International Banking Foreign Exchange

Module 5

International Banking Foreign Exchange

Foreign ExchangeForeign exchange is used to denote foreign currency or the means and methods by which accounts between the residents of the home country & those of the foreign country is settled.

It can also be defined s ‘Transaction of international monetary business, as between governments or businesses of different countries’.

Foreign ExchangeAs per FEMA (1999),Foreign exchange is defined as foreign currency including:

Deposits, credits and balances payable in any foreign currency

Drafts, travellers’ cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency

Any instrument giving anyone the option of making it payable either partly or wholly in foreign currency

Foreign Exchange MarketOrganisational setting within which individuals, governments and banks transact in foreign currencies

This is a market where national currencies are bought & sold against one another

Only a small fraction of daily transactions in foreign exchange involve trading of currency. Most foreign exchange transactions involve transfer of bank deposits

Foreign Exchange MarketImportant functions of Foreign exchange market are:

1.Transfer of purchasing power

2. Provision of Credit

3.Provision of Hedging facilities

Participants in FE MarketLarge Commercial banks

Central banks

Forex brokers

Large corporations

Exchange RateDenotes the price or the value at which one currency is

exchanged for anotherIt can also be defined as the amount of one currency

that will be exchanged for one unit of another currency

Exchange rate is very dynamic & fluctuatingThe foreign exchange market is a round-the-clock

market due to different time zones

Exchange Rate Determination The mechanism of exchange rate determination is

explained bya) Purchasing Power Parity Theoryb) Balance of Payments theory

Exchange Rate Determinationa) Purchasing Power Parity Theory:-• Put forth by Swedish economist,Gustav Cassel• The rate of exchange is determined on the basis of the

purchasing power of one currency in one country as against the purchasing power of another currency in that country.

• The rate of exchange tends to rest at that point which expresses equality between the respective purchasing power of the 2 currencies. This point is called the Purchasing power.

• If the price level goes up, the purchasing power will fall & thus its value in terms of a foreign currency will also fall .Thus Price level is a decisive factor

Exchange Rate Determinationb) Balance of payments Theory (Demand & Supply

Theory):-The Balance of payments states that the rate of exchange is

fixed at the point where the demand for foreign currency is equal to its supply.

The value of currency appreciates when the demand for it increases & depreciates when the demand falls, in relation to its supply in the foreign exchange market.

When the balance of payments is in equilibrium, the supply of & demand for the currency are equal

Types of Exchange RatesReady rate/cash rate- Settlement of funds on the same day (date of the deal).

Tom- Settlement of funds takes place on the next working day of the date of the deal

Spot- Settlement of funds takes place on the second working day following the date of the deal

Forward- Settlement of funds takes place on a date farther than the spot date

Types of Exchange RatesIn the forex market, all rates that are quoted

are generally spot ratesWhen delivery takes place beyond the spot

date then it is a forward transaction and the forward rate is applicable

Forward rate = Spot rate + Premium (- discount)

Forward RateIf the forward value of a currency is higher than the

spot value the currency is said to be at a premiumIf the above is reversed the currency is said to be at a

discountIf the forward value quoted is exactly equivalent to

the spot rate at the time of making the contract, the exchange rate is said to be at par

Types of Exchange rates contd…Fixed rate:- If the rate of a currency is fixed permanently .Flexible rate:- The rate is not permanently fixed.A

specified rate is fixed for a short period which is subject to revision from time to time

Floating rate:- Here the rate is fixed on the basis of demand & supply of currencies in the FE Market.It fluctuates according to market conditions from time to time.

Cross rates- It is the price of any currency other than the home currency .It can also be defined as a direct relationship between two non-home currencies in the foreign exchange market used in transactions in a country to which none of the currencies belong

Exchange rate QuotesTwo-Way quoteThe foreign exchange quotation always has two

rates for a given currency-The rate at which the bank is willing to buy (Bid price) a7 the rate at which it is willing to sell (Offer or Ask price).

Eg:- US$ 1- Rs 45.00 - Rs 45.20

Value date:- The date on which payment of funds or an entry into accounts become effective.

Modes of remittances (1)Telegraphic Transfers (TT) of funds are done from one

centre to another by way of instructions through telex, telegram or SWIFT (Society for Worldwide Interbank Financial Transfer). Of late SWIFT is becoming popular

Mail Transfer (MT) of funds is done by way of instructions sent by mail. An MT is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned

Modes of Remittances (2)Demand draft (DD): A DD is an order in writing on the

correspondent bank/branch abroad to pay the beneficiary the sum mentioned therein.

Fedai prescribed types of rates of merchant transactions:TT (buying)- clean inward remittancesBill (buying)- purchase/discount of export billsTT (selling) clean outward remittancesBill (selling) remittance for import bills

1.Short term factorsa) Commercial factorsb) Financial factors

2.Long term factorsa) Currency & credit conditionsb) Political & Industrial conditions

Factors affecting Exchange Factors affecting Exchange rate fluctuationrate fluctuation

1.Commercial factors:- They directly influence the supply of and demand for foreign currency

Trade factors:- These relate to the influence arising from the exports & imports.

Depending upon the fluctuations of imports & exports ,the market rate of exchange will move away from the equilibrium & thus the rate of exchange will fluctuate

Short term factorsShort term factors

2) Financial factors

a)Stock exchange factors :These relate to the influences arising from the granting & repayment of loans,receipt of interest payments,purchase & sale of foreign securities etc.

b)Banking factors relate to the influences arising from the operations of banks such as purchase or sales of banker’s draft,travellers’ letters of credit,changes in bank rate etc.

Short term factorsShort term factors

a) Currency & credit conditions:-Exchange dealers are always on the watch-out for

the probable trends in the external & internal value of a country’s currency.

Adverse balance of payments position due to increased prices & decreased exports will make the dealers dispose of the home currency ,which will increase the supply of home currency relative to demand,causing fluctation in exchange rate

The Budgetary policies of the country will also cause changes in exchange rate

Long term factorsLong term factors

b) Political conditions & industrial situation will also cause changes in exchange rate.

A stable government,strict maintenance of law & order etc will induce an inflow of foreign capital either for investment or for safety .

Amicable relations between labour & capital,evidence of enterprise & efficiency from the industry sectors will also induce foreign currency flow into the country.

Thus stable political & industrial conditions will lead to fluctuation in favour of the country concerned


Political unrest,attempts to overthrow the government etc will lead to withdrawal of foreign capital from the counrty

In the same way,unstable relationships between the government & the industrial sector will prevent any further influx of foreign currency into the country & will thus cause fluctuations in the exchange rate against the country concerned.


Exchange control denotes the methods by which a country controls the demand for and supply of foreign exchange.

It is defines as ‘the state regulation excluding the free play of economic forces from the foreign exchange market’.

Exchange control brings under official control all transactions affecting the demand for and supply of foreign exchange

Exchange ControlExchange Control

Objectives of Exchange control1. To conserve foreign exchange2. To correct adverse balance of payments3. To maintain exchange stability4. To regulate foreign companies & foreign

dealings5. To facilitate trade in a reciprocal basis6. To help the government


1.Unilateral methods: Those methods adopted by a country on its own without the help of any other country.

a)Intervention:-Government may sometimes intervene to raise or lower the exchange rate for its currency than the prevailing market rate. This is also called ‘Exchange pegging’.

When the rate is fixed above the market rate,it is called ‘pegging up’ & the reverse is ‘Pegging down’.

Pegging down has the effect of undervaluation of the home currency & hence, the exchange position will improve as a result of pegging down.


b) Restriction: the central bank of the country exercises its power to regulate the foreign exchange by enacting certain laws & by declaring all unauthorised dealings in foreign exchange illegal.

Transactions will only take place with prior approval & all foreign exchange earned is surrendered to the central bank


c) Regulation of export & import:- Regulation of foreign trade also affects exchange control. If exports increase, there will be a greater demand for the home currency in the exchange market which will raise the exchange rate vice versa.

d) Multiple exchange rate system:-System of adopting different rates for different countries or different rates for different categiries of transactions.


e) Exchange stabilisation fund:- Some countries maintain a separate exchange equilisation fund through which exchange rates are controlled.

When the exchange rate falls, the fund sells the foreign currencies in the market which increases the supply of foreign currency in the market,which will aid in arresting the fall of the home currency rate


2) Bilateral or Multilateral methods:-these are exchange control methods adopted with an understanding/agreement with other countries.

a) Payment agreements:-This agreement is between the debtor country & creditor country wherein the proceeds from the exports of the debtor country is utilised in meeting the debt obligations of the creditor country.


b) Clearing agreements:-An agreements with opponents of equal strength to settle their mutual claims that arise out of exports & imports in home currency only.

A specific fund –’clearing fund ‘ is maintained in their respective Central banks.

c) Standstill agreements: A method in which moratorium is granted on outstanding short term foreign debt of a country & arrangements are made for gradual payment.


d) Compensation agreements:-A private agreement under which the exporting firm of one country is required to equilise its exports with its imports from that country so that there is no surplus or deficit

Different countries adopt different methods of exchange control

Exchange Control

FEMA,1999An Act to consolidate and amend the law relating to

foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India.

FEMA replaced the FERA ,1973 & it gives the Central government & RBI extensive powers to control & regulate foreign exchange transactions.

RBI GuidelinesRBI has issued Authorised Dealers (AD) ie

licences to banks, financial institutions and a few co-operative banks to undertake foreign exchange transactions in India

It has also issued Money Changer licences to a large number of established firms, companies, hotels, shops, etc.

RBI GuidelinesMoney changers help facilitate encashment of foreign

currencies of foreign touristsEntities authorised to buy and sell foreign currency

notes, coins and travellers’ cheques are called full fledged money changers

Those authorised only to buy are called restricted money changers

RBI also plays a major role in fixing the exchange rate (Official rate) of the home currency in terms of other currencies.

FEDAIFEDAI (Foreign Exchange Dealers’ Association of

India) is a non-profit making body formed in 1958 with the approval of RBI

Its members are authorised dealers and it prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc.

FEDAI also advises RBI on market related issues and supplements RBI on strengthening the market

A documentary credit can be defined as a conditional undertaking of payment given by a bank.

It can also be defined as a written conditional undertaking issued on behalf of the importer (applicant) by the issuing bank to the exporter of goods (benefici ary) to pay for the goods or services, provided the documents submitted conform strictly to terms and conditions of the credit.

Documentary Letter of Credit

Importer(Applicant)

Issuing Bank Advising /Confirming bank

Exporter(Beneficiary)Underlying contract

Letter of Credit Transaction

The main advantage is that it Provides security to both the Buyer & the seller.

The security comes at a cost in the form of bank charges.The buyer knows that payment will only be made if the

documents received comply strictly with the terms and conditions of the credit as stipulated

The seller also knows that payment will be received , provided the terms and conditions of the credit are strictly complied with.

Letter of Credit

1. Irrevocable Letter of CreditAn irrevocable credit cannot be amended or

cancelled without the agreement of the issuing bank, the confirming bank (if the credit is confirmed) and the seller (beneficiary).

An irrevocable credit gives the seller greater comfort of payment if the credit terms and conditions are fully met.

Types of Letter of Credit

a) Irrevocable confirmed letter of credit

The buyer can request the advising bank to add its confirmation to an irrevocable credit if he is not satisfied with the assurance of the credit-issuing bank. If the advising bank agrees, the irrevocable credit becomes a confirmed irrevocable credit.

For adding confirmation, the bank will charge commission called Confirmation fee, which may vary from bank to bank within a country. The fee usually is added to the exporter's account.

The confirmed irrevocable L/C is particularly important from buyers in a country which is economically or politically unstable.


b) Irrevocable unconfirmed letter of credit

The beneficiary’s bank merely advises the beneficiary of the opening of a letter of credit. Such a letter of credit is advisable only if the political risk and risk in transferring funds are insignificant.

The promise to pay comes from the issuing bank only, unlike in a confirmed irrevocable L/C where both the issuing bank and the advising bank promise to pay the beneficiary.


2. Revocable Letter of CreditThis can be amended or cancelled by the issuing bank at any time

without the consent of the beneficiary, often at the request and on the instructions of the applicant. There is no security of payment in a revocable letter of credit (L/C).

A revocable credit gives the buyer maximum flexibility It is rarely seen these days in international trade.


Transferable Letter of creditA transferable credit is one under which the beneficiary has the right to

give instructions to the bank which is authorised by the credit-issuing bank to effect payment, accept drafts or negotiate documents to make the credit available in whole or in part to one or more parties.

It can be transferred once only (however, if part shipments are not prohibited, fractions of a transferable credit may be transferred to more th an one beneficiary).

it must be transferred only on the terms and conditions specified in the original credit


Revolving Letter of Credit These L/C’s renew themselves automatically or subject to certain

provisions .It is used for regular shipments of the same commodity to the same importer. It can revolve in relation to time or value

Under a revolving credit, the drawings made under the credit can be made re-available to the beneficiary, upon receipt of instructions from the opening bank to the effect that the amount has been reinstated in the credit.

Useful to avoid repetitious arrangement for opening or amending L/C


Standby letters of creditThis is used as a support where an alternative method of payment

has been agreed. If the exporter fails to receive payment,he may claim under this L/C.

Here the claim has to be supplemented with documents that prove that the payment has not been received by the due date & hence the reimbursement by L/C.

A stand-by letter of credit can be used as a tender guarantee, a performance guarantee, a payment guarantee, and an advance payment guarantee.


Back-to-back Letter of creditsA back-to-back credit can be described as credit and counter-credit. It

is a method of financing both sides of a transaction in which a middleman buys goods from one customer and sells them to another, both settlements being made under documentary credits


Restricted Negotiable Letter of CreditIn a restricted negotiable letter of credit, the authorization from the

issuing bank to pay the beneficiary is restricted to a specific nominated bank.

Freely Negotiable Letter of CreditThe authorization from the issuing bank to pay the beneficiary is not

restricted to a specific bank, any bank can be a nominated bank as long as the bank is willing to pay, to accept draft(s), to incur a deferred payment undertaking, or to negotiate the L/C.


Red clause Letter of Credit:-This is an LC with a clause providing for payment in

advance for purchasing raw materials/ processing, packing of goods etc.

This LC is so called because this clause is generally marked with red ink.


Foreign trade is the exchange of goods and services between the two countries, across their international borders.

Commercial banks extend trade finance products through their various specialised branches designated as foreign exchange specialised branches

In India, exports and imports are regulated by the Foreign Trade (Development and Regulation) Act, 1992, which replaced the Imports and Exports(Control) Act, 1947, and gave the Government of India enormous powers to control it.

Export & Import Facilities

The trade finance functions of banks are

1.Financing exportes2.Financing importers

Export credit is broadly classified as:-1)Pre-shipment finance2)Post-shipment finance

Export & Import Facilities

Pre-shipment credit is a short-term working capital finance provided by a bank to an exporter ,to enable him to procure the raw materials ,to process/manufacture of goods,arrange for transport & final shipment of finished goods. It is extended as:-

a)Packing Creditb)Advance against incentives receivable from

the governmentc)Advance against duty drawback & advance

against cheques & drafts receives ad initial payment.

Pre-shipment Finance

1.Packing credit:-This is a loan or advance granted to the

exporter for purchase of raw materials/ processing / packing etc. Based on the letter of credit opened in his favour by the importer or Confirmed order issued by a reputed foreign buyer on the exporter ,packing credit is given

The LC/ confirmed order will be endorsed or held by the bank to indicate that the credit has been availed by the exporter

Pre-shipment Finance

Pre-shipment credit in foreign currency(PCFC)

To make the prices of exporters competitive & thus to give a boost to exports, the government has made available financing for exporters in foreign currency at internationally competitive interest rates

PCFC is available only for cash exports in foreign currency

Pre-Shipment Finance

Advances against incentives receivable from Govt. of India are granted for a maximum period of 90 days

Freight forwarders act on exporters’ & importers’ behalf in arranging services such as loading & unloading of goods, obtaining payment on behalf of customers, customs clearance for cargo, delivery services etc.

Pre-Shipment Finance

Post-Shipment FinanceThis is defined as any loan or advance granted

by a bank to an exporter of goods from the date of extending the credit after the shipment of goods to the date of realisation of the export proceeds.

This is the working capital finance extended against the evidence of a shipping document for the purpose of financing the export receivables

Post-Shipment finance is extended in following conditions

1. Negotiation( payment of export bill & documents under LC)

2. Purchase( payment against export documents without LC but under confirmed orders/export contracts etc.)

3. Advances against receivables from the govt. of India.

4. The documents are to be submitted within 21 days from the date of shipment of goods

Post-Shipment Finance

Export Control regulationsExport Control Regulations are issued & administered

by RBI1. As per FEMA,every person engaged in the business

of exports is required to make a declaration giving full value on the export declaration form

2. Every prson/firm/company engaged in the business of exports has to obtain an importer-exporter code number from DGFT.Those without theis number will not be entertained for any purpose.

Financing Imports Import Financing is mainly extended in the

following forms:-Opening of import Letter of creditFinancing import in the form of cash credit,

loans effecting payment in Foreign exchange directly to overseas sellers.

Import Control RegulationsAny foreign exchange that is required for

import payment can be acquired only from an authorised dealer

As per FEMA,FE obtained by any person should be utilised for that purpose alone. If not used ,It should be surrendered without delay

The Government of India introduced in 1970, Non-Resident (External) Account Rules to meet the specific needs of non-resident Indians related to their remittances, savings, earnings, investments and repatriation,

NRI accounts are governed by the Exchange Control Regulations under FEMA,1999

NRI Bank Accounts

Maintain bank accounts in India.Invest in securities/shares, deposits with

Indian firms/companies.Investments in immovable properties in

India.

NRI investments

Ordinary Non-Resident Accounts in Rupees [NRO]

NRO account can be of any type Saving, current or Fixed deposit. Interest payable on NRO accounts is the same as on resident accounts.

It is also possible to have a joint account with residents in India

NRO accounts may be re-designated as resident accounts on the account holder becoming resident in India.

Types of NRI Bank Accounts

Interest earned on balances in NRO Accounts is not exempted from Indian Income tax.

Instead income tax (at present @ 20%) is deducted at source (TDS) i.e. at the time of payment of interest by the bank.

Balance held in NRO account can neither be repatriated nor any remittance in foreign currency is allowed without prior approval of Reserve Bank.

Disadvantages of NRO

Types of NRI Bank AccountsNon-Resident (External) Accounts in

Rupees [NR(E)]Any eligible Non-Resident Indian can open an

account with any RBI approved authorized bank.

No income Tax.No joint account with an indian resident.Non-Resident account holders can grant a

power of attorney or such other authority to any residents in India for operating their NR(E) Accounts in India. Such authority is restricted to withdrawals for local payments 65

NR(E) Accounts NRO account can't be converted into NRE, or

funds can't be transferred from NRO to NRE account without a special permission from RBI

The entire credit balance (inclusive of interest earned thereon) can be repatriated outside India at any time without any reference to Reserve Bank of India.

Upon your returning and becoming Indian resident, NRE account can be converted into your normal Resident Rupee Account

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Disadvantages of NR(E) Accounts:NR(E) Accounts are opened in Indian rupees, and

all foreign exchange remittances received for credit of that account are first converted to Indian rupees at the buying rates by the banks.

The bank will permit any withdrawal in foreign currency, by converting Indian rupees in the account to foreign currency at the selling rate.

All balances in the account are held in Indian rupees and are thus exposed to exchange fluctuation risk

The rates of interest payable on NR(E) accounts are subject to change from time to time as per directions issued from Reserve Bank of India.

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Types of NRI Bank AccountsFOREIGN CURRENCY (NON-RESIDENT)

ACCOUNTS -FCNR AccountIt can be in the form of fixed Deposits only,in the

five major foreign currencies ,namely US Dollars, GBP, DM, Euro, Japanese Yen.

The interest and the repayment of the deposit is also made in the same foreign currency in which the account is maintained

The funds in this account are fully Repatriable.

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Correspondent BankingA bank that provides credit, deposit, collection,

clearing and payment services for another depository institution in exchange for a fee.

Correspondent banks typically provide banking services when the others banks, often foreign banks, aren’t able to offer the services or find that it is more cost effective to outsource this need.

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Correspondent BankingNostro Account :- A foreign currency account

maintained by a bank in one country with a bank abroad. This allows for easy cash management because currency need not be converted. Eg:- SBI’s US Dollar account with Citibank,Newyork

Vostro Account :- Local currency account maintained by a local bank for a foreign (correspondent) bank.

Eg:- Citibank’s rupee account with SBI

Bank Performance EvaluationThe performance evaluation of banks holds important

results for creditors, investors and stakeholders since it determines banks' capabilities to competency and has a critical importance for the development of the sector.

Regulators,Analysts & investors periodically assess thePerformance of banks.

Banks are rated on a number of financial & non-financial parameters

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ROEThe bank’s owners (equity holders) care most about.

how much the bank is earning on their equity investment

This amount is measured by the return on equity (ROE), the net income per dollar of equity capital

Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

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ROEROE is expressed as a percentage and

calculated as:

Return on Equity = Net Income/ Shareholder's Equity

orReturn on Equity = [(Net profit after tax −

Preference dividend) / Equity share capital] × 100

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CAMEL RatingsCAMEL rating is used by most banks across the

world as a performance evaluation technique. It undertakes all the important criteria for the

evaluation of any bank. • C-CapitalA- AssetsM- ManagementE- EarningsL- LiquidityS- Sensitivity to market risk

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CAMEL RatingsC-Capital adequacy indicates the bank’s capacity

to maintain capital to the nature & extent of all types of risks & also the ability of the management to identify, measure, monitor & control these risks.

A- Asset Quality reflects the magnitude of credit risk prevailing in the bank due to the composition & quality of loans ,advances & investments

M-Management Quality gives an idea about the ability of the board of directors & senior managers to identify, measure,monitor & control risks associated with banking

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CAMEL Ratings

E- Earnings shows not only the amount & trend in earnings but also analyses the robustness of the expected earnings growth in future

L- Liquidity takes into account the adequacy of the bank’s current & potential sources of liquidity ,including the strength of its funds management practices

S-Sensitivity to market risk is a recently added parameter & it reflects the degree to which changes in interest rates , exchange rates ,commodity prices & equity prices can affect earning’s & hence the bank’s capital

CAMEL RatingsCAMELS model aim at achieving the following

objectives:-• Evaluation of bank’s safety & soundness• Appraisal of the quality of board & top management• Ensuring compliance with prudential regulations• Identifying the areas where corrective action is

required to strengthen the bank• Appraisal of soundness of Bank’s assets• Analysis of key financial factors like Capital,

earnings,liquidity & a Bank’s solvency

Balanced ScorecardThe Balanced Scorecard is a strategic planning

and management system that is used extensively in business and industry to align business activities to the vision and strategy of the organization, improve internal and external communications, and monitor organization performance against strategic goals.

It was originated by Drs. Robert Kaplan (Harvard Business School) and David Norton as a performance measurement framework that added strategic non-financial performance measures to traditional financial metrics to give managers and executives a more 'balanced' view of organizational performance.

The balanced scorecard is a management system that enables organizations to clarify their vision and strategy and translate them into action.

It provides feedback around both the internal business processes and external outcomes in order to continuously improve strategic performance and results.

When fully deployed, the balanced scorecard transforms strategic planning from an academic exercise into the nerve center of an enterprise.

Balanced Scorecard

Balanced Scorecard

Balanced ScorecardThe Balanced scorecard suggests that we view the

organization from four perspectives, and to develop metrics, collect data and analyze it relative to each of these perspectives:

The Learning & Growth PerspectiveThis perspective includes employee training and corporate cultural attitudes related to both individual and corporate self-improvement.

Kaplan and Norton emphasize that 'learning' is more than 'training'; it also includes things like mentors and tutors within the organization, as well as that ease of communication among workers that allows them to readily get help on a problem when it is needed.

Balanced ScorecardThe Business Process Perspective

This perspective refers to the internal business processes.

Metrics based on this perspective allow the managers to know how well their business is running, and whether its products and services conform to customer requirements

The Customer Perspective Business Institutions have realised the importance of

customer focus and customer satisfaction in any business. These are leading indicators

. Poor performance from this perspective is thus a leading indicator of future decline, even though the current financial picture may look good.

Balanced ScorecardThe Financial Perspective Kaplan and Norton do not disregard the

traditional need for financial data. Timely and accurate funding data will always be a priority, and managers will do whatever necessary to provide it.

Mergers & AcquisitionsA merger refers to the process whereby at least

two companies combine to form one single company.

All the assets & liabilities of the merging company is transferred to the surviving company

Mergers are a result of the combined decision of the different firms in picture & it is generally a result of the business strategy

M & A are considered as principal tools of corporate restructuring

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M & AObjectives of the merger:-

Merger is a well recognised commercial practice for growth & diversification

Improve profitabilityHave a bigger customer baseAcquire more assets at rates less than market

ratesBring separate enterprises under single control

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Types of Mergersa) Horizontal Merger:-These are mergers where the companies manufacturing

similar kinds of commodities or running similar type of businesses or giving same services merge with each other.

This results in achieving better economies of scale by : reducing the number of players in that industry reducing or eliminating competition widening the line of product decrease in working capital and fixed assets

investment, minimizing the advertising expenses & enhancing

the market capability86

Types of Mergersb) Vertical mergers involves merger of two

companies ,where one of them is an actual or potential supplier to the other .

Eg:- Product manufacturer merges with the supplier of inputs or raw materials. In can also be a merger between a product manufacturer and the product's distributor.

Main motive may be to ensure a source of continuous supply or to have an outlet for product

It may also to block a source from competitors & thus to create a bottle-neck

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Types of Mergers

c) Market Extension Merger Market extension merger takes place between

two companies that deal in the same products but in separate markets.

The main purpose of the market extension merger is to make sure that the merging companies can get access to a bigger market and that ensures a bigger client base.

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Types of Mergersd) Product Extension Merger takes place between

two business organizations that deal in products that are related to each other and operate in the same market.

The product extension merger allows the merging

companies to group together their products and get access to a bigger set of consumers. This ensures that they earn higher profits.

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Types of MergersThe difference between market extension

merger and product extension merger lies in the fact that the later is meant to add to the existing variety of products and services offered by the respective merging companies; while, in case of the former the two merging companies are dealing in similar products.

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Types of MergersA conglomerate merger is a type of merger

whereby the two companies that merge with each other are involved in different sorts of businesses.

The importance of the conglomerate mergers lies in the fact that they help the merging companies to be better than before.

It helps the company to obtain greater stability of earnings through diversification or to obtain benefits of economies of scale.

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M & AAdvantages of Merger:-1. The increased size of the company leads to a

growth in sales volume & profit2. Creates opportunities to penetrate markets3. Helps in product innovation as their

resources are more complementary

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AcquisitionAcquisitions or takeovers refers to acquiring

a controlling stake in the ownership of a company by another entity.

Friendly acquisition:-The acquisition of a target company that is willing to be taken over.

Usually, the target will accommodate overtures and provide access to confidential information to facilitate the acquisition processes.

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AcquisitionOne way to start is when the target

voluntarily puts itself into play by using an investment bank to prepare an offering memorandum

It can be initiated as a friendly overture by an acquisitor seeking information that will assist in the valuation process.

In friendly takeovers, both parties have the opportunity to structure the deal to their mutual satisfaction

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AcquisitionHostile acquisitionA takeover in which the target has no desire to be

acquired and actively rebuffs the acquirer and refuses to provide any confidential information.

The acquirer usually has already accumulated an interest in the target (20% of the outstanding shares) and this pre-emptive investment indicates the strength of resolve of the acquirer.

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The typical hostile takeover process is slowly acquire a toehold by open market purchase of shares at market prices without attracting attention.1. Accumulate 20% of the outstanding shares

through open market purchase over a longer period of time

2. Make a tender offer to bring ownership percentage to the desired level (either the control (50.1%) or amalgamation level (67%)) - this offer contains a provision that it will be made only if a certain minimum percentage is obtained.

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Hostile acquisition

Hostile acquisition

During this process the acquirer will try to monitor management/board reaction and fight attempts by them to launch other defensive tactics.

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Hostile acquisitionShareholders Rights Plan

• Known as a poison pill or deal killer• It provides shareholders (other than the

bidder) with rights to buy more stock at a discount price in the event of a takeover.

Selling the Crown Jewels• The selling of a target company’s key assets

that the acquiring company is most interested in to make it less attractive for takeover.

• Can involve a large dividend to remove excess cash from the target’s balance sheet.

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Hostile acquisitionWhite Knight

• The target seeks out another acquirer considered friendly to make a counter offer and thereby rescue the target from a hostile takeover

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M & AThe primary motive should be the creation of

synergy.

Synergy value is created from economies of integrating a target and acquiring a company; the amount by which the value of the combined firm exceeds the sum value of the two individual firms.

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Creation of Synergy Motive for M&As

Synergy is the additional value created (∆V) :

Where:VT = the pre-merger value of the target firmVA - T = value of the post merger firmVA = value of the pre-merger acquiring firm

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)V-(VVV TATA

Value Creation Motivations for M&AsOperating Synergies

1. Economies of Scale Reducing capacity (consolidation in the

number of firms in the industry) Spreading fixed costs (increase size of firm

so fixed costs per unit are decreased) Geographic synergies (consolidation in

regional disparate operations to operate on a national or international basis)

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Value Creation Motivations for M&As

2. Complementary Strengths Combining the different relative

strengths of the two firms creates a firm with both strengths that are complementary to one another

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Value Creation Motivations for M&AsEfficiency Increases

New management team will be more efficient and add more value than what the target now has.

The combined firm can make use of unused production/sales/marketing channel capacity

Financing Synergy Reduced cash flow variability Increase in debt capacity Reduction in average issuing costs Fewer information problems

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Value Creation Motivations for M&AsTax Benefits

Make better use of tax deductions and credits

Strategic Realignments Permits new strategies that were not

feasible for prior to the acquisition because of the acquisition of new management skills, connections to markets or people, and new products/services.

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Documents

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