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RETURN ON INVESTMENT
Return on Investment - Concept

The two complementary approaches to return on investment are:


• Return on total assets (ROTA)
• Return on equity (ROE)
The two separate measures are necessary because they throw light on different aspects of the business, both
of which are important. Return on total assets looks at the operating efficiency of the total enterprise, while
return on equity considers how that operating efficiency is translated into benefit to the owners.

RETURN ON EQUITY (ROE)


This ratio is arguably the most important in business finance. It measures the absolute return delivered to the
shareholders. A good figure brings success to the business – it results in a high share price and makes it easy
to attract new funds. These will enable the company to grow, given suitable market conditions, and this in
turn leads to greater profits and so on. All this leads to high value and continued growth in the wealth of its
owners.
ROE = PAT x 100
Owner’s funds
At the level of individual business, a good return on equity will keep in lace the financial framework for a
thriving, growing enterprise. At the level of the total economy, return on equity drives industrial investment,
growth in gross national product, employment, government tax receipts and so on.
It is, therefore, a critical feature of the overall modern market economy as well as of individual companies.

RETURN ON TOTAL ASSETS (ROTA)


Return on total assets provides the foundation necessary for a company to deliver a good return on equity. A
company without a good ROTA finds it almost impossible to generate a satisfactory ROE.
ROTA = PBIT x 100
Total Assets
PBIT is the amount remaining when total operating cost is deducted from total revenue, but before either
interest or tax have been paid. Total operating cost direct factory cost, plus administration, selling and
distribution overheads.
This operating profit figure is set against the total assets figure in the balance sheet. The percentage
relationship between the two values gives the rate of return being earned by the total assets. Therefore this
ratio measures how well management uses all the assets in the business to generate an operating surplus.
Return on total assets uses the three main operating variables of the business.
• Total revenue
• Total cost
• Assets employed
It is therefore the most comprehensive measure of total management performance.

CONCEPT QUESTIONS
ROI COMPOSITION
ROI consists of two components viz.
 Profit margin, and
 Investment turnover
As shown below:
ROI = Net profit
Investment
OR
ROI = Net profit x Sales
Sales Investment in Assets
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The basic elements of the return on investment ratio can be shown in the form of a Du Pont Chart.
TWO WAYS OF IMPROVING RETURN ON INVESTMENT –
The earning power or the return on investment ratio is a central measure of the over all profitability and
operational efficiency of the firm. It shows the interaction of the profitability and activity ratios. It implies that
the performance of a firm can be improved either by generating more sales volume per rupee of investment or
by increasing the profit margin per rupee of sales.

Example –

Earning power (ROI) = Net profit after taxes i.e.


Total assets.

Earning power (ROI) = Net profit after taxesx Sales


Sales Total assets

Assume a b

This ratio can be improved by either improving a or b.


a can be improved by increasing the net profit for the same amount of sales i.e. increase the profit margin.
b can be improved by increasing the sales volume for the same amount of investment.

TAX SHELTER
Return on investment i.e. the earning power of a firm is the ratio of net profit to total assets.
Net profit is the residual income after providing for all the expenses. These expenses include,
 Cost of direct material, labour and variable expenses
 Operating costs like salaries, wages etc.
 Fixed costs like interest and taxes.
Return on investment can be improved by increasing the profit margin for the same volume of sales. Profit can
be further improved by reducing costs. One of the elements of cost is interest payment.
One way of keeping the costs under control is by maintaining a proper balance between equity and debt.
Debt carries a fixed charge known as interest, which has to be paid irrespective of the amount of profits.
Equity does not carry a fixed charge and can be paid from the net profits after allowing for all the expenses.
The return to the equity holders i.e. payment of dividend is not a legal binding on the firm.
The interest on debt is tax deductible but the equity dividends are not tax-deductible payments. Hence a
proper proportion of debt and equity can be used to improve return on investment.

28%DEBT = 14% PREFERENCE SHARES, TAX RATE=50%


The above statement can be explained as follows:

Interest on debt is tax-deductible. Therefore, a 28% interest on debt would mean an interest payment of
28(1-.50)= 14% i.e. same as 14%interest on preference shares.

SOCIAL WEALTH
The shareholders of a company form a part of the society. Their investments in the company form a large
part of social wealth. As the society provides finance to a company, the goal of Financial Management is to
maximise the present wealth of the owners i.e. equity shareholders in a company. It is defined as value
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maximisation. The wealth of the shareholders is represented in the market value of equity shares. The
market price of a share serves as an index of the performance of the company. It indicates how well
management is doing on behalf of stockholders. The factors that bear upon the market price of stock are the
present and prospective future earnings per share, the timing and the risk of these earnings, the dividend and
retention policies of the firm and many others. Shareholder’s wealth and in effect social wealth is maximised
only when the market value of the share is maximised.

DU PONT CHART

Return on Investment

Earnings as % of sales multiplied Turnover

Earnings divided by Sales Sales divided by Total


Investment

Sales minus Cost of sales


Permanent plus Working investment
capital

Cost of sales plus Selling plus Administrative


expenses expenses
Inventories plus Accounts plus Cash
receivables

Du Pont control chart:

Origin –
A system for management control has been designed which is popularly known as the Du Pont Chart
system of control. This system utilizes the ratio inter-relationships to provide an important series of charts
and indicators calling management’s attention to desirable and undesirable trends of corporate performance.
Once a company has developed standards of performance regarding the various ratios, it becomes easy to
judge performance changes with such a system.

Objective -
An important objective of the Du Pont system is to isolate the elements entering into the final figure in order
to appraise the individual factors affecting performance.

Meaning -
It may be noted that the analytical chain in this chart is developed along two tiers –

The first sequence starts with turnover, determined by dividing sales by total investment; total investment
represents current assets plus net fixed assets. Current assets include inventories, accounts receivables and
cash.

In the second tier, the sequence starts with earnings as a percentage of sales, calculated by dividing
earnings by sales; earnings equal sales less cost of sales, and cost of sales includes cost of goods sold, selling
expenses, administrative and general expenses.
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Use -
The chart provides management with an overall perspective of the financial relationships leading to the
earnings rate on investment. Changes in any important segment of this structure will influence the final
investment returns. The two-tier approach concentrates attention on the separate forces contributing to
profits. Improvement can be accomplished either through more effective use of available capital, measured
by the turnover sequence or through a better relationship between sales and costs, measured by the profit
margin sequence. The same rate of return is achieved by either a low profit margin and high turnover or a
high margin and low turnover.

For providing standards of evaluation, calculations are made of the ratios of return on investment, assets
turnover and profit margins for comparable companies. Appropriate breakdowns can also be established for
individual units within the same organization for internal comparisons.

The return on investment has been used as a measure of performance and a means of evaluating alternative
investment opportunities. However, the approach is rearward and the data from which the ratio is calculated
are applicable to specific past periods. To be consistent, it is necessary that the earnings in the numerator of
the ratio should flow from the investment base used in the denominator. But, in practice, this consistency is
not usually observed.

THEORY QUESTIONS
EVALUATE DIFFERENT FINANCIAL MANAGEMENT OBJECTIVES.
Clear objectives are required for wise decision-making. Objectives provide a framework for optimum
financial decision-making. In other words they are concerned with designing a method of operating the
internal investment and financing of a firm. There are alternative approaches in financial literature regarding
objectives. Two of the most widely discussed approaches are:
1. Profit maximization approach
2. Wealth maximization approach

Profit maximization decision criteria:


Under this approach, actions that increase profits should be undertaken and those that decrease profits
are to be avoided. In specific operational terms, the profit maximization criterion implies that the
investment, financing and dividend policy decisions of a firm should be oriented towards the
maximization of profits.
The rationale behind profit maximization as a guide to financial decision making, is due to the following
reasons:
1. Profit is a test of economic efficiency. It provides the yardstick by which economic performance can
be judged.
2. It leads to efficient allocation of resources as resources tend to be directed to uses, which in terms of
profitability are the most desirable.
3. It ensures maximum social welfare. This is so because the quest fro value drives scarce resources to
their most productive uses and their most efficient users. The more effectively resources are
deployed; the more robust will be the economic growth and the rate of improvement in the standard
of living.

The profit maximization criterion however has been questioned and criticized on several grounds. It
suffers from the following limitations:
1. Profit in absolute terms is not a proper guide to decision making. It has no precise connotation. It
should be expressed either on a per share basis or in relation to investment. Also, profit can be long
term or short term, before tax or after tax, it may be the return on total capital employed or total
assets or shareholders equity and so on. If profit maximization is taken to be the objective, which of
these variants of profit should a firm try to maximize? Therefore, a loose term like profit cannot form
the basis of operational criterion for financial management.
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2. It leaves considerations of timing and duration undefined. There is no guide for comparing profit
now with profit in future or for comparing profit streams of different durations.
3. It glosses over the risk factor. It cannot, for example, discriminate between an investment project,
which generates a certain profit of Rs. 50,000, and an investment project, which has a variable profit
outcome with an expected value of Rs. 50,000.

Wealth maximization decision criterion:


This is also known as value maximization or net present worth maximization. The focus of financial
management is on the value to the owners or suppliers of equity capital. The wealth of the owners is
reflected in the market value of the shares. So wealth maximisation implies the maximisation of the
market price of shares. It has been universally accepted as an appropriate operational decision criterion
for financial management decisions as it removes the technical limitations, which characterise the earlier
profit maximisation criterion. Its operational features satisfy all the three requirements of a suitable
operational objective of financial courses of action, namely exactness, quality of benefits and the time
value of money.

Despite the forceful arguments in favour of the goal of maximising shareholder value its supremacy has
been challenged by many. They are as follows:
Maximisation of the wealth of shareholders (as reflected in the market value of equity) appears to be the
most appropriate goal for financial decision-making.

EXPLAIN THE ROLE OF FINANCE HEAD AS CONFLICT MANAGER


Conflict of goal between management and owners: Agency problem
A characteristic feature of corporate enterprise is the separation between ownership and management as a
corollary of which the latter enjoys substantial autonomy in regard to the affairs of the firm. With widely
diffused ownership, scattered and ill-organised shareholders hardly exercise any control/influence on
management, which may be inclined to act in its own interests rather than those of the owners. However
shareholders as owners of the enterprise have the right to change the management. Due to the threat of being
dislodged for poor performance, the management would have a natural inclination to achieve a minimum
acceptable level of performance to satisfy the shareholders requirements/ goals, while focussing primarily on
their own personal goals. Thus in furtherance of their objective of survival, management would aim at
satisfying instead of maximising shareholders’ wealth.

However, the conflicting goals of management objective of survival and maximising owners value/wealth can
be harmonised. The shareholders delegate the decision-making authority to professional management on the
premise that the latter will work in the best interest of the former, that is, management is an agent of the
owners. In order to ensure that management would take optimal decisions compatible with the shareholders’
interest of value maximisation and minimise agency problems in terms of conflicts of interest, two remedial
measures commend themselves:
1. Provision of appropriate incentives and
2. Monitoring of agents/managers

1. Incentives to management: the incentive given to management is of various types. Some of them
are as follows
i) Stock options: confer on management the right to acquire shares of the enterprise at a
special/concessional price
ii) Performance shares are given based on the performance of the management as reflected
in rates of return.
iii) Cash bonus- linked to specified performance targets
iv) Perquisites- such as company car, expensive offices and fringe benefits
These incentives are closely related to the stake of management in the ownership of the company. They
promote congruence between the personal goals of management and the interests of the owners.
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2. Monitoring of managers:
Since management accounts for a small portion of the ownership of the enterprise, they would not be
oriented to the maximisation of the value of the shareholders. Monitoring of the activities of
management can be done by:
i) Bonding the agent
ii) Auditing financial statements and limiting decision making by the management
In case of bonding, the enterprise obtains a fidelity bond from a bonding company to the effect that the latter
will compensate the former up to a certain specified amount of losses caused by dishonest acts of managers.
The audit and control procedures and limiting managerial decisions are intended to ensure that the actions of
management sub serve the interests of shareholders.

ANALYSIS OF DUPONT CHART (PROBLEM)


Abrasives ltd. has the following turnover ratios presented along with the corresponding industry
averages:
Ratio description Abrasive’s ratio Industry average
Sales/Inventory 530/101= 5 times 10 times
Sales/Receivables 530/44=12 times 15 times
Sales/Fixed assets 530/98= 5.4 times 6 times
Sales/Total assets 530/300= 1.77 times 3 times
Financial analysis of the company is presented below in the form of a Du Pont Chart. Study the chart,
along with the four turnover ratios and industry averages, and comment on the major weaknesses of
the company where managerial attention must be focused for future control.
Return on Investment

Earnings as % of sales multiplied Turnover


=2.8% =1.77

Earnings divided by Sales Sales divided by Total


= Rs.15 = Rs.530 =Rs.530 Investment
=Rs.300

Sales minus Cost of sales


=Rs.530 =Rs.515 Permanent plus Working investment
capital
=Rs.98 =Rs.202
Cost of sales plus Selling plus Administrative
=Rs.440 expenses expenses
=Rs.26 =Rs.49 Inventories plus Accounts plus Cash
=Rs.106 receivables
=Rs.44 =Rs.52
Solution:
a) Profit margin not too bad; assets turnover quite low. Action required.
b) Inventory per unit of sales higher than other firms. Action required. Implications and impact of
suggested action (like funds released in the wake of inventory utilized in liquidating debt and reducing
interest burden with improved profit prospects) should be highlighted.
c) Excess capacity situation may exist, though not with definitiveness
ROI IS NOT THE END OF FINANCIAL OBJECTIVES. EXPLAIN.
It must be noted that return on investment is a ratio. The term ratio refers to the numerical or quantitative
relationship between two items / variables. The rationale of ratio analysis is that it makes related
information comparable. However ratios by themselves mean nothing. Thus, the return on investment must
be compared with:
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 A norm or a target
 Previous ROI achieved in order to assess trends, and
 The ROI achieved in other comparable companies
ROI cannot be considered as the end of financial objectives because of the following reasons.
 ROI is calculated from financial statements which are affected by the financial bases and policies
adopted on such matters as depreciation and the valuation of stocks.
 Financial statements do not represent a complete picture of the business, but merely a collection of
facts, which can be expressed in monetary terms. These may not refer to other factors, which affect
performance.
 Over use of ROI as control on managers could be dangerous, in that management might concentrate
more on simply improving the ratio than on dealing with the significant issues. E.g. the return on
total assets can be improved by reducing assets rather than increasing sales.
 ROI is a comparison of two figures, a numerator and a denominator. In comparing ROI, it may be
difficult to determine whether differences are due to change in the numerator, or in the denominator
or in both.
Thus, ROI should be considered only as a tool for analysis rather than as the end of financial objectives.

HOW CAN ROI CONCEPT BE USED IN PROFIT PLANNING & CONTROL. EXPLAIN WITH
THE HELP OF DU PONT CHART
(Dupont chart is given in the earlier question)
Return on investment ratio assesses the overall operating efficiency of a firm. The earning power of a firm
i.e. the return on investment is the overall profitability of the enterprise. This ratio has two elements:
o profitability on sales reflected in the net profit margin and
Net profit margin = Net profit after taxes
Sales
The operating efficiency of a firm in terms of the efficient utilisation of the resources is reflected in the
net profit margin.

o the profitability of investments which is revealed by the investments / assets turnover.


Investment turnover = Sales
Average total investment
This ratio measures the efficiency of a firm in managing and utilising the assets.

Net profit margin can be improved by increasing the profit margin for the same volume of sales or by
increasing the volume of sales keeping the profit margin at the same level. Keeping a check on expenses
such as selling, administrative, financial, etc can improve profit margin. Interest is also one of the fixed
charges against net profit, which can be minimised by maintaining a balance between equity and debt.
As mentioned above, Investment turnover ratio indicates the efficiency of the firm in utilising its assets /
capital employed. Total investment comprises the permanent investment (fixed assets) and working
capital. Working capital includes inventories, accounts receivables, cash etc.
This ratio can be improved by increasing the sales for the same amount of capital employed. This means
effective use of the resources employed. Proper management of inventories, effective credit policies,
maintaining only the required cash balance can help to increase the turnover of assets.
Another way to improve on investment turnover is by injecting additional capital into the firm so as to
increase the sales. The firm can expand its activity level and thereby maximise the return on investment.

ROI shown by way of a Dupont chart is thus an important tool to measure the overall profitability of the
firm. Thus, ROI ratio can be used for profit planning and control and management can thus be alerted
about the desirable and undesirable trends of corporate performance.
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WHAT ARE THE DIFFERENT PROFIT CONCEPTS EMPLOYED FOR PROFIT PLANNING
WITH BUDGETING
The different profit concepts employed for profit planning with budgeting are as follows:

Gross profit – this is the amount of profit earned on purchases, manufacture and sales of goods and services
only. Gross profit is arrived at by deducting cost of sales from the amount of net sales. Adequate amount od
gross profit is necessary for meeting other expenses of business.

Operating profit – the amount of gross profit left after meeting all other indirect expenses is termed as
operating profit. This amount is arrived at by deducting various administrative, selling and distribution and
finance expenses. This amount is also known as earnings before interest, depreciation and tax (EBIDT)

Earnings before interest and tax (EBIT) – this is the amount of profit less depreciation.

Earnings before tax (EBT) – this is the amount of profit after interest is deducted.

Earnings after tax (EAT) – this is the final profit amount left after payment of taxes.
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CAPITAL BUDGETING
CONCEPTS QUESTIONS

CAPITAL BUDGETING:
Capital budgeting is the process of generating, evaluating, selecting and following-up on capital expenditure
projects. The term Capital budgeting is used interchangeably with capital expenditure decision, capital
expenditure management & long-term investment decision.
The methods employed to evaluate the worth of capital expenditure proposals are known as capital budgeting
techniques .The popular methods are-
(a) Average rate of return
(b) Pay back period
(c) Net present value
(d) Internal rate of return
(e) Profitability index
The following are the basic features of capital budgeting-
• Potentially large anticipated benefits
• A relatively high degree of risk
• A relatively long time period between the initial outlay & the anticipated return

INTERNAL RATE OF RETURN


The discount rate which equates the present values of an investment’s cash inflows and outflows is its
internal rate of return

Acceptance rule
Accept if IRR > k
Reject if IRR < k
Project may be accepted if IRR = k

Merits Demerits
• Considers all cash inflows • Requires estimates of cash flows which is
• True measure of profitability tedious task
• Based on the concept of time value of • Does not hold the value additively
money principle
• Generally consistent with wealth • At times fails to indicate correct choice
maximisation principle between mutually exclusive projects
• At times yields multiple rates
• Relatively difficult to compute

PROFITABILITY INDEX
The ratio of the present value of the cash flows to the initial outlay is profitability index or benefit cost
ratio .It is also referred to as Benefit cost ratio

Acceptance rule
Accept if PI > 1.0
Reject if PI < 1.0
Project may be accepted if PI = 1.0
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Merits Demerits
• Considers all cash flows • Requires estimates of the cash
• Recognises the time value of money flows which is a tedious task
• Relative measure of profitability • At times fails to indicate correct
• Generally consistent with the wealth choice between mutually exclusive
maximisation principle projects

NET PRESENT VALUE

The difference between PV of cash flows and PV of cash outflows is equal to NPV, the firm’s
opportunity cost of capital being the discount rate.

Acceptance rule
Accept if NPV > 0 (i e. NPV is positive)
Reject if NPV < 0 (i.e. .NPV is negative)
Project may be accepted if NPV= 0

Merits Demerits
• Considers all cash inflows • Requires estimates of cash flows which is
• True measure of profitability a tedious task
• Based on the concept of time value of • Requires computation of the opportunity,
money cost of capital which possess practical
• Consistent with wealth maximisation difficulties
principle • Sensitive to discount rates
• Satisfies the value additively
principle

ACCOUNTING RATE OF RETURN


An average rate of return is found by dividing the average profit by the average investment.

Acceptance rule
Accept if ARR > minimum rate
Reject if ARR < minimum rate

Merits Demerits
• Uses accounting data with which • Ignores the time value of money
executives are familiar • Does not use cash flows
• Easy to understand and calculate • Gives more weightage to future
receipts
• No objective way to determine the
minimum acceptable rate of return
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PAY BACK PERIOD


The number of years required to recover the initial outlay of the investment is called payback

Acceptance rule
Accept if PB < Standard pay back
Reject if PB > Standard pay back

Merits Demerits
• Easy to understand and compute and • Ignores the time value of money
inexpensive to use • Ignores the cash flow occurring after the
• Emphasises liquidity pay back period
• Easy and crude way to cope with risk • Not a measure of profitability
• Uses cash flow information • No objective way to determine the pay
back

DISCOUNTED CASH FLOW METHODS


The methods of appraising capital expenditure proposals can be classified into two broad categories
1. Unsophisticated or traditional
2. Sophisticated or time adjusted

The latter are more popularly known as discounted cash flow techniques as they take the time factor into
account .In this method all cash flows are expressed in terms of their present values .It recognises that cash
flow streams at different time periods differ in value & can be compared only when they are expressed in
terms of a common denominator i.e., present values.

The following are the various discounted cash flow techniques –


Net present value
Internal rate of return
Profitability index

CAPITAL RATIONING
The capital rationing refers to the situation in which the firm has more acceptable investments requiring a
greater amount of finance than is available with the firm .It is concerned with the selection of a group of
investment proposals acceptable under the accept-reject decision .Ranking of the investments project is
employed in capital rationing .Projects can be ranked on the basis of some pre determined criterion such as
the rate of return .The project with the highest return is ranked first and the project with the lowest
acceptable return last .The projects are ranked in the descending order of the rate of return .

NPV V/S IRR


The following are the various dissimilarities between NPV and IRR –
 Size disparity problem
NPV and IRR method give different ranking to projects when the initial investment in projects
under consideration i.e., mutually exclusive projects is different .The cash outlay of some projects is larger
than that of others.
 Timing of cash flows
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The most commonly found condition for the conflict between the NPV and IRR methods is the
difference in the timing of cash flow

 Projects with unequal lives


Another situation in which the IRR and NPV methods would give a conflict ranking to
mutually exclusive projects is when the projects have different expected lives.

TRADITIONAL V/S DCF METHODS

Traditional method DCF method

• The traditional method are also • The discounted cash flow method
referred to as unsophisticated or are also known as sophisticated or
non discounted cash flow method time adjusted methods
• These method is known as non • This are known as DCF method
DCF because they do not take time because it take time factor into
factor into consideration account
• These are the various Non DCF • The following are the various DCF
methods – methods –
I. Pay back period I. Net present value
II. Accounting rate of return II. Internal rate of return
III. Profitability index

THEORY QUESTIONS
DIFFERENT METHODS OF EVALUATION OF A PROJECT & DIFFERENT METHODS OF
CAPITAL BUDGETING?
Capital budgeting is the process of generating, evaluating, selecting and following-up on capital expenditure
projects. The methods of appraising capital expenditure proposals can be classified into two broad
categories –

Investment criteria

Discounted cash flow method Non discounted cash flow


1. Net present value 1. Accounting rate of return
2. Internal rate of return 2. Pay back period
3. Benefit cost ratio

DISCOUNTED CASH FLOW METHOD


1) Internal rate of return
The discount rate which equates the present values of an investment’s cash inflows and outflows is its
internal rate of return

Acceptance rule
Accept if IRR > k
Reject if IRR < k
Project may be accepted if IRR = k
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Merits Demerits
• Considers all cash inflows • Requires estimates of cash flows which is
• True measure of profitability a tedious task
• Based on the concept of time value of • Does not hold the value additively
money principle
• Generally consistent with wealth • At times fails to indicate correct choice
maximization principle between mutually exclusive projects
• At times yields multiple rates
• Relatively difficult to compute

2) Net present value


The difference between PV of cash flows and PV of cash outflows is is is equal to NPV, the firm’s
opportunity cost of capital being the discount rate .

Acceptance rule
Accept if NPV > 0 (i e.NPV is positive )
Reject if NPV < 0 (ie.NPV is negative )
Project may be accepted if NPV= 0

Merits Demerits
• Considers all cash inflows • Requires estimates of cash flows which is
• True measure of profitability a tedious task
• Based on the concept of time value of • Requires computation of the opportunity
money ,cost of capital which possess practical
• consistent with wealth maximisation difficulties
principle • Sensitive to discount rates
• Satisfies the value additively
principle

3) Profitability index
The ratio of the present value of the cash flows to the initial outlay is profitability index or benefit cost ratio
.It is also referred to as Benefit cost ratio

Acceptance rule
Accept if PI > 1.0
Reject if PI < 1.0
Project may be accepted if PI = 1.0

Merits Demerits
• Considers all cash flows • Requires estimates of the cash
• Recognises the time value of money flows which is a tedious task
• Relative measure of profitability • At times fails to indicate correct
• Generally consistent with the wealth choice between mutually exclusive
maximisation principle projects
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NON DISCOUNTED CASH FLOW


1) Average rate of return
An average rate of return is found by dividing the average profit by the average investment .

Acceptance rule
Accept if ARR > minimum rate
Reject if ARR < minimum rate

Merits Demerits
• Uses accounting data with which • Ignores the time value of money
executives are familiar • Does not use cash flows
• Easy to understand and calculate • Gives more weightage to future
receipts
• No objective way to determine the
minimum acceptable rate of return

2) Pay back period


The number of years required to recover the initial outlay of the investment is called payback
Acceptance rule
Accept if PB < Standard pay back
Reject if PB > Standard pay back

Merits Demerits
• Easy to understand and compute and • Ignores the time value of money
inexpensive to use • Ignores the cash flow occurring after the
• Emphasises liquidity pay back period
• Easy and crude way to cope with risk • Not a measure of profitability
• Uses cash flow information • No objective way to determine the pay
back

DISCUSS THE PHASES OF CAPITAL BUDGETING?


Capital budgeting is a complex process is which may be divided in to following phases:
• Identification of potential investment opportunities
• Assembling of proposed investments
• Decision making
• Preparation of capital budgeting and appropriations
• Implementation
• Performance review

Identification of potential investment opportunities


The capital budgeting process begins with the identification of potential investment opportunities. Typically
the planning body develops the estimates of future sales, which serves as the basis for setting production
target. This information in turn is helpful in identifying required investments in plant and equipment.

For imaginative identification of investment ideas it is helpful to


i) Monitor external environment regularly to scout investment opportunities,
ii) Formulate a well defined corporate strategy based on a through analysis of strengths,
weaknesses, opportunities and threats,
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iii) Share corporate strategy and prospective with person who are involved in the process of capital
budgeting and,
iv) Motivate employees to make suggestions.
Assembling of investment proposals
Investment proposal identified by the production department and other department is usually submitted in a
standardized capital investment proposal firm. Generally, most of the proposals before they reach the capital
budgeting committee or somebody who is assembles them are routed through several persons. The propose
of routing a proposal through several persons is a primarily to ensure that the proposal is viewed from
different angels. It also helps in creating a climate for bringing about co-ordination of interrelated activities.

Investment proposals are usually classified into various categories for a facilitating decision – making
budgeting and control.

Decision-making
A system of rupee gateway usually categorizes capital investment decision-making. Under this system,
executives are vested with the power to O.K. investment proposals to certain limits. For ex, in one company
the plant superintendent can O.K investment outlays upto Rs. 200000 the works manager upto. Rs. 500000
and the managing director upto Rs. 2000000. Investment requiring higher outlays needs the approval of the
board directors.

Preparation of capital budget and appropriation


Project involving smaller outlays and which executives at lower levels can decide are often covered by a
blanket appropriation for expeditious action. Project involving larger outlays are included in capital budget
after necessary approvals. Before undertaking such project appropriation order is usually required. The
purpose of this check is mainly to ensure that the funds position of the firm is satisfactory at the time of
implementation. Further, provided an opportunity to review the project at the time of implementation.

Implementation.
Translating an investment proposal into a concrete project is a complex, time consuming and risk-fraught
task. Delays in implementation, which are common, can lead to substantial cost – overruns. For expeditious
implementation at reasonable cost, the following are helpful.

Adequate formulation of project the major reason for delay is inadequate formulation of projects. Put
differently, in necessary homework in terms of preliminary studies and comprehensive and detail
formulation of the projects is not done. Many surprises and shocks are likely to spring on the way. Hence the
need for adequate formulation of the project cannot be overemphasized.

Use of the principal of responsibilities accounting Assigning specific responsibility to project managers for
a completing a project within a define time frame and cost limit is helpful for expeditious execution and cost
control.

Use of network techniques for project planning and control several network techniques like PERT (program
Evaluation Review Technique) and CPM (Critical path Method) are available. With the help of these
techniques monitoring becomes easier.

Performance Review
Performance review, post completion audit, is a feedback device it is a menace for comparing actual
performance with project performance. It may be conducted, most appropriately, when the operations of the
project have established. It is useful in several ways:
1. It throws the light on how realistic were the assumptions underlying the project.
2. It provides a documented log of experience that is highly valuable for decision making;
3. It helps in uncovering judgmental biases;
4. It includes a desired caution among project sponsors.
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LIMITATION WITH DEPRECIATION AS TAX SHIELD.
Depreciation, although a non-cash item of cost, is deductible expenditure in determining the taxable income.
Depreciation provisions are prescribed by the companies act for accounting purposes and by the income tax
act for taxation purpose.

The purpose of provisions of depreciation contained in the Companies Act is the computation of managerial
remuneration, dividend payment and disclosure in financial statements. Since the Companies Act regulates
companies in India, they should provide depreciation in books of accounts in accordance with schedule XIV
of the Act, which prescribes the rate of depreciation for various types of depreciable assets on written down
value (WDV) basis as well as strait line basis. It also permits companies to charge depreciation on any other
basis provided it has the effect of writing off 95% of the original cost of the asset on the expiry of the specified
period and has the approval of the government. In actual practice, however, companies follow the provisions
of the Income Tax Act with the basic objectives of its tax-deductibility.

The provisions of Income Tax Act relating to depreciation are containing in section 32. the section envisages
three important conditions for following depreciation, namely
i. The asset is owned by the assessee,
ii. The asset is used by the assessee for the purpose of business and
iii. The asset is in the form of buildings, furniture, machinery, and plants including ships, vehicles,
books scientific apparatus, surgical equipments and so on.

The amount of annual depreciation on an asset is determined by


a. The actual cost of asset and
b. Its classification in relevant block of assets.
The actual cost means the cost of acquisition of the asset and the expenses incidental thereto which are
necessary to put the asset in the usable state, for instance, freight and carriage inwards, installation charges and
expenses incurred to facilitate the use of the asset like expenses on the training of operator or on essential
construction work.

Depreciation is charged, with the view to simplify the computation, not on a block of asset. A block of assets
defined as a group of asset falling within a class of assets and in respect of which the same rate of depreciation
is prescribed. Thus, assets, which fall within the same class of assets and in respect of which qualify for
depreciation at 25 %, will form one block and depreciation is computed with reference to the actual cost of the
block. Similarly, asset depreciation at 50 %, and the fourth block comprises assets subjects to 100 percent
write-off.

Depreciation is computed at block-wise rate on the basis of written down value (WDV) method only.
Presently, the block- wise rate for plant and machinery are at 25%, 40% and 100%. The depreciation
allowance on office buildings and furniture and fittings is 10%. Where the actual cost of plant and machinery
dose not exceed Rs.5, 000, the entire cost is allowed to be written off in the first year of its use. If an asset
acquired during a year has been used for a period of less than 180 days during the year, depreciation on such
assets is allowed only at 505 of the computed depreciating according to the relevant rate.

Apart form the simplification of the computation of the amount of depreciation, the significant implication of
categorizing assets in to blocks is that if an asset falling in a block is sold out, there is no capital gain or
terminal depreciation or balancing charge. The scale proceed of the asset are reduced from the WDV of the
block. Capital gain/loss can arise in these situations:
i. When the sale proceeds exceeds the WDV of the whole block.
ii. When the entire block is sold out
iii. In case of 100 percent depreciable assets.
Te terminal losses is not allowed in the relevant assessment year but is spread over a number of years to be
allowed by way of depreciation.
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In case of insufficiency/ absence of profit, unabsorbed depreciation can be set off against income under any
head against business income as in case of unabsorbed loss. Effective 1996-97, it can be carried forward for a
maximum period of eight years. However, it cannot be assigned/transferred/claimed by the transfer of
business.

CAPITAL EXPENDITURE DECISIONS


RATIONALE OF CAPITAL EXPENDITURE:
The rationale underlying the capital budgeting decision is efficiency. Thus, the firm must replace
worn and obsolete plants and machinery, acquire fixed asset for current and new products and make strategic
investment decisions. This will enable the firm to achieve its objective of maximising profits either by way
of increased revenues or by cost reductions. The quality of these decisions is improved by capital budgeting.
Capital budgeting decisions can be of two types: (i) those which expand revenue, (ii) those which reduce
costs.

(i) Investment Decisions Affecting Revenue:


Such investment decisions are expected to bring in additional revenue, thereby raising the size of
the firm’s total revenue. They can be the result of either expansion of present operations or the
development of a new product line. Both types of investment decisions involve acquisition of
new fixed assets. Both types of investment decisions are income expansionary in nature in the
case of manufacturing firm.
(ii) Investment Decisions Reducing Costs:
Such decisions by reducing costs, add to the total earnings of the firm. The classic example of
such investment decisions is the replacement proposals. When an asset wears out or becomes
outdated, the firm must decide whether to continue with the existing asset or replace it. The firm
evaluates the benefit from the new machine in terms of lower operating cost and the outlay that
would be needed to replace the machine. An expenditure on a new machine may be quite
justifiable in the light of the total cost savings that result.

KINDS OF CAPITAL BUDGETING DECISIONS:

Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital
expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals.
Basically the firm may be confronted with tress types of capital decisions: (i) the accept- reject decision; (ii)
the mutually exclusive choice decision; and (iii) the capital rationing decision.

(i) The Accept- Reject Decision:


This is a fundamental decision in capital budgeting. If the project is accepted, the firm invests in it; if the
proposal is rejected, the firm does not invest in it. In general, all those proposals, which yield a rate of
return greater than a certain required rate of return or cost of capital is accepted and the rest, are rejected.
Under the accept- reject decision, all the independent projects that satisfy the minimum investment
criterion should be implemented.
(ii) Mutually Excusive Project Decisions:
Mutually exclusive projects are projects, which compete with other projects in such a way that the
acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually
exclusive and only one may be chosen. Suppose, a company is intending to buy a new folding machine.
There are three competing brands, each with different initial investment and operating costs. The three
machines represent mutually exclusive alternatives, as only one of the three machines can be selected.
Mutually excusive investment decisions acquire significance when more than one proposal is acceptable
under the accept- reject decision. Then some techniques have to be used to determine the “best” one. The
acceptance of this “best” alternative automatically eliminates the other alternatives.
(iii) Capital Rationing Decision:
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In a situation where the firm has unlimited funds, capital budgeting becomes a very simple process in
that all independent investment proposals yielding return greater than some predetermined level are
accepted. However, this is not the situation prevailing in most of the business firms in the real world.
They have a fix capital budget. A large number of investment proposals compete for these limited funds.
The firm must, therefore, ration them. The firm allocates funds to projects in a manner that it maximizes
long- run returns. Thus, capital rationing refers to the situation in which the firm has more acceptable
investments, requiring a greater amount of finance than is available with the firm. Ranking of the
investment projects is employed in capital rationing. Projects can be ranked on the basis of some pre-
determined criterion such as the rate of return. The project with the highest return is ranked first and the
project with the lowest acceptable return last. The projects are ranked in the descending order of the rate
of return. It may be noted that only acceptable projects should be ranked.

CALCULATION OF PROFITABILITY INDEX FOR 2 PROJECTS AND COMPARE THEM.


The capital budgeting department of a company has suggested 3 investment proposals. The after-tax cash
flows for each are tabulated below. If the company’s cost of capital is 12%, rank them in order of
profitability.

After-tax Cash Flows (Rs.)


Year Project A Project B Project C
0 -20000 -60000 -36000
1 5600 12000 13000
2 6000 20000 13000
3 8000 24000 13000
4 8000 32000 13000
Solution:
The profitability index (PI) has to be calculated to rank the projects in order of profitability. PI is the
ration of PV of CFAT to PV of cash outflow. Therefore, we should determine the PV’s of all the projects at a
cost of capital of 12%.

CFAT PV Total PV
Year Factor at
A B C A B C
12%
1 5600 12000 13000 0.893 5000.8 10716 11609
2 6000 20000 13000 0.797 4782.0 15940 10361
3 8000 24000 13000 0.712 5696.0 17088 9256
4 8000 32000 13000 0.636 5088.0 20352 8268
20566.8 64096 39494
NPVs = 566.8 4096 3494

PV of cash inflows
Profitability Index =
PV of cash outflows

Rs. 20566.80
PI(A) = = 1.028
Rs. 20000.00

Rs. 64096
PI(B) = = 1.068
Rs. 60000
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Rs. 39494
PI(c) = = 1.097
Rs. 36000

The Projects are ranked in descending order of the highest profitability index. Therefore, C would be
first, B next, and A last. It may be noted that the PI measures the per rupee of investment. Therefore,
Project B, which has the highest NPV, would not be ranked first.

CASE STUDY ANALYSIS

Two Projects considered by Venture capitalist.

Project A Project B
Pay Back 3 Yrs 4.5 Yrs
IRR 12% 16%

Which project should be selected & why? Does the type of industry have any impact on the decision?

Solution:
(i) The pay back method (PB) answers the question: How many years will it take for the cash benefits
to pay the original cost of an investment, normally disregarding salvage value? When mutually
exclusive projects are under consideration, they may be ranked according to the length of the pay
back period. Thus, the project having the shortest pay back may be assigned ranked one, followed in
that order so that the project with the longest pay back would be ranked the lowest.
In the above case, pay back period for project A is 3 years and for project B is 4.5 years. Thus,
Project A will be selected, as its PB Period is less than PB Period of project B.

(ii) The use of the IRR, as a criterion to accept capital investment decisions, involves a comparison of
IRR of mutually exclusive projects. The project would qualify to be accepted if the IRR is greater
than the other project.
IRR of project A is12% and IRR of project B is 16%. Therefore, project B will be selected.

Suppose if venture capitalist invests in project A as well as in B Rs.100/-. This Initial Investment
will get back within 3 yrs in project A and 4.5 years in project B.

Project A Project B

100 100
Rs. Rs.

Inflows Inflows

As IRR of project A is lesser than that of project B, interest on investment after the pay back period
of project A will be less than that of project B. Therefore, interest on investment in project A for 10 years
will be Rs.120/- and that of in project B will be Rs.160/-. Thus, total earnings from project A are Rs100 +
Rs.120 = Rs.220. And total earnings from project B are Rs.100 + Rs.160 = Rs.260.
But as Pay back period in project B is higher than project A, risk involved in project B is more.
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Therefore, if investor doesn’t want to take any risk, he will go for project A. And he will select
project B, if he is ready to take risk with more earnings.
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TERM LOANS AND PROJECT APPRAISAL
TERM LOANS
Term loans are also known as term/project finance. They represent a source of debt finance which is
generally repayable in more than one year but less than 10 years. The primary source of such loans are
financial institutions. Commercial banks also provide term finance in a limited way. The financial
institutions provide project finance for new projects as also for expansion/ diversification and modernization
whereas the bulk of term loans extended by banks is in the form of working capital loan to finance the
working capital gap.

FINANCIAL INSTITUTIONS
The following financial institutions cater major part of the financial needs of the industrial sector:
1. Industrial Development Bank of India
2. Industrial Credit and Investment Corporation of India
3. Industrial Finance Corporation of India
4. State Finance Corporations
5. State Industrial Development Corporations
6. Industrial Construction Bank of India
7. Small Industries Development Bank of India
8. Life Insurance Corporations
9. Unit Trust of India
10. General Insurance Corporation and its Subsidiaries
- New India Assurance Company Ltd
- Oriental Insurance Company Ltd
- United India Assurance Company Ltd
- National Insurance Company Ltd.
11. Shipping credit and investment Company of India Ltd.

TERM LOAN PROCEDURE


The procedure associated with a term loan involves the following principal steps:

Submission of loan application – the borrower submits an application form that seeks comprehensive
information about the project. The application form covers the following aspects:
Promoter’s background
Particulars of the industrial concern
Particulars of the project (capacity, process, technical arrangements, management, location, land and
buildings, plant and machinery, raw materials, effluents, labour, housing, and schedule of
implementation)
Cost of the project
Means of financing
Marketing and selling arrangements
Profitability and cash flow
Economic considerations
Government consents

Initial processing of loan Application – when the application is received, an officer of the financial
institution reviews it to ascertain whether it is complete for processing. If it is incomplete the borrower is
asked to provide the required additional information. When the application is considered complete, the
financial institution prepares a ‘flash report’ which is essentially a summarization of the loan application. On
the basis of the ‘Flash Report’, it is decided whether the project justifies a detailed appraisal or not.
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Appraisal of the proposed project - the detailed appraisal of the project covers the marketing, technical,
financial, managerial, and economic aspects. The appraisal memorandum is normally prepared within two
months after site inspetion. Based on that a decision is taken whether the project will be accepted or not.

Issue of the letter of sanction – if the project is accepted, a financial letter of sanction is issued to the
borrower. This communicates to the borrower the assistance sanctioned and the terms and conditions
relating thereto.

Acceptance of the terms and conditions by the borrowing unit - On receiving the letter of sanction from the
financial institution, the borrowing unit convenes its board meeting at which the terms and conditions
associated with the letter of sanction are accepted and an appropriate resolution is passed to that effect. The
acceptance of the terms and conditions has to be conveyed to the financial institution within stipulated
period.

Execution of loan agreement – the financial institution, after receiving the letter of acceptance from the
borrower, sends the draft of the agreement to the borrower to be executed by the authorized persons and
properly stamped as per the Indian Stamp Act, 1899. the agreement, properly executed and stamped,
alongwith other documents as required by the financial institution must be returned to it. Once the financial
institution also signs the agreement, it becomes effective.

Disbursement of loans - Periodically, the borrower is required to submit information on the physical
progress of the projects, financial status of the project, arrangements made for financing the project,
contributions made by the promoters, projected funds flow statement, compliance with various statutory
requirements, and fulfillment of the pre-disbursement conditions. Based on the information provided by the
borrower, the financial institution will determine the amount of term loan to be disbursed from time to time.
Before the entire term loan is disbursed, the borrower must fully comply with all the terms and conditions of
the loan agreement.

Creation of Security the term loans(both rupee and foreign currency) and the deferredpayment guarantee
assistance provided by the financial institutions are secured through the first mortgage, by way of deposit of
title deeds, of immovable properties and hypothecation of movable properties. As the creation of mortgage,
particularly in the case of land, tends to be a time consuming process, the institutions permit interim
disbursements against alternate security (in the form of guarantees by the promoters). The mortgage,
however, has to be created within a year from the date of the first disbursement. Otherwise, the borrower has
to pay an additional charge of 1 per interest.

Monitoring - Monitoring of the project is done at the implementation stage as well as at the operational
stage. During the implementation stage, the project is monitored through:
1. Regular reports, furnished by the promoters, which provide information about placement of
orders, construction of buildings, procurement of plant, installation of plant and machinery,
trial production, etc.
2. Periodic site visits
3. Discussion with promoters, bankers, suppliers, creditors, and other connected with the project
4. Progress reports submitted by the nominee directors, and
5. Audited accounts of the company.

During the operational stage, the project is monitored with the help of - (i) quarterly progress report on the
project, (ii) site inspection, (iii) reports of nominee directors, and (iv) comparison of performance with
promise.

The most important aspect of monitoring, of course, is the recovery of dues represented by interest and
principal repayment.
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PROJECT APPRAISAL BY FINANCIAL INSTITUTIONS


Project appraisal is the process by which a financial institution makes an independent and objective
assessment of the various aspects of the investment proposition for arriving at a financing decision.
Broad aspects of appraisal
There are four broad aspects of appraisal
1. Financial feasibility
2. Technical feasibility
3. Economic feasibility
4. Management competence
5. Market appraisal

 Financial feasibility
The basic data required for a financial feasibility analysis can be grouped as under
1. Cost of project and means of financing
2. Cost of production and profitability
3. Cash flow estimates during currency of loans
4. Proforma balance sheets at the end of each financial year during the period of the loan

1. Cost of project-
The cost of the project can be broadly classified into the following
- Land and site development
- Building
- Plant and machinery
- Transportations erections and commissioning
- Miscellaneous assets
- Preliminary and pre- operative expenses
- Contingency expenses
- Working capital margin
Though the cost of machinery often constitutes a major element in the total project cost, its
estimation need not pose problems since this can be based on competitive quotations. On the
other hand, cost of items such as land, site development expenses, ancillary facilities like power
and water connections, intangibles like preliminary expenses and preoperative expenses,
necessitates a careful inquiry and assessment. A realistic assessment of project cost with built in
cushions (a reasonable contingency margin) for absorbing normal cost escalations could take care
of the consequences of delay and cost overrun. Inflation factors are also considered.

• Means of financing-
There is no ideal pattern concerning means of financing for a project. The means of financing is
determined by a variety of factors and considerations like magnitude of funds required, risk associated with
the enterprise, nature of industry, prevailing taxation, laws etc.
The following are the sources of finance:
- Share capital
- Subsidies
- Long term borrowing (financial institutes / banks)
- Loans from friends and relatives
- Retained earnings
Financial institutes specify certain debt equity ratios and promoters will have to raise own finance to match
these ratios.

 Cost of production and profitability-


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The next step is the assessment of the earning capacity of the project. The unit should be in a position to
manufacture the product at a reasonable cost and sell them at a reasonable price, which would allow
adequate profit margin even in a competitive market. The profitability of an enterprise depends on the total
cost of production and aggregate sale price of the output. The cost of production and sale estimates are also
useful in working out the break-even point, the point at which the income sales would cover the working
costs of the project. At this point the unit begins to make profit.

 Cash flow estimates


The cash flow estimates are essential to ensure availability of cash to meet the requirements of the project
from time to time. The cash flow estimates will show the sources of funds including those arising from
depreciation and profits as well as uses of funds including repayment of term loan installments. The debt
service coverage ratio is arrived at by dividing cash accruals comprising net profits by total interest charges
and installments. This will indicate whether the cash flow would be adequate to meet the debt obligations
and also provide sufficient margin of safety, repayment of term loans beings drawn taking into consideration
the above aspect.

 Proforma balance sheets


Proforma balance sheets are drawn for existing concerns going for expansions as well as for new projects.
However in the case of existing concerns going for expansion the balance sheets for the past three years are
also analysed and compared, with the projections. The projected balance sheets can be drawn for the cash
flow estimates and profitability projections. Various ratios are derived from the balance sheets and
inferences drawn therefrom.

2. Technical feasibility
The project needs to be examined with particular reference to the following points regarding the technical
feasibility.
a) Location- the success of a project depends on its proper location yielding the
advantages of nearness to the sources of raw material, labour, availability of power
and transport facilities and market. The subsidies and other concessions available at
certain specified areas are to be compared with the basic infrastructural aspects.
b) Land and building- the land should necessarily be sufficient to take care of future
expansions. If the land is on lease the terms and conditions of the lease to be verified
and so also the municipal laws regarding the construction of the building. Actual plant
lay out is to be studied before deciding on the size of the building.
c) Plant and machinery- the important aspect to be noted in examining the list of plant
and equipments is ascertain the appropriateness of the process of technology, capacity
and the related sectional balance amongst various assembly lines. It has to be ensured
that the cost of the equipment is based on proper quotations from suppliers and that
suitable provisions have been made for insurance freight duty and transportation to
site etc. adequate provisions for spare parts is also essential especially if the same
have to be imported.
 Technical competence
The technology may be indigenous or imported through foreign collaboration. In case of indigenous
technology it should be ensured that suitable technical personnel are available. For technology acquired
through collaboration tie –ups the key areas to be probed are:
- The standing of the collaborators and past experiences concerning tie up arrangements with
them
- Adequacy of the scope and the competitiveness of the terms of the collaboration in relation to
the requirements of the project, project engineering, equipment specifications, drawings,
process know- how, erection and commissioning of the plant, trial operations and
performance test, training facilities etc.
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- Performance guarantee and its adequacy in relation to rated capacity of plant and machinery.
- Reasonableness of financial and other costs by way of down payments, royalties etc.

 Economic feasibility- the economic feasibility basically deals with the marketability of
the product. Basic data regarding demand and supply of a product in the domestic market
so also the marginal and artificial. Man-made shortages are not to be reckoned as genuine
demand and the market analysis is an essential part of a full appraisal. Projection or
forecasting of demand is no doubt is no doubt a complicated matter but is of vital
importance. Equally importance is to examine the sales promotion proposed by the
enterprise and its adequacy.

 Managerial competence- the success of a business enterprise depends largely on the


resourcefulness, competence and integrity of its management. However assessment of
managerial competence has to be necessariliy qualitative calling for understanding and
judgment. The managerial requirements are the experience and capability of the principal
promoters to implement and run the project. The adequacy of the management set up for
day to day operations like production maintenance marketing finance etc. and also the
homogeneity of the management set up. For a new entrepreneur it will always be
advisable to build up a competent team of specialists in the required discipline to join
hands with an entrepreneur who has the requisite organisational and managerial expertise
in the implementation and operation of the project.

 Financing decisions-the overall decision in a financing proposition is a composite of


several sub decisions on the various aspects gone into above. These sub decisions provide
the frame work for the formulation of a rational judgement. In this process the project
may have to be restructured involving location, plant size, phasing of output, product mix,
market strategy, capital structure etc. even after taking a financing decision the bank has
to be associated with the venture on a continuing basis.
Adequacy of rate of return -
The general norms for financial desirability are as follows:
o Internal rate of return: 15%
o Return on Investment: 20-25%
o Debt-service coverage ratio: 1.5-2.0

Appropriateness of the financing pattern-


The institutions consider the following in assessing the financial pattern:
o A general debt-equity ratio norm of 1.5:1
o A requirement that promoters should contribute a certain percentage of the project
cost
o Stock exchange listing requirements

 Market Appraisal – The importance of the potential market and the need to develop a
suitable marketing strategy cannot be over-emphasised. Hence efforts are made to:

• Examine the reasonableness of the demand projections by utilizing the findings of


available surveys, industry association projections, Planning Commission/DGTD
projections, and independent market surveys (which may sometimes be
commissioned)..
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• Assess the adequacy of the marketing infrastructure in terms of promotional
effort, distribution network, transport facilities, stock levels, etc.
• Judge the knowledge , experience, and competence of the key marketing
personnel.

FEATURES OF TERM LOANS


Maturity – The maturity period of term loans is typically longer in case of sanctions by financial
institutions in the range of 6-10 years in comparison to 3-5 years of bank advances. However, they are
rescheduled to enable corporate borrowers tide over temporary financial exigencies.

Negotiated – the term loans are negotiated loans between the borrowers and the lenders. They are akin to
private placement of debentures in contrast to their public offering to investors.

Security – Term loans typically represent secured borrowing. Usually assets, which are financed with the
proceeds of the term loan, provide the prime security. Other assets of the firm may serve as collateral
security.
All loans provided by financial institutions, alongwith interest, liquidated damages, commitment charges,
expenses, etc., are secured by way of:
a) First equitable mortgage of all immovable properties of the borrower, both present and future for the
entire institutional loan including commitment charges, interest, liquidated damages and so on; and
b) Hypothecation of all movable properties of the borrower, both present and future, subject to prior charges
in favour of commercial banks for obtaining working capital finance/advance.

Interest payment and principal repayment – The interest on term loans is a definite obligation that is
payable irrespective of the financial situation of the firm. To the general category of borrowers, financial
institutions charge an interest rate that is related to the credit risk of the proposal, subject usually to a certain
minimum prime lending rate/ floor rate (PLR). Financial institutions impose a penalty for defaults. In case of
default of payment of installments of principal and/or interest, the borrower is liable to pay by way of
liquidated damages additional interest calculated at the rate of 2 per cent per annum for the period of default
on the amount of principal and/or interest in default. In addition to interest, lending institutions levy a
commitment fee on the unutilized loan amount.
The principal amount of a term loan is generally repayable over a period of 6 to 10 years after the initial
grace period of 1 to 2 years. Typically, term loans provided by financial institutions are repayable in equal
semi-annual installments, whereas term loans granted by commercial banks are repayable in equal quarterly
installments. With this type of loan amortisation pattern, the total servicing burden declines over time, the
interest burden declining and principal repayment remaining constant. In other words, the common practice
in India to amortise loan is repayment of principal in equal installments (semi-annual/annual) and payment
of interest on the unpaid/outstanding loans.

Restrictive covenants – in order to protect their interest, financial institutions generally impose restrictive
conditions on the borrowers. These are known as covenants. They are both positive /affirmative and negative
in the sense of what the borrower should and should not do in conduct of its operations and fall into four sets
as respectively related to assets, liabilities, cash flows and control.
Negative Covenants - Some negative covenants are as under :
• Asset-related covenants – are intended to ensure the maintenance of a minimum asset base by the
borrowers. Included in this set of covenants are:
o Maintenance of working capital position in terms of a minimum current ratio,
o Restriction on creation of further charge on asset,
o Ban on sale of fixed assets without the lenders concurrence/ approval.
• Liability-related covenants – may include:
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o Restrain on the incurrence of additional debt/ repayment of existing loan, say, without the
concurrence/prior approval of the lender/financial institution,
o Reductionin debt-equity ratio by issue of additional capital, and
o Prohibition on disposal of promoters shareholding.
• Cashflow related covenants – which are intended to restrain cash outflows of the borrowers may
include:
o Restriction on new projects/expansion without prior approval of the financial institution,
o Limitation on dividend payment to a certain amount/rate and prior approval of the financial
institutions for declaration of higher amount/ rate,
o Arrangement to bring additional funds as unsecured loans/deposits to meet overrun/shortfall,
and
o Ceiling on managerial salary and perks.
• Control related covenants – aim at ensuring competent management for the borrowers. This set of
covenants may include
o Broad basing of board of directors and finalisation of management set-up in consultation with
the financial institution,
o Effective organizational changes and appointment of suitable professional staff, and
o Appointment of nominee directors to represent the financial institutions and safeguard their
interests.

Positive covenants – in addition to the foregoing negative covenants, certain positive/affirmative


covenants stating what the borrowing firm should do during the term of a loan are also included in a loan
agreement. They provide for:
i. Furnishing of periodical reports/financial statements to the lenders
ii. Maintenance of a minimum level of working capital
iii. Creation of sinking fund for redemption of debt, and
iv. Maintenance of certain net worth.

MARGIN MONEY
Margin money is one of the important factors, which is evaluated by financial institutions while considering
the project for financial assistance. The elements of cost of project are divided into tangible assets and non
tangible assets to find out the margin money as follows

Cost of project Rs. Lakhs

A) Tangible assets
1. Land and site development 9
2. Buildings and civil work 15
3. Plant and machinery 38
4. Miscellaneous fixed assets 6
5. Technical know how 3
6. Escalation and contingencies 7
7. Interest during construction 2
B) Non Tangible assets
1. Preliminary and preoperative expenses 6
14
6
2, Margin money for working capital 100

14
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Total

Tangible assets are those, which are physically present and whose cost can be allocated to either of the above
heads. It is only the escalation & contingencies, which is estimated and may give rise to some scope of error
while evaluating margin money.
In the above scheme tangible assets constitutes 80% of the cost of the project and non-tangible items
constitute 20% of the cost of project. Normally the financial institutions do not finance the non tangible assets
and it is to be financed by the promoter/ borrowing concern. The tangible assets will be financed between 70
to 85% of the value of each item of asset. Suppose if the financial institution maintains a 2:1 debt equity ratio
then the percentage of margin money is calculated by applying the following formula:

Margin Money = Tangible assets – Term loans x 100


Tangible assets
Where Tangible Assets = Rs. 80 Lakhs.
Term loan = Rs. 60 Lakhs

= 80-60 x 100
60

= 17.5%

MODES OF SECURITY
Term loans are provided on the basis of the following modes of security:
Hypothecation:
Under this mode of security, loans are provided against the security of movable property, usually inventory
of goods. The goods hypothecated, however, continue to be in the possession of the owner of these goods
(i.e., the borrower). The rights of the lending institution (hypothecatee)
Depend upon the terms of contract between the borrower and the lender. Although the lender does not have
physical possessions of the goods, it has legal right to sell the goods to realize the outstanding loan.
Hypothecation facility is normally not available to new borrowers.
Pledge:
Pledge as a mode of security, is different from hypothecation in that in the former, unlike in the latter, the
goods which are offered as security are transferred to the physical possession of the lender. An essential
prerequisite of pledge is that the goods are in the custody of the lender. The borrower who offers security is
called a “pawnor” (pledgor), while the lender is called the “pawnee” (pledgee). The lodging of the goods by
the pledgor to the pledgee is a kind of bailment. Therefore, the pledge creates some liabilities for the lender.
It must take reasonable care of goods pledged with it. The term “reasonable care” means care which a
prudent person would take to protect its property. He would be responsible for any loss or damage if he uses
the pledged goods for his own purposes. In case of non-repayment of the loans, the lender enjoys the right to
sell the goods.
Lien:
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The term lien refers to the right of a party to retain goods belonging to another party until a debt due to him
is paid. The lien can be of two types: particular lien, and general lien. Particular lien is a right to retain goods
until a claim pertaining to these goods is fully paid. On the other hand, general lien can be applied till all
dues of the claimant are paid.
Mortgage:
It is the transfer of a legal/ equitable interest in specific immovable property for securing the payment of
debt. The person who parts with the interest in the property is called ‘mortgagor’ and the person in whose
favour the transfer takes place is called ‘mortgagee’. The instrument of transfer is called the ‘mortgage
deed’. Mortgage is thus conveyance of interest in the mortgaged property. The mortgage interest in the
property is terminated as soon as th debt is paid. Mortgages are taken as an additional security for working
capital credit by banks.

CHARGE – where immovable property of one person is, by the act of parties or by the operation of law,
made security for the payment of money to another and the transaction does not amount to mortgage, the
latter person is said to have a charge on the property and all the provisions of simple mortgage will apply
such a charge. The provisions are as follows:
 A charge is not the transfer of interest in the property though it is security for payment. But mortgage
is a transfer of interest in the property.
 A charge may be created by the act of parties or by the operation of law. But a mortgage can be
created only by the act of parties.
 A charge need not be made in writing but a mortgage deed must be attested.
 Generally, a charge cannot be enforced against the transferee for consideration without notice. In a
mortgage, the transferee of the mortgaged property can acquire the remaining interest in the property,
if any is left.
First charge and second charge.
Loans are granted to borrowers against securities. Sometimes a borrower might use the same asset for
raising finance from 2 or more lenders. In this case the lender who has first lent to the borrower against
the asset will have a right on the asset, before the second lender, in case of default. This is known as the
first charge.
Only after the dues of the first lender are cleared, after selling off the asset, the second lender can claim
his dues. This is known as the second charge. Generally the lender who has a second charge will price
his loan higher, considering the fact that he has to bear a greater risk.

Fixed and floating charge.


Lenders lend money to borrowers against securities. A lender can have either a fixed or a floating charge
on the securities. In case of a fixed charge, the lender can recover his dues from a certain predecided
asset only, in case of a default by the borrower. On the other hand, a lender who has a floating charge can
recover his dues from a gamut of fixed assets. The lender who lends on a fixed charge therefore has to
bear higher risk than the one lending on a floating charge.

FIXED AND FLOATING RATES:


Floating rate as opposed to floating rates vary over the tenor of the loan. These variations are linked to
changes in an underlying benchmark rate. Thus a borrower with a floating rate loan for three years could end
up paying 3 percent in the first year, 4 in the second and six in the third.
In most floating rate arrangements, the effective rate is not revised on a daily or a weekly basis but over
longer intervals. Thus rates are revised every quarter, half yearly or yearly.
The benchmarks for most contracts are either the yield on government securities or an interbank rate like the
LIBOR. In the Indian case, the yield on government / treasury rate will be the benchmark. A formula then
decides how the interest on a specific loan relates to this. For instance, a 10 ten year floating rate loan could
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have its return defined as the prevailing yield on 10 year government securities plus say one percentage
point.

MORATORIUM – Financial institutions may allow for a delay in the payment of the first principal
installment to the borrowers. The period between the sanction of the loan and the first principal installment
repayment is known as moratorium.

RE-SCHEDULEMENT –in the event of a borrower not being able to pay their installments as per the
repayment schedule, financial institutions may restructure the repayment schedule of the borrowers so as to
prevent the asset from turning bad.

INTEREST –
Penal – financial institutions levy a penal interest on the borrowers who default on interest payment in spite
of having the ability to pay.
Rebate – financial institutions may grant a rebate in the interest payment to borrowers who are willing to
pay but do not have the ability to pay.
Waiver – financial institutions may also waiver off some part of the interest payment to borrowers who are
not in a sound financial position.

SENSITIVITY ANALYSIS – one measure which expresses risk in more precise terms is sensitivity
analysis. It provides information as to how sensitive the estimated project parameters, namely, the expected
cash flow, the discount rate and the project life are to estimation errors. The analysis on these lines is
important as the future is always uncertain and there will always be estimation errors. Sensitivity analysis
takes care of estimation errors by using a number of possible outcomes in evaluating a project. The method
adopted under sensitivity analysis is to evaluate a project using a number of estimated cash flows to provide
to the decision maker an insight into the variability of the outcomes.
Sensitivity analysis provides different cash flow estimates under three assumptions (i) the worst (i.e. the
most pessimistic), (ii) the expected (i.e. the most likely), and (iii) the best (i.e. the most optimistic) outcomes
associated with the project

VERIFICATION AND VALIDATION SECURITY


Once a charge has been created on a asset, the borrower can register the charge with the registrar of
companies. Thus, the asset is open for verification to any lender who may or may not want to place a charge
on the asset.
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CORPORATE TAXATION, INFLATION AND ITS IMPLICATIONS
ON CORPORATE FINANCING
CONCEPTS

IMPACT OF INFLATION ON CORPORATE FINANCE


Ans. Same as theory question no. 1

PROVISION OF MINIMUM ALTERNATIVE TAX (MAT)


Ans. Normally, a company is liable to pay tax on the income computed in accordance with the provisions of
the Income Tax Act, but the profit and loss account of the company is prepared as per provisions of the
Companies Act. There were large number of companies who had book profits as per their profit and loss
account but were not paying any tax because income computed as per provisions of the income tax act was
either nil or negative or insignificant. In such case, although the companies were showing book profits and
declaring dividends to the shareholders, they were not paying any income tax. These companies are
popularly known as Zero Tax companies. In order to bring such companies under the income tax act net,
section 115JA was introduced w.e.f assessment year 1997-98.

According to this section, if the taxable income of a company computed under this Act, in respect of
previous year 1996-97 and onwards is less than 30 % of its book profits, the total income of such company
is chargeable to tax for the relevant previous year shall be deemed to an amount equal to 30 % of such book
profits.

THEORY QUESTIONS:

IMPACT OF INFLATION ON CORPORATE FINANCE

Ans.

 Inflation and asset revaluation


 Inflation and firm value
 Inflation and financial returns
 Inflation and innovation in the financial markets
 Inflation and financial analysis
 Inflation and capital budgeting

INFLATION AND ASSET REVALUATION


In an inflationary period, the book value of assets, typically reflecting historical cost less accumulated
depreciation, do not reflect their true values. Hence it may be worthwhile to consider revaluation of assets
periodically so that the asset values shown in the balance sheet reflect economic reality more accurately.

Objectives of revaluation
Revaluation of asset is undertaken with one or more of the following objectives in mind:
To attract investors by indicating to them the current values of assets.
to make depreciation provision which will enable the firm to meet replacement needs adequately.
To provide a more reasonable and accurate perspective regarding the truth worth of assets in the
event of a possible takeover or merger.
to help management in assessing the “truth profitability” of different divisions, formulating a more
sensible dividend policy, pricing its products realistically, fixing the machine hour rates in a job order
situation, and determining the desirable insurance cover for the assets.
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to enhance the borrowing capacity of the firm.
It may be noted that irrespective of the objective sought by a firm from the revaluation study, an important
advantage of such an exercise is that the capital asset records of the company are streamlined.

INFLATION AND FIRM VALUE


If the actual rate of inflation is equal to the anticipated rate of inflation, the value of the firm remains more
orless unaffected. This is so because the anticipated rate of inflation is properly embodied in the returns
expected by the supplier of capital, the prices expected for the products/services sold by the firm, the
compensation expected by the suppliers of various inputs, so on and so forth. When the actual rate of
inflation differs from the anticipated rate of inflation, the firm value is likely to change. The impact on firm
value depends on several factors: debtors-creditors position, price-cost responsiveness, and depreciation and
inventory charges.

Debtor-creditor position
With an unsnticipated increase in inflation, the borrower benefits because the loan is repaid in cheaper
money than originally anticipated.
To illustrate, consider a loan which carries a 12% nominal rate of interest based on an 8% expected inflation
rate and a required 4% real rate of return. If the actual inflation rate turns out to be 10%, rather than the
expected 8%, the real rate of return would be 2%and not 4%. As a consequence, the borrower gains whereas
the lender loses. An unanticipated decrease in inflation would have the opposite consequences: the borrower
will lose whereas the lender will gain.
The impact of an unanticipated increase in inflation on the wealth of a firm will depend on whether the firm
is a net creditor or a net debtor. (A firm is a net debtor if the opposite is true, i.e., its financial liabilities
exceed its financial assets). If a firm is a net creditor, an unanticipated increase in inflation decreases its
wealth. On the other hand, if a firm is a net debtor, an unanticipated would have the opposite consequences:
net creditor will gain whereas a net debtor will lose.

Price-cost responsiveness
The sensitivity of prices(of the firm’s outputs) and costs (of the firm’s inputs like raw material, utilities,
manpower, etc.) to unanticipated inflation influences the value of the firm. If prices and costs vary
proportionally with unanticipated inflation, the change in the nominal value of the firm will be such that the
real rate of return on capital would remain more or less unchanged. If the prices respond quickly, whereas
costs respond slowly, to unanticipated inflation increase, the value of the firm tend to increase. On the other
hand, if costs respond quickly, but prices respond slowly, to anticipated inflation increase, the value of the
firm tends to decline. An unanticiapetd decrease in inflation would have the opposite effects:
1. the firm value tends to decrease when prices lead costs,
2. the firm value tends to increase when costs lead prices.

Depreciation and inventory charges


Depreciation charges are based on the historical costs of assets. During an inflationary period replacement
costs are greater than historical costs. Hence, depreciation charges, based on historical costs, not
replacement costs, entails a higher tax burden for the firm.
This tends to detract from the value of the firm.
A similar effect obtains with respect to inventories because inventory costs are charges on the basis of
original (historical) costs and not replacement costs. The effect is particularly pronounced when the firm
uses FIFO system of inventory accounting. Under this system, recorded inventory costs are lower than
replacement costs in an inflationary period. As a result, accounting income is overstated. This leads to a
higher tax burden and a consequent diminution in the value of the firm. This problem can be significantly
mitigated by following the LIFO system of inventory accounting. Under this system the recorded inventory
costs tend to be fairly close to their replacement costs and hence the additional burden on account of taxes
may be very marginal.
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INFLATION AND FINANCIAL MARKET RETURNS
The expected return on security was defined as the rate of discount which makes the present value of the
stream of expected cash inflows equal to the price of the security. Clearly, the expected rate of return was
defined in nominal terms. This implies that the cash flows are expressed in current rupees, at the time of
receipt and not adjusted for inflation.
In an inflationary period, the current rupees at the time of receipt will have lesser purchasing power than the
rupees deployed to buy the security. As a consequence, the real rate of return on the security will be less than
its nominal rate of return. For eg. If the nominal rate of return is 15% and the inflation rate is 10% the real
rate of return will be approximately 5%.

INFLATION AND INNOVATIONS IN THE FINANCIAL MARKETS


Inflation reduces the purchasing power of money. If the rate of inflation is, say, 10% p.a, the purchasing
power of money declines by 10% p.a. In such a situation, an income increase of 10%p.a is required to
protect one’s real income. Likewise, if the rate of inflation is 10%p.a, the rate of return on investment must
be at least 10% per year to avoid erosion in real wealth. To earn a positive real rate of return in a situation
like this, the nominal rate of return must be greater than the inflation rate, namely 10%.
In order to cope with inflation, employees seek wage increases related to consumer price index and business
firms include escalator clauses in supply contracts. What innovations/developments have occurred in
financial markets in response to inflation? The following have been the important inflation-induced
innovations/developments in financial markets:
1. Flexible interest rates
2. Lenders participation in equity
3. Financial futures

INFLATION AND FINANCIAL ANALYSIS


The financial performance of a firm as reflected in conventionally prepared financial statements
(which are based on historical costs) is influenced partly by managerial decisions and partly by external
influences, particularly inflation, which are beyond the control of management. As a result, the performance
shown by financial statements may cloud the economic performance.

Illustration: To illustrate the distortion caused by inflation consider an example.


XYZ Co. a retail firm, began business on December 31, 1999 and has the balance sheet at that time:

Liabilities Assets

Equity Rs.6, 00,000 Net Fixed Assets Rs.2, 00,000


Inventory Rs.3, 00,000
Cash Rs.1, 00,000

The fixed assets, assumed to have a life of 10 years, are depreciated at the rate of 10 per cent per year on
straight line basis. The firm follows the first-in-first-out (FIFO) method of inventory pricing. The inflation
rate for the year, which ended on December 31, 2001, was 20 per cent – for the sake of simplicity it may be
assumed that the inflation occurred at the beginning of the year. The sales for the year occurred at the end of
the year. The firm is not liable to pay any taxes.
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The income statement of the firm for the first year of its operations =, as reported on historical coat basis
was as follows:

Income statement
Sales Rs.5, 00,000
Cost of Goods Sold
Beginning Inventory Rs.3, 00,000
Purchases Rs.3, 60,000
Ending inventory Rs. (3,60,000) Rs.3, 00,000
Depreciation (2, 00,000/10) Rs.20, 000
Selling and Administrative expenses Rs.80, 000
Net Profit Rs.1, 00,000

It may be noted that the firm bought replenishment inventories at the end of the first year for Rs.3, 60,000
when the prices were 20 per cent higher than what they were at the beginning of the year. The balance sheet
of the firm as on December 31, 2001 was as follows:

Liabilities Assets

Equity Capital Rs.6, 00,000 Net Fixed Assets Rs.1, 00,000


Reserves Rs.1, 00,000 Inventories Rs.3, 60,000
Cash Rs.1, 60,000
__________ ___________
Rs.7, 00,000 Rs.7, 00,000

The two commonly used profitability ratios were:


Net profit margin (1, 00,000/5, 00,000) = 20 per cent
Return on total assets (1, 00,000/6, 00,000) = 16.67 per cent

These measures, however, over-state the underlying economic profitability for two reasons:
1. Under the FIFO method, inventories that are sold are assumed to have been bought at
prices prevailing when the oldest items in the inventories were bought. With inflation,
these prices are less than their replacement cost. In the case of XYZ company, inventories
sold have been valued at Rs.3, 00,000 for the purpose of accounting, though their
replacement cost at the time of sales was Rs.3, 60,000. Hence, the costing of inventories as
per FIFO methods result in understatement of economic costs and over-statement of
economic profits in an inflationary period.
2. Under historical cost accounting, depreciation charges are based on original cost of the
fixed assets. With inflation, the replacement cost of these assets is greater than the original
cost of fixed assets. With inflation, the replacement cost of these assets is greater than the
original cost. So, a depreciation charge based on original cost understates the economic
depreciation which is based on replacement cost. For XYZ Company the depreciation
charge based on original cost is Rs.20,000, whereas the economic depreciation is
RS.24,000 (10 per cent of the replacement cost of Rs.2, 40,000).

Using the replacement cost basis, the income statement of XYZ Company for the year 2001 is shown below:
Income Statement
Sales Rs.5, 00,000
Cost of goods sold Rs.3, 60,000
Depreciation (2, 40,000/10) Rs.24,000
Selling and Administrative expenses Rs.80,000
Net Profit Rs.36,000
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The profitability ratios based on economic profits, as against profits on a historical cost basis, are:

Net profit margin (36,000/5, 00,000) = 7.2 per cent


Return on total assets (36,000/7, 00,000) = 5.14 per cent

Thus, we find that the profitability measures based on economic performance are substantially lower than
those based on accounting data.
Continuing our example, suppose the rate of inflation in 2002 is nil and the income statement of the
company, on a historical basis, is as follows:

Income Statement

Sales Rs.5, 00,000


Cost of goods sold
Beginning inventory Rs.3, 60,000
Purchases Rs.3, 60,000
Ending inventory Rs.(3, 60,000) Rs.3, 60,000
Depreciation (2, 00,000/10) Rs.20,000
Selling and Administrative expenses Rs.80,000
Net profit Rs.40,000

Thus, there is a sharp decline in the accounting profit of XYZ Co. from Rs.1, 00,000 (for the year 2001) to
Rs.40,000 (for the year 2002). This deterioration in profit performance, however, is caused primarily by
inflation, not managerial inefficiency. To prove this point, let us look at the income statement for the year
2002 prepared on replacement cost basis:

Income Statement

Sales Rs.5, 00,000


Cost of goods sold Rs.3, 60,000
Depreciation (2, 40,000/10) Rs.24,000
Selling and Administrative expenses Rs.80,000
Net profit Rs.36,000

From the above statement we find that when the replacement cost basis is used the profit figure for the year
2002 is the same as that of 2001. since the sales of both the years are the same, the net profit margin ratio for
the years, too, is the same.
What about the return on total assets for the year 2002 on replacement cost basis?

To calculate this, we need the 2001 balance sheet prepared on replacement cost basis. This is shown below:

Liabilities Assets

Equity capital Rs.6, 00,000 Net fixed assets Rs.2, 16,000


Retained earnings Rs.36,000 Inventories Rs.3, 60,000
Holding period gains Rs.1, 00,000 Cash Rs.1, 60,000
______________ ______________
Rs.7, 36,000 Rs.7, 36,000

Two items in the above balance sheet need some explanation:


1. The net fixed asset figure of Rs.2, 16,000 is arrived at by adjusting upward the gross fixed asset
value of Rs.2, 40,000 (to reflect the inflation rate of 20 per cent) and subtracting 10 per cent
depreciation from thereon.
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2. The holding period gain comprises an increase in the value of fixed assets (Rs.40,000) and inventory
profit (Rs.60,000) from the FIFO method -- both the gains arise due to inflation in 2001.
Given the above balance sheet, the return on total assets for 2002, based on replacement cost data is:
36,000/7, 36,000 = 4.9 per cent.
Thus, while the net profit margin for 2002 is the same as for 2001, the return on total assets for 2002 is
lower than that of 2001. this is because the denominator, the beginning total assets, is larger for 2002 than
for 2001.

Implications:

The foregoing example shows clearly that in face of differing rates of inflation, financial ratios based on
such rates are vitiated. The vagaries of inflation may create the impression of changes in profitability even
though the underlying economic profitability may remained unchanged.

Inflation may lead to distortions in the inter-firm comparisons as well. In an inflationary environment, when
historical cost data are used, a firm with older assets, other things being equal, will show higher rate of
return on assets. This happens because for the firm with older assets (1) the reported profits are higher as the
depreciation charges are less, and (2) the book value of the assets is lower.

Recognizing that both time-series and cross-section comparisons can be distorted by the effects of inflation,
the financial analyst should exercise caution in analyzing financial statements. It may be advisable,
particularly in a period of rapidly changing inflation rates, to conduct financial analysis on the basis of
replacement cost data. Such an analysis, correcting the distortion of inflation, presents a more accurate
picture of managerial performance.

INFLATION AND CAPITAL BUDGETING:


Inflation has been a persistent feature in the Indian economy. Hence, it should be properly considered in
capital investment appraisal. In practice, however, adjustment for inflation is rarely, if ever, made. The use of
current price structure is deemed satisfactory and reasoning offered runs as follows:

Inflation is expected to raise the revenues and costs of the project in a similar fashion. Hence, net revenues
after adjustment for inflation would e equal to the net revenues in current terms.

The above argument, however, overlooks the following considerations which cause distortion:
1. The depreciation charge is based on historical costs and hence the tax benefit arising from
depreciation charge does not keep pace with inflation
2. the cost of capital used for investment appraisal contains a premium for anticipated
inflation

IMPACT OF INFLATION ON FINANCIAL STATEMENTS


Ans. Same as theory question A-5

IMPACT OF INFLATION ON CORPORATE TAX PLANNING


Ans.
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EXPLAIN THE IMPACT OF THE FOLLOWING FACTORS ON CORPORATE FINANCE
EXPORT INCENTIVES
BACKWARD AREA INCENTIVES
MERGERS & ACQUISITIONS

EXPORT INCENTIVES
Government provides various incentives for exporting companies, which has the impact on their corporate
finance in various ways.

The incentives are in the form of duty drawback, tax holiday (90% exemption), cash subsidy, import license,
easy credit from various institutions…

The impact of these incentives are that the company has to pay no or less tax on the exported goods which
otherwise has to be paid thus save lot of money. The export-oriented company’s also get the facility of duty
drawback, thus save lot of money. The company get import license with ease against the export done by
them. Companies also get cash subsidies against the purchase of fixed assets utilized for producing goods
for the purpose of export. The company will also get easy credit from various institutions against the export
done by the firm.

BACKWARD AREA INCENTIVES


Government provides various incentives for companies (plant) in Backward Area, which has the impact on
their corporate finance in various ways.

The incentives are in the form of duty drawback, tax holiday, cash subsidy, infrastructure facilities at cheaper
rate (electricity, fuel, water, etc), easy credit from various institutions…

The Backward Area Company’s get the facility of duty drawback, thus save lot of money. Companies also
get cash subsidies against the purchase of fixed assets utilized for producing goods. The company will also
get easy credit from various institutions for setup of plant in Backward Area. Plants in Backward Area get
infrastructure facilities at cheaper rate thus reduce their manufacturing cost.

MERGERS & ACQUISITIONS


Impact of mergers & acquisitions on corporate finance are as follows:
a) Company form after merger has higher purchasing ability due to increased capital base.
b) One company absorb the loss of another company and thus save the tax liability.
c) Merged company get the edge over its competitors in the market (national & international).

PROFIT & LOSS A/C AS PER COMPANIES ACT.


Particulars Amount Rs.
Sales 100.00
(-) Cost of Sales 50.00
Gross Profit 50.00
Less: Expenses
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Administrative 10.00
Finance 10.00
Selling & Distribution 10.00
Depreciation 10.00 40.00
Net Profit (Book Profit) 10.00

Less: Transfer to General Reserve 10.00


00.00

Notes

1. Depreciation as per I/T Act is Rs. 20


2. Calculate Book Profit Taxable Income, Tax Payable @ 30 % + 2 % surcharge (including MAT).

Ans.
Book Profit Rs. 10.00
Book Profit Taxable Income Rs. 3.00 (30 % of Book Profit)
Therefore, Tax Payable @ (30 + 2) % = Rs. 0.96
(See concept answer 2 for explanation)
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MERCHANT BANKING & UNDERWRITING
CONCEPT

CLASSIFICATION OF MERCHANT BANKING


•Fees Based Merchant Banking: These banks don’t take Balance Sheet Position i.e. these are only a
service provider or in other words these are channel between two or more parties that comply with each
other’s requirements.
•Fund Based Merchant Banking: These banks take Balance Sheet Position. They initially provide
funds to the client from their own resources in exchange of securities (Bonds, Debentures, Equity...) and
thereafter sell the same to others. These banks function mostly when funds requirement by client is urgent.

BOOK BUILDING
Issues raising over Rs. 100 crore are mandatorily required to go in for book building. Book building is an
auction process where the lead manager invites bids from potential subscribers in a price range. They must
mention the price at which they are willing to buy, and also what quantity they are willing to buy at a given
price. The Book running Managers do complicated calculations to announce an acceptable price. The pricing
is done at the price where the last share is sold and all subscribers pay that amount though they may have bid a
higher price. Investors who don’t want to miss the bus but can’t predict the issue price can bid at cut-off price.
There is also a part earmarked for small shareholders in the book built portion and also a public issue for the
retail investors later.

It is the prospect of a better valuation and getting a good price for its share offer to the public and eventually
getting shares listed on the stock market that attracts companies to the book building process. Earlier, the
normal route of issuing shares was to quote a fixed offer price and throw open the issue to the public to
subscribe. If the public liked the price, they lapped the issue up. If they did not the issue would be under
subscribed and chances were that the issuing company would not be able to garner money to finance its plans.

The book building exercise is basically a new method of pricing initial public issues above Rs.100 crore. Thus
according to SEBI guidelines, Smaller sized issues, are not allowed to take the route. They will have to take
the conventional route, as mentioned.

Book Building is of two types –


75% book building
100% book building
In the 75% book building exercise, 75% of the IPO will be through book building and 25% will be through a
separate issue. That is after the company completes raising 75% of the initial public issue through the book-
building route, it will come out with a separate issue for the remaining 25%.

According to SEBI rules at least 15% and 25% of the issue must be offered to the non-institutional investors
and retail investors respectively.

Book Building Route


The company first appoints lead manager for the issue. Lead managers are basically merchant bankers, who
evaluate the issue and based on this they decide the likely price that the company will be able to fetch for
each share from the primary market. The lead managers thus manage and market the issue for the company.
Further they may also act as underwriters to the issue or they appoint underwriters institutions as
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underwriters to the issue. The function of underwriters is to give an undertaking to the company to take up
all the un-subscribed shares of the public issue.
In return for their services and the risk they take they get a percentage of the proceeds of the issue. Further
the lead manager has also to see that all the shares offered for the public issue are subscribed to as he has an
undertaking to buy out those shares, which remain un-subscribed.

The company in consortium with the lead manager prepares the offer document for the issue and gets it
approved from SEBI (Securities and Exchange Board of India).

Any modification made by SEBI has to be incorporated by the lead manager in the draft prospectus.

After making the modifications in the prospectus if any directed by SEBI the company invites applications
from the public. The company has to place advertisements for the issue in not less than three newspapers
viz., a national English daily, a national Hindi daily and in the regional language daily of the city or town
where its registered office is situated.

The advertisement should mention the bid opening and closing date. Bidding shall be permitted only if an
electronically linked transparent facility is used. All the SEBI guidelines have to be adhered to in case of
inviting bids. Bids are accepted up to a minimum of five working days. Further the bidding centres are not
less than the collection centres.

The main difference between the conventional route of IPO and the book-building route is the pricing of the
issue. In case of the conventional issue the price was fixed by the issuing company and the lead manager and
than applications were invited on the basis of this price. In other words the applicants to the public issue
were required to pay the fixed price mentioned in the prospectus for each share.

On the other side in the case of book building, applications are invited on the basis of the likely price
decided upon by the company and lead manager. This likely price is just an estimate of the share price from
the issue. The price of the share is not fixed. No upper limit or lower limit is set. However one factor that
has to considered is that the issue price for the placement portion and offer to the public has to be the same.

The price of each share is decided upon the bids received. The price at which all the shares open for issue
are subscribed is decided as the issue price. The net offer to the public is to be made post book building
within a maximum period of 15 days. In the case of under subscription in the ‘net offer to the public’, spill
over from the ‘placement portion’ will be permitted. This will be entitled to only those who have opted for
this facility in the bid offer form. Preference will be given to individual investors. The vice-versa case is also
permissible.

The applicants who have bid less than the issue price will be refunded their application money within 15
days from the bid closing date. Also bidders who have bid above the issue price will be refunded the surplus
application money within the same period.

Bidders who have quoted the issue price or a higher price will be allotted shares within the specified period.
Allotment of securities offered to the public shall be made within 30 days of the closure of public issue. The
company has to pay at 15% per annum interest if the allotment letters / refund orders have not been
despatched to the applicants within 30 days from the date of the closure of the issue.

In case of over subscription, allotment to non-institutional investors will be made on pro-rata basis.
However, for institutional investors the allotment will be on discretionary basis.

Finally, after complying with all the above formalities shares are listed on the stock exchange. At this point the
underwriter or lead manager puts in an order on the stock exchange to buy back any amount of shares at the
allotment price. This order stays open for normally a week. The idea behind this requirement is to force the
lead manager to disclose the right price and set a benchmark price at which there are no sellers.
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Advantages
The book-building route is favoured as compared to the conventional fixed price route by companies as they
can get a better price for their issues by highlighting their earnings estimate. A company has the opportunity to
base its price on its expected valuations. Here it enjoys the chance of getting a better than expected price for
its shares. The lead manager will also try to get a better price for the shares as his earnings will be based on the
price of the shares.

All said and done the price of the issue will be based mainly on the assumption that the shares will be traded
in the secondary market at a price higher than the allotment price of the issue. Thus if the company is doing
well presently and offers a justifiable price earning ratio at the likely price of the issue, the turnout of the issue
will be successful. The investors will only subscribe to the shares, if they expect the price of the shares to rise
in the future so they can get good returns.

Investors who are ready to pay a higher price for the issue expecting a higher return in the future enjoy an
advantage in the book-building route. Here the chances of their getting the required number of share allotment
are more as compared to the fixed price route. In the fixed price route, as all share applicants quote the same
price for shares, the above stated shareholders receive only a pro rata allotment that is just a proportion of the
shares they have applied.

However for companies, which are going through a slowdown phase or have no valued background to count
on, the book-building route could be risky. It may in most cases result in lower than expected price for its
public issue.

Thus the book building IPO route with the passage of time should become the most sought after route for
companies, which can justify their issue prices with proper valuations. Also this will be favourable for
investors with good pricing power. However, this leaves small investor’s at a disadvantage with limited
pricing power.

BOUGHT OUT DEALS


It is a process by which an investor (usually the investment banker) buys out a significant portion of the equity
of an unlisted company with a view to make it public within an agreed time frame. In a bought-out deal, a
promoter off loads the security, which is to be issued to the public to raise finance, to a Member of OTCEI.
The Member takes up this equity at the price fixed after a thorough appraisal of the company. He then offloads
the equity, at a convenient time, to the public through an ‘Offer for Sale’.

PRIVATE PLACEMENT
A private placement is a private sale of unregistered securities by a public company to a select group of
individuals or institutions. It is a type of offering exempted from registration that allows the issuing company
to avoid registration requirements and save underwriting fees by offering company shares directly to
institutional and accredited investors.

Because the securities sold in a private placement are not registered, they cannot be re-sold into the public
market until a registration statement has been filed and declared effective. To compensate for the inability to
sell the securities immediately, private placement securities are often issued at a discount or are structured to
provide the investors certain protections against decreases in the common stock price.

The distinctive features of a private placement are:


1. There is no need for a formal prospectus and an underwriting arrangement.
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2. The terms of the issue are negotiated between the company and the investor.
In the private placement market in India, securities are sold mainly to institutional investors like UTI, Mutual
Funds, LIC, etc. All available instruments like equity shares, preference shares, convertible debentures, etc
may be privately placed.

Private placements are sometimes seen as negative because of the price that the company pays to obtain the
capital. The biggest concern with private placements is dilution. This concern is basically that the financing
will cause too many shares of the company to be sold into the market relative to the current number of issued
and outstanding shares.

Some transactions are structured so that the investor may convert and sell his shares at a discount to the future
market price of the common stock. With these transactions, the theoretical dilution is enormous because the
investor can convert no matter how much the stock price decreases in the future. Another important concern is
discounting. Many private placement investments provide the investor with a discounting feature, to
compensate it for the temporary illiquidity of the private placement securities. However, some discounts are
simply too large relative to the holding period of the investment, leaving shareholders to wonder why they are
holding stock at current prices when the private placement investors are able to buy the stock at lower levels.

Types
Private Placement securities can take many forms. The most basic is a Common Stock placement that is sold
at some set discount or premium to the market price at closing. This type of structure may also include
warrants that let the private placement investor purchase more stock at a set premium price for a period of
time. Another basic structure is the Fixed Convertible security (either Preferred Stock or Debt). These
securities yield a current return through interest or dividends and can be converted by the investors into shares
of the company’s common stock at a set price (usually at some premium to the market price at closing).
Private Placements structured in either of these basic structures are usually considered a good sign for the
public company. They convey that the private placement investors believe in the company's prospects for the
long term and are willing to take on market risk with their investment.

Criteria to be satisfied
Some of the important conditions that a company should satisfy in order to be acceptable to institutional
investors are –
1. The net worth of the company should be at least Rs. 1 crore.
2. The interest cover should be at least two times, as per the latest balance sheet.
3. The asset cover should be at least 1.25.
4. The company should have paid dividends for at least two years in the preceding three years.
5. In the case of a listed company, the stock price should be above par for six months prior to the issue.

INITIAL PUBLIC OFFER


An initial public offering (IPO) is the process through which a company makes the transition from a
privately held entity to a public company with stock traded on one of the major stock exchanges. It is a
source of collecting money from the public for the first time in the market to fund for its projects. Typically,
a company going through an IPO is young and relatively unknown; therefore IPOs generally are considered
riskier investments. However, established private companies occasionally decide to ‘go public’ in order to
raise more capital.

The issuing company (i.e., the company going public) needs the assistance of an investment bank -- referred
to as the ‘underwriter’ -- to price and market its stock offering. Banks compete for the issuing company's
business during a process known as the ‘beauty contest’ in which they present their credentials to the
company's board of directors and assess a preliminary valuation of the company. If the issuing company is
new and relatively unknown, the banks often make valuations based on the company’s competitors.
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The issuing company generally chooses an investment bank based on its underwriting experience,
particularly with IPOs in the same industry. Another consideration for the issuing company is the credibility
of the investment bank's research analyst, who issues reports on the company throughout the year.

The issuing company can give its business to more than one underwriter, in which case the bank that
manages the IPO becomes known as the ‘lead underwriter’ and the group of banks participating in the deal
are called the ‘syndicate’.

A prospectus has to be duly prepared. The prospectus includes the company’s financial history and growth
strategy, the details of its offering, and information on company management. It also outlines industry
competition and other risk factors that investors would want to know in advance. In essence, the prospectus
provides all of the information investors need to know in order to decide whether to participate in the IPO.
The preliminary prospectus is also known as a ‘red herring’ because of the red ink used on the front page,
which indicates that some information -- including the price and size of the offering -- is subject to change.

An essential part of the issuing company’s marketing campaign is the ‘road show’, which is a multi-city tour
during which the company pitches its business plan to potential investors, usually institutional investors such
as mutual funds, endowments, or pension funds. At these meetings, the underwriter attempts to gauge the
level of interest in the IPO, which helps lead to a decision on how to price the stock offering.

During and after the road show, in a process known as ‘book-building’, the lead underwriter surveys
potential investors and notes the interest in the stock so it can price the IPO accordingly. The issuing
company and the lead underwriter meet to set the ‘offering price’ and the number of shares to be issued at
the offering, based on the expected demand for the stock.

For the investment bank, the objective is to balance the company’s desire to price the stock so as to raise as
much money as possible and the investors’ interest in gaining some financial reward for taking on the risk of
investing in a company with an unproven public track record. Each bank in the syndicate receives a certain
number of shares to allocate to its clients.

IPO Terminologies
Conditional Offer: An offer to purchase securities depending upon the effectiveness of a registration
statement and the pricing of an IPO.
Direct Public Offer: Offering of securities directly by an issuer without the assistance of any Investment
Banking firm.
Minimum Subscription: The minimum shares the company needs to get from the public out of the total
issue by the date of closure. Presently a company needs to raise 90% of the issued amount; else, the
company shall refund the whole amount received.
Prospectus: The official offer document included in the registration statement filed with SEBI in
conjunction with a public offer. The prospectus contains information about the offer of securities and should
be given to the original purchasers no later than the written confirmation of their purchase.
Underwriter: An investment banking firm, which enters into a contract with the issuer of new securities to
distribute them to the investing public.
THEORY QUESTIONS
A) & B) FUNCTIONS AND SERVICES OF MERCHANT BANKS:
1. Consultancy services: Offers valuable consultancy services to their clients on financial, managerial,
technical, marketing and many other problems.

2. Government consent: Help their clients in completing lengthy legal formalities for securing
government consent or license for setting up a new venture or for expansion or modernization of
business.
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3. Project planning and feasibility study: Collect necessary information about the project and
prepares project report with the help of their expert staff.

4. Raising financial resources: Prepare financial plans on behalf of their clients and conduct
negotiations with financial institutions and get loans approved on favorable terms and conditions.
Also in a position to raise foreign currency for importing machinery and technical know how.

5. Issue management: Manages capital issues on behalf of their clients and provide finance to them.
This includes preparation and issue of prospectus, appointment of bankers, underwriting
arrangement, press publicity etc.

6. Portfolio management: Offer advice to their clients on investment in government securities, trust or
charitable institution. Undertake purchase and sale of securities and management of individual
investment portfolio of investors.

7. Advice on expansion programme: Assistance offered in framing and executing expansion and
diversification programmes systematically.

8. Loan syndication: Foreign currency loans have to be arranged from Indian financing agencies and /
or foreign financial institutions. Merchant bankers help in co coordinating above, drafting
agreements etc.

9. Corporate restructuring: Offer professional expertise in identifying the buyers/sellers, handling the
negotiations, processing the documents etc. when a company plans to acquire a new company or
when a group wants to disinvest and sell one of the units.

10. Revival packages for sick units: Provide for rehabilitation of sick units. Participate in negotiation
with BIFR and consortium meetings of banks and financial institutions.

SEBI has laid down following authorized activities of Merchant bankers:


•Issue management
•Corporate advisor
•Underwriting
•Portfolio management Services
•Managers, consultants or advisors.

11. Miscellaneous Services:


•Arrange finance for working capital need of business units.
•Arrangement of lease finance.
•Assistance in securing foreign collaborations.
•Help in framing capital structure and financial plan.
•Recruitment, selection and placement of managerial and technical staff.

C) DISCUSS THE ROLE OF A MERCHANT BANKER IN THE FOLLOWING:


 Instrument designing and pricing:
A cardinal principle of corporate finance is to maintain a proper proportion between public issue and
loan capital to increase the rate of return on capital employed. It is always a wise step to help the
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quantum of share capital higher than the loaned funds. The debt-equity ratio has to be considered for this
purpose for having a balanced mixture of owned/and loaned capital. Expert advice should be obtained
from the auditors/financial controller/legal advisers and stockbrokers of the company. The norms fixed
for this purpose by the stock exchange/controller of capital issues should also be taken into account. The
proportion of various types of funds has, therefore, be in optimum mix.
 Right issue / Bonus issue
The merchant’s bank work would also relate to advice to the companies on any right issue or bonus
issue. They may advice on the documents needed, size of bonus issues or right issues, the need for
underwriting & the institutions to underwrite, the terms & other necessary actions with regard to the
issues of rights & bonus shares.
 Private placement
When the financial institutions directly subscribe to the equity/preference shares &/or debentures issued
by the company the company is said to have privately placed these securities with the financial
institutions. This does not require either a prospectus or letter of offer. The company could, if it so desires,
approach, in the place of financial institutions, a well identifiable body of persons like merchant banks for
private placement. Merchant banks help these companies to privately place their securities.
 Lead manager/lead bank
Lead managers/merchant bankers would be responsible for ensuring timely refunds and allotment of
securities to the investors.
 Management of Public Issues:
Same as theory no. d

D) WHAT ARE THE PRE-ISSUES AND POST ISSUE FUNCTIONS?


Pre issue functions are as follows:
I. Capital Mix Structure: A cardinal principle of corporate finance is to maintain a proper
proportion between public issue and loan capital to increase the rate of return on capital employed.
It is always a wise step to help the quantum of share capital higher than the loaned funds. The debt-
equity ratio has to be considered for this purpose for having a balanced mixture of owned/and
loaned capital. Expert advice should be obtained from the auditors/financial controller/legal
advisers and stockbrokers of the company. The norms fixed for this purpose by the stock
exchange/controller of capital issues should also be taken into account. The proportion of various
types of funds has, therefore, be in optimum mix.
II. Deciding about type of securities to be issued: There are various types of shares and debentures,
which can be issued by a company. It is therefore, prudent to decide at first as to what type of
shares/debentures the company would like to issue with special reference to the Memorandum/and
Article of Association of the company.
III. Permission of SEBI: At this stage, necessary permission for issue of capital/exemption etc. has to
be obtained from SEBI.
IV. Preparation and Issue of Prospectus: The Board of Directors is to decide through passing of
resolution as to whether the work relating to the preparation and issue of prospectus is to be
entrusted to some officers of the company or the services of some professional firms are to be
availed of. Much will depend on the size and nature of public offer.
V. Printing and publicity of Prospectus: When the prospectus is properly drafted and approved,
then arrangement should be made for printing of required copies of it by entrusting the job to a
reputed firm of printers. After getting the required copies of the prospectus printed, announcement
of the public offer should be made in the leading newspapers at least seven days before the opening
of subscription list.
VI. Appointment/negotiations with Underwriters/Brokers and Bankers: For getting the issue
underwritten, necessary negotiations should be held with banks and other financial institutions. In
this connection the services of stockbrokers may also be obtained as they can underwrite a
substantial sum. The parties with whom negotiations are to be made must be supplied with the
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copies of the printed prospectus and their comments are obtained. When the things are settled with
the underwriters/brokers/and the bankers then necessary agreements should be executed in between
the parties and their consent letters be kept on records.
VII. Receipt of Application from the Bankers: The Registrars to the issue or the company as the case
may be, will arrange for the scrutiny and proper classification of the applications before making
allotment. In case of under subscription, full allotment can be made only after the underwriters
have subscribed upto the remaining extent. In case of over subscription, the basis has to be got
approved from the stock exchange.
VIII. Arrangement for issue of shares: After completing the process of allotment of shares
arrangement has to be made for the issue of share certificates to the concerned allottees.

Post issue functions:


I. Proper scrutiny and segregation of share applications received,
II. Furnishing of necessary information to the concerned stock exchange(s) and obtaining permission for
basis of allotment.
III. Making out a list to be submitted to board of Directors for allotment purpose,
IV. Preparing share certificates in the names of the allottees and obtaining the signature of the authorized
signatories on the certificates, and
V. Dispatching of shares certificates to the allottees and preparation of the register of members.

F) DISCUSS THE REGULATORY FRAMEWORK FOR MERCHANT BANKING?


The following are the SEBI guidelines for merchant bankers –
1. Authorisation
Any person or body proposing to engage in the business of merchant banking would need
authorisation by the Securities and Exchange Board of India
(SEBI) in their prescribed format. This will also apply to those presently engaged in merchant banking
activity, including as managers, consultants, or advisers to issues.

2. Authorised activities
(a) Issue of management, which will inter-alia consist of preparation of prospectus & other information
relating to the issues, determining financing structure, tie-up of financiers & final allotment &/or refund
of subscription
(b) Corporate advisory services relating to the issue
(c) Underwriting
(d) Portfolio management services
(e) Managers, consultant or adviser in the issue

3. Authorisation criteria
All merchant bankers are expected to perform with high standards of integrity & fairness in all their dealings.
A code of conduct for merchant bankers will be prescribed by SEBI. Within this context, SEBI’s authorisation
criteria would take into account mainly the following-
(a) Professional competence
(b) Personnel, their adequacy & quality, & other infrastructure
(c) Capital adequacy
(d) Past track record, experience, general reputation & fairness in all their transaction

4. Terms of authorisation
(a) All merchant bankers, including the existing ones, must obtained the authorisation from SEBI within
three months from the issue of these guidelines.SEBI may extend this period at its discretion by a
maximum of three more months .
(b) All merchant bankers must have a minimum net worth of RS 1 crore
(c) The authorisation will be for a initial period of 3 years
(d) SEBI may collect from the merchant bankers an initial authorisation fee, an annual fee & a renewal fee
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(e) All issues must be managed by atleast one authorised banker functioning as the sole or lead manager.
Ordinarily not more than two merchant bankers should be associated as lead managers, advisers or
consultants to a public issue
(f) The specific responsibilities of each lead manager must be submitted to SEBI prior to the issue
(g) While directors, promoters & every person who authorises the issue of prospectus shall bear full
responsibility for the contents of the prospectus, merchant banker shall exercise due diligence
independently verifying the contents of prospectus & reasonableness of the views expressed therein
(h) To ensure a direct stake of merchant bankers in the issue managed by them, lead managers would be
required to accept a minimum 5% underwriting obligation in the issue, subject to a ceiling .
(i) Lead managers/merchant bankers would be responsible for ensuring timely refunds and allotment of
securities to the investors .
(j) The involvement of the merchant banker in an issue should continue atleast till the completion of
essential follow- up steps, which must include the listing of the instrument, & dispatch of certificates
(k) The merchant banker shall make available to SEBI such information, documents, returns & reports as
may be prescribed & called for.
(l) SEBI shall prepare & prescribe a code of conduct for merchant bankers which they should adhere to
(m)SEBI may suspend/cancel the authorisation of merchant bankers for a suitable duration in case of
violations of the guidelines.
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EQUITY CAPITAL – SOURCE OF FINANCE
INTERNAL FUNDS – SOURCE OF FINANCE
DIVIDEND POLICY & RETENTION
MODELS OF DIVIDEND POLICY
To distribute dividend or not is a debatable issue. A person investing in shares for fixed income will always
want dividend while a person investing in the shares for capital gains will deem it indifferent. There have been
many theories/arguments as to whether distribution of dividend is really important or not. Some of them are as
follows:

Walter’s Model:

Argument: A firm’s dividend policy will be determined by the relationship between the return on
investment (ROI) and the expected rate of return.

Assumptions:
1. All financing through the retained earnings; no external source.
2. With additional business undertaken, firm’s business risk wont change. Thus, ROI (r) and required
rate of return on capital (k) are constant.
3. There’s no change in key variables, which are E and D.
4. Perpetual life of the firm.

Justification: The firm would have an optimum relation of r and k i.e. if r > k, then the firm will retain
earnings. But if r < k then the firm would distribute dividend so that shareholders can earn some ROI
from elsewhere. If r = k, it becomes matter of indifference.

Gordon’s model:

Argument: Being risk averse, an investor will always prefer present income to future income.

Assumptions:
1.Firm is an all equity firm.
2. ROI (r) and expected rate of return on capital (k) are constant.
3. Firm has perpetual life.
4. The retention ratio is constant.
5. Growth rate is constant and is less than expected rate of return on capital (k).
6. Investors are risk averse.
7. They put premium on certain investments and discount on uncertain.

Justification: ‘Bird in the hand is worth two in the bush.’ --- is the bottom line of this argument.
If investors are risk averse, the rational investors in general would prefer dividend - they’ll avoid risk.
The payment of current dividend removes any chance of risk. If firm retains earnings, dividends
obviously will be received in future. Future dividend is uncertain. Thus the rational investors will prefer
current dividends, and discount future dividends.
The argument that deems dividends to be irrelevant is the famous MM Model.

MM Model (Modigliani and Miller Model):

Argument: Dividend policy has no effects on share price of a firm and is therefore of no consequence.
What matters is the investment policy through which the firm can increase its earnings and therefore
t6he value of the firm.
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Assumptions:
1. Perfect capital markets i.e. all investors are rational, information is available to all, free of cost, there
are no transactional costs, securities are infinitely divisible, no floatation costs, etc.
2. No taxes or no difference in tax rates applicable to dividends and capital gains.
3. Firm has a given investment policy which does not change i.e. risk extent will be constant.

Justification: If a company retains earnings instead of giving it out as dividends, the shareholder enjoys
capital appreciation, which is equal to the amount of earnings retained. If it distributes dividends, the
shareholder will enjoy dividend in amount by which capital would have appreciated had the company
retained its earnings. Thus it’s quite irrelevant whether dividend is given or not.

LEGAL AND PROCEDURAL ASPECTS OF DIVIDEND

Dividend can be defined as:


A cash payment using profits that’s announced by a company’s Board of Directors to be distributed among
the stockholders.
Conceptually, dividends may be in the form of cash, stock or property. The Board of Directors must
declare all dividends.

Through the stocks, an investor can make income either through the capital gains or through the periodic
dividends. A company announces dividend either quarterly, semi- annually or yearly. Thus it is a steady
periodic source of income. It is in the proportion to the share of capital, which the investor actually holds in
the company. Though dividend is usually offered, it is necessary to note that a company is under no
obligation to pay the dividends. It may or may not pay the dividends. Even if it pays; there is no set level
as to the payment of dividend. That is there is no minimum or maximum limit on the amount of dividend
that can be paid.

Most often, the dividend comes in the form of cash: a company will pay a small percentage of its profits to
the owner of each share of stock. However, it is not unheard of for companies to pay dividends in the form
of stock. Dividends can be determined by a fixed rate known as preferred dividends, or a variable rate
based on the company's latest profits known as common dividends.

Usually, amount of profit made is announced in the AGMs or quarterly/semi-annual result. The company
declares amount of dividend on each share (Usually as percentage of face value). At this point of time, the
BoD announces that ‘ The dividend of the set amount will be paid to shareholders of record as of the record
date and will be paid or distributed on distribution date’.

Record date is a concept to enable proper distribution of dividend.


A company issues shares, and once it starts operating, the shares begin to be traded in the stock market. Thus
ownership of a single share might pass even 1000 hands within a year. Thus at the time of distributing
dividends it would have been very difficult to determine the exact owner of a share, if concept of ‘Record
Date’ wouldn’t have existed. A company usually maintains record of its shareholders. It declares a date
called ‘Record Date’, prior to which all the transferred names have to be entered into the company’s records.
The company will give dividends only to those investors whose names are found in company’s records on
the record date. Thus even if share is sold on the day after record date, the concerned seller-investor will
receive the dividend.

This is done because a dividend payout automatically reduces the value of the company (it comes from the
company's cash reserves), and the investor would have to absorb that reduction in value.
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Dividend is quite unpredictable; but a trend might be deciphered studying past pattern, future expectations,
industry trends etc.
On the distribution date, which as the name suggests is the date when dividends are distributed, the
shareholders on record as on record date will be mailed cheques.

The legal aspects of dividend distribution in the Indian Context (As per company law) are as follows:
1. Companies can pay only cash dividends (with the exception of bonus shares).
2. Dividends can be paid only out of the profits earned during the financial year after providing for
depreciation and after transferring to reserves such percentage of profits as prescribed by the law.
The companies (Transfer to reserves) Rules, 1975, provide that before dividend declaration a
percentage of profit as specified below should be transferred to the reserves of the company.
• Where the dividend proposed exceeds 10% but not 12.5% of the paid up capital, the amount
to be transferred to the reserves shall not be less than 2.5 % of the current profits.
• Where the dividend proposed exceeds 12.5% but not 15%, the amount to be transferred to
reserves shall not be less than 5% of the current profits.
• Where dividend proposed exceeds 15% but not 20%, the amount to be transferred to the
reserves shall not be less than 7.5% of the current profits.
• Where the dividend proposed exceeds 20% , the amount to be transferred to reserves shall not
be less than 10%.
3. Due to inadequacy or absence of profits in any year, dividend may be paid out of the accumulated
profits of previous years. In this context, the following conditions as stipulated by the companies
(Declaration of Dividends out of reserves) Rules, 1975, have to be satisfied:
• The rate of the dividend declared shall not exceed the average of the rates of which dividend
was declared by it in 5 years immediately preceding that year or 10% of its paid up capital,
whichever is less.
• The total amount to be drawn from the accumulated profits earned in the previous years and
transferred to the reserves shall not exceed an amount equal to one-tenth of the sum of its
paid up capital and free reserves and the amount so drawn shall first be utilized to set off the
losses incurred in the financial year before any dividend in respect of preference or equity
shares is declared.
• The balance of reserves after such drawal shall not fall below 15% of its paid up capital.
4. Dividends cannot be declared for past years for which the accounts have been closed.

RETAINED EARNINGS AS A PRUDENT INVESTMENT POLICY:


DRIPs: These days, because of lack of investment initiatives, industries are encouraging the investors to
reinvest their dividends. The concept is called DRIP or the Dividend Re-Investment Plan. As per this plan,
the shareholder will be given choice of accepting dividend or reinvesting it. If he/she opts for the latter, his
dividend is credited to his /her individual DRIP A/c and the equivalent shares will be allotted to him.

To pay or not to pay: Since the company is under no obligation as to payment of dividend, ‘Should a
company pay dividend’ is an important issue of discussion. In general it can be said that the younger
companies in growth markets are far more likely to pay a small or no dividend so that they can find further
expansion. In contrast, more mature companies in slower growing markets are likely to pay higher dividends
because they do not have opportunity to invest in the expansion.

Thus regular dividends are paid out to make holding the stock more appealing to investors, a move the
company hopes will increase demand for the stock and therefore increase the stock's price.
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FACTORS EFFECTING DIVIDEND POLICY:
Following reasons result into payment of dividends.
• Investor Preference for dividends: If taxes and transaction costs are ignored, dividends and capital
receipts could be perfect substitutes. Yet, according to Hersh Shefrin and Meir Statman principles of
self-control and aversion for regret lead to investor preference for dividends.
o Self Control and dividends: Individuals often lack self-control. So they rely on rules and
programmes, which check their temptations. In the realm of personal financial management,
individuals like to protect their principal from their spending tendencies. A simple way to do
this is to limit their spending to the dividend income so that the capital amount is maintained
intact.
o Aversion to regret and dividends: Although the dividend and the capital receipts are perfectly
substitutable, when taxes and transaction costs are abstracted away, empirical evidence
suggests that most people feel more regret when they sell the stock because they can readily
imagine the consequences of that action.
• Information Signaling: Management often has significant information about the prospects of the
firm that it cannot (or prefers not to) disclose to the investors. The information gap between
management and shareholders generally causes stock prices to be less than what they would be under
conditions of information symmetry. According to signaling theory, these firms need to take actions
that cannot be easily imitated by firms that do not have such promising projects. One such action is
to pay more dividends. Increasing dividends suggest to the market that the firm is confident of its
earning prospects that will enable it to maintain higher dividends in future as well. By the same
token, a decrease in dividends is perceived as a negative signal, because firms are reluctant to cut
dividends. This leads to consequent drop in stock prices.
• Clientele Effect: Investors have diverse preferences. Some want more dividend income; others want
more capital gains; still others want a balanced mix of both. Over a period of time, investors
naturally migrate to the firms, which have a dividend policy that matches their preferences. The
concentration of investors in companies with dividend policies that are matched to their preferences
is called clientele effect. The existence of clientele effect implies that: A) Firms get the investors they
deserve and B) It will be difficult for firm to change an established dividend policy.

PAYMENT OF DIVIDENDS VS. ISSUE OF BONUS SHARES


WHY DO INVESTORS HAVE STRONG PREFERENCE FOR DIVIDEND RATHER THAN
BONUS SHARE?
IN A CLOSELY HELD CO. IS IT PREFERRED TO ISSUE BONUS SHARES OR DIVIDENDS?

A dividend is a portion of a company's earnings that is returned to shareholders. Dividends provide an added
incentive (in the form of a return on the investment) to own stock in stable companies even if they are not
experiencing much growth. Many companies -- mature and young, large and small -- pay a regular dividend
to their stockholders. Companies use dividends to pass on their profits directly to their shareholders.
Dividend can be defined as follows.

A cash payment using profits that’s announced by a company’s Board of Directors to be distributed among
the stockholders.

In other words, dividends refer to a part of the firm’s net earnings, which is paid to the shareholders. Net
earnings mean the profit remaining after the payment of interest and taxes (PAT), some part of this may be
transferred to the reserves and surpluses, while the remaining part is usually distributed as dividend. The
shareholders are the actual owners of the company and should therefore get a return on the investment made
by them.

Through the stocks, an investor can make income either through the capital gains or through the periodic
dividends. A company announces dividend either quarterly, semi- annually or yearly. Thus it is a steady
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periodic source of income. It is in the proportion to the share of capital, which the investor actually holds in
the company. Though dividend is usually offered, it is necessary to note that a company is under no
obligation to pay the dividends. It may or may not pay the dividends. Even if it pays; there is no set level
as to the payment of dividend. That is there is no minimum or maximum limit on the amount of dividend
that can be paid.

As mentioned earlier, the dividend can be paid out either quarterly, semiannually or even annually. Sometimes,
the companies may also declare an extra or special dividend, usually to share profits made due to some
temporary changes in the market, or on special occasions in the company-genesis (E.g.: HDFC completing 25
years).

Most often, the dividend comes in the form of cash: a company will pay a small percentage of its profits to
the owner of each share of stock. However, it is not unheard of for companies to pay dividends in the form
of stock. Dividends can be determined by a fixed rate known as preferred dividends, or a variable rate
based on the company's latest profits known as common dividends.

Bonus Shares are the shares issued top existing shareholders as a result of capitalization of reserves. In the
wake of a bonus issue:
• The shareholders’ proportional ownership remains unchanged.
• The book value per share, the earnings per share, the market price per share decrease, but the number of
shares increase.
Following are the reasons for issue of bonus shares.
• The bonus issue tends to bring the market price per share within a more popular range.
• It increases the number of outstanding shares. This promotes more active trading.
• The nominal rate of dividend tends to decline. This may dispel the impression of profiteering.
• The share capital base increases and the company may achieve a more respectable size in the eyes of
investing community.
• Shareholders regard a bonus issue as a firm indication that the prospects of the company have brightened
and they can reasonably look for increase in total dividends.
• It improves the prospects of raising additional funds. In recent years many firms have issued bonus
shares prior to issue of convertible debentures or other financing instruments.
Thus the motives differ as regards to the issue of bonus shares and payment of dividends.
Since compared to receipt of dividends, receipt of additional stock is a risk. Hence investors do not prefer it.
Similarly, in case of a closely held company, since no active trading occurs, there is no point in increasing
the investor liquidity. Thus practice of issuing bonus shares is rarely followed in a closely held company.

TYPES OF DIVIDEND POLICIES


• Generous Dividend and Bonus Policy: Such firms reward shareholders generously by stepping up total
dividend payment overtime. Typically, these firms maintain the dividend rate at a certain level (15-25%)
and issue bonus shares when reserves position and earnings potential permit. Such firms naturally have a
strong shareholder orientation.
• More or less fixed dividend policy: Some firms have a target dividend rate which is usually in the range
10% to 20% which they consider as a reasonable compensation to equity shareholders. Such firms
normally do not issue bonus shares. Infrequently, may be once in a few years, the dividend rate may be
slightly raised to provide somewhat higher compensation to equity shareholders to match the higher
returns from other forms of investment.
• Erratic dividend policy: Firms which follow this dividend policy seem to be indifferent to the welfare of
equity shareholders. Dividends are paid erratically whenever management believes that it will not strain
its resources.
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CONCEPT TESTING:

SOURCES OF INTERNATIONAL FINANCE


The integration and associated globalisation of capital markets has opened up a vast of array of new sources
and forms of financing. The corporate treasurers in the present day can access foreign capital markets as
easily as the domestic ones.

EQUITY FINANCING – Equity refers to a share in the ownership of the company.


The firm might issue equity shares simultaneously in two or more countries. Such issues are known as
euroequity shares.
Equity can be raised in the form of ADR’S and GDR’s.

ADR’s – A significant portion of public offerings by non-US companies in the US is in the form of ADR’s
or American Depositary Receipts. ADR’s are negotiable instruments issued to investors by an authorised
depositary, normally a US bank or depositary, in lieu of the shares of the foreign company, which are
actually held by the depositary. ADR’s can be listed and traded in a US –based stock exchange.
Equity can be raised from the non US market by way of GDR’s. GDR’s or Global depositary receipts are
listed in a stock exchange other than American Stock exchange.

BOND FINANCING –
A corporate bond is a debt instrument indicating that a corporation has borrowed a certain amount of money
and promises to repay it in the future under clearly defined terms.
Foreign bond – A foreign bond is a bond sold in a foreign country in the currency of the country of
issue.For example, A canadian company selling a foreign bond in New York, denominated in dollars.
Eurobond – A eurobond is a bond issued that is denominated in a currency that is not that of the country in
which it is issued. For example, a US denominated band sold outside US.

BANK FINANCING AND DIRECT LOANS


A major part of financing of foreign subsidiaries is also done by its parent company. When a subsidiary
borrows from its parent, there is transfer of funds within the MNC and thus there is no increase in the cost
of bankruptcy. The subsidiary is able to deduct its interest payments from income (debt being tax-
deductible), while the parent treats the interest as income.

GOVERNMENT AND DEVELOPMENT BANK LENDING


Financing is also done by government or development banks. Because Government and development bank
financing is generally at favourable terms many corporations consider these official sources of capital before
considering the issue of stocks, bonds, etc. Host Government of foreign investments provide financing when
the projects are likely to generate jobs, earn foreign exchange or provide training to their workers.

STATE REASONS FOR USING INTERNAL FUNDS AS A SOURCE OF FINANCE.


Many companies use retained profit as a source of finance. Instead of paying dividends to shareholders &
borrowing funds from outside, Profit After Tax can be used as capital or a source of finance OR a part of
Profit After Tax can be used for payment of dividends & remaining can be used as internal funding. Terms
like, retained profits, retained earnings & internal funding indicate same thing. Following are the reasons for
using internal funds as a source of finance:
• Non-expensive – Retained earnings are self-evidently the cheapest form of finance. No interest is
charged on retained earnings & at the same time, no shares are issued. As a result, there are no
professional fees to be paid.
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• No change of ownership – Normally, existing owners of the business are reluctant to transfer the
ownership in the new hands. Due to internal funding, ownership remains with existing managers.
• Time – Reputed companies can get loans quite easily. But it takes several months to attract a suitable
equity partner. A detail study of capabilities of equity partner is required. It should also be kept in the
mind that chosen equity partner has to show interest in the company.
• Exit strategies – Normally, private equity investors require an exist within three to five years. This
means after every three to five years, company is bound to choose a new equity partner.
• History – History shows that companies which are looking to build a substantial size over a 10 to 15
years period & want to retain control & ownership of the original shareholders & management team,
retained earnings is the best source of finance.

EVALUATE INTERNAL FUNDS AS A SOURCE OF FINANCE.


Instead of paying dividends to shareholders & borrowing funds from outside, Profit After Tax can be used as
capital or a source of finance OR a part of Profit After Tax can be used for payment of dividends & remaining
can be used as internal funding. Terms like, retained profits, retained earnings & internal funding indicate
same thing. According to history, internal funding is used for a steady growth over a period over 10 to 15
years. On internal funding, no professional fees have to be paid. Company need not go for the search of the
private equity partner & at the same time, control & ownership are retained by existing partners &
shareholders.

On opposite side, as outsiders are not allowed to interfere in the business of the company due to fear of
losing control, company does get talented & experienced people on the board. Companies, which are growth
oriented, have to depend on private equity partner for working capital requirements.

One more aspect to be considered while evaluating internal funds as a source of finance is that the banks,
while giving loans or overdraft facilities, follow ‘one to one’ gearing rule which means that bank may be
reluctant to lend more than the sum of the share capital plus retained profits. If the share capital is to remain
unchanged, the only way a company can increase the amount a bank will be prepared to lend is through
increasing retained profit.

Now, it must be clear that it is up to individual company to decide whether to go for internal funding or
private equity. As long as the management team understands the urgency of maximizing retained profits,
company can be made fully self-sufficient in funding, with help from the bank. It can also be said that
internal equity is not just about providing the comfort of full control to owner managers who might
otherwise have to seek external equity investors, it is also about necessity of survival & success.

DISCUSS RETAINED EARNINGS AS A PRUDENT INVESTMENT POLICY.


Depreciation charges and retained earnings represent the internal sources of finance available to the
company. If depreciation charges are used for replacing worn-out equipment, retained earnings represent the
only internal source for financing expansion and growth. Companies normally retain 30 % to 80 % of profit
after tax for financing growth. Hence, these are an important source of long-term financing.

Retained earnings can be reviewed for their advantages and disadvantages from –

1. Firm’s Point of View:


Advantages –
1. They are readily available internally. They do not require talking to outsiders.
2. They effectively represent infusion of additional equity in the firm. Use of retained earnings, in lieu
of external equity, eliminates issue costs and losses on account of underpricing.
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3. There is no dilution of control when a firm relies on retained earnings.
Disadvantages –
1. The amount that can be raised by way of retained earnings may be limited. Further, the quantum of
retained earnings tends to be highly variable.
2. The opportunity cost of retained earnings is quite high, since it is nothing but the dividends foregone
by the equity shareholders.
2. Shareholder’s Point of View:
Advantages –
1. Compared to dividend income, the capital appreciation that arises as a sequel to retained earnings is
subject to a lower rate of tax.
2. Reinvestment of profits may be convenient for many shareholders as it relieves them to some extent
of the problem of investing on their own.
Disadvantages –
1. Shareholders who want a current income higher than the dividend income may be highly averse to
converting a portion of capital appreciation into current income, as it calls for selling some shares.
2. Many firms do not fully appreciate the opportunity cost of retained earnings.
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RIGHT ISSUES BONUS SHARES AND STOCKSPLITS


WHAT IS A BONUS SHARE?

Companies issue shares in lieu of consideration. The consideration may be either in the form of cash or kind.
Bonus shares are issued to the existing shareholders without payment of any consideration being received
form them, either in cash or kind, if authorized by article of association.

An issue of bonus shares represents a distribution of shares in addition to the cash dividend( known as stock
dividend in U.S.A.) to the existing shareholders. This has the effect of increasing the number of outstanding
shares of the company. The shares are distributed proportionately. Thus, shareholder retain its proportionate
ownership of the company. For e.g. if a shareholder owns 100 shares at the time when a 10% bonus issue is
made, he will receive 10 additional shares. The declaration of the bonus shares will increase the paid-up
share capital and reduce the reserves and surplus (retains earnings) of the company. The total net worth is
not affected by the bonus issue. In fact bonus issue represents a recapitalisation of owners’ equity portion,
i.e., the reserves and surplus. It is merely an accounting transfer from reserves and surplus to paid-up capital.
However, bonus shares can be issued out of balance in the share premium account.

SHARES SPLITS

A share split is a method to increase the number of outstanding shares through a proportional reduction in
the par value of share. A share split affects only the par value and the number of outstanding shares, the
shareholders’ total fund remains unchanged or unaltered. Consider the following illustration:

Capital structure of XYZ Co.


__________________________________________________________
Rs (crore)
__________________________________________________________
Paid-up share capital (1 crore Rs.10 par) 10
Share premium 15
Reserves and surplus 08
____________________________________________________

Total net worth 33

XYZ Co. split their shares two-for-one. The capitalization after split is:
___________________________________________________________
Rs (crore)
___________________________________________________________
Equity share capital (2 crores shares, Rs.5 par) 10
Share premium 15
Reserves and surpluses 08
____________________________________________________

Total net worth 33


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BONUS SHARES V/S SHARE SPLIT


As with the bonus share the total net worth does not change and the number of outstanding shares increase
substantially with the share split. The bonus issue and the share split are similar except for the difference in
their accounting treatment. In the case of bonus shares, the balance of the reserves and surpluses account
decreases due to a transfer to the equity capital and the share premium accounts. The par value per share
remains unaffected. With a share split, the balance of the equity accounts does not change, but the par value
per share changes. The earnings per share will be diluted and the market price per share will fall
proportionately with a share split. But the total value of the holdings of a shareholder remains unaffected
with a share split.

Authorised Share Capital


Authorised share capital is the maximum capital a company can raise as mentioned in the memorandum of
Association under its capital clause. it is also called as the Registered capital or Nominal capital of the
company.

Revenue reserves or Free reserves


These reserves amounts set aside out of divisible profit. They are appropriations of profits. Reserves may be
created for a special purpose or for a general purpose. Reserves created for a special purpose are called as
“special reserves” and a reserve created for general purpose are called as “General Reserve”. General
reserves are free and can be utilized for
i) Payment of dividends
ii) Development and Expansion.
iii) Any other purpose the company thinks proper.

General reserve is also called a revenue reserve or a free reserve. Free reserve is reserve available for any
purpose, including payment of dividend.

Reasons for share split

The following are reasons for splitting of a firm’s ordinary shares;


 To make trading in shares attractive.
 To signal the possibility of higher profits in the future.
 To give higher dividends to shareholders.

To make shares attractive: The main purpose of a stock split is to reduce the market price of the share in
order to it attractive to investors. With the reduction in the market price of the share, the shares of the
company are placed in a more popular trading range. For example, if the shares of a company are sold in the
lots of 100 shares, it requires Rs.10,000 to buy100 shares selling for Rs.100 per share. A five-for-one split
would lower the price to Rs.20 per share and the total cost of 100 shares to Rs.2000. the wealthy investor can
still purchase shares of Rs.10000 by acquiring a larger number of shares (500 share at Rs.20). But a small
investor can also afford to buy 100 shares for Rs.2000, for which he otherwise needed Rs.10000 before the
split. Thus, the reduction in the market price, caused by the share split, motivates more investors, particularly
those with small savings, to purchase the shares. This helps in increasing the marketability and liquidity of the
company’s shares.

Indication of higher future profits: The share splits are used by the company management to communicate
to investors that the company is expected to earn higher profits in future. The market price of high growth
firm’s shares increase very fast. If the shares are not split periodically, they fall outside the popular trading
range. Therefore these companies resort to shares splits from time to time. The share split like bonus shares,
thus, has an informational value that the firm is expected to perform efficiently and profitably and that the
shares have been splitted to avoid future high price per share.
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Increase dividend: When the share is split, seldom does a company reduce or increase the cash dividend per
share proportionately. However, the total dividends of a shareholder increase after a share split. For example,
a company may be paying a cash dividend of Rs.3 per share before the share split. But after a share split of
three-of-one, the company may pay a cash dividend of Rs.1.50 per share. A shareholder holding 100 shares
before the split will receive a total cash dividend of Rs.300. The number of shares owned by the shareholder
will increase to 300 after the split and his total cash dividend will be Rs.450. the increased dividends may
favourably affect the after-split market price of the share. It should be noted that the share split per se has no
effect on the market price of share.

REVERSE SPLIT
Under the situation of falling price of a company’s share, the company may want to reduce the number of
outstanding shares to prop up the market price per share. The reduction of the number of outstanding shares
by increasing per share par value is known as reverse split. For example, a company has 20 lakhs
outstanding shares of Rs.5 par value share. Suppose it it declares a reverse split of one-for-four. After the
split, it will have 5 lakh shares of Rs.20 par value per share. The reverse split is sometimes used to stop the
market price per share below a certain level, say Rs.10 per share which is the par value of most of the shares
in India. The reverse split is generally an indication of financial difficulty, and is, therefore, intended to
increase the market price per share.

Circumstances for issuing Bonus Shares

If company wants to avoid to show large amount of distributable income on balance sheet and plough back
its profits to capital, which it has to distribute otherwise, it can issue bonus shares.

Dividend payment is not obligatory for company but if company has huge accumulated profits investors
may demand for dividend. Dividend payment entails cash outflow also dividends must be kept stable and
should increase gradually. Hence in case of heavy profits to avoid heavy dividend payments company can
convert its accumulated profits in to share capital by issuing bonus shares. This also perks up market image
of company.

If company can earn more returns than market rate of return, which investors will earn if dividends are
distributed to them, then it is advisable to retain the profits by company itself instead of paying heavy
dividends, which will enhance national income of country.

Advantages of issuing Bonus Shares

Advantages of Bonus Shares


Prima facie, the bonus shares do not effect the wealth of the shareholders. In practice, however, it carries
certain advantages both to shareholders and the company.
SHAREHOLDERS
The following are advantages of the bonus shares to shareholders:

 Tax Benefits One of the advantages to shareholders in the receipt of bonus shares is the beneficial
treatment of such dividends with regard to income taxes. When a shareholder receives cash dividend
from company, this is included in his ordinary income and taxed at ordinary income tax rate. But the
receipt of bonus shares by the shareholders is not taxable as income. Further, the shareholder can sell
the new shares received by way of the bonus issue to satisfy his desire for income and pay capital
gain taxes, which are usually less than the income taxes on the cash dividends. The share holders
could sell a few shares of his original holding to derive capital gains. But selling the original shares
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are considered as a sale of principle by some shareholders. They do not mind selling the shares
received by way of the bonus shares as they consider it a windfall gain and not a part of the principal.
 Indication of higher future profits The issue of bonus shares is normally interpreted by
shareholders as an indication of higher profitability. When the profits of a company do not rise, and it
declares a bonus issue, the company will experience a dilution of earnings as a result of the
additional shares outstanding. Since dilution of earnings is not desirable, bonus shares are usually
declared by directors only when they expect rise in earning to offset the additional outstanding
shares. Bonus shares, thus may convey some information which may have a favorable impact on
value of the shares. But it should be noticed that the impact on value is that of the growth expectation
and not the bonus shares, which simply conveys the information.
 Future dividend may increaseIf a company has been following a policy of paying a fixed amount
of dividend per share and continues it after the declaration of the bonus issue, the total cash
dividends of the shareholders will increase in future. For example, a company may be paying a Re 1
dividend per share and pays 1:10 bonus shares with the announcement that the cash dividend per
share will remain unchanged. If a shareholder originally held 100 shares, he will receive additional
10 shares. His total cash dividend in future will be Re (Rs 1x 110)instead of Rs 100 (Re 1 x
100)received in the past. The increase in the shareholders’ cash dividend may have a favorable effect
on the value of the share. It should be, however, realized that the bonus issue per se has no effect on
the value of the share.
 Psychological value The declaration of the bonus issue may have a favourable psychological effect
on shareholders. The receipt of bonus shares gives them a chance to sell the shares to make capital
gains without impairing their principal investment. They also associate it with the prosperity of the
company. Because of these positive aspects of bonus issue, it is usually received positively by the
market. The sale of the shares, received by way of the bonus shares, by some shareholders widens
the distribution of the company’s shares. This tends to increase the market interest in the company’s
shares; thus supporting or raising its market price.
 Creates confidence for the investors / shareholders in the company – As market price increases
investors get confidence about their returns.

COMPANY
The bonus share also advantageous to the company in the following way

 Conservation of CashThe declaration of a bonus issue allows the company to declare a dividend
without using up cash that may be needed to finance the profitable investment opportunities within
the company. The company is, thus, able to retain earnings and at the same time satisfy the desires of
the shareholders to receive dividend. We have stated earlier that directors of the company must
consider the financial needs of the company and the desires of the shareholders while making the
dividend decision. These two objectives are often in conflict. The use of bonus issue represents a
compromise which enables directors to achieve both these objectives of a dividend policy. The
company could retain earnings without declaring bonus shares issue. But the receipt of bonus shares
satisfies shareholders psychologically. Also their total cash dividend can increase in future, when
cash dividend per share remains the same.
 Only way to pay dividend under financial difficulty and contractual restrictions In some
situations, even if the company’s intention is not to retain earnings, the bonus issue is the only means
to pay dividends and satisfy the desires of the shareholders. When a company is facing astringent
cash situation, the only way to replace the cash dividend is the issue of bonus shares. The declaration
of the bonus issue under such a situation should not convey a message of the company’s profitability,
but financial difficulty. The declaration of bonus issue is also necessitated when the restrictions to
pay the cash dividend are put under loan agreements. Thus, under the situation of financial
stringency or contractual constrain in paying cash dividend, the bonus issue is meant to maintain the
confidence of shareholders in the company.
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 More attractive share priceSometimes the intention of accompany in issuing bonus shares is to
reduce the market price of the share and make it more attractive to investors. If the market price of a
company’s share is very high, it may not appeal to small investors. If the price could be brought
down to a desired range, the trading activity would increase. Therefore, the bonus issue is used as a
means to keep the market price of the share within a desired trading range.
 It bridges the gap between capital and fixed assets – Generally the gap between capital and fixed
assets is bridged by borrowings. As bonus shares increase capital base of company it can finance
more for fixed assets and reduces borrowings of company.
 Good market reputation – Issuing of bonus shares shows that company is in profit. It does not
require extra capital and its own profits are sufficient, this improves market reputation and also leads
to
 Increases Liquidity of Shares – It increases number of shares in the market and so increase trading
of shares, thus liquidity increases.

DISADVANTAGES

• Shares are issued without any actual money coming in – In bonus shares only number of shares
increases it does not bring any extra capital from shareholders.
• Leads to reduction in Earning Per Share –

EPS = Net profit available to equity holders

Number of ordinary shares outstanding

As number of shareholders increases against the profit, earning per share decreases.

• Costly to administer There are cost implications such as stamp duty, printing & stationery, etc
• Reduces accumulated profits earned in past years – As it converts profits into capital.
• Shareholders wealth remains unaffected

Bonus shares are considered valuable by most shareholders. But they fail to realize that the bonus shares
do not affect their wealth and therefore, in itself it ahs no value for them. The declaration of bonus shares
is a method of capitalizing the past earnings of the shareholders. Thus, it is a formal way of recognizing
something (earnings) which the shareholders already own. It merely divides the ownership of the
company into a large number of share certificates. Bonus shares represents simply a division of
corporate pie into a large number of pieces. In fact, the bonus issue does not give any extra or special
benefit to a shareholder. His proportionate ownership in the company does not change. The chief
advantage of the bonus share issue is that it has a favourable psychological impact on shareholders. The
issue of bonus shares gives an indication of the company’s growth to shareholders. Shareholders
welcome the distribution of bonus shares since it has informational value.

The disadvantage of bonus issues form the company’s point of view is that they are more costly to
administer than cash dividend. The company has to now print certificates and post them to thousands of
shareholders. Te bonus issue can be disadvantageous if the company declares periodic small bonus
shares. The investment analysts do not adjust the earnings per share fro small issues of bonus shares.
Only the significant issues of Bonus shares are adjusted by them. When the earnings per share are not
adjusted , the measured growth in the earnings per share will be less than the true growth based on the
adjusted earnings per share. As a result the price-earnings ratio would be distorted downwards.

SEBI role in issue of bonus shares by companies(regulations)


SEBI is playing a vital role in regulating capital markets. Offer Documents / Prospectus for almost all types
of issues are sent to SEBI for their comments. SEBI has framed guidelines for all types of issues including
Bonus Issue.
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In case of Bonus Issue, there is no offer document as there is no involvement of any consideration. No funds
are coming into the corpus of the company. Therefore, companies are required to just follow the guidelines
issued by SEBI. Companies are not required to take any specific approval from SEBI.

Things to remember before considering Bonus Issue

• Bonus shares cannot be issued if the company has come out with any public / rights issue in the past
12 months.

• Bonus shares cannot be issued in lieu of Dividend.

• Bonus shares can be issued only out of free reserves (i.e. reserves not set apart for any specific
purpose) built out of the genuine profits or share premium collected in cash only.

• Bonus shares cannot be issued out of the reserves created by revaluation of fixed assets.

• If the existing shares are partly paid up, the company cannot issue Bonus Shares. It will be
appropriate to first make the shares fully paid up before issuing Bonus Shares.

• It should be ensured that the company has not defaulted in payment of interest or principal in respect
of fixed deposits and interest on existing debentures or principal on redemption thereof and

• It should be ensured that the company has sufficient reason to believe that it has not defaulted in
respect of the payment of statutory dues of the employees such as contribution to provident fund,
gratuity, bonus etc.

• If the company has already issued either fully convertible debentures or partly convertible debentures
than in that case the company is required to extend similar benefits to such holders of securities
through reservation of shares in proportion to their holding or in proportion to such convertible part.
The Bonus Shares so reserved may be allotted to such holders at the time of conversion.

• It should be checked whether Articles of Association contains the provision of capitalization of


reserves. If no such provisions are contained steps should be taken by altering the Articles of
Association by the consent of the members of the Company.

• It should be checked whether the post bonus capital is within the limits of authorized share capital. If
it is not so, steps should be taken to increase the authorized share capital by amending memorandum
and articles of association.

• It is very important for a company to implement the bonus proposal within a period of six months
from the date of approval at the meeting of the Board of Directors. The company has no option to
change the decision.

• All the shares so issued by way of bonus will rank pari-passu with the existing shares. The company
cannot create any other rights for the bonus shares.
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Steps involved in issuing Bonus Shares

• As per the listing agreement, at least 7 days prior to the board meeting in which bonus will be
considered, a notice has to be given to each stock exchange where securities of the company are
listed about the declaration of bonus shares.

• At the Board meeting approve the following :-

• Bonus Ratio
• Fixation of Record Date or Book Closure Notice.
• Notice convening general meeting for increase in authorized share capital and capitalization of
reserves and amendment in memorandum & articles of association thereof.

• Intimate to such stock exchanges on the same day about the result of the board meeting immediately
after the closure of the market hours.

• Intimate at least 42 days in advance to such stock exchanges about the closure of register of members
or fixing of record date fixed for allotting bonus shares to such shareholders.

• If the company intends to close its register of members at least 7 days prior to the book closure, a
notice has to be issued in the newspaper circulating in the district in which registered office of the
company is situated.

• Send at least 21 days clear notice to all such shareholders about the general meeting.

• Convene General Meeting and pass resolutions for amending Memorandum & Articles of
Association pertaining to increase in authorized share capital and capitalization of reserves.

• File Form No. 23 with ROC regarding amendment made in memorandum & articles of association
alongwith certified true copy of the resolutions passed, explanatory statement and prescribed fees.

• For increase in authorized share capital, affix stamp duty as applicable on Form No. 5 and alongwith
the prescribed fees file the same with ROC,

• Give Effect to all the transfers received before the closure of register of members or fixing of record
date.

• Convene a Board Meeting to allot shares to those shareholders whose name appears in the register of
members as on record date or at the time of closure of register of members.

• Make arrangements for the printing of share certificates. Issue Share Certificates in accordance with
the rules prescribed for issuing share certificates. (see to it that common seal and stamp duty is
affixed on it and signed by two directors and an authorized signatory as per the board resolution)

• File Form No. 2 with ROC along with the list of shareholders and prescribed fees.

It is very important to note that Bonus Shares have to be issued within a period of 6 months from the date of
board meeting at which the bonus issue was declared.
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Impact of Taxation in the hands of shareholders
If the taxpayer is in the business of dealing in shares, profits or losses on sale of bonus shares will be treated
as business profits or losses, as the case may be.

In case the taxpayer holds shares as investments, profit on sale will be treated as capital gains. The cost of
acquisition of bonus shares will be treated as nil for the purposes of determining profit. However if the
bonus shares have been acquired prior to 1/4/81, then the share market value of bonus shares as on 1/4/81
will be treated as the cost of acquisition.

In case the bonus shares are long term capital assets, ( i.e. held for at least 12 months from the date of
allotment of the bonus shares ), the income tax rate on capital gains is as follows :-

In case of listed shares :-

• 20 % of long term capital gains after indexation of the cost of acquisition or 10 % of long term
capital gains before indexation of the cost of acquisition, which ever is more favourable to the
taxpayer. If the bonus shares are acquired after 1 April 1981, it will make more sense for the taxpayer
to opt for the 10 % scheme since the cost of acquisition will in any case be treated as nil.

In case of non-listed shares :-

• 20 % of long term capital gains after indexation of the cost of acquisition.

In case the bonus shares are short term capital assets, ( i.e. held for less than 12 months from the date of
allotment of the bonus shares ), capital gains will be added to the other income of the taxpayer and the
taxpayer will have to pay income tax on his total income at the rates applicable to him.
Click here to know more about indexation of cost of acquisition. This is relevant only when the bonus shares
are acquired prior to 1 April 1981 and the taxpayer opts for the 20 % scheme.

BOUGHT OUT DEALS


It is a process by which an investor (usually the investment banker) buys out a significant portion of the equity
of an unlisted company with a view to make it public within an agreed time frame. In a bought-out deal, a
promoter off loads the security, which is to be issued to the public to raise finance, to a Member of OTCEI.
The Member takes up this equity at the price fixed after a thorough appraisal of the company. He then offloads
the equity, at a convenient time, to the public through an ‘Offer for Sale’.

PRIVATE PLACEMENT
A private placement is a private sale of unregistered securities by a public company to a select group of
individuals or institutions. It is a type of offering exempted from registration that allows the issuing company
to avoid registration requirements and save underwriting fees by offering company shares directly to
institutional and accredited investors.

Because the securities sold in a private placement are not registered, they cannot be re-sold into the public
market until a registration statement has been filed and declared effective. To compensate for the inability to
sell the securities immediately, private placement securities are often issued at a discount or are structured to
provide the investors certain protections against decreases in the common stock price.

The distinctive features of a private placement are:


3. There is no need for a formal prospectus and an underwriting arrangement.
4. The terms of the issue are negotiated between the company and the investor.
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In the private placement market in India, securities are sold mainly to institutional investors like UTI, Mutual
Funds, LIC, etc. All available instruments like equity shares, preference shares, convertible debentures, etc
may be privately placed.

Private placements are sometimes seen as negative because of the price that the company pays to obtain the
capital. The biggest concern with private placements is dilution. This concern is basically that the financing
will cause too many shares of the company to be sold into the market relative to the current number of issued
and outstanding shares.

Some transactions are structured so that the investor may convert and sell his shares at a discount to the future
market price of the common stock. With these transactions, the theoretical dilution is enormous because the
investor can convert no matter how much the stock price decreases in the future. Another important concern is
discounting. Many private placement investments provide the investor with a discounting feature, to
compensate it for the temporary illiquidity of the private placement securities. However, some discounts are
simply too large relative to the holding period of the investment, leaving shareholders to wonder why they are
holding stock at current prices when the private placement investors are able to buy the stock at lower levels.

Types
Private Placement securities can take many forms. The most basic is a Common Stock placement that is sold
at some set discount or premium to the market price at closing. This type of structure may also include
warrants that let the private placement investor purchase more stock at a set premium price for a period of
time. Another basic structure is the Fixed Convertible security (either Preferred Stock or Debt). These
securities yield a current return through interest or dividends and can be converted by the investors into shares
of the company’s common stock at a set price (usually at some premium to the market price at closing).
Private Placements structured in either of these basic structures are usually considered a good sign for the
public company. They convey that the private placement investors believe in the company's prospects for the
long term and are willing to take on market risk with their investment.

Criteria to be satisfied
Some of the important conditions that a company should satisfy in order to be acceptable to institutional
investors are –
1. The net worth of the company should be at least Rs. 1 crore.
2. The interest cover should be at least two times, as per the latest balance sheet.
3. The asset cover should be at least 1.25.
4. The company should have paid dividends for at least two years in the preceding three years.
5. In the case of a listed company, the stock price should be above par for six months prior to the issue.

ADVANTAGES OF PRIVATE PLACEMENT


The private placement market has grown phenomenally in recent years. The rate of growth of these has been
higher than that of public issues as well as rights issues. This may be attributed to the following factors –
1. Accessibility:
Almost any company, irrespective of whether it is a public company or a private company, can access the
private placement market. Further, the market can accommodate issues of smaller size whereas the public
issues market does not permit an issue below a certain minimum size.
2. Flexibility:
There is greater flexibility in working out the terms of issue. For example, when a non-convertible debenture
issue is privately placed, a discount may be given to institutional investors to make the issue attractive. The
absence of such freedom in a public issue appears to be the primary reason for its growth. In addition to
greater flexibility at the time of structuring the issue initially, there may be more latitude to re-negotiate the
terms of the issue subsequently and even roll-over the debt. This is because the issuer has to deal with one or
few institutional investors in the private placement market.
3. Speed:
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The time required for completing a public issue cycle is usually 6 months or more because of several
formalities that have to be gone through. On the other hand, a private placement requires lesser time,
perhaps two or three months, as the elaborate procedure followed in a public issue is largely bypassed.
4. Lower Issue Costs:
A public issue entails several statutory and non-statutory expenses like underwriting, brokerage, promotion,
etc. The sum of these costs often works out to 8-12 per cent of the issue amount. As against this, the issue
cost for a private placement is very less.

Given the above advantages, companies are likely to prefer private placements wherever feasible. If an issue is
large it will have to be made in the public issues market. This is because, the institutional investors would like
to limit their exposure to individual companies. Also, from the company’s point of view it is advisable to have
a wide base of shareholders. It helps in avoiding real dilution of control and forging links in capital market for
raising funds on a continual basis.

BUY-BACK – WHAT?
Share buy back is described as a procedure that enables a company to go back to its shareholders and offers
to purchase from them the shares they hold.

Buy-back of shares, simply stated, is the reverse of raising capital. To start a new business or to expand an
existing one or to diversify in to a new area, a company raises money by issuing shares. However, when it
earns substantial profits or closes down a particular business and raises money, it pays dividend or returns its
capital. In view of the peculiar nature of a company with limited liability, returning capital to shareholders
faces far more restrictions than raising capital. Creditors have an assurance that they have the buffer of the
paid-up capital for their dues in the sense that losses made by the company will not affect the recovery of
their dues so long as such losses do not exceed the paid-up capital. Hence, return of capital, known as
“Reduction of capital”, is normally permitted only under sanction of court where the principal concern of the
court is that the interests of the creditors are protected. Buy-back of shares makes a departure from this
tradition. Companies are now permitted to return capital to the shareholders to a significant though limited
extent.

In one sense, buy-back of shares constitutes partial liquidation of the company though, in many cases it
simply amounts to a special dividend or even substitution of the regular dividend mainly for perceived tax
savings. In a buy-back, the company pays off its dues to the shareholders though an important difference
between buy-back and liquidation is that, in buy-back, the amount paid to the shareholders is a mutually
agreed price while, in liquidation, the amount proportionately due to each shareholder is paid.2

According to Graham & Dodd in Security Analysis, "A company which buys and sells its stock
advantageously, thereby increasing- both the book value per share of the remaining shareholders and, in
particular, the earnings per share, has an attraction that goes beyond the basic earning power". A stock
buy-back plan can change a perception of a company that is willing to spend its own money to repurchase
outstanding shares. The size of an individual company's stock buy-back can make a difference in the
reaction from the investment world. A stock buy-back of 6 to 8 per cent of the outstanding shares can make
investors take notice, while a buy-back of 10 percent or more is often a screaming buy. Stock buy-back
programs have two sides to the story. Some view a buy-back program negatively, as skeptics believe the
company has no better strategy to use the excess cash. Other times buy-back programs can be viewed
extremely positively, as management believes that the company's stock is a strong buy at current prices. A
key caveat is to watch the percentage of shares that are being purchased and not the absolute monetary
amount.

Buy-back of shares can be carried out in many ways, though it should be noted that the new law permits it in
four specified ways only. Even these face further restrictions by the SEBI regulations.
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Before one undertakes buy-back, one need to clearly understand their benefits and implications to determine
not only whether the company should undertake buy-back, but also the financial implication including, in
particular the implication on cash flow, earnings per share, book value, market price, etc. Determining the
buy-back price can be a critical issue particularly when the intention is to have a positive effect on the
market price. In some cases, where buy-back is just another form of dividend, other implications may not be
important.

The buy-back has the potential of becoming a management, rather than a financial, tool. For, the buy-back
reflects a corporate's faith in its financial abilities, its strategic goals, and its knowledge base. It sends the
unequivocal message of value-consciousness to the employee, the shareholder, and the customer. Although
such a buy-in into one's strategy can be cheap--share-prices are ruling at their lowest levels in the last 5
years--there is no denying the fact that the buy-back strengthens the voice of the majority in corporate
boardrooms by consolidating shareholdings and quickening response times. In an era where survival has
become a pre-occupation, the buy-back has become a potent weapon.

RIGHT ISSUES
A right is an option to buy a security at a specified price during a designated period. Indian companies are
required, under section 81 of the Companies Act, 1956, to offer additional issues of shares to existing
holders of equity shares. This offer is known as “privileged subscription”. The legal provision requiring the
companies to offer new issues to holders of ordinary shares is referred to as the pre-emptive right. The
concept of rights has grown out of the common law of doctrine that a shareholder should have the
opportunity to preserve his share in the earnings, ownership and surplus of a company. The pre-emptive
right gives shareholders the first opportunity to purchase additional issues of the company’s securities.

When a company makes a rights issues, it sends a “letter of offer” to existing holders of equity shares
indicating the amount of new full shares or coupons to which they are entitled in proportion to their old
shareholding. This letter of offer is in the nature of share purchase warranting generally referred to as rights.

Example
If a company has 1,00,000 outstanding shares of equity stock and proposes to issue 20,000 additional equity
shares, an equity shareholder owning 100 shares has the right to purchase 20 of the 20,000 new shares before
those are offered to anyone else. The equity shareholders may, however, forfeit this right, partially or totally,
as per management’s request if this right creates problems or hindrances in issuing additional shares.

The procedure is fairly is simple in the sense that after the issue has been approved by the company and the
controller of capital issues, notices are sent to shareholders indicating that all those who are shareholders as on
a certain date may subscribe to additional shares that are being issued at par or premium. The issue price is
kept much below the ruling market price in order to make provision for a possible fall.
Eg. Suppose a company issues one new share for the 5 old shares at an issue price of Rs.120. The market
price of the old share is assumed at Rs.150. the holder of 5 old shares will receive one right for each of
his shares. If he sends his 5 rights together with Rs.120 he will get an additional share from the company.
The shareholder does not have to exercise his rights. He can also sell the rights through his broker.
However, he has to take the decision within a limited period, say, 30 days. After this period rights may
expire and become valueless.

Determination of Value of a Right


A right provides the privilege to the existing stockholders of buying a considerably higher priced stock for a
lower price. Therefore, it must have some market value. The market value of a right is dependent upon the
present market price of the stock, the subscription price and the number of rights required to buy an
additional share of stock.
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Illustration
Rashmi Corporation is planning to raise Rs. 1,00,000 of new equity funds through rights offering and
decides to sell the stock to stockholders for Rs. 8 a share. The company has 1,00,000 shares outstanding with
a market price of Rs. 10 a share. The company’s net earnings after taxes is Rs. 40,000. How many rights will
be needed to buy newly issued stock?

Solution:
1. Number of new shares = Funds to be raised
Subscription Price

= Rs. 1,00,000
Rs. 8

= 12,500 shares

2. Number of rights needed to buy a new share = Old shares


New shares

= 1,00,000
12,500

= 8 rights
Thus, a stockholder will have to surrender 8 rights plus Rs. 8 to receive one of the newly issued shares.

Where a company is selling rights, the following formula is applied to determine the market value of each
right:

R = Mo – S
N+1
Where R = Value of one right
Mo = Market value of stock on rights
S = subscription price
N = Number of rights needed to buy one share.

Substituting the appropriate value for Rashmi Corporation we can obtain value of a right:

R = Rs. 10 – 8
8+1
= Rs. 0.22 (Approx)

An investor not intending to exercise his privilege of buying the stock before the stipulated date will find
that his investment would suffer decline if he did not make any provision to sell rights before the date of
expiry. This decline would occur because the new shares can be purchased only at a bargain price. Thus, the
market value of one share of stock when it goes ex-rights will fall by the value of the right. This can also be
verified by the following formula used to determine market price of an ex-right stock:

Mx = (Mo x N) + S
N+1

Where Mx = Market price of stock when it goes ex-rights.


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Substituting the formula with figures given in the above illustration:
Mx = (Rs. 10 x 8 ) + Rs. 8
8+1
= Rs. 9.78
From the above illustrations, we can say that theoretically the right is of no significant value to the
stockholder. His stock is worth Rs. 10 before the date of record. After the expiration, it is worth Rs. 9.78.
The decline in market price ifs offset exactly by the right:

Rx = Mx – S
N

Where Rx = The market value of one right when the stock is selling ex-rights
Substituting the formula with the figures given above

Rx = Rs.9.78 – Rs. 8
8
= Rs. 0.22 (approx)

The value of a right in this case is exactly the same as earlier.


It may be noted in this regard that actual value of a right may be somewhat different from the theoretical
value. This is because of a number of factors, such as transaction cost, speculation and irregular exercise of
sale of rights over the subscription period.

SHARES ISSUED AT A PREMIUM


Section 78 of the companies act 1956, permits a joint stock company to issue shares at a premium i.e. a
higher price than their normal value. It further states that where a company issues shares at a premium sum
representing the total amount of the premiums on such shares must be transferred to an account known as
the ‘Share Premium account’. Such a premium cannot be regarded as capital and should not be mixed up
with the share capital of the company. In no case it should be transferred to the credit side of the profit and
loss account of the company. However, the amount of share premium may be utilized in writing down
fictitious assets i.e. preliminary expenses, brokerage or underwriting commission on issue of shares and
debentures or issue of bonus shares, or in providing for the premium payable on the redemption of
redeemable preference share or any debenture of the company.

SHARES ISSUED AT A DISCOUNT


Section 79 of the companies act, 1956 permits a company to issue shares at a discount only on the following
conditions:
The issue of shares at a discount must be of a class of shares issued by the company.
The issue of shares at a discount must be authorized by a resolution passed in the general meeting and
sanctioned by the company law board.
The maximum rate of discount must not exceed 10% unless the company law board is of the opinion
that higher percentage of discounted may be allowed in special circumstances.
The shares must be issued within two months from the date of sanction by the company law board or
within such extended time as the board may allow.
A company can do the issue of shares at a discount only a year after the commencement of the business
by the company.
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SHARES ISSUED FOR CONSIDERATION OTHER THAN CASH
A company may also issue shares as partly paid or fully paid for consideration other than cash under the
circumstances mentioned below:
To the underwriters of shares and promoters by way of payment of remuneration or for
expenses incurred.
To the vendors from whom the running business is purchased, as purchased price or consideration.
Issue of bonus shares out of the reserves to the existing shareholders of the company.

PRO-RATA OR PROPORTIONATE ALLOTMENT:


Pro rata means proportionately. Allotment on pro rata basis means that allotment on every application is
made in the ratio which the total number of shares to be allotted on this basis bears to the total number of
shares applied for in all such applications. If, 20,000 shares are allotted on pro rata basis on applications for
25,000 shares, it means that four shares are allotted for every five shares applied for.

EX RIGHT AND CUM RIGHT:


When a rights issue is announced, all existing shareholders have the right to subscribe for new shares, so
there are rights attached to the existing shares. The shares are therefore described as being ‘cum right’ (with
rights attached) and are traded cum rights. On the first day of dealings in the newly issued shares, the rights
no longer exist and the old shares are now ‘ex-rights’ (without rights attached).

IPO:
The first public offering of equity shares of a company, which is followed by a listing of its shares on the
stock market, is called the initial public offering (IPO).

DECISION TO GO PUBLIC:
The decision to go public (or more precisely the decision to make an IPO so that the securities of the
company are listed on the stock market and publicly traded) is a very important, but not well studied,
question in finance. It is a complex decision which calls for carefully weighing the benefits against costs.

Benefits of going public:

The potential advantages that seem to prod companies to go public are as follows:

Access to capital the principal motivation for going public is to have access to larger capital. A company that
does not tap the public financial market may find it difficult to grow beyond a certain point for want of
capital.

Respectability many entrepreneuers believe that they have “arrived” in some sense if their company goes
public because a public company may command greater respectability. Competent and ambitious executives
would like to work for growth. Other things being equal, public companies offer greater growth potential
compared to non-public companies. Hence, they can attract superior talent.

Investor recognition in his capital asset pricing model with incomplete information information, Robert
Merton shows that other things being equal stock prices are higher the larger the number of investors aware
of the securities of the firm.
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Window of opportunity there are periods in which stocks are overpriced. Hence, when a non public company
recognizes that other companies in its industry are overpriced, it has an incentive to go public and exploit
that opportunity.

Liquidity Promoters of a company would eventually like their investment to become liquid. This becomes
possible only when they take their company public.

Benefits of Diversification when affirm goes public those who have investment in it-original owners,
investors, managers, and others-can cash out of the firm and build a diversified portfolio.

Signal from the market stock prices represent useful information to the managers. Everyday, investors render
judgement about the prospects of the firm. Although the market may not be perfect, it provides a useful
reality check.

PRINCIPAL STEPS IN IPO:

The issue of securities to members of the public through a prospectus involves a fairly elaborate process, the
principal steps of which are briefly described below:

Approval of board: An approval of the board of directors of the company is required for raising capital from
the public.

Appointment of lead managers: The lead manager is a merchant banker who orchestrates the issue in
consultation with the company. The lead manager must be selected carefully.

Appointment of other intermediaries: Several intermediaries facilitate the public issue process. What they do
and how they may be selected is discussed briefly;

Co-managers and advisors: A co-manager shares the work of the lead manager and an advisor provides
counsel. The lead manager may appoint co-manager and advisors, if required.

Underwriters: An underwriter agrees to subscribe to a given number of shares in the event the public do not
subscribe to them. The underwriter, in essence, stands guarantee for public subsciption in consideration for
the underwriting commission. The principal underwriters in India are the public financial institutions,
commercial banks, insurance companies, merchant bankers and brokers.

Bankers: The bankers to the issue collect money on behalf of the company from the applicants. SEBI
guidelines stipulate the minimal banking arrangements that have to be made for collection of applications.
The bankers chosen for the issue typically are the ones

1.with whom the company has its cash credit accounts,

2.who provide term loans to the company, and

3.who underwrite and or manage the issue.

Brokers and principal brokers: The brokers to the issue facilitate its subscription. In appointing the brokers
to the issue, the following points should be borne in mind:

1.only members of recognised stock exchanges can be appointed as brokers.


2.the number of brokers appointed has to bear a reasonable relationship to the size of the issue. A company
may, if such a need is felt, appoint a principal broker to coordinate the work of brokers.
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Registrars: The registrars to the issue perform a series of tasks from the time the subscription is closed to the
time the allotment is made collection of application forms from the banks, scrutiny of application forms,
classification and tabulation of data, finalisation of the basis of allotment, issue and dispatch of allotment
letters, shares/debenture certificates, and refund orders. Registrars may be selected on the basis of
experience, expertise, credibility, and cost

Filing of the Prospectus with SEBI: The prospectus or the offer document communicates information about
the company and the proposed security issue to the investing public. All companies seeking to make a public
issue have to file their offer document with SEBI. If SEBI or the public does not communicate its
observations within 21days from the filing of the offer document, the company can proceed with its public
issue. The prospectus and the application form (along with Articles and Memorandum of Association) must
be forwarded to the concerned stock exchange, where the issue is proposed to be listed, for approval.

Filing of the Prospectus with the registrar of companies: Once the prospectus is approved by the concerned
stock exchanges and consent obtained from the bankers, auditors, legal advisors, registrars, underwriters,
and others, the prospectus, signed by the directors, must be filed with the Registrar of Companies, along
with requisite documents as required by the companies act, 1956.

Printing and Dispatch of Prospectus: After the prospectus is filed with the Registrar of Companies, the
company should print the prospectus (along with the application form).
The quantity in which the prospectus is printed should be sufficient to meet the requirements of brokers,
underwriters, and bankers to the issue. They should be sent to stock exchanges and brokers so they receive
them at least 21 days before the first announcement is made in the newspapers. Brokers, serving as links
between the company and the potential investors, receive the prospectus, application form, and brochure inn
bulk and, in turn, mail them to their clients. The company may share the cost of mailing incurred by brokers
on some basis.

Filing of Initial Listing application: Within ten days of filing the prospectus, the initial listing application
must be made to the concerned stock exchanges, along with the initial listing fees.

Promotion of the Issue: The promotional campaign typically commences with the filing of the prospectus
with the Registrar of companies and ends with the release of the statutory announcement of the issue. To
promote the issue the company holds conferences for brokers, press and investors. At these conferences the
company seeks to get adequate publicity. Advertisements are also released in newspapers and periodicals to
generate interest among potential investors.

Statutory announcement: The statutory announcement of the issue must be mad after seeking approval of the
lead stock exchange. This must be published at least ten days before the opening of the subscription list.

Collection of applications: The statutory announcement (as well as the prospectus) specifies when the
subscription would open, when it would close, and the banks where the applications can be made. During
the period the subscription is kept open, the bankers to the issue collect application money on behalf of the
company and the managers to the issue, with the help of the registrars to the issue, monitor the situation.
Information is gathered about the number of applications received in various categories, the number of
shares applied for, and the amount received. When the application information suggests that the issue is
over-subscribed, the company should take a decision, in consultation with the managers and registrars to the
issue, about closing the subscription. This, however, cannot be done before the minimum period prescribed
by the stock exchanges.

Processing of Applications: The application forms received by the bankers are transmitted to the registrars
of the issue for processing. This mainly involves:
 Scrutinising the applications to see whether the proper amount has been received, whether the
applicant’s name is correctly mentioned, whether particulars such as address, age, occupation, etc.
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have been provided, whether the application has been signed correctly, and whether the applicant is
genuine.
 Serially numbering the applications.
 Coding the applications for items like the name of the applicant, broker, underwriter, occupation, etc.
 Preparing a list of applications with all relevant details.

Establishing the Liability of Underwriters: If the issue is under subscribed, the liability of the underwriters
has to be established. For this purpose, the following procedure may be followed:
 Segregate the applications which bear the stamp of an underwriter and applications which do not
bear the stamp of any underwriter. Determine the number of shares procured by each underwriter and
carry the number of shares relating to applications which do not bear the stamp of any underwriter to
a general pool.
 Compare the number of shares procured by each underwriter with his underwriting commitment. If
an underwriter procures more shares than his underwriting commitment, carry the excess to the
general pool. If an underwriter procures less shares than his underwriting commitment, determine his
shortfall.
 Credit the total number of shares in the general pool to the underwriters with shortfall in proportion
of their underwriting commitments and then determine the net shortfall of each underwriter who
could not procure enough shares. This represents the underwriter’s liability.

Allotment of Shares: According to SEBI guidelines, one-half of the net public offer has to be reserved for
applications up to 1,000 shares and the balance one-half for larger applications. For each of these segments,
the “proportionate’ system of allotment is to be followed.

Listing of the Issue: The detailed listing application should be submitted to the concerned stock exchanges
along with the listing agreement and the listing fee. The allotment formalities should be completed within 30
days after the subscription list is closed or such extended period as permitted by the lead stock exchange.

PREFERENTIAL ALLOTMENT
An issue of equity by a listed company to selected investors at a price which may or may not be related to
the prevailing market price is referred to as preferential allotment in the Indian capital market. A preferential
allotment is not related to a public issue and it should not be confused with reservations that may be made on
a preferential basis for certain categories of investors in a public issue. Preferential allotment in India is
given mainly to promoters or friendly investors to ward off the threat of takeover.

PRIMARY & SECONDARY MARKETS:


The markets where issuers sell new claims is referred to as the primary market and the market where
investors trade outstanding securities is called the secondary market.
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PROSPECTUS FOR ISSUE OF SHARES
DEFINITION & EXPLANATION:

In order to finance its activities, a company needs capital which is raised by a public company by the issue
of a prospectus inviting deposits or offers for shares & debentures from public. A private company is
prohibited from making any invitation to the public to subscribe for any shares in or debentures of the
company. Hence, it need not issue a prospectus.

The central theme of a prospectus, from the money raising point of view, is that it sets out the prospects of
the company & the purpose for which the capital is required. The prospectus is the basis on which the
prospective investors form their opinion & take decisions as to the worth & prospects of the company.

According to companies act 1956, section 2 (36), “a prospectus is any document described or issued as a
prospectus & includes any notice, circular, advertisement or other document inviting deposits from the
public or inviting offers from the public for the subscription or purchase of any shares in, or debentures of, a
body corporate.”

In simple words, any document inviting deposits from the public or inviting offers from the public for the
subscription of shares or debentures of a company is a prospectus.

As per the Law, a prospectus has to be in writing. An oral invitation to subscribe for shares in, or debentures
of, a company, or deposits is not a prospectus. The word ‘subscription’ in the definition of prospectus means
‘taking’ or ‘agreeing to take’ shares for cash. It says that the person agreeing to take the shares puts himself
under a liability to pay the nominal amount thereof in cash.

Act further says that a document is not a prospectus unless it is an invitation to the public to subscribe for
shares in, or debentures of, a company. But if the document satisfies the condition of invitation to the public,
it is a prospectus even though it is issued to a defined class of the public. If, however, the invitation is made
to a small circle of friends of the directors or the existing shareholders, it is not an offer to the general
public.

DATING OF PROSPECTUS (SECTION 55):


A prospectus issued by or in relation to an intended company must be dated & that date is, unless the contrary
is proved, taken as the date of publication of the prospectus.

SIGNING OF PROSPECTUS:

In case the prospectus is issued by an intended company it has to be signed by the proposed directors of the
company or by their agents authorized in writing. In case of existing companies, the prospectus has to be
signed by every person who is named therein as director of the company or by his agent authorized in
writing.

REGISTRATION OF PROSPECTUS (SECTION 60):

A prospectus can be issued by or on behalf of a company only when a copy thereof has been delivered to the
Registrar for registration. The registration must be made on or before the date of publication thereof. The
copy must be signed by every person who is named therein as director pr proposed director of the company,
or by his agent authorized in writing. Further such a prospectus must state on the face of it that a copy of it
has been delivered to the Registrar for registration on or before the date of its publication.
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OBJECTIVES OF REGISTRATION OF PROSPECTUS:

• To keep an authenticated record of the terms & conditions of issue of shares or debentures.
• To pinpoint the responsibility of the persons issuing the prospectus for statements made by them in the
prospectus.

The issue of a prospectus is not necessary in the following cases –


• Where an offer is made in connection with a bona fide invitation to a person to enter into an
underwriting agreement with respect to the shares or debentures.
• Where the shares or debentures are not offered to the public. This will be the case when promoters are
confident of raising capital through private sources & contacts.
• Where the shares or debentures are offered to the existing members or debenture-holders of the
company.
• Where the shares or debentures offered are uniform in all respects with shares or debentures previously
issued & quoted on a recognized stock exchange.

CONTENTS OF PROSPECTUS

Prospectus is the window through which an investor can look into the soundness of a company’s venture.
The investor must, therefore, be given a complete picture of the company’s intended activities & its position
through prospectus.
According to section 56, the important contents of prospectus include the matters specified in Part I of
Schedule II & reports specified in Part II of Schedule II.

PART I OF SCHEDULE II :

• General information: (a) Name & address of the registered office of the company, (b) Consent of the
Central Government for the present issue declaration of the Central Government about non-
responsibility for financial soundness or correctness of statements, (c) Names of Regional Stock
Exchange & other Stock Exchanges where application made for listing of present issue and other
provisions,
(d) Declaration about refund of the issue if minimum subscription of 90% is not received within 120 days
from the opening of the issue.Date of opening of the issue.Date of the closing of the issue.(f)Date of earliest
closing of the issue.(g) Name and address of auditors and lead managers.(h)Name and address of
trusteeunder debenture trust deed (in case of debenture issue).(i)Rating from CRISIL(Credit Rating
Information Services of India Limited) or any rating agency obtained for the proposed debenture/preference
share issue.If no rating has been obtained,this fact sould be stated.(j)Under writing of the issue(Name and
addresses of the underwriters and the amount underwritten by them).

II. Capital structure of the company.


i. Authorised, issued, subscribed and paid up capital.
ii. Size of the present issue giving separately reservation for preferential allotment to promoters and
others.
iii. Paid-up capital :(a) after the present issue,
(b) after the conversion of the debenture(if applicable).

III. Terms of the present issue.


i. Terms of payments.
ii. Right of the instruments holders
iii. How to apply-availability of forms, prospectus and mode of payment.
iv. Any special tax benifitsfor company and shareholders.
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IV. Particulars of the issue.
i. Objects,
ii. Project cost
iii. Means of finance(including contribution of promoters)
V. Company, management and project.
i. History and the main objects and the present business of the company.
ii. Subsidary(ies) of the company, if any .
iii. Promoters and their background
iv. Names, addresses and occupations of managers, managing director and other directors including
nominee directors whole- time directors(giving their directorship in other companies).
v. Location of the project.
vi. Plant and machinery, technology process, etc.
vii. Collaboration aggrements,
viii. Infrastructure facilities for raw material, water, electricity etc.
ix. Schedule of implementations of project and progress sofar.
x. Nature of product, approach to marketing and export possibilities.
xi. Future prospects- expected capacity utilization during the first 3 years from the date of
commencement of production, and expected year when company would be able to earn the cash
profits and net profits. Stock market data for share/debentures of the company.[high/low in each
of the 3 years and monthly high/low during the last 6 months(where applicable).

VI. Particulars in regard to the company and other listed companies under the

Same management which made any capital issue during the last 3 years:
i. Name of the company,
ii. Year of the issue,
iii. Type of the issue (Public/Rights/Composite),
iv. Amount of issue,
v. Date of closure of the issue,
vi. Date of completion of delivery of share/debenture certificates,
vii. Date of completion of project, where object of the issue was financing of the project,
viii. Rate of dividend paid.

VII. (a)Outstanding litigation pertaining to –

i. Matters likely to affect operation and finance of the company including disputed tax liabilities of
any nature, and criminal prosecution launched against the company and the directors.
ii. Particulars of default, if any, in meeting statutory dues, institutional dues, and dues towards
debenture-holders, fixed depositors.
iii. Any material development after the date of latest balance sheet and their likely impact.

VIII. Management perception of risk factor (e.g., sensitivity to foreign exchange rate fluctuations,
difficulty in availability of raw materials or in marketing of products, cost/time over-run, etc.).

PART II OF SCHEDULE II:

A. General Information

1. Consent of Directors, Auditors, Solicitors/Advocates, Managers to Issue, Registrar of Issue, Bankers


to the Company, Bankers to the Issue and Experts.
2. Experts’ opinion obtained, if any.
3. Change, if any, in directors and auditors during last 3 years and reasons thereof.
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4. Authority for the issue and details of the resolution passed for the issue.
5. Procedure and time schedule for allotment and issue of certificates.
6. Names and addresses of the Company Secretary, Legal Advisor, Lead Manager, Co-managers,
Auditors, Bankers to the Company, Bankers to the issue and Brokers to the issue.

B. Financial Information

1. Report by the auditors regarding profits and losses, assets and liabilities and rates of dividends
(preceding 5 financial years).
2. Reports by the accountants on: (1) the profits or losses of the business for the preceding 5 financial
years, and on the assets and liabilities of the business on a date which shall not be more than 120
days before the date of issue of the prospectus; (2) principal terms of loans and assets charged as
security

C. Statutory and other information

1. Minimum subscription.
2. Expenses of the issue
3. Underwriting commission and brokerage.
4. Previous issue for cash.
5. Details of previous public or rights issue, if any
6. Issue of shares otherwise than for cash.
7. Debenture and redeemable preference shares and other instruments issued by the company
outstanding as on date of prospectus.
8. Option to subscribe.
9. Details of purchase of property.
10. Details of Directors- existing and proposed.
11. Rights of members.
12. Restrictions, if any, on transfers and transmission of shares.
13. Revaluation of assets, if any.
14. Material contacts and inspection of documents.

PART III OF SCHEDULE II:

This includes various legal provisions applying to Part I and II of Schedule II .

Statement by Experts
Where a prospectus includes a statement by an expert, he shall not be engaged in formation or management
of the company.

STATEMENT IN LIEU OF PROSPECTUS


Where a public company does not invite public to subscribe for its shares, but arranges to get money from
private sources, it need not issue a prospectus to the public. In such a case, the promoters are required to
prepare a draft prospectus known as ‘statement in lieu of prospectus’, which should contain the information
required to be disclosed by sec. III of the Act.

A company having a share capital, which does not issue a prospectus, shall not allot any of its shares or
debentures unless at least 3 days before the allotment of shares or debentures there has been delivered to the
Registrar for registration a statement in lieu of prospectus. The statement shall be signed by every person
who is named therein as a director or proposed director or by his agent authorized in writing.
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