Unit 1

Structure and Function of Indian Financial System

Financial System is a set of institutional arrangements through which financial surpluses in the economy
are mobilised from surplus units and transferred to deficit spenders.

The institutional arrangements include all conditions and mechanisms governing the production,
distribution, exchange and holding of financial assets or instruments of all kinds and the organisations as
well as the manner of operations of financial markets and institutions of all descriptions.

Thus, there are three main constituents of financial system:

(a) Financial Assets
(b) Financial Markets, and
(c) Financial Institutions.
Financial assets are subdivided under two heads:
Primary securities and secondary securities. The former are financial claims against real-sector units, for
example, bills, bonds, equities etc. They are created by real-sector units as ultimate borrowers for raising
funds to finance their deficit spending. The secondary securities are financial claims issued by financial
institutions or intermediaries against themselves to raise funds from public. For examples, bank deposits,
life insurance policies, UTI units, IDBI bonds etc.

Functions of Financial System:

The financial system helps production, capital accumulation, and growth by (i) encouraging savings, (ii)
mobilising them, and (iii) allocating them among alternative uses and users. Each of these functions is
important and the efficiency of a given financial system depends on how well it performs each of these
functions.

(i) Encourage Savings:

Financial system promotes savings by providing a wide array of financial assets as stores of value aided
by the services of financial markets and intermediaries of various kinds. For wealth holders, all this offers
ample choice of portfolios with attractive combinations of income, safety and yield.

With financial progress and innovations in financial technology, the scope of portfolio choice has also
improved. Therefore, it is widely held that the savings-income ratio is directly related to both financial
assets and financial institutions. That is, financial progress generally insures larger savings out of the same
level of real income.

As stores of value, financial assets command certain advantages over tangible assets (physical capital,
inventories of goods, etc.) they are convenient to hold, or easily storable, more liquid, that is more easily
encashable, more easily divisible, and less risky.

A very important property of financial assets is that they do not require regular management of the kind
most tangible assets do. The financial assets have made possible the separation of ultimate ownership and
management of tangible assets. The separation of savings from management has encouraged savings
greatly.

(ii) Mobilisation of Savings:

Financial system is a highly efficient mechanism for mobilising savings. In a fully-monetised economy
this is done automatically when, in the first instance, the public holds its savings in the form of money.
However, this is not the only way of instantaneous mobilisation of savings.

Other financial methods used are deductions at source of the contributions to provident fund and other
savings schemes. More generally, mobilisation of savings taken place when savers move into financial
assets, whether currency, bank deposits, post office savings deposits, life insurance policies, bill, bonds,
equity shares, etc.
(iii) Allocation of Funds:
Another important function of a financial system is to arrange smooth, efficient, and socially equitable
allocation of credit. With modem financial development and new financial assets, institutions and markets
have come to be organised, which are replaying an increasingly important role in the provision of credit.

In the allocative functions of financial institutions lies their main source of power. By granting easy and
cheap credit to particular firms, they can shift outward the resource constraint of these firms and make
them grow faster.

Structure of Indian Financial System:

Financial system operates through financial markets and institutions.

Classification of Financial Markets

The classification of financial markets in India is shown in Chart II.

(a) Unorganised Markets

In these markets there are a number of money lenders, indigenous bankers, traders etc., who lend money
to the public. Indigenous bankers also collect deposits from the public. There are also private finance
companies, chit funds etc., whose activities are not controlled by the RBI. Recently the RBI has taken
steps to bring private finance companies and chit funds under its strict control by issuing non-banking
financial companies (Reserve Bank) Directions, 1998. The RBI has already taken some steps to bring the
unorganized sector under the organized fold. They have not been successful. The regulations concerning
their financial dealings are still inadequate and their financial instruments have not been standardized.

(b) Organised Markets

In the organized markets, there are standardized rules and regulations governing their financialdealings.
There is also a high degree of institutionalization andinstrumentalisation. These markets are subject to
strict supervision and control by the RBI or other regulatory bodies.
These organized markets can be further classified into two. They are :
(i) Capital market
(ii) Money market
Capital Market :The capital market is a market for financial assets which have a long or indefinite
maturity. Generally, it deals with long term securities which have a maturity period of above one year.
Capital market may be further divided into three namely :
(i) Industrial securities market
(ii) Government securities market and
(iii) Long term loans market
I. Industrial securities marketAs the very name implies, it is a market for industrial securities namely:
(i) Equity shares or ordinary shares, (ii) Preference shares, and (iii) Debentures or bonds. It is a market
where industrial concerns raise their capital or debt by issuing appropriate instruments. It can be further
subdivided into two. They are :
(i) Primary market or New issue market
(ii) Secondary market or Stock exchange
Primary Market :Primary market is a market for new issues or new financial claims. Hence it is also
called New Issue market. The primary market deals with those securities which are issued to the public
for the first time. In the primary market, borrowers exchange new financial securities for long term funds.
Thus, primary market facilitates capital formation.
There are three ways by which a company may raise capital in a primaryThey are :
(i) Public issue
(ii) Rights issue
 (iii) Private placement
The most common method of raising capital by new companies is through sale of securities to the public.
It is called public issue. When an existing company wants to raise additional capital, securities are first
offered to the existing shareholders on a pre-emptive basis. It is called rights issue. Private placement is a
way of selling securities privately to a small group of investors.
Secondary Market :Secondary market is a market for secondary sale of securities. In other words,
securities which have already passed through the new issue market are traded in this market. Generally,
such securities are quoted in the stock exchange and it provides a continuous and regular market for
buying and selling of securities. This market consists of all stock exchanges recognized by the
Government of India. The stock exchanges in India are regulated under the Securities Contracts
(Regulation) Act, 1956. The Bombay Stock Exchange is the principal stock exchange in India which sets
the tone

Money Market
Money market is a market for dealing with financial assets and securities which have a maturity period of
upto one year. In other words, it is a market for purely short term funds. The money market may be
subdivided into four. They are:
(i) Call money market
(ii) Commercial bills market
(iii) Treasury bills market
(iv) Short term loan market
Call MoneyMarket :The call money market is a market for extremely short period loans say one day to
fourteen days. So, it is highly liquid. The loans are repayable ondemand at the option of either the lender
or the borrower. In India, call money markets are associated with the presence of stock exchanges and
hence, they are located in major industrial towns like Bombay, Calcutta, Madras, Delhi, Ahmedabad etc.
The special feature of this market is that the interest rate varies from day to day and even from hour to
hour and centre to centre. It is very sensitive to changes in demand and supply of call loans.
Recent Trends :With a view to bringing the interest rates nearer to the free market rates, the Government
has taken the following steps:
(i) The interest rates on company deposits are freed.
(ii) The interest rates on 364 days Treasury Bills are determined by auctions and they are expected
to reflect the free market rates.
(iii) The coupon rates on Government loans have been revised upwards so as to be market
oriented.
(iv) The interest rates on debentures are allowed to be fixed by companies depending upon the
market rates.
(v) The maximum rates of interest payable on bank deposits (fixed) are freed for deposits of above one
year.

Financial Instruments
Financial instruments refer to those documents which represent financial claims on assets. As discussed
earlier, financial asset refers to a claim to the repayment of a certain sum of money at the end of a
specified period together with interest or dividend. Examples are Bill of exchange, Promissory Note,
Treasury Bill, Government Bond,
Deposit Receipt, Share, Debenture, etc. Financial instruments can also be called financial securities.
Financial securities can be classified into:
(i) Primary or direct securities.
(ii) Secondary or indirect securities.
Primary Securities :These are securities directly issued by the ultimate investors to the ultimate savers,
e.g. shares and debentures issued directly to the public.
Secondary Securities :These are securities issued by some intermediaries called financial intermediaries
to the ultimate savers, e.g. Unit Trust of India and mutual funds issue securities in the form of units to the
public and the money pooled is invested in companies.
Again these securities may be classified on the basis of duration as follows :
(i) Short-term securities
(ii) Medium-term securities
(iii) Long-term securities
Short-term securities are those which mature within a period of one year. For example, Bill of Exchange,
Treasury Bill, etc. Medium-term securities are those which have a maturity period ranging between one
and five years like Debentures maturing within a period of 5 years. Long-term securities are those which
have a maturity period of more than five years. For example, Government Bonds maturing after 10 years.

Characteristic Features of Financial Instruments

Generally speaking, financial instruments possess the following characteristicfeatures:
(i) Most of the instruments can be easily transferred from one hand to another without many
cumbersome formalities.
(ii) They have a ready market i.e., they can be bought and sold frequently and thus trading in these
securities is made possible.(iii) They possess liquidity, i.e., some instruments can be
converted into cash readily. For instance, a bill of exchange can be converted into cash
readily by means of discounting and rediscounting.
(iv) Most of the securities possess security value, i.e., they can be given as security for the purpose
of raising loans.
(v) Some securities enjoy tax status, i.e., investment in these securities are exempted from Income
Tax, Wealth Tax, etc., subject to certain limits.
(vi) They carry risk in the sense that there is uncertainty with regard to payment of principal or
interest or dividend as the case may be.
(vii) These instruments facilitate future trading so as to cover risks due to price fluctuations,
interest rate fluctuations etc.
(viii) These instruments involve less handling costs since expenses involved in buying and selling
these securities are generally much less.
(ix) The return on these instruments is directly in proportion to the risk undertaken.
(x) These instruments may be short-term or medium term or long-term depending upon the maturity
period of these instruments
SEBI advises certain guidelines in issue of fresh share capital, first issue by new companies in Primary
Market and functioning of secondary markets in order to maintain quality standards. A few such
guidelines and objectives of the Securities and Exchange Board of India (SEBI) are discussed here.

SEBI Guidelines for issue of fresh share capital

1. All applications should be submitted to SEBI in the prescribed form.
2. Applications should be accompanied by true copies of industrial license.
3. Cost of the project should be furnished with scheme of finance.
4. Company should have the shares issued to the public and listed in one or more recognized stock
exchanges.
5. Where the issue of equity share capital involves offer for subscription by the public for the first time,
the value of equity capital, subscribed capital privately held by promoters, and their friends shall be not
less than 15% of the total issued equity capital.
6. An equity-preference ratio of 3:1 is allowed.
7. Capital cost of the projects should be as per the standard set with a reasonable debt-equity ratio.
8. New company cannot issue shares at a premium. The dividend on preference shares should be within
the prescribed list.
9. All the details of the underwriting agreement.
10. Allotment of shares to NRIs is not allowed without the approval of RBI.
11. Details of any firm allotment in favor of any financial institutions.
12. Declaration by secretary or director of the company.
SEBI Guidelines for first issue by new companies in Primary Market:
1. A new company which has not completed 12 months of commercial operations will not be allowed to
issue shares at a premium.
2. If an existing company with a 5-year track record of consistent profitability, is promoting a new
company, then it is allowed to price its issue.
3. A draft of the prospectus has to be given to the SEBI before public issue.
4. The shares of the new companies have to be listed either with OTCEI or any other stock exchange.
SEBI guidelines for Secondary market
1. All the companies entering the capital market should give a statement regarding fund utilization of
previous issue.
2. Brokers are to satisfy capital adequacy norms so that the member firms maintain adequate capital in
relation to outstanding positions.
3. The stock exchange authorities have to alter their bye-laws with regard to capital adequacy norms.
4. All the brokers should submit with SEBI their audited accounts.
5. The brokers must also disclose clearly the transaction price of securities and the commission earned by
them. This will bring transparency and accountability for the brokers.
6. The brokers should issue within 24 hours of the transaction contract notes to the clients.
7. The brokers must clearly mention their accounts details of funds belonging to clients and that of their
own.
8. Margin money on certain securities has to be paid by claims so that speculative investments are
prevented.
9. Market makers are introduced for certain scrips by which brokers become responsible for the supply
and demand of the securities and the price of the securities is maintained.

10. A broker cannot underwrite more than 5% of the public issue.

11. All transactions in the market must be reported within 24 hours to SEBI.
12. The brokers of Bombay and Calcutta must have a capital adequacy of Rs. 5 lakhs and for Delhi and
Ahmadabad it is Rs. 2 lakhs.
13. Members who are brokers have to pay security deposit and this is fixed by SEBI.
FUNCTIONS OF A STOCK EXCHANGE
The functions of stock exchange can be enumerated as follows:
1. Provides ready and continuous market: By providing a place where listed securities can be bought and
sold regularly and conveniently, a stock exchange ensures a ready and continuous market for various
shares, debentures, bonds and government securities. This lends a high degree of liquidity to holdings in
these securities as the investor can encash their holdings as and when they want.
2. Provides information about prices and sales: A stock exchange maintains complete record of all
transactions taking place in different securities every day and supplies regular information on their prices
and sales volumes to press and other media. In fact, now-a-days, you can get information about minute to
minute movement in prices of selected shares on TV channels like CNBC, Zee News, NDTV and
Headlines Today. This enables the investors in taking quick decisions on purchase and sale of securities in
which they are interested. Not only that, such information helps them in ascertaining the trend in prices
and the worth of their holdings. This enables them to seek bank loans, if required.
3. Provides safety to dealings and investment:
Transactions on the stock exchange are conducted only amongst its members with adequate transparency
and in strict conformity to its rules and regulations which include the procedure and timings of delivery
and payment to be followed. This provides a high degree of safety to dealings at the stock exchange.
There is little risk of loss on account of non-payment or nondelivery. Securities and Exchange Board of
India (SEBI) also regulates the business in stock exchanges in India and the working of the stock brokers.
4. Helps in mobilisation of savings and capital formation:
 Efficient functioning of stock market creates a conducive climate for an active and growing primary
market. Good performance and outlook for shares in the stock exchanges imparts buoyancy to the new
issue market, which helps in mobilising savings for investment in industrial and commercial
establishments. Not only that, the stock exchanges provide liquidity and profitability to dealings and
investments in shares and debentures. It also educates people on where and how to invest their savings to
get a fair return. This encourages the habit of saving, investment and risk-taking among the common
people. Thus it helps mobilising surplus savings for investment in corporate and government securities
and contributes to capital formation.
5. Barometer of economic and business conditions:
Stock exchanges reflect the changing conditions of economic health of a country, as the shares prices are
highly sensitive to changing economic, social and political conditions. It is observed that during the
periods of economic prosperity, the share prices tend to rise. Conversely, prices tend to fall when there is
economic stagnation and the business activities slow down as a result of depressions. Thus, the intensity
of trading at stock exchanges and the corresponding rise on fall in the prices of securities reflects the
investors’ assessment of the economic and business conditions in a country, and acts as the barometer
which indicates the general conditions of the atmosphere of business. 6. Better Allocation of funds: As a
result of stock market transactions, funds flow from the less profitable to more profitable enterprises and
they avail of the greater potential for growth. Financial resources of the economy are thus better allocated.
REGULATIONS OF STOCK EXCHANGES
As indicated earlier, the stock exchanges suffer from certain limitations and require strict
control over their activities in order to ensure safety in dealings thereon. Hence, as early as 1956, the
Securities Contracts (Regulation) Act was passed which provided for recognition of stock exchanges by
the central Government. It has also the provision of framing of proper bylaws by every stock exchange for
regulation and control of their functioning subject to the approval by the Government. All stock
exchanges are required submit information relating to its affairs as required by the Government from time
to time. The Government was given wide powers relating to listing of securities, make or amend bylaws,
withdraw recognition to, or supersede the governing bodies of stock exchange in extraordinary/abnormal
situations. Under the Act, the Government promulgated the Securities Regulations (Rules) 1957, which
provided inter alia for the procedures to be followed for recognition of the stock exchanges, submission of
periodical returns and annual returns by recognised stock exchanges, inquiry into the affairs of recognised
stock exchanges and their members, and requirements for listing of securities.
Meaning of Listing:
Listing forms the very basis of the operations of stock exchange. A stock exchange does not deal in the
securities of all the companies. Instead, it deals only in the listed securities of certain selected companies.
Listing here means an act of inclusion of securities in the official list of a stock exchange for the purpose
of trading.

The company issuing securities for public subscription has to apply to a recognised stock exchange to get
its securities listed. If the permission is granted, then the securities are said to have been listed. Listing,
therefore, is a sort of sanction of the stock exchange permitting dealings in the specific securities. In
technical language, listed securities are also called ‘scrip’s’.

Formalities for Listing:

A company wishing to have its securities listed has to apply in the prescribed form supported by
following documents and particulars:
(a) Copies of Memorandum and Articles of Association, Prospectus or Statement in lieu of Prospectus and
agreements with underwriters.

(b) Specimen copies of shares’ and debentures’ certificates, letters of allotment, etc.
(c) Particulars of bonuses and dividends declared during the last 10 years.
(d) Particulars of shares or debentures for which permission is sought.
(e) A statement showing the distribution of shares.
 (f) A brief history of the company’s activities since its incorporation with reference to its assets, liabilities
and capital structure.
After a careful examination of the application, the stock exchange authorities may call upon the company
to execute a listing agreement. This contains the obligations and restrictions on the part of the company.
The company undertakes:
(a) That it would offer not less than 49 per cent of its issued capital for public subscription;
(b) That it would be fair to all applicants for shares while making allotments;
(c) That it would keep the stock exchange fully informed about vital matters affecting the company.
(d) That it would ensure equitable voting rights and dividend rights.
Challenges faced by the financial service sector.
Financial service sector has to face lot of challenges in its way to fulfil the ever growing financial demand
of the economy. Some of the important challenges are listed below:
1. Lack of qualified personnel in the financial service sector.
2. Lack of investor awareness about the various financial services.
3. Lack of transparency in the disclosure requirements and accounting practices relating to financial
services.
4. Lack of specialisation in different financial services (specialisation only in one or two services).
5. Lack of adequate data to take financial service related decisions.
6. Lack of efficient risk management system in the financial service sector.
The above challenges are likely to increase in number with the growing requirements of the customers.
However, the financial system in India at present is in a process of rapid transformation, particularly after
the introduction of new economic reforms
Unit 2

Financial services

Financial services refer to services provided by the finance industry. The finance industry encompasses a
broad range of organizations that deal with the management of money. Among these organizations are
banks, credit card companies, insurance companies, consumer finance companies, stock brokerages,
investment funds and some government sponsored enterprises.

Functions of Financial Services

 Facilitating transactions (exchange of goods and services) in the economy.

 Mobilizing savings (for which the outlets would otherwise be much more limited).
 Allocating capital funds (notably to finance productive investment).
 Monitoring managers (so that the funds allocated will be spent as envisaged).
 Transforming risk (reducing it through aggregation and enabling it to be carried by those more
willing to bear it).

Characteristics and Features of Financial Services

1. Customer-Specific: Financial services are usually customer focused. The firms providing these
services, study the needs of their customers in detail before deciding their financial strategy, giving due
regard to costs, liquidity and maturity considerations. Financial services firms continuously remain in
touch with their customers, so that they can design products which can cater to the specific needs of
their customers. The providers of financial services constantly carry out market surveys, so they can
offer new products much ahead of need and impending legislation. Newer technologies are being used
to introduce innovative, customer friendly products and services which clearly indicate that the
concentration of the providers of financial services is on generating firm/customer specific services.
2. Intangibility: In a highly competitive global environment brand image is very crucial. Unless the
financial institutions providing financial products and services have good image, enjoying the
confidence of their clients, they may not be successful. Thus institutions have to focus on the quality
and innovativeness of their services to build up their credibility.
3. Concomitant: Production of financial services and supply of these services have to be concomitant.
Both these functions i.e. production of new and innovative financial services and supplying of these
services are to be performed simultaneously.
4. Tendency to Perish: Unlike any other service, financial services do tend to perish and hence cannot
be stored. They have to be supplied as required by the customers. Hence financial institutions have to
ensure a proper synchronization of demand and supply.
5. People Based Services: Marketing of financial services has to be people intensive and hence it’s
subjected to variability of performance or quality of service. The personnel in financial services
organisation need to be selected on the basis of their suitability and trained properly, so that they can
perform their activities efficiently and effectively.
6. Market Dynamics: The market dynamics depends to a great extent, on socioeconomic changes such
as disposable income, standard of living and educational changes related to the various classes of
customers. Therefore financial services have to be constantly redefined and refined taking into
consideration the market dynamics. The institutions providing financial services, while evolving new
services could be proactive in visualizing in advance what the market wants, or being reactive to the
needs and wants of their customers.

Scope of Financial Services

Financial services cover a wide range of activities. They can be broadly classified into two, namely:

1. Traditional Activities

Traditionally, the financial intermediaries have been rendering a wide range of services encompassing
both capital and money market activities. They can be grouped under two heads, viz.

1. Non-fund based activities.

Fund based activities: The traditional services which come under fund based activities are the following:

 Underwriting or investment in shares, debentures, bonds, etc. of new issues (primary market

activities).
 Dealing in secondary market activities.
 Participating in money market instruments like commercial papers, certificate of deposits, treasury
bills, discounting of bills etc.
 Involving in equipment leasing, hire purchase, venture capital, seed capital etc.
 Fund based activities and
 Dealing in foreign exchange market activities. Non fund based activities

Non fund based activities: Financial intermediaries provide services on the basis of non-fund activities
also. This can be called ‘fee based’ activity. Today customers, whether individual or corporate, are not
satisfied with mere provisions of finance. They expect more from financial services companies. Hence a
wide variety of services, are being provided under this head. They include:

 Managing the capital issue i.e. management of pre-issue and post-issue activities relating to the
capital issue in accordance with the SEBI guidelines and thus enabling the promoters to market their
issue.
 Making arrangements for the placement of capital and debt instruments with investment
institutions.
 Arrangement of funds from financial institutions for the clients project cost or his working capital
requirements.
 Assisting in the process of getting all Government and other clearances.

2. Modern Activities

Beside the above traditional services, the financial intermediaries render innumerable services in recent
times. Most of them are in the nature of non-fund based activity. In view of the importance, these
 activities have been in brief under the head ‘New financial products and services’. However, some of the
modern services provided by them are given in brief here under.

 Rendering project advisory services right from the preparation of the project report till the raising
of funds for starting the project with necessary Government approvals.
 Planning for M&A and assisting for their smooth carry out.
 Guiding corporate customers in capital restructuring.
 Acting as trustees to the debenture holders.
 Recommending suitable changes in the management structure and management style with a view
to achieving better results.
 Structuring the financial collaborations/joint ventures by identifying suitable joint venture partners
and preparing joint venture agreements.
 Rehabilitating and restructuring sick companies through appropriate scheme of reconstruction and
facilitating the implementation of the scheme.
 Hedging of risks due to exchange rate risk, interest rate risk, economic risk, and political risk by
using swaps and other derivative products.
 Managing in-portfolio of large Public Sector Corporations.
 Undertaking risk management services like insurance services, buy-back options etc.
 Advising the clients on the questions of selecting the best source of  funds taking into
consideration the quantum of funds required, their cost, lending period etc.
 Guiding the clients in the minimization of the cost of debt and in the determination of the optimum
debt-equity mix.
 Promoting credit rating agencies for the purpose of rating companies which want to go public by
the issue of debt instrument.

Regulation framework of financial services

•Better distribution of social benefits
.•To shape and monitor the market
.•To check mismanagement, deception, fraud etc.
•To ensure that the insurance company has adequate professional capability, is financially sound,
holds adequate reserves and invests its funds adequately
.•To check reckless rate wars, undercutting, unhealthy links with industrial houses and disregard for
prudential norms.
CONCEPT AND NATURE OF MERCHANT BANKING

Despite the fact that merchant banking is emerging as one of the prominent segment of financial service
sector, it is difficult to define what merchant banking is. The reason is very obvious as its limits
have never been adequately and strictly defined and it caters to wide variety of financial activities.
Dictionary of Banking and Finance explains merchant bank as an organisation that underwrites
securities for corporations, advisessuch clients on mergers and is involved in the ownership of
commercial ventures. Securities and Exchange Board of India (Merchant Bankers) Rules 1992
defines merchant bankers as “any person who is engaged in the business of issue management
either by making arrangement regarding selling, buying or subscribing to securities or acting as
manager, consultant, adviser or rendering corporate advisory services in relation to such issue
management. The Guidelines for Merchant Bankers (issued by Ministry of Finance, Deptt. of
Economic Affairs, Stock Exchange Division on 9-4-1990) instead of defining merchant banking
stated that these guidelines shall apply to those presently engaged in merchant banking activity
including as managers to issue and undertakes authorised activities. These activities interalia
include underwriting, portfolio management etc. Thus. to defines merchant bankers a definite
better approach is to include those agencies as merchant bankers which do what a merchant banker
does.

FUNCTIONS OF MERCHANT BANKER

i) Project counsellingThe first step to launch a business unit is selection of a viable project. Merchant
bankers undertake this assignment on a very large scale since they have experts with them in diverse
fields. Project counselling covers a variety of sub assignments. Illustrative list of services which can be
rendered under this category is :
• Guidance in relation to project viability i.e. project identification and counselling. It may be for
setting up new units, expansion or improvement of existing facilities.
• Selection of consultants for preparation of project reports/market surveys etc. Sometimes merchant
bankers also engage in preparation of project reports or market surveys.
• Advice on various procedural steps including obtaining of governmental approvals clearance etc. e.g.
for foreign collaboration.
• Proposing a suitable capital structure laying broad as well as specific features.
• Teachno- economic soundness of the project and marketing aspects. Financial engineering i.e.
selection of right mix of financing pattern specifically for short term requirements.
ii) Credit syndication

Normally every project has to raise debt funds for different sources as per need. Substantial debt raising
may be required for a new and capital intensive project. For such project merchant bankers may
undertake credit syndication. Credit syndication is credit procurement service. As per the
requirements, such syndication can be from national as well as international sources. Some of the
important credit syndication services offered are.
iii) Issue management
Traditionally this is one of the main functions of merchant banker. When ever an issue is made whether it
is public issue or private placement and further whether it is for equity shares, preference shares or
debentures, the merchant banker has a crucial role to play. Raising of funds from public has many
dimensions and formalities which are notpossible for the concerned. companies to comply with, where
merchant banker comes to their rescue. Marketing effort to convince the prospective investor needs
special attention. Here again merchant bankers are specialists. The specific important activities related to
issue management performed by merchant banks are mentioned here:
• Advise the company about the quantum and terms of raising funds.
• Advise as to what type of security may be acceptable in the market as well as to the
concerned lending institutions at the time of issue.
• Advise as to whether a fresh issue to be made or right issue to be made or if both, then in
what proportion, obtaining the desired consents, if any, from government or other
authorities

iv) Corporate counselling

Although the functions discussed up till now are also covered under corporate counselling but here other
dimensions will be deliberated. Corporate counselling is to rejuvenate the corporate units which are
otherwise having signals to low productivity, low efficiency and low profitability. The merchant bankers
can play a substantial role in reviving the sick units. They make mergers and acquisition exercise smooth,
They can advise on improvement in the systems operating in managing the show of a corporate unit.
Some of the specific assignments for the merchant banker are:-
• Rejuvenating old line and ailing/sick unit or appraising their technology and process,
assessing their requirements and. restructuring their capital base.
• Evolving rehabilitation programmes/packages which can be acceptable to the financial
institutions and banks.
• Assisting in obtaining approvals from Board for Industrial and Financial Reconstruction
(BlFR) and other authorities under the Sick Industrial Companies (special provisions)
Act1985 (SICA).
• Monitoring implementation of schemes of rehabilitation.
 • Advice on financial restructuring involving redeployment of corporate assets to refocus
companies line of business.
• Advice on rearranging the portfolio of business assets through acquisition etc.
• Assisting in valuing the assets and liabilities.
• Identifying potential buyers for disposal of assets if required. Identify the candidates for take
over.
• Advice on tactics in approaching potential acquisition.
• Assisting in deciding the mode of acquisition whether friendly or unfriendly or
v) Portfolio management
Merchant bankers as a body of professionally qualified persons also undertake assignments of managing
an individual investor's portfolio. Portfolio management is being practised as an investment management
counselling in which the investor is advised to seek financial assets like government securities,
commercial papers, debentures, shares, warrants etc. that would grow in value and/or provide income. The
investors whether local or foreigner with substantial amount for investment in securities seek portfolio
management services of authorised merchant bankers. The functioning of portfolio manager can be
regulated or unregulated. Portfolio manager may use totally his discretion or may act only after getting
signal from investor for each transaction of sale or purchase. A diverse range of services which may be
rendered by merchant banker include: -
• Advising what and when to sell and buy.
• Arranging sale or purchase of securities.
• Communicating changes in investment market to the client investor

 Compliance of regulations of different regulating bodies for sale of purchase of portfolio.

• Collection of returns and reinvest as per directions of clients.
• Evaluating the portfolio at regular intervals or at direction of investors.
• Advising on tax matters pertaining to income from and investment in portfolio
• Safe custody of securities

vi) Stock broking and dealership

The merchant bankers who have requisite professional knowledge and experience may also act as share
broker on a stock exchange and even as dealer for Over The Counter trading. To venture into this area it is
normally desired that the merchant banker has reasonable network. Their actions and activities are
regulated by rules and regulations of the concerned stock exchange. They are at liberty to appoint sub
brokers and sub dealers to ensure wider net work of their operations. They can be broker for inland as
well as foreign stock exchanges. In India the merchant bankers who desire to act as brokers are regulated
by SEBI (Stock Broker and Sub-brokers) Rules 1992.

viii) Debenture trusteeship :-The merchant bankers can get themselves registered to act as trustee. These
trustees are to protect the interests of debenture holders as per the terms laid down in trust deed. They are,
as trustees, to undertake redressal of grievances of debenture holders. They are to ensure that refund
monies are paid and debenture certificates are dispatched in accordance with the Companies Act.
Debenture trustees are expected to observe high standards of integrity and fairness in discharging their
functions. They can call for periodical reports from the body corporate. They charge fee for such services.

Bill discunting

Bill discounting is a service against which merchant banker has to arrange funds against the bills which
have been discounted. This service is undertaken by merchant bankers generally if bill market is big as
well as mature. Otherwise bill discounting is undertaken by banks only. Depending on their credibility
they may also undertake the assignment of bill acceptance. These bills accepted and or discounted can be
foreign and merchant bankers can specify what types of bills they entertain. They charge commission for
these services.
(ii) Venture capital

Venture capital is the organized financing of relatively new enterprises to achieve substantial capital
gains. Such new companies are chosen because of their potential for considerable growth due to advance
technology, new products or services or other valuable innovations. A high risk is implied in the term and
is implicit in this type of investment. Since certain ingredients necessary for success of such projects are
missing in the begging but are added later on. Merchant bankers undertake to arrange and if necessary, to
provide such venture capital since traditional sources of finance like banks, financial institutions or public
issue etc. may not be available. Since expected returns on projects involving venture capital is high, these
are normally provided on soft terms. Such scheme is also popular as seed capital or risk capital scheme.
Merchant bankers deeply study such proposals before releasing the money. At opportune time such
investment can be disinvested to keep the cycle of venture capital more on.(iv) Lease financing and hire
purchase

Depending on the funds available, merchant bankers can also enter the field of lease or hire purchase
financing. Lease is an agreement where by the lessor (merchant banker in our case) conveys to the lessee
(the user), in return for rent, the right to use an asset for an agreed period of time. On the other hand in
hire purchase the user at the end of the agreed period has an option to purchase the asset which he has
used till date. The merchant bankers can advise the client to go in for leasing or hire purchase system of
financing an asset

(v) Factoring
Factoring is a novel financing innovation. It is a mixed service having financial as well as non financial
aspects. On one hand it involves management and collection of books debts which arise in process of
credit sale. The merchant bankers can take up this assignment and are required to perform activities like
sales ledger administration, credit collection, credit protection, evolving credit policy, arranging letter of
credit etc. On the other hand there is involvement of finance. Against factored debts the merchant banker
may provide advance with a certain margin

Make a systematic analysis of relevant information for credit monitoring and control.
• Provide full or partial protection against bad debts and accepting the risk of non realization.
• Provide financial assistance to the client.
• Provide information about prospective buyers.
• Provide financial counseling and assisting managing the liquidity.

vi) Underwriting
It refers to a contract by means of which merchant banker gives an assurance to the issuing company that
the former would subscribe to the securities offered in the event of non-subscription by the persons to
whom it was offered. The liability of merchant banker arises if the issue is not fully subscribed and this
liability is restricted to the commitment extended by him. The merchant bankers undertaking underwriting
make efforts on their own to induce the prospective investors to subscribe to the concerned issue. Such
assignment is accepted after evaluating viz :
• Company’s standing and its past record.
• Competence of the management.
• Purpose of the issue.
• Potentials

Categories of Merchant Bankers

The merchant banking regulations require that any body seeking registration as merchant banker has to
apply in one of the following four categories :
Category I : These merchant bankers can carry on any activity of the issue management, which will
inter-alia consist of preparation of prospectus and other information relating to the issue, determining
financial structure, tie up of financiers and final allotment and refund of subscription. They can also act as
adviser, consultant, manager, underwriter, portfolio manager.
Category II :Such merchant bankers can act as adviser, consultant, co-manager, underwriter and portfolio
manager. This means they can not undertake issue management of their own.Category III :These
merchant bankers can neither undertake issue management nor act as co-manager. They cannot conduct
business of portfolio management. Thus the area of their operation restricts to act as underwriter, adviser
and consultant to the issue.
Category IV :Such merchant bankers do not undertake any activities requiring funds. They can act only
as adviser or consultant to an issue.(ii) Capital adequacy :In the categories where in fund based activities
are involved, SEBI desires them to have sufficient capital. The concept of adequate capital is expressed in
terms of ‘net worth’. ‘Net worth’ means the value of capital contributed to the business plus free reserves.
At the time of registration as well as subsequently following pattern of ‘net worth’ should be at least
maintained :
Category of Merchant Banker Minimum Networth
Category I Rs. 5,00,00,000
Category II Rs. 50,00,000
Category III Rs. 20,00,000
Category IV NIL
Role of Merchant Bankers in Managing Public Issue
In issue management, the main role of merchant bankers is to help the company issuing securities
in raising funds for the purpose of financing new projects, expansion/ modernization/ diversification of
existing units and augmenting long term resources for working capital requirements.
The most important aspect of merchant banking business is to function as lead managers to the
issue management.
The role of the merchant banker as an issue manager can be studied from the following points:
1. Easy fund raising: An issue manager acts as an indispensable pilot facilitating a public/ rights issue.
This is made possible with the help of special skills possessed by him to execute the management of
issues.
2. Financial consultant: An issue manager essentially acts as a financial architect, by providing advice
relating to capital structuring, capital gearing and financial planning for the company.
3. Underwriting: An issue manager allows for underwriting the issues of securities made by corporate
enterprises. This ensures due subscription of the issue
. 4. Due diligence: The issue manager has to comply with SEBI guidelines. The merchant banker will
carry out activities with due diligence and furnish a Due Diligence Certificate to SEBI. The detailed
diligence guidelines that are prescribed by the Association of Merchant Bankers of India (AMBI) have to
be strictly observed. SEBI has also prescribed a code of conduct for merchant bankers.
5. Co-ordination: The issue manger is required to co-ordinate with a large number of institutions and
agencies while managing an issue in order to make it successful.
6. Liaison with SEBI: The issue manager, as a part of merchant banking activities, should register with
SEBI. While managing issues, constant interaction with the SEBI is required by way of filing of offer
documents, etc. In addition, they should file a number of reports relating to the issues being managed.
Merchant Banking Regulations:
SEBI (Merchant Bankers’) Regulation Act, 1992 defines a ‘merchant banker’ as “any person who is
engaged in the business of issue management either by making arrangements regarding selling, buying or
subscribing to securities or acting as manager, consultant, adviser or rendering corporate advisory service
in relation to such issue management”.
At present no organisation can act as a ‘merchant banker’ without obtaining a certificate of
registration from the SEBI.
However, It must be noted that a person/ organisation has to get himself registered under these regulations
if he wants to carry on or undertake any of the authorised activities, i.e., issue management assignment as
manager, consultant, advisor, underwriter or portfolio manager.
 To obtain the certificate of registration, one had to apply in the prescribed form and fulfill two sets of
norms (i) operational capabilities and (ii) capital adequacy norms.

UNIT 3

Meaning of Venture Capital

The term venture capital comprises of two words, namely, ‘venture’ and ‘capital’. The term ‘venture’
literally means a ‘course’ or ‘proceeding’, the outcome of which is uncertain (i.e., involving risk). The
term capital refers to the resources to start the enterprise. Thus venture capital refers to capital investment
in a new and risky business enterprise. Money is invested in such enterprises because these have high
growth potential.

Venture capital is the money and resources made available to start up firms and small business with
exceptional growth potential (e.g., IT, infrastructure, real estate etc.). It is fundamentally along term risk
capital in the form of equity finance for the small new ventures which involve risk. But at the same time,
it a the strong potential for the growth. It thrives on the concept of high risk- high return. It is a means of
equity financing for rapidly growing private companies.

Characteristics of Venture Capital

The important characteristics of venture capital finance are outlined as bellow:

1. It is basically equity finance.

2. It is a long term investment in growth-oriented small or medium firms.
3. Investment is made only in high risk projects with the objective of earning a high rate of return.
4. In addition to providing capital, venture capital funds take an active interest in the management of the
assisted firm. It is rightly said that, “venture capital combines the qualities of banker, stock market
investor and entrepreneur in one”.
5. The venture capital funds have a continuous involvement in business after making the investment.
6. Once the venture has reached the full potential, the venture capitalist sells his holdings at a high
premium. Thus his main objective of investment is not to earn profit but capital gain.
Methods or Modes of Venture Financing (Funding Pattern)/Dimensions of Venture Capital

Venture capital is typically available in four forms in India: equity, conditional loan, income note and
conventional loan.

Equity: All VCFs in India provide equity but generally their contribution does not exceed 49 per cent of
the total equity capital. Thus, the effective control and majority ownership of the firm remain with the
entrepreneur. They buy shares of an enterprise with an intention to ultimately sell them off to make capital
gains.

Conditional loan: It is repayable in the form of a royalty after the venture is able to generate sales. No
interest is paid on such loans. In India, VCFs charge royalty ranging between 2 and 15 per cent; actual
rate depends on the other factors of the venture, such as gestation period, cost-flow patterns and riskiness.

Income note: It is a hybrid security which combines the features of both conventional loan and
conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at substantially low
rates.
Conventional loan: Under this form of assistance, the enterprise is assisted by way of loans. On the
loans, a lower fixed rate of interest is charged, till the unit becomes commercially operational. When the
company starts earning profits, normal or higher rate of interest will be charged on the loan. The loan has
to be repaid as per the terms of loan agreement.

Other financing methods: A few venture capitalists, particularly in the private sector, have started
introducing innovative financial securities like participating debentures introduced by TCFC.

Legal Aspects of Venture Capital

The legal aspects relating to venture capital in India may be briefly explained as follows:

Regulatory Structure:

The SEBI regulates venture capital industry in India. It announced the regulations for the venture
capital funds in 1996, with the primary objective of protecting the interest of investors and providing
enough flexibility to the fund managers to make suitable investment decisions. Venture capital funds
appoint an asset management company to manage the portfolio of the fund. Any company proposing to
undertake venture capital investments is required to obtain certificate of registration from SEBI. Venture
capital fund can invest up to 40% of the paid up capital of the invested company or up to 20% of the
corpus of the fund in one undertaking. At least 80% of funds raised by VCF shall be invested in equity
shares or equity related securities issued by company whose shares are not listed on recognised stock
exchange. Venture capital investments are required to be restricted to domestic companies engaged in
business of software, information technology, biotechnology, agriculture, and allied sectors.

Guidelines for the Venture Capital Companies

The Government of India has issued the following guidelines for various venture capital funds operating
in the country.

1. The financial institutions, State Bank of India, scheduled banks, and foreign banks are eligible to
establish venture capital companies or funds subject to the approval as may be required from the Reserve
Bank of India.

2. The venture capital funds have a minimum size of Rs. 10 crores and a debt equity ratio of 1:1.5. If
they desire to raise funds from the public, promoters will be required to contribute minimum of 40% of
the capital.
3. The guidelines also provide for NRI investment upto 74% on a non-repatriable basis.
4. The venture capital funds should be independent of the parent organisation.
5. The venture capital funds will be managed by professionals and can be set up as joint ventures even
with non-institutional promoters.

6. The venture capital funds will not be allowed to undertake activities such as trading, broking, and
money market operations but they will be allowed to invest in leasing to the extent of 15% of the total
funds deployed. The investment or revival of sick units will be treated as a part of venture capital activity.

7. A person holding a position of being a full time chairman, chief executive or managing director of a
company will not be allowed to hold the same position simultaneously in the venture capital
fund/company.

8. The venture capital assistance should be extended to the promoters who are now, and are
professionally or technically qualified with inadequate resources.

Meaning of leasing
 Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a
series of contractual, periodic, tax deductible payments. The lessee is the receiver of the services or the
assets under the lease contract and the lessor is the owner of the assets. The relationship between the
tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called
the term of the lease). The consideration for the lease is called rent.

Lease can be defined as the following ways:

1. A contract by which one party (lessor) gives to another (lessee) the use and possession of equipment for
a specified time and for fixed payments.
2. The document in which this contract is written.
3. A great way companies can conserve capital.
4. An easy way vendors can increase sales.
A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer
conveys to the equipment user the right to use the equipment in return for a rental. In other words, lease is
a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to use the asset
during a specified period in return for a mutually agreed periodic payment (the lease rentals). The
important feature of a lease contract is separation of the ownership of the asset from its usage.

TYPES OF LEASE

(a) Financial lease

(b) Operating lease.
(c) Sale and lease back
(d) Leveraged leasing and
(e) Direct leasing.

1) Financial lease
Long-term, non-cancellable lease contracts are known as financial leases. The essential point of financial
lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at
the end of the lease period at a nominal cost. At lease it must give an option to the lessee to purchase the
asset he has used at the expiry of the lease. Under this lease the lessor recovers 90% of the fair value of
the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement
is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there
from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title
deeds remain with the lessor. Financial lease is also known as 'capital lease‘. In India, financial leases are
very popular with high-cost and high technology equipment.
2) Operational lease
An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement
gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and
maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease
period. Normally the lease is for a short period and even otherwise is revocable at a short notice. Mines,
Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of
obsolescence is very high in this kind of assets.

3) Sale and lease back

It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the buyer),
who in turn leases back the same asset to the owner in consideration of lease rentals. However, under this
arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing but
a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected
depreciation but appreciation, say land. The advantage of this method is that the lessee can satisfy himself
completely regarding the quality of the asset and after possession of the asset convert the sale into a lease
arrangement

4) Leveraged leasing
Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The lessor
borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and the asset so
purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the
lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor, the owner of
the asset is entitled to depreciation allowance associated with the asset.
5) Direct leasing
Under direct leasing, a firm acquires the right to use an asset from the manufacture directly. The
ownership of the asset leased out remains with the manufacturer itself. The major types of direct lessor
include manufacturers, finance companies, independent lease companies, special purpose leasing
companies etc

Example

B-Tel, Inc. is a telecommunication services provider looking to expand to a new territory Z; it is analyzing
whether it should install its own telecom towers or lease them out from a prominent tower-sharing
company T-share, Inc.
Leasing out 100 towers would involve payment of $5,000,000 per year for 5 years.
Erecting 100 news towers would cost $18,000,000 including the cost of equipment and installation, etc.
The company has to obtain a long-term secured loan of $18 million at 5% per annum.
Owning a tower has some associated maintenance costs such as security, power and fueling, which
amounts to $10,000 per annum per tower.
The company’s tax rate is 40% while its long-term weighted average cost of debt is 6%. The tax laws
allow straight-line depreciation for 5 years.
Determine whether the company should erect its own towers or lease them out.

Solution

Annual cash out flows of leasing (Year 1 to Year 5) = $5,000,000 * (1 – 40%) = $3,000,000
Annual cash flows of purchasing have three components: the loan amount to be repaid in each period, the
maintenance costs to be borne each year, the tax shields associated with maintenance costs, depreciation
expense and interest expense. The following table summarizes the calculation of cash flows under this
alternative.
Period 1 2 3 4 5
Loan repayment A 4,157,546 4,157,546 4,157,546 4,157,546 4,157,546
Maintenance costs B 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Depreciation D 3,600,000 3,600,000 3,600,000 3,600,000 3,600,000
Interest expense I 900,000 737,123 566,101 386,529 197,978
Total tax T = 5,500,000 5,337,123 5,166,101 4,986,529 4,797,978
deductions B+D+I
Tax shield @ 40% t = 0.4×T 2,200,000 2,134,849 2,066,441 1,994,612 1,919,191
Net cash flows N = A+B–t 2,957,546 3,022,697 3,091,106 3,162,935 3,238,355
Annual loan repayment is based on present value calculation; it is the amount paid at the end of each year
for 5 years that would write off the loan completely. It is calculated using the following MS Excel
function: PMT (5%,5,-18000000).
Interest expense are calculated in the following debt amortization table:
Perio Opening Total Interest Principal Closing
d Principal Repayment Repayment Principal
0 18,000,000 - - - 18,000,000
1 18,000,000 4,157,546 900,00 3,257,546 14,742,454
0
2 14,742,454 4,157,546 737,12 3,420,424 11,322,030
3
3 11,322,030 4,157,546 566,10 3,591,445 7,730,585
1
4 7,730,585 4,157,546 386,52 3,771,017 3,959,568
9
5 3,959,568 4,157,546 197,97 3,959,568 -
8
It is necessary to prepare amortization table because tax laws do not allow deduction of total loan amount,
instead only interest expense is allowed as deduction.
Depreciation is calculated on straight-line basis using the 5-year useful life (i.e. $18,000,000/5 =
$3,600,000).
Tax shield is subtracted from loan repayments and maintenance costs while calculating the net cash
outflows because tax shield represents a cash inflow which arises due to tax deductibility of the expenses.
Now, we have to calculate the present value of cash outflows under both the options using the after-tax
cost of debt which is 3.6% (6% * (1-40%))
Present value of leasing at 3.6% = $13,545,157
Present value of purchasing at 3.6% = $13,950,176
Since leasing has a lower present value of cash outflows, it should be the preferred option.
UNIT 4
CREDIT RATING
Credit Rating is a symbolic indicator of the current objective assessment by a rating agency of the relative
capability and willingness of an issuer of a debt programmes to service the debt obligations as per the
terms of the contract. It may be referred as current opinion of a borrower’s credit quality in terms of
business and financial risk. On the basis of such evaluation the investors get some idea about the degree of
certainty of timely repayment of the principal amount of the debt instrument besides regular payment of
returns on it i.e. interest.

Investment Information and Credit Rating Agency of India Ltd. (ICRA)

Rating is a symbolic indicator of the current opinion of the relative capability of timely servicing of debt
and obligations by the corporate entity with reference to the instrument rated.

Credit Rating Information Services of India Ltd. (CRISIL)

Rating is current opinion as to the relative safety of timely payment of interest and principal on a
debenture, structured obligation, preference shares, fixed deposits programme or shot term instruments.

Credit Analysis and Research Ltd. (CARE)

Credit rating is an opinion on the relative ability and willingness of an issuer to make timely payment on
specific debt or related obligations over the life of the instrument.

Standard & Poors

Rating is current assessment of the credit worthiness of an obligor with respect to specific obligation.
From the above definitions it is understood that:
 (i) Credit rating is an assessment of the capacity of an issuer of debt security, by an independent
agency, to pay interest and repay the principal as per the terms of issue of debt. A rating
agency collects the qualitative as well as quantitative data from a company which has to be
rated and assesses the relative strength and capacity of company to honour its obligations
contained in the debt instrument
(ii) FUNCTIONS OF CREDIT RATINGS

1. Superior Information
Rating by an independent and professional firm offers a superior and more reliable source of information
on credit risk for three inter related risks:
(a) It provides unbiased opinion.
(b) Due to professional resources, a rating firm has greater ability to assess risks.
(c) It has access to lot of information which may not be publicly available.

2. Low Cost Information

A rating firm which gathers, analyses, interprets and summarizes complex information in a simple and
readily understood format for wide public consumption represents a cost effective arrange

3. Basis for a Proper Risk-Return Trade Off

If debt securities are rated professionally and if such ratings enjoy widespread investor acceptance and
confidence, a more rational risk return trade off would be established in the capital market.

4. Healthy Discipline on Corporate Borrowers

(i) Public exposure has healthy influence over the management of issuer because of its desire to
have a clear image

Credit Rating Information Service Ltd. (CRISIL)

On January 1, 1988 the Industrial Credit and Investment Corporation of India (ICICI) and Unit Trust of
India (UTI) joined hands to float CRISIL, first rating agency in India with an equity base of Rs.4.00
crores. Each of them holds 18 per cent of the stock. The other promoters are : The Asian Development
Bank (15 percent) ; the LIC, the GIC and its subsidiaries and the State Bank of India (each 5 per cent); the
Housing Development Finance Corporation (6.2 per cent); 9 nationalized Banks owning 19.5 per cent, the
remaining equity is distributed among 10 foreign banks i.e. Standard Chartered Bank, Banque Indo Suez,
Mitsui Bank, Bank of Tokyo, Hongkong and Shanghai Banking Corporation, Citi Bank, Grindlays Bank,
Deutsche Bank, Societe General, Banque Nationals de PerisCRISIL Debenture Rating Symbols

High Investment Grades

AAA (Triple A) : Highest Safety
AA (Double A) : High Safety
Investment Grades
A : Adequate Safety
BBB (Triple B) : Moderate Safety
Speculative Grades
BB (Double B) : Inadequate Safety
B : High Risk
C : Substantial Risk
(i) D :Default

CRISIL Fixed Deposit Rating Symbols

Notes :(1) CRISIL may apply ‘+’ (plus) or ‘-‘ (minus) sign for ratings from FAAA to FC to indicate the
relative position within the category.
(2) The contents within parenthesis are a guide to the pronunciation of the rating symbols.

Credit Rating for Short Term Instruments

Rating Symbol Indication
(Each rating indicates that the degree of safety regarding timely
payment on the instrument is shown against the symbol)
P-1 Very Strong
P-2 Strong
P-3 Adequate
P-4 Minimal
P-5 Expected to be in default on maturity or in default

Investment Grades
FAAA (F-Triple A) : Highest Safety
FAA (F-Double A) : High Safety
FA : Adequate Safety
Speculative Grades
FB : Inadequate Safety
FB : High Risk
(i) FC : Substantial

2. ICRA Ltd

The ICRA Ltd. has been promoted by the IFCI Ltd. as the main promoter to meet the requirements of the
companies based in the northern parts of the country. Apart from the main promoter, which holds 26 per
cent of the share capital, the other shareholders are the Unit Trust of India, banks, LIC, GIC, Exim Bank,
HDFC Ltd. and ILFS Ltd. It started operations in 1991. In order to bring international experience and
practices to the Indian capital markets, the ICRA has entered into a MOU with Moody’s Investors Service
to provide, through its company Financial Programmes Inc (FPI), credit education, risk management
software, credit research and consulting services to banks, financial/investment institutions, financial
services companies and mutual funds in India. As in the case of the CRISILICRA Rating Scale
Long Term including Debentures Medium Term including
Bonds and Preference Shares Deposits Fixed
Short Term Including Commercial Paper
Note : (i) The rating symbols group together similar (but not necessarily identical) concerns in terms of
their relative capability of timely servicing of a debts/obligations, as per terms of contracts, i.e.,
the relative degree of safety/risk.
(ii) The sign (+) or (-) may be used after the rating symbol to indicate the comparative

LAAA : Highest Safety LAA : High Safety

LA : Adequate Safety LBBB : Moderate Safety
LBB : Inadequate Safety LB : Risk Prone
LC : Substantial Risk LD: Default, Extremely Speculative

MAAA : Highest Safety MAA : High Safety

MA : Adequate Safety MB : Inadequate Safety
MC : Risk Prone MD : Default

A-1 Highest Safety A-2 High Safety

A-3 Adequate Safety A-4 Risk Prone
3. CARE Ltd.
The CARE Ltd. is a credit rating and information services company promoted by the Industrial
Development Bank of India (IDBI) jointly with financial institutions, public/private sector banks
and private finance companies. It commenced its credit rating operations in October 1993 and
offers a wide range of products and services in the field of credit information and equity research
FACTORING
The word ‘Factor’ has been derived from the Latin word ‘Facere’ which means to ‘to make or to
do’. In other words, it means ‘to get things done’. According to the Webster Dictionary ‘Factor’
is an agent, as a banking or insurance company, engaged in financing the operations of certain
companies or in financing wholesale or retail trade sales, through the purchase of account
receivables. As the dictionary rightly points out, factoring is nothing but financing through
purchase of account receivables. Thus, factoring is a method of financing whereby a company
sells its trade debts at a discount to a financial institution. In other words, factoring is a
continuous arrangement between a financial institution, (namely the factor) and a company
(namely the client) which sells goods and services to trade customers on credit
FUNCTIONS OF FACTORING

(i) Purchase and collection debts

Factoring envisages the sale of trade debts to the factor by the company, i.e., the client. It is
where factoring differs from discounting. Under discounting, the financier simply
discounts the debts backed by account receivables of the client. He does so as an agent of
the client

(ii) Credit investigation and undertaking of credit risk

Sales ledger management function is a very important one in factoring. Once the factoring
relationship is established, it becomes the factor’s responsibility to take care of all the
functions relating to the maintenance of sales ledger. The factor has to credit the
customer’s account whenever payment is received, send monthly statements to the
customers and to maintain liaison with the client and the customer to resolve all possible
disputes
(iii) Credit investigation and undertaking of credit risk
The factor has to monitor the financial position of the customer carefully, since, he assumes the
risk of default in payment by customers due to their financial inability to pay. This
assumption of credit risk is one of the most important functions which
(iv) Provision of Finance
After the finalization of the agreement and sale of goods by the client, the factor provides 80% of
the credit sales as prepayment to the client. Hence, the client can go ahead with his business
plans or production schedule without any interruption
TYPES OF FACTORING

(i) Full Service Factoring

Under this type, factor provides all kinds of services discussed above. Thus, a factor provides
finance, administers the sales ledger, collects the debts at his risk and renders consultancy
service. This type of factoring is a standard one. If the debtors fail to repay the debts, the
entire responsibility falls on the shoulders of the factor since the assumes the credit risk
also
(ii) With Recourse Factoring
As the very name suggest, under this type, the factor does not assume the credit risk. In other
words, if the debtors do not repay their dues in time and if their debts are outstanding beyond a
fixed period, say 60 to 90 days from the due date, such debts are automatically assigned back to
the client.

(iii) Maturity Factoring

Under this, the factor does not provide immediate cash payment to the client at the time of
assignment of debts. He undertakes to pay cash as and when collections are made from
the debtors. The entire amount collected less factoring fees is paid to the client
immediately.

(iv) Bulk Factoring

Under this type, the factor provides finance after disclosing the fact of assignment of debts to the
debtors concerned. This type of factoring is resorted to when the factor is not fully
satisfied with the financial condition of the client

(v) Invoice Factoring

Under this type, the factor simply provides finance against invoices without undertaking any
other functions. All works connected with sales administration, collection of dues etc. have to be
done by the client himself. The debtors are not at all notified and hence they are not aware of the
financing arrangement.

(vi) Agency Factoring

The word agency has no meaning as far as factoring is concerned. Under this type, the factor and
the client share the work between themselves as follows :
(i) The client has to look after the sales ledger administration and collection work and
(ii) The factor has to provide finance and assume the credit risk

(vii) International Factoring

Under this type, the services of a factor in a domestic business are simply extended to
international business. Factoring is done purely on the basis of the invoice prepared by
the exporter.

(ix) Limited Factoring

Under this type, the factor does not take up all the invoices of a client. He discounts only selected
invoices on merit basis and converts credit bills into cash in respect of those bills only.

(viii) Suppliers Guarantee Factoring

This type of factoring is suitable for business establishments which sell goods through
middlemen. Generally, goods are sold through wholesalers, retailers or through
middlemen. In such cases, the factor guarantees the supplier of goods against invoices
raised by the supplier upon another supplier.

(x) Buyer Based Factoring

In most cases, the factor is acting as an agent of the seller. But under this type, the buyer
approaches a factor to discount his bills. Thus, the initiative for factoring comes from the
buyers’ end. The approved buyers of a company approach a factor for discounting their
bills to the company in question.

(xi) Seller Based Factoring

Under this type, the seller, instead of discounting his bills, sells all his accounts receivables to the
factor, after invoicing the customers. The seller’s job is over as soon as he prepares the invoices.
Thereafter, all the documents connected with the sale are handed over to the factor who takes
over the remaining functions.

FACTORING IN INDIA
In India, the idea of providing factoring services was first thought of by the Vaghul Working
Group. It had recommended that banks and private non-banking financial companies should be
encouraged to provide factoring services with a view to helping the industrialists and traders to
tide over their financial crunch arising out of delays in the realisation of their book debts. The
RBI subsequently constituted a study group in January 1988 under the chairmanship of Mr. C.S.
Kalyansundaram, former Managing Director of the SBI, to examine the feasibility of starting
factoring services. On the recommendation of the committee, the Banking Regulations Act was
amended in July 1990 with a view to enabling commercial banks to take up factoring services by
forming separate subsidiaries.
FORFEITING
The term ‘forfeit’ is a French word denoting ‘to give something’ or ‘give up one’s rights’ or
‘relinquish rights to something’. In fact, under forfeiting scheme, the exporter gives up his right
to receive payments in future under an export bill for immediate cash payments by the forfeitor.
This right to receive payment on the due date passes on to the forfeitor, since, the exporter has
already surrendered his right to the forfeitor. Thus, the exporter is able to get 100% of the
amount of the bill minus discount charges immediately and get the benefits of cash sale.
Bill discounting:
Discounting of bill is an attractive fund based financial service provided by the finance
companies. In the case of time bill (payable after a specified period), the holder need not wait till
maturity or due date. If he is in need of money, he can discount the bill with his banker. After
deducting a certain amount (discount), the banker credits the net amount in the customer’s
account. Thus, the bank purchases the bill and credits the customer’s account with the amount of
the bill less discount. On the due date, the drawee makes payment to the banker. If he fails to
make payment, the banker will recover the amount from the customer who has discounted the
bill. In short, discounting of bill means giving loans on the basis of the security of a bill of
exchange

UNIT 5

MUTUAL FUNDS

Meaning of Mutual Funds

Small investors generally do not have adequate time, knowledge, experience and resources for
directly entering the capital market. Hence they depend on an intermediary. This financial
intermediary is called mutual fund.
Mutual funds are corporations that accept money from savers and then use these funds to buy
stocks, long term funds or short term debt instruments issued by firms or governments. These are
financial intermediaries that collect the savings of investors and invest them in a large and well
diversified portfolio of securities such as money market instruments, corporate and government
bonds and equity shares of joint stock companies. They invest the funds collected from investors
in a wide variety of securities i.e. through diversification. In this way it reduces risk

Mutual fund works on the principle of “small drops of water make a big ocean”. It is a form of
collective investment. To get the surplus funds from investors, it adopts a simple technique. Each
fund is divided into a small share called ‘units’ of equal value. Each investor is allocated units in
promotion to the size of his investment.

Mutual fund is a trust that pools the savings of investors. The money collected is then invested in
financial market instruments such as shares, debentures and other securities. The income earned
through these investments and the capital appreciations realized are shared by its unit holders in
proportion to the number of units owned by them. Thus mutual fund invests in a variety of
securities (called diversification). This reduces risk. Diversification reduces the risk because all
stock and/ or debt instruments may not move in the same direction.

In short, a mutual fund collects the savings from small investors, invests them in government and
other corporate securities and earns income through interest and dividends, besides capital gains.
Features of Mutual Funds
Mutual fund possesses the following features:
1. Mutual fund mobilizes funds from small as well as large investors by selling units.
2. Mutual fund provides an ideal opportunity to small investors an ideal avenue for investment.
3. Mutual fund enables the investors to enjoy the benefit of professional and expert management
of their funds.
4. Mutual fund invests the savings collected in a wide portfolio of securities in order to maximize
return and minimize risk for the benefit of investors.
5. Mutual fund provides switching facilities to investors who can switch from one scheme to
another.
6. Various schemes offered by mutual funds provide tax benefits to the investors.
7. In India mutual funds are regulated by agencies like SEBI.
8. The cost of purchase and sale of mutual fund units is low.
9. Mutual funds contribute to the economic development of a country.
Types of Mutual Funds (Classification of Mutual Funds)

Mutual funds (or mutual fund schemes) can be classified into many types. The following chart
shows the classification of mutual funds:

On the basis of on the basis of On the basis of

Operation Return Investment

 Open ended Income fund Equity fund

Close ended Growth fund Bond fund

Conservative fund Balanced fund

Money market mutual fund

Taxation fund

Leveraged fund

Index bond fund

These may be briefly described as follows:

A. On the basis of Operation

1. Close ended funds: Under this type of fund, the size of the fund and its duration are fixed in
advance. Once the subscription reaches the predetermined level, the entry of investors will be
closed. After the expiry of the fixed period, the entire corpus is disinvested and the proceeds are
distributed to the unit holders in proportion to their holding.
Features of Close ended Funds
(a) The period and the target amount of the fund is fixed beforehand.
(b) Once the period is over and/ or the target is reached, the subscription will be closed (i.e.
investors cannot purchase any more units).
(c) The main objective is capital appreciation.
(d) At the time of redemption, the entire investment is liquidated and the proceeds are liquidated
and the proceeds are distributed among the unit holders.
(e) Units are listed and traded in stock exchanges.
(f) Generally the prices of units are quoted at a discount of upto 40% below their net asset value.
2. Open-ended funds: This is the just reverse of close-ended funds. Under this scheme the size
of the fund and / or the period of the fund is not fixed in advance. The investors are free to buy
and sell any number of units at any point of time.

Features of Open-ended Funds

(a) The investors are free to buy and sell units. There is no time limit.

(b) These are not trade in stock exchanges.

(c) Units can be sold at any time.
(d) The main motive income generation (dividend etc.)
(e) The prices are linked to the net asset value because units are not listed on the stock exchange
B. On the basis of return/ income

1. Income fund: This scheme aims at generating regular and periodical income to the members.
Such funds are offered in two forms. The first scheme earns a target constant income at relatively
low risk. The second scheme offers the maximum possible income.

Features of Income Funds

(a) The investors get a regular income at periodic intervals.
(b) The main objective is to declare dividend and not capital appreciation.
(c) The pattern of investment is oriented towards high and fixed income yielding securities like
bonds, debentures etc.
(d) It is best suited to the old and retired people.
(e) It focuses on short run gains only.
2. Growth fund: Growth fund offers the advantage of capital appreciation. It means growth fund
concentrates mainly on long run gains. It does not offers regular income. In short, growth funds
aim at capital appreciation in the long run. Hence they have been described as “Nest Eggs”
investments or long haul investments.
Features of Growth Funds (a) It meets the investors’ need for capital appreciation.
(b) Funds are invested in equities with high growth potentials in order to get capital appreciation.
(c) It tries to get capital appreciation by taking much risk.
(d) It may declare dividend. But the main objective is capital appreciation.
(e) This is best suited to salaried and business people.
3. Conservative fund: This aims at providing a reasonable rate of return, protecting the value of
the investment and getting capital appreciation. Hence the investment is made in growth oriented
securities that are capable of appreciating in the long run.

C. On the basis of Investment

1. Equity fund: it mainly consists of equity based investments. It carried a high degree of risk.
Such funds do well in periods of favourable capital market trends.
2. Bond fund: It mainly consists of fixed income securities like bonds, debentures etc. It
concentrates mostly on income rather than capital gains. It carries lower risk. It offers secure and
steady income. But there is no chance of capital appreciation.
3. Balanced fund: It has a mix of debt and equity in the portfolio of investments. It aims at
distributing regular income as well as capital appreciation. This is achieved by balancing the
investments between the high growth equity shares and also the fixed income earning securities.
4. Fund of fund scheme: In this case funds of one mutual fund are invested in the units of other
mutual funds.
5. Taxation fund: This is basically a growth oriented fund. It offers tax rebates to the investors. It
is suitable to salaried people.
6. Leverage fund: In this case the funds are invested from the amounts mobilized from small
investors as well as money borrowed from capital market. Thus it gives the benefit of leverage to
the mutual fund investors. The main aim is to increase the size of the value of portfolio. This
occurs when the gains from the borrowed funds are more than the cost of the borrowed funds.
The gains are distributed to unit holders.

7. Index bonds: These are linked to a specific index of share prices. This means that the funds
mobilized under such schemes are invested principally in the securities of companies whose
securities are included in the index concerned and in the same proportion. The value of these
index linked funds will automatically go up whenever the market index goes up and vice versa.

8. Money market mutual funds: These funds are basically open ended mutual funds. They have
all the features of open ended mutual funds. But the investment is made is highly liquid and safe
securities like commercial paper, certificates of deposits, treasury bills etc. These are money
market instruments.

9. Off shore mutual funds: The sources of investments for these funds are from abroad.

10. Guilt funds: This is a type of mutual fund in which the funds are invested in guilt edged
securities like government securities. It means funds are not invested in corporate securities like
shares, bonds etc.

Objectives of Mutual Funds

1. To mobilise savings of people.

2. To offer a convenient way for the small investors to enter the capital and the money market
3. To tap domestic savings and channelize them for profitable investment.
4. To enable the investors to share the prosperity of the capital market.
5. To act as agents for growth and stability of the capital market.
6. To attract investments from the risk aversers.
7. To facilitate the orderly development of the capital market.
SEBI Guideline of Mutual Fund

SEBI Regulation Act 1996 GUIDELINES

Establishment of a Mutual Fund: In India mutual fund play the role as investment with trust,
some of the formalities laid down by the SEBI to be establishment for setting up a mutual fund.
As the part of trustee sponsor the mutual fund, under the Indian Trust Act, 1882, under the
trustee company are represented by a board of directors. Board of Directors is appoints the AMC
and custodians. The board of trustees made relevant agreement with AMC and custodian. The
launch of each scheme involves inviting the public to invest in it, through an offer documents.

Depending on the particular objective of scheme, it may open for further sale and repurchase of
units, again in accordance with the particular of the scheme, the scheme may be wound up after
the particular time period.

1. The sponsor has to register the mutual fund with SEBI

2. To be eligible to be a sponsor, the body corporate should have a sound track record and a
general reputation of fairness and integrity in all his business transactions.
Means of Sound Track Records
 The body corporate being in the financial services business for at least five years
 Having a positive net worth in the five years immediately preceding the application of
registration.
 Net worth in the immediately preceding year more than its contribution to the capital of
the AMC. Earning a profit in the three out of the five preceding years, including the
fifth year.
3. The sponsor should hold at least 40% of the net worth of the AMC.
4. A party which is not eligible to be a sponsor shall not hold 40% or more of the net worth of
the AMC.
5. The sponsor has to appoint the trustees, the AMC and the custodian.
 6. The trust deed and the appointment of the trustees have to be approved by SEBI.
7. An AMC or its officers or employees can not be appointed as trustees of the mutual fund.
8. At least two thirds of the business should be independent of the sponsor.
9. Only an independent trustee can be appointed as a trustee of more than one mutual fund, such
appointment can be made only with the prior approval of the fund of which the person is already
acting as a trustees.