CHAPTER 13 Business is concerned with the production and distribution of goods and ervices for the satisfaction of needs of society. in order to produce and distribute goods and services, business needs money, Therefore, finance is called the soul of any business Cocco Business Finance Business finance refers to “the provision of money at the time when itis needed by a business.” Tt includes the ways in which a company obtains and uses money usually in reference to loans. In broader context, business finance is about strategies ‘for earning, saving and mae Nature of Business Finance The concept of business finance is very wide and is used in every type of business house whether it is small or large. + It includes all types of funds and capital that are needed to start, run, expand and diversify the business. The primary goal of business finance is to increase the corporate value, Scope of Business Finance Necessary to Start Business Every new venture needs money to buy plant and “machinery, land and building, raw material etc, So, finance is needed to start a business. Necessary to Face Economic Cycle During recession and depression, the sales of the business go down and the profitability is adversely affected. To overcome problems during such times, a business needs finance. Necessary for Growth Sometimes, in order to attain more oF to achieve greater success, a company needs significant financial investment to acquire new capital, staff or inventory. Necessary for the Payments of Debts It is necessary that a business firm meets its liabilities in time. Prompt payment of debts can be possible only because of adequate arrangement of finance. “UNIT 4: Business Finance \\ Finance and Its Sources TAN @ In this Chapt ‘© Business Finance © Sources of Finance ‘+ Lease Financing * Risk and Return Analysis Asset Securitisation & scanned with OKEN Scanneree pinance ANd Its Source, Neate the etre Ore, only spon sources of Finance petained Earnings means 8 Part OF train, 1 te the form an roms sihich arent eto Fr Future expansion gf ghee’ DUt Fetained sre HOOBRI back of pag Tao OE oa na eat sharchann e seta, fered 10 28 internal equiey” Cae risesleuated as feasined Earnings (RE) = Net Income — 5 + Goodwill or reputation of the Purchasing firm, + The amount of purchases made, « ast record of the buyer and his financial position, ‘Ao, the terms to trade credit may vary from industry to industry and person to person, Public Deposits kk efers to the deposits that are raised by business awgaristions directly from the public. Under it. a company directly raises loans from the public, in the form. of deposits for a fixed period of time at a fixed rate of interest. This rate is generally higher than that offered on tank deposits. Companies generally invite public deposits fora period upto three years. Its acceptance is regulated by the Reserve Bank ‘of India. Any person who is interested in depositing money ‘with a company, can do so by filing a prescribed form. The company issues a deposit Tevipt as acknowledgement of debt. Inter-corporate Deposits (ICDs) |kis a deposit made by one company with another company for a period of upto six months. These are nerally unsecured. 269 wine anles Revo spas funds enw ther camp renee tec of fonds, "This rangesen ee benefiting, The lending company enn funds nA 7 nt the short-term fing Following are the types of tater corporate Aeposits Call Deposits Such d company by st on its idle borrenving, pany ts able te fulfil its nia o ‘Three Months Deposits As the name suygests, these deposits xs made for a period of three months, These are theaeey Popular form of inter-cor Porate deposits, These are ith the compa Six Months Deposits six-months, only wit credit rating, Issue of Shares made for a period of inies which enjoy a high pital obtained by issue the person holding the Equity Shares ‘The capital obtained equity share capital 1 is considered as a permanent source of capital for a company, as itis not req by issue of equity shares is known as jired to be returned during the life of the company. The retur m.On equity shares is paid in the form of dividend. ‘The com, n pany pays dividend only in ease of idend is not fixed and depends upon after paying divi idend to preference shareholders. Beca ss, the equity shareholders are known as the ‘residual owners’ of the busines. "They ae orginal Wok bearers; Voting aghs ne conferred upon them, to enable them to participate in the affairs of the business. + Note Generally, but in certain the surplus profit left lividend to equity shareholders is paid out of profs, ‘onditions it can be paid out of reserves also, Preference Shares ‘The capital raised by issue of preference shares is called Preference share capital. Preference shares confer following tno referential rights to its holders * Preferential right to receive dividend at a predetermined rate, before dividend is paid to equity shareholders, * Preferential right to receive repayment of capital at the time of dissolution of the company. This right authorises them to receive payment against capital before any amount is paid to equity shareholders. & scanned with OKEN Scanner270 reference shaves resem debentunes ay they hei Fate of Feta, Also, as the div discretion of the ditectors that extent, they rege ava ye iets payable ony at the Anu only ou of protic afier tay, 40 emble equity shares Debentures and Bonds Debentures We isa important fnstrament for Tong-term debt capital, Debentune acknowledgement af the borrowed certain amon Jong-term loan to the which they receive a cxising, 4s asically a written onnypahy, under its sel, ta has NC of money, In general, it refers to ‘company boy the debenture holders on lived rate of interest, Bonds These also loan instruments ancl ‘mall aspects except one, No pe announced einble debentures “determined rate of interest is the time of issuing bonds , but a specific rate of iNest announced while ising debentures, The above discussion brings orth the’ fllosing features. of debentures * Debentures are basically borrowed funds, Because of this feature, the Alebenture holders are deemed toe the creditors of the cdinpanys fenerally, Companies pr specified rate, to the deb Public issue of debentures requires that the ise be rated by a credit rating agency like Credit Rating and Information Services of India Lad, (CRISIL) on aspects like track record of company, its profitability, debt servicing capacity, credit worthiness risk of lending Thal yearly interest, at a Mure holders, and the perceived Commercial Banks ‘Commercial banks such as State Bank of India (SBI), Canara Bank etc, advance money to the business firms for different purposes and different time periods, Banks extend credit in many ways, like cash credits, overdrafts, discounting of bills of exchange and issue of letter of credit. ‘The repayment is made by the borrower in instalments as per the agreement between the bank and the borrower. Interest charged by banks depends upon a number of factors, such as nature of advance, period for which the loan is taken etc. Loan is generally offered by banks on the basis of security of assets. The loan can be repaid cither in instalments or in lumpsum, Loans from Financial Institutions The government has established a number of fin institutions all over the country to provide finance to business organisations. These institutions are established by the Central as well as State Governme ‘These institutions provide loan for medium and long-term needs of a business. These institutions also provide technical UGC NET Tutors Com, Ne 4 evial NeHviCe U0 Daina anger sr Ne vata a 1 r NAW, ogni wo tin pte Fr spect fag ‘eapingy Nes, Avutital ements OF bushiess ying, yi Bly, Me aera resem Feet lig trvutatione taelitate. tnestatal develop f Fart ane elle Aevelopnent hy ye ‘aiaity, a | Institutions clal Financlal Pomel Finance Comoran of alla (yy Dh aaah 1948, vation Ac Toe Tratstaal Hlnaice Comporation Act, 104 1 TY jeg Int i rowvards balanced replongl qos Pet in rete deep aa ena 8 EEN TY sector of the economy. ee : sate Flnanctal Corporations (SEC) N vay guy i ‘ste Finanelal Comporations Act, 1954, ‘i Cimpowsered the State Government 40 ey inanelal Corporations in thelr” respective providing, medivm and shortterm finance which are outalde the scape of the TFCL, Industrial Credit and Investment oporation of (ACICH) Ke was established in 1955-05 a pub ny "oglons 1 btu Hig company ander the Companies Act ass the eg expansion and modernisation of industaal Herp, exclusively inthe private vector, Industral Development Bank of India (DB yy, established in 1964 under the Industrial Developme Bank of India Act, 1964 Its objective is to coordinate sets of other aca” Istutons indy ‘commercial banks, State Industrial Development Corporations (SIDCS) The Ihave been set up by many State Govemments for purpose of promoting. industrial development in they respective states. The objectives of the SUDCS dite fg fone state to other. Unit Trust of India (UTD) We sas established by de Government of India in 1964 under the Unit Trust of tng Act, 1963, The basic objective of UTI is to mobilise ty ngs and channelise them into productive ventures, Industrial Investment Bank of India Ltd (HI) 1 yas Setup as a primary agency for rehabilitation of sick unis nu was known as Industrial Reconstruction Corporation of India, Te was again reconstituted Industeal Reconstruction Bank of Ind in 1997 ts name vy Bank of Ind The bank assists sick units in the reorganisation of the share capital, improve provision of fina wd re umed as the in 1985 and again changed to Industrial Investment went in management system ani ce at liberal terms, & scanned with OKEN Scannerpinance ANC Its Source. ance Corporati Insc CONPTALION oF tng Bho amuder the LIC eq, Ela CLIC) 1 yay set La 956 aft ang ISHFANCE Compania epohises tHe community, I mance premiums ’ ‘up in Rationalising. 245, say} ms And make SHS nthe form gg cose bath Pubic as wet gc pal ble to inde ins ad undenetiting gr subserips th nm of dre betes. we On of shares and international Finance ost from ance thy Sq SM8NCS, reference nant domestic sources such ag [Somer ; loans from Indian re various country 0 country, source of foreign cy international Agencies ang | development Banks a Sad 2 were setup by the gover national, regional and various projects, Intemational Finance Corporation (IFC), EXIM Bank and Asan Development Bank are the examples of ach institutions. International Capital Markets Domestic “companies can also raise finance from inemational capital markets by issuing American Depository Receipts (ADRs) and Global Depository Receipts (GDRs). These instruments are as follows American Depository Receipt (ADR) As we have already {cused that a company can raise owned funds by issuing Atty shares in the domestic market. But, if the company Mans to raise finance from the American capital Sark, then it ean issue equity shares specially targeted for the Ametican investors by issuing American Depository Receipts (ADRs). These receipts are basically shares of an itn company denominated in US dollars. 271 The stock of many non-US comp: exchanges through the use of ADI ‘also paid in US dollats and may domiciled comps anies trade on US stock Rs. Dividend on ADRs ig be traded like shares of US However, ADRS do not camry voting Race Deneitory Rept (GDR International Depository Receipt (IDR) Global Depository Reecipte (GDRs) are Similar to American Depository Receipts, except that they ‘Se ssued in some other foreign country, except Amerien mn the Indian context, a GDR is an instrument issued abroad by an Indian company to raise funds in some foreign eh? and is listed and traded on a forcign stack exchange, Classification of Sources of Finance Classification on the Basis of Period Long-term Sources business firms for a shares, These sources provide Period exceeding five retained earnings ete. Medium-term Sow business firms for five years. eg. Loan from bai Short-term Sources finance to years. eg. Equity Factoring etc. Classification onthe Basis of Ownership Onmer’s Funds Funds or finance provided by the owners the owners are not required tobe paid back during the life of Ihe business, therefore they ate a permanene source of finance, ¢g. Equity shares, GDRVADR. ete. Borrowed Funds ‘The funds Classification on the Basis of Source of Generation Internal Sources These inchude all those funds which ae ‘generated from within a business, such as, from collection of receivables, disposing off surplus inventories and ploughing back of profit. These sources can however, fulfil only limited needs, ¢. Equity shares, retained earnings etc. & scanned with OKEN ScannerExternal Sources “These inchule all those funds whieh rated from outsite a business, These sources € rough these sources. red to mortgage its sources. 6 fost, but large amounts eat be talse Also, in some cases, business ts requ from WES for raising finance these Debentures, public deposits ete Lease Financing an equipment. ow isa contract between the owner words, leas OF an asset (the lessor) and its user (the lessee) forthe right asset during a specified period in return for a “agreed periodic payment (the lease rentals). The + is separation of the , to use the mutual ImPortant feature of @ lease cont ONMeISHip of the asset From its usage, 'mportance of Lease Financing * Leasing industry plays an important role in the cconomic development of a country by providing Money incentives to lesse. The lessee does not have to pay the cost of asset at the time of signing the contract of lease. ing contracts are more flexible so, lessees can structure the leasing contracts according to their needs for finance, * The lessee can also pass on the risk of obsolescence to the lessor by acquiring those appliances, which have high technological obsolescence. * Leasing of houses, apartments, offices ete are familiar to most of us. Advantages of Lease Financing * Leasing covers the full cost of the equipment used in the business by providing 100% finance, The lessee is not to provide or pay any margin money as there is no down payment. Thus, the saving in capital or financial resources can be used for other productive purposes. + The lease agreement can be tailor made in respect of lease period and lease rentals according to the convenience and requirements of all lessees. + Leasing enables the lessee to plan its cash flows properly. The rentals can be paid out of the cash coming into the business from the use of the same assets. Leasing enables the lessee to improve their liquidity position by adopting the sale and lease back technique. UGC NET Tutor. Com mg \ es of Leas? Agreements bo ease peat ee ed serv I ny ince. IBM was ro, Sone gp ih Oper rig and mi bth a ingle conte and cae plonsers wachines, together with automo ag alice copy nostic equipment are the Primary 4) snd eal diagnostic equlbment or ~ eu eel require the esto to Operating ease fF equipment, the cost of ma ian, pute into the Tease payments Aaiionally operating § sre not fully amortised, in that the Payment egg the ease contac a 0H the 9M the full cost of the equipment. However, the lease, Contras Witten for a period considerably shorter than the ey % useful life of the leased asset a the lessor expects to ren al costs eventual ether by lease renewal paymeny sale of the equipment. , ; {A final feature of operating lease #8 that they frequen contain a cancelation clause that gives the lessee the rig? cancel the lease and retur the equipment to the lessee before the lease expires. This clause is important tothe se because it allows the equipment to be returned, if, rendered obsolete by technological developments ori needed because ofa decline in the lessee’s busineg lon; Fe (ial Lease Byncal ease, also called as capital lease, are diferent fg Vperating lease as they + typically do not provide for maintenance. + typically are not cancelable, + are generally for a period that approximates the useh life of the asset. * are fully amortised. Ina financial lease, the lessee selects the item it Tequires and negotiates the price and delivery terms with the ‘manufacturer. The lessee then arranges to have a leasing fim (lessor) to buy the equipment from the manufacturer and the lessee simultaneously, executes a lease agreement with the lessor. } Undera financial lease, the lease payments are set-up exacty the same way, the payments are just sufficient to return the full purchase price to the lessor plus a stated return on the lessor’s investment. At the end of a financial lease, the ownership of the leased asset is transferred from the lesorto the lessee. | : | ‘2 & scanned with OKEN Scannerjeand Lease Back of fn k a Its | inane’ aNd Its Sources «bn wes back dhe same "1 of Tease rentals nt, the assets, rm * AN consideration However. under this. array shysically exchanged, but it This is nothing, but gale and te © octs, Which are not all happens in records only. 4 Paper transaction, ¢ back transaction is sy are Mot subjected to dem appreciation, say land, oe advantage of this me satisfy himself completely asset and afte thod is that the regard possession of the into a lease arrangement, + Unier tis transaction, the seller assumes the role of a lessee and the buyer assumes the role of « lessor. The seller gets the agreed selling price and the buyer gets the lease rents: 1s possible to structure the ale se ‘agreed ralue (below oF above thy narket price) and to the effect of ‘scan be deferred. we risk and Return Analysis Risk Ininvestment analys stu return. on. ed return, lessee can, ing the quality of the asset convert the likelihood that the ived is different fromthe other words, risk can be referred as the votty in the return with respect to expected retu Types of Risk systematic Risk fisks, which are caused due to uncontiollable tnd to affect all sectors of business, government and any she entity and leads to unavoidable affects for the eon, ate systematic risk, These risks are practically ‘nqessibleto protect and influences large number of assets, Systematic risk factors. that *Market risk + Purchasing power risk + Interest rate risk Market Risk Risk caused due to market cycles, ‘slsupply pressures, sudden movements in the market and “18: in public fashions among investment alternatives a8 (O uncertainty of return is market risk. Factors that {0 market risks are recessions, wars and structural fH in the economy, tax law changes, even changes in ‘asumer preferences, ng Power Risk/fnflation Risk The purch: ising sk is also called as inflation risk. It refers te ie. demand orertal Cauteane da AKIO one Yoratta a Mouaiong he preraiil prwen. of riCeR and fou in Aso Jeg VAM OL PROWL posanasing 4 whtn “ee 273 exchange inv real Inflation Jead return as a result of inflation, Tesser wots. etc. These ska are inherent in all the investments and are beyond the control of an investor Interest Rate Risk The interest tate tisk refers to us teturns caused by the fro time to time adversely affects the Investor's return, Interest rate risk affects bonds more directly than common stocks and is a major risk faced by all bondholders. As interest rates change, bond prices ¢ direction, nge in the opposite Non-systematic Risk Risk are firm specific risks, caused due to known or controllable factors and can be eliminated oF reduced through diversification Nor risk = Business risk + Financial risk Business Risk ‘The risk of doing busi industry or environment is called busi stemat ess in a particular ess tisk, This risk refers to uncertain retum to the investor caused due to “uncertain business environment, in which it operates, These ¥y arise due to both internal and external fj factors, risk caused due to internal fi ctors leads to poor ce of the company, but can be reduced or avoided by some changes in the company's polic Financial Risk Risk caused due to inability of the Organisation to meet its financial obligations is referred to as financial risk. eg. Obligations such as interest and principal Payment of the funds borrowe ‘d. Investment in organisation that is heavily into debt may lends to greater uncert inty of cturn because of financial tisk to their owners. Types of Sinancial risk are as follows Credit Risk Wis also called ‘Tiss the risk that a company ot individual willbe unaeie to pay the contractual interest or Principal on its debt obligations. This type of risk is particulaly a conse ce asinsolv \cy risk or default risk. etums, while corporate bonds tend Amount of default risk, but also the higher interest rates, Liquidity Risk We refers tothe tisk of liquidating the assetsas and when required. Liquidity here means bath ability of Converting asset into cash and doing it without compromising on price levels. to have the highest ‘The more uncertainty about the time element ee ‘ession, the greater is the liquidity risk. su oT has little oF no liquidity risk, whereas 2 smal may have substantial liquidity Hho & scanned with OKEN Scanner 1274 Measurement of Risk aniance o 2 al eviation is a measure of dispe distribution. dof the actual returns around the EaPeeted return is measured by the variance oF standard eviation “of the distribution. The greater the deviation of the greater the the actual val returns from the expected return, va rom the expected return, on probability distributions of returns erent variances, these would be as follows af ovestments exiting Low Variance Investment ‘High Variance Investment Expected Retwn Rlation Between Variance and Expected Return If the actual return of an investment is always equal to the expected return, then such an investment is a risk free investment. Therefore, the probability of actual return being equal to expected return will be 1 and the variance of return will be zero. Total risk of any investment can be measured by the concept of variance, standard deviation, covariance ete Return Returns are always calculated as annual rates of return or the percentage of return created for each unit of original value, Returns are the value created by an investment, though either income or gains. Measurement of Return It is the weighted average of possible outcomes, where the weights represents the outcome probabilities. Total return is measured by taking the income plus the price change. Income is either in the form of dividend or interest and the price change of the security is capital gain or loss. This can be put into formula as under Tt ca =P) Return during a period (in %) red during the period Price at the end of the period Price at the beginning of the period price at the end of the period and f the period is called as price The difference between price at the beginning o appreciation. UGC NET Tutor. Comm, ey ty ped income Dearing Sty he rye My Las under received + (Principal repay, ~ Initial investmene) x 100 inceres Return = talculated by using two m, and geometric mean, return is ¢ tg, ne average Pett The averaft tic mean namely, aritlime' and Return decision Relationship are important in ‘The main motive of an investor beh ing imum resus ith minimum te tums, but dislikes risks but re arep ional to risk. The returns depend oe a directly proportion yy the investor. It is said higher thet Risk Investment rmanageme?™ i investment 3s mac at ces sh th the el fee gen bigs ‘# Equity Fos deposts of compares # debentures nasal ands # Post office cefficates # Bank deposits # Insurance schemes sk Relationship Between Risk and Return Return Portfolio Risk ‘A portfolio is a combination of assets or investment Investing in a portfolio helps us reduce the risk as compared to investing completely in one asset. When two or more securities are combined in a portfolio, their covariance or combined risk is to be considered. Thus, if the returns on ‘two assets move together, their covariance is positive and risk increases on such portfolio. But, if the returns move in opposite direction, then the covariance is negative and risk is lesser. Portfolio Returns ‘The return on a portfolio of assets is simply a weighted average of the return on the individual assets. The expected return on a portfolio is also a weighted average of the expected returns on the individual assets. R=DXR Where, R, = Expected return on the portfolio R, = Expected return on the dual asset N=Number of assets in the portfolio. X, = Weight of assets in the portfolio & scanned with OKEN ScannerEF yo and Its Sources jio Variance ance 074 Portfolio consi ting Mn mula Fassets 1 and 2 ig siven by Covariance = Ee -r-9 mT nation eoecient beteen ‘ours T and 2 and it ig wel ish the construction siaqulio thus, depends on the velue ee correlation cafcent between the two assets, Asset Securitisation seuitistion means the conversi ainflows into tradable security saiet. The cash inflow fro singage loans, automobile I calteceivables, fare collecti shih borrowings are raised, Ulin ts circular on Securitisation of Standard assets, Saas “Securitisation as a process by which assets we siitoa bankruptcy remote Special Purpose Vehicle (sPv) itum for an immediate cash pa yment,” ‘ertsttion can be defined as “Acquisition of financial ‘sts by any securitisation company or reconstruction Sax fom any originator, whether by raising funds by ‘i securitisation company or reconstruction company & qualified institutional buyers by ‘epts representing undivided interest in so otherwise.” {ty twnderstand it from a Layman’s View {te tomal course assets like loans and securities held by ancial institutions are expected to yield a Ytfable stream of future income (eg. EMls etc). ion of existing oF future ‘which then is sold in the m financial assets such ag loans, trade Teceivables, credit ions become the security against ue of security such financial 275 this income is yet to be realised, it can not their books immediately. ng the security s on Incoming cash flows from the asset oF pool of assets to th ird party investor's by issuance of tradable debt securities, Process of Securitisation Securitisation isa process by which the future cash inflows of an entity (originator) are converted and Sat as debt instruments. These debt instru iments are popularly known As ‘Pay through or Pass through Certfiarer ony, fixed Lite of return to the holders of beneficial interest Under this process, the originator of a typical securitisation Pauly transfers a portfolio of financial assets to ¢ ‘Special Purpose Vehicle” (SPV). An SPV is an entity, specially FrvenenetO” doing the securitisation deal it torn’, investment from investors, uses the invested funds to ‘{auite to receivables of the originator. An SPV may be a ‘trust, corporation holders of beneficial inter ‘Thus, we can say th, the following stages * First ofall the originator determines which assets they. Wants to securitise At second stage, 0 SPV is formed, * The SPV collects the funds fr issues secutities to them, The SPV acquires the receivables under an agreement at their discounted value. ‘The servicer for the transactio usually the originator, The debtors are/are not notified depending on the legal requirements. rests in the SPV, at scurtsation deal usually pases through iginator has to find out a SPV or new fom investors and in retum nis appointed, who is & scanned with OKEN Scanner276 yin an The servicer collects the reeetaytoyection r spy. ne spe imesto8 + The SPV citherpassesthe collects at stated rece eae ey we | itervats against the In case of deat, dhe servicer es 7 . inn ey aE fous he are let toe colette ena es te j pec ion by buying back the outstanding ngback the ator POM agreed * At thee: = the end of the transaction, the ov anes ind subject to any losses t0 1 °Y the originator, in the transaction is Pa" Merit *erits of Securitisation Tansfer of credit rs + Helps in easing fund ne extent UGE NET Tutor ‘Om, ee my counts through SPV and acquire ect” ny Nilability of more credit, Peneticial int My na + Ava pemerits of Securitisation tor may hide the true pi Picture of its finay © Origi health. Ms «It is opaqueness. 2 Limits investors to monitoring credit risk, securitisation in India Securitisation in India has been in existe Soo0s. The first securitisation deal took piace when citibank raised @ 16 crore from GIC ce in is securitising some of its auto loans. The maj sal Fun, ty asset securitisation market in India pa Players in f commercial Financial Institutions (FIs) Pubnrected te , Publ 0 (PSUs), Corporate Government Bodies, Ment Gi herara ny Pension Funds “U & scanned with OKEN Scanner