BA 1731- CORPORATE FINANCE Unit-I

Indian financial system: Financial system is the system which consists of variety of institutions, markets and instruments. It provides means by which savings are transferred in to investments. Financial Institution and Intermediaries.

Surplus Units

Deficit Units

Financial Market

Functions of financial system 1. 2. 3. 4. 5. Payment system Pooling of funds Transfer of resources Risk management Price information

Objectives of financial system 1. Speeding up economic growth 2. Rapid industrialization 3. Support to agriculture 4. Support to trade 5. Rural / Backward development 6. Project finance 7. Entrepreneurship development 8. Housing education and health 9. Infrastructure 10. Liquidity 11. Price control 12. Human development.

Financial market 1. Capital market 2. Money market 3. Forex market Capital market: Capital market compress various channels which make the individuals and community savings available for public trade, business and industry. Capital market is defined as a market which constitutes all long term lending by banks and financial institutions, ling term borrowings from foreign markets and rising of capital by new issue markets. Therefore capital market is the mechanism which provides long term finance like shares, debentures and ling term borrowings and not the short term finance. Elements of capital Market: Securities Equity share: Equity share is a share which is not a preference share i.e., no priority given to share holders. All the share holders are treated alike. Types 1. 2. 3. 4. Growth Share Income Share defensive share Cyclic Share.

Preference Shares: Preference share is a share, where the holder of the share will be given preference in paying dividends and settlement during liquidation. Types 1. Cumulative preference share 2. Non cumulative preference share 3. Participating preference share 4. Non participating preference share 5. Convertible preference share 6. Non convertible share 7. Redeemable preference share 8. Irredeemable preference share 9. Cumulative convertible preference share

Debenture and Bonds; Both the instruments are documents acknowledging the debt of the company. The difference between bond and debenture is bond unsecured where as debenture secured Types 1. Registered debenture / Bond 2. Bearer/ unregistered debenture /Bond 3. Fully convertible debenture 4. Partly convertible debenture 5. Non convertible debenture 6. Redeemable debenture 7. Sinking fund bondsInstallment 8. Serial bonds serial 3 to 4 times in a year 9. Collateral bonds floating charge 10. Secured debenture /bond fixed charge 11. Non secured debenture/ bond 12. Guaranteed bonds 13. Joint bonds 14. Income bondspayment of the rest will be made only when there is a profit Mutual fund: Mutual fund is collection of funds from small investors and investing large amounts out of collections in equalities and other securities. Types By structure 1. Open ended 2. closed ended 3. Interval schemes. By investment objective 1. Growth schemes 2. Income schemes 3. Balanced schemes 4. Money market schemes Other schemes 1. Tax saving schemes (ELSS) 2. Industry specific / sector specific 3. Index schemes 4. Load funds 5. No load fund 6. Theme fund 7. Children fund

Non Tradable Securities 1. Post office / Govt securities 2. term loan from bank and financial institution 3. Feed capture by financial institutions Capital MarketTypes 1. Primary market 2. Secondary market Primary Market: It is also called as new issue market. It deals with securities issued for the first time in the market. Corporate organizations are willing to raise the funds through primary market only. They raise funds through the issue equity and preference shares and debentures. There are two methods of raising funds in primary market they are. 1. Public issue: In this method the company will to the general public and raises the funds by issue of securities. It involves advertising in newspapers etc and equity subscription. 2. Rights issue: In this method the funds are raised by the money contributed by the equity share holders of the company. Secondary Market: Secondary Market is a market for trading existing securities of the companies. Stock market is an organized market through which the securities are bought and sold in an orderly manner. Since the securities market is called as secondary market it is also been known as stock exchange. Money Market: Money Market is the market deals with short term securities. It is a marker to provide short term finance for the organizations. 1. Call money market: Amount borrowed or lent on demand for a very shout period of 1 to 14 days. Interring holidays and Sundays are excluded for the purpose. 2. Bill market: The documents of bill of exchange will be issued by the passes which can be negotiable and will mature in a shout period of time. 3. Certificate deposits: A certificate of deposits is a marketable receipt of fund which is having a maturity period of up to one year. It is issued by bands in the form of promissory notes. 4. Commercial paper: Commercial paper is a short term negotiable instrument issued by the companies. The maturity period range from 30 to 364 days. Compulsory credit is also required.

5. Treasury bills: The lowest risk category instrument is Treasury bill which is issued by RBI. The maturity period ranges from 14 to 364 days. 6. Money market Mutual fund: Money market Mutual fund is introduced here to provide additional short term avenue through which the small investor could actually take part in the money market. Forex Market: Forex market is the market deals with the trading of foreign currencies. It is also considered as one of the important avenue of investment. Advantages, Disadvantages of various instruments \ Equity shares: Advantages: 1. Command and control 2. No fixed cost 3. No charge over assets 4. Permanent capital 5. Public issue Disadvantages: 1. Control /management by equity share holders 2. Market price- If it is low further raising can be possible 3. High dividend 4. Excessive capitalization of equity shares will affect the companys profit. Preference share: Advantages: 1. Assured return 2. Fixed return 3. Maturity period 4. Chance of convertibility 5. Preference right Disadvantages: 1. Not a permanent capital 2. Rigid capital structure Not able to alter the returns 3. Cost of capital higher than debenture 4. No tax benefits

Debenture: Advantages: 1. Assured return 2. Less risky and secured 3. Tax benefit 4. Flexibility/ convertibility Disadvantages: 1. Charge on assets 2. Not a permanent capital 3. More of debenture will affect the profit of the organization.

Problems of Industrial finance: 1. High cost 2. Difficulty in information transfer 3. Less response from house hold (10%of investment) 4. Prevalence of unorganized market 5. Inability of the poor to approach organized market 6. No integration between various segments of financial market 7. Pricing and allocation of resources is not efficient 8. Participation is not uniform 9. More amount of brokerage and underwriting exchanges 10. difficulty in attaining minimum subscription 11. Problem of repaying the amount of the minimum subscription is not attained 12. Gap between functional and institutional setup. Merchant banking is absent. 13. Due to risk aversion of investor they prefer less risky securities 14. the cost of flotation is very high 15. the Existing companies with sound track record can raise funds very easily but the new organization cant do it very easily. Problems other View: 1. 2. 3. 4. 5. 6. 7. 8. 9. Applicant submitting window dressed annual report Unrealizable accounting creates non performing assets Difficulty in assessing capital finance Diluting the loan other than original purpose Relevant norms not framed so it leads to failure Poor projects appraisal Double or multiple financing Improper monitoring of borrower by lender Undue delay in sanctioning loans.

SEBI Guide Lines Equity 1. Price band is free for existing companies but at par for fresh issue 2. The prospectus must contain the net asset value. 3. Proper justification of price should be given. 4. Promoters contribution 20 to 25 % on the issue. 5. Minimum No of share application and application money For at par 200 shares face value of 10 each For premium minimum application money is not less than Rs.2000 25% on face value of shares and not less than 5% on face value 6. Securities issued should be fully paid up with in 12 months. 7. 12 months elapsed between two issues. 8. Period of subscription 10 working days at least for 3 working says. Rights issue- 30 days not mare than 60 days. 9. Retention of oversubscription: 10% of the net offer for rounding off to the nearest multiple of 100 10. Underwriting optional but the underwriter has to give commit money for 5% of issue amount or 25 lakh which ever is less. 11. Merchant banker are also responsible for prospectus. 12. Promoters lock in period 5 years 13. For premium 3 years track record is needed and promoters contribution 25%. If not promoters contribution is 50%. 14. If the issue amount goes beyond Rs 500 crores the issuer has to arrange for monitoring by financial institution. SEBI Guide lines for debenture: 1. Conversion period not more than 36 months. 2. Compulsory credit rating 3. No restriction on fixing interest 4. Creation of Redemption reserves. 5. Premium can be collected for the company which has 3 years sound track record. 6. Disclose of loan certificate 7. If interest rate is less than bank rate, proper disclosure has to be made about it. 8. After interest dividend has to be paid. 9. Redemption can be made after 5 years. 10. Protection of interest of debenture holder. Monitor the progress financial institution Adjust certificate for utilization of fund Appointing trustees for debentures Filing of encumbrance certificate with SEBI and NOC from banks. Supervising by trustees. 7

Working Capital finance

Working capital: The capital required to run the day to day business is known as working capital. Concept of working capital: 1. Gross working capital- total current assets 2. Net working capital- difference between total current assets and current liability. Types 1. Permanent working capital. 2. Fluctuating working capital / temporary

Operating cycle concept

Cash

R/M A/C receivable WIP Finishes goods

Determinants of working capital: 1. Nature and size of business 2. Production cycle 3. Credit policy 4. Growth and expansion activities More working capital will be required. 5. Business cycle Boom/ Recession 6. Operating efficiency If it is more efficient the working capital requirement level will decrease. 7. Attitude to risk If they take more risk more working capital will be required. 8

8. Inflation More inflation needs More working capital. 9. Profit and Profitability More profits leads to more working capital 10. Govt policy. Estimating working capital Requirement Techniques 1. Estimation of components of working capital method: Since working capital is excess o current assets over current liabilities, an assessment of the working capital requirements can be made by estimating the amounts of different constituents of working capital. E.g. Inventoried, accounts receivable, cash, accounts payable etc. 2. Percent of sales method: This is a traditional and single method of estimating working capital requirements. According to this method on the basis of past experience between sales and working capital requirements; a ratio can be determined for estimating the working capital requirements in future. E.g the working capital has 30% of sales, we can predict the working capital based on future sales forecast. 3. Operating cycle Approach. According to this the requirements of working capital depends upon the operating cycle of the business. The operating cycle begins the acquisition of raw materials and ends with collection of receivables. It may be broadly Classified as i. Raw materials and stores storage stage. ii. Work in progress stage. iii. Finished goods inventory stage. iv. Receivables collection stages. The duration of the operating cycle for the purpose of estimating working capital requirements is equivalent to the sum of durations of each of these less the credit period allowed by the supplies of the firm. O=R+W+F+DC O- Duration of operating cycle R- Raw materials and stores storage period W- Work in process period F- Finished stock storage period D Debtors collection period C- Creditors payment period

Tandon committee Recommendations: In July 1974 a study group was setup by the RBI under the chairmanship of Mr.Prakash. Tandon is to look in to the optimum use of bank credit. Objectives: 1. Data collection from borrowers : To make recommendations for obtaining periodical data from borrowers regarding their business, production plans and credit needs which could enable banks to formulate their own credit plans more meaningfully. 2. Suggestion on inventory control: To suggest norms for inventory holding by industries both in the public and private sector with the use of bank credit. 3. Satisfactory financial structure: To lay down criteria for a satisfactory financial structure of borrowers by cash credit or over draft system. 4. Indication of changes required: To indicate the modification required in existing pattern of financing the working capital requirements of borrowers by cash credit or overdraft system. Norms for working capital lending The suggested flexible norms cover the working capital finance for inventories and receivables in respects of units at cotton textiles synthetic textiles, Jute textiles, Pharmaceuticals, Rubber products, Fertilizers, Vanspati, Light and Medium Engineering Industries. For these industries the maximum period required for holding the raw materials is individually mentioned. Tandon committee Norms for Working capital lending I method C.A 20000 (-) C.A(other t 5000 han bank borrowing) -------Working capital gap 15000 (-) 25% of long term (-) C L other than savings 3750 bank borrowings -------13500 10 II method C.A 20000 (-)25% from long 5000 term service --------15000 5000 --------(-) 25% from any term savings III method C.A 20000 (-)core assets as 2000 -sumed figure -------18000 4500 --------

(-)CL other then Bank 5000 MPBF ----------------11250 10000 ------------------------ Current Ratio 1.23 1.48 MPBF maximum Permissible Bank Finance

savings -------8500

1.33

Norms of Tandom Committee: 1. the banks should extend credit equivalent to 75% of working capital gap (I.e. CA CL) . The balance 25% being financed from owners fund or long term fund 2. The banks credit should be equal to 75%. CA CL. Remaining 25% must be contribute by long term 3.The methods suggests that bank credit should be equal to 75% of working capital other words 25% of working capital gap and rent of current assets considered core should be out of long term funds. Core C A is the absolute minimum level of inventories required for continuous procurement and remains fixed. I. Chore Committee: RBI has constituted chore committee in 1969. Under the chairmanship of Mr. KB. Chore to review the cash credit system. Recommendations of foris committee: 1. Setting up of peak; and non peak limits season 2. Utilization of funds: The nartery requirement has to be started by the companies and the report has to be submitted about usage of funds. 3. Ad hoe limits: The ad hoe limits should be retained only for genome cases. Working capital assessment methods adopted by commercial Banks: 1. Turn over method.- current assets 25% of bank finance turnover 20% of turnover. 2. Tandon / chore method popularly known as MPBF 3. Modified version of MPBF 4. cash budget method/ approach. 11

II. MPBF Methods discussed under Tandon III. Modified MPBF A modified version of MPBF is applied in a public sector band. This bank has also adopted a simplified version of norms on the aggregate amount o inventory and receivable held by the borrowing company. The entire system was evolved with the following factors. 1. It is essential that NWC should be positive which implied that current ratio should be more than 1. Some part of long term resources should finance current assets. 2. Manny borrowing companies are still not able to confirm to the II method of lending. 3. One of the major reasons for the current ratio being less than 1.33 is that current liabilities includes installment of term liabilities. To adjust this policy says i. Minimum CR (current ratio) being 1.20 including the installment payments Or ii. Minimum CR being 1.33 excluding the installments. IV. Cash budget Approach: RBI has appointed Mr.K.K.Kannan, the chairmen of the Bank of Baroda in 1996. the committee has recommended that the borrowers may be assessed based on cash Budget approach. The recommendations of the Kannan committees are 1. For all big companies enjoying money central limits of Rs.5 crores and above, a cash budget may be adopted to appraise their limits. The companies may be asked to submit quarterly cash budget. 2. The cash budgets will only contain pure cash transaction and will not reflect the movement of funds other then cash. 3. The cash budgets may have 4 components. i. Cash flow from business operations ii. Cash flow from non- business operations iii. Cash flow from capital accounts. iv. Cash flow from sundry items. 4. Banks were expected to grant working capital limits up to the gap in cash flow from business operations.

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Short term financing 1. Trade credit: This is the most common from of short term credit used by firms. Trade credit refers to the credit allowed by the suppliers on purchases The extent of trade credit depends priority on the credit worthiness of he business, nature of the business, quantum of purchases. Advantages: Common credit available No explicit cost Cyclical nature 2. Short term credit from commercial Bands. Cash credit / O/D Bills Discounting Loans etc Factors for cash credit: The financial strength of the business The fund requirement of the business The security offered by the business The credit standing of the business The second method suggested by the Tandon committee. 3. Commercial Paper: Commercial paper it is the latest addition on the list of short term finance. This mode can only be resorted by companies having good financial strength and a proven trade record. Benefits of Commercial papers to companies: The commercial papers have fixed maturity periods ranging from 3 months to one year. The cost o commercial papers are lower than the interest payable in cash credit facilitated extended by commercial banks. In times of tight bank credit, they offer viable alternative source of short term finance. Procedure for issuing commercial papers: Eligibility: Companies tangible net worth in more than 4 crores Working capital limit is more than 4 crores. Minimum current ratio as per RBI guidance is 1:3,3:1 Compulsory credit rating required. Mode of operation: The company makes arrangements for privately placing the CP issue. 13

 After the arrangements are made the company should ensure that the issue is completed with in 2 weeks. Companies should submit a proposal to the lead bank along with the credit rating certificate. The lead band on receipt of the proposal shall scrutinize the proposal and on satisfaction of the terms and conditions and other associated criteria will take the issue on record. The investors will pay the discounted price mentioned The companies shall pay the stamp duty as applicable before issuing the CP. Miscellaneous conditions: Minimum face value of a CP is Rs 5 lakhs. Minimum investment by any investor is Rs 25 lakhs. Maximum amount of CO issue is 75% of the working capital limit. Duration is 3 months to 1 year. Minimum credit rating is P2/A2/PRs in cash of credit ratings by CRISIL/ICRA/CARS. Cost of Commercial Paper for a company Discount being offered against the face value Credit ratings charges Stamp duty payable Issue management charges.

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