MF0017 - Merchant Banking and Financial Services

Roll no.

Q1. Explain the functions of merchant banking and functions of financial intermediaries.
Answer: Functions of merchant banking: The following are the main functions of merchant banking: Issue management - The issue can be through offer of sale or private placements, prospectus, and so on. The issue management includes the following functions with respect to issue through prospectus: To obtain approval for the issue from the SEBI. To arrange underwriting for the proposed issue. To draft and finalize the prospectus and to obtain clearance from the stock exchange, auditors, underwriters and registrar of companies. To select registrar of the issue, advertising agencies, underwriters, bankers and brokers to the issue and finalize the charges to be paid to the registrar. To arrange press conferences, and investors and brokers through advertising agency. To finalize the terms of issue to make the issue more attractive. Pre-investment studies of investors - The merchant bankers undertake the practicality surveys in selected areas of clients interest. Pre-investment study covers the study of the project and includes the following aspects: Developing or reviewing of project profile. Preparing project reports after analyzing financial, market and economic feasibility. Estimating the cost of the project. Studying the procedural aspects of project implementation. Determining the source of financing and deciding the capital structure. Assisting in legal formalities for implementing the project. Corporate counseling - Corporate counseling refers to the activities undertaken to ensure effective running of a corporate enterprise through efficient management of finance. Corporate counseling is a facility provided by merchant bankers to corporate enterprises free of charge. The following are the areas in which the corporate counseling is provided: Area of diversification considering the Governments licensing and economic policies. Market analysis for growth, present and future demand, and profitability of each product produced by the corporate enterprise. Project counseling - A merchant banker provides the clients project counseling that involves providing advice on procedural aspects of project implementation, conducting financial study of the project, providing assistance in project profiles, providing

assistance in seeking approvals from Government of India for foreign technical and financial collaboration agreements. Loan syndication - A merchant banker helps the clients to get loan for the project. They also help in conducting appraisal and designing capital structure. Portfolio management - A merchant banker helps the clients in making the right choice of investment to obtain optimum investment, undertaking investment in securities conducting critical evaluation of investment portfolio, and so on. Project finance - A merchant banker who undertakes a project scheme also assists in arranging a comprehensive package for the project funding. The merchant bankers work closely with the client and the technical consultant and submit a complete financial report to the client. They also provide assistance in legal documentation for the finance arranged. Working capital - Merchant bankers assist in arranging finance for working capital particularly for new ventures. For existing firms, the merchant bankers arrange the funds from non-traditional sources such as through issue of debentures. Managerial and technical services Merchant bankers provide services to deal with problems in technical, financial and managerial fields. Functions of financial intermediaries Financial intermediation is a process by which capital is mobilized from a large number of investors and is made available to all those who need them, mainly to corporate customers. Merchant banking is a financial intermediary which helps to transfer capital from one who owns it to those who require it. Many companies approach merchant banks to enhance their financial stability or to meet an essential capital requirement. Due to their knowledge in international finances, merchant banks specialize in dealing with multinational corporations. Merchant banks do not offer regular banking services to the public.

Q2. What do you understand by book building and Green shoe option? Explain the book building guidelines.
Answer: Book Building: Book-building is a process to generate, capture and record investors demands for securities proposed to be issued. The price of the securities is assessed to determine the quantum of such securities to be issued through notice, documents, advertisement or offer document. Book-building is a process commonly used in developed countries and the complete procedure is done online. Through this process the investors can view the chart that shows the bid price and the number of shares being bid for. This helps the investors to know the market price. Green shoe option:

Green Shoe Option (GSO) is an option where a company can retain a part of the oversubscribed capital by issuing additional shares. Oversubscription is a situation when a new stock issue has more buyers than shares to meet their orders. This excess demand over supply increases the share price. There is another situation called under subscription. In under subscription, a new stock issue has fewer buyers than the shares available. The stabilizing agent stabilizes the price for a period of 30 days from the date of listing as authorized by the SEBI. Book building guidelines: A company that intends to issue capital through book-building has to follow the bookbuilding guidelines. The following are the guidelines for book building: 75 percent book-building - The option for 75 percent book building is available in an issue of securities to the public though prospectus and is available to all the corporate that eligible to make issue of capital to the public. Here the issue is classified into two parts: Placement part - The placement part of the issue is offered to the public through the syndicate through the book building process. Public part - The public part is the offer to the public. It is responded by retail offering. The price agreed in the book building process is applicable to the public offer. The prospectus must specify the price band within which the securities are offered for subscription. 100 percent book-building - The SEBI has permitted the issuers to go for 100 percent book-building without offloading any portion of the issue in the market. In 100 percent book building, the entire issue is completed in a single stage without making a fixed price offering. This type of book building can accelerate the public offering and allotment process as it takes place entirely through the stock exchange network. The SEBI approved the process of book building in pricing new issues in November 1, 1995. According to the SEBI guidelines, the option of 100 percent book building is only available to those issuer companies which made an issue capital of Rs.100 crore and above. The guidelines were later modified in 1998 to 1999. In April 2000, the SEBI modified the guidelines for the 100 percent book building process As the maximum of 60 percent of the issue was permitted to be allotted to institutional investors, 15 percent to non-institutional investors who applied for 1000 shares and the remaining 25 percent were allotted to small investors on a pro-rate basis.

Q3. Explain the roles and responsibilities of custodian services. Write down the code of conduct prescribed by SEBI.
Answer: Roles and responsibilities of custodians: The SEBI regulations prescribe the roles and responsibilities of the custodians. According to the SEBI the roles and responsibilities of the custodians are to:

Administrate and protect the assets of the clients. Open a separate custody account and deposit account in the name of each client. Record assets. Conduct registration of securities. Segregate securities and cash belonging of each client from others including custodian himself. Take adequate insurance of risks. Maintain records manually or in machine readable form. State clearly the method and system of receiving instructions from the client regarding collection, receipt, reporting and delivery of securities. Conduct verification of securities and to follow the stated control mechanism. Mention specifically the fees charged in the agreement. Conduct audit annually. The custodian should have an adequate internal control system to prevent the manipulation of records and documents, which includes audit for securities and entitlements arising from securities, and held on behalf of the clients. On behalf of the client, the custodians have to maintain records and documents such as details of securities, money received and released registration of securities, and all reports submitted to the SEBI. The SEBI is authorized to conduct inspection or investigation of accounts, documents or records of the custodians to ensure that the provisions of the SEBI Act and regulations are followed. In case of default, the SEBI can suspend or cancel registration of a custodian. Code of conduct by SEBI: Every registered custodian must follow the code of conduct prescribed by SEBI. The following are the code of conduct prescribed by SEBI: Integrity - The custodian of securities must maintain high standards of integrity and professionalism while discharging duties. Prompt distribution - The custodian of securities must be prompt in distributing interests and dividends collected by him, on behalf of his clients on the securities held in custody. Infrastructure - The custodian of securities must establish and maintain suitable infrastructure to discharge custodial services to the satisfaction of the clients. The operating procedures and systems of the custodian of securities need to be well documented. Accountability - The custodian of securities is responsible for the movement of securities. The movement of securities can be from custody account, deposit and withdrawal of cash from the clients account. Confidentiality - The custodian of securities has to maintain confidentiality regarding the client.

 Precautions - The custodian of securities must take necessary precautions to ensure that continuity in custodial records is not lost or destroyed. To maintain sufficient backup records, the custodial records are kept electronically. Records - The custodian of securities must create and maintain records of securities held in custody appropriately. This must be done to locate securities or obtain duplicate documents easily if the original records are lost due to any reason. Cooperation - The custodian of securities must cooperate with other custodial entities and depositories which are necessary for the conduct of business, especially in the areas of inter custodial settlements and transfer of securities and funds. Diligence - The custodian of securities must exercise diligence in administrating and safekeeping the clients assets which are in his custody.

Q4. Explain the leases in the financial statements in case of lessees and lessors.
Answers: Leases in the financial statements of lessees: Operating lease: In an operating lease, the lease payments are recognized as an expenditure on a straightline basis over the lease term, unless another organized basis is more representative of the pattern of the users benefit. The incentives in operating leases will be in the form of up-front payments and rent-free periods. These need to be properly noticed over the lease term from its commencement. Finance lease: At the initiation of the lease term, lessees identify finance leases as assets and liabilities in their balance sheets on sum equal to the value of the leased asset or, if lower, on the current value of the minimum lease payments. The discount rate in calculating the current value of the minimum lease payments is the interest rate contained in the lease, if this is possible to determine. Else, the lessees incremental borrowing rate can be used. Any initial direct costs of the lessee are included to the amount identified as an asset. After the initial recognition, the lease payments are assigned between the repayment of the outstanding liability and the finance charge in order to reflect a constant periodic rate of interest on the liability. The asset needs to be depreciated over its expected useful life under IAS 16, using rates for similar assets. If there is no reasonable certainty that ownership will transfer to the lessee, then the shorter of the lease term and the useful life must be used. Leases in the financial statements of lessors: Operating lease: Lessors present assets under operating leases in their balance sheets based on the nature of the asset. The depreciation policy for depreciable leased assets will be consistent with the lessors normal depreciation policy for related assets, and depreciation is calculated in

accordance with International Accounting Standard (IAS 16 and IAS 38). Lease income from operating leases is identified in income on a straight-line basis over the lease term, unless another organized basis is more representative of the pattern in which user benefit derived from the leased asset is reduced. Finance lease: Lessors recognize assets held under a finance lease in their balance sheets and present them as a receivable on an amount equal to the net investment in the lease. The identification of finance income is based on a pattern showing a periodic rate of return on the lessors net investment in the finance lease. The dealer lessors recognize selling profit or loss in the period, based on the policy followed by the entity for outright sales. If low rates of interest are quoted, selling profit will be restricted which would apply if a market rate of interest were charged. Costs incurred by manufacturer or dealer lessors associated with negotiating and arranging a lease will be recognized as an expense when the selling profit is identified.

Q5. Give the meaning and characteristics of Hire Purchase finance. Differentiate between Hire Purchase Vs. Installment and Hire Purchase Vs. Leasing.
Answer: Hire Purchase finance: Hire purchase finance is a means of financing for purchase of goods or equipment to sell at a future date. In this transaction, the goods hired and the purchase price is paid on installments. The hirer has a choice to purchase the goods by paying all the installments. The following are the terms and conditions for hire purchase finance: The payment is made in installments for a specific period of time. The hirer gets the possession of goods at the time of entering the contract. The hirer gets the ownership of goods on payment of the last installment. In case of default in payment of installment, the seller is entitled to possess the goods. The hirer or purchaser is free to return the goods without being required to pay any further installments falling due after the return. Characteristics of hire-purchase: The following are the characteristics of hire purchase: The vendor transfers the possession of goods to the hirer after the contract for hire purchase is made. The goods are delivered to the hirer on the condition that he should pay the agreed amount in periodical installments. Each installment consists of the capital payment and the interest.

The ownership of the goods is transferred to the hirer at the time of payment of the last installment. The hirer has the right to terminate the agreement any time. Hire-purchase vs. installment: The hire purchase contract is different from installment payment sale. In installment sale the ownership of the goods is passed to the buyer on payment of the first installment. In case of hire purchase contract the ownership is passed on to the hirer on payment of the last installment. In the installment payment sale, in case of default in the payment of an installment, the goods cannot be taken back by the vendor. The vendor can file a suit for the recovery of the balance amount. In hire purchase contract, in case of default in the payment of any installment, the vendor can reclaim the goods and forfeit all the installments paid as hire charges. Hire-purchase vs. leasing: Hire-purchase and leasing financing differ in the following ways: Ownership - In hire-purchase financing, the ownership of the asset is with the finance company (vendor). After the payment of the last installment, the ownership is passed on to the hirer. In leasing, the lessor is the owner of the asset and the lessee is allowed to use the leased equipment. The ownership is not transferred to the lessee. Tax benefits - In hire-purchase, the hirer is allowed the depreciation claim and the finance charge. The seller can claim any interest on borrowed funds to obtain the asset for tax purposes. In leasing, the lessor is allowed to claim depreciation and the lessee is allowed to claim the rentals and maintenance cost against taxable income. Depreciation - The hirer is entitled to the depreciation shield on assets hired by him. In leasing, the depreciation on the asset is charged in the books of the lessor. Maintenance cost - The maintenance cost of the hired asset is borne by the hirer. In finance leasing, the maintenance of the leased assets is the responsibility of the lessee. In operating lease, the lessor bears the maintenance cost of the assets.

Q6. Explain the money market products.

Answer: Money Market Products: Money market provides the market for short-term financial instruments. The returns of money market instruments are low but they are the safest investments. Money market is an essential part of the economy. It plays a major role in the development of the economy. The RBI introduced financial sector reforms to make money market broad-based and integrated. The important money market products are: Call/notice money - The call/notice money is the money borrowed or lent on demand for a short period. The money borrowed or lent for a day is known as call (overnight) money. Holidays and Sunday are excluded for this purpose. It is money that is borrowed on a day

and repaid on the next working day. The money borrowed or lent for more than a day and up to 14 days is known as notice money. Collateral security is not required to cover these transactions. The participants of call/notice money market are banks, development finance institutions and insurance companies. Banks can operate as a borrower and lender in the market. The non-banks institutions are given specific permission to operate in call/notice money market as lenders only. Treasury bills - Treasury bills (T-bills) are the money market instruments that are used to finance the short-term requirements of the Government of India. The maturity of Tbills is of one year. As T-bills are highly liquid in nature and can be sold at any time, investors prefer to hold them instead of holding cash. The difference between the maturity value and issue price is the return to the investor. T-bills play a key role in the cash management of the Government. T-bills are risk-free instruments and their yields at various maturities serve as bench mark and help in pricing different floating rates instruments in the market. Commercial bills - Commercial bill is a short term, self-liquidating, negotiable, low risk instrument. Bills of exchange that are drawn by the seller (drawer) on the buyer (drawee) for the value of the goods delivered by him are called trade bills. When trade bills are accepted by commercial banks it is called commercial bills. If the seller is need of funds during the currency of the bill, he can approach the bank for discounting the bill. Discounting commercial bills at negotiated discount rate is a method used by banks for providing credit to customers. Money market mutual funds - Money market mutual fund is a channel through which investors can earn market related yield from investment in money market instruments. Mutual fund is a fund managed by an investment company that collects money from the shareholders and invests in assets. Money market mutual fund is a mutual fund which invests only in money markets. These funds invest in short term debt obligations such as treasury bills and commercial paper. These funds are liquid investments and are used by financial institutions to store money that is not invested. Commercial paper - Commercial paper investments are unsecured promissory notes issued by corporations. Promissory note is a document signed by a borrower promising to repay a loan under an agreement. Companies issue commercial paper (CP) to finance seasonal cash flow and working capital needs at lower rates. CP is issued in one, two and three month terms. It is highly liquid and can be sold at any time. Investors buy CP because this investment provides the highest return compared to other short-term alternatives such as T-bills. Investment is CP is secure because companies issuing the notes are large.