FINANCIAL MANAGEMENT – IMP Theory – IPCC NOV....

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FINANCIAL MANAGEMENT – IMP Theory – IPCC NOV. 2010

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TOPIC NAME PAGE NO.

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Introduction to Financial Management

Time Value of Money

Leverage

Capital Structure

Cost of Capital

Capital Budgeting

Management of Cash and Marketable Securities

Management of Account Receivable

Management of Working Capital

Sources of Finance

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Name :

Batch : Roll No. :

SEPTEMBER 2010

FM IMP Theory – IPCC Nov. 2010 P a g e | 1

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Q.1. Explain as to how the wealth maximisation objective is superior to the profit

maximisation objective.

A firm’s financial management may often have the following as their objectives:

(i) The maximisation of firm’s profit.

(ii) The maximisation of firm’s value / wealth.

The maximisation of profit is often considered as an implied objective of a firm. To

achieve the aforesaid objective various type of financing decisions may be taken.

Options resulting into maximisation of profit may be selected by the firm’s decision

makers. They even sometime may adopt policies yielding exorbitant profits in short run

which may prove to be unhealthy for the growth, survival and overall interests of the

firm. The profit of the firm in this case is measured in terms of its total accounting profit

available to its shareholders.

The value/wealth of a firm is defined as the market price of the firm’s stock. The market

price of a firm’s stock represents the focal judgment of all market participants as to

what the value of the particular firm is. It takes into account present and prospective

future earnings per share, the timing and risk of these earnings, the dividend policy of

the firm and many other factors that bear upon the market price of the stock.

The value maximisation objective of a firm is superior to its profit maximisation

objective due to following reasons.

1. The value maximisation objective of a firm considers all future cash flows,

dividends, earning per share, risk of a decision etc. whereas profit maximisation

objective does not consider the effect of EPS, dividend paid or any other returns to

shareholders or the wealth of the shareholder.

2. A firm that wishes to maximise the shareholders wealth may pay regular dividends

whereas a firm with the objective of profit maximisation may refrain from dividend

payment to its shareholders.

3. Shareholders would prefer an increase in the firm’s wealth against its generation of

increasing flow of profits.

4. The market price of a share reflects the shareholders expected return, considering

the long-term prospects of the firm, reflects the differences in timings of the

returns, considers risk and recognizes the importance of distribution of returns.

Part I – Important Theory Questions

Chapter 1: Introduction to Financial

Management


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The maximisation of a firm’s value as reflected in the market price of a share is viewed

as a proper goal of a firm. The profit maximisation can be considered as a part of the

wealth maximisation strategy.

Q.2. Discuss the functions of a Chief Financial Officer.

Functions of a Chief Financial Officer

The twin aspects viz procurement and effective utilization of funds are the crucial tasks,

which the CFO faces. The Chief Finance Officer is required to look into financial

implications of any decision in the firm. Thus all decisions involving management of

funds comes under the purview of finance manager. These are namely

− Estimating requirement of funds

− Decision regarding capital structure

− Investment decisions

− Dividend decision

− Cash management

− Evaluating financial performance

− Financial negotiation

− Keeping touch with stock exchange quotations & behaviour of share prices.

Q.3. Inter relationship between investment, financing and dividend decisions.

Inter-relationship between Investment, Financing and Dividend Decisions

The finance functions are divided into three major decisions, viz., investment, financing

and dividend decisions. It is correct to say that these decisions are inter-related because

the underlying objective of these three decisions is the same, i.e. maximisation of

shareholders’ wealth. Since investment, financing and dividend decisions are all

interrelated, one has to consider the joint impact of these decisions on the market price

of the company’s shares and these decisions should also be solved jointly. The decision

to invest in a new project needs the finance for the investment. The financing decision,

in turn, is influenced by and influences dividend decision because retained earnings

used in internal financing deprive shareholders of their dividends. An efficient financial

management can ensure optimal joint decisions. This is possible by evaluating each

decision in relation to its effect on the shareholders’ wealth.

The above three decisions are briefly examined below in the light of their inter-

relationship and to see how they can help in maximising the shareholders’ wealth i.e.

market price of the company’s shares.

Investment decision: The investment of long term funds is made after a careful

assessment of the various projects through capital budgeting and uncertainty analysis.

However, only that investment proposal is to be accepted which is expected to yield at


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least so much return as is adequate to meet its cost of financing. This have an influence

on the profitability of the company and ultimately on its wealth.

Financing decision: Funds can be raised from various sources. Each source of funds

involves different issues. The finance manager has to maintain a proper balance

between long-term and short-term funds. With the total volume of long-term funds, he

has to ensure a proper mix of loan funds and owner’s funds. The optimum financing mix

will increase return to equity shareholders and thus maximise their wealth.

Dividend decision: The finance manager is also concerned with the decision to pay or

declare dividend. He assists the top management in deciding as to what portion of the

profit should be paid to the shareholders by way of dividends and what portion should

be retained in the business. An optimal dividend pay-out ratio maximises shareholders’

wealth.

The above discussion makes it clear that investment, financing and dividend decisions

are interrelated and are to be taken jointly keeping in view their joint effect on the

shareholders’ wealth.

Q.4. Explain the two basic functions of Financial Management.

Two Basic Functions of Financial Management

Procurement of Funds: Funds can be obtained from different sources having different

characteristics in terms of risk, cost and control. The funds raised from the issue of

equity shares are the best from the risk point of view since repayment is required only

at the time of liquidation. However, it is also the most costly source of finance due to

dividend expectations of shareholders. On the other hand, debentures are cheaper than

equity shares due to their tax advantage. However, they are usually riskier than equity

shares. There are thus risk, cost and control considerations which a finance manager

must consider while procuring funds. The cost of funds should be at the minimum level

for that a proper balancing of risk and control factors must be carried out.

Effective Utilization of Funds: The Finance Manager has to ensure that funds are not kept

idle or there is no improper use of funds. The funds are to be invested in a manner such

that they generate returns higher than the cost of capital to the firm. Besides this,

decisions to invest in fixed assets are to be taken only after sound analysis using capital

budgeting techniques. Similarly, adequate working capital should be maintained so as to

avoid the risk of insolvency.

Q.5. Discuss conflict in profit versus wealth maximization objective.

Conflict in Profit versus Wealth Maximization Objective

Profit maximisation is a short–term objective and cannot be the sole objective of a

company. It is at best a limited objective. If profit is given undue importance, a number

of problems can arise like the term profit is vague, profit maximisation has to be

attempted with a realisation of risks involved, it does not take into account the time

pattern of returns and as an objective it is too narrow.


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Whereas, on the other hand, wealth maximisation, is a long-term objective and means

that the company is using its resources in a good manner. If the share value is to stay

high, the company has to reduce its costs and use the resources properly. If the company

follows the goal of wealth maximisation, it means that the company will promote only

those policies that will lead to an efficient allocation of resources.

Q.6. Explain the limitations of profit maximization objective of Financial Management.

Limitations of Profit Maximisation Objective of Financial Management

(a) Time factor is ignored.

(b) It is vague because it is not clear whether the term relates to economic profit,

accounting profit, profit after tax or before tax.

(c) The term maximization is also ambiguous.

(d) It ignores the risk factor.

Q.7. Differentiate between Financial Management and Financial Accounting.

Differentiation between Financial Management and Financial Accounting

Though financial management and financial accounting are closely related, still they

differ in the treatment of funds and also with regards to decision - making.

Treatment of Funds: In accounting, the measurement of funds is based on the accrual

principle. The accrual based accounting data do not reflect fully the financial conditions

of the organisation. An organisation which has earned profit (sales less expenses) may

said to be profitable in the accounting sense but it may not be able to meet its current

obligations due to shortage of liquidity as a result of say, uncollectible receivables.

Whereas, the treatment of funds, in financial management is based on cash flows. The

revenues are recognised only when cash is actually received (i.e. cash inflow) and

expenses are recognised on actual payment (i.e. cash outflow). Thus, cash flow based

returns help financial managers to avoid insolvency and achieve desired financial goals.

Decision-making: The chief focus of an accountant is to collect data and present the data

while the financial manager’s primary responsibility relates to financial planning,

controlling and decisionmaking. Thus, in a way it can be stated that financial

management begins where financial accounting ends.

Q.8. Explain importance of financial management.

The best way to demonstrate the importance of good financial management is to

describe some of the tasks that it involves:-

- Taking care not to over-invest in fixed assets

- Balancing cash-outflow with cash-inflows

- Ensuring that there is a sufficient level of short-term working capital


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- Setting sales revenue targets that will deliver growth

- Increasing gross profit by setting the correct pricing for products or services

- Controlling the level of general and administrative expenses by finding more cost-

efficient ways of running the day-to-day business operations, and

- Tax planning that will minimize the taxes a business has to pay.

Q.9. Explain the finance function in large organisation.


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Q.1. Explain the relevance of time value of money in financial decisions.

Time value of money means that worth of a rupee received today is different from the

worth of a rupee to be received in future. The preference of money now as compared to

future money is known as time preference for money.

A rupee today is more valuable than rupee after a year due to several reasons:

o Risk - there is uncertainty about the receipt of money in future.

o Preference for present consumption - Most of the persons and companies in

general,

o prefer current consumption over future consumption.

o Inflation - In an inflationary period a rupee today represents a greater real

purchasing power than a rupee a year hence.

o Investment opportunities - Most of the persons and companies have a preference

for present money because of availabilities of opportunities of investment for

earning additional cash flow.

Many financial problems involve cash flow accruing at different points of time for

evaluating such cash flow an explicit consideration of time value of money is required.

Chapter 2: Time Value of Money


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Q.1. Discuss the impact of financial leverage on shareholders wealth by using return-

on-assets (ROA) and return-on-equity (ROE) analytic framework.

The impact of financial leverage on ROE is positive, if cost of debt (after-tax) is less than

ROA. But it is a double-edged sword.

ROA = employed Capital

Sales

Sales

NOPAT×

ROE = ROA + E

D (ROA − Kd)

Where

NOPAT = EBIT * ( 1 − Tc)

Capital employed = Shareholders funds + Loan funds

D = Debt amount in capital structure

E = Equity capital amount in capital structure

Kd = Interest rate * ( 1 − Tc) in case of fresh loans of a company.

Kd = Yield to maturity *(1−Tc) in case of existing loans of a company.

Q.2. Differentiate between Business risk and Financial risk.

Business Risk and Financial Risk

Business risk refers to the risk associated with the firm’s operations. It is an

unavoidable risk because of the environment in which the firm has to operate and the

business risk is represented by the variability of earnings before interest and tax (EBIT).

The variability in turn is influenced by revenues and expenses. Revenues and expenses

are affected by demand of firm’s products, variations in prices and proportion of fixed

cost in total cost.

Whereas, Financial risk refers to the additional risk placed on firm’s shareholders as a

result of debt use in financing. Companies that issue more debt instruments would have

higher financial risk than companies financed mostly by equity. Financial risk can be

measured by ratios such as firm’s financial leverage multiplier, total debt to assets ratio

etc.

Chapter 3: Leverage


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Q.3. Explain advantages of Debt in using capital structure.

Financing a business through borrowing is cheaper than using equity. This is because:

- Lenders require a lower rate of return than ordinary shareholders. Debt financial

securities present a lower risk than shares for the finance providers because they

have prior claims on annual income and liquidation.

- A profitable business effectively pays less for debt capital than equity for another

reason: the debt interest can be offset against pre-tax profits before the calculation

of the corporate tax, thus reducing the tax paid.

- Issuing and transaction costs associated with raising and servicing debt are

generally less than for ordinary shares.

These are some benefits from financing a firm with debt. Still firms tend to avoid very

high gearing levels.


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Q.1. Discuss the major considerations in capital structure planning.

Major considerations in capital structure planning

There are three major considerations, i.e. risk, cost of capital and control, which help the

finance manager in determining the proportion in which he can raise funds from various

sources.

Although, three factors, i.e., risk, cost and control determine the capital structure of a

particular business undertaking at a given point of time.

Risk: The finance manager attempts to design the capital structure in such a manner, so

that risk and cost are the least and the control of the existing management is diluted to

the least extent. However, there are also subsidiary factors also like − marketability of

the issue, maneuverability and flexibility of the capital structure, timing of raising the

funds. Risk is of two kinds, i.e., Financial risk and Business risk. Here we are concerned

primarily with the financial risk. Financial risk also is of two types:

• Risk of cash insolvency

• Risk of variation in the expected earnings available to equity share-holders

Cost of Capital: Cost is an important consideration in capital structure decisions. It is

obvious that a business should be at least capable of earning enough revenue to meet its

cost of capital and finance its growth. Hence, along with a risk as a factor, the finance

manager has to consider the cost aspect carefully while determining the capital

structure.

Control: Along with cost and risk factors, the control aspect is also an important

consideration in planning the capital structure. When a company issues further equity

shares, it automatically dilutes the controlling interest of the present owners. Similarly,

preference shareholders can have voting rights and thereby affect the composition of

the Board of Directors, in case dividends on such shares are not paid for two

consecutive years. Financial institutions normally stipulate that they shall have one or

more directors on the Boards. Hence, when the management agrees to raise loans from

financial institutions, by implication it agrees to forego a part of its control over the

company. It is obvious, therefore, that decisions concerning capital structure are taken

after keeping the control factor in mind.

Q.2. Explain, briefly, Modigliani and Miller approach on Cost of Capital

Modigliani and Miller approach to Cost of Capital: Modigliani and Miller’s argue that

the total cost of capital of a particular corporation is independent of its methods and

level of financing. According to them a change in the debt equity ratio does not affect the

cost of capital. This is because a change in the debt equity ratio changes the risk element

of the company which in turn changes the expectations of the shareholders from the

Chapter 4: Capital Structure


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particular shares of the company. Hence they contend that leverages has little effect on

the overall cost of capital or on the market price.

Modigliani and Miller made the following assumptions and the derivations there from:

Assumptions:

(i) Capital markets are perfect. Information is costless and readily available to all

investors, there are no transaction costs; and all securities are infinitely divisible.

Investors are assumed to be rational and to behave accordingly.

(ii) The average expected future operating earnings of a firm are represented by a

subjective random variable. It is assumed that the expected values of the

probability distributions of all investors are the same. Implied in the MM

illustration is that the expected values of the probability distributions of expected

operating earnings for all future periods are the same as present operating

earnings.

(iii) Firms can be categorised into “equivalent return” classes. All firms within a class

have the same degree of business risk.

(iv) The absence of corporate income taxes is assumed.

Their three basic propositions are :

(i) The total market value of the firm and its cost of capital are independent of its

capital structure. The total market value of a firm is given by capitalising the

expected stream of operating earnings at a discount rate appropriate for its risk

class.

(ii) The expected yield of a share of stock, Ke is equal to the capitalisation rate of a pure

equity stream, plus a premium for financial risk equal to the difference between the

pure equity capitalization rate and Kg times the ratio B/S. In other words, Ke

increases in a manner to exactly offset the use of cheaper debt funds.

(iii) The cut-off rate for investment purposes is completely independent of the way in

which an investment is financed. This proposition alongwith the first implies a

complete separation of the investment and financing decisions of the firm.

Conclusion: The theory propounded by them is based on the prevalence of perfect

market conditions which are rare to find. Corporate taxes and personal taxes are a

reality and they exert appreciable influence over decision making whether to have debt

or equity.

Q.3. Discuss the relationship between the financial leverage and firms required rate of

return to equity shareholders as per Modigliani and Miller Proposition II.

Relationship between the financial leverage and firm’s required rate of return to equity

shareholders with corporate taxes is given by the following relation :

rE = r0 + )r(r )T(1E

DBOC −−


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Where,

rE = required rate of return to equity shareholders

r0 = required rate of return for an all equity firm

D = Debt amount in capital structure

E = Equity amount in capital structure

TC = Corporate tax rate

r B = required rate of return to lenders

Q.4. Explain the principles of “Trading on equity”.

The term trading on equity means debts are contracted and loans are raised mainly on

the basis of equity capital. Those who provide debt have a limited share in the firm’s

earning and hence want to be protected in terms of earnings and values represented by

equity capital. Since fixed charges do not vary with firms earning before interest and tax,

a magnified effect is produced on earning per share. Whether the leverage is favourable,

in the sense, increase in earning per share more proportionately to the increased

earning before interest and tax, depends on the profitability of investment proposal. If

the rate of returns on investment exceeds their explicit cost, financial leverage is said to

be positive.

Q.5. Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while

determining the capital structure of a company.

Concept of Debt-Equity or EBIT-EPS Indifference Point while Determining the

Capital Structure of a Company

The determination of optimum level of debt in the capital structure of a company is a

formidable task and is a major policy decision. It ensures that the firm is able to service

its debt as well as contain its interest cost. Determination of optimum level of debt

involves equalizing between return and risk.

EBIT – EPS analysis is a widely used tool to determine level of debt in a firm. Through

this analysis, a comparison can be drawn for various methods of financing by obtaining

indifference point. It is a point to the EBIT level at which EPS remains unchanged

irrespective of debt-equity mix. The indifference point for the capital mix (equity share

capital and debt) can be determined as follows:

( )( )

1

1

E

T1IEBIT −− =

( )( )2

2

E

T1IEBIT −−


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Q.6. Explain the assumptions of Net Operating Income approach (NOI) theory of

capital structure.

Assumptions of Net Operating Income (NOI) Theory of Capital Structure

According to NOI approach, there is no relationship between the cost of capital and

value of the firm i.e. the value of the firm is independent of the capital structure of the

firm.

Assumptions

(a) The corporate income taxes do not exist.

(b) The market capitalizes the value of the firm as whole. Thus the split between debt

and equity is not important.

(c) The increase in proportion of debt in capital structure leads to change in risk

perception of the shareholders.

(d) The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.

Q.7. What do you understand by optimal capital structure?

The theory of optimal capital structure deals with the issue of the right mix of debt and

equity in the long term capital structure of a firm. This theory states that if a company

takes on debt, the value of the firm increases up to a point. Beyond that point if debt

continues to increase then the value of the firm will start to decrease. Similarly if the

company is unable to repay the debt within the specified period then it will affect the

goodwill of the company in the market and may create problems for collecting further

debt. Therefore, the company should select its appropriate capital structure with due

consideration to the factors mentioned above.

Q.8. Write short note on Over Capitalisation.

It is a situation where a firm has more capital than it needs or in other words assets are

worth less than its issued share capital, and earnings are insufficient to pay dividend

and interest. This situation mainly arises when the existing capital is not effectively

utilized on account of fall in earning capacity of the company while company has raised

funds more than its requirements. The chief sign of over-capitalisation is the fall in

payment of dividend and interest leading to fall in value of the shares of the company.

1. Causes of Over Capitalization

Over-capitalisation arises due to following reasons:

(i) Raising more money through issue of shares or debentures than company can

employ profitably.

(ii) Borrowing huge amount at higher rate than rate at which company can earn.

(iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.


ZPAPL/IPCC/FM/2010

(iv) Improper provision for depreciation, replacement of assets and distribution

of dividends at a higher rate.

(v) Wrong estimation of earnings and capitalization.

2. Consequences of Over-Capitalisation

Over-capitalisation shall result into following consequences:

(i) Considerable reduction in the rate of dividend and interest payments.

(ii) Reduction in the market price of shares.

(iii) Resorting of “window dressing”.

(iv) Some company may opt for reorganization. However, sometimes the matter

goes worse, the company may go into liquidation.

3. Remedies for Over-Capitalisation

Following steps may be adopted to avoid the evil consequences of over-

capitalisation:

(i) Company should go for thorough reorganization.

(ii) Buyback of shares.

(iii) Reduction in claims of debenture-holders and creditors.

(iv) Value of share may also be reduced. This will result insufficient funds for the

company to carry out replacement of assets.

Q.9. Write short note on Under Capitalisation.

It is just reverse of over-capitalisation. It is a state, when its actual capitalization is lower

than its proper capitalization as warranted by its earning capacity.

This situation normally happens with companies which have insufficient capital but

large secret reserves in the form of considerable appreciation in the values of the fixed

assets not brought into the books.

According to Gerstenberg “a corporation may be under capitalized when the rate of

profit is exceptionally high in relation to the return enjoyed by similar situated

companies in the same industry. He adds further that in case of such companies “the

assets may be worth more than the values reflected in the books”. Other authors such as

Hoagland also confirms this view by defining “an excess of true asset values over the

aggregate of stocks and bonds outstandings”.

1. Consequences of Under Capitalization

Under-capitalisation results in following consequences:

(i) The dividend rate will be higher in comparison of similarly situated other

companies.


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(ii) Market value of shares shall be higher than value of share of other similar

companies because their earning rate being considerably more than the

prevailing rate on such securities.

(iii) Real value of shares shall be higher than their book value.

2. Effects of Under Capitalization

Under-capitalisation has the following effects:

(i) It encourages acute competition. High profitability encourages new

entrepreneurs to come into same type of business.

(ii) High rate of dividend encourages the workers’ union to demand high wages.

(iii) Normally common people (consumers) start feeling that they are being

exploited.

(iv) Management may resort to manipulate the share values.

(v) Invite more government control and regulation on the company and higher

taxation also.

3. Remedies

Following steps may be adopted to avoid the evil consequences of under

capitalization:

(i) The shares of the company should be split up. This will reduce dividend per

share, though EPS shall remain unchanged.

(ii) Issue of Bonus Shares is the most appropriate measure as this will reduce

both dividend per share and the average rate of earning.

(iii) By revising upward the par value of shares in exchange of the existing shares

held by them.

4. Over Capitalization vis-à-vis Under Capitalization

From above discussion it can be said that both over capitalization and under

capitalisation are bad.

However, over capitalisation is more dangerous to the company, shareholders and

the society than under capitalization.

The situation of under capitalization can be handled more easily than the situation

of over capitalisation.

Moreover under capitalization is not an economic problem but a problem of

adjusting capital structure.

Thus, under capitalization should be considered less dangerous, both situations are

bad and every company should strive to have a proper capitalization.


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Q.1. What do you understand by Weighted Average Cost of Capital?

Weighted Average Cost of Capital

The composite or overall cost of capital of a firm is the weighted average of the costs of

various sources of funds. Weights are taken in proportion of each source of funds in

capital structure while making financial decisions. The weighted average cost of capital

is calculated by calculating the cost of specific source of fund and multiplying the cost of

each source by its proportion in capital structure. Thus, weighted average cost of capital

is the weighted average after tax costs of the individual components of firm’s capital

structure. That is, the after tax cost of each debt and equity is calculated separately and

added together to a single overall cost of capital.

Q.2. Discuss the dividend-price approach, and earnings price approach to estimate

cost of equity capital.

In dividend price approach, cost of equity capital is computed by dividing the current

dividend by average market price per share. This ratio expresses the cost of equity

capital in relation to what yield the company should pay to attract investors. It is

computed as:

o

1e

P

DK =

Where,

D1 = Dividend per share in period 1

P0 = Market price per share today

Whereas, on the other hand, the advocates of earnings price approach co-relate the

earnings of the company with the market price of its share. Accordingly, the cost of

ordinary share capital would be based upon the expected rate of earnings of a company.

This approach is similar to dividend price approach, only it seeks to nullify the effect of

changes in dividend policy.

Q.3. Write a short note on capital Asset Pricing model (CAPM).

Capital Asset Pricing Model Approach (CAPM): CAPM model describes the risk-

return trade-off for securities. It describes the linear relationship between risk and

return for securities. The risks to which a security is exposed are divided into two

groups, diversifiable and non-diversifiable.

The diversifiable risk can be eliminated through a portfolio consisting of large number

of well diversified securities.

Chapter 5: Cost of Capital


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The non-diversifiable risk is attributable to factors that affect all businesses. Examples

of such risks are:-

- Interest Rate Changes

- Inflation

- Political Changes etc.

As diversifiable risk can be eliminated by an investor through diversification, the non-

diversifiable risk in the only element risk, therefore a business should be concerned as

per CAPM method, solely with non-diversifiable risk.

The non-diversifiable risks are assessed in terms of beta coefficient (b or β)

Thus, the cost of equity capital can be calculated under this approach as:

Ke = Rf + b (Rm − Rf)

Where,

Ke = Cost of equity capital

Rf = Rate of return on security

b = Beta coefficient

Rm = Rate of return on market portfolio


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Q.1. Do the profitability index and the NPV criterion of evaluating investment

proposals lead to the same acceptance-rejection and ranking decisions? In what

situations will they give conflicting results?

In the most of the situations the Net Present Value Method (NPV) and Profitability Index

(PI) yield same accept or reject decision. In general items, under PI method a project is

acceptable if profitability index value is greater than 1 and rejected if it less than 1.

Under NPV method a project is acceptable if Net present value of a project is positive

and rejected if it is negative. Clearly a project offering a profitability index greater than 1

must also offer a net present value which is positive. But a conflict may arise between

two methods if a choice between mutually exclusive projects has to be made. Consider

the following example:

Project A Project B

PV of Cash inflows 2,00,000 1,00,000

Initial cash outflows 1,00,000 40,000

Net present value 1,00,000 60,000

P.I 2

000,00,1

000,00,2= 5.2

000,40

000,00,1=

According to NPV method, project A would be preferred, whereas according to

profitability index method project B would be preferred.

This is because Net present value gives ranking on the basis of absolute value of rupees.

Whereas profitability index gives ranking on the basis of ratio. Although PI method is

based on NPV, it is a better evaluation technique than NPV in a situation of capital

rationing.

Q.2. Distinguish between Net Present Value and Internal Rate of Return.

NPV and IRR: NPV and IRR methods differ in the sense that the results regarding the

choice of an asset under certain circumstances are mutually contradictory under two

methods. In case of mutually exclusive investment projects, in certain situations, they

may give contradictory results such that if the NPV method finds one proposal

acceptable, IRR favours another. The different rankings given by the NPV and IRR

methods could be due to size disparity problem, time disparity problem and unequal

expected lives.

The net present value is expressed in financial values whereas internal rate of return

(IRR) is expressed in percentage terms.

In the net present value cash flows are assumed to be re-invested at cost of capital rate.

In IRR reinvestment is assumed to be made at IRR rates.

Chapter 6: Capital Budgeting


ZPAPL/IPCC/FM/2010

Q.3. Write a short note on internal rate of return.

Internal Rate of Return: It is that rate at which discounted cash inflows are equal to

the discounted cash outflows. In other words, it is the rate which discounts the cash

flows to zero. It can be stated in the form of a ratio as follows:

1Outflows Cash

inflows Cash=

This rate is to be found by trial and error method. This rate is used in the evaluation of

investment proposals. In this method, the discount rate is not known but the cash

outflows and cash inflows are known.

In evaluating investment proposals, internal rate of return is compared with a required

rate of return, known as cut-off rate. If it is more than cut-off rate the project is treated

as acceptable; otherwise project is rejected.

Q.4. What is Capital rationing? Describe various ways of implementing it.

Capital Rationing: Generally, firms fix up maximum amount that can be invested in

capital projects during a given period of time, say a year. The firm then attempts to

select a combination of investment proposals that will be within the specific limits

providing maximum profitability and rank them in descending order according to their

rate of return; such a situation is of capital rationing.

A firm should accept all investment projects with positive NPV, with an objective to

maximise the wealth of shareholders. However, there may be resource constraint due to

which a firm may have to select from among various projects. Thus, capital rationing

situation may arises when there may be internal or external constraints on procurement

of necessary funds to invest in all investment proposals with positive NPVs.

Ways of implementing Capital Rationing

(i) It may be implemented through budgets.

(ii) It can be done by putting up a ceiling when it has been financing investment

proposals only by way of retained earnings.

(iii) It can also be done by ‘Responsibility Accounting’, whereby management may

authorise a particular department to make investment only up to a specified limit,

beyond which the investment decisions are to be taken by higher-ups.

Q.5. Define Modified Internal Rate of Return method.

Modified Internal Rate of Return (MIRR): There are several limitations attached with

the concept of the conventional Internal Rate of Return. The MIRR addresses some of

these deficiencies. For example, it eliminates multiple IRR rates; it addresses the

reinvestment rate issue and produces results, which are consistent with the Net Present

Value method.


ZPAPL/IPCC/FM/2010

Under this method, all cash flows, apart from the initial investment, are brought to the

terminal value using an appropriate discount rate(usually the cost of capital). This

results in a single stream of cash inflow in the terminal year. The MIRR is obtained by

assuming a single outflow in the zeroth year and the terminal cash in flow as mentioned

above. The discount rate which equates the present value of the terminal cash in flow to

the zeroth year outflow is called the MIRR.

Q.6. Explain the concept of Multiple Internal Rate of Return.

Multiple Internal Rate of Return (MIRR)

In cases where project cash flows change signs or reverse during the life of a project for

example, an initial cash outflow is followed by cash inflows and subsequently followed

by a major cash outflow, there may be more than one internal rate of return (IRR). The

following graph of discount rate versus net present value (NPV) may be used as an

illustration:

In such situations if the cost of capital is less than the two IRRs, a decision can be made

easily, however, otherwise the IRR decision rule may turn out to be misleading as the

project should only be invested if the cost of capital is between IRR1 and IRR2. To

understand the concept of multiple IRRs it is necessary to understand the implicit re-

investment assumption in both NPV and IRR techniques.

Q.7. Explain the concept of discounted payback period.

Concept of Discounted Payback Period

Payback period is time taken to recover the original investment from project cash flows.

It is also termed as break even period. The focus of the analysis is on liquidity aspect

and it suffers from the limitation of ignoring time value of money and profitability.

Discounted payback period considers present value of cash flows, discounted at

company’s cost of capital to estimate breakeven period i.e. it is that period in which

future discounted cashflows equal the initial outflow. The shorter the period, better it is.

It also ignores post discounted payback period cash flows.


ZPAPL/IPCC/FM/2010

Q.8. Explain the term “Desirability factor”.

Desirability Factor: In certain cases we have to compare a number of proposals each

involving different amount of cash inflows. One of the methods of comparing such

proposals is to work out, what is known as the ‘Desirability Factor’ or ‘Profitability

Index’. In general terms, a project is acceptable if the Profitability Index is greater than

1.

Mathematically,

Desirability Factor = outflows Cash Discounted Total of Outlay Cash Initial

inflows Cash Discounted of Sum

Q.9. Why Capital Budgeting Decisions are important for the business ?

The capital budgeting decisions are important, crucial and critical business decisions

due to following reasons:

(i) Substantial expenditure: Capital budgeting decisions involves the investment of

substantial amount of funds. It is therefore necessary for a firm to make such

decisions after a thoughtful consideration so as to result in the profitable use of its

scarce resources.

The hasty and incorrect decisions would not only result into huge losses but may

also account for the failure of the firm.

(ii) Long time period: The capital budgeting decision has its effect over a long period

of time. These decisions not only affect the future benefits and costs of the firm but

also influence the rate and direction of growth of the firm.

(iii) Irreversibility: Most of the investment decisions are irreversible. Once they are

taken, the firm may not be in a position to reverse them back. This is because, as it

is difficult to find a buyer for the second-hand capital items.

(iv) Complex decision: The capital investment decision involves an assessment of

future events, which in fact is difficult to predict. Further it is quite difficult to

estimate in quantitative terms all the benefits or the costs relating to a particular

investment decision.

Q.10. Explain various types of Capital Budgeting decisions.

There are many ways to classify the capital budgeting decision. Generally capital

investment decisions are classified in two ways. One way is to classify them on the basis

of firm’s existence. Another way is to classify them on the basis of decision situation.

On the basis of firm’s existence: The capital budgeting decisions are taken by both

newly incorporated firms as well as by existing firms. The new firms may be required to

take decision in respect of selection of a plant to be installed. The existing firm may be

required to take decisions to meet the requirement of new environment or to face the

challenges of competition. These decisions may be classified as follows:


ZPAPL/IPCC/FM/2010

(i) Replacement and Modernisation decisions: The replacement and modernization

decisions aim at to improve operating efficiency and to reduce cost. Generally all

types of plant and machinery require replacement either because of the economic

life of the plant or machinery is over or because it has become technologically

outdated. The former decision is known as replacement decisions and later one is

known as modernization decisions. Both replacement and modernisation decisions

are called cost reduction decisions.

(ii) Expansion decisions: Existing successful firms may experience growth in demand

of their product line. If such firms experience shortage or delay in the delivery of

their products due to inadequate production facilities, they may consider proposal

to add capacity to existing product line.

(iii) Diversification decisions: These decisions require evaluation of proposals to

diversify into new product lines, new markets etc. for reducing the risk of failure by

dealing in different products or by operating in several markets.

Both expansion and diversification decisions are called revenue expansion decisions.

On the basis of decision situation: The capital budgeting decisions on the basis of

decision situation are classified as follows:

(i) Mutually exclusive decisions: The decisions are said to be mutually exclusive if

two or more alternative proposals are such that the acceptance of one proposal will

exclude the acceptance of the other alternative proposals. For instance, a firm may

be considering proposal to install a semi-automatic or highly automatic machine. If

the firm install a semi-automatic machine it exclude the acceptance of proposal to

install highly automatic machine.

(ii) Accept-reject decisions: The accept-reject decisions occur when proposals are

independent and do not compete with each other. The firm may accept or reject a

proposal on the basis of a minimum return on the required investment. All those

proposals which give a higher return than certain desired rate of return are

accepted and the rest are rejected.

(iii) Contingent decisions: The contingent decisions are dependable proposals. The

investment in one proposal requires investment in one or more other proposals.

For example if a company accepts a proposal to set up a factory in remote area it

may have to invest in infrastructure also e.g. building of roads, houses for

employees etc.


ZPAPL/IPCC/FM/2010

Q.1. Discuss Miller-Orr Cash Management model.

Miller – Orr Cash Management Model

According to this model the net cash flow is completely stochastic. When changes in

cash balance occur randomly, the application of control theory serves a useful purpose.

The Miller – Orr model is one of such control limit models. This model is designed to

determine the time and size of transfers between an investment account and cash

account. In this model control limits are set for cash balances. These limits may consist

of ‘h’ as upper limit, ‘z’ as the return point and zero as the lower limit.

When the cash balance reaches the upper limit, the transfer of cash equal to ‘h – z’ is

invested in marketable securities account. When it touches the lower limit, a transfer

from marketable securities account to cash account is made. During the period when

cash balance stays between (h, z) and (z, 0) i.e. high and low limits, no transactions

between cash and marketable securities account is made. The high and low limits of

cash balance are set up on the basis of fixed cost associated with the securities

transaction, the opportunities cost of holding cash and degree of likely fluctuations in

cash balances. These limits satisfy the demands for cash at the lowest possible total

costs. The formula for calculation of the spread between the control limits is:

Spread =

3/1

rate Interest

Cashflows of VarianceCost nTransactio3/43

××

And, the return point can be calculated using the formula:

Return point = Lower limit + 3

Spread

Chapter 7: Management of Cash and

Marketable Securities


ZPAPL/IPCC/FM/2010

Q.2. Explain Baumol’s Model of Cash Management.

William J. Baumol developed a model for optimum cash balance which is normally used

in inventory management. The optimum cash balance is the trade-off between cost of

holding cash (opportunity cost of cash held) and the transaction cost (i.e. cost of

converting marketable securities in to cash). Optimum cash balance is reached at a point

where the two opposing costs are equal and where the total cost is minimum. This can

be explained with the following diagram:

Transaction Cost

Holding CostCost(Rs.)

Total Cost

Optimum Cash Balance

The optimum cash balance can also be computed algebraically.

Optimum Cash Balance = H

AT2

A = Annual Cash disbursements

T = Transaction cost (Fixed cost) per transaction

H = Opportunity cost one rupee per annum (Holding cost)

The model is based on the following assumptions:

(i) Cash needs of the firm are known with certainty.

(ii) The cash is used uniformly over a period of time and it is also known with certainty.

(iii) The holding cost is known and it is constant.

(iv) The transaction cost also remains constant.

Q.3. Explain briefly the functions of Treasury Department. (PCC-May 2008 & June

2009)(3 marks)

The functions of treasury department management is to ensure proper usage, storage

and risk management of liquid funds so as to ensure that the organisation is able to

meet its obligations, collect its receivables and also maximize the return on its

investments. Towards this end the treasury function may be divided into the following:


ZPAPL/IPCC/FM/2010

(i) Cash Management: The efficient collection and payment of cash both inside the

organization and to third parties is the function of treasury department. Treasury

normally manages surplus funds in an investment portfolio.

(ii) Currency Management: The treasury department manages the foreign currency

risk exposure of the company. It advises on the currency to be used when invoicing

overseas sales. It also manages any net exchange exposures in accordance with the

company policy.

(iii) Fund Management: Treasury department is responsible for planning and sourcing

the company’s short, medium and long-term cash needs. It also participates in the

decision on capital structure and forecasts future interest and foreign currency

rates.

(iv) Banking: Since short-term finance can come in the form of bank loans or through

the sale of commercial paper in the money market, therefore, treasury department

carries out negotiations with bankers and acts as the initial point of contact with

them.

(v) Corporate Finance: Treasury department is involved with both acquisition and

disinvestment activities within the group. In addition, it is often responsible for

investor relations.


ZPAPL/IPCC/FM/2010

Q.1. Explain the ‘Aging Schedule’ in the context of monitoring of receivables.

Ageing Schedule : An important means to get an insight into collection pattern of

debtors is the preparation of their ‘Ageing Schedule’. Receivables are classified

according to their age from the date of invoicing e.g. 0 – 30 days, 31 – 60 days , 61 – 90

days, 91 – 120 days and more. The ageing schedule can be compared with earlier

month’s figures or the corresponding month of the earlier year.

This classification helps the firm in its collection efforts and enables management to

have a close control over the quality of individual accounts. The ageing schedule can be

compared with other firms also.

Q.2. Write short notes on the following:

(a) Different kinds of float with reference to management of cash.

(b) Factoring

(a) Different Kinds of Float with Reference to Management of Cash: The term float is

used to refer to the periods that affect cash as it moves through the different stages of

the collection process. Four kinds of float can be identified:

(i) Billing Float: An invoice is the formal document that a seller prepares and sends to

the purchaser as the payment request for goods sold or services provided. The time

between the sale and the mailing of the invoice is the billing float.

(ii) Mail Float: This is the time when a cheque is being processed by post office,

messenger service or other means of delivery.

(iii) Cheque processing float: This is the time required for the seller to sort, record and

deposit the cheque after it has been received by the company.

(iv) Bank processing float: This is the time from the deposit of the cheque to the

crediting of funds in the seller’s account.

(b) Factoring: Factoring is a new financial service that is presently being developed in

India. Factoring involves provision of specialised services relating to credit

investigation, sales ledger management, purchase and collection of debts, credit

protection as well as provision of finance against receivables and risk bearing. In

factoring, accounts receivables are generally sold to a financial institution (a subsidiary

of commercial bank-called “Factor”), who charges commission and bears the credit risks

associated with the accounts receivables purchased by it.

Its operation is very simple. Clients enter into an agreement with the “factor” working

out a factoring arrangement according to his requirements. The factor then takes the

Chapter 8: Management of Account

Receivable


ZPAPL/IPCC/FM/2010

responsibility of monitoring, follow-up, collection and risk-taking and provision of

advance. The factor generally fixes up a limit customer-wise for the client (seller).

Factoring offers the following advantages which makes it quite attractive to many firms.

(1) The firm can convert accounts receivables into cash without bothering about

repayment.

(2) Factoring ensures a definite pattern of cash in flows.

(3) Continuous factoring virtually eliminates the need for the credit department. That

is why receivables financing through factoring is gaining popularly as useful source

of financing short-term funds requirements of business enterprises because of the

inherent advantage of flexibility it affords to the borrowing firm. The seller firm

may continue to finance its receivables on a more or less automatic basis. If sales

expand or contract it can vary the financing proportionally.

(4) Unlike an unsecured loan, compensating balances are not required in this case.

Another advantage consists of relieving the borrowing firm of substantially credit

and collection costs and to a degree from a considerable part of cash management.

However, factoring as a means of financing is comparatively costly source of financing

since its cost of financing is higher than the normal lending rates.


ZPAPL/IPCC/FM/2010

Q.1. Discuss the factors to be taken into consideration while determining the

requirement of working capital.

Factors to be taken into consideration while determining the requirement of

working capital:

(i) Production Policies (ii) Nature of the business

(iii) Credit policy (iv) Inventory policy

(v) Abnormal factors (vi) Market conditions

(vii) Conditions of supply (viii) Business cycle

(ix) Growth and expansion (x) Level of taxes

(xi) Dividend policy (xii) Price level changes

(xiii) Operating efficiency.

Q.2. Why Working Capital Management is important to the firm?

There are many aspects of working capital management which makes it important

function of financial management.

- Time: Working capital management requires much of the finance manager’s time.

- Investment: Working capital represents a large portion of the total investment in

assets.

- Credibility: Working capital management has great significance for all firms but it is

very critical for small firms.

- Growth: The need for working capital is directly related to the firm’s growth.

Q.3. Explain importance of Adequate Working Capital.

Management of working capital is an essential task of the finance manager. He has to

ensure that the amount of working capital available with his concern is neither too large

nor too small for its requirements.

A large amount of working capital would mean that the company has idle funds. Since

funds have a cost, the company has to pay huge amount as interest on such funds.

If the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity

of working capital may lead to a situation where the firm may not be able to meet its

liabilities.

Chapter 9: Management of Working

Capital


ZPAPL/IPCC/FM/2010

The various studies conducted by the Bureau of Public Enterprises have shown that one

of the reason for the poor performance of public sector undertakings in our country has

been the large amount of funds locked up in working capital This results in over

capitalization. Over capitalization implies that a company has too large funds for its

requirements, resulting in a low rate of return a situation which implies a less than

optimal use of resources. A firm has, therefore, to be very careful in estimating its

working capital requirements.

Maintaining adequate working capital is not just important in the short-term. Sufficient

liquidity must be maintained in order to ensure the survival of the business in the long-

term as well. When business make investment decisions they must not only consider the

financial outlay involved with acquiring the new machine or the new building, etc., but

must also take account of the additional current assets that are usually required with

any expansion of activity. For e.g.:-

- Increased production leads to hold additional stocks of raw materials and work in

progress.

- Increased sales usually means that the level of debtors will increase.

- A general increase in the firm’s scale of operations tends to imply a need for greater

levels of working capital.

A question then arises what is an optimum amount of working capital for a firm? We can

say that a firm should neither have too high an amount of working capital nor should

the same be too low. It is the job of the finance manager to estimate the requirements of

working capital carefully and determine the optimum level of investment in working

capital.


ZPAPL/IPCC/FM/2010

Q. 1. What Parameters should be considered by Finance manager while selecting a

source of finance?

• Cost of source of fund

• Tenure

• Leverage planned by the company

• Financial conditions prevalent in the economy

• Risk profile of both the company as well as the industry in which the company operates.

• Each and every source of fund has some advantages as well as disadvantages.

• All the financial needs of a business may be grouped into the following three categories:

o Long term financial needs

o Medium term financial needs

o Short term financial needs

Q. 2. List down various sources of Finance available for the business enterprise?

Long-term Sources Medium-term Short-term

1. Share capital or Equity share

2. Preference shares

3. Retained earnings

4. Debentures/Bonds of

different types

5. Loans from financial

institutions or Loans from

State Financial Corporation

6. Loans from commercial

banks

7. Venture capital funding

8. Debt / Asset Securitisation

9. International financing like

Euro-issues, Foreign currency

loans

1. Preference shares

2. Debentures/Bonds

3. Public deposits/fixed

deposits for duration of

three years

4. Commercial banks

5. Financial institutions

6. State financial corporations

7. Lease financing/Hire-

Purchase financing

8. External commercial

borrowings

9. Euro-issues

10. Foreign Currency bonds

1. Trade credit

2. Accrued expenses and

deferred income

3. Commercial banks

4. Fixed deposits for a period of

1 year or less

5. Advances received from

customers

6. Various short-term

provisions

These sources are discussed below in sequence.

Chapter 10: Sources of Finance


ZPAPL/IPCC/FM/2010

Q.3. Explain the advantages and disadvantages of equity share capital as source of

finance.

• Advantages of Equity Shares

o It is Permanent source of finance

o Issue of equity increases the borrowing capacity of the firm. Logic: More the

amount of equity, more debt can be raised by the company.

o Payment of dividend is not obligatory. Repayment of principal is also not

obligatory. Hence there is no financial risk from companies point of view.

o The company can make further issue of share capital by making a right issue.

• Disadvantages of Equity Shares

o Highest cost of capital due to higher risk taken by shareholders. Investors find

ordinary shares riskier because of uncertain dividend payments and capital

gains.

o Company is supposed to pay Dividend Distribution Tax while paying the

dividend. This increases the cost of equity.

o The issue of new equity shares reduces the earning per share of the existing

shareholders until and unless the profits are proportionately increased.

o Dilution of Control: The issue of new equity shares can also reduce the

ownership and control of the existing shareholders.

Q.4. Explain the advantages and disadvantages of preference share capital as source of

finance.

• Advantages of preference Shares

o No dilution in EPS on enlarged capital base.

o There is no risk of takeover as the preference shareholders do not have voting

rights.

o There is leveraging advantage as it bears a fixed charge.

o The preference dividends are fixed and pre-decided. Preference shareholders

do not participate in surplus profit as the ordinary shareholders

o Preference capital can be redeemed after a specified period.

• Disadvantages of preference Shares

o One of the major disadvantages of preference shares is that preference dividend

is not tax deductible and so does not provide a tax shield to the company. Hence

a preference share is costlier to the company than debt e.g. debenture.

o Preference dividends are cumulative in nature. This means that although these

dividends may be omitted, they shall need to be paid later. Also, if these

dividends are not paid, no dividend can be paid to ordinary shareholders.


ZPAPL/IPCC/FM/2010

Q.5. Explain the term ‘Ploughing back of Profits’ or Retained earnings as source of

finance.

• Ploughing back of Profits: Long-term funds may also be provided by accumulating

the profits of the company and by ploughing them back into business. Such funds

belong to the ordinary shareholders and increase the net worth of the company. A

public limited company must plough back a reasonable amount of its profits each year

keeping in view the legal requirements in this regard and its own expansion plans.

Such funds also entail almost no risk. Further, control of present owners is also not

diluted by retaining profits.

• Advantages of Retained Earning:

o No flotation / issue cost

o No financial risk of repayment

o Retained earnings help to go for expansion plans

o Retained earnings increase the net worth / equity and thereby boosts the

borrowing capacity

o Use of retained earnings as source of finance does not result in dilution of

EPS. Logic: New shares are not issued.

Q.6. Explain the advantages and disadvantages of Debentures as source of finance.

• Advantages of raising finance by issue of debentures are

o The cost of debentures is much lower than the cost of preference or equity

capital as the interest is tax-deductible. Also, investors consider debenture

investment safer than equity or preferred investment and, hence, may require a

lower return on debenture investment.

o Debenture financing does not result in dilution of control.

o In a period of rising prices, debenture issue is advantageous. The fixed

monetary outgo decreases in real terms as the price level increases.

• The disadvantages of debenture financing are:

o Debenture interest and capital repayment are obligatory payments.

o The protective covenants associated with a debenture issue may be restrictive.

o Debenture financing enhances the financial risk associated with the firm.

o Since debentures need to be paid during maturity, a large amount of cash

outflow is needed at that time


ZPAPL/IPCC/FM/2010

Q.7. Explain the features of Loans from Financial Institutions.

• E.g. Industrial Finance Corporation of India (IFCI) State Finance Corporations (SFC),

LIC, ICICI, IDBI

• A firm needs to fulfill the criteria's of these institutions relating to project finance.

• These are secured loans.

• Credit rating is carried out by lending institution.

• Long term source of finance.

• For large projects there is consortium of institutions.

• Such loans are available at different rates of interest under different schemes of

financial institutions and are to be repaid according to a stipulated repayment

schedule. The loans in many cases stipulate a number of conditions regarding the

management and certain other financial policies of the company.

Q.8. Explain the features of Loans from Commercial Banks.

• The primary role of the commercial banks is to cater to the short term requirements of

industry. Of late, however, banks have started taking an interest in long term financing

of industries in several ways as follows

o The banks provide long term loans for the purpose of expansion or setting up of

new units.

o As part of the long term funding for a company, the banks also fund the long

term working capital requirement it is also called WCTL i.e. working capital

term loan.

Q.9. Explain the Concept of Bridge finance.

• Bridge Finance: Bridge finance refers, normally, to loans taken by the business,

usually from commercial banks for a short period, pending disbursement of term loans

by financial institutions.

• Normally it takes time for the financial institution to finalise procedures of creation of

security, tie-up participation with other institutions etc. even though a positive

appraisal of the project has been made.

• However, once the loans are approved in principle, firms in order not to lose further

time in starting their projects arrange for bridge finance. Such temporary loan is

normally repaid out of the proceeds of the principal term loans.

• It is secured by hypothecation of moveable assets, personal guarantees and demand

promissory notes.

• Generally rate of interest on bridge finance is higher as compared with that on term

loans.

• Sanction of Loan – Financial Institution agrees to give the loan

• Disbursement of Loan- The Actual payment of loan by financial institution.


ZPAPL/IPCC/FM/2010

Q.10. Explain the importance of trade credit and accruals as source of working capital.

What is the cost of these sources?

• Trade credit and accruals as source of working capital refers to credit facility given by

suppliers of goods during the normal course of trade. It is a short term source of

finance. SSI firms in particular are heavily dependent on this source for financing their

working capital needs. The major advantages of trade credit are − easy availability,

flexibility and informality.

• There can be an argument that trade credit is a cost free source of finance. But it is not.

It involves implicit cost . The supplier extending trade credit incurs cost in the form of

opportunity cost of funds invested in trade receivables. Generally, the supplier passes

on these costs to the buyer by increasing the price of the goods or alternatively by not

extending cash discount facility.

Q.11. What is meant by “Venture Capital Financing”?

• Venture Capital Financing: The venture capital financing refers to financing of new

high risky ventures promoted by qualified entrepreneurs who lack experience and

funds to give shape to their ideas. The person / organisation making the investment is

known as Venture capitalists.

• In broad sense, under venture capital financing, venture capitalists make investments

to purchase equity or debt securities from inexperienced entrepreneurs who

undertake highly risky ventures with a potential of success.

• It is capital investment made in a business or industrial enterprise, which carries

elements of risks and insecurity and the probability of business hazards. Capital

investment may assume the form of either equity or debt or both as a derivative

instrument. The risk associated with the enterprise could be so high as to entail total

loss or be so insignificant as to lead to high gains.

Q.12. What are various methods of “Venture Capital Financing”?

• Methods of Venture Capital Financing: The venture capital financing refers to

financing and funding of the small scale enterprises, high technology and risky

ventures. Some common methods of venture capital financing are as follows:

(i) Equity financing: The venture capital undertakings generally requires funds for a

longer period but may not be able to provide returns to the investors during the

initial stages. Therefore, the venture capital finance is generally provided by way of

equity share capital. The equity contribution of venture capital firm does not

exceed 49% of the total equity capital of venture capital undertakings so that the

effective control and ownership remains with the entrepreneur.

(ii) Conditional Loan: A conditional loan is repayable in the form of a royalty after the

venture is able to generate sales. No interest is paid on such loans. In India Venture

Capital Financers charge royalty ranging between 2 to 15 per cent; actual rate

depends on other factors of the venture such as gestation period, cash flow

patterns, riskiness and other factors of the enterprise. Some Venture Capital

financers give a choice to the enterprise of paying a high rate of interest (which


ZPAPL/IPCC/FM/2010

could be well above 20 per cent) instead of royalty on sales once it becomes

commercially sound.

(iii) Income Note: It is a hybrid security which combines the features of both

conventional loan and conditional loan. The entrepreneur has to pay both interest

and royalty on sales but at substantially low rates.

(iv) Participating Debenture: Such security carries charges in three phases- in the start-

up phase, no interest is charged, next stage a low rate of interest is charged upto a

particular level of operations, after that, a high rate of interest is required to be

paid.

Q.13. Factors that a venture capitalist should consider before financing any risky

project?

• Level of expertise of company’s management: Most of venture capitalist believes

that the success of a new project is highly dependent on the quality of its management

team. They expect that entrepreneur should have a skilled team of managers.

Managements also be required to show a high level of commitments to the project.

• Level of expertise in production: Venture capital should ensure that entrepreneur

and his team should have necessary technical ability to be able to develop and produce

new product / service.

• Nature of new product / service: The venture capitalist should consider whether the

development and production of new product / service should be technically feasible.

They should employ experts in their respective fields to examine idea proposed by the

entrepreneur.

• Future Prospects: Since the degree of risk involved in investing in the company is

quite fairly high, venture capitalists should seek to ensure that the prospects for future

profits compensate for the risk. Therefore, they should see a detailed business plan

setting out the future business strategy.

• Competition: The venture capitalist should seek assurance that there is actually a

market for a new product. Further venture capitalists should see the research carried

on by the entrepreneur.

• Risk borne by entrepreneur: The venture capitalist is expected to see that the

entrepreneur bears a high degree of risk. This will assure them that the entrepreneur

have the sufficient level of the commitments to project as they themselves will have a

lot of loss, should the project fail.

• Exit Route: The venture capitalist should try to establish a number of exist routes.

These may include a sale of shares to the public, sale of shares to another business, or

sale of shares to original owners.

• Board membership: In case of companies, to ensure proper protection of their

investment, venture capitalist should require a place on the Board of Directors. This

will enable them to have their say on all significant matters affecting the business.


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Q.14. Explain the concept of Debt / Asset securitization.

Debt securitization is a method of recycling of funds. It is especially beneficial to

financial intermediaries to support the lending volumes. Assets generating steady cash

flows are packaged together and against this assets pool, market securities can be

issued. The debt securitization process can be classified in the following three functions.

1. The origination function: The credit worthiness of a borrower seeking loan from a

finance company, bank, housing company or a leasing company is evaluated and a

contract is entered into and repayment schedule is structured over the life of the

loan.

2. The pooling function: Similar loans or receivables are clubbed together to create an

underlying pool of assets. This pool is transferred in favour of a special purpose

vehicle (SPV).

3. The securitization function: After structuring, issue the securities on the basis of

asset pool. The securities carry a coupon and an expected maturity, which can be

asset based or mortgaged based. These are generally sold to investors through

merchant bankers.

The process of securitization is generally without recourse i.e. the investor bears credit

risk or risk of default and the user is under an obligation to pay to investor only if the

cash flow are received by him from the collateral.

Q.15. Explain the advantages of Debt / Asset securitisation.

Advantages of Debt Securitisation: Debt securitisation is a method of recycling of

funds and is especially beneficial to financial intermediaries to support lending volumes.

Simply stated, under debt securitisation a group of illiquid assets say a mortgage or any

asset that yields stable and regular cash flows like bank loans, consumer finance, credit

card payment are pooled together and sold to intermediary. The intermediary then

issue debt securities.

The advantages of debt securitisation to the originator are the following:

(i) The asset are shifted off the Balance Sheet, thus giving the originator recourse to off

balance sheet funding.

(ii) It converts illiquid assets to liquid portfolio.

(iii) It facilitates better balance sheet management, assets are transferred off balance

sheet facilitating satisfaction of capital adequacy norms.

(iv) The originator’s credit rating enhances.

For the investors securitisation opens up new investment avenues. Though the investor

bears the credit risk, the securities are tied up to definite assets.


ZPAPL/IPCC/FM/2010

Q.16. Explain the concept of lease financing.

• Leasing is a general contract between the owner and user of the asset over a specified

period of time.

• The asset is purchased initially by the lessor (leasing company) and thereafter leased

to the user (lessee company) which pays a specified rent at periodical intervals

• Thus, leasing is an alternative to the purchase of an asset out of own or borrowed

funds.

• Lease finance can be arranged much faster as compared to term loans from financial

institutions

Q.17. Explain the various types of leases.

• Operating Lease: A lease is classified as an operating lease if it does not secure for the

lessor the recovery of capital outlay plus a return on the funds invested during the

lease term. The period of operating lease is lesser than useful life. Lessor takes back the

asset from one lessee and gives to another lessee.

• Finance Lease: In contrast to an operating lease, a financial lease is longer term in

nature and lessee buys the asset at the end of lease period. Here asset is used by one

lessee only. Lessor only acts a financer.

• Sales and Lease Back –

o Under this type of lease, the owner of an asset sells the asset to a party (the

buyer), who in turn leases back the same asset to the owner in consideration of

a lease rentals.

o Under this arrangement, the asset are not physically exchanged but it all happen

in records only.

o The main advantage of this method is that the lessee can satisfy himself

completely regarding the quality of an asset and after possession of the asset

convert the sale into a lease agreement.

o Under this transaction, the seller assumes the role of lessee and the buyer

assumes the role of a lessor. The seller gets the agreed selling price and the

buyer gets the lease rentals.

• Leveraged Lease

o Under this lease, a third party is involved beside lessor and lessee.

o The lessor borrows a part of the purchase cost (say 80%) of the asset from the

third party i.e., lender and asset so purchased is held as security against the

loan.

o The lender is paid off from the lease rentals directly by the lessee and the

surplus after meeting the claims of the lender goes to the lessor.

o The lessor is entitled to claim depreciation allowance under Income Tax Act.


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• Sales-aid Lease

o Under this lease contract, the lessor enters into a tie up with a manufacturer for

marketing the latter’s product through his own leasing operations, it is called a

sales-aid-lease.

o In consideration of the aid in sales, the manufacturers may grant either credit,

or a commission to the lessor.

o Thus, the lessor earns from both sources i.e. from lessee as well as the

manufacturer.

• In the close-ended lease, the assets get transferred to the lessee at the end of lease,

the risk of obsolescence, residual value etc., remain with the lessor being the legal

owner of the asset.

• In the open-ended lease, the lessee has the option of purchasing the asset at the end

of the lease period.

Q.18. Differentiate between Finance Lease and Operating Lease.

Finance Lease Operating Lease

The risk and reward incident to ownership

are passed on to the lessee. The lessor only

remains the legal owner of the asset.

The lessee is only provided the use of the

asset for a certain time. Risk incident to

ownership belong wholly to the lessor.

The lessee bears the risk of Obsolescence The lessee is only provided the use of asset

for a certain time. Risks incidental to

ownership belong wholly to the lessor.

The lessor is interested in his rentals and not

in the asset. He must get his principal back

along with interest. Therefore, the lease is

non-cancellable by either party.

As the lessor does not have difficulty in

leasing the same asset to other willing lessor,

the lease is kept cancelable by the lessor.

The lessor enters into the transaction only as

financier. He does not bear the cost of repairs,

maintenance or operations.

Usually, the lessor bears cost of repairs,

maintenance or operations.

The lease is usually full pay out, that is, the

single lease repays the cost of the asset

together with the interest.

The lease is usually non-payout, since the

lessor expects to lease the same asset over

and over again to several users.


ZPAPL/IPCC/FM/2010

Q.19. Explain the importance of trade credit and accruals as source of working capital.

What is the cost of these sources?

• Trade credit and accruals as source of working capital refers to credit facility given by

suppliers of goods during the normal course of trade.

• It is a short term source of finance. Small Scale Industry firms in particular are heavily

dependent on this source for financing their working capital needs. The major

advantages of trade credit are − easy availability, flexibility and informality.

• There can be an argument that trade credit is a cost free source of finance. But it is not.

It involves implicit cost. The supplier extending trade credit incurs cost in the form of

opportunity cost of funds invested in trade receivables. Generally, the supplier passes

on these costs to the buyer by increasing the price of the goods or alternatively by not

extending cash discount facility.

Q.20. Explain the Accrued Expenses and Deferred Income as source of working capital.

• Accrued expenses represent liabilities which a company has to pay for the services

which it has already received.

• Deferred income, on the other hand, reflects the amount of funds received by a

company in lieu of goods and services to be provided in the future.

• Since these receipts increase a company’s liquidity, they are also considered to be an

important source of spontaneous finance.

Q.21. Discuss the risk-return considerations in financing of current assets.

• The financing of current assets involves a trade off between risk and return. A firm can

choose from short or long term sources of finance. Short term financing is less

expensive than long term financing but at the same time, short term financing involves

greater risk than long term financing.

• Depending on the mix of short term and long term financing, the approach followed by

a company may be referred as matching approach, conservative approach and

aggressive approach.

• In matching approach, long-term finance is used to finance fixed assets and permanent

current assets and short term financing to finance temporary or variable current

assets. Under the conservative plan, the firm finances its permanent assets and also a

part of temporary current assets with long term financing and hence less risk of facing

the problem of shortage of funds.

• An aggressive policy is said to be followed by the firm when it uses more short term

financing than warranted by the matching plan and finances a part of its permanent

current assets with short term financing.


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Q.22. Explain in brief the features of Commercial Paper.

• Features of Commercial Paper (CP)

• A commercial paper is an unsecured money market instrument issued in the form of a

promissory note. Since the CP represents an unsecured borrowing in the money

market, the regulation of CP comes under the purview of the Reserve Bank of India

which issued guidelines in 1990 on the basis of the recommendations of the Vaghul

Working Group. These guidelines were aimed at:

o Enabling the highly rated corporate borrowers to diversify their sources of

short term borrowings, and

o To provide an additional instrument to the short term investors.

• It can be issued for maturities between 15 days and a maximum upto one year from

the date of issue.

• These can be issued in denominations of Rs. 5 lakh or multiples therefore.

• All eligible issuers are required to get the credit rating from credit rating agencies.

• The aggregate amount of CP from an issuer shall be within the limit as approved by its

Board of Directors or the quantum indicated by the Credit Rating Agency for the

specified rating, whichever is lower.

• CP will be issued at a discount to face value as may be determined by the issuer. The CP

is redeemed at Par.

• Benefits of CP

o Quick Short Term Financing

o Less Procedural requirements

o Additional Investment tool for the investors

o Rate of interest matched with the Credit Rating

Q.23. Discuss the eligibility criteria for issue of commercial paper.

The companies satisfying the following conditions are eligible to issue commercial paper.

o The tangible net worth of the company is Rs. 5 crores or more as per audited

balance sheet of the company.

o The fund base working capital limit is not less than Rs. 5 crores.

o The company is required to obtain the necessary credit rating from the rating

agencies such as CRISIL, ICRA etc.

o The issuers should ensure that the credit rating at the time of applying to RBI

should not be more than two moths old.

o The minimum current ratio should be 1.33:1 based on classification of current

assets and liabilities.


ZPAPL/IPCC/FM/2010

o For public sector companies there are no listing requirement but for companies

other than public sector, the same should be listed on one or more stock exchanges.

o All issue expenses shall be borne by the company issuing commercial paper.

Q.24. Write short note of Advances given by the Bank.

• Short term loan

o Entire amount is transferred once to the loan account.

o Interest is paid of total amount whether it is withdrawn or not.

o Repayment may be in lump sum or in instalments

• Overdraft

o Business is allowed to withdraw amount in excess of credit balance

o Fixed limit is granted to the customer

o Interest is charged on daily balances. OD facility is attached with Current

account only. Separate account is not required to be opened.

• Cash Credit

o Customer is allowed to borrow upto certain limit.

o Separate cash credit account is opened. It is different from the Current account.

o Interest is charged on amount actually availed by the user.

• Other advances by banks

o Advances against the goods

o Bill discounting

Q.25. Write short note Financing of Export Trade by Banks

• The commercial banks provide short term export finance mainly by way of

o pre shipment credit and

o post-shipment credit.

• Export finance is granted in Rupees as well as in foreign currency.

• In view of the importance of export credit in maintaining the pace of export growth,

RBI has initiated several measures in the recent years to ensure timely and hassle free

flow of credit to the export sector.

Q.26. Write short note on Pre Shipment Finance or Packing Credit.

• Packing Credit: Packing credit is an advance made available by banks to an exporter.

Any exporter, having at hand a firm export order placed with him by his foreign buyer

on an irrevocable letter of credit opened in his favour, can approach a bank for availing

of packing credit. An advance so taken by an exporter is required to be repaid within

180 days from the date of its commencement by negotiation of export bills or receipt of


ZPAPL/IPCC/FM/2010

export proceeds in an approved manner. Thus Packing Credit is essentially a short-

term advance.

• Normally, banks insists upon their customers to lodge the irrevocable letters of credit

opened in favour of the customer by the overseas buyers. The letter of credit and firms’

sale contracts not only serve as evidence of a definite arrangement for realisation of

the export proceeds but also indicate the amount of finance required by the exporter.

• Packing Credit, in the case of customers of long standing may also be granted against

firm contracts entered into by them with overseas buyers. Packing credit may be of the

following types:

o E.C.G.C. guarantee: Any loan given to an exporter is supported by Guarantee

issued by Export Credit Guarantee Corporation (ECGC). Borrower takes

insurance policy from ECGC by paying the premium. In case borrower does not

receive the amount from foreign customer ECGC pays the amount to Bank.

o Clean Packing credit: This is an advance made available to an exporter only on

production of a firm export order or a letter of credit without exercising any

charge or control over raw material or finished goods. It is a clean type of

export advance. Each proposal is weighted according to particular requirements

of the trade and credit worthiness of the exporter. A suitable margin has to be

maintained. Also, Export Credit Guarantee Corporation (ECGC) cover should be

obtained by the bank.

o Packing credit against hypothecation of goods: Export finance is made available

on certain terms and conditions where the exporter has pledgeable interest and

the goods are hypothecated to the bank as security with stipulated margin. At

the time of utilising the advance, the exporter is required to submit, alongwith

the firm export order or letter of credit, relative stock statements and thereafter

continue submitting them every fortnight and whenever there is any movement

in stocks.

o Packing credit against pledge of goods: Export finance is made available on

certain terms and conditions where the exportable finished goods are pledged

to the banks with approved clearing agents who will ship the same from time to

time as required by the exporter. The possession of the goods so pledged lies

with the bank and are kept under its lock and key.

o Forward exchange contract: Another requirement of packing credit facility is

that if the export bill is to be drawn in a foreign currency, the exporter should

enter into a forward exchange contact with the bank, thereby avoiding risk

involved in a possible change in the rate of exchange.


ZPAPL/IPCC/FM/2010

Q.27. Write short note on Post Shipment Finance.

It takes the following forms

• Purchase/discounting of documentary export bills : Finance is provided to

exporters by purchasing export bills drawn payable at sight or by discounting usance

export bills covering confirmed sales and backed by documents including documents of

the title of goods such as bill of lading, post parcel receipts, or air consignment notes.

• E.C.G.C. Guarantee: Post-shipment finance, given to an exporter by a bank through

purchase, negotiation or discount of an export bill against an order, qualifies for post-

shipment export credit guarantee. It is necessary, however, that exporters should

obtain a shipment or contracts risk policy of E.C.G.C.

• Advance against export bills sent for collection: Finance is provided by banks to

exporters by way of advance against export bills forwarded through them for

collection, taking into account the creditworthiness of the party, nature of goods

exported, usance, standing of drawee, etc. appropriate margin is kept.

• Advance against duty draw backs, cash subsidy, etc.: To finance export losses

sustained by exporters, bank advance against duty draw-back, cash subsidy, etc.,

receivable by them against export performance. Such advances are of clean nature;

hence necessary precaution should be exercised.

• Other facilities extended to exporters

o On behalf of approved exporters, banks establish letters of credit on their

overseas or up country suppliers.

o Guarantees for waiver of excise duty, etc. due performance of contracts, bond

in lieu of cash security deposit, guarantees for advance payments etc., are also

issued by banks to approved clients.

o To approved clients undertaking exports on deferred payment terms, banks

also provide finance.

o Banks also endeavour to secure for their exporter-customers status reports

of their buyers and trade information on various commodities through their

correspondents

o Economic intelligence on various countries is also provided by banks to their

exporter clients.

Q.28. Write short note on Inter Corporate Deposits, Certificate of Deposit (CD), Public

Deposits.

• Inter Corporate Deposits (ICD)

o The companies can borrow funds for a short period say 6 months from other

companies which have surplus liquidity.

o Companies Act deals with the provisions regarding ICD. Generally ICD’s are

effected between sister concerns.


ZPAPL/IPCC/FM/2010

o The rate of interest on inter corporate deposits varies depending upon the

amount involved and time period.

• Certificate of Deposit (CD)

o The certificate of deposit is a document of title similar to a time deposit receipt

issued by a bank except that there is no prescribed interest rate on such funds.

o The main advantage of CD is that banker is not required to encash the deposit

before maturity period and the investor is assured of liquidity because he can

sell the CD in secondary market.

o CD is similar to CP with only difference that it is issued by Bank.

• Public Deposits

o A company can accept public deposits from the public and shareholders. These

deposits may be accepted for a period of six months to three years.

o Public deposits are unsecured loans; they should not be used for acquiring fixed

assets since they are to be repaid within a period of 3 years.

o These are mainly used to finance working capital requirements.

o Sec. 58A of Companies Act deals with it.

Q.29. Write short note on Seed Capital Assistance.

• The Seed capital assistance scheme is designed by IDBI for professionally or technically

qualified entrepreneurs and/or persons possessing relevant experience, skills and

entrepreneurial traits.

• The project cost should not exceed Rs. 2 crores and the maximum assistance under the

project will be restricted to 50% of the required promoter’s contribution or Rs. 15 lacs

whichever is lower.

• The Seed Capital Assistance is interest free but carries a service charge of one per cent

per annum for the first five years and at increasing rate thereafter.

Q.30. Write short note on Deferred Payment Guarantee

• Many a time suppliers of machinery provide deferred credit facility under which

payment for the purchase of machinery can be made over a period of time.

• The entire cost of the machinery is financed and the company is not required to

contribute any amount initially towards acquisition of the machinery.

• Normally, the supplier of machinery insists that bank guarantee should be furnished by

the buyer.

Q.31. Write short note on Capital Incentives.

• The backward area development incentives available often determine the location of a

new industrial unit. These incentives usually consist of a lump sum subsidy and

exemption from or deferment of sales tax and octroi duty. The quantum of incentives

is determined by the degree of backwardness of the location.


ZPAPL/IPCC/FM/2010

Q.32. Write short note on Zero Coupon Bonds or Deep Discount Bonds.

• Features of Deep Discount Bonds: Deep discount bonds are a form of zero-interest

bonds. These bonds are sold at discounted value and on maturity; face value is paid to

the investors. In such bonds, there is no interest payout during the lock- in period. The

investors can sell the bonds in stock market and realise the difference between face

value and market price as capital gain.

• IDBI was the first to issue deep discount bonds in India in January 1993. The bond of a

face value of Rs. 1 lakh was sold for Rs. 2700 with a maturity period of 25 years.

Q.33. Discuss the features of Secured Premium Notes (SPNs).

• Secured premium notes are issued along with detachable warrants and are redeemable

after a notified period of say 4 to 7 years.

• This is a kind of Non Convertible Debenture attached with warrant.

• It was first introduced by Tisco, which issued the SPNs to existing shareholders on

right basis. Subsequently the SPNs will be repaid in some number of equal instalments.

• The warrant attached to SPNs gives the holder the right to apply for and get allotment

of equity shares as per the conditions within the time period notified by the company.

Q.34. Discuss the features of Zero interest fully convertible debentures:

• These are fully convertible debentures which do not carry any interest. The debentures

are compulsorily and automatically converted after a specified period of time and

holders thereof are entitled to new equity shares of the company at predetermined

price.

• From the point of view of company this kind of instrument is beneficial in the sense

that no interest is to be paid on it, if the share price of the company in the market is

very high than the investors tends to get equity shares of the company at the lower

rate.

Q.35. Discuss the features of Double Option Bonds.

• These have also been recently issued by the IDBI. The face value of each bond is Rs.

5,000. The bond carries interest at 15% per annum compounded half yearly from the

date of allotment. The bond has maturity period of 10 years.

• Each bond has two parts in the form of two separate certificates, one for principal of

Rs. 5,000 and other for interest (including redemption premium) of Rs. 16,500. Both

these certificates are listed on all major stock exchanges. The investor has the facility of

selling either one or both parts anytime he likes.

Q.36. Discuss the features of Inflation Bonds.

• Inflation Bonds are the bonds in which interest rate is adjusted for inflation. Thus,

the investor gets interest which is free from the effects of inflation.


ZPAPL/IPCC/FM/2010

• For example, if the interest rate is 11 per cent and the inflation is 5 per cent, the

investor will earn 16 per cent meaning thereby that the investor is protected

against inflation.

Q.37. Discuss the features of Floating Rate Bonds.

• This as the name suggests is bond where the interest rate is not fixed and is allowed to

float depending upon the market conditions.

• This is an ideal instrument which can be resorted to by the issuer to hedge themselves

against the volatility in the interest rates.

• This has become more popular as a money market instrument and has been

successfully issued by financial institutions like IDBI, ICICI etc.

Q.38. Name the various financial instruments dealt with in the international market.

• Financial Instruments in the International Market: Some of the various financial

instruments dealt with in the international market are:

a) Euro Bonds

b) Foreign Bonds

c) Fully Hedged Bonds

d) Medium Term Notes

e) Floating Rate Notes

f) External Commercial Borrowings

g) Foreign Currency Futures

h) Foreign Currency Option

i) Euro Commercial Papers.

Q.39. Explain briefly the features of External Commercial Borrowings (ECBs).

• External Commercial Borrowings are loans taken from non-resident lenders in

accordance with exchange control regulations. These loans can be taken from:

� International banks

� Capital markets

� Multilateral financial institutions like IFC, ADB, IBRD etc.

� Export Credit Agencies

� Foreign collaborators

� Foreign Equity Holders.

• ECBs can be accessed under automatic OR approval routes depending upon the

purpose and volume.

• In automatic there is no need for any approval from RBI / Government while approval

is required under approval route.


ZPAPL/IPCC/FM/2010

Q.40. Explain briefly the features of Euro Bonds.

• Euro bonds are debt instruments which are not denominated in the currency of the

country in which they are issued. E.g. a Yen note floated in Germany.

• Such bonds are generally issued in a bearer form rather than as registered bonds and

in such cases they do not contain the investor’s names or the country of their origin.

• These bonds are an attractive proposition to investors seeking privacy.

Q.41. Explain briefly the features of Foreign Bonds.

• These are debt instruments issued by foreign corporations or foreign governments.

Such bonds are exposed to default risk, especially the corporate bonds.

• These bonds are generally denominated in the currency of the country where they are

issued, however, in case these bonds are issued in a currency other than the investors

home currency, they are exposed to exchange rate risks.

• An example of a foreign bond ‘A British firm placing Dollar denominated bonds in USA’

Q.42. Explain briefly the features of Fully Hedged Bonds.

• In foreign bonds, the risk of currency fluctuations exists. Fully hedged bonds eliminate

the risk by entering forward exchange contract (a contract where exchange rate for

future date is decided in advance.)

Q.43. Explain briefly the features of Medium Term Notes.

• Certain issuers need frequent financing through the Bond route including that of the

Euro bond.

• However it may be costly and ineffective to go in for frequent issues. Instead, investors

can follow the MTN programme.

• Under this programme, several lots of bonds can be issued, all having different features

e.g. different coupon rates, different currencies etc. The timing of each lot can be

decided keeping in mind the future market opportunities.

• The entire documentation and various regulatory approvals can be taken at one point

of time

Q.44. Explain briefly the Concept of Depository receipts.

(First two points are for understanding – Answer should start from 3rd Point)

• Depository receipts – A description of problem

Mr. Phillip a resident of USA has heard a lot about the Reliance Industries Ltd. Due to

the strong financial results and sound business profile of RIL Mr. Phillip wants to invest

in the equity shares of the RIL. But he has one problem. RIL shares are listed only on

the Stock exchanges in India and not abroad. Since Mr. Phillip does not have any

knowledge of India Capital market he is reluctant to invest. Also he says that shares are

denominated in Rs. and he do not want to carry out any Exchange risk. What is the

solution to the problem faced by Mr. Phillip?


ZPAPL/IPCC/FM/2010

• The solution mechanism is as follows

o The equity shares of the RIL will be bought by the Indian Bank (referred as

Investment Bank).

o These shares will be then be transferred to the bank in USA (Depository Bank)

o Depository Bank will issue the financial Instrument which will be denominated

in the USD and will be backed by the Equity shares of RIL purchased by an

Investment bank. This financial instrument will then be listed on the New York

Stock Exchange in USD and will be subscribed by the investors like Mr. Phillip.

So this Instrument will link the Equity shares of the RIL in India to the financial

instrument issued in the USA. This Financial Instrument is technically referred

to as the Depository Receipt.

o Dividend declared by the RIL will then be distributed amongst the holders of

the Depository Receipts in proportion to their holding. Appreciation in market

price of the equity share of RIL will increase the market price of DR and vice

versa.

o By this way by subscribing to the Depository Receipt Mr. Phillip will get what he

desires!!! Let’s understand DR.

• Concept of Depository Receipt

o DR is an instrument in the form of depository receipt or certificate created by

the overseas Depository Bank outside India and issued to the non - resident

investors against the issue of equity shares.

o A depository receipt is a negotiable instrument evidencing a fixed number of

equity shares of the issuing company generally denominated in US Dollars.

o DRs are commonly used by those companies which sell their securities in

international market and expand their shareholdings abroad.

o These securities are listed and traded in International Stock Exchanges.

• Types of Depository Receipt

o DR’s are either American Depository Receipts (ADR) or Global Depository

Receipts (GDR).

o ADR’s are issued in case the funds are raised through retail market in United

States.

o In case of GDR’s, the invitation to participate in the issue cannot be extended to

retail US investors.

o The issuing companies are required to pay the listing fees to the stock

exchanges abroad and they are also required to present their financial

statements as per the accounting principles of those countries.

o Lets understand ADR & GDR.


ZPAPL/IPCC/FM/2010

Q.45. Explain briefly the Concept of Global Depository Receipts (GDR)

• Global Depository Receipts (GDRs): It is a negotiable certificate denominated in US

dollars which represents a Non-US company’s publically traded local currency equity

shares.

• GDRs are created when the local currency shares of an Indian company are delivered to

Depository’s local custodian Bank against which the Depository bank issues depository

receipts in US dollars.

• The GDRs may be traded freely in the overseas market like any other dollar-expressed

security either on a foreign stock exchange or in the over-the-counter market or among

qualified institutional buyers.

• By issue of GDRs Indian companies are able to tap global equity market to raise foreign

currency funds by way of equity. It has distinct advantage over debt as there is no

repayment of the principal and service costs are lower.

Q.46. Explain briefly the Concept of American Depository Receipts (ADR)

• American Depository Receipts (ADRs) are securities offered by non- US companies who

want to list on any of the US exchanges.

• It is a derivative instrument (Instrument which derives its value from other instrument).

• It represents a certain number of company’s shares. These are used by depository bank

against a fee income.

• ADRs allow US investors to buy shares of these companies without the cost of investing

directly in a foreign stock exchange.

• ADRs are listed on either NYSE or NASDAQ. It facilitates integration of global capital

markets.

• The company can use the ADR route either to get international listing or to raise money in

international capital market.

• Apart from legal impediments, ADRs are costlier than Global Depository Receipts (GDRs).

Legal fees are considerably high for US listing. Registration fee in USA is also substantial.

Hence ADRs are less popular than GDRs.

Q.47. Differentiate between ADR and GDR.

GDR ADR

Quoted on stock exchanges other than USA Quoted in USA only

Disclosure requirements are less stringent Disclosure requirements are more stringent

Only Institutional Investors can participate in

the offer

US Retail investors in addition to US

Institutional Investors can participate in offer.


ZPAPL/IPCC/FM/2010

GDR ADR

Limited institutional investors, so stock may

not valued at fair value.

Wider interest of the investors and better

valuation of stocks on account of

participation of retail investor s

Low cost of compliance as compared to the

ADR

High cost of compliance as compared to the

GDR

Traded in more than one currency Traded in US $ only.

Q.48. Explain the concept of Indian depository receipts.

Concept of Indian Depository Receipts: The concept of the depository receipt

mechanism which is used to raise funds in foreign currency has been applied in the

Indian capital market through the issue of Indian Depository Receipts (IDRs). Foreign

companies can issue IDRs to raise funds from Indian market on the same lines as an

Indian company uses ADRs/GDRs to raise foreign capital. The IDRs are listed and traded

in India in the same way as other Indian securities are traded.

Q.49. Explain the Other types of International Issues.

• Foreign Euro Bonds: In domestic capital markets of various countries the Bonds

issues referred to above are known by different names such as Yankee Bonds in the US,

Swiss Frances in Switzerland, Samurai Bonds in Tokyo and Bulldogs in UK.

• Euro Convertible Bonds: A convertible bond is a debt instrument which gives the

holders of the bond an option to convert the bonds into a pre-determined number of

equity shares of the company. Usually the price of the equity shares at the time of

conversion will have a premium element. These bonds carry a fixed rate of interest and

if the issuer company so desires may also include a Call Option (where the issuer

company has the option of calling/ buying the bonds for redemption prior to the

maturity date) or a Put Option (which gives the holder the option to put/sell his bonds

to the issuer company at a pre-determined date and price).

• Euro Convertible Zero Bonds: These bonds are structured as a convertible bond. No

interest is payable on the bonds. But conversion of bonds takes place on maturity at a

pre- determined price. Usually there is a five years maturity period and they are

treated as a deferred equity issue.

• Euro Bonds with Equity Warrants: These bonds carry a coupon rate determined by

market rates. The warrants are detachable. Pure bonds are traded at a discount. Fixed

In- come Funds Management may like to invest for the purposes of regular income


ZPAPL/IPCC/FM/2010

Q.50. Differentiate between Factoring and Bills discounting.

Differentiation between Factoring and Bills Discounting

The differences between Factoring and Bills discounting are:

(a) Factoring is called as “Invoice Factoring’ whereas Bills discounting is known as

‘Invoice discounting.”

(b) In Factoring, the parties are known as the client, factor and debtor whereas in Bills

discounting, they are known as drawer, drawee and payee.

(c) Factoring is a sort of management of book debts whereas bills discounting is a sort

of borrowing from commercial banks.

(d) For factoring there is no specific Act, whereas in the case of bills discounting, the

Negotiable Instruments Act is applicable.

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