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(Syllabus) Sources and cost of finance; Concept of cost of capital; Cost of different sources of capital; Short term capital and Long term capital; Equity, Preference and bonds; International sources of finance; GDR, ADR; Money market, Money market instruments for corporate firms; Leasing, Factoring, Hire purchase, Installment, Securitisation, Commercial paper, Venture capital.

Sources of Finance
Capital required for a business can be classified under two main categories: Fixed capital and Working capital. Thus, every business needs funds for two purposes: for its establishment and to carry out its day-to-day operations (i.e. long term funds to create production facilities and short term funds for day-to-day operations.) these funds are raised through various sources. The various sources of raising long-term funds include issue of shares, debentures, ploughing back of profits and loans from financial institutions etc. the short-term requirement of funds can be raised from commercial banks, trade credit, installment credit, advances, factoring or receivable credit, accruals, deferred incomes and commercial paper etc. The various sources of finance can be classified as follows:

I. Sources of Finance According to Period

1. Short Term Term

2. Medium Term

3. Long

(1) Bank Credit (1) Issue of Debentures (1) Issue of Shares (2) Customer Advances (2) Issue of Preference Shares (2) Issue of Debentures (3) Trade Credit (3) Bank Loans (3) Ploughing back of (4) Factoring (4) Public Deposits / profit (5) Accruals Fixed Deposits (4) Loans from (6) Deferred Incomes (5) Loans from specialised (7) Commercial Paper Financial Institutions financial institutions (8) Installment Credit

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II. Sources of Finance According to Ownership

1. Owned Capital Capital (Such as share capital, retained earnings, debentures, bonds, profit & surplus etc.) etc.)

2. Borrowed (such as public deposits, loans

III. Sources of Finance According to Nature

Internal Sources Sources (Such as Ploughing back of profit, Debentures, Retained earnings, Profits, Surpluses, loans etc.) Depreciation funds etc.) External (Such as Shares, Public deposits,

IV. Sources of Finance According to Mode of Financing

Security Financing or Internal Financing Loan Financing External Financing (i.e. financing through raising of ( i.e. financing through retained (i.e. financing through corporate securities such as earnings, capitalization of raising of long-term, shares, debentures, etc.) profits, depreciation of funds etc.) medium-term & short-term loans)

Cost of Capital

The term cost of capital refers to the minimum rate of return a firm must earn on its investment so that the market vale of the companys equity share doesnt fall. Thus it is related with the overall firms objective of wealth maximisation. If a firm fails to earn return at the expected rate, the market value of the share would fall and thus result in reduction of overall wealth of the share holders. Thus a firms coast of capital may be defined as the rate of return the firm requires from investment in order to increase the value of the firm in the market place.

Importance of Cost of Capital

The concept of cost of capital is very important in the financial management as it plays a crucial role in capital budgeting as well as decision relating to planning of capital structure. 1) Capital Budgeting Decisions Capital budgeting decisions can be made by considering the cost of capital. For example, according to present value method of capital budgeting, if the present value of expected return from investments is greater than or equal to the cost of investment the project may be accepted; otherwise the project may be rejected. 2) Capital Structure Decisions While designing an optimum capital structure, the management has to keep in mind the objective of maximizing the value of the firm and minimising the cost of capital. 3) Basis for Evaluating the Financial Performance The cost of capital can be used to evaluate the financial performance of top management. If the actual profitability of the project when compared with the overall projected cost of capital is more, then the performance is said to be satisfactory. 4) Basis for Taking Other Financial Decisions, such as dividend policy, capitalization of profits, making the rights issue and working capital etc.

Classification of Cost of Capital

1. Historical Cost and Future Cost Future cost refers to the expected cost of funds to finance the project, while historical cost is the cost which has already been incurred for financing a particular project. In financial decisions future costs are more relevant than the historical cost. However, historical costs are useful in projecting future costs by comparing with standard or pre-determined costs.

4 2. Specific Cost and Composite / Combined Cost The cost of each component of capital i.e., equity shares, preference shares debentures, loans etc. is known as specific cost of capital. Thus it refers to the cost of specific source of capital. The composite or combined cost of capital is inclusive of all cost of capital from all sources i.e. equity, preference, debentures and other loans. Thus it refers to combined cost of various sources of capital. 3. Explicit Cost and Implicit Cost An explicit cost is discount rate which equates the present value of cash inflows with the present value of cash outflows. In other words, it is the internal rate of return, the firm pays for financing. Implicit cost also known as opportunity cost is the cost of the opportunity foregone in order to take up a particular project. 4. Average Cost and Marginal Cost The average cost of capital is the weighted average of the costs of each component of the funds employed by the firm. Marginal cost of capital on the other hand is the weighted average cost of new funds raised by the firm. For capital budgeting and financial decisions, the marginal coat of capital is the most important factor to be considered.

Computation of Cost of Capital

Computation of overall cost of capital of a firm involves; I Computation of specific source of finance II Computation of weighted average cost of capital I Computation of Specific Source of Finance Cost of each specific source of finance viz. debt, preference capital and equity capital can be determined as follows: a) Cost of Debt Capital Cost of debt is the rate of interest payable on debt. Cost of debt issued at par, at premium and at discount can be calculated separately. b) Cost of Redeemable Debt If the debentures are redeemable after the expiry of a fixed period the effective cost of debt before tax or after tax will be computed based on the maturity of debentures. c) Cost of Preference capital Here, the cost of preference share capital when it is issued at premium or discount will be computed. A fixed rate of dividend will be payable on preference shares. So, annual dividend earned will be taken in to consideration for the calculation. d) Cost of Equity Share Capital Cost of equity is the minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged, the

5 market price of such shares. The market price of equity shares therefore depends on the return expected by the share holders. Cost of equity capital will be calculated on:

External equity or new issue of equity shares. The cost of external equity or new issue of equity shares will be calculated under (i) Dividend price approach Here the cost of equity capital is the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale of a share. This method is also known as Dividend Yield Method or Price Ratio Method. This approach emphasizes the importance of dividend, but doesnt take into consideration the capital gains. So, it doesnt seem to be very logical. This method is only suitable for those companies which have stable earnings and stable dividend policy over a period of time. (ii) Dividend yield plus growth approach This method takes into consideration the rate of growth in dividend which will be determined on the basis of amount of dividends paid by the company for the last few years. (iii) Earning Price / Yield Approach According to this approach, it is the earning per share which determines the market price of the shares. Here, the cost of equity capital is the discount rate that equates the present value of expected future earnings per share with the net proceeds or current market price of a share. Thus it takes into consideration both dividend as well as retained earnings. (iv) Realised Yield Approach Here the cost of equity capital should be determined on the basis of return actually realised by the investors in a company on their equity shares. 2) The retained earnings. Here, the opportunity cost of dividends or retained earnings may be taken as the cost of retained earnings. The companies do not generally distribute the entire profits earned by them by way of dividend among their share holders. Instead, they retain some of the profits for future expansion of the business. Thus, cost of retained earnings is actually the earnings foregone by the share holders by way of dividend. Adjustments will be made regarding income tax, brokerage cost etc. for the dividends received by the share holders. 1) II Weighted Average Cost of Capital After calculating the cost of each component of capital, the average cost of capital is calculated on the basis of weighted average method. This is also termed as Composite Cost of Capital or Average Cost of Capital. It involves the following steps:

6 i) Determination of cost of each specific source of funds i.e., cost of debt, cost of equity capital, cost of preference capital etc., either on before tax basis or after tax basis. ii) Assigning weights to specific costs either marginal or historical weight. iii) Adding of the weighted cost of all sources of funds to get an overall Weighted Average Cost of Capital.

Security Financing
Corporate securities can be classified under two categories:

Ownership Securities or Capital Stock Capital (1)Ordinary or Equity Shares Bonds (2)Preference Shares (3) No Par Stock / Shares (4)Deferred Shares

Creditorship Securities or Debt Debentures or

Ownership Securities
Section 2(46) of the companies Act 1956 defines,a share is the share capital of a company and includes stock except where a distinction between stock and share is expressed or implied.

Equity Shares
The holders of equity shares are the real owners of the company, having control over the working of the company. Equity shares provide permanent capital to the company, and cannot be redeemed during the lifetime of the company. Equity shareholders have a residual claim on the income of the company after paying dividend to the preference shareholders. The rate of dividend on equity shares is not fixed. It depends upon the earnings available after paying dividends on preference shareholders. In many cases, equity shareholders may not get anything if profits are insufficient; or may even get a higher rate of dividend. That is why equity shares are called variable income security.

Preference Shares
As the name suggests these shares have some preferences when compared with equity shares. Mainly these shares are given two preferences: i) Preference on dividend over equity shares. ii) Preference for repayment of capital at the time of liquidation of the company.

Types of Preference Shares

1. Cumulative Preference Shares Holders of the cumulative preference shares have a right to claim dividend for those years for which dividend could not be paid, whenever the company has sufficient profits during the incoming period. Thus the dividend goes on cumulating unless otherwise paid. 2. Non Cumulative Preference Shares Such holders have no claim for the arrears of dividend in the subsequent years. They are paid dividend only if there is a sufficient profit. 3. Redeemable Preference Shares Normally the capital of the company is repaid only at the time of liquidation. However, the company can issue redeemable preference shares, if Articles of Association allow such an issue. The company has the right to return the redeemable preference share capital after a certain period; provided the share to be redeemed should be fully paid up and the redemption should be made either out of accumulated profits or out of the fresh issue of capital. 4. Irredeemable Preference Shares Irredeemable Preference Shares are those preference shares which cannot be redeemed unless the company is liquidized. 5. Participative Preference Shares The holders of these shares can participate in the surplus profit of the company (after paying fixed rate of dividend to the preference shareholders and reasonable rate of dividend to the equity shareholders.) in accordance with the provisions given in the Articles of Association. 6. Non- Participative Preference Shares These shareholders have no right for participating in the surplus profit of the company. They get only fixed dividend. 7. Convertible Preference Shares These shares can be converted into equity shares after a specific period, in accordance with the Articles of Association. 8. Non - Convertible Preference Shares These shares have no right to convert into equity shares.

No Par Stock / Share

No par stock means shares having no face value. Here, the share certificate of the company simply states the number of shares held by its owner without mentioning its face value. The value of shares can be determined by dividing the real

8 net worth of the company with the total number of shares of the company. Dividend of such shares is paid per share (and not as a fixed percentage of nominal value of shares).

Deferred Shares
These shares are normally issued to the promoters or founders for service rendered to the company.

Creditorship Securities
Debentures or Bonds
The term creditorship securities/debt capital represents debentures & bonds. A debenture or bond is an acknowledgement of debt. It is a certificate issued by a company under its seal acknowledging a debt due by it to its holders. According to sec 2(12)of the companies Act 1956, debenture includes debenture stock, bonds and any other securities of the company, whether constituting a charge on the assets of the company or not. So in India, the term debenture and bond have been used interchangeably.

Types of Debentures
1. Simple or Naked or Unsecured Debentures These debentures are not given any security on assets. The holders of these debentures have no priority as compared to other creditors and treated along with other creditors at the time of winding up of the company. They are unsecured creditors. 2. Mortgaged or Secured Debentures These debentures are given security or floating charge over all the assets of a company. In case of default in the payment of interest or principal amount, these debenture holders can sell the assets in order to satisfy their claims. 3. Bearer Debenture These debentures are easily transferable, just like negotiable instruments. These debentures are handed over to the purchaser without any registration deed. 4. Registered Debenture Under registered debenture both transferor and transferee are expected to sign a transfer voucher. The form is sent to the company along with the registration fees.

9 The coupons for interest are sent only to the person in whose name the debentures are registered. 5. Redeemable Debenture These debentures are to be redeemed on the expiry of a certain period. The interest on debentures is paid periodically, but the principal amount is returned after a fixed period. 6. Irredeemable Debenture Such debentures are not redeemable during the lifetime of the company. They are payable either winding up of the company or at the time of any default on the part of the company. The company can retain the right to redeem these debentures after giving due notice to the debenture holders.

7. Convertible Debentures Convertible debentures are issued by a company so that the debenture holders are given an option to exchange the debentures into equity shares after the lapse of a specified period. Thus it gives a privilege to the investor to change his status from being a secured creditor of the company to that of a shareholder if the returns are lucrative and the company is financially strong. 8. Guaranteed Debentures These debentures principal amount and interest is guaranteed by third parties, generally banks, Government etc. 9. Collateral Debentures A company may issue debentures in favor of a lender of money, generally the banks and financial institutions as a collateral i.e. subsidiary or secondary security for loan raised by it. 10. Zero Debentures or Bonds It is usually convertible debentures which have no interest, but could be converted into equity shares at a specified future date. 11. Zero Coupon Bonds or Deep Discount Bonds These are bonds which carry no interest, but it can be sold by the issuing company at deep discount from its eventual maturity value. Maturity value minus issue price will be the interest or gain for the investor. 12. Inflation Adjusted Bonds These are bonds where the interest and principal amount will be adjusted according to the price level changes. 13. Floating Debentures Here, the interest is adjusted based on the market rate of interest payable on gilt edged securities.

10 14. Collateral Bonds These are bonds callable and be paid off by the issuer at a price called call price, stipulated in the bond contract. 15. Equity Warrants Here, a paper is attached with the bond or [referred stock that gives the holder the right to buy a fixed number

Differences between Shares and Debentures

SHARES 1. A share is a part of owned capital 2. Shareholders dividend. are entitled to

DEBENTURES 1. A debenture is an acknowledgement of debt. 2. Debenture holders can claim interest. 3. A fixed rate of interest is paid on debentures irrespective of profit and loss. 4. Interest on debentures is a charge against profit & loss account. 5. Debenture holders are the creditors of the company. They have no say in the company. 6. Debentures can be redeemed after a certain period. 7. Debentures are paid in priority over share capital.

3. Rate of dividend depends upon the amount of divisible profits and policy of the Board of Directors. 4. Dividend on shares is a charge against profit & loss appropriation account. 5. Shareholders have voting rights and control over the management of the company. They are the owners. 6. Shares are not redeemable (except redeemable preference shares) during the life time of the company. 7. At the time of liquidation of the company, share capital is payable after meeting all outside liabilities.

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International Sources of Finance

Important constituent of Global Financial Market 1. Euro Currency Market: where the market is dominated by Euro-Dollar Deposit in the form of bank deposits and loans in Europe, particularly in London. Dollar dominated time deposits that are available at foreign branches of U.S Banks and also at some foreign banks are called Euro Dollar Deposits. 2. Export Credit Facility: are credit facilities made available through the mechanism of an institutional framework called EXIM Banks playing significant role in financing exports and other off-shore financial deals. 3. International Bond Market: also known as Euro Bond Market facilitates to raise long term funds by using different types of instruments like: Straight debt Eurobonds which are fixed interest bearing securities Foreign Currency Convertible bonds: issued through Depository Receipt mechanism scheme 1993. Multiple Tranche Bonds: which are issued in parts depending on the market conditions. Currency Option Bonds: which gives the investors the option of buying them in one currency while taking payment of interest and principal in another. Floating Rate Notes: that offers rate of return adjusted at regular interest to reflect changes in the short-term money market rates. Floating Rate CDs: are bearer instruments which carry floating rate of interest. Global Bonds: which was I issued by the World Bank as a primary method of borrowing, where liquidity is linked with the cost; the more liquid the issue the narrower will be the bid spread. Drop-Lock Bonds: are floating rate bonds which automatically get converted into fixed rate bonds on reaching a predetermined rate of interest. Detachable Warrant Bonds: suitable to the investors who are interested in acquiring shares; which provide them money for purchasing equities. Euro Notes: which may be either underwritten by banks or not underwritten by banks; also called as Euro Commercial Papers, where banks commit themselves to

12 purchase them at predetermined rates or distributed to dealers on best effort basis with flexible amount and maturities. Global Bond market is an international market for the purchase and sale of bonds where currency Swap has made the exchange of currency of with another easier for comparative cost advantage. 4. Institutional Finance: where foreign currencies are available through international financial institutions like International Monetary Fund (IMF), World Bank and its allied agencies such as Asian Development Bank (ADB), International Finance Corporation etc.,

Depository Receipts
Depository Receipts are negotiable certificates that represent beneficial ownership of equity securities. It was launched in 1972 to help U.S. investors who wished to purchase the shares of Non-U.S. companies. When companies making public offering in a market other than home market, they must launch Depository Receipt Program which represents shares of a company held in a depository in the issuing companys country. A company may issue Depository Receipt for a number of reasons:1. To increase capital in foreign markets. 2. To increase consumer interest in their products by strengthening name recognition in foreign market. 3. To potentially increase the liquidity of shares by broadening shareholders base as it facilitates cross border trading. 4. To allow employees outside the home market to participate in the parent company. 5. To gain visibility through financial market presence which can generate support for and interest in potential mergers and acquisitions. The depository bank act as an agent for the issuer and provide all stock transfer and agency services in connection with the depository receipt program, which includes the custodial arrangement for the safe keeping of shares, issues and cancellation of receipts, clearance, share holder services, announcement and processing of corporate actions, distribution of dividend, etc.

GDR (Global Depository Receipt)

GDR allows an issuer to raise capital simultaneously in two or more markets through a global offering. Issuers will be the organizations from those countries where direct foreign investment highly regulated and restricted. A GDR may represent one or more shares, which will be listed in a domestic stock exchange where the depository releases them as per the terms of the offer. Once a GDR is issued it can be freely traded among international investors in the overseas market or in the OTC. GDRs are marketed through a syndicated process which is the responsibility of lead managers. GDR was first issued by Samsung Co. Ltd., a South Korean trading company.

Important Features of GDR

13 Issuers: GDRs are the organizations from those countries where the direct foreign investment is highly regulated and restricted. Liquidity: GDR are highly popular in developing economies for the main reason that investors have enough liquidity and is simple to understand and trade with a single depository bank, which in turn facilitates the inter-market trading among various investors based in different countries. Flexibility: issuer can restrict holders of non-exchangeable GDRs, from exercising voting rights. The trading ratio of GDRs to ordinary shares can be adjusted and set in the price range of comparable foreign shares. Equity Funds: GDRs are generally issued as an instrument for raising equity funds by the enterprises based in Asian regions and are subscribed by simultaneous placement in the USA and Europe. GDR issue allows a company to raise capital both in Europe and USA simultaneously through one security.

ADR (American Depository Receipt)

ADR is a dollar denominated negotiable certificate that represents a non-US companys public traded equity, issued by a US commercial bank referred to as a depository. Thus, it represents shares of a non-US company that are deposited with the depositorys overseas custodian. It was devised in the late 1920s to help Americans invest in overseas securities and to assist non-US companies wishing to have their stock traded in the USA. It falls with the regulatory framework of the USA and requires registration with the US Securities Exchange Commission and is traded like any other securities in the OTC market or an NSE. ADR facilities may be Sponsored (initiated by the issuer and a depository) and Unsponsored (initiated by a third party and not the issuing firm). For companies with a desire to build a strong presence in the US market an ADR program can help much by providing enhanced communication network with US share holders in the US. Non-US companies have a choice of 5 types of ADR facilities: one Unsponsored, three levels of Sponsored and one type of Private (Rule 144A) ADR facility. All issues listed on the New York Stock Exchange can access the US retail market network. For meeting large requirement of funds, raising funds through ADR is the solution. It is generally recommended that ADR should be made for above US $ 300 million, so that the issuing company must be a significant player in the global arena. The main hurdle in raising money in the US capital market is that the Indian companies find it difficult to meet the US GAAP. An ADR issue will require complete recasting of accounts and companies will have to disclose far more information than they are used to. More over, it is issued under the US law and the directors of the company are personally liable to the share holders.

EDR (European Depository Receipt): are quite similar to ADR except that EDRs
are denominated in European Currency and are issued in Europe.

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Money Market and Capital Market

Classification of Financial Markets

Un organized Market Organised Market Capital Market Money Market

Industrial Government Securities Securities Market Market

Long Term Loans Market

Call Money Market

Commercial Bill Market

Treasury Bill Market

Short Term Loan Market

Primary Market

Secondary Market

Term Loan Market

Market For Mortgages

Market For Financial Guarantees

Money Lenders, Indigenous Bankers etc

Money Market Money Market is a market for dealing with financial assets and securities which have a maturity period of up to one year. In other words, it is a market for purely short term funds.

Players in the Indian Money Market

RBI DFHI (Discount & Finance House of India) Acceptance houses Financial institutions like, IDBI, ICICI, LIC, UTI etc. Commercial banks (Scheduled and non-scheduled) Foreign banks Public sector undertakings

15 Provident Funds Brokers Large corporate units etc.

The money market may be subdivided into four. They are: (i) Call money market (ii) Commercial bills market (iii) Treasury bills market (iv) Short-term loan market.

I Call Money Market

The call money market is a market for extremely short period loans say one day to fourteen days. So, it is highly liquid. The loans are repayable on demand at the option of either the lender or the borrower. In India, call money markets are associated with the presence of stock exchanges and hence, they are located in major industrial towns like Mumbai, Kolkata, Chennai, Delhi Ahmedabad etc. The special feature of this market is that the interest rate varies form day-to-day and even from hour-to-hour and centre-to-centre. It is very sensitive to changes in demand and supply of call loans. A call money market is part of the money market where day to day surplus funds mostly of banks are traded. The call money market is most liquid of all short term money market segments and it is also the most sensitive barometer measuring the liquidity conditions prevailing in financial markets. The call money is the money repayable on demand. The maturity period of call loans varies between 1 to 14 days. The money that is lent for one day in call money market is also known as Overnight money. The numbers of days are specified and all the call money has to be repaid on the due date. The term notice money also refers to the money lent in the call market, but a notice is served by the lender for the payment in a day or two before payment date. The intimation for repayment enables to borrower to arrange the money on the due date and the duration of notice money is similar to that of call money. Therefore the notice money is not seen in the market. The Indian call money market deals only with call money. The money, i.e., is lent for more than 14 days is known as Term Money. In call money market any amount could be lent or borrowed at an interest rate which is acceptable to both borrower and lender, These loans are considered as highly liquid; as they are repayable on due date which is usually the next day. Initially banks were only permitted to deal in this market; it was then referred to as inter bank market. Purpose In India call money is lent mainly to even out the short term mismatches of assets and liabilities and to meet CRR requirements of banks. Some banks may borrow and lend simultaneously from the market they find an opportunity to arbitrage.

16 Firstly the short term mismatches arise due to variation in maturities i.e., the deposits mobilized are developed by the bank at a longer maturity to earn more returns and duration of withdrawal of deposit by customers vary. These banks borrow money from call money markets to meet short term maturity mismatches such as large payments and remittance. Secondly the banks borrow from this market to meet the CRR requirements, which they should maintain with RBI every fortnight. ERR represents the balances to be maintained by banks with RBI, which is computed as percentage of the net demand and time liabilities. Thirdly, money is borrowed in the call/ notice market for short periods to discount commercial bills. The volume of loans thus very small in India due to underdeveloped bill markets. Thus the utility of the call money to meet short term mismatches forms a significant volume when compared to other purposes. Location Mumbai, Koltkata, Delhi, Chennai and Ahmedabad because of existence of stock market. Mumbai and Kolkata play a significant role. Due to the location of the biggest stock market and the various head offices of RBI many other banks Mumbai play a vital role. The main participants of call money market are all scheduled banks including cooperative banks and private sector banks can operate in this market. Intermediaries like Discount and Finance House of India (DFHI) and Securities Trading Cooperators of India Limited (STCI) and Primary Dealers are also the participants of call money market. The interest paid on call loans is known as call rates. The interest of the call money market is calculated on a daily basis. The call rate is expected to freely reflect the day to day market scarcities or lack of funds. The rates vary from day to day with in the day or even in hours. High rates indicate a tightness of liquidity in the financial system while low rate indicates an easy liquidity position in the market. The rate is largely depends on the supply and demand for funds. How Call Money Market Operates Once the deals is struck the funds are immediately available to the borrowing bank and are repaid with interest on the next /due date. The funds are lent and pick back through a bankers pay order, which is cleared by the special high value clearing all in the RBI. Role of Primary Dealers in the call markets Primary dealers have significant role in the call money market. Some commercial banks including co-operative and regional bank, which are not allowed to participate directly in the call money market will participate through primary dealers. The primary dealers offer a two day quote take spread and allow the basis to participate in the call money market. The call rates can be spot rate or the weighted average rate. As the Indian call money market usually opens high and closes with low, the average rate received by the lender will be normally lower than the middle rates. Developments of call money market Character of Indian call money market in 1970s

17 The Indian call money market was a restricted market with a narrow base and limited numbers of participants. Banks and a few all India financial Institution participated in the market and the entry of others in to the market was tightly regulated. 1. The existing participants lacked an active market as there were few lenders and large number of borrowers. 2. Another feature was that the market was considerably organized with a part of the dealings taking place in Mumbai and Kolkata, Chennai and Delhi played a secondary role in this activity. 3. There was no ceiling on the call money rates and the movements were quite erratic. The forces of demand and supply to funds largely influenced the call rates. In India call rates are prove to fluctuations which are unidirectional due to the presence of a large number of players with similar needs. The call loans were also subjected to seasonal fluctuations and the call rates usually climbed high during busy seasons than in a slack seasons. The seasonal ups and down was reflected in the volume of money call and short notice, at different periods of time in a year. These seasonal variations will high due to limited number of lenders and many borrowers. The absence of participants who alternate between borrowing and lending activity has in some way inhibited the active development of this market. The year 1970 emerged as a remarkable year in the history of Indian call money market when the term lending institutions like LIC, UTI were allowed to lend in the market. The SBI which was away from the market till 1970s entered as a major lender and a small borrower.

II Commercial Bills Market

It is a market for Bills of Exchange arising out of genuine trade transactions. In the case of credit sale, the seller may draw a bill of exchange on the buyer. The buyer accepts such a bill promising to pay at a later date the amount specified in the bill. The seller need not wait until the due date of the bill. Instead, he can get immediate payment by discounting the bill. In India the bill market is under-developed. The RBI has taken many steps to develop a sound bill market. The RBI has enlarged the list of participants in the bill market. The Discount and Finance House of India was set up in 1988 to promote secondary market in bills. In spite of all these, the growth of the bill market is slow in India. There are no specialized agencies for discounting bills. The commercial banks play a significant role in this market.

III Treasury Bills Market

It is a market for treasury bills which have short term maturity. A treasury bill is a promissory note or a finance bill issued by the Government. It is highly liquid because its repayment is guaranteed by the Government. It is an important instrument for short-term borrowing of the Government. There are two types of treasury bills namely (i) ordinary or regular and (ii) ad hoc treasury bills popularly known as ad hocs.

18 Ordinary treasury bills are issued to the public, banks and other financial institutions with a view to raising resources for the Central Government to meet its short-term financial needs. Ad hoc treasury bills are issued in favour of the RBI only. They are not sold through tender or auction. They can be purchased by the RBI only. Ad hocs are not marketable in India but holders of these bills can sell them back to RBI. Treasury bills have a maturity period of 91 days or 182 days or 364 days only. Financial intermediaries can part their temporary surpluses in these instruments and earn income. Treasury bill market refers to the market where T-Bills are bought and sold. Just like com. Bills which represent com. Debt, treasury bills represent short term borrowings of the government. It constitutes a major portion of short term borrowings of Govt. of India. T-Bills are issued in the form of promissory notes or finance bills (a bill which does not arise from any genuine transaction in good is called a finance bill) by the govt. to tide over short term liquidity short falls. The govt. promised to pay the specified amount mentioned there is to the bearer of the instrument on the due date the period does not exceed 1 year. They are the most liquid instrument after cash and call money market as they are issue by the government. T- Bills do not require any grading or further endorsement like ordinary bills as they are claim against the govt. The main features of T- bills are Zero default and risk, assured yield low transaction cost, negligible capital depreciation and eligible for inclusion in SLR (Statutory Liquidity Ratio) and easy availability etc. apart from high liquidity. The RBI acts as a banker to govt. of India it issues T- Bills and other Govt. securities to raise funds on behalf of the Govt. of India by acting as an issuing agent. Through various groups of investors including individuals are eligible to invest, the main investors of the T- bills are mostly banks (If accounts for nearly 90% of annual sale) to meet their SLR requirements. Other includes, primary dealers, financial institution, insurance companies, provident fund (as per investment guidelines), Non- banking finance companies (NBFCs), corporations, financial institutional investors and state govt. Operations of T-Bills (TB) The T-Bills are available in physical form if an investor desires so. The market is mostly dominated by institutional players who have a facility to hold the T-Bills in scrapples form. For this purpose the investors opens an SGL A/c (Subsidiary General Ledger) When transaction of sale is undertaken between two institutional players, the seller issues an SGL transfer from specifying the details of the transaction. The SGL transfer form is then lodged by the buyer with the public accounts department of RBI to credit its account by debiting the value of the securities o the sellers account. Usually inter bank traders are settled n the same business day where as traders with non bank counter parties are settles either on the same day or business day after trade date.

19 On the same way the investors who do no have HGL account can purchase and sell T-Bills through DFHI. The DFGI does this function on behalf of investors with the help of SGL transfer form. The DFHI actively participate in the auctions of T-Bills. It is playing a significant role in the secondary market also by quoting daily buying and selling rates. T also gives buy back and sell back facilities for periods up to 14 days at an agreed rate f interest to institutional investors. The establishment of DFHI has imparted greater liquidity in the T-Bill market. Merits of T-Bill 1. Safety: - Investments in T-Bill are highly safe since the payment of interest and repayment of principal are assured by Govt. They carry 0 default risk since they are issued by the RBI for and on behalf of he central govt. 2. Liquidity: - Investment in T-Bills are also highly liquid because they can be converted into cash at any time at the option of the investors. The DFHI announce daily buying and selling rates. They can be discounted with the BI and further reference facility is available from the RBI against T-Bills. Hence there is a ready market for T-Bill. 3. Ideal Short Term Investment: - Ideal cash can be profitably invested for a very short period in T-Bills-Bills available on top through out the week at specified rates. Financial institutions can employ their surplus funds on any ay. The yield on Bills is also assured. 4. Ideal Fund Management: - T-Bills are available on tap as well as through periodical auctions. They are also available in the secondary market. Fund managers of financial institution build up a portfolio of T-Bills in such a way that the dates of maturities of T-Bills may be matched with the dates of payment of their liabilities like deposits of short-term maturities. Thus T-Bills help financial manager to manage the und effectively and profitably. 5. Statutory Liquidity Requirement: - As per RBI directives, commercial banks have o maintain Statutory Liquidity Ratio(SLR) and for measuring this ratio investment in T-Bills are taken into account. T-Bills are eligible securities for SLR purpose. Moreover to maintain CRR, T-Bills are very helpful. They can readily converted into cash there by CRR can be maintained. 6. Source of Short-term funds: - The govt. can raise short term funds for meeting its temporary budget deficits through the issue of T-Bills. It is a source of cheap finance to the Govt. since the discount sales are very low. 7. Non - inflationary Monetary tool: -T-Bills enable the central government to support its monetary policy in the economy. For instance excess liquidity, if any in the economy can be absorbed through the issue of t-Bills. 8. Moreover T-Bills are subscribed by the investors other than RBI. Hence they cannot be mentioned and their issue does not lead to any inflationary pressure at all. 9. Hedging Facility: - T-Bills can be used as a hedge against heavy interest rate fluctuations in the call loan market. Hen the call rates are very high money can be raised quickly against T-Bills and invested in the call money market and vice versa. T-Bills can be in ready forward transactions.

20 DEMERITS 1. Poor Yield: - The yield from T-Bills is the lowest. Long-term Govt. securities fetch more interest and hence subscriptions for T- Bills are on the decline in recent times. 2. Absences of Competitive Bids: - Though T-Bills are sold through auction in order to ensure market rates for the investors in actual practice, competitive bids are conspicuously absent. The RBI is compelled to accept these non- competitive bids. Hence adequate return is not available. It makes T-Bill unpopular. 3. Absence of active trading: - Generally, the investors hold T-Bills till maturity and they do not come for circulation. Hence active trading in T-Bills adversely affected.

Types of T-Bills In India there are two types of T-Bills 1. Ordinary or regular and 2. Adhocs Ordinary T-Bills are issued to the public and other financial institutions for meeting the short-term financial requirements of the central govt. These bills are freely marketable and they can be bought and sold at any time they have secondary market also. Adhoc T-Bills are issued in favor of the RBI when the needs cash. They are neither issued nor available to the public. These bills are purchased by RBI on Tap and are held in its issue department and the RBI issues currency notes against these bills to the govt. if required and bills are renewed a maturity. Adhoc T-Bills are issued to serve two purposes firstly to replenish cash balances of the central government and secondly to provide a medium of investment for temporary surpluses to state governments, semi- governments, departments and foreign central banks. On the basis of periodically TBs may be classified into 4: 91 Day T Bills 152 Day T Bills and 364 days T Bills 14 and 28 Days T Bills 91 days TB Starting from July 1965 91 days TBs issued on tap basis at a discount rate ranging from 2.5 4.6% P A till July 1974, the discount rate was 4.6%. Even later, the discount rate hovered around the same. The extremely low yield on these bills was totally alignment with other interest rate in the system. The banks used these

21 instruments to park their funds for a very short period 1-2 days. This resulted in violent fluctuations of volumes of outstanding TBs. The RBI had introduced 2 measures in order to cope with this situation. Firstly to recycle the TBs under which the bills are rediscounted by the RBI and are resold to the banks. Secondly an additional early rediscounting fee was imposed if banks rediscounted the TBs with in 14 days of purchase. Following the Sulchmay Chakravarty Committee recommendation in Nov 1986, 182 bills were introduced. In order to develop the short term money market and also provide an additional avenue for the Government to raise financial resources for its budgetary, expenditure. Initially these were the first type of TBs to be auctioned on monthly basis without any rediscounting from RBI. The State Government and Provident Fund were not allowed to participate in these auctions. To impart an element of flexibility, the Central Bank was not announcing the amount in advance. The Market participants were allowed to bid the amount and price of their choice. The authorities would determine the cut off discount rate and the amount of TBs sold in an auction. In 1998, April these bills were re introduced in order to obtain a continuous yield curve for a period of one year. However these bills were again discounted from May 2001. 364 Day TBS. The Government considered that it is important to develop Government Securities Market for monetary control. It also had an intention to ensure that Governments credit needs are met more and more directly from the market instead of Pre-emption of deposit insurance with this view treasury bills was developed as a monetary instrument with market related rates. As a part of the overall development of Government Securities, market the Government of India proposed to float treasury bills of varying maturities upto 364 days on auction basis. The Government with an intention to stabilize money market in the country introduced 364 TBS on 28th April 1992. The RBI neither discounted these bills nor participated in this auction. 364 bills are auctioned fortnightly but the amount however is not notified in advance. These TBs have become popular due to the higher yield coupled with liquidity and safety. The yield on 364 day TBS is used as benchmark by financial institution such as IDBI, ICICI, etc for determining the rate of interest on floating bonds/notes. These bills widened the scope of money market and provided an outlet for surplus funds. The introduction of TBS of varying maturities would offer investors a wider choice of investing in different instruments and thereby foster the development of Government Securities market. 14 days and 28 days TBs The presence of 91 days, 182 days and 364 days 7 B an opportunity for investors to choose varying maturities either from the primary market or from the secondary market. However an investor who is interested in a maturity less than 91 days had to necessarily look for secondary market. In order to enhance the breadth of the market RBI decided to introduce 14 day 28 day TB only. WMA

22 The Union budget 1994-95 state that automatic monetization of budget deficit through creation of Adhoc T-Bills would be phased out completely over 3 years period with an objective to reduce inflation. Subsequently a limit on the issue of adhoc was imposed under an agreement between union government and RBI. The union government and government therefore entered in to an agreement to change the way the budget deficit is financed. The agreement was signed in March 1997 bringing in to existence the new system of Ways and Means Advances (WMA) replacing he system of adhoc treasury bills. WMA is not a permanent source of financing government deficit. But this is likely to provide greater autonomy to RBI conducting monetary policy. According to the agreement, the RBI will no longer monetize the fiscal deficit and the government should borrow from the market to finance the fiscal deficit. But the RBI will extend the advances to the central and state government to tide over temporary or short term finance requirements which needs to be repaid in 3 months. Drawls in excess of WMA limit will be allowed for a maximum of ten consecutive days. The RBI allows for 3 types of WMAs. 1. The clean WMAs (unsecured) 2. The secured WMAs which are secured against central government securities and the special WMAs which are allowed in exceptional circumstances against the pledge of government securities.

4. Short-Term Loan Market

It is a market where short-term loans are given to corporate customers for meeting their working capital requirements. Commercial banks play a significant role in the market. Commercial banks provide short term loans in the form of cash credit and overdraft. Overdraft facility is mainly given to business people whereas cash credit is given to industrialists. Overdraft is purely a temporary accommodation and it is given in the current account itself. But cash credit is for a period of one year and it is sanctioned in a separate account.

Other Money Market Instruments (other than Treasury Bills)

1. Commercial Bills
Commercial bill or bill of exchange popularly known as a bill is a written instrument containing an unconditional order. The bill is signed by the drawer, directing a certain person to pay a certain sum of money only to, or order of a certain person, or to the bearer of the instrument at a fixed time in future or on demand. Once the buyer signifies his acceptance on the bill itself it becomes a legal document. Bill of exchange is a very important document in commercial transaction. When the buyer is unable to make the payment immediately, the seller may draw a bill upon him payable after a certain period. The buyer accepts the bill and returns to the seller. The seller may either retain the bill till the due date, or get it discounted from some banker and get immediate cash. Usually such bills are discounted or rediscounted by commercial banks to lend credit to the bill holders or to borrow from the central bank. A well organised bill market or discount market for short term bill is essential for establishing an effective link between credit agencies and Reserve Bank of India. The reasons for the poor development of bill market in India are historical and include:

23 (i) preference for cash to bills; (ii) lack of uniform practices with regard to bills; (iii) excessive stamp duty; (iv) preference for cash credit and overdraft arrangements as a means of borrowing from commercial banks; and (v) lack of specialised discount houses.

2. Call and Short Notice Money

Call money refers to the money given for a very short period. It may be taken for a day or overnight but not exceeding seven days in any circumstances. Surplus funds of the commercial banks and other institutions are usually given as call money. Banks are the borrowers as well as lenders for the call funds. Banks borrow call funds for a short period to meet the CRR requirements and repay back once the requirements has been met. Sometimes individuals of high financial standing may borrow money for a very short period to meet their business financial needs. The rate of interest is very low on call funds. If the loan is given for one day, it is called money at call and if the loan cannot be called back on demand and will require at least notice of 3 days for calling back it is called money at short notice. It includes deposits repayable within 10 days or less than 15 days notice. The rate of interest on which money is lent fluctuates everyday, or very quickly depending on demand for and supply of money.

3. Commercial Paper

Commercial Paper is a short-term, unsecured promissory note issued at a discount to face value by well known or reputed companies, who carry a high credit rating and have a strong financial background. It is an unsecured obligation issued by a bank or a corporation to finance its short term credit requirements like accounts receivable and inventory. In other words the commercial paper is an unsecured short term loan issued by a corporation typically to finance accounts receivable and inventories and it is usually issued at a discount reflecting the prevailing market interest rate. Any private sector company, public sector, non banking, primary dealers, satellite dealers, etc can raise funds through commercial paper. But the company, public sector, non-banking, primary dealers, satellite dealers, etc can raise funds through capital market. But the company has to satisfy the eligibility criteria prescribed by RBI. The conditions laid by RBI restrict the entry of issuers in to the capital market. Commercial papers are generally open to all investors individuals, banks, corporates, and also NRI can participate only on a non-repairable and nontransferable basis. SEBI has permitted foreign institutional investors to in commercial paper. Features 1. Commercial Paper is a short-term money market instrument comprising usance promissory note with a fixed maturity. 2. It is a certificate evidencing an unsecured corporate debt of short-term maturity. 3. Commercial paper is issued at a discount to face value basis but it can also be issued in interest bearing firm.

24 4. The issuer promises to pay the buyer some fixed amount on some future period but pledges no assets, only liquidity and established earning power to guarantee that promise. 5. Capital Market cab be issued directly by a company to inve3stors or through banks / merchant bankers. Maturity Commercial paper has a minimum maturity period of 15 days and a maximum of 1 year. Unlike commercial deposit the issuer can buy back this commercial paper. Types of Commercial papers Commercial paper can be issued either directly or through dealer. If the company issues the paper directly to the investors without dealing with an intermediary, it is referred to as Direct Paper. The companies gong for a direct paper will announce the current rates of commercial paper with various maturities, so that the investors can choose the commercial papers based on the requirements. If a commercial paper is issued by intermediary on behalf of its corporate client, it is known as Dealer Paper. The role of dealer in Capital market is to arrange for the private placement of the instrument. Generally, dealers also play advisory roles in timing the issue, determining discount rate and appropriate maturity period.

Advantages of Commercial Paper 1. Simplicity:- The advantages of CP lies units simplicity. It involves hardly any documentation between the issuer and the investor. 2. Flexibility:- The issuer can issue CP with the maturities tailored to match the cash flow of the company. 3. Diversification:-A well rated company can diversify its sources of finance from banks to short term money markets ate somewhat cheaper cost. 4. Easy to raise long term capital:- The companies which are able to raise funds through become better known in the financial world and are their by placed in a more favourable position for raising such long term capital as they may from time to time require thus there is an inbuilt incentive for companies to remain financially strong. 5. High returns:- The CP provides investors with higher returns than they could get from banking system. 6. Movement of funds:- CP facilitates securitization of loans resulting in creation of a secondary market for the paper and efficient movement of funds providing cash surplus to cash deficit entities. The concept of raising funds through com. Paper is new to Indian Corporate. The introduction of CPs is a result of the suggestion of the Working Group on Money Market in 1987. The Vaghul working group was of the opinion that the Capital Market had the advantage of giving high rated corporate borrowers, while providing the investors higher yield than they could obtain from the banking system. In 1989 RBI announced its decision to introduce commercial paper. It was launched with a view to enable highly rated Corporate borrowers to diversify their

25 sources of short term borrowing and also provide an additional instrument to investors by which certain Money Market. It was also allowed because the RBI desired to discourage the practice of lending in the inter Corporate Deposit Market (ICD).As ICDs were unsecured and the transactions were not transparent the RBI felt that CPs may serve as a good substitute for such funds. Initially RBI issued guidelines on issue of CPs in Jan 1190 and these guidelines later were revised many times to facilitate the growth of the market. It was indicated in April 2000 policy statement that the current guidelines to issue the CPs would be modified in the light of recommendations made by an internal group. Accordingly a draft of the revised guidelines as also the report of the internal group was circulated in July 2000. Taking into account the suggestions received from the participants, the guidelines have now flexibility to participates and add depth and vibrancy to the capital market while at the same time ensuring prudential safeguards and transparency. In particular the guidelines will enable companies in the service sector to more easily meet their short term working capital needs. At the same time banks and financial institutions will have the flexibility to fix working capital limits duly taking into account the resources pattern of companies finances including commercial papers. Guidelines of Vagul Working Group 1. There is need to have a limited introduction of commercial paper. It should be carefully planned and the eligibility criteria for the issuer should be sufficiently vigorous to ensure that the capital market develops on healthy lines. 2. Initially access to the commercial paper market should be restricted to rated companies having a net worth of Rs. 5crores and above with good dividend payment record. 3. (The capital market should function within overall discipline is CAS). The RBI would have to administer the entry on the market the amount of each issue and the total quantum that can be raised a year. 4. No restriction be placed on the participants in the capital market except by way of minimum size of note. The size of any single issue should not be less than Rs.1 core and the size of each lot should be less than 5 lakhs. 5. Commercial paper should be excluded from the stipulation on unsecured advances in case of banks. 6. Commercial paper would not be tied to any specific transaction and the maturity period may be 7 days and above but not exceeding six months backed up if necessary by a revolving underwriting facility of less than 3 years. 7. The issuing company should have a net worth of not less than /Rs. 5 crores a debt equity ratio of not more than 1.5crores, a current ratio of more than 1.33 crores, a debt servicing ratio closer to 2, and be listed on the stock exchange. 8. The interest rate on commercial paper would be market dominated and the paper could be issued at a discount to face value or could be interest bearing. 9. Commercial paper should not be subject to stamp duty at the time of issue as well as at the time of transfer by endorsement and delivery. RBI Guidelines of CP 1. A company can issue CP only if it has:-

26 1. A tangible network of not less than Rs. 10 crores as per latest sheet. 2. Minimum CR of 1.33 :1 3. A fund based working capital limit of Rs. 25 crores or more. 4. A debt serving ratio closer to 2. 5. The company is listed on a stock exchange. 6. Subject to CAS discipline. 7. It is classified under Health code no.1 by financing banks. 8. The issue company would need to obtain P1 (Rating notches for CP i e, degree of safety regarding timely payment)from CRISIL. 2. The commercial paper shall be issued in multiplies of 25 lakhs but the minimum amount to be invested by a single investor shall be Rs. 1 crore. 3. The CP shall be issue for a minimum maturity period of 7days and the maximum period of 6 months from the date of issue. There will be grace period on maturity. 4. The aggregate amount shall not exceed 20% of the issue is fund based working capital. 5. The CP is issued in the form of usance promissory notes negotiable by endorsement and delivery the rate of discount could be freely determined by the issuing company. The issuing company has to bear all floating cost including stamp duty, dealers fee and credit rating agency fee. 6. The issue of CP can not be withdrawn or co opted in any manner. However commercial banks can provide stand by facility for redemption of the paper on the maturity date. 7. Investment in CP can be made by any person or banks or corporate bodies registered or incorporated in India and unincorporated bodies too NRI can investment in CP on repatriation basis. 8. The companies issuing CP would be required to ensuring that the relevant provisions of the various statutes such Companies Act of 1956, the IT Act of 1961 and Negotiable Instruments Act 1981 are complied with. Procedure and time frame for issue of CP 1. Application to RBI through financing bank or leader of consortium bank for working capital facilities together with a certificate from credit rating agency. 2. RBI to communicate in writing their decision on the amount of CP to be issued to the leader bank. 3. Issue of CP to be completed within 2 weeks from the date of approval of RBI through private placement. 4. The issue may be spread over 2 weeks on different rates but all the CPs shall bear the same maturity date. Issuing Company to advise RBI through the bank/leader of the bank, the amount of actual issue of CP within the days of completion of the issue. balance

4. Certificate of Deposit
Definition CDs are the instruments issued by banks in the form of usance promissory notes. These bank deposits are negotiable and are in marketable form bearing specific face

27 value and maturity. They are transferable from one party to other unlike term deposit. Due to their negotiable nature, these are also known as Negotiable Certificates of Deposit (NCDs). A certificate of deposit can also be referred to as a money market instrument a receipt for funds deposited in a financial institution for a specific time for a specific interest rate. Features The main features of CDs are as follows 1. CD is a document of title to a time deposit and is distinct from conventional time deposit with respect to negotiability and marketability. 2. CDs are considered as virtually risk less instruments as the default risk is almost nil, and investors are sure of receiving the invested amount with interest. 3. The liquidity and marketability features are considered as the hallmarks of CDs. 4. CDs are issued at a discount to face value. 5. CD s are maturity dated obligations of banks forming a par of time liabilities and are subjected to usual reserve requirements. 6. CDs may be either registered or in a bearer form. The latter form, however is considered better for secondary market operations. 7. CDs attract stamp duty and there is no grace period as in the case of bill financing. 8. CDs are freely transferable by endorsement and delivery. 9. The CDs issued are with in the limit as specified by RBI 10. CDs are also issued in demat forms. Thus the various advantages of dematerialization can be availed. 11. CDs held in the demat form can be transferred as per the procedure applicable to other demat securities. 12. The trade settlement will take place on T+1 day basis; however the settlement period will be subject to the ceiling of T+5 days or such period of settlement as specified by the exchanges, when ever the trade is done on a recognized stock exchange. Purpose CDs benefit both issuers and investors. From the issuers point of view CDs are issued foreseeing the advantages over conventional deposits. The motives behind issuing CDs are control over cost of funds and assured availability of funds for specific period. The banks are constrained to define an interest rate structure for their customers across the board. It is operationally difficult to offer different rates of interest for different deposits especially with a wide network as seen on the Indian scenario. Consequently most of the depositors will be paid the same rate of interest. However in case of Certificates of Deposit the interest is determined on a case to case basis. Since the volumes are large the rates offered on CDs are more sensitive to call rates than the rates on term deposits. It is possible to discriminate between two customers and give different rates which is not normally possible in case of term deposits. The conventional deposits though having a fixed maturity can be withdrawn prematurely ; whereas investors have to wait till the CDs mature or approach the secondary market to sell them. Issuance of CDs helps banks to maintain the market share. From the investors point of view CDs form a better way of deploying their short-term surplus funds. CDs offer higher yields when compared to conventional

28 deposits, while the secondary market offers liquidity. They can be assured of interest and principal payment normally. The primary function of banks and financial institution is to mobilize funds from the surplus economic units and lend them to the users or the deficit spending economic units. In the process banks charge interest or brokerage based on the type of transactions. They pay interest to the saving public and receive interest from the borrowers and in the process make a spread. The depositors maintain account with banks in the form of demand and time deposits. Savers generally opt for demand deposits as they consider them to be as liquid as cash. Banks invest these deposits in short term instruments to gain a return over them. Otherwise they have to maintain idle funds losing the interest on those funds. The banks are exposed to interest rate risk when they deploy their demand liabilities in short or medium term investment or credit because of maturity mismatch. In the early 90s the RBI introduced an instrument called Certificate of Deposit with a view to further widen the range of money market instruments and give investors greater flexibility in the deployment of their short term surplus funds. Recently the RBI had assigned FIMMDA( Fixed Income Money Market and Derivative Association for India ) the task if framing standardized procedures and documentations for CDs in consultation with depositories and market participants FIMMDA after a detailed discussion with the market players and the RBI has issued the final guidelines for the issue of CDs. Issuers As per the latest guidelines issued by FIMMDA, CDs can be issued by all scheduled commercial banks other than Regional Rural Banks, selected Financial Institutions that have been permitted to raise short term resources under the limit fixed by RBI. Subscribers CDs are available to individuals, corporations, companies, trust, funds, associations etc for subscription. Non resident Indians can also subscribe to these instruments but only non repatriable basis which cannot be endorsed to another NRI in the secondary market Maturity Banks can issue CDs for a minimum period of 15 days to a maximum period of one year where as financial institution can issue it for a minimum of one year and a maximum of 3 years. Advantages 1. CDs are the most convenient instruments to depositors as they enable their short term surpluses to earn higher return. 2. CDs also offer maximum liquidity as they are transferable by endorsement and delivery. The holder can resell his certificate to another. 3. From the point of view of issuing bank it is a vehicle to raise resources in times of need and improve their lending capacity. The CDs are fixed term deposits which cannot be withdrawn until the redemption date.

29 4. This is an ideal instrument for banks with short term surplus funds to invest at attractive rates.

Repurchase agreement
Repurchase agreements (RPs or repos) are financial instruments used in the money markets and capital markets. A more accurate and descriptive term is Sale and Repurchase Agreement, since what occurs is that the cash receiver (borrower/seller) sells securities to the cash provider (lender/buyer) now in return for cash, and agrees to repurchase those securities from the buyer for a greater sum of cash at some later date, that greater sum being all of the cash lent and some extra cash (constituting interest, known as the repo rate). A reverse repo is simply the same repurchase agreement as described from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a 'repo', while the buyer in the same transaction would describe it a 'reverse repo'. So 'repo' and 'reverse repo' are exactly the same kind of transaction, just described from opposite viewpoints. A repo is economically similar to a secured loan, with the buyer receiving securities as collateral to protect against default. There is little that prevents any security from being employed in a repo; so, Treasury or Government bills, corporate and Treasury / Government bonds, and stocks / shares, may all be used as securities involved in a repo. However, the legal title to the securities clearly passes from the seller to the buyer, or "investor". Coupons (installment payments that are payable to the owner of the securities) which are paid while the repo buyer owns the securities are, in fact, usually passed directly onto the repo seller which might seem counterintuitive, as the ownership of the collateral technically rests with the buyer during the repo agreement. It is possible to instead pass on the coupon by altering the cash paid at the end of the agreement, though this is more typical of Sell/Buy Backs. Although the underlying nature of the transaction is that of a loan, the terminology differs from that used when talking of loans due to the fact that the seller does actually repurchase the legal ownership of the securities from the buyer at the end of the agreement. So, although the actual effect of the whole transaction is identical to a cash loan, in using the 'repurchase' terminology, the emphasis is placed upon the current legal ownership of the collateral securities by the respective parties.

Leasing
It is a financial arrangement that provides a firm with the advantage of using an asset without owning it. It is an agreement where by the Lessor conveys to the Lessee, in turn for rent, the right to use an asset for an agreed period of time. Lessor is a person who conveys to another person (Lessee) the right to use an asset in consideration for payment of periodical rent, under a lease agreement. Lessee is a person who obtains from the Lessor, the right to uses the asset for a periodical rental payment for an agreed period of time.

30 A financial lease is a contract involving payment over an obligatory period, of specified sums sufficient in total to amortize the capital outlay, besides giving some profits to the lessor. Here the lessee is responsible for the maintenance of asset leased. Thus it is a lease where the entire risks and rewards incident to the ownership of asset is transferred. Title may or may not be eventually transferred. In case of Full Payout Lease the lessor recovers the full value of the leased asset, within the period of lease, by way of lease rentals and the residual value. In True Lease typical tax benefits, such as investment tax credit, depreciation tax shields etc are offered to the lessor. In Operating Lease the asset is not fully amortized during the non- cancelable period of the lease, where by the lessor does not depend on the lease rentals or profit. It is basically an economic service for a short term where the lease will be cancelable at short notice by the lessee. A type of lease where by the lessor is not considered about the repairs and maintenance of the leased asset is known as Net Lease. Conveyance Lease is another type where the lease will be for a very long tenure applicable to immovable properties. When a part or whole part of the financial requirement involved in a lease is arranged with the help of a financier, it takes the form of Leveraged Lease. Under Sale and Lease Back system, the owner of an asset sells it to the lessor, and get backs the assets under the lease agreement which has an effect of providing immediate free finance to the selling company, the lessee. Leasing of consumer durables is called as Consumer Leasing. A type of lease, which has zero residual value at the end of the lease period, is called as Balloon Leasing. The lessee further subleases the asset to the end user, retaining a fee and share of the residual value, is called as Wrap Leasing. In Swap Leasing, the lessee is allowed to exchange equipment leased out whenever the original asset have to be sent to the lessor for some repair or maintenance. In Open-ended Leasing the lessee guarantees that the lessor will realize a minimum value at the time of end of the lease period from the sale of the asset. The leasing of imported capital goods is known as Import Leasing. A type of lease where the lessor in one country leases out assets to a lessee in another country is known as Cross-boarder Leasing. When a leasing company is operated in different countries through its branches, it is a case of International Leasing. When there is advantage of depreciation tax benefits twice, depending on the taxation laws of two countries it is called as Double-dip Lease. When it is available under three different jurisdictions for a single use of asset leased out it is called as Triple-dip Lease.

Advantages of Leasing
1. 2. 3. 4. Tax benefits for the receipt of lease rentals High return on equity because of better leveraging Absorption of obsolescence risks by the lessor Efficient use of funds by the lessee

31 5. 6. 7. 8. 9. 10. Leasing is an off-balance sheet item for the lessee contributing better ROI Provides better liquidity especially in case of sale and lease-back. Leasing is a highly flexible and cheaper source of finance for the lessee Provides cent percentage of finance for the lessee by avoiding initial cash outlay. Ideal mode of asset acquisition especially for a non-profit organization No disturbance to the normal line of credit.

Factoring
Factoring can be defined as an agreement in which receivables arising out of sale of goods/services are sold by a firm (Client) to a financial intermediary (Factor), as a result of which the title of the goods and services represented by the said receivables passes on to the Factor. A Factor then becomes responsible for all credit control, sales accounting and debt collection from the credit customers. Thus under factoring the seller does not maintain a credit / collection department. After each sale a copy of the invoice and delivery note, the agreement and other related papers are handed over to the factor. The factor in turn receives payment from the buyer on the due date as agreed, where the buyer is reminded of the due date payment account for collection. The factor then remits the money collected to the seller after deducting and adjusting its own service charges at an agreed date. Thereafter the seller closes all the transactions with the factor. Under factoring arrangements, while making credit sales, the invoice is made in the name of the factor. The receivables then become the assets of the factor as the clients debts are purchased by the factor.

Advantages of Factoring
Administrative Cost savings for the client Helps to improve the operating leverage Enhances liquidity of the firm by ensuring efficient working capital management Factoring brings better credit discipline amongst customers due to regular realization of dues Accelerated cash flows help the client to meet liabilities promptly Factoring facilitates prompt payments and credits by providing insurance against bad debts Allows for promotion of linkages between bankers and factors Allows for reduction in uncertainty and risk associated with the collection cycle

Disadvantages
Engaging a factor may be reflective of the inefficiency of the management of the firms receivables Factoring may be redundant if a firm maintains a nationwide network of branches Difficulties arising from financial evaluation of clients A competitive cost of factoring has to be determined before taking decision about engaging a factor

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Functions of a Factor
Maintenance/ administration of sales ledger Collection facility of accounts receivables Financing facility trade debts Assumption of credit risk, credit control and credit protection 5. Provision of advisory services though providing information about customers perception of the clients products, marketing strategies, emerging trends, procedures to be followed in invoicing, delivery, and dealing with sales returns, etc.,

Hire Purchase Finance

According to Hire Purchase Act 1972, the term Hire Purchase means an agreement under which goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms of the agreement, and includes an agreement under which: 1. Possession of the goods is delivered by the owner thereof to a person on the condition that such person pays the agreed amount in periodic payments 2. The property of the goods is to pass to such a person on the payment of the last of such installment 3. Such a person has a right to terminate the agreement at any time before the property so passes Hire purchase is a transaction of finance whereby goods are bought and sold as per certain terms and conditions. The various terms and conditions of hire purchase finance are: 1. Payment of periodic installments 2. Immediate possession of goods by the buyer 3. Ownership of good remaining with the vendor until the payment of the last installment 4. Vendors right to repossess the goods in the event of default committed by the buyer 5. Treatment of each installment as hire charges till the payment of last installment

Difference between Leasing and Hire Purchase

1. Ownership: In Leasing it lies with the finance company, the lessor and it is usually never transferred to the lessee, the user. But in HP financing the property of the goods is transferred to the hirer on the payment of last installment 2. Depreciation: Lessor and not the Lessee is entitled to claim depreciation tax shield in the Leasing. But in HP financing the Hirer (owner) is entitled to claim depreciation tax shield. 3. Capitalization: Capitalization of the asset is done in the books of the Lessor, the leasing company. But in HP it is done in the books of the Hirer.

33 4. Payments: The entire lease payments are eligible for tax computation in the books of the lessee. But in case of HP only the hire-interest is eligible for tax computation in the books of the hirer. 5. Salvage Value: The lessor and the Lessee have the right to claim the benefit of salvage value. But in HP only the hirer can claim the benefit of salvage value as the prospective owner of the asset. 6. Down payment: No Down payment is required for acquiring the use of leased assets. Down payment is required to be made for acquiring the asset in case of HP. 7. Maintenance of asset: Where the lessee has to maintain the leased asset in case of financial lease, upkeep is the responsibility of the lessor in case of operating lease. But in HP it is the hirers responsibility to ensure the maintenance of the asset bought. 8. Nature of the asset: An asset given on lease by a leasing company is considered as the fixed asset of the lessor. But in HP the hire-vendor normally shows the asset let under HP as stock in trade or as receivables. 9. Receipts: All receipts from the lessee are taken into the lessors profit and loss account. Only the interest portion is taken into hire-vendors profit and loss account in case of HP. 10. Reporting: In case of leasing leased assets are disclosed by way of note forming parts of accounts. But in HP the asset bought under HP will be shown as asset and the amount of installments payable to the lessor as liability.

Installment Credit System

Installment credit is a type of consumer financing, where by the payment of the purchase price is deferred, to be paid in reasonable installments known as installment credit system.

Features:
1. An ordinary sale of goods with an easy payment system 2. The buyer obtains ownership and possession on payment of the first installment 3. Payment is made through number of installments 4. No possibility of the article sold being returned to the seller, since sale is complete immediately after the execution of the agreement 5. Seller has no right to recover the possession of the goods even if the buyer commits a default in the payment of outstanding installments and there is no question of forfeiture of paid installments against default. However, he is entitled to recover his dues with the help of the court.

Differences between Hire Purchase System and Installment Credit System

34 1. Actual sale: HP becomes an actual sale only on the payment of last installment. But in ICS the first installment payment is sufficient to be an outright sale. 2. Legal ownership: The buyer obtains the possession without any legal ownership until the last payment in case of HP. In ICS, the buyer obtains the ownership and possession immediately after the agreement is executed and the first installment is paid to the seller. 3. Hirer/Owner: In HP the buyer is merely hiring the article until the last hire charge is paid. But in ICS the buyer is the rightful owner on the payment of first installment, 4. Right to sell: A hire-purchaser cannot sell the article until the last hire-charge is paid in case of HP. But in ICS the buyer can sell the article at any time 5. Legal Protection: The seller gets maximum protection of the law in case of HP. But in ICS, the buyer gets the maximum protection of law. 6. Default: The buyer can lose both the article and the entire amount paid if there is any default of payment in case of HP. But in ICS no risk of lose is there to the buyer even on default. 7. Sellers Ownership: The seller can get back ownership and possession if there is default in case of HP. But in ICS the seller cannot repossess, but has a remedy to sue the buyer in the court. 8. Bad debt: There is limited risk of bad debt in case of HP. But in case of ICS it is high.

Securitization
Securitization is the process of pooling and repacking of homogeneous long term illiquid financial assets and non-performing assets into marketable securities, which can be sold to investors. Thus it is taking a primary role in imparting liquidity & profitability to marketers by converting long term illiquid and non-performing assets into short term liquid and performing assets. The process leads to creation of financial instruments that represents ownership interest in/ is secured by segregated income producing assets /pool of assets, where the pool of assets collaterises the securities. These assets are generally secured by personal/real property such as automobiles, real estates or equipment loans (but in some cases unsecured). Securitization in India is regulated by the SARFAESI Act 2002- (Securitization & Reconstruction of Financial Assets & Enforcement of Security Interest). Process of Securitization involves the following:

35 1. Assets are originated through receivables, leases, housing loans/ any other form of debt by a company and funded on its balance sheet.(The company is normally referred to as the originator) 2. Once a suitable large portfolio of assets has been originated, the assets are analyzed as portfolio and then sold to a third party, which is normally a Special Purpose Vehicle Company (SPV) formed for the purpose of funding the assets. SPV issues debt and purchases receivables from the originator. The SPV will be owned by a trust or the originator. 3. The administration of the asset is then sub-contracted back to the originator by the SPV. It is responsible for collecting the principal amount and interest on the loans in the underlying pool of assets. 4. The SPV issues tradable securities to fund the purchase of assets. The performances of these securities are directly linked to the performance of the assets. 5. The investors purchase the securities (because they are satisfied that the securities would be paid in full and on time from the cash flow available from the asset pool). 6. As cash flow of arise on the assets they are used by SPV to repay funds to the investors in the securities.

Advantages of Securitization
1. It provides liquidity to the originators(Non-Banking Finance Companies/Banks) 2. Better Credit Rating is possible. 3. Securitized debt is cheaper as the original investors can beat the ratings given by the rating agencies and thereby diversify their credit risk. 4. Originators can plan their capital adequacy requirements by using securitization to reduce the risk of weighted assets and thereby improve their capital adequacy. Main demerit of Securitization is that, it is an off balance sheet funding, where the true picture of the originators financial position is not clear merely from the balance sheet. The best assets of the company may be transferred to the SPV and the company may be left with the substandard assets on its books. Similarly if the receivables which have been securitized to the SPV become bad, the SPV will have the right to recover the dues from the originator.

Venture Capital
A form of equity financing designed specially for funding high risk and high reward projects is known as Venture Capital. It helps in financing high-tech projects, research and development projects etc., Thus it is a typical private equity investment. Venture Capitalists finance high risk return ventures, usually in new enterprises small or medium ones to produce new products, in expectation of high gains or spectacular returns. They continuously involve themselves with the clients investments, either by providing loans or managerial skills or any other support. The basic objective of venture capitalists is to make capital gain or equity investment at the time of exit and to get regular return on debt financing. They provide value-added services to the invested firms without any interference of the management but

36 usually make huge capital gains at the time of exit. Liquidity of the venture capital depends upon the success of the new venture or product. It was Bhatt Committee (Committee on Small and Medium Entrepreneurs) in the year 1972, which recommended the creation of venture capital in India. Stages of Venture Capital Financing

Turnaround Finance Mezzanine Finance

EXIT

IPO

Sale of Shares

Puts and Calls

Seed Capital Involves primarily R&D financing, for product development and capital provision to startup. Startup Finance Stage where new activity is launched which is related with initial marketing and establishment of product facilities.

37 Early stage Finance Finance to initiate commercial manufacturing and sales. Follow on Finance Second round finance where the project has passed the test of acceptability and has proved to be successful. Expansion Finance Finance provided to fund the expansion or growth of a company which is breaking even; used to finance increased production capacity, market or product development and to provide additional working capital; sometimes also made available for acquisition or takeover. Replacement Finance Also known as money-out deal, where venture capitalists extend financing for the purchase of the existing shares from an entrepreneur or their associates in order to reduce their holdings in the unlisted company. The venture capitalists may buy ordinary shares from vendors and may convert them into preference shares bearing a fixed dividend coupon. Such shares may be converted back into ordinary shares if the company is listed. Turnaround Finance Type of finance provided in the event of an enterprise becoming unprofitable after the launch of commercial production; to sustain the current operation of the enterprise. MBOs Management Buy-Outs The acquisition of a company from the existing owners by a team of existing management / employees who may or may not have been actively involved in the day-to-day running of the company & are making the acquisition with a view towards becoming active owner-managers. MBIs Management Buy-Ins Involves bringing in a management team comprising of outsiders, who are strangers to the company, where they are part of the existing team.

Mezzanine Finance The last stage of equity related funding is Mezzanine finance, which is actually half way between equity and loan capital, in terms of risk and return. It is often the last type of financing supplied to a private company in the final run up to trade a sale or public floatation. It may be issued either as a debt (high coupon bonds) or as a high ranking equity (preference shares). It is a bridge finance having a maturity of less than 2 years. Every venture capital will be liquidated after accomplishment of the purpose of the venture investment. several factors will be taken into consideration before

38 deciding the exit , such as the nature of the venture, the extent and type of financial stake, the state of actual and potential competition, market condition, the style of functioning, as well as the perception of the venture capital companies, etc., It will exit from the venture assistance in terms of equity investment by going public or floatation through IPO, or Sale of Shares to entrepreneurs who have promoted the ventures or through Put option(the right to sell) or though Call option (the right of the entrepreneurs to buy) by determining the price using the Book Value of net assets of the units assisted or through trade sales where the entire investee company is sold to another company at an agreed price or even though liquidation where the exit takes place in a voluntary manner.