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Dharmendra Gupta Classes(DGC) Source of Finance.13.

1
SOURCES OF FINANCE
Q.1. How would you classify financial needs based on time facto!
Ans. The financial needs of a business can be classified as under :
"y#e "ime $eiod E%am#les
Long Term Periods exceeding five
years
Investment in Fixed Assets viz. Land, uilding,
Plant and !achinery, and in Permanent "or#ing
$a%ital
!edium Term Above one year but less
than five years
$osts of intensive advertising cam%aign or similar
deferred revenue ex%enditure
&hort Term Less than one year Investment in current assets 'for (or#ing ca%ital
re)uirements.
Q.&. 'in( out t)e *aious a##oac)es of aisin( finance +o, How s)ould souces and
a##lication of funds be matc)ed by an ente#ise !
The various a%%roaches to funding are:
Name of
A##oac)
-atc)in(
A##oac)
Conse*ati*e
A##oac)
A((essi*e A##oac)
Long Term
Funds used in
Fixed Assets and
Permanent "or#ing
$a%ital
Fixed Assets,
Permanent "or#ing
$a%ital and %art of
Tem%orary "or#ing
$a%ital
Fixed Assets and %art of
Permanent "or#ing $a%ital
&hort Term
Funds used in
Tem%orary "or#ing
$a%ital
alance %art of
Tem%orary "or#ing
$a%ital
alance %art of Permanent
"or#ing $a%ital and entire
Tem%orary "or#ing $a%ital
Im%act on
Li)uidity
$om%aratively (ell'
balanced
*igh Li)uidity Lo( Li)uidity
Im%act on
Profitability
$om%aratively (ell'
balanced
Lo( %rofitability and
return on assets
*igh return on assets but ris#y.
Q... /ist some souces fom w)ic) finance can be aised.
Long Term &ources !edium Term &ources &hort Term &ources
+)uity &hare $a%ital
Preference &hare
$a%ital.
,etained earnings.
-ebentures and onds
Long Term Loans from
Preference &hare $a%ital
-ebentures and onds
Public de%osits . Fixed
de%osits for / year duration
!edium Term Loans from
financial institutions &tate
Trade credit ' &u%%liers.
Loans from $ommercial
ban#s.
Fixed de%osit for a %eriod
of 0 year or less
$ommercial Pa%ers
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financial
Institutions, &tate
Financial
$or%orations or
$ommercial an#s
1enture $a%ital
assistance
Asset securitiesation
International financing
li#e +uro issues, Foreign
currency loans.
Financial $or%orations or
$ommercial ban#s lease .
*ire ' %urchase financing
+xternal $ommercial
orro(ings
International financing li#e
+uro'issues, Foreign
$urrency bonds
Advances received from
customers.
&hort Term unsecured
loans from
Q.0. 1)at ae t)e *aious bases on w)ic) financial souces of a business be classified!
The financial sources of a business can be categorised based on :
(a) "ime $eiod 2 Long Tern0 &ources, !edium Tern0 &ources and &hort Tern0 &ources as in /
above.
+b, Ownes)i# 2
2(ners $a%ital '+)uity $a%ital, ,etained +arnings etc.
orro(ed $a%ital '-ebentures, Loans etc.
+c, Souces of 3eneation 2
Internal &ources ',etained +arnings, &in#ing Funds, -e%reciation +arnings etc.
+xternal &ources '-ebentures, Fresh issue of $a%ital etc.
Q.4. 1ite s)ot notes on E5uity Ca#ital as a souce of lon( tem finance.
A##licability 2 $om%anies registered under the Indian $om%anies Act, 0345, can raise finance by
(ay of +)uity $a%ital, sub6ect to the regulations laid do(n in the $om%anies Act, &+I 7uidelines and
related la(s.
Featues2 The features of e)uity ca%ital are :
(a) Ris62 The shares are to be %aid off only u%on li)uidation. &o ris# is the least.
(b) Cost2 +)uity &hareholders are entitled to residual income, i.e. Profit after tax and their
ex%ectations are high. Therefore, the cost of e)uity ca%ital is high.
(c) Contol2 +)uity &hareholders are the o(ners of the $om%any and have control over the
management of the $om%any.
Ad*anta(es 2
2rdinary share ca%ital also %rovides a security 8e)uity base9 to other su%%liers of funds. &o, a
$om%any (ith a high %aid'u% e)uity ca%ital can raise further funds from other sources easily.
It is a %ermanent source of finance. It is to be re%aid only in the event of li)uidation.
There are no committed %ayments to holders of e)uity shares. -ividends are discretionary and is
not mandatory li#e interest on debentures etc.
Q.7. 1ite s)ot notes on $efeence S)ae Ca#ital as a souce of lon( tem finance.
-eanin(2 These are a s%ecial #ind of shares (here the shareholders en6oy %riority or %reference over
e)uity shareholders, as regards:
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Dharmendra Gupta Classes(DGC) Source of Finance.13.3
8a9 Payment of dividend at a fixed rate: and
8b9 ,e%ayment of $a%ital on the (inding u% of the com%any
Featues 2
Cumulati*e O#tion2 Preference shares may be issued as cumulative, i.e., the dividend %ayable in
a year of loss, gets carried over to subse)uent years till there are ade)uate %rofits to %ay the
accumulated dividends. ;on'cumulative %reference shares may also be issued.
Redeemability and Con*etibility2 7enerally, %reference shares carry a sti%ulation of re%ayment
at the end of a time %eriod., &ometimes, they may carry the o%tion of conversion into e)uity share
ca%ital also.
$efeence 8i*idend2 The rate of dividend on %reference shares is normally higher than the rate
of interest on debentures, loans etc. This is an a%%ro%riation of %rofits and not a charge against
%rofits.
Hybid Fom of financin(2 Preference $a%ital has features of both debt and e)uity. It can be
com%ared (ith debt since the rate of dividend is fixed and the ca%ital is re%ayable at the end of a
%eriod. It can also be li#ened to e)uity because dividend is not tax'deductible.
Ad*anta(es 2
There is no dilution of +P& on the enlarged ca%ital base. Issue of further e)uity ca%ital (ill reduce
the +P& and affect mar#et %erce%tion about the com%any'
There is leveraging advantage as it bears a fixed charge.
There is no ris# of ta#eover or loss of control.
Preference ca%ital can be redeemed after a s%ecified %eriod.
Q.9. How can a Com#any effecti*ely use Retained Eanin(s as a souce of finance !
8a9 It is a general %ractice of $om%anies to accumulate %rofits and %lough them bac# into business.
&uch accumulated %rofits are called ,etained +arnings. They belong to the e)uity shareholders
and increase the ;et "orth of the com%any.
8b9 +nter%rises must hold bac# or retain a reasonable amount of %rofit every year for their ex%ansion
%lans, and other legal re)uirements in this regard.
8c9 ,etained +arnings entail almost no ris#. There is no dilution of control in retaining %rofits.
8d9 +xisting %rofit ma#ing com%anies that underta#e an ex%ansion . diversification %rogramme should
invest a %art of their accumulated reserves or cash %rofits for creation of ca%ital assets. In other
(ords, the sur%lus generated from o%erations, after meeting all the contractual, statutory and
(or#ing re)uirements of funds, is available for further ca%ital ex%enditure.
Q.:. 1ite s)ot notes on 8ebentues and 'onds as a souce of lon( tem finance.
Featues2
809 Public Limited $om%anies raise funds from %ublic by issuing <debentures or bonds. They are
issued on the basis of a debenture trust deed that lays do(n the terms and conditions of issue.
8=9 -ebentures are normally secured against the assets of the com%any.
8/9 Interest ,ate on debentures is lo( (hen com%ared to rate of %reference dividend or $ost of +)uity
$a%ital.
8>9 -ebentures are issued (ith ne( inventive schemes li#e (arrants, o%tions, convertibility etc.
849 The %ublic issue of debentures is made sub6ect to &+I guidelines.
859 $redit ,ating is com%ulsory for %ublic issue of debentures or %rivate %lacement to mutual funds.
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Dharmendra Gupta Classes(DGC) Source of Finance.13.4
The rating is based on trac# record, %rofitability, debt servicing ca%acity, credit (orthiness and the
ris# of lending.
Ad*anta(es of debentues 2
809 $ost of -ebt $a%ital is lo(er (hen com%ared to e)uity or %reference ca%ital. Thus 7earing is:
advantageous.
8=9 -ebenture financing does not result in dilution of control.
8/9 In a %eriod of rising %rices, debenture issue is advantageous. The fixed monetary outgo decrcases
in real terms as the %rice level increases.
8isad*anta(es of debentue financin( ae2
809 -ebenture interest and ca%ital re%ayment are obligatory %ayments.
8=9 There may be restrictive covenants in a -ebenture Trust -eed.
8/9 -ebenture financing enhances the financial ris# associated (ith the firm.
Q.;. 1ite s)ot notes on /on( "em /oans fom Financial Institutions and Commecial 'an6s.
Institutions2 &%ecialised Financial Institutions and $ommercial an#s %rovide long term financial
assistance to industry. &ome of these institutions are: the Industrial $redit and Investment $or%oration
of India 8I$I$I9, the Industrial Finance $or%oration of India 8IF$I9, the &tate Financial $or%orations
8&F$9, the Life Insurance $or%oration of India 8LI$9, the ;ational &mall Industries $or%oration Limited
8;&I$9.
$o<ect Analysis2 The enter%rise or a%%licant has to satisfy the lending institution as regards
feasibility of the %ro6ect in the follo(ing as%ects: 8a9 Technical, 8b9 $ommercial, 8c9 +conomic, 8d9
Financial and 8e9 !anagerial.
/oan "ems2 The rates of interest charged by the institutions differ under various schemes. The loans
are to be re%aid according to a sti%ulated re%ayment schedule. The loans are fully secured.
Q.1=. 1)at do you mean by 'id(e Finance !
-eanin(2 ridge Finance refers to loans ta#en by a com%any normally from commercial ban#s for a
<short %eriod, %ending disbursement of loans sanctioned by financial institutions. <
Sanction 2
"hen a %romoter or an enter%rise a%%roaches a financial institution for a long'term loan, there
may be some time delays in %ro6ect evaluation, administrative and %rocedural %a%er(or# and final
sanction.
&ince the %ro6ect commencement cannot be delayed, the %romoter may start his activities after
receiving <in'%rinci%le< a%%roval from the term lending institution.
To meet his tem%orary fund re)uirements for starting the %ro6ect, the %romoter may arrange short
term loans from commercial ban#s or from the term lending institution itself.
&uch tem%orary finance, %ending sanction of the long term loan, is called as <ridge Finance<.
"ems 2
Interest: The rate of interest on bridge finance is higher (hen com%ared to interest on term loans.
,e%ayment: These are re%aid or ad6usted out of the term loans as and (hen disbursed by the
concerned institutions.
&ecurity : These are secured by hy%othecating movable assets, %ersonal guarantees and
%romissory notes.
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Q.11. 1ite S)ot Notes on >entue Ca#ital Financin(. ?No*.&==&@
-eanin(2 1enture $a%ital Financing refers to financing of high ris# ventures %romoted by ne(,
)ualified entre%reneurs (ho re)uire funds to give sha%e to their ideas. *ere, a financier 8called
1enture $a%italist9 invests in the e)uity or debt of an +nter%reneur 8Promoter . 1enture $a%ital
?nderta#ing9 (ho has a %otentially successful business idea, but does not have the desired trac#
record or financial bac#ing.
7enerally, venture ca%ital funding is associated (ith heavy initial investment businesses li#e
energy conservation, )uality u% gradation or (ith sunrise sectors li#e information technology.
1enture $a%ital $om%any 1enture $a%ital Assistance 1enture $a%ital ?nderta#ing
In*esto $omote A Ente#eneu
-et)ods of *entue ca#ital financin( 2
8i9 E5uity financin(2 The 1enture $a%ital ?nderta#ings generally re)uire funds for a longer
%eriod but may not be able to %rovide returns to the investors during initial stages. *ence,
e)uity share ca%ital financing is advantageous. The investor@s contribution does not exceed >3
A of the total e)uity ca%ital of the underta#ing. *ence, the effective control and o(nershi%
remains (ith the entre%reneur.
8ii9 Conditional loan 2 A conditional loan is re%ayable in the form of a royalty after the venture is
able to generate sales. ;o interest is %aid on such loans. The rate of royalty may range
bet(een =A and 04A based on factors li#e gestation %eriod, cash flo( %atterns, extent of ris#,
etc. &ometimes, the entre%reneur has a choice of %aying a high rate of interest 8say =BA9
instead of royalty on sales once the activity becomes commercially sound.
8iii9 Income note2 It is a hybrid ty%e of finance, (hich combines the features of both conventional
loan and conditional loan. The entre%reneur has to %ay both interest and royalty on sales but at
substantially lo( rates.
8iv9 $atici#atin( debentues2 Interest on such debentures is %ayable at three different rates
based on the %hase of o%erations as under :
8a9 &tart u% %hase ';IL Interest
8b9 ;ext stage 'Lo( rate of interest
8c9 After a %articular level of o%erations '*igh rate of interest.
Q.1&. 1)at do you undestand by 8ebt Secuitisation !
-eanin(2 It is a mode of financing (herein securities are issued on the basis of a %ac#age of assets
8called Asset Pool9. In this method of recycling funds, assets generating steady cash flo(s are
%ac#aged together and against this asset %ool, mar#et securities can be issued.
$ocess2 The debt securitisation %rocess has the follo(ing functions . activities :
8i9 The 2rigination Function: A borro(er see#s a loan from a lending institution 8finance com%any
or ban#9. The credit (orthiness of the borro(er is evaluated and the loan is sanctioned. A
contract is signed bet(een the %arties, (ith re%ayment schedule s%read over the life of the
loan. The lender is called the 2riginator, to (hom the loan constitutes an asset 8receivable9.
8ii9 The Pooling Function: The 2riginator 8Lender9 clubs together similar loans or receivables, to
create an underlying %ool of assets. This %ool is transferred in favour of a &P1 8&%ecial
Pur%ose 1ehicle9, (hich acts as a trustee for the investor. 2nce the assets are transferred, they
are held in the 2riginators@ %ortfolios.
8iii9 The &ecuritisation Function: ;o(, the &P1 issues securities on the basis of the asset %ool. The
securities carry a cou%on and an ex%ected maturity, (hich can be asset based or mortgage
based. These are generally sold to investors through merchant ban#ers.
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Featues 2
8a9 7enerally institutional investors li#e mutual funds 8not individuals9 are interested in -ebt
&ecuritisation.
8b9 The 2riginator usually #ee%s the s%read available 8i.e.difference9 bet(een yield from secured
assets 8interest received from borro(er9 and interest %aid to investors 8of securities9. This
constitutes originator@s income.
8c9 The securitisation %rocess is generally (ithout recourse i.e. the investor bears the credit ris# or
ris# of default and the issuer is under an obligation to %ay to investors only if the cash flo(s are
received by him from the asset %ool.
8d9 The 2riginator ho(ever, has a right to legal recourse against the borro(er in the event of default.
8e9 The ris# run by the investor can be further reduced through credit enhancement facilities li#e
insurance, letters of credit and guarantees.
8f9 In a sim%le <%ass through structure<, the investor o(ns a %ro%ortionate share of the asset %ool and
the cash flo(s (hen generated are %assed on directly to the investor. This is .done by issuing
<%ass through certificates<.
8g9 In mortgage or asset bac#ed bonds, the investor has a lien on the underlying asset %ool. The &P1
accumulates collections from borro(ers from time to time and ma#es %ayments to investors at
regular %redetermined intervals. The &P1 can invest the funds received in short term instruments
and im%rove yield (hen there is time lag bet(een recei%t and %ayment.
'enefits 2
"o t)e Oi(inato 2
The assets are shifted off the balance sheet, thus giving the originator recourse to off balance
sheet funding. <
It converts illi)uid assets to li)uid %ortfolio.
It facilitates better balance sheet management as assets are transferred off balance sheet
facilitating satisfaction of ca%ital ade)uacy norms.
The originator@s credit rating enhances.
"o t)e In*esto 2
&ecurities are tied u% to definite assets 8asset %ool9.
;e( investment avenues are o%ened u%.
8ia(ammatic Re#esentation2
/oans ta6en2
'
O
R
R
O
1
E
R
Loan ta#en:
$onsumer
Loan
1ehicle Loan
*ousing Loan
,e%ays +!I@s
Financing
Institution
OR3ANISA"OR
+!I@s C Assets
,eceivable C
Assets $ool
Trustee for
2riginator
&%ecial
%ur%ose
1ehicle +S$>,
Asset Pool
hy%othecated
. transferred
Issues
bonds or
debentur
es
&ecurity
C Assets
Pool
IN>ES"ORS
!utual Funds
LI$ and other
Institutions
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Dharmendra Gupta Classes(DGC) Source of Finance.13.
Q.1.. 'in( out t)e ole of /ease Financin(.
-eanin(2 Leasing is a contract (here one %arty 8o(ner . Lessor . Leasing $om%any9 %urchases the
assets and %ermits its use by another %arty 8Lessee9 over a s%ecified %eriod of time. Thus, leasing is
an alternative to the %urchase of an asset out of o(n or borro(ed funds.
Consideation2 The Lessee %ays a s%ecified rent at %eriodical intervals as consideration for the use
of the asset. The Lessee claims Lease ,ental $harges as his revenue ex%enses. The Lessor is
entitled to claim de%reciation as he is the o(ner of the asset.
Ad*anta(es to /essee 2
Immediate $ash 2utflo( i.e. investment in $a%ital Asset is eliminated.
Lease ,entals are tax deductible ex%enses.
$.10. riefly describe Trade $redit and Advances as sources of &hort Term finance.
"RA8E CRE8I" 2
Featues 2
It re%resents credit granted by su%%liers of goods, in the normal course of business.
The duration of such trade credit is based on various factors including %revailing %ractices, and is
usually bet(een 04 to 3B days.
It is common to a0most all business o%erations.
It can be in the form of an @o%en account@ or bills %ayable.
Ad*anta(es 2
There is no ex%licit cost associated (ith $redit Period availed.
It is available and #ee%s on rotating as long as the business is a going concern.
It enhances automatically (ith the increase in the volume of business.
A8>ANCES FRO- CUS"O-ERS 2
In certain areas of activity, it is usual business %ractice to obtain advance money from customers. This
is a%%licable (hen the goods are costly or (hen considerable time %eriod is involved. For exam%le,
$onstruction of a bridge . building
!anufacture of a s%ecialised e)ui%ment involving heavy cost based on customer@s re)uirements
This is a cost free source of finance and hence substantially useful.
Q.14. 1)at ae *aious foms in w)ic) s)otB tem finance can be obtained fom 'an6s !
3eneal Featues 2
8a9 an# advances are in the form of loan, overdraft, cash credit and bills %urchased.discounted etc.
8b9 The terms, conditions and norms for lending are based on the general %olicy laid do(n by the ,I
and also by the schemes of the concerned an#.
8c9 Advances are granted against securities (hich can be classified as:
$imay Secuity 2 *y%othecation of stoc#s, boo# debts, e)uitable mortgage of fixed assets,
Pro'notes etc.
Collateal Secuity 2 +)uitable mortgage of Land, uildings or other %ro%erty belonging to the
enter%rise or its %romoters.
3uaantees2 Personal 7uarantees of the concerned %romoters, %artners or -irectors
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+1, /oans2
8a9 It is a single advance, (herein the entire amount of loan is disbursed at one time by transfer to
the current account of the borro(er.
8b9 Interest and other charges li#e ins%ection, insurance, %rocessing charges etc. are charged to
this account.
8c9 ,e%ayment of instalments by the borro(er as %er the agreed schedule is credited to this
account.
8d9 Loan accounts are not running accounts li#e overdraft and cash credit accounts.
+&, O*edaft2
8a9 ?nder this facility, a fixed limit is granted (ithin (hich the borro(er is allo(ed to overdra( from
his account.
8b9 Technically, overdrafts are re%ayable on demand, but they generally continue for longer
%eriods by annual rene(al of limits.
8c9 The borro(er can use and dra( u%to the extent of limit sanctioned, according to his
re)uirements. Interest is charged on daily balances.
8d9 These accounts are o%erative li#e cash credit and current accounts and hence che)ue boo#s
are %rovided.
+., Clean O*edafts 2
8a9 A $lean 2verdraft refers to an advance by (ay of overdraft facility, but not bac#ed by any
tangible security.
8b9 *ence, re)uest for clean advances are entertained only from %arties, (hich are financially
sound and re%uted for their integrity. The an# has to rely u%on the %ersonal security of the
borro(ers.
8a9 &ome factory to be considered by the an# before granting clean 2-@s are 8a9 Past o%erations
of the %arty 8b9 Turnover in the account 8c9 &atisfactory dealings for considerable %eriod and
8d9 ,e%utation in the mar#et
8b9 As a safeguard, ban#s ta#e guarantees from other %ersons (ho are credit. "orthy before
granting this facility.
8c9 A clean advance is generally granted for a short %eriod and must not be continued for long.
+0, Cas) Cedits 2
8a9 It is an arrangement under (hich a customer is allo(ed an advance u% to certain limit against
credit granted by ban#.
8b9 The customer need not borro( the entire amount of advance at one time: he can only dra( to
the extent of his re)uirements and de%osit sur%lus funds in his account.
8c9 Interest is charged only on the amount actually availed of by the customer and not on the full
amount.
8d9 7enerally cash credit limit are sanctioned against %ledge or hy%othecation of goods.
8e9 Technically, $ash $redit Advances are re%ayable on demand, but these are continued and
also enhanced from time'to'time by the borro(er and the ban# as %art of (or#ing ca%ital
financing.
+4, Ad*ances a(ainst (oods2
8a9 ?nder this arrangement, a an# grants advance as a %ercentage of value of goods offered as
security.
8b9 The term @goods@ includes all forms of movables (hich are offered to the ban# as security.
They may be agricultural commodities or industrial ra( materials or %artly finished goods.
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Floor Laxmi Chamber, Laxmi Nagar Delhi 92 Mo. 9810521310, 9968760918
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8c9 "hen goods are %rovided as security, they %rovide a reliable source of re%ayment. Advances
against them are safe and li)uid. Also, there is a )uic# turnover in goods, as they are in
constant demand.
8d9 7enerally goods are charged to the ban# either by (ay of %ledge or by (ay of hy%othecation.
8e9 For the %ur%ose of calculation of dra(ing limits, valuation of the goods is made from time to
time. The ban# also ta#es %eriodical statements of stoc#s from the borro(er.
+7, 'ills $uc)ased A 8iscounted 2
8a9 These advances are allo(ed against the security of bills, (hich may be clean or documentary.
8b9 This arrangement o%erates as under :
orro(er 8manufacturer9 su%%lies goods to his customers and raises su%%ly bills 8invoices9
on them, falling due for %ayment on a future date.
The ban# discounts su%%ly bills 8invoices9 by %aying the amount of the bill after deducting
its margin and discounting charges. For exam%le, for a bill of ,s.0BBB, the ban# may
advance ,s.DEB 8,s.lBBB less 0BA margin ,s.lBB less discounting charges ,s./B9.
?%on collection of amount due from the customer, the ban# ta#es the full amount of the bill
and credits the balance amount earlier (ithheld as margin. In the above case, the ban#
may credit ,s.3=.' 8,s. 0BB margin less $harges ,s.D9.
The difference bet(een the amounts collected 8,s.0BBB9 and the amounts credited
8,s.DEB F ,s.3=9 re%resents earnings of the ban#ers for the %eriod. This item of income is
called @discount@.
8c9 Although the term @bills %urchased@ gives the im%ression that the ban# becomes the o(ner or
%urchaser of such bills, in actual %ractice the ban# holds bills only as security for advance. The
borro(er is ultimately liable on the advance, in case of default by the customer. The ban#, in
addition to the rights against the %arties liable, can also exercise a %ledgee@s rights over goods
covered by the documents.
8d9 &ometimes, overdraft or cash credit limits may also be allo(ed against the security of bills,
after maintaining a suitable margin. *ere the bill is not a %rimary security but only a c:
collateral security. The ban#er in the case, does not become a %arty to the bill, but merely iG
collects it as an agent for its customer.
+9, Ad*ance a(ainst documents of title to (oods 2
8a9 A document becomes a document of title to goods (hen its %ossession is recognised by la(
or business custom as %ossession of the goods.
8b9 +xam%les of documents of title to goods are bill of lading, (arehouse #ee%er@s certificate, <
rail(ay recei%t, etc.
8c9 A %erson in %ossession of a document to goods can enable another %erson to ta#e delivery of
the goods in his right, by endorsement or delivery 8or both9 of the document.
8d9 An advance against the %ledge of such documents is e)uivalent to an advance against the
%ledge of goods themselves.
+:, Ad*ance a(ainst su##ly of bills 2
8a9 an#s may also %rovide advances against bills raised on government or semi'government
de%artments. &ome ty%es of bills are :
ills for su%%ly of goods against firm orders after acce%tance of tender.
ills from contractors for (or# executed either (holly or %artially under firm contracts
8b9 7enerally, these bills are accom%anied by ins%ection notes from re%resentatives of
government agencies for having ins%ected the goods before they are des%atched. If bills are
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(ithout the ins%ection re%ort, ban#s examine them (ith the acce%ted tender or contract to
verify that the goods su%%lied under the bills strictly conform to the terms and conditions.
8c9 These bills re%resent a debt in favour of su%%liers.contractors, due from the 7overnment
Agency. This debt is assigned to the ban# by endorsement of su%%ly bills and executing a
irrevocable %o(er of attorney in favour of the ban#s for receiving the amount due from the
7overnment de%artments. The %o(er of attorney has to be registered (ith the 7overnment
de%artment concerned.
8d9 The ban#s also ta#e a se%arate letter from the su%%liers.contractors instructing the
government body to %ay the amount of bills direct to the ban#.
8e9 &u%%ly bills do not en6oy the legal status of negotiable instruments because they are not , bills
of exchange. The security available to a ban#er is by (ay of assignment of debts re%resented
by the su%%ly bills.
+;, "em /oans by ban6s 2
8a9 $ommercial an#s grant tem0loans for small %ro6ects falling under %riority sector, small scale
sector etc.
8b9 Term Loans are granted after careful %ro6ect analysis and evaluation of credit (orthiness of the
borro(er.
8c9 The loans shall be re%ayable over a %eriod of time in monthly . )uarterly . half'yearly or yearly
instalments.
8d9 The loan %eriod is detem0ined on a case'to'case basis, nom0ally / to E years and some times
even more.
8e9 The loans are granted on the security of fixed assets and other suitable collateral securities.
Q.17. 1ite s)ot notes on #eBs)i#ment finance fo e%#ot i.e $ac6in( Cedit Facility.
-eanin(2 Pac#ing $redit is an advance extended by ban#s to an ex%orter for the %ur%ose of buying,
manufacturing, %rocessing, %ac#ing, shi%%ing goods to overseas buyers.
A##licability2
8a9 If an ex%orter has a firm ex%ort order %laced (ith him by his foreign customer 8buyer9 or an
irrevocable Letter of $redit o%ened in his favour, he can a%%roach a an# for Pac#ing $redit
Facility.
8b9 The letter of credit and firm sale contracts serve as evidence of a definite arrangement for
realisation of the ex%ort %roceeds and also indicate the amount of finance re)uired by the
ex%orter. Pac#ing credit, in the case of customers of long standing, may also be granted against
firm contracts entered into by them (ith overseas buyers.
8c9 An advance so ta#en by an ex%orter is re)uired to be li)uidated (ithin 0DB days from the date of
its commencement by negotiation of ex%ort bills or recei%t of ex%ort %roceeds in an a%%roved
manner. Thus %ac#ing credit is essentially a short'term advance.
"y#es of $ac6in( Cedit 2
+1, Clean $ac6in( Cedit 2
This facility is extended only on %roduction of a firm ex%ort order or a letter of credit.
There is no charge or control over ra( material or finished goods that constitute the su%%ly.
The an# ta#es into consideration trade re)uirements, credit (orthiness of ex%orter and its
margin.
+x%ort $redit 7uarantee $or%oration 8+$7$9 insurance cover should be obtained by the ban#
+&, $ac6in( cedit a(ainst )y#ot)ecation o (oods2
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This facility is extended on %roduction of a firm ex%ort order or a letter of credit.
The goods (hich constitute the su%%ly are hy%othecated to the an# as security, (ith sti%ulated
margin.
The goods shall be ex%orted by the borro(er. The an# does not have any effective %ossession of
the same.
The ex%orter has to submit stoc# statements at the time of sanction and also %eriodically and for
(henever there is any movement in stoc#s.
+., $ac6in( cedit a(ainst #led(e of (oods 2
This facility is extended on %roduction of a firm ex%ort order or a letter of credit.
The goods (hich constitute the su%%ly are %ledged to the an# as security, (ith the sti%ulated
margin.
The goods shall be handed over to a%%roved clearing agents (ho shi% the same from time to time
as re)uired by the ex%orter.
The effective %ossession of the goods so %ledged lies (ith the ban# and are #e%t under its loc#
and #ey.
Fomalities and Re5uiements 2
8a9 EC3C 3uaantee2 +x%ort $redit 7uarantee $or%oration 8+$7$9 guarantees the recovery of
advance granted to an ex%orter, against %ayment of insurance %remium. The ban# arranges for
this insurance cover by recovering the same from the ex%orter 8borro(er@s9 account.
8b9 Fowad e%c)an(e contact2 If the ex%ort bill is dra(n in a foreign currency, the ex%orter should
enter into a for(ard exchange contract (ith the ban#, thereby avoiding ris# involved in fluctuations
of exchange rates.
8c9 8ocuments e5uied2 The follo(ing documentary formalities should be com%lied (ith:
8i9 Promissory ;ote in an#@s favour : Hoint and several demand %ro'note signed on behalf of the
firm . $om%any as (ell as by the %artners . -irectors individually.
8ii9 Letter of continuity 8signed on behalf of the firm and %artners individually9.
8iii9 Letter of %ledge to secure demand cash credit against goods 8in case of %ledge9 or
Agreement of *y%othecation to secure demand cash credit 8in case of hy%othecation9.
8iv9 Letter of Authority to o%erate the account.
8v9 -eclaration of Partnershi% . &ole Pro%rietorshi% . ,esolution from the $om%any.
8vi9 Agreement to utilise the monies dra(n in terms of contract.
8vii9 Letter of 7uarantee by %artners . -irectors in their 6oint and several %ersonal ca%acities.
8viii9 Letter of hy%othecation 8in case of bills9.
8ix9 Firm +x%ort 2rder . &ale $ontract and Irrevocable Letter of $redit.
Q.19. 1)at ae t)e *aious modes in w)ic) $ostBS)i#ment Finance can be (i*en fo e%#ot
tade!
Post'shi%ment finance, i.e. after shi%ment of goods, can be in the follo(ing forms :
+1, $uc)aseA discountin( of documentay e%#ot bills 2
8a9 Hust li#e discounting . %urchasing of local su%%ly bills, an#s %rovide finance to ex%orters by
%urchasing ex%ort bills dra(n %ayable at sight or by discounting usance ex%ort bills.
8b9 &uch bills should be based on confirmed sales orders and su%%orted by documentary evidence
for actual ex%ort li#e %ac#ing list, bill of lading, %ost %arcel recei%ts, or air consignment notes.
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8c9 The documents to be obtained in this regard are :
Letter of hy%othecation covering the goods, and
7eneral guarantee of directors or %artners of the firm as the case may be.
+$7$ 7uarantee against ris#s by ta#ing a contract shi%ment 8com%rehensive ris#s9 %olicy
covering both %olitical and commercial ris#s. +$7$@s liability is restricted to the credit limit
fixed for the individual ex%orter irres%ective of the amount of the %olicy.
+&, Ad*ance a(ainst e%#ot bills sent fo collection 2
8a9 an#s also %rovide advance to ex%orters against ex%ort bills for(arded through them for
collection.
8b9 The evaluation factors include the credit(orthiness of the %arty, nature of goods ex%orted,
usance, standing of dra(ee, marginetc.
8c9 The documents to be obtained are: 8i9 -emand %romissory note: 8ii9 Letter of continuity: 8iii9
Letter of hy%othecation covering bills: 8iv9 7eneral 7uarantee of directors or %artners.
+., Ad*ance a(ainst duty daw bac6C cas) subsidyC etc.C
8a9 an#s also %rovide advance against duty dra('bac#, cash subsidy, etc., receivable by ex%orters
against ex%ort %erformance. &uch advances are of clean nature hence necessary %recaution
should be exercised.
8b9 It is insisted that the ex%ort bills are either negotiated or for(arded for collection through the
an#, so that the an# is in a %osition to verify the ex%orter@s claims for duty dra(' bac#s, cash
subsidy, etc.
8c9 An advance so availed of by an ex%orter should be settled (ithin 0DB days from the date of
shi%ment of the relative goods.
8d9 The documents to be obtained are: 8i9 -emand %romissory note: 8ii9 Letter of continuity: 8iii9
7eneral 7uarantee of directors of %artners: 8iv9 ?nderta#ing from the borro(ers that they (ill
de%osit the che)ues . ,%ayments received from the a%%ro%riate authorities. Immediately (ith the
ban# and not use them m any other manner.
Q.1:. /ist out t)e facilities e%tended by 'an6s to e%#otesC in addition to #e and #ost
s)i#ment finance.D
8i9 /ettes of Cedit2 2n behalf of a%%roved ex%orters, ban#s establish letters of credit on their
overseas or u% country su%%liers.
8ii9 3uaantees2 7uarantees for (aiver of excise duty, due %erformance of contracts, bond in lieu
of cash security de%osit, guarantees for advance %ayments etc., are also issued by ban#s to
a%%roved clients.
8iii9 8efeed $ayment Finance2 an#s %rovide finance to a%%roved clients underta#ing ex%orts on
deferred %ayment terms.
8iv9 Cedit Re#ots2 an#s also try to secure for their ex%orter'customers, status re%orts of their
buyers and trade information on various commodities through their corres%ondents.
8v9 3eneal Infomation2 an#s also %rovide economic intelligence on various countries to their
ex%orter clients.
Q.1;. 1ite S)ot notes on IC8EsC C8Es and $ublic 8e#osits.
+1, Inte co#oate de#osits 2 +IC8Es,
8a9 $om%anies can borro( funds for a short %eriod, for exam%le 5 months or less, from other
com%anies (hich have sur%lus li)uidity.
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8b9 &uch de%osits made by one com%any in another are called Inter'$or%orate -e%osits 8I$-@s 9.
8c9 The rate of interest on inter cor%orate de%osits varies de%ending u%on the amount involved
and time %eriod.
+&, Cetificate of 8e#osit +C8, 2
8a9 The certificate of de%osit is a document of title similar to a fixed de%osit recei%t 8F-,9 issued
by a ban#.
8b9 There is no %rescribed interest rate on such $-@s. It is based on the %revailing mar#et
conditions.
8c9 The main advantage of a $- is that the ban#er is not re)uired to encash the de%osit before
maturity %eriod. ut the investor is assured of li)uidity because he can sell the $- in
secondary mar#et.
+., $ublic de#osits 2
8a9 Public de%osits are a very im%ortant source for short'term and medium term finance.
8b9 A $om%any can acce%t %ublic de%osits from members of the %ublic /:nd shareholders,
sub6ect to the sti%ulations of ,I from time to time.
8c9 The maximum amount that can be raised by (ay of Public -e%osits is /4A of its %aid u%
ca%ital and reserves.
8d9 The maturity %eriod of these de%osits may be for a %eriod of six months to three years.
8e9 These de%osits are unsecured loans and are used for (or#ing ca%ital re)uirements. They
should not be used for ac)uiring fixed assets since they are to be re%aid (ithin a %eriod of /
years.
Q.&=. 1)at do you undestand by Seed Ca#ital Assistance !
8a9 A##licability 2 The &eed $a%ital Assistance &cheme is designed by the I-I for %rofessionally or
technically )ualified entre%reneurs and . or %ersons %ossessing relevant ex%erience, s#ills and
entre%reneurial traits. All the %ro6ects eligible for financial assistance from I-I directly or indirectly
through refinance are eligible under the scheme.
8b9 Amount of Finance2 The %ro6ect cost should not exceed ,s.= crores. The maximum assistance
under the scheme (ill be 8a9 4BA of the re)uired %romoter@s contribution or 8b9 ,s.04 lacs,
(hichever is lo(er.
8c9 Inteest and C)a(es2 The assistance is initially interest free but carries a service charge of 0A
%er annum for the first five years and at increasing rate thereafter. "hen the financial %osition and
%rofitability is favourable, I-I may charge interest at a suitable rate even during the currency of
the loan.
8d9 Re#ayment2 The re%ayment schedule is fixed de%ending u%on the re%aying ca%acity of the unit
(ith an initial moratorium of u%to five years.
8e9 Ot)e A(encies2 For %ro6ects (ith a %ro6ect cost exceeding ,s.= crores, seed ca%ital may be
obtained from the ,is# $a%ital and Technology cor%oration Ltd. 8,$T$9. For small %ro6ects costing
u%to ,s.4 la#hs, assistance under the ;ational +)uity Fund of the &illI may be availed.
Q.&1. In t)e conte%t of lon( tem financin(C unsecued loans ae ele*ant. 8iscuss.
8a9 ?nsecured Loans constitute a significant %art of long term finance available to an enter%rise.
8b9 These loans come to the rescue of the enter%rise, in case the financial institution does not
sanction the re)uired funds in full. For exam%le, if a term loan of ,s.4B la#hs is a%%lied for, but
only ,s.>B la#hs is sanctioned, the balance of ,s. 0B la#hs may be raised as unsecured loans.
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8c9 Thus, unsecured loans are ty%ically %rovided by %romoters to meet the %romoters contribution
norm. ?nsecured loans are considered as %art of the e)uity for the %ur%ose of calculating debt
e)uity ratio.
8d9 These loans are subordinate to institutional loans. *ence,
,ate of interest on these loans should be less than or e)ual to the rate of interest on
institutional loans.
Interest can be %aid only after %ayment of institutional dues.
,e%ayment of unsecured loans is %ossible only (ith the %rior a%%roval of the financial
institutions.
Q.&&. 1)at do you undestand by 8efeed $ayment 3uaantee in case of fi%ed assets !
8a9 &u%%liers of machinery may %rovide deferred credit facility under (hich %ayment for the %urchase
of machinery can be made over a %eriod of time.
8b9 &ometimes, an initial do(n %ayment is made and the balance %aid in suitable instalments. In
some other cases, the entire cost of the machinery is financed and the com%any is not re)uired to
contribute any amount initially to(ards ac)uisition of the machinery. :
8c9 ;ormally, the su%%lier of machinery insists that ban# guarantee should be furnished by the buyer.
8d9 -eferred Payment 7uarantee does not have a moratorium %eriod for re%ayment. *ence, it is
advisable only for an existing %rofit ma#ing com%any.
Q.&.. 'in( out t)e ole of Subsidy A Ca#ital Incenti*e as a souce of financin(.
(a) "y#es of Incenti*es 2 In order to %romote balanced regional and economic develo%ment, s%ecial
incentives are %rovided to units set u% in bac#(ard areas. &uch incentives may either be 8a9
lum%sum subsidy or 8b9 deferment of sales tax and octroi duty etc. The more bac#(ard the area,
higher (ill be the incentive.
(b) Conditions2 These incentives are sanctioned by the im%lementing agency as a %ercentage of the
fixed ca%ital investment sub6ect to an overall ceiling. It forms %art of the long'term means of
finance for the %ro6ect. These are sanctioned and released to the units only after they have
com%lied (ith the re)uirements of the relevant scheme. The re)uirements may be classified into
initial effective ste%s and final effective ste%s.
Initial Effecti*e Ste#s 2
Formation of the firm . com%any,
Ac)uisition of land in the bac#(ard area and
,egistration for manufacture of the %roducts
Final Effecti*e Ste#s2
2btaining relevant clearances from a%%ro%riate statutory bodies for setting u% of the unit,
$onversion of Letter of Intent to Industrial License,
Tie u% of the means of finance i.e. in'%rinci%le sanction of various finance %roviders,
Incurring aggregate ex%enditure greater than =4A of the %ro6ect cost and atleast 0BA of the fixed
assets should have been created or ac)uired at site.
(c) $o<ect >iability 2 The viability of the %ro6ect must not be de%endent on the )uantum and
availability of incentives. -uring %ro6ect a%%raisal, the im%act of s%ecial ca%ital incentives should
not be considered for analysing cash flo(s and %rofitability.
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(d) 'id(e Finance a(ainst Incenti*es2 The release of s%ecial ca%ital incentives by the concerned
&tate 7overnment generally ta#es one to t(o years. *encei bridge finance may be availed against
the $a%ital incentives. Further the bridge finance may not be fully available to the entire extent of
the subsidy. Therefore, the balance margin may have to be brought in by the %romoters from their
o(n resources.
Q.&0. 1)at do you mean by 8ee# 8iscount 'onds +88'Es, !
8a9 -ee% -iscount onds is a form of zero'interest bonds, (hich are sold at a discounted value 8i.e.
belo( %ar9 and on maturity, the face value is %aid to investors.
8b9 For exam%le, a bond of a face value of ,s.0 la#h may be issued for ,s.=EBB initially. The investor
%ays ,s.=EBB at first. *e realises the maturity value of ,s. 0 la#h at the end of the holding %eriod,
say =4 years.
8c9 &ometimes, the issuing com%any may give o%tions for redem%tion at %eriodical intervals say, after
4 years, 0B years, 04 years, =B years etc.
8d9 There is no interest %ayment during the loc# in %eriod.
8e9 These bonds can be traded in the mar#et. *ence, the investor can also sell the bonds in stoc#
mar#et and realise the difference bet(een initial investment and mar#et %rice.
Q.&4. 1ite a bief note on some new financial instuments.
In addition to -ee% -iscount onds and $ommercial Pa%ers, the follo(ing are the ne( financial
instruments.
+a, Secued $emium Notes +S$NEs, 2
&ecured Premium ;otes is issued along (ith a detachable (arrant and is redeemable after a
notified %eriod, say > to E years. There is an o%tion to convert the &P;@s into e)uity shares. The
conversion of detachable (arrant into e)uity shares (ill have to be done (ithin the time %eriod
notified by the com%any.
+b, Feo inteest fully con*etible debentues 2
These are fully convertible debentures, (hich do not carry any interest.
The debentures are com%ulsorily and automatically converted after a s%ecified %eriod of time and
its holders are entitled to ne( e)uity shares of the com%any at the %redetermined %rice.
The $om%any is benefited since no interest is to be %aid on it. The investor is benefited if the
mar#et %rice of the $om%any@s shares is very high since he tends to get e)uity shares of the
com%any at an agreed lo(er rate.
+c, Feo Cou#on 'onds 2
Iero $ou%on onds do not carry any interest. It is sold by the issuing com%any at a discount.
The difference bet(een the discounted value and maturing or face value re%resents the interest to be
earned by the investor on such bonds. It o%erates in the same manner as a --, but the loc#'in
%eriod is com%aratively lesser.
+d, 8ouble O#tion 'onds 2
These (ere first issued by the I-I. The face value of each bond is ,s.4,BBB. The bond
carries interest at 04A %er annum com%ounded half yearly from the date of allotment. The bond has a
maturity %eriod of 0B years. +ach bond has t(o %arts in the form of t(o se%arate certificates, one for
%rinci%al of ,s.4,BBB and other for interest 8including redem%tion %remium9 of ,s.05,4BB. oth these
certificates are listed on all ma6or, stoc# exchanges. The investor has the facility of elling either one
or both %arts at anytime he (ishes so.
+e, O#tion 'onds 2
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These are cumulative and non'cumulative bonds (here interest is %ayable on maturity or
%eriodically. ,edem%tion %remium is also offered to attract investors. These (ere issued by
institutions li#e I-I, I$I$I etc.
+f, Inflation 'onds 2
Inflation onds are bonds in (hich interest rate is ad6usted for inflation. Thus, the investor.gets
an interest free from the effects of inflation. For exam%le, if the interest rate is 00 %er cent and the
inflation is 4 %er cent, the investor (ill earn 05 %er cent meaning thereby that the investor is %rotected
against inflation.
+(, Floatin( Rate 'onds 2
In this ty%e of bond, the interest rate is not fixed and is allo(ed to float de%ending u%on the
mar#et conditions. This is an ideal instrument (hich can be resorted to by the issuing com%anies to
hedge themselves against the volatility in the interest rates. Financial institutions li#e I-I, I$I$I etc.
have raised funds from these bonds.
;e( financial instruments cro% u%, as institutions offer investors more advantages and
facilities in order to attract the vital resource viz., cash from the investors.
Q.&7. 1)at ae t)e ma<o souces of foei(n cuency funds !
The ma6or sources of foreign currency funds are :
(a) Commecial ban6s2 $ommercial an#s extend foreign currency loans for international
o%erations, 6ust li#e ru%ee loans 8domestic loans9. The ban#s also %rovide facilities for overdraft.
(b) 8e*elo#ment ban6s2 -evelo%ment ban#s offer long and medium term loans including foreign
currency loans. These are national level agencies and offer a number of concessions to foreign
com%anies to invest (ithin their country and to finance ex%orts from their countries, c.g. +JI!
an#.
(c) Intenational a(encies2 International agencies li#e the International Finance $or%oration 8IF$9,
The International an# for ,econstruction K -evelo%ment 8I,-9, The Asian -evelo%ment an#
8A-9, The International !onetary Fund 8I!F9 etc. %rovide indirect assistance for obtaining
foreign currency.
(d) Intenational Ca#ital -a6ets 2 &avings of individual investors can be effectively ta%%ed by issue
of &hares of debentures in the (orld mar#et and not 6ust in the local mar#et. International ca%ital
mar#ets in To#yo, London, Lusembourg, ;e( Lor# cater to the needs of !ulti ;ational
$or%orations and Transnatinal $or%orations to raise substantial sums from investors s%read
across the globes not 6ust in one country.
Q.&9. How can Foe(in Cuency to ta##ed fom t)e intenational ma6et!
In the International !ar#et, the availability of foreign currency is ensured in the follo(ing (ays:
8a9 +uro'currency mar#et
8b9 +x%ort $redit Facilities
8c9 onds Issues
8d9 Financial Instruments
Q.&:. 1ite s)ot notes on EuoBCuency -a6et.
The origin of the +uro'currency mar#et (as (ith the dollar denominated ban# de%osits K loans in
+uro%e %articularly in London. +uro'dollar de%osits are dollar denominated time de%osits available at
foreign branches of ?& ban# and at some foreign ban#s. an#s based in +uro%e acce%t dollar
denominated de%osits and ma#e dollar'denominated advances to the clients. This forms the
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bac#bone of the +uro'currency mar#et all over the globe. In this mar#et, funds are made available as
loans through syndicated euro'credit instruments.
Q.&;. /ist out a few financial Instuments in t)e intenational ma6et.
(a) Euo 'onds2 +uro bonds are debt instruments denominated in a currency issued outside the
country of that currency. For exam%le, a ,u%ee ond floated in France, a Len ond floated in
7ermany.
(b) Foei(n 'onds2 These are debt instruments denominated in a currency (hich is foreign to the
borro(er and is sold in the country of that currency. +xam%le A ritish firm %lacing -ollar
denominated bonds in ?&A.
(c) Fully Hed(ed 'onds2 In foreign bonds, the ris# of currency fluctuations exists. Fully hedged
bonds eliminate the ris# by selling the entire stream of %rinci%al and interest %ayments in for(ard
mar#ets.
(d) Floatin( Rate Notes2 These are issued u% to seven years maturity. Interest rates are ad6usted to
reflect the %revailing exchange rates. They %rovide chea%er money than foreign loans.
(e) Euo Commecial $a#es 2 +$P@s are short' term money mar#et instruments (ith a maturity
%eriod of less than one year. They are usually designated in ?& -ollars.
(f) Foei(n Cuency o#tion2 A Foreign $urrency 2%tion is the right to buy or sell, s%ot, future or
for(ard, a s%ecified foreign currency. It %i @vides a hedge against financial and economic ris#s.
(g) Foei(n Cuency Futues2 These are obhgations to buy or sell a s%ecified currency in the
%resent for settlement at a future date.
Q..=. 1)at do you undestand by Euo Issues ! E%#lain t)e o#eation of 38REsC A8REs etc.
In the Indian context, +uro Issue means that the issue is listed on a +uro%ean &toc# +xchange. The
subscri%tion can come from any %art of the (orld. exce%t India.
Finance can be raised by 7lobal -e%ository ,ecei%ts 87-,@s9 Foreign $urrency $onvertible onds
8F$$@s9 and %ure debt bonds. *o(ever 7-,@s and F$$@s are more %o%ular. 7-,@s do not carry
voting rights and hence there is not dilution of control.
3lobal 8e#ositoy Recei#ts 2 +38REs,
A -e%ository ,ecei%t 8-,9 is basically a negotiable certificate, denominated in ?& -ollars that
re%resents a non'?& com%any@s %ublicly traded local currency 8Indian ,u%ee9 +)uity share.
-,@s are created (hen the local currency shares of an Indian $om%any are delivered to the
de%ository@s local custodian ban#, against (hich the de%ository ban# issues -,@s in ?& -ollars.
These -,@s may be freely traded in the overseas mar#ets li#e any other dollar denominated
security through either a foreign stoc# exchange or through over the $ounter 82T$9 mar#et or
among a restricted grou%s li#e )ualified institutional buyers.
38R wit) 1aants2
These recei%ts are more attractive than %lain 7-,s in vie( of additional value of attached (arrants.
Ameican 8e#ositoy 8e#osit +A8REs, 2
-e%ository ,ecei%ts issued by a com%any in the ?&A are #no(n as A-,@s. &uch recei%ts have to be
issued in accordance (ith the %rovisions sti%ulated by the &ecurities +xchange $ommission 8&+$9 of
the ?&A (hich is a regulatory body li#e the &+I in India.
&ince the conditions laid do(n by &+$ are stringent, Indian com%anies have, chosen the
indirect route to ta% the vast American financial mar#et through %rivate %lacement of 7-,@s listed in
London and Luxembourg &toc# +xchanges.
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Q..1. List a fe( ty%es of international issues.
8a9 Foreign +uro onds: In domestic ca%ital mar#ets of various countries the ond issues referred to
above are #no(n by different names such as Lan#ee onds in the ?&, &(iss Frances in
&(itzerland, &amurai onds in To#yo and uldogs in ?M.
8b9 +uro $onvertible onds : It is a +uro'ond, a debt instrument (hich gives the bondholders an
o%tion to convert them into a %re'determined number of +)uity shares of the com%any. ?sually the
%rice of the +)uity &hare at the time of conversion (ill have a call o%tion 8(here the issuer
com%any has the o%tion of calling.buying the bonds for redem%tion %rior to the maturity date9 or a
Put 2%tion 8(hich gives the holder the o%tion to %ut.sell his bonds to the issuer com%any at a %re'
determined date and %rice9
8c9 Plain Euro Bonds : Plain +uro onds are nothing but debt instruments. These are not very
attractive for an investor (ho desires to have valuable additions to his investment.
8d9 Euro Convertible Zero Bonds: These bonds are structured as a convertible bond. ;o interest is
%ayable on the bonds. ut conversion of bonds ta#es %lace on maturity at a %re'determined %rice.
?sually there is a five years maturity %eriod and they are treated as a deferred +)uity issue.
8e9 Euro Bonds with Equity Warrants: These bonds carry a cou%on rate determined by mar#et rates.
The (arrants are detachable. Pure bonds are traded at a discount. Fixed Income Funds
!anagement may li#e to invest for the %ur%oses of regular income.
Q..&. 1)at do you undestand by Commecial $a#e ! 2
-eanin(2 A $ommercial Pa%er 8$P9 is a short'term usance %romissory note issued by a com%any,
negotiable by endorsement and delivery, issued at a discount on face value, as may be determined by
the issuing com%any. It is issued at a discount and redeemed at face value.
+xam%le: A commercial %a%er for ,s.4 la#hs is issued for ,s.>,D/,4BB. The investor %ays ,s.>,D/,4BB
initially and is re%aid ,s.4.la#hs. The difference bet(een investment amount and redem%tion value
constitutes his interest income for the %eriod.
Q.... /ist t)e boad featues of Commecial $a#e.
8a9 S)ot "em +i.e. . to 7 mont)s, 2 It is a short 'term money mar#et instrument. The minimum
maturity %eriod shall be three months and the maximum %eriod shall be six months from the date
of issue. ;o grace %eriod is allo(ed for re%ayment. 8unli#e a bill of exchange9
8b9 $omissoy Note2 It is essentially a usance %romissory note (ith a fixed maturity value.
8c9 Unsecued2 It is a certificate evidencing an unsecured cor%orate debt of short'term maturity.
Assets are not %ledged against $P@s.
8d9 Issued at 8iscount2 It is issued at a discount on face value, but it can also be issued in interest
bearing form. +ach $P (ill have a denomination of ,s.4 la#hs and a single borro(er may
subscribe to at least ,s.=4 la#hs in the %rimary mar#et.
8e9 $ocedue2 It can be issued directly by a com%any to investors or through ban#s . merchant
ban#ers. +ach $P (ill bear a certificate from the ban# verifying the signatures of the executants.
Q..0. 1)at ae t)e eli(ibility conditions fo issue of C$ !
The issue of $P is sub6ect to the norms and conditions sti%ulated by ,I from time to time. The broad
conditions are:
(1) /istin(2 The Issuing $om%any should be listed in at least one recognised stoc# exchange.
*o(ever, relaxation from this rule is given to 8a9 Public &ector $om%anies and 8b9 $losely held
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com%anies.
(2) Cedit Ratin(2 The Issuing $om%any should obtain the necessary credit rating from agencies li#e
I$,A, $,I&IL etc. A%%lication to ,I for a%%roval should be made (ithin t(o months of obtaining
the rating.
(3) Standad Asset2 In addition to credit rating, the issuing com%any should be classified as
<&tandard Asset< 8as o%%osed to sub'standard, loss asset etc.9 by its ban#ers . lending financial
institutions.
(4) Net 1ot)2 The Issuer should have a minimum Tangible ;et "orth of ,s.4 crores as %er recent
audited alance &heet. ;et "orth C Paid u% $a%ital F Free ,eserves 'Accumulated Losses and
Fictitious Assets.
(5) 1o6in( Ca#ital2 The fund based (or#ing ca%ital limit should be minimum of ,s.4 $rores.
(6) Cuent Ratio2 The minimum current ratio should be 0.//:0.
(7) Issue e%#enses2 All issue ex%enses li#e dealer@s fees, credit rating agency fee etc. shall be borne
by the issuer com%any.
Q..4. Outline t)e #ocedue fo Issue of Commecial $a#e.
809 A##lication to R'I 2 The $om%any shall a%%ly to the ,I, through the financing ban#. It has to
meet all eligibility criteria, including sound credit rating.
8=9 A##o*al by R'I 2 ,I shall grant a%%roval to the issue if it is satisfied that the issuing $om%any
meets all the eligibility conditions.
8/9 $i*ate $lacement2 The Issuing $om%any shall ma#e arrangements for %rivate %lacement of the
issue. The %rocess should be com%leted (ithin t(o (ee#s from the date of a%%roval from ,I.
8>9 Intimation of Com#liance2 "ithin three (ee#s of a%%roval, the $om%any shall intimate the ,I
on the com%letion of issue and com%liance (ith all necessary conditions.
Q..7. -ention a few ad*anta(es of Commecial $a#e.
(1) Sim#licity 2 The advantage of $P lies in its sim%licity. -ocumentation involved is minimum.
(2) Cas) Flow mana(ement2 The issuer can issue commercial %a%er (ith the maturities tailored to
match the cash flo( of the com%any.
(3) 8i*esification fom ban6 finance2 A (ell'rated com%any can diversify its sources of finance
from ban#s to short term money mar#ets at relatively chea%er cost.
(4) Incenti*e fo financial sten(t)2 $om%anies (hich raise funds through $P become better #no(n
in the financial (orld and are thereby %laced in a more favourable %osition for raising long term
ca%ital also. Thus there is an in'built incentive for com%anies to remain financially strong.
(5) Retuns to In*estos2 $P@s %rovide investors (ith higher returns than the ban#ing system.
Q..9. 1ite s)ot notes on 2
+a, Call and #ut o#tion wit) efeence to debentues. +b, Fowad as )ed(e instument.
+a, Call and #ut o#tion wit) efeence to debentues2
809 A debenture is an instrument for a fixed %eriod of time mostly at fixed rate of interest.
8=9 ;o(adays the rate of interest varies significantly.
8/9 "ith inflo( of enormous foreign funds this has assumed greater significance.
8>9 A call o%tion gives a liberty to the issuer of the debenture to %ay bac# the amount earlier to the
redem%tion ate at a %re'determined %rice 8stri#e %rice9 (ithin the s%ecified %eriod. In case the
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Floor Laxmi Chamber, Laxmi Nagar Delhi 92 Mo. 9810521310, 9968760918
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o%tion is not exercised the debenture continues.
849 2n the other hand, a %ut o%tion means, a right to investors to demand bac# the money earlier
to the redem%tion date at a %re'determined %rice 8stri#e %rice9 (ithin s%ecified %eriod.
859 The debenture holder can get bac# the money and invest it else(here.
8E9 These #inds of o%tions are necessary to ma#e the instrument investor friendly and to ensure
li)uidity in debentures mar#et.
+b, Fowad as )ed(e instument2 International transactions both trade and financial give rise to
currency ex%osures. A currency ex%osure If left unmanaged leaves a cor%orate o%en to %rofits or
losses arising on account of fluctuations in currency ratio. 2ne (ay in (hich cor%orate can %rotect
itself from effects of fluctuations in currency rates is through buying 9 or selling in for(ard mar#ets.
A for(ard transaction is a transaction re)uiring delivery at a future date of a s%ecified amount
of one currency for a s%ecific amount of another currency. The exchange rate is determined at the
time of entering into the contract but the %ayment and delivery ta#es %lace on maturity. $or%orates
use for(ards to hedge themselves against fluctuations in currency %rice that (ould have a significant
im%act on their financial %osition. an#s use for(ard to offset the for(ard contracts entered into (ith
non' ban# customers.
Q..:. 1ite a s)ot note on t)e O*e G Ca#italiHation.
The term 2ver $a%italisation signifies that the com%any %ossesses an excess of ca%ital in relation to
its activity level and re)uirements. It means that the total ca%ital of the com%any is more than the
amount of %ro%er $a%italisation.
&uch a state of affairs occurs (hen the earning ca%acity of the com%any has falled due to internal
or external factory some of (hich are stated belo(:
8a9 (hen a com%any is in %ossession of assets (hich are ac)uired at a %rice for above their mar#et
%rice or (hen their mar#et %rice has a%%reciably reduced subse)uent to their %urchase. &uch (as
the condition of several com%anies after the First "orld "ar (hen the (hen the %rices of %lants
and machinery %urchased during the (ar %eriod slum%ed in the %ost (ar %eriod.
8b9 "hen it has %aid an excessive amount for the %urchase of good(ill or some other intangible
assets. +.g. %atents, design, co%yright or trademar#s (hich have outlived their utility.
8c9 "hen due to continued losses, it has been %ossible for the com%any to %rovide ade)uate
de%reciation on the fixed assets or to carry out current re%airs.
A study on de%reciation, carried out by the ;ational $ouncil of A%%lied +conomics ,esearch,
some years ago, sho(s that most of the textile mills in the country had not %rovided ade)uate
de%reciation on their assets for a number of years due to (hich they (ere carrying fixed assets at
values much higher than (arrented by their %roductive ca%acities.
It may be mentioned that %rovisions regarding de%reciation under &ection =B4809 of the
com%anies Act have been included only to %revent recurrence of such a state of affairs.
8d9 "hen a com%any is not able to fully utilise its assets.
8e9 "hen the com%any is in %ossession of funds far in excess of its needs.
Q..;. 1ite a s)ot note on t)e $ac6in( Cedit.
Pac#ing credit is an advance made available by ban#s to a ex%orter. Any ex%orter, having at hand a
firm ex%ort order %laced (ith him by him foreign buyer or an irrevocable letter of credit o%ened in him
favour, can a%%roach a ban# for availing of %ac#ing credit. An advance so ta#en by an ex%orter is
re)uired to be li)uidated (ithin 0DB days from the date of its commencement by negotiation of ex%ort
bills or recei%t of ex%ort %roceeds in an a%%roved manner.
Thus, Pac#ing $redit is essentially a short'term advance.
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Dharmendra Gupta Classes(DGC) Source of Finance.13.21
;ormally, ban#s insist u%on their customers to lodge the irrevocable letters of credit o%ened in
favour of the customer by the overseas buyers. The letter of credit and firms sale contracts not only
serve as evidence of a definite arrangement for realisation of the ex%ort %roceeds but also indicate the
amount of finance re)uired by the ex%orter. Pac#ing $redit, in the case of customers of long standing
may also be granted against firm contracts entered into by them (ith overseas buyers. Pac#ing credit
may be of the follo(ing ty%es:
(a) Clean #ac6in( cedit2 This is an advance made available to an ex%orter only on %roduction of a
firm ex%ort order or a letter of credit (ithout exercising any charge or control over ra( material or
finished goods. It is clean ty%e of ex%ort advance. +ach %ro%osal is (eighed according to
%articular re)uirements of the trade and credit (orthiness of the ex%orter. A suitable margin has to
be maintained. Also. +x%ort $redit 7uarantee $or%oration 8+$7$9 cover should be obtained by
tile ban#.
(b) $ac6in( cedit a(ainst )y#ot)ecation of (oods2 +x%ort finance is made available on certain
terms and conditions (here the ex%orter has %ledgeable interest and the goods are hy%othecated
to the ban# as security (ith sti%ulated margin. At the time of utilising the advance, the ex%orter is
re)uired to submit, along(ith the firm ex%ort order or letter of credit, relative stoc# statements and
thereafter continue submitting them every fortnight and or (henever there is any movement in
stoc#s.
(c) $ac6in( cedit a(ainst #led(e of (oods2 +x%ort finance is made available on certain terms and
conditions (here the ex%ortable finished goods are %ledged to the ban#s "ith a%%roved clearing
agents (ho (ill shi% tile sanle from time to tune as re)uired by the ex%orter. The %ossession of the
goods so %ledged lies (ith tile ban# and are #e%t under its loc# and #ey.
Q.0=. 1ite a s)ot note on t)e Ris6 Ca#ital Foundation.
Ans. This Foundation (as registered in 03E4 under the &ocieties ,egistration Act 0D5B. It has been
s%onsored by the Industrial Finance $or%oration of India. The main ob6ective of the Foundation is to
encourage ne( entre%reneurs, %articularly technologists and %rofessionals by %roviding seed ca%ital.
-uring the recent years the 7overnment of India has been laying increasing em%hasis on
encouragement of ne( entre%reneurs, %articularly technologists and %rofessionals, for %romoting
medium'size industries (ith a vie( to utilising their ex%erience and ex%ertise and thus broadening the
entre%reneurial base in the Indian industry. 2ne of the most difficult %roblems faced by these
technologists and %rofessionals in their efforts to %romote an industrial %ro6ect is to %rovide necessary
amount of the %romotersN contribution (hich re%resents their financial sta#e in the %ro6ect. This
foundation (ould %rovide su%%lementary finance in the industrial and business ex%erience to enable
them to ma#e good the shortfall in the %romoterNs contribution to the e)uity ca%ital of medium'size
industrial %ro6ects %romoted by them and (hich have been granted financial assistance by one or
more of the All India Financial Institutions, namely, Industrial Finance $or%oration of India, Industrial
develo%ment an# of India and Industrial $redit and Investment $or%oration of India Limited.
Q.01. 1ite a s)ot note on t)e $led(e and Hy#ot)ycation.
Pledge is bailment of goods 8i.e. delivery of goods by one %erson to another9 as security for %ayment
of debt or %erformance of a %romise. Any #ind of articles, goods, valuables documents or securities
may be %ledged. In this case of %ledge, the delivery of the goods to the %ledged is essential. The
advantage of %ledge is that %ossession of goods %asses to the creditor, (ho has actual control over it.
A %ledge is also called a %a(n. The de%ositor is #no(s as the %ledger and the other %arty is #no(n as
the %ledgee. A valid %ledge can also be made by a mercantile agent (ho is in %ossession of the
goods. "ith the consent of the o(ner as (ell as by one of the 6oint o(ners of goods. From the
ban#ers@ %oint of vie(, of all the methods of charging the security, %ledge is %erha%s the most
satisfactory. The ban# has a right of lien and can retain %ossession of the goods %ledged until
%ayment of %rinci%al, interest and other ex%enses.
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*y%othecation on the other hand, is a charge against %ro%erty for an amount of debt (here
neither o(nershi% nor %ossession is %assed to the creditor. Thus hy%othecation is a legal transaction,
(hereby goods or other movable assets are made available as security for a debt, (ithout transferring
either the %ro%erty or %ossession thereof to the lender. It is a useful means of raising loan on the
security of movable %ro%erty (hich cannot be %ledged. It is sometimes granted side by side (ith
%ledge. For exam%le, in a manufacturing unit the stoc#s of ra( material and finished goods can be
conveniently %ledged and, therefore, for such stoc#s (hich can be %ut under tile loc# and #ey of the
ban#, only %ledge unit is sanctioned. ut for the goods in %rocess (hich have to be in the o%en and
the ban# cannot ta#e %ossession, only a hy%othecation limit can be considered. The margin in such
limit is higher because of the difficulties in verification of the valuation of the stoc#s. eing only an
e)uitable charge on movable %ro%erty (ithout %ossession, hy%othecation facility is granted only to first
class customers (ith higher integrity. ;om0ally, ban#s do not grant hy%othecation facilities to ne(
customers.
Q.0&. I$omotesJ contibution is one of t)e #inci#al means of financin( t)e #o<ectK. 8iscuss.
The %romoter is re)uired to %rovide funds irres%ective of (hether the %ro6ect is an existing one or a
ne( venture.
PromotersN contribution consists of :
8a9 &hare ca%ital to be subscribed by the %romoters in the form of e)uity share ca%ital and .or
%reference share ca%ital.
8b9 +)uity shares issued as rights shares to the existing shareholders.
8c9 $onvertible debentures issued as OrightP to existing shareholders.
8d9 ?nsecured loans.
8e9 &eed ca%ital assistance.
8f9 1enture ca%ital
8g9 Internal cash accruals.
In the case of %ro6ect established in 6oint or assisted sector, the contribution of state industrial
investment cor%oration to(ards share ca%ital is also considered as %art of %romotersN total
contribution.
The government of India has classified the locations into three categories Q A, and $ such as:
$ategory A as no industrial district
$ategory as districts (here industrial activity has started
$ategory $ as districts (here industrial activity has gained sufficient ground
7enerally %romoters are ex%ected to contribute minimum =BA of cost of the %ro6ect in the
case of listed and unlisted com%anies uniformly. *o(ever, concessional norms for contributions have
been %rescribed by All India Financial Institutions de%ending u%on (hether the %ro6ect is located in
notified 8bac#(ard9 area in category A: or $ districts. PromotersN contribution indicates the extent of
their involvement in a %ro6ect in terms of their o(n financial sta#e. In case the %romoters are unable to
raise funds to meet the norms of financial institutions, they can avail the benefit of seed ca%ital
assistance under nay of the schemes of ,-$ or I-I or ,$T$ etc. The investments made by
recognised covered by non'dis%osal underta#ing or buy'bac# clause.
Among different means of finance such as ca%ital incentives deferred %ayment guarantees,
lease finance . hire %urchasing, term loans from financial institutions in the form of ru%ee loans and
foreign currency loans etc, %romoters, contribution is one of the most im%ortant source of finance.
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Q.0.. 1ite s)ot note on Im#act of co#oate ta%ation on co#oate financin(.
Tax is levied on the %rofits of the com%any. Tax is also levied on the dividends %ayable by a com%any.
This dividend tax is in addition to the cor%orate tax %ayable by a com%any. Thus the cor%orate entity
suffer tax t(ice. This %ushes the cost of e)uity ca%ital. 2n the other hand interest %aid on the debt
ca%ital is a deductible ex%enditure and hence com%any doeR not %ay tax on interest on debt ca%ital.
This reduces the cost of debts. -ebt is a less cost source of funds and if the finance manager
%rudently mixes debt and e)uity the (eights average cost of ca%ital (ill get greatly reduce.
-e%reciation is not an outgo in cash but it is deductible in com%uting the income sub6ect to tax.
There (ill be saving in tax on de%reciation and such savings could be %rofitable em%loyed. Thus, both
interest and de%reciation %rovide tax shield and have a tendency t increase +P&. Further, the
unabsorbed de%reciation can be carried for(ard for eight yeaR and this (ill be hel%ful for loss ma#ing
concerns (hich start earning %rofits in future. The business loss and de%reciation loss of one
com%any can be carried for set off in another com%any@s %rofit in case of amalgamations in s%ecified
circumstances and such a %rovision (ill hel% in the gro(th of com%anies and rehabilitation of sic#
units. The finance manager , amalgamating com%any (ill bear this benefit for tax shield it carries in
%lanning the activities
Thus, the im%act of tax (ill be felt in cost of ca%ital, earnings %er share and the cash flo(s
(hich are relevant for ca%ital budgeting and in %lanning the ca%ital structure.
Tax considerations are im%ortant as they affect the li)uidity of the concerns. They D relevant in
deciding the leasing of assets, transactions of sale and lease bac#, and also floating 6oint venture in
foreign countries (here tax rates and concessions may advantageous. Tax im%lications (ill be felt in
choosing the size and nature of industry a incentives are given for bac#(ard areas. Tax
considerations in these matters are relevant for %ur%ose of %reserving and %rotecting internal funds
Q.00. 1ite t)e s)ot note on Euo Con*etible bond.
+uro $onvertible bonds are )uasi'debt securities 8unsecured9 ( , can be converted into de%ository
recei%ts or local shares. +$s offer the investor an o%tion convert the bond into e)uity at a fixed %rice
after the minimum loc# in %eriod. The %rice of +)uity shares at the time of conversion (ill have a
%remium element. The bonds carry a fixed rate interest. These are bearer securities and generally the
issue of such bonds may carry t(o o%h viz. call o%tion and rut o%tion. A call o%tion allo(s the
com%any to force conversion if them %rice of the shares exceed a %articular %ercentage of the
conversion %rice. A %ut o%tion all the investors to get his money bac# before maturity. In the case of
+$s, the %ayment of interest Dd the redem%tion of the bonds (ill be made by the issuer com%any in
?& dollars. +$s issues le listed at London or Luxembourg stoc# exchanges.
Indian com%anies (hich have o%ted +$s issue are Hindal &tri%s, ,eliance, +ssar 7u6arat,
&tarlite etc. Indian com%anies are increasingly loo#ing at +uro'$onvertible bond in %lace of 7lobal
-e%ository ,ecei%ts because 7-,s are falling into disfavour among international fund managers.
An issuing com%any desirous of raising the +$s is re)uired to obtain %rior %ermission of -e%artment
of +conomic Affairs, !inistry of Finance, 7overnment of India, $om%anies ving / years of good trac#
record (ill only be %ermitted to raise funds. This condition is not licable in the case of %ro6ects in
infrastructure sector. The %roceeds of +$s (ould be %ermitted for follo(ing %ur%oses:
8i9 Im%ort of ca%ital goods.
8ii9 ,etiring foreign currency debts.
8iii9 $a%italising Indian 6oint venture abroad.
8iv9 =4A of total %roceedings can be used for (or#ing ca%ital and general cor%orate restricting.
The im%act of such issues has been to %rocure for the issuing com%anies finances at very com%etitive
rates of interest. For the country a higher debt means a forex outgo in terms of Interest.
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Q.04. 1ite a s)ot note on t)e Ris6 $emium tade off.
There are many #inds of ris#s (hich a business enter%rise has to %rotect itself against. It is the duty of
the insurance manager to minimise these ris#s and to ta#e ade)uate insurance %olicies against the
ris#s (hich cannot be avoided. For exam%le, very strict safeguards and extremely efficient fire fighting
service arrangements may abviate the necessarily a trade'off bet(een the nature and )uantum of ris#
that exists for an underta#ing and the amount of %remium re)uired to be %aid to %rotect it against the
%articular ris#. In many cases, it may be beneficial not to insure at all (ith outside insurers. This is
%articularly true of all large organisations (ho may have assets of such huge values that %aying
insurance %remiums to outside insurers may be much more ex%ensive than the %ossible loss that may
reasonably occur annually on account of fire, theft, or accident, etc. A ty%ical exam%le in this regard is
that of the rail(ays. The monetary value of the rolling stoc# and other assets of the rail(ays is so
huge that they do not need to insure (ith outsiders. Instead, they can have self insurance: every year
they can created out of (hich all losses can be met. This is exactly the function of an insurance
com%any also, (hich collects %remiums from many %arties and thereby distributes the ris# over a
large number of units. If the same ris#s can be distributed (ithin an organization itself there is no %oint
ta#ing an insurance %olicy (ith an outsider. Therefore, in larger business, the decision to create an
insurance fund or to insure (ith an outside %arty is a very vital one. This decision should ta#e into
account the relative advantages and disadvantages of ta#ing out %olicies from outsiders or creating an
insurance fund.
Q.07. 1ite s)ot notes as2
+a, Coss Cuency Roll O*e +b, Financial Swa#s
+a, Coss Cuency Roll O*e2 $ross currency ,oll 2ver contracts are contracts to cover overseas
leg of long'term foreign exchange liabilities or assets. The cover is initially obtained for six months
and later extended for further %eriod of six months and so on.
,oll over charge or benefit de%ends on for(ard %remium or discount, (hich in turn, is a
function of interest rate differentials bet(een us dollar and the other currency. There is no ris# of
currency a%%reciation or de%reciation in the overseas leg:
,oll over for a maturity %eriod exceeding six months is not %ossible because in the inter'ban#
mar#et, )uotations beyond six months are not available.
?nder the ,oll 2ver $ontract the basic rate of exchange is fixed but loss or gain arises at the time
of each ,oll 2ver de%ending u%on the mar#et conditions.
+b, Financial &(a%s: Financial s(a%s are a funding techni)ue (hich %ermit a borro(er to access one
mar#et and then exchange the liability for another ty%e of liability. Investors can exchange one
ty%e of asset for another (ith a %referred income stream. &(a%s by themselves are not a funding
instrument, they are a device to obtain the desired form of financing indirectly (hich other(ise
might be inaccessible or too ex%ensive.
All s(a%s involve exchange of a series of %eriodic %ayments bet(een t(o %arties, usually
through an intermediary (hich is a large international financial institution. The t(o %ayment
streams are estimated to have identical %resent values at the outset (hen discounted at the
res%ective cost of funds in the relevant %rimary financial mar#ets.
The t(o ma6or ty%es of financial s(a%s are interest rate s(a%s and currency s(a%s. The t(o
are combined to give a cross'currency interest rate sna%. A number of variations are %ossible
(ithin each ma6or ty%e. In the follo(ing %ara the conce%t of interest rate and currency s(a%s has
been described.
Interest rate s(a%s: "ith an interest rate s(a%, interest'%ayment obligations are exchanged
bet(een t(o %arties, but they are denominated in the same currency. The s(a% can be longer
term in nature than either the for(ard or the future contracts. Terms extend out to 04 years or
more, (hereas the range for for(ard or futures contracts is u%(ard to five year. The mar#et for
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Floor Laxmi Chamber, Laxmi Nagar Delhi 92 Mo. 9810521310, 9968760918
Dharmendra Gupta Classes(DGC) Source of Finance.13.25
s(a%s is unregulated and began in the early 03DB@s. The most common interest rate s(a% is the
floating'fixed rate exchange. For exam%le, a cor%orate that has borro(ed on a fixed rate, term
basis may s(a% (ith a counter %arty to ma#e floating rate interest %ayments.
Cuency swa#s2 Let another device for shifting ris# is the currency s(a%. In a currency s(a%,
t(o %arties exchange debt obligations denominated in different currencies. +ach %arty agrees to
%ay the other@s interest obligation. At maturity, %rinci%al amounts are exchanged, usually at a rate
of exchange agreed u%on in advance. The currency s(a% mar#et traces its roots to the 035B@s,
(hen %arallel loans (ere arranged bet(een t(o borro(ers of different nationalities.
In currency s(a%s both the %rinci%al and interest in one currency are s(a%%ed for %rinci%al
and interest in another currency. 2n maturity the %rinci%al amounts are s(a%%ed bac#.
?sually in %ractice s(a% is intermediated by a ban# (hich ta#es a(ay a %art of the savings, r
leaving the balance to be shared by the %arties. &(a% gains or losses arises because of , s%read
com%ression (hich varies in different financial mar#ets.
Q.09. 1ite s)ot note on 'ud(et as a tool fo accountin( based #efomance measues .
An organisation is divided into res%onsibility centres, (hich are headed by res%onsible managers.
+ach res%onsibility centre has in%uts and out%uts. In%uts are the resources that the res%onsibility
centre uses. 2ut%uts are the results of its (or#. Technically, these out%uts are %roducts, not
necessarily %roducts sold to outside customers, but also services rendered by one res%onsibility
centre to another res%onsibility centre. ,es%onsibility centres can be classified according to the
degree to (hich their in%uts and out%uts are measured in monetary terms. ,es%onsibility centres can
be divided into ex%ense centres and revenue centres. An o%erating budget is the organisation@s
financial %lan for a s%ecified %eriod usually, one year. The budget sho(s the ex%enses that can be,
incurred by each manager (ho is res%onsible for his %art of the %rogramme or the %rofit of the return
on investment.
$om%anies ma#e a monthly analysis of the differences bet(een actual and budgeted
revenue.ex%enses for each business unit and for the (hole organisation. Analysis identifies the
causes of variance, and the organisation unit res%onsible. +ffective system identifies variances do(n
to the lo(est level of management. ,evenue variances are further divided into volume and %rice
variances for the total business units and for each mar#eting res%onsibility centre (ithin the unit.
+x%ense variances can be divided bet(een manufacturing ex%ense and other ex%enses.
!anufacturing ex%enses can be further subdivided by factories and the de%artments (ithin factories.
+ach variance can be identified (ith the individual manager (ho is res%onsible for it.
Q.0:. I")eoeticallyC etained eanin(s s)ould be teated as t)e acti*e decision *aiable and
di*idends as t)e #assi*e esidualC but t)e #actice does not confom to t)is in most cases.K
E%amine t)is statement.
A com%any has to allocate its annual earnings bet(een retained earnings and dividends. For this, the
com%any has to treat either retained earnings or dividends as the active decision variable. If it actively
determines the amount of retained earnings, the resident (ill be distributed by (ay of dividends. 2n
the other hand, if the amount of dividends is actively determined, the retained earnings (ill
automatically become the %assive residual.
The main consideration in determining the dividend %olicy is the ob6ective of maximisation of
(ealth of shareholders. Theoretically, therefore, a com%any should treat retained earnings as the
active decision variable. It should retain its earnings so long as their %roductivity inside the com%any is
at least e)ual to (hat the shareholders can earn from an investment of the same degree of ris#
outside the com%any. It is a fact that normally com%anies do not %ay any tax on retained %rofits
(hereas the shareholders have to %ay tax on the dividends received by them. Therefore, de%ending
u%on the average rate of tax, the shareholders (ill receive a much smaller sum than the amount of
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Floor Laxmi Chamber, Laxmi Nagar Delhi 92 Mo. 9810521310, 9968760918
Dharmendra Gupta Classes(DGC) Source of Finance.13.26
%rofit earned by the com%any even if it is fully distributed. *o(ever, if the com%any feels that the
shareholders can earn more outside the com%any than (hat the com%any can earn on its internal
investment, it should return the earnings to the form of dividends so that they may be free to use them
as they li#e. ut it is difficult to assess (hether or not the shareholders (ould be able to ma#e a better
use of the funds distributed by (ay of dividends. 2ften the com%anies find it difficult to ascertain the
return on investment of the same ris# category outside the com%any. The tax status of the
shareholders also ma#es it difficult to determine the amount of dividend income that (ill be available
for investment in the hands of the shareholders after %aying income'tax. Thus, retained earnings
should generally constitute the active decision variable and dividends as the %assive residual.
In actual %ractice, ho(ever, (e find that most com%anies determine the amount of dividends
first and the residue constitutes the retained earnings. ;ormally, there is no choice'bet(een %aying
dividends and not %aying dividends. Almost all com%anies have a moral commitment to %ay dividends.
This is so because the com%anies believe that by follo(ing a stable dividend %olicy, they can
maximise the mar#et value of their shares. -eclaration of dividends has a direct bearing on the
mar#et %rice of the com%anyNs shares. If not com%elled other(ise, no com%any (ould li#e to s#i% or
reduce the rate of dividends (hich it has been %aying in the earlier years. It is also believed that a
high %ay'out ratio may attract investors to invest in the com%anyNs shares. The com%any can easily
%rocure additional ca%ital by selling ne( issues of share ca%ital to existing and ne( shareholders.
!oreover, this %olicy also satisfies such shareholders (ho need regular income form their investment.
In fact, the dividend %olicy of the com%any itself has a great deal of influence on the image of the
com%any, i.e. the vie( (hich outside investors ta#e about the %rofitability and financial soundness of
the com%any. A com%any (hich regularly %ays dividends and is able to sho( a good rate of gro(th
(ill generally be favoured by investors. The %rices of shares of such com%anies (ill rise much. The
)uestion of the image of the com%any is often more im%ortant to such com%anies as re)uire fresh
funds to be raised from the mar#et. ecause of these considerations, the actual %ractice (ith regard
to dividends, is often at variance (ith (hat the theory %rescribes, and dividends, not the retained
earnings, are ta#en as active decision variable in the allocation of com%anyNs earnings bet(een
dividends and retained earnings.
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Floor Laxmi Chamber, Laxmi Nagar Delhi 92 Mo. 9810521310, 9968760918

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