(Indian Financial System)
Full Marks: 80
The figures in the margin indicate full marks for the questions.
1. (a) Discuss the importance of financial system in Economic Development of a country like India. (16)
-> The development of any country depends on the economic growth the country achieves over a period of time. Economic growth deals about investment and production and also the extent of Gross Domestic Product in a country. Only when this grows, the people will experience growth in the form of improved standard of living, namely economic development.
Role of financial system in economic development of a country
The following are the roles of financial system in the economic development of a country.
To attain economic development, a country needs more investment and production. This can happen only when there is a facility for savings. As, such savings are channelized to productive resources in the form of investment. Here, the role of financial institutions is important, since they induce the public to save by offering attractive interest rates. These savings are channelized by lending to various business concerns which are involved in production and distribution.
Financial systems help in growth of capital market
Any business requires two types of capital namely, fixed capital and working capital. Fixed capital is used for investment in fixed assets, like plant and machinery. While working capital is used for the day-to-day running of business. It is also used for purchase of raw materials and converting them into finished products.
- Fixed capital is raised through capital market by the issue of debentures and shares. Public and other financial institutions invest in them in order to get a good return with minimized risks.
- For working capital, we have money market, where short-term loans could be raised by the businessmen through the issue of various credit instruments such as bills, promissory notes, etc.
Foreign exchange market enables exporters and importers to receive and raise funds for settling transactions. It also enables banks to borrow from and lend to different types of customers in various foreign currencies. The market also provides opportunities for the banks to invest their short term idle funds to earn profits. Even governments are benefited as they can meet their foreign exchange requirements through this market.
Government Securities market
Financial system enables the state and central governments to raise both short-term and long-term funds through the issue of bills and bonds which carry attractive rates of interest along with tax concessions. The budgetary gap is filled only with the help of government securities market. Thus, the capital market, money market along with foreign exchange market and government securities market enable businessmen, industrialists as well as governments to meet their credit requirements. In this way, the development of the economy is ensured by the financial system.
Financial system helps in Infrastructure and Growth
Economic development of any country depends on the infrastructure facility available in the country. In the absence of key industries like coal, power and oil, development of other industries will be hampered. It is here that the financial services play a crucial role by providing funds for the growth of infrastructure industries. Private sector will find it difficult to raise the huge capital needed for setting up infrastructure industries. For a long time, infrastructure industries were started only by the government in India. But now, with the policy of economic liberalization, more private sector industries have come forward to start infrastructure industry. The Development Banks and the Merchant banks help in raising capital for these industries.
Financial system helps in development of Trade
The financial system helps in the promotion of both domestic and foreign trade. The financial institutions finance traders and the financial market helps in discounting financial instruments such as bills. Foreign trade is promoted due to per-shipment and post-shipment finance by commercial banks. They also issue Letter of Credit in favor of the importer. Thus, the precious foreign exchange is earned by the country because of the presence of financial system. The best part of the financial system is that the seller or the buyer does not meet each other and the documents are negotiated through the bank. In this manner, the financial system not only helps the traders but also various financial institutions. Some of the capital goods are sold through hire purchase and installment system, both in the domestic and foreign trade. As a result of all these, the growth of the country is speeded up.
Employment Growth is boosted by financial system
The presence of financial system will generate more employment opportunities in the country. The money market which is a part of financial system, provides working capital to the businessmen and manufacturers due to which production increases, resulting in generating more employment opportunities. With competition picking up in various sectors, the service sector such as sales, marketing, advertisement, etc., also pick up, leading to more employment opportunities. Various financial services such as leasing , factoring , merchant banking, etc., will also generate more employment. The growth of trade in the country also induces employment opportunities. Financing by Venture capital provides additional opportunities for techno-based industries and employment.
There are various reasons for lack of growth of venture capital companies in India. The economic development of a country will be rapid when more ventures are promoted which require modern technology and venture capital. Venture capital cannot be provided by individual companies as it involves more risks. It is only through financial system, more financial institutions will contribute a part of their investable funds for the promotion of new ventures. Thus, financial system enables the creation of venture capital.
Financial system ensures balanced growth
Economic development requires a balanced growth which means growth in all the sectors simultaneously. Primary sector, secondary sector and tertiary sector require adequate funds for their growth. The financial system in the country will be geared up by the authorities in such a way that the available funds will be distributed to all the sectors in such a manner, that there will be a balanced growth in industries, agriculture and service sectors.
Financial system helps in fiscal discipline and control of economy
It is through the financial system, that the government can create a congenial business atmosphere so that neither too much of inflation nor depression is experienced. The industries should be given suitable protection through the financial system so that their credit requirements will be met even during the difficult period. The government on its part, can raise adequate resources to meet its financial commitments so that economic development is not hampered. The government can also regulate the financial system through suitable legislation so that unwanted or speculative transactions could be avoided. The growth of black money could also be minimized.
Financial system’s role in balanced regional development
Through the financial system, backward areas could be developed by providing various concessions or sops. This ensures a balanced development throughout the country and this will mitigate political or any other kind of disturbances in the country. It will also check migration of rural population towards towns and cities.
2. (a) Discuss how the Indian Money Market is regulated by RBI. (16)
· Firstly the central bank (RBI) could do this by setting a necessary
, which would restrict the ability of the commercial banks to increase the
money supply by loaning out money. If this condition were above the ratio
the commercial banks would have wished to have then the banks will have to
create fewer deposits and make fewer loans then they could otherwise have
profitably done. If the central bank imposed this requirement in order to
reduce the money supply, the
will probably be unable to borrow from the central bank in order to
increase their cash reserves if they wished to make further loans. They
might try to attract further deposits from customers by raising their
interest rates but the central bank may retaliate by increasing the
necessary reserve ratio.
(RBI) can influence the supply of money through special deposits. These
are deposits at the central bank which the
is required to lodge. These are then frozen, thus preventing the sector
from accessing them even though interest is paid at the average
Treasury bill rate. Making these special deposits reduces the level of
the ‘commercial banks’ operational deposits which forces them to cut
back on lending.
· The supply of money can also be prohibited by the central bank (RBI) by adjusting its interest rate which it charges when the commercial banks wish to borrow money (the discount rate). Banks generally have a ratio of cash to deposits which they consider to be the minimum safe level. If command for cash is such that their reserves fall below this level they will able to borrow money from the central bank at its discount rate. If market rates were 8% and the discount rate were also 8%, then the banks might decrease their cash reserves to their minimum ratio knowing that if demand exceeds supply they will be able to borrow at 8%. The central bank, even if, may raise its discount rate to a value above the market level, in order to encourage banks not to reduce their cash reserves to the minimum during excess loans. By raising the discount value to such a level, the commercial banks are given an incentive to hold more reserves thus reducing the money multiplier and the money supply.
· Another way the money supply can be affected by the central bank is through its operation of the interest rate. By raising or lowering interest rates the demand for money is respectively reduced or increased. If it sets them at a certain level it can clear the market at level by supplying sufficient money to match the demand. Alternatively it could fix the money supply at a convinced rate and let the market clear the interest rates at the balance. Trying to fix the money supply is not easy so central banks regularly set the interest rate and provide the amount of money the market demands .
· The central bank (RBI) may also involve the money supply through operating on the open market. This allows it to influence the money supply through the financial base. It may choose to either buy or sell securities in the marketplace which will either inject or remove money respectively. Thus the monetary base will be affected causing the money supply to modify.
(b) What do you mean by New Issue Market (NIM)? Discuss the role played by the brokers of stock exchanges and the bankers in the New Issue Market. (5+11=16)
-> Primary market is also known as new issue market. As in this market securities are sold for the first time, i.e., new securities are issued from the company. Primary capital market directly contributes in capital formation because in primary market company goes directly to investors and utilizes these funds for investment in buildings, plants, machinery etc.
The primary market does not include finance in the form of loan from financial institutions because when loan is issued from financial institution it implies converting private capital into public capital and this process of converting private capital into public capital is called going public. The common securities issued in primary market are equity shares, debentures, bonds, preference shares and other innovative securities.
Method of Floatation of Securities in Primary Market:
The securities may be issued in primary market by the following methods:
1. Public Issue through Prospectus: Under this method company issues a prospectus to inform and attract general public. In prospectus company provides details about the purpose for which funds are being raised, past financial performance of the company, background and future prospects of company. The information in the prospectus helps the public to know about the risk and earning potential of the company and accordingly they decide whether to invest or not in that company Through IPO company can approach large number of persons and can approach public at large. Sometimes companies involve intermediaries such as bankers, brokers and underwriters to raise capital from general public.
2. Offer for Sale: Under this method new securities are offered to general public but not directly by the company but by an intermediary who buys whole lot of securities from the company. Generally the intermediaries are the firms of brokers. So sale of securities takes place in two steps: first when the company issues securities to the intermediary at face value and second when intermediaries issue securities to general public at higher price to earn profit. Under this method company is saved from the formalities and complexities of issuing securities directly to public.
3. Private Placement: Under this method the securities are sold by the company to an intermediary at a fixed price and in second step intermediaries sell these securities not to general public but to selected clients at higher price. The issuing company issues prospectus to give details about its objectives, future prospects so that reputed clients prefer to buy the security from intermediary. Under this method the intermediaries issue securities to selected clients such as UTI, LIC, General Insurance, etc. The private placement method is a cost saving method as company is saved from the expenses of underwriter fees, manager fees, agents’ commission, listing of company’s name in stock exchange etc. Small and new companies prefer private placement as they cannot afford to rise from public issue.
4. Right Issue (For Existing Companies): This is the issue of new shares to existing shareholders. It is called right issue because it is the pre-emptive right of shareholders that company must offer them the new issue before subscribing to outsiders. Each shareholder has the right to subscribe to the new shares in the proportion of shares he already holds. A right issue is mandatory for companies under Companies’ Act 1956.
The stock exchange does not allow the existing companies to go for new issue without giving pre-emptive rights to existing shareholders because if new issue is directly issued to new subscribers then the existing equity shareholders may lose their share in capital and control of company i.e., it would water their equity. To stop this pre-emptive or right issue is compulsory for existing company.
5. e-IPOs, (electronic Initial Public Offer): It is the new method of issuing securities through on line system of stock exchange. In this company has to appoint registered brokers for the purpose of accepting applications and placing orders. The company issuing security has to apply for listing of its securities on any exchange other than the exchange it has offered its securities earlier. The manager coordinates the activities through various intermediaries connected with the issue
3. Write short notes on any two of the following: (8×2=16)
a) Merchant bankers.
-> Merchant banking can be defined as a skill-oriented professional service provided by merchant banks to their clients, concerning their financial needs, for adequate consideration, in the form of fee.
Merchant banks are a specialist in international trade and thus, excel in transacting with large enterprises.
Services offered by Merchant Banks
Merchant Banks offers a range of financial and consultancy services, to the customers, which are related to:
· Marketing and underwriting of the new issue.
- Merger and acquisition related services.
· Advisory services, for raising funds.
- Management of customer security.
· Project promotion and project finance.
- Investment banking
- Portfolio Services
- Insurance Services.
Merchant banking helps in reinforcing the economic development of the country, by acting as a source of funds and information to the business entities.
Any person indulged in issue management business by making arrangements with respect to trade and subscription of securities or by playing the role of manager/consultant or by providing advisory services, is known as a merchant banker. The activities carried out by merchant bankers are:
- Private placement of securities.
- Managing public issue of securities
- Satellite dealership of government securities
· Management of international offerings like Depository Receipts, bonds, etc.
- Syndication of rupee term loans
- Stock broking
- International financial advisory services.
In India, the functions of the merchant bankers are governed by the Securities and Exchange Board of India (SEBI) Regulations, 1992.
Functions of Merchant Banking Organization
1. Portfolio Management: Merchant banks provide advisory services to the institutional investors, on account of investment decisions. They trade in securities, on behalf of the clients, with the aim of providing them with portfolio management services.
2. Raising funds for clients: Merchant banking organization assist the clients in raising funds from the domestic and international market, by issuing securities like shares, debentures, etc., which can be deployed for starting a new project or business or expansion activities.
3. Promotional Activities: One of the most important activities of merchant banking is the promotion of business enterprise, during its initial stage, right from conceiving the idea to obtaining government approval. There is some organization, which even provides financial and technical assistance to the business enterprise.
4. Loan Syndication: Loan Syndication means service provided by the merchant bankers, in raising credit from banks and financial institutions, to finance the project cost or working capital of the client’s project, also termed as project finance service.
5. Leasing Services: Merchant banking organizations renders leasing services to their customers. There are some banks which maintain venture capital funds to help entrepreneurs.
Merchant Banking helps in coordinating the operations of intermediaries, with respect to the issue of shares like registrar, advertising agency, bankers, underwriters, brokers, printers and so on. Further, it ensures compliance with the rules and regulations, of the capital market.
b) Insurance Regulatory and Development Authority (IRDA).
-> The Insurance Regulatory and Development Authority of India (IRDAI) is a regulatory body under the jurisdiction of Ministry of Finance , Government of India and is tasked with regulating and promoting the insurance and re-insurance industries in India. It was constituted by the Insurance Regulatory and Development Authority Act, 1999, an Act of Parliament passed by the Government of India . The agency’s headquarters are in Hyderabad , Telangana , where it moved from Delhi in 2001.
IRDAI is a 10-member body including the chairman, five full-time and four part-time members appointed by the government of India.
In India insurance was mentioned in the writings of many historical documents, which examined the pooling of resources for redistribution after fire, floods, epidemics and famine.[ relevant? ] The life-insurance business began in 1818  with the establishment of the Oriental Life Insurance Company in Calcutta; the company failed in 1834. In 1829, Madras Equitable began conducting life-insurance business in the Madras Presidency. The British Insurance Act was enacted in 1870, and Bombay Mutual (1871), Oriental (1874) and Empire of India (1897) were founded in the Bombay Presidency. The era was dominated by British companies.
In 1914, the government of India began publishing insurance-company returns. The Indian Life Assurance Companies Act, 1912 was the first statute regulating life insurance. In 1928 the Indian Insurance Companies Act was enacted to enable the government to collect statistical information about life- and non-life-insurance business conducted in India by Indian and foreign insurers, including provident insurance societies. In 1938 the legislation was consolidated and amended by the Insurance Act, 1938, with comprehensive provisions to control the activities of insurers.
The Insurance Amendment Act of 1950 abolished principal agencies, but the level of competition was high and there were allegations of unfair trade practices. The Government of India decided to nationalize the insurance industry.
An ordinance was issued on 19 January 1956, nationalizing the life-insurance sector, and the Life Insurance Corporation was established that year. The LIC absorbed 154 Indian and 16 non-Indian insurers and 75 provident societies . The LIC had a monopoly until the late 1990s, when the insurance industry was reopened to the private sector.
General insurance in India began during the Industrial Revolution in the West and the growth of sea-faring commerce during the 17th century. It arrived as a legacy of British occupation, with its roots in the 1850 establishment of the Triton Insurance Company in Calcutta. In 1907 the Indian Mercantile Insurance was established, the first company to underwrite all classes of general insurance. In 1957 the General Insurance Council (a wing of the Insurance Association of India) was formed, framing a code of conduct for fairness and sound business practice.
Eleven years later, the Insurance Act was amended to regulate investments and set minimum solvency margins and the Tariff Advisory Committee was established. In 1972, with the passage of the General Insurance Business (Nationalization) Act, the insurance industry was nationalized on 1 January 1973. One hundred seven insurers were amalgamated and grouped into four companies: National Insurance Company, New India Assurance Company, Oriental Insurance Company and United India Insurance Company. The General Insurance Corporation of India was incorporated in 1971, effective on 1 January 1973.
The re-opening of the insurance sector began during the early 1990s. In 1993, the government set up a committee chaired by former Reserve Bank of India governor R. N. Malhotra to propose recommendations for insurance reform complementing those initiated in the financial sector. The committee submitted its report in 1994, recommending that the private sector be permitted to enter the insurance industry. Foreign companies should enter by floating Indian companies, preferably as joint ventures with Indian partners.
Following the recommendations of the Malhotra Committee, in 1999 the Insurance Regulatory and Development Authority (IRDA) were constituted to regulate and develop the insurance industry and were incorporated in April 2000. Objectives of the IRDA include promoting competition to enhance customer satisfaction with increased consumer choice and lower premiums while ensuring the financial security of the insurance market.
The IRDA opened up the market in August 2000 with an invitation for registration applications; foreign companies were allowed ownership up to 26 percent. The authority, with the power to frame regulations under Section 114A of the Insurance Act, 1938, has framed regulations ranging from company registrations to the protection of policyholder interests since 2000.
In December 2000, the subsidiaries of the General Insurance Corporation of India were restructured as independent companies and the GIC was converted into a national re-insurer. Parliament passed a bill de-linking the four subsidiaries from the GIC in July 2002. There are 28 general insurance companies, including the Export Credit Guarantee Corporation of India and the Agriculture Insurance Corporation of India, and 24 life-insurance companies operating in the country. With banking services, insurance services add about seven percent to India’s GDP.
In 2013 the IRDAI attempted to raise the foreign direct investment (FDI) limit in the insurance sector to 49 percent from its current 26 percent.  The FDI limit in the insurance sector has been raised to 74 percent according to the 2021 union budget.
c) Advantages of Mutual Funds.
-> Advantages of Mutual Funds
Unless you opt for close-ended mutual funds , it is relatively easier to buy and exit a mutual fund scheme. You can sell your open-ended equity mutual fund units when the stock market is high and make a profit. Do keep an eye on the exit load and expense ratio of the mutual fund.
Equity mutual funds have their share of risks as their performance is based on the stock market movements. Hence, the fund manager spreads your investment across stocks of companies across various industries and different sectors called diversification . In this way, when one asset class doesn’t perform, the other sectors can compensate to avoid loss for investors.
A mutual fund is good for investors who don’t have the time or skills to do the research and asset allocation. A fund manager takes care of it all and makes decisions on what to do with your investment.
The fund manager and the team of researchers decide on the appropriate securities such as equity, debt or a mix of both depending on the investment objectives of the fund. Moreover, the fund manager also decides on how long to hold the securities.
Your fund manager’s reputation and track record in fund management should be an essential criterion for you to choose a mutual fund. The expense ratio (which cannot be more than 2.25% annualized of the daily net assets as per SEBI) includes the fees of the fund manager.
Less cost for bulk transactions
You must have noticed how price drops with the purchase of increased volumes. For instance, if 100g toothpaste costs Rs 10, you might get a 500g pack for say, Rs 40.
The same logic applies to mutual fund units as well. If you buy multiple mutual fund units at a time, the processing fees and other commission charges will be lesser as compared to buying one mutual fund unit.
Invest in smaller denominations
By investing in smaller denominations of as low as Rs 500 per SIP installment, you can stagger your investments in mutual funds over some time. This reduces the average cost of investment – you spread your investment across stock market lows and highs. Regular (monthly or quarterly) investments, as opposed to lumpsum investments, give you the benefit of rupee cost averaging.
Suits your financial goals
There are several types of mutual funds available in India catering to investors across all walks of life. No matter what your income is, you must make it a habit to set aside some amount (however small) towards investments. It is easy to find a mutual fund that matches your income, time horizon, investment goals and risk appetite.
You can check the expense ratio of different mutual funds and choose the one with the lowest expense ratio. The expense ratio is the fee for managing your mutual fund.
Quick and hassle-free process
You can start with one mutual fund and slowly diversify across funds to build your portfolio. It is easier to choose from handpicked funds that match your investment objectives and risk tolerance.
Tracking mutual funds will be a hassle-free process. The fund manager , with the help of his team, will decide when, where and how to invest in securities according to the investment objectives. In short, their job is to beat the benchmark index and deliver maximum returns to investors, consistently.
You can invest in tax-saving mutual funds called ELSS which qualifies for tax deduction up to Rs 1.5 lakh per annum under Section 80C of the Income Tax Act, 1961. Though a 10% tax on Long-Term Capital Gains (LTCG) above Rs 1 lakh is applicable, they have consistently delivered higher returns than other tax-saving instruments in recent years.
It is common to delay SIPs or postpone investments due to some reason. You can opt for paperless automation with your fund house or agent by submitting a SIP mandate, where you instruct your bank account to automatically deduct SIP amounts when it’s due. Timely email and SMS notifications make sure you stay on track with mutual fund investments.
There is a general notion that mutual funds are not as safe as bank products. This is a myth as fund houses are strictly under the purview of statutory government bodies like SEBI and AMFI . One can easily verify the credentials of the fund house and the asset manager from SEBI. They also have an impartial grievance redressal platform that works in the interest of investors.
Systematic or one-time investment
You can plan your mutual fund investment as per your budget and convenience. For instance, starting a SIP (Systematic Investment Plan) on a monthly or quarterly basis in an equity fund suits investors with less money. On the other hand, if you have a surplus amount, go for a one-time lumpsum investment in debt funds.
d) State Financial Corporations.
-> The State Finance Corporations (SFCs) are an integral part of institutional finance structure of a country where SFC promotes small and medium industries of the states. Besides, SFC helps in ensuring balanced regional development , higher investment, more employment generation and broad ownership of various industries.
SFC – State Finance Corporation
At present in India, there are 18 state finance corporations (out of which 17 SFCs were established under the SFC Act 1951). Tamil Nadu Industrial Investment Corporation Ltd. which is established under the Company Act, 1949, is also working as state finance corporation.
Organization and Management
A Board of ten directors manages the State Finance Corporations. The State Government appoints the managing director generally in consultation with the RBI and nominates the name of three other directors.
All insurance companies, scheduled banks, investment trusts, co-operative banks, and other financial institutions elect three directors.
Thus, the state government and quasi-government institutions nominate the majority of the directors .
Functions of State Finance Corporations
The various important functions of State Finance Corporations are:
(i) The SFCs provides loans mainly for the acquisition of fixed assets like land, building, plant, and machinery.
(ii) The SFCs help financial assistance to industrial units whose paid-up capital and reserves do not exceed Rs. 3 crore (or such higher limit up to Rs. 30 crores as may be notified by the central government).
(iii) The SFCs underwrite new stocks, shares, debentures etc., of industrial units.
(iv) The SFCs grant guarantee loans raised in the capital market by scheduled banks, industrial concerns, and state co-operative banks to be repayable within 20 years.
Working of SFCs
The Indian government passed the State Financial Corporation Act in 1951. It is applicable to all the States.
The authorized Capital of a State Financial Corporation should be within the minimum and maximum limits of Rs. 50 lakhs and Rs. 5 crores which are fixed by the State government.
It is divided into shares of equal value which were acquired by the respective State Governments, the Reserve Bank of India , scheduled banks, co-operative banks, other financial institutions such as insurance companies, investment trusts, and private parties.
The State Government guarantees the shares of SFCs. The SFCs can augment its fund through issue and sale of bonds and debentures also, which should not exceed five times the capital and reserves at Rs. 10 Lakh.
Problems of State Financial Corporations
No Independent Organization
All SFCs are dependent upon the rules and regulations made by the state government.
SFCs’ problem is that all decision of these institutions is dependent on the political environment of the state.
Due to this, the loan is not available at the right time for the right person.
Like other government offices of our country, we can also see the evil of corruption in state financial corporation.
Hoarding of wealth and money, SFCs’ officer object has become to earn by a good or bad way.
That is the problem that these institutions have no proper transparency like banks.
Effect of the World Bank and WTO Policies
Approx. all SFCs in India are tied up with World Bank and WTO agreement.
Due to this, these institutions’ decisions are influenced by the World Bank and WTO policies.
World Bank can easily pressurize for accepting his policies. It may also influence the Indian small scale industry adversely.
4. (a) What are the sources of short term funds available in India? Explain any three of such sources. (4+12=16)
-> Short-term financing may be defined as the credit or loan facility extended to an enterprise for a period of less than one year.
It is a credit arrangement provided to an enterprise to bridge the gap between income and expenses in the short run. It helps the enterprise to manage its current liabilities, such as payment of salaries and wages to labors and procurement of raw materials and inventory.
The availability of short-term funds ensures the sufficient liquidity in the enterprise. It facilitates the smooth functioning of the enterprise’s day-to-day activities.
The various short-term sources of finance are as follows:
Source 1. Trade Credit:
Trade credit refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business. It occupies a very important position in short-term financing due to the competition. Almost all the traders and manufacturers are required to extend credit facility (a portion), without which there is no business. Trade credit is a spontaneous source of finance that arises in the normal business transactions without specific negotiation, (automatic source of finance).
In order to get this source of finance, the buyer should have acceptable and dependable creditworthiness and reputation in the market. Trade credit is generally extended in the form of open account or bills of exchange. Open account is the form of trade credit, where supplier sends goods to the buyer and the payment to be received in future as per terms of the sales invoice.
As such trade credit constitutes a very important source of finance, represents 25 per cent to 50 per cent of the total short-term sources for financing working capital requirements.
Getting trade credit may be easy to the well-established, but for a new or a firm with financial problems, will generally face problems in getting trade credit. Generally, suppliers look for earnings record, liquidity position and payment record while extending credit. Building confidence in suppliers is possible only when the buyer discusses his/her financial condition, future plans and payment record. Trade credit involves some benefits and costs.
The main advantages are:
(i) Easy availability when compared to other sources of finance (except financially weak companies)
(ii) Flexibility is another benefit, as the credit increases with the growth of the firm’s sales.
(iii) Informality as stated in the above that it is an automatic finance.
Costs of Trade Credit:
The above discussion on trade credit reveals two things:
(i) Cost of trade credit is very high beyond the cash discount period, company should not have cash discount for prompt payment.
(ii) If the company is not able to avail cash discount it should pay only at the end of the last day of credit period, even it can delay one or two days if it does not affect the credit standing.
Source 2. Accruals:
Accrued expenses are those expenses which the company owes to the other, but not yet due and not yet paid the amount. Accruals represent a liability that a firm has to pay for the services or goods, it has received. It is spontaneous and interest-free source of financing. Salaries and wages, interest and taxes are the major constituents of accruals. Salaries and wages are usually paid on monthly and weekly base, respectively.
The amounts of salaries and wages are owed but not yet paid and shown them as accrued salaries and wages on the balance sheet at the end of the financial year. The longer the time lag in–payment of these expenses, the greater is the amount of funds provided by the employees. Similarly, interest and tax are accruals, as source of short-term finance. Tax will be paid on earnings.
Income-tax is paid to the government, on quarterly basis and some other taxes may be payable half- yearly or annually. Amount of taxes due as on the date of the balance sheet but not paid till then are shown as accrued taxes on the balance sheet. Like taxes, interest is paid periodically in the year but the funds are used continuously by a firm. All other such items of expenses can be used as a source of short-term finance but shown on the balance sheet.
The amount of accrual varies with the level of activities of a firm. When the level of activity expands, accruals increase and automatically they act a source of finance. Accruals are treated as “cost free” source or finance, since it does not involve any payment of interest.
But in actual terms it may not be true, since payment of salaries and wages is determined by provisions of law and industry practice. Similarly, tax payment is governed by laws and delay in payment of tax leads to penalty. Hence, a firm must note that use of accruals as a source of working capital paying may not be possible.
Source 3. Deferred Income:
Deferred income is income received in advance by the firm for supply of goods or services in future period. This income increases the firm’s liquidity and constitutes an important source of short-term finance. These payments are not showed as revenue till the supply of goods or services, but showed in the balance sheet as income received in advance.
Advance payment can be demanded by firms which are having monopoly power, great demand for its products and services and if the firm is manufacturing a special product on a special order.
Source 4. Commercial Papers (CPs):
Commercial paper represents a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating. It was first introduced in the USA and it is an important money market instrument. In India, Reserve Bank of India introduced CP on the recommendations of the Vaghul Working Group on Money Market. CP is a source of short-term finance to only large firms with sound financial position.
1. The maturity period of CP ranges from 15 to 365 days (but in India it ranges between 91 to 180 days).
2. It is sold at a discount from its face value and redeemed at its face value.
3. Return on CP is the difference between par value and redeemable value.
4. It may be sold directly to investors or indirectly through dealers.
5. There is no developed secondary market for CP.
Source 5. Public Deposits:
Public deposits or term deposits are in the nature of unsecured deposits, are solicited by the firms (both large and small) from general public primarily for the purpose of financing their working capital requirements.
Fixed deposits accepted by companies are governed by the Companies (Acceptance of Deposits) Amendment Rules, 1978.
The main features of this regulation are:
1. A firm cannot issue public deposits for more than 25 per cent of its share capital and free reserves.
2. The public deposits can be issued for a period ranging from a minimum 6 months to maximum 3 years, only for an amount up to 10% of the company’s share capital and free reserves. Maximum period of 5 years allowed for non-banking financial corporation (NBFC’s).
3. The company that has raised funds by way of issue of public deposits is required to set aside, a deposit and/or investment, by the 30th April each year an amount equal to 10 per cent of the maturity deposits by the 31st March of the next year. The amount, so set aside can be used only for repaying the amount of deposits.
4. Finally, and importantly, a company soliciting and accepting the public deposits from the public is required to disclose true, fair, vital and relevant facts in regard to its financial position and performance.
(b) What are Deep Discount Bonds? How do they differ from Zero Interest bonds? Explain. (6+10=16)
-> A discount bond is a bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the secondary market. Discount Bonds are similar to zero-coupon bonds, which are also sold at a discount, but the difference is that the latter does not pay interest. A common example of a discount bond is a savings bond. A bond is considered a deep-discount bond if it is sold at a significantly lower price than par value, usually 20% or more.
Investors that purchase bonds are paid interest by the bond issuer. This interest rate, also called a coupon, is usually paid semiannually. The frequency at which these coupons must be paid doesn’t change; however, the amount of interest does, depending on market factors. As interest rates go up, bond prices go down, and vice versa. To illustrate this phenomenon, say, interest rates go up after an investor purchases a bond. The higher interest rate in the Economy decreases the value of the bond since the bond is paying a lower interest or coupon rate to its bondholders. When the value of a bond decreases, it is likely to sell at a discount to par. This bond is referred to as a discount bond. A bond is considered a discount bond when it has a lower interest rate than the current market rate and, consequently, is sold at a lower price. The “discount” in a discount bond doesn’t necessarily mean that investors get a better yield than the market is offering, just a price below par. For example, if a corporate bond is trading at Rs. 980, it is considered a discount bond since its value is below the Rs. 1,000 par value.
A discount bond is the opposite of a premium bond, which occurs when the market price of a bond is higher than the price for which it was originally sold. To compare the two in the current market, and to convert older bond prices to their value in the current market, you can use a calculation called yield to maturity (ytm). Yield to maturity considers the bond’s current market price, par value, coupon interest rate, and time to maturity in order to calculate a bond’s return. Discount bonds can be bought and sold by both businesses and individuals. Businesses have strict regulations for the selling and purchasing of discount bonds; they must keep detailed expense records of the discount bonds bought and sold on a Balance Sheet.
Pros and Cons of Purchasing a Discount Bond:-
If you buy a discount bond, the chances of seeing the bond appreciate in value are fairly high, as long as the lender doesn’t Default. If you hold out until the bond matured, you’ll be paid the face value of the bond, even though what you originally paid was less than face value. Maturity rates vary between short-term and long-term bonds; short-term bonds mature in less than a year, while long-term bonds mature over ten to fifteen years, or even longer. However, the chances of default might be higher, as a discount bond can indicate that the lender is in a less than ideal place in the market or will likely be in the future. The presence of discount bonds can indicate many things, such as predictions of falling dividends or a reluctance to buy on the part of the investors. A zero coupon bonds is a great example of deep discount bonds. Depending on the length of time until maturity, zero-coupon bonds can be issued at very large discounts to par, sometimes 20% or more. Because a bond will always pay its full face value at maturity (assuming no credit events occur), zero-coupon bonds will steadily rise in price as the maturity date approaches. These bonds don’t make periodic interest payments and will only make one payment (the face value) to the holder at maturity. A distressed bond (one that has a high likelihood of default) can also trade for huge discounts to par, effectively raising its yield to very attractive levels. The consensus, however, is that these bonds will not receive full or timely interest payments at all. Because of this, investors who buy into these securities are very speculative, possibly even making a play for the company’s assets or equity.
Deep-Discounts and Zero-Coupon Bonds
A deep discount bond does not have to pay coupons, as seen with zero-coupon bonds . Some zero-coupon bonds are offered at a deep discount, and these bonds do not make periodic payments to bondholders. The yield on these bonds is the difference between the par value and the discounted price. This means that the price of zero-coupons will fluctuate more than bonds that provide periodic interest payments. All zero-coupon bonds are not deep-discount bonds; some are original issue discount (OID) bonds. For example, an OID bond may be one issued at $975 with a $1,000 par value, and a deep-discount bond may be one issued at $680 with a $1,000 par value.
Deep-discount bonds are typically long term, with maturities of five years or longer (except for Treasury bills which are short-term zero-coupon), and are issued with call provisions . Investors are attracted to these discounted bonds because of their high return or minimal chance of being called before maturity. Issuers seek the least cost method of raising capital through debt. Deep discount bonds appreciate faster than other types of bonds when market interest rates fall and depreciate faster when the rates rise. If interest rates increase in the economy, the existing bonds will carry lower interest payments and, thus, a lower cost of debt to the issuer. It will, therefore, be in the issuer’s best financial interest to not call the bonds.
5. (a) Discuss the importance of foreign capital for economic development of India. What initiatives are taken by the Modi Govt. to attract more foreign capital to India? (8+8=16)
-> FDI plays an important role in the economic development of a country. The capital inflow of foreign investors allows strengthening infrastructure, increasing productivity and creating employment opportunities in India. Additionally, FDI acts as a medium to acquire advanced technology and mobilize foreign exchange resources. Availability of foreign exchange reserves in the country allows RBI (the central banking institution of India) to intervene in the foreign exchange market and control any adverse movement in order to stabilize the foreign exchange rates. As a result, it provides a more favorable economic environment for the development of Indian economy.
There are various factors that signify the importance of FDI in India some of which are listed below:
1) Helps in Balancing International Payments:
FDI is the major source of foreign exchange inflow in the country. It offers a supreme benefit to country’s external borrowings as the government needs to repay the international debt with the interest over a particular period of time. The inflow of foreign currency in the economy allows the government to generate adequate resources which help to stabilize the BOP (Balance of Payment).
2) FDI boosts development in various fields:
For the development of an economy, it is important to have new technology, proper management and new skills. FDI allows bridging of the technology gap between foreign and domestic firms to boost the scale of production which is beneficial for the betterment of Indian economy. Thus, FDI is also considered an asset to the economy.
3) FDI & Employment:
FDI allows foreign enterprises to establish their business in India. The establishment of these enterprises in the country generates employment opportunities for the people of India. Thus, the government facilitates foreign companies to set up their business entities in the country to empower Indian youth with new and improved skills.
4) FDI encourages export from host country:
Foreign companies carry a broad international marketing network and marketing information which helps in promoting domestic products across the globe. Hence, FDI promotes the export-oriented activities that improve export performance of the country.
Apart from these advantages, FDI helps in creating a competitive environment in the country which leads to higher efficiency and superior products and services.
Government Initiates to Promote FDI
The Indian government has initiated steps to promote FDI as they set an investor-friendly policy where most of the sectors are open for FDI under the automatic route (meaning no need to take prior approval for investment by the Government or the Reserve Bank of India). The FDI policy is reviewed on a continuous basis with the purpose that India remains an investor-friendly and attractive FDI destination. FDI covers various sectors such as Defense, Pharmaceuticals, Asset Reconstruction Companies, Broadcasting, Trading, Civil Aviation, Construction and Retail, etc.
In the Union Budget 2018, the cabinet approved 100% FDI under the automatic route for single-brand retail trading. Under this change, the non-resident entity is permitted to commence retail trading of ‘single brand’ product in India for a particular brand. Additionally, the Indian government has also permitted 100% FDI for construction sector under the automatic route. Foreign airlines are permitted to invest up to 49% under the approval route in Air India.
The main purpose of these relaxations in foreign investment by the government is to bring international best practices and employee the latest technologies which propel manufacturing sector and employment generation in India. To boost manufacturing sector with a focus on ‘Make in India’ initiative, the government has allowed manufacturers to sell their products through the medium of wholesale and retail, including e-commerce under the automatic route.
(b) What do you mean by External Commercial Borrowings? Discuss the importance of ECB as a source of foreign capital. (6+10=16)
-> The External Commercial Borrowings or ECBs is the financial instrument used to borrow money from the foreign sources of financing to invest in the commercial activities of the domestic country. Simply, borrowing money from the non-resident lenders and investing it in the commercial activities of India is called as external commercial borrowings.
The external commercial borrowings are considered as a source of finance to expand the existing capacity of the Indian corporate and finance new investment ventures, with an objective to have a sound economic growth.
The government of India seeks investment in the infrastructure and core sectors such as power, coal, railways, roads, telecom, etc. which are directly related to economic development of the country.
External commercial borrowings cannot be used for the investments in a stock market or any speculation business. And to keep a check on it, department of economic affairs, finance ministry, government of India and RBI monitor and regulates the policies of external commercial borrowings.
The ECBs is known as the money borrowed from the foreign sources or the non-resident lenders and include Commercial bank loans, Floating rate notes and fixed rate bonds (securitized instruments), Buyer’s and supplier’s credit, credit notes, mortgage-backed securities, etc.
Here, one thing should be made clear that such borrowing is a type of funding other than equity. This means, if the money is used to finance the core capital (equity shares, preference shares, convertible preference shares, convertible debentures, etc.) of any company, then it will be termed as a foreign direct investment and is not included under external commercial borrowings.
Advantages of ECBs
· ECBs provide opportunity to borrow large volume of funds
· The funds are available for relatively long term
· Interest rate are also lower compared to domestic funds
· ECBs are in the form of foreign currencies. Hence, they enable the corporate to have foreign currency to meet the import of machineries etc.
· Corporate can raise ECBs from internationally recognized sources such as banks, export credit agencies, international capital markets etc.