Financial Management
Unit-5
INDIAN FINANCIAL SYSTEM
Meaning and Definition of Financial System:
According to Christy, the objective of the financial system is to "supply funds to various
sec-tors and activities of the economy in ways that promote the fullest possible utilization
of resources without the destabilizing consequence of price level changes or unnecessary
interference with individual desires".
Features of Financial System:
The features of a financial system are as follows:
1) Financial system provides an ideal linkage between depositors and investors, thus
encouraging both savings and investments.
2) Financial system facilities expansion of financial markets over space and time.
3) Financial system promotes efficient allocation of financial resources for socially
desirable-and economically productive purposes.
4) Financial system influences both the quality and the pace of economic development.
Constituents of Financial System:
Financial institutions, financial markets, financial instruments, and financial services.
I) Financial Institutions: Financial institutions are intermediaries that mobilize savings and
facilitate the allocution of funds in an efficient manner.
Financial Markets: Financial markets are a mechanism enabling participants to 'deal in
financial claims. The markets also provide a facility in which their demands and
requirements interact to set a price for such claims.
Characteristics of Financial Markets
i) Large Volume of Transactions: Financial markets are characterized by a large
volume of transactions and the speed with which financial resources move from one
market to another.
ii) Various Segments: There are various segments of financial markets such as
stock markets, bond markets — primary and secondary segments, where savers
themselves decide when and where they should invest money.
iii) Instant Arbitrage: There is scope for instant arbitrage among various
markets and types of instruments.
iv) Volatility: Financial markets are highly volatile and susceptible to panic and
distress selling as the behavior of a limited group of operators can get generalized.
v)
Dominated By Financial Intermediaries: Markets are dominated by financial
intermediaries who take investment decisions as well as risks on behalf of their
depositors.
vi) Negative Externalities: Negative externalities are associated with financial
markets. A failure in any one segment of these markets may affect other segments,
including non-financial markets.
vii) Integration with Worldwide Financial Markets: Domestic financial markets are
getting integrated with worldwide financial markets. The failure and vulnerability in a
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particular domestic market can have international 'ramifications'. Similarly, problems in
external markets can affect the functioning of domestic markets.
Types of Financial Markets
On the basis of credit requirement for short-term and long-term purposes, financial markets
are divided into two categories:
i) Money Market: The term 'money market' is used in a composite sense to mean financial
institutions, which deal with short-term funds in the economy. It refers to the
institutional arrangements facilitating borrowing and lending of short-term funds. The
money market brings together the lenders who have surplus short-term investible funds
and the borrowers who are in need of short-term funds. In a money market, funds can
be borrowed for a short period varying from a day, a week, a month, or 3 to 6 months and
against different types of instruments, such as bill of exchange, bankers' acceptances,
bonds, etc., called 'near money'.
ii)
Capital Market:
Financial Instruments: A financial instrument is /a claim against a person or an
institution for the payment at a future date a sum of money and/or a periodic payment
in the form of interest or dividend. The term 'and/or' implies that either of the payments
will be sufficient but both of them may be promised.
Financial securities may be primary or secondary securities:
i) Primary Securities: Primary securities are also termed as direct securities as they are
directly issued by the ultimate borrowers of funds to the ultimate savers. For
example, primary or direct securities include equity, shares and debentures.
ii) Secondary Securities: Secondary securities are also referred to as indirect
securities, as they are the financial intermediaries to the ultimate savers. Mutual fund
units, insurance policies and deposits are secondary securities.
Financial Services: Financial intermediaries provide key financial services such as
merchant banking leasing, hire purchase, credit-rating, and so on. Financial services
rendered by the financial intermediaries’ bridge the gap between lack of knowledge on
the part of investors and increasing sophistication of financial instruments and markets.
These financial services are vital for creation of firms, industrial expansion, , economic
growth.
Meaning and Definition of Capital Market:
.Capital market is generally understood as the market for long-term funds. This market
supplies funds f financing the fixed capital requirement of trade and commerce as well as
the long-term requirements of government. The long-term funds are made available
through various instruments such as debenture, preference shares, and common shares..
According to MN. Khan, "It is a market for long-term funds. Its focus is on financing of
fixed investments contrast to. Money market which is the institutional source of working
capital finance".
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Features of Capital Market
I) Securities Market: The dealings in a capital market are done through the securities like
shares, debentures, etc.-The capital market is thus called securities market.
2) Security Prices: The price of securities that are dealt with in the capital market , is
determined through the general laws of demand and supply. The equilibrium in demand
and supply of securities is brought about by - the prices. The price depends upon a large
number of factors such as the following:
i) Yield on securities,
ii) Extent of funds available from public savings,
iii) Level of demand for funds,
iv) Flow of funds from the banking system,
v) Price situation in general,
vi) Attitude towards liquidity on the part of investors.
Participants: There are many players in the capital market. The participants
constitute a plethora of institutions, which provide a wide variety of services of access
to capital. The capital is either directly supplied or arranged through financial
intermediaries. These intermediaries form the basic structure of a capital market. The
participants in the capital market include:
Financial intermediaries like insurance companies, investment companies, pension funds,
etc.
ii) Non-financial business enterprises.
iii) Ultimate economic units like households and Governments.
Functions of Capital Market
Allocation Function: Capital market allows for the channelization of the savings
of innumerable investors into various productive avenues of investments. Accordingly,
the current savings for a period are allocated amongst the various users and uses.
Liquidity Function: Capital market provides a means whereby buyers and sellers can
exchange securities at mutually satisfactory prices. This allows better liquidity for the
securities that are traded.
Other Functions: In addition to the functions of funds allocation and liquidity, capital
market also renders the following functions:
i) Indicative Function: A capital market acts as a barometer showing not only the
progress of a company, but also of the economy as a whole through share price
movements.
ii) Savings and Investment Function: Capital market provides a means of quickly
converting long-term investment into liquid funds thereby generating confidence
among investors and speeding up the process of saving and investment_
Transfer Function: Capital market facilitates the transfer of existing assets -tangible and intangible — among individual economic units or groups.
iii)
iv) Merger Function: Capital market encourages voluntary or coercive take-over
mechanism to put the management of inefficient companies into more competent hands.
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Importance of Capital Market
Capital Market serves as reliable guide to the performance and financial position of
company.
I) A continuous valuation of companies as reflected in the share price and the implied
possibility of merger and takeovers.
Stock market promotes growth through the creation of liquidity.
2) Stock market attracts foreign investment, which leads to improved accountin g,
reporting standards and exposes domestic companies to advance managerial techniques.
Stock market at times helps companies to obtain equity finance in the absence of loans
from money market.
Structure of Indian Capital Market:
Stock/Secondary Market: A market, which deals in securities that have been
already issued by companies, is known as 'the secondary market'. It is also
called the stock exchange or the share market.
The importance of the secondary market springs from the fact that it is the base
upon which rests the (structure) of the primary market. In other words, for the
efficient growth of the primary market, a secondary market is an essential
requirement. This is because the secondary market offers an facility' of transfer
of securities
New Issue Market/Primary Market: Primary market also known as New
Issues Market (NLM) market for raising fresh capital in the form of shares and
debentures. Corporate enterprises, whith desirous of raising capital funds through
the issue of securities, approach the primary market. Is - exchange financial
securities for long-term funds. The primary market allows for the formation of capital
the country and the accelerated industrial and economic development.
Secondary market:
The secondary market, is the financial market where previously
Securities and financial instruments such as stock, bonds, options and futures are bought
and sold. The tern "secondary market" is also e .1 to refer to the market for any used goods
or assets or an alternative use for existing product or asset where the customer base is the
second market With primary issuances of securities or financial instruments or the primary
market, investors purchase the securities directly from issuers such as corporations
issuing shares in an IPO or private placement or dire from the federal government in
the case of treasuries. After the initial issuance, investors can purchase of other
investors in the secondary market.
Features of Secondary Market
 Secondary market deals in previously issued securities.
 This market is not the place of the origin of the security.
 Securities are not issued directly by the company to investors.
 Securities are sold by the existing investors to other investors.
 The intending buyer and seller can buy and sell securities through brokers.
 Securities market provides liquidity to the investment and enhances th e
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marketability of securities.
 Secondary markets merely transfer existing securities between buyers and sellers.
 Secondary markets do not directly contribute to capital formation.
Functions of Secondary Market:
Ensure Liquidity of Capital: The stock exchanges
provide a place where shares and stock are
converted into cash. The exchanges provide a ready
market where buyers and sellers are always
available and those who a r e i n n e e d o f h a r d
c a s h c a n s e l l t h e i r holdings.
Continuous Market for Securities: The stock exchanges
provide a ready market for securities. The securities
once listed continue to be traded at the exchanges irrespective of the fact that their
owners go on changing. The exchanges provide a regular market for trading in
securities.
Limitations/Weaknesses of Secondary Market
1)
Rampant Speculation: Indian stock exchanges have been witnessing spells of
unprecedented booms crashes. While the cost has been experiencing generally
4-5% rate of growth, the share prices have high volatility
2)
Insider Trading: Like speculation, insider trading is rampant. In Indian
stock exchanges. Insider tract* means operation information which is price
sensitive and not available to the public. Insider trading is tikes trading from a
position of privilege in respect of price-sensitive information.
3)
Oligopolistic: The Indian stock Market cannot be called truly competitive. It is
highly dominated by large financial and institutional big brokers and operators and is,
thus, oligopolistic in structure.
4)
Limited Forward Trading: There can be three types of transactions
undertaken at the stock exchanges namely spot delivery, hand delivery and
forward delivery. Trading in share for clearing was common banned in India in
1969. It had a very adverse effect on share prices.
5)
Outdated Share Trading System: The share trading system followed in Indian
stock exchanges, when matched an international prospectus is thoroughly
outdated and inefficient. Major problem areas include settlement periods, margin
system and carry for (bad la system.
6) Lack of a Single Market: Due to the inability of various stock exchanges to
function cohesively, the growth in business in any one exchange or region has
not been transmitted to other exchanges. The limited inter-market operations have
resulted in increased costs and risks of investors in smaller towns.
7) Problem of Interface between the Primary and Secondar y Markets: The recent
upsurge of the primary market has created serious problem §' of interfacing with
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the secondary market, viz., the stock exchanges which still, by and large,
continue with the same old infrastructure and ways of long which suited the very!'
narrow base of the capital market in the yester years. but are totall y out of tune
with fast market and the desired tempo of work at present. .
8)
Inadequacy of Investor Service: It is commonly felt that exchanges,
particularly the smaller ones, hate been unable to service their investors
adequately, and have been able to make only a limited contribution to the spread of
the equity cult in their region.
New issue market/primary market/IPO:
Meaning of Primary Market
The primary market represents the new issue market where new securities, i.e.
shares or bonds that have never been previously issued, are offered. Both the new
Companies and the existing ones can raise capital on the neve issue market. The
prime function of the new issue market is to facilitate the transfer of funds from the
willing investors to the entrepreneurs setting up new corporate enterprises or going
in for expansion, diversification, growth or modernization.
Features of Primary Market
 Primary market concerns new long-term capital.
 Securities are sold for the first time in this market.
It is also known as New Issue Market (NIN).
 Securities are issued directly to investors.
 Security certificates are issued to investors.
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Securities are issued by companies for setting new business and for
expanding or modernizing existing 'business. .
It facilitates capital formation in the economy.
Funds generated in this market are utilized for the purchase of fixed assets.
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It does not include long-term loans from financial institutions.
It is the process of going public, i.e., converting private capital into public capital.
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Functions of Primary Market:
The main service functions of the primary market are as follows:
1) Origination: Origination deals with the origin of the new issue. The proposal
is analyzed in terms of the nature of the security, the size of the issue, and
timing of the issue and floatation method of the issue.
Time of Floating of an Issue: This determines the mood of the investment
Market. Timing is crucial because it has a reflection on the subscription of an issue.
ii) Type of Issue: This refers to the kind of securities to be issued whether equity,
preference, debentures or convertible securities. These have significance with the
existing trends in the investment market.
iii) Price: The encouragement of the public to a particular issue will largely
depend on the price of an issue. Well established firms of some group
connections may be able to sell their shares at a premium at the time of a new
issue, but relatively unknown firms will have to be cautious of the price.
Price of shares of these firms should be fixed at par. There is a danger of fixing
prices at a discount as these may undervalue the firm and bring down their
reputation.
i)
2) Underwriting: Underwriting is a kind of guarantee undertaken by an institution
or firm of brokers ensuring the marketability of an issue. It is a method whereby
the guarantor makes a promise to the stock issuing company that he would
purchase a certain specified number of shares in the event of their not being
invested by the public.
3) Distribution: The third function is that of distribution of shares. Distribution means the
function of sale of shares and debentures to the investors. This is performed by brokers
and agents. They maintain regular lists of clients and directly contact them for purchase
and sale of securities.
Operations in Primary Market
Primary market is the issuance place for new securities. There are four ways in which a
company may raise equity capital in the primary market:
1) Public Issue: By far the most important method of issuing securities, a public
issue, involves sale of securities to the public at large, Public issues in India are
governed by the provisions of the Companies Act, 1956, SEBI Guidelines on Investor
Protection, and the listing agreement between the. Issuing company and the stock
exchanges.
Advantages of Public Issue
The advantages of public issue through prospectus are as follows:
i) The company and the issue get full publicity.
ii) The entire issue process becomes transparent to the public and the authorities.
iii) The issue gets widely 'distributed and thus helps in reducing concentration of
wealth and economic power.
iv) The issue is allotted among the applicants on non-discriminatory basis.
v) Artificial scarcity of shares in the market is avoided, thus minimizing the
artificial jacking up of prices of new floatation.
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Disadvantages of Public Issue:
i) The company has to bear the publicity costs.
ii) The company has to incur floatation costs, like brokerage, underwriting expenses, etc.
iii) The company also has to incur administrative costs, like cost of printing
the prospectus and other documents, postage, other administration costs, bank
charges, etc.
iv) The company has to bear legal costs, like stamp duty, registration fees, etc.
v) This mode of issuing securities is beneficial only for large issues due to these high
costs.
2) Rights Issue: A rights issue involves selling securities in the primary market
by issuing rights to the existing shareholders. When a company issues additional
equity capital, it has to be offered in the first instance to the existing shareholders on a
pro rata basis. This is required under Section 81 of the Companies Act 1956. The
shareholders, however, may by a special resolution forfeit this right, partially or fully,
to enable a company to issue additional capital to the public.
Rules of Right Issue
I he rules regarding the rights issue are as follows:
 Only that company can make right issue whose shares are already in the market.
 Rights should be issued on pro-rata basis.
 A notice should be issued to the shareholders to specify the number of shares issued.
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
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The time given to accept the right offer should not be less than 15 days.
Each shareholder should be given an option either to subscribe it or renounce it or
surrender.
After the expiry of the time given in the notice, the board of directors has the
right to depose the unsubscribed shares in such a manner, as they think beneficial to
the company.
Private Placement: Private placement and preferential allotment involve sale of
securities to a limited number of sophisticated investors such as financial
institutions, mutual funds, venture capital funds, banks, and so on.
In a preferential allotment, the identity of investors is known when the issuing company
seeks the approval of its shareholders, whereas in a private placement, the identity of
investors is not known when the offer document (popularly known as the information
memorandum) is prepared.
Advantages of Private Placement
i) Cost Effective.
ii) Time Effective.
iii) Structure Effectiveness.
iv) Access Effective.
v) Disadvantages of Private Placement
i) The issue may be concentrated in fewer hands.
ii) The intermediaries may create artificial scarcity of these securities for
increasing their prices temporarily.
iii) This method does not generate confidence in the minds of investing public.
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Preferential Allotment: An issue of equity by a listed company to selected investors at a
price which may or may not be related to the prevailing market price is referred to as
preferential allotment in the Indian capital market. A preferential allotment is not related to
a public issue and it should not be confused with
Limitations of Primary Market
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Inadequate Mobilization of Savings.
Under-development of Merchant Banking
Valuation of Securities.
Mobilizing Surplus Savings.
Helpful in Raising New Capital.
Safety in Dealings.

Listing of Securities
 Platform for Public Debt
 Diversion of Funds
Relationship between Primary and Secondary Market
I) Liquidity: The new issue market c4nnot function without the secondary market.
The secondary market or the stock market provides liquidity for the issued
securities. The issued securities are traded in the secondary market offering
liquidity to the stocks at a fair price.
2) Listing: The stock exchanges through their listing requirements, exercise control
over the primary market. The company seeking for listing on the respective stock
exchange has to comply with Al the rules and regulations given by the stock
exchange.
3) Marketability: The primary market provides a direct link between the
prospective investors and the company. By providing liquidity and safety, the stock
markets encourage the public to subscribe to the new issues. The marketability and the
capital appreciation provided in the stock market are the major factors that attract the
investing public towards the stock market. Thus, it provides an indirect link between the
savers and the company.
4.Complementary: Even though they are complementary to each other, their
functions and the organizational set up are different from each other. The health
of the primary market depends on the secondary market and vice-versa.
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Leasing:
The lease rentals can also be agreed both in terms of amount and timing as per the profits
and cash flow position of the lessee. At the expiry of the lease period, the asset reverts
back to the lessor who is the legal owner of the asset. However, in long-term lease
contracts, the lessee is generally given an option to buy or renew the lease.
Essential Elements of Lease Financing
1) Parties to the Contract: There are essentially two parties to a contract of lease
financing, namely, the owner and the user, called the lessor and the lessee
respectively. Lessors as well as lessees may be individuals, partnerships, joint stock
companies, corporations or financial institutions. Sometimes there may be joint lessors
or joint lessees, particularly where the properties or the amount of finance
involved is enormous.
2) Asset: The asset, property or equipment to be leased is the subject-matter of a contract
of lease financing. The asset may be an automobile, plant and machinery, equipment,
land and building, factory, a running business, aircraft, and so on. The 'asset must,
however, be of the lessee's choice suitable for his business needs.
3)
Ownership Separated From User: The essence of a lease financing contract is
that during the lease- tenure, ownership of the asset vests with the lessor and its use
is allowed to the lessee. On the expiry of the lease tenure, the asset reverts to the
lessor.
4) Term of Lease: The term of lease is the period for which the agreement of lea'se
remains in operation. Every lease should have a definite period otherwise it will be
legally inoperative. The lease period may sometiraes stretch over the entire economic
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life of the asset (i.e., financial lease) or a period shorter than the useful life of the asset
(i.e., operating lease). The lease may be perpetual, that is, with an option at the end of
lease period to renew the lease for the further specific period.
5) Lease Rentals: The consideration which the lessee pays to the lessor for the lease
transaction is the lease rental. The lease rentals are so structured as to compensate the
lessor for the investment made in the asset (in the form of depreciation), the interest on
the investment, repairs and so forth — borne by the lessor, and servicing charges over
the lease period.
6)
Modes of Terminating Lease: The lease is terminated at the end of .the lease period
and various courses are possible, namely,
i) The lease is renewed on a perpetual basis or for a definite period, or
ii) The asset reverts to the lessor, or
iii) The asset reverts to the lessor and the lessor sells or leases it to a third party,or
iv) The lessor sells the asset to the lessee.
Types of Leasing
I) Operating or Service Lease: According to the IAS (International Accounting
Standard), an operating lease is one which is not a finance lease. In an operating
lease, the lessor does not transfer all the risks and rewards incidental to the
ownership of the asset and the cost of the asset is not fully amortized during the
primary lease period. The lessor provides services (other than the financing of the
purchase price) attached to the leased asset, such as maintenance, repair and technical
advice
2)- Financial Lease: A lease is classified as financial lease if it ensures the lessor for
amortization of the entire cost of investment plus the expected return on capital outlay during
the term of the lease Such a lease is usually for a longer period and non-cancelable
3) Sale and Lease Back: Under sale and lease back type of lease, a firm may sell
an asset which it owns to another party and lease it back from the buyer. The
lessee receives immediate cash for his and repays the lease rentals over the
stipulated period.
4) Direct Lease: In direct lease, the
lessee, and the owner of the
equipment are two different
entities. A lease can be of two
types: Bipartite and Tripartite
lease.
i) Bipartite Lease: There are two
parties in the lease transaction,
namely,
a) equipment supplier-cumlessor, and
b) Lessee.
/
ii) Tripartite Lease: Such type of lease involves three different parties in the lease
agreement: equipment supplier, lessor and lessee.
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5) Single Investor Lease: There are only two parties to the lease transaction: the lessor
and the lessee. The leasing company.
6) Leveraged Lease: In a leveraged lease, there are three parties involved — lessor
(leasing company), lessee (user of the equipment), and financer. Leasing company
contributes by way of equity capital, financial institution, and/or banks finance by way
of term loans towards the purchase of an asset to be leased.
7) Domestic Lease: A lease transaction is said to be a domestic lease if all parties to
the transaction are domiciled in the same country.
8) International Lease: If the parties involved in the leasing transaction are located in
two different nations, the transaction is clarified as an international lease transaction.
This type of lease is further sub-classified into:
i) Import Lease: In an import lease, the lessor and the lessee are domiciled in the
same country but the equipment supplier is located in a different country. Th e
lessor imports the asset and leases it to the lessee.
Cross-Border Lease: When the lessor and the lessee are domiciled in different
countries, the lease is classified as cross-border lease. The domicile of the supplier is
immaterial.
Advantages of Leasing
The advantages of leasing to the lessee and to the lessor are as follows:
1) To the Lessee
i) Financing of Capital Goods: Lease financing enables the lessee to have finance for
huge investments in land, building, plant, machinery, heavy equipments, and so on,
up to 100 percent, without requiring any immediate down payment. Thus, the lessee
is able to commence his business virtually without making any initial investment (of
course, he may have to invest the minimal sum of working capital needs).
ii)
Additional Source of Finance: Leasing facilitates the acquisition of equipment, plant
and machinery, without the necessary capital outlay, and, thus, has a competitive
advantage of mobilizing the scarce financial resources of the business enterprise.
It enhances the working capital position and makes available the internal accruals
for business operations.
iii) Less Costly: Leasing, as a method of financing, is less costly than other alternatives
available.
iv) Ownership Preserved: Leasing provides finance without diluting the ownership
or control of the promoters. M against it; other modes of long-term finance, for
example, equity or debentures normally dilute the ownership of the promoters.
v)
Avoids Conditionalities: Lease finance is considered preferable to institutional
finance, as in the former case, there are no strings attached. Lease financing is
beneficial, since it is free from restrictive covenants and conditionalities, such as,
representations on the Board, conversion of debt into equity, payment of dividend,
and so on, which usually accompany institutional finance and term loans from
banks.
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vi) Flexibility in Structuring of Rentals: The lease rentals can be structured to
accommodate the cash flow position of the lessee, making the payment of rentals
convenient to him. The lease rentals are so tailor-made that the lessee is able to pay
the rentals from the funds generated from operations.
vii) Simplicity: A lease finance arrangement is simple to negotiate and free from
cumbersome procedures with faster and simple documentation. As against it,
institutional finance and term loans require compliance of covenants, formalities
and bulk of documentation, causing procedural delays.
viii) Tax Benefits: By suitable structuring of lease rentals, a lot of tax advantage can
be derived. If the lessee is in a tax paying position, the rental may be increased to
lower his taxable income.
ix)
Obsolescence Risk is Averted: In a lease arrangement, the lessor, being the owner,
bears the risk of obsolesce rice and the lessee is always free to replace the asset with
latest technology.
2) To the Lessor
i) Full Security: The lessor's interest is fully secured since he is always the owner of
the leased asset an can take repossession of the asset if the lessee defaults. As
against it, realizing an asset secured against a loan is more difficult and
cumbersome.
ii) Tax Benefit: The greatest advantage for the lessor is the tax relief by way of
depreciation. If the lessor is in high tax bracket, he can lease out assets with high
depreciation rates and, thus, reduce his tax liability substantially. Besides, the
rentals can be suitably structured, to pass on some tax benefit to tht_ assessee.
iii) High Profitability: The leasing business is highly profitable, since the rate of return
is more than what the lessor pays on his borrowings. Also the rate of return is
more than in case of lending finance directly.
iv) Trading on Equity: Lessors usually carry out their operations with greater financial
leverage. That is, they have a very low equity capital and use a substantial amount
of borrowed funds and deposits. Thus, the ultimate return on equity is very high.
v) High Growth Potential: The leasing industry has a high growth potential. Lease
financing enables the lessees to acquire equipment and machinery even during a
period of depression, since they do not have to invest any capital. Leasing, thbs,
maintains the economic growth even during recessionary period.
Disadvantages of Leasing
1) To the Lessee
i) High Cost: The lease rentals include a margin for the lessor as also the cost of risk
of obsolesce is, thus, regarded as a form of financing at higher cost.
ii)
Loss of Moratorium Period: The lease rentals do not take care of the gestation
period. It usually • a long time before the asset generates funds to pay it back. The
term loan provides certain suspect period in repayment's for that reason. But no
such moratorium is permitted under lease arrangements.
iii) Risk of being deprived of the Use of Asset: The lessee may be deprived of the
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use of the asset due the deterioration in the financial position of the lessor or
winding up of the leasing company.
iv) No Alteration or Change in Asset: As the lessee is not the owner of the asset, he
cannot make substantial changes in the asset. Contrary to it, in case of outright
purchase, the buyer can mod if. Alter the asset to increase its utility.
v)
Loss of Ownership Incentives: There are certain advantages of owning the assets,
such as depreciative and investment allowance. In case of lease, the lessee is not
entitled to such benefits.
vi) Penalties on Termination of Lease: The lessee is usually required to pay
certain penalties if terminates the lease before the expiry of the lease period.
vii) Loss of Salvage Value of the Asset: An asset generally has certain salvage value
at the expiry of the useful life. As the lessee does not become the owner of the
asset, he cannot realize the salvage value a: the expiry of the lease rather he has to
return the asset to the lessor.
2) To the Lessor
i) High Risk of Obsolescence: The lessor has to bear the-risk of obsolescence
especially in the present era of rapid technology developments.
ii) Competitive Market: As a number of leasing companies have emerged in
recent years in India, the lessor has to face a tough competition from Indian
as well foreign companies. Due to this competition, the lessor may not be able
to obtain sufficient lease rentals to recover the cost of the asset and his expected
profit on investment as well as taking the risk.
iii) Price-Level Changes: In spite of the increase in prices of assets due to inflation,
the lessor gets only fixed rentals based on previous costs.
iv) Management of Cash Flows: The success of a leasing business depends to a
large extent upon efficient use of cash flows which are very difficult to
manage because of unexpected market fluctuations.
v) Increased Cost due to Loss of User Benefits: The lessor is not entitled to certain
benefits available to buyers who are actual users of the assets such as concession
in sales tax, duties, etc. This increases the cost of the asset and compels the lessor to
charge higher lease rentals.
Hire Purchase:
Hire purchase means hiring of an asset for a period of time and at the end of the period,
purchasing the same_ Actually, this is time sharing of the asset — the person hiring the asset
acquires its possession and the right to use it. As a legal ,device it is being used for financing
of capital goods such as industrial finance, financing consumer goods and for selling
consumer good on hire purchase.
--According to Pearce E.H., R.F.G., as "a contract on hire with an option of purchase, in
Which the owner of goods out on hire to the hirer for a fixed term at an agreed rental to be
paid at intervals mutually agreed upon as installments, and the owner in addition to
letting the goods out, further agrees that if the hirer keeps them for the agreed
Period and regularly pays the rent, they shall become the hirer's property".
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Financial Management
Hire purchase means a transaction where goods are purchased and sold
on the terms that: Features:





Payment will be made in installments,
The possession of the goods is given to the buyer immediately,
The property (ownership) in the goods remains with the vendor till the last installment
is paid,
The seller can repossess the goods in case of default in payment of any installment,
and
Each installment is treated as hire charges till the last installment is paid.
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Financial Management
Types of Hire Purchase
Consumer Installment Credit: Consumer installment
credit is finance offered to consumers for acquiring
consumer durables. Installment credit may be in the form
of a personal loan credit sale, rental or conditional sale in
the forin of hire purchase.
. It may be in the form of direct collection, agency
collection or block discounting.
Advantages of Hire Purchase:
Higher Realized Income: Higher rate of interest can be
charged and as the calculation is on the original advance, higher income would be realized.
Low NPAs: As the company is the owner, attachment of the vehicle and subsequent
sale even by private auction would keep the NPAs low.
1)
Fewer Defaulters: As the borrowers would end up losing the installments paid as
well as the vehicle, defaults would be lower
Recycle Recovered Funds: The banks can effectively recycle the funds recovered.
Disadvantages of Hire Purchase
1) Encourages Lavish Expenditure: On account of the easy payment facility,
consumers go in for articles, which may be beyond their means. Thus, this encourages
lavish expenditure.
2)
Future Income is Mortgaged: As consumers have to pay installments over a period
of time, their future income is mortgaged.
3)
Higher Installment Price: The installment price is higher than the cash-down price.
4)
Difficulty in Re-sale of Goods: Even though the hire-seller has the right to repossess the
articles in case of default, to sell them again is difficult as they are second hand goods.
5.5.9.4. Differences between Leasing and Hire Purchase
Point of Difference
Leasing
Hire
Purchase
1) Ownership
Ownership is not transferred to the lessee.
Ownership is
transferred to the hirer
on - payment of last
installment
2 ) ' Tax Entire lease rentals are tax-deductible
Only the interest component and not In
Deductibility expenses.
entire installment is deductible,..
I 3 Depreciation and Cannot be claimed by the lessee
Can be claimed by the hirer.
. Other
4) Salvage
Value
Lessee cannot realize salvage value of Hirer can realize the salvage value o f
Allowances
the asset on
asset after payment of last installment
the expiry of the lease of life of the asset. expiry of the life of the asset.
5) Magnitude
The magnitude of funds involved in the The cost of acquisition in .hire.,'
purchase
lease
finance is very large, for example, for relatively low, that is, automobiles,
,
equipments and generators and so on
the
purchase of aircrafts, ships, machinery, are
generally hire-purchased.
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conditioning
plants and so on.
Financial Management
r
6) Margin
Money
•
7.Maintenance •
_
.
Lease financing is invariably 100
In a hire-purchase transaction typically
percent
a
margin
equal to t h e.
financing. It requires no margin money or
.
of
the
equipment
is *wired to be paid
immediate
cash down
In case of finance
leasepayment
only, theby the
The
cost of maintenance of hired asset
the
hirer.
lessee.
is
maintenance of
the leased assets is the responsibility of be borne typically by the hirer himself.
.
the lessee.
It is the lessor (seller) who has to bear
Venture Capital Financing
the fund is usually used to denote Mutual funds or Institutional
The term Venture Capital
maintenance
cost in an
lease.to little known, unregistered,
investors."They provide
equity finance
or operating
risk capital
highly risky, young and small private business, 1 especially in technology oriented and
knowledge intensive business.
According to 1995 Finance Bill, "Venture capital is defined as long-term equity
investment in novel technology based projects with display potential for significant
growth and financial return".
Features of Venture Capital Financing:
 Venture Capital consists of high risk and high return based financing,

Venture Capital Financing is equity and quasi-equity financing
instruments,


Venture Capital provides moderate interest bearing instruments,
Venture Capital reduces the financial burden of the business
concern at the initial stage,
Venture Capital is suitable for risk-oriented and high-technology
based industry.

Steps/stages of venture capital financing:
1. Seed capital
(i) Startup stage
(ii)Second round financing
2. Later stage financing:
(i) Development capital
(ii) Expansion/bridge
(iii)Buyout
Seed capital:
(i)Startup stage: in this stage when product/service is commercialized for the first time in
association with venture capital institutions.
(ii) Second round financing:
This represents the stage at which the product has already been launched in the market but
the business has not yet become profitable enough for public for attract new investors.
iii) Later stage financing: This stage of venture capital financing involves established
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Financial Management
business which requires additional financial support but cannot take recourse to public
issues of capital.
Development capital:
This is financing of established businesses which have overcome the extremely high risk
early stage have recorded profits for a few years but to reach stage when they can go
public and raise money from the capital market/conventional sources.
Expansion/bridge : It involves low risk perception and a time frame of one to three years.
It undertakes use such finance to expand business by way of growth of their own productive
assets or by the acquisition of other firm/growth of their firms.
Buyout:
Management buyout: provisions of funds to enable existing management /investors to
acquire an existing product.
Management buy in: funds provided to enable an outside group buy an ongoing
venture/company.
Advantages of Venture Capital Financing:
1) They can provide large sums of equity finance and bring a wealth of expertise to
business.
2) Successfully attracting a VC can help the business to find easier and secure funding from
other sources.
3) They could also be a part of economic growth.
4) The venture capitalist could take part in promoting innovative ideas which otherwise
would have buried due to paucity of funds
5) It could encourage new breed entrepreneurs to take risk.
6) Moreover the venture capitalist could benefit from the growing economy and can take
advantage from it.
Disadvantages of Venture Capital
1) Securing a deal with a VC can be a long and complex process.
2) Person will be required to draw up a detailed business plan, including financial
projections for which the entrepreneur may need professional help. Support from his local
business link may be available for this.
3) If he gets through the deal negotiation stage, he will have to pay legal and accounting fees
whether or not he becomes successful in securing funds.
4) Since the venture capitalist is taking the risk, the management control may get out of the
entrepreneur.
5) He will-also be forced to partner the benefits, such as the profit he got from the business,
with the venture capitalist.
Private Equity:
Private equity funds have historically been a major source of funding for start -up
companies and for firms that are in financial distress. Private equity funds are investment
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Financial Management
companies that buy publicly held companies and convert them to private ownership —
usually through a limited partnership. Although the market for private equity started in
the 1960s it expanded rapidly in the mid-2000s. This represents a significant change in the
way corporations are owned. Private equity firms avoid the disclosure regulations that publicly traded firms face. They also avoid the accounting regulations put on publicly traded
firms.
Means of Private Equity Investment
The principal means of private equity
investment are:
1) Investing in private equity funds.
2) Outsourcing selection of private
equity funds.
3).
Direct
investment
in
private
companies.
While it is sometimes the ultimate objective of investors to make direct investments into
companies, compared with investing through funds it requires more capital, a
different skill set, more resource and different evaluation techniques.
Advantages of Private Equity
1) Absolute
Returns: Excessive volatility and poor investment performance
experienced by quoted portfolios, many of which have index-tracking strategies or are
benchmarked to an index have led to a swing in favor of strategies that seek
absolute returns.
2) Improvement in Portfolio Diversification: Within a balanced portfolio, the
introduction of private equity can improve diversification. Although lower correlation of
returns between private equity and public mark -et classes is widely debated and needs
further investigation, the numbers do indicate a lower correlation.
3) Exposure to the Smaller Companies Market: The private equity industry has
brought co , governance to smaller companies and provides an attractive manner of
gaining exposure to a growth Car that went out of favor with market investors in the
mid 1990s for reasons of liquidity.
4)
Ability to Back Entrepreneurs: Entrepreneurs have also created value in both
traditional and industries. The private equity asset class offers the ability to gain
investment exposure to entrepreneurial sectors of the economy.
5) Influence over Management and Flexibility of Implementation: Private equity
managers generally seek active participation in a company's strategic direction, from
the development of a business plan to selection' of senior executives, introduction of
potential customers, M&A strategy and identification of ev acquirers of the
business.
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Financial Management
Disadvantages of Private Equity
1) Long-Term Investment: In general, holding periods between investment and
realization can be especially to average three or more years (although this may be
shorter when IPO markets are especially healthy). Because the underlying portfolio
assets are less. liquid, the structure of private equity funds is normally a closed-end
structure, meaning that the investor has very limited or no ability to withdraw its
investment during the fund's life.
2) Increased Resource Requirement: As a result of the active investment style typical of
the industry and the confidentiality of much of the investment information involved, the
task of assessing the relative merits of different private equity fund managers is
correspondingly more complex than that of benchmarking quoted fund managers.
3) Investing: When committing to a private equity fund, the commitment is typically to
provide cash to the fund on notice from the general partner. Whilst launch
documentation will outline the investment strategy and restrictions, investors give a
very wide degree of discretion to the manager to select the companies that the
investors will have a share in.
Explain in detail the cash management models proposed by Baumol and Miller
with their merits and demerits.
Cash Management Models
Two important cash management models which lead to determination of optimum balance of
cash are,
Optimum Cash Balance under Certainty: Baumol's Model
•
The Baumol cash management model provides a formal approach for determining a firm's
optimum cash balance under certainty. It considers cash management similar to an
inventory management problem. As such, the firm attempts to minimize the sum of the
cost of holding cash (inventory of cash) and the cost of converting marketable securities to
cash.
Assumptions of Baumol's Model
The Baumol's model makes the following assumptions:
 The firm is able to forecast its cash needs with certainty.
 The firm's cash payments occur uniformly over a period of time.
 The opportunity cost of holding cash is known and it does not change over time.
 The firm will incur the same transaction cost whenever it converts securities to
cash.
Let us assume that the firm sells securities and starts with a cash balance of C rupees. As
the firm spends cash, its cash balance decreases steadily and reaches to zero. The firm
replenishes its cash balance to C rupees by selling marketable securities. This pattern
continues over time. Since the cash balance decreases steadily, the average cash balance will
be:
The firm incurs a holding cost for keeping the cash balance. It is an opportunity
cost; that is, the return foregone on the marketable securities. If the opportunity cost is
k, then the firm's holding cost for maintaining an alit... age cash balance is as follow:
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Financial Management
Holding cost = k (C/2)
The firm incurs a transaction cost whenever it converts its marketable securities to cash.
Total number of transactions during the year will be total funds requirement, T, divided by
the cash balance, C, i.e. TIC. T he per transaction cost is assumed to be constant. If per
transaction cost is c, then the total transaction cost will be:
Transaction cost = c (TIC)
The total annual cost of the demand for cash will be Total cost = k(C/2) + c(T/C)
Figure 2: Cost Trade-off Baumol's Model
The holding cost increases as demand for cash, C, increases. However, the transaction
cost reduces because with increasing C the number of transaction will decline. Thus, there is
a trade-off between the holding cost and the transaction cost. Figure 2 depicts this trade-off.
The optimum cash balance, C*, is obtained when the total cost is minimum. The formula
for the optimum cash balance is as follow: Where C* is the optimum cash balance, c is the
cost per transaction, T is the total cash needed during the year and k is the opportunity cost
of holding cash balance. The optimum cash balance will increase with increase in per
transaction cost and total funds required and decrease with the opportunity cost.
Merits of the Baumol Model
The unconstrained nature of the neo-classical model in the price, output, and profit is not
achievable since there are other market factors that can affect the three variables. By
assuming that some constraints exist for one or more of the three variables above,.
Demerits of the Baumol Model
1) Assumes a constant disbursement rate.
2) Ignores cash receipts during the period.
3) Does not allow for safety cash reserves.
Optimum Cash Balance under Uncertainty: Miller-Orr Model
The Miller-Off (MO) model is also known as stochastic model. This model overcomes
the shortcoming of Baumol's model and allows for daily cash flow variation. It assumes
that net cash flows are normally distributed with a zero value of mean and a standard
deviation. As shown in figure 3, the MO model provides for two control limits-the upper
control limit and the lower control limit as well as a return point. If the firm's cash flows
fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to
come back to a normal level of cash balance (the return point). Similarly, when the firm's
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Financial Management
cash flows wander and hit the lower limit, it sells sufficient marketable securities to
bring the cash balance back to the normal level (the return paint).
The firm sets the lower control limit as per its requiremem of maintaining minimum cash
balance. At what distance the upper control limit will be set? The difference between the
upper limit and the lower limit depends on the following factors:
i) The transaction cost (c)
ii) The interest rate, (i)
iii) The standard deviation (g) of net cash flows.
The formula for determining the distance between upper and lower control limits (called Z)
is as follows:
(Upper Limit — Lower Limit) = (3/4x Transaction Cost x Cash Flow Variance/Interest
Rate)1/3
Z (3/4 x ca2 / i) 113
Merits of the Miller-Orr Model
1) Allows for net cashflows occurring in a random fashion.
2) Transfers can take place at any time and are instantaneous with a fixed transfer
cost.
3) Produces control limits which can be used as basis for balance management.
4) The Miller-ORR model may save management time which might otherwise be spent in
responding to those cash inflows and outflows which cannot be predicted.
Demerits of the Miller-Orr Model
1) May prove difficult to calculate.
2) Monitoring needs to be continuous, for the organization to benefit.
3) The usefulness of the Miller-ORR model is limited by the assumptions on which it is
based.
4) In practice cash flows and outflows are unlikely to be entirely unpredictable.
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