MODUEL-3 CAPITAL BUDGETING

Principles of Capital Budgeting

1. Decisions are based on cash flow not accounting income

The capital budgeting decisions are based on the cash flow forecasts instead of relying on the
accounting income. These are the incremental cash flows, that is, the additional cash flow that will
occur if the project is undertaken compared to if the project is not undertaken. While estimating these
cash flows certain costs such as the sunk cost will be ignored. This is because sunk cost is the cost that
is already incurred whether the project is undertaken or not. Similarly any intangible costs and benefits
are ignored.

The investment analysis should also account for any externalities. An externality refers to the effect
of the project/investment on other things than the project itself. A common externality
is cannibalization, where a new project reduces the cash flow of another project. This is a negative
externality. A project can also have a positive externality where a new project has positive effect on
the revenue from another project.

2. Timing of cash flow

Another important aspect of the analysis is to estimate the timing of cash flow as accurately as possible.
As the capital budgeting analysis uses the concept of time value of money, the time at which the cash
flow occurs significantly impacts the present value of the project. The earlier the cash flow occurs the
more valuable it is.

3. Opportunity cost should be considered

The project analysis should include opportunity costs. Opportunity cost is the cash flow that the
company loses because of undertaking the new project.

4. Cash flow should be adjusted for taxes

After-tax cash flow should be used for capital budgeting analysis.

5. Financing Costs Should be Ignored

Financing costs should not be included in the cash flow. Analysts will take the after-tax operating cash
flows and will discount them using the required rate of return to arrive at the net present value. The
financing costs are already reflected in the required rate of return and the cash flow should not be
adjusted for the same, irrespective of whether the project is financed using equity, debt or a
combination of both.

A project may have conventional or unconventional cash flow pattern. In case of a conventional cash
flow pattern, there is an initial outflow of cash followed by one or more cash inflows. In case of
unconventional cash flows, there could be a series of cash inflows and outflows at different times.

Capital Budgeting: Meaning, Importance and Type

Meaning - Capital budgeting, and investment appraisal, is the planning process used to determine
whether an organization's long term investments such as new machinery, replacement of machinery,
new plants, new products, and research development projects are worth the funding of cash through
the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating
resources for major capital, or investment, expenditures.[1] One of the primary goals of capital
budgeting investments is to increase the value of the firm to the shareholders.

Importance

1. Long-term Implications of Capital Budgeting: A capital budgeting decision has its effect over a
long time span and inevitably affects the company’s future cost structure and growth. A wrong
decision can prove disastrous for the long-term survival of firm. On the other hand, lack of investment
in asset would influence the competitive position of the firm. So the capital budgeting decisions
determine the future destiny of the company.

2. Involvement of large amount of funds in Capital Budgeting: Capital budgeting decisions need
substantial amount of capital outlay. This underlines the need for thoughtful, wise and correct
decisions as an incorrect decision would not only result in losses but also prevent the firm from earning
profit from other investments which could not be undertaken.

3. Irreversible decisions in Capital Budgeting: Capital budgeting decisions in most of the cases are
irreversible because it is difficult to find a market for such assets. The only way out will be scrap the
capital assets so acquired and incur heavy losses.

4. Risk and uncertainty in Capital budgeting: Capital budgeting decision is surrounded by great
number of uncertainties. Investment is present and investment is future. The future is uncertain and
full of risks. Longer the period of project, greater may be the risk and uncertainty. The estimates about
cost, revenues and profits may not come true.

5. Difficult to make decision in Capital budgeting: Capital budgeting decision making is a difficult
and complicated exercise for the management. These decisions require an over all assessment of future
events which are uncertain. It is really a marathon job to estimate the future benefits and cost correctly
in quantitative terms subject to the uncertainties caused by economic-political social and technological
factors.

6. Large and Heavy Investment: The proper planning of investments is necessary since all the
proposals are requiring large and heavy investment. Most of the companies are taking decisions with
great care because of finance as key factor.

7. Permanent Commitments of Funds: The investment made in the project results in the permanent
commitment of funds. The greater risk is also involved because of permanent commitment of funds.

8. Long term Effect on Profitability: Capital expenditures have great impact on business profitability
in the long run. If the expenditures are incurred only after preparing capital budget properly, there is a
possibility of increasing profitability of the firm.
9. Complicacies of Investment Decisions: Generally, the long term investment proposals have more
complicated in nature. Moreover, purchase of fixed assets is a continuous process. Hence, the
management should understand the complexities connected with each projects.
10. Maximize the worth of Equity Shareholders: The value of equity shareholders is increased by
the acquisition of fixed assets through capital budgeting. A proper capital budget results in the
optimum investment instead of over investment and under investment in fixed assets. The management
chooses only most profitable capital project which can have much value. In this way, the capital
budgeting maximize the worth of equity shareholders.

11. Difficulties of Investment Decisions: The long term investments are difficult to be taken because
decision extends several years beyond the current account period, uncertainties of future and higher
degree of risk.

12. Irreversible Nature: Whenever a project is selected and made investments as in the form of fixed
assets, such investments is irreversible in nature. If the management wants to dispose of these assets,
there is a heavy monetary loss.

13. National Importance: The selection of any project results in the employment opportunity,
economic growth and increase per capita income. These are the ordinary positive impact of any project
selection made by any company.

Type - Generally the business firms are confronted with three types of capital budgeting
decisions.

1. Accept-reject decisions: Business firm is confronted with alternative investment proposals. If the
proposal is accepted, the firm incur the investment and not otherwise. Broadly, all those investment
proposals which yield a rate of return greater than cost of capital are accepted and the others are
rejected. Under this criterion, all the independent proposals are accepted.

2. Mutually exclusive decisions: It includes all those projects which compete with each other in a
way that acceptance of one precludes the acceptance of other or others. Thus, some technique has to
be used for selecting the best among all and eliminates other alternatives.
3. Capital rationing decisions: Capital budgeting decision is a simple process in those firms where
fund is not the constraint, but in majority of the cases, firms have fixed capital budget. So large amount
of projects compete for these limited budgets. So the firm rations them in a manner so as to maximize
the long run returns. Thus, capital rationing refers to the situations where the firm has more acceptable
investment requiring greater amount of finance than is available with the firm. It is concerned with the
selection of a group of investment out of many investment proposals ranked in the descending order
of the rate or return.

Capital Budgeting Process/Steps Involved

A) Project identification and generation: The first step towards capital budgeting is to generate a
proposal for investments. There could be various reasons for taking up investments in a business. It
could be addition of a new product line or expanding the existing one. It could be a proposal to either
increase the production or reduce the costs of outputs.

B) Project Screening and Evaluation: This step mainly involves selecting all correct criteria’s to
judge the desirability of a proposal. This has to match the objective of the firm to maximize its market
value. The tool of time value of money comes handy in this step.
Also the estimation of the benefits and the costs needs to be done. The total cash inflow and outflow
along with the uncertainties and risks associated with the proposal has to be analyzed thoroughly and
appropriate provisioning has to be done for the same.

C) Project Selection: There is no such defined method for the selection of a proposal for investments
as different businesses have different requirements. That is why, the approval of an investment
proposal is done based on the selection criteria and screening process which is defined for every firm
keeping in mind the objectives of the investment being undertaken.
Once the proposal has been finalized, the different alternatives for raising or acquiring funds have to
be explored by the finance team. This is called preparing the capital budget. The average cost of funds
has to be reduced. A detailed procedure for periodical reports and tracking the project for the lifetime
needs to be streamlined in the initial phase itself. The final approvals are based on profitability,
Economic constituents, viability and market conditions.

D) Implementation: Money is spent and thus proposal is implemented. The different responsibilities
like implementing the proposals, completion of the project within the requisite time period and
reduction of cost are allotted. The management then takes up the task of monitoring and containing
the implementation of the proposals.

E) Performance review: The final stage of capital budgeting involves comparison of actual results
with the standard ones. The unfavorable results are identified and removing the various difficulties of
the projects helps for future selection and execution of the proposals.

Role of Financial Manager

Some of the major functions of a financial manager are as follows: 1. Estimating the Amount of Capital
Required 2. Determining Capital Structure 3. Choice of Sources of Funds 4. Procurement of Funds 5.
Utilisation of Funds 6. Disposal of Profits or Surplus 7. Management of Cash 8. Financial
Control.Financial Manager is the executive who manages the financial matters of a business.

1. Estimating the Amount of Capital Required:

This is the foremost function of the financial manager. Business firms require capital for:

 purchase of fixed assets,

 meeting working capital requirements, and
 modernisation and expansion of business.

The financial manager makes estimates of funds required for both short-term and long-term.
2. Determining Capital Structure:
Once the requirement of capital funds has been determined, a decision regarding the kind and
proportion of various sources of funds has to be taken. For this, financial manager has to determine
the proper mix of equity and debt and short-term and long-term debt ratio. This is done to achieve
minimum cost of capital and maximise shareholders wealth.

3. Choice of Sources of Funds:

Before the actual procurement of funds, the finance manager has to decide the sources from which the
funds are to be raised. The management can raise finance from various sources like equity
shareholders, preference shareholders, debenture- holders, banks and other financial institutions,
public deposits, etc.

4. Procurement of Funds:
The financial manager takes steps to procure the funds required for the business. It might require
negotiation with creditors and financial institutions, issue of prospectus, etc. The procurement of funds
is dependent not only upon cost of raising funds but also on other factors like general market
conditions, choice of investors, government policy, etc.

5. Utilisation of Funds:
The funds procured by the financial manager are to be prudently invested in various assets so as to
maximise the return on investment: While taking investment decisions, management should be guided
by three important principles, viz., safety, profitability, and liquidity.

6. Disposal of Profits or Surplus:

The financial manager has to decide how much to retain for ploughing back and how much to distribute
as dividend to shareholders out of the profits of the company. The factors which influence these
decisions include the trend of earnings of the company, the trend of the market price of its shares, the
requirements of funds for self- financing the future programmes and so on.

7. Management of Cash:
Management of cash and other current assets is an important task of financial manager. It involves
forecasting the cash inflows and outflows to ensure that there is neither shortage nor surplus of cash
with the firm. Sufficient funds must be available for purchase of materials, payment of wages and
meeting day-to-day expenses.

8. Financial Control:
Evaluation of financial performance is also an important function of financial manager. The overall
measure of evaluation is Return on Investment (ROI). The other techniques of financial control and
evaluation include budgetary control, cost control, internal audit, break-even analysis and ratio
analysis. The financial manager must lay emphasis on financial planning as well.

MODULE – 4 ISSUE AND PRICE FIXING

Credit Rating

A credit rating is an evaluation of the credit risk of a prospective debtor (an individual,
a business, company or a government), predicting their ability to pay back the debt, and an implicit
forecast of the likelihood of the debtor defaulting. The credit rating represents an evaluation of a credit
rating agency of the qualitative and quantitative information for the prospective debtor, including
information provided by the prospective debtor and other non-public information obtained by the
credit rating agency's analysts.

A credit reporting (or credit score) – in distinction to a credit rating – is a numeric evaluation of an
individual's credit worthiness, which is done by a credit bureau or consumer credit reporting agency.
When you use credit, you are borrowing money that you promise to pay back within a specified period
of time. A credit score is a statistical method to determine the likelihood of an individual paying back
the money he or she has borrowed.

The credit bureaus that issue these scores have different evaluation systems, each based on different
factors. Some may take into consideration only the information contained in your credit report, which
we look at below. The primary factors used to calculate an individual's credit score are his or her credit
payment history, current debts, time length of credit history, credit type mix and frequency of
applications for new credit. Because the scoring systems are based on different criteria which are
weighted differently, the three major credit bureaus in the U.S. (Equifax, TransUnion, and Experian)
may issue differing scores for an individual, even though the scores are based on the same credit report
information.

You may hear the term FICO score in reference to your credit score - the terms are essentially
synonymous. FICO is an acronym for the Fair Isaacs Corporation, the creator of the software used to
calculate credit scores.

Purpose of Credit Rating

(1) Lower cost of borrowing: A company with highly rated instrumet has the opportunity to reduce
the cost of borrowing from the public by quoting lesser interest on fixed deposits or debentures or
bonds as the investors with low risk preference would come forward to invest in safe securities though
yielding marginally lower rate of return.
(2) Wider audience for borrowing: A company with a highly rated instrument can approach the
investors extensively for the resource mobilisation using the press media. Investors in different strata
of the society could be attracted by higher rated instrument as the investors understands the degree of
certainty about timely payment of interest and principal on a debt instrument with better rating.
(3) Rating as marketing tool: Companies with rated instrument improve their own image and avail
of the rating as a marketing tool to create better image in dealing with its customers feel confident in
the utility products manufactured by the companies carrying higher rating for their credit instruments.
(4) Reduction of cost in public issues: A company with higher rated instrument is able to attract the
investors and with least efforts can raisefunds. Thus, the rated company can economise and minimise
cost of public issues by controlling expenses on media coverage, conferences and other publicity stunts
and gimmicks. Rating facilitates best pricing and timing of issues.
(5) Motivation for growth: Rating provides motivation to the company for growth as the promotors
feel confident in their own efforts and are encouraged to undertake expansion of their operations or
new projects.
With better image created though higher credit rating the company can mobilise funds from public
and instructions or banks from self assessment of its own status which is subject to self-discipline and
self-improvement, it can perceive and avoid sickness.
(6) Unknown issuer: Credit rating provides recognition to a relatively unknown issuer while entering
into the market through wider investor base who rely on rating grade rather than on ‘name recognition’.
(7) Benefits to brokers and financial intermediaries: Highly rated instruments put the brokers at
an advantage to make less efforts in studying the company’s credit position to convince their clients
to select an investment proposal.
This enables brokers and other financial intermediaries to save time, energy, costs and manpower in
convincing their clients about investment in any particular instrument.

Procedure for Credit Rating

Generally, CRA follows the following procedure/process for credit rating:

 Seek information required for the rating from the company
 On receipt of required information, have discussion with the company’s management and
visit the company’s operating locations, if required.
 Prepare an analytical assessment report.
 Present the analysis to a committee comprising senior executives of the concerned CRA
 The aforesaid committee would discuss all relevant issues and assign a rating
 Communicate the rating to the company along with an assessment report outlining the
rationale for the rating assigned

IPO Grading : Concept

It is a rating assigned by the Securities and Exchange Board of India-registered credit rating agencies
to initial public offerings (IPOs) of various firms. The grade indicates an assessment of business
fundamentals and market conditions in comparison to other listed equities at the time of the issuance.
These ratings are generally assigned on a five-point scale, with a higher score indicating stronger
companies. IPO grading can be done either before filing the draft offer documents or thereafter.
However, the red herring prospectus must have the grades given by all the rating agencies.

A company which has filed the draft offer document for an IPO on or after May 1, 2007, must be rated
by at least one agency. Companies cannot reject the grade. If dissatisfied, they can opt for another
agency. But, all grades obtained for the IPO must be disclosed to the regulator and the investors.
IPO grading was introduced to make additional information about unlisted companies or those without
any track record of their performance available to the investors, helping them assess the issue before
investing and burning their fingers. Grading is additional investor information and assistance to enable
informed investment decisions and more realistic pricing of shares. It helps issuing companies in that
if they are given a higher score — indicating stronger fundamentals — they command a higher
premium for their issue. IPO grading by a professional credit rating agency informs investors about
the issuing company after analysing factors like business and financial prospects, management quality
and corporate governance practices etc. The grade is not a recommendation to subscribe to the IPO. It
needs to be read with the disclosures, including risk factors
Procedure for IPO Grading
Credit Rating agencies (CRAs) registered with SEBI will carry out IPO grading.

SEBI does not play any role in the assessment made by the grading agency. The grading is intended
to be an independent and unbiased opinion of that agency.

It is intended that IPO fundamentals would be graded on a five point scale from grade 5 (indicating
strong fundamentals) to grade 1 (indicating poor fundamentals). The grade would read as: “Rating
Agency name” IPO Grade 1 viz. CARE IPO Grade 1, CRISIL IPO Grade 1 etc.

The assigned grade would be a one time assessment done at the time of the IPO and meant to aid
investors who are interested in investing in the IPO. The grade will not have any ongoing validity.

The company needs to first contact one of the grading agencies and mandate it for the grading exercise.
The agency would then follow the process outlined below.

 Seek information required for the grading from the company.

 On receipt of required information, have discussions with the company’s management and visit
the company’s operating locations, if required.

 Prepare an analytical assessment report.

 Present the analysis to a committee comprising senior executives of the concerned grading
agency. This committee would discuss all relevant issues and assign a grade.
  Communicate the grade to the company along with an assessment report outlining the rationale
for the grade assigned.

Though this process will ideally require 2-3 weeks for completion, it may be a good idea for companies
to initiate the grading process about 6-8 weeks before the targeted IPO date to provide sufficient time
for any contingencies.

Public Issue

A public offering is the offering of securities of a company or a similar corporation to the public.
Generally, the securities are to be listed on a stock exchange. In most jurisdictions, a public offering
requires the issuing company to publish a prospectus detailing the terms and rights attached to the
offered security, as well as information on the company itself and its finances. Many
other regulatory requirements surround any public offering and they vary according to jurisdiction.

Initial public offering (IPO) is one type of public offering. Not all public offerings are IPOs. An IPO
occurs only when a company offers its shares (not other securities) for the first time for public
ownership and trading, an act making it a public company. However, public offerings are also made
by already-listed companies. The company issues additional securities to the public, adding to those
currently being traded. For example, a listed company with 8 million shares outstanding can offer to
the public another 2 million shares. This is a public offering but not an IPO. Once the transaction is
complete, the company will have 10 million shares outstanding. Non-initial public offering of equity
is also called seasoned equity offering.

A shelf prospectus is often used by companies in exactly that situation. Instead of drafting one before
each public offering, the company can file a single prospectus detailing the terms of many different
securities it might offer in the next several years. Shortly before the offering (if any) actually takes
place, the company informs the public of material changes in its finances and outlook since the
publication of the shelf prospectus.

Other types of securities, besides shares, can be offered publicly. Bonds, warrants, capital notes and
many other kinds of debt and equity vehicles are offered, issued and traded in public capital markets.
A private company, with no shares listed publicly, can still issue other securities to the public and have
them traded on an exchange. A public company, of course, may also offer and list other securities
alongside its shares.
Most public offerings are in the primary market, that is, the issuing company itself is the offerer of
securities to the public. The offered securities are then issued (allocated, allotted) to the new owners.
If it is an offering of shares, this means that the company's outstanding capital grows. If it is an offering
of other securities, this entails the creation or expansion of a series (of bonds, warrants, etc.). However,
more rarely, public offerings take place in the secondary market. This is called a secondary market
offering: existing security holders offer to sell their stake to other, new owners, through the stock
exchange. The offerer is different from the issuer (the company). A secondary market offering is still
a public offering with much the same requirements, including a prospectus.

The services of an underwriter are often used to conduct a public offering

a) Common condition and eligibility requirement Any issuer offering specified securities
through a public issue or rights issue shall satisfy the conditions of this Chapter at the time of
filing draft offer document with the Board (unless stated otherwise in this Chapter) and at the
time of registering or filing the final offer document with the Registrar of Companies or
designated stock exchange, as the case may be.

(2) No issuer shall make a public issue or rights issue of specified securities:
 if the issuer, any of its promoters, promoter group or directors or persons in control of the
issuer are debarred from accessing the capital market by the Board;
 if any of the promoters, directors or persons in control of the issuer was or also is a promoter,
director or person in control of any other company which is debarred from accessing the capital
market under any order or directions made by the Board;
 if the issuer of convertible debt instruments is in the list of wilful defaulters published by the
Reserve Bank of India or it is in default of payment of interest or repayment of principal
amount in respect of debt instruments issued by it to the public, if any, for a period of more
than six months;
 unless it has made an application to one or more recognised stock exchanges for listing of
specified securities on such stock exchanges and has chosen one of them as the designated
stock exchange:
 �Provided that in case of an initial public offer, the issuer shall make an application for listing
of the specified securities in at least one recognised stock exchange having nationwide trading
terminals;�
 unless it has entered into an agreement with a depository for dematerialisation of specified
securities already issued or proposed to be issued;
 unless all existing partly paid-up equity shares of the issuer have either been fully paid up or
forfeited;
 unless firm arrangements of finance through verifiable means towards seventy five per cent.
of the stated means of finance, excluding the amount to be raised through the proposed public
issue or rights issue or through existing identifiable internal accruals, have been made.
Eligilibilty
SEBI has stipulated the eligibility norms for companies planning an IPO which are as follows:

Entry Norm I (Profitability Route)

 Net tangible assets of at least Rs. 3 crore in each of the preceding three full years of which not
more than 50% are held in monetary assets. However, the limit of 50% on monetary assets
shall not be applicable in case the public offer is made entirely through offer for sale.

 Minimum of Rs. 15 crore as average pre-tax operating profit in at least three years of the
immediately preceding five years.

 Net worth of at least Rs. 1 crore in each of the preceding three full years.

 If there has been a change in the company’s name, at least 50% of the revenue for preceding
one year should be from the new activity denoted by the new name

 The issue size should not exceed 5 times the pre-issue net worth

Alternative routes

To provide sufficient flexibility and also to ensure that genuine companies are not limited from fund
raising on account of strict parameters, SEBI has provided the alternative route to the companies not
satisfying any of the above conditions, for accessing the primary market, as under:

Entry Norm II (QIB Route)

Issue shall be through book building route, with at least 75% of net offer to the public to be mandatory
allotted to the Qualified Institutional Buyers (QIBs). The company shall refund the subscription money
if the minimum subscription of QIBs is not attained.

For FPO’s A listed issuer making a public issue (Further Public Offer i.e. FPO) is required to satisfy
the following requirements:

 If the company has changed its name within the last one year, at least 50% revenue for the
preceding 1 year should be from the activity suggested by the new name.
 The aggregate of the proposed issue and all previous issues made in the same financial year in
terms of issue size does not exceed five times its pre-issue net worth as per the audited balance
sheet of the preceding financial year. Any listed company not fulfilling these conditions shall
be eligible to make a public issue (i.e. FPO) by complying with QIB Route as specified for
IPOs i.e. issue shall be through book building route, with at least 75% to be mandatory allotted
to the Qualified Institutional Buyers (QIBs).
b) Initial public offer An initial public offering (IPO) is the first time that the stock of a private
company is offered to the public. IPOs are often issued by smaller, younger companies seeking
capital to expand, but they can also be done by large privately owned companies looking to
become publicly traded. In an IPO, the issuer obtains the assistance of an underwriting firm,
which helps determine what type of security to issue, the best offering price, the amount of
shares to be issued and the time to bring it to market.

c) Further public offering A follow-on public offer (FPO) is an issuing of shares to investors
by a public company that is already listed on an exchange. An FPO is essentially a stock issue
of supplementary shares made by a company that is already publicly listed and has gone
through the IPO process. FPOs are popular methods for companies to raise
additional equity capital in the capital markets through a stock issue.

Bonus Issue
A bonus issue, also known as a scrip issue or a capitalization issue, is an offer of free
additional shares to existing shareholders. A company may decide to distribute further shares as an
alternative to increasing the dividend payout. For example, a company may give one bonus share for
every five shares held.

Conditions for bonus issue.

Subject to the provisions of the Companies Act, 1956 or any other applicable law for the time being
in force, a listed issuer may issue bonus shares to its members if:
 it is authorised by its articles of association for issue of bonus shares, capitalisation of reserves,
etc.:
�Provided that if there is no such provision in the articles of association, the issuer shall pass
a resolution at its general body meeting making provisions in the articles of associations for
capitalisation of reserve;
 it has not defaulted in payment of interest or principal in respect of fixed deposits or debt
securities� issued by it;
 it has sufficient reason to believe that it has not defaulted in respect of the payment of statutory
dues of the employees such as contribution to provident fund, gratuity and bonus;
 the partly paid shares, if any outstanding on the date of allotment, are made fully paid up
Right Issue

A rights issue is an invitation to existing shareholders to purchase additional new shares in the
company. More specifically, this type of issue gives existing shareholders securities called "rights,"
which, well, give the shareholders the right to purchase new shares at a discount to the market price on
a stated future date. The company is giving shareholders a chance to increase their exposure to
the stock at a discount price.

But until the date at which the new shares can be purchased, shareholders may trade the rights on the
market the same way that they would trade ordinary shares. The rights issued to a shareholder have a
value, thus compensating current shareholders for the future dilution of their existing shares' value.

Troubled companies typically use rights issues to pay down debt, especially when they are unable to
borrow more money. But not all companies that pursue rights offerings are shaky. Some with clean
balance sheets use rights issues to fund acquisitions and growth strategies. For reassurance that it will
raise the finances, a company will usually, but not always, have its rights issue underwritten by
an investment bank.

Restriction on rights issue.

 No issuer shall make a rights issue of equity shares if it has outstanding fully or partly
convertible debt instruments at the time of making rights issue, unless it has made reservation
of equity shares of the same class in favour of the holders of such outstanding convertible debt
instruments in proportion to the convertible part thereof.
 The equity shares reserved for the holders of fully or partially convertible debt instruments
shall be issued at the time of conversion of such convertible debt instruments on the same terms
on which the equity shares offered in the rights issue were issued.

Book Building
Every business organisation needs funds for its business activities. It can raise funds either externally
or through internal sources. When the companies want to go for the external sources, they use various
means for the same. Two of the most popular means to raise money are Initial Public Offer (IPO) and
Follow on Public Offer (FPO).

During the IPO or FPO, the company offers its shares to the public either at fixed price or offers a
price range, so that the investors can decide on the right price. The method of offering shares by
providing a price range is called book building method. This method provides an opportunity to the
market to discover price for the securities which are on offer.

Book Building may be defined as a process used by companies raising capital through Public
Offerings-both Initial Public Offers (IPOs) and Follow-on Public Offers (FPOs) to aid price and
demand discovery. It is a mechanism where, during the period for which the book for the offer is open,
the bids are collected from investors at various prices, which are within the price band specified by
the issuer. The process is directed towards both the institutional investors as well as the retail investors.
The issue price is determined after the bid closure based on the demand generated in the process.
Book Building in India: The introduction of book-building in India was done in 1995 following the
recommendations of an expert committee appointed by SEBI under Y.H. Malegam. The committee
recommended and SEBI accepted in November 1995 that the book-building route should be open to
issuer companies, subject to certain terms and conditions. In January 2000, SEBI came out with a
compendium of guidelines, circulars and instructions to merchant bankers relating to issue of capital,
including those on the book-building mechanism.

The following are the important points in book building process:

 The Issuer who is planning an offer nominates lead merchant banker(s) as ‘book runners’.

 The Issuer specifies the number of securities to be issued and the price band for the bids.

 The Issuer also appoints syndicate members with whom orders are to be placed by the
investors.

 The syndicate members put the orders into an ‘electronic book’. This process is called
‘bidding’ and is similar to open auction.

 The book normally remains open for a period of 5 days.

 Bids have to be entered within the specified price band.

 Bids can be revised by the bidders before the book closes.

 On the close of the book building period, the book runners evaluate the bids on the basis of
the demand at various price levels.

 The book runners and the Issuer decide the final price at which the securities shall be issued.

 Generally, the number of shares is fixed; the issue size gets frozen based on the final price
per share.

 Allocation of securities is made to the successful bidders. The rest bidders get refund orders.
 Bidding Procedure
1. Specifications The first step in the bidding process deals with coming up with the
specifications for the job. The company or customer looking for bids has to develop
specifications for the bidding process. For example, if the customer needs a building
constructed, a schematic or blueprints must be developed first. All of the details for the entire
project must be outlined in the documentation.
2. Request for Bids After the details of the project have been developed, the customer must
request that bids be made. This can involve sending out invitations to bid on projects and
posting the opportunity online. In some cases, the client will only request bids from a pre-
selected list of contractors. In other situations, the bid opportunity may be open to anyone who
qualifies to bid on it.
3. Bidding After the information about the project has been distributed to contractors, the bidding
process begins. The bidding process can differ, depending on the rules set by the client. In
some cases, sealed bids will be submitted and the customer will evaluate them. In other cases,
a more informal bidding process will be involved in which contractors simply give a total
amount that they can do the job for.
4. Reviewing the Bids The customer will typically set a deadline on when the last bids will be
accepted. Once that deadline is reached, the customer will begin reviewing the bids. The length
of time that it takes to review the bids could vary, depending on the number of bids received.
5. Awarding the Contract After the bids have been thoroughly reviewed, the customer will
award the contract to one bidder. In most cases, the bidder with the lowest bid wins. In some
situations, the bidder will award the contract not only on price but other factors as well. For
instance, the customer may be inclined to go with a more reputable provider or with those
where a prior relationship exists.
 MODULE – 5 EQUITY FINANCE

Equity financing is the process of raising capital through the sale of shares in an
enterprise. Equity financing essentially refers to the sale of an ownership interest to raise funds for
business purposes. Equity financing spans a wide range of activities in scale and scope, from a few
thousand dollars raised by an entrepreneur from friends and family, to giant initial public
offerings (IPOs) running into the billions by household names such as Google and Facebook. While
the term is generally associated with financings by public companies listed on an exchange, it includes
financings by private companies as well. Equity financing is distinct from debt financing, which
refers to funds borrowed by a business.

Share Capital

Share capital consists of all funds raised by a company in exchange for shares of either common
or preferred shares of stock. The amount of share capital or equity financing a company has can
change over time. A company that wishes to raise more equity can obtain authorization to issue and
sell additional shares, thereby increasing its share capital.
A joint stock company should have capital in order to finance its activities. It raises its capital by issue
of shares. The Memorandum of Association must state the amount of capital with which the company
is desired to be registered and the number of shares into which it is to be divided. When total capital
of a company is divided into shares, then it is called share capital. It constitutes the basis of the capital
structure of a company. In other words, the capital collected by a joint stock company for its business
operation is known as share capital. Share capital is the total amount of capital collected from its
shareholders for achieving the common goal of the company as stated in Memorandum of Association.

Types Of Share Capital

Share capital of a company can be divided into the following different categories:
1. Authorized, registered, maximum or normal capital
The maximum amount of capital, which a company is authorized to raise from the public by the
issue of shares, is known as authorized capital. It is a capital with which a company is registered,
therefore it is also known as registered capital.

2. Issued Capital
Generally, a company does not issue its authorized capital to the public for subscription, but issues a
part of it. So, issued capital is a part of authorized capital, which is offered to the public for
subscription, including shares offered to the vendor for consideration other than cash. The part of
authorized capital not offered for subscription to the public is known as 'un-issued capital'. Such
capital can be offered to the public at a later date.

3.Subscribed Capital
It can not be said that the entire issued capital will be taken up or subscribed by the public. It may be
subscribed in full or in part. The part of issued capital, which is subscribed by the public, is known
as subscribed ccapital

4.Called Up Capital
It is that part of subscribed capital, which is called by the company to pay on shares allotted. It is not
necessary for the company to call for the entire amount on shares subscribed for by shareholders.
The amount, which is not called on subscribed shares, is called uncalled capital.

5. Paid-up Capital
It is that part of called up capital, which actually paid by the shareholders. Therefore it is known as
real capital of the company. Whenever a particular amount is called and a shareholder fails to pay
the amount fully or partially, it is known an unpaid calls or calls in arrears.
Paid-up Capital = Called up capital - calls in arrears

6. Reserve Capital
It is that part of uncalled capital which has been reserved by the company by passing a special
resolution to be called only in the event of its liquidation. This capital can not be called up during the
existence of the company.It would be available only in the event of liquidation as an additional
security to the creditors of the company.

Importance of shares : For individuals, investing in the stock market is a relatively

straightforward way to generate income. While there are no guaranteed profits, almost anyone can
open an online trading account to buy and sell shares of publicly traded stock. In addition to its
transactional simplicity, investment in ordinary shares has the potential for unlimited gains, while the
potential loss is limited to the original amount invested.

Ordinary shares provides a small degree of ownership in the issuing company. Stockholders have a
certain amount of say in how the company is run and are allowed to vote on important decisions, such
as the appointment of a board of directors. For each share of common stock owned, the stockholder
gets one vote, so the stockholder's opinion becomes weightier when he owns more shares.

While this may be an important advantage for an individual or institutional investor who controls a
large percentage of a company's stock, for the average retail investor, the chief benefit of common
shares lies in their potential dividend payments.

When a company turns a profit, it often rewards its investors by paying a small portion of that profit
to each shareholder according to the number of shares owned. While this dividend is not guaranteed,
as with preferred stock, many companies pride themselves on consistently paying higher dividends
each year, encouraging long-term investment.
For businesses, issuing common shares is an important way to raise capital to fund expansion without
incurring too much debt. While this dilutes the ownership of the company, unlike debt funding,
shareholder investment need not be repaid at a later date.

Of course, shareholders do expect returns on their investments either through stock growth or dividend
payments. But the company always has the option to repurchase some or all of its outstanding shares if
and when it no longer has need of equity capital, thereby consolidating ownership and eliminating the
need to generate returns for their shareholders.

Prospectus

A prospectus is a formal legal document that is required by and filed with the Securities and Exchange
Commission that provides details about an investment offering for sale to the public. The preliminary
prospectus is the first offering document provided by a security issuer and includes most of the details
of the business and transaction in question; the final prospectus, containing finalized background
information including such details as the exact number of shares/certificates issued and the
precise offering price, is printed after the deal has been made effective. In the case of mutual funds, a
fund prospectus contains details on its objectives, investment strategies, risks, performance,
distribution policy, fees and expenses, and fund management.

Importance of Prospectus

A prospectus is a document that companies and others file with the Securities and Exchange
Commission when they are offering new shares of a security to the public. One of the most common
reasons for issuing a prospectus is when a company is making an initial public offering, putting
shares of stock up for sale for the first time. Mutual funds issue a prospectus at regular intervals
because they routinely make new shares available.

Issuer Information
Among the most salient details in the prospectus for a new stock are the descriptions that the company
offers of itself, its assets, its operations, its goals and its business plan. The prospectus also features a
section known as "certain considerations," which explains any particular risk factors that could impede
the success of the company and harm a shareholder's investment in its stock. Other company
information includes an examination of the competition, pending legislation and the broader economy
and its influence on the company. A prospectus for a stock also features a financial statement for the
company and the opinion of an independent auditor about the company's financials. A bond prospectus
similarly features relevant financial information about the corporation or public entity issuing the
bond.

Offering Information
In addition to issuer information, a prospectus for a stock or bond offering includes information about
the security itself. It describes the number of shares or bond certificates being sold in an offering, the
price, the underwriter and how the security will be available for purchase. For either a stock or a bond,
the prospectus should specify how the company or public entity that is selling the security will use the
funds that are being raised from the sale. If the prospectus is for a stock, it will include information
about its dividend policy and it will describe the different classes of stock and the voting rights for
shareholders.

Mutual Fund Activity, Objectives and Leadership

A mutual fund prospectus details the performance of the fund, often including both recent quarterly
results and those from previous calendar years. It also specifies the various goals for the fund and the
basic overarching investment strategies that guide it. For instance, the prospectus for a fund might
indicate that the fund invests in American stocks with strong long-term growth potential. This type of
description gives investors an opportunity to review a fund's objectives to make sure that they match
the investors' own goals. The identity of the managers who are steering the fund also often appears in
the prospectus.

Mutual Fund Fees, Expenses and Guidance

A mutual fund prospectus provides investors with guidance to help with their role as shareholders. For
instance, it gives investors instructions on their tax obligations related to the shares that they own, and
it also details instructions on how to buy and sell shares of the fund. The prospectus provides a reliable
place for investors to track down the various fees that are attached to owning shares of the fund, such
as the amount of the management fee. In addition, the prospectus is a document that an investor can
study in order to understand all of a fund's expenses to determine if it is operating efficiently enough
for the investor's taste.
Prospectus: Section 2(70) of the Companies Act, 2013 defines a prospectus as ““A prospectus means
Any documents described or issued as a prospectus and includes any notices, circular, advertisement,
or other documents inviting deposit fro the public or documents inviting offer from the public for the
subscription of shares or debentures in a company.” A prospectus also includes shelf prospectus and
red herring prospectus. A prospectus is not merely an advertisement.
A document shall be called a prospectus if it satisfy two things:
1. It invites subscription to shares or debentures or invites deposits.
2. The aforesaid invitation is made to the public.
Contents of a prospectus:
1. Address of the registered office of the company.
2. Name and address of company secretary, auditors, bankers, underwriters etc.
3. Dates of the opening and closing of the issue.
4. Declaration about the issue of allotment letters and refunds within the prescribed time.
5. A statement by the board of directors about the separate bank account where all monies received
out of shares issued are to be transferred.
6. Details about underwriting of the issue.
7. Consent of directors, auditors, bankers to the issue, expert’s opinion if any.
8. The authority for the issue and the details of the resolution passed therefore.
9. Procedure and time schedule for allotment and issue of securities.
10. Capital structure of the company.
11. Main objects and present business of the company and its location.
12. Main object of public offer and terms of the present issue.
13. Minimum subscription, amount payable by way of premium, issue of shares otherwise than on
cash.
14. Details of directors including their appointment and remuneration.
15. Disclosure about sources of promoter’s contribution.
16. Particulars relation to management perception of risk factors specific to the project, gestation
period of the project, extent of progress made in the project and deadlines for completion of the project.

Various Kinds of Prospectus

1. Statement in lieu of Prospectus: A public company, which does not raise its capital by public
issue, need not issue a prospectus. In such a case a statement in lieu of prospectus must be filed with
the Registrar 3 days before the allotment of shares or debentures is made. It should be dated and signed
by each director or proposed director and should contain the same particulars as are required in case
of prospectus proper.

2. Deemed Prospectus: Section 25 of the companies Act, 2013 provides that all documents containing
offer of shares or debentures for sale shall be included within the definition of the term prospectus and
shall be deemed as prospectus by implication of law.
Unless the contrary is proved an allotment of or an agreement to allot shares or debentures shall be
deemed to have been made with a view to the shares or debentures being offered for sale to the public
if it is shown
a. That the offer of the shares or debentures of or any of them for sale to the public was made within
6 month after the allotment or agreement to allot; or
b. That at the date when the offer was made the whole consideration to be received by the company
in respect of the shares or debentures had not been received by it.
All enactments and rules of law as to the contents of prospectus shall apply to deemed prospectus.

3. Abridged Prospectus [Sec. 2(1)]: Abridged prospectus means a memorandum containing such
salient features of a prospectus as may be specified by the SEBI by making regulations in this behalf.
No form of application for the purchase of any of the securities of a company shall be issued unless
such form is accompanied by an abridged prospectus. A copy of the prospectus shall, on a request
being made by any person before the closing of the subscription list and the offer, be furnished to him.

Object of a prospectus
The objects of issuing a prospectus are as under:
1. To invite the public to invest in the shares or debenture of a market.
2. To give a bureau of a condition on which the public is invited to invest in shares and debentures.
3. To make a declaration that the directors of the company are liable for the condition stated in the
prospectus.
Nature of prospectus:
As said earlier that the prospectus is an invitation to the public to invest in the shares or debentures of
a company. But the term public is nowhere defined in the Companies Act. So, far as it is related to
prospectus, public is meant to be the ordinary common people[4]. Whether or not the invitation for
investment is made to the ‘public’ depends upon some situation, such as:
1. How many copies of the prospectus were printed?
2. To how many members of the public were the copies distributed.
3. How many members of the public accepted the copies?
4. Under what conditions did the member of the public accept the prospectus?
When the prospectus need to be issued
In the following situation, there is no need for a prospectus to be issued.
 When the shares and debentures are to be allotted to the existing holders of shares and
debentures.
 When the shares and debenture to be allotted are similar to the current (already issued) shares
and debentures that are being traded in a recognized stock exchange.
 When the allotment of shares and debenture is not permissible by law as in the case of a private
company.
 When the invitation is to some such person who has a contract for underwriting the shares and
debentures of the company
Golden rule in prospectus
Prospectus is the basis of the contract between the company and the person’s who incest in the
company’s shares or debentures. The officers of the company have knowledge of the company’s
present status and its prospects in future or have the means to acquire such knowledge. But the
potential investor has no such knowledge, nor the means to acquire it. It, therefore, becomes the duty
of those who issue the prospectus that they not only projects the company’s image in the right
perspective but also makes sure that no vital information which could be of interest to the potential
investors in the company’s shares and debentures is left out from the company’s prospectus. it
therefore become important that the prospectus states the basic important facts about the company
with utmost honesty and good faith and that no information that is important is twisted or partially
presented. That is what is refers to as the ‘golden rule for making a prospectus’.
In short the following must be kept in mind when preparing the prospectus of a company:
  The prospectus must be an honest statement of the company’s profile; there must be no
misleading, ambiguous or erroneous reference to the company in its prospectus.
 Every important aspect of a contract of the company should be clarified.
 The contents of the prospectus should conform to the provision of the Companies Act.
 The restrictions on the appointment of directors must be kept in mind.
 The conditions of civil liability as laid down must be strictly adhered to issue and registration
of prospectus or legal requirement regarding issue of prospectus
Legal requirement regarding issue of prospectus:
The Companies Act has defined some legal requirements about the issue and registration of a
prospectus. The issue of the prospectus would be deemed to be legal only if the requirements are met.
Issue after the incorporation: As a rule, the prospectus of a company can only be issued after its
incorporation. A prospectus issued by, or on behalf of a company, or in relation to an intended
company, shall be dated, and that date shall be taken as the date of publication of the prospectus.
Registration of prospectus: it is mandatory to get the prospectus registered with the Registrar of
Companies before it is issued to the public. The procedure of getting the prospectus registered is as
under:
a. A copy of the prospectus, duly signed by every person who is named therein as a director or a
proposed director of the company must be filed with Registrar of Companies before the prospectus is
issued to the public.
b. The following document must be attached thereto:
 Consent to the issue of the prospectus required under any person as an expert confirming his
written consent to the issue thereof, and that he has not withdrawn his consent as aforesaid
appears in the prospectus.
 Copies of all contracts entered into with respect to the appointment of the managing director,
directors and other officers of the company must also be filed with Registrar.
 If the auditor or accountant of the company has made any adjustments in the company’s
account, the said adjustments and the reasons thereof must be filed with the documents.
 There must be a copy of the application which is to be filled for the issue of the company’s
shares and debentures attached with the prospectus.
 The prospectus must have the written consent of all the persons who have been named as
auditors, solicitors, bankers, brokers, etc.
  Every prospectus must have, on the face of it, a statement that:
 A copy of the prospectus has been delivered to the Registrar for registration.
 Specifies that any documents required to be endorsed by this section have been delivered to
the Registrar.
 A copy of the prospectus must be filed with the Registrar of Companies. The Registrar should
register the prospectus only when:
 The prospectus is dated. The date shall, unless the contrary is proved, be taken as the date of
publication of the prospectus.
 The contents of prospectus conform to Section 56 of the Act.
 The consent of the expert, if it is necessary, has been obtained. But such expert should not be
engaged or interested in the formation or promotion of the company.
 The written consent of the expert with respect to the issue of his statement included in the
prospectus has been obtained.
 If the above provision of law has been fulfilled, or the necessary documents have nit been
attached, the Registrar can refuse to register the company’s prospectus.
 According to the Section 60(4), no prospectus shall be issued more than ninety days after the
date on which a copy thereof is delivered for registration. Of the prospectus is so issued. It
shall be deemed to be a prospectus a copy of which has not been delivered to the Registrar.
 If a prospectus issued in contravention of the above –stated provisions, then the company and
every person who knows a party to the issue of the prospectus shall be punishable with a fine.

MODULE – 6 DEBT FINANCE

Debt financing occurs when a firm raises money for working capital or capital expenditures by selling
bonds, bills or notes to individuals and/or institutional investors. In return for lending the money, the
individuals or institutions become creditors and receive a promise the principal and interest on the debt
will be repaid. The other way to raise capital in the debt markets is to issue shares of stock in a public
offering; this is called equity financing.

Difference between equity financing and debt financing

Equity financing often means issuing additional shares of common stock to an investor. With more
shares of common stock issued and outstanding, the previous stockholders' percentage of ownership
decreases.
Debt financing means borrowing money and not giving up ownership. Debt financing often comes
with strict conditions or covenants in addition to having to pay interest and principal at specified
dates. Failure to meet the debt requirements will result in severe consequences. In the U.S. the
interest on debt is a deductible expense when computing taxable income. This means that the
effective interest cost is less than the stated interest if the company is profitable. Adding too much
debt will increase the company's future cost of borrowing money and it adds risk for the company.

Debentures

Meaning: If a company needs funds for extension and development purpose without increasing its
share capital, it can borrow from the general public by issuing certificates for a fixed period of time
and at a fixed rate of interest. Such a loan certificate is called a debenture. Debentures are offered to
the public for subscription in the same way as for issue of equity shares. Debenture is issued under the
common seal of the company acknowledging the receipt of money.
Features of Debentures:
The important features of debentures are as follows:
 Debenture holders are the creditors of the company carrying a fixed rate of interest.
 Debenture is redeemed after a fixed period of time.
 Debentures may be either secured or unsecured.
 Interest payable on a debenture is a charge against profit and hence it is a tax deductible
expenditure.
 Debenture holders do not enjoy any voting right.
 Interest on debenture is payable even if there is a loss.

Advantage of Debentures:
Following are some of the advantages of debentures:
(a) Issue of debenture does not result in dilution of interest of equity shareholders as they do not have
right either to vote or take part in the management of the company.

(b) Interest on debenture is a tax deductible expenditure and thus it saves income tax.
(c) Cost of debenture is relatively lower than preference shares and equity shares.

(d) Issue of debentures is advantageous during times of inflation.

(e) Interest on debenture is payable even if there is a loss, so debenture holders bear no risk.

Disadvantages of Debentures:
Following are the disadvantages of debentures:
(a) Payment of interest on debenture is obligatory and hence it becomes burden if the company incurs
loss.

(b) Debentures are issued to trade on equity but too much dependence on debentures increases the
financial risk of the company.

(c) Redemption of debenture involves a larger amount of cash outflow.

(d) During depression, the profit of the company goes on declining and it becomes difficult for the
company to pay interest.

Different Types of Debentures:

A company can issue different types of debentures for raising funds for long term purposes.

1. Ordinary Debenture: Such debentures are issued without mortgaging any asset, i.e. this is
unsecured. It is very difficult to raise funds through ordinary debenture.
2. Mortgage Debenture: This type of debenture is issued by mortgaging an asset and debenture
holders can recover their dues by selling that particular asset in case the company fails to repay
the claim of debenture holders.
 3. Non-convertible Debentures: A non-convertible debenture is a debenture where there is no
option for its conversion into equity shares. Thus the debenture holders remain debenture
holders till maturity.
4. Partly Convertible Debentures: The holders of partly convertible debentures are given an
option to convert part of their debentures. After conversion they will enjoy the benefit of both
debenture holders as well as equity shareholders.
5. Fully Convertible Debenture: Fully convertible debentures are those debentures which are
fully converted into specified number of equity shares after predetermined period at the option
of the debenture holders.
6. Redeemable Debentures: Redeemable debenture is a debenture which is redeemed/repaid on
a predetermined date and at predetermined price.
7. Irredeemable Debenture: Such debentures are generally not redeemed during the lifetime of
the company. So, it is also termed as perpetual debt. Repayment of such debenture takes place
at the time of liquidation of the company.
8. Registered Debentures: Registered debentures are those debentures where names, address,
serial number, etc., of the debenture holders are recorded in the register book of the company.
Such debentures cannot be easily transferred to another person.
9. Unregistered Debentures: Unregistered debentures may be referred to those debentures
which are not recorded in the company’s register book. Such a type of debenture is also known
as bearer debenture and this can be easily transferred to any other person.

ISSUE OF DEBENTURES
The procedure of issuing debentures by a company is similar to the one followed while issuing equity
stocks. The company starts by releasing a prospectus declaring the debenture issuance. The interested
investors, then, apply for the same. The company may need the entire amount while applying for the
debentures or may ask for installments to be paid while submitting the application, on allotment of
debentures or on various calls by the company. The company can issue debentures at a par, at a
premium or at a discount as explained below.

DIFFERENT WAYS FOR ISSUING OF DEBENTURE

Once the company invites the applications and the investors apply for the debentures, the company
can issue debentures in one of the following ways:

1. ISSUE OF DEBENTURE AT PAR When the issue price of the debenture is equal to its face
value, the debenture is said to be issued at par. When a debenture is issued at par, the long-
term borrowings in the liabilities section of the balance sheetequals the cash in the assets side
of the balance sheet. Thus, no further adjustment is required to balance the assets and the
liabilities of the company. The company can collect the whole amount in one installment i.e
on an application or in two installments i.e. on an application and subsequent allotment.
However, there might be a scenario in which money is collected in more than two installments
i.e. on an application, on an allotment and at various calls by the company.
2. ISSUE OF DEBENTURE AT DISCOUNT The debenture is said to be issued at a discount
when the issue price is below its nominal value. Let us take an example – a Rs. 100 debenture
is issued at Rs. 90, then Rs.10 is the discount amount. In such a scenario, the liabilities and the
assets sides of the balance sheet do not match. Thus, the discount on debentures’ issuance is
noted as a capital loss and is charged to ‘Securities Premium Account’ and is reflected as an
asset. The discount can be written off later.
3. ISSUE OF DEBENTURE AT PREMIUM When the price of the debenture is more than its
nominal value, it is said to be issued at a premium. For example, a Rs. 100 debenture is issued
for Rs.105 and Rs.5 is the premium amount. Again, assets and liabilities do not match in such
situation. Therefore, the premium amount is credited to Securities Premium Account and is
reflected under ‘Reserves and Surpluses’ on the liabilities side of the balance sheet.
4. THE ISSUE OF DEBENTURE AS COLLATERAL The debentures can be issued as a
collateral security to the lenders. This happens when the lenders insist on additional assets as
security in addition to the primary security. The additional assets may be used if the complete
amount of loan cannot be realized from the sale of the primary security. Therefore, the
companies tend to issue debentures to the lenders in addition to some other physical assets
already pledged. The lenders may redeem or sell the debentures on the open market if the
primary assets do not pay for the complete loan.
5. ISSUE OF DEBENTURE FOR CONSIDERATION OTHER THAN CASH Debentures
can also be issued for consideration other than cash. Generally, companies follow this route
 with their vendors. So, instead of paying the cash for the assets purchased from the vendor, the
companies issue debentures for consideration other than cash. In this case, also, the debentures
can be issued at a par, premium or discount and are accounted for in the similar fashion.
6. OVER SUBSCRIPTION The company invites the investors to subscribe to its debenture
issue. However, it may happen that the applications received for the debentures may be more
than the original number of debentures offered. This scenario is referred to as over-
subscription. In the case of over-subscription, a company cannot allocate more debentures than
it had originally planned to issue. So, the company refunds the money to the applicants to
whom debentures are not allotted. However, the excess money received from applicants who
are allocated debentures is not refunded. The same money is used towards allotment
adjustment and the subsequent calls to be made.

Deposit and Acceptance

The Companies Act, 2013(“Act of 2013”), which had been in the offing for quite some
time, and has seen much discussion in the recent past, has recently been notified by the
Government of India. Alongside this, the Ministry of Corporate Affairs (MCA) has also
notified the rules under the notified provisions of the Act of 2013. The notified sections
in fact replace the corresponding sections of the Companies Act, 1956 (“Act of 1956”),
although some provisions of the latter still remain in force.

This article discussed the concept of deposits as provided under Chapter V of the Act of
2013 and the Companies (Acceptance of Deposits) Rules, 2014, and how these may have
an impact on the companies post the enactment.

Chapter V of the Companies Act, 2013 (sections 73 to 76), except for section 75 and
provisions relating to, or involving the National Company Law Tribunal, have been
notified to come into effect from 1st April 2014. The Companies (A cceptance of
Deposits) Rules, 2014 (“Deposits Rules”) have been legislated thereunder, to provide for
the nitty gritties relating to the acceptance and treatments of deposits under the Act.

Acceptance of Deposits
Deposits as understood in general parlance, are the funds procured by any company in
the form of a loan etc. for repayment with interest at a future date. The Companies Act,
 2013 defines these as amounts including any receipt of money by way of deposit or loan
or in any other form by a company, but does not include such categories as may be
prescribed in consultation with the Reserve Bank of India. The Act of 2013, and the
Deposits Rules provide for specific conditions subject to which a company may accept
deposits, a detailed definition of ‘deposits’, and for specific exclusions from the
definition.
As per the provisions of the Act, deposits may be accepted by a company either from its
members or persons other than its members i.e. the general public. Howe ver, a private
company cannot accept deposits from the public, being one of the very conditions to its
incorporation as a private company under the Act. Further, only those public companies
may accept deposits from the public in which the net worth or turn over is equal to or
more than the prescribed net worth or turnover.

As per Section 73 of the Act, a company, whether public or private, may accept deposits
from its members after passing of a resolution in general meeting of the company, subject
to the fulfillment of the terms and conditions prescribed under the section and the Rules.

Deposits The Deposits Rules provide a definition of the term ‘deposit’ as including any
receipt of money by way of deposit or loan or in any other form, by a company, but not
including:
Here it is important to note that while exclusions and exemptions were also provided
under the Act of 1956, the Act of 2013 sees many departures from the erstwhile
provisions of law relating to deposits, providing for more stringent regulations,
conditionalities and penal provisions.

 any amount received from:

1. the Central Government or a State Government,

2. any other source whose repayment is guaranteed by the Central Government

or a State Government, or

3. a local authority, or

4. a statutory authority constituted under an Act of Parliament or a State

Legislature
 any amount received from:

1. foreign Governments,

2. foreign or international banks,

3. multilateral financial institutions (including, but not limited to,

International Finance Corporation, Asian Devel opment Bank,
Commonwealth DevelopmentCorporation and International Bank for
Industrial and Financial Reconstruction),

4. foreign Governments owned development financial institutions,

5. foreign export credit agencies,

6. foreign collaborators,

7. foreign bodies corporate and foreign citizens,

8. foreign authorities or persons resident outside India subject to the

provisions of Foreign Exchange Management Act, 1999 (42 of 1999) and
rules and regulations made there under;

 any amount received as a loan or facility from:

1. any banking company or

2. the State Bank of India or any of its subsidiary banks or

3. a banking institution notified by the Central Government under section 51

of the Banking Regulation Act, 1949 (10 of 1949), or a corresponding new
bank as defined in clause (d) of section 2 of the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1970 (5 of 1970) or in
clause (b) of section (2) of the Banking Companies (Acquisition and
Transfer of Undertakings) Act, 1980 (40 of 1980) , or

4. a co-operative bank as defined in clause (b-ii) of section 2 of the Reserve

Bank of India Act, 1934 (2 of 1934)

 any amount received as a loan or financial assistance from Public Financial Institutions
notified by the Central Government in this behalf in consultation with the Reserve Bank
 of India or any regional financial institutions or Insurance Companies or Scheduled
Banks as defined in the Reserve Bank of India Act, 1934 (2 of 1934);

 any amount received against issue of commercial paper or any other instruments issued
in accordance with the guidelines or notification issued by the Reserve Bank of India;

 any amount received by a company from any other company;

 any amount received and held pursuant to an offer made in accordance with the
provisions of the Act towards subscription to any securities, including share application
money or advance towards allotment of securities pending allotment, so long as such
amount is appropriated only against the amount due on allotment of the securities applied
for;

Creation of Charges
Companies Act, 2013 defines "charge" as an interest or lien created on the property or assets of a
company or any of its undertakings or both as security and includes a mortgage. ... It is the duty of
every company to register with the Registrar of Companies specific charges created by the company
on its assets. Almost all the large and small companies depend upon share capital and borrowed capital
for financing their projects. Borrowed capital may consist of funds raised by issuing debentures, which
may be secured or unsecured, or by obtaining financial assistance from Financial institution or banks.

The financial 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 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

Type of Charges to be registered: Companies Act, 1956 : Section 125 specifies only 9 types
of charges to be registered. Companies Act, 2013 : Section 77 states that Companies are required to
register ALL TYPES OF CHARGES, with ROC within 30 days of its creation.

 within or outside India,

 on its property or assets or any of its undertakings,
 whether tangible or otherwise, and
 situated in or outside India
For Creation of Charge Form CHG-1 will be filed with fees prescribed under Act. Form should be
signed by the Company and the Charge-holder and should be filed together with instrument creating
charge.

Fixed Charge

Fixed Charge is defined as a lien or mortgage created over specific and identifiable fixed 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 off the asset, then either previous
approval of the lender is to be taken, or it has to discharge all the dues first.

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 fixed charge and so on.

In this type of arrangement the company (borrower) has the right to sell, transfer or dispose off 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 off the dues first.

The conversion of floating charge into fixed charge is known as crystallization, as a result of it, the
security is no more floating 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.

Differences Between Fixed Charge and Floating Charge

The following are the major differences between fixed charge and floating charge:

1. The charge that can be easily identified with a certain asset is known as Fixed Charge. The charge
which is created on assets that changes periodically is Floating Charge.
2. Fixed Charge is specific in nature. Unlike floating charge which is dynamic.
3. Registration of movable assets is voluntary, in the case of fixed charge. Conversely, when there is a
floating charge, the registration is compulsory irrespective of the asset type.
4. The fixed charge is a legal charge while the floating charge is an impartial one.
5. Fixed Charge is given preference over floating charge.
6. The fixed charge covers those assets that are specific, ascertainable and existing during the creation of
the charge. On the other hand floating charge, covers present or future asset.
7. When the asset is covered under fixed charge, the company cannot deal with the asset until and unless
the charge holder agrees for so. However, in the case of floating charge the company can deal with the
asset until the charge is converted to fixed charge.
 MODULE – 7 INTERMEDIARIES

Intermediaries - Meaning

Firm or person (such as a broker or consultant) who acts as a mediator on a link between parties to a
business deal, investment decision, negotiation, etc. In money markets, for example, banks act as
intermediaries between depositors seeking interest income and borrowers seeking debt capital.
Intermediaries usually specialize in specific areas, and serve as a conduit for market and other types
of information. Also called a middleman
Individual or firm (such as an agent, distributor, wholesaler, retailer) that links producers to other
intermediaries or the ultimate buyer. Marketing intermediaries help a firm to promote, sell, and make-
available a good or service through contractual arrangements or purchase and resale of the item. Each
intermediary receives the item at one pricing point and moves it to the next higher pricing point until
the item reaches the final buyer. Also called distribution intermediary.
Marketing intermediaries fulfill an information role and a logistics role. They create value by adding
efficiency to marketplaces for goods or services which are inherently “many-to-many” in nature. That
is, most markets have many suppliers, and many consumers.

INTERMEDIARIES IN THE CAPITAL MARKET

The following market intermediaries are involved in the Capital Market:

 Merchant Bankers
 Registrars to an issue and Share Transfer Agents
 Underwriters
 Bankers to issue
 Debenture Trustees
FINANCIA 6.12

 Portfolio managers
 Stock brokers and sub-broker

We will discuss them one by one in the following paragraphs:

Merchant Bankers

SEBI (Merchant Banker) Regulations, 1992, define ‘merchant banker’ as any

person who is engaged in the business of issue management, either by making
arrangements regarding selling, buying, or subscribing, or acting as a manager,
consultant, or advisor, or rendering corporate- advisory services in relation to
such issue management. In case of both the public issues and right issues, it is
mandatory to appoint a Merchant Banker. The task of Merchant Banker is
basically that of a facilitator or coordinator. It coordinates the process of issue
management by helping the underwriters, registrars and bankers, in pricing and
marketing the issue and complying with the SEBI guidelines. Merchant
Bankers are prohibited from carrying on certain activities such as acceptance
of deposits, leasing and bill discounting. They are not allowed to borrow any
money from the market. They are also debarred from engaging in the
acquisition and sale of securities on a commercial basis.

Registrars to an issue and Share Transfer Agents

‘Registrar to an Issue’ means a person who is involved with the following activities:

 Collecting applications on behalf of the investors and keep a

proper record of monies received and paid.
 Helping the company which has issued shares in determining
the basis of allotment of the securities in consultation with the
stock exchange.
 Finalizing the list of person entitled to allotment of securities.
  Processing and dispatch of allotment letters, share certificates and refund
orders.

‘Share Transfer Agent’ means a person who on behalf of the issuer company
maintains the records of holders of securities issued by such company.

The Registrars to an Issue and Share Transfer Agents are important

intermediaries in the primary market. They help in mobilizing new capital and
ensure that proper records of the details of the investors maintained, so that the
decisions regarding basis for allotment and the number of securities to be
allotted can be smoothly implemented.
Underwriters

An underwriter is a person who engages in the business of underwriting the

public issue of securities of a particular company. An underwriting is an
arrangement in which a SEBI registered underwriter gives an undertaking to the
issuing company that in case the company’s public issue is not fully subscribed,
the underwriter will purchase the unsubscribed portion of the public issue.

Underwriting is compulsory for a public issue. It is necessary for a public

company which invites public subscription for its securities to ensure that 90%
of its public issue is fully subscribed otherwise the whole issued amount has to
be refunded. The company cannot fully rely on advertisements to ensure full
subscription. In case of any under subscription, it has to be made good by the
underwriters. And, the underwriting agreement has to be made in advance of
the opening of the public issue.

Bankers to an issue

Banker to an Issue means a scheduled bank doing any one of the following tasks:

(i) Acceptance of application money;

(ii) Acceptance of allotment or call money;

(iii) Refund of application money;

(iv) Payment of dividend or interest warrants.

Therefore, as the name indicates, Bankers to the issue carries out

the important task of ensuring that the funds are collected and
transferred to the Escrow accounts. The Banks do a great favour
to the companies in mobilization of capital.
Debenture Trustee
A debenture trust deed is a document created by the company where debenture trustees are
appointed to protect the interest of the debenture holders. To act as debenture trustee, the entity
should either be a scheduled bank carrying on commercial activity, a public financial
institution, an insurance company, or a body corporate. The entity should be registered with
SEBI to act as a debenture trustee.The contract deed entered into with a debenture trustee must
specify the interest rate and date of interest and principal repayments.
Duties of the Debenture Trustee include:
(a) Call for periodical reports from the body corporate, i.e., issuer of
debentures.
(b) Take possession of trust property in accordance with the provisions of the
trust deed.
(c) Enforce security in the interest of the debenture holders.
FIN 6.14

(d) Ensure on a continuous basis that the property charged to the

debenture is available and adequate at all times to discharge
the interest and principal amount payable in respect of the
debentures and that such property is free from any other
encumbrances except those which are specifically agreed
with the debenture trustee.
(e) Exercise due diligence to ensure compliance by the body
corporate with the provisions of the Companies Act, the
listing agreement of the stock exchange or the trust deed.
(f) To take appropriate measures for protecting the interest of
the debenture holders as soon as any breach of the trust deed
or law comes to his notice.
(g) To ascertain that the debentures have been converted or
redeemed in accordance with the provisions and conditions
under which they are offered to the debenture holders.
(h) Inform the Board immediately of any breach of trust deed or provision of
any law.
(i) Appoint a nominee director on the board of the body corporate when
required.(Source: SEBI FAQ’s
- Debenture Trustee)

Portfolio Managers

As per SEBI, a portfolio manager is a body corporate who, pursuant to a

contract or arrangement with a client, advises or directs or undertakes on behalf
of the client (whether as a discretionary portfolio manager or otherwise), the
management or administration of a portfolio of securities or the funds of the
client.
Simply stated, a portfolio manager is a person who is responsible for investing
a fund's assets, monitoring investment strategy and doing day-to-day trading.
A portfolio manager manages mutual funds and other investment funds, such
as hedge or venture funds. He may be an experienced investor, a broker, a fund
manager, or a trader with good knowledge of industry and a having a track
record of producing good results.

The portfolio manager provides to the client the Disclosure Document at least
two days prior to entering into an agreement with the client. The Disclosure
Document contains the quantum and manner of payment of fees payable by the
client for each activity, portfolio risks, complete disclosures in respect of
transactions with related parties, the performance of the portfolio manager and
the audited financial statements of the portfolio manager for the immediately
preceding three years. Please note that the disclosure document is neither
approved nor disapproved by SEBI nor does SEBI certify the accuracy or
adequacy of the contents of the Documents.(Source: SEBI FAQ’s - Portfolio
Managers)

Stock brokers and sub-broker

Stock broker is a person who buys and sells stocks and other securities for its
clients through a stock exchange. Stock brokers should be registered with SEBI
and are governed by SEBI Act and Securities
Contract Regulation Act. Stock brokers may also call themselves investment
consultants and financial consultants. A stockbroker should have good
knowledge about the securities market. Further, he should be good with
numbers, have excellent interpersonal skills and should be attentive enough not
to oversee any important details.

On the other hand, a sub broker is a person who is not a trading Member of a
Stock Exchange but who acts on behalf of a trading member as an agent. His
task is to help investors in dealing in securities through such trading
members(brokers). The leading stock brokers in India are listed as below:

India Infoline
ICICI Direct
Share Khan
India Bulls
Geojit Securities
HDFC
Reliance Money
Religare
Angel Broking
A credit rating agency (CRA, also called a ratings service)
Is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by
making timely interest payments and the likelihood of default. An agency may rate the
creditworthiness of issuers of debt obligations, of debt instruments,[1] and in some cases, of the
servicers of the underlying debt,[2] but not of individual consumers.

The debt instruments rated by CRAs include government bonds, corporate

bonds, CDs, municipal bonds, preferred stock, and collateralized securities, such as mortgage-
backed securities and collateralized debt obligations.[3]

The issuers of the obligations or securities may be companies, special purpose entities, state or
local governments, non-profit organizations, or sovereign nations.[3] A credit rating facilitates
the trading of securities on a secondary market. It affects the interest rate that a security pays
out, with higher ratings leading to lower interest rates. Individual consumers are rated for
creditworthiness not by credit rating agencies but by credit bureaus (also called consumer
reporting agencies or credit reference agencies), which issue credit scores.
The value of credit ratings for securities has been widely questioned. Hundreds of billions of
securities that were given the agencies' highest ratings were downgraded to junk during
the financial crisis of 2007–08.[4][5][6] Rating downgrades during the European sovereign debt
crisis of 2010–12 were blamed by EU officials for accelerating the crisis.[3]

Credit rating is a highly concentrated industry, with the "Big Three" credit rating
agencies controlling approximately 95% of the ratings business.[3] Moody's Investors
Service and Standard & Poor's (S&P) together control 80% of the global market, and Fitch
Ratingscontrols a further 15%.

When companies and countries need to borrow money from the market, there needs to be an
agency that determines their creditworthiness or their ability to repay and be a source of good
investment. Even for individuals when they apply for a loan, the banks and financial institutions
assess their ability to repay and their soundness. For instance, when you apply for a home or
an automobile loan or for a credit card, the bank has internal processes that determine whether
you should be given the loan. Similarly, when companies and countries borrow, there are credit
rating agencies that assign ratings to them to signal to the market about their creditworthiness.
The difference between individuals, companies, and countries as far as rating agencies are
concerned is the scale of borrowing and the depth of analysis. Whereas countries are rated on
a whole host of parameters, companies are rated according to the assets they hold, the cash
flow both future and current, and individuals according to their credit history. The point to note
is that more often than not, lenders need independent agencies that assess the creditworthiness
of the parties and this is where credit rating agencies come into the picture.
 MODULE – 8 CORPORATE FUND RAISING

1. Dematerialisation of Securities: Concepts, Benefits and working machinery of a

Depository

Your investments in shares and debentures can be held in electronic or dematerialised form in
a depository. Depository is an entity which holds securities (shares, debentures, bonds,
government securities, mutual fund units etc.) of investors in electronic form at the request of
the investors.

National Securities Depository Ltd (NSDL) and Central Depository Services (India) Ltd
(CDSL) are the depositories that are licensed to operate in India and are registered with SEBI
(Securities and Exchange Board of India).

Dematerialisation is comparable to keeping your money in a bank account. In demat form, your
physical share certificates are replaced by electronic book entries; purchase of shares are
reflected as credits in your demat account and sales are reflected as debits.

1.1. Who is a depository participant?

 A depository participant (DP) is an agent of the depository through which you maintain
and operate your demat account; the DP provides the interface between you and the
depository.

 Just as banking services can be availed through a branch, depository services can be
availed through a DP. Any financial service provider, including, financial institutions,
banks, state financial corporations, stock-brokers, NBFC etc complying with SEBI’s
norms can be register and function as a DP.

1.2. What are the advantages / benefits of demat?

It is advisable to hold your securities in demat form as it offers many advantages as under:

Primary markets

 Nowadays, public issues are taking place in demat mode. Accordingly, to apply in
public issues, you need to have demat account.
  Allotment of shares in public issue is credited to your demat account and hence there is
no scope of loss of share certificates in transit.

Secondary markets

As per the available statistics at BSE and NSE, 99.9% transactions are taking place in
dematerialised mode only. Shares bought through the stock exchange is credited to your demat
account.

Unlike in physical shares, there is no scope for bad delivery or fake shares. Further, unlike
physical certificates, you do not have to send the shares purchased to the company to transfer
it to your name. Therefore, there is no scope for delay in transfer or for loss of share certificates
in transit. There is considerable reduction in paperwork and transaction cost in demat mode.

You can view all your investments in listed companies or mutual funds in single account. You
receive all the corporate benefits like rights, bonus shares directly into your demat account and
dividend into bank account registered in your demat account.

1.3. Process of conversion of securities into the demat form

Securities specified as being eligible for dematerialization by the depository in its bye laws and
as under the SEBI (Depositories and Participants) Regulations, 1996 (the Regulations) can be
converted or issued in a dematerialized form. The process of conversion of securities into a
dematerialized form or the issuance of the same in a dematerialized form can be explained thus:

1. Firstly, the issuer company, whose securities are eligible for dematerialization, has to enter
into an agreement with a depository for dematerialization of securities already issued, or
proposed to be issued to the public or existing shareholders.

2. The investor is given an option to hold the securities in a dematerialized form and it is his
prerogative to exercise the option to hold the securities in that manner.

3. The depository enters into an agreement with the participants who are the agents of the
depository and co-functionaries in the process of dematerialization of securities.
4. Any person can then enter into an agreement, through the participant, with the depository
for availing the services provided by the depository.

5. Upon the entering into such agreement with the depository, the person has to surrender the
certificate pertaining to the securities sought to be dematerialized to the issuer. This surrender
is effected in the following manner:
(i) The person (beneficial owner) who has entered into an agreement with the participant for
dematerialization of the securities has to inform the participant about the details of the
certificate of such securities.
(ii) The beneficial owner has to then surrender the said certificate to the participant.
(iii) The participant informs the depository about the particulars of the securities to be
dematerialized and the agreement entered into between him and the beneficial owner.
(iv) The participant then transfers the certificate pertaining to the said securities to the issuer
along with the details and particulars of the securities.
(v) These certificates are mutilated upon receipt by the issuer and substituted in the records
against the name of the depository, who is the registered owner of the said securities. A
certificate to this effect is sent to the depository and all stock exchanges where the security is
listed.
(vi) Subsequent to this, the depository enters the name of the person who has surrendered the
certificate of security as the beneficial owner of the dematerialized securities.
(vii) The depository also enters the name of the participant through whom the process has been
carried out and sends an intimation of the same to the said participant.

6. Once the aforesaid process of dematerialization is carried out, the depository has the
responsibility to maintain all the records pertaining to the securities that have been
dematerialized.

1.6. What is a Depository Receipt?

A depositary receipt is a negotiable financial instrument issued by a bank to represent a foreign

company's publicly traded securities. With a depositary receipt, a custodian bank in the foreign
country holds the actual shares, often in the form of an American depositary receipt (ADR),
which is listed and traded on exchanges based in the United States, or a global depositary
receipt GDR, which is traded in established non-U.S. markets such as London and Singapore.

When a foreign-listed company wants to create a depositary receipt abroad, it typically hires
a financial advisor to help it navigate regulations, a domestic bank to act as custodian and
a broker in the target country to list shares of the firm on an exchange, such as the New York
Stock Exchange (NYSE), in the country where the firm is located.

ADRs typically trade on the American Stock Exchange (AMEX), the NYSE or the Nasdaq.
ADRs provide investors with the benefits and rights of the underlying shares, which may
include voting rights, and open up markets investors would not have access to otherwise. For
example, ICICI Bank Ltd. is listed in India and is typically unavailable to foreign investors.
However, the bank has an ADR issued by Deutsche Bank that is traded on the NYSE, which
most U.S. investors can access.

Pros and Cons of a Depository Receipt

Depositary receipts let U.S. investors purchase shares in foreign companies in a more
convenient and less expensive manner than purchasing stocks in foreign markets. Also, U.S.
investors may use depositary receipts to diversify their portfolios on a worldwide scale.

However, many depositary receipts are not listed on a stock exchange and are illiquid or traded
only by institutional investors. Also, the liquidity of trading unsponsored depositary receipts is
low, and the securities are not backed by a company. Investors may lose their entire principal.
The depositary receipt may be withdrawn at any time, and the waiting period for the shares
being sold and the proceeds distributed to investors may be long. The bank may impose a
substantial administration fee for each depositary receipt holder, reducing any potential gain
from the receipt.

1.5. Workings of a Depository: Models and Types of Ownership

1.5.1. The two models of the depository system are:

1. Dematerialization, wherein, by operation, there is no physical scrip1 in existence as neither
the individual who owns the shares nor the depository keeps scrips. The depository maintains
the electronic ledger of the securities under his control.

1
A provisional certificate of money subscribed to a bank or company, entitling the holder to a formal
certificate and dividends
2. Immobilization, wherein the physical scrips are held in the depository vaults, supporting
the book entry records kept on the computer.

1.5.2. Two types of ownership are contemplated under the depository system are:-
1. A registered owner is the depository who holds the securities in his name.
2. A beneficial owner is the person whose name is recorded as such with the depository. Though
the securities are registered in the name of the depository actually holding them, the rights,
benefits and liabilities in respect of the securities held by the depository vest in the beneficial
owner.

The depository model is based on the deposit of securities by the owner of the securities with
a certified depository. Subsequently, an entry is made in the name of the said owner,
manifesting his ownership of the securities upon which the person depositing the securities
becomes the beneficial owner in respect of the said securities. The service provided in relation
to this by the depository is that of recording of allotment of securities or transfer of ownership
of securities in the record of the depository.

2. Various instruments of raising finance

a) Indian Depository Receipts (IDR)

IDR stands for Indian Depository Receipts. As per the definition given in the Companies (Issue
of Indian Depository Receipts) Rules, 2004, IDR is an instrument in the form of a Depository
Receipt created by the Indian depository in India against the underlying equity shares of the
issuing company.
An IDR is a way for a foreign company to raise money in India. In an IDR, foreign
companies would issue shares,
to an Indian Depository, which would in turn issue depository receipts (IDR) to investors in
India. The actual shares underlying the IDRs would be held by an Overseas Custodian, which
shall authorize the Indian Depository to issue the IDRs. To that extent, IDRs are derivative
instruments because they derive their value from the underlying shares.

IDR are issued by a domestic depository in India and denominated in Rupees. It represents an
ownership interest in a fixed number of underlying equity shares of the Issuing Company.
These shares are called Deposited Shares.
 Standard Chartered Bank created history in the Indian Capital Market by becoming the first
foreign company to come up with an IDR issue.

Standard Chartered Bank (SCB) took about 18 months of planning before coming out with its
Indian depository receipt (IDR) issue and creating history in the Indian capital markets on May
25, 2010.
SCB had to work out a number of issues in terms of establishing the regulatory framework
around the issue and obtaining the necessary clearances from the Securities and Exchange
Board of India and the Reserve Bank of India. The biggest challenge was to explain to investors
how IDR works and how to make investors think about it as an investment proposition.
In this case, Standard Chartered Bank, Mumbai was the domestic depository, and it has
appointed Bank of New York, Mellon as its overseas depository.

IDRs has the following features:

a) Overseas Custodian: It is a foreign bank having branches in India and requires approval
from Finance Ministry
for acting as custodian and Indian depository has to be registered with SEBI.
b) Approvals for issue of IDRs: IDR issue will require approval from SEBI and application
can be made for this purpose 90 days before the issue opening date.
c) Listing: These IDRs would be listed on stock exchanges in India and would be freely
transferable.
d) Eligibility conditions for overseas companies to issue IDRs:

1. Capital: The overseas company intending to issue IDRs should have paid up capital and
free reserve of at least $ 100 million.
2. Sales turnover: It should have an average turnover of $ 500 million during the last three
years.
3. Profits/dividend: Such company should also have earned profits in the last 5 years and
should have declared dividend of at least 10% each year during this period.
4. Debt equity ratio: The pre-issue debt equity ratio of such company should not be more
than 2:1.
5. Extent of issue: The issue during a particular year should not exceed 15% of the paid up
capital plus free reserves.
6. Redemption: IDRs would not be redeemable into underlying equity shares before one
year from date of issue.
7. Denomination: IDRs would be denominated in Indian rupees, irrespective of the
denomination of underlying shares.
8. Benefits: In addition to other avenues, IDR is an additional investment opportunity for
Indian investors for overseas investment.
9. Minimum issue size: $500 million
e) Dividends related to IDR: IDR stands for a particular percentage share of one equity share.
The dividend declared by the IDR issuer will be apportioned according to the IDR holdings,
and distributed to the IDR holder by the depository.
f) Taxation related to IDR: The current tax provisions put IDRs at a distinct disadvantage
when compared with other shares listed on Indian stock exchanges. Dividend tax will be
assessed at 30% (plus 10% surcharge) on all the dividends from IDRs.
Short term capital gains: On Indian stocks, the short term capital gains is charged at 15%,
however in the case
of IDRs, the short term capital gains will be charged at 30%.
Long term capital gains: On stocks in India, there is no tax on long term capital gain. But in
the case of IDRs –
investors will need to pay a 20% long term capital gains.
The Direct Tax Code which is expected to be implemented next year will change a lot of things
and eliminate most of the above referred differences.

b) American Depository Receipts (ADR)

Globalization is the dissolution of barriers to trade and the tendency of the world's businesses
to integrate customs and values. Globalization is making it increasingly easy to travel,
correspond and even invest in other countries.

Investing money in your own country's stock market is relatively simple. You call your broker
or login to your online account and place a buy or sell order. Investing in a company that is
listed on a foreign exchange is much more difficult. Would you even know where to start?
Does your broker provide services in other countries? For example, imagine
the commission and foreign exchange costs on an investment in Russia or Indonesia.

However, now there is an easy way around this through American depositary receipts (ADRs).
More than 2,000 foreign companies provide this option for U.S. and Canadian investors
interested in buying shares. In this tutorial, we'll explain how this investment vehicle works
and help you sort out whether it could be a good choice for your portfolio.

Introduced to the financial markets in 1927, an American depositary receipt (ADR) is a stock
that trades in the United States but represents a specified number of shares in a foreign
corporation. ADRs are bought and sold on American markets just like regular stocks, and are
issued/sponsored in the U.S. by a bank or brokerage.

ADRs were introduced as a result of the complexities involved in buying shares in foreign
countries and the difficulties associated with trading at different prices and currency values.
For this reason, U.S. banks simply purchase a bulk lot of shares from the company, bundle the
shares into groups, and reissues them on either the New York Stock
Exchange (NYSE), American Stock Exchange (AMEX) or the Nasdaq. In return, the foreign
company must provide detailed financial information to the sponsor bank. The depositary bank
sets the ratio of U.S. ADRs per home-country share. This ratio can be anything less than or
greater than 1. This is done because the banks wish to price an ADR high enough to show
substantial value, yet low enough to make it affordable for individual investors. Most investors
try to avoid investing in penny stocks, and many would shy away from a company trading for
50 Russian roubles per share, which equates to US$1.50 per share. As a result, the majority of
ADRs range between $10 and $100 per share. If, in the home country, the shares were worth
considerably less, then each ADR would represent several real shares.

There are three different types of ADR issues:

 Level 1 - This is the most basic type of ADR where foreign companies either don't
qualify or don't wish to have their ADR listed on an exchange. Level 1 ADRs are found
on the over-the-counter market and are an easy and inexpensive way to gauge interest
for its securities in North America. Level 1 ADRs also have the loosest requirements
from the Securities and Exchange Commission (SEC).

 Level 2 - This type of ADR is listed on an exchange or quoted on Nasdaq. Level 2

ADRs have slightly more requirements from the SEC, but they also get higher visibility
trading volume.
  Level 3 - The most prestigious of the three, this is when an issuer floats a public
offering of ADRs on a U.S. exchange. Level 3 ADRs are able to raise capital and gain
substantial visibility in the U.S. financial markets.

The advantages of ADRs are twofold. For individuals, ADRs are an easy and cost-effective
way to buy shares in a foreign company. They save money by reducing administration costs
and avoiding foreign taxes on each transaction. Foreign entities like ADRs because they get
more U.S. exposure, allowing them to tap into the wealthy North American equities markets.

Brief
 ADR is an acronym for American depositary receipt.
 ADRs trade just like stocks but represent shares of a foreign company trading on a
foreign stock exchange.
 ADR shares float on supply and demand, just like a regular stock.
 There are three types of ADRs - Level 1, Level 2 and Level 3. Levels 1 and 2 are listings
in the U.S., while Level 3 ADRs are public offerings to investors.
 Remember that there are other risks associated with buying ADRs,
including inflationary risk, political risk and exchange rate risk.

c) Global Depository Receipts

A global depositary receipt (GDR) is a bank certificate issued in more than one country
for shares in a foreign company. The shares are held by a foreign branch of an international
bank. The shares trade as domestic shares but are offered for sale globally through the various
bank branches. A GDR is a financial instrument used by private markets to raise capital
denominated in either U.S. dollars or euros.

A GDR is very similar to an American depositary receipt (ADR). GDRs are called EDRs when
private markets are attempting to obtain euros.
GDRs may be traded in multiple markets, generally referred to as capital markets, as they are
considered to be negotiable certificates. Capital markets are used to facilitate the trade of long-
term debt instruments, primarily for the purpose of generating capital. GDR transactions in the
international market tend to have lower associated costs than some other mechanisms that can
be used to trade in foreign securities.
Shares Per Global Depositary Receipt
Each GDR represents a particular number of shares in a specific company. A single GDR can
represent anywhere from a fraction of a share to multiple shares, depending on its design. When
multiple shares are involved, the receipt value shows an amount higher than the price for a
single share. Depository banks manage and distribute various GDRs and function in an
international context.

Trading of Global Depositary Receipt Shares

Companies issue GDRs to attract interest by foreign investors, providing a lower-cost
mechanism in which these investors can participate. These shares are traded as though they are
domestic shares, but they can be purchased in an international marketplace. Often, the actual
shares that are allocated within the GDR are put in the possession of a custodian bank as
transactions are processed, ensuring both parties a level of protection while facilitating
participation.

The purchase and sale of GDRs are managed through brokers representing the buyer, generally
from the home country, and seller within the foreign market. The actual purchase of the assets
are multi-staged, involving a broker in the investor's home, a broker located within the market
associated with the company that has issued the shares, a bank representing the buyer and the
custodian bank.

If an investor desires, GDRs can be sold through their brokers as well. They can be sold as is
on the proper exchanges, or they can be converted into regular stock for the company.
Additionally, they can be canceled and returned to the issuing company