Project Evaluation

Under Risk and

Uncertainty

BLOCK 4
LONG TERM FINANCING DECISIONS

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Investment
Decisions Under
Uncertainty BLOCK 4 INTRODUCTION

Developing countries aiming at higher growth rate require aiming amount of

funds for setting up new projects and expansion of existing facilities.
Traditionally the companies were mostly dependent on internal accruals and
loans from banks and financial institutions for their expansion needs. As the
companies grew in size and complexity the requirement of quantum of funds
also increased thereby forcing the companies and regulators to innovate and
look at new avenues of financing.

Unit 10 deals with raising of finances through domestic markets. In recent

years, we have seen many innovations in financial instrument design as well
as method of placement of financial instruments.

Unit 11 deals with raising of finances from global markets. Deregulation of

financial markets has thrown up new opportunities. The rate of savings and
high cost of intermediation increases the cost of capital, therefore the
companies are increasingly looking towards global financial markets, apart
from this listing on global financial markets give these companies high
visibility in the international arena.

Unit 12 deals with other modes of financing these modes of financing are
leasing and hire purchase, supplier’s credit, asset securitization & venture
capital. These are some of the innovative techniques, which are increasingly
used by the companies as these techniques prevent large outflow of funds at a
time, better sales realisation, locking of the suppliers, prevention of bad debts
etc.

This block basically discusses about various methods, instruments and

sources of raising finances.

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UNIT 10 FINANCING THROUGH Financing Through
Domestic Capital

DOMESTIC CAPITAL MARKETS Markets

Objectives
The objectives of this unit are to:
• provide an understanding of money market and capital market,
• highlight redeeming features of capital market,
• explain different methods of raising funds by corporate through capital
market.

Structure

10.1 Introduction
10.1.1 Money Market
10.1.2 Capital Market

10.2 Methods of Procuring Finance

10.2.1 Equity shares
10.2.2 Rights Issues
10.2.3 Private Placement
10.2.4 Non Voting Shares
10.2.5 Preference Shares
10.2.6 Cumulative Convertible Preference Shares (CCP)
10.2.7 Warrants
10.2.8 Debentures
10.2.9 Bonds
10.2.10 Secured Premium Notes
10.2.11 Public Deposits
10.2.12 Bank Credit
10.2.13 Venture Capital

10.3 Summary
10.4 Self-Assessment Questions
10.5 Further Readings

10.1 INTRODUCTION

Economic growth implies a long-term rise in per capita national output. The
basic conditions determining the rate of growth are effort, capital and
knowledge. Among these, capital formation has been recognized as the most
crucial factor in the economic growth of the developing countries. Capital
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formation implies the diversion of the productive capacity of the economy to
the making of capital goods, which increase future productivity capacity. The
process of capital formation, thus, involves transfer of savings from those
who have them in the hands of those who invest the same for productive
purpose. Saving & investment activities are linked by finance. Finance
provides mechanism through which savings of myriads of savers are pooled
together and are put into the hands of those able and willing to invest. The
mechanism includes a wide variety of institutions, which cater, on the other
hand, to the safety, liquidity and profitability notions of the savers; and on the
other to the different types of requirements for working and fixed capital of
the investors.

These institutions are generally grouped into Money Market and Capital
Market.

10.1.1 Money Market

Money market comprises those financial institutions that cater to the notions
of savers who prefer high liquidity and safety along with decent returns and
provide working capital to trade and industries mainly in the form of loans
and advances. Thus, money market is reservoir of short-term funds. Money
market provides a mechanism by which short-term funds are lent and
borrowed; it is through this market that large parts of the financial
transactions of a country are cleared. It is a place where a bid is made for
short-term investible funds at the disposal of financial and other institutions,
individuals and the Government itself.

10.1.2 Capital Market

Capital market is the place where the medium-term and long-term financial
needs of business and other sectors of the economy are met by financial
institutions which supply medium and long-term funds to borrowers. The
capital market is composed of primary market and secondary market (also
known as stock market).

While the primary market provides a mechanism through which the resources
of the investing public are mobilized, the secondary market provides
mechanism to facilitate an investor to buy and sell securities through
dispensation of benefits of easy liquidity, transferability and continuous price
discovery of securities. Thus, both the primary market and secondary market
play an important role in raising maximum resources for capital formation for
balanced and diversified industrial growth in the country. However, geo
political developments and technological advancements in and outside the
country have led to functional integration of international financial markets
with domestic financial markets. Simultaneously there has been
intensification of competition among various players both in banking and
non- banking sectors, blurring of boundaries between money and capital
markets and culminating in the emergence of more diversified multipurpose
financial institutions and financial innovations of unprecedented dimensions.
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10.2 METHODS OF PROCURING FINANCE Financing Through
Domestic Capital
Markets

A company can raise funds through capital market by issuing the financial
securities. A financial security is a legal document that represents a claim on
the issuer. The corporate securities are broadly classified into ownership
securities and creditor ship securities. There are also securities known as
hybrid securities having the mix of the features of ownership security as well
as creditor ship security. Further, company can also raise the funds through
public deposits and borrowings from banking sector. Each method of
financing has got its distinctive features in terms of risk, return, control,
repayment requirements, and security. Depending upon the market conditions
and financing strategies, the issuers adopt different methods.

10.2.1 Equity Shares

According to the Companies Act 2013, a share is a part of unit by which the
share capital of a company is divided. The Act makes a provision for only
two types of shares capital, Viz., equity share capital and preference share
capital, Equity share capital refers to the share capital, which is not
preference share capital. Equity share capital is also defined as the “amount
of the value of property over and above the total liens and charges. In other
words, equity share capital is whatever the debts remain in the way of assets
after all and other charges have been paid or provided for. Thus, equity share
capital is also appropriately referred to as residual capital.

Equity shares represent the owner’s equity. Its holders are residual owners
who have unrestricted claim on income and assets and who enjoy all the
voting power in the company and thus can control the affairs of the company.

Equity share capital is also known as risk capital as the equity shareholders
are exposed to greater amounts of risk, but at the same time they have greater
opportunities for getting higher returns. The equity shareholders also enjoy
getting higher returns.

Another redeeming feature of equity shares is that its holders have pre-
emptive right, right to purchase additional issues of equity shares before the
same is placed in the market for public subscription. As a result, equity
shareholders have the power their proportionate interest in the assets,
earnings and control of the company.

The following are the advantages and disadvantages of raising capital by

issuing equity shares.

Advantages:

1) The equity shares are not repayable to the shareholders. So it is a

permanent capital for the company, unless the company opts to return it
through buying its own shares.
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2) The debt capacity of a company depends on its equity including reserves.
Raising capital through equity enhances the company’s debt capacity.

3) The company has no legal obligation to service the equity by paying a

certain rate of dividend, unlike the debt for which interest is payable. So,
the firm can conserve the cash when it faces the shortages, and pay when
its earnings are adequate to do so.

Disadvantages:

1) Among the alternative sources of capital the equity capital’s cost is high,
because of various reasons like higher risk, flotation costs, non-
deductibility of dividend for tax purposes, etc;

2) Investors perceive the equity shares as highly risky due to last claim on
assets, uncertainty of dividend and capital gains. Therefore, the
companies should offer higher return to attract equity capital.

3) Addition to equity capital may not raise profits immediately, but will
dilute the earnings per shares, adversely affecting the value of the
company.

4) Raising of capital by offering equity shares will reduce the controlling

power of promoters, unless they contribute proportionately, or opt for
non- voting shares, which are costlier than ordinary equity shares.

Companies can raise funds by issuing equity shares in five ways, Viz.,
through public issue, rights issue, private placement, convertible debentures,
and warrants, while the first three are discussed here. The other two are
explained in the later part.

Public Issue:

To approach the public with a public issue to raise capital, the company
should follow various regulations and guidelines of the Companies Act, and
Securities and exchanges Board of India (SEBI).

The important activities to public issue are:

1) Prepare a detailed project report, for which funds are intended.

2) Preparation of prospectus, and filing the same with SEBI.

3) Arrangements for listing the equity share in the stock exchanges.

4) Underwriting agreement with merchant bankers, brokers, etc.

5) Bridge loan arrangements to complete the project before equity share

capital is raised.

6) Finalization of quotas to promoters, NRI’s employees, and firm

allotments, and public.
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7) If the public issue is not subscribed to the extent of atleast 90 percent of Financing Through
Domestic Capital
the equity issue, the money so collected should be returned to the public Markets
within 120 days of the last subscription date. In case of over
subscription, proportional allotment has to be made as per SEBI
guidelines.

10.2.2 Rights Issues

Under section 62(1) of the Companies Act, exiting shareholders of a

company have a right to subscribe for news equity shares. If the company
intends to raise additional equity capital in proportion to their share holding,
these shares are called rights shares. Instead of acquiring the rights, shares the
shareholders can transfer the rights to others or can simply forego them.
Those shares not subscribed will be allotted to the other shareholders
applying for more, proportionately.

If shares are left out even after giving additional allotment to the existing
shareholders, those shares can be issued to the public. When rights are
offered in proportion to the existing shares of the shareholders, the rights
pricing will not influence the value of the company, when adjusted for the
capital collected towards rights shares.

The right issue offers three main advantages. First, the existing shareholding
pattern will remain constant. Therefore, the controlling power of the
shareholders including promoter will not be disturbed the promoters may
enhance their controlling power, by allotting themselves additional shares to
the extent of rights un-utilized by other shareholders. Second, raising of
capital through rights issue instead of public issue leads to lower flotation,
commission, and can reduce the publicity costs.

Even the over subscription will be limited, leading to lower costs of returning
the excess capital received. Third, the response to the rights issue is easy to
gauge, especially when the rights share price is set much below the prevailing
price of the share.

The wealth and controlling power of the shareholder will be reduced if he

fails to subscribe to the rights issue. In India, the financial institutions
acquired large number of shares by using the loan conversion clause policy.
The loan extended can be converted into equity shares at a pre-determined
conversion price at the option of the financial institution. In some profitable
companies, their share holdings become more than, that of the promoters
making their controlling power valuable. In such cases, the promoters prefer
public issue to rights issue.

10.2.3 Private Placement

In this method of raising capital, shares will be issued in bulk to issuing

houses through financial intermediaries, investment companies, or other
companies. As per SEBI norms, a company cannot issue shares to more than
99 persons under private placement. Often these institutions buy the shares
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Financing Decisions
through private placement, with an intention to make profit by selling them to
the investors in the secondary market through clients. The sale can take place
in short-term or long-term. While issuing bankers and brokers normally resell
the shares acquired through private placement in the short-term. This method
has the advantages of negligible floatation’s costs (if any) and better price for
the shares.

10.2.4 Non-Voting Shares

As per the Provisions of section 43 and 47 of Companies Act, 2013,

companies can issue The equity shares issued “with differential rights as to
dividend, voting or otherwise” .This implies that these holders of these shares
will have rights different than the rights attached with the equity shares with
voting rights. When Company issues equity shares with differential rights,
they are required to adhere to certain conditions. The Companies (Share
Capital and Debentures) Rules, 2014 lays down several conditions for a
company to issue equity shares with differential voting rights and one of the
main condition is that at any point of time shall shares with differential rights
shall not exceed 26% of the total post issue paid up equity share capital,
including equity shares with differential rights issued.

The owners of nonvoting shares do not possess voting right, and as a

compensation for losing the voting rights, they will be paid a few percentage
points of higher dividend than that was paid to ordinary equity holders. If a
company fails to pay dividend for more than a stipulated period, the non-
voting shares will automatically stand converted into ordinary equity shares
with voting rights.

10.2.5 Preference Share

Preference shares are those, which carry certain preferential rights as

compared to other securities. The preference shareholders have the right to
get dividend at a fixed rate prior to any other class of shareholders. Similarly,
the preference shareholders get repayment of capital before any other class of
shareholders get it when the company is liquidated. In other words,
preference shares have prior claims over equity shares on earnings and assets
in the event of liquidation, but rank below creditors. But unlike interest on
bonds, dividend declaration by the company is not obligatory and may not be
paid in a year when profits are not enough. In other words, the preference
shareholders cannot take legal action against the company for not declaring
dividends. However, the preference shareholders have got the protection that
no dividend can be declared on the ordinary shares, unless dividend on
preference shares is declared and paid. Further, if the preference shares are
cumulative type, dividends not paid in any year will accumulate and must be
paid at a later date, before paying dividend on ordinarily shares.

Preference shares are also of different kinds like redeemable preference

shares, cumulative preference shares and convertible preference shares.
Redeemable preference shares are those which will be redeemed in course of
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time as per the terms and conditions as stated in the offer document. Financing Through
Domestic Capital
Markets
Cumulative preference shares carry accumulated unpaid dividends year to
year till the company is in a position to pay all the dividends including the
arrears at a stated rate. While the convertible preference shares get converted
into equity shares as per the terms and conditions as stated into offer
document, the investors who seek security and assured returns than in found
in equity shares generally subscribe preference shares. Companies generally
issue preference shares in order to maintain the status quo in the control of
the equity stock and also to reduce the cost of capital as the preferred stock
carries lower rates of dividends as compared to other debt securities like
debentures, which usually carry higher rates of interest. At time, the
preference shareholders may have a right to share the surplus profits by way
of additional dividend and the right to share in the surplus assets in the event
of winding up after all kinds of capital have been repaid.

As per the Companies Act, 2013 Preference Shares must be redeemed within
a period of 20 years of their issuance. As an extension of this clause is that
companies cannot issue irredeemable preference shares,

10.2.6 Cumulative Convertible Preference Shares (CCP)

The government in 1985 introduced cumulative Convertible Preference
(CCP) shares.

The features of CCP are:

1) The CCP’s can be issued by any public limited company to raise funds
for new projects, expansion etc.

2) The amount of funds raised can be to the extent of the equity shares to
the public for subscription.

3) The dividend payable is 10 per cent.

4) The entire amount of CCP would be convertible into equity shares

between three and five years.

This instrument is yet to become popular. Companies did not prefer it

because the dividend on CCP’s is not tax deductible as in case of interest on
debt..

10.2.7 Warrants
Warrants is similar to call options. It is a right to buy a share of a company,
which issues them at a certain price during a specified period of time. When a
warrant is exercised, the number of shares of the company increases, at the
same time resulting in cash flow for the company. Warrants may be issued in
the following circumstances.

i) Warrants may be attached to the sale of new equity shares as sweetener.

ii) Through exchange as a result of reorganization. 211
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Financing Decisions
iii) Through separate sale, as issued to promoters of some Indian companies
to strengthen their controlling power. This is not a common practice.

Price of Shares Issued Through Warrants

The company will receive the consideration for shares issued through
warrants in three parts of (a) Cash received on sale of the warrants, (b) Cash
received on exercise of warrants, and sale of the warrants, and (c) the
consideration for the earlier financing supplied to the company. The fair
value of shares issued on the exercise of warrants is the most reasonably
determinable measure of the total consideration for the shares issued through
warrants. The difference between the total considerations for the cash
received represents the cost of corporate financing. The following are the
benefits to the company and investor, when warrants are issued.

Benefits to the Company

By issuing warrants, the company will receive funds for its investment needs.
However, it has no obligation to service those funds raised, in terms of
paying interest, and principal amount. The price of this privilege is the
obligation to deliver the share wherever the warrant holder desires so during
the pre specified time period. Normally, the exercise price will be more than
the current price of the share.

Benefits to the Investor

The investors seeking warrants advance funds to a company bearing the risk
of expecting return based on future share price of that company. The
investors do not get any interest, or dividends on their investment unless the
warrants are converted into shares. The possible gains to the investor are :

i) Instead of investing in the equity shares of a company at current price,

the investor can opt for warrants with a right to buy the same number of
shares at a specified price in future paying a small amount for the
warrants. The funds, thus, saved can be used for other investment
avenues.
ii) The warrants are usually traded on the stock exchanges offering
liquidity. The Investor can book profits, or can en-cash the warrants, if
necessary.

10.2.8 Debentures
Debentures are one of the principal sources of funds to meet long-term
financial needs of companies. Though there is no specific definition of
debenture, according to the Companies Act 2013, the word debenture
includes debenture stock, bonds and any other securities of a company. Thus,
a debenture is widely understood as a document issued by a company as
evidence of debt to the holder, usually arising out of loan and mostly secured
by charge. The major differences between shares and debentures are as
follows;
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i) The equity shareholders have proprietary interest in the company Financing Through
Domestic Capital
whereas the debenture holders are only creditors of the company. Markets

ii) The equity shareholders have voting rights whereas debenture holders do
not enjoy such a right.

iii) Debenture holders are entitled to interest at a fixed rate whereas the
equity Shareholders are entitled to dividends at varying rates.

iv) Debenture are usually redeemable and therefore have maturity period
whereas the equity shares are not redeemable.

v) Debenture holders have priority over shareholders in the distribution of

assets on liquidation of the company.

Debenture holders can initiate legal proceedings against a company, if it

defaults on its interest payment or principal repayment when these become
due. The company using debentures usually offers some sort of a security,
which is called charge. The charge may be fixed charge or floating charge.

Debenture are of various forms like: (i) secured and unsecured debentures,

(ii) Fully convertible, partly convertible and non-convertible debentures,

(iii) Redeemable and irredeemable debentures.

Of all the various kinds of debentures, convertible debentures, of late, have

become more appealing to the investors. The investors may also have the
option of retaining the debentures without exercising the conversion option.
The partly convertible debentures with buy back facility are also issued,
wherein one part of the debenture is converted into equity and non-
convertible part may have the facility of buy back either by the company or
its associates. The convertible debentures can be exchanged for equity shares
of the same company on the terms and conditions stipulated at the time of
issue of the debentures. Till conversion, these debentures are treated as debt
instruments and enjoy the same priority in claims as those of ordinary
debenture holders, on the assets of the company. For the company, there is
scope for reducing the cost of capital, since investors would be content with a
lower return than that on ordinary debentures, if there is a high likelihood of
capital appreciation of the company’s shares in later years.

There are many advantages of debenture issues for the company. More
particularly, the debenture holders cannot interfere with the operation of the
company as they do not have voting rights. The cost of debentures is usually
low, as the interest payments on debentures are tax-deductible expenses.

10.2.9 Bonds

A bond is a creditor ship security whereby a company obtains money from

the lenders for a promise to pay the stipulated rate of interest at specified
intervals and to repay the principal on maturity, and they get the principal
sum on maturity, which is also mentioned in the agreement. Bondholders
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Long Term
Financing Decisions
have a prior claim on the receipt of the interest and repayment of the
principal over other creditors of the company.

Bonds are of different types like secured and unsecured bonds, bearer bonds,
perpetual bonds, sinking funds bonds, zero coupon bonds, convertible bonds,
floating rate bonds, etc.

Zero coupon bonds have become very popular in recent years with the
investing public. The zero coupon bondholders are not entitled to any interest
and they get the principal sum on maturity. The zero coupon bonds are
usually sold at a hefty discount and the difference between the face value of
the certificate and the acquisition cost is the gain to the investors. There are
certain advantages to both the investors and issuers. As far as investors are
concerned, they need not bother about reinvestment of interest as there is no
periodical interest payment. Further, the difference between the acquisition
cost and maturity value of the bond is considered as capital gain and
therefore, it attracts lower rate of tax as compared to the tax rates applicable
to interest incomes. For the issuer, since there is no periodical payment of
interest, the company may not have the cash flow problem in the initial years
of the projects where after the payment to the bondholders can be
synchronized with cash flow pattern of the project.

Floating Rate Bonds (FRB) has also become popular in recent years. The first
floating rate bond in the Indian capital market was issued by the State Bank
of India adopting a reference rate of one-year bank deposit rate plus 300 basis
points (BP). The bank also had the call option after 5 years to redeem the
bonds earlier than the maturity period of 10 years at certain premium. Later
many corporate and development finance institutions came out with floating
rate bonds of different maturity periods. But most of them used 364-days
Treasury bill rate as the benchmark plus certain basis Points, which again
varied from issue to issue. For example, ICICI issued floating rate Bonds
adopting 364-days T-bill rate : 180 BP but Anvind Mills launched floating
rate Bonds adopting 364 days T Bill rate : 325 BP. Thus, the floating rate
bonds provide varying rates of return with a minimum assured return to the
investors. The issuers may also have the benefits of making interest payments
according to the current market.

10.2.10 Secured Premium Notes (SPN)

The Tata Iron and Steel company was the first corporate to issue SPN on
rights basis. The main features of SPN, as issued by TISCO are as follows:

The face value of a SPN was Rs 300 and no interest will become due or
accrue during the first three years after allotment. Therefore, each SPN will
be repaid in four equal annual installments of Rs. 75 from the end of the
fourth year together with an equal amount of Rs. 75 with each installment,
which will consist of a mix of interest and premium on redemption. Further,
each SPN will have a warrant attached to it, which will give the holder the
right to apply for or seek allotment of one equity share for cash payment of
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Rs. 80 per share. Financing Through
Domestic Capital
Markets
Such rights are exercisable between first year and one and a half year after
allotment.

Thus, SPN can serve as long-term securities and given more flexibility to the
companies as well as investors.

10.2.11 Public Deposits

According to the companies Act, 2013, all types of money received by a
company except the contribution to capital would fall in the category of
deposits. Fixed deposits, which are also known as public deposits, have
become attractive for companies as well as investors. For the companies,
public deposits are easy form of fund mobilization without mortgaging
assets. For the investors, public deposits provide a simple avenue for
investment in good and popular companies at a better rate of interest without
many formalities as involved in the case of shares and debentures. However,
the public deposits being unsecured, the repayment of deposits and regular
payment of interest are subject to a lot of uncertainty. That is, by presenting
false information some companies manage to collect large deposits from the
gullible public and fail to honour commitments on payments, inspire of many
regulatory provisions, as contained in the Companies Act and Companies
(Acceptance of Deposits) Rules, 1975.

10.2.12 Bank Credit

Banks including the development finance institutions have become chief
source of funds to the corporate sector. In other words, the industrial credit is
a major revenue earner to the banking sector as other types of credit like
agricultural credit are subject to many restrictive conditions and regulations
of RBI and therefore, the margins on such credits are very thin. Banks extend
credit to industries and commercial establishments at varying rates of interest
depending upon the credit worthiness of the borrower as well as period of
loan. The proportion of bank credit in the total funds of the companies is very
high in many a case. The major advantage for the companies in that the bank
credit is a flexible source of financing and it is relatively easy to mobilize
funds through this source.

10.2.13 Venture Capital

Governments around the world have been actively encouraging small and
medium business, especially feasible projects. The usual sources of capital
generally do not suit those promoters who are not in a position to put in
enough contribution to satisfy the other investors and lending institutions.
Even if other investors are willing to chip in despite negligible promoter
contributions, the promoter cannot retain the control of the business after
establishing and stabilizing in a profitable path, if the other investors chose to
vote them out.

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Financing Decisions
The objective of the venture capital is to encourage those desiring
entrepreneurs by providing long-term capital without the risk of losing
control. By 1980’s, the U.S.A. had a well-developed venture capital market.
In India, venture capital market is emerging as a new source of funds.

Features:
It is defined as (similar to) equity investment in growth oriented small or
medium business to enable the investors to accomplish corporate objectives,
in return for minority shareholding in the business or the irrevocable right to
acquire it. Further, venture capital organization provides value addition in the
form of management advice and contribution of overall strategy. The
relatively high risk will normally be compensated by the possibility of high
return in the form of capital gains in the medium term. Venture capital is also
called as private equity. The following are main features that distinguish the
venture capital from other sources of capital market.

i) Venture capital is a form of equity capital for relatively new companies,

which find it too premature to approach the capital market to raise funds.
It can also be in the form of loan or convertible debt. However, the basic
objective of a venture capital fund is to earn capital gain, which usually
will be higher than interest at the time of exit.

ii) It is long-term investment. The transfer of existing shares from other

shareholders cannot be considered as venture capital investment. The
funding should be for new project or for rapid growth of the business,
with cash transferring from the fund to the company.

iii) The venture capital organization will actively participate with the top
management of the firm.

iv) All the projects financed by the venture capitalists will not be successful.
However, some of the ventures yield very high return to more than
compensate for heavy losses on others.

Selection for Investment

The appraisal procedure for investment is similar to feasibility studies of the
development finance institutions for grant of term loans and other financial
assistance. In addition, the venture capital organization may peruse track
record of entrepreneurs, threats from technological obsolescence and
preliminary views on preferred exits. The stages of financing and the mode of
financing will also be finalized at this stage.

Stage of Financing: Generally, the stages of financing are (a) early stage and
(b) later stage.

Early stage Financing: This stage is essentially an applied research phase

where the concepts and ideas of the promoters are discussed and tested
leading to a prototype. If the prototype is satisfactory, this stage moves
towards the development phase leading to product testing and
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commercialization. Normally promoters complete this phase with their own Financing Through
Domestic Capital
resources, because very few venture capital funds finance this stage. Markets

Start-up : This refers to the stage when commercial production is ready to

begin. At this stage product will be commercialized in association with the
venture capital organization. In this stage some indication of the potential
market for the new product will be available. The risk perception is still high.
The involvement of the venture capital organization at this stage also is
relatively less. Due to the unwillingness of the promoters to dilute their
controlling stake, or too small amounts involved, or even unclear risk
perceptions.

Later stage Financing: At this stage the investor firms require funds but
cannot approach markets. This stage includes development capital,
expansion, buy-outs and turn around.

Development Capital: It is for financing of established firms, which have

overcome the high-risk stage with a profit record for a few years, but cannot
raise funds in the capital market. The reasons for venture capital funds at this
stage are for purchase of new equipment/plant, expansion, improving
marketing facilities, refinancing of existing debt etc. In this stage the risk
perception is medium and venture capital funds involve actively.

Expansion and Buy-outs: In this stage the firms try to expand their
productive assets and marketing facilities considerably either by procuring
assets or by acquiring controlling power of other similar firms through
controlling stakes or other options.

Turn Around: This is an important segment of venture capitalists business.

They require not only money but also management skills. Once the venture
capitalists identify the firms with good management skill, they come forward
to provide money. As the risk perception is high, skill is a focus area for
many venture capital funds.

Thus, the venture capital firms fund both early and later stage of
requirements of investor firms, balancing between risk and profitability. This
is an ideal source of capital for promotes having very good technical and
management skills, with limited financial resources.

10.3 SUMMARY

Capital market plays a very important role in the mobilization of funds for
Investment. Capital market can be classified as primary market and
secondary market, which are complimentary to each other. The capital
market has experienced metamorphic changes over the last few years. The
competition in the market has become so intense necessitating the
introduction of several kinds of securities. The corporate in India mostly raise
their funds through capital market by issuing equity shares, preference shares,
debentures, bonds and secured premium notes. They also raise their funds
through public deposits and borrowings from banks. Technocrats and
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entrepreneurs with feasible project but having limited financial resources can
approach venture capital organization. Each method has got its own
distinctive features and depending upon the market conditions and financing
strategies the issuers adopt different methods.

10.4 SELF ASSESSMENT QUESTIONS

1. What are the characteristics of capital market? How is it different from
money market.
2. Explain the relationship between primary market and secondary market?
3. Assess utility of equity shares as source of corporate financing.
4. “Preference shares are known as ‘hybrid’ securities”. Comment.
5. What is creditor ship security? How is it different from ownership
security?
6. Examine potentiality bonds as source of corporate financing.

10.5 FURTHER READINGS

James C. Vanhorne, Financial Management and Policy, Prentice Hall of

India, New Delhi.

S.L.N. Sinha, D. Hemalatha and S. Balakrishan, Investment Management,

IFMR, Chennai.

I.M. Pandey, Financial Management, Vikas Publishing House, Bombay.

M.Y. Khan, Indian Financial system, Vikas Publishing House, Bombay.

218
UNIT 11 FINANCING THROUGH GLOBAL Financing through
Global Capital

CAPITAL MARKETS Markets

Objectives

The objectives of this unit are to :

• explain the concept of globalisation,

• throw light on globalisation of world Financial systems,
• scan the Indian Scenario of globalisation,
• study the various global sources of financing.

Structure

11.1 Introduction
11.2 Deregulation in Financial Markets
11.3 Developments in the Banking Sector
11.4 Developments in the Foreign Exchange Markets
11.5 Special Financial Institutions
11.6 Global Sources of Financing
11.7 Raising of Foreign Capital In India
11.8 External Commercial Borrowings
11.9 Foreign Direct Investment and Portfolio Investment
11.10 Summary
11.11 Self Assessment Questions
11.12 Further Readings

11.1 INTRODUCTION
In financial circles in recent years, the word ‘globalisation’ is often heard,
most commonly with reference to the heightened internationalisation of
financial transactions. This catch word sums up the Phenomenon in which
financial transactions increasingly transcend the geographical and time
limitations of local financial markets, giving rise to a single, uniform ‘global’
market. While the Phrase ‘internationalisation’ refers to cross border
transactions among national markets, globalisation goes beyond national
frontier to create a ‘borderless’ market in which national borders gradually
disappear.

The international financial system is characterised by the following types of

institutions:
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a) Financial markets;

b) The banking sector;

c) Foreign exchange markets; and

d) Special financial institutions, such as the World Bank, IMF, etc.

Since the early eighties, there has been a virtual transformation of these
markets. Not only has there been a complete integration of these markets in
any given country or economy, but the ties have been strengthened as to
result in a unified financial system on a worldwide scale. Not surprisingly,
we hear of tendencies towards common transaction methods and common
settlement periods across the globe. A complete integration of the markets
worldwide, no doubt, requires swift communication between countries. The
developments in technology whereby information can be had within a matter
of seconds from any part of the globe have made the process of globalisation
much easier and profitable. Financial managers across the world are
concerned with identifying profitable opportunities with associated minimum
risk. The financial integration of markets whereby funds can be easily
transferred from one place to another has certainly influenced the financing
and investment decisions financial managers make on a day-to-day basis.

11.2 DEREGULATION IN FINANCIAL

MARKETS

Many factors have helped the globalisation process in which no market,

howsoever remote, remains isolated and insulated from developments taking
place worldwide. The October 1987 crash is much too recent to be forgotten
and a telling evidence of the extent to which markets have been integrated.

Popularly too, of American and Japanese markets, it is said that when

America catches a cold, Japan sneezes. There have also been a number of
studies on the integration of European markets with the American market. In
general, the share prices move in tandem with each other.

The introduction of the floating exchange rate regime in 1973, interest rate
deregulation and securitisation since the 1970s have been among the major
factors behind the steady progress of financial globalisation. The OPEC
phenomenon of the 1970s and the debt crisis triggered by the developing
countries in the 1980s also significantly influenced the volume of
international capital flows and the restructuring of the financial system as a
whole.

Innovative financing techniques are constantly being designed to turn the

financing game, instead of the zero-sum game that was witnessed in the
1980s. The innovativeness in finacing techniques and tools have also been
accompanied by the growing deregulation of the national financial markets,
characterised by relaxation of barriers separating the activities of different
types of institutions, relaxation of interest rate ceiling, extension of the
220
geographical domain of existing institutions, and reduction in barriers to Financing through
Global Capital
entry into the domestic financial system by both foreign and non-banking Markets
institutions. The abolition or relaxation of exchange controls, elimination of
quantitative credit ceilings, removal or reduction of withholding tax on
interest earnings of non-residents and changes in regulations governing
access of foreigners to domestic markets, and access of residents to
international markets has tremendously helped the national markets to forge a
global financial market. The increasing competition among banks themselves
on the one hand and between banks and non-banks on the other, for
providing finance and financial services compelled banks to look into
hitherto uncharted territories.

The deregulation of the London Stock Exchange that took effect from
October 27,1986, ecstatically referred to as the ‘Big Bang’, has been the most
memorable one in the far-reaching changes that were introduced in the
financing of the London financial market. The liberalisation, though initially
intended to be limited to the abolition of the fixed commission on broking
business and the separation of the functions of brokers and jobbers, now
encompasses a wide range of related aspects for facilitating competition and
internationalisation of the London Stock Exchange. The traditional
distinction between brokers (who buy and sell on behalf of investors) and
jobbers (who make the markets on the floor of the Stock Exchange) has been
given a body blow in other financial centres also. The permitting of
institutional membership into the stock market has meant the injection of new
capital into the UK. Not to be left behind is the Bombay Stock Exchange in
India, which besides permitting institutional membership has also taken up
computerization on a mass scale.

The prominence of the Swiss market to its present status has been largely due
to its deregulated functioning. A significant portion of the Euro-deposits
came to be parked in the Swiss market because of the virtual absence of
Governmental control as well as tax-free income from securities. The
emerging role of Tokyo as an important financial center has also been
because of the easy access it provides to both domestic and overseas
investors and financial intermediaries to a growing variety of instruments
issued by or for Japanese entities. Foreign banks can now engage in trust
business (although on a selected basis) and can join in the government bond
underwriting syndicate. Foreign securities houses can lead-manage Euro-yen
bonds and can be members of the Tokyo Stock Exchange. Amongst the great
variety of debt instruments and financial packages available in Japan are also
the multi- currency bonds and the leasing bonds, where in by providing funds
to leasing companies to purchase high-valued items such as aircraft, cross-
border financial leasing is facilitated.

The need for financial innovation to make large amounts of funds easily
accessible has also been felt because of the growing trend towards
privatisation of nationalised industries and increase in flexibility of
operations leading to mass restructuring and consolidation of business
entities. Competitive pressures have led to a growing awakening towards
maximising both economies of scale and scope. The mass restructuring and
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consolidation of business entities have resulted in more frequent breakups
and dispositions, leveraged buyouts (LBOs) and management buyouts of
units of companies that do not fit into coherent strategic alliances, often with
significant equity stakes, have also been entered into as alternatives to full
mergers or acquisitions. Resources for financing merger transactions have
also been provided with bridge loans, ‘mezzanine financing’ synthetic
securities, junk bonds, and other related techniques. While ‘mezzanine
financing’ refers to the issue of equity-related bonds, e.g., bonds with
warrants, the term synthetic securities refers to a package of securities such
as a Eurobond and a currency swap arrangement that converts an original
security into a security with different currency or other characteristics. Junk
bonds are simply bonds rated below investment grade (BBB) by rating
agencies but are popular because of the extremely high yields they promise.
The junk bond market flourished initially by financing large volumes of LBO
transactions.

12.3 DEVELOPMENTS IN THE BANKING

SECTOR

The banking sector too, has gone through revolutionary changes. At least
three trends characterise the future of banking the world over:

i) The banks’ role as funding intermediaries is diminishing and instead

banks are taking on the role of broker and/or underwriter for credit
transactions;

ii) Banks’ formerly protected turf is being invaded by investment banks,

thrifts, insurance companies, and even retail firms. In response, banks are
expanding their activities into the domain of investment banks and
insurance companies; and finally

iii) Banks are expanding geographically as they compete in inter-state and

even international markets.

However, although the role banks play as funding intermediaries is

diminishing, it will not disappear entirely. Banks’ ability to fund loans will
continue to be important in, at least, two ways.

First, banks will continue to make and hold loans that are not readily
securitised. To make loan-backed securities marketable, securitisation
requires the standardisation of loan terms and conditions. Similarly, it
requires that investors can able to evaluate the credit risk of the underlying
pool of loans at relatively little cost. Loans that require special knowledge of
the expertise in local markets, therefore, are not easily standardised. To
compensate lenders for the higher costs associated with making these non-
standardised loans, their yields will rise relative to the yields on debt
obligations that can be securitised. Consequently, banks will have incentives
to continue to make and hold non- securitised loans. A second way in which
banks will remain important intermediaries is as backup sources of liquidity
222 when borrowers find it difficult and/or costly to raise funds in capital
markets. For this reason, even the borrowers that have ready access to Financing through
Global Capital
commercial paper and other direct securities markets still pay banks Markets
substantial fees to maintain lines of credit and loan commitments. Likewise
in international capital markets, borrowers have been attracted to the note
issuance facilities offered by banks. These facilities ensure access to funds,
should the borrowers be unable to sell their notes directly to investors.

Other fee-generating activities include issuing stand-by letters of credit,

commercial letters of credit, and loan commitments and indulging in foreign-
exchange obligations and interest rate swaps. Such business for major players
run into billions of dollars.

Foreign exchange transactions and interest rate swaps are now the most
important sources of revenues from Off Balance Sheet Activities (OBSAs).
Profits in foreign exchange trading come from two main sources:

i) trading profits generated by the bank trading for its own accounts; and

ii) fees generated by trading in currencies for its customers.

Multinational banks are very active in Euro-currency markets wherein they

gather deposits and make loans, usually in Eurodollars. Interest-arbitrage
transactions are frequently entered into, i.e., borrowing funds in one foreign
currency and country and making loans in another currency and country, due
to substantially different interest rates across countries. The objective of these
arbitrage transactions is to maximise the interest-rate spreads, given the
banks’ risk preferences.

11.4 DEVELOPMENTS IN THE FOREIGN-

EXCHANGE MARKETS

Foreign-exchange markets exist because of trade between countries with

different currencies. That is, exporters prefer not to hold foreign currencies;
they want to be paid in their national currency. Foreign exchange transactions
have, thus, become an integral, even essential, part of international trade and
finance. In the immediate aftermath of World War II, foreign exchange
trading was relatively limited, as most major currencies were subject to
extensive exchange controls, and the opportunities for the movement of funds
across national boundaries were severely limited. The subsequent recovery
and growth of the world economy brought a gradual relaxation of these
controls and as a result foreign exchange trading became more and more
active. The really explosive growth of the exchange markets began, however,
with the advent of floating exchange rates following the collapse of the
Breton Woods system in the early 1970s. Since then, not only has world trade
continued to expand very rapidly, but international financial transactions
have grown exponentially and with them, the foreign exchange markets.
Moreover, not only has the volume grown, but the markets have become
increasingly volatile, and that, in itself, has drawn in additional players to the
market, both, for defensive and aggressive trading.
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Financing Decisions
The foreign exchange market is dominated by giant commercial banks. To
provide foreign exchange services to customers, these banks take a position
(i.e., hold inventories) in the major currencies of the world. Some banks do
this by keeping deposits with foreign banks. In addition to providing for
customers’ foreign currency needs in either the spot or the forward markets,
banks also trade on their own account in the foreign exchange market. The
importance of foreign-exchange income to the major US banks is reflected by
the fact that it accounts for anywhere from 10 per cent to 60 per cent of the
overseas operating income of these banks.

This increased internationalisation has, nevertheless, meant increased

vulnerability of the players in these markets. Amongst the various risk-
reduction methods that have come to be employed, swaps, futures and
options are the most conspicuous. These facilities enable banks and
corporations to hedge their exposure to financial risks arising from interest
rate and exchange rate changes. In the international markets, currency options
are more predominant than interest rate options. In currency options, standard
period options (3 months, 6 months, etc.) for major currencies against US
dollars are being increasingly traded. In the options market, banks may act as
agents for other parties or as principals. Financial futures have registered
significant expansion in recent years with the expansion of the business of
existing futures markets and also with the setting up of futures markets in
other centres particularly London, Singapore and Amsterdam. Interest and
currency futures not only offer actual hedging facilities but also speculative
innovative techniques, which, though useful to transfer risks to counterparties
has also called for appropriate management control and monitoring systems.
Capital adequacy norms for the banking sector was one such step in the
regulatory system. The need for regulation is heightened with fiascoes of
massive proportions, such as the failure of BCCI.

11.5 SPECIAL FINANCIAL INSTITUTIONS

The World Bank’s role as a catalyst in attracting development finance for
high- priority programmes in the developing countries through co-financing
has increased significantly in recent years. Co-financing has been a feature in
about 37 per cent of Bank/IDA operations and the volume of funds mobilised
from other sources external to borrowing countries has been equivalent to
more than 36 per cent of the total volume of banks group lending. Although
historically, the major source of co-financing has been official bilateral and
multilateral aid agencies, projects with private co-financing especially in the
industrial and power sectors are becoming more and more popular.

The Special Drawing Rights (SDRs) mechanism operated by the

International Monetary Fund whereby member countries bail each other out
in times of foreign exchange crisis has provided a fair measure of stability to
the international development agencies such as the export-import banks in
various countries providing loans to domestic borrowers for export, import
and overseas projects, as well as technical service credits in such projects as
the construction of factories, dams, etc., and direct loans to foreign
224 governments, banks and corporations.
India has been financing its Public Sector as well as private sector industrial, Financing through
Global Capital
social and economic projects from the funds available from international Markets
financial institutions like World Bank, IMF, Asian Development Bank, etc.,
right from the inception of these institutions. India has figured amongst the
top ten borrowing nations of the world. Currently, about over $ 100 billion
worth of funds are being made available by various international financial
institutions.

11.5 GLOBAL SOURCES OF FINANCING

Major segments of international financial markets from where the domestic

corporate can raise funds are:

The Foreign Bond Market: The foreign bond market is that portion of the
domestic bond market, which represents issues floated by foreign companies
or governments. In context of US or Germany the bond issues floated by
Indian or any other foreign corporate or government and subscribed by
residents or corporate of these countries will represent the foreign bond
market for them. The main advantages of using foreign bond market is
increase in reputation due to close scrutiny by institutional investors,
diversifying and broadening of investor base and lower cost of funds. The
foreign bond instruments are primarily of three types, which are : fixed rate
issues, floating –rate issues and equity related issues. In fixed rate issues the
interest rate is fixed for the whole tenure of the issue, maturity date is fixed
and principal amount is paid in full at time of maturity. Floating rate bonds
have variable interest rates during the tenure of the bond and the interest rate
is reset at fixed interval. The new interest is set at a fixed margin over and
above some pre decided reference benchmark rate such as treasury bills or
the commercial paper rate. The equity related bonds combine features of both
bond and equity and are of principally of two types. Convertible bonds are
fixed rate bonds that are convertible into equity in pre decided rate before
maturity. Equity warrants provide the holders the right to buy a specified
number of shares at a specified price during a designated time period.

The Foreign Equity Market: When companies decide to raise equity capital
from diversified investors the natural choice is cross listing of share of the
company over various stock exchanges located in different countries either
through Initial Public Offering or through seasoned equity offering.Foreign
listing allows companies to diversify equity funding risk.Some times the
equity offerings are large enough that a single domestic market may not meet
the entire funding requirement. Foreign offering can also increase the
potential demand for the company’s share and hence the price. Foreign listing
especially in US can lead to lower cost of capital and enhance the valuation
by up to 10% relative to country and industry benchmarks. Nowadays
corporate governance is a serious issue with investors across the board.
Foreign listing assures the investors about the adequacy of corporate
governance as listing on these exchanges require close scrutiny of corporate
governance. Foreign listing can also increase the potential sales of company’s
products and services in these markets as people become more aware about 225
Long Term
Financing Decisions
the company.

Foreign Bank Market :The foreign bank market represents that portion of
domestic bank loans supplied to overseas customer for use in another
country.

Project Finance: Large scale, capital intensive, long-term capital

investments are usually financed through project finance. Project finance is a
nonrecourse lending secured by project and potential cash flows associated
with the project. The distinguishing future of project finance is the ownership
structure of the project, which is owned by single purpose corporation also
known as special purpose vehicle(SPV).This SPV is legally independent of
its sponsors. Project finance is defined as “ the raising of funds to finance an
economically separable capital investment project in which the providers of
the funds look primarily to the cash flow from the project as the source of
funds to service their loans and provide the return of and a return on their
equity investment in the project”

The main features of project finance are:

1. It focuses on economically separable investment projects such as power

plants, highways, transmission lines gas pipelines, etc

2. Since projects are designed as legally independent units, nonrecourse

lenders have resort only to project assets and associated project cash
flows

3. The underlying assets in project finance are illiquid industrial assets

4. Since project has finite life, at the end of the project all equity and debt
investors are paid off

5. The project sponsors are shielded from risk associated with large
borrowings

6. Project finance is faced with greater credit risk therefore the cost of
borrowing is comparatively high and often exceeds that of the project
sponsors

The Euro Currency Market:

The Euro Currency Market is outside the legal purview of the country in
whose currency the finances are raised. The term ‘Euro’ is affixed to an
offshore currency transaction. Capital raised in the Euro Currency Market
can be classified temporarily as under:

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Eurocurrency Finance: Financing through
Global Capital
Short term Medium term Long term Markets
(upto 365 days) (2 to 10 years) (10 Yrs and above)

i) Euro loans (ii) Syndicat 1. Eurobonds

from banks ed Loans
ii) Euro (iii) Revolving 2. Euro equities
commercial Underwriting
paper (ECP) Facilities
(RUFs)

Euro Loans are essentially short-term accommodations provided by bankers

to their clients. The interest charged is a mark up on the London Interbank
Offered Rate (LIBOR), which varies according to the credit worthiness of the
borrowing company.

Euro-commercial Papers are short-term promissory (bearer) Eurocurrency

notes. These are typically issued at a discount of their face value, which
represent the yield to the investors.

Syndicated (Euro-currency) loans are given by syndicates of banks to

borrowers at a variable rate of interest (e.g. Libor + 0.25%).

Revolving Underwriting Facility (RUF) involves sale of bearer notes to

investors on a revolving basis. The investors under RUF undertake to make
certain amount of funds available to the borrower upto a certain date during
which the borrower is free to draw down, repay and redraw the funds after
giving due notice.

Eurobonds are long-term unsecured debt securities usually fixed rate

instruments, with bullet repayments. These are targeted at high net worth
individual and institutions and are listed on stock exchanges such as
Luxembourg or London to provide liquidity.

Euro equities are company shares, which could either be directly offered
listing on the foreign stock exchanges or take the form of global depository
receipts with shares underlying such receipts.

11.7 RAISING OF FOREIGN CAPITAL IN INDIA

Capital can be raised from non-residents either in the form of equity or in the
form of debt by Indian companies subject to Foreign Exchange Regulations
and other relevant provisions in this regard. For raising of equity capital
ADR/GDR route has been used by the corporate which has been further
refined with the Introduction of Depository Receipts Scheme, 2014. This
scheme repealed the earlier Issue of Foreign Currency Convertible Bonds and
Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993
(FCCBDRMS 1993). The main features of this scheme are :

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Eligibility to issue depository receipts
Eligibility:
1. The following persons are eligible to issue or transfer permissible
securities to a foreign depository for the purpose of issue of depository
receipts:

a) any Indian company, listed or unlisted, private or public;

b) any other issuer of permissible securities;

(c) any person holding permissible securities; which has not been
specifically prohibited from accessing the capital market or dealing
in securities.

2. Unsponsored depository receipts on the back of listed permissible

securities can be issued only if such depository receipts: (a) give the
holder the right to issue voting instruction; and (b) are listed on an
international exchange.

As per the previous scheme only listed companies could make issuance of
GDRs in foreign markets. Now unlisted and even private companies in India
can make depository receipt issuances abroad

Issue

1. A foreign depository may issue depository receipts by way of a public

offering or private placement or in any other manner prevalent in a
permissible jurisdiction.

2. An issuer may issue permissible securities to a foreign depository for the

purpose of issue of depository receipts by any mode permissible for issue
of such permissible securities to investors.

3. The holders of permissible securities may transfer permissible securities

to a foreign depository for the purpose of the issue of depository receipts,
with or without the approval of issuer of such permissible securities,
through transactions on a recognized stock exchange, bilateral
transactions or by tendering through a public platform.

Limits
1. The aggregate of permissible securities which may be issued or
transferred to foreign depositories for issue of depository receipts, along
with permissible securities already held by persons resident outside
India, shall not exceed the limit on foreign holding of such permissible
securities under the Foreign Exchange Management Act, 1999.
For example, foreign investment in a company is ordinarily permissible
up to x%. However, it can be increased up to y% with the approval of the
company in the general body meeting. If no such approval has been
granted, the permissible securities on which depository receipts may be
issued, whether sponsored or unsponsored, cannot exceed x%.
228
2. The depository receipts may be converted t o underlying permissible Financing through
Global Capital
securities and vice versa, Markets

Pricing
The permissible securities shall not be issued to a foreign depository for the
purpose of issuing depository receipts at a price less than the price applicable
to a corresponding mode of issue of such securities to domestic investors
under the applicable laws.

Explanation 1: A company listed or proposed to be listed on a recognized

stock exchange shall not issue equity shares on preferential allotment to a
foreign depository for the purpose of issue of depository receipts at a price
less than the price applicable to preferential allotment of equity shares of the
same class to investors

Explanation 2: Likewise, where a listed company makes a qualified

institutional placement of permissible securities to a foreign depository for
the purpose of issue of depository receipts, the minimum pricing norms for
such placement as applicable under the ICDR shall be complied with.

Jurisdictions of Issuance:
A depository receipts can only be issued in permissible jurisdictions, i.e.
which is Financial Action Task Force compliant and is a member of the
International Organization of Securities Commissions.
Nature of securities that can be issued under GDR?
Any instrument that is considered as a security under Securities Contracts
(Regulation) Act, 1956 can be the basis of a GDR issuance. Thus, shares,
bonds, debentures Government securities, rights or interests in securities can
all be the underlying basis of a GDR issuance.
Sponsored and Unsponsored DRs
Depository receipt issuance can be led by a company itself, that is, the
company’s shares are issued or existing company shares are created into
depository receipts at the instance of the company. Alternately, an institution
that validly holds shares of a company can create and issue depository
receipts (unsponsored) at its own instance, without the involvement of the
company and sell them to investors, which can be traded on a stock
exchange. Thus, the types of Depository Receipt issuances are as follows:

A. Sponsored: Where the Indian issuer enters into a formal agreement with
the foreign depository for creation or issue of DRs. A sponsored DR
issue can be further classified as:

Capital Raising: The issuer issues new securities, which are deposited
with a domestic custodian

Non-Capital Raising: No fresh underlying securities are issued. Rather,

the issuer gets holders of its existing securities to deposit these securities
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Long Term
Financing Decisions
with a domestic custodian, so that DRs can be issued abroad by the
foreign depository. Sponsored non-capital raising of DRs has been
allowed in the DR Scheme, 2014.

B. Unsponsored: Unsponsored DRs are where any person other than the
Indian issuer may, without any involvement of the issuer, deposit the
securities with a domestic custodian in India. A foreign depository then
issues DRs against such deposited securities. This is not a capital raising
exercise for the Indian issuer, as the proceeds from the sale of the DRs
go to the holders of the underlying securities. This can create incentives
for financial intermediaries who hold shares to issue depository receipts
offshore for secondary trading. In such situations, the Indian company
will not earn any extra money as no investment is received into the
company, but it creates an opportunity for offshore investors to gain
exposure to the Indian market. This will help them diversify their
portfolio and also engage in trading of shares.

Process

The process of issuing GDRs by a company typically involves the following

steps:

1. The domestic company enters into an agreement with the overseas

depository bank for the purpose of issue of GDR, this is known as a
Depository Agreement.

2. The overseas depository bank then enters into a custodian agreement

with a domestic custodian bank.

3. The domestic custodian (which is an agent of the depository bank) holds

the equity shares of the company.

4. On the instruction of domestic custodian, the overseas depository bank

issues depository receipts (against the said equity shares) to foreign
investors in foreign currency.

Depository receipt mechanism can be used by companies to raise fresh

capital or provide liquidity to already issued capital . In recent years use of
this is on decline and external commercial borrowing is becoming a preferred
route to raise capital as high liquidity in advanced countries has push down
the interest rate.(this was before the outbreak of conflict between Russia and
Ukraine)

11.7 EXTERNAL COMMERCIAL BORROWINGS

External Commercial Borrowings

External Commercial Borrowings are commercial loans raised by eligible

resident entities from recognised non-resident entities. The main attraction
for using this type of funding is the low interest rate at which they can be
raised.. The parameters given below apply in totality and not on a standalone
basis. In addition to ECB companies can also raise debt through Trade credit.
230
Trade Credits (TC) refer to the credits extended by the overseas supplier, Financing through
Global Capital
bank, financial institution and other permitted recognised lenders for Markets
maturity, as prescribed , for imports of capital/non-capital goods permissible
under the Foreign Trade Policy of the Government of India. Depending on
the source of finance, such TCs include suppliers’ credit and buyers’ credit
from recognised lenders. Apart from TC &ECB another route through which
helps companies to access debt is STRUCTURED OBLIGATIONS, which
includes Non-resident guarantee for domestic fund based and non-fund based
facilities, and Facility of Credit Enhancement. The detailed features of these
schemes is given in Appendix 1

The important features of this scheme such as minimum maturity, permitted

and non-permitted end-uses, maximum all-in-cost ceiling, etc. are discussed
below

Currency of Borrowing: Borrowing can be in either any freely convertible

currency or Indian rupee.

Forms of ECB : ECB can be raised in the form of Loans including bank
loans; floating/ fixed rate notes/ bonds/ debentures (other than fully and
compulsorily convertible instruments); Trade credits beyond 3 years; FCCBs;
FCEBs and Financial Lease if they are raised in convertible currency. In case
they are raised in Indian Rupees ECB can include Loans including bank
loans; floating/ fixed rate notes/bonds/ debentures/ preference shares (other
than fully and compulsorily convertible instruments); Trade credits beyond 3
years; and Financial Lease. Also, plain vanilla Rupee denominated bonds
issued overseas, which can be either placed privately or listed on exchanges
as per host country regulations.

Eligible borrowers: All entities eligible to receive FDI. Further, the

following entities are also eligible to raise ECB: Port Trusts; Units in
SEZ;SIDBI; and EXIM Bank of India. In case ECB is raised in Indian
Currency, in addition to above following entities can also raise ECB.
Registered entities engaged in micro-finance activities, viz., registered Not
for Profit companies, registered societies/trusts/ cooperatives and Non-
Government Organisations.

Minimum Average Maturity Period (MAMP): The maturity period can

range from 1 year to 10 years depending on kind of borrowers and purpose of
borrowings.

11.9 FOREIGN DIRECT INVESTMENT

Foreign Direct Investment:

Foreign Investment means any investment made by a person resident outside

India on a repatriable basis in capital instruments of an Indian company or to
the capital of an LLP.

Foreign Direct Investment (FDI) is the investment through capital

instruments by a person resident outside India

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Long Term
Financing Decisions
a) in an unlisted Indian company; or
b) in 10 percent or more of the post issue paid-up equity capital on a fully
diluted basis of a listed Indian company.

Foreign direct investment is very necessary for any developing country as it

brings not only badly needed financial resources but new technology as well.
Since 1991 India has made hectic efforts to attract FDI and in the process has
entered into top 100 club on Ease of Doing Business. FDI inflows was
$45.15 bn in 2014-15, which has grown to $84,835 mn in FY 21-22 .
Total FDI inflows in the country in the last 22 years (April 2000 - March
2022) are $ 847 bn . The highest ever-annual FDI inflow was of $ 83.57 bn in
the FY 2021-22.

The top 5 countries making FDI in India are Singapore (27.01%), USA
(17.94%), Mauritius (15.98%), Netherland (7.86%) and Switzerland (7.31%)

In FY 2021-22.Top 5 sectors receiving highest FDI 22 are :

Computer Software & Hardware (24.60%), Services Sector (Fin., Banking,

Insurance, Non Fin/Business, Outsourcing, R&D, Courier, Tech. Testing and
Analysis, Other) (12.13%), Automobile Industry (11.89%), Trading 7.72%
and Construction (Infrastructure) Activities (5.52%).

Portfolio Funds:

Portfolio funds are basically brought in by foreign institutional investors. It is

largely through pension funds, mutual funds, investment trust, asset
management companies, institutional Portfolio managers or their power of
attorney holders in securities traded in the primary and secondary capital
markets. Foreign Portfolio Investment is any investment made by a person
resident outside India in capital instruments where such investment is (a) less
than 10 percent of the post issue paid-up equity capital on a fully diluted
basis of a listed Indian company or (b) less than 10 percent of the paid up
value of each series of capital instruments of a listed Indian company.

Regulated by SEBI, the FPI regime is a route for foreign investment in

India. The FPI regime came as a harmonised route of foreign investment in
India, merging the two existing modes of investment, that is, Foreign
Institutional Investor ('FII') and Qualified Foreign Investor ('QFI').

A foreign portfolio investment can be done in the following instruments:

a) shares, debentures and warrants issued by a body corporate listed or to
be listed on a recognized stock exchange in India;
b) units of schemes launched by mutual funds under Chapter V ,VI-A and
VI-B of the Securities and Exchange Board of India (Mutual Fund)
Regulations, 1996;
c) units of schemes floated by a Collective Investment Scheme in
accordance with the Securities and Exchange Board of India (Collective
Investment Schemes) Regulations 1999;
232
d) derivatives traded on a recognized stock exchange; Financing through
Global Capital
e) units of real estate investment trusts , infrastructure investment trusts and Markets

units of Category III Alternative Investment Funds registered with the

Board;
f) Indian Depository Receipts ;
g) any debt securities or other instruments as permitted by the Reserve
Bank of India for foreign portfolio investors to invest in from time to
time and
h) such other instruments as specified by the Board from time to time

In respect of investments in the debt securities, the foreign portfolio investors

shall also comply with terms, conditions or directions, specified or issued by
the Board or Reserve Bank of India, from time to time, in addition to other
conditions specified in these regulations The purchase of equity shares of
each company by a single foreign portfolio investor including its investor
group shall be below ten per cent of the total paid -up equity capital on a fully
diluted basis of the company Provided that where the total investment under
these regulations by a foreign portfolio investor including its investor group
exceeds the threshold of below ten per cent of the total paid up equity capital
in a listed or to be listed company on a fully diluted basis, the foreign
portfolio investor shall divest the excess holding within five trading days
from the date of settlement of the trades resulting in the breach: Provided
further that in case the foreign portfolio investor fails to divest the excess
holding, the entire investment in the company by such foreign portfolio
investor including its investor group shall be considered as investment under
the Foreign Direct Investment as per the procedure specified by the Board
and the foreign portfolio investor and its investor group shall not make
further portfolio investment in that company under these regulations.

Asset under custody (AUC) of FIIs/Sub--accounts for the month of

September 2022

Assets Under Custody (AUC) of FIIS/Sub Account for the Month of

September, 2022
Equity Debt DebtVRR Hybrid Total
Total: 4612296 245553 138960 38829 5029638

Debt VRR :The Reserve Bank, in consultation with the Government of India
and Securities and Exchange Board of India (SEBI), introduces a separate
channel, called the ‘Voluntary Retention Route’ (VRR), to enable FPIs to
invest in debt markets in India. Broadly, investments through the Route will
be free of the macro-prudential and other regulatory norms applicable to FPI
investments in debt markets, provided FPIs voluntarily commit to retain a
required minimum percentage of their investments in India for a period.
Participation through this Route will be entirely voluntary.

233
Long Term
Financing Decisions
The new financing instruments possess great potential to fund the
requirements of the Indian industry. Their imaginative use can provide
finance in abundance at a lower cost, making Indian industry competitive and
enabling it to globalise its operations. The current intensity of the Indian
financial market reveals that there is a tremendous scope to deploy new
financial instruments connected to equity, debentures/bonds, add-on products
and derivatives. This may require appropriate changes in certain legislations
and the will on the part of the Indian corporate enterprises to take risks and
tune their decision making to the investor’s psychology and market
preference.

The alternate sources of finance have to be increasingly tapped. This would

necessitate efforts on the part of the industry as well as necessary relaxations
in policy guidelines. In the new economic environment, which stresses on
opening and globalising the Indian economy, Indian industry will have to
play a major role to keep the economy on a high growth curve. Finance is a
vital input for accelerating the pace of industrial progress. To ensure the
timely availability of sufficient funds at reasonable cost, it would be
important to strengthen the existing sources of finance and simultaneously
initiate measures to tap alternate sources and new financial instruments.

11.10 SUMMARY

Globalisation has lead to increased degree of trade between various countries

and as a consequence of that the domestic financial systems are aligning
themselves to international financial systems. In this process the basic
building blocks of financial system viz. the banking system, the foreign
exchange markets and the capital markets are becoming more and more
integrated with world financial systems.

Recent years have witnessed a change of roles of the financial institutions i.e.
banks moving into insurance and activities of non-banking financial
companies.

During the last decade the forex market has also witnessed quite a change,
now forex rate are market determined with little or no intervention from the
government.

One of the major impact of globalisation on Indian companies is that now

they can raise low cost funds from abroad by ADRs, GDRs, and ECBs etc.
Apart from this due to the increased FII’s activities the shares of Indian
companies are being quoted at fair value and there is less of information
asymmetry in the capital markets.

11.11 SELF- ASSESSMENT QUESTIONS

1. What do you mean by globalisation? Comment on the level of
globalisation of Indian capital market.
234
2. What are euro issues? Discuss some important instruments of euro Financing through
Global Capital
currency. Markets
3. Discuss some of the major types of institutions that constitute the
international financial system.
4. What are the major global sources of financing? How far have Indian
Corporate tapped these global sources?

11.10 FURTHER READINGS

Emerging Financial Markets in the Global Economy. (2000). Singapore:
World Scientific.
Handbook of Key Global Financial Markets, Institutions, and
Infrastructure. (2012). Germany: Elsevier Science.
Jacque, L. L. (2019). International Corporate Finance: Value Creation with
Currency Derivatives in Global Capital Markets. United Kingdom: Wiley.
Jones, F. J., Fabozzi, F. A., Fabozzi, F. J., Mann, S. V. (2019). Foundations
of Global Financial Markets and Institutions. United States: MIT Press.
Obstfeld, M., Taylor, A. M. (2005). Global Capital Markets: Integration,
Crisis, and Growth. United Kingdom: Cambridge University Press.
Strumeyer, G. (2017). The Capital Markets: Evolution of the Financial
Ecosystem. Germany: Wiley.

235
Long Term
Financing Decisions Appendix 1

EXTERNAL COMMERCIAL BORROWINGS FRAMEWORK

External Commercial Borrowings are commercial loans raised by eligible
resident entities from recognised non-resident entities. The terms of ECB
shall confirm to the guidelines issued by RBI and parameters such as
minimum maturity, permitted and non-permitted end-uses, maximum all-in-
cost ceiling, etc shall be strictly adhered to. The parameters given below
apply in totality and not on a standalone basis.ECB can be either raised
through foreign currency denominated ECB or Indian rupee denominated
ECB

ECB Framework as per the RBI/FED/2018-19/67 FED Master Direction

No.5/2018-19 is as follows:

Sl. Parameters FCY denominated ECB INR denominated ECB

No.
I Currency of Any freely convertible Indian Rupee (INR)
Borrowing Foreign Currency
Ii Forms of Loans including bank loans; Loans including bank loans;
ECB floating/ fixed rate notes/ floating/ fixed rate
bonds/ debentures (other than notes/bonds/ debentures/
fully and compulsorily preference shares (other
convertible instruments); than fully and compulsorily
Trade credits beyond 3 years; convertible instruments);
FCCBs; FCEBs and Financial Trade credits beyond 3
Lease. years; and Financial Lease.
Also, plain vanilla Rupee
denominated bonds issued
overseas, which can be
either placed privately or
listed on exchanges as per
host country regulations.
Iii Eligible All entities eligible to receive a) All entities eligible to
borrowers FDI. Further, the following raise FCY ECB; and
entities are also eligible to
b) Registered entities
raise ECB:
engaged in micro-
i. Port Trusts; finance activities, viz.,
ii. Units in SEZ; registered Not for Profit
companies, registered
iii. SIDBI; and societies/
iv. EXIM Bank of India. trusts/cooperatives and
Non-Government
Organisations.

236
Iv Recognised The lender should be resident of FATF or IOSCO compliant Financing through
lenders country, including on transfer of ECB. However, Global Capital
Markets
a) Multilateral and Regional Financial Institutions where
India is a member country will also be considered as
recognised lenders;
b) Individuals as lenders can only be permitted if they are
foreign equity holders or for subscription to
bonds/debentures listed abroad; and
c) Foreign branches / subsidiaries of Indian banks are
permitted as recognised lenders only for FCY ECB
(except FCCBs and FCEBs). Foreign branches /
subsidiaries of Indian banks, subject to applicable
prudential norms, can participate as arrangers/
underwriters/market-makers/traders for Rupee
denominated Bonds issued overseas. However,
underwriting by foreign branches/subsidiaries of Indian
banks for issuances by Indian banks will not be allowed.
V Minimum MAMP for ECB will be 3 years. Call and put options, if
Average any, shall not be exercisable prior to completion of
Maturity minimum average maturity. However, for the specific
Period categories mentioned below, the MAMP will be as
(MAMP) prescribed therein:

Sr.No. Category MAMP

(a) ECB raised by manufacturing companies up to 1 year
USD 50 million or its equivalent per financial year.
(b) ECB raised from foreign equity holder for working capital 5 years
purposes, general corporate purposes or for repayment of
Rupee loans
4
(c) ECB raised for 10 years
(i) working capital purposes or general corporate purposes
(ii) on-lending by NBFCs for working capital purposes or
general corporate purposes
(d) ECB raised for 7 years
(i) repayment of Rupee loans availed domestically for
capital expenditure
(ii) on-lending by NBFCs for the same purpose
(e) ECB raised for 10 years
(i) repayment of Rupee loans availed domestically for
purposes other than capital expenditure
(ii) on-lending by NBFCs for the same purpose

for the categories mentioned at (b) to (e) –

(i) ECB cannot be raised from foreign branches / subsidiaries of Indian
banks
(ii) the prescribed MAMP will have to be strictly complied with under all
circumstances.

237
Long Term 5
Financing Decisions
vi All-in-cost Benchmark Rate plus 550 bps Benchmark rate plus 450
ceiling per spread: For existing ECBs bps spread.
annum linked to LIBOR whose
benchmarks are changed to
ARR.
Benchmark rate plus 500 bps
spread: For new ECBs.
vii Other costs Prepayment charge/ Penal interest, if any, for default or
breach of covenants, should not be more than 2 per cent over
and above the contracted rate of interest on the outstanding
principal amount and will be outside the all-in-cost ceiling.

viii End-uses The negative list, for which the ECB proceeds cannot be
(Negative utilised, would include the following:
list) a) Real estate activities.
b) Investment in capital market.
c) Equity investment.
d) 7Working capital purposes, except in case of ECB
mentioned at v(b) and v(c) above.
e) General corporate purposes, except in case of ECB
mentioned at v(b) and v(c) above.
f) Repayment of Rupee loans, except in case of ECB
mentioned at v(d) and v(e) above.
g) On-lending to entities for the above activities, except in
case of ECB raised by NBFCs as given at v(c), v(d) and
v(e) above.
Ix Exchange Change of currency of FCY For conversion to Rupee,
rate ECB into INR ECB can be at the exchange rate shall be
the exchange rate prevailing on the rate prevailing on the
the date of the agreement for date of settlement.
such change between the
parties concerned or at an
exchange rate, which is less
than the rate prevailing on the
date of the agreement, if
consented to by the
ECB lender.
X Hedging The entities raising ECB are Overseas investors are
provision required to follow the eligible to hedge their
guidelines for hedging issued, exposure in Rupee through
if any, by the concerned permitted derivative
sectoral or prudential products with AD Category
regulator in respect of foreign I banks in India. The
investors can also
currency exposure. access the domestic market
Infrastructure space companies through branches /
shall have a Board approved subsidiaries of Indian
risk management policy. banks abroad or branches
Further, such companies are of foreign banks with
required to mandatorily hedge Indian presence on a back-
70 per cent of their ECB to-back basis.
exposure in case the average
maturity of the ECB is less
238
than 5 years. The designated Financing through
AD Category-I bank shall Global Capital
verify that 70 per cent hedging Markets
requirement is complied with
during the currency of the ECB
and report the position to RBI
through Form ECB 2. The
following operational aspects
with respect to hedging should
be ensured:
a. Coverage: The ECB
borrower will be required to
cover the principal as well
as the coupon through
financial hedges. The
financial hedge for all
exposures on account of
ECB should start from the
time of each such exposure
(i.e. the day the liability is
created in the books of the
borrower).
b. Tenor and rollover: A
minimum tenor of one year
for the financial hedge
would be required with
periodic rollover, duly
ensuring that the exposure
on account of ECB is not
unhedged at any point
during the currency of the
ECB.
c. Natural Hedge: Natural
hedge, in lieu of financial
hedge, will be considered
only to the extent of
offsetting projected cash
flows / revenues in
matching currency, net of
all other projected outflows.
For this purpose, an ECB
may be considered
naturally hedged if the
offsetting exposure has the
maturity/cash flow within
the same accounting year.
Any other arrangements/
structures, where revenues
are indexed to foreign
currency will not be
considered as a natural
hedge.

239
Long Term
Financing Decisions Xi Change of Change of currency of ECB Change of currency from
currency of from one freely convertible INR to any freely
borrowing foreign currency to any other convertible foreign
freely convertible foreign currency is not permitted.
currency as well as to INR is
freely permitted.

Note: The ECB framework is not applicable in respect of investments in

Non-Convertible Debentures in India made by Registered Foreign Portfolio
Investors. 8Lending and borrowing under the ECB framework by Indian
banks and their branches/subsidiaries outside India will be subject to
prudential guidelines issued by the Department of Banking Regulation of the
Reserve Bank. Further, other entities raising ECB are required to follow the
guidelines issued, if any, by the concerned sectoral or prudential regulator.

Limit and leverage: Under the aforesaid framework, all eligible borrowers
can raise ECB up to USD 750 million or equivalent per financial year under
the automatic route. Further, in case of FCY denominated ECB raised from
direct foreign equity holder, ECB liability-equity ratio for ECB raised under
the automatic route cannot exceed 7:1. However, this ratio will not be
applicable if the outstanding amount of all ECB, including the proposed one,
is up to USD 5 million or its equivalent. Further, the borrowing entities will
also be governed by the guidelines on debt equity ratio, issued, if any, by the
sectoral or prudential regulator concerned.

1. Issuance of Guarantee, etc. by Indian banks and Financial

Institutions: Issuance of any type of guarantee by Indian banks, All
India Financial Institutions and NBFCs relating to ECB is not permitted.
Further, financial intermediaries (viz., Indian banks, All India Financial
Institutions, or NBFCs) shall not invest in FCCBs/ FCEBs in any manner
whatsoever.

2. Parking of ECB proceeds: ECB proceeds are permitted to be parked

abroad as well as domestically in the manner given below:

Parking of ECB proceeds abroad: ECB proceeds meant only for

foreign currency expenditure can be parked abroad pending utilisation.

Parking of ECB proceeds domestically: ECB proceeds meant for

Rupee expenditure should be repatriated immediately for credit to their
Rupee accounts with AD Category I banks in India..

3. Procedure of raising ECB: All ECB can be raised under the automatic
route if they conform to the parameters prescribed under this framework.
For approval route cases, the borrowers may approach the RBI with an
application in prescribed format (Form ECB) for examination through
their AD Category I bank. Such cases shall be considered keeping in
view the overall guidelines, macroeconomic situation and merits of the
specific proposals. ECB proposals received in the Reserve Bank above
certain threshold limit (refixed from time to time) would be placed
240
 before the Empowered Committee set up by the Reserve Bank. The Financing through
Global Capital
Empowered Committee will have external as well as internal members Markets
and the Reserve Bank will take a final decision in the cases taking into
account recommendation of the Empowered Committee. Entities
desirous to raise ECB under the automatic route may approach an AD
Category I bank with their proposal along with duly filled in Form ECB.

Refinancing of existing ECB: Refinancing of existing ECB by fresh ECB

provided the outstanding maturity of the original borrowing (weighted
outstanding maturity in case of multiple borrowings) is not reduced and all-
in-cost of fresh ECB is lower than the all-in-cost (weighted average cost in
case of multiple borrowings) of existing ECB. Further, refinancing of ECB
raised under the previous ECB frameworks may also be permitted, subject to
additionally ensuring that the borrower is eligible to raise ECB under the
extant framework. Raising of fresh ECB to part refinance the existing ECB is
also permitted subject to same conditions. Indian banks are permitted to
participate in refinancing of existing ECB, only for highly rated corporate
(AAA) and for Maharatna/Navratna public sector undertakings.

Conversion of ECB into equity: Conversion of ECB, including those which

are matured but unpaid, into equity is permitted subject to the following
conditions:

i. The activity of the borrowing company is covered under the automatic

route for FDI or Government approval is received, wherever applicable,
for foreign equity participation as per extant FDI policy.

ii. The conversion, which should be with the lender’s consent and without
any additional cost, should not result in contravention of eligibility and
breach of applicable sector cap on the foreign equity holding under FDI
policy;

iii. Applicable pricing guidelines for shares are complied with;

iv. In case of partial or full conversion of ECB into equity, the reporting to
the Reserve Bank will be as under:

a. For partial conversion, the converted portion is to be reported in Form

FC-GPR prescribed for reporting of FDI flows, while monthly reporting
to DSIM in Form ECB 2 Return will be with suitable remarks, viz., and
“ECB partially converted to equity".

b. For full conversion, the entire portion is to be reported in Form FC-GPR,

while reporting to DSIM in Form ECB 2 Return should be done with
remarks “ECB fully converted to equity”. Subsequent filing of Form
ECB 2 Return is not required.

c. For conversion of ECB into equity in phases, reporting through Form

FC-GPR and Form ECB 2 Return will also be in phases.

v. If the borrower concerned has availed of other credit facilities from the
Indian banking system, including foreign branches/subsidiaries of Indian
241
Long Term
Financing Decisions
banks, the applicable prudential guidelines issued by the Department of
Banking Regulation of Reserve Bank, including guidelines on
restructuring are complied with;

vi. Consent of other lenders, if any, to the same borrower is available or

atleast information regarding conversions is exchanged with other
lenders of the borrower.

vii. For conversion of ECB dues into equity, the exchange rate prevailing on
the date of the agreement between the parties concerned for such
conversion or any lesser rate can be applied with a mutual agreement
with the ECB lender. It may be noted that the fair value of the equity
shares to be issued shall be worked out with reference to the date of
conversion only.

Security for raising ECB: AD Category I banks are permitted to allow

creation/cancellation of charge on immovable assets, movable assets,
financial securities and issue of corporate and/or personal guarantees in
favour of overseas lender / security trustee, to secure the ECB to be
raised/ raised by the borrower, subject to satisfying themselves that:

i. the underlying ECB is in compliance with the extant ECB guidelines,

ii. there exists a security clause in the Loan Agreement requiring the ECB
borrower to create/cancel charge, in favour of overseas lender/security
trustee, on immovable assets/movable assets/financial securities/issuance
of corporate and/or personal guarantee, and

iii. No objection certificate, as applicable, from the existing lenders in India

has been obtained in case of creation of charge.

Once the aforesaid stipulations are met, the AD Category I bank may permit
creation of charge on immovable assets, movable assets, financial
securities and issue of corporate and/or personal guarantees, during the
currency of the ECB with security co-terminating with underlying ECB,
subject to the following:

PART II – TRADE CREDITS FRAMEWORK

4. Introduction: Trade Credits (TC) refer to the credits extended by the

overseas supplier, bank, financial institution and other permitted
recognised lenders for maturity, as prescribed in this framework, for
imports of capital/non-capital goods permissible under the Foreign Trade
Policy of the Government of India. Depending on the source of finance,
such TCs include suppliers’ credit and buyers’ credit from recognised
lenders.

5. Trade Credits Framework: TC for imports into India can be raised in

any freely convertible foreign currency (FCY denominated TC) or Indian
Rupee (INR denominated TC), as per the framework given in the table
below:

242
Sr. Parameters FCY denominated TC INR denominated TC Financing through
Global Capital
No. Markets
i Forms of TC Buyers’ Credit and Suppliers’ Credit.
ii Eligible Person resident in India acting as an importer.
borrower
iii Amount under Up to USD 150 million or equivalent per import transaction
automatic route for oil/gas refining & marketing, airline and shipping
companies. For others, up to USD 50 million or equivalent
per import transaction.
iv Recognised 1. For suppliers’ credit: Supplier of goods located
lenders outside India.
2. For buyers’ credit: Banks, financial institutions,
foreign equity holder(s) located outside India and
financial institutions in IFSCs located in India.
Note: Participation of Indian banks and non-banking
financial companies (operating from IFSCs) as lenders will
be subject to the prudential guidelines issued by the
concerned regulatory departments of the Reserve Bank.
Further, foreign branches/subsidiaries of Indian banks are
permitted as recognised lenders only for FCY TC.
v Period of TC The period of TC, reckoned from the date of shipment,
shall be up to three years for import of capital goods. For
non-capital goods, this period shall be up to one year or the
operating cycle whichever is less. For shipyards /
shipbuilders, the period of TC for import of non-capital
goods can be up to three years.
15
vi All-in-cost Benchmark Rate plus 350 Benchmark rate plus 250
ceiling per bps spread: For existing TCs bps spread.
annum linked to LIBOR whose
benchmarks are changed to
ARR. Benchmark rate plus 300
bps spread: For new TCs.
vii Exchange rate Change of currency of FCY For conversion to Rupee,
TC into INR TC can be at the exchange rate shall be the
exchange rate prevailing on the rate prevailing on the date
date of the agreement between of settlement.
the parties concerned for such
change or at an exchange rate,
which is less than the rate
prevailing on the date of
agreement, if consented to by
the TC lender.

243
Long Term
Financing Decisions
viii Hedging The entities raising TC are
provision required to follow the
guidelines for hedging, if any,
issued by the concerned
sectoral or prudential regulator
in respect of foreign currency
exposure. Such entities shall
have a board approved risk
management policy.
ix Change of Change of currency of TC
currency of from one freely convertible
borrowing foreign currency to any other
freely convertible foreign
currency as well as to INR is
freely permitted.
The overseas investors
are eligible to hedge their
exposure in Rupee
through permitted
derivative products with
AD Category I banks in
India. The investors can
also access the domestic
market through branches /
subsidiaries of Indian
banks abroad or branches
of foreign banks with
Indian presence on a back
to back basis.
Change of currency from
INR to any freely
convertible foreign
currency is not permitted.

6. Trade Credits in SEZ/FTWZ/DTA:

TC can be raised by a unit or a developer in a SEZ including FTWZ for

purchase of non- capital and capital goods within an SEZ including
FTWZ or from a different SEZ including FTWZ subject to compliance
with parameters given at paragraph 14 above. Further, an entity in DTA
is also allowed to raise TC for purchase of capital / non-capital goods
from a unit or a developer of a SEZ including FTWZ.

7. Security for Trade Credit: The provisions regarding security for raising
TC are as under:

Bank guarantees may be given by the ADs, on behalf of the importer, in

favour of overseas lender of TC not exceeding the amount of TC. Period
of such guarantee cannot be beyond the maximum permissible period for
TC. TC may also be secured by overseas guarantee issued by foreign
banks/overseas branches of Indian banks.

PART III – STRUCTURED OBLIGATIONS

8. Non-resident guarantee for domestic fund based and non-fund based

facilities: Borrowing and lending in Indian Rupees between two
residents does not attract any provisions of the Foreign Exchange
Management Act, 1999. In cases where a Rupee facility which is either
fund based or non-fund based (such as letter of credit / guarantee / letter
of undertaking / letter of comfort) or is in the form of derivative contract
by residents that are subsidiaries of multinational companies, is
guaranteed by a non-resident (non-resident group entity in case of
derivative contracts), there is no transaction involving foreign exchange
until the guarantee is invoked and the non-resident guarantor is required
to meet the liability under the guarantee. The arrangements shall be with
the following terms:

244
i. The non-resident guarantor may discharge the liability by i) payment out Financing through
Global Capital
of rupee balances held in India or ii) by remitting the funds to India or Markets
iii) by debit to his FCNR(B)/NRE account maintained with an AD bank
in India.
ii. In such cases, the non-resident guarantor may enforce his claim against
the resident borrower to recover the amount and on recovery he may
seek repatriation of the amount if the liability is discharged either by
inward remittance or by debit to FCNR(B)/NRE account. However, in
case the liability is discharged by payment out of Rupee balances, the
amount recovered can be credited to the NRO account of the non-
resident guarantor.
iii. General Permission is available to a resident, being a principal debtor to
make payment to a person resident outside India, who has met the
liability under a guarantee.
iv. In cases where the liability is met by the non-resident out of funds
remitted to India or by debit to his FCNR(B)/NRE account, the
repayment may be made by credit to the FCNR(B)/NRE/NRO account of
the guarantor provided, the amount remitted/credited shall not exceed the
rupee equivalent of the amount paid by the non-resident guarantor
against the invoked guarantee.
9. Facility of Credit Enhancement: The facility of credit enhancement by
eligible non- resident entities (viz. Multilateral financial institutions
(such as, IFC, ADB, etc.) / regional financial institutions and
Government owned (either wholly or partially) financial institutions,
direct/ indirect equity holder) to domestic debt raised through issue of
capital market instruments, such as Rupee denominated bonds and
debentures, is available to all borrowers eligible to raise ECB under
automatic route subject to the following conditions:
i. The underlying debt instrument should have a minimum average
maturity of three years;
ii. Prepayment and call/ put options are not permissible for such capital
market instruments up to an average maturity period of 3 years;
iii. Guarantee fee and other costs in connection with credit enhancement will
be restricted to a maximum 2 per cent of the principal amount involved;
iv. On invocation of the credit enhancement, if the guarantor meets the
liability and if the same is permissible to be repaid in foreign currency to
the eligible non-resident entity, the all-in-cost ceilings, as applicable to
the relevant maturity period of the TC/ECB, as per the extant guidelines,
is applicable to the novated loan.
v. In case of default and if the loan is serviced in Indian Rupees, the
applicable rate of interest would be the coupon of the bonds or 250 bps
over the prevailing secondary market yield of 5 years Government of
India Security, as on the date of novation, whichever is higher;

245
Long Term
Financing Decisions UNIT 12 OTHER MODES OF FINANCING

Objectives
The objectives of this unit are to:
• provide an understanding of non-traditional sources of long-term
financing,
• focus on non-traditional sources of short-term financing.

Structure

12.1 Introduction
12.2 Non Traditional of Sources Long-term Financing
12.2.1 Leasing and Hire-Purchase
12.2.2 Suppliers’ Credit
12.2.3 Asset Securitization
12.2.4 Venture Capital

12.3 Non Traditional Services of Short-term Financing

12.4 Summary
12.5 Self-Assessment Questions
12.6 Further Readings

12.1 INTRODUCTION

Raising funds is an important activity of finance managers. Business units

require funds for two reasons - to acquire fixed assets and to run the
operations of the units. Several factors influence the need for funds and
typically a growing firm needs more funds year after year. In the previous
units, we discussed how a firm can raise money from capital market and
institutions. In this unit, we will look into other alternative sources of funds.
Before we discuss these sources, let us quickly review the financing options
available before a firm and what the need for additional non-conventional
sources of finance is.

It was noted earlier that firms typically raise money in the form of equity or
debt. Equity is risk capital and brought by owners, who want to take risk
while investing money. Debt holders are typically risk-averse investors, and
hence want safety but willing to provide funds at a lower rate of return. Debt
holders are less interested on the future prospects of the company but they are
interested to know whether the company would be liquid enough to pay
interest and principal on the due date. In between the equity and debt, firms
also raise money through preference capital and convertible debt instruments.
Also, firms retain substantial part of the profit to meet their requirement.
Fixing a broad mix and then choosing different sources of capital is an
246
important job of financial managers. You would by now know why financial Other Modes of
Financing
managers spend lot of time on this issue particularly, when we also say
finance mix is irrelevant in valuation of firm (Modigliani and Miller Theory).

While equity capital is raised not so frequently, firms take additional debt
from institutions and other sources regularly. In fact, debt is found to be
important source of capital next to retained earnings. While retained earning
provide convenience (easy to tap), debt is often believed cost effective
particularly for tax reasons. In terms of convenience also, debt scores over
fresh equity issue since banks and financial institutions are easily
approachable than approaching capital market for equity issue. Equity issue
involves considerable amount of legal and other formalities and also there is
no assurance that investors will be interested in putting their money in the
company. Finance managers choose a particular source of capital after
considering the following issues:

i) Whether the duration for funds required and funds available match?
ii) What is the size of funds requirement?
iii) What is the risk involved in the investments for which funds are
demanded?
iv) Whether the funds are required urgently?
v) What is the current and future financial markets scenario?

Finance managers look for constantly alternative sources of funding and

depending on the demand and nature of funds, a particular source of funds is
tapped. Often, the finance managers tap non-conventional source of funds.
We will discuss some of the non-conventional source of funds in this unit.

12.2 NON-TRADITIONAL SOURCES OF LONG-

TERM FINANCING

Long-term finance is raised when the need for funds is for more than one
year. Typically, long-term finance is required for acquisition of fixed assets
having a life more than one year or investments, which have long-term
impact on the earnings of the company. For instance, if a firm wants to buy a
patent or brand, which in turn contributes to the sales of the firm for a long-
term, it requires long-term funds for such acquisition. While equity and debt
are conventional source of finance, such source of finance is not available for
many investments. Some time, the investment needs may not be large enough
for the financial managers to approach banks or financial institutions. They
look for alternative source of finance under these circumstances. In the
following sections, we will discuss four such sources of alternative long-term
finance available for the firms. They are (a) Leasing and Hire-purchase (b)
Suppliers’ Credit (c) Asset Securitization and (d) Venture capital.

247
Long Term
Financing Decisions
12.2.1 Leasing and Hire-Purchase

Firms need finance to acquire assets. Instead of borrowing and acquiring

assets, it is possible for firms to acquire the assets on lease. There are two
types of leasing - operational lease and financial lease. Operational lease is
used when the assets are used for temporary period and the asset is returned
at the end of the short period. Suppose a firm gets an extra order for which it
requires some additional equipment. Such additional equipment can be taken
on lease for few days, say three weeks and at the end of the three weeks, the
equipment is returned to the owner. Some of the assets that are normally
acquired under operational lease arrangement are computers, vehicles,
generators, small movable equipment, etc. While operational lease is not
considered a source of finance, financial lease is used when the assets are
required permanently or for a long period. Normally, the assets are ultimately
purchased by the firm from the lessor at a nominal value. During the period
of lease, the firm, which acquired the assets on lease (called lessee), can use
the assets but it is not the owner of the asset. The ownership rests with the
company, which provided the assets on lease. During the period of lease, the
lessee has to pay lease rent to the lessor. Lessee is not entitled for any
depreciation whereas lessor can claim depreciation for the assets for tax
purpose. Hire purchase is similar to financial lease. A hire-purchase
transaction is usually defined as one where the hirer (user) has, at the end of
the fixed term of hire, an option to buy the asset at a token value. In other
words, financial leases with an option to buy the asset at the end of the lease
term can be called a hire-purchase transaction.
So the basic question is why firms acquire assets on financial lease and why
someone wants to buy an asset and then lease the same to another firm. There
are several reasons given below:
a) Easy Procedure: Acquiring an asset through a lease transaction is much
simpler than borrowing money from a bank or financial institution for
acquiring the same asset. Leasing companies have developed fairly
simple procedure to process lease application. The level of legal
documentation is also fairly simple. In other words, you can acquire the
asset in a very short period of time through lease transaction. Suppose, a
firm wants to buy 10 lorries, it can be done within two or three days
through lease transaction. Acquisition of computers and other such
electronics items like Air-conditioning can be done within a day. Since
the ownership of the asset rests with the lessor, the leasing companies are
willing to take additional risk while processing the lease application. If
the assets leased are special type assets, whose re-sale value is low,
leasing companies will take longer time to process such lease application
since the risk involved in funding such assets is fairly high. Typically, in
borrowing the end use of the funds will not differentiate the loan
application processing. Hence, firms use lease for acquiring certain type
of assets.

b) Size of Loan: Many banks and financial institutions fix certain

minimum loan amount. If the need of firm is much lower, it doesn’t
make sense to borrow more and keep the cash idle. Leasing company
248
 funds assets of any value. If the requirement of funds is large, a Other Modes of
Financing
consortium of leasing companies funds such acquisition.

c) Cost: It is difficult to say whether lease cost will be lower than

borrowing cost but it is possible in certain cases due to tax impact. When
a firm borrows money and then acquires the assets, it pays interest and
also claims depreciation. Both interest and depreciation can be claimed
as deduction under income tax. The net outflow will be thus much lower.
On the other hand, when a firm acquires an asset on lease, it pays lease
rent, which qualifies for income tax deduction but there is no
depreciation benefit. However, depreciation benefit is claimed by the
lessor and in all probability, the lessor will pass on the impact of the tax
shield to the lessee by fixing lower lease rent. In other words, it is
possible to fix a lease rental such that it is equal to borrowing to both
lessor (borrower) and lessee (lender). The following example explains
the issue further.

Illustration: Suppose a firm requires an asset worth of Rs. 1,00,000 and it

can raise the funds at 10% for five years from a bank. The bank requires the
firm to repay the loan with interest in 60 equated monthly installment (EMI)
at the rate of Rs. 2124.70. Present value of annuity of Rs. 2174.20 at an
interest rate of 0.83% per month for 60 months is equal to Rs. 1,00,000. It
means by paying Rs. 2174.20 every month for the next 60 months, you can
wind up Rs. 1 lakh loan you have taken today with an interest rate of 10%.
Since each installment consists of interest as well as principal, the interest
and principal paid over the five years are to be separated. While interest is
eligible for tax deduction, the amount paid towards principal will not qualify
for income tax deduction.
Financing Decisions The values of interest and principal are as follows:
Year Interest Principal Total
1 9269.644 16226.76 25496.40
2 7570.491 17925.91 25496.40
3 5693.414 19802.99 25496.40
4 3619.782 21876.62 25496.40
5 1329.015 24167.39 25496.40
Total 27482.35 99999.65 127482.00

If the life of the asset is also 5 years and the asset qualifies a depreciation rate
of 25%, the depreciation schedule is as follows:

Year Opening Balance Depreciation Closing Balance

1 100000 20000 80000
2 80000 16000 64000
3 64000 12800 51200
4 51200 10240 40960
5 40960 8192 32768
249
Long Term
Financing Decisions
Let us assume that the asset is sold at the end of 5 years at Rs. 32768. If the
firm pays income tax at the rate of 35%, the after tax cost of the asset is as
follows:

Year Interest Depreciation Total Tax Shield Cost net of

@ 35% Tax Shield
1 9269.644 20000 29269.64 10244.38 19025.27
2 7570.491 16000 23570.49 8249.672 15320.82
3 5693.414 12800 18493.41 6472.695 12020.72
4 3619.782 10240 13859.78 4850.924 9008.859
5 1329.015 8192 9521.01 3332.355 6188.66

The present value of cost net of tax shield at a discount rate of 10% is equal
to Rs. 48985. Suppose a leasing company is willing to provide the asset on
lease at a lease rental of Rs. 7561 per month for five years and at the end is
willing to transfer the asset to you at a nominal cost of Re. 1, the present
value of lease rent net of tax is as follows:

Year Lease Rent Tax Shield Lease Rent Present value

Net of Tax of Lease Rent
1 90732 31756.2 58975.8 33486.91
2 90732 31756.2 58975.8 10669.96
3 90732 31756.2 58975.8 3399.77
4 90732 31756.2 58975.8 1083.27
5 90732 31756.2 58975.8 345.16
Total 453660 158781.0 294879.0 48985.09
In other words, both lease and borrowing leads to same effect. However, the
actual lease rent may be higher or lower depending on the cost of funds to the
lessor and tax shield the lessor get on leasing the asset. Further, if the lessee
firm is not taxpaying entity, then there is no actual tax benefit from
depreciation and in that process, the cost of owning the asset will go up.
Thus, in a situation where the tax rates of lessor and lessee are different and
the cost of funds to lessor and lessee are different, then lease may be cost
effective. Since lease transactions also attract some additional taxes like sales
tax, one has to consider such additional costs in evaluating lease vs. borrow
decision. Students desiring to know more on this may refer some specialized
book on Lease Finance (Vinod Kothari, Lease Financing and Hire Purchase,
Wadhwa and Company, Nagpur).

Though leasing is not a major source of finance, Indian companies today

acquire assets through lease finance. Some of the prominent companies that
use leasing extensively are ONGC, Shipping Corporation of India, Larsen &
Toubro, Reliance Industries, etc. Companies like ONGC hire most of the
drilling equipment on lease and hence the lease amount is significant.
Transport companies like shipping companies, airlines also acquire their
assets through lease transactions. Companies that prominently use leased
assets, whose percentage on total assets is significant are Asian Paints, ,
250
Siemens, and BHEL. Today, there are several types of leasing. There are also Other Modes of
Financing
mega international lease transactions called cross-broader leasing. Lease
finance is likely to grow in the future due to its flexibility and convenience.

Activity 1
“Leasing is nothing but borrowing and acquiring the asset” - Do you agree
with this statement?
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Activity 2
Collect the details of lease/hire-purchase installment per Rs. 1 lakh from a
local leasing company. Evaluate whether it is cheaper than borrowing Rs. 1
lakh at an interest rate of 10% and buying the asset. Summarise your findings
below:
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12.2.2 Suppliers Credit

The concept of supplier credit is fairly simple and in existence for a long
time. Under this, the equipment suppliers provide long-term credit and accept
the payment for the supply of equipment over a longer period of time say 5 to
8 years. In that process, the company, which acquires the assets, neither take
bank loan nor approach leasing company for credit but directly takes the
credit from the supplier of the equipment. In other words, the supplier of
equipment acts as a lender or lessor. The question is how it is superior to
other forms of acquiring the assets. First of all, the buyer need not approach
any other agency for credit. Normally, suppliers provide short period of
credit, and in this special case, the suppliers provide long-term credit. Since
there is no intermediary to fund the acquisition between the seller and buyer,
it reduces the cost. In addition, it is possible that the supplier may be a cash
rich company or may get funds at a much lower rate than the buyer. For
instance, the credit rating of the supplier is far above than the credit rating of
buyer or seller may be in another country where the interest rates are low.
There are specialised government agencies to provide funds to the suppliers
in order to improve the export sales or to help a particular sector. Though
suppliers provide long-term credit to the buyers, there is no need for the
suppliers to stuck with such huge long-term receivables because they can get
finance under certain specific scheme against such receivables. They can also
sell such receivables through securitization.
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Long Term
Financing Decisions
12.2.3 Asset Securitization
Securitization is fairly a simple concept. It is the process through which an
asset (fixed or current) is converted into financial claim. It other words, it
brings liquidity to an illiquid asset. The concept is very popular in housing
finance. Let us explain the concept with a simple example. Suppose a
housing finance company has Rs. 100 cr. During the first six months, it
accepts the loan proposals and lent Rs. 100 cr. at an average interest rate of
10% and the duration of the loan is 15 years. Suppose the housing finance
company gets some more loan applications say for Rs. 20 cr. in seventh
month. The company has to look for new source of finance to fund the new
loan proposals since it has already invested the entire capital and converted
them into illiquid long-term 15 years receivables. The growth of the housing
finance company is thus restricted to its ability to raise additional funds.
Securitization assumes importance in this context. Suppose a group of
pension companies is willing to buy Rs. 100 cr. 15-years receivables from the
housing finance company discounting the receivables at say 9%. With this
new cash flow, the housing finance company can finance new loans without
making any fresh borrowing. In other words, the housing finance company
has sold its 15-year illiquid receivables and raised money against it. The
process of selling makes the concept slightly different from simple bill
discounting concept. Under securitization, an intermediary agency is created,
which initially buys the illiquid asset and against that it issues securities,
which are trade able in the market through listing. Thus, it is also called
asset-backed securities or mortgaged- backed securities. The value of the
securities is improved by taking credit rating and often through insurance
cover.

Securitization improves operating cycle of the capital in the sense the

housing finance company can recycle the capital several times and finance
more houses without borrowing on its book. Every time when the cycle is
completed, the firm receives profit. You might wonder why pension funds or
other companies prefer to buy housing loans instead of investing or lending
to housing finance company. The logic is fairly simple. For instance, if the
pension funds give loan to housing finance company, there is no guarantee
that housing finance company will lend money to quality loan proposals. The
lender has no control on the business of borrower. On the other hand, in
buying the existing loan, the pension company can ask a credit rating agency
to assess the quality of loans. In this process, the risk is reduced considerably.
In addition, lending will block the funds of pension funds for a long-term
whereas an investment in securitized asset brings liquidity for the funds
invested. So it is a rare case of win-win situation for both the housing finance
company and pension fund investors. Like pension fund, there are many
investors who are looking for such investments, which essentially creates
liquidity for these kinds of securities. Though this concept is yet to become
popular in India, already several securitization deals have taken place.

While securitization as a concept was developed to help finance companies to

convert their loans into liquid assets, it is now extensively used in several
252 other business situations. It is possible for manufacturing or service firms to
raise long-term funds through securitization. For example, many electricity Other Modes of
Financing
boards, whose balance sheet is very weak and no financial institutions would
be willing to lend money to such companies, have raised long-term funds at a
cheaper interest rate by securitizing future receivables of some good clients.
By securitizing, the company actually sells the receivables to the
intermediary agency (called Special Purpose Vehicle or SPV), which collects
the money and distributes to the holders of such securities. Figure 14.1 shows
the structure of future flow securitization. There are several variation of this
model but the essential principle is to protect the interest of investors. It is
possible for companies producing commodities, where the demand is
predictable, and raise long- term resources by securitizing their future
receivables. Companies like Reliance Petroleum have done such
securitization. The amount thus raised can be used to strengthen long-term or
permanent working capital needs of the firms or invest in fixed assets to
expand the capacity.

Structure of a typical future flow securitization

Figure 12.1: Structure of Future Flow Securitization

Source: Suhas Ketkar and Dilip Ratha, “Securitization of Future Flow Receivables: A
Useful Tool for Developing Countries”, Finance & Development, March 2001
Activity 3
Briefly discuss any one Securitization deal completed in India. You can get
the details from business magazines and economic dailies, which periodically
report such details.
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Long Term
Financing Decisions
Activity 4
Why securitization is not popular in India? Find the details from some of
your friends working for financial services company or bank.
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...........................................................................................................................

12.2.4 Venture Capital

While leasing/hire-finance, suppliers’ credit or securitization are debt
financing, venture capital is a equity finance. Venture capital is investment in
early-stage, high-growth projects, which are high-risk with the potential to
give extraordinarily high returns over a period ranging from three to seven
years. The risk factor being high, the probability of failure is also high. The
returns to the venture capitalist are from the handful of the projects, which
succeed.

Venture capital investment is generally in equity or quasi-equity instruments

in unlisted companies, often set up to commercialise a novel idea. The
venture capitalist will, in the normal course of business, like to have a 20% to
50% stake in the company invested in. The returns to the venture capitalist
are at the time of disinvestment from the venture-backed unit. This could be
in several ways, such as buy-back of the stake of the venture capitalist by the
promoters, disinvestment of the investment at time of an IPO, or during a
merger or acquisition transaction. Venture capital investment is “hands-on”
investment, where the investor mentors and advises the promoters of the
business in which the investment has been made. The venture capitalist is an
investor who guides the project through its different stages of growth by
identifying avoidable pitfalls and directs the business along possible avenues
of growth. The venture capitalist is, therefore, a partner who brings much
more than money to the project.

Venture capitalists receive several proposals for investment. Many projects,

which find it difficult to raise funds from banks and other financial
institutions, approach venture capitalists for assistance. Venture capitalists
conduct a preliminary project appraisal. This includes verification of whether
the project is in the area of their investment and a review of the promoters of
the business. If the venture capitalists are interested in the project they offer
a term sheet to the promoters. The term sheet is a summary of the proposed
principal terms and conditions of a venture capital investment. It sets out the
broad terms and conditions of investment and is signed by both the venture
capitalist and the proposed venture capital investee. Signing of a term sheet
by both parties is a statement of good faith and is not an obligation until an
agreement is signed by the parties. It is normally subject to satisfactory
completion of due diligence review and signing of legal documents such as
an equity subscription agreement.
254
A venture capitalist will look for a project that has potential for great returns. Other Modes of
Financing
The project should be feasible and though it may be risky, there must be a
definite chance that it can be successful. The venture capitalist would like to
maximize the upside potential in any project, and would like to exit from a
project at a time when he can get a maximum return on his investment in the
project. The venture capitalist will look at different aspects of the projects.

Some of these aspects are the integrity and ability of the promoters and key
management, the details of the project, the market potential and strategy for
sale. A professional venture capitalist would validate all the data included in
business plans. A venture capitalist is most concerned about the ability of the
entrepreneurs to adapt to different circumstances, good and bad. The
promoters must be committed and have a passion for their project. They must
believe that they can do something different or differently. They must believe
that they can succeed. The venture capitalist backs the promoter first and then
the project. In fact sometimes, the project may be excellent, but if the venture
capitalist feels that the promoters lack the required skills, the project may get
rejected. This is not very surprising as venture investment is akin to a
partnership, particularly in the initial stages of the project. If the partners in
the project are not in agreement or have different ways of functioning, the
entire project can be in jeopardy, despite having phenomenal potential.

A venture capitalist will also scan the project in great depth. The project must
have the potential to be commercially viable. Ultimately the investor wants a
financial return, so it is important that the investment makes commercial
sense. It must have the potential for commercial success. The project must be
feasible, it must be marketable, i.e. it must meet an existing requirement or
fill a gap in the market or it must have the potential to create a market.

Further, the venture capitalist would like to have higher than normal returns
as compared to other financial investors in a project. This is not surprising,
since the venture capitalist does not expect all investments to do well, he
would like the few that do well to give above average returns. Professional
venture capitalists mentor projects they invest in. They are closely involved
in the operations of the investee. This does not stop at appointing a member
to the Board of Directors of the company and attending Board meetings
regularly. The venture capitalist often visits the project frequently. Some
venture capitalists visit the projects every week, even spending half-a-day in
each visit. This is one of the reasons why most venture capitalists do not
invest in many projects at a time.

A venture capitalist does not take any collateral or guarantee (there have been
cases of risk financiers who have asked for personal guarantees of the
promoters, but that is not typical of venture capital financing). If the project
does well, the venture capitalist would get good returns, if it fails, the entire
investment would be written off. A venture capitalist looks for very great
returns in say five years time. In many cases cash inflows in initial years are
ploughed back into the business.
255
Long Term
Financing Decisions
Activity 5
Collect the details of any one projects funded by venture capital company,
which run successfully today?
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...........................................................................................................................
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Activity 6
Do you have any idea that fits venture capital funding? If yes, briefly discuss
the idea here. Later on you can prepare a detailed business plan.
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...........................................................................................................................

12.3 NON-TRADITIONAL SERVICES OF SHORT-

TERM FINANCING

As in the case of long-term finance, firms can raise short-term finance from
banks and other investors. However, in recent time, new methods of
financing are also be used to raise funds for working capital. We will review
briefly some of these new methods in this section.

a) Commercial Paper:

Companies with good credit rating can raise money directly from the market
for working capital purpose by issuing commercial papers. Commercial
papers are unsecured notes but negotiable and hence liquid. Why firms issue
commercial paper and other invest in commercial paper? As discussed
earlier, loan typically binds both lender and borrower for a period. The option
for exit is difficult to exercise whereas instruments like commercial papers
enable both lenders and borrowers to move out of the relationship in a short
period of time. Since lender and borrower meet directly, the cost of
commercial paper borrowing will be lesser than working capital loan. Many
banks and cash rich companies participate in commercial papers, which are
issued by high-quality companies. Since they are liquid, even banks are
willing to invest money in commercial papers.

b) Factoring Service:

Factoring is essentially a management (financial) service designed to help

firms better manage their receivables; it is, in fact, a way of off-loading a
firm’s receivables and credit management on to someone else - in this case,
the factoring agency or the factor. Factoring involves an outright sale of the
256
receivables of a firm by another firm specialising in the management of trade Other Modes of
Financing
credit, called the factor. Under a typical factoring arrangement a factor
collects the accounts on the due dates, effects payments to its client firm on
these days (irrespective of whether or not it has received payment or not) and
also assumes the credit risks associated with the collection of the accounts.
For rendering these services, the factor charges a fee, which is usually
expressed as a percentage of the total value of the receivables, factored.
Factoring is, thus, an alternative to in-house management of receivables. The
complete package of factoring services includes (1) sales ledger
administration; (2) finance; and (3) risks control. Depending upon the
inherent requirements of the clients, the terms of factoring contract vary, but
broadly speaking, factoring service can be classified as (a) Non-recourse
factoring; and (b) recourse factoring. In non-recourse factoring, the factor
assumes the risk of the debts going “bad”. The factor cannot call upon its
client-firm whose debts it has purchased to make good the loss in case of
default in payment due to financial distress. However, the factor can insist on
payment from its client if a part of the receivables turns bad for any reason
other than financial insolvency. In recourse factoring, the factoring firm can
insist upon the firm whose receivables were purchased to make good any of
the receivables that prove to be bad and unrealisable. However, the risk of
bad debt is not transferred to the factor. Canbank Factor and SBI Factor, the
two factoring companies, have done an annual turnover of nearly Rs. 2000 cr.
and they are growing at an attractive rate. Many foreign and private banks
have also started providing the factoring services.

Activity 7

Visit the branch office of Canbank Factor or SBI Factor in your city or their
web site. Collect the details of factoring service schemes they provide for
different types of companies.

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...........................................................................................................................

...........................................................................................................................

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...........................................................................................................................

12.4 SUMMARY
Apart from traditional sources of finance like debt and equity from
institutions and others, finance managers today look into several non-
traditional sources of finance. The reasons for raising finance from such non-
traditional sources are cost advantage and flexibility. In this unit, we
discussed three such sources of long-term finance namely leasing/hire-
purchase, asset securitization, and venture capital. Leasing definitely scores
over others in terms of flexibility and in special cases, it may also be cheaper.
Asset Securitization is suitable when a firm wants to raise funds against
257
Long Term
Financing Decisions
future receivables or against some existing illiquid assets. Venture capital is
most suitable for high-risk venture where venture capitalist is willing to put
equity capital and assumes risk provided the project has a scope for high
return. Commercial paper and factoring are two prominent sources through
which firms can raise short-term funds in addition to traditional source of
short-term finance like bank loan. While traditional source of finance
contribute significant part of capital, these additional sources of finance are
often used to leverage cost advantage and in some cases to gain flexibility.
Finance managers have to bring innovative financial products that satisfy
different segments of investors. The job is as challenging as selling products
to consumers.

12.5 SELF-ASSESSMENT QUESTIONS

1) How is lease finance different from that of equity or debt finance?
2) In evaluating funding options, when do you chose lease finance?
3) Is lease finance cheaper than other sources of finance? If so, under what
conditions will it be cheaper than other sources of finance?
4) Explain how Securitization is considered as a source of finance? Who
are the typical investors for such papers?:
5) Suppose you are working for a venture capital company. What are the
things you will look into a proposal that comes to you for venture capital
funding?
6) Is it possible to get funds from venture capitalist for all kinds of projects?
Explain.
7) How is factoring different from that of traditional bill discounting
scheme?

12.6 FURTHER READINGS

Bygrave, William et. al. (Ed), Venture Capital Handbook, Financial Times/
Pitman, London
Felix, Richard, Commercial Paper, Euro money, London
Gupta, Naresh Kumar, Lease Financing: Concepts and Practice, Deep and
Deep Publication, New Delhi
Lerner, Josh, Venture Capital and Private Equity, John Wiley & Sons, New
York
Sengupta A K and Kaveri V S, International Factoring in India: Issues,
Problems and Prospects, Macmillan India, New Delhi
Sriram K, Handbook of Leasing, Hire Purchase and Factoring, ICFAI,
Hyderabad.
Vinod Kothari, Lease Financing and Hire Purchase, Wadhwa and Company,
Nagpur.
Vinod Kothari, Securitisation: The Financial Instrument of the New
Millennium, Academy of Financial Services, Calcutta.

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