Case Study: Inflation and Investment Decisions

The net present value method (NPV) is the classic economic method of evaluation of investment proposals. The NPV method explicitly considers the time value of money. It correctly calculates future cash flows arising at different point of time. But such cash flows are only comparable once they are adjusted with respective time value to find the respective present value. Summation of all present value represents the total value of the cash flow as on the day of evaluation. The time value of money represents the value of money may be earned by way of interest over a given amount of time. Discounted Cash Flow represents the cash flow adjusted with discount rate of the project. Discount rate is equivalent to expected rate of return of the project. Discount rate may the opportunity cost of capital. Assumptions:

Cash flow of the project should be estimated using realistic assumptions. Appropriate discounted Rate should be identified. This rate should be projects opportunity cost of capital which is equal to the required rate of return expected by investors on similar risky projects. Present value of cash flows should be calculated using the opportunity cost of capital as discount rate. NPV= Present Value of Cash Inflows MINUS Present Value of Cash Outflow.

Methodology:

NPV = [{1st Year Cash Inflow/ (1+r)1+..+nth year cash inflow/(1+r)n}+discounted salvage value -Initial outlay]
Decision Making: A project with positive NPV should be accepted as eligible for investment A project with negative NPV should be rejected A project with zero NPV, whether be accepted or rejected, has to be decided considering the strategic position of the company on this particular project and other criteria.

Merits: NPV method takes into account the time value of money The entire cash flows is considered NPV can be seen as addition to the wealth of share holders NPV uses discounted cash flow which means cash flows at the current rupee value term. Every project can be evaluated independent of other project.

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The projects can ranked for the purpose of selection of mutually exclusive projects

Demerits:

Cash flows estimation can be difficult as they are spread over project term. Identification of a discounting rate is also difficult because cost of capital varies with interest rates, suppliers may provide credit for longer period, customers may provide amount as advance and such other such factors. Working capital requirement must be considered in the year the plant start commercial production. Such working capital is recoverable and treated in the last year.

Inflation: In economics, inflation is the rise in the general price level of goods and services over a period of time. Due to inflation real value currency goes down as currency looses buying power as each unit of currency fetches fewer goods and services. Thus it reflects erosion of purchasing power of the currency. Let us discuss above issues with a practical illustration.

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Case study: Activity Based Costing (ABC) Introduction:

The Activity-based costing (ABC) identifies activities in an organization and allocates the cost of each activity resource to all products and services as per the actual usage or consumption by each activity. It allocates indirect costs (overhead) into direct costs. Cost Driver for an activity is the factor that influences the amount of resources to be consumed by a given activity. A cost driver is designed to allocate the activity cost pool to the cost objects. Activity is the work that is done. Resources is what the activity uses to do the work i.e. man, material, machine, method (know - how), money, organizational motivation. The cost of the activity depends on the quantity of resources used to accomplish the activity. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives. Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns in their book Accounting and Management: A Field Study Perspective Scope: The knowledge of customer need and product profitability can refer to the difference between promoting products and services that generate the greatest returns and wasting resources on a losing proposition. So, companies look to leverage their investment in enterprise performance management (EPM) through ABC, improved profitability analysis is a necessary part of a firms performance. With the improved insight, ABC enables managers to take strategic decisions. Thus it is a key performance indicator of every business unit. Objectives: To know the concept of Activity Based Costing with practical illustrations.

Methodology:

Fixed cost allocation

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Variable cost allocation Cost driver determination Cost driver rate

Applications:

To identify inefficient products, departments and activities, unnecessary costs To allocate more resources on profitable products, departments and activities To control the costs at an micro level and on macro level

Limitations: In activity-based costing, some overhead costs are difficult to allocate to products, such as the Top management executive's salary. These costs are termed as unallocable cost. Lean accounting methods have been developed in recent years to provide relevant and thorough accounting, control, and measurement systems without the complex method of ABC. ABC Analysis: ABC analysis is a business term used to define an inventory categorization technique, it is also known as Selective Inventory Control. ABC analysis provides a mechanism for identifying items which will have a significant impact on overall inventory cost whilst also providing a mechanism for identifying different categories of stock that will require different management and controls When carrying out an ABC analysis, inventory items are valued (item cost multiplied by quantity issued/consumed in period) with the results then ranked. The results are then grouped typically into three bands. These bands are called ABC codes.ABC codes "A class" inventory will typically contain items that account for 80% of total value, or 20% of total items. "B class" inventory will have around 15% of total value, or 30% of total items. "C class" inventory will account for the remaining 5%, or 50% of total items.

There are three major differences between traditional cost accounting and ABC Method: In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.

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Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels. Traditional cost accounting is structure-oriented whereas ABC is processoriented.

The ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations. Process Flowchart:

Start

Receiving Materials

Setup Machine

Start TV Assembling

Insert Machine Handled Components

Complete Quality Test

Solder Components

Manual Work

Job Done
Practical Illustration: The following information provides details of the costs, volume and transaction cost drivers for a period in respect of HGL Ltd:

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H Sales and production 30,000 (units) Raw materials usage 5 (units) Direct materials cost 25 (Rs) Direct labour hours 1.33 Machine hours 1.33 Direct labour cost (Rs) 8 Number of production 3 runs Number of deliveries 9 Number of receipts 15 Number of production 15 orders Overhead costs Rs. Set up 30,000 Machines 7,60,000 Receiving 4,35,000 Packing 2,50,000 Engineering 3,73,000 Total 18,48,000

Products G 20,000 5 20 2 1 12 7 3 35 10

Total 58000

8,000 11 11

12,38,00 0 1 88,000 2 76000 6 30 32 270 50

20 20 220 25

Note: The company operates a just in time policy and receives each component once per production run. The company has allocated to products on direct labour hour basis (DL). Maximum overheads are allocated to machine hours rather than direct labour hours. The company has reviewed its cost system by recovering overheads using two volume related bases: machine hours and a materials handling overhead rate for recovering overheads of the receiving department. Both existing and new cost system reported low profit margins for product H, which is the cash cow for the company. The management has decided to use ABC method for this purpose. You are required to (a) calculate the total costs for each product if all overhead costs are absorbed on a labour hour basis (Overheads of receiving dept. are recovered by a material handling overhead rate and the remaining overheads are recovered using a machine hour rate; (b) calculate the total costs for each product, using activity based costing. Solution: Firstly to see how traditional cost accounting methods or direct labour hour (DLH) might deal with them, afterwards, to look at the ABC method itself.

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a) Computation of the product cost using traditional volume related costing system viz. all overheads are recovered on the basis of direct labour Products H Direct labour Direct materials Overhead Total (Rs.) 8 25 21 61 G 12 20 42 74 L 6 11 21 38

Overheads to be charged to products: Direct labour overhead rate: Total Overheads/ Total Direct Labor Hours = Rs. 18,48,000/Rs.88,000 hours =Rs.21/ direct labour hour The overheads of the receiving dept. are recovered by a material handling overhead rate & the remaining overheads are recovered by using machine hour rate. Products H Direct labour Direct Materials Material handling overhead G 8.00 25.00 8.79 L 12.00 20.00 7.03 6.00 11.00 3.87

(Rs. 25x35.14%)(Rs20x35.14%)(Rs11x35.14%) Other overheads (Using machine hour) Total Cost: 24.79 18.59 37.18

(1.33hrs*Rs18.79)(1hr*Rs18.59)(2hrs*Rs18.59) 66.58 57.62 58.05

Overheads to be charged to products: Material Handling Overheads Rate: Receiving Dept. Overheads/Direct Material Cost

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=Rs.4,35,000/Rs.12,38,000*100 =Rs.35.14% of direct material cost Machine Hour Overhead Rate: Other Overheads/Machine Hour*100 =Rs14,13,000/76,000 hrs =Rs. 18.59 per machine hour ABC method To apply the ABC method, we need to identify cost drivers for two stages: 1 cost drivers reflecting the costs of inputs into cost pools; and 2 cost drivers reflecting the cost pools into product costs The workings that follow illustrate clearly how such cost drivers work through the ABC system in these two stages: an initial overhead rate or amount being further subdivided according the needs of the situation. The calculations for each of the rates will be used are: Machine hour overhead rate Rs. 7,60,000 76,000 machine hours This rate is used as normal. For the set up costs, the cost per set up: total set up overheads divided by the number of set ups: in this case, this is Cost per Set up =Rs.1,0 Rs.30,000 00 30 production runs All of the other rates are calculated similarly. Receiving rate Rs.4,35,000 = Rs.1,611 270 receipts Rs. = Rs.7812 2,50,000 32 deliveries =Rs.1 0

Packing rate

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Engineering rate

Rs.3,73,000 = Rs.7,460 50 production orders

The cost per unit statement follows: Unit costs Direct materials Direct labour Machine overheads Set up costs Receiving costs Packing costs Engineering costs Total Costs H Rs 25.00 8.00 13.33 0.10 0.81 2.34 3.73 Rs53. 31 G L Rs Rs 20.00 11.00 12.00 6.00 10.00 20.00 0.35 2.50 2.82 44.30 1.17 19.53 3.73 23.31 Rs50. Rs126. 07 64

Overheads per unit using each of the two methods: Product H G L 66.5 58. 57.62 7 05 53.31 50.0 126.6 7 4

DLH

ABC

The receiving, packing and engineering costs are all calculated in the same way as the set up costs. Summarizing each of these methods now we can see the impact of the different methods on product costs, assuming that the ABC method is really more effective than the traditional approach. Interpretations: The product cost varies depending on the use of the activities. Although the material costs for H are higher than those of G and L, the total cost for G is less. This is because H uses less of the more expensive activities. The number of machine insertions appears to be a key factor affecting the final cost. The fewer the manual insertions, the lesser the chance of manual error, resulting in less testing time and fewer rejects. Therefore, if more components can be

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inserted by machine, the product cost will decrease. The component insertion costs will decrease, and the testing cost may decrease as well. The defect rate may also decrease, if there are more machine insertions.

Conclusion & Summary:

Activity Based Costing method is the better method to allocate to each activity contributing to total cost of the business organization. It gives an opportunity to the management and decision makers to understand necessity of each activity and their value addition. Activity Based Costing method helps at the time of decision making whether to make or buy, in the merger & acquisition, to calculate synergy and operational cost advantage of companies under consideration. Thus Activity Based Costing method reflects better way of cost allocation which further ensures transparency in various business processes.
References: 1. Symbiosis Centre for Distance Learning www.scdl.net 2. Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective (Harvard Business School Press, 1987) ISBN 0-87584-186-4 3. Cost and Managemen tAccounting PrenticeHall

Case Study: Mutual Fund as an investment vehicle

Introduction:

A mutual fund is a professionally managed financial institution which pools money from many investors to buy stocks, bonds, short-term or long term money market instruments, and/or other securities with the objective to increase the Net Assets Value of the mutual fund. The mutual
fund house offers investors a wide range of Schemes to choose from depending on their individual profiles. Benchmark is a standard for a fund. Benchmark is used to measure the performance of the fund. Each fund has a benchmark. When a fund performs better than the benchmark, then it is called the fund has outperformed. Converse situation is known as under performance. Need for the Study: The main purpose of doing this project was to know about mutual fund and its

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functioning. It also helps in understanding different schemes of mutual funds and their benefits. Scope: The scope is limited to general nature of the mutual fund industry as a whole. Objective: To give an idea about the benefits available from Mutual Fund investment To give an idea of the types of schemes available To discuss about the cost structure and evaluate the performance of mutual funds Merits: Professional management: Investors can access at low cost the highly professional and skilled management services. The managers have sound knowledge and wide experience in investment. Their skills and much needed research into available investment options reduce risks of wrong investments. Low cost high value portfolio diversification: Market related risks can be reduced by diversification of portfolio. A retail investor faces challenge to diversify portfolio due to limited fund. By Investing in mutual funds, small portfolio gets automatically diversified. Reduction / Diversification of Risks: Investment in mutual fund means investment in a pool of funds. These funds will be then invested in securities. So, every investor has to share profit & loss with other investors. Reduction of transaction cost: A mutual fund economizes the cost of search and verification due to size and scale of operations. Liquidity: As mutual fund house does not invest 100% of the assets under management (AUM), they keep certain percentage of AUM in cash, so it is possible for the investors to en-cash the value of units by simply selling back to mutual fund. However, in case of close ended fund, investor can sell their units only after lock in period is over. Limitations: Despite Negative Returns Investors must pay sales charges, annual fees, and other expenses regardless of how the fund performs. And, depending on the timing of their investment, investors may also have to pay taxes on any capital gains distribution they receive.

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Lack of Control Investors typically cannot ascertain the exact make-up of a fund's portfolio at any given time, nor can they directly influence which securities the fund manager buys and sells or the timing of those trades.

Industry Profile: As per AMFI, latest total assets under management is around Rs. 6670000 Crore. History: The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at the initiative of the Government of India and Reserve Bank of India. Investment Options: To cater to different investment needs, Mutual Funds offer various investment options. Some of the important investment options include: Growth Option: Dividend is not paid-out under a Growth Option and the investor realizes only the capital appreciation on the investment (by an increase in NAV). Dividend Payout Option: Dividends are paid-out to investors under the Dividend Payout Option. However, the NAV of the mutual fund scheme falls to the extent of the dividend payout. Dividend Re-investment Option: Here the dividend accrued on mutual funds is automatically re-invested in purchasing additional units in open-ended funds. In most cases mutual funds offer the investor an option of collecting dividends or re-investing the same. Retirement Pension Option: Some schemes are linked with retirement pension. Individuals participate in these options for themselves, and corporate participate for their employees. Exchange-traded funds: ETFs are a type of nvestment Company that aims to achieve the same return as a particular market index. They can be either open-end companies or UITs. Tax Exempt Funds: If investor invests in a tax-exempt fund such as a bond fund some or all of your dividends will be exempt from income tax. You will, however, owe taxes on any capital gains. Insurance Option: Certain Mutual Funds offer schemes that provide insurance cover to investors as an added benefit.

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Mode of Withdrawn: An investor can sell his units in holding at any point of time. He/ She can sell all or part of their total holdings in terms of units. Systematic Investment Plan (SIP): Here the investor is given the option of preparing a pre-determined number of postdated cheques in favour of the fund. The investor is allotted units on a predetermined date specified in the offer document at the applicable NAV. Systematic Withdrawal Plan (SWP): As opposed to the Systematic Investment Plan, the Systematic Withdrawal Plan allows the investor the facility to withdraw a pre-determined amount / units from his fund at a pre-determined interval. The investor's units will be redeemed at the applicable NAV as on that day. Cost Structure: The total expenses of the scheme as charged by the AMC exclude issue / redemption expenses but including investment management and advisory fees are subject to as follows: On the first Rs.100 cr. of average weekly net assets cost is 2.5% On the next Rs.300 cr. of average weekly net assets cost is 2.25% On the next Rs.300 cr. of average weekly net assets cost is 2.00% On the balance of the assets cost is 1.75%

Entry Load: There is no entry load in investment through NFO, in open ended scheme, in closed ended scheme. Exit Load: It varies from fund to fund. Some fund charges around 2.5% in investment if withdrawn within first year of investment. From 1 year onward to 3 year, the charge could be around 1.5%. After 3rd year to 5th year the charge is 1% and above 5th year charge is nil. Normally, Index funds have lower exit load while minimum holding period is also around 7days to 10 days. Evaluation of the fund performance: Treynor Ratio: This ratio is also known as the reward to volatility ratio. It is the ratio of a funds average excess return to the funds beta. It measures the returns earned in excess of those that could have been earned on a riskless investment per unit of market

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risk assumed. The formula is typically used in ranking Mutual Funds with similar objectives. T= (Return of portfolio minus Risk free rate of return)/ Beta of the portfolio The absolute risk adjusted return is the Treynor plus risk free rate of return Fund Name Return (%) Beta Risk free Return = 9% Calculate Treynor Ratio. For Fund A Treynor Ratio: =(0.12 minus 0.09)/0.70 Risk Adjusted Rate of Return = 0.043+0.09 =0.043 A 12 0.70 B 14 1.2

=0.133 =13.3% =0.04

For Fund B Treynor Ratio: =(0.14 minus 0.09)/1.2 Risk Adjusted Rate of Return = 0.04+0.09

=0.13 =13%

So after above calculation, we can get risk adjusted rate of return (RARR). In Fund B, RARR has gone up to 13% while in Fund A it has fallen down to 13.3% corresponding to respective portfolio return rate. RARR is a factor investor should consider. Thats why investment advisors always suggest not to put all the money into either one or one type of funds because it reduces benefit of diversification portfolio. Basis for Analysis: Net Asset Value (NAV) is the best parameter on which the performance of a mutual fund can be studied. Investor need to study the performance of the NAV based on the compounded annual return of the Scheme in terms of appreciation of NAV, dividend and bonus issues. The NAVof the Fund is the cumulative market value of the assets Fund net of its liabilities. It is calculated simply by dividing the net asset value of the Fund by the number of units outstanding.

Equity or Growth Scheme: These schemes, also commonly called Growth Schemes, seek to invest a majority of their funds in equities and a small portion in money market instruments. Such schemes have the potential to deliver superior returns over the long term. These schemes are exposed to fluctuations in value especially in the short term.

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Balanced Scheme: The aim of Balanced Funds is to provide both growth and regular income while reducing risks. Such schemes periodically distribute a part of their earning and invest both in equities and fixed income securities in the proportion indicated in their offer documents. Portfolio of balanced funds may include some or all of the following types of securities: A portion of fund is invested in stocks. A portion of fund is Debt Funds is invested in fixed or floating interest paying securities issued by government, semi-government bodies, public sector units and corporates. Categorizing Equity: Diversified invest in large capitalized stocks belonging to multiple sectors. Sectorial Invest in specific sectors like technology, FMCG, Pharma, etc. Categorized Debt: Gilt Invest only in government securities, long maturity securities with average of 9 to 13 years, very sensitive to interest rate movement. Medium Term Debt (Income Funds) Invest in corporate debt, government securities and PSU bonds. Average maturity is 5 to 7 years. Short Term Debt Average maturity is 1 year. Interest rate sensitivity is very low with steady returns. Liquid Invest in money market, other short term paper, and cash. Highly - liquid. Average maturity is three months. References: www.mutualfundsofindia.com www.amfi.com www.nseindia.com www.bseindia.com Symbiosis Centre for Distance Learning www.sebi.gov.in

Case Study: Alternative Structure of Micro Finance Institution

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Introduction: In an age of Liberalization, Globalization and Wealth Maximization, access to financial system viz. banking system is still beyond reach of many marginal farmers, micro enterprises and women entrepreneurs of rural and other parts of India. The basic need of these people can be addressed to a large extent by setting up Micro-finance Institutions. The lack of Micro-finance Institution is related to their structure which is a burning issue. Objective: Identify the alternative structures of an ideal Micro-finance Institution. Scope of Micro Finance: Micro finance is boon for many poor people to mobilize resources to develop their enterprises and their dwellings slowly over time. Financial services could enable the poor to leverage their initiative, accelerating the process of building incomes, assets and economic security. However, conventional finance institutions seldom lend down-market to serve needs of low-income families and women-headed households. They are very often denied access to credit for many purposes, making the discussion of the level of interest rate, credit risk and other terms of finance. The lack of access to credit for the poor is attributable to practical difficulties arising from the discrepancy between the mode of operation followed by financial institutions and the economic characteristics and financing needs of low-income households. Financial institutions ask for collateral with a clear title - which many low-income households do not have. In addition bankers tend to consider low income households a prone to risk imposing exceedingly high information monitoring costs on operation and administration. The successful experiences in providing finance to small entrepreneur and producers demonstrate that poor people, when given access to responsive and timely financial services at market rates, repay their loans and use the proceeds to increase their income and assets. Community banks, Micro Finance Institutions and grass root savings and credit groups around the world have shown that these microenterprise loans can be profitable for borrowers and for the lenders, making microfinance one of the most effective poverty reducing strategies. To the extent that microfinance institutions become financially viable, self sustaining, and integral to the communities in which they operate, they have the potential to attract more resources and expand services to clients. Although only about 2% of world's roughly 50 crores small entrepreneurs are estimated to have access to financial services. However, there is a demand for credit by poor and women at market interest rates, the volume of financial transaction of microfinance institution must reach a certain level before their financial operation becomes self sustaining.

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The question is how micro lenders and micro borrowers can be included as an integral part of the financial sector with sustainability (financial inclusions) and how their financial services can be further expanded using the principles, standards and modalities that have proven to be effective. The traditional finance sector institutions could form a joint venture with unorganized sector institutions in which the former provide funds in the form of equity and the later extends savings and loan facilities to the urban poor. Another form of partnership can involve the organized sector institutions refinancing loans made by the unorganized sector lenders. Under these settings, the organized sector institutions are able to tap additional resources as well as having an incentive to exercise greater financial discipline in their management. Microfinance institutions play as intermediaries between borrowers and the organized financial sector and on-lend funds backed by a public sector guarantee. Business-like Micro Finance Institutions can offer commercial banks ways of funding micro entrepreneurs at low cost and risk. So, banks make one bulk loan to Micro Finance Institutions and the Micro Finance Institutions packages it into large number of micro loans at market rates and recover them. In this context, following strategic, institutional and connectivity issues related to micro-finance arise.

Strategic Issues To set organizations principles and operational imperatives. To identify beneficiaries To identify prevailing paradigm for micro-finance To identify methodological issues. Administrative Issues To identify Leadership traits To identify the need for a new institution. To identify business geography of micro institutions External Environmental Issues To identify conflict with government policies To identify political tussles that should be explicitly considered To identify interactions with Corporate Financial Sector To identify communities involvement Tradition Financial Institutions: Traditionally, the organized sector Banking Institutions in India have been serving only the needs of the commercial sector and providing loans for middle and upper income groups. Similarly, for housing the HFIs have generally not evolved a lending product to serve the needs of the Very LIG

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primarily because of the perceived risks of lending to this sector. Following risks are generally perceived by the organized sector financial institutions: Credit Risk High transaction and service cost Absence of land tenure for financing housing Irregular flow of income due to seasonality Lack of tangible proof for assessment of income Unacceptable collaterals such as crops, utensils and jewellery Organized financial Sources: At present, the local money lenders charge exorbitant rates, generally ranging from 36% to 60% interest due to their monopoly in the absence of any other source of credit for non-conventional needs. Chit Funds and Bishis are other forms of credit system operated by groups of people for their mutual benefit which have their own limitations. Another type of Micro Finance Institutions promotes savings at micro level. Theses Micro Finance Institutions collect money from rural households and fund micro credit. Although the savings of group members small in nature do not attract high returns, it is still practiced due to security reasons and for getting loans at lower rates compared to that available from money lenders. The interest rates on such credit are not subsidized and generally range between 12% to 36%. Most of the loans are unsecured. In few cases personal or group guarantees or other collaterals like jewellery is offered as security. Most of the Micro Finance Institutions and NGOs like SHARAN in Delhi, FEDERATION OF THRIFT AND CREDIT ASSOCIATION (FTCA) in Hyderabad or SPARC in Bombay have adopted the first model where they initiate the groups and provide the necessary management support. Others like SEWA in Ahmedabad, BKB, SKS Micro Finance, FWWB and BARODA CITIZEN's COUNCIL in Baroda pertain to the second model. There are 250-300 Micro Finance Institutions each with 50-100 Self Help Groups (SHG) in India. Few of them, not more than 20-30 Micro Finance Institutions have started forming SHG Federations. There are also agencies which provide bulk funds to the system through Micro Finance Institutions. These intermediaries perform just as a wholesaler like NABARD, Rashtriya Mahila Kosh-New Delhi and the Friends of Women's World Banking in Ahmedabad. Few of the Micro Finance Institutions supporting SHG Federations include MYRADA in Bangalore, SEWA in Ahmedabad, PRADAN in Tamilnadu and Bihar, ADITHI in Patna, SPARC in Mumbai and ASSEFA in Madras etc. While few of the Micro Finance Institutions directly retailing credit to Borrowers are SHARE in Hyderabad, ASA in Trichy, RDO Loyalam Bank in Manipur. Credit Mechanisms Adopted for Lending Micro Income Group Beneficiaries:

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The need for better housing and living environment for the poor, both, in the urban and rural sectors materialized in its collaboration with HDFC, Kreditanstalt fur Wiederaufbau (KfW), a German Development bank. KfW sanctioned DM 55 million to HDFC for low cost housing projects in India. HDFCs' approach to low-income lending has been extremely professional and developmental in nature. HDFC also ensures that the newly constructed houses are within the affordability of the beneficiaries, and thus promotes the usage of innovative low cost technologies and locally available materials for construction of the houses. The security for the loan is generally the mortgage of the property being financed. The loans from HDFC are disbursed depending upon the stages of construction. To date, HDFC has experienced 100% recovery for the loans disbursed to various projects. Criteria to Success: These Micro Finance Institutions have been successful to balance financial discipline through collection of savings and have demonstrated a matching value themselves before lending. A recovery system based on social intermediation and various options including non-financial mechanisms has proved to be effective. The communities in which households are direct stake holders have successfully demonstrated the success of programs. A precondition for success is to involve community directly in the program. The programs designed with women for women are more successful. Operating Factor: The effective and responsive accounting and monitoring mechanisms has been an important and critical ingredient for the success of programs. The operational success has been more when interest rates are at or near market rates: The experience of Micro Finance Institutions indicates that low income households are willing to pay market rates. The crucial problem is not the interest rates but access to finance. In absence of such programs, households end up paying much higher rates when borrowing from unorganized markets. A combination of the three i.e. interest rates, amount and repayment period if decided by community, the program is most likely to succeed. The interest spreads should be available to meet operational costs of Micro Finance Institutions . Facilitating Factor: Another factor that has contributed to the success is the broad environment. A facilitative environment and enabling regulatory regime contributes to the success. The Micro Finance Institutions which have been able to leverage funds from organized programs have been successful. An essential factor for success is that all development programs should converge across sectors. Ineffectiveness in Existing Microfinance Structures:

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The Grameen model of micro finance is successfully serving the rural poor in Bangladesh with no physical collateral relying on a micro borrower group responsibility to replace the collateral requirements. This model, however, has some weaknesses. It involves too much of external subsidy which is not replicable Grameen bank has not oriented itself towards mobilizing peoples' resources. The repayment system of 50 weekly equal installments is not practical because poor do not have a stable job and have to migrate to other places for jobs. If the communities are agrarian during lean seasons it becomes impossible for them to repay the loan. Pressure for high repayment drives members to money lenders. Another model is Kerala model (Shreyas). The rules to give adequate credit {make it difficult only 40-50 percent of amount available for lending). Most of the existing microfinance institutions are facing problems regarding skilled labour which is not available for local level accounting. Risk Management : yield risk and price risk Insurance & Commodity Future Exchange could be explored All the models lack in appropriate legal and financial structure. There is a need to have a sub-group to brainstorm on statutory structure/ ownership control/ management/ taxation aspects/ financial sector prudential norms. A forum/ network of micro-financier (self regulating organization) are desired. A New Horizon: A new critical job to link poor to organized financial system, if the goal of poverty alleviation has to be achieved, then new structure of financial institution has to be designed. The strengths and weaknesses of existing Micro Finance Institutions and microfinance institutions in India indicate that despite their best of efforts they have not been able to link themselves with organized systems. It is desired that an intermediary institution is required between organized financial markets and grass root. The intermediary should encompass the strengths of both organized financial systems and Micro Finance Institutions should be flexible to the needs of end users. There are, however, certain unresolved dilemmas regarding the nature of the intermediary institutions. These dilemmas are very contextual and only strengthen the argument that no unique model is applicable for all situations. They have to be context specific. Alternatives: Community Based

Investor Owned

Community (self) financed Community Managed Non profit / mutual benefit Integrated (social & finance)

Accepting outside funds for on-lending Professionally managed For profit Minimalist (finance only) For all under served clients Externally regulated

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Only for poor 'Self regulated'

There are four pillars of microfinance credit system viz supply, demand for finance, intermediation and regulation. Whatever may the model of the intermediary institution, the end situation is accessibility of finance to poor. The following tables indicate the existing and desired situation for each component. Demand: Existing Situation

Desired Situation

Fragmented Undifferentiated Addicted, corrupted by capital & subsidies Communities not aware of rights and responsibilities

Organized Differentiated (for consumption, housing) De-addicted from capital & subsidies Aware of rights and responsibilities

Supply: Existing Situation

Desired Situation

Grant based (Foreign/GOI) Directed Credit unwilling and corrupt Not linked with mainstream Mainly focused for credit Dominated

Regular fund sources (borrowings/deposits) Demand responsive Part of mainstream (banks/FIs) Add savings and insurance Reduce dominance of informal, unregulated suppliers

Intermediation: Existing Situation

Desired Situation

Non specialized Not oriented to financial analysis Non profit capital Not linked to mainstream FIs Not organized

Specialized in financial services Thorough in financial analysis For profit Link up to FIs Self regulating

Legality:

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Registration No: 200744432

SCDL, Pune

Existing Situation

Desired Situation

Focused on organized service providers (unorganized not regulated) regulating the wrong things e.g. interest rates Multiple and conflicting (FCRA, RBI, IT, ROC, MOF/FIPB, ROS/Commerce) Negatively oriented

include/unorganized recognize e.g. SHGs Regulate rules of game Coherence and coordination across regulators Enabling environment

Feasible Alternatives: The three options that emerge out of above discussion regarding structure of intermediary institution are discussed below. Alternatives -I It is need to increase the flow of funds to unorganized lenders to supplement their own funds. The organized sector will take advantage of the lower transaction costs and risk premia of the unorganized sector so as to reach the low income group borrowers beyond the profitable reach of the organized sector. Despite high transaction cost of the organized and the unorganized sector, total cost will remain low as compared to interest rate on money form money lenders.

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Registration No: 200744432

SCDL, Pune

This approach of promoting linkages combines the strengths of both sectors to supplement the resources of the unorganized sector. The existing modes of borrowing for the low income group through the Co-operative Societies like Thrift and Credit Cooperative Societies are already gaining momentum. The Organized Financial Institutions can establish linkages with these cooperative bodies. Funds could be channelized from the organized financial institutions at market rates to the low income group beneficiaries through the intermediaries like the co-operative bodies stated above. The credit worthiness of the intermediaries would be the basic security for the loans advanced by the organized financial institutions. However, the savings mobilized by the intermediaries from the unorganized sector could also be accepted as collaterals. The intermediaries could then lend to groups of beneficiaries. The transaction cost of the organized sector would be transferred on to the intermediaries who would pass on the same to the beneficiaries. In the process, the intermediaries would also charge additional fees to borrowers to cover their costs. The intermediaries would accept the savings from groups as collaterals and would transfer the same to the organized sector for getting the deposits serviced better. The beneficiaries would benefit as the cost of borrowing would be low for them and their savings would be safe and would be serviced better. Micro Finance Institutions must aim at an adequate scale of operation and while it may be supported by grants to meet administrative costs in the initial period, dependency on such grants should be reduced over time. Micro Finance Institutions should be able to recover all costs through its financial operations, by building up their capacity for financial management, through training and interaction with the organized sector institutions. Alternatives -II An Institution combine with the strengths of an NGO and the expertise of a financial institution, with participation from the community will be better suited to meet housing and credit demand of the target group beneficiaries. The concept of Development Association for Savings and Credit (DASC) could be utilized to address the issue of providing better access to housing finance and economic loans for the participating community in the project area. These Groups mobilize savings from their constituent members and other formal/unorganized sources. The funds mobilized are thus used for meeting the credit needs of the members. The DASC is proposed to be a registered company which will affiliate the Groups based on affiliation criteria and have community representation on its decision making body. The DASC will be initiated with the objective to create an alternate, self-sustainable, community based financial organization appropriate to meet the shelter development and livelihood needs of the weaker section belonging to the rural community.

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Registration No: 200744432

SCDL, Pune

The long term perspective of DASC will include: Developing group based approach as a sustainable development paradigm for community development. The establishment of a resource centre for shelter and livelihood development for the weaker sections of the society. Demonstration of a viable community based credit system in operation where the communities have access to and control over financial resources based on their own strength. Alternatives -III The Micro Finance Institutions will have the responsibility for loan origination and servicing and therefore would also bear the credit risk. The multi-tiered structure is one in which the bulk loans from the organized sector are routed through a Federation or Apex Agency or an Micro Finance Institutions, which in turn lends to a primary Micro Finance Institutions. In the single-tiered structure, the organized sector Institution deals directly with the Micro Finance Institutions. It is felt that the administrative costs incurred with lending through the multi-tiered model are much higher than under the single-tier model. It is essential that a delinquency risk fund (DRF) be placed as a deposit with the organized institution to cover delinquency risk which may draw against the DRF if the primary Micro Finance Institutions fails to make a regularly scheduled loan payment. In order to meet the DRF requirement, Micro Finance Institutions should be encouraged to start a savings scheme. An appropriate legal status for the Micro Finance Institutions to be able to receive the bulk credit is essential. This may involve a simple registration under the Societies Act. The legal form should permit the receipt of bulk credit for on lending to the individual members. In promoting these linkages between the organized institutions and Micro Finance Institutions, directly or through the NGO, it is important that basic financial principles are developed for giving bulk credit to community-based financial institutions. The purpose of the loan, credit terms and underwriting criteria should be clearly defined for the bulk credit that is provided to the CBFI. Conclusion and Summary: The precious lessons can be drawn from the experience of successful Microfinance operations. First of all, the poor repay their loans and are willing to pay for higher interest rates than commercial banks provided that access to credit is provided. The solidarity group pressure and sequential lending provide strong repayment motivation and produce extremely low default rates. Secondly, the poor save and hence microfinance should provide both savings and loan facilities. However, attaining financial viability and sustainability is the major institutional challenge. Deposit mobilization is the

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Registration No: 200744432

SCDL, Pune

major means for microfinance institutions to expand outreach by leveraging equity. In order to be sustainable lending, microfinance lending should be grounded on market principles because large scale lending cannot be accomplished through subsidies. A main conclusion is that microfinance can contribute to solving the problem of inadequate housing and urban services as an integral part of poverty alleviation programs. The challenge lies in finding the level of flexibility in the credit instrument that could make it match the multiple credit requirements of the low income borrowers without imposing unbearably high cost of monitoring its end-use upon the lenders. Eventually, it will be ideal to enhance the creditworthiness of the poor and to make them more "bankable" to financial institutions and enable them to qualify for long-term credit from the organized sector. Furthermore, by deploying an efficient Micro Finance Institutional system, India can create large number of new jobs which will further propel the economy forward. This can become a new economic policy too; Government can push this Micro Finance System in order to reduce disparity of resource mobilization among high, medium and low income class groups. References: Chriseten, R.Peck Rhyne, Elisabeth and Vogel, Robert C (1994) "Maximizing the Outreach of Microenterprise Finance: The Emerging Lessons of Successful Programs," September IMCC, Arlington, Virginia. Barry, Nancy, Armacost, Nicola and Kawas Celina (1996) "Putting Poor people's Economics at the Center of Urban Strategies," Women's World Banking, New York. Grameen Bank , Bangladesh, www.grameen-info.org

Remarks on Case Studies:

PGDBM Finance

Registration No: 200744432

SCDL, Pune