Mf0008 I


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Mf0008 I

  1. 1. MF0008 MERCHANT BANKING AND FINANCIAL SERVICES 1. A) Briefly state the differences between commercial banks and Merchant Bankers (6 Marks) Answer: The world of banking and finance is one of many intricacies. Many types of financial institutions exist, including commercial banking and merchant banking. The difference between commercial banking and merchant banking lies mainly in the services they provide, and to whom they are provided. Commercial banking is generally accessible to anyone for basic banking needs, whereas merchant banks serve mainly large companies and very wealthy individuals. Commercial banks are what people typically refer to as “banks.” A commercial bank can provide loans to individuals and small businesses. It raises funds by collecting deposits from these same groups of people, as well as from interest charged on loans. It also purchases bonds from governments and corporate entities. Commercial banking is also sometimes defined as the provision of banking services such as checking and loans to large businesses, as distinguished from individual citizens. In this case, banking provided to individuals is referred to as retail banking to differentiate it from the second definition of commercial banking. Commercial banking and merchant banking both involve the provision of financial services and advice. Merchant banking, however, often focuses on investing a depositor’s assets in a finance portfolio and managing these investments. Merchant banks are commonly called investment banks in the United States. Apart from investing and managing the assets of wealthy clients, merchant banks also offer counsel and advice to large corporations. This advice is particularly useful when a corporation is considering getting involved in a merger with, or acquisition of, another corporation. Both commercial banking and merchant banking have roots that go back hundreds of years, if not more. Merchant banks were actually the original banks, and were invented in the middle Ages by Italian grain merchants. These merchants, as well as Jewish traders fleeing persecution in Spain, used merchant banking to finance long trading journeys as well as the production of grain. Page 1 of 9
  2. 2. MF0008 MERCHANT BANKING AND FINANCIAL SERVICES 1. B) What is the concept of securitization? (4 Marks) Answer: Securitization is the process of conversion of existing assets or future cash flows into marketable securities. In other words, securitization deals with the conversion of assets which are not marketable into marketable ones. For the purpose of distinction, the conversion of existing assets into marketable securities is known as asset-backed securitization and the conversion of future cash flows into marketable securities is known as future-flows securitization. Some of the assets that can be securitized are loans like car loans, housing loans, et cetera and future cash flows like ticket sales, credit card payments, car rentals or any other form of future receivables. Suppose Mr. X wants to open a multiplex and is in need of funds for the same. To raise funds, Mr. X can sell his future cash flows (cash flows arising from sale of movie tickets and food items in the future) in the form of securities to raise money. This will benefit investors as they will have a claim over the future cash flows generated from the multiplex. Mr. X will also benefit as loan obligations will be met from cash flows generated from the multiplex itself. The process and participants Section 5 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, mandates that only banks and financial institutions can securitize their financial assets. In the traditional lending process, a bank makes a loan, maintaining it as an asset on its balance sheet, collecting principal and interest, and monitoring whether there is any deterioration in borrower's creditworthiness. This requires a bank to hold assets (loans given) till maturity. The funds of the bank are blocked in these loans and to meet its growing fund requirement a bank has to raise additional funds from the market. Securitization is a way of unlocking these blocked funds. In order to facilitate a wide distribution of securitized instruments, evaluation of their quality is of utmost importance. This is carried on by rating the securitized instrument which will acquaint the investor with the degree of risk involved. Page 2 of 9
  3. 3. MF0008 MERCHANT BANKING AND FINANCIAL SERVICES The rating agency rates the securitized instruments on the basis of asset quality, and not on the basis of rating of the originator. So, particular transaction of securitization can enjoy a credit rating which is much better than that of the originator. High rated securitized instruments can offer low risk and higher yields to investors. The low risk of securitized instruments is attributable to their backing by financial assets and some credit enhancement measures like insurance/underwriting, guarantee, etc used by the originator. Once assets are securitized, these assets are removed from the bank's books and the money generated through securitization can be used for other profitable uses, like for giving new loans. For an originator, securitization is an alternative to corporate debt or equity for meeting its funding requirements. As the securitized instruments can have a better credit rating than the company, the originator can get funds from new investors and additional funds from existing investors at a lower cost than debt. Page 3 of 9
  4. 4. MF0008 MERCHANT BANKING AND FINANCIAL SERVICES 2. A) What are the different instruments dealt in Treasury market? Briefly explain them. (5 Marks) Answer: The market which deals in treasury bills is known as the Treasury bill market. In India treasury bills are short term liability of the Central Government. Theoretically, treasury bills should be used for meeting temporary deficits which a government faces due to its excess of expenditure over revenue at the same point of time. However, in India, till recently, they were a permanent source of funds for the Central Government as every year more new bills were issued than those retired. Further, every year a part of the treasury bills held by the RBI was converted into long term bonds. The following types of treasury bills have been in use in recent years: ⇒ 14 Day Intermediate Treasury Bills: Treasury Bills with the discontinuance of top treasury bills, the Central Government had introduced the scheme of 14 day treasury bills to provide the state governments, foreign central banks and specialized bodies with an alternative arrangement to invest their surplus funds. These treasury bills were to be sold only to the state governments, foreign central banks and other specified bodies with whom the RBI had in agreement for investing their temporary surplus funds. Auction of these treasury bills was discontinued from May 14, 2001. ⇒ 14 Day Auction Treasury Bills: The RBI introduced 14 day auction treasury bills on a weekly basis with effect from June 6, 1997. The dual purpose of introducing these treasury bills was to facilitate the cash management requirements of various segments of the economy and to help in forming a complete yield curve for aiding in the pricing of debt instruments. The 14 day auction treasury bills did not develop on the RBI unlike the 91 day treasury bills. Auction of these treasury bills was discontinued from May 12, 2001. ⇒ 91 Day Treasury Bills: Earlier there were two types of 91 day treasury bills – ordinary and ad hoc with effect from August 1, 1997 ad hoc treasury bills were discontinued. On this day 91 day ad hoc treasury bills amounting to Rs. 38,130/- crores were converted into special securities without any specific maturity. The interest on these securities was fixed at 46% per annum. Page 4 of 9
  5. 5. MF0008 MERCHANT BANKING AND FINANCIAL SERVICES ⇒ 182 Day Treasury Bills: 182 day treasury bills were reintroduced with effect from May 26, 1999. ⇒ 364 Day Treasury Bills: 364 day treasury bills were introduced in April 1992. Since then, these treasury bills were auctioned on a fortnightly basis in a regular manner. These treasury bills are not re-discountable with RBI. However, very often provide short term investment opportunities to banks and other financial institutions. Page 5 of 9
  6. 6. MF0008 MERCHANT BANKING AND FINANCIAL SERVICES 2. B). A company in which public are interested substantially, has been offered certain heavy machinery on lease for a period of 5 years. The lease rent of Rs.7500 per annum and at the end of the lease, the machinery would be sold to the assessee for Re.1. If the company were to buy the machinery outright at present, it would cost it Rs.3,00,000. You are required to advise on the course of action which would bring the maximum tax advantage. (5 Marks) Answer: Page 6 of 9
  8. 8. MF0008 MERCHANT BANKING AND FINANCIAL SERVICES 3. A) What are the differences between lease and hire purchase transactions? (3 Marks) Answer: Ownership: The lessor (finance company) is the owner and the lessee (user/ manufacturer) is entitled to the economic use of the leased assets/ equipment only in case of lease financing. The ownership is never transferred to the user (lessee). In contrast, the ownership of the assets passes on to the user (hirer), in case of hire-purchase finance, on payment of last installment; before the payment of the last installment, the ownership of the asset vests in the finance company/ intermediary (seller). Depreciation: The depreciation on the asset is charged in the book of the lessor in case of leasing while the hirer is entitled to the depreciation shield on the assets hired by him. Magnitude: Both lease finance and hire-purchase is generally used to acquire capital goods. However, the magnitude of funds involved in the former is very large, for example, for the purchase of aircrafts, ships, machinery, air conditioning plants and so on, the cost of acquisition in hire-purchase is relatively low hence automobiles, office equipments, generators etc. are generally hire-purchased. Extent: Leasing financing is invariably 100% financing. It requires no margin money or immediate cash down payment by the lessee. In a hire-purchase transaction typically a margin equal to 20-25% of the cost of the equipments is required to be paid by the hirer. Alternatively, the hirer has to invest an equivalent amount on fixed deposit with the finance company, which is returned after the payment of last installment. Maintenance: The cost of a hired asset is to be borne, typically, by the hirer himself. In case of finance lease only, the maintenance of the leased asset is the responsibility of the lessee. It is the lessor (seller) who has to bear the maintenance cost in an operating lease. Tax Benefit: The hirer is allowed the depreciation claim and finance charge and the seller may claim any interest on borrowed funds to acquire the asset for tax purposes. In case of leasing, the lessor is allowed claim depreciation and the lessee is allowed to claim the rentals and maintenance cost against taxable income. Page 8 of 9
  9. 9. MF0008 MERCHANT BANKING AND FINANCIAL SERVICES 3. B). J Ltd. proposes to acquire a machine on 1st April 2006 for its business. It will cost about Rs.1,50,000. It is expected to have a working life of 3 years. Scrap value of the machine will be Rs.40,000. If the machine is purchased through borrowed funds, the rate of interest is 15% p.a. The loan is repayable in three annual installments of Rs.50,000 each. If the machine is acquired through lease, the rent would be Rs.60,000 per annum. Profits before depreciation and tax, is expected Rs.1,00,000 every year. Rate of depreciation is 15% and average rate of tax may be taken at 33.66%. J Ltd., seeks your advice whether it should i) Acquire the machine through own funds or borrowed funds ii) Take it on lease. (7 marks) Answer: In Rupees 0 1 2 3 1. Cost of machinery +1,50,000 2. Depreciation 22,500 19,125 16,256.25 3. Loss of depreciation tax shield -7,573.5 -6,437.475 -5471.854 4. Lease payment -60,000 -60,000 -60,000 5. Tax shield on lease payment 20,196 20,196 20,196 6. Loss of salvage value -40,000 - - 7. Cash flow of lease +1,50,000 8. Present value factor NAL of leasing 1,50,000 = Page 9 of 9