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Debt or loans (international) – all are subject to forex risk but interest rates could be an advantage in
comparison with Indian Rupee Loan – Note separately given for FCCB & ECB
Foreign currency loan (by an international bank or an institution like WB etc.)
Fixed rate bonds (Could be for a very long period and discounted bonds)
Floating rate notes (not exceeding 5 years)
External commercial borrowing (as controlled by RBI)
Foreign currency convertible bonds (FCCBs – as controlled by RBI)
Short-term (Working capital)
From a factor (even a scheduled commercial bank can be a ‘Factor’ duly holding such a licence from RBI)
Factoring of bills receivables
1. Equity share capital = Well known to the students and hence not detailed here
3. Preference share capital = Well known to the students and hence not detailed here
4. Debentures:
a. Characteristics:
i. Debt instrument not exceeding 10 years usually
ii. There could be what is known as ‘Redemption premium’ in the case of
redeemable debentures only
iii. Can be a public issue or a private placement
iv. Market practice to get the instrument credit rated by a registered credit rating
agency; as per SEBI regulations, all public issues require credit rating
mandatorily
v. Can be cumulative or non-cumulative
vi. Can be convertible or redeemable
vii. Is being phased out slowly but definitely by bonds
viii. Certificate is issued by the borrowing corporate
ix. Debenture trustees ( a registered legal body) have to be appointed
x. As per provisions of The Companies Act, 2013 [known shortly as CA, 2013],
prescribed reserve for redemption has to be created
b. Investors get interest (in the case of non-cumulative) and in the case of cumulative, the
interest gets accumulated by adding to the principal amount so much so the investors
get compound interest.
c. Mode of operations
i. Can be a public issue or a private placement
ii. Private placement comes under The CA, 2013 and SEBI does not have any
authority in this behalf
iii. All public issues come under SEBI and The CA, 2013
iv. Certificates of debt are issued to the investors detailing all the terms and
conditions and type of debenture
v. If it is non-cumulative debenture, periodic interest is credited to the investors’
account through NEFT
vi. If it is a cumulative debenture, periodic interest is credited to the debenture
account, thereby earning compound interest
vii. If it is a convertible debenture, it gets converted at a pre-agreed rate in the
debenture agreement to equity shares
viii. If it is a premium debenture, premium is paid at the time of redemption
d. Investors:
i. Corporate houses
ii. High net worth investors
iii. Public sector undertakings which are cash rich subject to investment limits
prescribed
iv. NBFCs subject to prescribed limits in this behalf
v. Scheduled Commercial Banks subject to prescribed limits on investment in
private sector securities
vi. Business houses who are partnership firms
e. Collateral, if any: Fixed assets of the borrowing corporate ranking on par with project
loans if any; only such collateral is created in favour of the debenture trustees and not
individual investors
f. Rate of interest – Market driven; cumulative debenture may attract slightly higher rate
of interest; again depends upon the credit rating given to the instrument by credit rating
agency. The better the rating, the less would be the market expectation of interest rate.
g. Periodicity of payment or credit of interest – Depends upon the terms of the debenture
– Could be quarterly or half yearly; rarely annually
5. Bonds:
a. Almost all the terms are the same as for debentures
b. Investors get interest, either paid or credited as per the terms of instrument
c. Mode of operations:
i. Periodic interest gets credited or paid as the case may be
ii. There could be a minimum period of holding, usually six months in most of the
cases, before which there cannot be any withdrawal
iii. There would always be a minimum amount of investment required to be made
iv. Similarly corporate houses cannot accept fixed deposits for a duration longer
than the one prescribed by statutory authorities, be it CA, 2013 or RBI
v. In case the contract period is not over and premature withdrawal occurs, there
could be a penalty in terms of reduction in contracted rate of interest
d. Investors:
i. Individuals
ii. NBFCs subject to limits prescribed
iii. Corporate houses
iv. PSUs subject to limits prescribed
v. Business houses who are partnership firms
e. Collateral – None
b. Investors get interest that is usually higher than secured loans, debentures, bonds etc.
c. Usually get paid last before preference share capital and equity share capital
e. Collateral – None
f. Rate of interest – Market and need driven; no prescription by any statute on the rate of
interest
b. Lenders get interest and this is charged on a monthly basis and gets recovered through
EMI that has interest element also.
c. Mode of operations:
i. Total cost of project would include expenses too like pre-operative, preliminary
and margin money on working capital. These are not financed by lenders in
project finance. The borrowers have to bring in equity at D:E ratio of 2:1.
ii. Project loan is sanctioned in stages, the first stage being ‘Acceptance in
principle’ based on feasibility studies. This confirms that the project is a
bankable project. The final stage is based on ‘Detailed project report’ and if
everything is alright, final sanction is done before disbursement
iii. Disbursement only after the borrower signs security documents and creates
charge on its assets and registers the same with ‘ROC’.
iv. An application is made requesting for disbursement based on amount spent on
the project so far; means, disbursement not in lump sum but in stages, keeping
one third of equity contribution at each stage.
v. Mode of disbursement direct to the contractors, suppliers etc. and not to the
borrower; a small percentage of disbursement could be in cash like payment of
wages to construction contractors.
vi. Nowadays disbursement is not made on re-imbursement basis (exceptional
cases apart); means suppose due to exigencies, the borrower puts in the entire
money for an asset during project implementation stage, this asset gets
excluded automatically from the project loan.
vii. While making financial projections for the project, cushion period is also
included to take care of possible swings in the project cash flows during
operations. Besides this cushion period, there is a repayment holiday period,
known as ‘Moratorium’ period. Students should note that while there is no
holiday for payment of interest (this starts from the first day of disbursement).
For example, a project has a repayment period of 5 years and it takes one year
to generate positive cash flows. This one year is known as ‘moratorium’ period.
Positive cash flows = Cash inflows > cash expenses. Again to be noted – non-
cash expenses like depreciation and amortization are not included in cash
flows. Hence in the given example, suppose the project sponsors keep one year
as cushion period, the cash flow projections would be for a period of 5 years
(projected repayment period) + 1 year (moratorium period) + 1 year (cushion
period).
viii. Hence a question arises in the mind of students as to how the interest is getting
paid even before EMI begins. This depends upon the financial planning for the
project. There are two options as under:
1. Full disbursement as per amount sanctioned is done. In this case the
interest as and when levied has to be paid so that there is no penalty to
the borrower
2. As can be agreed to by and between the two parties involved in the
loan, there could be some portion left out of the amount of sanction
(without being disbursed fully) and the interest will be added to the
principal outstanding. However it should be noted here that such
unpaid interest attracts ‘compounding’ of interest; whereas in the
former case due to prompt payment of interest, there would be no
compounding of interest
3. For example, the total loan amount sanctioned = Rs. 100 crores and the
entire amount gets disbursed too to finance the projects. Then any
interest charged by the lender is expected to be paid in time to avoid
any penalty. In the same case, suppose the borrowers and the lenders
agree to disburse only Rs. 90 crores, the balance Rs. 10 crores would
take care of interest charged but not paid; however the bank would
recover any interest that is charged, in case the outstanding amount in
the loan account goes beyond Rs. 100 crores.
d. Lenders – Scheduled commercial banks, Debenture holders, Bond holders and other
sources as listed above. It should be noted that all the details so far seen are applicable
only to domestic loans. A borrowing from the international market works on a different
process.
e. Collateral – the basic principle in collateral is that the assets financed by the lenders are
given as collateral. The collateral in India would be fixed assets. The different charges on
the assets are – hypothecation in the case of movable fixed assets and mortgage in the
case of immovable fixed assets – Land, building, plant and ship
f. Rate of interest – Nowadays floating rate of interest is preferred by lenders; means the
rates of interest would depend on three factors – the market, the duration of the loan
and the credit risk of the borrower (as measured through credit rating). Please bear in
mind that home loan interest rates are totally out of this as they are offered on
‘special rates’.
1. The rates of interest on international borrowing are always ‘floating rates’ mostly linked to LIBOR
rates. The students may be aware that LIBOR or any such floating rate internationally would be
dependent upon duration. Any international floating rate depends upon two factors – duration of
the loan and the currency of the loan.
2. The rates of interest on international borrowing are always less than the domestic rates due to
differential rates of inflation in developed countries; the rates of inflation in all developed countries
are less than what we experience in India.
3. As opposed to this advantage, the disadvantage is the probability of exchange rate against Indian
Rupee being adversely affected. Thus there is always a trade off between the advantage of lower
rates of interest and exchange loss due to depreciation of Indian Rupee. For example, at the time of
borrowing in US $, the exchange rate is 1 US# = Rs.68/-. At the time of repayment, this could go up
to Rs.70/- means a loss of two Rupees per $.
4. These two have to be weighed properly with the help of specialists in the field before taking a
decision; of course, there is no finality in the growing world of uncertainty. Hence periodic review
and on line corrective action is required critically.
5. There are tools available now more than ever in the past like forex derivatives to minimize the risk
associated with international borrowing.
6. In all foreign currency loan transactions, an Indian bank is invariably involved as a correspondent
bank. This bank serves the following purposes broadly:
a. Holds the security/collateral on behalf of the foreign lender like an international bank etc.
b. Gives guarantee on behalf of the Indian borrower on repayment as per schedule
c. Is a conduit for all transactions to and fro India
d. Most of the times, such correspondent bank would be having banking relationship with the
international banker/funder in more than one form. One of the forms of banking
relationship usually observed is maintaining the Indian bank’s ‘Nostro’ account with the
foreign lender involved in the international borrowing.
1. The term ‘note’ refers to promissory note and the duration does not exceed 5 years
2. Fixed rate bonds could be for longer duration
3. RBI comes out with periodic circulars and notifications on ‘External Commercial Borrowing (ECB)’ –
these instructions cover various aspects of ECB like duration, purpose, extent of borrowing, limits
prescribed in two different routes of borrowing – automatic and approved routes etc. The students
would be well advised to keep themselves updated by accessing RBI circulars, notifications etc.
from time to time.
4. For comprehensive understanding of international borrowing, please use a standard textbook like
‘International finance’ by Prof. P.G. Apte (Ex-Director of IIM Bangalore)
Short-term borrowing:
1. Cash credit/overdraft:
Just for information – the nomenclature does not matter. While public sector banks refer to it
as cash credit, the private sector banks prefer to use the term ‘overdraft’
a. Features:
1. Fluctuating balances and regular operations even on a daily basis
2. Only for business and not for saving units like persons etc.
3. Based on estimated sales and current assets for the current year, limit is
sanctioned by the bank on an annual basis.
4. The limit gets reviewed every year and the performance is subject to what is
known as ‘credit rating’. The parameters for credit rating are separately discussed in
the class
b. What the lenders get – Interest determined on the actual amount utilized on a daily
product basis as explained under:
1. Products are determined – outstanding x number of days for which the balance
has remained unchanged
2. The aggregate of such products is dividend by 365 to determine annual average
outstanding
3. This is multiplied by the rate of interest as divided by 100
4. Thus interest amount is determined
c. Mode of operations:
1. Running account like current account
2. Operations are only through cheques
3. The outstanding in the account cannot exceed the sanctioned limit
4. The drawable limit on a monthly basis is determined on the basis of value of
inventory and receivables outstanding as at the end of the previous month; it is
obvious that drawable limit cannot be higher than the sanctioned limit
5. At times, depending upon the urgency and the discretion of the branch manager
of the bank, over limit beyond the sanctioned limit can be granted at 1% – 2%
higher rate of interest than the normal rate for a short period.
6. Such requests for over limit cannot be entertained every now and then.
2. Bill finance:
a. Features:
1. Unlike overdraft account, this is not a running account
2. Each bill (Bill of exchange and not commercial bill) is a transaction in itself
3. BOE (bill of exchange) is drawn by the seller on the buyer as an order
instrument to pay a specified sum on a specified date for value received in terms of
goods and or services; hence applicable to a credit transaction where the buyer pays
after a specific duration.
4. BOE is a well recognized legal document provided it is accepted by the buyer.
Acceptance by the buyer means acknowledging his/her liability towards value of
goods and/or services received from the seller.
5. In India, RBI permits only BOE backed by merchandising and not
accommodation bills drawn only instruments of finance without any commercial
transaction
6. Minimum period – even though 15 days, in practice not less than 30 days.
Similarly maximum period – even though 180 days, in practice not exceeding 90 –
120 days with the majority of the bills being in 90 days tenor.
7. Bill finance is known as ‘bills discounted’ as the lender recovers the interest for
the period in advance and credits only the discounted amount to the seller. The
seller transfers all his rights in the bill to his bank.
b. Lenders get interest that too in advance. This interest is referred to as discount in banking
parlance. Besides this, they also get reimbursed with collection charges.
c. Mode of operation:
1. There is a contract or a proforma invoice preceding the actual supply of goods
or services; this spells out terms of supply and the mutual obligations of the supplier
and buyer.
2. Just to have a readymade legal document, a bill of exchange is drawn by the
seller on the buyer as on ‘order instrument’.
3. This is duly accepted by the buyer accepting his liability towards the value of the
goods or services received by him from the seller
4. The seller’s bank receives all the rights transferred to him by the seller and
discounts the bill to the seller
5. On due date the buyer pays to his bank who in turn remits the amount to the
seller’s bank.
6. Suppose on due date, the amount does not get paid, in India, as per RBI
guidelines, the amount gets recovered from the seller to whom his bank transfers all
the rights back.
7. The seller files a suit against the buyer based on the legal document of BOE and
recovers the amount.
8. The banks, both the buyer’s and the seller’s deal only with documents and not
goods.
9. They will not be a party to any dispute arising between the seller and the buyer
relating to goods or delivery or any other terms and conditions as per proforma
invoice (Proforma invoice = Quotation).
d. Lenders: Banks, both commercial and co-operative. NBFCs and large PSUs like LIC etc.
e. Collateral – None
4. Letter of credit:
a. It is a conditional undertaking given by a bank on behalf of the buyer to the seller and/or his
bank that payment for the bill will be made only and only if all the conditions prescribed in
the L/C are fulfilled by the seller.
b. Could be domestic or international
c. Giving finance against a letter of credit is known as ‘Negotiation’
d. All international letters of credit are covered by International Chamber of Commerce (the
commercial arm of WTO) under its document known as ‘UCPDC 700).
e. UCPDC = Uniform Customs and Practices for Documentary Credits
f. There are two sets of conditions in any letter of credit – One set of conditions relates to the
goods and/or services proposed to be supplied and the second set of conditions relates to
the inter-bank documents
g. There could be two types of L/Cs, namely payable on demand (without any credit) and the
second one payable after some time (involving credit)
h. Parties involved are as under:
1. Buyer
2. Seller
3. Buyer’s bank or L/C establishing bank
4. Seller’s bank or L/C negotiating bank (means financing bank)
5. In case of international letters of credit, if the buyer’s bank is not known to the
seller’s bank, they may insist on a reputed international bank to confirm the letter
of credit. This most often happens in the case of very poor countries like some of
the African nations.
i. There will be bank charges from the buyer’s bank as well as the seller’s bank. Usual practice
is buyer’s bank charges to the buyer’s account and seller’s bank charges to the seller’s
account. Not to confuse with negotiation charges which would be the interest chargeable by
the seller’s bank.
1. To cover these charges, the practice is to draw a separate bill of exchange for
interest for the credit period. This amount will be the same as charged by the
negotiating bank.
2. Hence in practice, there will be two bills of exchange, one for the invoice
amount and the other for interest charges. The percentage of interest cannot be
more than the prime rate of the exporting country.
j. The negotiating bank is not liable to negotiate the letter of credit in case there are serious
discrepancies in the documents submitted by the exporter in comparison with the terms of
the letter of credit. (This is a case of non-compliance by the seller and the payment to the
seller is not free but conditional as per ‘a’ above)
k. Usually the letters of credit in international trade are irrevocable.
l. The terms and conditions are changeable as per mutual agreement between the buyer and
the seller.
m. For each amendment, the buyer’s bank levies certain charges
n. The documents usually submitted in an international trade transaction:
1. Commercial invoice
2. Packing slip
3. Bill or bills of exchange (depending upon whether it is without credit or with
credit – in the case of credit transactions, there are two bills of exchange, one for
the bill amount and the second for the interest for the credit period)
4. Certificate of origin
5. Certificate of quality (optional)
6. Certificate of insurance
7. Goods consignment note like Bill of lading etc.
8. Note: The number of copies of the documents like invoice etc. Is specified by
the importer in the terms of L/C
9. Conditions by the importer/buyer:
1. Nature of goods to be supplied
2. Quantity of goods
3. Price of goods
4. Last date of delivery
5. Last date for negotiation
6. Quality of goods
7. Documents required and how many copies
8. INCO term of supply as to be mentioned in the commercial invoice, like CIF
etc.
10. As mentioned elsewhere, in all trade transactions involving banks, the banks
deal only with documents and not goods or services involved in the transaction. This
means that any dispute between the seller and the buyer, the banks involved will
not be a party to the same; such disputes are settled out of the banking system in
courts of law.
5. Bank guarantees:
a. Guarantees are unconditional unlike letters of credit
b. In the sense, in case the bank gives any guarantee on behalf of its client in favour of a third
party, suppose the guarantee is invoked (claim preferred by the beneficiary for whatever
reason/s), the bank has to make the payment without any questions to the beneficiary.
c. That is why guarantees are more risky than letters of credit. Hence the banks may ask for
25% collateral against the guarantees issued by them to a client.
d. Beneficiaries of guarantees could be domestic or international.
e. It should be noted that bank guarantees are contingent liabilities both for banks and for
their clients. This is a contingent liability as the liability arises only if the client of the bank
fails to fulfil his obligations as per guarantee.
f. Guarantees are of two kinds – Performance guarantee and Financial guarantee
g. Banks earn commission on guarantees
h. Commission for performance guarantee is usually less than that for finance guarantee
i. Whether it is performance guarantee or financial guarantee, the settlement is always in
money.
j. Examples of performance guarantee – performance of delivery in a contract, performance
of goods or services supplied in a contract etc.
k. Examples of finance guarantees – amounts in dispute between the clients of the bank and
other external parties like government departments like I.T. , excise or customs
departments, advance money guarantee, earnest money guarantee etc.
l. There is a minimum period for which guarantee is payable – six months
m. The guarantees are for a maximum period of 36 months.
n. Guarantee period can be extended within the cap of 36 months
o. In very rare cases, depending upon merits, the banks do give guarantees for a period
exceeding 36 months.
Note:
Scheduled commercial banks set up distinct limits, for L/Cs and guarantees either combined or
separate as fee based facilities.