1. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
1. A) Who are regarded as Merchant bankers? State the depository services rendered
by them. (5 Marks)
Answer:
The term “Merchant Banking” originated among the Dutch and Scottish traders and
was later on developed and professionalized in Britain. It should be noted that merchant
banking although a non-banking activity resembles banking function. It is said that a set of
functions and services rendered by a merchant banker may be termed as ‘merchant banking’.
According to Random House Dictionary, “merchant bank is organisations that
underwrites securities for corporations, advise such clients on mergers and is involved in
ownership of commercial ventures. These organizations are sometimes banks which are not
merchants and sometimes houses which are neither merchants nor banks.”
According to Charles P Kindleberger, “merchant banking is the development of
banking from commerce which frequently encountered a prolonged intermediate stage known
in England originally as merchant banking”.
The SEBI (Merchant Bankers) Rules 1992, states: “ A merchant banker has been
defined as any person who is engaged in the business of issue management either by making
arrangements regarding selling, buying or subscribing to securities or acting as managers
consultant, advisor or rendering corporate advisory services in relation to such issue
management”.
A set of financial institutions that are engaged in providing specialist services which
generally include the acceptance of bills of exchange, corporate finance, portfolio
management and other banking services are known as ‘merchant bankers’.
Merchant banks in India carry out the following functions and services:
» Corporate Counseling
» Project Counseling
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2. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
» Pre-investment Studies
» Capital Restructuring
» Credit Syndication and Project Finance
» Issue Management and Underwriting
» Portfolio Management
» Working Capital Finance
» Acceptance Credit and Bills Discounting
» Mergers, Amalgamations and Take-over
» Venture Capital
» Lease Financing
» Foreign Currency Finance
» Fixed Deposit Banking
» Mutual Funds
» Relief to Sick Industries
» Project Appraisal
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3. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
1. B) State the tax (Sales tax and income tax) issues in case of hire purchase
transactions? (5 Marks)
Answer:
In case of hire-purchase transactions, the hire-vendor pays tax on the income inherent
in hire installments, not on the whole of the hire rentals. Thus, the tax is charged only on the
income, and not the inflow. There are no well-defined rules on determination of income in
case of hire-purchase transactions - therefore, accounting method adopted by the tax payer
will generally be followed. Thus, either of the straight-line, sum-of-digits, or actuarial or IRR
basis can be adopted for income allocation.
In the case of Nagarjuna Investment Trust, recently, the Hyderabad Tax Tribunal has
made a detailed analysis of the straight-line method. Though this was a case where the tax
payer sought to follow different methods of income allocation for tax purpose and for
accounting purposes, the case has brought to fore the possible interpretation of the word
quot;evenlyquot; (not necessarily meaning quot;equallyquot;) as used in the 1943 Circular relating to hire-
purchase tax treatment.
Sales taxes are considered to be regressive tax; that is, low income people tend to
spend a greater percentage of their income in taxable sales (using a cross section time-frame)
than higher income people. However, this calculation is derived when the tax paid is divided
not by the tax base (the amount spent) but by income, which is argued to create an arbitrary
relationship. If all purchases are subject to the same tax rate, the tax rate itself is flat with
those who consume more paying more in taxes. While the tax on spending as a percentage of
gross income may be regressive, the effective tax rates can be progressive on consumption
due to exemptions or rebates. If a sales tax is to be related to income, then the unspent income
can be treated as tax-deferred (spending savings at a later point in time), at which time it is
taxed. Sales taxes often exclude items or provide rebates in an effort to create progressive
effects. In many locations, quot;necessaryquot; items such as non-prepared food, clothing, or
prescription drugs are exempt from sales tax to alleviate the burden on the poor.
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4. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
A personal or individual income tax is levied on the total income of the individual
(with some deductions permitted). It is often collected on a pay-as-you-earn basis, with small
corrections made soon after the end of the tax year. These corrections take one of two forms:
payments to the government, for taxpayers who have not paid enough during the tax year;
and tax refunds from the government for those who have overpaid. Income tax systems will
often have deductions available that lessen the total tax liability by reducing total taxable
income. They may allow losses from one type of income to be counted against another. For
example, a loss on the stock market may be deducted against taxes paid on wages.
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5. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
2. Discuss the procedure involved in public issue of securities of a new corporate
enterprise.
Answer:
For private companies, the first issue of securities to the public is referred to as an
Initial Public Offering (IPO). IPO's are extremely speculative and rarely do they result in
large gains for investors. However, since capital is often needed to grow a private company
and values of companies are best determined in the marketplace, IPO's continue to be used as
a way for growing private companies.
IPO's are often one of the hottest topics in financial management. Behind the glamour
and the glitz of Initial Public Offerings (IPO's) there is a tremendous amount of hard work
and personal sacrifice. IPO's require a core group of highly skilled professionals who must
literally work around-the-clock for one year. Therefore, one of the first steps to a successful
IPO is the formation of a seasoned, experienced team of professionals who will make the IPO
happen. You must recruit the best possible people you can find.
Once an IPO team (Investment Banker, Legal Council, Securities Exchange
Commission (SEC) Expert, Outside Auditor, etc.) has been formed, you can establish a plan
for the IPO Process. A basic timeline for an IPO will usually consist of:
Month 12: Recruit new management to run the public company - CEO, CFO, etc. Start
compiling the financial information.
Month 11: Start due diligence work - worthless assets are written off, inconsistencies with
GAAP are resolved, etc.
Month 10: Start drafting the prospectus. Coordinate the collection of data to minimize
duplicative efforts.
Month 9: Establish a board of directors for the newly formed public company.
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6. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
Month 8: Draft three-year historical financial statements.
Month 7: Circulate draft prospectus for comments.
Month 6: Establish transition contracts for services and products that will now be provided to
the newly formed public company. Some new contracts will be needed, such as independent
audits of financial statements.
Month 5: Finalize historical financial statements. Start preparing interim financial statements
for current period.
Month 4: Finalize pro forma and interim financial statements. Make revisions to draft
prospectus.
Month 3: Convene new board of directors. Audit of interim financials should be complete.
Month 2: Outside auditors opinion is issued. Membership with stock exchange is complete.
Month 1: File prospectus with SEC (Securities Exchange Commission). Issue press release
and sell the company to investors.
Before the IPO Process is complete, it is essential to implement all of the necessary
controls, procedures, and systems that will now be required within quot;public life.quot; Staff
changes must be made, new financial systems tested, functions like human resources must be
managed, etc. The entire IPO process is much more involved than most people realize. A
great IPO team and proper planning are the key to a smooth IPO process.
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7. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
3. A) What are the personal factors of customers that influence marketing of financial
products? (5 marks)
Answer:
Consumer behavior refers to the behavior that consumers display in searching for,
purchasing, using, evaluating and disposing of products and services that they expect will
satisfy their needs. Consumer behavior focuses on how individuals make decisions to spend
their available resources on consumption-related items.
A consumer buying behavior is influenced by various internal and external factors.
Out of these, the personal factors are as follows:
Age and Life Cycle Stages: People buy different products in different stages of their life
cycle. The products that are purchased in the early part of the life may not be preferred in the
later part of their life.
The Family Life Cycle: This concept was developed in the 1960s as a tool for segmenting
the market for goods and services. It was based on age, marital status, number and age of
children and work status – each of which affects the consumer’s needs, wants and ability to
buy.
Occupation: A person’s occupation affects the goods and services brought. Blue collar
workers tend to buy more work clothes; whereas white collar workers buy more suits and
ties. Marketers try to identify the occupational groups that have an above average interest in
their products and services.
Economic Circumstances: A person’s economic situation will affect the product choice.
Because income changes over time, an individual’s ability to use financial services will also
change. Personal economic factors such as income, savings, net worth and ability to borrow
affect people’s power to buy all types of goods and services, but they are especially relevant
to the purchase of financial services.
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8. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
Personality: It can be defined as the aggregate of an individual’s trait or characteristics that
make him or her unique. Some are extroverts, some are sky, some are perfectionists other are
casual minded. Some are risk takers; others are cautions.
Life Style: It refers to a person’s pattern of living. Marketers must find the relationship
between the product and life style. The measurement of life style is known as Values and Life
Style (VALS).
Based on the life style, we can classify the people as below:
1) Believers- conservatives, conventional and orthodox.
2) Strivers- uncertain, try to follow successful people, have limited resources and
exposure.
3) Struggler- lower incomes, lowest renounces, brand loyal, buy on purpose.
4) Makers- practical, self-sufficient, family-oriented, buy on purpose.
5) Achievers- successful, work-oriented, status-conscious.
6) Actualizes- highest income, self-oriented, image-conscious, wide range of interests.
7) Fulfilled- mature, responsible, and well-educated professionals.
8) Experiences- outgoing, young, risk takers and youthful customers.
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9. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
3. B) Excellent Company Ltd. has an investment plan amounting to Rs.250 lakh. The tax
relevant rate of depreciation of the Excellent Company is 25%; its marginal cost of capital
and marginal cost of debt are 16% and 20% respectively. The company falls in the tax
bracket of 33.66% of income tax. The company is considering two different alternatives for
its capital expenditure. In the case of hire purchase plan, the interest is 16%; the down
payment is 20% and the rest in 36 equated monthly installments.
In the other plan of leasing, the rentals are payable at Rs.28 ptpm, in advance. The
primary lease period can be assumed to be 5 years. Assume that the SOYD method is used to
allocate total charge for credit under hire purchase plan. The net salvage value of the
equipment after 3 years can be assumed to be Rs.50 lakh. Which alternative -leasing or hire
purchase should the company use and why? (5 Marks)
Answer:
Cost of Hire-purchase
1. Down Payment (working note 1) Rs. 50 lakh
2. Plus: present value of monthly hire-purchase installment Rs. 229.60 lakh
(working note 2)
3. Minus: present value of depreciation tax shield (working note Rs. 45.51 lakh
3)
4. Minus: present value of net salvage value
Total Rs.
Working notes:
1. Down payment = 250 lakh X 0.20 = 50 lakh
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10. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
2. Monthly hire-purchase installment = [ Rs. 200 lakh (250 – 20% down payment) +
(Rs. 200 lakh X 0.16 X 3 years)] / 36 = Rs. 8.222 lakh
Present value of monthly hire-purchase installment:
= Rs. 8.222 lakh X 12 X 1/d (12) X PVIFA (20, 3) where I = 0.20
= (Rs. 8.222 lakh X 12) X 1.105 X 2.106 = 229.60 lakh
3. Present value of depreciation tax shield:
= [Rs. 62.5 lakh X PVIF (16, 1) + Rs. 46.875 lakh X PVIF (16, 2) + Rs.
35.156 X PVIF (16, 3) + Rs. 26.367 X PVIF (16, 4) + Rs. 19.776 X PVIF (16,
5)] X 0.3366
= [(62.5 X 0.862) + (46.875 X 0.743) + (35.156 X 0.641) + (26.367 X 0.552)
+ (19.776 X 0.476)] X 0.3366
= Rs. 45.51 lakh
Cost of Leasing
1. Present value of lease payments (working note 1) Rs. 92.57 lakh
2. Minus: present value of tax shield on lease payment (2) Rs. 96.00 lakh
3. Plus: present value of tax shield on charge of credit (3)
Total
Working note:
1. Present value of lease payments:
= [(Rs. 250 lakh X 0.028 X 12) X 1/d (12) X PVIF (20, 5)], where I = 0.20
= Rs value of tax shield on lease payment = [Rs. 250 lakh X 0.028 X 12
X {PVIF (16, 5)} X 0.3366]
= Rs. 92.57 lakh
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11. MFOOO8 MERCHANT BANKING AND FINANCIAL SERVICES
2. Present value of tax shield on charge for credit:
Total charge for credit = Rs. 250 lakh X0.80 X 0.16 X 3 = Rs. 96 lakh
Allocation of total charge for credit; SOYD Method
Year SOYD factor Annual
charge(Lakh)
1 36+35+34…..+25/36+35+…..+1=366/666 22.79
2 24+23+….+13/36+35+…..+1=222/666 13.82
3 12+11+…..+1/36+35+….+1=366/666 4.86
3. Present value of tax shield:
= [(Rs. 22.79 X 0.862) + (Rs. 13.82 X 0.743) + (Rs. 4.86 X 0.641)] X 0.3366
= Rs. 11.12 lakh
Decision:
Since the cost of leasing exceeds the cost of hire-purchase, the Excellent Company should
acquire the equipment under the hire-purchase plan.
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