MERCHANT BANKING AND FINANCIAL SERVICES

Indian Financial system consists of four parts:

1) Financial Institutions

2) Financial markets

3) Financial Instruments

4) Financial Services

Financial Institutions

They mobilize the savings and transfer it to deficit units. They are divided into regulatory,

intermediaries, non- intermediaries and others. They deal only in financial assets like deposits,

securities, etc. They collect fund from those units having savings.

Financial Markets

1. This is the place from where savings are transferred from surplus units to deficit units. There are

two segments of financial market. They are money market and capital market. Money market is

concerned with short-term funds or claims.

2. Capital market deals with those financial assets, which have maturity period of more than a

year.

3. Another classification could be primary and secondary markets.

4. Primary market deals with new issues. The secondary market deals with outstanding securities.

5. Primary markets by issuing new securities mobilise the savings directly. Secondary markets

provide liquidity to the securities.

Financial Instruments

1. The products, which are traded in a financial market, are financial assets or financial

instruments. The requirement of lenders and borrowers are varied.

2. Therefore, there is a variety of securities in the financial markets. Financial assets represent a

claim on the repayment of principal at a future date.

Financial Services

Financial services include the services offered by both types of companies- Asset Management

Companies and Liability Management Companies

FUNCTIONS OF FINANCIAL SERVICES

Financial services firms not only help to raise the required funds but also assure the efficient

deployment of funds.

1. They assist in deciding the financing mix.

2. They extend their service up to the stage of servicing of lenders.

3. They provide services like bill discounting, factoring of debtors, parking of short-term funds in

the money market, e-commerce, Securitisation of debts, etc. in order to ensure an efficient

management of funds.

4. Financial services firms provide some specialised services like credit rating, venture capital

financing, lease financing, factoring, mutual funds, merchant banking, stock lending, depository,

credit cards, housing finance, book building, etc.

REGULATING AUTHORITIES

There are 3 main regulatory authorities. They are:

1. The Structural Regulation,

2. The Prudential Regulation, and

3. The Investor Protection Regulation.

FEATURES OF FINANCIAL SERVICES

1. It is a customer-intensive industry.

2. Financial services are intangible in nature.

3. Production and supply of financial services must be performed simultaneously.

4. Marketing of financial service is people intensive.

5. Financial services firms should always be proactive in visualizing in advance what the market

wants, or reactive to the needs and wants of customers.

6. They must always be changing to the tune of the market.

PROBLEMS of Indian financial Services

1. Indian financial industry hardly finds suitable personnel to deal with financial services.

2. Expensive physical accommodation is another problem being faced by the financial services firms.

3. The financial services firms lack core competence.

4. They cannot review their performance without a benchmarking.

5. They fully depend on fee-based business.

6. Lack of proper appreciation of the advantages that could be derived by using the advances

7. In computer and telecommunication technology has constrained the growth of the industry.

Merchant Banking – Meaning

“Merchant banking means any person who is engaged in the business of issue management

either by making arrangements regarding selling, buying, underwriting or subscribing to the securities

underwriter, manager, consultant, advisor or rendering corporate advisory services in relation to such

issue management”

Merchant Banking- Definition

“Merchant banks mostly provide advisory services, issue management, portfolio management

and underwriting, which require less capital but generate more income (non interest income).”

Services Rendered by Merchant Banker

1. Corporate Counseling

2. Project Counseling and Pre-investment Studies

3. Capital Restructuring

4. Credit Syndication and Project Finance

5. Issue Management and Underwriting

6. Portfolio Management

7. Non-resident Investment

8. Working Capital Finance

9. Acceptance Credit and Bill Discounting

10. Mergers, Amalgamations and Takeovers

11. Venture Capital Financing

12. Lease Financing

13. Foreign Currency Finance

14. Fixed Deposit Broking

15. Mutual Funds Floatation and Management

REGISTRATION OF MERCHANT BANKER

1. The applicant should be a body corporate.

2. The applicant should not carry on any business other than those connected with the

securities market.

3. The applicant should have necessary infrastructure like office space, equipment, manpower, etc.

4. The applicant must have at least two employees with prior experience in merchant banking.

5. Any associate company, group company, subsidiary or inter connected company of the applicant

should not have been a registered merchant banker.

6. The applicant should not have been involved in any securities scam or proved guilty for any

offence.

7. The applicant should have a minimum net worth of Rs. 5 crores

FUNCTIONS OF A MERCHANT BANKER

1. Management of debt and equity offerings

2. Promotional activities

3. Placement and distribution

4. Corporate advisory services

5. Project advisory services

6. Loan syndication

7. Providing venture capital and mezzanine financing

8. Leasing Finance

9. Bought out deals

10. Non-resident Investment

11. Advisory services relating to mergers and acquisitions

12. Portfolio management

ISSUE MANAGEMENT

Issue management refers to management of securities offering of clients to the general public

and existing shareholders on right basis. Issue managers are known as Merchant Banker or Lead

managers.

Type of Issues

Issues are of three types. They are as follows:

(a) Public Issue,

(b) Right Issue, and

(c) Private Placements.

Public Issue-Reasons for Going Public

1. To raise funds for financing capital expenditure needs like expansion, diversification, etc.

2. To finance increased working capital requirement.

3. As an exit route for existing investors.

4. For debt financing.

Public Issue-Advantages

1. The IPO provides avenues for funding future needs of the company.

2. It provides liquidity for the existing shares.

3. The reputation and visibility of the company increases.

4. Additional incentive for employees in the form of the company’s stocks. This also helps to

attract potential employees.

5. It commands better valuation for the company.

Public Issue-Disadvantages

1. The profit earned by the company should be shared with its investors in the form of dividends.

2. An IPO is a costly affair. Around 15-20% of the fund realised is spent on raising the same.

3. In an IPO, the company has to disclose results of operations and financial position to the public and

the Securities and Exchange Board of India (SEBI).

4. The company has to invest substantial management time and effort.

Marketing of the Issue

1. Timing of the Issue

2. Retail Distribution

3. Reservation of the Issue

4. Advertising Campaign

Post-issue Activities

Principles of Allotment

Formalities associated with Listing

RIGHTS ISSUE

Existing shareholders have pre-emptive right in taking part in the right issue.

In right issue, shares are offered to existing shareholders according to the proportion of their

shareholding.

PRIVATE PLACEMENT

The direct sale of shares by a company to investors is called private placement.

No prospectus is issued in private placement.

Private placement covers equity shares, preference shares and debentures.

ISSUE MANAGER

Issue managers generally do issue management. To be an issue manager, they register

themselves with SEBI.

Roles of Issue Manager

Merchant banker floats the shares for and behalf of issuing company. It may be either right or

public issue. It is the stipulation of SEBI.

One of the important areas of issue management relates to capital structuring, capital gearing

and financial planning for the company. Merchant banker acts as a master designer in

performing these activities.

Merchant banker underwrites and invests in the issue lead managed by them.

They invest, continue to hold and offer buy and sell quotes for the scrip's of the company after

listing. His association with the company is not merely restricted to management of issue but

continues throughout.

Every merchant banker is expected to perform due diligence while managing a capital issue.

A merchant banker is required to coordinate with a large number of institutions and agencies.

They are expected to interact and file offer documents with SEBI while managing issues.

They file number of reports related to issues. They have to revolve around SEBI.

Marketing of an issue is an essential component of issue management. Merchant banker makes

number of promises to the potential investors. He puts him in the shoes of a dream merchant.

PRICING OF PUBLIC ISSUES

1. A new company set up by entrepreneurs without a track record will be permitted to issue capital to

public only at par.

2. A new company set up by existing companies with a five-year track record of consistent profitability

will be free to price its issue provided the participation of the promoting companies is not less than 50

per cent of the equity of the new company and the issue price is made applicable to all new investors

uniformly.

3. An existing private/closely held company with a three-year track record of consistent profitability

shall be permitted to freely price the issue.

4. An existing listed company can raise fresh capita! by freely pricing further issue.

CODE OF CONDUCT OF MERCHANT BANKERS

A merchant banker in the conduct of his business shall observe high standards of integrity and

fairness in all his dealings with his clients and other merchant bankers.

A merchant banker shall render at all times high standards of service, exercise due diligence,

ensure proper care and exercise independent professional judgment.

A merchant banker shall not make any statement or become privy to any act, practice or unfair

competition, which is likely to be harmful to the interests of other merchant bankers.

A merchant banker shall not make any exaggerated statement, whether oral or written, to the

client either about the qualification or the capability to render certain services or his

achievements in regard to services rendered to other clients.

CODE OF CONDUCT OF MERCHANT BANKERS

A merchant banker shall not—

(a) creation of false market;

(b) price rigging or manipulation

(c) passing of price sensitive information to brokers,

(d) divulge to other clients, press or any other party any confidential information about his client, which

has come to his knowledge

(e) deal in securities of any client company without making disclosure to the Board.

REGISTRATION CHARGES

1. Category I Merchant Banker- A sum of Rs. 2.5 lakhs to be paid annually for the first two

years.

2. Category II Merchant Banker- A sum of Rs. 1.5 lakhs to be paid annually for the first two

years.

3. Category III Merchant Banker- A sum of Rs 1 lakh to be paid annually for the first two years.

4. Category IV Merchant Bankers- A sum of Rs. 5,000 to be paid annually for the first two

years.

Book-Building

Book-building is a process of offering securities in which bids at various prices from investors

through syndicate, members and based on bids, demand for the security is assessed and its

price discovered.

Other Requirements of Book-building

(a) issuer to provide indicative floor price and no ceiling price,

(b) bids to remain open for at least 5 days,

(c) only electronic bidding is permitted,

(d) bids are submitted through syndicate members,

(e) investors can bid at any price,

(f) retail investors have option to bid at cut off price,

(g) bidding demand is displayed at the end of everyday, and

(h) the lead manager analyses the demand generated and determines the issue price in

consultation with the issuer, etc.

e-IPOS

A company proposing to issue capital to public through on-line system of the stock exchange has

to comply with Section 55 to 68A of the Companies Act, 1956 and SEBI (DIP) Guidelines,2000.

MUTUAL FUNDS

A Mutual Fund is a trust that pools the savings of a number of investors who share a common

financial goal.

Types of Mutual Funds Schemes

Based on Maturity Period:

1) Open End Scheme 2) Close End Scheme

Based on Investment objective :

1) Growth 2) Income 3) Money Market 4) Gilt edged 5) Others

Special Schemes:

1) Tax Savings 2) Load 3) No-Load 4) Industry Specific 5) Sector Specific

Risk vs. Mutual Funds

The following are some risks associated with investment in mutual funds:

Market Risk

Interest Rate Risk

Inflation Risk

Business Risk

Credit Risk

Political Risk

Liquidity Risk

Timing Risk

Performance Measures of Mutual Funds

The performance of a mutual fund, in general, can be evaluated by using the beginning and the end

period net asset values (NAV) as follows:

Rp= ((NAVt- NAVT-1) + D1 + C1) / NAV T-1

The one period rate of return for a mutual fund (Rp) is defined as the change in net asset value

(NAV) plus its cash disbursements (D) and capital gains disbursements (C). Net asset values of the fund

are adjusted for bonus and rights.

The most important and widely used measures of performance are:

1. The Treynor Measure

2. The Sharpe Measure

3. Jenson Model

4. Eugene Fama Model

Treynor Measure

Treynor’s Index (Ti) = (Ri - Rf)/Bi

where, Ri represents return on fund, Rf is risk free rate of return and Bi is beta of the fund.

Sharpe Measure

Sharpe Index (Si) = (Ri - Rf)/Si

where, Si is standard deviation of the fund.

Jenson Model

Required return of a fund at a given level of risk (Bi) can be calculated as:

Ri = Rf + Bi (Rm - Rf)

where, Rm is average market return during the given period.

Eugene Fama Model

Required return can be calculated as :

Ri = Rf + Si / Sm (Rm - Rf)

where, Sm is standard deviation of market returns.

Advantages of Mutual Funds

1. Reduced Risk

2. Diversified investment

3. Stress free investment

4. Revolving type of investment

5. Selection and timings of investment

6. Wide investment opportunities

7. Investment care

8. Low investment and easy liquidity

9. Tax benefits

10. Moderate Returns

Mutual Fund Taxation

Tax provisions applying to fund investments and funds themselves in respect of various matters

are listed below:

Capital Gains

Tax Deducted at Source (TDS)

Wealth Tax

Income from Units

Income Distribution Tax

Section 88

Growth of Mutual Funds

There are several yardsticks available to measure the performance of a fund sector. They are:

(a) Asset Under Management (AUM),

(b) Number of Unit Schemes in Operation,

(c) Net Asset Value

(d) Return and

(e) Volume of Investment expressed in Rupee Value

LEASE FINANCE

“A Lease is a transfer of a right to enjoy the property. The consideration may be a price or a

rent. The rent may be either money, or share of crops, service of anything of value, to be rendered

periodically by the transferee to the transferor.”

Classification of Lease

Finance Lease and Operating Lease.

Sale and Lease Back and Direct Lease.

Single Investor Lease and Leveraged Lease.

Domestic Lease and International Lease.

Finance lease

A finance lease or capital lease is a type of lease. It is a commercial arrangement where:

the lessee (customer or borrower) will select an asset (equipment, vehicle, software);

the lessor (finance company) will purchase that asset;

the lessee will have use of that asset during the lease;

the lessee will pay a series of rentals or installments for the use of that asset;

the lessor will recover a large part or all of the cost of the asset plus earn interest from the

rentals paid by the lessee;

the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or

bargain option purchase price);

operating lease

An operating lease is a lease whose term is short compared to the useful life of the asset or

piece of equipment (an airliner, a ship, etc.) being leased. An operating lease is commonly used

to acquire equipment on a relatively short-term basis. Thus, for example, an aircraft which has

an economic life of 25 years may be leased to an airline for 5 years on an operating lease.

Conveyance-type lease

It is a very long tenure lease applicable to immovable properties.

The intention is to convey title in property.

Periods 99yrs or 999yrs

Leveraged lease

A leveraged lease is a lease in which the lessor puts up some of the money required to purchase

the asset and borrows the rest from a lender. The lender is given a senior secured interest on

the asset and an assignment of the lease and lease payments. The lessee makes payments to

the lessor, who makes payments to the lender

In this type of lease, the lessor provides an equity portion (often 20% to 50%) of the equipment

cost and lenders provide the balance on a nonrecourse debt basis. The lessor receives the tax

benefits of ownership.

Sale and leaseback

Arrangement in which one partysells a property to a buyer and the buyer immediately leases

the property back to the seller. This arrangement allows the initial buyer to make full use of the

asset while not having capital tied up in the asset. Leasebacks sometimes provide

taxbenefits.also called leaseback

Balloon lease

Arrangement in which rent is low at the beginning, higher in the middle, and low again at the

end of the term.

Accounting Treatment of Lease

Accounting transaction for the Lessor:

Assets under financial leases should be disclosed as “assets given on lease” as a separatesection

under the head “fixed assets” in the balance sheet of the lessor. The classification of the assets

should correspond to that adopted for other fixed assets.

Lease rentals should be shown separately under gross income in the income statement of the

relevant period.

There would be a lease equalization charge where the annual lease charge is more than the

minimum statutory depreciation.

Accounting transaction for the Lessee:

A lessee should disclose assets taken under a finance lease by way of a note to the accounts,

disclosing the future obligations of the lessee as per the agreement.

Lease rentals should be accounted for on an accrual basis over the lease period to recognise an

appropriate charge in this respect in the income statement, with a separate disclosure thereof.

The excess of lease rentals paid over the amount accrued in respect thereof should be treated

as pre-paid lease rental and vice versa.

Regulatory Authority

There is no specific Act or legislation governing leasing in India. All legislations or Acts referring

to assets and management of assets encompass leased assets, either in terms of assets held by the

lessor or joined with assets for which payment in full has not been received. Some of the Acts include:

Companies Act, 1956

Consumer Protection Act, 1986

Easements Act, 1882

Foreign Exchange Regulation Act, 1973, now replaced with Foreign Exchange Management Act,

2000.

Hire Purchase Act, 1972

Income Tax Act, 1962

Indian Contract Act, 1872

Indian Stamp Act, 1899

Manufacturing and Other Companies (Auditor’s Report) Order, 1988

Motor Vehicles Act, 1988

Recovery of Debts due to Banks and Financial Institutions Act, 1993

Registration Act, 1908

Reserve Bank of India Act, 1934

Sale of Goods Act, 1930

Sick Industrial Companies (Special Provisions) Act, 1985

Transfer of Property Act, 1882g

Advantages of Leasing

Flexibility

Leased With User Oriented Variants

Tax-Based Benefits

Less Paper Work and Quick Disbursement

Convenience

Financing for the Total Requirements

Scope for Better Use of Own Funds

Off-Balance Sheet Financing

Miscellaneous Benefits

Disadvantages of Leasing

1. Lease contracts may have terms restricting use of leased assets resulting in under-utilisation of

operating capacity.

2. Since, most of the equipment lease transactions are finance leases, the chances of the lessee

disinvesting is restricted. The non-cancelable nature is a disadvantage where equipments have uncertain

technology and market life.

3. ‘Off-balance sheet financing’ through leasing exposes the firm to high financial risks as they tend to be

highly geared (high debt equity ratios).

4. In an imperfect financial market, and different methods of leasing and owning by tax authorities,

leasing may be costlier than other forms of borrowing.

Indian Context

Salient Features of the Lease Structured In The Indian Context

1. The leases structured in the Indian context are only ‘finance lease’.

2. Operating leases are very limited as the resale market for the used capital equipment is Nil.

3. Lease agreements do not provide for transfer of ownership to the lessee either during the lease

period or at the end of the lease, as it will turn out to be a hire-purchase transaction from tax angle.

4. The lease rentals are structured to recover the entire investment cost during the primary period.

Lease rentals for the secondary period are very nominal, e.g., Lease rates.

HIRE PURCHASE

A hire purchase can be defined:

“as a contractual arrangement under which the owner lets his goods on hire to the hirer and

offers an option to the hirer for purchasing the goods in accordance with the terms of the contract.”

Features of Hire Purchase

The hire-vendor (the counterpart of lessor) gives the asset on hire to the hirer (the counterpart

of lessee).

The hirer is required to make a down payment of around 20 per cent of the cost of the

equipment and repay the balance in regular hire purchase installments over a specified

period of time.

When the hirer pays the last installment, the title of the asset is transferred from the hire

vendor to the hirer.

The hire-vendor charges interest on a flat basis. This means that a certain rate of interest

(usually around 10%) is charged on the initial investment (made by the hire-vendor) and not on

the diminishing balance.

Theoretically the hirer can exercise the cancelable option and cancel the contract after giving

due notice to the finance company.

Hire Purchase And Lease Compared

Ownership of the vehicle is with the owner in HP but it is with the lessor in leasing.

After the repayment vehicle is transferred to the owner but in leasing after the lease period the

vehicle may not be transferred to the user.

Risk is very high in HP due to technological Obsolescence. But it is less in leasing.

Cancellation of lease is possible, which is not in HP.

Law & Accounting on HP & Leasing

Motor vehicles law in India contains specific provisions relating to lease and hire purchase

transactions.

Basic Tax Treatment of Hire Purchase and Lease Transactions.

Depreciation Allowance on Hire Purchase

Accounting for Hire Purchase Transactions

Indian and International Accounting Standards

Problems

Taxation

Shortage of Low-cost Funds

Slow Market Growth

Less Number of Players

Increasing Conservatism in the Market

FACTORING

Factoring is of recent origin in Indian Context.

Kalyana Sundaram Committee recommended introduction of factoring in 1989.

Banking Regulation Act, 1949, was amended in 1991 for Banks setting up factoring services.

SBI/Canara Bank have set up their Factoring Subsidiaries:-

SBI Factors Ltd., (April, 1991)

CanBank Factors Ltd., (August, 1991).

RBI has permitted Banks to undertake factoring services through subsidiaries.

Factoring is essentially a financial service designed to help firms manage their trade credit or

receivables effectively.

Factoring is defined as an asset-based means of financing by which the factor buys up the book

debts of a company on a regular basis, paying cash down against receivables, and then collects

the amounts from the customers to whom the company has supplied goods.

Factoring is the Sale of Book Debts by a firm (Client) to a financial institution (Factor) on the

understanding that the Factor will pay for the Book Debts as and when they are collected or on

a guaranteed payment date. Normally, the Factor makes a part payment (usually upto 80%)

immediately after the debts are purchased thereby providing immediate liquidity to the Client.

So, a Factor is,

1. A Financial Intermediary

2. That buys invoices of a manufacturer or a trader, at a discount, and

3. Takes responsibility for collection of payments.

The parties involved in the factoring transaction are:-

1. Supplier or Seller (Client)

2. Buyer or Debtor (Customer)

3. Financial Intermediary (Factor)

SERVICES OFFERED BY A FACTOR

1. Follow-up and collection of Receivables from Clients.

2. Purchase of Receivables with or without recourse.

3. Help in getting information and credit line on customers (credit protection)

4. Sorting out disputes, if any, due to his relationship with Buyer & Seller.

Reasons to Factor

a. It helps to obtain a source of working capital.

b. It increases sales.

c. It expands client’s business or fills more orders.

d. It eliminates the risk of credit losses on client’s customers.

e. Factor has a professional credit checking and collection payment system

f. It has flexible funding programme that increases as seller increases his sales (the goal of

factoring).

g. It helps to pay suppliers timely or take cash discounts or increase credit limits with suppliers.

h. It facilitates to have funds for payroll and taxes.

i. Clients can extend credit to customers on large orders without having to ask them pay Cash on

Delivery (COD).

j. It helps to buy equipment or inventory on demand.

Mechanism of Factoring

The Client (Seller) sells goods to the buyer and prepares invoice with a notation that debt due

on account of this invoice is assigned to and must be paid to the Factor (Financial Intermediary).

The Client (Seller) submits invoice copy only with Delivery Challan showing receipt of goods by

buyer, to the Factor.

The Factor, after scrutiny of these papers, allows payment (,usually upto 80% of invoice value).

The balance is retained as Retention Money (Margin Money). This is also called Factor Reserve.

The drawing limit is adjusted on a continuous basis after taking into account the collection of

Factored Debts.

Once the invoice is honoured by the buyer on due date, the Retention Money credited to the

Client’s Account.

Till the payment of bills, the Factor follows up the payment and sends regular statements to the

Client.

CHARGES FOR FACTORING SERVICES

Factor charges Commission (as a flat percentage of value of Debts purchased) (0.50% to 1.50%)

Commission is collected up-front.

For making immediate part payment, interest charged. Interest is higher than rate of interest

charged on Working Capital Finance by Banks.

If interest is charged up-front, it is called discount.

Types Of Factoring

Recourse Factoring

Non-recourse Factoring

Advance Factoring

Invoice Discounting

Full Factoring

Bank Participation Factoring

Supplier Guarantee Factoring

Cross-border Factoring

Maturity Factoring

RECOURSE FACTORING

Upto 75% to 85% of the Invoice Receivable is factored.

Interest is charged from the date of advance to the date of collection.

Factor purchases Receivables on the condition that loss arising on account of non-recovery will

be borne by the Client.

Credit Risk is with the Client.

Factor does not participate in the credit sanction process.

In India, factoring is done with recourse.

NON-RECOURSE FACTORING

Factor purchases Receivables on the condition that the Factor has no recourse to the Client, if

the debt turns out to be non-recoverable.

Credit risk is with the Factor.

Higher commission is charged.

Factor participates in credit sanction process and approves credit limit given by the Client to the

Customer.

In USA/UK, factoring is commonly done without recourse.

MATURITY FACTORING

Factor does not make any advance payment to the Client.

Pays on guaranteed payment date or on collection of Receivables.

Guaranteed payment date is usually fixed taking into account previous collection experience of

the Client.

Nominal Commission is charged.

No risk to Factor.

CROSS - BORDER FACTORING

It is similar to domestic factoring except that there are four parties, viz.,

a) Exporter,

b) Export Factor,

c) Import Factor, and

d) Importer.

It is also called two-factor system of factoring.

Exporter (Client) enters into factoring arrangement with Export Factor in his country and assigns

to him export receivables.

Export Factor enters into arrangement with Import Factor and has arrangement for credit

evaluation & collection of payment for an agreed fee.

Notation is made on the invoice that importer has to make payment to the Import Factor.

Import Factor collects payment and remits to Export Factor who passes on the proceeds to the

Exporter after adjusting his advance, if any.

Where foreign currency is involved, Factor covers exchange risk also.

FACTORING vs BILLS DISCOUNTING

BILL DISCOUNTING

1. Bill is separately examined and discounted.

2. Financial Institution does not have responsibility of Sales Ledger Administration and collection of

Debts.

3. No notice of assignment provided to customers of the Client.

4. Bills discounting is usually done with recourse.

5. Financial Institution can get the bills re-discounted before they mature for payment.

FACTORING

1. Pre-payment made against all unpaid and not due invoices purchased by Factor.

2. Factor has responsibility of Sales Ledger Administration and collection of Debts.

3. Notice of assignment is provided to customers of the Client.

4. Factoring can be done without or without recourse to client. In India, it is done with recourse.

5. Factor cannot re-discount the receivable purchased under advanced factoring arrangement.

Financial Aspects of Factoring

To use the services of a factor, one should meet two types of expenses. They

a. Factoring commission, and

b. Interest on funds advances.

Advantages

Factoring offers the following advantages from the firm’s point of view:

(a) There will be no liquidity problem if firms effectively use the factoring services. The factoring

improves the cash flow.

(b) Factoring is invaluable as it leads to a higher level of activity resulting in profitability.

(c) Division of work is effectively carried out if a firm hires a factor. The management has more

time for planning, running and improving business.

(d) Factoring also helps the firms to explore and exploit opportunities.

(e) The improved cash flows and speedy collection will bring down the cost of debt. This will

contribute towards cost savings.

Disadvantages

Factoring could prove to be costlier to in-house management of receivables. Large firms having

access to similar sources of funds function like factors, themselves as they have large size of

business and well-organised credit and receivable management. Therefore, there is no need for

factor services separately.

Factoring is perceived as an expensive form of financing and also as finance of the last resort.

This tends to have a negative effect on the creditworthiness of the company in the market.

STATUTES APPLICABLE TO FACTORING

Factoring transactions in India are governed by the following Acts:-

a) Indian Contract Act

b) Sale of Goods Act

c) Transfer of Property Act

d) Banking Regulation Act.

e) Foreign Exchange Regulation Act.

WHY FACTORING HAS NOT BECOME POPULAR IN INDIA

Banks’ reluctance to provide factoring services

Bank’s resistance to issue Letter of Disclaimer (Letter of Disclaimer is mandatory as per RBI

Guidelines).

Problems in recovery.

Factoring requires assignment of debt which attracts Stamp Duty.

Cost of transaction becomes high.

Forfaiting

“Forfait” is derived from French word ‘A Forfait’ which means surrender of fights.

Forefaiting is a mechanism by which the right for export receivables of an exporter (Client) is

purchased by a Financial Intermediary (Forfaiter) without recourse to him.

It is different from International Factoring in as much as it deals with receivables relating to

deferred payment exports, while Factoring deals with short term receivables.

Exporter under Forfaiting surrenders his right for claiming payment for services rendered or

goods supplied to Importer in favour of Forefaiter.

Bank (Forefaiter) assumes default risk possessed by the Importer.

Credit Sale gets converted as Cash Sale.

Forfaiting is arrangement without recourse to the Exporter (seller)

Operated on fixed rate basis (discount)

Finance available upto 100% of value (unlike in Factoring)

Introduced in the country in 1992.

It is a technique of trade finance, which has attracted growing interest in the banking sector and the

financial press of export-orientated countries over the last years. This is certainly due to the fact that in

many cases it has proven to be the most efficient instrument when it comes to export finances.

Definition of Forfaiting

“Forfaiting is the term generally used to denote the purchase of obligations falling due at some

future date, arising from deliveries of goods and services—mostly export transactions— without

recourse to any previous holder of the obligation.”

ESSENTIAL REQUISITES OF FORFAITING TRANSACTIONS

Exporter to extend credit to Customers for periods above 6 months.

Exporter to raise Bill of Exchange covering deferred receivables from 6 months to 5 years.

Repayment of debts will have to be avallised or guaranteed by another Bank, unless the

Exporter is a Government Agency or a Multi National Company.

Co-acceptance acts as the yard stick for the Forefaiter to credit quality and marketability of

instruments accepted.

IN FORFAITING:-

Promissory notes are sent for avalling to the Importer’s Bank.

Avalled notes are returned to the Importer.

Avalled notes sent to Exporter.

Avalled notes sold at a discount to a Forefaiter on a NON-RECOURSE basis.

Exporter obtains finance.

Forfaiter holds the notes till maturity or securitises these notes and sells the Short Term

Paper either to a group of investors or to investors at large in the secondary market.

CHARACTERISTICS OF FORFAITING

Converts Deferred Payment Exports into cash transactions, providing liquidity and cash flow to

Exporter.

Absolves Exporter from Cross-border political or conversion risk associated with Export

Receivables.

Finance available upto 100% (as against 75-80% under conventional credit) without recourse.

Acts as additional source of funding and hence does not have impact on Exporter’s borrowing

limits. It does not reflect as debt in Exporter’s Balance Sheet.

Provides Fixed Rate Finance and hence risk of interest rate fluctuation does not arise.

Exporter is freed from credit administration.

Provides long term credit unlike other forms of bank credit.

Saves on cost as ECGC Cover is eliminated.

Simple Documentation as finance is available against bills.

Forfait financer is responsible for each of the Exporter’s trade transactions. Hence, no need to

commit all of his business or significant part of business.

Forfait transactions are confidential.

COSTS INVOLVED IN FORFAITING

Commitment Fee:- Payable to Forfaiter by Exporter in consideration of forefaiting services.

Commission:- Ranges from 0.5% to 1.5% per annum.

Discount Fee:- Discount rate based on LIBOR for the period concerned.

Documentation Fee:- where elaborate legal formalities are involved.

Service Charges:- payable to Exim Bank.

FACTORING vs. FORFAITING

POINTS OF DIFFERENCE FACTORING FORFAITING

Extent of Finance Usually 75 – 80% of the value of the

invoice

100% of Invoice value

Credit Worthiness Factor does the credit rating in case

of non-recourse factoring

transaction

The Forfaiting Bank relies on

the creditability of the

Avalling Bank.

Services provided Day-to-day administration of sales

and other allied services

No services are provided

Recourse With or without recourse Always without recourse

Sales By Turnover By Bills

COMPARATIVE ANALYSIS

BILLS

DISCOUNTED

FACTORING FORFAITING

1. Scrutiny Individual Sale

Transaction

Service of Sale

Transaction

Individual Sale

Transaction

2. Extent of Finance Upto 75 – 80% Upto 80% Upto 100%

3. Recourse With Recourse With or Without

Recourse

Without Recourse

4. Sales Administration Not Done Done Not Done

5. Term Short Term Short Term Medium Term

6. Charge Creation Hypothecation Assignment Assignment

Advantages of Forfaiting

100 % Risk Cover

Country Risk (Political and Transfer Risk)

Currency Risk

Commercial Risk

Interest Rate Risk

Instant Cash

Flexibility and Simplicity

WHY FORFAITING HAS NOT DEVELOPED

Relatively new concept in India.

Depreciating Rupee

No ECGC Cover

High cost of funds

High minimum cost of transactions (USD 250,000/-)

RBI Guidelines are vague.

Very few institutions offer the services in India. Exim Bank alone does.

Long term advances are not favoured by Banks as hedging becomes difficult.

Lack of awareness.

STAGES INVOLVED IN FORFAITING:-

Exporter approaches the Facilitator (Bank) for obtaining Indicative Forfaiting Quote.

Facilitator obtains quote from Forfaiting Agencies abroad and communicates to Exporter.

Exporter approaches importer for finalising contract duly loading the discount and other charges

in the price.

If terms are acceptable, Exporter approaches the Bank (Facilitator) for obtaining quote from

Forfaiting Agencies.

Exporter has to confirm the Firm Quote.

Exporter has to enter into commercial contract.

Execution of Forfaiting Agreement with Forefaiting Agency.

Export Contract to provide for Importer to furnish avalled BoE/DPN.

Forfaiter commits to forefait the BoE/DPN, only against Importer Bank’s Co-acceptance.

Otherwise, LC would be required to be established.

Export Documents are submitted to Bank duly assigned in favour of Forfaiter.

Bank sends document to Importer's Bank and confirms assignment and copies of documents to

Forefaiter.

Importer’s Bank confirms their acceptance of BoE/DPN to Forfaiter.

Forfaiter remits the amount after deducting charges.

On maturity of BoE/DPN, Forfaiter presents the instrument to the Bank and receives payment.

Forfaiter commits to forefait the BoE/DPN only against Importer Bank’s Co-acceptance.

Otherwise, LC would be required to be established.

Export Documents are submitted to Bank duly assigned in favour of Forfaiter

Importer’s Bank confirms their acceptance of BoE/DPN to Forfaiter.

Forfaiter remits the amount after deducting charges.

On maturity of BoE/DPN, Forfaiting Agency presents the instruments to the Bank and receives

payment

STAGES INVOLVED IN EXPORT FACTORING

Exporter (Client) gives his name, address and credit limit required to the Export Factor.

Export Factor submits the details of Buyer to the Import Factor.

Import Factor decides on the credit cover and communicates decision to Export Factor.

Export Factor enters into Factoring Agreement with Exporter.

Overseas Buyer is notified of this arrangement.

Exporter is then free to ship the goods to Buyers directly.

Exporter submits original documents, viz., invoice and shipping documents duly assigned and

receives advance there-against (upto 80%).

Export Factor despatches all the original documents to Importer/Buyer after duly affixing

“Assignment Clause” in favour of the Import Factor.

Export Factor sends copy of invoice to Import Factor in the Debtor’s country.

Import Factor follows up and receives payment on due date and remits to Export Factor.

Export Factor, on receipt of payment, releases the balance of proceeds to Exporter.

VENTURE CAPITAL

Evolution

R.S. Bhat, the chairman of Bhat Committee highlighted the problems of new entrepreneurs and

technologists in setting up industries in 1972. The concept of Venture Capital was introduced in

India by the All India Financial Institutions in 1975.

The Risk Capital Foundation (RCF) sponsored by the Industrial Finance Corporation of India (IFCI)

was inaugurated. The purpose of establishing the institution was to supplement promoters’

equity with a view to motivate technologists and professionals to promote new firms. Industrial

Development Bank of India (IDBI) introduced Seed Capital Scheme in 1976. Till 1984, the

concept of venture capital was known as ‘Risk Capital’ and “Seed Capital’. The objectives of risk

capital were different to those understood under venture capital today.

Meaning

Venture capital is a private equity investment in entrepreneurial companies used to finance the

working capital requirement and asset needs of growing businesses.

Venture Capital Funds generally:

(a) Finance new and rapidly growing companies;

(b) Invest in typically knowledge-based, sustainable, up-scaleable companies;

(c) Purchase equity or quasi-equity securities;

(d) Assist in the development of new products or services;

(e) Add value to the company through active participation;

(f) Take higher risks with the expectation of higher rewards;

(g) Have a long-term orientation.

Mechanism of Venture Capital

The flow of venture capital from the investor to a Start-up Company and back can be thought of

as a cycle that runs through several phases.

(A) Raising of venture fund.

(B) Investing in, monitoring of, adding value to firms.

(C) Exiting successful companies; returning capital to investors.

Mechanism of Venture Capital

Types of Venture Capitalist

The types of venture investors are classified based on (a) the investment strategy and (b) their

specialization.

Based on the Investment Strategy

Gen era lists

Venture Capitalists of Early Stage

Specialists

Venture Capitalists of Expansion Stage Financing

Later Stage Investors

Turnaround Investors

Diverse Investors

Synergetic Venture Investment

Based on their Specialization

Incubators

Angel Investors

Venture Capitalists (VCs)

Private Equity Players

Types of Venture Capital Firms

Limited Partnership Firms

Independent Venture Firms

Affiliates or Subsidiaries

Affiliates of Government

Corporate Venturing

Benefits of Venture Capital

(a) Venture backed companies have been shown to grow faster than other types of companies. This is

made possible by the provision of a combination of capital and experienced personal input from venture

capital executives, which sets it apart from other forms of finance.

(b) Venture capital can help you achieve your ambitions for your company and provide a stable base for

strategic decision making.

(c) The venture capital firms will seek to increase a company’s value to its owners, without taking day-

to-day management control. Although you may have a smaller “slice of cake”, within a few years your

“slice” should be worth considerably more than the whole “cake” was to you before.

(d) Venture capital firms often work in conjunction with other providers of finance and may be able to

help you to put a tats funding package together for your business.

Types of Investors

Informal Investors

Formal Investors

Venture Capital Fund Stages

Problems With Vcs in India

License Raj

Scalability

Valuation

Mindsets

Enforceability

Exit

Returns, Taxes and Regulations

HOUSING FINANCE

Housing Vs Retail Lending

Housing is one of the basic human needs of the society. It is closely linked with the process of

overall socio-economic development of a country.

The retail lending business is growing at an outstanding rate of over 30% every year. Banks in

India have gone a long way since 1990s where the retail portfolio was less than 5% to the

current level of around 18%. The proportion of the retail share in the lending portfolio is slated

to close in at around 40% by 2005-2006.

Reasons for lending housing loan

• Poor credit off take of companies, commercial and other traditionally industrial sector.

• Growing risk of lending to industry on account of recession.

• Growing financial disintermediation process enabling many triple A rated companies to access

the market directly.

• Relatively less risk for retail borrowers.

• Rising disposable income and changing life style aspiration of a sizable section of the Population.

• Continuous softening of lending rates which has improved the borrowers’ ability to repay.

• Increased governmental incentives by way of tax relief or concessions on certain types of Loans.

• Improved liquidity with banks following a reduction in Cash Reserve Ratio (CRR) and low credit

off take in the face of continued accretion of deposits.

• Availability of better spread to banks.

• Widespread of risk among large number of borrowers and

• Developments in technology which have reduced transaction costs on a large number of

borrower accounts.

Housing Finance organisations

Housing Finance Institutions

The Housing Finance Institutions can be segregated into three categories:

• Public Sector Finance

• Banks

• Private Sector Finance

Public Sector Institutions

HUDCO (Housing and Urban Development Corporation Limited)

LICHFL (Life Insurance Corporation Housing Finance Limited)

GICHFL (General Insurance Corporation Housing Finance Limited)

PNBHFL (Punjab National Bank Housing Finance Limited)

SBIHF (State Bank of India Housing Finance)

The other major players in the public sector are the Indian Housing, Corp bank Homes, Cent

Bank Home Finance Limited, etc.

Private Sector Finance

HDFC (Housing Development Finance Corporation)

DHFCL (Dewan Housing Finance Corporation Limited)

GHFCL (Global Housing Finance Corporation Limited)

BHFL (Birla Home Finance Limited)

Maharishi Housing

Others

Other key housing finance providers in the private sector are Sundaram Home Finance,

Hometrust Housing, Grihaa Finance, Weizmann Homes, GLFL Housing, etc.

National Housing Bank

The National Housing Bank was setup in 1988 as a subsidiary of Reserve Bank of India. It is a

principal agency promoting housing finance institutions both at local and regional levels and

provides financial and other support to such institutions.

Types of Home Loans

Home Purchase Loan

Home Improvement Loan

Home Construction Loan

Home Extension Loan

Home Conversion Loan

Land Purchase Loan

Bridge Loan

Balance Transfer Loan

Refinance Loan

Stamp Doty Loan

Loans to WRXs

CREDIT RATING

“Credit ratings help investors by providing an easily recognizable, simple tool that couples a

possibly unknown issuer with an informative and meaningful symbol of credit quality.”

Rating Process

Rating is an interactive process with a prospective approach. It involves series of steps. The main

points are described as below:

Mandate

Team

Information

Secondary Data

Meetings and Visits

Preview/Meeting

Committee Meeting

Rating Communication

Rating Reviews

Surveillance

Rating Framework

These factors can be conceptually classified into business risk and financial risk drivers.

Business risk drivers Financial risk drivers

Industry characteristics Funding policies

Market position Financial flexibility

Operational efficiency New projects

Management quality

Credit Rating Agencies in India

Credit Rating Information Services of India Limited (CRISIL)

Investment Information and Credit Rating Agency of India (ICRA)

Credit Analysis and Research Limited (CARE)

Criticisms

Since issuers are charged for ratings by CRAs, i.e., the issues are pay masters,the independence

of ratings becomes questionable.

CRAs are not accountable for the ratings given by them.

Ratings may lead to herding behaviour thereby increasing the volatility of capital flows.

Credit ratings change infrequently since the rating agencies are unable to constantly monitor

developments.

Regulations

In India, in 1998, SEBI constituted a Committee to look into draft regulation for CRAs that were

prepared internally by SEBI. The Committee held the view that in keeping with international

practice, SEBI Act 1992 should be amended to bring CRAs outside the purview of SEBI for a

variety of reasons.

In consultation with Government, in July 1999, SEBI issued a notification bringing the CRAs

under its regulatory ambit in exercise of powers conferred on it by Section 30 read with Section

11 of the SEBI Act 1992.

CONSUMER FINANCE

Consumer Finance includes all asset-based financing options provided to investors for acquiring

consumer durables. In a consumer finance transaction, an individual initially pays a fraction of

the cash on purchase while promising to pay the balance with interest over a specified time

period.

Consumer finance is available for a large number of durables like televisions, refrigerators, air

conditioners, washing machines, cars, two-wheelers, personal computers and four-wheelers

too.

Consuming Class in India

Structure of the Indian consumer market

Characteristics of Consumer Finance

Parties and Structure of the transaction

Payment for the transaction

Rate of Interest and Repayment Period

Security

Eligibility Criteria for Borrowers

Importance of Consumer Finance

Increasing Risk of Disintermediation in Corporate Lending

Housing Loans

Consumer Durables

Reduction in Interest Rates

Impact of Consumer Finance Growth on Consumer Durables Market

Passenger Cars and Two-wheelers

Key Issues and Success Factors

Innovative Solutions

Credit Constraint in Rural India for Consumer Durables

Consumer Preferences

Consumer Finance by GE Countrywide

Consumer Protection

Complaint Procedure

Under the Consumer Protection Act, every district has at least one Consumer Redressal

Forum,more commonly called a Consumer Court.

CREDIT CARD

Credit card is a monetary instrument that enables the cardholder to obtain goods and services

without actual payment at the time of purchase. It is also popularly known as plastic money.

The value of purchases made by the cardholder using the card is recovered at the end of a

specified period, usually a month, called the billing cycle. It can be said that a credit card is basically a

“Pay Later” card that is provided to a customer.

Benefits of Holding Credit Card

(a) Credit can be availed for a period of 30-45 days (Max.52 days).

(b) A cardholder need not have the required amount in his account to the extent of the transaction

made.

(c) The card carries a predetermined limit up to which the holder can spend.

(d) At the end of each billing cycle, the cardholder has to pay only 5-10% of the outstanding value

and the rest can be paid in installments over the next few months/years.

(e) An outstanding balance, a nominal rate of 2-3% per month is charged as interest.

(f) Regular use of the credit card by the user earns him additional points that provide the

cardholder with discounts on purchases.

Mechanism of a Credit Card Transaction

Every transaction made on a credit card involves three parties:

(a) The Card Issuer

(b) The Cardholder

(c) The Merchant Establishment (ME)

Debit Card

It is the accountholder’s mobile ATM. Open an account with a bank that offers a debit card, and

payments for purchases are deducted from your bank account. The retailer swipes the card over an

electronic terminal at this outlet, you enter the personal identification number on a PIN pad and the

money is immediately debited at the bank.

Benefits of Debit Cards

Debit cards offer wide range of benefits to the customers. Some of them are:

(a) One can plan Budget within the savings instead of going for credit

(b) He can access his own money 24 hours a day

(c) He saves fee and other service changes on cash withdrawals.

(d) He can carry one card to use both at ATMs and at merchant locations

Types of Cards

MasterCard

VISA Card

Affinity Cards

Standard Card

Classic Card

Gold Card or Executive Card

Platinum Card

Titanium Card

Secured Card

Charge Card

Rebate Card

Co-branded Card

Travel Card

Laghu Udyarni Credit Card (LUCC) Scheme

New Types of Credit Card

1. Corporate Credit Cards

2. Smart Cards

3. Global Credit Cards

Eligibility To Get A Card

Place of Residence

Telephone

Profession

Place of Work

Age

Costs of Credit Card Payment

Renewal

Interest-free period on ‘every bill’

Purchases on credit

Fuel on credit

Billing period

Cash advance

Choosing The Right Card

Acceptability

Eligibility

Fees

Other Charges

Credit Period

Cash Advance

Insurance Cover

Uses of Credit Cards

(a) Personal Accident Insurance.,

(b) Cash Withdrawal Facility.

(c) Increase in Credit.

(d) “Add-On” Facility.

(e) Leveraged Investment Facility.