease

Depreciation is claimed by the purchaser/ agreement.
hirer

Hire purchase agreement is more common Lease agreement is entered more among business
with the consumer durable goods concerns.

Sales tax is paid by the buyer on the value of Sales tax depends on the actual value at the time of
goods. sale.
Repossession in HP

The right of repossession is not available to the hire vendor, unless sanctioned
by the court in the following cases,

• One half of the price has been paid where the hire purchase price is les than
Rs.15000/-(Rs.5000/- in the case of motor vehicles)
• Three forth of the price has been paid where the hire purchase price is not less
than Rs.15000/- (Rs.5000/- in the case of motor vehicles)
Three forth or such higher proportion, not exceeding nine- tenth, where the hire

purchase price is not less than Rs.15000/-

Instalment Sale

Instalment Sale is a credit sale and the legal ownership of the asset passes immediately to
the buyer as soon as the agreement is made between the buyer and the seller.
Except for the timing of the transfer of ownership, instalment sale and hire purchase are
similar in nature.
 UNIT V
OTHER FUND BASED FINANCIAL SERVICES

CONSUMER CREDIT

CONSUMER CREDIT
According to E.R.A.Seligman, An Authority on consumer finance, “The term
consumer credit refers to a transfer of wealth,the payment of which is deffered in whole
or in part, to future and is liquidated piecemeal or in successive function under a plan
agreed upon at the time of the transfer.”

Types of consumer Credit

1)Revolving
2)Fixed credit
3)Cash loan
4)Secured finance
5)Unsecured finance

Sources of Consumer credit

1.Traders- (eg) Hirepurchase
2. Commercial Banks
3.Credit cards
4.NBFC’s
5. Credit Unions
6.Middlement
7.Other sources like Savings & Loan associationetc

Mode of consumer Finance

1.Open Account
2.Credit card
3.Revolving Account
4.Option Plan
5.Instalment Account

Factors determining demand for consumer loans

a) Increase in consumer disposal income
b)Enhancement in real income of consumers
c)Convenient size of instalment payments
d)Growth of necular families
e)Lower charges
f)Down payment & Credit control

Terms of Finance
1.Eligibility
2.Guarantee
3.Tenure
4.Rate of Interest
5.Other charges
6.Mode of payment & Credit evaluation

Consumer Finance –Common Practices in India

 Instalment credit
 Co-operative societies

CREDIT CARDS
Credit cards provide convenience and safety to the buying process. It enables individuals
to purchase certain products/services without paying immediately. The buyer only needs
to present the credit card at the cash counter and to sign the bill. Credit cards can be
considered as a good substitute for cash and cheques

Facilities and Services

a) Risk coverage
b) Emergency cash withdrawal
c) 24 hour service
d) Photocard option
e) Travel privileges
f) Credit line increase
g) Service overphone
h) Purchase protection
i) Medical advance facility
j) Joint credit card & ATM facility
CLASSIFICATION OF CREDIT CARDS
1) Based on modes of credit Recovery
2) Based on status of credit card
3) Based on geographical validity
4) Based on franchise/tie up
5) Based on Issuer category
 Difference between credit cards and ATM cards is as under:
Credit Cards ATM Cards
1 Can be issued by any Can be issued only by banks
institutions
2 Not necessary for the Necessary for the card holder
card holder to have a to have a bank account
bank account
3 The card holder can The card holder can only
purchase goods on credit draw cash from the ATM and
up to the limit specified cannot make credit
purchases.
4 For eg. Master card, Visa For eg. SBI ATM card, Bank
card of Baroda ATM card etc.

Credit card cycle

1.Credit purchase
2.Credit card processing
3.Bill raising
4.Payment
5.Bill to card holder
6.Card payment

Smart card
Smart cards sometimes called as chip cards, contain a computer
chip embedded in the plastic. Where a typical credit card’s magnetic strip can hold only
a few dozen characters, smart cards are now available with 16 kb of memory. When
read by a special terminal, the cards can perform a number of functions or access data
stored in the chip. These cards can be used as cash cards or as credit cards with the
preset credit limit or used as ID cards with stored-in passwords.

REAL ESTATE FINANCING

Real Estate Financing
A set of financial arrangements that are made available by housing finance institutions to
meet the requirements of housing is called ‘Real Estate Financing.’

Models of housing projects:

a) Town planning scheme
b) Development Authority projects
c) Housing Board projects
d) Co-operative society projects
e) Private real estate developers
f) Slum Board projects
g) Government housing
h) Government Programmes

Major Issues relating to Real Estate Financing in India

a) Archaic law
b) Lack of clear title
c) High stamp duty
d) Obsolete Rental laws
e) Foreclosure laws
f) Inadequate building codes & standards
g) Inadequate development and planning
h) Inadequate infrastructure
i) Recognition of housing as an industry
j) Slum clearance & public housing
k) Land supply

Factors Assisting Real Estate Financing

1. Loan amount
2. Tenure
3. Administrative & processing cost
4. Prepayment charges
5. Services
6. Value addition
7. Sources of finance like Housing Financing Companies & Banks
8. EMI calculation method
Objectives of Real Estate Industries in India
• To promote a sound, healthy viable & efficient housing finance.
• To promote savings from housing
• To make housing more affordable
• To promote appropriate technology for housing
• To augment supply of land & building material for housing
• To augment the financial resources for the sector
• To enable the housing financing system to access the capital market for
resources.
• To finance or undertake wholly or partly the setting up of
new satellite towns.

Types of loans offered by HDFC a major HFC in India

The different types of loans offered by HDFC are as follows:
• For dwelling house

• Extension of existing houses

• Purchase of land

• Repairs /Renovation
• Large scale construction

• Facility to weaker sections

• To finance or undertake wholly or

partly the setting up of new satellite towns.

Bill financing
Bill financing
A method of financing of trade activities through bills of exchange s
known as “Bill Financing”

Features of Bills
1. Written instrument
2. Negotiable instrument
3. Making a bill of exchange
4. Discounting of Bills
Types of Bills
1. Demand bills – payment on demand
2. Usance bills – Time based demands
3. Documentary bills – bills accompanied by documents
4. D/A bills – Delivery by acceptance
5. D/P bills – Delivery against payment
6. Clean bills – No document of proof, interest rate is high
7. Inland bills – Drawn on Indian residents in foreign country
8. Foreign bills – Drawn on foreign residents
9. Accommodation bills –for mutual help
10. supply bills
11. Hundies
12.
Commercial bill discounting
The act of handing over the endorsed bill for ready money to the bank or financial
institution by the seller is Commercial Bill Discounting. The margin between the ready
money paid and the face value of the bill is called the discount.

Factoring

Factoring
A financial service, whereby an institution called the ‘Factor’, undertakes the task of
realizing accounts receivables such as book debts, bill receivables and managing sundry
debts and sales registers of commercial and trading firms in the capacity of an agent for
a commission is known as ‘Factoring’

Parties to factoring Agreement:

Factor - Financial institution
Client - Business concern
Customer - Consumer

Function performed by a factor

A factor provides the following functions:
• Bill-discounting facility

• Undertaking collection and credit services designed to improve cash

flow by timely realization of debts or receivables

• Undertaking maintenance of client’s sales ledger

• Providing monthly sales analysis, invoice overdue analysis and

customer payment reports to clients
The following advisory services are rendered by a factor:
• Providing information about the customer’s perception of the client’s
products, changes in marketing strategies, emerging trends

• Evaluating the procedures followed for invoicing, delivery and

dealing with sales returns

• Operating the credit department for banks and other institutions which are
engaged in leasing, hire-purchase, merchant banking, etc.
Steps in factoring transactions
1) Order received by seller from buyer
2) Selling obtains details of buyer
3) Seller executes the order
4) Seller raises invoice with the factor
5) Factor pays 80% of invoice price
6) Factor sending statement of accounts to buyer regarding dues
7) Buyer settling transaction
8) Factor paying balance amount to seller

Types of Factoring
1. Full Factoring – collection of debts & sales ledger maintained by factor & risk is
borne by factor.
2. With recourse factoring – Credit risk taken by seller
3. Without recourse factoring – Factor will bear the risk of credit
4. Maturity factoring – Payment by factor on maturity of bills
5. Advance factoring – Factor provides advance to client
6. Bank finance factoring – Bank finances the portion reserved by factor.
7. Confidential factoring – Factoring arrangement is not disclosed
8. Supplier guarantee factoring – Factor guarantees the supplier against invoice
raised by supplier upon the supplies to wholesales & retails
9. International factoring - Deals with export and import factoring

Legal aspects of factoring

1.Agreement between the seller and buyer should be clear regarding the role of each
party
2. Legally, claim on buyer is assigned by the seller to the factor
3. Buyer to be informed by the seller regarding the payment to be made
4. In case of default by the buyer the factor will take action against buyer in his
capacity as consignee
5. No other creditor can have any claim settled with buyer towards the sale of goods
except the factor
6. The factor must have right to take legal actions against buyer in case of default.
Factoring in India
It is still in infant stage 2 factoring companies in public sector banks SBI factor &
commercial services and Canbank Factors Ltd are engaged in these services.
Recommendations of Kalyana Sundaram Committee
RBI appointed committee in 1989 to study feasibility of factoring in India and the
recommendations are
1) More scope for factoring especially through banks
2) Exporters cn enjoy more through factoring.

Cost of factoring
Seller can adopt 2 methods
1. Maintaining own collection department – here seller will have to incur
expenses like cash discount, Making bills for a/c receivables, bad debts, lost
contribution on past sales ----Commission
2. For discount charges for the period between the date of advance payment
and date of collection --- Interest Charges
Difference between factoring and bill discounting:
Factoring Bill Discounting
1 May be with or without recourse Only with recourse
2 Factor is the collector of receivables Drawer is the collector of
receivables
3 Besides financing, many other Only financing facility is
services are also extended available
4 Financing arrangement covers entire Financing is bill based
quantum of receivables
5 It is an off-balance sheet financing No such possibility

Forfaiting
A form of financing receivables arising from international trade is known as forfaiting.
Within this arrangement, a bank/financial institution undertakes the purchase of trade
bills/promissory notes without recourse of the seller. Purchase is through discounting of
the documents covering the entire risks of non-payments at the time of collection. All
risks become the full responsibility of the purchaser. Forfaiter pays cash to the seller
after discounting the bills/notes.

Characteristic features
1. Non recourse bill discounting
2. Aimed at protecting exporters from default
3. Promissory notes accepted by importer
4. Discount rates at a charge above the euro market interest rates
Steps In Forfaiting
1. Commercial contract – Between exporter & Importer
2. Transaction – Exporter sells on deferred payment
3. Notes acceptance – Importer accepts series of promissory notes
4. Factoring contract – Exporter enter forfeiting contract with forfeiter agency
being a reputed bank
5. Sale of notes – Exporter sells the notes/bills to forfeiter
6. Payment – Exporter makes payment to forfeiter for the facevalue of bills, notes
less discount.

Difference between factoring and forfeiting:

Factoring Forfaiting
1 Can be either with or Can be with recourse
without recourse only
2 Risk can be transferred to All risks are assumed by
the seller the forfaiter
3 Only a certain percent of Hundred percent
receivables factored is finance is available
advanced
4 Besides financing, many It is a pure financing
other services are also arrangement
extended
5 No security against Security provided for a
exchange rate premium charge
fluctuations

Venture Capital Financing

According to the Bank Of England Quaterly Bulletin of 1984, “Venture capital
investment is defined as an activity which investors support entrepreneurial talent with
finance and business skills to exploit market opportunities and thus obtain long –term
capital gains.”

Features of Venture Capital

Equity Participation.
Long-term Investments.
Participation in Management.
 Venture capitalist combines the qualities of bankers, stock market investors and
entrepreneur in one.
VC Development
Impetus
Internal context
External context
Sustainability

Stages in Venture Financing

Early Stage Financing
Expansion Financing
Acquisition/Buyout Financing

Venture Capital Investment Process

Deal Origination
Screening
Evaluation
Deal Structuring
Post-investment activity
Exit
Methods of Venture Financing
Equity
Conditional Loan
Income Note
Other Financing Methods
Participating Debentures
Partially Convertible Debentures
Cumulative Convertible Preference Shares
Deferred Shares
Convertible Loan Stock
Special Ordinary Shares
Preferred Ordinary Shares
Disinvestment Mechanisms
Buybacks
Initial Public Offerings
Secondary Stock Markets
Entrepreneurs’ Role
Entrepreneurs are drivers of innovations, of job creation and of economic development.
Entrepreneurship should be advocated and supported by the entire business world.
Entrepreneurs in developed economies consider the primary contribution of the venture
capitalists to be other than financial.
Assistance with recruitment, financial planning, strategic partnering and complex
negotiations are important contributions of VCs.

Entrepreneurial Requirement
To build entrepreneurial companies, there is need
To develop service infrastructure.
To reduce bureaucracy with regard to the creation of small businesses.
To provide adequate incentives for entrepreneurs by reforming tax treatment of stock
options and capital gains.
To reform labour laws that takes into account the needs and limitations of small
businesses.
Future Prospects of Venture Financing
Rehabilitation of sick units.
Assist small ancillary units to upgrade their technologies.
Provide financial assistance to people coming out of universities etc.

Success of Venture Capital in India

Entrepreneurial Tradition.
Unregulated Economic Environment.
Disinvestment Avenues.
Fiscal Incentives.
Broad Based Education.
Venture Capital Managers.
Promotion Efforts.
Institute Industry Linkage.
R&D Activities.