Corporate finance Pattern in Bangladesh

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Cox’s Bazar International University

Faculty of Business Administration

An Assignment on:
Corporate Finance Pattern in Bangladesh
Subject Name: Advanced Corporate Finance
Course Code: FIN 5206

Submitted by:
Salsabil Dalia
ID No: 190092000103
RMBA Program
Major in Finance
Faculty of Business Administration
Cox’s Bazar International University

Submitted to:
Kazi Noor-E-Jannat
Senior Lecturer
Department of Finance
Faculty of Business Administration
Cox’s Bazar International University
Kolatoli Circle, Cox’s Bazar-4700, Bangladesh

Date of Submission: 16th November, 2019

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 Letter of Transmittal

Date: 16th November, 2019

To,
Kazi Noor-E-Jannat
Senior Lecturer
Faculty of Business Administration
Cox’s Bazar International University

Subject: To submit a assignment on “Corporate finance Pattern in Bangladesh”

Dear Mam,
This is to inform you that I have completed my assignment on “Corporate finance Pattern
in Bangladesh” Here I tried my best to give an overview of Corporate finance Pattern in
Bangladesh and finally some findings.
In preparing this assignment I have followed the instructions of yours. I will be glad to clarify
any discrepancy that may arise.

Thank you for your co-operation.

Sincerely,

Salsabil Dalia
ID 190092000103
Major in Finance
RMBA 9thBatch
Faculty of Business Administration
Cox’s bazaar International University

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 Acknowledgement

In preparation of my assignment, I had to take the help and guidance of some respected
persons, who deserve my deepest gratitude. As the completion of this assignment gave me
much pleasure, I would like to show my gratitude Kazi Noor-E-Jannat. Course Instructor,
on Cox`s Bazar International University for giving me a good guidelines for assignment
throughout numerous consultations. An assignment to be submitted on 16th November, 2019

I have made a detailed analysis on my assigned topic “Corporate finance Pattern in

Bangladesh”. I would also like to expand my gratitude to all those who have directly and
indirectly guided me in writing this assignment.

Many people, especially my classmates have made valuable comment suggestions on my

paper which gave me an inspiration to improve the quality of the assignment

Prepared By

Salsabil Dalia
ID 190092000103
Major in Finance
RMBA 9thBatch
Faculty of Business Administration
Cox’s bazaar International University

Prepared By: Salsabil Dalia 4|P a g e

Introduction:
Several theoretical and empirical studies in the last three decades have emphasized the relationship
between finance and investment, and argued that firms’ financing decisions had implications for their
investment activities. With the changes introduced in India’s economic policies during the last two decades,
the emphasis has been more on corporate investment- led growth, replacing the hitherto public sector
investment-led growth. Investment activity of corporate sector, thus, lies central to the economic
performance of the country. Given the link between finance and investment, this paper seeks to examine
the financing practices of corporate sector.
Definition of Corporate Finance:

Big business equals big money. At least that's how they've always said it. Of course, when
you are an integral part of the business' decision-making process concerning finances, there
never seems to be enough money. If you work for a small business, especially a start-up, it
seems like no one wants to give you money and no one starting the business has any either.
Some days it feels like a no-win situation. We need money to grow and provide our product
or service in order to earn revenue - we need money to make money.
Never fear. This problem has been dealt with by business owners and corporate executives
ever since humans first had the idea to go into business. One of the benefits of today's
modern business owner or corporate executive is that there are more sophisticated sources
from which to draw capital and more defined and mature capital streams from which to seek
financing.

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Corporate finance is the area of finance that deals with providing money for businesses and
the sources that provide them. These sources provide capital to corporations to pay for
structural improvements, expansion, and other value-added projects and enterprises. Capital
is a good that can be used now. For this lesson, it will primarily refer to money. The purpose
of corporate finance is to maximize shareholder value. There are many methods that a
corporation can utilize to maximize shareholder value.
Capital Budgeting:
One method is capital budgeting, which involves long-term planning for use of capital on
corporate financial projects that affect the overall capital structure of the corporation.
Managers and executives must select criteria for the funding of projects that will provide the
best possibility of maximizing value for shareholders. When executives determine that there
is no additional room for value growth, they are expected to pay out through dividend
policies or stock repurchase programs using the surplus of capital. This adds perceived value
to the corporation because of its ability to pay out extra cash to investors.
Capital Sources:
A corporation has two primary capital sources for investment purposes. These include:
 Self-generation of capital (primarily through revenue streams)
 External capital funding sources (primarily through debt and equity capital)
As managers and executives consider their options, they must determine the optimum mix of
capital funding in order to maximize value for the corporation. For example, self-generation
of capital takes time and resources and the end product (free cash on hand) can be minimal.
This would decrease shareholder value over time. If they consider debt capital, the debt
becomes a liability on the balance sheet and affects cash flow. Equity capital is less risky than
debt capital, but it dilutes the value of share ownership.
The Analytical Framework:
The role of investment for economic growth is well emphasized in the economic literature. Studies of
investment behavior in the neoclassical tradition had, however, ignored the role of financial factors. As aptly
remarks, the lack of emphasis on financial variables in the investment equation was due to the formal
proposition of Modigliani and Miller (MM) which had two important implications, namely, investment
decision was the only decision that mattered and firms need not care as to how to finance investment (MM,
1958). Thus, a firm’s choice of a particular source of funds, whether it is retained earnings or issue of
bonds/equity or borrowing, had no bearing on its investment decision.

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The crucial assumption underlying the MM theorem is the ‘existence of perfect capital market’. Implicit in
this was the symmetric distribution of information between firms and investors, no transactions cost, no
taxes, no bankruptcy, both firms and individuals had equal access to capital market, securities issued had
perfect substitutes, investors maximize welfare (Fama and Miller, 1972), and that the existence of financial
intermediaries would be of no consequence to real activity (Bernanke and Gertler, 1987). The MM
theorem and its assumptions however came to be questioned in the course of time. Increasingly, there is a
wider recognition that factors such as tax, asymmetric information and financial intermediaries could influence
firms’ financing behavior and thereby their investment decisions. In what follows, these factors have
been discussed briefly.
Tax and Financing Practices:
In corporate taxation, debt and equity finance are given different treatment. While interest payments (cost of
debt) are generally allowed to be treated as an expense, dividend payments (cost of equity) are not. Because of
this, the relative cost of debt decreases. Though this holds good only if firms show taxable income and
depends upon the tax rate facing firms, to the extent of its deductibility, interest payments shield profit
(known as interest tax shield), which in turn increases value of firms. In their own later version, MM (1963)
recognized the gain associated with debt because of interest deductibility. They had shown that in the
presence of taxes that allowed interest deductibility, value of leveraged firms was greater than that of
unleveraged firms implying that a firm could increase its value by increasing leverage. Firms would
therefore prefer debt financing.
It is also argued that such leverage gain need not arise under bankruptcy and when non- interest tax shields are
available. Firstly, an increase in debt increases the probability of debt obligations exceeding the earnings of
firms. This could lead to bankruptcy and so debt is considered risky. The risk aversive firms would,
therefore, not be indifferent to debt. Thus, firms tend to follow an optimal capital structure policy, which is
essentially a trade-off between tax advantage of debt and bankruptcy cost. Secondly, availability of non-
interest tax shields, arising from various investment-related incentives, also reduces tax liability of firms.
The higher the ceiling of such shields, the lower is the debt because the expected marginal interest tax shield
would decline with additional debt added to capital structure. Thus, when there is a possibility of losing
non-interest tax shield, there is likely to be a substitution between interest tax savings and non-interest tax
savings. This shows that the presence of corporate tax and various tax incentives impact firms’ capital
structure decisions. Fiscal environment, in which corporate operate, matters for their financing choice.
Asymmetric Information and Financing Practices:
Symmetric distribution of information between firms/borrowers and investors/lenders, implicit in MM
theorem, came to be questioned with the development in the theories of economics of information in

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general and information asymmetry in particular, which got extended to the study of financial market as
well. Situations of information asymmetry arise in the financial market (credit and equity) when a firm
possesses information about its future streams or investment opportunities but does not dispense it fully with
suppliers of funds. So much so, in a given situation, financial market can be inundated with projects of both
low and high quality. Due to information asymmetry, market would not be in a position to distinguish
between low and high quality projects. As a result, it is possible that the market could place premium on low
quality projects at the expense of high quality projects (Leland and Pyle, 1977). This can drive out high
quality projects, leading to inefficient functioning of financial market.
When credit market is characterized by imperfect information with indistinguishable borrowers, credit
rationing occurs. Cost of credit is positively related to the riskiness of loans, that is, the higher the risk,
the higher is the interest rate. Because lenders cannot observe the riskiness of borrowers’ projects, they
raise the interest rate, leading to a revision of critical value of investment, which affects the probability of
repayment. This could attract risk-neutral borrowers (adverse selection effect) or induce borrowers to
switch from safe projects to risky ones (moral hazard / incentive effect). As a result, those borrowers with
good projects get rationed out because of the hike in cost of credit. Firms’ ability to raise funds from equity
market beset with imperfect information remains limited. A firm, which comes to equity market, is
considered bad because good firms can always increase leverage. As a result, equity market adds to the return
of not only monetary interest rate but bankruptcy cost as well, which eventually increases effective cost of
equity (Greenwald et al., 1984). Thus, even those firms not facing credit constraints also find it difficult to
raise equity because of the increase in effective cost. Besides this, the informational problems in equity
market also lead to under pricing of equity so that managers sometimes pass on the projects even with positive
net present value (Myers, 1984; and Myers and Majluf, 1984).
Problems of asymmetric information can also arise after contracting, leading to a moral hazard situation.
This arises because suppliers of external funds cannot monitor and control allocation of funds by firms among
different uses. Because of moral hazard, firms tend to put their funds into assets that are poor generators of cash
flows or whose realizable value oscillates, so that cash commitments could exceed cash flows they would
get over short period from their operation. Firms expect to meet the difference between cash
commitments and cash flows in the short period by refinancing. They are lured into investing in these assets
because they expect the cash flows to be greater than cash commitments in the long term. Minsky (1986)
calls these firms speculative firms. Information asymmetry, thus, creates uncertainty which increases the
likelihood of bankruptcy, aggravating risk factor. It affects both suppliers of external funds and firms
(Wolfson, 1996).
Information asymmetry in financial market, thus, has strong implications for the availability and cost
of credit and equity financing. And, consequently, firms face financial constraints and such firms have to take

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greater recourse to internal funds. Faced with financial constraints, firms may delay undertaking of investment
or decide not to invest at all—thus, drag capital formation in the economy (Campello et al., 2010). The
problems arising from asymmetric information makes the financing decisions of firms matter for their
investment activity.
Financial Intermediaries and Financing Practices:
Yet another implication of MM’s theorem is that the existence of financial intermediaries is of no
consequence for real activity (Bernanke and Gertler, 1987). As noted by Gertler (1988), the relevance of this
proposition is questioned and the central place of financial system in the development process of an
economy is increasingly well recognized. Essentially, financial system facilitates intermediation between
savers (public) and investors (firms), and helps to translate savings into investment. The system can be bank
(credit)-based or market (equity or bond)-based. Bank-based financial system is one where firms depend
largely on credit from banks and other financial institutions, whereas market-based financial system is one
where issuing of securities such as equity is the main source of funding (Studart, 1995/96).
The severity of information asymmetry is likely to be different in each of these systems. Banks have long-
term relationship with firms and have less cost of obtaining information, monitoring, and enforcing
repayment, besides having the expertise to scrutinize projects. It is, thus, easy in a bank-based system to
eschew adverse selection and prevent moral hazard. Chava and Roberts (2008) argue that debt covenants,
involved in commercial lending activities, are found to be effectual in mitigating the ill-effects of
informational problems as it facilitates transfer of control rights—which acts as a disincentive for managers
to violate the covenants. Further they note that presence of such covenants help to reduce financial
constraints and underinvestment as well. Though these authors do not mention about the nature of
commercial lenders, in a context like India, they are commercial banks and development finance
institutions, which enjoy preeminence in the country’s financial system. It is possible to enforce discipline on
the borrowers by monitoring their actions. In sharp contrast to such possibility, in market-based system,
monitoring of actions of firms by public (shareholders or individual bond holders) is costly. Under these
circumstances, informational problems tend to be severe. The presence of intermediary financial
institutions can, thus, reduce market imperfections arising from informational problems and thereby help to
achieve greater efficiency in resource allocation.
Trends in Corporate Finance:
Though in finance literature, debt and equity are considered as two broad categories of financing, the
structure of balance sheet of a company in India shows that there are different sources from which it can
mobilize funds. The relative share of each source in total funds reveals the importance attached to a
particular source of funds and determines the financing pattern. We analyze the corporate financing pattern

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by using the data extracted from the study of ‘Finances of Non-government Non-financial Public Limited
Companies’, which is annually conducted by NBR and published in NBR Bulletin. It may be mentioned
that public limited companies are the dominant institutional category within corporate sector and NBR
provides valuable information on different sources of funds.
Financing pattern of corporate sector has been examined for the period 1956-57 to 2010-11. The
entire study period is divided into four distinct phases based. Who identified these phases after examining
the institutional framework in which corporate sector had to operate. These phases are: (i) 1956-57 to
1969-70 when both public and private sector functioned, but public sector dominated; (ii) 1970-71 to
1979-80 when a gradual decline in the role of the public sector was noticed and the private sector was severely
controlled; (iii) 1980-81 to 1991-92, a period marked by a gradual relaxation of controls and a slow
withdrawal of the public sector; and (iv) 1992-93 onward when private sector was given greater freedom
and assigned the leading role in industrial growth. The last phase is further sub-divided into 1992-93 to
1999-2000 and 2000-01 to 2010-11.
The structure of corporate finance has been reported in Table 1. Rosen (1962) observed that internal
savings was the principal form of corporate financing in the 1940s. Firms were then governed by a system
of managing agents, who helped to transfer earnings of old enterprises to new ones. Public deposits
were the primary external funds. Banks were also important external source, but mostly followed short-term
financing. Bank financing depended on the personal security and guarantee extended by managing agents.
The dominance of internal financing was attributed to the dormant and underdeveloped capital market
(Rosen, 1962, p. 9). in the post-independence period too, the predominance of internal sources of
funds continued until the 1960s. Since then, corporate sector began to rely on external sources of
funds (see Table 1).

Table 1: Structure of Corporate Finance, 1956-57 to 2010-11 (% of Total)

1956-57 1970-71 1980-81 1992-03 2000-01 to
Avera to to to 2010-11
to 1999-2000
ge of 1969-70 1979-80 1991-92
A. Internal Sources 51.7 50.0 33.2 34.6 47.9
Of which: a) Paid-Up 7.1 5.1 2.1 1.1 0.5
Capital
b) Reserves and Surplus 13.6 11.2 8.1 13.5 17.7
c) Provisions 30.9 33.7 23.0 20.0 29.7
B. External Sources 48.3 50.0 66.8 65.4 52.1
Of which: d) Issue of Fresh [7.0]* 2.3 5.4 19.0 12.4
Capital
e) Borrowings 27.9 22.1 37.1 31.7 19.9
f) Trade Dues 15.7 25.5 23.9 14.3 19.3
Total (A + B) 100 100 100 100 100

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 Note: * Available since 1961-62.
Source: Author’s estimates based on the data extracted from RBI Bulletin,
Various Issues
Using the broad classification of sources of funds into internal and external, and comparing their relative shares
in total funds, it is seen from Table 1 that internal funds contributed, on an average, 51.7% of total funds
during 1957-1970. Since then, it steadily declined and its average contribution was 34.6% during the 1990s;
however, it had risen thereafter to 47.9%. As against this, we find that since 1970-71 external funds has gained
importance, as its share in total funds steadily increased, contributing about two-thirds of total funds in the
1990s, which thereafter declined in the last decade.
Looking at the disaggregated data on various internal sources of funds, it is seen that provisions
constituted the major component of internal funds. While the decline in the share of internal sources was
brought about by the decline in the share of ‘paid-up capital’ and of ‘reserves and surplus’ during the 1970s, it
is the decline in the share of ‘provisions’ that largely accounted for the overall decline in the importance of
internal sources in the 1980s and 1990s. In the 1990s, ‘reserves and surpluses sharply increased its share
from 8.1% of the previous decade to 13.5% of total funds and further to about 17.7% in the last
decade. Nevertheless, we find that amongst internal sources, ‘reserves and surplus’ has gained
importance since the 1990s and ‘provisions’ in the last decade, which together increased the relative share
of internal funds in the total.
At the disaggregated level, it is seen that the rise in the share of external funds in total funds is largely due to
‘trade credit’ in the 1970s, ‘borrowings’ in the 1980s, and ‘fresh issues of share capital’ since the 1990s.
Borrowing is the major component of external sources, next only to trade dues in the 1970s by a small
margin. However, the share of ‘borrowing’ has registered a marginal decline in the 1990s, but a sharp
decline thereafter. While these are the broad trends in internal and external funds in relation to total funds,
it is important to examine the composition of each of these to gain more insights into these broad changes.
It may be noted that NBR providesdetailed classification of these funds from 1961-62 onwards and so further
analysis at the disaggregated level has been done starting from this year.

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Composition of Internal Funds:
Internal sources comprise paid-up capital, reserves and surplus, and provisions. The relative share of each of
these sources to total internal funds is presented in Table 2.

Table 2: Composition of Internal Sources of Funds, 1961-62 to 2010-11

(% of Total)
1961-62 1970-71 1980-81 1992-93 2000-01
Average of to to to to to
1969-70 1979-80 1991-92 1999-2000 2010-11
A. Paid-Up Capital 10.5 10.7 6.3 3.2 1.1
B. Reserves and Surplus 22.9 21.9 24.7 39.7 42.7
Of which: Investment Allowance 13.7 6.7 4.0 –0.8 –0.1
C. Provisions 66.6 67.4 69.0 57.1 56.2
Of which: Depreciation 65.5 58.6 65.6 54.5 42.3
Total (A + B + C) 100.0 100.0 100.0 100.0 100.0
Source: Author’s estimates based on the data extracted from RBI Bulletin, Various Issues

As seen in Table 2, the share of ‘paid-up capital’ was not only relatively low but had dwindled over the
years. It suggests that corporate sector had low reliance on own ‘paid-up capital’. Second major source of
internal funds was ‘reserves and surpluses’. It contributed around 22-25% till the 1980s and this had
increased sharply to 39.7% in the 1990s and further to 42.7% thereafter. Within ‘reserves and surplus’,
the component called ‘other reserves’, which included profit retained, showed a phenomenal increase
during the 1990s. Provisions had dominated internal financing. Its share was not only the major one, but had
increased from 66.6% in the 1960s to 69.0% in the 1980s. However, in the 1990s its share came down to
an average of 57.1% and remained around that level thereafter. Thus, within internal sources, ‘provisions’
(mainly depreciation) predominated during the period 1956- 57 to 1990-91, and both ‘reserves and
surplus’ and ‘provision’ contributed almost entire internal funds in the subsequent periods. These two
dominant sources are affected by the fiscal environment.
Fiscal Environment and Internal Funds:
After a review of various fiscal measures pertaining to corporate sector, identified corporate income tax,
depreciation allowance and several other investment-related tax concessions as having a direct bearing upon the
ability of firms to generate funds internally.
In order to understand whether fiscal measures were conducive for the generation of internal funds, we view
the corporate income tax rate in conjunction with other tax allowances. The combined effects of this can be
observed only by looking at the actual tax burden expressed as Effective Tax Rate (ETR), which is defined as
percentage of tax provisions to profit before tax. The rate of depreciation allowance as such is not a clear
indicator because the basis of its calculation varies over the years—for some years it is based on
individual assets and for others on block of assets; methods used for estimation also varies across time

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(accelerated, straight-line method, etc.). So the depreciation provision, which is the net result of all this, is
viewed as a better indicator and expressed with respect to net fixed assets to obtain the rate of depreciation
(see Table 3).

Table 3: Trends in the Indicators of Influence of Fiscal Measures

on Internal Funds, 1961-62 to 2010-11 (%)
1956-57 1970-71 1980-81 1992-93 2000-01
Average of to to to to to
1969-70 1979-80 1991-92 1999-2000 2010-11
1. Statutory Tax Rate 50.4 57.1 53.2 42.9 34.9
2. Effective Tax Rate 46.6 50.7 41.6 27.2 27.9
3. Profitability (PAT to Net Worth) 8.8 10.7 9.6 9.7 12.7
4. Retention Ratio 35.2 50.2 47.9 62.0 66.0
(Profits Retained to PAT)
5. Dividend Payout Ratio 64.8 49.8 52.1 38.0 34.0
(Dividend to PAT)
6. Other Tax Savings to PAT 6.7 11.7 19.2 21.1 9.6
7. Depreciation Provision to 8.6 10.1 9.3 4.7 5.3
Net Fixed Assets
Source: Statutory tax rates till 2008-09 were taken from Table 1 and thereafter from Union Budget Volumes, Various
Issues. Other information was author’s estimates based on the data extracted from RBI Bulletin, Various Issues

As seen in Table 3, the Statutory Tax Rate (STR), which is the corporation income tax rate proposed in the
Union Budgets, has consistently gone up over the years until the 1980s. There has been a considerable
reduction in the STR during the last two decades. Though the ETR has gone up in the 1970s, it declined
sharply in the 1980s and 1990s. It suggests that, though corporate sector was subject to higher level of
statutory tax rate, the actual burden was considerably low, particularly in the last two decades, and this was,
ceteris paribus, favorable for generation of internal funds.
However, what actually gets retained and goes as internal funds depends upon both the level of profitability,
measured as the ratio of Profit after Tax (PAT) to net worth, and profits distributed. The ETR and
profitability are negatively and significantly (at 1%) correlated with a correlation coefficient of 0.7784 for
the entire period between 1992-93 and 2010-11. This clearly shows that the reduction in the ETR had
enhanced profitability of firms. As far as dividend is concerned, more than a half of post-tax earnings were
distributed as dividend till the 1980s, and since then, it was gradually reduced to a little over one-third of
post-tax earnings. This also gets reflected in the rising profit retention ratio during the last two decades.
Thus, our analysis shows that though ETR is conducive to the generation of internal funds, it also depends
on the dividend policy being followed.
Tax savings accruing due to several other tax relief measures also protects income (profit) from being taxed.
To measure such savings on account of all other tax concessions, we first take the difference between STR
and ETR. The difference is used to blow up Profit before Tax (PBT) and then divided by 100, to arrive at

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the absolute figure. That is,
Other Tax Savings = [(STR – ETR) * PBT] / 100
When expressed as a percentage of PATS, it shows the extent of income shielded by utilizing other tax
concessions. It is seen that other tax savings to PAT has increased (see Row 6 in Table 3), particularly in
the 1980s and in the 1990s. It suggests that other tax concessions were also favorable to generation of
internal funds. The major tax saving instrument is depreciation allowance. As a percentage of net fixed
assets, this has improved in the 1970s and more or less remained stable in the 1980s, but sharply came down
in the 1990s (see Row 7 of Table 3). This shows that depreciation provision was conducive to the
generation of internal funds until about the late 1980s. Since then, its role has declined while tax saving
effect of ‘other tax relief measures’ improved.
Thus, the fiscal measures seem to influence the generation of internal funds. There is a decline in the
effective tax rate and a rise in ‘other tax savings’ since the 1980s. Depreciation declined in the 1990s only.
This shows that higher corporate tax rate could have discouraged generation of internal funds, but for
depreciation and other tax relief till the 1980s, and this had reflected in the dwindling share of internal
funds. However, the sharp reduction in statutory corporate tax since the early 1990s and rising profit
retention had a major role in enhancing the share of internal funds in the last two decades
Pattern of External Funds:
Under NBR’s classification, external sources broadly comprise of ‘fresh issue of share capital’, ‘borrowing’,
and ‘trade dues and current liabilities’. As seen in Table 4, share of ‘fresh issue of share capital’ in external
funds has continuously declined from an average of 13.9% in the 1960s to 5.0% in the 1970s. The trend has
reversed since the 1990s and this contributed 29% of external funds. The ‘fresh issues of share capital’ has
two components, namely, ‘net issues’ (face value) and ‘premium on shares’. The premium component was
meager during the 1970s accounting for 0.8% of external funds. But in the 1980s, this gradually increased to
4.4% and sharply increased to 21.7% in the 1990s. The observed increased share of ‘fresh issues of share
capital’ in external funds in the 1990s is, thus, largely due to the rise in the ‘share premium’. The significance
of ‘fresh issues of share capital’, particularly of ‘premium’, as a source of external funds, has become a
hallmark of corporate financing in India since the 1990s.

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 Table 4: Composition of External Sources of Funds,
1961-62 to 2010-11 (% of Total)
1961-62 1970-71 1980-81 1992-93 2000-01
Average of to to to to to
1969-70 1979-80 1991-92 1999-2000 2010-11
A. Fresh Issue of Share Capital (a + b) 13.9 5.0 8.2 29.0 23.6
a. Net Issues NA 4.2 3.8 7.3 5.7
b. Premium on Shares NA 0.8 4.4 21.7 17.9
B. Borrowings (c + d + e) 54.7 42.6 55.5 48.5 35.9
c. From Banks 34.1 23.0 17.7 15.8 36.3
d. From Other Financial Institutions 3.7 –0.3 12.8 12.0 –3.4
e. Other Borrowings 16.8 19.8 25.0 20.7 3.0
C. Trade Dues and Other Current 31.3 52.6 35.9 21.8 39.5
Liabilities
Of which: Sundry Creditors 26.9 35.3 20.8 15.9 23.2
Total (A + B + C) 100 100 100 100 100
Note: NA means not available.
Source: Author’s estimates based on the data extracted from NBR Bulletin, Various Issues

In terms of relative share, ‘borrowing’ was the major external source of funds. Though its share went up to
55.5% in the 1980s from 42.6% in the 1970s, it declined consistently thereafter. To understand the role
of various institutions, ‘borrowing’ has further been classified by types of institutions. It is seen that
‘banks’ and ‘other financial institutions’ are the major suppliers of institutional finance. Banks contributed
about one-third of external funds till the 1960s. Since then, its significance as an external source of
funds declined sharply and it contributed only 15.8% of external funds in the 1990s. Its share has, however,
gone up to 36.3% during the last period. As against this, borrowing from ‘other financial institutions’
assumed significance in the 1980s and they became more important than banks in the 1990s. Its relative
importance has considerably come down in the last decade. The category ‘other borrowings’
(consisting of ‘government and semi-government bodies’, ‘companies’, ‘public deposits’ and ‘others’)
together constituted around 17-25% till the 1990s with no definite trend. The decline in the share of ‘other
borrowing’ has broadly contributed to the overall decline in the share of ‘borrowing’ in total external funds.
Notably, the share of ‘banks’ in external funds has gone up during the last decade with a concomitant
reduction in the share of ‘other financial institutions’. This was a period marked by the conversion of
some erstwhile large term lending institutions (development finance institutions) into commercial
banks Trade dues are another major source of external funds. In particular, it increased its share in external
funds substantially to about one-half in the 1970s. Since then, its share had diminished to 35.9% in the
1980s and further to 21.8% in the 1990s, but increased substantially to 39.5% thereafter. Sundry creditors
constituted the major portion of trade credit. An important characteristic of trade credit is that such source
is less costly as compared to debt and equity.

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Although external funds have become more broad-based over the years, ‘fresh issues of share capital’ and
institutional borrowings together dominate external sources. In the 1950s, corporate sector’s reliance on
internal savings was largely attributed to underdeveloped financial system (Rosen, 1962). There was a
phenomenal progress in the development of financial system during post-independence period.
Financial System and External Funds:
Financial system helps to accelerate economic growth to the extent it facilitates migration of funds to its best
use. From firms’ point of view, availability and terms of finance affect their investment decision. During the
time of independence, financial system in India was in its rudimentary form and the link between financial
system and industrial finance was rather weak (Rosen, 1962). The role of State in developing a broad-based
financial system to facilitate growth process was well recognized by the planners. In keeping with the strategy
of planned development, the State played a vital role in fostering the development of each of the different
segments of financial system to facilitate the growth process and also exercised control over distribution of
credit and finance so as to align the functioning of various financial institutions to the overall priorities set
out in the Plans. The control was extended to institutions, instruments and interest rates. Several hitherto
large commercial banks were nationalized in 1969 and further in 1980, new development financial
institutions were created to provide long-term loans to corporate and insurance and mutual funds were
nationalized or created to mobilize savings with specific fund deployment policies.
What Is a Financial System?
A financial system is a set of institutions, such as banks, insurance companies, and stock
exchanges that permit the exchange of funds. Financial systems exist on firm, regional, and
global levels. Borrowers, lenders, and investors exchange current funds to finance projects,
either for consumption or productive investments, and to pursue a return on their financial
assets. The financial system also includes sets of rules and practices that borrowers and
lenders use to decide which projects get financed, who finances projects, and terms of
financial deals.
Understanding the Financial System:
Like any other industry, the financial system can be organized using markets, central
planning, or some mix of both.
Financial markets involve borrowers, lenders, and investors negotiating loans and other
transactions. In these markets, the economic good traded on both sides is usually some form
of money: current money (cash), claims on future money (credit), or claims on the future
income potential or value of real assets (equity). These also include derivative instruments.
Derivative instruments, such as commodity futures or stock options, are financial instruments

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that are dependent on an underlying real or financial asset's performance. In financial
markets, these are all traded among borrowers, lenders, and investors according to the normal
laws of supply and demand.
In a centrally planned financial system (e.g., a single firm or a command economy), the
financing of consumption and investment plans is not decided by counterparties in a
transaction but directly by a manager or central planner. Which projects receive funds, whose
projects receive funds, and who funds them is determined by the planner, whether that means
a business manager or a party boss.
Most financial systems contain elements of both give-and-take markets and top-down central
planning. For example, a business firm is a centrally planned financial system with respect to
its internal financial decisions; however, it typically operates within a broader market
interacting with external lenders and investors to carry out its long term plans.
At the same time, all modern financial markets operate within some kind of government
regulatory framework that sets limits on what types of transactions are allowed. Financial
systems are often strictly regulated because they directly influence decisions over real assets,
economic performance, and consumer protection.
Financial Market Components:
Multiple components make up the financial system at different levels. The firm's financial
system is the set of implemented procedures that track the financial activities of the company.
Within a firm, the financial system encompasses all aspects of finances, including accounting
measures, revenue and expense schedules, wages, and balance sheet verification.
On a regional scale, the financial system is the system that enables lenders and borrowers to
exchange funds. Regional financial systems include banks and other institutions, such as
securities exchanges and financial clearinghouses.
The global financial system is basically a broader regional system that encompasses all
financial institutions, borrowers, and lenders within the global economy. In a global view,
financial systems include the International Monetary Fund, central banks, government
treasuries and monetary authorities, the World Bank, and major private international banks.
As far as capital market was concerned, regulating the functioning of stock exchange has been recognized as
an integral part of economic policy since independence. More importantly, the State exercised control over
capital issues through the Capital Issues (Control) Act, 1947. Controller of Capital Issues (CCI)
administered this. The capital issues of corporate sector had to adhere to various guidelines as formulated by
CCI from time to time. Companies were required to seek prior approval of CCI for fixing the issue price as

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well as quantum of resources to be raised from the market. To promote an orderly and healthy development
of the securities markets and to provide adequate investor protection, the Government established
Securities and Exchange Board of India (SEBI) on April 12, 1988.
Through nationalization of some of the erstwhile major financial institutions, by establishing new
institutions and by controlling capital issues by companies, the State attained control over financial
system gradually in the 1950s and 1960s. The intervention of the State had essentially promoted bank-based
system rather than capital market-based one. This continued till the early 1990s.
Narasimham Committee (Government of Bangladesh, 1991) argued that government control over the
financial system had diverted resources away from productive sectors and caused operational inefficiency
within the system on the whole. The Committee recommended various measures to make Indian financial
system ‘more efficient, competitive and vibrant’ and thereby enable them to complement reform measures
addressed to real sector. These recommendations found expression in the policy framework,
culminating in financial liberalization in the 1990s. As part of it, reserve requirements of commercial
banks were progressively reduced, entry of private sector into banking sector was allowed, issue of fresh
capital by banks to public through capital market was encouraged and interest rates on bank advances was
almost freed (Reddy, 1999). With the move towards financial liberalization, it was found that the practice of
Government control over capital issues as well as pricing of issues including premium fixation had lost its
relevance (Union Budget 1992-93). As a result, CCI was abolished in 1992, which ended an era of
government’s control over the volume and pricing of capital issues. Companies were allowed to approach the
market directly, provided SEBI cleared their offer documents. Another development was, foreign institutional
investors were allowed to transact in the stock exchanges with a view to infusing more foreign savings into
Indian capital market. Thus, with the ushering in of financial sector reforms since 1992, there was a gradual
withdrawal of controls and a move towards greater autonomy in terms of ownership and functioning for the
different institutions within financial sector. While these changes need not imply weakening of the bank-
based financial system of the pre-reform period, they have overwhelmingly increased the emphasis on
equity market within the financial system.
A significant positive coefficient for D is expected if there is a shift in the preference for that particular
source of funds. For the purpose of estimation, we have considered the period 1980-81 to 2010-11. We
have also merged borrowings from both banks and other financial institutions so as to reflect bank
borrowings by corporate sector. The estimates are reported in Table 5.

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 Table 5: Regression Results
Dependent Variable Estimates
Equity Financing a 5.428 (1.874)*
b 9.764 (2.393)*
SEE 6.49
R 2
0.365
F-stat. 16.644*
n 31
Bank Borrowings a 20.484 (1.629)*
b –1.990 (2.081)
SEE 5.643
R2 0.031
F-stat. 0.915
n 31
Note: * indicates significance at 1% level.

As reported in Table 5, intercept (a) is significant for both equity financing and bank borrowing. The
dummy coefficient (b) is positively significant in the case of equity financing. On the other hand, it is negative
but insignificant for bank borrowing. Equity financing used to be about significant one-fourth of bank
borrowings during the pre-reform period, and it accounts for significant three-fourths in the post-reform
period. These results indicate a significant shift in corporate preference for equity financing during the
financial sector reform period (that is, since 1992-93), whereas their reliance on borrowings from banks and
other financial institutions remained more or less the same as that of pre-reform period.

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Conclusions:
The above analysis brought out the changing pattern of financing in India. Until the 1960s, corporate sector
had greater reliance on internal savings and subsequently external sources of funds became dominant. In
the last one decade or so, internal funds have once again become more important. Larger reliance on
internal generation of funds till the 1960s is to be seen in the background of the then underdeveloped state of
financial system. Thereafter, the State promoted and regulated the financial system comprising banks,
development financial institutions and capital market, and this could have stimulated a shift to external
financing. An examination of the fiscal framework suggests that it had been conducive to the generation of
internal funds. It is possible that the requirements of large investments could also have compelled the shift
from internal to external financing.
The nature of intervention made in the development of financial system since the early 1950s had mostly
resulted in creating a bank-based system. With the changes brought about by financial sector reforms since
the early 1990s, the thrust on equity market has increased. As much as the growth and functioning of these
institutions have implications for the availability and cost of funds, they have implications for the pace
of corporate investment activities. In line with the changing contour of financial system, the financing
pattern of corporate sector has also changed, with increased reliance on issue of equity, which suggests a
certain degree of financial disintermediation. As noted above, capital market system can be replete with
adverse selection or moral hazard problems, which could cause information inefficiency in the financial
system. Under this, resource allocation need not be efficient (Tobin, 1984) and this need not result in a
desired level of corporate investment, which has become a key to sustaining growth. Moreover, the shift to
equity financing can potentially force the firms to become shareholder-centric. Unless there are strong corporate
ethics and governance practices, such tendency may make the firms speculative and manipulative as well.
The preponderance of banks with greater monitoring facilities can help to mitigate informational
problems in the financial system and thereby help achieve greater efficiency in resource allocation. The
dilution of government ownership and entry of private players have however increasingly made banks
profit-centric. The recent move to grant bank license to corporate houses could potentially lead banks to
extend more finance facilities to group- affiliated companies and eventually the banking system could
become a channel of economic wealth concentration. Though the NBR has instituted several safeguards in
bank licensing, it is imperative that the central bank continues to regulate credit intermediation
process so as to strengthen the role of banks as agents of development.

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