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SOURCES OF FINANCINGTwo main heads:
Equity – Share capital, Retained earnings Debt – Term loans, Bonds/Debentures, Leasing & HP, Deposits, Factoring, Securitisation
Share capital – Equity & Preference Equity –
Ownership, Control through voting rights
Voting can be done through Proxy also Holders assume owner’s risk & rewards Permanent; Unsecured Dividend; no obligation, not fixed. Limited liability In case of winding up, entitled to only
residual assets. Categorisation in B/s – Authorised,
Issued/subscribed, Paid up. Par/face value Rs.10 or lower. If issued at price higher than par value,
excess over par value is Share Premium. Equity capital can also be with
differential rights Par value+premium+retained earnings is
called “Networth”of shareholders. Issue procedure –IPO, rights,
preferential allotment, pvt. placement,Preference –
No ownership, Conditional voting right- if dividend in
arrears. Gets preference for payment of dividend
over equity shareholders; Redeemable; always at face value Redemption fund is created for setting
aside annual portion of redemption amount.
Unsecured Dividend- Fixed, preference &
predetermined rate, can be cumulative Preference over equity in case of
winding up but after secured creditors Convertibility–NCPS, FCPS, PCPS, OCPS.
VENTURE CAPITAL
Risk Capital; High risk high returnInvests where common investors are unwilling to investInvestment generally in -
Innovative ideas/technology; High growth potential Cos. having long gestation
FEATURES Direct purchase of shares/convertibles/conditional
loans Provides long term finance for new,
expansion, buy-out, turn around Three stages of financing:
Early stage – Seed financing, R&D financing
Second stage – Expansion, working capital, bridge finance for IPO
Third stage – Buy-outs, Turn arounds Realises investment by selling at premium :
Back to promoters/ownersI P O – Offer for sale/sale in secondary market
VC acts as Friend, Philosopher and Guide. Guides Co. through board representation in
marketing, technology & management skills
VC Fund raises funds in different forms for onward investment
VC’s due diligence Looks for superior, high entry barrier businesses
having competitive advantage, sustainable revenue model & operating economies
Quality management Corporate governance Exit plan
SEBI guidelines for VC funds Have to be registered with SEBI & obtain
certificate for undertaking business Can be a Company or a Trust Can not raise money from public Minimum corpus size not less than Rs.5 cr. Can not carry on any other business other than VC Investment in one Co. can not exceed 25% of
Corpus At least 75% of investable funds to be invested in
unlisted companies Balance 25% can be invested in pre investment
IPOs or by way of preferential allotments of listed companies.
Tax regulationDividend &/or Capital gains Income are exempt from Income tax.
DEBTTerm loan
Long term maturity Secured/ unsecured Transaction through negotiation/
agreement Agreement contain end use, RoI,
repayment schedule, nature of security, other covenants
Can also be convertible Syndicated loan – Several banks/FIs
participate in loan; one bank is appointed as lead bank, it prepares info. Memo & negotiates loan on behalf of Co.
Debentures / Bonds Acknowledgement of Debt- Promissory
note Has par/face value, specific maturity,
fixed interest. Can have Put or Call option. Payment of interest is contractual
obligation; default can result in winding up. Generally secured; Secured Debentures
have priority for interest & claim on assets over Equity & Preference shareholders.
Has to be credit rated Convertibility – NCD, PCD,FCD, , Conversion price, Conversion optional & credit rating essential if conversion after 18 months; conversion period of more than 36 months must have “put” & “call” option.
Convertibility can lower intt. Cost, enables better price on issue of shares
Preferred in time of depressed market
Debenture Trustee- holds security, Protects DH’s rights. Debenture Redemption Reserve Comparatively lesser cost to Co.;
interest being tax deductible.
External Commercial borrowings
Commercial loans, In foreign exchange, Availed by persons resident in India, From non-resident lenders.
ECB is administered & monitored by RBI and can be availed under provisions of FEMA, 1999.
ECB can be availed by specific borrowers, from specified lenders, for specified purpose and with minimum maturity of 3 years.
Eligible borrowers :All companies, NGOs engaged in micro- finance for at least 3 years.
Ineligible borrowers: Financial intermediaries– Banks, FIs,
HFCs, except NBFCs who are allowed to raise ECB only to finance import of infrastructure equipments for leasing to infrastructure projects.
Individuals Trusts Non profit organizations
Maximum amount that can be raised p.a, without RBI approval:
NGOs –$ 5 mn Companies - $ 500 mn
Permitted end use:For meeting foreign exchange expenditure for:
Investment in industrial & infrastructure sector
Investment in overseas joint ventures or wholly owned subsidiaries
Acquisition of shares in disinvestment process & subsequent IPOs
Lending for micro-finance by NGOs
Not permitted for: On lending, Investment in capital market, Acquiring a company in India, Real estate, Working capital, Repayment of existing rupee loan
Minimum maturity 3 years up to $ 20 mn 5 years for 20-500 mn 10 years for above $500 mn.
Repayment only in foreign exchange
Borrower can have multi currency option; thus provides flexibility.
ECB outstanding as on 31.12.2007 – $ 57 bn
Leasing Lessee/User of Asset: Has right to use asset without having title to it. Can use it for specific period Has option to revert asset back to Lessor,
renew lease or purchase leased asset Has to pay periodic Lease
rent(principal+interest) -tax deductible Can avoid risk of obsolescence Can save on initial cash outflow
Lessor-Owner of Asset Acts as financier Recognises leased asset in its B/S as asset Claims depreciation for the asset leased
Types of LeasesFinancial lease -
Long term, non-cancellable Transfers all risks and rewards of an asset to
Lessee. Lessee bears cost of maintenance Recovers major part of cost thru lease rent
during primary lease period Asset can be transferred back to lessor at
minimal price at end of lease period, lease
can be renewed or lessee can buy the assetOperating lease – Short term(shorter than useful life of
asset), cancellable Asset reverts back to lessor after end of
lease period Lease rent does not include full cost of
asset Lessor present asset in its B/S under
fixed assets & bears cost of maintenance, insurance, obsolescence
Lease payments are recognized as expense by Lessee & income by Lessor over the lease term
Sale & Lease Back Asset/s owned by Lessee is/are sold to Lessor Lessor leases back to Lessee Characteristics of Financial lease applies
Leveraged leasing Three parties involved- Lessor, Lessee,
Lender Lessor gets the asset financed Secures it by mortgage or assigning lease
rentals Can operate by way of Financial, Operating
lease
Accounting treatment of L eases In Books of LESSEES
Finance Leases Recognize lease as an asset and Liability
At fair value of the leased asset or present value of the minimum lease payments, whichever is lesser.
Lease payment liability to be discounted at the interest rate implicit in the lease, or lessee’s incremental borrowing rate.
Lease payments should be apportioned between the finance charge and the reduction of the outstanding liability.
The finance charge should be allocated to periods during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability for each period.
To charge depreciation as expense for the asset and well as finance expense for lease rent payment for each accounting period.
The depreciation on leased asset is evenly allocated during the period of expected use of depreciable assets.
If there is reasonable certainty that the lessee will obtain ownership by the end of the lease term, the period of expected use is the useful life of the asset; otherwise the asset is depreciated over the lease term or its useful life, whichever is shorter.
Operating LeasesShould be recognized as an expense in P&L on a straight line basis over the lease term
In Books of LESSORSFinance Leases Recognise assets given under a finance lease in
its balance sheet as a receivable at an amount equal to the net investment in the lease.
Lease payment receivable is treated as A. Repayment of principal, i.e., net investment in
the lease, and
B. Finance income to reimburse and reward the lessor for its investment and services.
Operating Leases Present asset given under operating
lease in its balance sheet under fixed assets.
Lease income should be recognised in P&LA/c on a straight line basis over the lease term
Costs, including depreciation, incurred in earning the lease income are recognised as an expense
Lease Evaluation By Lessor
Lessor has to finance the asset, either wholly through equity or partly leveraged & then lease out.
Evaluation is done by comparing his Weighted Average Cost of capital (WACC) with IRR of net cash flows from lease.Out flows – Purchase of asset & related costsIn flows – lease rentals less income tax [net of tax shield on depreciation].If IRR of lease cash flows is more than WACC, only then lease transaction will be entered into.Lease rentals would, in turn, depend upon risk involved in leasing the asset. Higher the risk, higher the lease rentals.
By Lessee For lessee, choice is between lease or borrow.
Evaluation can be done by comparing present values of cash flows in case of borrow & lease.
Option having lower PV will be preferred
Hire PurchaseAsset is delivered to user on agreement that user pays designated periodical installments.
Hirer retains title to the asset till last installment is paid by Hiree. There after title passes to Hiree automatically.
Hiree can claim depreciation & interest, included in EMIs.
SecuritisationPackaging a designated pool of assets & issuing securities which are collateralised by the underlying assets & associated cash flow streams.Securities backed by mortgage loans are called “mortgage backed securities” & securities backed by other assets are called “ asset backed securities”.
Pool of assets is transferred to an SPV, organized as Trust, for consideration. After transfer assets are taken off from the balance sheet of the originator.
SPV issues securities backed by pool of assets, which are called “Pass through certificates”. Cash flow received from pool of assets are passed on to holders os securities on pro-rata basis.
Total volume of securitisation deals was Rs 68,000 crore in 2007-08 compared with Rs 23,000 crore in 2006-07, according to Crisil.
Volume of asset-backed securities more than doubled to Rs 37,000 crore in 2007-08 as against Rs 17,000 crore in 2006-07.
SHORT TERM LOANSBank loanCash credit facility/overdraft, bills purchased/discounting, L.C
Present lending system is result of recommendations made by several committees set up by RBI. One most adopted is recommendations made by Tandon committee.
Cash credit – a limit is fixed based on net working capital requirement. GWC is worked on the basis of expected sale, total optg. income of following year and related w/c requirement on the basis of holding period requirement of inventory & receivables less CL.
MPBF is determined as 75% of CA less CL.25% is retained as borrower’s margin/stake.CA -50 ; CL- 15; MPBF= (75% *50)-15 =22.5Overall C.R=CA-50; CL22.5+15=37.5 -
50/37.5=1.33
Both inventory & receivables are hypothecated to bank as security. Collaterals could also be obtained by way of mortgage.
Bills discounting:75% of amount of bill of exchange drawn by seller on buyer accompanied, generally, by TR/RR is paid by bank on acceptance by buyer. Bill could be sight or usance bill. Goods covered in TR/RR are hypothecated to bank as security. Bank collects money from buyer on due date.
Letter of credit:Established by buyer through his bank.Commitment letter from buyer’s bank to seller that when money is due at the end of credit period, agreed between seller & buyer, the same would be paid by buyer’s bank.
Commercial Paper
Introduced in India in 1990 An alternative sources of short-term borrowings
for highly rated corporate borrowers, as a privately placed instrument
Unsecured Promissory Note Money market instrument Issued at discount to face value Regulated by RBI Investors could be Corporates, Banks,
insurance Cos, & AIFIs
Prerequisites for issuers
Tangible Net Worth of not less than Rs.10 crore ;
Sanctioned working capital limit by bank of not less than Rs.25 cr
Can raise 75% of sanctioned bank credit Borrower a/c is classified as a Standard
Asset by the financing banks Must be a listed Co. Obtain minimum CRISIL equivalent P-2
credit rating
Characteristics Can be issued for maturities between 7
days and up to one year
Amount invested by a single investor not to be less than Rs.5 lakh (face value).
Every issuer must appoint a scheduled bank as an agent for issuance of CP.
Investors are given certificate by bank that all documents are in order.
Banks can adjust w/c limits after Co. issues CP
Certificates can be issued in physical or De-mat form.
Interest on CP is determined by PLR of banks, maturity, credit rating of issuer. Interest generally less than bank rate
No renewals of CP; no prepayments
Interest yield of CP Face value Rs.100, Issue price Rs.96, maturity 120 days.Face value-sale price * 360
Sale price maturity period
100-96 * 360 =12.5% 96 120
Advantages Rating reduces cost of CP Generally interest cost is less than bank
interest Being negotiable instrument easy exit
possible
Being unsecured gives investor flexibility for raising funds
Factoring
An effective tool for Working capital/ cash management
An alternative way of drawing money against receivables from banks.
Working capital is locked up till Credit sale is carried in Seller’s books as Receivables.
Involves selling/assigning invoices to Factoring Agent(FA)
Businesses that supply this service are called Factors.
Factoring involves three parties: Seller, Buyer, FA.
FA provides 80/85% funds immediately to the Seller & steps into the shoes of Seller.
This unshackles the amount locked up as receivables.
Risk of receivable going bad may/may not (with/without recource) be passed on to FA. Credit insurance
For undertaking without recourse risk FA charges extra premium in addition to the interest charges. – Costly funding.
FA carries out receivables audit before factoring - quality of the debt, genuineness of the deal, timely payments , sales returns.
FA accepts factoring of only those debts which he is confident of recovering in the normal course.
Funds advanced by FA are totally unsecured.
Factoring is carried out by both by private players & Banks
IMPACT ON FINANCIAL STATEMENTS
After factoring debtors slip out of Seller’s Balance Sheet.
Receivables get converted into cash.
Debtors'/ turnover ratio improves.
REVERSE FACTORING - Factoring for payables
Buyer of goods on credit may be entitled to discounts for immediate payment.
FA factors payables, pays to seller before due date; receives payment from buyer on due date.
Charges interest for the intervening period.
Buyer enjoys both discount & credit period from the seller.
After receiving payment, Seller’s stocks
become "paid stocks" thus entitled for additional drawing power.
In buyer’s books liability is converted from Supplier to FA.
Factoring of receivables and payables is useful to SMEs.
The trader has to consider cost of funds for factoring vis-à-vis W/C borrowings.
Banker insists on higher margins to offset the profit element.
Combo –
Trader seeks credit limits from bank against debtors up to 30 days. Debts o/s for more than 30 days can be factored for the remaining period.
PUBLIC DEPOSITS For meeting medium term requirement
of funds ROI comparatively less than banking
system Unsecured
End use not defined Governed by Co.Act for protecting
depositors : Advertisement for financial
position Co. should not be in default for
any deposit Penalties, imprisonment in case of
default
DEPOSITORY RECEIPT
A Depositary receipt (DR) is a type of negotiable instrument, in physical form by an International Depository
, which is traded on a foreign stock exchange.
It represents a security, usually in the form of equity that is issued by an Indian publicly-listed company. DR, allows foreign
investors to hold shares in equity of Indian company.
DR is created when an Indian company wishes to raise capital by listing its already publicly-traded/non-listed shares or debt securities on a foreign stock exchange.
DR is a negotiable financial security, held in physical form Global Depository Receipt –
Offered for sale globally,
Shares are commonly listed & traded on European stock exchanges such as the Luxemburg or London Stock Exchange.
Dividend is paid in local currency & converted in investors currency by ther depository.
American Depository Receipt
Traded on a U.S. Stock Exchange, such as the New York Stock Exchange (NYSE) or NASDAQ.
Both ADRs and GDRs are usually denominated in U.S. dollars, but can also be denominated in euros.
Example
A company in India wants to list its publicly-traded shares on foreign Stock Exchange in the form of an ADR/GDR.
A foreign broker, or a local broker, purchases domestic shares from the Indian market and then delivers to the custodian bank in India of the American Depository Bank (ADB).
ADB's local custodian bank then informs ADB in New York that DRs can now be issued in the United States.
ADB then issues ADRs to the broker who initially purchased them.
sEach ADR may be issued as representing one or more of the Indian shares,
Price of each ADR would be in U.S. dollars converted from the equivalent Indian price of the shares being held by ADB.
ADRs now represent the local Indian shares held by the depository, and can be freely traded amongst investors on the NYSE.
ADR transactions of the Indian Co. will now take place in U.S dollars and are settled like any other U.S. transaction on the NYSE
ADR investor holds similar privileges as Indian share holders, such as voting rights and cash dividends.
Rights of the ADR holder are stated on the ADR certificate.
U.S. broker may also sell ADRs back into the local Indian market.
On selling amount of ADRs is canceled by ADB
Local shares are released from the Indian custodian bank and delivered back to the Indian broker who bought them.
Indian broker pays for them in rupees, which are converted into dollars by the U.S. broker.
Benefits Increases global trade
Increases Indian Co. share’s liquidity by increasing volumes on local and foreign markets
Boosts Co's prestige on its local market
Enables exchange of information, technology, regulatory procedures as well as market transparency.
Helps foreign investment, in emerging markets, without worrying about entry barrier restrictions for foreign investor.
Turns local investors' portfolio into a global one, without having the risks of going directly into foreign markets.
Investor and company can both benefit from investment abroad.
An investor may have to bear some foreign-
exchange risk
Ploughing back of retained cash earnings
CREDIT RATING
Expression of opinion by independent agencies on ability of borrower to timely service debt. – Debentures, FDs of NBFCs/ Companies, commercial
Paper
Rating done for a specific instrument, period & renewed periodically
Small investors are not able to make such analysis
Rating Agency can’t be legally held responsible for default.
Rating Agencies – Credit Rating & Information Services of India
Ltd Investment Information & Credit Rating Agency Credit Analysis & Research FITCH
SYMBOLS BY CRISILDebentures - Commercial
PaperHighest safety AAA- P1High safety AA- P2Adequate safety A- P3Moderate safety BBB- Inadequate safety BB- P4High risk B- Substantial risk C- Default D- P5
METHODOLOGYBusiness risk – demand/supply, competition, market share, distribution arrangements, Govt. policies
Operating efficiency – Ratio analysis, adequacy of infrastructure facilities, and scope for expansion.
Financial analysis – accounting policies, adequacy of cash flows, financial leverage
Management evaluation – Age, track record, capacity to overcome adversities, strategies.
Certificates of Deposit
Negotiable money market instrument
Issued for funds deposited at a bank or other eligible FIs for a specified time
Can be issued in dematerialised form or as a Usance Promissory Note
Minimum amount of a CD should be Rs.1 lakh,
CDs to NRIs can be issued only on non-repatriable basis
Maturity period of CDs issued by banks is between 7 days and one year.
Maturity period of CDs issued by FIs is between1 year and 3 years from the date of issue.
CDs may be issued at a discount on face value or on floating rate basis