Understanding the Indian Financial Markets


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Understanding the Indian Financial Markets

  1. 1. RUNNING HEAD: FINANCING AN INTERNET CAFÉ IN INDIA Financing an Internet Café in India Benjamin S. Cheeks International School of Management, Paris Author Note This paper was submitted to fulfill the requirements of Indian Financial Markets, IFNM 7019. I would like to thank all of the faculty and staff at Amity University, Noida, for their support and dedication to make the first ISM / Amity Seminar a success. Correspondence concerning this article should be addressed to Benjamin S. Cheeks. Email: bencheeks@hotmail.com 1
  2. 2. FINANCING AN INTERNET CAFÉ IN INDIA Abstract India has developed a sophisticated financial system in order to facilitate the mobilization of savings within the economy. This system is characterized by a strong legal and regulatory environment and a sophisticated network of financial markets, financial intermediaries, and financial instruments working together to meet the funding needs of businesses of all sizes. This paper presents a high-level overview of this system and then reviews the network through the eyes of a retail start-up to determine the most suitable sources and instruments for funding. Keywords: Indian financial system, business financing 2
  3. 3. FINANCING AN INTERNET CAFÉ IN INDIA Financing a Internet Café in India This paper will look at the various funding options for a new business enterprise in India. For illustrative purposes, a draft business proposal for an internet café, Social Café, will be used. The paper is divided into three sections. The first provides an overview of the Indian financial system; including the types of financial regulators, the financial markets, the common financial instruments available, and the main intermediaries of these instruments. The second section will review the funding needs of Social Café. The final section will review and recommend the most suitable instruments and sources for funding. The Indian Financial System A financial system consists of an interconnecting network of markets, institutions, and instruments through which the savings in the economy are mobilized and effectively allocated among the ultimate borrowers and investors. Ensuring this timely and adequate supply of capital is critical to promote industrial growth and economic well-being of the country. Levine (2004) suggests that a well-developed financial system can encourage economic growth through improved information on firms and managers, intensity with which creditors monitor and exert corporate governance, better management of risk, pooling of savings, and ease of exchange. In recognition of this fact, India has created a well-developed financial system. The International Monetary Fund (2013) stated that “India has made remarkable progress toward developing a stable financial system. Since liberalization in the early 1990s, the system’s growth and increasing commercial orientation have been 3
  4. 4. FINANCING AN INTERNET CAFÉ IN INDIA accompanied by steady improvements in the legal, regulatory, and supervisory framework”. India’s financial system consists of financial regulators, financial markets, financial instruments, and financial intermediaries. Financial Regulators There are two primary regulatory bodies in the Indian financial system. These are the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). The RBI is the supreme monetary authority of the country. It is responsible for formulating and implementing monetary policy, maintaining price stability and ensuring adequate flow of capital. The RBI issues currency, serves as the banker to the government, sets bank rates, reverse repurchase (repo) rates, the statutory liquidity ratio, and the cash reserve ratio. The SEBI was established under the Securities and Exchange Board of India Act, 1992. It is governed by the Capital Markets Division of the Department of Economic Affairs, Ministry of Finance. SEBI has the authority to regulate capital markets, check trading of securities, investigate malpractice in securities markets, regulate stockbrokers and sub-brokers, promote investor interests, and make rules and regulations for the securities market. Generally speaking, government securities and bonds, instruments issued by banks and financial institutions are regulated by the RBI while issues of nongovernment securities (i.e. issues of corporations) are regulated by SEBI. Financial Markets The Indian financial markets are broadly categorized into the capital market, the money market, and the foreign exchange (forex) market. 4
  5. 5. FINANCING AN INTERNET CAFÉ IN INDIA The capital market is primarily involved in long-term funding. It has two segments, the primary or new issue market and secondary or stock market. The primary or new market deals with securities offered to investors for the first time. The issuer sells the securities in this market to raise funds. The secondary or stock market supports the buying and selling of previously issued securities. The secondary market enables holders of security to adjust their holdings in response to charges in their evaluation of the stock or to meet cash flow needs. The money market is involved in short-term funding. It is the organized exchange where participants can lend and borrow money for a period of one year or less. Key submarkets within the money market are markets for commercial paper, call money, and treasury bills. The forex market assists with the exchange of foreign currency. As the forex market is not a traditional market for business financing, it is beyond the scope of this paper. Financial Instruments Kahn (2006) describes three broad categories of financial instruments: direct, indirect, and derivatives. Direct instruments are those issued by non-financial economic units such as corporations. Key types of direct instruments are equity shares (both common and preferred), debentures such as bonds, and innovative debt instruments such as convertible bonds and warrants. Indirect instruments are those issued by financial economic units. Key types of indirect instruments include mutual fund units, insurance policies, and bank deposits. The final category of financial instruments is derivatives. Derivatives are products whose value is derived by that of another asset. The key types of derivatives are forwards, futures, and options. 5
  6. 6. FINANCING AN INTERNET CAFÉ IN INDIA Financial Intermediaries The primary roles of financial intermediaries are to bring together buyers and sellers of securities, and where necessary to repackage these securities to make them more attractive. An example of the latter would be repackaging securities into smaller units for individual investors. The key financial intermediaries in India are banks, financial institutions, mutual funds and insurance funds, and non-banking financial companies (NBFCs). Banks. The primary providers of credit in India are the banks. The banking sector in India is comprised of commercial banks and cooperative banks. The commercial banks include 19 Nationalized Banks, the State Bank of India (SBI) and its six associate banks, the Regional Rural Banks (RRBs), Foreign Banks, and other Indian private sector banks. The cooperative banks are comprised of the State Cooperative Banks and the Urban Cooperative Banks. Financial institutions. Financial institutions were originated to drive public economic development. At the time of their formation, the capital markets were relatively underdeveloped. This sector has undergone changes in recent years when two major financial institutions, ICICI and IDBI, converted into banks. Financial institutions are broadly categorized into All-India financial institutions, State-Level financial institutions, and Specialized Financial Institutions. Key All-India institutions are Industrial Finance Corporation of India Ltd (IFCI Ltd), Small Industries Development Bank of India (SIDBI), and Industrial Investment Bank of India Ltd (IIBI). Generally speaking, All-India institutions invest in long and medium term projects, while State-Level institutions invest in medium and small scale projects. The list of specialized financial institutions in India includes: Export-Import 6
  7. 7. FINANCING AN INTERNET CAFÉ IN INDIA Bank Of India, Export Credit Guarantee Corporation of India Ltd, Board for Industrial & Financial Reconstruction, and National Housing Bank. Mutual funds and insurance organizations. Mutual funds and insurance organizations invest in a wide-cross section of securities and sell units to investors. This allows investors to diversify their holdings without having to buy individual securities. The primary difference between the two is that investments with insurance organizations also serve as life insurance policies. Also, insurance organizations are regulated by the Insurance Regulatory and Development Authority (IRDA). NBFC. The Reserve Bank of India (2013) states that a NBFC is a company whose “principal business is lending, investments in various types of shares / stocks / bonds / debentures / securities, leasing, hire-purchase, insurance business, chit business, and its principal business is receiving deposits under any scheme or arrangement in one lump sum or in installments.” There are three key categories of heterogeneous NBFCs. These are Asset Finance Companies (AFC), Investment Companies (IC), Loan Companies (LC). A separate category of NBFCs call the residuary non-banking companies (RNBCs). These include Infrastructure Finance Companies (IFC), Stock Exchanges, and Venture Capital-Private Equity Funds. Funding Needs of the Internet Café The following business plan has been created for Social Café (Bplans.com, 2013). Social Café is the answer to ever increasing internet demand and the growing coffee-drinking culture in India. It will provide a unique social environment for young people in New Delhi to socialize with their friends, be entertained, and access the internet at affordable prices. 7
  8. 8. FINANCING AN INTERNET CAFÉ IN INDIA 8 Based upon the business plan, Social Café requires US$62,290 in initial funding for start-up expenses. These expenses include such items as site preparation and legal fees. In addition to start-up expenses, Social Café requires an addition US$23,000 to purchase or lease equipment, furniture, and fixtures. An additional US$3,000 is required for initial inventory and supplies. This brings the total start-up funding requirements to US$88,290. Table 1: Start-up funding required for Social Café in US$. Start-up Funding Start-up Expenses to Fund $62,290 Start-up Assets (Equipment, Furniture, and Fixtures) $23,000 Start-up Assets (Inventory and Supplies) $3,000 Total Funding Required $88,290 In order to determine the working capital requirements, it is initially assumed that the start-up funding would be borrowed from a bank at 12.5% interest over seven years and working capital advanced at 14.75%. Using these assumptions, working capital requirements peak at slightly over US$10,000 in month three and slowly reduce until month eight, at which time the business is self financing. Table 2: Pro forma cash flow analysis for Social Café. Pro Forma Cash Flow Month 1 Month 2 Subtotal Cash Received $7,600 $10,730 Subtotal Cash Spent $8,574 $15,156 Net Cash Flow -$974 -$4,426 Net Working Capital Requirements -$974 -$5,400 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 $12,425 $20,812 $21,611 $24,454 $23,277 $24,135 $25,023 $25,959 $26,920 $27,922 $17,435 $17,522 $22,424 $20,963 $22,177 $22,484 $23,025 $23,591 $26,180 $26,520 -$5,010 $3,290 -$813 $3,491 $1,100 $1,651 $1,998 $2,368 $740 $1,402 -$10,410 -$7,120 -$7,933 -$4,442 -$3,342 -$1,691 $307 $2,675 $3,415 $4,817 Now that Social Café has created its initial business plan, it must determine the best sources and instruments of financing. Selecting the Most Suitable Instruments and Intermediaries There are two primary avenues for raising capital. These are equity financing and debt financing. With equity financing, the investor has an ownership stake in the
  9. 9. FINANCING AN INTERNET CAFÉ IN INDIA business and therefore a claim on the future earnings of the firm. With debt financing, the investor does not gain an ownership stake in the business, but will be repaid the principal and interest at the agreed upon intervals. There are advantages and disadvantages of each. With equity financing, the money does not have to be repaid, so the risk falls more heavily on the investor. However, the more shareholders a company has, the more claims on the earnings as well as involvement in key decisions of the organization. With debt financing, companies must comply with repayment schedules. This increases the amount of profit required to break-even. For this example, we will assume that the owner of Social Café is open to equity financing to some degree, but wants to retain a majority ownership stake in the business. Equity Financing Within the Indian financial system, there are three main intermediaries for equity financing. The most basic is the personal savings-friends and family, the second is venture capital-private equity funds (VC/PE), and the final is stock exchanges. Personal savings-friends and family. Personal savings, friends, and family are key sources of funding for most start-up businesses. Many of the most successful businesses in India today are family owned and managed. Some advantages of funding from this source is the hopeful sharing of profits with friends and family as well as having investors that are truly interested in your success. It is generally timelier and involves less bureaucracy than dealing with professional investors. The key disadvantages are family squabbles and meddling from family members. These can be overcome by clarifying roles and responsibilities in the beginning. Another key consideration is that funding from personal savings will be a prerequisite from 9
  10. 10. FINANCING AN INTERNET CAFÉ IN INDIA future investors. Many require the owner provide at least 10% of the initial funding. VC/PE. For a business of this size, the second key source of equity financing is venture capital-private equity funds (VC/PE). Primarily due to the presence of high-information technology skills, India has a robust VC/PE industry. According to Venture Intelligence (2011), India had the fourth largest VC/PE penetration as a percentage of GDP behind only Israel, the United States, and the United Kingdom. Venture Intelligence (2012) divides the VC/PE community in India into five categories based upon the level of investment and the timing of the investment. These are Incubators, Angel Networks, Seed Level Funds, Early Stage Funds, Growth Stage Funds, and SME Focused. Based upon the funding requirements of Social Café, the Angel Networks would be the category of VC/PE to focus. Angel Investors tend to be high net-worth individuals or groups of the same that invest in early stages of businesses for an equity stake. In additional to the generic advantages and disadvantages are equity investments by VC/PE funds, there are advantages and disadvantages specific to this type of funding. The key advantage when accepting capital from VC/PE funds is that they tend to invest in industries where they have experience. This creates great opportunities for mentoring and network building. A key disadvantage is the VC/PE fund often look to take a large equity position and push for active involvement in decision making. Before reaching out to the VC/PE community, the entrepreneur must first consider the likelihood of this type of investment. Venture Intelligence (2011) reports that only 3% of VC/PE investments in 2011 were in the food and beverage industries. VC/PE firms tend towards industries with high-growth potential and low capital requirements. For 2011, the bulk of the venture funds flowed towards IT, ecommerce, Mobile VAS, education, 10
  11. 11. FINANCING AN INTERNET CAFÉ IN INDIA and health care. Therefore, while VC/PE investments offer a great potential, it is an unlikely source of funding for an internet café. Therefore, it is advisable for the entrepreneur to focus on more accessible sources of funding. Stock exchanges. The final source of equity funds are the stock exchanges. India currently has 25 stock exchanges with the key exchanges being the Bombay Stock Exchange (now just BSE) and the National Stock Exchange (NSE). According to the World Confederation of Exchanges (2013), as of January 2013, the BSE listed more than 5,195 companies (number one in the world) with a total market capitalization of US$1.32 trillion. The same report showed the NSE had 1,664 listings with US$1.29 trillion of market capitalization. Many of India’s major companies are listed on both exchanges. Trading on both exchanges are done by computer. There are no market makers or specialists floor traders. Currently orders must be placed on each exchange by a broker, but many of these brokers provide trading facilities to their customers. The two main indices are the Sensex and the S&P CNX Nifty. The Sensex includes 30 firms listed on BSE. The Nifty includes 50 shares listed on the NSE. These two exchanges are not appropriate for Social Café for two primary reasons. First, they cater to companies much larger than Social Café and equity funding through these types of exchanges tend to occur once a business has established themselves as private companies and are looking for funds to expand. Most of the stock exchanges in India require at least a three-year track record before listing. The stock exchange that offers the most promise for a company such as Social Café would be the OTC Exchange of India (OTCEI). According to their website, the OTCEI (2013) “was set up to aid enterprising promoters in raising finance for new 11
  12. 12. FINANCING AN INTERNET CAFÉ IN INDIA projects in a cost effective manner and to provide investors with a transparent & efficient mode of trading”. However, despite this encouraging mission, it is not recommended that Social Café attempt an offering on the OTCEI. For a company without a track record, investors on the OTCEI would have similar hesitations as would the VC/PE community in investing. Also, the costs associated with listing could easily exceed the initial funding requirements. Once again, the entrepreneur’s time would be better spent looking for alternative sources of funding. To conclude the section of equity financing, there are many advantages that equity financing can provide to a business. However, with the exception of friends and family, early stage equity investment is difficult to come by unless your business is a high-growth business with small capital investment. This is not just true in India, but around the world. Nonetheless, the Indian financial system offers extensive intermediary and instruments for those companies that fit the right profile. Debt Financing Other than equity financing, the other alternative is debt financing. The primary instruments of debt financing in India are loans. However, the Indian financial system ensures a full range of debt financing vehicles. In addition to loans, some of the more common debt financing instruments are bonds, commercial paper (CP), and leases. Commercial paper. Commercial paper can be eliminated immediately as a source of funding for Social Café. The Reserve Bank of India (2011) defines commercial paper as an unsecured money-market instrument issued in the form of a promissory note. In India, commercial paper can be issued by corporates and AllIndia Financial Institutions. They are a great alternative to working capital loans to 12
  13. 13. FINANCING AN INTERNET CAFÉ IN INDIA secure short-term cash flow needs. CP can be issued with maturities between seven days and one year and can be denominated in Rs. 5 lakh or multiples there of. Social Café could not issue CP for several reasons, but most notably it does not meet the minimum credit rating of A-2 and does not have an audited net worth of Rs. 4 crore. Corporate bonds. In India, the term corporate bond and debenture are used interchangeably. As per Security and Exchange Board of India (2009) a corporate bond is a “debt instruments issued by a corporation, the holder of which receives interest from the corporation periodically for a fixed period of time and gets back the principal along with the interest due at the end of the maturity period.” In India, public and private companies can issue corporate bonds. However, a company incorporated outside India cannot issue corporate bonds in India. Corporate-bond funding in India makes up a very small percentage of corporate funding needs in India. An article in the Financial Times Chilkoti (2013), reports that in 2010-11, corporate bonds made up 4% of funding needs whereas in China it made up 17%. One problem holding back the corporate bond market is the lack of liquidity. In India corporate bonds are sold over-the-counter (OTC) rather than through an organized market. Therefore, due to the limitations of the bond market, this type of debt financing would not be appropriate for Social Café. Leases. There are a variety of NBFCs that specialize in the leasing of equipment or financing of such an activity. A lease is defined as a contract between two parties for the hire of an asset where the lessor retains ownership of the asset while the lessee has possession and use of the asset and pays specified rentals over a period of time. The most common type of leases are short-term and long-term leases. Short-term leases are usually two to three years for assets such as computers that have 13
  14. 14. FINANCING AN INTERNET CAFÉ IN INDIA high depreciation. Long-term leases are for assets with lower depreciation such as machinery, cars, and furniture. Leases offer a number of advantages over loans. For example, many leasing companies will finance 100% of the capital required for the equipment; including administrative fees. Social Café should consider lease financing as a funding option; especially for its computers as well as its furniture and fixtures. Based upon the initial business plan, this amount was estimated at US$23,000 in furniture and fixtures. Loans. The primary source of loans in India are banks. However, loans can be obtained from financial institutions and an NBFC such as loan companies. Many banks and financial institutions have created loan schemes designed to meet the funding needs of businesses. In addition, there are many loans in India backed by government funding and schemes. Many of these schemes were designed specifically with the small to medium-size business in mind. The advantages of these loan schemes are that they can provide loans to businesses without previous credit and/or provide interest-rate subsidies. For companies such as Social Café, the Credit Guarantee fund Trust for Micro and Small Enterprises (CGTMSE) is the trust behind the Credit Guarantee Scheme (CSG). The objective of this scheme is to make available bank credit without collateral or third party guarantees. There are currently 131 banks that are eligible to extend loans backed by the CSG. Summary and Recommendation Based upon the review of funding sources and types, Social Café should look to personal savings-friends and family for initial equity investment. For debt financing, Social Café should consider financing their computers with short-term leases and its equipment, furniture, and fixtures with a leasing company. Naturally, 14
  15. 15. FINANCING AN INTERNET CAFÉ IN INDIA this recommendation is dependent upon a lease versus buy comparison. For the additional financing needs for start-up expenses and working capital, Social Café should look at loan packages from banks and financial institutions; particularly those loans backed by one of the government schemes, such as the CSG, designed to support small to medium-size businesses. Limitations of Analysis This paper analysed the formal financial system in India. India has an extensive informal network consisting of money lenders, funding clubs, chit funds, and landlords. Due to the fragmentation of this market, it was considered beyond the scope of this paper. Also, this paper focused on more traditional sources of funding. Intermediaries in India also support derivatives and other innovative instruments. However these instruments are thinly traded and not appropriate for Social Café and therefore considered out of scope. Conclusion Ensuring a timely and adequate supply of capital is critical to promote industrial growth and economic well-being of the country. To this end, India has developed a sophisticated network of financial markets, intermediaries, and instruments, supported by a strong legal and regulatory environment. This paper has presented a high-level overview of this system. It then reviewed this system through the eyes of Social Café to determine the most suitable sources and instruments for funding. The recommendation was for Social Café to tap into personal savingsfriends and family of the owner for initial equity funding. This is the most common source of seed capital for a new enterprise and is usually a prerequisite for subsequent 15
  16. 16. FINANCING AN INTERNET CAFÉ IN INDIA funding. To fund the remaining shortfall, Social Café should investigate lease financing for its computers, equipment, furniture, and fixtures from one of India’s NFBC leasing companies. For the funding of the remaining expenses and working capital, Social Café should pursue a SME Loan Pack, especially one supported by government schemes, from one of India’s many banks or financial institutions. 16
  17. 17. FINANCING AN INTERNET CAFÉ IN INDIA References Bose, Suchismita. 2005. “Securities Markets Regulation: Lessons from US and Indian Experience”, Money and Finance, Jan-June, 83-124. Bplans.com. (2013). Internet Cafe Sample Business Plan. Retrieved June 15, 2013, from http://www.bplans.com/internet_cafe_business_plan/executive_summary_fc.php #.UcrurDvUmSo BSE. (2013). BSE-Introduction. Retrieved June 20, 2013, from http://www.bseindia.com/static/about/introduction.aspx?expandable=0 Business Portal of India. (n.d.). Business Portal of India : Business Financing : Banks. Retrieved June 15, 2013, from http://business.gov.in/business_financing/banks.php Chilkoti, A. (2013, February 5). India: corporate bond market held back by bureaucratic red tape. Financial Times. Retrieved from http://blogs.ft.com/beyond-brics/2013/02/05/india-corporate-bond-market-heldback-by-bureaucratic-red-tape/?#axzz2XMdlvE6R Embassy of India. (n.d.). Embassy of India - Washington DC (official website) United States of America - Financial System in India. Retrieved June 13, 2013, from https://www.indianembassy.org/financial-system-in-india.php International Monetary Fund. (2013). India: Financial system stability assessment update. (13/8). Washington, D.C: International Monetary Fund. Kahn, M. Y. (2006). Indian Financial System (5th ed.). New Delhi, India: Tata McGraw-Hill Education. 17
  18. 18. FINANCING AN INTERNET CAFÉ IN INDIA Levine, R. (2004). Finance and growth: theory and evidence. Handbook of economic growth, 1, 865-934. Ministry of Finance - Government of India. (n.d.). Acts and Rules Governed by the Capital Markets Division: Ministry of Finance, Government of India. Retrieved June 23, 2013, from http://finmin.nic.in/the_ministry/dept_eco_affairs/capital_market_div/Acts%20a nd%20Rules.asp Reserve Bank of India. (2011, October 5). FAQs - Commercial Paper. Retrieved from http://www.rbi.org.in/scripts/FAQView.aspx?Id=25 Reserve Bank of India. (2013, June 3). All you wanted to know about NBFCs. Retrieved June 20, 2013, from http://www.rbi.org.in/scripts/FAQView.aspx?Id=92 Reserve Bank of India (n.d.). Reserve Bank of India. Retrieved June 15, 2013, from http://rbi.org.in/scripts/AboutusDisplay.aspx#MF Securities and Exchange Board of India (2009). Investor guide for corporate bonds market. Retrieved from http://investor.sebi.gov.in/Reference%20Material/corporatebonds.pdf Venture Intelligence (2011). Private Equity & Venture Capital in India: The Changing Landscape. Retrieved from http://chennai.tie.org/sites/default/files/chennai/article/image/funding-landscapeindia.pdf Venture Intelligence (2012). Handbook on Venture Capital - An Entrepreneur's guide to Early Stage Funding. Retrieved from http://www.ventureintelligence.in/vchandbook-2012.pdf 18
  19. 19. FINANCING AN INTERNET CAFÉ IN INDIA World Federation of Exchanges. (2013, January). Statistics. Retrieved June 15, 2013, from http://www.world-exchanges.org/statistics 19