Module 1

INTRODUCTION

1.1 Financial system overview

A nancial system is a network of nancial institutions – such as insurance companies,
stock exchanges, and investment banks and more – that work together to exchange and
transfer capital from one place to another. Through the nancial system, investors receive
capital to fund projects and receive a return on their investments. A nancial system can
be perceived on a company, regional, or global scale, which facilitates the practice of
exchanging funds between one entity to another.Financial systems are regulated, as their
processes in uence and contribute to the growth of many assets.

Financial markets involve various players, including borrowers, lenders, and investors that
negotiate loans for investment purposes. The borrowers and lenders tend to trade money
in exchange for a return on the investment at some future date. Derivative instruments are
also traded in the nancial markets as well, which are contracts that are determined
based on an underlying asset’s performance.When determining the guidelines of raising
capital within a nancial system, the project being funded and who funds them are
decided upon by the planner, who can be a business manager. Thus, the nancial system
is typically organized through central planning, a market economy, or a combination of
both.

A centrally planned economy is structured around a central authority, such as a

government, which makes economic decisions regarding the manufacturing and
distribution of products for a speci c country. A market economy is when the pricing of
goods and services is dictated by the aggregated decision of citizens and business
owners, often resulting in the e ects of supply and demand.Financial markets operate
within a government regulatory framework that lters the sort of transactions that can be
conducted. Financial systems are heavily regulated due to their in uence and facilitation
capabilities to contribute to the growth of real assets.

Finance is more than capital, and it is a di erent concept. It is concerned with how
economic agents in a given society can and do make intertemporal choices, and with
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 inter-temporal relationships between economic units. Finance is about how economic
agents carry over income and consumption opportunities from one time period to later
time periods, that is, how they save or accumulate and hold wealth and how they invest;
about how agents nance investments; and how they deal with risk. Many of those who
now say that nance is important refer to this concept, and that is why it should also
shape the de nition of the term nancial system.

In most economies, many nancial decisions and relationships of the households and the
rms involve banks, capital markets, insurance companies and similar institutions in some
way. In their totality, those institutions that specialise in providing nancial services2
constitute the nancial sector of the economy. Of course, the nancial sector is a very
important part of almost any nancial system. But there can in principle even be nancial
systems almost without a nancial sector. The third approach goes one step further and
generalises the idea of looking at how certain nancial functions are ful lled in an
economy. This is the so-called functional approach, which has been championed by
Merton and Bodie in a series of papers. Any nancial system has to ful l certain functions.
They include the transfer of resources across space and time and the transformation of
claims and obligations (as already captured in the approach of Gurley and Shaw) as well
as the allocation of risk, the provision of information, the easing of incentive problems
and, last but not least the provision of a payment mechanism.

Three conventional ways of analysing a nancial system : There are several

approaches of describing and analysing the nancial system of a country or a region. One
approach, which one may call the institutional approach, is largely descriptive, focusing
on the nancial institutions that exist or, as the case may be, fail to exist in a country. The
second approach is the intermediation approach. It goes back to early work by Gurley
and Shaw (1960), and focuses on how the funds of the so-called surplus units in an
economy, the savers, are channelled to the so-called de cit units, the investors, and
analyses the extent to which banks and other nancial intermediaries are involved in this
transfer of resources. This approach was originally conceived to understand and measure
the role of intermediaries, but it can easily be extended to include the role of nancial
markets. Like intermediaries, organised nancial markets perform some transformation
functions and thereby facilitate investment and nancing.
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 Role of government :
General government units exercise legislative, judicial, or executive authority over other
institutional units within a speci ed area. Governments have authority to impose taxes, to
borrow, to allocate goods and services to the community at large or to individuals, and to
redistribute income. They a ect and can be a ected by the activities of nancial
corporations. The general government sector consists of departments, branches,
agencies, foundations, institutes, non-market nonpro t institutions controlled and
nanced mainly by government, and other publicly controlled organizations engaging in
nonmarket activities. Various units of general government may operate at the central,
state, or local government level.

Since about 15 years, the notion has become more and more widely accepted that
nancial systems are an important eld of public policy and of academic research. The
underlying assumption behind this “discovery” is that in some sense the “quality” of a
country’s nancial system is important. This new conviction is re ected in the fact that
policy makers have started to be concerned about improving the nancial systems for
which they have a certain responsibility. In the European Union almost all elements of the
so-called nancial sector action plan have recently been implemented. International
organisations like the World Bank, the EBRD and the IMF have for quite some time spent
a great deal of their e ort and money on helping to improve the nancial systems of
countries on which they have some in uence.

However, there are a number of problems coming with this “discovery” and the apparent
consensus. One can summarize them by stating that it is not at all clear what it means to
say that nancial systems are important,Another factor is that in many countries the
nancial system has undergone dramatic changes in recent years. Some countries have
good nancial systems while others have not.

Components of Financial systems

Multiple components make up the nancial system at di erent levels. The rm's nancial
system is the set of implemented procedures that track the nancial activities of the
company. Within a rm, the nancial system encompasses all aspects of nances,
including accounting measures, revenue and expense schedules, wages, and balance
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 sheet veri cation.The global nancial system is basically a broader regional system that
encompasses all nancial institutions, borrowers, and lenders within the global economy.
In a global view, nancial systems include the International Monetary Fund, central banks,
government treasuries and monetary authorities, the World Bank, and major private
international banks.The nancial system is composed of many components depending on
the level. From a company’s perspective, its nancial system includes procedures that
follow its nancial activities. It would include aspects such as nances, accounting,
revenue, expenses, wages, and more.From a regional standpoint, the nancial system, as
mentioned above, facilitates the exchange of funds between borrowers and lenders.
Players on a regional level would include banks and other nancial institutions such as
clearinghouses.
On a global scale, the nancial system includes the interactions between nancial
institutions, investors, central banks, government authorities, the World Bank, and more.
• Financial service industries are calculated and disseminated for the purpose of
assisting in the assessment and monitoring of the strengths and vulnerabilities of
nancial systems. Such assessments need to take account of country-speci c factors,
not least the structure of the nancial system.
• A nancial system consists of institutional units1 and markets that interact, typically in a
complex manner, for the purpose of mobilizing funds for investment and providing
facilities, including payment systems, for the nancing of commercial activity. The role
of nancial institutions within the system is primarily to intermediate between those that
provide funds and those that need funds, and typically involves transforming and
managing risk.
• Financial markets provide a forum within which nancial claims can be traded under
established rules of conduct and can facilitate the management and transformation of
risk.
• Financial corporations : deposit takers- Within a nancial system, the role of deposit
takers is central. Commercial banks, which typically take deposits and are central to the
payment system, fall under the de nition of deposit takers.They often provide a
convenient location for the placement and borrowing of funds and, as such, are a
source of liquid assets and funds to the rest of the economy. They also provide
payments services that are relied upon by all other entities for the con- duct of their
business. Thus, failures of deposit takers can have a signi cant impact on the activities
of all other nancial and non- nancial entities and on the con dence in, and the
functioning of, the nancial system as a whole.
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 • Holding corporations are entities that control a group of subsidiary corporations and
whose principal activity is owning and directing the group rather than engaging in
deposit taking.
• The central bank is the national nancial institution that exercises control over key
aspects of the nancial system and carries out such activities as issuing currency,
managing international reserves, and providing credit to deposit takers. Central banks
are excluded from the reporting population for com- piling FSIs.
• Other nancial corporations (OFCs) are those nancial corporations that are primarily
engaged in nancial intermediation or in auxiliary nancial activities that are closely
related to nancial intermediation but are not classi ed as deposit takers.6 Their
importance within a nancial system varies by coun- try. Other nancial corporations
include insurance corporations, pension funds, other nancial interme- diaries, and
nancial auxiliaries. Other nancial intermediaries include securities dealers, investment
funds (including money market funds), and others, such as nance companies and
leasing companies.
• As customers, non- nancial corporations are important to the health and soundness
of nancial corporations. Non- nancial corporations are institutional entities whose
principal activity is the production of goods or non- nancial services for sale at prices
that are economically signi cant.8 They include non- nancial corporations, non-
nancial quasi corporations,9 and nonpro t institutions that are producers of goods or
non- nancial services for sale at prices that are economically signi cant. They can be
controlled by the government sector.
• Households are also customers of nancial corporations. They are de ned as small
groups of per- sons who share the same living accommodation, pool some or all of their
income and wealth, and consume certain types of goods and services.
• The public sector includes the general government, central bank, and those entities in
the deposit- taking and other sectors that are public corporations. A public corporation
is de ned as a non- nancial or nancial corporation that is subject to control by
government units, with control over a corporation de ned as the ability to determine
general corporate policy by choosing appropriate directors, if necessary.
• A nancial market can be de ned as a market in which entities can trade nancial
claims under some established rules of conduct. There are various types of nancial
markets, depending on the nature of the claims being traded. They include money mar-
kets, bond markets, equity markets, derivatives mar- kets, commodity markets, and the
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 foreign exchange market.In nancial markets, liquidity is important, because it allows
investors to manage their portfolios and risks more e ciently, which tends to reduce the
cost of borrowing.The money market is the market that involves the short-term lending
and borrowing of funds among a range of participants. The typical instruments traded in
a money market have a short maturity and include treasury bills, central bank bills,
certi cates of de- posit, bankers’ acceptances, and commercial paper.

A payment system consists of instruments, banking procedures, and (typically) interbank

fund transfer systems that ensure the circulation of money. The payment system is a
channel through which shocks can be transmitted across nancial systems and markets.
A robust payment system is a key re- quirement in maintaining and promoting nancial
stability. Thus, a broad international consensus has developed on the need to strengthen
payment systems by promoting internationally accepted standards and practices for their
design and operation.

Types of nancial systems

For many years, students of nancial systems have used classi cations to characterise
nancial systems. The idea behind any classi cation is that of a typology. A classi cation
makes sense if there are certain types of nancial systems; the number of existing types
is small; the types are clearly di erent; and real nancial systems conform more or less to
one of these types. The types are idealised descriptions of how the elements of a nancial
system can t together. Using the terminology of the systemic approach one could say
that types of nancial systems are consistent combinations of nancial system elements.
In recent years, the common classi cation or typology distinguishes only between two
classes or types of nancial systems: the bank-based nancial system and the capital
market-based nancial system.

As the name indicates, banks play the dominant role in a bank-based nancial system.
They are important providers of nancing for rms, and conversely, rms depend to a
large extent on bank loans as a source of external nancing. Banks are the most
important deposit takers within the system. Banks are organised as true universal banks,
and they dominate the entire nancial sector.The corporate governance regime in bank-
dominated nancial systems is pluralistic and stakeholder-oriented and allows di erent
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 stakeholder groups, including banks, to play an active governance role. The stock market
is not a fundamental element of a bank based nancial system since it does not play a
major role in rm nancing nor as a “market for corporate control”.

A capital market-based nancial system is the polar opposite. Not banks but capital
markets are the main sources of nancing for rms and serve as the places where
households place a large part of their savings. Bank lending is rather restricted in terms of
volume and maturities. Bank-client relationships are typically not close but rather at arm’s
length, and banks do not have an active role in corporate governance and in the
restructuring of rms that nd themselves in nancial di culties. In a capital market-
based nancial system banks are often specialized either by law or tradition. Even if
universal banking is allowed, banks are still specialised or organized in a way which neatly
separates their investment and commercial banking activities. Non-bank nancial
intermediaries play an important role in capital market-based nancial systems. They are
important depositories of household savings, including retirement savings, and they
invest a large part of their assets in the stock market.

How are nance and development related? The rst link is that the nancial sectors of
most developing countries are underdeveloped. Lack of nancial development re ects
general underdevelopment and is both a consequence and a cause of general
underdevelopment. A low level of nancial development shows up in a lack of nancial
institutions, in ine ciency and instability of those institutions that exist and in a nancial
sector that does not provide services to a large part of the economically active
population. In many developing countries not only the really poor but also middle class
business people do not get bank loans. The better the arrangement of nancial system
the better the development or GDP of a country as Finance has to overcome pervasive
information and incentive problems that are even stronger in developing countries than in
advanced countries with well functioning legal systems.

1.2 Overview Of Indian Financial Market : Debt and Capital

De ntion : Financial Markets are an important component of a country’s nancial system.

It is the infrastructure that connects lender and borrowers. The Indian Financial System
plays a very important role in the Indian Economy and it shows the economic growth of
our economy. Financial Markets include any place or system that provides buyers and
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 sellers the means to trade nancial instruments, including bonds, equities, the various
international currencies, and derivatives. Financial markets facilitate the interaction
between those who need capital with those who have capital to invest. Some of the
securities include stocks and bonds, raw materials and precious metals, which are known
in the nancial markets as commodities.

Functions of Financial Market

Financial Markets helps in mobilizing savings, determining and settling the prices of
various securities, providing liquidity to assets, and easing access to all types of traders.

- Mobilising Funds: Among the diverse types of functions served by Financial Markets,
one of the most crucial functions is that of mobilisation of savings. Financial Markets
also utilise this savings investing it for productive use, thereby contributing to capital
and economic growth.
- Determination of Prices: Another vital function served by Financial Markets is that of
pricing di erent securities. Essentially, demand and supply in Financial Markets along
with its interaction between investors determine these pricing.
- Liquidity of Financial Holdings: Tradable assets must be provided with liquidity for its
smooth functioning and ow. This is another role of the Financial Market which goes on
to help in the functioning of a capitalist economy. It not only allows investors to easily
sell their securities and assets, but also allows them to easily convert them into cash
money.It provides security to dealings in nancial assets.
- Ease of Access: Financial Markets also o er e cient trading since they bring traders to
the same Market. As a result, relevant parties do not have to spend any resource, be it
capital or time, to nd interest buyers or sellers. Additionally, it also provides necessary
information related to trading, which also reduces the e ort that interested parties must
put in to complete their trades. It ensures liquidity by providing a mechanism for an
investor to sell the nancial assets. It ensures low cost of transactions and information

Reforms : Financial Sector in the Indian economy has had a checkered history. The story
of the post-independent (i.e., post-1947) Indian nancial sector can perhaps be portrayed
in terms of three distinct phases – the rst phase spanning over the 1950s and 1960s
exhibited some elements of instability associated with laissez faire but underdeveloped
banking; the second phase covering the 1970s and 1980s began the process of nancial
development across the country under government auspices but which was
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 accompanied by a degree of nancial repression; and the third phase since the 1990s has
been characterized by gradual and calibrated nancial deepening and liberalization.

At the time of independence in 1947, India had 97 scheduled1 private banks, 557 “non-
scheduled” (small) private banks organized as joint stock companies, and 395
cooperative banks. Thus, at the time of India’s independence, the organized banking
sector comprised three major types of players, viz., the Imperial Bank of India, joint-stock
banks (which included both joint stock English and Indian banks) and the foreign owned
exchange banks.The decade of 1950s and 1960s was characterized by limited access to
nance of the productive sector and a large number of banking failures.2 Such
dissatisfaction led the government of left-leaning Prime Minister (and then Finance
Minister) Mrs. Indira Gandhi to nationalize fourteen private sector banks on 20 July 1969;
and later six more commercial banks in 1980. Thus, by the early 1980's the Indian
banking sector was substantially nationalized, and exhibited classical symptoms of
nancial repression, viz., high pre-emption of banks' investible resources (with associated
e ects of crowding out of credit to the private sector), subject to an intricate cobweb of
administered interest rates, and accompanied by quantitative ceilings on sectoral credit,
as governed by the Reserve Bank of India. Thus, by the end of the 1980s, the nancial
sector in India was virtually owned by the government with nationalized banks and
insurance companies and a single public sector mutual fund. Consequently, reforming the
nancial sector was a very important part of Indian economic reforms initiated in the early
1990s. Thus, over the years, the Indian nancial sector has emerged as a substantial
segment of the economy comprising diverse nancial institutions and various markets.

The initial foundation of the banking sector reforms in India came from two o cial reports,
viz., the Report of the Committee on Financial System (Reserve Bank of India, 1991) and
the Report of the Committee on Banking Sector Reforms (Government of India, 1998),
both chaired by former Governor of the RBI, M Narasimham. The Narasimham Committee
1991 was primarily devoted to enhancing operational freedom in the commercial banking
sector and recommended measures.

Narasimham Committee 1998 recommended further measures for modernizing the

banking sector through better regulation and supervision, and introduction of prudential
norms. It also suggested a review of the bank ownership structure in India.
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 Other elements of nancial sector reforms in India include signi cant reduction of nancial
repression (including removal of automatic monetization); dismantling of the complex
administered interest rate structure to enable the process of price discovery; providing
operational and functional autonomy to public sector institutions; preparing the nancial
system for increasing international competition; opening the external sector in a
calibrated manner; and promoting nancial stability in the wake of domestic and external
shocks. All these measures were designed to create an e cient, productive and pro table
nancial sector.

With the initiation of reforms and the transition to indirect, market-based instruments of
monetary policy in the 1990s, the RBI made conscious e orts to develop an e cient,
stable and liquid money market by creating a favorable policy environment through
appropriate institutional changes, instruments, technologies and market practices.

The Reserve Bank of India (RBI) was founded in 1935 under the Reserve Bank of India
Act “...to regulate the issue of Bank Notes and keeping the reserves with a view to
securing monetary stability in India and generally to operate the credit and currency
system of the country to its advantage.” Apart from being the central bank and monetary
policy authority, the RBI is the regulator of all banking activity, including non-banking
nancial companies, manager of statutory reserves, debt manager of the government,
and banker to the government.
Besides the commercial banks, there were four other types of nancial institutions in the
Indian nancial sector: development nance institutions (DFIs), co-operative banks,
regional rural banks and post-o ces. The sources of funds of these DFIs were diverse but
raised primarily from the domestic bond market, from multilateral institutions like the
World Bank, re nance window of the RBI, and government budgetary provisions. But by
the 1990s, with stoppage of re nance from the RBI and government budgetary
provisions, and accumulation of nonperforming assets, it became clear that the DFIs
would not be viable in the long run. Consequently, the IDBI and ICICI have been
converted into commercial banks, and the IFCI is e ectively non-functional. NABARD, the
NHB and SIDBI are continuing largely as re nance institutions with support from the
government.
As of 2015, there are 1,579 urban co-operative and 94,178 rural cooperative banks. A
majority of these banks tend to operate in a single state, and they are regulated and
supervised by state-speci c Registrars of Cooperative Societies (RCS), along with overall
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 oversight by the Reserve Bank of India. Thus there has been dual control of regulation
and supervision of co-operative banks between the state-speci c RCSs and the RBI,
which has often been problematical.
Regional Rural Banks (RRBs) were established in 1975 as local level banks in di erent
states of India. They are co-owned by the Central and State Governments, and by
sponsoring public sector banks.
The Post O ce Savings Bank (POSB) has a customer base of about 330 million account
holders as on March 2015 (Government of India, 2016) thereby contributing signi cantly
to nancial inclusion on the deposit side.5 However, observers of nancial inclusion in
India often count only bank accounts and neglect the coverage of post o ce accounts.
The POSB o ers only deposit and remittance facilities but not any credit to account
holders.
The Bombay Stock Exchange, the rst stock exchange in India, was founded in 1875.
However, by modern standards, the Indian equity market was still quite underdeveloped
till about the late 1980s.
The life insurance business was nationalized in 1956 giving birth to the Life Insurance
Corporation of India (LIC), which then had had a monopoly in the insurance business till
the late 1990s when the Insurance sector was opened to the private sector.

Debt and capital :

Capital markets are used primarily to sell nancial products such as equities and debt
securities. Equities are stocks, which are ownership shares in a company. Capital market
is a market for long-term debt and equity shares. In this market, the capital funds
comprising of both equity and debt are issued and traded. This also includes private
placement sources of debt and equity as well as organized markets like stock exchanges.
Capital market includes nancial instruments with more than one year maturity
Signi cance of Capital Markets
A well functioning stock market may help the development process in an economy
through the following channels:
1. Growth of savings,
2. E cient allocation of investment resources,
3. Better utilization of the existing resources.
In market economy like India, nancial market institutions provide the avenue by which
long-term savings are mobilized and channelled into investments. Con dence of the
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 investors in the market is imperative for the growth and development of the market.
Capital Market Instruments – some of the capital market instruments are:
• Equity
• Preference shares
• Debenture/ Bonds
• ADRs/ GDRs
• Derivatives

Debts : A contractual arrangement in which the issuer agrees to pay interest and repay
the borrowed amount after a speci ed period of time is a debt instrument. Debt
securities, such as bonds, are interest-bearing IOUs.

Debt instruments may be of various kinds depending on the repayment:

• Bullet payment – instruments where the issuer agrees to repay the entire amount
at the maturity date, i.e lumpsum payment is called bullet payment
• Sinking fund payment – instruments where the issuer agrees to retire a speci ed
portion of the debt each year is called sinking fund requirement
• Amortization – instruments where there are scheduled principal repayments
before maturity date are called amortizing instruments

Equity Market: These Markets are designed for residual claims. Investors can deal in
equity Financial holdings in such Markets.

Indian nancial system and components :

The various type of services that are provided by nancial institutions like banks,
insurance companies, pensions, fund etc. to the people of the country makes a nancial
system.

1. The Financial Institutions in India are broadly divided into two categories viz. Banks and
Non-Banking Financial Institutions (NBFI). A bank accepts demand deposits while NBFIs
do not accept them. The banks have been authorised to issue checks but NBFIs cannot
issue them.
2. Banks are classi ed into commercial and cooperative. Commercial banks operate
their business for pro t purposes while the basis of operation for cooperative banks is on
cooperative lines i.e. service to its members and the society. In comparison to a
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commercial bank, Cooperative banks provide a higher rate of interest.
Commercial banks are of two categories viz.
a) Scheduled commercial banks - A scheduled bank is a bank that has been included in
the 2nd schedule of the RBI Act 1934. A scheduled bank also had to be a corporation
and the Paid-up capital for it should be at least Rs. 500 crores.
b) Non-scheduled commercial banks- The Non-Scheduled banks have to put some
reserve requirements like SLR, and CRR according to the banking regulation act 1949.
Scheduled Banks are required to maintain reserve requirements with RBI as per the RBI
Act 1934.
3. Co-operative Banks: These are of two types-
a) Urban Co-operative banks (UCB)
b) Rural Co-operative banks.
The Urban Co-operative banks (UCB) are also known as Primary Co-operative Banks.
They help the communities, and localities workplace groups and are set up mostly in
urban and semi-urban areas. Their main customers are mainly small borrowers and
businesses.
These UCBs are also classi ed into Scheduled and Non-scheduled categories, which are
then further classi ed into a single state and multi-state.
4. Public Sector Banks:
Banks are controlled by the federal or state governments, with a combined ownership of
more than 51 percent. SBI and its a liates, Punjab National Bank, Bank of India, and
others are examples. Those Nationalized Banks (private banks taken over by the
government) which were nationalized in 1969 and 1980s are also public sector banks as
the government owns more than 51% of these banks.
5. Private Sector Banks:
These are those Indian Banks that are owned by private individuals for example ICICI
bank, HDFC bank, Axis Bank etc.
6. Foreign Banks:
Those Banks that are established and provided services of banking in India but are
owned by foreign entities are called foreign banks. for example, Citi Bank, HSBC Banks,
Standard chartered banks etc.
7. Regional Rural Banks (RRBs):
The Regional Rural Banks Act of 1976 established RRBs in 1975 with the goal of
developing the rural economy by providing credit and other facilities, particularly to small
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and marginal farmers, agricultural labourers, artisans, and small entrepreneurs, for the
purpose of developing agriculture, trade, commerce, industry, and other productive
activities in rural areas. The national government, the concerned state government, and
the sponsor bank each own 50:15:35 of RRBs (each RRB is sponsored by a particular
bank). RRBs are required to distribute 75% of their funding to priority industries. NABARD
also supervised RRBs.
8. Local Area Banks (LAB):
They were established in 1996 as part of a Government of India scheme. The government
intended to establish new private local banks with control over two or three adjacent
areas. The goal of establishing local area banks was to allow local institutions to mobilise
rural savings and make them available for investments in local areas. There are just four
Non-Scheduled Local Area Banks in India, one of which is Coastal Local Area Bank in
Vijayawada, Andhra Pradesh.
The RBI regulates and supervises three main areas of the Non-Banking Financial
Institutions (NBFIs) sector in India: All India Financial Institutions (AIFIs), Non-Banking
Financial Companies (NBFCs), and Primary Dealers (PDs). Credit Information Companies
(CIC) are a type of non-banking nancial organisation regulated by the Reserve Bank of
India.
9. AIFIs are institutional mechanisms tasked with delivering long-term nance to speci c
sectors. The RBI currently regulates and supervises four AIFIs, also known as
Development Financial Institutions (DFIs).
10. NABARD:
NABARD was established in 1982 under the provisions of the National Bank for
Agriculture and Rural Development Act 1981. NABARD gives credit to promote
agriculture, small scale industries, cottage and village industries, handicrafts and other
rural crafts and other allied economic activities in rural areas. NABARD extends
assistance to the government, RBI and other organizations in matters relating to rural
development. It o ers training and research facilities for banks, cooperatives and
organizations in matters relating to rural development
11. Small Industries Development Bank of India (SIDBI):
SIDBI was established in 1990 under the provisions of the Small Industries Development
of India Act 1989 SIDBI serves as the primary nancial institution for promoting, funding,
and developing the Micro, Small, and Medium Enterprise (MSME) sector, as well as for
coordinating the functions of other organisations involved in similar activities. SIDBI
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 primarily provides banking institutions with indirect nancial support (in the form of
re nancing) in order for them to lend to MSMEs.
12. MUDRA Bank:
MUDRA (Micro Units Growth and Re nance Agency Ltd.) is a government-owned
nancial agency dedicated to the development and re nancing of micro-enterprises.
MUDRA Ltd, a non-banking nance company, has been set up as a subsidiary of SIDBI
pending the passing of an act creating MUDRA Bank. MUDRA’s goal is to provide funding
to non-corporate (informal sector) small businesses in rural and urban areas with
nancing needs of up to Rs 10 lakhs, such as small manufacturing units, shopkeepers,
etc.
13. Non-Banking Financial Companies (NBFCs):
The NBFC is a company governed by the Companies Act, 1956/2013, that deals with
loans and advances, the acquisition of shares/bonds/debentures issued by the
government or a local authority, or other marketable securities of a similar nature, leasing,
hire-purchase, insurance, and chit business, but not with agriculture, industrial activity, or
the purchase or sale of any goods. Private sector institutions make up the majority of
NBFCs.
14. Primary dealers (PDs):
Primary dealers are RBI-registered companies with the authority to buy and sell
government securities. In the primary market, PDs purchase government securities
directly from the government (RBI issues these assets on behalf of the government), with
the intention of reselling them to other buyers in the secondary market. As a result, they
play an important role in the primary and secondary government securities markets.
15. Credit Information Companies (CIC):
A CIC is a non-pro t organisation that accepts banks, NBFCs, and nancial institutions as
members and collects data and identity information for individual customers and
enterprises. CICs tell banks whether or not a potential borrower is creditworthy based on
his payment history. The ability of lenders to assess risk and of consumers to receive
credit at competitive rates is determined by the quality of information available. The RBI
regulates and licenses credit information companies (CICs) under the Credit Information
Companies (Regulation) Act 2005. TransUnion Credit Information Bureau of India Limited
(CIBIL), Equifax, Experian, and High Mark Credit Information Services are the four CICs
currently operating in India.
16. Payment Banks:
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 In August 2015, the Reserve Bank of India (RBI) approved 11 applications for Payment
Bank licenses. The Reserve Bank of India has capped the amount of deposits that
payment banks can receive from individuals at Rs. 1 lakh. Only those companies that are
truly engaged in targeting the poor will be able to apply for payment bank licenses as a
result of this restriction. As a result, migrant workers, self-employed individuals, low-
income households, and others will be the primary bene ciaries of payment banks’ low-
cost savings accounts and remittance services, allowing those who currently transact
only in cash to make their rst foray into the formal banking system (payment banks will
not be permitted to lend or issue credit cards). Only demand deposits will be accepted by
payment banks.
17. Small Finance Banks:
In September 2015, RBI granted licenses to 10 applicants for Small Finance Banks which
is a step in the direction of furthering nancial inclusion.
The small nance banks shall primarily undertake basic banking activities of acceptance
of deposits and lending to unserved and underserved sections including small business
units, small and marginal farmers, micro and small industries and unorganized sector
entities.

Other components of IFS :

1. Financial institutions
The term nancial institution de nes those institutions which provide a wide variety of
deposit, lending, and investment products to individuals, businesses, or both. Some other
nancial institutions provide services and account for the general public, others are more
likely to serve only certain consumers with more specialized o erings.
1. Central Banks - These are the nancial institutions that regulate, oversight and look
after the management of all other banks. RBI is known as the central bank of India. An
individual does not have direct contact with a central bank instead, large nancial
institutions work directly with the RBI to provide products and services to the general
public.
2. Retail and Commercial Banks - These Banks provide products to consumers and
commercial banks worked directly with businesses.
3. Internet Banks
These types of banks work the same as retail banks. Internet bank is of two type-
• Digital banks- These are online-only platforms a liated with traditional banks.
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 • Neo banks- These banks are not a liated with any bank but themselves. These are pure
digital native banks.
4. Credit Unions - These are the nancial institution that was founded and administered
by its member and provide standard banking services. These unions help a speci c
population based on their eld of membership, such as military personnel or teachers.
5. Insurance Companies
These companies help individuals in transferring the risk of loss. These companies take
care of individuals and businesses from nancial loss caused due to disability, death,
accidents, property damage and other catastrophes.

2. Financial market
The marketplace where buyers and sellers participate in the trade of assets such as
equities, bonds, currencies, and derivatives.
Consists of 2 types:
1. Money Market – deals in short-term credit (< 1 yr).
2. Capital Market –handles medium-term & long-term credit. (> 1 yr).

-Money Market:
It is characterised by two sectors:
1. Organised sector — this sector comes within the direct purview of RBI. It includes
banking & sub-markets.
a. Banking sector – Commercial banks [under Banking regulation act 1949 & consist of
both private & public], RRBs, Cooperative Banks.
b. Sub Markets – Meet the need of govt and industries. It includes call money, Bill market
[Commercial bill, T-Bill], Certi cate of Deposit [CD] & Commercial Paper [CP].
2. Unorganised sector– consists of indigenous bankers, money lenders, non-banking
nancial institutions, etc.

- Capital Market:
This market comprises buyers & sellers, who trade in equity (ownership of asset) &debt
(loan). It is regulated by SEBI (established in 1992).
The institutions in the capital market are called NBFCs (Non-banking nancial
companies). But it’s not necessary that all NBFCs are capital market institutions.
RBI de nes NBFC as – ‘A NBFC is a company registered under the Companies Act, 1956
and is engaged in the buss of loans & advances, acquisition of share/ stock issued by
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 Government. It doesn’t include any institution whose principal buss is agriculture activity,
industrial activity, or sale/purchase of the immovable property.
- Security Market:
This market is known as-
a) Government Securities [gilt edge] security market and
b) Industrial Security Market [New Issue Market is the primary market & Old Issue Market
is the secondary market].
- Development Financial Institutions: They provide long-term loans to industries engaged
in infrastructure where projects have long gestation periods & require long term loans.
3. Financial services:
- The purpose of Financial Services is to cater for a person with borrowing, selling or
purchasing securities, allowing payments and settlement, lending and
borrowing. These services help in the management of funds as the money is invested
e ciently and also help to get the required funds. These services are provided by the
assets management and liability management companies.
These services are-
• Banking services- like cash deposit, issuing debit and credit cards, opening accounts,
Fixed deposit, loan facility etc.
• Insurance services- like issuing of insurance, selling policies, insurance undertaking
and brokerages, etc.
• Foreign exchange services- currency exchange, foreign exchange, etc.
• Investment services- like asset management etc.
4.. Financial Assets
The products which are traded in the Financial Markets are called Financial Assets. Based
on the di erent requirements and needs of the credit seeker, the securities in the market
also di er from each other.
- Call Money: Without any assurance, this is a loan lent for just a day which is repaid the
next day.
- Notice Money: Without any assurance, this is a loan rent for more than a day but less
than a duration of 14 days.
- Term Money: When the duration of the maturity of a particular amount deposited is
more than 14 days.
- Treasury Bills: With the duration of maturity of less than a year, these belong to the
government in the bond or debt security format. These are bought in the form of
government T– Bills which are taken as loans from the government.
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 - Certi cate of Deposit: This works on the format of electronic funds that remain
deposited in a particular bank for a xed period of time.
- Commercial Paper: Used by corporates, it is an instrument that is not secured even
though for a short duration of debt

1.3 corporate nance and nancial management

A. Corporate nance : Corporate nance is the area of nance that deals with sources
of funding, the capital structure of corporations, the actions that managers take to
increase the value of the rm to the shareholders, and the tools and analysis used to
allocate nancial resources. Corporate nance is often concerned with maximizing
shareholder value through long- and short-term nancial planning and the implementation
of various strategies. Corporate nance is split into three sub-sections: capital budgeting,
capital structure, and working capital management.
Corporate nance activities range from capital investment to tax considerations.
Corporate nance departments are charged with governing and overseeing their rms'
nancial activities and capital investment decisions. Such decisions include whether to
pursue a proposed investment and whether to pay for the investment with equity, debt, or
both. They also include whether shareholders should receive dividends, and if so, at what
dividend yield. Additionally, the nance department manages current assets, current
liabilities, and inventory control.

Corporate nance focuses on the long-term, overall picture of the nancial structure and
plans for a business. Its areas of responsibility are nancing, capital structure, investment
decisions, and dividends and return of capital.

- Financing: Corporate nance has the responsibility for:

• The analysis and budgeting for capital projects. It determines which projects are
approved, how they are nanced, the interest rates, and the schedule of loan payments.
• Finding sources of capital as debt or as additional equity contributions. A company can
borrow from commercial banks, issue debt securities in the capital markets, or raise
equity by selling more shares of stock.
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 • Maintaining a proper balance between debt and equity. Too much debt puts the rm at
risk of default in economic downturns, while too much equity dilutes the company's
earnings return to investors.
Capital Structure: Corporate nance has the objective of optimizing the company's
capital structure with a balance of debt and equity to obtain the lowest possible weighted
average cost of capital.
- Investment Decisions: Corporate nance uses various methods, such as the Internal
Rate of Return or Net Present Value, to evaluate the viability of long-term capital
investments. These methods estimate an investment's potential return on capital, prepare
the schedule of out ows for expenses, and make projections of future returns from cash
ow.Finance managers recommend capital investments if the rate of return is greater than
the company's cost of capital, also known as the hurdle rate.
- Dividends and Return of Capital: Corporate nance managers make decisions about
how pro ts are allocated. Are funds reinvested in the business or distributed as dividends
to shareholders? Which choice generates the highest return for the shareholders?
The purpose of corporate nance is to ensure that shareholders receive a good return on
their investment.
The cash ow statement (CFS), is a nancial statement that summarizes the movement
of cash and cash equivalents (CCE) that come in and go out of a company. The
CFS measures how well a company manages its cash position, meaning how well the
company generates cash to pay its debt obligations and fund its operating expenses. As
one of the three main nancial statements, the CFS complements the balance sheet and
the income statement. It helps in anticipate future de cits (or lack of) cash, and hence
make a nancing decision beforehand.

To properly manage your business's cash ow, you must rst analyze the components
that a ect the timing of your cash in ows and cash out ows. A good analysis of these
components will point out problem areas that lead to cash ow gaps for your business.
Narrowing, or even closing, cash ow gaps is the key to cash ow management.The
following analysis tools can be used to help determine the e ect your business's
accounts receivable (investment) is having on your cash ow:
• Average collection period measurement
• Collection of accounts receivable - An AR represents cash tied up that could have been
used to run and grow the business.
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 • Credit terms and trade discounts - Avoid giving longer credit terms to your customers
than your suppliers give to you.
• Enforcement of credit policy
• A Credit Policy ensures cash is available when you need it – but you must be prepared
to enforce it. This means applying discounts as outlined, charging penalties on late
payments and calling your customers when payments are overdue.
• Using the average collection period
• Purchase and sale of inventory
• Having too much inventory a ects your cash ow as, again, that is cash tied up with
unsold merchandise. Monitor how much inventory you have and select inventory that
sells.
• Repayment of accounts payable - Your Accounts Payable schedule should be in line
with your credit terms. Stretch payments on your payables until they’re due (but not
overdue).
• Accounts receivable to sales ratio.
• Employing management and market environment.
• Accounts receivable aging schedule
• Using the accounts receivable aging schedule

Functions of corporate nance :

The primary objective of corporate nance includes making sound nancial decisions to
improve the monetary impact by implementing sustainable goals, bene ting both the
shareholder and the organization.The role of corporate nance in an organization is to
manage the responsibility relevant to capital raising, managing nances for projects,
dealing with Mergers and Acquisitions (M&A), nancial monitoring, and several other/
associated complicated tasks. It uses proven tools and analysis to achieve sustainable
growth rather than a mere momentary pro t.

Scope of CF
1. The scope of corporate nance refers to the various objectives and responsibilities
under the corporate nancing sector. The objectives primarily focus on maximizing the
company’s sustainable expansion and wealth generation, as summarized below:
2. Keeping expenditures in check by capital budgeting while allocating only the most
pro table projects.
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 3. Market analysis to keep up with the rapidly changing trends by accumulating the
same practices.
4. Making decisions only after in-depth market research around raising funds from the
capital market through trustworthy and most e ective sources.
5. Take up advisory roles in case of mergers, acquisitions, and takeovers.
6. Undertaking an analysis of di erent investment options using fundamentals of
corporate nance to redeem an optimal mix of the most e cient nancing
instruments.
7. Taking decisions to diversify and expand according to the growth of the company.

Types of Corporate Finance

Types of corporate nance are the various methods of raising funds for the business. The
two main types/divisions suitable for boosting funds for the company are –
1. Short-term Corporate nance - Corporate nance loan is extended to a company for a
short period of a few months (or a maximum of one year) is short-term nance.
2. Long-term Corporate nance - Corporate nancial loan or aid spreading over a year or
more is long term corporate nance.

Principles of Corporate Finance

Three main principles of corporate nance to boost the company’s value are:
1. Investment Principle: This principle warrants the usage of scarce nancial resources
to make the most e cient decisions. A company must properly allocate nances
keeping the potential opportunities in mind. The investment must be made to secure a
stable ow of economic opportunities while keeping funds in check for future use.
2. Financing Principle: Orchestrating a business structure needs capital, a mix of debt
and equity. This principle deals with reaching an optimal blend of many nancial
instruments while keeping the future implications under vigilance.
3. Dividend Principle: Due to relentless participation in investment opportunities,
companies where generated cash ow surpasses the existing investments and hurdle
rate – companies try to nd out the proper ways to reward investors and repay debts.
Companies can either utilize the excess cash to pay o or expand their businesses.

B. Financial management
Financial management involves planning, organizing, and controlling the nancial
activities of an organization. It applies general management principles to oversee the
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 resources of a business e ciently.Financial Management is all about planning, organizing,
directing, and controlling the economic pursuits such as acquisition and utilization of
capital of the rm. To put it in other words, it is applying general management standards
to the nancial resources of the rm.

The objectives and functions of nancial management include:

• Maintaining a system of controls and creating reporting systems that compare actual
results to budgeted expectations and note any discrepancies that require management
actions.
• Using ratio analysis and key performance indicators to identify nonperforming areas and
taking corrective actions.
• Controlling a company's cash ow to make sure that adequate funds are always
available to pay wages, suppliers, creditors and utility bills.
• Maintaining adequate working capital. Financial management monitors the collection of
accounts receivable, maintains optimal inventory turnover, and keeps adequate cash
balances to support operations.
• Taking part in utilising the funds and controlling productivity.
• Recognizing the requisites of capital (funds) and picking up the sources for that capital.
• Investment accords incorporate investment in xed assets known as capital budgeting.
Investing in current assets are part and parcel of investment decisions known as
working capital decisions.
• Financial decisions associated with the nance raised from di erent sources which
would rely upon the accord on – the kind of resource, when is the nancing done, cost
incurred and the returns as well.
• In the case of dividend decision, the nance manager is the who is responsible for the
accord that is taken by him or her; regarding the net pro t distribution (NPD). However,
Net pro ts are classi ed into two types:
- Dividend for shareholders: The rate of dividend and the amount of dividend has to be
decided
- Retained pro ts: The amount of contained (retained) gains has to be ascertained which
would rely upon the development and variety of strategies of the trading concern

Scope of nancial management :

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 To understand the nancial management scope, rst, it is essential to understand the
approaches that are divided into two sections.
1. Traditional Approach : During the 20th century, the traditional approach was also
known as corporate nance. This approach was initiated to procure and manage funds
for the company. For studying nancial management, the following three points were
used
(i) Institutional sources of nance.
(ii) Issue of nancial devices to collect refunds from the capital market.
(iii) Accounting and legal relationship l between the source of nance and business.
In this approach, nance was required not for regular business operations but occasional
events like reorganization, promotion, liquidation, expansion, etc. It was considered
essential to have funds for such events and regarded as one of the crucial functions of a
nancial manager.
Though he was not accountable for the e ective utilization of funds, however, his
responsibility was to get the required funds from external partners on a fair term. The
traditional approach of nance management stayed until the 5th decade of the 20th
century. The traditional approach only emphasized on the fund’s procurement only by
corporations. Hence, this approach is regarded as narrow and defective.
Limitations of Traditional Approach
- One-sided approach- It is more considerate towards the fund procurement and the
issues related to their administration, however, it pays no attention to the e ective
utilization of funds.
- Gives importance to the Financial Problems of Corporations- It only focuses on the
nancial problems of corporate enterprises, so it narrows the opportunity of the nance
function.
- Attention to Irregular Events- It provides funds to irregular events like consolidation,
incorporation, reorganization, and mergers, etc. and does not give attention to
everyday business operations.
- More Emphasis on Long Term Funds- It deals with the issues of long-term nancing.

• 2. Modern Approach : With technological improvement, increase competition, and the

development of strong corporate, it was important for Management to use the available
nancial resources in its best possible way. Therefore, the traditional approach became
ine cient in a growing business environment.
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• The modern approach had a more comprehensive analytical viewpoint with a focus on
the procurement of funds and its active and optimum use. The fund arrangement is an
essential feature of the entire nance function.
• The main elements of this approach are an evaluation of alternative utilisation of funds,
capital budgeting, nancial planning, ascertainment of nancial standards for the
business success, determination of cost of capital, working capital management,
Management of income, etc. The three critical decisions taken under this approach are.
(i) Investment Decision
(ii) Financing Decision
(iii) Dividend Decision

Features of Modern Approach

The following are the main features of a modern approach.
More Emphasis on Financial Decisions- This approach is more analytic and less
descriptive as the right decisions for a business can be taken only on the base of
accounting and statistical data.
Continuous Function- The modern approach is a constant activity where the nancial
manager makes di erent nancing decisions unlike the traditional method,
Broader View- It gives importance not only to optimum use of nance also abut the fund’s
procurement. Similarly, it also incorporates features relating to the cost of capital, capital
budgeting, and nancial planning, etc.
The measure of Performance- Performance of a rm is also a ected by the nancial
decision taken by the Management or nance manager. Therefore, to maximize revenue,
the modern approach keeps a balance between liquidity and pro tability.
The other scope of nancial management also includes the acquisition of funds, gathering
funds for the company from di erent sources, assessment and evaluation of nancial
plans and policies, allocation of funds, use of funds to buy xed and current assets,
appropriation of funds, dividing and distribution of pro ts, and the anticipation of funds
along with estimation of nancial needs of the company.

Relationship and di erentiations between the two : The relationship between nancial
accounting and nancial management provides the reports and metrics that managers
need to gauge the performance of the business by comparing the data with budgets and
standards to keep the company on track toward its goals. : While nancial management
deals with the day-to-day optimization of the cash ow, corporate nance aims to
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 maximize the worth of a company by analyzing and decision-making. Although both are
pertinent to the nance division of any company, they deal with purely opposing duties.
Although corporate nance may seem to apply only to large corporations, entrepreneurial
nance applies the same principles and objectives on a smaller scale. Small-business
owners also need to think about the viability of investments, the e ects of borrowing
money, the need to raise equity capital, and keeping enough cash owing to pay the bills.
Although they interact with each other, corporate nance and nancial management have
di erent objectives. Corporate nance aims to maximize the value of the rm by
optimizing the capital structure of the business, while nancial management is more
focused on maximizing pro ts with e cient planning and control of day-to-day operations

Objectives of corporate nance

• The primary objective of corporate nance is the maximization of shareholder value

through the application of short-term and long-term strategies that assist companies in
obtaining new funds either from equity or debt sources.
• Secondly, corporate nance is concentrated on the investment decisions made by a
company in order to achieve the maximum potential return among a set of new ventures
and projects
• The objective is conventional nancial theory is to maximise the value of the rm ,
Consequently any decision whether investment or nancial that maximises the
• value of the rm is called good decision

Module 2

CONCEPTS RELATING TO CORPORATE

2.1 Capital Investment: Needs and Factors e ecting Capital Investment

Capital investment decisions are the responsibility of managers of investment centers.

Capital investments often involve large sums of money and considerable risk. Speci c
investments over a certain amount require approval by the board of directors in many
companies. Although the nal decision about asset acquisition is management's
responsibility, accountants, economists, and other nancial experts have developed
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 capital investment models to help managers make those decisions. Accountants have the
particularly important role of estimating the amount and timing of the cash ows used in
capital investment decision models.

Capital investment is the money used by a business to purchase xed assets, such as
land, machinery, or buildings. The money may be in the form of cash, assets, or
loans.Without capital investment, businesses may have a hard time getting o the
ground.

Capital investment models are based on the future cash ows expected from a particular
asset investment opportunity. The amount and timing ofthe cash ows from a capital
invest- ment project determine its economic value. The timing ofthose ows is important
because cash received earlier in time has greater economic value than cash received
later. As soon as cash is received, it can be reinvested in an alternative pro t-making
opportunity. Thus, any particular investment project has an opportunity cost for cash
committed to it. Because the horizon of capital investment decisions extends over many
years, the time value of money is often a signi cant decision factor for managers making
these decisions.

To recognize the time value of money, the future cash ows associated with a project are
adjusted to their present value using a predetermined discount rate. Summing the
discounted values of the future cash ows and subtracting the initial investment yields a
project's net present value (NPV), which represents the economic value of the project to
the company at a given point in time.

The decision models used for capital investments attempt to optimize the economic value
to the rm by maximizing the net present value of future cash ows. If the net present
value of a project is positive, the project will earn a rate of return higher than its discount
rate, which is the rate used to compute net present value.

Distinguishing between Revenues, Costs, and Cash Flows - A timing di erence often
exists between revenue recognition and cash in ow on the one hand and the incurrence
of a cost and the related cash out ow on the other hand. When this occurs, it is important
to distinguish cash ows from revenues and costs. Note that capital investment analysis
uses cash . ows, not revenues and costs.
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 How Capital Investment Works ?

Capital investment is a broad term that can be de ned in two distinct ways:

An individual, a venture capital group or a nancial institution may make a capital

investment in a business. The money can be provided as a loan or a share of the pro ts
down the road. In this sense of the word, capital means cash.
The executives of a company may make a capital investment in the business. They buy
long-term assets such as equipment that will help the company run more e ciently or
grow faster. In this sense, capital means physical assets.

In either case, the money for capital investment must come from somewhere. A new
company might seek capital investment from any number of sources, including venture
capital rms, angel investors, or traditional nancial institutions. When a new company
goes public, it is acquiring capital investment on a large scale from many investors.

An established company might make a capital investment using its own cash reserves or
seek a loan from a bank. It might issue bonds or stock shares in order to nance capital
investment.

The present value of cash ows is the amount of future cash ows discounted to their
equivalent worth today. The net present value of a project can be computed by using the
equation:
where
C, = Cash to be received or disbursed at the end of time period 11
d =Appropriate discount rate for the future cash ows
n = Time period when the cash ow occurs
N = Life of the investment, in years
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 This section outlines a method for estimating cash ows for investment projects, which
we illustrate using the expansion project of Mezzo Diner. We start by setting four major
categories of cash ows for a project:
• Investment cash ows.
• Periodic operating cash ows.
• Cash ows from the depreciation tax shield.
• Disinvestment cash ows.

Need for capital investment

Capital investment gives businesses the money they need to achieve their goals. There
are typically three main reasons for a business to make capital investments:
• To acquire additional capital assets for expansion, which enables the business to—for
example—increase unit production, create new products, or add value
• To take advantage of new technology or advancements in equipment or machinery to
increase e ciency and reduce costs
• To replace existing assets that have reached end-of-life (a high-mileage delivery vehicle
or an aging laptop computer, for example)
• Capital investment is considered to be a very important measure of the health of the
economy. When businesses are making capital investments, it means they are con dent
in the future and intend to grow their businesses by improving existing productive
capacity.
• However, after having received investments, the invested amount must be utilised to
develop and push the business ahead. In the same line, if a company announces to go
public, the large amount of funds pooled in from the investors is also considered as a
form of capital investment.
• Capital investment has its own disadvantages. While capital investment is made to
improve a company's cash ow in operations, it may sometimes be insu cient to cover
the expected costs. In such cases, the company could be forced to borrow funds from
an external nancier to cover for the miscalculations.
•

Capital Investment Factors

Capital investment factors are factors a ecting the decisions surrounding capital
investment projects. Capital investment factors are elements of a project decision, such
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 as cost of capital or the duration of investment, which must be weighed to determine
whether an investment should be made, and if so, in what manner it can be best
executed to maximize utility for the investor. Capital investment factors may also be
described as "factors in uencing investment decisions" or "capital investment decisions.”

Capital investment is the procurement of money, obtained by a company in order to

further its business goals and objectives.

Capital investment factors can relate to almost any aspect of an investment decision.
These choices may re ect and take into consideration the regulatory environment, risks
associated with the investment, macro-economic outlooks, competitive landscapes,
times to complete a project, concerns of shareholders, governance, probability of
success/failure, and opportunity costs, to name a few.

All factors should be examined before coming to a nal decision on capital investment
projects. Other aspects that a ect decision-making can include:

The outlook of a company's management team

• Cash ow budget - It’s important to know how much money enters and leaves the
business in a period deemed necessary for analysis. The data determine the areas in
the operation needed to be studied further, the nancial
standing of the company, and the capability of the company in getting upgrades or new
equipment purchases.
• Rate of return - The rate of return (RoR) refers to the pro t of the investment over a
speci ed time. The changes in the investment value – the net gains or losses – are
expressed as a percentage of the initial cost. There
should be an expected return and risk to watch out for from the proposal.
• Fiscal policy and legal mandates - Business upgrades or expansion should be carried
out within the laws as to prevent issues and losses in the future. Review the tax
obligations and incentives that can be helpful in carefully coming up with investments.
• Competitor strategies - Always include the strategies of your competitors in the data to
make an informed business decision.
• Opportunities out of the technological changes - The economy has entered the
transitory phase of the digital age, where almost all processes are done at a faster
speed yet with high accuracy. You should be familiar with the changes in the industry
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 brought by technology and research development, and you should also have foresight
on how you can use them to your advantage or avoid the possible pitfalls.
• Market forecast - It’s a no-brainer that the market should be monitored to learn about
opportunities that will help the business grow or stay a oat amid possible concerns.
• The management outlooks - All investment decisions should be made with the board or
authorities deemed to have a say with your business.
• Other non-economic factors - These factors may refer to the welfare of the workforce,
goodwill of the company, and urgency of the project.

Capital Investment Factors Method

Typically, the capital investment factors process takes the following steps:

• Project identi cation: Finding an appropriate project for consideration.

• Project de nition and vetting: Accurately categorising a project as a means to fully
understanding it, as well as ensuring that it is appropriate.
• Analysing and accepting: Setting and checking the parameters for a successful project
that meets an organisation's goals, as well as formally engaging in a project.
• Implementation: Where the work on a project begins, and actions are undertaken to
work toward a successful outcome.
• Monitoring: Constantly reviewing decisions and actions to ensure that a project is kept
on track, as well as to provide an opportunity to improve and alter processes and
decision-making.
• Post audit: Analysing the outcome of a project or investment to determine whether it
delivered on the original goals and intents. This step helps determine whether it was
successful and also provides a means to improve further and re ne processes.

2.2 Risk and return correlation

Increased potential returns on investment usually go hand-in-hand with increased risk.

Di erent types of risks include project-speci c risk, industry-speci c risk, competitive
risk, international risk, and market risk. Return refers to either gains or losses made from
trading a security. The return on an investment is expressed as a percentage and
considered a random variable that takes any value within a given range. Several factors
in uence the type of returns that investors can expect from trading in the markets.
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 How can business executives make the best investment decisions? Is there a method of
risk analysis to help managers make wise acquisitions, launch new products, modernize
the plant, or avoid overcapacity? “Risk Analysis in Capital Investment” takes a look at
questions such as these and says “yes”—by measuring the multitude of risks involved in
each situation. Mathematical formulas that predict a single rate of return or “best
estimate” are not enough. The nature and processing of the data used and speci c
combinations of variables like cash ow, return on investment, and risk to estimate the
odds for each potential outcome. Managers can examine the added information provided
in this way to rate more accurately the chances of substantial gain in their ventures. Of all
the decisions that business executives must make, none is more challenging—and none
has received more attention—than choosing among alternative capital investment
opportunities. This is where the element of risk enters, and it is in the evaluation of risk
that the executive has been able to get little help from currently available tools and
techniques.

Need for New Concept

The evaluation of a capital investment project starts with the principle that the productivity
of capital is measured by the rate of return we expect to receive over some future period.
Comparing alternative investments is thus complicated by the fact that they usually di er
not only in size but also in the length of time over which expenditures will have to be
made and bene ts returned. It is not surprising, then, that much e ort has been applied
to the development of ways to improve our ability to discriminate among investment
alternatives. The focus of all of these investigations has been to sharpen the de nition of
the value of capital investments to the company. The controversy and furor that once
came out in the business press over the most appropriate way of calculating these values
have largely been resolved in favor of the discounted cash ow method as a reasonable
means of measuring the rate of return that can be expected in the future from an
investment made today.

Thus we have methods which are more or less elaborate mathematical formulas for
comparing the outcomes of various investments and the combinations of the variables
that will a ect the investments. As these techniques have progressed, the mathematics
involved has become more and more precise, so that we can now calculate discounted
returns to a fraction of a percent.
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 But sophisticated executives know that behind these precise calculations are data which
are not that precise. At best, the rate-of-return information they are provided with is based
on an average of di erent opinions with varying reliabilities and di erent ranges of
probability. When the expected returns on two investments are close, executives are likely
to be in uenced by intangibles—a precarious pursuit at best. In short, the decision
makers realize that there is something more they ought to know, something in addition to
the expected rate of return. What is missing has to do with the nature of the data on
which the expected rate of return is calculated and with the way those data are
processed. It involves uncertainty, with possibilities and probabilities extending across a
wide range of rewards and risks. The fatal weakness of past approaches thus has
nothing to do with the mathematics of rate-of-return calculation. We have pushed along
this path so far that the precision of our calculation is, if anything, somewhat illusory. The
fact is that, no matter what mathematics is used, each of the variables entering into the
calculation of rate of return is subject to a high level of uncertainty.

the rate of return actually depends on a speci c combination of values of a great many
di erent variables. But only the expected levels of ranges (worst, average, best; or
pessimistic, most likely, optimistic) of these variables are used in formal mathematical
ways to provide the gures given to management. Thus predicting a single most likely
rate of return gives precise numbers that do not tell the whole story. The expected rate of
return represents only a few points on a continuous cure of possible combinations of
future happenings.

Limited improvements
A number of e orts to cope with uncertainty have been successful up to a point, but all
seem to fall short of the mark in one way or another.
1. More accurate forecasts
Reducing the error in estimates is a worthy objective. But no matter how many estimates
of the future go into a capital investment decision, when all is said and done, the future is
still the future. Therefore, however well we forecast, we are still left with the certain
knowledge that we cannot eliminate all uncertainty.
2. Empirical adjustments
Adjusting the factors in uencing the outcome of a decision is subject to serious
di culties. We would like to adjust them so as to cut down the likelihood that we will
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make a “bad” investment, but how can we do that without at the same time spoiling our
chances to make a “good” one? And in any case, what is the basis for adjustment? We
adjust, not for uncertainty, but for bias.
3. Revising cuto rates
Selecting higher cuto rates for protecting against uncertainty is attempting much the
same thing. Management would like to have a possibility of return in proportion to the risk
it takes. Where there is much uncertainty involved in the various estimates of sales, costs,
prices, and so on, a high calculated return from the investment provides some incentive
for taking the risk. This is, in fact, a perfectly sound position. The trouble is that the
decision makers still need to know explicitly what risks they are taking—and what the
odds are on achieving the expected return.
4. Three-level estimates
A start at spelling out risks is sometimes made by taking the high, medium, and low
values of the estimated factors and calculating rates of return based on various
combinations of the pessimistic, average, and optimistic estimates. These calculations
give a picture of the range of possible results but do not tell the executive whether the
pessimistic result is more likely than the optimistic one—or, in fact, whether the average
result is much more likely to occur than either of the extremes. So, although this is a step
in the right direction, it still does not give a clear enough picture for comparing
alternatives.
5. Selected probabilities
Various methods have been used to include the probabilities of speci c factors in the
return calculation. L.C. Grant discussed a program for forecasting discounted cash ow
rates of return where the service life is subject to obsolescence and deterioration. He
calculated the odds that the investment will terminate at any time after it is made
depending on the probability distribution of the service-life factor. After having calculated
these factors for each year through maximum service life, he determined an overall
expected rate of return.2
Edward G. Bennion suggested the use of game theory to take into account alternative
market growth rates as they would determine rate of return for various options. He used
the estimated probabilities that speci c growth rates would occur to develop optimum
strategies.

Analysis
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 Since every one of the many factors that enter into the evaluation of a decision is subject
to some uncertainty, the executives need a helpful portrayal of the e ects that the
uncertainty surrounding each of the signi cant factors has on the returns they are likely to
achieve.

The objective is to give a clear picture of the relative risk and the probable odds of
coming out ahead or behind in light of uncertain foreknowledge.
A simulation of the way these factors may combine as the future unfolds is the key to
extracting the maximum information from the available forecasts. In fact, the approach is
very simple, using a computer to do the necessary arithmetic. To carry out the analysis, a
company must follow three steps:
1. Estimate the range of values for each of the factors (for example, range of selling price
and sales growth rate) and within that range the likelihood of occurrence of each value.
2. Select at random one value from the distribution of values for each factor. Then
combine the values for all of the factors and compute the rate of return (or present value)
from that combination. For instance, the lowest in the range of prices might be combined
with the highest in the range of growth rate and other factors. (The fact that the elements
are dependent should be taken into account, as we shall see later.)
3. Do this over and over again to de ne and evaluate the odds of the occurrence of each
possible rate of return. Since there are literally millions of possible combinations of values,
we need to test the likelihood that various returns on the investment will occur. This is like
nding out by recording the results of a great many throws what percent of 7s or other
combinations we may expect in tossing dice. The result will be a listing of the rates of
return we might achieve, ranging from a loss (if the factors go against us) to whatever
maximum gain is possible with the estimates that have been made.

For each of these rates we can determine the chances that it may occur. The average
expectation is the average of the values of all outcomes weighted by the chances of each
occurring.We can also determine the variability of outcome values from the average. This
is important since, all other factors being equal, management would presumably prefer
lower variability for the same return if given the choice. When the expected return and
variability of each of a series of investments have been determined, the same techniques
may be used to examine the e ectiveness of various combinations of them in meeting
management objectives.
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 The information we need includes the possible range of values for each factor, the
average, and some idea as to the likelihood that the various possible values will be
reached.The ranges are directly related to the degree of con dence that the estimator has
in the estimate. Thus certain estimates may be known to be quite accurate. The next step
in the proposed approach is to determine the returns that will result from random
combinations of the factors involved. A computer can be used to carry out the trials for
the simulation method in very little time and at very little expense.
Data comparisons
The nine input factors described earlier fall into three categories:
1. Market analyses : Included are market size, market growth rate, the company’s share of
the market, and selling prices. For a given combination of these factors sales revenue
may be determined for a particular business.
2. Investment cost analyses : Being tied to the kinds of service-life and operating-cost
characteristics expected, these are subject to various kinds of error and uncertainty; for
instance, automation progress makes service life uncertain.
3. Operating and xed costs : These also are subject to uncertainty but are perhaps the
easiest to estimate. These categories are not independent, and for realistic results my
approach allows the various factors to be tied together.

Comparing Opportunities : From a decision-making point of view one of the most

signi cant advantages of the new method of determining rate of return is that it allows
management to discriminate among measures of (1) expected return based on weighted
probabilities of all possible returns, (2) variability of return, and (3) risks. Our new analysis
thus may help management to avoid an unwise investment as we can attest deduce the
uncertainties present.

Relationship between the Risk and Return

Relationship between risk and return means to study the e ect of both elements on each
other. We measures the e ect of increase or decrease risk on return of investment. There
is a positive correlation (a relationship between two variables in which both move in the
same direction) between risk and return. There is no guarantee that taking greater risk
results in a greater return. Rather, taking greater risk may result in the loss of a larger
amount of capital.
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 A more correct statement may be that there is a positive correlation between the amount
of risk and the potential for return. Generally, a lower risk investment has a lower potential
for pro t. A higher risk investment has a higher potential for pro t but also a potential for a
greater loss. The risk associated with investments can be thought of as lying along a
spectrum. On the low-risk end, there are short-term government bonds with low yields.
The middle of the spectrum may contain investments such as rental property or high-yield
debt. On the high-risk end of the spectrum are equity investments, futures and
commodity contracts, including options.

Investments with di erent levels of risk are often placed together in a portfolio to
maximize returns while minimizing the possibility of volatility and loss. Modern portfolio
theory (MPT) uses statistical techniques to determine an e cient frontier that results in
the lowest risk for a given rate of return. Using the concepts of this theory, assets are
combined in a portfolio based on statistical measurements such as standard deviation
and correlation.

The Risk-Return Tradeo -The correlation between the hazards one runs in investing
and the performance of investments is known as the risk-return tradeo . The risk-return
tradeo states the higher the risk, the higher the reward—and vice versa. Using this
principle, low levels of uncertainty (risk) are associated with low potential returns and high
levels of uncertainty with high potential returns. According to the risk-return tradeo ,
invested money can render higher pro ts only if the investor will accept a higher
possibility of losses. Investors consider the risk-return tradeo as one of the essential
components of decision-making. They also use it to assess their portfolios as a whole.

Risk Tolerance
An investor needs to understand his individual risk tolerance when constructing a
portfolio of assets. Risk tolerance varies among investors. Factors that impact risk
tolerance may include:

• the amount of time remaining until retirement

• the size of the portfolio
• future earnings potential
• ability to replace lost funds
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 • the presence of other types of assets: equity in a home, a pension plan, an insurance
policy

Managing Risk and Return - Formulas, strategies, and algorithms abound that are
dedicated to analyzing and attempting to quantify the relationship between risk and
return. Roy's safety- rst criterion, also known as the SFRatio, is an approach to
investment decisions that sets a minimum required return for a given level of risk. Its
formula provides a probability of getting a minimum-required return on a portfolio; an
investor's optimal decision is to choose the portfolio with the highest SFRatio.

Another popular measure is the Sharpe ratio. This calculation compares an asset's,
fund's, or portfolio's return to the performance of a risk-free investment, most commonly
the three-month U.S. Treasury bill. The greater the Sharpe ratio, the better the risk-
adjusted performance. The existence of risk does not mean that you should not invest –
only that you should be aware that any investment has some degree of risk which should
be considered when deciding whether the expected returns of that investment are worth
it.
Therefore, when considering the suitability of any investment, you must understand both
the likely returns and the risks involved. The appropriate risk-return combination will
depend on your nancial objectives. Some people prefer a low-risk, steady income
stream while others don’t mind taking on more risk for the chance of making higher
returns. In investing, risk and return are highly correlated. Investing can be a highly
e ective way to grow your money and build a foundation for a good nancial life. It’s also
important to be aware that investing is not a risk-free strategy and there’s always a
chance you could lose money or not make as much as you expected. However, not
taking any risk is not the solution or will not help your investments grow. “The biggest risk
is not taking any risk”.
All investments carry some risk due to factors such as in ation, tax, economic downturns
and market factors. The volatility associated with Financial market is nothing but the
Market Risk. While investing, risk is measured to evaluate the kind of returns you should
expect from the investment. Or your return expectations should be based on the level of
risk that you can bear. The connection between high returns and high risk is probabilistic.
The chances are that high returns come with a higher risk but that’s it – it’s a chance, a
higher probability, that’s all as shown in graph above.
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An investment that has the chance of a higher return is likely to have higher risk. However,
the reverse is not true. High risk by itself does not mean higher returns.

2.3 Time Value of Money

The time value of money is a basic nancial concept that holds that money in the present
is worth more than the same sum of money to be received in the future. This is true
because money that you have right now can be invested and earn a return, thus creating
a larger amount of money in the future. (Also, with future money, there is the additional
risk that the money may never actually be received, for one reason or another). The time
value of money is sometimes referred to as the net present value (NPV) of money.

Time Value and Purchasing Power - The time value of money is also related to the
concepts of in ation and purchasing power. Both factors need to be taken into
consideration along with whatever rate of return may be realized by investing the
money.Why is this important? Because in ation constantly erodes the value, and
therefore the purchasing power, of money. In ation and purchasing power must be
factored in when you invest money because to calculate your real return on an
investment, you must subtract the rate of in ation from whatever percentage return you
earn on your money.If the rate of in ation is actually higher than the rate of your
investment return, then even though your investment shows a nominal positive return,
you are actually losing money in terms of purchasing power.

Time Value of Money Formula - The time value of money is an important concept not
just for individuals, but also for making business decisions. Companies consider the time
value of money in making decisions about investing in new product development,
acquiring new business equipment or facilities, and establishing credit terms for the sale
of their products or services. A speci c formula can be used for calculating the future
value of money so that it can be compared to the present value:

FV = PV x [1 + (i/ n)](nxt)
Where:
FV = the future value of money
PV = the present value
i = the interest rate or other return that can be earned on the money
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 t = the number of years to take into consideration
n = the number of compounding periods of interest per year

The formula can also be used to calculate the present value of money to be received in
the future. You simply divide the future value rather than multiplying the present value.
This can be helpful in considering two varying present and future amounts.

Investors prefer to receive money today rather than the same amount of money in the
future because a sum of money, once invested, grows over time. If it is not invested, the
value of the money erodes over time. It will have even less buying power when you
retrieve it because in ation has reduced its value. Opportunity cost is key to the concept
of the time value of money. Money can grow only if it is invested over time and earns a
positive return.

Money that is not invested loses value over time. Therefore, a sum of money that is
expected to be paid in the future, no matter how con dently it is expected, is losing value
in the meantime.

How Is the Time Value of Money Used in Finance? It would be hard to nd a single
area of nance where the time value of money does not in uence the decision-making
process.The time value of money is the central concept in discounted cash ow (DCF)
analysis, which is one of the most popular and in uential methods for valuing investment
opportunities. It is also an integral part of nancial planning and risk management
activities. Pension fund managers, for instance, consider the time value of money to
ensure that their account holders will receive adequate funds in retirement.

2.4 Agency Problem : Features and Solution

In every company, there is a separation of ownership and control of the company which
means that the company is owned by one person and controlled by another person. This
is because most of the time the owners of the company do not have enough time and
knowledge to run and look after the daily workings of the company hence, they delegate
the work and management of a company to someone quali ed to do that. The delegation
of work sometimes results in a con ict of interest between the shareholders of the
company i.e., owners and the managers of the company i.e., controller, such con ict of
interest is known as ‘Agency Problems’. In layman’s terms ‘Agency Problems’ means a
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situation where the agent works towards achieving his own goals and interests rather
than working towards the goals and interests of the owners.

Agency Problem: – According to the paper “The Essential Elements of Corporate Law,”[1]
there are in total three types of con icts which could be termed as ‘Agency Problems’
and these con icts are: –

1. The con ict between shareholders and managers – In most cases the shareholders of a
company i.e., the principal do not have enough time and enough knowledge to run the
company hence to delegate the work they hire managers i.e., agents. Since the job is
delegated to managers the owners of a company are constantly in fear to ascertain
whether the managers are working towards achieving company goals, or they are working
towards achieving their personal goals.
2. The con ict between majority shareholders and minority shareholders – Shareholders
are further divided into majority shareholders and minority shareholders. Majority
shareholders are the shareholders who own the majority of shares and as a result, their
vote has a higher value. Due to this, the interests of minority shareholders are overlooked,
and the managers of the company i.e., the Board of Directors take a decision that is
favorable to majority shareholders. As a result, the majority shareholders have the power
to manipulate the company’s decisions at the expense of minority shareholders. With
respect to India, this type of con ict is more prevalent because the majority of the
companies are owned by few families.
3. The con ict between shareholders and the corporations’ other constituencies – Most of
the time the owners in an e ort to achieve their personal goals overlook the company’s
goal and what might be bene cial for the future of the company, in the process of doing
that they don’t optimally utilize all the resources and the corporations’ other
constituencies such as creditors, its workforce and its customers.

Why agency problem arises :

There are numerous reasons due to which “Agency Problems” occur in a company, and
the reasons could be: –
1. the owner i.e., the principal of the company provides the money to the managers i.e.,
agent and desires pro t in return and is ready to take greater risks for greater
investments whereas managers of a company are inclined towards safer alternatives,
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2. other reason could be lack of participation in the day to day activity of the company
from the owners’ side which puts managers in a position where they could easily use
the money for their bene t rather than for the bene t of the company,
3. another reason could be the lack of transparency and communication of information
since the owners do not play an active role in the functioning of the company they are
not made aware of all the information and updates and are provided with the
information which the managers deems necessary, which obviously puts the
managers in an advantageous position.
4. The agent may act independently from the principal in order to obtain some sort of
previously agreed upon incentive or bonus. Con dentiality breach regarding the
personal and nancial information of the principal
5. Insider trading with the information provided by the principal. When the principal acts
against the recommendations provided by the agent.

Solutions

1. Corporate Governance: – To minimize the extent of Agency Problems the government

has implemented various laws which makes it necessary for the management of the
company to release the company report, its nancial condition to the public to
increase transparent communication. The government through the enactment of the
Securities and Exchange Board of India (hereinafter referred to as SEBI) regulations of
1992 grants the authority to SEBI to conduct a regular inspection in all the companies
that enlisted in the Bombay Stock Exchange and National Stock Exchange. The
Companies Act, 2013 made serval modi cations and brought much-needed changes
such as: – section 92 of the act makes it necessary for all the companies to upload
the annual report of the company for the public, section 149 which makes it
mandatory for the appointment of at least one independent director, section 169 of
the act which gives shareholders the power to remove the director, section 177 of the
Act makes it mandatory for every company to have an audit committee, and section
203 which makes it necessary for every company to have a company secretary, to
name a few.

2. Loopholes in them: – Implementation and introduction of all these laws are a welcome
change which has lots of bene ts with it but there remains a huge problem because
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 the Indian government after the 1991 ‘liberalization, privatization, and globalization of
the economy “unwittingly borrowed corporate governance mechanisms from the
developed jurisdictions where the companies mostly have a dispersed shareholding
pattern, whereas in case of India private enterprises continued to be the exclusive
domain of few families who could override the red tape of the license raj era for
running their business”[2] and keep on taking advantage of minority shareholders,
which rendered several sections of the Companies Act 2013 rather ine ective
because of the existence of loopholes in them. Some of the loopholes in the
corporate governance were brought to the attention after the promoters of Tata Sons
Ltd. proposed to remove Mr. Cyrus Mistry from the position of director of Tata Group
companies. The whole incident brought the focus on the loopholes present in sections
149 and 169 of the Companies Act 2013.

The intention behind having section 149 which makes it mandatory for a company to have
at least one independent director, was to have a person in a position who gives a fair and
unbiased decision. But this does not usually happen because of the various reasons such
as: – usually the majority shareholders appoint their relatives, friends, or someone who
has previously given decisions in their favor, as an independent director. Another reason
could be the fact that the majority shareholders have the power to appoint and remove
independent directors and hence in most cases independent directors give decisions in
favor of majority shareholders. The proposal to remove Mr. Wadia from his position of
independent director in Tata Sons Ltd companies after supporting Mr. Cyrus Mistry is a
clear signal of the existence of loopholes in the law. According to section 169 “a company
may, by ordinary resolution, remove a director before the expiry of the period of his o ce
after giving him a reasonable opportunity of being heard”, this means that a director could
be removed from his position through a simple majority of votes given by the
shareholders present in the shareholders meeting. “Under Indian company law, signi cant
powers are conferred upon a shareholder who has a controlling stake to re members of
the board of directors. And it is precisely this power that’s being exercised by Tata Sons”
[4] to remove Mr. Cyrus Mistry from his position as they have the majority of shares. This
not only gives majority shareholders extra power but also which the minority shareholders
in a vulnerable position as their opinion does not matter because of the rule “majority
democracy”.
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 3. The Kotak Committee Report and Suggestions: – Due to the increase in
misappropriation of these laws, SEBI formed The Kotak Committee to suggest
modi cations in the existing law. The committee suggested numerous proposals such
as people holding 20% or more shares of a company should be considered ‘related to
each other’ for listing regulations, the board of directors must meet once every year to
decide upon topics which are important for the longevity of the company, such as
succession and risk management so that the company is well prepared in an adverse
situation, it also suggested changes in the eligibility criteria and process of electing an
independent director, the committee “also seeks to prevent board interlocks. Thus, if a
non-independent director in a company is an independent director in another, any
non-independent of the latter company cannot be an independent director in the
former, the other signi cant change suggested pertains to prohibiting the interlocking
of boards arising due to the presence of the common non-independent directors on
the board of listed companies.”[5] Apart from the suggestions mentioned by the Kotak
Committee I believe the rule of “one share one vote” should be replaced with the rule
“one person one vote” this will not only stop majority shareholders from running the
company on their terms but also would place minority shareholders on an equal
footing where their opinions will be heard.
4. Transparency - To reduce the potential in ux of agency problems, it is crucial for both
the principal and the agent to be completely transparent with one another. Decisions
and transactions that will be implemented must be agreed upon by each party and
must be reasonably fair. Once transparency is present, con ict is reduced due to the
fact that there is less confusion on decision-making and fewer implications that one
party is against the other.
5. Restrictions - Imposing restrictions or abolishing negative restrictions is a good way to
signi cantly reduce the e ect of agency loss.Setting speci c restrictions on factors
such as agency power allows the principal to feel more con dent in their relative
agent.Conversely, abolishing negative restrictions is bene cial because it instills trust
within the agent and allows them to make decisions freely on behalf of the principal.
6. Bonuses - Introducing and eradicating incentives and bonuses lessens the chances
of a relationship that consists of con icts and disagreements. Introducing bonuses is
a good way to motivate an agent and will allow them to make decisions with the best
intentions of the principal in order to achieve their desired incentive. Contrarily,
bonuses may motivate the agent to make decisions just for nancial gain,
disregarding the best intentions of the principal to only achieve the incentive.Each
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 relationship between a principal and agent is di erent, it is crucial to choose the best-
tted methods for each speci c situation to ensure a positive, healthy relationship.

2.5 Capital Budgeting

• Capital budgeting refers to the decision-making process that companies follow with
regard to which capital-intensive projects they should pursue. Such capital-intensive
projects could be anything from opening a new factory to a signi cant workforce
expansion, entering a new market, or the research and development of new
products.Capital budgeting is a formal process used for evaluating potential
expenditures or investments that are signi cant in amount for the company.
• It involves the decision to invest funds for addition, disposition, modi cation or
replacement of xed assets.
• This type of capital expenditures include the purchase of xed assets such as, land,
new buildings and equipments, or rebuilding or replacing existing buildings and
equipments, etc.
• Capital Budgeting is a tool for maximizing a company’s future value. Companies are
able to manage only a limited number of large projects at any one time.
• These investments are so important that ultimately they decide the future of the
company
• Most capital expenditures cannot be reversed at a low cost, consequently, mistakes are
very costly.

Features of capital budgeting

• High risk
• Requires large amount of capital
• Requires a process to search and select the best projects available
• They will ensure the value creation of the company
• Usually there is a long time period between the initial investment and the cash
generation (“time to cash”). Usually the longer the time to cash the riskier is the project.

Principles of capital budgeting

• Principles of capital budgeting are based on value creation, as a consequence they
have been adapted for many other decisions such as working capital, leasing, nancing
and re nancing, mergers and acquisitions.
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 • Valuation principles used in capital budgeting are similar to principles used in security
analysis, portfolio management and M&A.
• Capital budgeting information is not ordinarily available to outside the company. An
external nancial analyst may be able to appraise the quality of the company’s capital
budgeting process.

Capital budgeting process

• Project identi cation and generation of opportunities and alternatives according to the
corporate strategy
• Project screening and evaluation (Analysis of individual projects)
• Project selection and approval
• Implementation and monitoring
• Performance review (Post-audit)

Categories of capital budgeting

• Replacement projects
• Expansion projects (including new geographies)
• New products and services
• New businesses (Diversi cation)
• Regulatory, safety and environmental projects
• Other (minor projects)

Type of decisions in capital budgeting

1. INDEPENDENT PROJECT There is only one project to be analyzed
Decision: Accept or reject
2. MUTUALLY EXCLUSIVE PROJECTS - It refers to a set of projects out of which only
one project can be selected for investment
Decision: Which one is the best in terms of value creation
3. A SET OF INVESTMENT OPPORTUNITIES – Capital rationing
Considering the resources available, namely capital, only a subset of all opportunities
might be selected and approved.
4. PROJECT SEQUENCING - Investing in one project creates the option to invest in future
projects

The bases of capital budgeting decisions in nance

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 • Decisions are based on cash- ows, not on pro ts
• Timing of cash ows is crucial because the time value of money.
• Cash ows are valued considering the opportunity use of resources – space,
equipment, people, money:
• Incremental cash ows
• Cost of capital
• Cash ows are analyzed net of taxes
• The separation of investment and nancing decisions
• The investment must create value by itself

More on Capital Budgeting

Capital budgeting involves choosing projects that add value to a company. The capital
budgeting process can involve almost anything including acquiring land or purchasing
xed assets like a new truck or machinery.Corporations are typically required, or at least
recommended, to undertake those projects that will increase pro tability and thus
enhance shareholders' wealth.

However, the rate of return deemed acceptable or unacceptable is in uenced by other

factors speci c to the company as well as the project.For example, a social or charitable
project is often not approved based on the rate of return, but more on the desire of a
business to foster goodwill and contribute back to its community.

Need for capital budgeting

Capital budgeting is important because it creates accountability and measurability. Any

business that seeks to invest its resources in a project without understanding the risks
and returns involved would be held as irresponsible by its owners or shareholders.

Furthermore, if a business has no way of measuring the e ectiveness of its investment

decisions, chances are the business would have little chance of surviving in the
competitive marketplace.

Businesses (aside from non-pro ts) exist to earn pro ts. The capital budgeting process is
a measurable way for businesses to determine the long-term economic and nancial
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 pro tability of any investment project. When a rm is presented with a capital budgeting
decision, one of its rst tasks is to determine whether or not the project will prove to be
pro table. The payback period (PB), internal rate of return (IRR) and net present value
(NPV) methods are the most common approaches to project selection.

Although an ideal capital budgeting solution is such that all three metrics will indicate the
same decision, these approaches will often produce contradictory results. Depending on
management's preferences and selection criteria, more emphasis will be put on one
approach over another. Nonetheless, there are common advantages and disadvantages
associated with these widely used valuation methods.

The payback period calculates the length of time required to recoup the original
investment. Payback periods are typically used when liquidity presents a major concern.
If a company only has a limited amount of funds, they might be able to only undertake
one major project at a time. Therefore, management will heavily focus on recovering their
initial investment in order to undertake subsequent projects. Another major advantage of
using the PB is that it is easy to calculate once the cash ow forecasts have been
established.

The net present value approach is the most intuitive and accurate valuation approach to
capital budgeting problems. Discounting the after-tax cash ows by the weighted average
cost of capital allows managers to determine whether a project will be pro table or not.
And unlike the IRR method, NPVs reveal exactly how pro table a project will be in
comparison to alternatives.

The NPV rule states that all projects with a positive net present value should be accepted
while those that are negative should be rejected. If funds are limited and all positive NPV
projects cannot be initiated, those with the high discounted value should be accepted.

2.6 Securitisation and Asset/Mortgage based securities

Securitization is a nancial arrangement that consists of issuing securities that are backed
by a pool of assets, in most cases debt. The underlying assets are “transformed” into
securities, hence the expression “securitization.” The holder of the security receives
income from the products of the underlying assets,Securitization is the process of
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converting illiquid loans into marketable securities. The lender sells his or her right to
receive future payments from the borrowers to a third party, and is paid for it. The lender
is therefore repaid at the time of securitization. These future cash ows from the
borrowers are sold to investors in the form of marketable securities.
Securitization in India mainly takes the form of a trust structure, wherein the underlying
assets are sold to a trustee company, which holds the security in trust for investors. The
trustee company in this case is a special-purpose vehicle (SPV), which issues securities in
the form of pass-through or pay-through certi cates (PTCs). The trustee is the legal owner
of the underlying assets. Investors holding the PTCs are entitled to bene cial interest in
the underlying assets held by the trustee. As per legal de nition, ‘Securitisation’ means
acquisition of nancial asset by any Asset Reconstruction Company from any originator,
whether by raising funds by such Asset Reconstruction Company from quali ed buyers
by issue of security receipts representing undivided interest in such interest or otherwise.
[section 2(1)(z) of SARFAESI Act as amended w.e.f. 1-9-2016]. RBI had issued guidelines
for securitisation of standard assets. Later, guidelines were issued to Banks.The
guidelines have been extended to NBFC.

History of Securitization
Banks in the U.S. rst started securitizing home mortgages in the 1970s. The initial
“mortgage-backed securities” were seen as relatively safe and allowed banks to give out
more mortgage loans to prospective homeowners. The practice created a housing boom
in the U.S. and resulted in a tremendous increase in house prices.In the 1980s, Wall
Street investment banks extended the idea of mortgage-backed securities to other types
of assets. They realized that securitization drastically increased the number of securities
available in the market without raising any real economic variable. The number of
securities available raised the number of potential transactions the banks could make
(most banks were paid according to the number of transactions they were involved
in).The rapid deterioration in the quality of the underlying assets within the market for
asset-backed securities and a general lack of government regulation were key reasons for
the 2008 recession.Securitisation started in the US in 1970 with the issue of residential
mortgages by public housing nance corporations. The institutions found that they had to
pay higher interest to attract short-term deposits, while rates earned on long-term
mortgage loans was less. This created mismatch between assets and liabilities. The
solution was found in securitisation.
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 Now, securitisation is used in more complicated nancial structures also. There is a
de nite move towards securitisation in capital market in various assets such as insurance
receivables, commercial bank loans, obligations of purchases to natural gas producers,
future rights to royalty payments etc.Major buyers of such debt instruments in USA are
mutual funds, insurance companies, trusts and corporates with excess liquidity. In India,
presently, only mutual funds and to a lesser extent Banks with surplus funds can be the
buyers. Insurance companies may also be buyers.Securitisation is sale and purchase of
debts and receivables, normally through Asset Reconstruction Company.

The parties involved in the securitization process and their respective roles are stated
brie y below.
(i) Originator. The original lender and seller of receivables. In India, this is typically a bank,
an NBFC, or a housing nance company.
(ii) Seller. One who pools the assets to securitize them. In India, the seller and the
originator are usually the same entity.
(iii) Borrower. The counterparty to whom the originator makes a loan. Payments (typically
in the form of equated monthly installments) by borrowers fund investor payouts.
(iv) Issuer (SPV). The entity that issues marketable securities (to which investors
subscribe) and ensures that transactions are executed on speci c terms. In India, the SPV
is typically set up as a trust.
(v) Arranger. Investment banks responsible for structuring the securities. They coordinate
with other parties (such as investors, rating agencies, and legal counsel) to execute the
transaction successfully.
(vi) Investor. The purchaser of securities. In India, investors are typically banks, insurance
funds, and mutual funds.
(vii) rating agency. These agencies analyze risks associated with each transaction,
stipulate credit enhancements commensurate with the ratings of the PTCs, monitor the
performance of the transactions until maturity, and take appropriate rating actions.
(viii) credit enhancement provider. Typically the originator, as a facility that covers any
shortfall in pool collections in relation to investor payouts. The enhancement can also be
provided by a third party for a fee.
(ix) Servicer. The entity that collects periodic installments due from individual borrowers,
makes payouts to investors, follows up on delinquent borrowers, and furnishes periodic
information about pool performance to the rating agency. In India, the originator typically
acts as the servicer.
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Three types of securitized instruments are prevalent in the Indian market today.
1. Asset-backed securities (ABSs) are instruments backed by receivables from nancial
assets, such as vehicle and personal loans, credit cards, and other consumer loans
(but excluding housing loans).
2. Mortgage-backed securities (MBSs) are instruments backed by receivables from
housing loans.
3. Collateral debt securities are instruments backed by various types of debt, including
corporate loans or bonds.

The most direct link is in the case of fund units, such as UCITS: one unit in a mutual fund
represents investments that the fund manager has made in stocks and bonds, and the
value of the unit correlates directly to the market valuation of the securities in question.

In the case of stocks and bonds, the security itself constitutes an asset for the investor
and a liability for the issuer – capital in the case of stock, a long-term loan in the case of a
bond. However, the purpose of this liability is to nance investments, and it is the
investor’s con dence in the issuer’s ability to make the investment increase in value (i.e.
create assets) that creates the incentive to purchase the security.

However, in the case of stocks and bonds, the issuer’s ability to ultimately repay the
security issued is subject to all sorts of uncertainties that go beyond the issuer’s
managerial and entrepreneurial skills. It is di erent in the case of a security created
through the process of securitization: since the security is backed by a pool of assets that
already existed before the securitization took place, the issuer’s ability to honor the
payments due has nothing to do with his or her own skills, but depends solely on the
quality of the underlying debt. In most cases, the asset has already been created, which
is why we use the term “re nancing” instead of just “ nancing” when talking about
securitization. However, some securities can also be backed by future debt.

A variety of assets are used in securitizations. For example, securitizations may involve
residential or commercial mortgages, credit card receivables, auto loans, student loans,
corporate loans, or other nancial assets.
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 A key feature of securitizations is legal isolation of the underlying assets. The underlying
assets are transferred to the issuer of the securities on a “true sale” basis, and the issuer
is structured in such a way as to be isolated from the bankruptcy risk of the originator.
Another feature of securitizations is credit enhancement. There are several methods for
credit enhancement, including “tranching,” whereby the bonds are divided in a number of
tranches with varying risk pro les. Another is “overcollateralization,” which involves
having more assets than necessary to cover payment on the securities.

Purpose of Securitize? The credit enhancement inherent to securitizations, especially

due to the aforementioned legal isolation techniques, permits the originating companies
to obtain higher ratings than if such companies were to obtain a traditional loan.
Consequently, the originating companies can obtain nancing at a lower cost of funding.

• Normally, a lender ( nancier) nances loans to borrowers and gets repayment with
interest over a period. The lender would collect the periodic instalments and use them
to nance new loans. This limits his capacity to give fresh loans, as he has to wait till he
recovers the instalments along with interest. Instead of waiting for a long time, he can
pool the loans together and sell his right to receive future payments from the borrowers
of these loans.
• This is termed as securitisation of loans. The original lender will receive consideration
for the same upfront, i.e. immediately, by securitising his loan portfolio. Of course, he
will get the amount at a discounted value. He can then use the proceeds to further
develop his business, which is of giving loans.
• Securitisation is a form of nancing involving pooling of nancial assets and the
issuance of securities that are repaid from the cash ows generated by the assets. This
is generally accomplished by actual sale of the assets to a bankruptcy remove vehicle,
i.e. a special purpose vehicle (like Asset Reconstruction Company), which nances the
purchase through issue of bonds.
• These bonds are backed by future cash ow of the asset pool. The most common
assets for securitisation are mortgages, credit cards, auto and consumer loans, student
loans, corporate debt, export receivables, o shore remittances etc.
• These ‘securitised loans’ will be purchased by mutual funds, provident funds and
insurance companies, which have funds but do not have mechanism to assess, grant
and recover loans. Thus, corporate bodies like nance companies having expertise in
assessing, granting and recovering loans get the funds from corporate bodies like
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 mutual funds, provident funds, insurance companies etc. which have funds but do not
have expertise in loan assessment and disbursal, through process of securitisation.
Thus, securitisation helps both.
• Securitisation is done through Special Purpose Vehicles (SPVs). These are termed as
Asset Reconstruction Companies in the present SARFAESI Act.
• Thus, securitisation is a process through which illiquid assets are transferred into a
more liquid form of assets and distributed to a broad range of investors through capital
markets. The lending institution’s assets are removed from its balance sheet and are
instead funded by investors through a negotiable nancial instrument. The security is
backed by the expected cash ows from the assets.
• Securitisation is a process under which a pool of individual homogeneous loans are
packaged and distributed to various investors having liquid funds in the form of
coupons/pass through or pay through certi cates; through SPVs (Special Purpose
Vehicles), with the provision that the in ow of cash in the shape of recoveries will be
distributed pro-rata to coupon holders.
• In securitisation, the lending institution’s assets are removed from balance sheet of that
lending institution and are instead, funded by investors. These investors purchase a
negotiable nancial instrument evidencing this indebtedness.
• By securitisation, long-term illiquid assets of original lender get converted into current
assets.

The securitization process

Securitization is a complex procedure that involves several actors. The diagram below,
taken from the IMF website, illustrates the basic mechanism for transferring assets and
creating securities:

The entity that originally holds the assets (the originator) initiates the process by selling
the assets to a legal entity, an SPV (Special Purpose Vehicle), specially created to limit the
risk of the nal investor vis-à-vis the issuer of the assets. An SPV is also referred to as a
“conduit.” Then, depending on the situation, the SPV either issues the securities directly
or resells the pool of assets to a “trust” that, in turn, issues the securities(the trust is
actually used for several securitization transactions and therefore oversees several SPVs).
An SPV is more of a legal framework than an element that plays an active part in the
transaction. The most important role is played by the arranger, typically a bank, who sets
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 up the transaction and evaluates the pool of assets,the way in which it will be fed, the
characteristics of the securities to be issued, and the potential structuring of the fund.
The object of the structuring is to model the characteristics of the securities such that
they correspond to the needs of the nal investor. Instead of simply paying the nal
investor the revenue generated by the assets, the amortization rules for the security are
de ned in advance.
Some ABSs are able to be “topped up,” meaning that the pool of assets can be refed
during the life of the security. This makes it possible to re nance short-term debts (such
as credit-card debt) with long-term bonds.
Finally, the arranger plays an important role in distributing the securities to the nal
investors (distribution). Quite often, the securities are not issued on an exchange, but are
distributed over-the-counter to a small number of investors.
The trio of actors comprising the “originator, SPV,and arranger” constitutes the
“Originate-to-Distribute” model, which has thrived over the course of the past few years.
An important distinction must be made between “traditional” securitization, where the
assets are actually sold to the SPV (“true sale”), and what is known as “synthetic”
securitization, where the originator retains ownership of the assets and transfers only the
risk to the SPV, via a credit derivative. This transaction brings no liquidity to the assignor,
but enables himto externalize the risk associated with holding the securitized assets

OR

In step one, a company with loans or other income-producing assets—the originator—

identi es the assets it wants to remove from its balance sheet and pools them into what is
called the reference portfolio. It then sells this asset pool to an issuer, such as a special
purpose vehicle (SPv)—an entity set up, usually by a nancial institution, speci cally to
purchase the assets and realize their o -balance-sheet treatment for legal and accounting
purposes.

In step two, the issuer nances the acquisition of the pooled assets by issuing tradable,
interest-bearing securities that are sold to capital market investors. The investors receive
xed or oating rate payments from a trustee account funded by the cash ows
generated by the reference portfolio. In most cases, the originator services the loans in
the portfolio, collects payments from the original borrowers, and passes them on—less a
servicing fee—directly to the SPv or the trustee.
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 The SPV acts as intermediary. It buys nancial assets from seller or transferor and issues
securities to the investors. Money received from investors is paid to the transferor. The
investors are serviced and repaid out of the assets realised over a period of time.
Pass through certi cates– In pass through certi cates, a direct participation in the cash
ow is sold. Receipt of asset cash ow is deposited in designated accounts. The funds
are then passed on to Certi cate Holders. Receivables are directly assigned to investors
through SPV. Thus, the cash is collected by the original lender which is then passed on to
SPV (Asset Reconstruction Company)
Pay through certi cates– This involves a speci c assignment/sale of asset cash ow to
the SPV. The SPV then issues pay through certi cates to the investors. In this case,
normally, the cash is collected by the SPV from the borrower and then distributed to the
certi cate holders.

In a more recent re nement, the reference portfolio is divided into several slices, called
tranches, each of which has a di erent level of risk associated with it and is sold
separately. Both investment return (principal and inter- est repayment) and losses are
allocated among the various tranches according to their seniority. The least risky tranche,
for example, has rst call on the income generated by the underlying assets, while the
riskiest has last claim on that income. The conventional securitization structure assumes
a three-tier security design—junior, mezzanine, and senior tranches.

Securitisation with or without recourse - Securitisation can be with or without recourse

to the original lender. ‘Without recourse’ means that if the borrower does not pay, the
loser is Asset Reconstruction Company and/or investors, as the amount cannot be
recovered from original lender. If the lending is with recourse, the Asset Reconstruction
Company/investors can recover the principal and interest from original lending institution,
if the borrower does not pay.
Even if securitisation is without recourse, in some cases, limited recourse may be
provided, e.g. if fraud, forgery, suppression of facts, misstatements etc. by the original
lender is alleged and established.

Assets that can be securitised - Basically, all assets which generate cash ow can be
securitised e.g. mortgage loans, housing loans, automobile loans, credit card receivables,
trade receivables, consumer loans, lease nance etc. A perfectly healthy and normal
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 nancial asset is normally securitised. It is not necessary that it should be non-performing
asset.
Securitisation and factoring – distinction– Di erence between factoring and
securitisation is that in case of factoring, the assets are debts which have crystallized but
are not due.
Long dated assets and short dated funding sources - Traditionally, banks have short
dated deposits. If advances are on long-term basis, these will be long dates assets,
where credit risks are high. Securitisation is a way to convert the potential risks of long
dated assets into viable sources of capital. Thus, mismatch between funding of assets
and liabilities can be reduced.
Mortgage securitisation or asset securitisation - Securitisation can be mortgage
securitisation or asset securitisation. In mortgage securitisation, pools of mortgage
backed loans are converted into tradable debt securities called mortgage-backed
securities. This is common in housing loans.In Asset securitisation, assets which have an
income stream are pooled and repackaged in the form of marketable securities for sale to
investors. The securities are secured by the assets themselves or by income derived from
them. The underlying asset generally backs the loan or security.In case of industrial loans,
the instrument may be termed as ‘collateralized loan obligations’.

Assignment of debts/NPAs between banks inter se is permissible - Assignment of

debts or NPA (Non-Performing Assets) between banks inter se is permissible. Scope of
‘banking business’ is not limited to core baking of accepting deposits and lending. RBI
can formulate policy enabling banking companies to enlarge in such other activities and in
that process it can de ne what constitutes ‘banking business’.
RBI guidelines dated 13-7-2005 authorising Banks to deal inter se in NPAs have statutory
force and are not ultra vires the Banking Regulation Act, 1949 – ICICI Bank Ltd. v. O cial
Liquidator of APS Star Industries Ltd. Assignee of debt can le petition for winding up
– Assignee of debt under Securitisation Act can le petition for winding up – Horizon Flora
India Ltd. v. Asset Reconstruction Co. India Ltd.

Advantages of Securitisation
• Securitisation is designed to o er a number of advantages to the seller, investor and
debt markets. Advantages of securitisation can be summarised as follows –
• Banks can keep loans o their balance sheet, thus reducing need for additional capital
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 • Alternative form to banks and nancial institutions of funding risk transfer and capital
market development
• Reduce lending concentration and improve liquidity
• Attainment of funds at lower costs since these are isolated from potential bankruptcy
risk of originator
• Better matching of assets and liabilities and development of long-term debt market
• Provides diversi ed pool of uniform assets to banks and nancial institutions
• Converting non-liquid loans or assets into liquid assets or marketable securities.
• Transfer of funds from less e cient debt market to more e cient capital market through
securitisation.
• Securitisation helps in recycling and roll over of assets.
• For investor, securitisation essentially provides an avenue for relatively risk-free
investment. The credit enhancement provides an opportunity to investors to acquire
good quality assets and to diversify their portfolios.
• From the point of view of the nancial system as a whole, securitisation increases the
number of debt instruments in the market, and provides additional liquidity in the
market. It also facilitates unbundling, better allocation and management of project risks.
It could widen the market by attracting new players on account of superior quality
assets being available.
• The credit rating is of the transaction of the assets securitised and not of the originator
or issuer. Thus, it is possible that credit rating of the securitised assets will be quite
di erent from the credit rating of the originator. In extreme case, even if the originator
company is liquidated, the asset securitised will still be good and the investor investing
in the securitised asset will be protected.

Legal framework for securitisation

• As per the SARFAESI Act, the nancial asset will be rst acquired by Asset
Reconstruction Company from bank or nancial institution.‘Securitisation’ means
acquisition of nancial asset by any Asset Reconstruction Company from any originator,
whether by raising funds by such Asset Reconstruction Company from quali ed buyers
(QB) by issue of security receipts representing undivided interest in such interest or
otherwise. [section 2(1)(z) of SARFAESI Act as amended w.e.f. 1-9-2016].The words ‘or
otherwise’ means that the funds can also be raised by means other than issue of
security receipts to QB. India’s Finance Act, 2013, passed in July 2013, provides the
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 legal framework governing securitization trusts and their transactions. The provisions of
this act are legally binding for all securitization transactions in India.
• Originator– ‘Originator’ means the owner of a nancial asset which is acquired by Asset
Reconstruction company, for the purpose of securitisation or asset reconstruction.
[section 2(1)(r) of SARFAESI Act]
• Under the RBI’s securitization guidelines, originators are allowed to securitize all assets,
except revolving credit facilities (such as credit card loans), assets purchased from
other rms, collateralized debt obligations of ABSs, and loans with bullet repayment of
principal and interest.
• The RBI has also mandated a minimum holding period and minimum retention
requirements for securitized transactions, aimed at ensuring that better underwriting
standards are implemented by banks

Growth of securitization
The landscape of securitization has changed dramatically in the last decade. No longer is
it wed to traditional assets with speci c terms such as mortgages, bank loans, or
consumer loans (called self-liquidating assets). Improved modeling and risk quanti cation
as well as greater data availability have encouraged issuers to consider a wider variety of
asset types, including home equity loans, lease receivables, and small business loans, to
name a few. although most issuance is concentrated in mature markets, securitization
has also reg- istered signi cant growth in emerging markets, where large and highly rated
corporate entities and banks have used secu- ritization to turn future cash ow from hard-
currency export receivables or remittances into current cash.
In the future, securitized products are likely to become simpler. after years of posting
virtually no capital reserves against highly rated securitized debt, issuers will soon be
faced with regulatory changes that will require higher capital charges and more
comprehensive valuation. reviving securi- tization transactions and restoring investor
con dence might also require issuers to retain interest in the performance of securitized
assets at each level of seniority, not just the junior tranche.

MODULE 4
DEBT FINANCE

4.1 Debt and Types of Debt Instruments

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A debt instrument is a xed income asset that allows the lender (or giver) to earn a xed
interest on it besides getting the principal back while the issuer (or taker) can use it to
raise funds at a cost. Debt acts as a legal obligation on the issuer (or taker) part to repay
the borrowed sum along with interest to the lender on a timely basis. A debt instrument
can be in paper or electronic form. Bonds, debentures, leases, certi cates, bills of
exchange and promissory notes are examples of debt instruments.

These instruments also give market participants the option to transfer the ownership of
debt obligation from one party to another. The lender receives a xed amount of interest
during the lifetime of the instrument. Debt instruments provide xed and higher returns,
thus giving them an edge over bank xed deposits. The duration of debt instruments can
either be long-term or short-term. Funds raised through short-term debt instruments are
to be repaid. However, long-term debt instruments are the ones that are paid over a year
or more. Credit card bills and treasury notes are examples of short-term debt whereas
long-term loans and mortgages form part of long-term debt instruments.

Types of the debt instrument are:

1. Debentures -Debentures are not backed by any security. They are issued by the
company to raise medium and long term funds. They form the part of the capital structure
of the company, re ect on the balance sheet but are not clubbed with the share capital.

2. Bonds - Bonds on the other hands are issued generally by the government, central
bank or large companies are backed by a security. Bonds also ensure payment of xed
interest rates to the lenders of the money. On maturity of the bond, the principal amount
is paid back. Bonds essentially work the way loans do.

3. Mortgage
A mortgage is a loan against a residential property. It is secured by an associated
property. In a case of failure of payment, the property can be seized and sold to recover
the loaned amount.

4. Treasury Bills -Treasury bills are short-term debt instruments that mature within a year.
They can be redeemed only at maturity. They are sold at a discount if sold before
maturity.
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4.4 creation of charge, xed and oating charges
Charge as per section 2(16) of Companies Act, 2013 refers to creation of interest or a
right on a property or asset of a company or any of its undertaking as a security against
loan provided to the company in respect of such interest. Charge is created by
Companies who are in need of nancial assistance for making their companies productive
and in doing so creating any right or interest in assets of companies. Charge also includes
mortgage. Charge is created so that the nancial institutions such as banks have security
for the loans provided by creation of charge on assets of company and having it
registered with the Registrar.

Applicability -
1. Section 77 to 81 of Companies Act, 2013.
2. Companies (Registration of Charge) Rules, 2014.

Registration of Charges under Companies Act, 2013 - Section 77(1) provides that it
shall be the duty of every company creating a charge within or outside India, on its
property or assets or any of its undertakings, whether tangible or otherwise, and situated
in or outside India.
A company creating a charge on its property situated within India or outside India shall
register its charge with the Registrar within 30 days of creation or modi cation (in terms
and conditions) of such charge along with particulars of Charge and a copy of instrument
creating the charge signed by the Company and Charge-Holder in such Form speci ed
below:
1. CHG-1: – For other than Debentures.
2. CHG-9: – For Debentures.
3. CHG-7: – Register of Charge (only to be maintained by company for its members).

SATISFACTION OF CHARGE: A company shall within a period of thirty days from the
date of the payment or satisfaction in full of any charge registered, give intimation of the
same to the Registrar in Form No. CHG-4 along with the fee. Where the Registrar enters a
memorandum of satisfaction of charge in full in pursuance of section 82 or 83, he shall
issue a certi cate of registration of satisfaction of charge in Form No. CHG-5. 6.)
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 REGISTER TO BE MAINTAINED BY THE COMPANY: The particulars of every charge
shall be entered in a register of charges to be kept at the registered o ce of the company
in Form No. CHG-7 wherein all particulars of charge shall be entered. Such entries shall
be authenticated by secretary or any person authorized by the Board for the purpose.
Such register shall be open for inspection by any member or creditor without any fee and
by any other person on payment of fee.

In the Companies Act, 1956 there was a list of transactions on which registration of
charge was mandatory. With the enactment of the Companies Act, 2013, the list of
charges requiring mandatory registration has been done away with. Thus, in the absence
of a speci c list of charges to be registered, and the wide de nition of the word “charge”,
‘pledges’ and ‘liens’ are also required to be registered. As per section 125(4) of the
Companies Act 1956, the following charges are required to be led with the Registrar of
Companies (ROC).
1. A charge for the purpose of securing any issue of debentures;
2. A charge on uncalled share capital of the company; 3
3. A charge on any immovable property, wherever situate, or any interest therein;
4. A charge on any book debts of the company;
5. A charge, not being a pledge, on any movable property of the company
6. A oating charge on the undertaking or any property of the company including stock
in trade
7. A charge on calls made but not paid;
8. A charge on a ship or any share in a ship;
9. A charge on goodwill, on a patent or a license under a patent, on a trade mark, or on a
copyright or a license under a copyright.

PARTICULARS OF CHARGES: The following particulars in respect of each charge are

required to be led with the Registrar: date and description of instrument creating charge;
total amount secured by the charge; date of the resolution authorizing the creation of the
charge (in case of issue of secured debentures only); general description of the property
charged; a copy of the deed/instrument containing the charge duly certi ed or if there is
no such deed, any other document evidencing the creation of the charge to be enclosed;
list of the terms and conditions of the loan; and Name and address of the charge holder.
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 Extension for Registration of Creation or Modi cation of Charge under companies
Act, 2013
1. Charge created before commencement of Companies (Amendment) Ordinance, 2019,
then extension shall be granted for 270 days more after expiry of 30 days.
2. Charge created on or after commencement of Companies (Amendment) Ordinance
2019, extension of 60 days from expiry of 30 days for registration to registrar shall be
granted.
3. After the expiry of 60 days the charge can be registered within 6 months from the date
of commencement of the Companies (Amendment) Ordinance, 2019, on payment of such
additional fees as may be prescribed and di erent fees may be prescribed for di erent
classes of Companies. In clause (b) to the rst proviso, the Registrar may, on an
application, allow such registration to be made within further period of sixty days after
payment of ad-valorem fees.

Failure to register Charge by Company - Charge holder may apply to registrar for
Creation/Modi cation of charge on failure of the company to register the charge within 30
days with the registrar. The Registrar on such application of Charge holder give notice to
the company for providing the reason for such delay in registration and shall within 14
days of sending such notice register the charge. The Charge holder is entitled to receive
the fees paid by him on application for registration of charge with the Registrar from the
Company. Certi cate of Registration for Creation or Modi cation of Charges
1. For Creation of Charge the registrar shall issue certi cate as per Form CHG-2.
2. For Modi cation of Charge the registrar shall issue certi cate as per Form CHG-3.

FEES for Creation or Modi cation of Charges under companies Act, 2013
In case of Indian company not having share capital: – Rupees 200.
In case of foreign company: – Rupees 6,000

NEED FOR CREATING CHARGE: Almost all the large and small companies depend
upon share capital and borrowed capital for nancing their projects. Borrowed capital
may consist of funds raised by issuing debentures, which may be secured or unsecured,
or by obtaining nancial assistance from nancial institution or banks. The nancial
institutions/banks do not lend their monies unless they are sure that their funds are safe
and they would be repaid as per agreed repayment schedule along with payment of
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 interest. In order to secure their loans they resort to creating right in the assets and
properties of the borrowing companies, which is known as a charge on assets. This is
done by executing loan agreements, hypothecation agreements, mortgage deeds and
other similar documents, which the borrowing company is required to execute in favour of
the lending institutions/ banks etc.

De nition of Fixed Charge

Fixed Charge is de ned as a lien or mortgage created over speci c and identi able xed
assets like land & building, plant & machinery, intangibles i.e. trademark, goodwill,
copyright, patent and so on against the loan. The charge covers all those assets that are
not sold by the company normally. It is created to secure the repayment of the debt.
In this type of arrangement, the unique feature is that after the creation of charge the
lender has full control over the collateral asset and the company (borrower) is left over
with the possession of the asset. Therefore, if the company wants to sell, transfer or
dispose o the asset, then either previous approval of the lender is to be taken, or it has
to discharge all the dues rst.

De nition of Floating Charge

The lien or mortgage which is not particular to any asset of the company is known as
Floating Charge. The charge is dynamic in nature in which the quantity and value of asset
changes periodically. It is used as a mechanism to secure the repayment of a loan. It
covers the assets like stock, debtors, vehicles not covered under xed charge and so on.
In this type of arrangement the company (borrower) has the right to sell, transfer or
dispose o the asset, in the ordinary course of business. Hence, no prior permission of
the lender is required and also there is no obligation to pay o the dues rst.
The conversion of oating charge into xed charge is known as crystallization, as a result
of it, the security is no more oating security. It occurs when:
• The company is about to wind up.
• The company ceases to exist in future.
• The court appoints the receiver.
• The company defaulted on payment, and the lender has taken action against it to
recover the debts.

The following are the major di erences between xed charge and oating charge:
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 • The charge that can be easily identi ed with a certain asset is known as Fixed Charge.
The charge which is created on assets that changes periodically is Floating Charge.
• Fixed Charge is speci c in nature. Unlike oating charge which is dynamic.
• Registration of movable assets is voluntary, in the case of xed charge. Conversely,
when there is a oating charge, the registration is compulsory irrespective of the asset
type.
• The xed charge is a legal charge while the oating charge is an impartial one.
• Fixed Charge is given preference over oating charge.
• The xed charge covers those assets that are speci c, ascertainable and existing during
the creation of the charge. On the other hand oating charge, covers present or future
asset.
• When the asset is covered under xed charge, the company cannot deal with the asset
until and unless the charge holder agrees for so. However, in the case of oating charge
the company can deal with the asset until the charge is converted to xed charge.

4.5.1 Overview of the SARFAESI Act, 2002

Introduction : The nancial sector has been a crucial player in India’s e orts to succeed
in swiftly building the nation’s economy. As our current legal framework for business
transactions has not kept up with evolving commercial practices and banking sector
changes. This assures a poor rate of loan recovery and rising volumes of nonperforming
assets at banks and other nancial institutions.

The Central Government established the Narasimham Committees I and II, as well as the
Andhyarujina Committee, to investigate banking sector reforms. These committees
assessed the necessity for changes in the legal framework in these sectors. These
committees proposed new laws for Securitisation and permitting nancial institutions to
hold securities and sell them in a timely manner without the involvement of a court, and
the recommendations formed the SARFAESI Act, 2002.

Under the Securitisation and Reconstruction of Financial Assets and Enforcement of

Security Interest (SARFAESI) Act, 2002, banks in India have been granted the ability to
acquire the security supplied by the defaulting borrower against the loan and sell it to
recover losses, without the intervention of any court of law, providing them with a method
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 to dramatically decrease their non-performing assets (NPA’s). The statute is abbreviated
as the SARFAESI Act or simply SARFAESI

Overview : The SARFAESI Act is de ned as “an act to govern Securitisation and
reconstruction of nancial assets, as well as the enforcement of security interests, and to
provide for a centralised database of security interests formed on property rights, and for
issues associated with or incidental thereto.”
The SARFAESI Act was enacted with the intention of allowing banks and other nancial
institutions (FIs) to recuperate on NPAs without the intervention of a court. The non
performing assets are de ned under Section 2(1) of the Act. These are the nancial
institutions that have a presence in India and have been noti ed by the Indian
government. The Act speci es two broad strategies for recovering NPAs. This involves
either taking ownership of the borrower’s secured assets (with the power to lease, assign,
or resell the secured assets) or taking over the borrower’s management or company until
the NPA is retrieved. The Act also allows banks and other nancial institutions to sell
nancial assets to Asset Reconstruction Companies (ARCs). The nancial assets can be
sold to ARCs in compliance with the Reserve Bank of India’s (RBI) norms and
recommendations.
The secured creditor’s right to pursue the security interest under the Act does not arise
until the borrower’s account has been categorised as an NPA in the secured creditor’s
(banks or nancial institutions’) books of account in accordance with the RBI standards.
The secured creditor must serve the borrower with a 60-day notice seeking repayment of
the amount owed and describing the borrower’s assets on which the secured creditor
intends to exercise its security interest.
If the borrower fails to ful l its liability to the secured creditors after the 60-day notice
period has expired, the secured creditor may enforce security interest over secured
assets by:
• Taking control of the secured assets;
• Take over management of the secured assets, as well as the right to transfer the
secured assets via lease, assignment, or sale;
• Designate someone to administer the secured assets; and
• Compel any individual who has acquired any of the borrower’s secured assets to pay
the sums required to settle the obligation.
If a secured creditor is unable to recover the whole sum owed through the enforcement of
a security interest over the assets secured, the secured creditor may seek recovery of the
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 balance amounts through the Debts Recovery Tribunal (DRT) or the applicable court. A
secured creditor may seek its remedies under both the SARFAESI Act and the DRT at the
same time. For the SARFAESI Act to apply, the borrower’s account must be classed as an
NPA by the secured creditor and have an outstanding balance of INR 100,000 or more.
Furthermore, the requirements of the Act are not enforceable in certain cases, as outlined
in Section 31 of the SARFAESI Act, such as an account where the residual debt is less
than 20% of the initial principal amount and interest.

Elements of the SARFAESI Act : The SARFAESI Act is applied to the entire country of
India. The SARFAESI Act, 2002 provisions are in e ect for modifying the four laws listed
below:
• Indian Stamp Act, 1899.
• The recovery of the debts due to the Banks and Financial Institutions Act, 1993
(RDDBFI).
• The Depositories Act, 1996 and for those matters that are connected therewith or
incidental thereto.
• The Reconstruction and Securitisation of Financial Assets and Enforcement of Security
Interest Act, 2002.

Aim of the SARFAESI Act :The SARFAESI Act has two main objectives, namely:
• Recovering the nancial institutions’ and banks’ non-performing assets (NPAs) in a
timely and e ective manner.
• Allows nancial organisations and banks to sell residential and commercial assets at
auction if a borrower defaults on his or her debt.

Need for the SARFAESI Act

The characteristic of Indian industry is economic indiscipline or nancial illiteracy. The
ever-increasing Non-Performing Assets (‘NPA’), a ne euphemism devised to describe
poor loans, led to the passage of the Recoveries of Debts due to Banks and Financial
Institutions Act, 1993, which established a special Debt Recovery Tribunal (‘DRT’), de ned
under Section 2(1)(i) of the Act to reclaim NPA. However, on one hand, this did not speed
up the recovery, and on the other hand, the severe civil law requirements rendered the
attachment and foreclosure of the assets o ered as security for the loan nearly worthless.
Furthermore, the balance sheets of banks and other nancial institutions were turning red
as a result of large mandated provisions for non-performing assets (NPAs).
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 Recognising that one out of every ve borrowers is a defaulter, the government was under
obligation to provide proper mechanisms for debt recovery as well as to foreclose the
security. Hence, The SARFAESI Act, 2002 (the Securitisation Act) attempts to ful l these
dual goals, as well as to provide a wide legal framework for asset Securitisation and asset
reconstruction.

Applicability of the SARFAESI Act

The Act addresses the following issues:
1. The Reserve Bank of India registers and regulates Asset Reconstruction Companies
(ARCs).
2. Facilitating the Securitisation of bank and nancial institution nancial assets with or
without the advantage of underlying securities.
3. The ARC promotes seamless nancial asset transferability by issuing debentures,
bonds, or any other instrument that may be used as a debenture to buy nancial
assets from banks and nancial organisations.
4. Entrusting Asset Reconstruction Companies with the task of raising cash through the
issuance of security receipts to eligible purchasers.
5. Enabling the reconstruction of nancial assets obtained when exercising securities
enforcement authorities, changing management, or other powers planned to be
imposed on banks and nancial organisations.
6. Representation of any securitisation or asset reconstruction rm licensed as a public
nancial institution with the Reserve Bank of India.
7. ‘Security interest’ is de ned as any sort of security, including mortgages and changes
on immovable assets, issued in exchange for timely repayment of any nancial aid
provided by any bank or nancial organisation.
8. The borrower’s account is classi ed as a non-performing asset in compliance with the
orders provided or guidelines published by the Reserve Bank of India from time to
time.
9. The o cials authorised shall enforce the obligations of a secured creditor in line with
Central Government laws.
10. An appeal to the relevant Debts Recovery Tribunal against any bank or nancial
institution’s action, followed by a second appeal to the Appellate Debts Recovery
Tribunal.
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 11. The Central Government may establish or cause the establishment of a Central
Registry with the objective of registering transactions involving Securitisation, asset
reconstruction, and the development of a security interest.
12. Applicability of the proposed legislation rstly to banks and nancial institutions, with
the central government, empowered to extend the proposed legislation’s application
to non-banking nancial enterprises and other entities.
13. The proposed legislation does not apply to agricultural land security interests, loans
under one lakh rupees, or circumstances where the borrower repays 80% of the loan.

The SARFAESI Act does not apply to:

Rural Regional Banks.
Nationalised Banks.
State Bank of India and its a liates.

Purpose of the SARFAESI Act

• The e orts of the nancial industry have been a crucial role in the rapid advancement of
India’s economy. Despite the fact that Indian banks and nancial institutions were
keeping up with international standards and rules, there were gaps in several areas.
Concerns included a lack of power with nancial rms to reclaim defaulted loans.
• Therefore, the SARFAESI Act, 2002 was passed after careful consideration, allowing
banks and nancial institutions to solve issues like liquidity, long-term assets, growing
NPAs, and loan recovery delays (reconstruction).
• Features of the SARFAESI Act
• The following are the key aspects of the SARFAESI Act:
• Formation of Special Purpose Vehicles, namely a Securitisation Company and a
Reconstruction Company;
• Financial asset securitisation;
• Securitisation funding;
• Reconstruction of assets;
• Enforcing security interests, i.e. seizing the assets pledged as collateral for the loan;
• The establishment of a Central Registry for the regulation and registration of
Securitisation transactions;
• Plate provisions for the boiler;
• Dilution of provisions of SICA;
• Transactions that are exempted.
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Formation of special purpose vehicles, namely a securitisation company and a
reconstruction company - The SARFAESI Act intends to securitize and rebuild nancial
assets via two special purpose entities, namely the ‘Securitisation Company (‘SCO’)’ and
the ‘Reconstruction Company (RCO’). SCO and RCO must be companies formed under
the Companies Act of 1956 with the primary purpose of securitisation and asset
reconstruction, respectively. Before conducting business, SCO and RCO must be
registered under the SARFAESI Act. Furthermore, a minimum nancial stability criterion is
established by mandating SCO and RCO to have an owned fund of Rs. 2 crores or up to
15% of total nancial assets acquired or to be acquired. The RBI has the authority to set
the rate of owned funds at any moment. For di erent types of SCO and RCO, various
rates might be set. Existing SCO and RCO are likewise obliged by the SARFAESI Act to
register. The RBI must be contacted in order to process the registration application. The
SCO or RCO that has acquired a certi cate of registration under the SARFAESI Act is a
Public Financial Institution as de ned in Section 4A of the Companies Act of 1956.

Securitisation funding - By issuing a security receipt, the SCO/RCO may raise the
required money from the QIB for the acquisition of nancial assets. The Registration Act
exempts security receipts from mandatory registration. Securities receipts provided by
any SCO or RCO are considered “securities” under Section 2(h)(ic) of the Securities
Contracts (Regulation) Act, 1956. For each purchase, a scheme of acquisition must be
developed, describing the description of nancial assets to be acquired, the amount of
investment, the rate of return guaranteed, and so on. In addition, separate and unique
accounts must be kept for each plan of purchase. Realisations from nancial assets must
be kept and utilised for the redemption of investments and the payment of guaranteed
returns.The SARFAESI Act established a much-needed legal framework for the
securitisation of nancial assets. Securitisation of nancial assets is a nancial instrument
that allows lenders to securitise their future cash ows from secured assets and therefore
free up funds that have been held in such assets.

Enforcing security interests, i.e. seizing the assets pledged as collateral for the
loan- The secondary purpose of the SARFAESI Act is to allow for the enforcement of
security interests, which entails taking ownership of the assets pledged as collateral for
the loan. Section 13 of the Act gives detailed provisions allowing a lender (referred to as a
“secured creditor”) to seize the borrower’s security.
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 A central registry is being established to govern and control the functions of
securitisation, asset reconstruction, and the development of security interests. Branch
o ces of the central registry may be formed on an as-needed basis. The registry will be
led by a central registrar.

Plate provisions for the boiler

• The general provisions of the SARFAESI Act are as follows:
• No civil court shall hear any case over which the DRT or Appellate Tribunal has
jurisdiction under this SARFAESI Act.
• The provisions of the SARFAESI Act take precedence over the provisions of any other
laws or documents.
• The Central Government has the authority to enact rules to implement the requirements
of the SARFAESI Act.
• As the Central Registry has not yet been formed, the provisions pertaining to the central
registry will be relevant once the central registry is established.

Dilution of provisions of the SICA - By introducing two provisions in Section 15 of the

SICA, the protective canopy of registering with BIFR under the Sick Industrial Companies
(Special Provisions) Act, 1985 (‘SICA’), which had previously incentivized industrial illness,
has been abolished.

Procedure of the SARFAESI Act - Banks must follow particular procedures before they
may repossess and claim a property in order to recoup their debts. They work in
accordance with the SARFAESI Act procedure. Under the SARFAESI Act mechanism, if a
borrower seems unable to settle his loan (including house loans) for six months, the
nancial institution has the legal authority to issue him a notice requesting that he clear
the dues within 60 days. If the borrower fails to satisfy this obligation, the nancial
institution has the authority to sell the property in distress in order to collect the debt.
A borrower in default who is dissatis ed with the bank’s order may le an appeal with the
appellate body established by law within 30 days of the date the order is issued.
Once the bank obtains possession of the property, it has the option to sell or lease it. It
can also provide another entity the right to the property. The revenues from the sale are
used to pay down the bank’s outstanding debts rst. The leftover funds, if any, are paid to
the defaulting borrower.
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 Methods for recovery under the SARFAESI Act - The RBI is responsible for the regulation
and registration of securitisation or rebuilding businesses under the SARFAESI Act of
2002. These rms have been given permission to raise cash by selling security receipts to
a quali ed institutional buyer. This has enabled banks and nancial institutions the
authority to take control of securities issued in exchange for nancial assistance and sell
or lease them in order to take over management in the event of a failure. The SARFAESI
Act speci es two basic techniques for recovering non-performing assets and these are as
follows:
Asset reconstruction: The Asset reconstruction industry in India was born as a result of
the SARFAESI Act. It is de ned under Section 2(1)(b) of the Act. It can be accomplished
by either proper management of the borrower’s business, or by taking over it, or by selling
a portion or the entire business, or by rescheduling payment of debts payable by the
borrower, or by the enforcement of a security interest in compliance with the conditions of
this Act.
Securitisation: The practice of creating marketable securities supported by a pool of
potential assets such as auto or house loans is known as securitisation. It is de ned
under Section 2(1)(z) of the Ac.t An asset is sold once it has been turned into a
marketable security. By developing schemes for obtaining nancial assets, a
securitisation or reconstruction rm can acquire capital from exclusively QIB (Quali ed
Institutional Buyers).
The SARFAESI Act also includes an exception for security receipt registration. It implies
that when a securitisation or reconstruction rm issues receipts, the holder of the receipts
is entitled to undivided interests in the nancial assets and there is no requirement for
registration until and until the Registration Act, 1908 requires it. However, in the following
circumstances, the security receipt must be registered:
• There is a receipt transfer;
• The security receipt creates, declares, assigns, limits, and extinguishes any right, title,
or interest in real property.

O ences and penalties under the SARFAESI Act

The SARFAESI Act de nes the following o ences under Chapter-V under Section 27-30D:
• Failure to le particulars of transactions involving asset securitisation, asset
reconstruction, and the formation of a security interest.
• Failure to le particulars of the amendment.
• Failure to provide indications of particulars satisfactorily.
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 • SCO and RCO’s failure to follow RBI orders.
• Violation of any of the sections of the SARFAESI Act or any rules issued thereunder,
including attempting to violate and aiding and abetting in contravention.

The SARFAESI Act under Section 27 imposes the following penalties:

• For failure to le particulars of the above-mentioned transactions, every rm and every
o cer of the company, as well as every lender and o cer of the lender, will be ned up
to Rs.5000/- for each day the default persists.
• Non-compliance with RBI directions will result in a punishment of up to Rs.5,00,000/-
for each rm and each o cer of the company, as well as an additional ne of
Rs.10,000/- for each day the default persists.
• Any violation of any provision of the SARFAESI Act is punishable by imprisonment for a
term of up to one year, a ne, or both.
• Under the SARFAESI Act, only a Metropolitan Magistrate or a Judicial Magistrate of the
First Class has the authority to take cognizance and trial a crime.

Signi cance of the SARFAESI Act

• The administration has indicated that it wants to dramatically reduce the number of
non-performing assets (NPAs) and remove the obstacles they provide to the economy.
The SARFAESI Act is a method for achieving this aim by reducing NPAs. As a result, the
e cacy or success of the Act must be measured by the results obtained throughout its
implementation. If the Act has resulted in a downward cycle of NPAs, it will be
considered a policy success. Most banks have signi cantly lower levels of non-
performing assets, and many have budgeted for even lower NPA levels this scal year.
• Cooperative banks were previously excluded from the category of banks to whom the
SARFAESI Act applied. The Indian government revised this act in 2013 to include
cooperative banks formally under the scope of banks quali ed to employ this Act. This
action has greatly aided cooperative banks in avoiding excessive delays in collecting
problematic debts that are involved in civil courts and cooperative tribunals.
• With signi cant deposits from ordinary investors, the Indian Banking System today
contains 1,544 urban cooperative banks and 96,248 rural cooperative banks. Given
their magnitude in order to timely recover the default debts the SARFAESI Act plays a
vital role leading to the cooperative banks’ smooth operation.
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Shortcomings and lacunae in the SARFAESI Act
• The SARFAESI Act, regardless of how advantageous it is, is not without aws. One of
the Act’s signi cant aws is that it does not apply to unsecured creditors.
• The bank has no in uence over what happens to the asset after it is placed up for
auction. If there are no buyers for the asset at the auction, the bank cannot proceed,
pursuant to the previous conditions. Furthermore, the Government of India added a new
clause in 2011 declaring that the bank might acquire the asset if there was no better
bidder. This created another issue that if the factory was in the city, the bank might buy
it and use it to erect a new branch or build a housing colony for its employees.
However, if it was in an extremely remote place, it was useless to the bank.
• The Act’s provision permitted the bank to keep a speci c asset for a maximum of seven
years. However, if the bank does not get a reasonable bid within the speci ed time
frame, the remedy for such a situation is not speci ed in the Act.

Important case laws

1. The legality of the Act was questioned in the case of Mardia Chemicals v. Union of
India, 2004 before the Supreme Court.
Facts: The IDBI Bank led a notice against Mardia. Mardia defaulted—appealed in Court,
where a number of similar petitions were grouped together and addressed collectively.
Issue: The Court had to decide whether it was permissible to challenge the SARFAESI Act
on the grounds that it was not necessary to enact it in the circumstances at the time,
particularly when another statute was already in e ect, whether Section 13 of the Act was
unconstitutional, and whether Section 17, particularly Section 17(2), is unreasonable and
arbitrary, and thus unconstitutional.
Held: The Supreme Court upheld the Act’s constitutional validity, noting that “certain
provisions of the Act may be a bit harsh for some of the borrowers, but on the ground that
the impugned provisions of the Act cannot be said to be unconstitutional for the very fact
that the object of the Act is to achieve faster recovery of the dues declared as NPAs and
for better availability of capital liquidity and resources to help in the growth of the
country’s economy and borrowers.” The Court further permitted the debtors to le an
appeal against the lending institutions at the DRT without having to deposit 75% of the
outstanding debt, and if the tribunal does not grant a stay order, the bank may sell the
possessions.
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 2. In the case of Pandurang Ganpati Chaugule and Others v. Vishwarao Patil Murgud
Sahakari Bank Ltd.,2020
Facts: The appellant challenged Vishwasrao Patil Murgud Sahakari Bank Limited’s action
under the SARFAESI Act before the Civil Judge in Spl. Civil Suit on August 13, 2008. In
deciding the primary issue, the Trial Court determined that it lacked jurisdiction to hear
the case. The rst appeal led was denied. Against that, an appeal has been led with
this Court. A supplementary writ challenge under Article 32 of the Indian Constitution has
also been led, disputing the scope of the SARFAESI Act by co-operative banks sending
noti cations under Section 13.
Issue: One point of contention was whether cooperative banks at the state and multi-
state levels are subject to the SARFAESI Act.
Held: A Five-Judge Constitution Bench of the Supreme Court of India ruled that
cooperative banks created by cooperative societies should be recognised as banks under
the SARFAESI Act, 2002.

3. In the case of Karnataka State Financial Corporation v. N. Narasimahaiah, 2008

Facts: In relation to the loans taken out by the industrial enterprises, the respondent
provided sureties and/or guarantees. It sought the appellant-Corporation for a loan of 100
lakhs in the shape of a non-convertible debenture facility to cover its working capital
requirements. respondents who were directors of the company signed guarantee and
collateral security deeds that eventually failed.
Issue: The legitimacy of SARFAESI Act,2002 was challenged.
Held: The Supreme Court correctly emphasised the importance of the fundamental right
to property. As a result, both creditors and lenders are guided as to the requirement of the
asset mortgaged to the bank. The Supreme Court of India maintained the SARFAESI Act,
2002 as constitutionally legitimate, with the exception of the provisions under Section
17(2) of the Act, 2002, which was found to be in violation of Article 14 of the Indian
Constitution.

4. In the very famous case of King sher Airlines Ltd. v. State Bank Of India And Ors, 2017
I,
Facts: In 2005 the respondent approached the applicant banks for working capital and
term loan facilities, including short-term loans, and entered into loan agreements with the
applicant banks. However, due to nancial problems, the respondent defaulted on
repayment of such loans, and in response to bank requests for repayment of the loans,
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 the respondent sought applicant banks, among other things, to restructure and recast the
said credit facilities. However, the respondent is now a fugitive o ender. Under the
SARFAESI Act, the applicant-banks have begun proceedings against the defendants’
secured assets.
Issue: The main issue was as the respondent is a fugitive o ender, can he remain outside
the jurisdiction during the winding-up process.
Held: The Karnataka High Court held that a secured creditor may opt to remain outside
the winding-up process while also preferring a company petition, and the Company Court
may not exercise sovereignty over the property when recourse is sought against the
secured asset by a secured creditor under the SARFAESI Act. When a secured creditor
has sought recourse under the SARFAESI Act, the Company Court cannot exercise
jurisdiction over the secured assets, whether before or after the winding-up order is
issued, according to the Court. This is due to the fact that if a secured creditor les a
petition for winding up, he is not required to renounce his secured asset.

4.5.2 overview of RDDBFI Act

Origin of the Act : We are fth largest developing economy in the world and just left
behind UK and France few days back. We are second largest country in the world in case
of population. We have largest young skilled workforce in the world. For sustainable
development of a country a sound and perfect, protected system of banking is required.
Banks and Financial Institutions are backbone of a country. Through a sound system of
banking a country will develop very fast. In Indian, we have a robust and sound banking
system, that is regulated by Reserve Bank of India. RBI is the central bank and regulating
all banks, nancial institutions and non-banking nancial institutions.

The Banks/ Financial Institutions or NBFCs play crucial role in development of mini, micro
and large industries in India. Mini, Micro and Large industries have employed more than
40% workforce of India and to protect them we have to protect interests of banking
systems. Before, the enactment of the RDDBFI Act, banks, and nancial institutions were
facing huge challenges in recovering debts from the borrowers as the courts were
overburdened with large numbers of regular cases due to which courts could not accord
priority to recovery matters of the banks and nancial institutions. The Government of
India in 1981 constituted a committee headed by Mr T. Tiwari, this committee suggested
a quasi-judicial setup exclusively for banks and nancial institutions which by adopting a
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 summary procedure can quickly dispose-o the recovery cases led by the banks and
nancial institutions against the borrowers.

Again in 1991, a committee was set up under Mr Narashmam, which endorsed the view
of the Mr T. Tiwari Committee and recommended the establishment of quasi-judicial for
the speedy recovery of debts. Pursuant to which Government of India enacted the
RDDBFI Act. Through, the RDDBFI Act quasi-judicial authorities were constituted, and the
procedure was speci ed for the speedy recovery of debt.

We have seen large number of frauds in previous years in which greedy politicians and
banking personnel for their interest cheated a large number of banks and money of
general public. Some of banks such as PMC, Yes Bank, State Bank of India, Bank of
India, ICICI Bank etc., su ered huge losses. They have not only cheated banks but also
hamper interest of genuine borrowers and public. There are large numbers of Non-
Performing Assets on Balance Sheets of majority banks and these assets are non-
recoverable in some cases. The Non-Performing Assets at last treated as Bad Debts.
Recovery of these debts by banks through normal court procedure is a Herculean Task
and takes long years. The Government to remove these di culties and to give Banks /
Financial Institution an edge on the debtors passed “Recovery of Debts Due to Banks and
Financial Institutions Act, 1993 (RDDBFI Act,1993) on 24th June, 2006. The act was
amended in 1995, 2000, 2003 and 2013. The Act was again amended in year, 2016. The
Act is renamed as “Recovery of Debts due to Banks and Financial Institutions and
Bankruptcy Act, 1993”

The Main Features of 2016 Act are;

1. Financial Leasing and Conditional Sale (like Hire purchase) transactions and
Transactions in intangible assets brought in de nition property and security interest.
2. Debenture Trustees and Assets Reconstruction Companies brought within de nition
of “Financial Institutions” and “Secured Creditors”.
3. DRT Act amended to cover liabilities over debt securities and security interest.
4. Appeal against order of DRT before DRAT with 50% pre deposit against 75% earlier.
5. Presiding O cer of DRT Act proposed to function also as Adjudicating Authority
under Insolvency and Bankruptcy Code, 2016. 6. Chairperson of DRAT will also
function as Appellate Authority under Insolvency Code. The main purpose of the Act
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 is to establish Tribunals for expeditious adjudication and recovery of debts due to
Banks and Financial Institutions. Now Act is applicable whole India.

Applicability Of Debt Recovery Act

The Act is applicable on Banking Companies, SBI, Subsidiaries of SBI, Regional and
Rural Banks and Multistate Co-operative Banks, Financial Institutions, Assets Re-
construction Companies, the Debenture Trustees registered with SEBI and other as
speci ed by government. DRT Act is also applicable on Cooperative Banks.

Greater Bombay Cooperative Bank Vs. United Yarn Tex(P) Ltd.(2007): it was held that
provisions of Sections 5( c) and 56(a)(i) of Banking Regulations Act are also applicable to
Cooperative Banks and hence provisions of DRT Act are also applicable to Cooperative
Banks and Registrar of Societies ,when DRT has been established in relation to any
dispute related to cooperative bank has nothing to say.

M Babu Rao Vs. Dy. Registrar of Cooperative Societies: it was held that disputes
regarding recovery of debts due to cooperative banks are to be adjudicated by DRT and
Registrar of Cooperative Societies has no jurisdiction to adjudicate upon the dispute.

Monetary limit : Save as otherwise provided, the provisions are applicable where amount
of debt due to bank or FIs or consortium of banks/FIs is Rs. 10.00 Lakhs or more. The
Central Government through amendment reduce the monetary limit from Rs.10.00 Lakhs
to Rs. 1.00 Lakhs in 2016.

Authorities under RDDBFI Act

Debt Recovery Tribunal : Section 3, provides for the establishment of Debt Recovery
Tribunal (DRT), by noti cation to be issued by the Central Government, for exercising,
jurisdiction, powers, and authority conferred on such tribunal under the RDDBFI Act. First
DRT was established in Kolkata in the year 1994. Presently 33 DRTs are functioning at
various places in India, and more DRTs are also being established. As per section 4, DRT
consists of sole member only, known as Presiding O cer. Section 5, provides that a
person who has been or is quali ed to become District Judge can be appointed as
Presiding O ce of DRT. Section 6 provides that the terms of the Presiding O ce shall
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 end after the expiry of the period of 5 years from the date he enters the o ce and he will
be eligible for reappointment provided he has not attained the age of 65 years.

Debt Recovery Appellate Tribunal : Sections 8 -11 deals with the establishment,
quali cation, and term of the Chair Person of the Debt Recovery Appellate Tribunal
(DRAT). DRAT is established to exercise control and powers conferred under the RDDBFI
Act. DRAT consist of sole member to be known as Chair Person. A person is eligible to
become a Chair Person, if he has been an or quali ed to become a High Court Judge, or
has been a member of the Indian Legal Services and held a Grade 1 post as such
member for the minimum period of three years or has held o ce of Presiding O cer of
Tribunal for period of at least three years. The Chair Person of DRAT can hold his o ce for
the period of ve years and is also eligible for reappointment, provided, that he has not
attained the age of seventy years. Presently there are 5 DRATs in India in Delhi, Chennai,
Mumbai, Allahabad, and Kolkata. DRAT has appellate and supervisory jurisdiction over
DRTs.

Who can recover money from DRT under RDDBFI Act : As per section 1(4), the
provisions of RDDBFI Act does not apply where the amount of debt due to the bank or
nancial institution or the consortium of banks and nancial institutions is less than
Rupees Ten Lakh or any other amount not below Rupees One Lakh, cases where the
central government may by noti cation specify. Thus, in essence, minimum debt which is
to be recovered from DRT should not be less than Rupees Ten Lakh. In the case of
SARFESAI Act, if the asset has been declared as Non-Preforming Asset (NPA), eligible
banks and nancial institutions after enforcing security can recover remaining amount
under RDDBFI Act which is in excess, of Rupees One Lakh.

What type of debt can be recovered under the RDDBFI Act : As per section 2 (g) debt
is any liability inclusive of interest, which is claimed to due from any person by any bank
or nancial institution or consortium thereof. Such liability may be secured or unsecured
or assigned, whether payable under the order of court or arbitration award or under the
mortgage. Such a liability shall be subsisting and validly recoverable on the date of
application.
The debt also includes liability towards debt securities which remains unpaid in full or part
after notice of ninety days served upon the borrowers by the debenture trustees or any
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 authority in whose favor a security interest is created for the bene t of the holder of the
debt security. Clause 2(ga) de nes debt security as securities listed in accordance with
regulations de ned by SEBI under Securities and Exchange Board of India Act, 1992.

Jurisdiction, Powers, and Authority of DRT and DRAT : As per section 17 of RDDBFI
Act, vests jurisdiction, power and authority on DRT to entertain and decide application
from banks and nancial institutions to recover a debt due to such banks and nancial
institutions. Further, section 17A confers on DRAT power of general superintendence and
control and confers appellate jurisdiction on DRAT. DRAT is also empowered to transfer a
case from one DRT to another DRT. DRAT is also empowered to call for information from
DRT, about cases pending and disposed of them. DRAT is also empowered to convene
the meeting of Presiding O cers. It also empowered to conduct an inquiry of Presiding
O cer and recommend suitable action to the Central Government.
Section 18 bars the jurisdiction of any civil court or authority for recovery of debt, except
High Court and Supreme Court in the exercise of their writ jurisdiction under Article 226
and 227 of the Constitution of India. Thus in essence order of DRAT can be challenged
in writ jurisdiction of High Court or Supreme Court

Procedure for ling cases for recovery of money under RDDBFI Act : Now having
understood the basics of RDDBFI Act, including DRT and DRAT, now understand the
procedure which is to be followed or the process of recovering money under this Act:

• Types of pleadings/applications generally led before DRT

• Following are the pleadings which are led in DRT by the parties
• Original Application (O.A) refers to the claim led by the bank or nancial institution for
recovery of debt from the borrower.
• Interlocutory Application (I.A) refers to the applications led during the pendency of the
case. Miscellaneous Interlocutory Application (Misc. I.A) refers to applications led
under clause e,g or h of section 22(2) of the RDDBFI Act.
• Written Statement/ reply refers to defense of the borrower

Application to be led in local jurisdiction of DRT : An Application has to be led within

the local jurisdiction of relevant DRT, as per section 19(1) of the Act, Application can be
led within the local limit of DRT in whose jurisdiction where:
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• the branch or any other o ce of the bank or nancial institution is maintaining an
account in which debt claimed is outstanding;
• the defendant voluntarily resides or carries on his business or works for gain;
• in case there are more than one defendant, at the place where any one of the
defendants voluntarily resides or carries on his business or works for gain;
• where the cause of action wholly or partly arose.
• Further, where a bank or a nancial institution, which has to recover its debt from any
person, has led an O.A and against the same person another bank or nancial
institution also has claim to recover its debt, then, the later bank or nancial institution
may join the applicant bank or nancial institution at any stage of the proceedings,
before the nal order is passed, by making an application to that DRT.

Application contents : Along with the Application certi ed true copies of the documents
on which the bank or nancial institution is relying in support of its claim needs to be led.
Further, Applicant inter-alia should state the following:
• Grounds of an application under di erent heads should be stated concisely;
• Particulars of debt secured by a security interest in the property or assets belonging to
the debtor and estimated value thereof;
• If the secured assets are not su cient to cover the debt then the particulars of any
other property or assets owned by the debtor should be stated;
• If the value of other assets is not su cient to cover the debt, then a prayer must be
made requesting for direction to the debtor for disclosing his other property or assets
details.

Language and forms of pleading and other formalities : All pleadings shall be done in
English or Hindi language. If in the English language then font should be Times New
Roman with a font size of 13. There should be double spacing between the lines. Left-
hand margin should be 5 centimetres and right-hand margin should be 2.5 centimetres. In
all pleadings, legal size (A3) paper should be used.

Fee : While ling O.A or I.A or review or appeal. The fee must be paid by way of Demand
or Postal Order in favour of Register, of DRT, payable at the place where DRT is situated.

Presentation/ ling of application for recovery

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 After completing pre- ling formalities as mentioned above, the application can be led
before Registrar or any other o cer of DRT as authorised by the Registrar. The
application can be led before 4:30 PM on any working day. The application can also be
led through e- ling.
One presentation of application Registrar or the o cer authorised by him shall give diary
number, date of ling with his endorsement, to the party ling the application. The
application so led will be securitized by Registrar or the o cer authorised by him within
15 days. In the case of defects were found applicant will be given 15 days’ time to
remove the de ciency, in case applicant failed to cure the de ciency within the period of
15 days, he can apply for extension and registrar can give him extension subject to a
maximum of one month. Even after extension if the applicant fails to cure the defect
application will not be registered by the Registrar.
Once all the defects are cured, or there are no defects in the application, Registrar of DRT
will get the application/case registered and allot a serial number to the application. Cause
list of cases to be listed before Registrar will be placed in board or website of DRT a day
before scheduled hearing.

Service of Summon/Notice : The Registrar of DRT or any other o cer authorised by

Presiding O cer will issue Summon/Notice, which will be served by the applicant to the
defendant/respondent. The Summon/Notice which also contains the paper book of
petition/application is generally served on to the defendant/respondent by hand or
registered post with acknowledgement due (AD) or speed post or courier. With the
permission, of Registrar, Summon/Notice can also be also sent through email or fax,
however, in such event, it must be ensured that defendant/respondent gets a copy of the
paper book on the rst date of his appearance. If the Summon/Notice is delivered to any
adult family member of respondent/defendant at his address, it shall be deemed to be
delivered.

Hearing of the case before Presiding O cer

Filing of reply/written statement – Defendant/Respondent within one month from the

date of service of Notice/Summon on him is required to le the reply. However, with the
permission of DRT respondent/defendant can seek time for ling reply/written statement.
Even if in the extended time period the defendant/respondent failed to le his reply then
DRT may proceed ex-prate.
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 The claim of set o /counter claim – Defendant at the rst date of hearing can le a
claim for set o /counterclaim. He cannot le it afterwards without the permission of DRT.
The claim of set o /counterclaim shall have the same e ect as a counter suit in any
proceedings.
Admission of liability by respondent/defendant – If the respondent/defendant admits
his liability, in that event Presiding O cer will pass an order directing respondent/
defendant to pay the admitted amount within the period of 30 days from the date of the
order of the DRT. If defendant/respondent fails to pay the admitted amount within that
period, then Presiding O ce may issue a certi cate of debt due in terms of section 19 of
the Act.
A davits- In the case where defendant/respondent denies his obligation, in that event
Presiding O ce may require the parties to him to prove any fact by ling an a davit and
such a davits shall be read in the hearing in the manner which DRT deems t. After ling
of the a davits by the respective parties where it appears to DRT that either the applicant
or the defendant/respondent desires the production of a witness for cross-examination
and that such witness can be produced and it is necessary for the case, DRT shall for
su cient reasons to be recorded, order the witness to be present for cross-examination,
and in the event of the witness does not appears for cross-examination, then, the a davit
shall not be taken into evidence.

Interim Order by DRT : In cases where the applicant apprehends that the borrower may
take steps which may frustrate attempt of execution may make an application to DRT
along with details of property to be attached and value thereof, and on such application
may pass an interim order directing respondent/defendant, directing him to deposit
before it amount equivalent to property value or amount which may be su cient to
recover the debt or as and when required by DRT to place before it disposal the property.

Judgment and Recovery Certi cate by DRT : DRT after giving both the parties
opportunity of hearing and hearing their submissions will within 30 days of the conclusion
of such hearing pass its interim or nal order. Within 15 days of the passing of the order,
DRT will issue RC and forward the same to Recovery O cer. RC will contain the details of
the amount to be paid by recovered by the borrower debtor. RC shall have the same
e ect as the decree of the civil court.
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 Appeal :An appeal by any aggrieved party against the order of DRT can be led within the
period of 30 days from the date of receipt of the order. No appeal can be led against any
order which has been led with the consent of the parties. DRAT shall endeavour to
dispose-o appeal nally within the period of six months.
Amount to be deposited for ling an appeal – Where the appeal is being preferred by the
debtor, who as per the order of DRT is liable to pay money to bank or nancial institution
at the time of ling appeal is required to deposit before DRAT 50% of the amount he is
required to pay as per the order of the DRT. However with the permission of DRAT, this
amount can be reduced by DRAT, but reduced amount should not below 25% of the debt
amount which Borrower is required to pay as per DRT order.

Recovery of debt by Recovery O cer

After receipt of RC from DRT, Recovery O ce will initiate recovery by one or more of
following modes:
• Attachment and sale of movable or immovable property of defendants/debtors;
• Taking possession of property over which security interest was created or any other
property of defendant/debtor and appointing receiver for the management of the same;
• Arrest of defendant/debtor and his detention in prison;
• Appointment of receiver for management of movable or immovable property of
defendant/debtor;
• Any other mode as may be prescribed by the central government.
Apart from above modes Recovery O cer may also, direct any person who is liable to
pay any amount to defendant/borrower, deduct from such amount the recovery amount,
and transfer to the credit of Recovery O cer the amount so deducted. However,
Recovery O cer will not deduct any such amount which is exempt from attachment
under Code of Civil Procedure, 1908.

MODULE 6
EMERGING AREAS IN LAW OF CORPORATE FINANCE

6.1 Corporate Finance and Blockchain : In the era of the digital revolution,
organizations are surrounded by disruptive technologies and nd themselves constantly
in the middle of change processes. Blockchain technology has the potential to change
the structure and function of corporate nance—and to do so incredibly quickly. Known
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 widely as the technology that underpins Bitcoin, blockchain is a distributed system for
maintaining distributed ledgers. Because each ledger is replicated across the members’
nodes in the blockchain network, all authorized members can see every change in real
time, creating an audit trail of trusted transactions that eliminates the need for a
centralized third party. The distributed ledger technology rst gained prominence years
ago as the backbone of bitcoin, the pioneering crypto-currency. But while the digital
currency’s value has uctuated, blockchain’s potential as a groundbreaking technology
for business, capable of slicing through layers of ine ciency, is gaining momentum.

The ability to share veri ed and trusted data within an organization, or with an external
network in real time, opens up opportunities for wholesale changes to business
processes and business models. Among the many potential blockchain applications are
farm-to-table food tracking, real-time contractor licensing, real estate transfers and all
types of nancial transactions. The bene ts for organizations include reducing settlement
risk, addressing discrepancies across enterprise resource planning (ERP) applications and
lowering audit costs and complexity.The caveat, however, is that if nance organizations
aren’t prepared for blockchain-powered business opportunities, they will nd themselves
crushed by this latest wave of disruption—in the very near future, experts say.

Blockchain in the Short Term

Global spending on blockchain solutions will more than double this year, to $2.1 billion,
and will increase at a compound annual growth rate of 81.2 percent to reach $9.2 billion
in 2021, according to market intelligence rm IDC.
Currently, many organizations are interested in using blockchain internally, as a shared
ledger among divisions and subsidiaries. “They want to eliminate the pain of di erent
units within their own organization passing spreadsheets of data back and forth and
verifying and re-verifying that information,” Haimes says.Once they gain con dence that
they’ve got the right business processes around their internal blockchain projects, they’ll
look to establish blockchain networks with their external trading partners, he says.

One prototype would push invoices due in 90 days to a blockchain network, where
nancial services companies can buy them. “They can create a blockchain marketplace
that’s completely transparent,” Haimes says, “so they’ll see how much money the rms
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will pay for those invoices. And as the rms that buy them can trust that the invoices are
valid, taking on less risk, the completion will also drive down costs.”Today, such invoice
factoring is manual, often involving fax machines and even bicycle messengers shu ing
paper documents between companies and banks.

Building the Right Foundation

As blockchain technology continues to mature, one of the biggest challenges is
integration—tying blockchain services into an enterprise’s nancial, inventory, logistics
and other systems of record. Most companies can’t a ord to build one-o integrations
with each back-end system. “The chance to make nance transactions touchless is very
high and it’s very real,” deMoll told a standing-room-only audience at Oracle’s Modern
Finance Experience conference in New York. “As a former CFO, it struck me that with
blockchain, we’re not going to need accounts payable or accounts receivable. If you get
the data right at origination, you don’t need all that back-end reconciliation.”
While blockchain is very much in the pilot stage at most companies, that stage could be
brief. Haimes predicts that blockchain will really start to take o in 2020, fundamentally
changing the way companies look at business processes, opportunities and trading
models. “The caveat,” he says, “is things always move faster than we expect.”

In addition to driving signi cant e ciencies and cycle-time reductions, blockchain

provides full end-to-end transparency across operations and nance, enabling predictive
operational insights and opportunities to optimize working capital. Blockchain has the
potential to reshape processes that are de ned inside nance, primarily because of its
cost and control bene ts.

How blockchain works ?

Put simply, a blockchain serves as a distributed, shared ledger that can be integrated with
the existing applications (enterprise resource planning (ERP), order entry, etc.) of one or
many trading partners. On blockchains for business, participants are invited to join, and
their identity is controlled with cryptographic keys. Before any nancial transaction is
updated to a blockchain, its validity must be veri ed by the participants through a
consensus protocol. Each piece of data in a block is encrypted and each block is linked
to the prior block with a unique identi er (a “hash”). Transactions recorded on the
blockchain are updated almost simultaneously and distributed across the network of
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 participants’ computers, with each having an exact copy. If anyone tries to modify data in
a block, the hash noti es participants. Blockchain can also execute rules for processing a
transaction by means of pre-agreed “smart contracts,” which are business rules
converted into computer code (see Getting smart about smart contracts, CFO Insights,
July 2017). Once the parties have agreed to certain conditions, the self-executing and
self-enforcing code automatically implements the contract terms.4 The arrival of a certain
shipment at an agreed-upon day and time, for example, triggers an immediate message
from the customer to the supplier—noti cation that the payment process has been
initiated.
The technology has several key attributes that make it uniquely suited to enable direct
and trusted interaction between two business trading parties. The block chain technology
works by storing the relevant data in the encrypted form in a blocks having de nite
amount of storage and further data going into the next block and each block is joined
with other block through chain and it is called the block chain technology. It is a
decentralized way to store date which makes it more safe and secure for any mis-
happening or fraud. This data is immutable and hence no alteration can be done it in
easily. The decentralized technology which eliminates the need for any intermediary or the
central body is also known as decentralized ledger technology.
This technology has the potential to disrupt the traditional market like mentioned above
what email did to the letters and posto ce. It removed the need for the third party for the
task accomplishment also the chance of mistake was reduced to nil. The same goes with
the technology behind the blockchain. The chance to breach the security is minimum,
almost impossible.
This technology was given by satoshi nakamoto in japan in 2008 and it became popular
because of the cryptocurrency bitcoin. This technology can be helpful in corporate
nance because it can transform corporate governance, corporate voting, shareholder
activism, stock exchange transactions etc. The development of bitcoin will be equal to
the scenario of the World wide web in 1990 which transformed the internet model and
ourished the business model in a di erent way. The blockchain is going to transform the
nance in a di erent way.
The breaking point for the technology was in the 2008 when a big bank goes bankrupt
and there is a huge recession seen in the global market due to banking disruption. The
faith in the technology increased because the trust in the currencies were gone. The
relying on bank and nancial institutional started to dip. There is no intermediary, high
cost reduction in this technology. As a result investment has rised in this technology. The
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 business process is optimized by sharing of data in e cient, secure and transparent
manner.
After the backlash even the central banks of many countries are investing in the
blockchain technology because they are satis ed that it will rule the future of the nancial
sector. Although they are careful in adopting any technology but they are the rst one
because it can solve the longstanding problem of the traditional nancial market.

Those characteristics include:

• Cryptographic security. To write to, or read, any private blockchain requires the use of
two cryptographic keys. A “public key” consists of numbers generated at random that
lead a user to where the data is stored; a “private key” resembles a password,
permitting access to certain digital assets.
• Privacy. Blockchains come in both a public and permissioned (private) incarnation. With
bitcoin, participants could come and go without any permission. But on a permissioned
blockchain, which would be used for nancial applications, companies must be invited
to participate.
• Built-in redundancy. Blockchain’s decentralized structure means that every computer in
the network harbors a copy of the database. Should one fail, there are many others.
More important, there is no single point of failure.
• Process integrity. In addition to having the correct credentials, users can only update
the blockchain once a consensus of participants has validated the information.
As nance grows increasingly automated and digitized, blockchain will increase in
strategic importance. As noted in Crunch time IV: Blockchain for nance: “Business
blockchains can operate as standalone solutions, but the value realized increases
signi cantly when they’re combined with other technologies, such as automation or
arti cial intelligence, to reimagine an entire end-to-end process.”

Principles of blockchain
1. Distributed Database: Each party on a blockchain has access to the entire database
and its complete history. There is no central control and every party can verify the
records without an intermediary.
2. Peer-To-Peer Transmission : Communication takes place directly between peers
instead through a central node. Each node stores and forwards information to all other
nodes.
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 3. Transparency with Pseudonymity : Transactions are visible and transparent to anyone
with system access. Users can however remain anonymous or provide proof of their
identify.
4. Irreversibility of Records : Once a transaction is entered the records cannot be
altered.
5. Computational Logic : Users can set up algorithms and rules that automatically trigger
transactions between nodes.

Block chain and smart contracts : A key emerging use case of blockchain technology
involves “smart contracts. smart contracts feature the same kind of agreement between
di erent parties but unlike conventional contracts established by written words, speech or
action; smart contracts are algorithmic, self-executing, and self-enforcing computer
programs which can implement contract terms automatically. The blockchain is the ideal
place to store such a contract, because of its immutability and its cryptographic security.
The special characteristic of smart contracts is that they remove the need for an
intermediary to trust the execution of the contract. A trustless network is created, and the
parties can transact even though they may not really trust each othe

How blockchain will help corporate nance ?

Blockchain can be used to remake a wide range of nance processes: intercompany

transactions (when there are multiple ERPs), procure-to-pay, order-to-cash, rebates,
warranties, and nancing (such as trade nance, letters of credit, and invoice
factoring). Any place paper piles up presents an opportunity for blockchain to move in
and knock it down. Companies connected to blockchain-powered platforms can boost
the e ciency of traditional letters of credit, which require an abundance of documentation
and time. The back-and-forth transaction, conducted among parties on a shared
platform, could conceivably be completed in hours, compared to the ve days a paper-
based system devours. Blockchain can also reduce the cost and friction involved in
repetitive nance tasks, cutting both errors and delays. In a typical accounts payable or
receivable function, an inordinate amount of time can be wasted reconciling the supplier’s
data with that of the buyer. Having both parties share access to a single source of truth
can eliminate such ine ciencies.
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 By providing a single source of truth—certi ed by all participants involved—blockchain
eliminates the need to continually con rm that the transaction record on one CFO’s
screen matches that of his or her counterpart’s on the other side of a deal. By giving
nance leaders a real-time picture of a given nancial situation—even an intercompany
transaction, which involves such shifting components as tax laws, exchange rates, and
compliance requirements—blockchain equips them to improve their decision-making.

Where blockchain ts

Beyond its impact on any individual organization or function, blockchain may ultimately
disrupt paper-clogged industries, such as health care and insurance. At this point, the
earliest rumbles of those upheavals are now barely audible. Among respondents to the
2018 global blockchain survey, 84 percent say that blockchain will eventually reach
mainstream adoption.
Yet, half of the respondents reported that blockchain is either not among their
organization’s top ve strategic priorities (29 percent) or not a strategic priority at all (21
percent).7 They are choosing to take a wait-and-see approach, likely because they can’t
gure out where to start.
For now, CFOs should consider beginning the journey with a few steps that can provide
them with a better understanding of the technology. From there, they can identify and
prioritize the nance pain points that the technology could potentially address. The
blockchain technology has the ability to help with obtaining nancial sources such as
debt, equity instrument, collateralized asset management, guarantee of adherence to law
and regulations and also voting in absence of annual shareholder meeting of the
company. Earlier this was not possible but through the introduction of blockchain it is
seen that it can be helpful in many industries out of which the nance industry is the one
which is running in the traditional way till now. There are massive ine ciencies which are
human based and large cost issues to maintain records. In the corporate nance world
there is continuous change in security ownership over a long chain of nancial
transaction. The technology helps in not keeping faith in human but in math.

Here are a few steps for CFOs to consider:

Assign a blockchain champion -Blockchain should be a business-led initiative, requiring
strong sponsorship and leadership provided from the ranks of nance executives. The
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 designated leader can assign a few junior resources to study the ever-growing body of
literature about blockchain. While doing so, they can start to envision how the various
functions might bene t from implementing blockchain, identify value drivers, and build
business case frameworks.
Invest in talent - Pull together a focused cross-section team from supply chain, customer/
channel operations, service, and nance to identify and prioritize pain points that could be
targeted and develop a hypothesis around how the use of blockchain will solve the
business problem. Make sure this group represents professionals from both the functional
and technical teams within the ecosystem.
Forget the technology -Focus on how blockchain will potentially disrupt or shift your
operating model. The process involves understanding the transformative nature of
blockchain, then talking with customers, suppliers, and C-suite peers to identify potential
use cases. Since blockchain validates data at the source, it will set a new standard for
data integrity that can be applied across the enterprise—ultimately rede ning core
processes.
Think big, start small, and iterate often - Blockchain’s capabilities may be put to more
e cient use in the external world, but as an introduction to the technology, it may be best
to focus on an internal issue, such as intercompany transactions. This can provide the
opportunity to safely learn more about the technology, gain experience in solution design,
and acquire con dence from doing an implementation. Then, the team can leverage its
knowledge of, and experience with, blockchain in the outside world.
Launch a pilot - Having identi ed nance pain points, select a use case where blockchain
will likely produce a real return on investment (ROI). Track the results, especially
transaction times and costs, to judge the technology’s suitability for larger-scale iterative
processes.
For CFOs, blockchain is one of many tools that can reshape the nance function process
by process. Like arti cial intelligence (AI), machine learning, predictive analytics, and big
data, blockchain has matured to the point where it’s unwise for nance leaders to
hesitate. Only by gaining a practical understanding of blockchain now can CFOs position
nance to fully realize its bene ts by the time it reaches the mainstream.

Bene ts of Blockchain and transforming Corporate nance

The bene ts of the blockchain technology is the characteristics on which this technology
is developed. It is the one
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 Corporate Governance – in the area of corporate governance we see that there is
human intervention, there are di erent stakeholders in a rm and there is di erent
rationality in each of them related to corporate governance. As long as human are taking
it, it is hard to solve the problem. There is always a probability that there will be some
mistake in the human transaction. It was an imaginary thing to think o an some solution.
After the blockchain the ultimate aim of the corporate governance i.e. the fairness. The
transaction are irreversible and immutable which makes transaction transparent and
available to all. Transparency is the achieved through it. Through the distributed ledger
property all the data is available with all the parties and thus there is no need for auditing
and veri cation which saves good amount of money. There is no need of validation by any
intermediary such as bank which makes system fast and e cient and free from
corruption. The transaction with blockchain is also more safe than traditional method.

Through the smart contracts in the corporate world it reduces the chance of error in the
principal and agent. It also remove the chance for any opportunity for the agent as the
contracts are coded. There is no need for any protocol or any veri cation of the contracts
time to time. All this remove the chance for any breach of contract and fraud impossible.
Thus the blockchain makes the corporate governance mechanism far better and the
bene ts we underline from this section is the transparency, e ciency, cheap, safe etc.
Capital Markets–It is the place where buyer and seller are engaged in trading of nancial
securities such as bonds, stocks etc. The trading is done by individual and institution.
Many countries around the globe are exploiting the advantages of block chain to the
maximum possible extent so that the transactions and settlement can be fast and the
cost is low, also keeping the transaction safe. The idea is that trade settlement will be
made by the parties in the peer to peer network of buyers and sellers enabled by
blockchain technology. There will be no custody for the settlement with the exchange and
the settlement will be made by the parties simultaneously with no need for intermediary
and also cutting down on T+3 scheme which also cuts cost. Time will be saved as there
is no need for the work of the intermediaries. The stock exchanges seem very much
interested as they want the ine cient and cost consuming traditional method of the stock
exchanges to go away. They are not preferring the centralized system which required
veri cation necessarily. The advantages for the capital market in adopting block chain is
manifold ranging from reconciliation, trade validation, reference data, faster settlement,
collateral management, regulatory reporting and audit trail.
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 Reconciliation – this reduces the cost because there is no need for stock agent and the
role of intermediary is gone.
Trade Validation – blockchain enables smart contracts which makes trade validation
simpler and e cient. The parties in peer to peer network can view ownership and
contract terms in more e cient way.
Faster settlement – Blockchain would decrease the time spent in custody and the
settlement processes. This reduces cost and associated risk.
Guarantees Management – Smart contracts enabled by block chain technology can run
coded rules for margin call for a trade. Seller and buyer are on the same network.
Regulatory reporting - as there will be single, reliable and transparent archive of all the
transactions. The regulator will monitor transaction in real time increasing e ciency of
supervision.
Reference Data – in the long sheet to store the large share related data of buyer and
seller. The reference data can be stored in the blockchain. With each party access any
change in the codes can be traced by the parties. It takes validation of parties and make
the process easier.
Audit Trail – distributed ledger make every day entry transparent seen by parties and
there is no chance of falsify. All the things can be done digitally through this and reduces
much manual work, time and cost.
Corporate Voting–it is one of the essential component under the company’s run. There
were many problems regarding the corporate voting process. It reduces the cost of voting
as the process goes completely digital so there is no need to manage such big crowd
physically. It reduces the organization cost for the company as the data in one place
helps in speedy decision making. Through the involvement of technology there is fast and
e cient manner in voting in the company with large participation of the shareholder
through technology. All the problem with the voting system can be solved by veri cation,
transparency, and identi cation which is there in the blockchain technology. All the
ine ciencies like incomplete voting, error with the ballot etc. can be overcome by
distributed ledger and smart contracts of the block chain which helps in safe recording of
votes. The digital voting process has helped a lot in maintaining the voting as well as
ensuring attendance of the voters. The opinion of the shareholders will increase in this
way. The more participation in the company for any resolution will increase democratic
environment in company.
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 Corporate Accounting – accounting process is very important to assess the function of
any company from the nancial perspective. We see that there is a lot of complication
involved in the accounting process because the traditional accounting process there was
the trend of double entry principle. The process was all manual and human involvement
which is evident that there was errors in balancing the accounts in many cases. The
process was also very long involving the paper register way of noting than all the data
uploading in the digital software and then to the auditor again for veri cation. Through the
technology of blockchain i.e. distributed ledger technology the information about all the
transaction is available to all the concerned parties which is safe because it is immutable,
irreversible records. The technology is also preferred because it provides data as needed
in the chronological order. The blockchain technology is authenticated that it eliminates
the need for any auditing approval of the accounts. There is complete transparency with
the data as all the data is available to all the parties at the same in a secure manner so
that there can be no copying and no chance for the abuse by any manager or some
o cials in the company. This corporate accounting process is fully automated through
smart contracts coding. There is no chance of any error as each nodes veri es data. This
technology also reduces the cost of the accounting and auditing sharply. All the data is
secured and thus there is no chance of misdeed and passing o any insider information
related to the company nancial position. This technology secures all the data and there
is no chance of any alteration which also eliminates chance of tax evasion.
Cryptocurrencies and corporate nance : Cryptocurrency is a type of virtual currency
or digital asset which is secured by cryptography. As a consequence it is impossible to
counterfeit this currency and as a result money- laundering can be stopped. The amount
of physical notes used in the economy can be controlled. All these currencies are the
decentralized network and hence provides full privacy and security of the money over the
decentralized ledger technology. The purpose of cryptocurrency in the corporate nance
is that this currency is based on blockchain technology. All the advantages of the
blockchain in the corporate nance is already discussed above and hence crypto can
also be used as the mode of transactions in the nancial market for ease and secure
transaction. It can also be kept as digital asset which has very high potential to grow.
Crypto can become a normal routine for give and take in place of cash in the market.

6.2 Funding Mechanisms for Startups

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 According to a recent study, over 94% of new businesses fail during rst year of
operation. Lack of funding turns to be one of the common reasons. Money is the
bloodline of any business. The long painstaking yet exciting journey from the idea to
revenue generating business needs a fuel named capital. That’s why, at almost every
stage of the business, entrepreneurs nd themselves asking – How do I nance my
startup?
Now, when would you require funding depends largely on the nature and type of the
business. But once you have realized the need for fund raising, below are some of the
di erent sources of nance available. In recent years, investors have found ways to make
alternative funding available to growth and even early stage companies.

Why Funding is Required by Startups ? A startup might require funding for one, a few,
or all of the following purposes. It is important that an entrepreneur is clear about why
they are raising funds. Founders should have a detailed nancial and business plan
before they approach investors.

De nition of Startups in the Indian Context : Though there is no precise de nition, the
accepted characteristics of a “startup” span its age, scale of operations, and mode of
funding. It is usually de ned as a young company, a few years old, and yet to establish a
steady stream of revenue. These rms have a small scale of operations, usually with a
working prototype or paid pilot with the potential to grow and scale rapidly. They are
initially funded by the founders’ own private network of friends and family and actively
seek additional funds to sustain themselves and become a viable business.
As an example, the GoI’s Startup India program de nes a “startup” as a company (PIB
2017) that is:
1. Headquartered in India with not more than ten years since incorporation or registration
2. Having an annual turnover of less than INR 1 billion (roughly $14 million) (Startup India
2019)

Following a revision in 2019, Startup India has updated its list of bene ts (Startup India
2019) to include income tax exemptions on capital gains and investments above fair
market value, options for self-certi cation on various compliances, fast-tracking of patent
applications at a discounted rate, the ability to sell to the government, and the ability to
wind up a failed company within 90 days. Registering with Startup India provides
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 exemptions from Angel Tax, access to a Knowledge Bank, partnered services, online
courses, and innovation challenges. The program has recognized nearly 27,000 startups.

Steps Towards Receiving The Funding You Need

Seed funding is the preliminary stage of funding when the business is primarily a concept
with the potential to grow. This stage is mainly about acquiring capital for product
development and expansion – which helps in lifting things o the ground so that the
business has a running start in its operations before earning the revenue to sustain itself.
The path to receiving such funding is not simple, however. Usually, the entrepreneur
needs to assess criteria such as the type of investor, what funding scheme to pick, and
whether or not it suits the nature of the company or its nancial setup. Fortunately, in an
entrepreneurial ecosystem such as India's, start-ups have multiple sponsorship sources
to compare and assess. The three types of funding available for start-ups are equity
funding, debt funding, and government grants.

Business incubators are institutions that work with startups. Also, they help
entrepreneurs develop their businesses at the beginning of their development. They assist
these startups with their nancial and other needs to accelerate the growth of these new
startups. Incubators may have multiple startups under their wing and work together to
accelerate their development process. Technical facilities and guidance, the provision of
initial growth, capital networks and links, co-working space, mentoring, lab facilities and
advice are just a few examples of incubation assistance. Angel investors, economic
development coalitions, government agencies, venture capitalists and others frequently
seek them for nancing.

• Irrespective of the source of funding, it is observed that the entrepreneur has to follow
speci c steps to ensure funding. They are as follows:
• Assess the need and the readiness of the company before raising capital. It is especially
important for angel investors and VCs as they do their due diligence about the start-
up's history, transactions, and nature before investing.
• Get recognized by the Department for Promotion of Industry and Internal Trade (DPIIT)
and be incorporated for a?maximum of 2 years at the time of application.
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 • Get the company registered using Articles of Association, Memorandum of Association
and a company valuation report by an accredited chartered accountant.
• Apply for all registrations under the tax regime.
• Protect the intellectual property rights of the product.
• Conduct a board meeting, and an extraordinary general meeting (for allotment of
shares) to nalise upon funding.
• Prepare a detailed presentation about the start-up outlining all the important aspects12
and the utility of the product. This should be done after having researched a suitable
investor.
• Negotiate the nal deal according to the entrepreneur's needs without losing the deal.

What Happens After Being Approved?

For most of the funding rounds (excluding crowdfunding), both parties' post-selection
procedure is:
• Signing a Non-Disclosure Agreement (NDA)
• Drafting stock-purchase and voting agreements
• Due diligence by the investor
• Drafting the subscription or loan agreement
• Deciding the investment terms
• Formulating the term sheet on mutually decided terms.
• These can vary slightly according to the type of investor.

Stages of Startups and Source of Funding

A. Ideation : Pre-seed : This the stage where the entrepreneur has an idea and is
working on bringing it to life. At this stage, the amount of funds needed is usually small.
Additionally, at the initial stage in the startup lifecycle, there are very limited and mostly
informal channels available for raising funds.
1. Personal savings : Put your money where your mouth is and go ahead and fund those
early steps yourself. Investors will always try to gure out how invested you are in your
idea and funding your own startup is de nitely a good sign for them.

The business itself :The preferred startup funding source: let the business pay for itself
and grow your business from the revenue coming in. In reality, this is the best type of
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funding and it shows that your business is truly taking o . But your di culty here is
timing, as expenses typically come before revenue. Therefore you need to nd a way to
get cash up front. A great way to do this is by working with annual plans and prepaid
orders.Growing your business this way will allow you to keep total control and you’ll have
a constant reminder of the importance of sales.

2. Friends & Family : This is also a commonly utilized channel of funding by

entrepreneurs still in the early stages. The major bene t of this source of investment is
that there is an inherent level of trust between the entrepreneurs and the investors
3. Business Plan/Pitching Events : This is the prize money/grants/ nancial bene ts that
are provided by institutes or organizations that conduct business plan competitions
and challenges. Even though the quantum of money is not generally large, it is usually
enough at the idea stage. What makes the di erence at these events is having a good
business plan.

B. Validation : seed stage - A startup will need to conduct eld trials, test the product on
a few potential customers, onboard mentors, and build a formal team for which it can
explore the following funding sources:

1. Get Funding From Business Incubators & Accelerators - Incubators are organizations
set up with the speci c goal of assisting entrepreneurs with building and launching their
startups. Not only do incubators o er a lot of value-added services (o ce space, utilities,
admin & legal assistance, etc.), they often also make grants/debt/equity investments.
Early stage businesses can consider Incubator and Accelerator programs as a funding
option. Found in almost every major city, these programs assist hundreds of startup
businesses every year.
Though used interchangeably, there are few fundamental di erences between the two
terms. Incubators are like a parent to to a child, who nurture the business providing
shelter tools and training and network to a business. Accelerators so more or less the
same thing, but an incubator helps/assists/nurtures a business to walk, while accelerator
helps to run/take a giant leap.These programs normally run for 4-8 months and require
time commitment from the business owners. You will also be able to make good
connections with mentors, investors and other fellow startups using this platform.
In US, companies like Dropbox and Airbnb started with an accelerator – Y Combinator.
Here is a list of top 10 incubators & accelerators in US.In India, popular names are Amity
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 Innovation Incubator, AngelPrime, CIIE, IAN Business Incubator, Villgro, Startup Village
and TLabs.

2. Government scheme funding - example : Startup India Seed Fund Scheme

The government has initiated a few loan schemes to provide collateral-free debt to
aspiring entrepreneurs and help them gain access to low-cost capital such as the Startup
India Seed Fund Scheme and SIDBI Fund of Funds. A list of government schemes can be
found here. Developing a startup from scratch is a challenging task; in India, the startups
predominantly su er due to insu cient funds during the proof of concept phase. The
following points highlight the objective behind the SISFS:
• Providing adequate seed funds to the startups plays the role of multiplier e ect for
validating their business ideas, leading to exponential growth in employment
opportunities.
• The Startup India Seed Fund aims to transform India into a country with a robust startup
ecosystem in its Tier 2 & 3 cities, as the entrepreneurs in smaller cities cannot get the
required funding.
• This Startup Seed Fund Scheme will grant a capital of up to Rs. 5 Crores to the
quali ed incubators chosen through a select committee.
• These incubators will have the authority to give out grants with a maximum limit of Rs.
20 Lakhs to support the startups in their prototype development, product trials, or
proving their concept.

3. Get Angel Investment In Your Startup - Angel investors are individuals who invest their
money into high-potential startups in return for equity. Reach out to angel networks such
as Indian Angel Network, Mumbai Angels, Lead Angels, Chennai Angels, etc., or relevant
industrialists for this. Angel investors are individuals with surplus cash and a keen interest
to invest in upcoming startups. They also work in groups of networks to collectively
screen the proposals before investing. They can also o er mentoring or advice alongside
capital. Angel investors have helped to start up many prominent companies, including
Google, Yahoo and Alibaba. This alternative form of investing generally occurs in a
company’s early stages of growth, with investors expecting a upto 30% equity. They
prefer to take more risks in investment for higher returns. Angel Investment as a funding
option has its shortcomings too. Angel investors invest lesser amounts than venture
capitalists
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 4. Crowdfunding As A Funding Option - Crowdfunding is one of the newer ways of
funding a startup that has been gaining lot of popularity lately. It’s like taking a loan, pre-
order, contribution or investments from more than one person at the same time.
This is how crowdfunding works – An entrepreneur will put up a detailed description of his
business on a crowdfunding platform. He will mention the goals of his business, plans for
making a pro t, how much funding he needs and for what reasons, etc. and then
consumers can read about the business and give money if they like the idea. Those giving
money will make online pledges with the promise of pre-buying the product or giving a
donation. Anyone can contribute money toward helping a business that they really believe
in.

Why you should consider Crowdfunding as a funding option for your business:
The best thing about crowd funding is that it can also generate interest and hence helps
in marketing the product alongside nancing. It is also a boon if you are not sue if there
will be any demand for the product you are working on. This process can cut out
professional investors and brokers by putting funding in the hands of common people. It
also might attract venture-capital investment down the line if a company has a particularly
successful campaign.Also keep in mind that crowdfunding is a competitive place to earn
funding, so unless your business is absolutely rock solid and can gain the attention of the
average consumers through just a description and some images online, you may not nd
crowdfunding to work for you in the end.

Speci c provisions of the Startup India Fund allow an investment of up to Rs. 50 Lakhs to
enable the business for commercialisation, paving the way for market entry, or scaling up
the business through debt-linked nancial instruments or convertible debentures.

Raise Funds By Winning Contests - An increase in the number of contests has

tremendously helped to maximize the opportunities for fund raising. It encourages
entrepreneurs with business ideas to set up their own businesses. In such competitions,
you either have to build a product or prepare a business plan. Winning these competitions
can also get you some media coverage.

C. Early Traction : Series A stage - At the Early Traction stage startup’s products or
services have been launched in the market. Key performance indicators such as
customer base, revenue, app downloads, etc. become important at this stage. Funds are
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 raised at this stage to further grow the user base, product o erings, expand to new
geographies, etc. Common funding sources utilized by startups in this stage are:

1. Venture Capital Funds

Venture capital (VC) funds are professionally managed investment funds that invest
exclusively in high-growth startups. Each VC fund has its investment thesis – preferred
sectors, stage of the startup, and funding amount – which should align with your startup.
VCs take startup equity in return for their investments and actively engage in the
mentorship of their investee startups. This is where you make the big bets. Venture
capitals are professionally managed funds who invest in companies that have huge
potential. They usually invest in a business against equity and exit when there is an IPO or
an acquisition. VCs provide expertise, mentorship and acts as a litmus test of where the
organisation is going, evaluating the business from the sustainability and scalability point
of view.A venture capital investment may be appropriate for small businesses that are
beyond the startup phase and already generating revenues. Fast-growth companies like
Flipkart, Uber, etc with an exit strategy already in place can gain up to tens of millions of
dollars that can be used to invest, network and grow their company quickly.However,
there are a few downsides to Venture Capitalists as a funding option. VCs have a short
leash when it comes to company loyalty and often look to recover their investment within
a three- to ve-year time window. If you have a product that is taking longer than that to
get to market, then venture-capital investors may not be very interested in you.They
typically look for larger opportunities that are a little bit more stable, companies having a
strong team of people and a good traction. You also have to be exible with your
business and sometimes give up a little bit more control, so if you’re not interested in too
much mentorship or compromise, this might not be your best option.

2. Banks/Non-Banking Financial Companies (NBFCs) or Micro nance Providers - Formal

debt can be raised from banks and NBFCs at this stage as the startup can show market
traction and revenue to validate its ability to nance interest payment obligations. This is
especially applicable for working capital. Some entrepreneurs might prefer debt over
equity as debt funding does not dilute equity stake.- What do you do when you can’t
qualify for a bank loan? There is still an option. Micro nance is basically access of
nancial services to those who would not have access to conventional banking services.
It is increasingly becoming popular for those whose requirements are limited and credit
ratings not favoured by bank.Similarly, NBFCs are Non Banking Financial Corporations
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 are corporations that provide Banking services without meeting legal requirement/
de nition of a bank.Check MicroFinance Institute Network for more details. Here is a list
of top MicroFinance companies in India.

Raise Money Through Bank Loans - Normally, banks is the rst place that entrepreneurs
go when thinking about funding. The bank provides two kinds of nancing for businesses.
One is working capital loan, and other is funding. Working Capital loan is the loan required
to run one complete cycle of revenue generating operations, and the limit is usually
decided by hypothecating stocks and debtors. Funding from bank would involve the
usual process of sharing the business plan and the valuation details, along with the
project report, based on which the loan is sanctioned.Almost every bank in India o ers
SME nance through various programs. For instance, leading Indian banks – Bank Of
Baroda, HDFC, ICICI and Axis banks have more than 7-8 di erent options to o er
collateral free business loans. Check out the respective bank sites for more details.

3. Venture Debt Funds - Venture Debt funds are private investment funds that invest
money in startups primarily in the form of debt. Debt funds typically invest along with an
angel or VC round.

Debt funding - Rather than giving up equity in these early stages, there are several debt
funding options available. Bear in mind most high street banks are not interested in
signi cant business loans for start ups, these provide some alternatives. The best known
company in this space is Funding Circle and Silicon Valley Bank is also worth a mention
here.

- Asset-based nancing (debt) - Asset-based nancing works well for those companies
with clear and valuable assets - as the name suggests. These assets are then used as
collateral against a loan. This functions much like a mortgage: if you fail to make
repayments, the bank can take the assets. In practice, this funding instrument is often
used by companies with production facilities, or those in the sharing economy.

- Revenue-based nancing (debt) - Revenue-based nancing tied directly to marketing or

advertising spend, where the company can show a positive return on investment.
So if you can show that every euro you invest in advertising brings back two in return,
you’ll be able to borrow against this return.
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D. Scaling : Series B, C, D & E - At this stage, the startup is experiencing a fast rate of
market growth and increasing revenues. Common funding sources utilized by startups in
this stage are:
Venture Capital Funds - VC funds with larger ticket sizes in their investment thesis provide
funding for late-stage startups. It is recommended to approach these funds only after the
startup has generated signi cant market traction. A pool of VCs may come together and
fund a startup as well.
Private Equity/Investment Firms - Private equity/Investment rms generally do not fund
startups however, lately some private equity and investment rms have been providing
funds for fast-growing late-stage startups who have maintained a consistent growth
record.
Each of the stages listed above are commonly funded through equity nancing. This type
of capital is commonly raised through the sale of shares to institutional investors (VCs) or
angels; giving away equity in exchange for cash to enable growth. Equity nancing is
extremely common for startups due to the large number of angel syndicates and VC rms
looking to invest in high potential businesses, but is far from the only option available to
an ambitious startup.

E. Exit option :
• Mergers & Acquisitions : The investor may decide to sell the portfolio company to
another company in the market. In essence, it entails one company combining with
another, either by acquiring it (or part of it) or by being acquired (in whole or in part).
• Initial Public O ering (IPO) : IPO refers to the event where a startup lists on the stock
market for the rst time. Since the public listing process is elaborate and replete with
statutory formalities, it is generally undertaken by startups with an impressive track
record of pro ts and who are growing at a steady pace.
• Selling Shares : Investors may sell their equity or shares to other venture capital or
private equity rms.
• Buybacks : Founders of the startup may also buy back their shares from the fund/
investors if they have liquid assets to make the purchase and wish to regain control of
their company.

6.3 Approaches to SME Financing

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 Meaning : The Indian economy has bene ted from the growth of the Micro, Small &
Medium Enterprises (MSME) sector and this sector has emerged as one of the most
robust and dynamic sectors of the economy, according to the Ministry of Micro, Small &
Medium Enterprises. A small and medium-sized enterprise (SME) is no di erent than a
large corporation, except that it is one that generates revenues, and assets, and employs
fewer people. Small and medium-sized enterprises (SME) are de ned in every country
di erently, and each has its own rules about what constitutes an SME.

SME in India : Small and Medium Enterprises (SMEs) are common in India because the
country possesses a highly valued demographic dividend. As per Section 7 of the Micro,
Small and Medium Enterprises Development Act, 2006, small and medium enterprises are
de ned as : Investments in these sectors are used to classify them. A minimum of Rs. 1
crore and a maximum of Rs. 10 crores are required to invest in the small enterprise sector,
with a minimum of Rs. 5 crores and a maximum of Rs. 50 crores in revenue/turnover.
For medium-sized enterprises, investment criteria range from INR 10 crores to INR 50
crores, while turnover thresholds range from INR 50 crores to INR 100 crores.

Consequently, they are considered a signi cant component of both the manufacturing
and service sectors of the economy and are therefore imperative components of
secondary, tertiary, and quaternary sectors. Also, those enterprises are unrestricted in
their nature and type. As a result, there is a variety of SMEs such as proprietorships,
corporations, cooperatives, Hindu Undivided Families (HUF), partnerships, etc. A key
aspect of these provisions in India pertains to the fact that enterprises are not classi ed
as SMEs based on factors like the number of employed individuals or the quantity of
electricity they consume, as was done in the past and as is still done across the globe,
including most of the countries in the European Union (EU).

The present scenario of SME sector in India : In India, SMEs contribute nearly half of
the industrial output, 40% of exports, and generate one million jobs a year, and
approximately 45% of the industrial output in India is produced by them. These
enterprises produce over 8000 quality products that are exported to overseas markets.
SME numbers have risen to over 48 million in recent years, with a 4.5% growth rate. The
funds that target SMEs face several challenges, including a lack of resources to raise
money. The truth is that the government continues to ignore the importance of this sector
in boosting the GDP overall, even though it provides an impetus to it. An announcement,
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in October 2021, stated that the Government of India will o er small and medium
businesses up to 1 crore in loans with interest rates beginning at 8% within 59 minutes.
Increasing access to credit will be easier with this historic initiative that will develop the
MSME sector.
A new website has been launched to facilitate this and an integrated digital platform has
been created. Through this online portal, the MSME sector will be able to access loans in
a fully automated manner; i.e. the process of applying for a loan will now be completely
automated.
It used to take a month for the loans to be processed. With the new portal, the processing
time will now be reduced to less than a minute, after submitting all required documents.
Following this approval, the applicant will be disbursed with the loan within seven or eight
business days.
Several measures are being taken by the Indian Government to boost the manufacturing
sector. These measures are aimed at creating jobs and strengthening India’s economy. It
is extremely important because, in addition to directly generating employment, it can also
indirectly create employment.

Importance of SMEs : SMEs play an essential role in a nation’s economic development.

According to some authors (Leutkenhorst, 2004), SMEs contribute signi cantly to jobs
creation in developing countries because of the following reasons:
• Production via labour-intensive techniques: Producing goods and services in a more
labour-intensive manner than much larger enterprises, thus generating more
employment and distributing income more equitably.
• Providing more opportunities: SMEs provide more opportunities in an agricultural-based
economy than any other enterprise, as they encompass simple and value-added
processes in work.
• Promote entrepreneurship: SMEs contribute and support several entrepreneurial
activities.
• Development of a strong economic system: By leveraging the strengths of small and
large enterprises, SMEs improve the development of productive capacity and create
strong economic systems.

Why SMEs often complain about nances ?

SMEs often complain that the lack of nancing prevents them from capturing lucrative
investment opportunities and growing. Moreover, it is considered to be an extremely
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 di cult task to start even a small business from scratch, even if someone has a terri c
idea or a product that is highly innovative. The majority of SMEs look for lenders who can
help ease the cost of setting up their business. Yet, not every institution is helpful to new
business owners. This is the reason why SMEs face the problem of insu cient credit
availability in India. Small businesses face a nancing gap between what they can a ord
and what they can use for productive purposes. Understanding why this happens is
therefore vital.
• Firstly, it is important to realise that investors have a limited pool of funds. Investors
rarely have much left to invest after satisfying their needs and desires to spend and pay
their taxes. Secondly, investors’ funds are limited, thus, resulting in a competitive
market. In addition, governments and large companies acquire a large number of
allocated funds and, consequently, the SME sector su ers.
• Thirdly, SME sectors su er because they are perceived to have higher risk and
uncertainty levels than many others, which makes investing in them less attractive. The
following reasons can contribute to the above-mentioned:
• SMEs have an unproven track record in raising money and providing investors with
satisfactory returns.
• They frequently lack adequate internal controls and the external controls are also
usually minimal. Because of their size in the market and the economy, for example, they
are unlikely to attract a lot of attention from the press.
• The owner of such a smaller business is often the only one who can question his or her
decisions.Small businesses often have few tangible assets that can serve as collateral.

What is corporate nance and the associated ways of corporate nance

The function of corporate nance is to create capital for a company. Financing and
management steps that increase the company’s value are part of corporate nance. This
function serves as a conduit between the organisation and the capital markets.
Finance in corporations includes decisions made by companies that a ect their nances,
tools, and analyses aimed at prioritising and allocating resources. As a result, corporate
loans aim to maximise a business’s value by implementing resources and planning to
balance risk and pro tability.
There are many convenient options available to businesses when they need nancing.
Some of the options include :
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 1. Funds from internal sources: The majority of businesses prefer to fund their growth with
their internal resources, which primarily include cash and savings. It is better this way
since no money must be repaid or debts were taken on.The downside to internal funding
is that it drains your company’s cash ow. This can lead to cash ow problems. You may
also be unable to take advantage of opportunities if your business is sti ed.
2. Debt nancing: Debt nancing involves borrowing money from a nancial institution or
a bank. Credit cards, overdrafts, and loans are the most common ways to obtain credit.
Since no other party will share ownership of your business in the future, you will be able
to maintain control over your business and keep your pro ts. Tax-deductible interest is
another advantage. A major reason why organizations choose to nance their operations
through debt rather than equity is to safeguard the company’s value by preserving
ownership. The investor retains an ownership stake in the company, such as selling
common and preferred shares, as part of equity nancing. Lenders provide debt capital,
and in return, they are entitled to receive repayment plus interest. Consequently, business
owners have the opportunity to keep full ownership of their company and end their
obligations to their lender once the debt is repaid.
3. Equity nancing: Thirdly, equity nancing o ers funding in exchange for ownership of
the business. Investment professionals, such as venture capitalists and angel investors,
are two common types of investors.Since the investment is not a debt, this can be a
better option than debt nancing, but losing ownership and control of a part of your
business is one downside.

Regulatory/government initiatives for the advancement of SMEs

With the introduction of the Micro, Small & Medium Enterprises Development (MSMED)
Act in October 2006, India has taken numerous steps to promote the SME sector, such as
enhancing the investment in plants and pieces of machinery from INR 1 crore to INR 2.5
crore and encompassing trading activities in MSMEs.
In addition, the act substitutes the word ‘Enterprises’ for ‘Industry’ to refer to services
provided to MSMEs. The Nair Committee in its report dated 21st of February 2012
recommended that the threshold for investment in plant, machinery, and equipment for
Micro and Small Enterprises (MSEs) be increased from INR 50 Lacs for manufacturing
companies and INR 20 Lacs for services companies.
In 2000, the Indian Central Government launched a credit guarantee scheme that
provides guarantees against default for loans to SMEs, even if no collateral is provided,
up to 75 per cent of the lending bank’s credit loss. Unless the proposal meets the bank’s
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 credit requirements, even new companies could avail of this facility. Yet, despite the lapse
of considerable time, most banks are reluctant to o er free collateral-free loans to SMEs
despite the availability of this product for a long time.

SME Loans:
The loans that banks and other lending institutions o er to small and medium-sized
enterprises are known as SME loans. There are various loan schemes designed by banks
and nancial institutions speci cally for SMEs, each with a di erent set of terms and
conditions. Female entrepreneurs may have a special scheme. Furthermore, many of
these loans do not require collateral. The following banks o er di erent types of
schemes :
State Bank of India (SBI) : SME loan schemes o ered by the SBI are Cotton Ginning Plus,
Doctor Plus Scheme, Export Packing Credit, E Dealer/Vendor Finance Scheme, etc.
HDFC Bank : SME loan schemes o ered by the HDFC are Working Capital Finance,
Working Capital for Contractors, Working Capital for Transporters, Term Loans, business
loans, etc.
Axis Bank : SME loan schemes o ered by Axis Bank are MSE Power, Services Power,
SME Power, Business MPower Overdraft, Business MPower Term Loan, Power Rent, etc.
ICICI Bank : SME loan schemes o ered by ICICI Bank are cash credit/overdraft, export
credit, and term loans.

Government Scheme:
There are some schemes and programmes initiated by the Government of India for
supporting and encouraging SMEs besides bank loans. The Government has established
guidelines and processes with respect to who can avail of the scheme’s bene ts, as well
as the purpose of each scheme. Some of these schemes, amongst others, include :
Pradhan Mantri Mudra Yojana (PMMY),
Credit-Linked Capital Subsidy Scheme,
MSME Business Loan for Startups in 59 Minutes.

SME Resources:
In addition to raising capital for purchases of raw materials and nished goods, SMEs can
use various other sources of nancing. Some of these include merchant cash, invoice
nance, business credit score, and business credit card.
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 New approaches :
Many SMEs and startup businesses rely heavily on traditional bank loans in order to ful ll
their cash ow and investment needs. However, there are many ways or techniques of
getting external nances other than straight debt. Some of these techniques are:

1. Alternative debt di ers from traditional debt in that it does not involve banks. In fact,
investors from capital markets provide nance to borrowing companies or businesses.
Alternative forms of debt di er from traditional lending, in that investors in the capital
market, rather than banks, provide the nancing for SMEs. These include “direct” tools for
raising funds from investors in the capital market, such as corporate bonds, and “indirect”
tools, such as securitised debt and covered bonds. With alternative debt, the SME does
not access capital markets directly, but rather receives bank loans, whose extension is
supported by activities by the banking institutions in the capital market. hese instruments
have existed for some time, but they can be viewed as “innovative” nancing
mechanisms for SMEs and entrepreneurs, to the extent that they have had until now been
applied in a limited fashion to the SME sector.To obtain funds, an SME can issue or use
the following nancial instruments:
- Corporate Bonds (long-term debt instruments with a xed rate of return)
- Securitized Bonds (pooling of nancial assets and converting them into debt
instruments). Crowdfunding (funding a project by raising money from a large number of
people)

2. Asset-based Finance : Through this technique, SMEs can get nancing based on the
value of its current and non-current assets including merchandise inventory, debtors or
accounts receivables, equipment, machinery and real estate, instead of their own credit
standing. This technique is more suitable for startups and SMEs having di culties in
getting loans from banks. Asset-based lending also provides more exible terms and
conditions than collateralized bank loans. It has been expanding in recent years, in
countries with advanced nancial expertise and e cient legal systems.

3. Hybrid Instruments : Hybrid instruments combine features of both equity and debt
instruments into a single nancing vehicle. These instruments are an attractive form of
nance particularly for the entities undergoing restructuring, when the new opportunities
and their associated risks are increasing, a strong capital structure is required but access
to debt nancing is limited, or the owners do not want dilution of their control by issuing
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 equity instruments. Hybrid nancing instruments lie in the middle of the investors’ risk/
return spectrum, from “pure” debt to “pure” equity, combining features of both debt and
equity into a single nancing vehicle. These instruments di er from straight debt nance,
in so far as they imply greater sharing of risk and reward between the user of capital and
the investor. The latter accepts more risk than a provider of a senior loan and expects a
higher return, which implies a higher nancing cost for the rm. However, the risk and the
expected return are lower than in the case of equity, which thus implies the cost of
nancing for the enterprise is lower. In the event of insolvency, where the rm is unable to
meet all its contractual obligations, investors in hybrid instruments have lower rankings
than other creditors, but higher ranking than investors in “pure” equity capital.

Some of the most commonly used hybrid instruments include: i) subordinated debt (loans
or bonds); ii) participating loans, with pro t or earning participation mechanisms; iii) silent
participation; iv) convertible debt and warrants, whereby investors can convert debt into
stock, thus receiving a reward that re ects the increased value of the company enabled
by the capital provision, and; v) mezzanine nance, which combines two or more of these
instruments within a facility.

4. Equity Financing : Equity nance is used by the companies that seek long-term
nance, to sustain innovation, improve value creation and business growth. This form of
nancing is highly relevant for companies that have a high risk and return pro les. Equity
nance refers to all nancial resources that are provided to rms in return for an
ownership interest. Equity investors participate in the entrepreneurial risk, as no security
is provided by the investee company, and the investment return is entirely determined by
the success of the rm. Investors may sell their shares in the rm, if a market exists, or
they may get a share of the proceeds if the rm is sold. The main categories of equity
nance are private equity and public equity. Whereas public equity concerns companies
that are traded in some form of stock exchange, private equity investors provide capital to
unlisted companies. Also, while public equity investors are not generally involved in the
management of the company, private equity nanciers provide advice or assist the
owners or managers in the development of the rm.

5. Venture Financing : Venture nancing o ers an opportunity for SMEs to raise capital
and share risks. It usually comes from venture capital rms that specialize in creating a
high-risk portfolio and provide a good opportunity for SMEs to share the risks and gains
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 arising out of approved projects. The Credit BPO Rating Report is used as a measure of
an SME’s creditworthiness using nancial technology and is used by lenders for quicker
decision making and provision of nances. If you are an SME, our CreditBPO Rating
Report® will lay the groundwork for improving your competitiveness. CreditBPO is
dedicated to helping your business grow and succeed.

6. Crowdfunding : Crowdfunding is a technique to raise external nance from a large

audience, rather than a small group of specialised investors (e.g. banks, business angels,
venture capitalists), where each individual provides a small amount of the funding
requested. The concept of “crowdfunding” is related to the one of “crowdsourcing”,
which refers to the outsourcing to the “crowd” of speci c tasks, such as the
development, evaluation or sale of a product, by way of an open call over the internet
(Howe, 2008). Through online platforms, the task, traditionally performed by contractors
or employees, can be undertaken by individuals for free or in exchange for some
speci ed return, whose value is however generally lower than the one of the contribution
made to the rm. Crowdsourcers may in fact have intrinsic motivations, such as the
pleasure of undertaking the task or participating to a community, as well as extrinsic
motivations, related to monetary rewards, career bene ts, learning or dissatisfaction with
the current products. Crowdfunding is not only a mean to raise funds, but can also
represent an important mechanism to share information with a large public, increase
awareness about projects and products, seek feedback to improve them, and get
recognition which may help in future commercialisation

7. Traditional debt nance - bank loans, overdrafts, credit lines and the use of credit
cards- is the most common source of external nance for many SMEs and entrepreneurs.
The de ning characteristic of straight debt instruments is that they represent an
unconditional claim on the borrower, who must pay a speci ed amount of interest to
creditors at xed intervals, regardless of the nancial condition of the company or the
return on the investment. The interest rate may be xed or adjusted periodically according
to a reference rate. Straight debt does not include any features other than payment of
interest and repayment of principal, i.e. it cannot be converted into another asset, and
bank claims have high priority in cases of bankruptcy. In traditional debt nance, the
extension of the credit is primarily based on the overall creditworthiness of the rm and
the lender considers the expected future cash ow of the rm as the primary source of
repayment. However, the techniques to assess and monitor the rm’s creditworthiness,
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thus addressing the problem of information asymmetry between lender and borrower,
may vary signi cantly. Di erent lending technologies combine di erent sources of
information about the borrower, screening and underwriting procedures, structure of the
loan contracts, monitoring strategies and mechanisms.1

1 https://www.oecd.org/cfe/smes/New-Approaches-SME-full-report.pdf
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