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Question-1

What is business finance? Why do businesses need funds? Explain.

Solution:
Business is related to production and distribution of goods and services for the fulfillment of requirements of society. For effectively carrying out various activities, business requires funds which is known as business finance. Hence, finance is called the life blood of any business. A business would get stranded unless there is sufficient funds available for utilization. The capital invested by the entrepreneur to set up the business is not sufficient to meet the financial requirements of the business. Hence, a business person has to look for sources to generate funds. A vivid analysis of the financial requirements and sources of funds available has to be done in order to arrive at an effective money management and run the business in a better way. The basic requirements of a business organization would be purchase of a plant or machinery, or it could be purchase of raw materials, expansion of business that leads to more recruitments, payment of salaries etc.,

Question-2

List sources of raising long-term and short-term finance.

Solution:
Source of Generation Basis, Ownership Basis and Period Basis.

Question-3

What preferential rights are enjoyed by preference shareholders. Explain.

Solution:
The capital raised by issuing preference shares is called preference share capital. The preference shareholders are entitled to enjoy a preferential position over equity shareholders in two ways:

(i) entitled to receive a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders; and

(ii) entitled to receive their capital after the claims of the company’s creditors have been settled, at the time of termination of the company. On a comparison, the equity shareholders and the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. As the dividend is payable only at the discretion of the directors and only from the gains after tax, to that extent, these resemble equity shares. Thus, preference shares bear some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy the right to vote.

Question-4

Name any three special financial institutions and state their objectives.

Solution:
Special Financial Institutions

1. Industrial Finance Corporation of India (IFCI): It was established in July 1948 as a statutory corporation under the Industrial Finance Corporation Act, 1948. Its objectives include assistance towards balanced regional development and encouraging new entrepreneurs to enter into the priority sectors of the economy. IFCI has also contributed to the development of management education in the country.

2. State Financial Corporations (SFC): The State Financial Corporations Act, 1951 empowered the State Governments to establish State Financial Corporations in their respective regions for providing medium and short term finance to industries which are outside the scope of the IFCI. Its scope is wider than IFCI, since the former covers not only public limited companies but also private limited companies, partnership firms and proprietary concerns.

3. Industrial Credit and Investment Corporation of India (ICICI): This was established in 1955 as a public limited company under the Companies Act. ICICI assists the creation, expansion and modernisation of industrial enterprises exclusively in the private sector. The corporation has also encouraged the participation of foreign capital in the country.

4. Industrial Development Bank of India (IDBI): It was established in 1964 under the Industrial Development Bank of India Act, 1964 with an objective to coordinate the activities of other financial institutions including commercial banks. The bank performs three types of functions, namely, assistance to other financial institutions, direct assistance to industrial concerns, and promotion and coordination of financial-technical services.

5. State Industrial Development Corporations (SIDC): Many state governments have set up State Industrial Development Corporations for the purpose of promoting industrial development in their respective states. The objectives of the SIDCs differ from one state to another.

6. Unit Trust of India (UTI): It was established by the Government of India in 1964 under the Unit Trust of India Act, 1963. The basic objective of UTI is to mobilize the community’s savings and channelise them into productive ventures. For this purpose, it sanctions direct assistance to industrial concerns, invests in their shares and debentures, and participates with other financial institutions.

7. Industrial Investment Bank of India Ltd.: It was initially set up as a primary agency for rehabilitation of sick units and was known as Industrial Reconstruction Corporation of India. It was reconstituted and renamed as the Industrial Reconstruction Bank of India in 1985 and again in 1997 its name was changed to Industrial Investment Bank of India. The Bank assists sick units in the reorganisation of their share capital, improvement in management system, and provision of finance at liberal terms.

8. Life Insurance Corporation of India (LIC): LIC was set up in 1956 under the LIC Act, 1956 after nationalising 245 existing insurance companies. It mobilizes the community’s savings in the form of insurance premia and makes it available to industrial concerns, both public as well as private, in the form of direct loans and underwriting of and subscription to shares and debentures.

Question-5

Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion.

Solution:
Factoring

Factoring is a financial service under which the ‘factor’ renders various services which includes:

(a) Discounting of bills (with or without recourse) and collection of the client’s debts. Under this, the receivables on account of sale of goods or services are sold to the factor at a certain discount. The factor becomes responsible for all credit control and debt collection from the buyer and provides protection against any bad debt losses to the firm. There are two methods of factoring - recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring i.e., full amount of invoice is paid to the client in the event of the debt becoming bad.

(b) Providing information about credit worthiness of prospective client’s etc., Factors hold large amounts of information about the trading histories of the firms. This can be valuable to those who are using factoring services and can thereby avoid doing business with customers having poor payment record. Factors may also offer relevant consultancy services in the areas of finance, marketing, etc. The factor charges fees for the services rendered. Factoring appeared on the Indian financial scene only in the early nineties as a result of RBI initiatives. The organisations that provides such services include SBI Factors and Commercial Services Ltd., Canbank Factors Ltd., Foremost Factors Ltd., State Bank of India, Canara Bank, Punjab National Bank, Allahabad Bank. In addition, many non-banking finance companies and other agencies provide factoring service.

 

Merits

The merits of factoring as a source of finance are as follows:

(i) Obtaining funds through factoring is cheaper than financing through other means such as bank credit;

(ii) When the cash flow is being accelerated by factoring, the client is able to meet his/her liabilities on time as and when the need arise;

(iii) This Factoring source of funds is flexible and ensures an exact pattern of cash inflows from credit sales. It gives security for a debt that an organisation might otherwise be unable to obtain;

(iv) This does not produce any charge on the belongings of the firm;

(v) The client is able to concentrate on other functional arena of business as the responsibility of credit control is being handled by the factor.

 

Limitations

The limitations of factoring as a source of finance are as follows:

(i) This source is very expensive when the invoices are many in number and smaller with respect to amount;

(ii) The advance finance produced by the factor organisation is generally available at a higher interest cost than the customary rate of interest;

(iii) This factor referred to is a third party to the customer who is likely to feel uncomfortable while dealing with it.

Question-6

What advantages does issue of debentures provide over the issue of equity shares?

Solution:
Debentures

Debentures can be addressed as a vital tool for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is referred to as an acknowledgment that the company has borrowed a particular amount of money that has to be repaid at a future date. Debenture holders are, hence, known as creditors of the company. Debenture holders are paid a fixed amount of interest at precise intervals may be, six months or one year. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like past performance and track record of the company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of lending. A company is liable to issue different types of debentures (see Box C and D). The Zero Interest Debentures (ZID) have become very popular in the recent past and the issue of Zero Interest Debentures (ZID) does not carry any explicit rate of interest. The difference between the face value of the debenture and its purchase price is the return to the investor

Convertible and Non-Convertible: Preference shares that can be converted into equity shares within a specified period of time are known as convertible preference shares. On the other hand, non-convertible shares are such that cannot be converted into equity shares.

 

Merits

The advantages of raising funds through debentures are given as follows:

(i) It is preferred by investors who want fixed income at lesser risk;

(ii) Debentures are fixed charge funds and do not partake the profits of the company;

(iii) The issue of debentures is appropriate when the sales and earnings are relatively stable;

(iv) Since debentures do not carry the right to vote, financing through debentures does not dilute control of equity shareholders on management;

(v) Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductible.

 

Limitations

Debentures have specific limitations. These are listed below:

i) As fixed charge instruments, debentures put a permanent burden on the earnings of a company. There is a greater risk when earnings of the company show variation;

(ii) With respect to redeemable debentures, the company has to make provisions for repayment on a specified date, even during if the company is facing financial crisis;

(iii) Each company is bound by certain borrowing capacity. With the issue of debentures, the capacity of the company to further borrow reduces.

Question-7

State the merits and demerits of public deposits and retained earnings as methods of business finance.

Solution:
Public Deposits

The deposits that are raised by enterprises directly from the public are called as public deposits. The Rates of interest obtained on public deposits are comparatively higher than that obtained from the bank deposits. A person can fill up a prescribed form of the organization and deposit the money on to it. The organization would in return issue an acknowledgement in the form of a deposit receipt. It is only Public deposits take care of both medium and short-term financial requirements of a business. These deposits prove to be beneficial to both the depositor and the organisation. Even as the depositors gain higher interest rate than that offered by the banks, the cost of deposits to the company is comparatively lesser than the cost of borrowings from banks. Companies by and large invite public deposits for a prescribed period of three years. The acceptance of public deposits is regulated by the Reserve Bank of India.

Merits

The merits of public deposits are:

(i) The procedure for obtaining deposits are simple and does not involve restrictions unlinke loan agreement;

(ii) The cost of public deposits is usually lower than the cost of borrowings from banks and financial institutions;

(iii) Public deposits does not generate any charge on the assets of the company. The assets as always, can be used as security for applying loans from other sources;

(iv) The depositors are deprived of voting rights and their control over the company does not get diluted.

 

Limitations

The most important limitation of public deposits is listed below:

(i) New companies normally find difficulty in raising funds through public deposits;

(ii) It is an undependable source of finance as the public is unlikely to respond when the company requires money;

(iii) The public deposits may prove thorny, particularly when the size of deposits the company requires is large.

Retained Earnings

A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of

the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or self-financing or ‘ploughing back of profits’. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation.

 

Merits

The merits of retained earning as a source of finance are as follows:

(i) Retained earnings is a permanent source of funds available to an organisation;

(ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost;

(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility;

(iv) It enhances the capacity of the business to absorb unexpected losses;

(v) It may lead to increase in the market price of the equity shares of a company.

Limitations

Retained earning as a source of funds has the following limitations:

(i) Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends;

(ii) It is an uncertain source of funds as the profits of business are fluctuating;

(iii) The opportunity cost associated with these funds is not recognized by many firms. This may lead to Sub-optimal use of the funds.

Question-8

Discuss the financial instruments used in international financing.

Solution:
International Financing

Apart from the sources discussed above, there are several other avenues for organizations to raise funds internationally. With the commencement of the global business organizations and the global activities of the business organizations, Indian companies have an access to funds in global capital market. International sources from where funds may be generated include:

 

(i) Commercial Banks: Globally, Commercial banks provide foreign currency loans for business purposes. They play a vital role in sourcing finance to non-trade international operations. The different types of loans and services provided by banks vary from country to country. For instance, Standard Chartered has now recognized as a major source of foreign currency loans to the Indian industry.

 

(ii) International Agencies and Development Banks: Numerous international agencies and development banks have evolved over the years to finance international trade and business. These bodies offer medium and long term loans and grants to elevate the development of economically backward areas in the world. These bodies were initiated by the Governments of developed countries of the world at national, regional and international levels for financial endowment of various projects. The most prominent among them include International Finance Corporation (IFC), EXIM Bank and Asian Development Bank.

 

(iii) International Capital Markets: Modern organisations as well as multinational companies depend upon sizeable borrowings in rupees and in foreign currency as well. Important financial instruments used for this purpose are:

(a) Global Depository Receipts (GDR’s): The local currency shares of a company are given to the depository bank. The depository bank in turn, issues depository receipts against these shares. These depository receipts accounted in US dollars are known as Global Depository Receipts (GDR). GDR can be defined as a negotiable instrument that can be traded free like any other security. In the Indian context, a GDR serves as an instrument issued abroad by an Indian company to raise funds in any foreign currency and can be listed and traded on a foreign stock exchange. A holder of GDR can convert it into the number of shares it represents as and when it feels the need for it. The holders of GDRs do not possess any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro and ICICI have raised money through issue of GDRs (see Box F).

 

(b) American Depository Receipts (ADR’s): American Depository Receipts can be defined as the depository receipts issued by a company in USA. It is bought and sold in American markets as regular stocks. It is similar to a GDR except for one limitation that it can be issued only to American citizens and can be listed and traded on a stock exchange of USA.

 

(c) Foreign Currency Convertible Bonds (FCCB’s): Foreign currency convertible bonds are equity linked debt securities that has to be converted into equity or depository receipts within the stipulated time limits. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price or exchange rate, or retaining the bonds. The FCCB’s are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar nonconvertible debt instrument. FCCB’s are listed and traded in foreign stock exchanges. FCCB’s are akin to the convertible debentures issued in India.

Question-9

What is the difference between internal and external sources of raising funds? Explain

Solution:
Retained earnings form a part of the internal source of funds where the funds is a result from the profit earned by the organization.

External sources are mainly from deposits collected from the public, financial institutions etc.

Question-10

What is the difference between GDR and ADR?

Solution:
GDR serves as an instrument issued abroad by an Indian company to raise funds in any foreign currency and can be listed and traded on a foreign stock exchange whereas ADR can be issued only to American citizens and can be listed and traded on a stock exchange of USA.

Question-11

Discuss the financial instruments used in international financing

Solution:
Global Depository Receipts (GDR’s): The local currency shares of a company are given to the depository bank. The depository bank in turn, issues depository receipts against these shares. These depository receipts accounted in US dollars are known as Global Depository Receipts (GDR). GDR can be defined as a negotiable instrument that can be traded free like any other security. In the Indian context, a GDR serves as an instrument issued abroad by an Indian company to raise funds in any foreign currency and can be listed and traded on a foreign stock exchange. A holder of GDR can convert it into the number of shares it represents as and when it feels the need for it. The holders of GDRs do not possess any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro and ICICI have raised money through issue of GDRs (see Box F).

 

(b) American Depository Receipts (ADR’s): American Depository Receipts can be defined as the depository receipts issued by a company in USA. It is bought and sold in American markets as regular stocks. It is similar to a GDR except for one limitation that it can be issued only to American citizens and can be listed and traded on a stock exchange of USA.

 

(c) Foreign Currency Convertible Bonds (FCCB’s): Foreign currency convertible bonds are equity linked debt securities that has to be converted into equity or depository receipts within the stipulated time limits. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price or exchange rate, or retaining the bonds. The FCCB’s are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar nonconvertible debt instrument. FCCB’s are listed and traded in foreign stock exchanges. FCCB’s are akin to the convertible debentures issued in India.

Question-12

What is commercial paper? What are its advantages and limitations?

Solution:
Commercial Paper evolved as a source of short term finance in our country in the early years of 1990s. Commercial paper can be defined as an unsecured promissory note issued by an organization to raise funds for a short period of time ranging from 90 days to 364 days. It is issued by one organization to other business organizations viz., insurance companies, pension funds and banks. The money raised by CP is usually very sizeable. The debt being unsecured, the organization having good credit rating is entitled to issue the CP. Its regulation falls under the purview of the Reserve Bank of India. The merits and limitations of a Commercial Paper are as follows:

 

Merits

(i)A commercial paper is very insecure and does not contain any restrictive conditions;

(ii)Due to its freely transferable nature, it has high liquidity;

(iii) It is liable to provide more funds compared to other sources. Generally, the cost of CP to the issuing firm is comparatively lower than the cost of commercial bank loans;

(iv) A commercial paper generates a continuous source of funds. This is due to the maturity that can be tailored to suit the needs of the issuing firm. In addition to this, the a commercial paper that matures can be repaid by selling new commercial paper;

(v) Companies can deposit their surplus funds in commercial paper that can generate good returns.

 

Limitations

(i) Companies that are wealthy and highly rated can raise money through commercial papers. New and moderately rated companies may not be in a position to raise funds through this method;

(ii) The magnitude of money that can be raised through commercial paper is limited to the glut liquidity available with the suppliers of funds at that point of time;

(iii) Commercial paper is a remote method of financing because when an organization is incapable of redeeming its commercial paper, an extension of the maturity period is not provided.





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