FINANCIAL SERVICE

(Specialization paper in Finance)

VI SEMESTER
CORE COURSE

BBA6 B15

B.B.A
(2019 Admission onwards)

UNIVERSITY OF CALICUT
School of Distance Education,
Calicut University P.O.,
Malappuram - 673 635, Kerala.

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UNIVERSITY OF CALICUT
SCHOOL OF DISTANCE EDUCATION
BBA 2019 Admission onwards

BBA6 B15 (Finance Elective 3)

FINANCIAL SERVICE

Prepared by:
Siddeeque Melmuri
Asst. Prof.
School of Distance Education
University of Calicut

Scruitinized by:
Abdurahiman Karuthedath
Asst. [Link] Commerce
Malabar College of Advanced Studies, Vengara.

DISCLAIMER
“The author(s) shall be solely responsible for the
content and views expressed in this book”

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Module Contents Page

I Financial Services 7 - 38

2 Fund Investments 39 - 65

Investment Banking and

3 66 - 87
Merchant Banking
Lease Finance and Venture
4 88 – 107
Capital Finance
Credit Rating and Factoring
5 108 - 131
Services

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Syllabus
BBA6B15 (Finance Elective 3)
FINANCIAL SERVICES

Time:5 Hours per week Credits: 4

Internal: 20 External 80
Course Objective:
the students with an understanding of the various
financial services and investment opportunities
available in the country
Learning Outcomes:
On completion of the course students will be able to
aware of various financial services available in Indian
financial system
Module I : Financial Services: Meaning and
importance of financial services- classification of
financial services- fund based and fee based services-
capital market services – stock broking and depository
services – regulation of capital market services in India.
10 Hours
Module II : Fund Investments: Mutual funds-meaning
and importance-organisation of mutual funds-types of
schemes- fund units and valuation- merits and demerits
of mutual funds- mutual fund regulations in India.
Pension funds; Exchange Traded Funds (ETFs)-ETF vs
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Mutual Funds- investment implications of ETF.

20 Hours
Module III : Investment Banking and Merchant
Banking: Meaning, nature and functions of merchant
banking – pre and post issue management services – loan
syndication- Merchant banking services in India –SEBI
merchant bank regulations.
20 Hours
Module IV : Lease Finance and Venture Capital
Finance: Lease finance- meaning and definition- types
of lease- merits and demerits of lease financing. Venture
capital finance: meaning and importance – risk capital –
angel investing, crowd funding and private equity (PE).
15 Hours
Module V : Credit Rating and Factoring Services:
Credit rating – meaning, importance and advantages –
rating methodology- credit rating agencies in India.
Factoring services – meaning, scope and functions –
types of factoring services – forfaiting and international
factoring. 15 Hours
Reference Books:
1. Khan M Y, Financial Services, Tata McGraw-Hill
Publishing [Link] New Delhi.
2. Gupta, N K and Monika
Chopra,FinancialMarkets,Institutions and Servoces,
Ane Books India.
3. Bharathi V Pathak, Indian Financial System, Pearson
Education, New Delhi.
4. YogeshMaheswari, Investment Management, PHI
New Delhi
5. Avadhani, V A, Security Analysis and Portfolio
Management, Himalaya Publishing House.

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Module I
FINANCIAL SERVICES

The Indian financial services industry has undergone a

metamorphosis since1990. Before its emergence the
commercial banks and other financial institutions dominated
the field and they met the financial needs of the Indian
industry. It was only after the economic liberalisation that the
financial service sector gained some prominence. Now this
sector has developed into an industry.
In fact, one of the world’s largest industries today is the
financial services industry.
Financial service is an essential segment of financial system.
Financial services are the foundation of a modern economy.
The financial service sector is indispensable for the prosperity
of a nation.
Meaning of Financial Services
In general, all types of activities which are of financial nature
may be regarded as financial services. In a broad sense, the
term financial services means mobilisation and allocation of
savings.
Thus, it includes all activities involved in the transformation
of savings into investment.

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Financial services refer to services provided by the finance

industry. The finance industry consists of a broad range of
organisations that deal with the management of money. These
organisations include banks, credit card companies, insurance
companies, consumer finance companies, stock brokers,
investment funds and some government sponsored
enterprises.
Financial services may be defined as the products and services
offered by financial institutions for the facilitation of various
financial transactions and other related activities.
Financial services can also be called financial intermediation.
Financial intermediation is a process by which funds are
mobilised from a large number of savers and make them
available to all those who are in need of it and particularly to
corporate customers. There are various institutions which
render financial services. Some of the institutions are banks,
investment companies, accounting firms, financial
institutions, merchant banks, leasing companies, venture
capital companies, factoring companies, mutual funds etc.
These institutions provide variety of services to corporate
enterprises. Such services are called financial services. Thus,
services rendered by financial service organisations to
industrial enterprises and to ultimate consumer markets are
called financial services. These are the services and facilities
required for the smooth operation of the financial markets. In
short, services provided by financial intermediaries are called
financial services.
Functions of financial services
1. Facilitating transactions (exchange of goods and services)
in the economy.

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2. Mobilizing savings (for which the outlets would otherwise

be much more limited).
3. Allocating capital funds (notably to finance productive
investment).
4. Monitoring managers (so that the funds allocated will be
spent as envisaged).
5. Transforming risk (reducing it through aggregation and
enabling it to be carried by those more willing to bear it).
Characteristics or Nature of Financial Services
From the following characteristics of financial services, we
can understand their nature:
1. Intangibility: Financial services are intangible. Therefore,
they cannot be standardized or reproduced in the same form.
The institutions supplying the financial services should have
a better image and confidence of the customers. Otherwise,
they may not succeed. They have to focus on quality and
innovation of their services. Then only they can build
credibility and gain the trust of the customers.
2. Inseparability: Both production and supply of financial
services have to be performed simultaneously. Hence, there
should be perfect understanding between the financial service
institutions and its customers.
3. Perishability: Like other services, financial services also
require a match between demand and supply. Services cannot
be stored. They have to be supplied when customers need
them.
4. Variability: In order to cater a variety of financial and
related needs of different customers in different areas,

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financial service organisations have to offer a wide range of

products and services.
This means the financial services have to be tailor-made to the
requirements of customers. The service institutions
differentiate their services to develop their individual identity.
5. Dominance of human element: Financial services are
dominated by human element. Thus, financial services are
labour intensive. It requires competent and skilled personnel
to market the quality financial products.
6. Information based: Financial service industry is an
information based industry. It involves creation,
dissemination and use of information. Information is an
essential component in the production of financial services.
Importance of Financial Services
The successful functioning of any financial system depends
upon the range of financial services offered by financial
service organisations. The importance of financial services
may be understood from the following points:
1. Economic growth: The financial service industry
mobilises the savings of the people, and channels them into
productive investments by providing various services to
people in general and corporate enterprises in particular. In
short, the economic growth of any country depends upon these
savings and investments.
2. Promotion of savings: The financial service industry
mobilises the savings of the people by providing
transformation services. It provides liability, asset and size
transformation service by providing huge loan from small
deposits collected from a large number of people. In this way
financial service industry promotes savings.
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3. Capital formation: Financial service industry facilitates

capital formation by rendering various capital market
intermediary services. Capital formation is the very basis for
economic growth.
4. Creation of employment opportunities: The financial
service industry creates and provides employment
opportunities to millions of people all over the world.
5. Contribution to GNP: Recently the contribution of
financial services to GNP has been increasing year after year
in almost countries.
6. Provision of liquidity: The financial service industry
promotes liquidity in the financial system by allocating and
reallocating savings and investment into various avenues of
economic activity. It facilitates easy conversion of financial
assets into liquid cash.
Types of Financial Services
Financial service institutions render a wide variety of services
to meet the requirements of individual users. These services
may be summarized as below:
1. Provision of funds:
(a) Venture capital
(b) Banking services
(c) Asset financing
(d) Trade financing
(e) Credit cards
(f) Factoring and forfaiting
2. Managing investible funds:
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(a) Portfolio management

(b) Merchant banking
(c) Mutual and pension funds
3. Risk financing:
(a) Project preparatory services
(b) Insurance
(c) Export credit guarantee
4. Consultancy services:
(a) Project preparatory services
(b) Project report preparation
(c) Project appraisal
(d) Rehabilitation of projects
(e) Business advisory services
(f) Valuation of investments
(g) Credit rating
(h) Merger, acquisition and reengineering
5. Market operations:
(a) Stock market operations
(b) Money market operations
(c) Asset management
(d) Registrar and share transfer agencies
(e) Trusteeship
(f) Retail market operation

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(g) Futures, options and derivatives

6. Research and development:
(a) Equity and market research
(b) Investor education
(c) Training of personnel
(d) Financial information services
Scope of Financial Services
The scope of financial services is very wide. This is because
it covers a wide range of services. The financial services can
be broadly classified into two: (a) fund based services and (b)
non-fund services (or fee-based services)
Fund based Services
The fund based or asset based services include the following:
1. Underwriting
2. Dealing in secondary market activities
3. Participating in money market instruments like CPs, CDs
etc.
4. Equipment leasing or lease financing
5. Hire purchase
6. Venture capital
7. Bill discounting.
8. Insurance services
9. Factoring
10. Forfaiting
11. Housing finance
12. Mutual fund
Non-fund based Services

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Today, customers are not satisfied with mere provision of

finance. They expect more from financial service companies.
Hence, the financial service companies or financial
intermediaries provide services on the basis of non-fund
activities also. Such services are also known as fee based
services. These include the following:
1. Securitisation
2. Merchant banking
3. Credit rating
4. Loan syndication
5. Business opportunity related services
6. Project advisory services
7. Services to foreign companies and NRIs.
8. Portfolio management
9. Merger and acquisition
10. Capital restructuring
11. Debenture trusteeship
12. Custodian services
13. Stock broking
The most important fund based and non-fund based services
(or types of services) may be briefly discussed as below:
A. Asset/Fund Based Services
1. Equipment leasing/Lease financing: A lease is an
agreement under which a firm acquires a right to make use of
a capital asset like machinery etc. on payment of an agreed fee
called lease rentals. The person (or the company) which
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acquires the right is known as lessee. He does not get the

ownership of the asset. He acquires only the right to use the
asset. The person (or the company) who gives the right is
known as lessor.
2. Hire purchase and consumer credit: Hire purchase is an
alternative to leasing. Hire purchase is a transaction where
goods are purchased and sold on the condition that payment is
made in instalments. The buyer gets only possession of goods.
He does not get ownership. He gets ownership only after the
payment of the last instalment. If the buyer fails to pay any
instalment, the seller can repossess the goods. Each instalment
includes interest also.
3. Bill discounting: Discounting of bill is an attractive fund
based financial service provided by the finance companies. In
the case of time bill (payable after a specified period), the
holder need not wait till maturity or due date. If he is in need
of money, he can discount the bill with his banker. After
deducting a certain amount (discount), the banker credits the
net amount in the customer’s account. Thus, the bank
purchases the bill and credits the customer’s account with the
amount of the bill less discount. On the due date, the drawee
makes payment to the banker. If he fails to make payment, the
banker will recover the amount from the customer who has
discounted the bill. In short, discounting of bill means giving
loans on the basis of the security of a bill of exchange.
4. Venture capital: Venture capital simply refers to capital
which is available for financing the new business ventures. It
involves lending finance to the growing companies. It is the
investment in a highly risky project with the objective of
earning a high rate of return. In short, venture capital means
long term risk capital in the form of equity finance.

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5. Housing finance: Housing finance simply refers to

providing finance for house building. It emerged as a fund
based financial service in India with the establishment of
National Housing Bank (NHB) by the RBI in 1988. It is an
apex housing finance institution in the country. Till now, a
number of specialised financial institutions/companies have
entered in the filed of housing finance.
Some of the institutions are HDFC, LIC Housing Finance, Citi
Home, Ind Bank Housing etc
6. Insurance services: Insurance is a contract between two
parties. One party is the insured and the other party is the
insurer. Insured is the person whose life or property is insured
with the insurer. That is, the person whose risk is insured is
called insured. Insurer is the insurance company to whom risk
is transferred by the insured. That is, the person who insures
the risk of insured is called insurer. Thus insurance is a
contract between insurer and insured. It is a contract in which
the insurance company undertakes to indemnify the insured
on the happening of certain event for a payment of
consideration. It is a contract between the insurer and insured
under which the insurer undertakes to compensate the insured
for the loss arising from the risk insured against.
According to Mc Gill, “Insurance is a process in which
uncertainties are made certain”. In the words of Jon Megi,
“Insurance is a plan wherein persons collectively share the
losses of risks”.
Thus, insurance is a device by which a loss likely to be caused
by uncertain event is spread over a large number of persons
who are exposed to it and who voluntarily join themselves
against such an event. The document which contains all the
terms and conditions of insurance (i.e. the written contract) is
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called the ‘insurance policy’. The amount for which the

insurance policy is taken is called ‘sum assured’. The
consideration in return for which the insurer agrees to make
good the loss is known as ‘insurance premium’. This premium
is to be paid regularly by the insured. It may be paid monthly,
quarterly, half yearly or yearly.
7. Factoring: Factoring is an arrangement under which the
factor purchases the account receivables (arising out of credit
sale of goods/services) and makes immediate cash payment to
the supplier or creditor. Thus, it is an arrangement in which
the account receivables of a firm (client) are purchased by a
financial institution or banker. Thus, the factor provides
finance to the client (supplier) in respect of account
receivables. The factor undertakes the responsibility of
collecting the account receivables. The financial institution
(factor) undertakes the risk. For this type of service as well as
for the interest, the factor charges a fee for the intervening
period. This fee or charge is called factorage.
8. Forfaiting: Forfaiting is a form of financing of receivables
relating to international trade. It is a non-recourse purchase by
a banker or any other financial institution of receivables
arising from export of goods and services. The exporter
surrenders his right to the forfaiter to receive future payment
from the buyer to whom goods have been supplied. Forfaiting
is a technique that helps the exporter sells his goods on credit
and yet receives the cash well before the due date. In short,
forfaiting is a technique by which a forfaitor (financing
agency) discounts an export bill and pay ready cash to the
exporter. The exporter need not bother about collection of
export bill. He can just concentrate on export trade.
9. Mutual fund: Mutual funds are financial intermediaries
which mobilise savings from the people and invest them in a
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mix of corporate and government securities. The mutual fund

operators actively manage this portfolio of securities and earn
income through dividend, interest and capital gains. The
incomes are eventually passed on to mutual fund
shareholders.
Non-Fund Based/Fee Based Financial Services
1. Merchant banking: Merchant banking is basically a
service banking, concerned with providing non-fund based
services of arranging funds rather than providing them. The
merchant banker merely acts as an intermediary. Its main job
is to transfer capital from those who own it to those who need
it. Today, merchant banker acts as an institution which
understands the requirements of the promoters on the one
hand and financial institutions, banks, stock exchange and
money markets on the other. SEBI (Merchant Bankers) Rule,
1992 has defined a merchant banker
as, “any person who is engaged in the business of issue
management either by making arrangements regarding
selling, buying or subscribing to securities or acting as
manager, consultant, advisor, or rendering corporate advisory
services in relation to such issue management”.
2. Credit rating: Credit rating means giving an expert opinion
by a rating agency on the relative willingness and ability of
the issuer of a debt instrument to meet the financial
obligations in time and in full. It measures the relative risk of
an issuer’s ability and willingness to repay both interest and
principal over the period of the rated instrument. It is a
judgement about a firm’s financial and business prospects. In
short, credit rating means assessing the creditworthiness of a
company by an independent organisation.

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3. Stock broking: Now stock broking has emerged as a

professional advisory service. Stock broker is a member of a
recognized stock exchange. He buys, sells, or deals in
shares/securities. It is compulsory for each stock broker to get
himself/herself registered with SEBI in order to act as a
broker. As a member of a stock exchange, he will have to
abide by its rules, regulations and bylaws.
4. Custodial services: In simple words, the services provided
by a custodian are known as custodial services (custodian
services). Custodian is an institution or a person who is
handed over securities by the security owners for safe custody.
Custodian is a caretaker of a public property or securities.
Custodians are intermediaries between companies and clients
(i.e. security holders) and institutions (financial institutions
and mutual funds). There is an arrangement and agreement
between custodian and real owners of securities or properties
to act as custodians of those who hand over it. The duty of a
custodian is to keep the securities or documents under safe
custody. The work of custodian is very risky and costly in
nature. For rendering these services, he gets a remuneration
called custodial charges.
Thus custodial service is the service of keeping the securities
safe for and on behalf of somebody else for a remuneration
called custodial charges.
5. Loan syndication: Loan syndication is an arrangement
where a group of banks participate to provide funds for a
single loan. In a loan syndication, a group of banks comprising
10 to 30 banks participate to provide funds wherein one of the
banks is the lead manager. This lead bank is decided by the
corporate enterprises, depending on confidence in the lead
manager.

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A single bank cannot give a huge loan. Hence a number of

banks join together and form a syndicate. This is known as
loan syndication. Thus, loan syndication is very similar to
consortium financing.
6. Securitisation (of debt): Loans given to customers are
assets for the bank. They are called loan assets. Unlike
investment assets, loan assets are not tradable and
transferable. Thus loan assets are not liquid. The problem is
how to make the loan of a bank liquid. This problem can be
solved by transforming the loans into marketable securities.
Now loans become liquid. They get the characteristic of
marketability. This is done through the process of
securitization. Securitisation is a financial innovation. It is
conversion of existing or future cash flows into marketable
securities that can be sold to investors. It is the process by
which financial assets such as loan receivables, credit card
balances, hire purchase debtors, lease receivables, trade
debtors etc. are transformed into securities. Thus, any asset
with predictable cash flows can be securitised.
Securitisation is defined as a process of transformation of
illiquid asset into security which may be traded later in the
opening market. In short, securitization is the transformation
of illiquid, non- marketable assets into securities which are
liquid and marketable assets. It is a process of transformation
of assets of a lending institution into negotiable instruments.
Securitisation is different from factoring. Factoring involves
transfer of debts without transforming debts into marketable
securities. But securitisation always involves transformation
of illiquid assets into liquid assets that can be sold to investors.

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Capital Market Services

Capital market simply refers to a market for long term funds.
It is a market for buying and selling of equity, debt and other
securities. Generally, it deals with long term securities that
have a maturity period of above one year. Capital market is a
vehicle through which long term finance is channelized for the
various needs of industry, commerce, govt. and local
authorities.
According to W.H. Husband and J.C. Dockerbay, “the capital
market is used to designate activities in long term credit,
which is characterised mainly by securities of investment
type”.
Thus, capital market may be defined as an organized
mechanism for the effective and smooth transfer of money
capital or financial resources from the investors to the
entrepreneurs.
Characteristics of Capital Market
1. It is a vehicle through which capital flows from the
investors to borrowers.
2. It generally deals with long term securities.
3. All operations in the new issues and existing securities
occur in the capital market.
4. It deals in many types of financial instruments. These
include equity shares, preference shares, debentures, bonds,
etc. These are known as securities. It is for this reason that
capital market is known as ‘Securities Market’.
5. It functions through a number of intermediaries such as
banks, merchant bankers, brokers, underwriters, mutual funds
etc. They serve as links between investors and borrowers.
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6. The constituents (players) in the capital market include

individuals and institutions. They include individual
investors, investment and trust companies, banks, stock
exchanges, specialized financial institutions etc.
Functions of a Capital Market
The functions of an efficient capital market are as follows:
1. Mobilise long term savings for financing long term
investments.
2. Provide risk capital in the form of equity or quasi-equity to
entrepreneurs.
3. Provide liquidity with a mechanism enabling the investor
to sell financial assets.
4. Improve the efficiency of capital allocation through a
competitive pricing mechanism.
5. Disseminate information efficiently for enabling
participants to develop an informed opinion about investment,
disinvestment, reinvestment etc.
6. Enable quick valuation of instruments – both equity and
debt.
7. Provide insurance against market risk through derivative
trading and default risk through investment protection fund.
8. Provide operational efficiency through:
(a) simplified transaction procedures,
(b) lowering settlement times, and
(c) lowering transaction costs.
9. Develop integration among:

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(a) debt and financial sectors,

(b) equity and debt instruments,
(c) long term and short term funds.
10. Direct the flow of funds into efficient channels through
investment and disinvestment and reinvestment.
Major Players or Participants (or Intermediaries) in the
Capital Market
There are many players (intermediaries) in the primary market
(or capital market). Important players are as follows:
1. Merchant bankers: In attracting public money to capital
issues, merchant bankers play a vital role. They act as issue
managers, lead managers or comanagers (functions in detail
is given in following pages)
2. Registrars to the issue: Registrars are intermediaries who
undertake all activities connected with new issue
management. They are appointed by the company in
consultation with the merchant bankers to the issue.
3. Bankers: Some commercial banks act as collecting agents
and some act as co-ordinating bankers. Some bankers act as
merchant bankers and some are brokers. They play an
important role in transfer, transmission and safe custody of
funds.
4. Brokers: They act as intermediaries in purchase and sale of
securities in the primary and secondary markets. They have a
network of sub brokers spread throughout the length and
breadth of the country.
5. Underwriters: Generally investment bankers act as
underwriters. They agreed to take a specified number of
shares or debentures offered to the public, if the issue is not
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fully subscribed by the public. Underwriters may be financial

institutions, banks, mutual funds, brokers etc.
Special Features of the Indian Capital Market
Indian capital market has the following special features:
1. Greater reliance on debt instruments as against equity and
in particular, borrowing from financial institutions.
2. Issue of debentures specifically, convertible debentures
with automatic or compulsory conversion into equity without
the normal option given to investors.
3. Floatation of Mega issues for the purpose of take over,
amalgamation etc. and avoidance of borrowing from financial
institutions for the fear of their discipline and conversion
clause by the bigger companies, and this has now become
optional.
4. Avoidance of underwriting by some companies to reduce
the costs and avoid scrutiny by the FIs. It has become optional
now.
5. Fast growth of mutual funds and subsidiaries of banks for
financial services leading to larger mobilisation of savings
from the capital market.
Procedure for Dealing at Stock Exchange (Trading
Mechanism or Method of Trading on a Stock Exchange)
Outsiders are not allowed to buy or sell securities at a stock
exchange. They have to approach brokers. Dealings can be
done only through brokers. They are the members of the stock
exchange. The following procedure is followed for dealing at
exchanges:

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1. Selection of a broker: An individual cannot buy or sell

securities directly at stock exchange. He can do so only
through a broker. So he has to select a broker through whom
the purchase or sale is to be made. The intending investor or
seller may appoint his bank for this purpose. The bank may
help to choose the broker.
2. Placing an order: After selecting the broker, the next step
is to place an order for purchase or sale of securities. The
broker also guides the client about the type of securities to be
purchased and the proper time for it. If a client is to sell the
securities, then the broker shall tell him about the favourable
time for sale.
3. Making the contract: The trading floor of the stock
exchange is divided into different parts known as trading
posts. Different posts deal in different types of securities. The
authorised clerk of the broker goes to the concerned post and
expresses his intention to buy and sell the securities. A deal is
struck when the other party also agrees. The bargain is noted
by both the parties in their note books. As soon as order is
executed a confirmation memo is prepared and is given to the
client.
4. Contract Note: After issue of confirmation memo, a
contract note is signed between the broker and the client. This
contract note will state the transaction fees (commission of
broker), number of shares bought or sold, price at which they
are bought or sold, etc.
5. Settlement: Settlement involves making payment to sellers
of shares and delivery of share certificate to the buyer of
shares after receiving the price. The settlement procedure
depends upon the nature of the transactions. All the

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transactions on the stock exchange may be classified into two-

ready delivery contracts and forward delivery contracts.
a. Ready delivery contract: A ready delivery contract involves
the actual payment of the amount by the buyer in cash and the
delivery of securities by the seller. A ready delivery contract
is to be settled on the same day or within the time period fixed
by the stock exchange authorities.
b. Forward delivery contracts: These contracts are entered
into without any intention of taking and giving delivery of the
securities. The traders in forward delivery securities are
interested in profits out of price variations in the future. Such
transactions are settled on the settlement days fixed by the
stock exchange authorities. Such contracts can be postponed
to the next settlement day, if both the parties agree between
themselves. Such postponement is called ‘Carry over’ or
‘badla’. Thus ‘carry over’ or ‘badla’ means the postponement
of transaction from one settlement period to the next
settlement period.
Rolling Settlement
Rolling settlement has been introduced in the place of account
period settlement. Rolling settlement system was introduced
by SEBI in January 1998.
Under this system of settlement, the trades executed on a
certain day are settled based on the net obligations for that
day. At present, the trades relating to the rolling settlement are
settled on T + 2day basis where T stands for the trade day.
It implies that the trades executed on the first day (say on
Monday) have to be settled on the 3rd day (on Wednesday),
i.e., after a gap of 2 days. This cycle would be rolling and
hence there would be number of set of transactions for
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delivery every day. As each day’s transaction are settled in

full, rolling settlement helps in increasing the liquidity in the
market. With effect from January 2, 2002, all scrips have been
brought under compulsory rolling mode.
Depository Services
A depository is an organization which holds securities in
electronic book entries at the request of the shareholder
through the medium of a depository participant. A depository
keeps the scrips on behalf of the investors. It undertakes the
custodian role. A depository participant is an agent of the
depository through which it interfaces with the investor. A
depository can be compared to a bank. Investors can avail the
services offered by a depository. To utilize the services
offered by a depository, the investor is required to open an
account called ‘demat account with the depository. The demat
account is opened through a depository participant. Thus it is
very similar to the opening of an account with any of the
branches of a bank in order to utilize the services of that bank.
The objective is to allow for the faster, convenient and easy
mode of affecting the transfer of securities. Thus, financial
services relating to holding, maintaining and dealing
securities in electronic form by a financial intermediary
known as depository are called depository services.
Constituents of Depository System
There are four players in the depository system. They are : (1)
Depository Participant, (2) Investor (Beneficial owner), (3)
Issuer, and (4) Depository.
Depository Participant: DP is an agent of the depository. If
an investor wants to avail the services offered by the
depository, the investor has to open an account with a DP. It
function as a bridge between the depository and the owners.
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A DP may be a financial institution, bank, custodian, a

clearing corporation, a stock broker or a “NBFC.
Investor (Beneficial Owner): He is the real owner of the
securities who has lodged his securities with the depository
in the form of a book entry.
Issuer: This is the company which issues the security.
Depository: It is a firm which holds the securities of an
investor in electronic form in the same way a bank holds
money. It carries out the transaction of securities by means of
book entry, without any physical movement of securities.
National Securities Depository Ltd. (NSDL)
NSDL was registered by SEBI on June 7, 1996 as India’s first
depository to facilitate trading and settlement of securities in
the dematerialized form. It was promoted by IDBI, UTI and
NSE (National Stock Exchange). The objective is to provide
electronic depository facilities for securities traded in the
equity and debt markets in the country. NSDL has been set up
to cater to the demanding needs of the Indian capital markets.
Functions / Services of NSDL
The following are the functions or services of NSDL :
1. Maintenance of individual investors’ beneficial holdings in
an electronic form.
2. Trade settlement
3. Automatic delivery of securities to the clearing corporation
4. Dematerialisation and rematerialisation of securities.
5. Allotment in the electronic form in case of IPOs.
6. Distribution of dividend
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7. Facility for freezing / locking of investor accounts

8. Facility for pledge and hypothecation of securities.
9. Internet based services such as SPEED-c and IDeAS
Central Depository Services (India) Ltd. (CDSL)
The CDSL is the second depository set up by the Bombay
Stock Exchange and co-sponsored by the SBI, Bank of India,
Union bank of India, and Centurian Bank. The CDSL
commenced operations on March 22, 1996. The CDSL was
set up with the objectives of providing convenient,
dependable and secure depository services at affordable cost
to all market participants. All leading stock exchanges such as
Bombay Stock Exchange, National Stock Exchange, and
Kolkata Stock Exchange etc. have established connectivity
with CDSL.
Securities Exchange Board of India (SEBI)
Securities and Exchange Board of India (SEBI) is the nodal
agency to regulate the capital market and other related issues
in India. It was established in 1988 as an administrative body
and was given statutory recognition in January 1992 under the
SEBI Act 1992 which came into force on January 30, 1992.
Before that, the Capital Issues (Control) Act, 1947 was
repealed. SEBI has been constituted on the lines of Securities
and Exchange Commission of USA. SEBI is consisting of the
Chairman and 8 Members (one member representing the
Reserve Bank of India, two members from the officials of
Central Government and five other public representatives to
be appointed by the Central Government from different
fields). Securities and Exchange Board of India has been
playing an active role in the Indian Capital Market to achieve

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the objectives enshrined in the Securities and Exchange Board

of India Act, 1992.
The major objective of the SEBI may be summarised as
follows:
• To provide a degree of protection to the investors and
safeguard their rights and to ensure that there is a steady
flow of funds in the market.
• To promote fair dealings by the issuer of securities and
ensure a market where they can raise funds at a relatively
low cost.
• To regulate and develop a code of conduct for the financial
intermediaries and to make them competitive and
professional.
• To provide for the matters connecting with or incidental
to the above.
Section 11 of the SEBI Act deals with the powers and
functions of the SEBI as follows:
• It shall be the duty of Board to protect the interests of the
investors in securities and to promote the development of
and to regulate the securities market by measures as
deemed fit.
• To achieve the above, the Board may undertake the
following measures :
1. Regulating the business in stock exchanges;
2. Registering and regulating the working of stock brokers,
sub-brokers, share transfer agents, bankers to an issue,
merchant bankers, underwriters, portfolio managers;

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3. Registering and regulating the working of the depositories,

participants, credit rating agencies;
4. Registering and regulating the working of venture capital
funds and collective investment schemes, including mutual
funds;
5. Prohibiting fraudulent and unfair trade practices relating to
securities markets;
6. Promoting investors education and training of
intermediaries of securities markets;
7. Prohibiting insider trading in securities;
8. Regulating substantial acquisition of shares and take-over
of companies; and
9. Calling for information from undertaking, inspection,
concluding inquiries and audits of the stock exchanges,
mutual funds, other persons associated with the securities
market intermediaries and self-regulatory organisations in the
securities market.
Role of SEBI in Primary Market
The primary market is under the control of Securities and
Exchange Board of India. Securities and Exchange Board of
India has an important role to keep the primary market healthy
and efficient. It has been taking several measures for the
development of primary market in India. In the meantime it is
attempting to protect the interest of investors. It is issuing
guidelines in respect of new issues of securities in the primary
market. The role being played by the Securities and Exchange
Board of India in the primary market can be understood from
the following points:

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1. The prime objective of establishing Securities and

Exchange Board of India was to protect the interests of
investors in securities, promoting the development of, and
regulating the securities markets.
2. The Securities and Exchange Board of India Act came into
force on 30th January, 1992. With its establishment, all public
issues are governed by the rules and regulations issued by
Securities and Exchange Board of India.
3. Securities and Exchange Board of India was formed to
promote fair dealing in issue of securities and to ensure that
the capital markets function efficiently, transparently and
economically in the better interests of both the issuers and
investors.
4. The promoters should be able to raise funds at a relatively
low cost. At the same time, investors must be protected from
the unethical practices. Their rights must be safeguarded so
that there is a ready flow of savings into the market.
There must be proper regulation and code of conduct and fair
practice by intermediaries to make them competitive and
professional. These are taken care of by Securities and
Exchange Board of India. instrumental in bringing greater
transparency in capital issues. Under the umbrella of
Securities and Exchange Board of India, companies issuing
shares are free to fix the premium provided that adequate
disclosure is made in the offer documents. Securities and
Exchange Board of India has become a vigilant watchdog
with the focus towards investor protection.
6. The Securities and Exchange Board of India introduced the
concept of anchor

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investor on June 18, 2009 to enhance issuer’s ability to sell

the issue, generate more confidence in the minds of retail
investors and better price discovery in the issue process.
Anchor investors are qualified institutional buyers that buy a
large chunk of shares a day before an IPO opens. They help
arriving at an appropriate benchmark price for share sales and
generate confidence in retail investors. A retail investor is one
who can bid in a book-built issue or applies for securities for
a value of not more than Rs. 1,00,000.
Role of SEBI in Secondary Market
Since its birth, Securities and Exchange Board of India has
been playing an active role to make the secondary market
healthy and efficient. It will issue guidelines for the proper
functioning of the secondary market. It has the power to call
periodical returns from stock exchanges. It has the power to
prescribe maintenance of certain documents by the stock
exchanges. It may call upon the exchange or any member to
furnish explanation or information relating to the affairs of the
stock exchange or any members.
Recent Developments in the Secondary Market (Steps
taken by SEBI and Govt to reform the Secondary
Market).
In recent years several steps have been taken to reform the
secondary market with a view to improve the efficiency and
effectiveness of secondary market. Some of the developments
in this direction are as follows:
1. Regulation of intermediaries: Strict control is being
exercised on the intermediaries in the capital market with a
view to improve their functioning. The intermediaries such as
merchant bankers, underwriters, brokers, sub-brokers etc.
must be registered with the Securities and Exchange Board of
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India. To improve their financial adequacy, capital adequacy

norms have been fixed.
2. Insistence on quality securities: Securities and Exchange
Board of India has announced recently revised norms for
companies accessing the capital market so that only quality
securities are listed and traded in stock exchanges. Further,
participation of financial institutions in the capital is essential
for entry into the capital market.
3. Prohibition of insider trading: Now Securities and
Exchange Board of India (Insider Trading) Amendment
Regulations, 2002 have been formed giving more powers to
Securities and Exchange Board of India to curb insider
trading. An insider is prevented from dealing in securities of
any listed company on the basis of any unpublished price
sensitive information.
4. Transparency of accounting practices: To ensure correct
pricing and wider participation, greater efforts are being taken
to achieve transparency in trading and accounting practices.
Brokers are asked to show their prices, brokerage, service tax
etc. separately in the contract notes and their accounts.
5. Strict supervision of stock market operations: The Ministry
of Finance and Securities and Exchange Board of India
supervise the operations in stock exchanges very strictly. The
Securities and Exchange Board of India monitors the
operations of stock exchanges very closely in order to ensure
that the dealings are conducted in the best interest of the
overall financial environment in the country in general and the
investors in particular. Strict rules have been framed with
regard to recognition of stock exchanges, membership,
management, maintenance of accounts etc. Again, stock

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exchanges are inspected by the officers of the Securities and

Exchange Board of India from time to time.
6. Discouragement of manipulations: The Securities and
Exchange Board of India is taking all steps to prevent price
manipulations in all stock exchanges. It has given instructions
to all stock exchanges to keep special margins in addition to
normal ones on the scrips which are subject to wide price
fluctuations. The
Securities and Exchange Board of India itself insists upon a
special margin of 25% or more (in addition to the regular
margin) on purchases of scrips which are subject to sharp rise
in prices. All stock exchanges have been directed to suspend
trading in scrip in case any one of the stock exchanges
suspends trading in that scrip for more than a day due to price
manipulation or fluctuation.
7. Prevention of price rigging: Greater powers have been
given to Securities and Exchange Board of India under
Securities and Exchange Board of India (Prohibition of
fraudulent and unfair trade practices relating to security
markets) Regulations, 1995 to curb price rigging.
8. Protection of investors’ interests: Stock exchanges are
given instructions to take timely action for the redressal of
grievances of investors. For this purpose, the Securities and
Exchange Board of India issues “Investors Guidance Service’
to guide and educate the investors about grievances and
remedies available. It also gives information about various
investment avenues, their merits, tax benefits available etc.
Disciplinary Action Committees have been set up in each
stock exchange to take up complaints against companies,
brokers etc. The Securities and Exchange Board of India itself
takes up complaints against companies, brokers etc. Further,
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each stock exchange is under a legal obligation to create an

investor protection fund.
9. Free pricing of securities: Now any company is free to enter
the capital market to raise the necessary capital at any price
that it wants. Recently, the Securities and Exchange Board of
India has permitted companies to issue shares below the face
value of Rs. 10 and liberalised the norms for initial public
offerings.
10. Freeing of interest rates: Interest rates on debentures and
on PSU bonds were freed in August 1991 with a view to
raising funds from the capital market at attractive rates
depending on the credit rating.
11. Setting up of credit rating agencies: Credit rating agencies
have been set up for awarding credit rating to the money
market instruments, debt instruments, deposits and equity
shares also. Now all debt instruments must be compulsorily
credit rated by a credit rating agency so that the investing
public may not be deceived by financially unsound
companies.
12. Introduction of electronic trading: The OTCEI has started
its trading operations through the electronic media. Similarly,
BSE switched over to electronic trading system in 1995,
called BOLT. Again, NSE went over to screen based trading
with a national network.
13. Establishment of OTC / OTCEI / NSE: To overcome
delay, price rigging, manipulation etc., OTC/ OTCEI and NSE
have been established. OTC markets are fully automated
exchanges where trading would be carried out through
network of telephone/ computers/ tellers spread throughout
the country.

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14. Introduction of depository system: To avoid bad delivery,

forgery, theft, delay in settlement and to speed up the transfer
of securities, the depository system has been approved by the
Parliament on July 23, 1996.
15. Buy back of shares: Now companies have been permitted
to buy back their own shares.
16. Disinvestment of shares of PSUs: To bring down the Govt.
holding and to push up the privatisation process, the
disinvestment programme has been implemented. A
Disinvestment Commission has been established for this
purpose.
17. Stock watch system: The Securities and Exchange Board
of India introduced a new stock watch system to trace out the
source of undesirable trading if any in the market. The stock
watch system simply works as a mathematical model which
keeps a constant watch on the market movements.
18. Trading in derivatives: L.C. Gupta Committee which had
gone into the question of introduction of derivative trading,
has recommended introducing trading in index futures to start
with and then trading in options. Recently, future funds also
have been permitted to trade in derivatives.
19. Stock lending mechanism: To make the capital market
active by putting idle stocks to work, stock lending scheme
has been introduced by the Securities and Exchange Board of
India.
20. International listing: The big event in the history of Indian
capital market is the listing company’s share on an American
stock exchange.
21. Rolling settlement: In July 2001, Securities and Exchange
Board of India made rolling settlement on a T + 5 cycles
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compulsory in 414 stocks and the rest of the stocks should

follow it from January 2002. But now T + 2 rolling settlement
have been introduced for all securities.
22. Margin trading: Another development in the secondary
market is the introduction of margin trade.

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Module II
FUND INVESTMENTS
Mutual funds represent one of the most important institutional
forces in the market. They are institutional investors. They
play a major role in today’s financial market. The first mutual
fund was established in Boston in 1924 (USA).
Meaning of Mutual Funds
Small investors generally do not have adequate time,
knowledge, experience and resources for directly entering the
capital market. Hence they depend on an intermediary. This
financial intermediary is called mutual fund.
Mutual funds are corporations that accept money from savers
and then use these funds to buy stocks, long term funds or
short term debt instruments issued by firms or governments.
These are financial intermediaries that collect the savings of
investors and invest them in a large and well diversified
portfolio of securities such as money market instruments,
corporate and government bonds and equity shares of joint
stock companies. They invest the funds collected from
investors in a wide variety of securities i.e. through
diversification. In this way it reduces risk.
Mutual fund works on the principle of “small drops of water
make a big ocean”. It is a form of collective investment. To
get the surplus funds from investors, it adopts a simple
technique. Each fund is divided into a small share called
‘units’ of equal value. Each investor is allocated units in
promotion to the size of his investment.
Mutual fund is a trust that pools the savings of investors. The
money collected is then invested in financial market
instruments such as shares, debentures and other securities.
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The income earned through these investments and the capital

appreciations realized are shared by its unit holders in
proportion to the number of units owned by them. Thus
mutual fund invests in a variety of securities (called
diversification). This reduces risk. Diversification reduces the
risk because all stock and/ or debt instruments may not move
in the same direction.
According to the Mutual Fund Fact Book (published by the
Investment Company Institute of USA), “a mutual fund is a
financial service organization that receives money from
shareholders, invests it, earns return on it, attempts to make it
grow and agrees to pay the shareholder cash demand for the
current value of his investment”.
SEBI (mutual funds) Regulations, 1993 defines a mutual fund
as ‘a fund established in the form of a trust by a sponsor, to
raise monies by the trustees through the sale of units to the
public, under one or more schemes, for investing in securities
in accordance with these regulations.
Features of Mutual Funds
Mutual fund possesses the following features:
1. Mutual fund mobilizes funds from small as well as large
investors by selling units.
2. Mutual fund provides an ideal opportunity to small
investors an ideal avenue for investment.
3. Mutual fund enables the investors to enjoy the benefit of
professional and expert management of their funds.
4. Mutual fund invests the savings collected in a wide
portfolio of securities in order to maximize return and
minimize risk for the benefit of investors.

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5. Mutual fund provides switching facilities to investors who

can switch from one scheme to another.
6. Various schemes offered by mutual funds provide tax
benefits to the investors.
7. In India mutual funds are regulated by agencies like SEBI.
8. The cost of purchase and sale of mutual fund units is low.
9. Mutual funds contribute to the economic development of a
country.
Types of Mutual Funds (Classification of Mutual Funds)
Mutual funds (or mutual fund schemes) can be classified into
many types. The following chartshows the classification of
mutual funds:
Mutual Funds
On the basis of Operation
Open ended
Close ended
On the basis of Return
Income fund
Growth fund
Conservative fund
On the basis of Investment
Equity fund
Bond fund
Balanced fund
Money market mutual fund
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Taxation fund
Leveraged fund
Index bond fund
These may be briefly described as follows:
A. On the basis of Operation
1. Close ended funds: Under this type of fund, the size of the
fund and its duration are fixed in advance. Once the
subscription reaches the predetermined level, the entry of
investors will be closed. After the expiry of the fixed period,
the entire corpus is disinvested and the proceeds are
distributed to the unit holders in proportion to their holding.
Features of Close ended Funds
(a) The period and the target amount of the fund is fixed
beforehand.
(b) Once the period is over and/ or the target is reached, the
subscription will be closed (i.e. investors cannot purchase any
more units).
(c) The main objective is capital appreciation.
(d) At the time of redemption, the entire investment is
liquidated and the proceeds are liquidated and the proceeds
are distributed among the unit holders.
(e) Units are listed and traded in stock exchanges.
(f) Generally the prices of units are quoted at a discount of
upto 40% below their net asset value.
2. Open-ended funds: This is the just reverse of close-ended
funds. Under this scheme the size of the fund and / or the

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period of the fund is not fixed in advance. The investors are

free to buy and sell any number of units at any point of time.
Features of Open-ended Funds
(a) The investors are free to buy and sell units. There is no
time limit.
(b) These are not trade in stock exchanges.
(c) Units can be sold at any time.
(d) The main motive income generation (dividend etc.)
(e) The prices are linked to the net asset value because units
are not listed on the stock exchange.
Difference between Open-ended and Close-ended
Schemes
1. The close-ended schemes are open to the public for a
limited period, but the open-ended schemes are always open
to be subscribed all the time.
2. Close-ended schemes will have a definite period of life. But
he open-ended schemes are transacted in the company.
3. Close-ended schemes are transacted at stock exchanges,
where as open-ended schemes are transacted (bought and
sold) in the company.
4. Close-ended schemes are terminated at the end of the
specified period. Open-ended schemes can be terminated only
if the total number of units outstanding after repurchase fall
below 50% of the original number of units.
B. On the basis of return/ income
1. Income fund: This scheme aims at generating regular and
periodical income to the members.
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Such funds are offered in two forms. The first scheme earns a
target constant income at relatively low risk. The second
scheme offers the maximum possible income.
Features of Income Funds
(a) The investors get a regular income at periodic intervals.
(b) The main objective is to declare dividend and not capital
appreciation.
(c) The pattern of investment is oriented towards high and
fixed income yielding securities like bonds, debentures etc.
(d) It is best suited to the old and retired people.
(e) It focuses on short run gains only.
2. Growth fund: Growth fund offers the advantage of capital
appreciation. It means growth fund concentrates mainly on
long run gains. It does not offers regular income. In short,
growth funds aim at capital appreciation in the long run.
Hence they have been described as “Nest Eggs” investments
or long haul investments.
Features of Growth Funds
(a) It meets the investors’ need for capital appreciation.
(b) Funds are invested in equities with high growth potentials
in order to get capital appreciation.
(c) It tries to get capital appreciation by taking much risk.
(d) It may declare dividend. But the main objective is capital
appreciation.
(e) This is best suited to salaried and business people.
3. Conservative fund: This aims at providing a reasonable
rate of return, protecting the value of the investment and
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getting capital appreciation. Hence the investment is made in

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

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The gains are distributed to unit holders.

7. Index bonds: These are linked to a specific index of share
prices. This means that the funds mobilized under such
schemes are invested principally in the securities of
companies whose securities are included in the index
concerned and in the same proportion. The value of these
index linked funds will automatically go up whenever the
market index goes up and vice versa.
8. Money market mutual funds: These funds are basically
open ended mutual funds. They have all the features of open
ended mutual funds. But the investment is made is highly
liquid and safe securities like commercial paper, certificates
of deposits, treasury bills etc. These are money market
instruments.
9. Off shore mutual funds: The sources of investments for
these funds are from abroad.
10. Guilt funds: This is a type of mutual fund in which the
funds are invested in guilt edged securities like government
securities. It means funds are not invested in corporate
securities like shares, bonds etc.
Objectives of Mutual Funds
1. To mobilise savings of people.
2. To offer a convenient way for the small investors to enter
the capital and the money market.
3. To tap domestic savings and channelize them for profitable
investment.
4. To enable the investors to share the prosperity of the capital
market.

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5. To act as agents for growth and stability of the capital

market.
6. To attract investments from the risk aversers.
7. To facilitate the orderly development of the capital market.
Advantages (Importance) of Mutual Funds
Mutual funds are growing all over the world. They are
growing because of their importance to investors and their
contributions in the economy of a country. The following are
the advantages of mutual funds:
1. Mobilise small savings: Mutual funds mobilize small
savings from the investors by offering various schemes. These
schemes meet the varied requirements of the people. The
savings of the people are channelized for the development of
the economy. In the absence of mutual funds, these savings
would have remained idle.
2. Diversified investment: Small investors cannot afford to
purchase the shares of the highly established companies
because of high market price. The mutual funds provide this
opportunity to small investors. Even a very small investor can
afford to invest in mutual funds. The investors can enjoy the
wide portfolio of the investments held by the fund. It
diversified its risks by investing in a variety of securities
(equity shares, bonds etc.) The small and medium investors
cannot do this.
3. Provide better returns: Mutual funds can pool funds from
a large number of investors. In this way huge funds can be
mobilized. Because of the huge funds, the mutual funds are in
a position to buy securities at cheaper rates and sell securities
at higher prices. This is not possible for individual investors.

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In short, mutual funds are able to give good and regular

returns to their investors.
4. Better liquidity: At any time the units can be sold and
converted into cash. Whenever investors require cash, they
can avail loans facilities from the sponsoring banks against the
unit certificates.
5. Low transaction costs: The cost of purchase and sale of
mutual fund units is relatively less. The brokerage fee or
trading commission etc. are lower. This is due to the large
volume of money being handled by mutual funds in the capital
market.
6. Reduce risk: There is only a minimum risk attached to the
principal amount and return for the investments made in
mutual funds. This is due to expert supervision, diversification
and liquidity of units.
7. Professional management: Mutual funds are managed by
professionals. They are well trained. They have adequate
experience in the field of investment. Thus investors get
quality services from the mutual funds. An individual investor
would never get such a service from the securities market.
8. Offer tax benefits: Mutual funds offer tax benefits to
investors. For instance, under section 80 L of the Income Tax
Act, a sum of Rs. 10,000 received as dividend from a mutual
fund (in case of
UTI, it is Rs. 13,000) is deductible from the gross total
income.
9. Support capital market: The savings of the people are
directed towards investments in capital markets through
mutual funds. They also provide a valuable liquidity to the
capital market.
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In this way, the mutual funds make the capital market active
and stable.
10. Promote industrial development: The economic
development of any nation depends upon its industrial
advancement and agricultural development. Industrial units
raise funds from capital markets through the issue of shares
and debentures. Mutual funds supply large funds to capital
markets. Besides, they create demand for capital market
instruments (share, debentures etc.). Thus mutual funds
provide finance to industries and thereby contributing towards
the economic development of a country.
11. Keep the money market active: An individual investor
cannot have any access to money market instruments. Mutual
funds invest money on the money market instruments. In this
way, they keep the money market active.
Valuation of Mutual Funds
Net Asset Value
NAV or Net Asset Value is the market value of the securities
held by the scheme. Since market value of securities changes
every day, NAV of a scheme also changes daily. The NAV
per unit of all mutual fund schemes is updated on AMFI’s
website and the Mutual Funds’ website by 9 p.m. that very
day.
NAV= Market or Fair Value of Scheme's investments +
Current Assets - Current Liabilities and Provision NAV /
Number of Units outstanding under Scheme on the Valuation
Date
All the Asset Management Companies value the investments
of their Schemes as mandated by the principles of ‘fair
valuation’ or such other principles/regulations as be
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prescribed by SEBI from time to time. This is done to ensure

fair treatment to all investors including existing investors as
well as investors seeking to purchase or redeem units of
mutual funds in all schemes at all points of time.
This policy and procedures are reviewed at least once in a
financial year by an internal auditor. The periodic report from
the internal auditor verifying accuracy and authenticity of
valuation of investments in accordance with this policy is
presented before the Board of AMC and Trustee.
Whenever there is an investment in new type of securities /
assets other than mentioned in existing policy, it shall be made
only after establishment of the valuation methodologies for
such securities / assets by the Valuation Committee with the
approval of the Board of the AMC and Trustee.
Underlying Valuation Methodology
The valuation of investments shall be based on the principles
of fair valuation i.e. valuation should reflect the realizable
value of the securities/assets.
Investment in any new type of security shall be made only
after establishment of the valuation methodology for such
type of security with the approval of the AMC Board.
The valuation norms of each of the asset class is as follows:
1. Valuation of Traded Securities - equity / equity related
security (such as convertible debentures, equity warrants,
etc.)/preference shares
On a valuation day, these securities will be valued at the last
quoted closing price on the National Stock Exchange of India
Limited (NSE). In case a security is not traded on the NSE, it
will be valued at the last quoted closing price on the Bombay

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Stock Exchange Limited (BSE). If a security is not traded on

any stock exchange on a valuation day, the last quoted closing
price on NSE or BSE (in the order of priority) on the earliest
previous day would be considered. Such day should not be
more than thirty days prior to the valuation day.
If the security cannot be priced as per the above-mentioned
criteria, then the valuation will be determined by the
Valuation Committee based on the principles of fair valuation.
During this process, the Valuation Committee will also
consider if the price of the security is available on any
recognized stock exchange other than the NSE and BSE and
if the same is reliable/ can be considered for fair valuation.
Valuation of Exchange Traded Fund (ETF)
ETFs are - valued at closing market prices available on the
stock exchange i.e. NSE. If the closing price is not available
on NSE then the closing prices available on BSE is
considered. If price at both NSE and BSE are not available,
the latest NAV of the fund is considered
Valuation of Debt & Money Market Instruments
Asset Management Companies usually appoint independent
external valuation agencies approved by AMFI, such as ICRA
and CRISIL Ltd, an, to conduct the daily valuation of all debt
and money market instruments by following all the
procedures as laid below and provide the daily MTM prices
for valuation with necessary justification. Securities are then
valued at the average of the prices provided by these 2
valuation agencies.
Valuation of money market and debt securities with
residual maturity of < 60 days:

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All money market and debt securities, including floating rate

securities, with residual maturity of up to 60 days shall be
valued at the weighted average price at which they are traded
on the valuation day. When such securities are not traded on
a valuation day, they shall be valued on amortization basis.
Valuation of money market and debt securities with
residual maturity of > 60 days
All money market and debt securities, including floating rate
securities, with residual maturity of more than 60 days shall
be valued at weighted average price at which they are traded
on the valuation day.
Mutual Funds in India
In India the first mutual fund was UTI. It was set up in 1964
under an Act of parliament. During the year 1987-1992, seven
new mutual funds were established in the public sector. In
1993, the government changed its policy to allow the entry of
private corporates and foreign institutional investors into the
mutual fund segment. Now the commercial banks like the
SBI, Canara Bank,
Indian bank, Bank of India, Punjab National Bank etc. have
entered into the field. LIC and GIC have also entered into the
market. By the end of March 2000, there was 36 mutual funds,
9 in the public sector and 27 in the private sector. However
UTI dominated the mutual fund sector. In India mutual funds
are being regulated by agencies like SEBI. Mutual funds play
an important role in promoting saving and investment within
the country. There are around 196 mutual fund schemes, and
the amount of assets under their management was Rs. 47,000
crores in 1993, Rs. 80,590 crores in 2003 and it went up to Rs.
2, 17,707crores by 31.3.2006. Thus mutual funds are growing
in India. However, their growth rate is very slow.
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PROBLEMS OF MUTUAL FUNDS IN INDIA

The following are some of the main problems that are being
faced by Indian mutual funds.
1. Liquidity crisis.
2. Lac of innovation.
3. Inadequate research.
4. Conventional pattern of investment.
5. No provision for performance guarantee.
6. Inadequate disclosures.
7. Delays in service.
8. No rural sector investment base.
9. Poor risk management.
SEBI GUIDELINES ON MUTUAL FUNDS
Mutual funds in India are now governed under the Securities
and Exchange Board of India( mutual fund)
Regulations,1996. SEBI has provided a four tier system for
managing the affairs of mutual funds. The four constituents in
the organisation of a mutual funds are:
1. The sponsoring company, called Sponsor: SEBI(mutual
funds) Regulations define Sponsor as any person who acting
alone or in combination with another body corporate,
establishes a mutual fund. SBI Mutual fund is sponsored by
State Bank of India, LICMF is sponsored by Life Insurance
Corporation (LIC) of India. Sponsors have to comply with the
following regulations laid down by SEBI.
a. Application and fee: a sponsor has to file an application for
registration of a mutual fund in the prescribed form along with
an application with fee of Rs.100000. the sponsors must
furnish all information and give clarifications as may be
required by the board.
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b. Eligibility criteria: the sponsor may be granted a certificate

of registration provided following conditions are satisfied.
i. The sponsor has a sound track reecord and general
reputation of fairness and integrity in all his business
transactions for not less than 5 years.
ii. The sponsor has contributed atleast 40% of the worth of
AMC.
iii. A trustee has been appointed by the sponsers who will act
as trustee for the mutual fund.
iv. An AMC is appointed to manage and operate the scheme
of such funds.
v. A custodian is appointed to keep custody of the securities
and carry out the custodian activities.
c. Grant of certificate of registration.
d. Annual fee.
2. The trustees: SEBI(mutual fund) Amendment regulations.
1999 defines trustee as “a person who holds the property of
the mutual fund in trust for benefit of the unit-holders and
includes a trustee company and the directors of the trustee
company.” SEBI (mutual fund) regulatons, 1996 from 16to 18
contain guidelines with regard to operation of trustees
3. Asset management company (AMC):
SEBI regulations require that mutual funds be managed by a
seperate body corporate. The sponsor or the trustee shall
appoint an AMC. The application for the approval of AMC
has to be made in Form D. The appointment of AMC can be
terminated by majority of the trustees or by 75% of the unit-
holders of the scheme. Any change in the appointment of

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AMC requires the prior approval of the Board and the unit-
holders.
4. Custodian: custodian is defined under SEBI (mutual
funds) Regulations.1996 as “ a person who has been granted
a certificate of registration to carry on the business of
custodian of securities under the securities and Exchange
Board of India (custodian of securities) Regulations, 1996.
Custodian provides custodial services and ensures safe-
keeping of securities. He performs the following functions.
i. Maintains accounts of securities of a client.
ii. Collects the benefits or rights accuring to the client in
respect of secutities.
iii. Maintains and reconciles the records of securities.
iv. Helps in transfer of the securities in the name of trust.
v. Prevents any manipulation of records and documents.
The following are the SEBI regulations with regard to
custodian.
Appointment of custodian (SEBI Regulation 26)
i. The mutual fund shall appoint a custodian to carry out the
custodian services for the schemes of the fund and sent
intimation of the same to the board within fifteen days of the
appointment of the custodian.
ii. No custodian in which the sponsor or its associates holds
50% or more of the voting rights of the share capital of the
custodian or where 50 % or more of the directors of the
custodian represent the interest of the sponsor or its associates,
shall act as custodian for a mutual fund constitutes by the same
sponsor or any of its associate or subsidiary company.

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PENSION FUND
Pension funds, which are also known as retirement funds, is a
kind of savings scheme where you (as an employee) invest a
small portion of your income/salary into a designated savings
plan. The main objective of this plan is to get a steady flow of
income after you complete your active years of service.
In India, the pension funds are divided into two stages. The
first stage is the accumulation stage wherein you pay or invest
in the pension plan throughout your active work years until
the retirement age. Once you attain the retirement age, the
second stage begins, which is the vesting stage. In this stage,
you start getting annuities until death.
BENEFITS OF INVESTING IN PENSION FUNDS
One of the most significant pension benefits is that lets you
save for long-term. Whether you choose a scheme that
requires you to invest a lump sum amount or smaller amounts,
you get guaranteed savings. The pension funds create an
annuity that you can use to invest further and get steady
income post retirement.
Many pension funds offer a lump sum payback to the investor
when they attain the retirement age or in case of their death,
whichever event occurs earlier. This implies that the pension
fund also gives you the benefit of an insurance cover.
Another benefit of investing in a pension fund is that it
negates the effect of inflation and provides inflation-adjusted
returns.
TYPES OF PENSION FUNDS IN INDIA
In India, the pension plans are broadly classified into three
types, which are: The funds that are sponsored by an insurance
company. In the fund, the investor’s money is invested in
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debts alone and is best suited for conservative and low-risk

investors.
Unit Linked Plans invest the funds in both debt funds and
equities. It is one of the most popular pension funds and lets
the investors create a balanced portfolio. Lastly, the National
Pension Scheme, which is the government-sponsored fund.
Under this scheme, the funds are either invested in
government securities or debt securities.
1. NPS
The government of India introduced the National Pension
Scheme (NPS) as a financial cushion for retired persons.
Some of its features are as follows:
• You have to invest in this scheme until 60 years of age.
• The least sum you must invest is Rs. 1000. There is no upper
limit.
• Your money will be invested in debt and equity funds based
on your preference.
• The returns depend on the performance of the funds you
choose.
• When you retire, you can withdraw 60% of the savings.
• You must use the remaining 40% to buy an annuity – a
retirement plan offering periodic income.
2. Public Provident Fund (PPF)
PPF is a long-term investment scheme with a 15 years' tenure.
Thus, the impact of compounding is enormous, especially
towards the end of the term.
Every year you can invest a maximum of Rs. 1.5 lakhs in your
PPF account. You can pay upfront or through twelve
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instalments staggered over the financial year. Your PPF

investments are eligible for tax deductions under Section
80C of the Income Tax Act (ITA). The interest you earn is
also tax-free.
The government sets the interest rate on PPF every financial
quarter, based on the profits from government securities. The
funds are not market-linked.
3. Employee Provident Fund (EPF)
EPF is a government savings platform for salaried employees.
Both your employer and you have to make equal contributions
towards your EPF account. Your share is removed from your
salary every month. The Employees' Provident Fund
Organisation (EPFO) sets the interest rate on the investment.
On retirement, you receive the total funds contributed by you
and your employer along with the accrued interests.
4. Annuity plans with life cover
Such plans provide a life cover along with a regular source of
income. If an unfortunate event occurs while the plan is active,
your family member receives a lump-sum payout, however
there are other options too that do not offer this financial
coverage. Annuity plans are of two types:
A. Deferred Annuity
It is a contract with an insurance provider helping you build a
retirement corpus. You can make a single lump-sum payment
or pay regular premiums over a fixed time-frame – the policy
term. Thus, this scheme helps you invest as per your
resources.
When the policy period ends, your pension starts. If your
retirement date is far in the future, this plan is suitable for you.

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B. Immediate annuity
It is a contract between an individual and insurance company,
where in the individual pays a lump sum amount and receives
guaranteed income for lifetime, starting almost immediately.
Exchange Traded Fund (ETF)
An exchange traded fund (ETF) is a type of security that tracks
an index, sector, commodity, or other asset, but which can be
purchased or sold on a stock exchange the same way a regular
stock can. An ETF can be structured to track anything from
the price of an individual commodity to a large and diverse
collection of securities. ETFs can even be structured to track
specific investment strategies.
A well-known example is the SPDR S&P 500 ETF (SPY),
which tracks the S&P 500 Index. ETFs can contain many
types of investments, including stocks, commodities, bonds,
or a mixture of investment types. An exchange traded fund is
a marketable security, meaning it has an associated price that
allows it to be easily bought and sold.
An ETF is called an exchange traded fund because it's traded
on an exchange just like stocks are. The price of an ETF’s
shares will change throughout the trading day as the shares are
bought and sold on the market. This is unlike mutual funds,
which are not traded on an exchange, and trade only once per
day after the markets close. Additionally, ETFs tend to be
more cost-effective and more liquid when compared to mutual
funds.
Types of ETFs
There are various types of ETFs available to investors that can
be used for income generation, speculation, price increases,
and to hedge or partly offset risk in an investor's portfolio.
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Here is a brief description of some of the ETFs available on

the market today.
Bond ETFs
Bond ETFs are used to provide regular income to investors.
Their income distribution depends on the performance of
underlying bonds. They might include government bonds,
corporate bonds, and state and local bonds—called municipal
bonds. Unlike their underlying instruments, bond ETFs do not
have a maturity date. They generally trade at a premium or
discount from the actual bond price.
Stock ETFs
Stock ETFs comprise a basket of stocks to track a single
industry or sector. For example, a stock ETF might track
automotive or foreign stocks. The aim is to provide diversified
exposure to a single industry, one that includes high
performers and new entrants with potential for growth. Unlike
stock mutual funds, stock ETFs have lower fees and do not
involve actual ownership of securities.
Industry ETFs
Industry or sector ETFs are funds that focus on a specific
sector or industry. For example, an energy sector ETF will
include companies operating in that sector. The idea behind
industry ETFs is to gain exposure to the upside of that industry
by tracking the performance of companies operating in that
sector. One example is the technology sector, which has
witnessed an influx of funds in recent years. At the same time,
the downside of volatile stock performance is also curtailed in
an ETF because they do not involve direct ownership of
securities. Industry ETFs are also used to rotate in and out of
sectors during economic cycles.
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Commodity ETFs
As their name indicates, commodity ETFs invest in
commodities, including crude oil or gold. Commodity ETFs
provide several benefits. First, they diversify a portfolio,
making it easier to hedge downturns. For example,
commodity ETFs can provide a cushion during a slump in the
stock market. Second, holding shares in a commodity ETF is
cheaper than physical possession of the commodity. This is
because the former does not involve insurance and storage
costs.
Currency ETFs
Currency ETFs are pooled investment vehicles that track the
performance of currency pairs, consisting of domestic and
foreign currencies. Currency ETFs serve multiple purposes.
They can be used to speculate on the prices of currencies
based on political and economic developments for a country.
They are also used to diversify a portfolio or as a hedge
against volatility in forex markets by importers and exporters.
Some of them are also used to hedge against the threat of
inflation.
Inverse ETFs
Inverse ETFs attempt to earn gains from stock declines by
shorting stocks. Shorting is selling a stock, expecting a decline
in value, and repurchasing it at a lower price. An inverse ETF
uses derivatives to short a stock. Essentially, they are bets that
the market will decline. When the market declines, an inverse
ETF increases by a proportionate amount. Investors should be
aware that many inverse ETFs are exchange traded notes
(ETNs) and not true ETFs. An ETN is a bond but trades like
a stock and is backed by an issuer like a bank. Be sure to check

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with your broker to determine if an ETN is a good fit for your

portfolio.
In the U.S., most ETFs are set up as open-ended funds and are
subject to the Investment Company Act of 1940 except where
subsequent rules have modified their regulatory
requirements. Open-end funds do not limit the number of
investors involved in the product.
How to Begin Investing in ETFs
With a multiplicity of platforms available to traders, investing
in ETFs has become fairly easy. Follow the steps outlined
below to begin investing in ETFs.
1. Find an investing platform: ETFs are available on
most online investing platforms, retirement account
provider sites, and investing apps like Robinhood.
Most of these platforms offer commission-free
trading, meaning you don't have to pay fees to the
platform providers to buy or sell ETFs. However, a
commission-free purchase or sale does not mean that
the ETF provider will also provide access to their
product without associated costs. Some areas in which
platform services can distinguish their services from
others are convenience, services, and product variety.
For example, smartphone investing apps enable ETF
share purchase at the click of a button. This may not
be the case for all brokerages, which may ask investors
for paperwork or a more complicated situation. Some
well-known brokerages, however, offer extensive
educational content that helps new investors become
familiar with and research ETFs.
2. Research ETFs: The second and most important step
in ETF investing involves researching them. There is
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a wide variety of ETFs available in the markets today.

One thing to remember during the research process is
that ETFs are unlike individual securities like stocks
or bonds. You will need to consider the whole
picture—in terms of sector or industry—when you
commit to an ETF. Here are some questions you might
want to consider during the research process:
3. What is your time frame for investing?
4. Are you investing for income or growth?
5. Are there particular sectors or financial instruments
that excite you?
6. Consider a trading strategy: If you are a beginning
investor in ETFs, dollar-cost averaging or spreading
out your investment costs over a period of time is a
good trading strategy. This is because it smooths out
returns over a period of time and ensures a disciplined
(as opposed to a haphazard or volatile) approach to
investing. It also helps beginning investors learn more
about the nuances of ETF investing. When they
become more comfortable with trading, investors can
move out to more sophisticated strategies like swing
trading and sector rotation.

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7.
Exchange Traded Funds Mutual Funds
ETFs are a type of index funds Mutual funds are pooled
that track a basket of securities. investments into bonds,
securities, and other
instruments that provide
returns.
ETF prices can trade at a Mutual fund prices trade at the
premium or at a loss to the net net asset value of the overall
asset value of the fund. fund.
ETFs are traded in the markets Mutual funds can be redeemed
during regular hours just like only at the end of a trading day.
stocks are.
Some ETFs can be purchased Some mutual funds do not
commission-free and are charge load fees, but most are
cheaper than mutual funds more expensive than ETFs
because they do not charge because they charge
marketing fees. administration and marketing
fees.
ETFs do not involve actual Mutual funds own the
ownership of securities. securities in their basket.

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ETFs diversify risk by tracking Mutual funds diversify risk by

different companies in a sector creating a portfolio that spans
or industry in a single fund. multiple asset classes and
security instruments.
ETF trading occurs in-kind, Mutual fund shares can be
meaning they cannot be redeemed for money at the
redeemed for cash. fund's net asset value for that
day.
Because ETF share exchanges Mutual funds offer tax benefits
are treated as in-kind when they return capital or
distributions, ETFs are the include certain types of tax-
most tax-efficient amongst all exempt bonds in their portfolio.
three types of financial
instruments.

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Module III
INVESTMENT BANKING AND MERCHANT
BANKING

The word ‘merchant banking’ was originated among the

Dutch and Scottish traders. Later on it was developed and
professionalised in the UK and the USA. Now this has become
popular throughout the world.
Meaning and Definition of Merchant Banking
Merchant banking is non-banking financial activity. But it
resembles banking function. It is a financial service. It
includes the entire range of financial services.
The term merchant banking is used differently in different
countries. So there is no universal definition for merchant
banking. We can define merchant banking as a process of
transferring
capital from those who own it to those who use it. According
to Random House Dictionary, “merchant bank is an
organization that underwriters securities for corporations,
advices such clients on mergers and is involved in the
ownership of commercial ventures. These organizations are
sometimes banks which are not merchants and sometimes
merchants who are not bankers and sometimes houses which
neither merchants nor banks”. According to SEBI (Merchant
Bankers) Rules 1992, “A merchant banker has been defined
as any person who is engaged in the business of issue
management either by making arrangements regarding
selling, buying or subscribing to securities or acting as
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manager, consultant advisor or rendering corporate advisory

services inrelation to such issue management”. In short,
“merchant bank refers to an organization that underwrites
securities and advises such clients on issues like corporate
mergers, involving in the ownership of commercial ventures”.
Thus merchant banking involves a wide range of activities
such as management of customer services, portfolio
management, credit syndication, acceptance credit,
counseling, insurance, preparation of feasibility reports etc. It
is not necessary for a merchant banker to carry out all the
above mentioned activities. A merchant banker may specialise
in one activity, and take up other activities, which may be
complementary or supportive to the specialized activity.
In short, merchant banking involves servicing any financial
need of the client.
Difference between Merchant Bank and Commercial
Bank
Merchant banks are different from commercial banks. The
following are the important differences between merchant
banks and commercial banks:
1. Commercial banks basically deal in debt and debt related
finance. Their activities are clustered around credit proposals,
credit appraisal and loan sanctions. On the other hand, the area
of activity of merchant bankers is equity and equity related
finance. They deal with mainly funds raised through money
market and capital market.
2. Commercial banks’ lending decisions are based on detailed
credit analysis of loan proposals and the value of security
offered. They generally avoid risks. They are asset oriented.

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But merchant bankers are management oriented. They are

willing to accept risks of business.
3. Commercial banks are merely financiers. They do not
undertake project counselling, corporate counselling,
managing public issues, underwriting public issues, advising
on portfolio management etc. The main activity of merchant
bankers is to render financial services for their clients. They
undertake project counselling, corporate counselling in areas
of capital restructuring, mergers, takeovers etc., discounting
and rediscounting of short-term paper in money markets,
managing and underwriting public issues in new issue market
and acting as brokers and advisors on portfolio management.
Functions (Services) of Merchant Bankers (Scope of
Merchant Banking)
Merchant banks have been playing an important role in
procuring the funds for capital market for the corporate sector
for financing their operations. They perform some valuable
functions. The functions of merchant banks in India are as
follows:
1. Corporate counseling: One of the important functions of
a merchant banker is corporate counseling. Corporate
counseling refers to a set of activities undertaken to ensure
efficient functioning of a corporate enterprise through
effective financial management. A merchant banker guides
the client on aspects of organizational goals, vocational
factors, organization size, choice of product, demand
forecasting, cost analysis, allocation of resources, investment
decisions, capital and expenditure management, marketing
strategy, pricing methods etc. The following activities are
included in corporate counseling:

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(a) Providing guidance in areas of diversification based on the

Government’s economic and licensing policies.
(b) Undertaking appraisal of product lines, analyzing their
growth and profitability and forecasting future trends.
(c) Rejuvenating old-line companies and ailing sick units by
appraising their technology and process, assessing their
requirements and restructuring their capital base.
(d) Assessment of the revival prospects and planning for
rehabilitation through modernization and diversification and
revamping of the financial and organizational structure.
(e) Arranging for the approval of the financial
institutions/banks for schemes of rehabilitation involving
financial relief, etc.
(f) Monitoring of rehabilitation schemes.
(g) Exploring possibilities for takeover of sick units and
providing assistance in making consequential arrangements
and negotiations with financial institutions/banks and other
interests/authorities involved.
2. Project counseling: Project counseling relates to project
finance. This involves the study of the project, offering
advisory services on the viability and procedural steps for its
implementation.
Project counseling involves the following activities:
(a) Undertaking the general review of the project ideas/project
profile.
(b) Providing advice on procedural aspects of project
implementation.

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(c) Conducting review of technical feasibility of the project

on the basis of the report prepared by own experts or by
outside consultants.
(d) Assisting in the preparation of project report from a
financial angle, and advising and acting on various procedural
steps including obtaining government consents for
implementation of the project.
(e) Assisting in obtaining
approvals/licenses/permissions/grants, etc from government
agencies in the form of letter of intent, industrial license,
DGTD registration, and government approval for foreign
collaboration.
(f) Identification of potential investment avenues.
(g) Arranging and negotiating foreign collaborations,
amalgamations, mergers, and takeovers.
(h) Undertaking financial study of the project and preparation
of viability reports to advise on the framework of institutional
guidelines and laws governing corporate finance.
(i) Providing assistance in the preparation of project profiles
and feasibility studies based on preliminary project ideas,
covering the technical, financial and economic aspects of the
project from the point of view of their acceptance by financial
institutions and banks.
(j) Advising and assisting clients in preparing applications for
financial assistance to various national financial institutions,
state level institutions, banks, etc.
3. Pre-investment studies: Another function of a merchant
banker is to guide the entrepreneurs in conducting pre-
investment studies. It involves detailed feasibility study to

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evaluate investment avenues to enable to decide whether to

invest or not. The important activities involved in
preinvestment studies are as follows:
(a) Carrying out an in-depth investigation of environment and
regulatory factors, location of raw material supplies, demand
projections and financial requirements in order to assess the
financial and economic viability of a given project.
(b) Helping the client in identifying and short-listing those
projects which are built upon the client’s inherent strength
with a view to promote corporate profitability and growth in
the long run.
(c) Offering a package of services, including advice on the
extent of participation, government regulatory factors and an
environmental scan of certain industries in India.
4. Loan syndication: A merchant banker may help to get term
loans from banks and financial institutions for projects. Such
loans may be obtained from a single financial institution or a
syndicate or consortium. Merchant bankers help corporate
clients to raise syndicated loans from commercial banks. The
following activities are undertaken by merchant bankers
under loan syndication:
(a) Estimating the total cost of the project to be undertaken.
(b) Drawing up a financing plan for the total project cost
which conforms to the requirements of the promoters and their
collaborators, financial institutions and banks, government
agencies and underwriters.
(c) Preparing loan application for financial assistance from
term lenders/financial institutions/banks, and monitoring their
progress, including pre-sanction negotiations.

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(d) Selecting institutions and banks for participation in

financing.
(e) Follow-up of term loan application with the financial
institutions and banks, and obtaining the approval for their
respective share of participation.
(f) Arranging bridge finance.
(g) Assisting in completion of formalities for drawing of term
finance sanctioned by institutions by expediting legal
documentation formalities, drawing up agreements etc. as
prescribed by the participating financial institutions and
banks.
(h) Assessing working capital requirements.
5. Issue management: Issue management involves marketing
or corporate securities by offering them to the public. The
corporate securities include equity shares, preference shares,
bonds, debentures etc. Merchant bankers act as financial
intermediaries. They transfer capital from those who own it to
those who need it. The security issue function may be broadly
classified into two – pre-issue management and post-issue
management. The pre-issue management involves the
following functions:
(a) Public issue through prospectus.
(b) Marketing and underwriting.
(c) Pricing of issues.
These may be briefly discussed as follows:
(a) Public issue through prospectus: To being out a public
issue, merchant bankers have to coordinate the activities
relating to issue with different government and public bodies,
professionals and private agencies. First the prospectus should
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be drafter. The copies of consent of experts, legal advisor,

attorney, solicitor, bankers, and bankers to the issue, brokers
and underwriters are to be obtained from the company making
the issue. These copies are to be filed along with the
prospectus to the Registrar Companies. After the prospectus
is ready, it has to be sent to the SEBI for clearance. It is only
after clearance by SEBI, the prospectus can be filed with the
Registrar. The brokers to the issue, principal agent and
bankers to issue are appointed by merchant bankers.
(b) Marketing and underwriting: After sending prospectus to
SEBI, the merchant bankers arrange a meeting with company
representatives and advertising agents to finalise
arrangements relating to date of opening and closing of issue,
registration of prospectus, launching publicity campaigns and
fixing date of board meeting to approve and pass the necessary
resolutions. The role of merchant banker in publicity
campaigns to help selecting the media, determining the size
and publications in which the advertisement should appear.
The merchant bank shall decide the number of copies to be
printed, check accuracy of statements made and ensure that
the size of the application form and prospectus are as per stock
exchange regulations. The merchant banker has to ensure that
he material is delivered to the stock exchange at least 21 days
before the issue opens and to the brokers to the issue, and
underwriters in time.
(c) Pricing of issues: Pricing of issues is done by companies
themselves in consultation with the merchant bankers. An
existing listed company and a new company set up by an
existing company with 5 year track record and existing private
closely held company and existing unlisted company going in
for public issues for the first time with 2 ½ years track record
of constant profitability can freely price the issue. The
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premium can be determined after taking into consideration net

asset value, profit earning capacity and market price. The
price and premium has to be stated in the prospectus.
Post-issue management consists of collection of application
forms and statement of amount received from bankers,
screening applications, deciding allotment procedures,
mailing of allotment letters, share certificates and refund
orders. Merchant bankers help the company by co-ordinating
the above activities.
6. Underwriting of public issue: In underwriting of public
issue the activities performed by merchant bankers are as
follows:
(a) Selection of institutional and broker underwriters for
syndicating/ underwriting arrangements.
(b) Obtaining the approval of institutional underwriters and
stock exchanges for publication of the prospectus.
(c) Co-ordination with the underwriters, brokers and bankers
to the issue, and the Stock Exchanges.
7. Portfolio management: Merchant bankers provide
portfolio management service to their clients. Today every
investor is interested in safety, liquidity and profitability of his
investment. But investors cannot study and choose the
appropriate securities. Merchant bankers help the investors in
this regard. They study the monetary and fiscal policies of the
government. They study the financial statements of
companies in which the investments have to be made by
investors. They also keep a close watch on the price
movements in the stock market.
The merchant bankers render the following services in
connection with portfolio management:
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(a) Undertaking investment in securities.

(b) Collection of return on investment and re-investment of
the same in profitable avenues, investment advisory services
to the investors and other related services.
(c) Providing advice on selection of investments.
(d) Carrying out a critical evaluation of investment portfolio.
(e) Securing approval from RBI for the purchase/sale of
securities (for NRI clients).
(f) Collecting and remitting interest and dividend on
investment.
(g) Providing tax counseling and filing tax returns through tax
consultants.
8. Merger and acquisition: A merger is a combination of two
or more companies into a single company where one survives
and others lose their corporate existence. A take over refers to
the purchase by one company acquiring controlling interest in
the share capital of another existing company. Merchant
bankers are the middlemen in setting negotiation between the
offeree and offeror. Being a professional expert they are apt
to safeguard the interest of the shareholders in both the
companies. Once the merger partner is proposed, the merchant
banker appraises
merger/takeover proposal with respect to financial viability
and technical feasibility. He negotiates purchase
consideration and mode of payment. He gets approval from
the government/RBI, drafts scheme of amalgamation and
obtains approval from financial institutions.
9. Foreign currency financing: The finance provided to fund
foreign trade transactions is called ‘Foreign Currency
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Finance’. The provision of foreign currency finance takes the

form of exportimport trade finance, euro currency loans,
Indian joint ventures abroad and foreign collaborations.
The main areas that are covered in this type of merchant
activity are as follows:
(a) Providing assistance for carrying out the study of turnkey
and construction contract projects.
(b) Arranging for the syndication of various types of
guarantees, letters of credit, pre-shipment credit, deferred
post-shipment credit, bridge loans, and other credit facilities.
(c) Providing assistance in opening and operating bank
accounts abroad.
(d) Arranging foreign currency loans under buyer’s credit
scheme for importing goods.
(e) Arranging deferred payment guarantees under suppliers
credit scheme for importing capital goods.
(f) Providing assistance in obtaining export credit facilities
from the EXIM bank for export of capital goods, and
arranging for the necessary government approvals and
clearance.
(g) Undertaking negotiations for deferred payment, export
finance, buyers credits, documentary credits, and other
foreign exchange services like packing credit, etc.
10. Working capital finance: The finance required for
meeting the day-to-day expenses of an enterprise is known as
‘Working Capital Finance’. Merchant bankers undertake the
following activities as part of providing this type of finance:
(a) Assessment of working capital requirements.

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(b) Preparing the necessary application to negotiations for the

sanction of appropriate credit facilities.
11. Acceptance credit and bill discounting: Merchant banks
accept and discount bills of exchange on behalf of clients.
Merchant bankers give loans to business enterprises on the
security of bill of exchange. For this purpose, merchant
bankers collect credit information relating to the clients and
undertake rating their creditworthiness.
12. Venture financing: Another function of a merchant
banker is to provide venture finance to projects. It refers to
provision of equity finance for funding high-risk and high-
reward projects.
13. Lease financing: Leasing is another function of merchant
bankers. It refers to providing financial facilities to companies
that undertake leasing. Leasing involves letting out assets on
lease for a particular period for use by the lessee. The
following services are provided by merchant bankers in
connection with lease finance:
(a) Providing advice on the viability of leasing as an
alternative source for financing capital investment projects.
(b) Providing advice on the choice of a favourable rental
structure.
(c) Providing assistance in establishing lines of lease for
acquiring capital equipment, including preparation of
proposals, documentations, etc.
14. Relief to sick industries: Merchant bankers render
valuable services as a part of providing relief to sick
industries.

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15. Project appraisal: Project appraisal refers to evaluation

of projects from various angles such as technology, input,
location, production, marketing etc. It involves financial
appraisal, marketing appraisal, technical appraisal, economic
appraisal etc. Merchant bankers render valuable services in
the above areas.
The functions of merchant banker can be summarized as
follows:
(a) Issue management.
(b) Underwriting of issues.
(c) Project appraisal.
(d) Handling stock exchange business on behalf of clients.
(e) Dealing in foreign exchange.
(f) Floatation of commercial paper.
(g) Acting as trustees.
(h) Share registration.
(i) Helping in financial engineering activities of the firm.
(j) Undertaking cost audit.
(k) Providing venture capital.
(l) Arranging bridge finance.
(m) Advising business customers (i.e. mergers and takeovers).
(n) Undertaking management of NRI investments.
(o) Large scale term lending to corporate borrowers.
(p) Providing corporate counseling and advisory services.
(q) Managing investments on behalf of clients.
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(r) Acting as a stock broker.

Objectives of Merchant Banking
The objectives of merchant banking are as follows:
1. To help for capital formation.
2. To create a secondary market in order to boost the industrial
activities in the country.
3. To assist and promote economic endeavour.
4. To prepare project reports, conduct market research and
pre-investment surveys.
5. To provide financial assistance to venture capital.
6. To build a data bank as human resources.
7. To provide housing finance.
8. To provide seed capital to new enterprises.
9. To involve in issue management.
10. To act as underwriters.
11. To identify new projects and render services for getting
clearance from government.
12. To provide financial clearance.
13. To help in mobilizing funds from public.
14. To divert the savings of the country towards productive
channel.
15. To conduct investors conferences.
16. To obtain consent of stock exchange for listing.
17. To obtain the daily report of application money collected
at various branches of banks.
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18. To appoint bankers, brokers, underwrites etc.

19. To supervise the process on behalf of NRIs for their
ventures.
20. To provide service on fund based activities.
21. To assist in arrangement of loan syndication.
22. To act as an acceptance house.
23. To assist in and arrange mergers and acquisitions.
Role of Merchant Bankers in Managing Public Issue
In issue management, the main role of merchant bankers is to
help the company issuing securities in raising funds for the
purpose of financing new projects, expansion/ modernization/
diversification of existing units and augmenting long term
resources for working capital requirements.
The most important aspect of merchant banking business is to
function as lead managers to the issue management. The role
of the merchant banker as an issue manager can be studied
from the following points:
1. Easy fund raising: An issue manager acts as an
indispensable pilot facilitating a public/ rights issue. This is
made possible with the help of special skills possessed by him
to execute the management of issues.
2. Financial consultant: An issue manager essentially acts as
a financial architect, by providing advice relating to capital
structuring, capital gearing and financial planning for the
company.
3. Underwriting: An issue manager allows for underwriting
the issues of securities made by corporate enterprises. This
ensures due subscription of the issue.
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4. Due diligence: The issue manager has to comply with SEBI

guidelines. The merchant banker will carry out activities with
due diligence and furnish a Due Diligence Certificate to SEBI.
The detailed diligence guidelines that are prescribed by the
Association of Merchant Bankers of India (AMBI) have to be
strictly observed. SEBI has also prescribed a code of conduct
for merchant bankers.
5. Co-ordination: The issue manger is required to co-ordinate
with a large number of institutions and agencies while
managing an issue in order to make it successful.
6. Liaison with SEBI: The issue manager, as a part of
merchant banking activities, should register with SEBI. While
managing issues, constant interaction with the SEBI is
required by way of filing of offer documents, etc. In addition,
they should file a number of reports relating to the issues
being managed.
Merchant Banking in India
Prior to the enactment of Indian Companies Act, 1956,
managing agents acted as merchant bankers. They acted as
issue houses for securities, evaluated project reports, provided
venture capital for new firms etc. Few share broking firms also
functioned as merchant bankers.
With the rapid growth in the number and size of the issues
made in the primary market, the need for specialized merchant
banking service was felt. Grindlays Bank (foreign bank)
opened its merchant banking division in 1967, followed by
Citibank in 1970. SBI started its merchant banking division in
1972 and it followed up by setting up a fully owned subsidiary
in 1980, namely SBI

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Capital Markets Ltd. The other nationalized banks and

financial institutions, like IDBI, IFCI, ICICI, Securities and
Finance Company Ltd., Canara Bank (Can Bank Financial
Services Ltd.),
Bank of India (BOI Finance Ltd.) and private sector financial
companies, like JM Financial and Investment Consultancy
Services Ltd., DSP Financial Consultancy Ltd. have also set
up their merchant banking divisions.
With over 1,100 merchant bankers operating in the country,
the primary market activity is picking up. Merchant banking
services have assumed greater importance in the present
capital market scenario. With the investor becoming more
cautious and discerning, the role of merchant banker has
gained more prominence.
In India, apart from the overall control by the RBI, merchant
bankers’ operations are closely supervised by the SEBI for
their proper functioning and investor protection.
Setting up and management of merchant banks in India
In India a common organizational set up of merchant bankers
to operate is in the form of divisions of Indian and Foreign
banks and financial institutions, subsidiary companies
established by bankers like SBI, Canara Bank, Punjab
National Bank, Bank of India, etc. some firms are also
organized by financial and technical consultants and
professionals. Securities and exchanges Board of India (SEBI)
has divided the merchant bankers into four categories based
on their capital adequacy. Each category is authorized to
perform certain functions. From the point of Organizational
set up India’s merchant banking organizations can be
categorized into 4 groups on the basis of their linkage with
parent activity. They are:
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a) Institutional Base:-
Merchant banks function as an independent wing or as
subsidiary of various Private/ Central Governments/ State
Governments Financial institutions. Most of the financial
institutions in India are in public sector and therefore such set
up plays a role on the lines of governmental priorities and
policies.
b) Banker Base:-
These merchant bankers function as division/ subsidiary of
banking organization. The parent banks are either nationalized
commercial banks or the foreign banks operating in India.
These organizations have brought professionalism in
merchant banking sector and they help their parent
organization to make a presence in capital market.
c) Broker Base:-
In the recent past there has been an inflow of Qualified and
professionally skilled brokers in various Stock Exchanges of
India. These brokers undertake merchant banking related
operating also like providing investment and portfolio
management services.
d) Private Base:-
These merchant banking firms are originated in private
sectors. These organizations are the outcome of opportunities
and scope in merchant banking business and they are
providing skill oriented specialized services to their clients.
Some foreign merchant bankers are also entering either
independently or through some collaboration with their Indian
counterparts. Private Sectors merchant banking firms have
come up either as sole proprietorship, partnership, private
limited or public limited companies. Many of these firms were
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in existence for quite some time before they added a new

activity in the form of merchant banking services by opening
new division on the lines of commercial banks and All India
Financial Institution (AIFI).
Categories of Merchant Banks
Merchant bankers are classified into four categories according
to the SEBI (Merchant Banking) Regulations 1992. These are
as follows:
(a) Category – I: To carry on any activity relating to issue
management and act as adviser, consultant manager,
underwriter and portfolio manager for capital issues.
(b) Category – II: To act as adviser, consultant, co-manager,
underwriter and portfolio manager for capital issues.
(c) Category – III: To act as underwriter, adviser, and
consultant to an issue.
(d) Category – IV: To act only as adviser or consultant to an
issue.
Weakness of merchant banks / Problems of merchant
banks
1. SEBI guidelines have authorised merchant bankers to
undertake issue related activities only with an exception of
portfolio management. It restricts the scope of merchant bank
activities.
2. SEBI guidelines stipulate a minimum net worth of Rs.1
crore for authorisation of merchant bankers. Small but
professional merchant bankers are facing difficulty for
adhering such net worth norms.

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3. Non cooperation of the issuing companies in timely

allotment of securities and refund application money is
another problem of merchant bankers.
4. Unhealthy competition among large number of merchant
banks compels them to reduce their profit margin,
commission etc.
5. There is no exact regulatory framework for regulating and
controlling the working of merchant banks in India.
6. Fraudulent and fake issue of share capital by the companies
are also posing problems for merchant banks who act as lead
manager or issue manager of such issues.
Regulations by SEBI on Merchant Banking
Reforms for the merchant bankers
SEBI has made the following reforms for the merchant banker
1. Multiple categories of merchant banker will be abolished
and there will be only one equity merchant banker.
2. The merchant banker is allowed to
perform underwriting activity. For performing portfolio
manager, the merchant banker has to seek separate
registration from SEBI.
3. A merchant banker cannot undertake the function of a non
banking financial company, such as accepting deposits,
financing others’ business, etc.
4. A merchant banker has to confine himself only to capital
market activities.
Recognition by SEBI on merchant bankers
SEBI will grant recognition a merchant banker after taking
into account the following aspects
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1. Considering how much the merchant are professionally

competent.
2. Whether they have adequate capital
3. Track record, experience and general reputation of
merchant bankers.
4. Quality of staff employed by merchant bankers, their
adequacy and available infrastructure are taken into account.
After considering the above aspects, SEBI will grant
permission for the merchant banker to start functioning.
Conditions by SEBI for merchant bankers
SEBI has laid the following conditions on the merchant
bankers, for conducting their operations. They are
1. SEBI will give authorization for a merchant banker to
operate for 3 years only. Without SEBI’s authorization,
merchant bankers cannot operate.
2. The minimum net worth of merchant banker should be Rs.
1 crore.
3. Merchant banker has to pay authorization fee, annual fee
and renewal fee.
4. All issue of shares must be managed by one authorized
merchant banker. It should be the lead manager.
5. The responsibility of the lead manager will be clearly
indicated by SEBI.
6. Lead managers are responsible for allotment of securities,
refunds, etc.
7. Merchant banker will submit to SEBI all returns and send
reports regarding the issue of shares.

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8. A code of conduct for merchant bankers will be given by

SEBI, which has to be followed by them.
9. Any violation by the merchant banker will lead to the
revocation of authorization by SEBI

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Module IV
LEASE FINANCE AND VENTURE CAPITAL
FINANCE
Meaning of leasing

Leasing is a process by which a firm can obtain the use of a

certain fixed assets for which it must pay a series of
contractual, periodic, tax deductible payments. The lessee is
the receiver of the services or the assets under the lease
contract and the lessor is the owner of the assets. The
relationship between the tenant and the landlord is called a
tenancy, and can be for a fixed or an indefinite period of time
(called the term of the lease). The consideration for the lease
is called rent.
Lease can be defined as the following ways:
1. A contract by which one party (lessor) gives to another
(lessee) the use and possession of equipment for a specified
time and for fixed payments.
2. The document in which this contract is written.
3. A great way companies can conserve capital.
4. An easy way vendors can increase sales.
A lease transaction is a commercial arrangement whereby an
equipment owner or Manufacturer conveys to the equipment
user the right to use the equipment in return for a rental. In
other words, lease is a contract between the owner of an asset
(the lessor) and its user (the lessee) for the right to use the
asset during a specified period in return for a mutually agreed
periodic payment (the lease rentals). The important feature of
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a lease contract is separation of the ownership of the asset

from its usage.
Importance of Lease Financing
Lease financing is based on the observation made by Donald
B. Grant:
“Why own a cow when the milk is so cheap? All you really
need is milk and not the cow.”
Leasing industry plays an important role in the economic
development of a country by providing money incentives to
lessee. The lessee does not have to pay the cost of asset at the
time of signing the contract of leases. Leasing contracts are
more flexible so lessees can structure the leasing contracts
according to their needs for finance. The lessee can also pass
on the risk of obsolescence to the lessor by acquiring those
appliances, which have high technological obsolescence.
Today, most of us are familiar with leases of houses,
apartments, offices, etc.
The advantages of leasing include:
a. Leasing helps to possess and use a new piece of machinery
or equipment without huge investment.
b. Leasing enables businesses to preserve precious cash
reserves.
c. The smaller, regular payments required by a lease
agreement enable businesses with limited capital to manage
their cash flow more effectively and adapt quickly to changing
economic conditions.
d. Leasing also allows businesses to upgrade assets more
frequently ensuring they have the latest equipment without
having to make further capital outlays.
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e. It offers the flexibility of the repayment period being

matched to the useful life of the equipment.
f. It gives businesses certainty because asset finance
agreements cannot be cancelled by the lenders and
repayments are generally fixed.
g. However, they can also be structured to include additional
benefits such as servicing of equipment or variable monthly
payments depending on a business’s needs.
h. It is easy to access because it is secured – largely or entirely
– on the asset being financed, rather than on other personal or
business assets.
i. The rental, which sometimes exceeds the purchase price of
the asset, can be paid from revenue generated by its use,
directly impacting the lessee's liquidity.
j. ’ease instalments are exclusively material costs.
k. Using the purchase option, the lessee can acquire the leased
asset at a lower price, as they pay the residual or non-
depreciated value of the asset.
l. For the national economy, this way of financing allows
access to state-of-the-art technology otherwise unavailable,
due to high prices, and often impossible to acquire by loan
arrangements.
Limitation of leasing
a. It is not a suitable mode of project financing because rental
is payable soon after entering into lease agreement while new
project generate cash only after long gestation period.
b. Certain tax benefits/ incentives/subsidies etc. may not be
available to leased equipments.

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c. The value of real assets (land and building) may increase

during lease period. In this case lessee may lose potential
capital gain.
d. The cost of financing is generally higher than that of debt
financing.
e. A manufacturer(lessee) who want to discontinue business
need to pay huge penalty to lessor for pre-closing lease
agreement
f. There is no exclusive law for regulating leasing transaction.
g. In undeveloped legal systems, lease arrangements can result
in inequality between the parties due to the lessor's economic
do’inance, which may lead to the lessee signing an
unfavourable contract.
TYPES OF LEASE
(a) Financial lease
(b) Operating lease.
(c) Sale and lease back
(d) Leveraged leasing and
(e) Direct leasing.
1) Financial lease
Long-term, non-cancellable lease contracts are known as
financial leases. The essential point of financial lease
agreement is that it contains a condition whereby the lessor
agrees to transfer the title for the asset at the end of the lease
period at a nominal cost. At lease it must give an option to the
lessee to purchase the asset he has used at the expiry of the
lease. Under this lease the lessor

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recovers 90% of the fair value of the asset as lease rentals and
the lease period is 75% of the economic life of the asset. The
lease agreement is irrevocable. Practically all the risks
incidental to the asset ownership and all the benefits arising
there from are transferred to the lessee who bears the cost of
maintenance, insurance and repairs. Only title deeds remain
with the lessor. Financial lease is also known as 'capital lease‘.
In India, f’nancial leases are very popular with high-cost and
high technology equipment.
2) Operational lease
An operating lease stands in contrast to the financial lease in
almost all aspects. This lease agreement gives to the lessee
only a limited right to use the asset. The lessor is responsible
for the upkeep and maintenance of the asset. The lessee is not
given any uplift to purchase the asset at the end of the lease
period. Normally the lease is for a short period and even
otherwise is revocable at a short notice. Mines, Computers
hardware, trucks and automobiles are found suitable for
operating lease because the rate of obsolescence is very high
in this kind of assets.
3) Sale and lease back
It is a sub-part of finance lease. Under this, the owner of an
asset sells the asset to a party (the buyer), who in turn leases
back the same asset to the owner in consideration of lease
rentals.
However, under this arrangement, the assets are not physically
exchanged but it all happens in records only. This is nothing
but a paper transaction. Sale and lease back transaction is
suitable for those assets, which are not subjected depreciation
but appreciation, say land. The advantage of this method is
that the lessee can satisfy himself completely regarding the
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quality of the asset and after possession of the asset convert

the sale into a lease arrangement.
4) Leveraged leasing
Under leveraged leasing arrangement, a third party is involved
beside lessor and lessee. The lessor borrows a part of the
purchase cost (say 80%) of the asset from the third party i.e.,
lender and the asset so purchased is held as security against
the loan. The lender is paid off from the lease rentals directly
by the lessee and the surplus after meeting the claims of the
lender goes to the lessor. The lessor, the owner of the asset is
entitled to depreciation allowance associated with the asset.
5) Direct leasing
Under direct leasing, a firm acquires the right to use an asset
from the manufacture directly. The ownership of the asset
leased out remains with the manufacturer itself. The major
types of direct lessor include manufacturers, finance
companies, independent lease companies, special purpose
leasing companies etc
Other types of leasing:
1) First Amendment Lease: The first amendment lease gives
the lessee a purchase option at one or more defined points with
a requirement that the lessee renew or continue the lease if the
purchase option is not exercised. The option price is usually
either a fixed price intended to approximate fair market value
or is defined as fair market value determined by lessee
appraisal and subject to a floor to insure that the lessor's
residual po’ition will be covered if the purchase option is
exercised.
2) Full Payout Lease: A lease in which the lessor recovers,
through the lease payments, all costs incurred in the lease plus
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an acceptable rate of return, without any reliance upon the

leased equipment's future resi’ual value.
3) Guideline Lease: A lease written under criteria established
by the IRS to determine the availability of tax benefits to the
lessor.
4) Net Lease: A lease wherein payments to the lessor do not
include insurance and maintenance, which are paid separately
by the lessee.
5) Open-end Lease: A conditional sale lease in which the
lessee guarantees that the lessor will realize a minimum value
from the sale of the asset at the end of the lease.
6) Sales-type Lease: A lease by a lessor who is the
manufacturer or dealer, in which the lease meets the
definitional criteria of a capital lease or direct financing lease.
7) Synthetic Lease: A synthetic lease is basically a financing
structured to be treated as a lease for accounting purposes, but
as a loan for tax purposes. The structure is used by
corporations that are seeking off-balance sheet reporting of
their asset based financing, and that can efficiently use the tax
benefits of owning the financed asset.
8) Tax Lease: A lease wherein the lessor recognizes the tax
incentives provided by the tax laws for investment and
ownership of equipment. Generally, the lease rate factor on
tax leases is reduced to reflect the lessor's recognition’of this
tax incentive.
9) True Lease: A type of transaction that qualifies as a lease
under the Internal Revenue Code.
It allows the lessor to claim ownership and the lessee to claim
rental payments as tax deductions.

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Differences between financial lease and operating lease

1. While financial lease is a long term arrangement between
the lessee (user of the asset) and the owner of the asset,
whereas operating lease is a relatively short term arrangement
between the lessee and the owner of asset.
2. Under financial lease all expenses such as taxes, insurance
are paid by the lessee while under operating lease all expenses
are paid by the owner of the asset.
3. The lease term under financial lease covers the entire
economic life of the asset which is not the case under
operating lease.
4. Under financial lease the lessee cannot terminate or end the
lease unless otherwise provided in the contract which is not
the case with operating lease where lessee can end the lease
anytime before expiration date of lease.
5. While the rent which is paid by the lessee under financial
lease is enough to fully amortize the asset, which is not the
case under operating lease.
Regulatory frame work for Leasing in India
As there is no separate statue for leasing in India, the
provisions relating to bailment in the Indian Contract Act
govern equipment leasing agreements as well section 148 of
the Indian Contract Act defines bailment as:
“The delivery of goods by one person to another, for some
purpose, upon a contract that they shall, when the purpose is
accomplished, be returned or otherwise disposed off
according to the directions of the person delivering them. The
person delivering the goods is called the ‘bailor’ and the
person to whom they are delivered is called the ‘bailee’.

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Since an equipment lease transaction is regarded as a contract

of bailment, the obligations of the lessor and the lessee are
similar to those of the bailor and the bailee (other than those
expressly specified in the least contract) as defined by the
provisions of sections 150 and 168 of the Indian Contract Act.
Essentially these provisions have the following implications
for the lessor and the lessee.
1. The lessor has the duty to deliver the asset to the lessee, to
legally authorise the lessee to use the asset, and to leave the
asset in peaceful possession of the lessee during the currency
of the agreement.
2. The lessor has the obligation to pay the lease rentals as
specified in the lease agreement, to protect the lessor’s title,
to take reasonable care of the asset, and to return the leased
asset on the expiry of the lease period.
VENTURE CAPITAL
There are some businesses that involve higher risks. In the
case of newly started business, the risk is more. The new
businesses may be promoted by qualified entrepreneurs. They
lack necessary experience and funds to give shape to their
ideas. Such high risk, high return ventures are unable to raise
funds from regular channels like banks and capital markets.
Generally people would not like to invest in new high risk
companies. Some people invest money in such new high risk
companies. Even though the risk is high, there is a potential
of getting a return of ten times more in less than five years.
The investors making such investments are called venture
capitalists.
The money investd in new, high risk and high return firms is
called venture capital. Venture capitalists not only provide
money but also help the entrepreneur with guidance in
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formalizing his ideas into a viable business venture. They get

good return on their investment. The percentage of the profits
the venture capitalists get is called the carry
Meaning of Venture Capital
The term venture capital comprises of two words, namely,
‘venture’ and ‘capital’. The term ‘venture’ literally means a
‘course’ or ‘proceeding’, the outcome of which is uncertain
(i.e., involving risk). The term capital refers to the resources
to start the enterprise. Thus venture capital refers to capital
investment in a new and risky business enterprise. Money is
invested in such enterprises because these have high growth
potential.
A young hi-tech company that is in the early stage of financing
and is not yet ready to make a public issue may seek venture
capital. Such a high risk capital is provided by venture capital
funds
in the form of long term equity finance with the hope of
earning a high rate of return primarily in the form of capital
gain. In fact, the venture capitalist acts as a partner with the
entrepreneur.
Venture capital is the money and resources made available to
start up firms and small business with exceptional growth
potential (e.g., IT, infrastructure, real estate etc.). It is
fundamentally a long term risk capital in the form of equity
finance for the small new ventures which involve risk.
But at the same time, it a the strong potential for the growth.
It thrives on the concept of high riskhigh return. It is a means
of equity financing for rapidly growing private companies.
Venture capital can be visualized as ‘your ideas and our
money’ concept of developing business. It is ‘patient’ capital
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that seeks a return through long term capital gain rather than
immediate and regular interest payments as in the case of debt
financing.
When venture capitalists invest in a business, they typically
require a seat on the company’s board of directors. But
professional venture capitalists act as mentors and provide
support and advice on a number of issues relating to
management, sales, technology etc. They assist the company
to develop its full potential. They help the enterprise in the
early stage until it reaches the stage of profitability. When the
business starts making considerable profits and the market
value of the shares go up to considerable extent, venture
capitalists sell their equity holdings at a high value and
thereby make capital gains.
In short, venture capital means the financial investment in a
highly risk project with the objective of earning a high rate of
return.
Characteristics of Venture Capital
The important characteristics of venture capital finance are
outlined as bellow:
1. It is basically equity finance.
2. It is a long term investment in growth-oriented small or
medium firms.
3. Investment is made only in high risk projects with the
objective of earning a high rate of return.
4. In addition to providing capital, venture capital funds take
an active interest in the management of the assisted firm. It is
rightly said that, “venture capital combines the qualities of
banker, stock market investor and entrepreneur in one”.

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5. The venture capital funds have a continuous involvement

in business after making the investment.
6. Once the venture has reached the full potential, the venture
capitalist sells his holdings at a high premium. Thus his main
objective of investment is not to earn profit but capital gain.
Types of Venture Capitalists
Generally, there are three types of venture capital funds. They
are as follows:
1. Venture capital funds set up by angel investors (angels):
They are individuals who invest their personal capital in start
up companies. They are about 50 years old. They have high
income and wealth. They are well educated. They have
succeeded as entrepreneurs. They are interested in the start up
process.
2. Venture capital subsidiaries of Corporations: These are
established by major corporations, commercial banks, holding
companies and other financial institutions.
3. Private capital firms/funds: The primary source of
venture capital is a venture capital firm.
It takes high risks by investing in an early stage company with
high growth potential.
Methods or Modes of Venture Financing (Funding
Pattern)/Dimensions of Venture Capital
Venture capital is typically available in four forms in India:
equity, conditional loan, income note and conventional loan.
Equity: All VCFs in India provide equity but generally their
contribution does not exceed 49 per cent of the total equity
capital. Thus, the effective control and majority ownership of
the firm remain with the entrepreneur. They buy shares of an
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enterprise with an intention to ultimately sell them off to make

capital gains.
Conditional loan: It is repayable in the form of a royalty after
the venture is able to generate sales.
No interest is paid on such loans. In India, VCFs charge
royalty ranging between 2 and 15 per cent; actual rate depends
on the other factors of the venture, such as gestation period,
cost-flow patterns and riskiness.
Income note: It is a hybrid security which combines the
features of both conventional loan and conditional loan. The
entrepreneur has to pay both interest and royalty on sales, but
at substantially low rates.
Conventional loan: Under this form of assistance, the
enterprise is assisted by way of loans. On the loans, a lower
fixed rate of interest is charged, till the unit becomes
commercially operational.
When the company starts earning profits, normal or higher
rate of interest will be charged on the loan. The loan has to be
repaid as per the terms of loan agreement.
Other financing methods: A few venture capitalists,
particularly in the private sector, have started introducing
innovative financial securities like participating debentures
introduced by TCFC.
Stages of Venture Capital Financing
Venture capital takes different forms at different stages of a
project. The various stages in the venture capital financing are
as follows:
1. Early stage financing: This stage has three levels of
financing. These three levels are:
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(a) Seed financing: This is the finance provided at the project

development stage. A small amount of capital is provided to
the entrepreneurs for concept testing or translating an idea into
business.
(b) Start up finance/first stage financing: This is the stage of
initiating commercial production and marketing. At this stage,
the venture capitalist provides capital to manufacture a
product.
(c) Second stage financing: This is the stage where product
has already been launched in the market but has not earned
enough profits to attract new investors. Additional funds are
needed at this stage to meet the growing needs of business.
Venture capital firms provide larger funds at this stage.
2. Later stage financing: This stage of financing is required
for expansion of an enterprise that is already profitable but is
in need of further financial support. This stage has the
following levels:
(a) Third stage/development financing: This refers to the
financing of an enterprise which has overcome the highly
risky stage and has recorded profits but cannot go for public
issue. Hence it requires financial support. Funds are required
for further expansion.
(b) Turnarounds: This refers to finance to enable a company
to resolve its financial difficulties.
Venture capital is provided to a company at a time of severe
financial problem for the purpose of turning the company
around.
(c) Fourth stage financing/bridge financing: This stage is the
last stage of the venture capital financing process. The main
goal of this stage is to achieve an exit vehicle for the investors
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and for the venture to go public. At this stage the venture

achieves a certain amount of market share.
(d) Buy-outs: This refers to the purchase of a company or the
controlling interest of a company’s share. Buy-out financing
involves investments that might assist management or an
outside party to acquire control of a company. This results in
the creation of a separate business by separating it from their
existing owners.
Advantages of Venture Capital
Venture capital has a number of advantages over other forms
of finance. Some of them are:
1. It is long term equity finance. Hence, it provides a solid
capital base for future growth.
2. The venture capitalist is a business partner. He shares the
risks and returns.
3. The venture capitalist is able to provide strategic
operational and financial advice to the company.
4. The venture capitalist has a network of contacts that can add
value to the company. He can help the company in recruiting
key personnel, providing contracts in international markets
etc.
5. Venture capital fund helps in the industrialization of the
country.
6. It helps in the technological development of the country.
7. It generates employment.
8. It helps in developing entrepreneurial skills.
9. It promotes entrepreneurship and entrepreneurism in the
country.

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Venture Capital in India

In India, the venture capital plays a vital role in the
development and growth of innovative entrepreneurships.
Venture capital activity in the past was possibly done by the
developmental financial institutions like IDBI, ICICI and state
financial corporations. These institutions promoted entities in
the private sector with debt as an instrument of funding.
For a long time, funds raised from public were used as a
source of venture capital. And with the minimum paid up
capital requirements being raised for listing at the stock
exchanges, it became difficult for smaller firms with viable
projects to raise funds from the public.
In India, the need for venture capital was recognised in the 7
th five-year plan and long term fiscal policy of the
Government of India. In 1973, a committee on development
of small and medium enterprises highlighted the need to foster
VC as a source of funding new entrepreneurs and technology.
VC financing really started in India in 1988 with the formation
of Technology Development and Information Company of
India Ltd. (TDICI) – promoted by ICICI and UTI.
The first private VC fund was sponsored by Credit Capital
Finance Corporation (CEF) and promoted by Bank of India,
Asian Development Bank and the Commonwealth
Development Corporation, namely, Credit Capital Venture
Fund. At the same time, Gujarat Venture Finance Ltd. and
AFIDC Venture Capital Ltd. were started by state-level
financial institutions. Sources of these funds were the
financial institutions, foreign institutional investors or pension
funds and high networth individuals.

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Risk Capital
Risk capital refers to funds allocated to speculative activity
and used for high-risk, high-reward investments. Any money
or assets that are exposed to a possible loss in value is
considered risk capital, but the term is often reserved for those
funds earmarked for highly speculative
investments. Diversification is key for successful investment
of risk capital, as the prospects of each investment tend to be
uncertain by nature, although the returns can be far above
average when an investment succeeds. Moreover, an investor
needs to ensure that only a portion of total capital is
considered risk capital.
In the context of venture capital, risk capital may also refer to
funds invested in a promising, but still unproven, startup
Angel Investment
Angel investments are made by wealthy individuals (such as
accredited investors) that invest their personal money into a
company in exchange for equity in that company. This is the
basic principle of angel investing.
Angel investors help startups during the seed stages, so there
is a higher risk in angel investments since they are connected
to unproven business models. Also, if the company does not
have a product or even if they have customers, they might not
have significant revenue.
But angel investors are more forgiving about the metrics that
venture capitalists use to measure a potential investment. In
fact, many business professionals believe that angels
expanded the reach of the venture capital model.
Since angel investors can work independently or in large
groups, it is not unusual for a typical investment to range
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anywhere from $25,000 to $100,000. In addition, there are

cases when angel investors contributed even more than that.
Advantages of angel funding:
• Great for companies that need quick capital
fast. Getting the right funds at the right time can make
a huge difference when it comes to business success.
• Funds are not loans. There is no legal obligation to
repay what is borrowed as one would have to do with
business loans. Angel investors do not expect money
in return, they are banking on the company increasing
in value as it grows.
• Angel investors do not only provide money. These
individuals are often well-established business
professionals with years of experience under their
belts. They can also help companies by sharing their
thoughts and even guidance.
Disadvantages of angel funding:
• Higher risks. Since there is no obligation to repay the
investment, investors face higher risks.
• Pressure can be quite difficult to handle. Investors
want to see their investment pay off in a tangible way.
Crowd funding
Raising funds or capital from individuals or organizations that
invest in (or donate to) projects in return for a potential profit
or a reward is called crowdfunding.
We have witnessed significant growth in the popularity of
crowdfunding thanks to platforms such as Indiegogo or
Kickstarter. This rise has indicated great advancements for

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non-profits and other organizations. Thanks to this concept,

many startups have secured the needed funds to launch their
ideas and show the world what they have to offer.

However, keep in mind that in most jurisdictions, restrictions

apply to who can fund a new business and how much they can
contribute. These limitations are similar to the ones dealing
with hedge fund investing.
These measures are supposed to protect unsophisticated or
non-wealthy investors from putting too much of their savings
at risk. After all, there are a number of businesses that fail and
their investors face a high risk of losing their principal.
The majority of crowdfunding projects are based on rewards.
To be precise, investors may get to participate in the launch of
a new product or receive a gift for their investment. For
example, the developer of a new video game may send a free
copy of the game to each of the investors as a small gift.
Additionally, it is worth mentioning that equity-based
crowdfunding is slowly becoming more and more popular,
since it allows early-stage businesses to raise money without
giving up control to venture capital investors. Still, this type
of crowdfunding also allows investors to earn an equity
position in the venture.
Take a look at the advantages of crowdfunding:
• Keeping equity. Investors are not shareholders of the
company. This is the main benefit and the main reason
why many entrepreneurs choose crowdfunding as a
method to raise enough funds for their businesses.

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• Low financial risk. This kind of funding enables

entrepreneurs to test the waters and see if their idea has
merit without having to take a lot of financial risks.
• Tapping into an existing community. Crowdfunding
allows you to leverage an engaged community that is
already looking to support ideas such as yours.
On the other hand, there are various shortcomings of
crowdfunding:
• Sustainability problem. This method is not
sustainable in the long-run nor it is an accurate
representation of how successful the business venture
will be in the market.
• It may take some time (and money). Successful
crowdfunding campaigns require a lot of effort and
even the founders have to invest some amount of
money to build prototypes, marketing videos, and so
on.
• Idea theft. Many entrepreneurs forget to protect their
ideas and sometimes they get stolen. It often happens
that established companies try to mimic what an
entrepreneur is building.

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Module V
CREDIT RATING AND FACTORING
SERVICES

CREDIT RATING

Credit rating is a numerical representation of the

creditworthiness of an individual or a business. The credit
rating is a key aspect that makes or breaks a loan application.
The credit rating/score acts as an indicator stating if the
borrower has defaulted on loan payments before and if he is
worth trusting with the new loan.
A credit score is a 3-digit number that represents the
creditworthiness of the borrower. Credit rating is the analysis
of the possible credit risks associated with granting a financial
instrument to an individual or a company. Based on the credit
score, a lender determines whether the borrower can repay the
loan amount or not.
The rating is provided based on the creditworthiness and the
credentials of an individual or a company. The
creditworthiness of an individual or a company is decided
based on the lending and borrowing transactions done in the
past. Credit rating is determined after weighing the statements
of liabilities and assets, and their ability to meet the debt
obligations.
Objectives of Credit Rating
Credit rating aims to:
Provide superior information to the investors at a low cost;
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Provide a sound basis for proper risk-return structure;

Subject borrowers to a healthy discipline, and
Assist in the framing of public policy guidelines on
institutional investment.
Significance of Credit Rating
Credit rating is always project/instrument specific. Credit
rating for different financial instruments issued by the same
company at the same time can be different. In the same way
credit rating for similar instruments issued by the same
company at different times can also be different. Credit rating
is useful for investors, banks and other financial institutions
and investments advisers as it helps them taking business
decisions. Credit rating by an authorized competent authority
gives a bird’s eye view of financial strength of an organisation
and its instruments. It is of considerable help to an investor in
deciding whether his investment is likely to be safe.
As financial markets have grown increasingly complex and
global and borrowers base has become increasingly
diversified, investors and regulators have increased their
reliance on the opinions of credit rating agencies. Credit
ratings attempt to provide a consistent and reasonable rank
ordering of relative credit risks, with specific reference to the
instrument being rated.
Credit rating can be applied in the following
areas/instruments:
• Equity shares
• Rating for banking sector
• Individual credit rating

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• Rating for insurance sector

• New instruments, floating rate notes, index based
bonds, long-term deep discount bonds, etc.
• Rating of intermediaries in financial services
• Securitization
• Rating of companies raising funds overseas
Methodology of Credit Rating
The process of credit rating begins with the prospective issuer
approaching the rating agency for evaluation. The experts in
analyzing banks should be given a free hand and they will
collect data and informant and will investigate the business
strength and weaknesses in detail. The entire process of rating
stands on the for of confidentiality and hence even the most
confidential business strategies, marketing plans, future
outlook etc., are revealed to the steam of analysis.
The rating is based on the investigation analysis, study and
interpretation of various factors. The world of investment is
exposed to the continuous onslaught of political, economic,
social and other forces which does not permit any one to
understand sufficiently certainty. Hence a logical approach to
systematic evaluation is compulsory and within the
framework of certain common features the agencies employ
different methodologies. The key factors generally
considered are listed below:
1. Business Analysis or Company Analysis
This includes an analysis of industry risk, market position of
the company, operating efficiency of the company and legal
position of the company.

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Industry risk: Nature and basis of competition, key success

factors; demand supply position; structure of industry;
government policies, etc.
Market position of the company within the
Industry: Market share; competitive advantages, selling and
distribution arrangements; product and customer diversity etc.
Operating efficiency of the company: Locational
advantages; labor relationships; cost structure and
manufacturing as compared to those of competition.
Legal Position: Terms of prospectus; trustees and then
responsibilities; system for timely payment and for protection
against forgery/fraud, etc.
2. Economic Analysis
In order to evaluate an instrument an analyst must spend a
considerable time in investigating the various economic
activities and also analyze the characteristics peculiar to the
industry, whose issue the analyst is concerned with. It will be
an error to ignore these factors as the individual companies
are always exposed to changing environment and the
economic activates affect corporate profits, attitudes and
expectation of investors and the price of the instrument. hence
the relevance of the economic variables such as growth
rate, national income and expenditure cannot be ignored. The
analysis, while doing the economic forecasting use surveys,
various economic indicators and indices
3. Financial Analysis
This includes an analysis of accounting, quality, earnings,
protection adequacy of cash flows and financial flexibility.

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Accounting Quality: Overstatement/under statement of

profits; auditors qualification; methods of
income recognition’s inventory valuation and depreciation
policies, off balance sheet liabilities etc.
Earnings Protection: Sources of future earnings
growth; profitability ratios; earnings in relation to fixed
income changes.
Adequacy of cash flows: In relation to dept and fixed
and working capital needs; variability of future cash flows;
capital spending flexibility working capital management etc.
Financial Flexibility: Alternative financing plans in ties of
stress; ability to raise funds asset redeployment.
4. Management Evaluation
Track record of the management planning and control system,
depth of managerial talent, succession plans. Evaluation of
capacity to overcome adverse situations Goals, philosophy
and strategies.
5. Geographical Analysis
Location advantages and disadvantages
Backward area benefit to the company/division/unit etc.
6. Fundamental Analysis
Fundamental analysis is essential for the assessment of
finance companies. This includes an analysis of liquidity
management, profitability and financial position and interest
and tax sensitivity of the company.
Liquidity Management: Capital structure; term matching of
assets and liabilities policy and liquid assets in relation to
financing commitments and maturing deposits.
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Asset Quality: Quality of the company’s credit-risk

management; system for monitoring credit; sector risk;
exposure to individual borrower; management of problem
credits etc.
Profitability and financial position: Historic profits, spread
on fund deployment revenue on non-fund based services
accretion to reserves etc.
Interest and Tax sensitivity: Exposure to interest rate
changes, hedge against interest rate and tax low changes, etc.
Credit Rating Agency (CRA)
A credit rating agency (CRA) evaluates and assesses an
individual’s or a company’s creditworthiness. That is, these
agencies consider a debtor’s income and credit lines to
analyse the debtor’s ability to repay the debt or if there is any
credit risk associated.
Securities and Exchange Board of India (SEBI) reserves the
right to authorise and regulate credit rating agencies according
to SEBI Regulations, 1999 of the SEBI Act, 1992.
Working of Credit Rating Agencies
Credit rating agencies analyse an organisation, individual, or
entity and assign ratings to it. These agencies have the
authority to rate companies, state governments, non-profit
organisations, countries, securities, local government bodies,
and special purpose entities.
Many factors are considered while settling with a rating such
as financial statements, type of debt, lending and borrowing
history, repayment capability, past credit repayment
behaviour, and more. Each of these factors contributes to a
specified share in computing the end result, credit score.

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The credit rating agency does not provide any decision to

financial institutions on whether an entity should get a credit
facility or not; rather it provides the report and additional
inputs making it easier for the lender to analyse and an
informed decision.
Credit Rating Agencies in India
There are several credit rating agencies in India, such as
CRISIL Ltd, India Ratings and Research Pvt Ltd, ICRA
Limited, CARE, Brickwork Ratings India Pvt Ltd, SMERA
Ratings Limited, and Infometrics Valuation and Rating Pvt
Ltd.
According to SEBI, the following credit rating agencies are
registered and authorised to compute and share credit
score/report with the financial institutions and applicants.
Credit Rating Information Services of India Limited
Credit Rating Information Services of India Limited
(CRISIL), one of the oldest credit rating agencies, was set up
in 1987. The agency stepped on to infrastructure rating in
2016. CRISIL has been operational in countries such as the
USA, UK, Poland, Hong Kong, China, and Argentina in
addition to India.
India Ratings and Research Pvt Ltd. (Ind-Ra)
India Ratings and Research, a wholly-owned subsidiary of
Fitch Group, provides accurate and timely credit opinions on
the country’s credit market. The firm covers corporate issuers,
financial institutions, managed funds, urban local bodies,
project finance companies, and structured finance companies.
The headquarters is in Mumbai and the other branch offices
are in Ahmedabad, Delhi, Chennai, Bengaluru, Hyderabad,
Pune, and Kolkata.
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ICRA Limited
The Investment Information and Credit Rating Agency
(ICRA), a joint venture of Moody’s and Indian Financial and
Banking Service Organisation was established in 1991. The
organisation is known for assigning corporate governance
rating, performance rating, mutual funds ranking, and more
CARE Limited
Credit Analysis and Research Limited (CARE) is a credit
rating agency that is operational since April 1993. The agency
provides a credit rating that helps corporates to raise funds for
their investment requirements. Investors can make decisions
based on credit risk and risk-return expectations. In addition
to the head office in Mumbai, the firm has regional offices in
New Delhi, Pune, Kolkata, Chandigarh, Jaipur, Ahmedabad,
Bengaluru, Chennai, Coimbatore, and Hyderabad.
Brickwork Ratings India Pvt Ltd
In addition to registering with SEBI, Brickwork Ratings
(BWR) is accredited by RBI and empanelled by NSIC, NCD,
MSME ratings and grading services. It has received
accreditation from NABARD for MFI and NGO grading.
Brickwork is also authorised to grade companies seeking
credit facilities from IREDA, Renewable Energy Service
Providing Companies (RESCOs) and System Integrators
(SIs). Canara Bank was the leading promoter and strategic
planner for Brickwork.
SMERA Ratings Limited
SMERA analyses and establishes the credibility of existing
micro, small, and medium enterprises (MSMEs). MSMEs can
improve, grow, and avail cheaper/faster loans.

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Infometrics Valuation and Ratings Pvt Limited

This SEBI-registered, RBI-accredited credit rating agency
was founded by finance professionals, former bankers, and
administrative services personnel. It evaluates entities such as
banks, non-banking financial companies, large corporates,
and small and medium scale units (SMUs).
Benefits of Credit rating:
Credit rating offers various benefits from the point of view of
investors, companies, regulating authorities and public. Credit
score of a company matters a lot when it comes to boost
confidence in investors. Good credit rating reflects how much
a company is financially strong and secure.
Benefits of credit ratings from the point of view of
investors:
1. The investors can choose their investments on the basis
of good credit ratings.
2. As the credit rating is done by professionals, the investors
can rely on the credit rating.
3. It gives scope for the investors to forecast about the future
of their investments.
4.A comparative study between different credit
instruments enables the investors to choose their investments.
5. Even unknown securities could be purchased based on
credit rating. It also enables the investors to go for a
diversified investment.
6. As there is periodical review of the companies by credit
rating agencies, the investors have the opportunity of
swapping their weaker investment with a stronger investment,
based on the credit rating.
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6. The investors can minimize their existing loss by choosing

effective future investment. Thus, credit ratings acts as hedge
for the investors.
7. Liquidity, safety and profitability are duly considered
through credit rating mechanism by investors.
Benefits of good credit ratings from the point of view of
companies:
1. Companies will be able to raise funds from the market as
their debt instruments are backed by good credit rating.
2. Credit rating acts as a motivation for companies to either
improve their position or maintain their existing position, if
they are in a higher level of credit rating.
3. When companies of equal standing are issuing their credit
instruments, better placed companies are identified with a
positive signal on the credit rating such as A+.
4. In the market, companies with a higher rating will be in a
position to provide better liquidity for their credit instruments.
5. When companies are raising funds in the overseas market,
credit rating enables them to mobilize more funds.
6. Good Credit rating will provide better security from the
lenders’ point of view. This will enable the companies to sell
their credit instruments easily.
Benefits of credit ratings from the point of view of
Regulating authorities:
1. The regulatory authorities can discipline financial
institutions by insisting on good credit rating before going for
public issue.

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2. By imposing various conditions in credit rating, the

financial soundness of the companies is maintained.
3. Any down-grading of credit rating will send clear signals to
the regulating authorities to closely monitor the functioning
of the company concerned.
4. The general economic condition in the company could also
be analyzed by the regulating authorities from the credit rating
of various companies.
5. Good Credit rating also provides authority, responsibility
and accountability to the regulating authorities.
Benefits of credit ratings from the point of view of public:
1. Any unknown company or infant company cannot try to
cheat the public by offering an unusually higher rate of
interest, as without credit rating, the reliability of the company
will be in question.
2. Proper credit rating also channelizes the savings of the
public to productive purposes and prevents unwanted
conspicuous consumption, such as investing in gold.
3. Public can also discriminate their investments and go in for
better credit instruments on the basis of good credit rating.
4. Off-shore savings can be attracted through credit rating.
Individuals settled abroad can choose investment in domestic
companies based on credit rating.
5. Legal action could be taken when credit rating companies
fail to fulfill their obligations. This will instill confidence in
the minds of the investors.

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FACTORING
When a firm sells goods on credit, cash is not received
immediately. This means there is a time gap between sale of
goods/services and receipt of cash out of such sale. The
outstanding amounts get blocked for a period. This period
depends upon the credit period allowed to buyers.
The outstanding amounts are called ‘Debtors’ or ‘Accounts
Receivables’. If the debts are not collected in time, the firm
will be handicapped due to lack of sufficient working capital.
The other side is that if the debts were collected speedily the
amount could be used productively. Further, it is very difficult
to collect debts. Moreover, there is the problem of defaults
(i.e. bad debts) . In short, debtors or accounts receivables
involve risks. So, business enterprises are always looking for
selling the debtors for cash, even at a discount. This is possible
through a financial service. Such a financial service is known
as factoring.
Factoring is one of the oldest forms of commercial finance.
Some scholars trace its origin to the Roman Empire. Some
others trace its origin even further back to Hammurabi, 4000
years ago.
Meaning and Definition of Factoring
Like securitisation factoring also is a financial innovation.
Factoring provides resources to finance receivables. It also
facilitates the collection of receivables. The word factor is
derived from the Latin word facere. It means to make or do or
to get things done. Factoring simply refers to
selling the receivables by a firm to another party. The buyer
of the receivables is called the factor.

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Thus factoring refers to the agreement in which the

receivables are sold by a firm (client) to the factor (financial
intermediary). The factor can be a commercial bank or a
finance company. When receivables are factored, the factor
takes possession of the receivables and generally becomes
responsible for its collection. It also undertakes administration
of credit i.e. credit control, sales accounting etc.
Thus factoring may be defined as selling the receivables of a
firm at a discount to a financial organisation (factor). The cash
from the sale of the receivables provides finance to the selling
company (client). Out of the difference between the face value
of the receivables and what the factor pays the selling
company (i.e. discount), it meets its expenses (collection,
accounting etc.).
The balance is the profit of the factor for the factoring
services.
Factoring can take the form of either a factoring agreement or
an assignment (pledging) agreement. The factoring agreement
involves outright sale of the firm’s receivables to a finance
company (factor) without recourse. According to this
agreement the factor undertakes the receivables, the credit, the
collection task, and the risk of bad debt. The firm selling its
receivables (client) receives the value of the receivables minus
a commission charge as compensation for the risks the factor
assumes. Thereafter, customers make direct payments to the
factor. In some cases receivables are sold to factor at a
discount. In this case factor does not get commission. The
discount is its commission. From this its expenses and losses
(collection, bad debt etc.) are met. The balance represents the
profit of the factor.

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In an assignment (pledging) agreement, the ownership of the

receivables is not transferred; the receivables are given to a
finance company (factor) with recourse. The factor advances
some portion of the receivables value, generally in the range
of 50 – 80%. The firm (client) is responsible for service
charges and interest on the advance (due to the factor) and
losses due to bad debts.
According to this arrangement, customers make direct
payment to the client. It should be noted that both factoring
and securitisation provide financing source for receivables. In
factoring, the financing source is the factor. But in
securitisation, the public (investors) who buys the securities is
the factoring source.
Objectives of Factoring
Factoring is a method of converting receivables into cash.
There are certain objectives of factoring. The important
objectives are as follows:
1. To relieve from the trouble of collecting receivables so as
to concentrate in sales and other major areas of business.
2. To minimize the risk of bad debts arising on account of non-
realisation of credit sales.
3. To adopt better credit control policy.
4. To carry on business smoothly and not to rely on external
sources to meet working capital requirements.
5. To get information about market, customers’ credit
worthiness etc. so as to make necessary changes in the
marketing policies or strategies.

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Types of Factoring
There are different types of factoring. These may be briefly
discussed as follows:
1. Recourse Factoring: In this type of factoring, the factor
only manages the receivables without taking any risk like bad
debt etc. Full risk is borne by the firm (client) itself.
2. Non-Recourse Factoring: Here the firm gets total credit
protection because complete risk of total receivables is borne
by the factor. The client gets 100% cash against the invoices
(arising out of credit sales by the client) even if bad debts
occur. For the factoring service, the client pays a commission
to the factor. This is also called full factoring.
3. Maturity Factoring: In this type of factoring, the factor
does not pay any cash in advance. The factor pays clients only
when he receives funds (collection of credit sales) from the
customers or when the customers guarantee full payment.
4. Advance Factoring: Here the factor makes advance
payment of about 80% of the invoice value to the client.
5. Invoice Discounting: Under this arrangement the factor
gives advance to the client against receivables and collects
interest (service charge) for the period extending from the date
of advance to the date of collection.
6. Undisclosed Factoring: In this case the customers (debtors
of the client) are not at all informed about the factoring
agreement between the factor and the client. The factor
performs all its usual factoring services in the name of the
client or a sales company to which the client sells its book
debts. Through this company the factor deals with the
customers. This type of factoring is found in UK.

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7. Cross boarder 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.
Process of Factoring (Factoring Mechanism)
The firm (client) having book debts enters into an agreement
with a factoring agency/institution. The client delivers all
orders and invoices and the invoice copy (arising from the
credit sales) to the factor. The factor pays around 80% of the
invoice value (depends on the price of factoring agreement),
as advance. The balance amount is paid when factor collects
complete amount of money due from customers (client’s
debtors). Against all these services, the factor charges some
amounts as service charges. In certain cases the client sells its
receivables at discount, say, 10%. This means the factor
collects the full amount of receivables and pays 90% (in this

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case) of the receivables to the client. From the discount (10%),

the factor meets its expenses and losses.
The balance is the profit or service charge of the factor.
Thus there are three parties to the factoring. They are the
buyers of the goods (client’s debtors), the seller of the goods
(client firm i.e. seller of receivables) and the factor. Factoring
is a financial intermediary between the buyer and the seller.
Features (Nature) of Factoring
From the following essential features of factoring, we can
understand its nature:
1. Factoring is a service of financial nature. It involves the
conversion of credit bills into cash.
Account receivables and other credit dues resulting from
credit sales appear in the books of account as book credits.
2. The factor purchases the credit/receivables and collects
them on the due date. Thus the risks associated with credit are
assumed by the factor.
3. A factor is a financial institution. It may be a commercial
bank or a finance company. It offers services relating to
management and financing of debts arising out of credit sales.
It acts as a financial intermediary between the buyer (client
debtor) and the seller (client firm).
4. A factor specialises in handling and collecting receivables
in an efficient manner.
5. Factor is responsible for sales accounting, debt collection,
credit (credit monitoring), protection from bad debts and
rendering of advisory services to its clients.

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6. Factoring is a technique of receivables management. It is

used to release funds tied up in receivables (credit given to
customers) and to solve the problems relating to collection,
delays and defaults of the receivables.
Functions of a Factor
Factor is a financial institution that specialises in buying
accounts receivables from business firms. A factor performs
some important functions. These may be discussed as follows:
1. Provision of finance: Receivables or book debts is the
subject matter of factoring. A factor buys the book debts of
his client. Generally a factor gives about 80% of the value of
receivables as advance to the client. Thus the nonproductive
and inactive current assets i.e. receivables are converted into
productive and active assets i.e. cash.
2. Administration of sales ledger: The factor maintains the
sales ledger of every client. When the credit sales take place,
the firm prepares the invoice in two copies. One copy is sent
to the customers. The other copy is sent to the factor. Entries
are made in the ledger under open-item method. In this
method each receipt is matched against the specific invoice.
The customer’s account clearly shows the various open
invoices outstanding on any given date. The factor also gives
periodic reports to the client on the current status of his
receivables and the amount received from customers. Thus the
factor undertakes the responsibility of entire sales
administration of the client.
3. Collection of receivables: The main function of a factor is
to collect the credit or receivables on behalf of the client and
to relieve him from all tensions/problems associated with the
credit collection. This enables the client to concentrate on

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other important areas of business. This also helps the client to

reduce cost of collection.
4. Protection against risk: If the debts are factored without
resource, all risks relating to receivables (e.g., bad debts or
defaults by customers) will be assumed by the factor. The
factor relieves the client from the trouble of credit collection.
It also advises the client on the creditworthiness of potential
customers. In short, the factor protects the clients from risks
such as defaults and bad debts.
5. Credit management: The factor in consultation with the
client fixes credit limits for approved customers. Within these
limits, the factor undertakes to buy all trade debts of the
customer. Factor assesses the credit standing of the customer.
This is done on the basis of information collected from credit
relating reports, bank reports etc. In this way the factor
advocates the best credit and collection policies suitable for
the firm (client). In short, it helps the client in efficient credit
management.
6. Advisory services: These services arise out of the close
relationship between a factor and a client. The factor has better
knowledge and wide experience in the field of finance. It is a
specialised institution for managing account receivables. It
possesses extensive credit information about customer’s
creditworthiness and track record. With all these, a factor can
provide various advisory services to the client. Besides, the
factor helps the client in raising finance from banks/financial
institutions.
Advantages of Factoring
A firm that enters into factoring agreement is benefited in a
number of ways. Some of the important benefits of factoring
are summarised as follows:
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1. Improves efficiency: Factoring is an important tool for

efficient receivables management.
Factors provide specialised services with regard to sales
ledger administration, credit control etc. Factoring relieves the
clients from botheration of debt collection.
2. Higher credit standing: Factoring generates cash for the
selling firm. It can use this cash for other purposes. With the
advance payment made by factor, it is possible for the client
to pay off his liabilities in time. This improves the credit
standing of the client before the public.
3. Reduces cost: The client need not have a special
administrative setup to look after credit control. Hence it can
save manpower, time and effort. Since the factoring facilitates
steady and reliable cash flows, client can cut costs and
expenses. It can avail cash discounts. Further, it can avoid
production delays.
4. Additional source: Funds from a factor is an additional
source of finance for the client.
Factoring releases the funds tied up in credit extended to
customers and solves problems relating to collection, delays
and defaults of the receivables.
5. Advisory service: A factor firm is a specialised agency for
better management of receivables.
The factor assesses the financial, operational and managerial
capabilities of customers. In this way the factor analyses
whether the debts are collectable. It collects valuable
information about customers and supplies the same for the
benefits of its clients. It provides all management and
administrative support from the stage of deciding credit

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extension to the customers to the final stage of debt collection.

It advocates the best credit policy suitable for the firm.
6. Acceleration of production cycle: With cash available for
credit sales, client firm’s liquidity will improve. In this way
its production cycle will be accelerated.
7. Adequate credit period for customers: Customers get
adequate credit period for payment of assigned debts.
8. Competitive terms to offer: The client firm will be able to
offer competitive terms to its buyers. This will improve its
sales and profits.
Limitations of Factoring
The main limitations of factoring are outlined as below:
1. Factoring may lead to over-confidence in the behaviour of
the client. This results in overtrading or mismanagement.
2. There are chances of fraudulent acts on the part of the client.
Invoicing against non-existent goods, duplicate invoicing etc.
are some commonly found frauds. These would create
problems to the factors.
3. Lack of professionalism and competence, resistance to
change etc. are some of the problems which have made
factoring services unpopular.
4. Factoring is not suitable for small companies with lesser
turnover, companies with speculative business, companies
having large number of debtors for small amounts etc.
5. Factoring may impose constraints on the way to do
business. For non - recourse fac–oring most factors will want
to pre- approve customers. This may cause delays. Further ,the
factor will apply credit limits to individual customers.

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FORFAITING
Generally there is a delay in getting payment by the exporter
from the importer. This makes it difficult for the exporter to
expand his export business. However, for getting immediate
payment, the concept of forfeiting shall come to the help of
exporters.
The concept of forfaiting was originally developed to help
finance German exports to Eastern block countries. In fact, it
evolved in Switzerland in mid 1960s.
Meaning of Forfaiting
The term ‘forfait’ is a French world. It means ‘to surrender
something’ or ‘give up one’s right’. Thus forfaiting means
giving up the right of exporter to the forfaitor to receive
payment in future from the importer. It is a method of trade
financing that allows exporters to get immediate cash and
relieve from all risks by selling their receivables (amount due
from the importer) on a ‘without recource’ basis. This means
that in case the importer makes a default the forfaitor cannot
go back to the exporter to recover the money. Under forfaiting
the exporter surrenders his right to a receivable due at a future
date in exchange for immediate cash payment, at an agreed
discount.
Here the exporter passes to the forfaitor all risks and
responsibilities in collecting the debt. The exporter is able to
get 100% of the amount of the bill immediately. Thus he gets
the benefit of cash sale. However, the forfaitor deducts the
discount charges and he gives the balance amount to the
exporter. The entire responsibility of recovering the amount
from the importer is entrusted with the forfaitor. The forfaitor
may be a bank or any other financial institution.

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In short, the non-recourse purchase of receivables arising

from an export of goods and services by a forfaitor is known
as forfaiting.
Forfaiting is not the same as international factoring. The
tenure of forfaiting transaction is long. International factoring
involves short term trade transactions. In case of forfaiting,
political and transfer risks are also borne by the forfaitor. But
in international factoring these risks are not borne by the
factor.
Characteristics of Forfaiting
The main characteristics of forfaiting are:
1. It is 100% financing without recourse to the exporter.
2. The importer’s obligation is normally supported by a local
bank guarantee (i.e., ‘aval’).
3. Receivables are usually evidenced by bills of exchange,
promissory notes or letters of credit.
4. Finance can be arranged on a fixed or floating rate basis.
5. Forfaiting is suitable for high value exports such as capital
goods, consumer durables, vehicles, construction contracts,
project exports etc.
6. Exporter receives cash upon presentation of necessary
documents, shortly after shipment.
Advantages of Forfaiting
The following are the benefits of forfaiting:
1. The exporter gets the full export value from the forfaitor.
2. It improves the liquidity of the exporter. It converts a credit
transaction into a cash transaction.
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3. It is simple and flexible. It can be used to finance any export

transaction. The structure of finance can be determined
according to the needs of the exporter, importer, and the
forfaitor.
4. The exporter is free from many export credit risks such as
interest rate risk, exchange rate risk, political risk, commercial
risk etc.
5. The exporter need not carry the receivables into his balance
sheet.
6. It enhances the competitive advantage of the exporter. He
can provide more credit. This increases the volume of
business.
7. There is no need for export credit insurance. Exporter saves
insurance costs. He is relieved from the complicated
procedures also.
8. It is beneficial to forfaitor also. He gets immediate income
in the form of discount. He can also sell the receivables in the
secondary market or to any investor for cash.

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