MODULE 2 SOURCES OF FINANCING

The business firm should have sufficient sources of financing to meet its investment needs. All firms requires two types of finance namely: 1) 2) Long term financing/ financing for capital assets Short term financing / working capital financing

The firm may have basically two sources of financing namely internal sources and external sources. Former includes depreciation fund and retained earning where as later includes various debt and equity sources. Internal sources: i) ii) Depreciation fund Capitalization of retained earnings

External sources: 1) Long term: a) b) c) Equity / preference shares Term loans Debentures/ bonds

d) e) 2)

Leasing/ hire purchase Venture capital etc.

Short term: a) b) c) d) Trade creditors Cash credit / overdraft Short-term loans/ bill discounting Export financing etc.

1)

INTERNAL SOURCES OF FINANCING: Depreciation fund maintained and retained earnings constitute

important source of internal source of financing. By capitalization the retained earnings the firm can use the fund for desired purpose. Advantages: 1) 2) 3) It is readily available internally It is additional equity without any cost No dilution of control

Limitations: i) ii) iii) Amount funds that can be raised is minimum This source is available only with an existing firm Opportunity cost of this source is very high.

2)

EQUITY SHARES: Equity capital is also a ownership capital. Equity shareholders

enjoys the profit of the firm on one hand and bears the risk on the other hand.
i)

Authorized capital: It is the maximum capital which an organization can issue.

ii)

Issued capital: It is that part of authorized capital which is actually issued by the company.

iii)

Subscribed capital: It is that capital which is subscribed by the public when it was issued.

iv)

Called up and paid up capital: It is the equity capital which is actually paid by the investor.

Book value: It is the value of the equity shares, as shown in the balance sheet. = Paid up equity capital + reserves and surplus / No. of equity shares. Face value: It is the normal price of the shares to be issued by the company. Issue price: It is the price at which the company issues the shares, usually its more than face value.

Market price: When shares are traded in secondary market the prevailing price is a market price. Features of equity shares:
i)

Residual claim on income:- After paying interest, tax, preference dividend, the remaining profit is distributed to equity share holder.

ii)

Residual claim on asset: While repaying capital also equity shareholders stands last.

iii)

Right to control : the firm Voting rights are available to share holders Pre-emptive rights: This rights of equity shareholders makes the company to offer additional equity shares to existing equity holders before it is offered to general public.

iv)
v)

vi)

Limit liability arises in case of equity capital.

Merits: a) b) c) d) It is a permanal source no maturity period No compulsion to pay dividend It provides cushion to lenders Dividend on equity capital is tax exempted in the hands of investors.

Limitations: i) ii) iii) Dilutes the control Floatation (issue cost) cost is very high Dividend on equity is not allowed as deduction for tax purpose, more over there will be a additional tax on dividend declared. Issue of equity shares: Firm can raise finance by issuing equity shares in different forms like: a) By going for IPO b) By going for subsequent issue c) By right issue d) By private placement e) By preferential allotment a) Initial public offer of equity shares (IPO):If the firm is issuing the shares for the first time, it is referred to as initial public offer. Initial public offer will be followed by listing of the equity shares in the stock exchange. Benefits of going public: Access to capital Respectability

Investors recognition Liquidity to promoters Signals from markets

Cost of going public (limitations): Dilution of control Loss of flexibility Disclosure Accountability Public pressure Costs associated with issue

Steps involved in IPO Approval of board of directors Appointment of lead managers (merchant banker) Appointment of other intermediaries like co-managers, underwriters, registrar, bankers, brokers etc. Filing of prospectus with SEBI Filing of prospectus with Registrar of companies. Printing and dispatch of prospectus Statutory announcement of the issue

 b)

Promotion of the issue Collection of application by lead manager Processing of application by lead manager Allotment of shares Listing of the shares in stock exchange.

Subsequent issue/ public issue by listed companies: A company whose shares are already listed in stock exchanges may

think of generating some more finance by issuing equity shares. this is referred to as subsequent issue. The company need to fulfill certain conditions before going for subsequent issue of equity shares like: a) Company should be listed in stock exchange for atleast 3 years. b) Company need to have a track record of payment of dividend for atleast 3 years immediately proceeding the year of issue. Procedure for issue of equity shares of a limited company is similar to that of an IPO. The company is having a freehand in fixing the prices

of subsequent issue. The general practice in India is that 6 months average closing price is taken as issue price. c) Right issue: Right issue involves selling equity/securities in the primary market to existing shareholders. This can be done after meeting some requirements specified by SEBI. When company issues additional capital, it has to be first offered to existing shareholders. The shareholders however may forfeit this right partially or fully to enable the company to issue additional capital to public. Characteristics of right issue:1) Number of rights that a shareholders gets is equal to the number of shares held by him. 2) The number of rights required to subscribe an additional shares is determined by issued company. 3) 4) Price per share is determined by the company. Existing shareholders can exercise right and can apply for the share.

5)

Shareholders who renounce their rights are not entitled for additional shares.

6) 7)

Rights can be sold Rights can be exercised only during a fixed period (usually 1 month) Desired funds Number of new shares = --------------------------------Subscription / offer price Existing shares

Number of rights required to get an additional shares = ---------------------New shares Price of the share after right issue = Existing shares x current M.P. + new shares x subscription price = -------------------------------------------------------------------------------------Total shares (existing + new shares) Merits of right issue: 1) 2) Less expensive as compared to direct public issue Management of applications and allotment is less cumbersome.

Limitations: i) Can be used by only existing company

ii) iii) d)

Cannot be used for large issues Wider ownership bare cannot be achieved. Private placements It involves allotment of shares (or other securities) by a company to

few selected sophisticated investors like mutual funds, insurance companies, banks etc. Private placement of equity:- Usually unlisted companies who are not ready for IPOs can go for this. Price can be freely determined by company as it is not regulated by SEBI. Private placement of debt:- Companies can directly place their debentures, bonds etc. In Indian context private placement of debt of listed companies and equity of unlisted companies are popular. Advantages of private performance: 1) 2) 3) e) Helpful in rising small size of funds Less expensive as compared to other methods Takes less time as compared to other type of issues.

Preferential allotment:

It is an issue of equity by a listed company to selected investors at a price which may or may not be related to prevailing market price. It is not a public issue of shares. This kind of preferential allotment is made mainly to promoter or their friends and relative. The company should pass special resolution to do preferential allotment. In case if the government is having a state in the company., the central government permission is necessary. Pricing:- price of preferential allotment must not be lower than 6 months average closing price. Pricing regulations of preferential allotment to FIIs are more stringent. Lock in period:- The shares allotted under preferential allotment process will attract a lock in period. If it is allotted a promoter, the lock in period will be 3 years and to others, it is 1 year. 3) PREFERENCE SHARE CAPITAL: It is an unique type of long tem financing which combines some of the characteristics of equity shares as well as debentures. It is similar to equity capital because:-

a) b) c)

Dividend to equity capital because: Not obligatory to pay dividend Irredeemable type does not have any maturity.

It is similar to debenture because: a) b) c) d) It carries fixed dividend It is ranked higher than equity on the basis of claim It does not have any voting rights normally It does not have any share in residual earnings.

Features of preference shares: 1) Prior claim on income/ asset:- Prior claim arises as compared to equity shares. 2) Cumulative dividend:- Dividends get accumulated and must be paid before paying dividend to equity shareholders. 3) Redeemability:- At the end of maturity period the preference shares need to be redeemed. 4) 5) Fixed divided:- Preference shares carries fixed of dividend. Convertibility:- Preference shares can be converted into equity shares at the end of maturity period. 6) Voting rights:- Generally preference shareholders does not possess voting rights, but if dividend on preference shares is not paid for 2

or more consecutive years than preference shareholders gets voting rights. 7) Participation feature:- Preference shares holders may enjoy participation in additional profits of the organization. 8) Sinking fund:- Sinking fund may be created by issuing company to retire preference shares. 9) Call feature:- If preference shares carried call option, company can buy back the preference shares before its maturity. Types of preference shares: i) Redeemable and irredeemable preference shares:Redeemable is one which can be redeemed/ re-purchased by the company after the maturity period of shares on the other hand the shares which cannot be retired by the company is termed as irredeemable preference shares. ii) Convertible and non convertible preference shares If the preference shares can be converted into equity shares at the end of maturity period it is termed as convertible preference shares. If the

company does not convert preference shares into equity shares it is called as non-convertible preference shares.

iii)

Participative and non-participative preference shares If preference shareholders enjoys additional dividend in case of

extra profit or if they enjoys additional capital in case of liquidation of the company. It is termed as participative preference shares. If such participation is not available it is termed as non-participative preference shares. iv) Cumulative and non cumulative preference shares: Unpaid dividend of one year it gets accumulated to next period it is termed as cumulative preference shares. If dividend does not get accumulated it is termed as non-cumulative preference shares. Advantages of preference shares: a) Risk less source of finance: Dividend payment is not compulsory in case of preference shares and claims of promoters does not get dilated, it is considered as risk less source of finance. b) Stable dividend: The company need not have to pay any extra dividends even when there is a extra profit.

c) d)

Limited voting rights is available to preference shares Redemption of preference shares can be delayed without any significant penalty

Limitations of preference shares: i) No tax advantage: Payment of dividend on preference shares is not allowed as deduction for tax purpose. ii) Cumulative dividend: The company has to pay all the accumulated dividend on preference shares before dividend is payable to equity shareholders. 4) DEBENTURES: Debentures / bond is a debt instrument indicating that a company has borrowed certain sum of money and promises to repay if future under clearly defined terms. Debenture holders are the long term creditors of the organization and are eligible to get stipulated amount of interest and re-payment on the maturity.

Features:
a)

Interest:- Debentures carries a fixed rate of interest, which is a contractual payment by the company. Interest is allowed as deduction for tax purpose.

b)

Maturity:- debentures have fixed maturity usually 7 10 years. They are redeemable after the maturity period.

c)

Redemption:- After the maturity debentures are redeemed. They may be redeemed at par or at premium.

d)

Sinking fund:- A sinking fund si created by the company for the purpose of redemption of the bond. Every year a fixed sum is transferred to the fund and that money will be used to redeem the debentures.

e)

Buy back/ call provision:- Company may exercise call option, there by can redeem the debentures before the maturity wherever buy back is done the company has to redeem at a premium.

f)

Trust:- When the debentures is issued by the company a trust is created. It includes trustees drawn from companys directors, investors, bankers etc. it is the duty of the trust to protect the interest of the investors.

g)

Security: Debentures are either secured or unsecured. If it is secured the debenture holders can exercise lien on companys assets.

h)

Yield:- Debentures are listed in the stock exchange there will be a market value of debentures. Yield on the debenture is related with its market value.

i)

Claims on asset and income:- Before payment of dividend to shareholders interest on debentures are paid same way. Before payment of capital to shareholders, capital be paid to debenture holders, therefore debentures holders are having preferential claim over shareholders.

j)

Compulsory credit rating:- The company issuing debentures need to take compulsory credit rating from approved agencies.

Types of debentures:
i)

Non convertible debentures: There are the debentures, which will not converted in to equity shares by the company.

ii)

Fully convertible debentures:- These are the debentures which will be fully converted into equity shares as per the terms of issue. The conversion will be made at the end of stipulated period.

iii)

Partly convertible debentures: Here only a part of debenture will be converted into equity shares at the end of the period and remaining part will be redeemed by the company.

iv)

Innovative debt instruments 1) Zero interest debentures/bonds (ZIB):Zero interest bonds, do not carry any explicit interest. They are sold at discount, the difference between face value and acquisition price is the return/ gain on the bond. For eg:- Rs. 100 face value bond may be issued at Rs. 50 for period of 6 years. The investor pays Rs. 50 on the bond at the time of issue and gets RS. 100 on maturity. Face value/ market value Acquisition price = ---------------------------------(1 + K)n 2) Deep discount bonds: It is similar to ZIB. In case of deep discount bond, it carries a marginal rate of interest and issued at discount and redeemed as par.

Example :- Rs. 100 face value bond issued at Rs. 70, 6 years and redeemed at Rs. 100 over 6 years period it carries a interest of 3 years. Organization like IDBI, SIDBI have issued this type of debentures. 3) Secured premium notes: It is a secured debenture which is redeemable at premium in different installments. It carries no interest in lock-in period. TISCO has issued in 1992. Example:- Rs. 100 face value instrument is issued at par, for 3 years there will be no interest from 4th year onwards till the 8th year it will be redeemed at RS. 35 per annual. 4) Floating rate bonds: Interest rate on these bonds are not fixed. Interest is linked to market rate of interest. Interest is payable on the benchmark rates like bank rate, maximum interest on term deposits etc. Advantages of debentures: a) b) Less costly : as compared to equity shares Tax deduction :- Interest payable on debentures is allowed as deduction for tax purpose.

c)

No ownership dilution:- As the debenture holders does not carry any interest payment.

d)

Fixed interest:- Interest rate does not increases with increase in profits of organizatin.

e)

Reduced real obligation:- Although interest payable is fixed, with the change in inflation rate, the real obligation the part of the company reduces.

Limitations of debentures: i) Obligatory payment:- If the company fails to pay the interest on debentures the investors can ask for the declaring company as bankrupt. Interest payment on debenture is obligatory. ii) iii) iv) Financial risk associated with debenture is higher than shares. Cash out flow on maturity is very high. The investors may put various restrictions/ covenants while investing in the debentures. COVENANTS: There are different ways in which the equity holders can mismanage the funds belonging to debenture holders. This leads to default risk to debentures. This possibility arises in the following circumstances.

Excess dividend payment to equity shareholders. By issuing more debentures diluting the claim. Asset substitution where by funds may be used for higher risk projects.

Under investment of funds.

Therefore debt holders should try to protect their interest. Supplier of debt may include several covenants (conditions) in the debt agreements to protect their interest. Covenants are meant to protect the interest of debentures against dilution of claim, asset depletion, asset substitution and under-investment. Broad categories of covenants: 1) Positive covenants: These covenants indicates what the firm should do in order to protect the interest of the investors. Example: a) b) c) d) Submission of periodical returns Maintaining minimum working capital Maintaining sinking fund Maintaining minimum networth etc.

2)

Negative covenants:

There covenants restricts certain actions by borrowing firm without prior permission of lender. Not to issue additional debt and dilute the claim Not to diversity the activity Not to dispose or lease out the asset Not to declare the dividend to shareholders beyond a given percentage. LEASING: Leasing is one of the important indirect sources of financing. It is a process by which firm can obtain the use of certain fixed assets, for which it must makes a series of contractual periodic tax deductable payments. Parties to lease
a)

Lessor:- Lessor is the owner of the asset. Leasing is a core business to the lessor.

b)

Lessee:- user of the capital asset is a lessee. For lessee leasing is a indirect source of financing.

Features of leasing a) Asset owned by lessor is used by lessee for, which he makes periodical lease rentals. b) Ownership of the lease remains with the lessor throughout the period of lease. c) The scrap value of the asset is enjoyed by lessor, as he is the owner of the asset. d) Period of the lease agreement may be throughout the economic life of the asset, or for a period shorter than that e) Lease rental payment made by lessee is allowed as a deduction for tax purpose. Types of lease 1) Operating lease:Characteristics:i) ii) iii) Period of lease is less than economic life of the asset Lessee has got the right to terminate the lease. Usually lessor needs to take care of insurance and maintenance of the asset. iv) Operating lease is used usually in case of general purpose asset.

2)

Financial lease:a) This type of lease is used in case of special types of assets needed specifically by a lessee. b) c) d) Period of lease is throughout the life of the asset It is a non cancelable agreement Lessee is responsible for insurance and maintenance of the asset.

3)

Sale and lease back: In this type of lease the lessee sells the asset belongs to him to lessor and same asset is taken back on lease basis again.

4)

Single investor lease:- In this case the asset is fully financed by the lessor alone.

5)

Leveraged lease:- Here the asset is not solely financed by lessor. There will be a financier who invest the major portion of the investment in asset.

Domestic lease and international lease:If both the parties to lease agreement is situated in the country it is termed as domestic lease and if any one party to the case is residing abroad it is a international lease.

Advantage of lease To lessee: It provides financing or capital asset It is an additional source of finance It is less costly method, especially where the asset is required for a shorter period. To lessor: Full security of asset is ensured in lease agreement Lessor can charge depreciation on asset and thereby can enjoy tax benefit. Leasing business is highly profitable. No dilusion of control and ownership is preserved. There will be a flexibility in structuring the lease rent. It is simple source of finance Obsolescence risk is alerted.

Limitation of lease: There will be restriction on the usage of the asset. Lessee loses the residual (scrap) value of the asset.

Financial evaluation of lease: Leasing v/s buying the asset out of own funds Buying alternative: a) Pr of cash outflow on account of buying the asset out of own funds b) NPR of cash outflow on account of leasing the asset xxx xxx

Wherever cash flow is less that alternative is selected: B year (i) lease rent (ii) tax savings on a/c of lease rent (iii) = (i ii) Effective lease rent Pr of effective lease rent xxx B

1 2 3 -

N.Pr of effective lease rent

HIRE PURCHASE FINANCING Similar to leasing, hire purchasing is also one of the method of capital asset financing. Here gods are let on hire, the purchase price is to be paid in installments and hirer is allowed an option to purchase the goods by paying all the installments. Parties: Features Hiree purchases the assets and gives it on hire to the hirer. Possession is delivered to the hirer at the time of entering into the contract. The hirer pays the regular installments over a specified period of time. (The installments covers principle amount and interest). Usually interest is charged on flat basis on initial investment. Default in payment of installments entitus seller to take away the goods. Hiree :- Owner of the asset who gets hire charges. Hirer :- User of the asset

Hirer becomes the owner of the asset on payment of last installments.

The hire purchaser is tree to return the goods without required to pay any further installments.

Leasing v/s hire purchasing Leasing Hire purchasing

1) Lessee cannot claim depreciation Hirer is although the owner of the for tax purpose 2) Lessee cannot enjoy asset can claim depreciation the Hirer enjoys the salvage value of

ownership therefore he cannot the asset. enjoy salvage value 3) Entire lease rentals is tax Only interest component of hire purchase deductable. VENTURE CAPITAL Venture capital plays a strategic role as a source of finance especially in case of small scale, high technologies drivers and risky ventures. It is a very populars concept in advanced countries and it is gaining its importance in developing countries also. Venture capital is considered as synonym of high risk capital. installments is tax

deductable for lease

A business organization involving in new, innovative, and risky business/ project may not be able to get its financial requirements fulfilled from any traditional sources. Therefore they approach a specialized agency specially meant for financing such project. Such agencies are called as venture capitalist or venture capital firm. Venture capital is early stage financing of new and young enterprises seeking to grow rapidly. Features: Venture capitalist or venture capital firm is inclined to assume a high degree of risk for earning high return. Venture Capital Firm (VCF) not only provides fund but also takes active part in management. Financial burden of assisted firm is negligible in first few years. VCF normally plans to liquidate its investment in the assisted firm after 3 7 years. VCF normally invests in equity capital of assisted firm and tends to invest for long term.

Stages in venture capital financing 1) Early stage financing a) b) c) d) 2) Seed financing for supporting a concept/ idea. R & D financing for product development Start up capital for initial production and marketing First stage financing for full scale production and financing.

Expansion financing a) Second stage financing for working capital and initial expansion. b) Development finance for facilitating public issue.

3)

Acquisition / buyout finance a) b) Acquisition finance to acquire new firm for further growth. Turnaround financing for turning around a sick unit.

Venture capital investment process Deal origination Screening of the project Detailed evaluation of projects:- It includes technical, marketing and financial evaluation.

Post investment activity :- It includes providing technical and management assistance and controlling the project.

Liquidating the investment or exit from the project.

Venture capital in India: In Indian context venture capital gained importance in post liberalization era. Various financial institutions like IDBI, IFCE, ICICI, SFCs, SIDBI and most of the commercial banks have set up their own fully owned subsidiary company to carry on venture capital business. Limitations of venture capital in India: Inadequacy of equity capital financing by venture capitalists. Focus on low risk ventures by venture capital firms. Conservative approach followed by venture capital firms. Delay in project evaluation by venture capital firms.

CREDIT RATING: It is an old concept in USA. It is essentially giving opinion by a rating agency on the relative willingness and ability at the issuer of a debt instrument to meet the debt servicing obligation in time and in full.

In simple words it is a process where by a credit rating agency after thorough analysis, gives its opinion about creditworthiness of the company issuing debt instruments. It helps the investors to analyze the risk associated with the debt instruments. Features 1) Specificity:- credit rating is done specifically to a particular debt instrument. 2) Relativity:- It is based on the relative capability and willingness of the issuer of the debt instruments to meet obligation. 3) 4) 5) 6) Guidance: Credit rating is just a guidance given by the agency. It is not a recommendation to buy the debt instruments. It is based on the broad parameters. No guarantee by credit rating agency on the debt instruments issued by the company. 7) Uses both qualitative and quantitative information to give the rating.

Advantages of credit rating 1) To investors a) b) c) d) e) f) Provides information about the company and instrument. It is a systematic risk evaluation. Professional competency is used to give rating. It is easy to understand Lost of analysis will be less. Efficient portfolio management can be done by credit norms worth. 2) To Issuer (Company): a) b) c) Credit ranking is an index of faith It assists the company to have wider investors base. It is a benchmark.

Key factors considered in credit rating:

i)

Business analysis :- In includes nature or business, risk associated with business growth prospects etc.

ii)

Financial analysis: here it includes profitability, liquidity, conditions, networth etc.

iii)

Management evaluation:- Promoters, their credit worthiness, their post tract records are analyzed.

iv)

Regulatory and competitive environment:- Which includes government regulations on the basis of competitions the business etc.

v)

Fundamental analysis:- It includes liquidity, profitability , interest loan

SEBI and RBI guidelines on credit rating: SEBI guidelines requires issue of debentures, bonds, convertibles, or redeemable for a period beyond 18 months needs credit rating. As per RBT guidelines issue of commercial papers requires credit rating. Credit rating agencies in India: 1) CRISIC(Credit Rating Information Services India Ltd.): Jointly set up in 1988 by ICICI, UTI, LIC, GIC and few others financial institutions. Head office at Mumbai most of the grading is done by CRISIL. 2) ICRA (Investors Information and Credit rating agencies:- started in 1991 promoted by IFCI and others

3)

Care (Credit analysis and Research Ltd):- set up in 1993 by IDBI and other financial institutions.

4)

Different and phase:- Set up in private sector in 1996.

Certain ranges of Crisil:AAA AA A BBB BB B C D Highest Security Limitations of credit rating Adequate safety Moderate safety Inadequate safety High risk Substantial risk Default There is a need to have a different credit rating for different instruments like, debentures, bonds, medium term debt including FDs and short term debt instruments including commercial papers. Limitations of credit rating: No rating for equity Only indicator of risk Only opinion and no guarantee

Need to be updated frequently

Sources of working capital financing 1) Trade credits Trade credits refers to the credit that the business firm gets from supplier of goods in the normal course of business. It is usually on an open account basis. Advantages: Easily available Flexibility No formality No cost

Implied cost: When a credit period is offered there may be a discount offered by the supplier. If the firm wants to avail the excess credit period they cannot avail the discount and vice versa. 2) Accrued expenses and deferred income

Accrued expenses is the liability that the firm has to pay for the service which it has already received. For example:- outstanding salary, wages taxes, insurance etc. Deferred income refers to income received in advance. Eg:advance payment by customer. Both of these are the sources of financing working capital. 3) Bank finance:

Bank financing is one of the most important sources of working capital financing. The bank finance can be availed in the following ways: a) Bank overdraft and cash credit:Here the business firm is allowed to withdraw more than the balance available in the bank account. The interest is charged only on the withdrawn amount and not on the sanctioned amount. Incase of old no security required where as some collateral is required in case of cash credit.
b)

Short term working capital loan: Loan for a period not

exceeding a year. c) Term loan for working capital:

Especially for permanent working capital a term loan for a period ranging between 3 7 years can be arranged.

d)

Purchase or discounting of bills of exchange:Bankers discounts/ purchases the bill of business firm for a

discount. e) Letter of credit (LOC):It is an indirect way of financing by banker. Here banker issues a LOC to foreign supplier undertaking a guarantee to pay the money if the customer fails to make the payment. On the basis of LOC business firms can get trade credit especially from foreign suppliers. Security required for bank finance
i)

Hypothecation:-In case of movable assets, the property is hypothecated to the banker, but physical possession remains with the owner.

ii)

Mortgage:- It is used in case of immovable assets physical possession remains with borrower but, property cannot be sold unless settling the loan to banker.

iii)

Pledge:- In this case physical possession of the property is kept by the banker on the loan given.

Regulations of bank finance: Banks are following certain norms in granting credit. These norms are influenced by reports of certain committees which are appointed by RBI. Few of these committees includes. i) Tandon committee report

This committee was appointed in July 1974, to suggest guidelines for rational allocation and optimum use of bank credit. Recommendations of this committee can be summed up as follows: 1) Operational plans:- Business firms need to give their operational plans to get bank credit. 2) Production based finance:- Banks are required to finance only on the banks of production activity by business firm. 3) Partial bank finance:-Banks should do only partial financing and not full financing. 4) Fixing of inventory and receivable norms for business organization requiring bank finance. 5) 6) Banker is suppose to finance only working capital gap. Fixation of maximum permissible bank finance (MPBF)

ii)

Chore committee report:

In 1979, RBI has setup a committee under K.B. Chore. This committee has given the following recommendations: a) b) Reduction of dependence on banks as a source of finance. Credit limit available to business firms should be separated into peak level and normal level limits. c) Existing system of cash credit, loans, bills discounting should be continued. d) Quarterly statement from business organization is needed by the banks when the firm is borrowing more than RS. 50 lakhs loan. iii) Commercial papers (CP): Commercial papers are important sources of short term financing. It is form of financing consisting of short term unsecured promissory notes issued by firms with a high credit rating. In India RBI introduced commercial paper in 1989.

Features: a) Commercial papers maturity period varies between 15 days 1year. b) Commercial papers sold at discount and redeemed at face value. c) Investors of commercial papers includes, insurances

companies, banks, MFs etc. but not individual investors. d) Commercial papers directly sold to investors or through brokers. e) There is no secondary market for commercial papers. Commercial papers in India: 7) 8) Regulated by RBI Companies having a networth of RS. 10 crores and good credit rating can issue commercial papers. 9) Minimum size of an issue is RS. 25 lakhs and each commercial paper should be of more than Rs. 5 lakhs. 10) Maximum amount can be raised in upto 100% of working capital unit. 11) Investors of commercial papers are bank LIC, UTI, NRIs etc.

12)

Holder of commercial papers is on maturity to the issuer and gets the refund.

Effective yield on commercial papers/ cost of commercial papers Face vale net amount realized Net amount realized Merits of commercial papers: Alternative sources of financing to bank credit during tight bank credit. Cheaper than bank credit in some cases. For investors it is a short term safe investment. 365 maturity period ( in days)

-------------------------------------- x ------------------------------

Limitations of commercial papers: Not possible to extend the maturity Can be issued by companies having good credit rating and financial stability 5) Cannot be redeemed until maturity. FACTORING Debtor receivables arising out of credit sales are sold to a financial institution called as factors at a discount.

It involves the outright sale of receivables at a discount to a factor to obtain funds. It provides a source of finance as well as facilitates the collection of receivables. It is an agreement in which receivables arising out of sale of goods / services are sold by a firm to the factor (financial intermediary) as a result of which title of goods represented by receivables passed on to the factor. Factor becomes responsible for debt collection. Types:
i)

With reference:- If the factor is not able to collect the receivables from the buyers/ debtors the loss has to be incurred by the firm and not by factor

ii)

Without recourse:- If factor cannot collect it is his loss and it cannot be passed on to the firm.

Advantages Ensures definite and continuous cash flows to the firms No need for credit collection department.

Limitations:

a) b)

High cost especially in case of without recourse. Indicates financial weakness of the firm.