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Project Financing in India (Module 7)

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MBA Fourth Semester HB (Project Appraisal, Planning & Control) VTU

7.1. PROJECT FINANCING
7.1.1. Introduction
Project financing may be defined as the raising of funds required to finance an economically separable capital investment proposal in which the lenders mainly rely on the estimated cashflow from the project to service their loans. Project financing differs from conventional financing in the following aspects: 1) In conventional financing, cashflow from different assets and businesses are co-mingled. A creditor makes an assessment of repayment of his loan by looking at all the cashflows and resources of the borrower. In project financing, cashflows from the project related assets alone are considered for assessing the repaying capacity. 2) In conventional financing, end-use of the borrowed funds is not strictly monitored by the lenders. In project financing, the creditors ensure proper utilization of funds and creation of assets as envisaged in the project proposal. Funds are also released in stages as and when assets are created. 3) In conventional financing, the creditors are not interested in monitoring the performance of the enterprise and they are interested only in their money getting repaid in one way or the other. Project financiers are keen to watch the performance of the enterprise and suggest/take remedial measures as and when required to ensure that the project repays the debt out of its cash generations.

7.1.2.

Advantages of Project Financing

There are a variety of reasons for the investors to make use of project finance: 1) High Leverage: One major reason for using project finance is that investments in ventures such as power generation or road building have to be long-term but do not offer an inherently high return; high leverage improves the return for an investor. 2) Tax Benefits: A further factor that may make high leverage more attractive is that interest is tax deductible, whereas dividends to shareholders are not, which makes debt even cheaper than equity and hence encourages high leverage. 3) Off-Balance Sheet Financing: If the investor has to raise the debt and then inject it into the project, this will clearly appear on the investor’s balance sheet. A project finance structure may allow the investor to keep the debt-off the consolidated balance sheet, but usually only if the investor is a minority shareholder in the project – which may be achieved if the project is owned through a joint venture. Keeping debt-off the balance sheet is sometimes seen as beneficial to a company’s position in the financial markets, but a company’s shareholders and lenders should normally take account of risks involved in any off-balance sheet activities, which are generally revealed in notes to the published accounts even if they are not included in the balance
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sheet figures; so although joint ventures often raise project finance for other reasons, project finance should not usually be undertaken purely to keep debt-off the investors’ balance sheets. 4) Borrowing Capacity: Project finance increases the level of debt that can be borrowed against a project; non-recourse finance raised by the project company is not normally counted against corporate credit lines (therefore in this sense it may be off-balance sheet). It may thus increase an investor’s overall borrowing capacity, and hence, the ability to undertake several major projects simultaneously. 5) Risk Limitation: An investor in a project raising funds through project finance does not normally guarantee the repayment of the debt – the risk is therefore limited to the amount of the equity investment. A company’s credit rating is also less likely to be downgraded if its risks on project investments are limited through a project finance structure. 6) Risk Spreading/Joint Ventures: A project may be too large for one investor to undertake, so others may be brought-in to share the risk in a joint venture project company. This both enables the risk to be spread between investors and limits the amount of each investor’s risk because of the non-recourse nature of the project company’s debt financing. 7) Long-Term Finance: Project finance loans typically have a longer-term than corporate finance. Long-term financing is necessary if the assets financed normally have a high capital cost that cannot be recovered over a short-term without pushing-up the cost that must be charged for the project’s end-product. So, loans for power projects often run for nearly 20 years, and for infrastructure projects even longer. 8) Enhanced Credit: If the off-taker has a better credit standing than the equity investor, this may enable debt to be raised for the project on better terms than the investor would be able to obtain from a corporate loan. 9) Unequal Partnerships: Projects are often put together by a developer with an idea but little money, who then has to find investors. A project finance structure, which requires less equity, makes it easier for the weak developer to maintain an equal partnership, because if the absolute level of the equity in the project is low, the required investment from the weak partner is also low.

7.1.3.

Disadvantages of Project Financing

Project financing will not necessarily lead to a lower cost of capital in all circumstances. Project financings are costly to arrange, and these costs may outweigh the advantages explained above. 1) Complexity of Project Financings: Project financing is structured around a set of contracts that must be negotiated by all the parties to a project. They can be quite complex and therefore costly to arrange. They normally take more time to arrange than a conventional financing. Project financings
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typically also require a greater investment of management’s time than a conventional financing.

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2) Indirect Credit Support: For any particular (ultimate) obligor of the project’s debt and any given degree of leverage in the capital structure, the cost of debt is typically higher in a project financing than in a comparable conventional financing because of the indirect nature of the credit support. The credit support for a project financing is provided through contractual commitments rather than through a direct promise to pay. Lenders to a project will naturally be concerned that the contractual commitments might somehow fail to provide an uninterrupted flow of debt service in some unforeseen contingency. As a result, they typically require a yield premium to compensate for this risk. 3) Higher Transaction Costs: Because of their greater complexity, project financings involve higher transaction costs than comparable conventional financings. These higher transaction costs reflect the legal expense involved in designing the project structure, researching and dealing with project-related tax and legal issues, and preparing the necessary project ownership, loan documentation and other contracts.

7.1.4.

Sources of Project Finance

The nature of the project and the type of finance required will determine the most appropriate source of finance. The criteria for assessing the likely return on a project and attitudes for the risks involved will differ between sources of finance. Following are the sources of finance: 1) Shareholders: These are public or private investors, institutions, or individuals who provide the equity or quasi-equity in a company. Sources of equity includes the following: i) Retained profit of a company, ii) Funds raised through the stock market, iii) Venture capital companies, iv) Joint venture partners, and v) International investment institutions such as the World Bank. 2) Banks: Banks and other financial institutions are the main providers of debt. Commercial banks are the most readily available to most project investors. They split into retail banks, which provide finance in the local, main-street and merchant banks. There is a large choice available for companies raising finance, and this has led to intense competition. In choosing a bank, the decision will not be so much based on the interest rate charged as on the following factors: i) The size of the bank, ii) The experience in financing that type of project, and iii) Any support they may offer with the financial engineering. 3) International Financial Markets: International financial markets offer an alternative to domestic markets, giving easy access to foreign sources of funds. There are many, but the two most important are the Eurocurrency and Eurobond markets. The Eurocurrency and Eurobond markets are the most efficient in the world and provide for smooth movement of funds. They provide short-term finance at competitive rates but are primarily for large organizations.
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4) Institutions: The institutions, i.e., pension funds, insurance funds and trust funds, generally require a fixed, steady income stream and a low level of risk when making an investment or lending money. They will generally consider construction developments only on prime sites with few planning problems, preferably a freehold pre-let scheme, using an established developer. They usually look for large schemes in which to invest. However, the institutions are becoming more flexible and may consider short-term finance. They have also become more prepared to undertake their own developments. 5) Finance for Overseas Projects: A number of additional sources of finance are open to overseas project, in particular: i) National or International Development Banks: National development organizations and regional or international agencies sometimes offer long-term loans for certain classes of projects at low rates of interest. Each organization or agency has its own lending criteria and the eligibility of a specific project will depend on its size, purpose and sponsors. Development banks tend to take a long time to evaluate a project and are likely to impose conditions such as putting-out all constuction and equipment contracts to competitive tender. However, they can be helpful in attacting other sources of finance once the project has been approved and will finance supporting infrastructure. For example, European Development Bank, the World Bank, the Opec Fund, the African Development Bank and the Inter-American Development Bank are developing agencies. ii) Export Credit Finance: Export credit finance should be considered where a project requires capital goods and associated services to be imported because: a) The term of the loan can sometimes be longer than the term for commercial funds. b) The rate of interest is often subsidized and fixed for the life of the loan. c) The loan is very often available in both local and foreign currency. d) The buyer credit itself will provide for a loan upto 85% of the cost of eligible goods and services.

7.1.5.

Project Financing In India

In India, long-term industrial finance is usually the single largest source of project financing. There are a number of financial institutions responsive to the growing and varied long-term financial requirements in industry. To cater to the need for financial assistance to industrial projects, there are six generally known All India Development Financial Institutions (AIDFIs) as follows: 1) The Industrial Development Bank of India (IDBI). 2) The Industrial Finance Corporation of India (IFCI).
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3) The Industrial Credit and Investment Corporation of India Limited (ICICI). 4) The Industrial Investment Bank of India (IIBI). 5) The Shipping Credit and Investment Company of India Limited (SCICI). 6) The Small Industries Development Bank of India (SIDBI). Besides these, there are three Specialized Development Financial Institutions (SDFIs) as follows: 1) The Risk Capital and Technology Finance Corporation Limited (RCTC), 2) The Technology Development and Information Company of India Limited (TDICI), and 3) The Tourism Finance Corporation of India Limited (TFCI). Of the above SDFIs, RCTC, and TDICI provide risk capital, venture capital and technology development finance and the TFCI extend finance to hotels and tourism related projects. There are also three other financial institutions popularly known as investment institutions, which are as follows: 1) The Life Insurance Corporation of India (LIC). 2) The Unit Trust of India (UTI). 3) The General Insurance Corporation of India (GIC) and its subsidiaries, the National Insurance Company Ltd., the New India Assurance Company Ltd., the Oriental Insurance Company Ltd., and United India Insurance Company Ltd. Among the investment institutions, LIC and GIC deploy their funds in accordance with the priorities set-out for them while UTI channelize them into corporate investments. Investment institutions are the major players in the secondary market. They also extend assistance to corporate sector by way of term loans, underwriting, and direct subscription to shares and debentures.

7.2. MEANS OF PROJECT FINANCE
After the project cost is ascertained, the sources of finances available for meeting the project cost are to be analyzed and a proper combination of the different sources shall be chosen that is most suitable for the project. The various sources of finance can be broadly divided into two categories, viz., equity capital and debt capital (borrowed capital). The combination of equity and debt should be judiciously chosen, and it will vary according to the nature of the project.
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The following are the main instruments of project finance:
Means of Project Finance Preference Shares Debentures Term Loans Unsecured Loans Lease Financing Ordinary Shares Bonds Internal Accruals Public Deposits Deferred Credits

Capital Investment Subsidy

7.2.1.

Preference Shares

Preference capital represents a hybrid form of financing – it par takes some characteristics of equity and some attributes of debentures. It resembles equity in the following ways: 1) Preference dividend is payable only out of distributable profits; 2) Preference dividend is not an obligatory payment (the payment of preference dividend is entirely within the discretion of directors); and 3) Preference dividend is not a tax-deductible payment.

7.2.1.1.

Features of Preference Shares

1) Accumulation of Dividends: Preference shares may be cumulative or noncumulative with respect to dividends. Barring a few exceptions, preference shares in India carry a cumulative feature with respect to dividends. The unpaid dividends on cumulative preference shares are carried forward and payable when the dividend is resumed. For example, if the dividend payment on a 13 per cent cumulative preferred share is skipped for 4 years, a dividend arrear of 52 per cent is payable. Note that a company cannot declare equity dividends unless preference dividends are paid with arrears. 2) Callability: The terms of preference share issue may contain a call feature by which the issuing company enjoys the right to call the preference shares, wholly or partly, at a certain price. 3) Convertibility: Preference shares may sometimes be convertible into equity shares. The holders of convertible preference shares enjoy the option of converting preference shares into equity shares at a certain ratio during a specified period. For example, the preference shareholders may enjoy the option of converting preference shares into equity shares in the ratio of 1: 5 after 2 years for a period of 3 months. 4) Redeemability: Preference shares may be perpetual or redeemable. A perpetual preference share has no maturity period, whereas a redeemable preference share has a limited life after which it is supposed to be retired. Most preference issues are redeemable.
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5) Participation in Surplus Profits and Assets: Companies may issue participating preference shares which entitle preference shareholders to participate in surplus profits (profits left after preference dividend and equity dividend at certain rates) every year and residual assets (assets left after meeting the claims of preference shareholders) in the event of liquidation according to a specific formula. 6) Voting Power: Before the commencement of the Companies Act, 1956, companies could issue preference shares carrying voting rights. Preference shares issued after the commencement of the Companies Act, 1956 do not carry voting right. A preference shareholder, however, is entitled to vote on every resolution placed before the company if: i) The preference dividend is in arrears for two years or more in the case of cumulative preference shares, or ii) The preference dividend has not been paid for a period of two or more consecutive preceding years or for an aggregate period of three or more years in the preceding six years ending with the expiry of the immediately preceding financial year. The small numerical strength of preference shareholders, however, makes their voting right meaningless in most of the cases -preference shareholders are often helpless and unable to use their votes effectively.

7.2.1.2.

Advantages of Preference Shares

The advantages of preference shares can be grouped under two categories: 1) Advantages to Investors: These include: i) Priority in Re-payment of Capital: Preference shareholders get the priority of repayment of capital as compared to equity shareholders. ii) Best Security: At the time of recession or decline profits preference shares are the best investment. iii) Regular and Fixed Income: Fixed and Regular dividend is paid on preference shares. It is a source of regular and fixed income for the investors. iv) Less Risk: Due to the preference in re-payment, dividend, the preference shareholders have less risk in the investment. v) Safety of Interest: Like the equity shareholders, preference share holders have the veto power to protect their rights. 2) Advantages to Company: It includes: i) No Interference in Management: Preference shareholders do not get the right to interfere in the management. ii) Economical Financing: Issuing the preference shares is cheaper than equity shares, so it is economical to get finance from this source. iii) Availability of Wide Capital Market: Non progressive and less risk taking investors prefer to invest in preference shares. In this way company gets a wide market for getting the capital.
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iv) No Change on Assets: For issuing these shares company need not to mortgage its assets. In this way the company doesn’t have any problem in getting the finance in the future.

7.2.1.3.

Disadvantages of Preference Shares

1) Disadvantages to Investors: It includes: i) Dividend at Fixed Rate: In this case of non-participative preference share, the dividend is paid at a fixed rate. So they are not benefited by the progress of the business. ii) Uncertain Position of Redeemable Preference Shares: Encashment of the redeemable preference shares on the will of the company. Whenever the management wants, it can return the money giving the information. iii) Limited Voting Rights: Preference shareholders have the limited voting right. Despite being the owner of the company, they cannot participate in the management of the company. 2) Disadvantages to Company: It includes: i) Disadvantage to Equity Shareholders: In the case of less profit equity shareholder suffers because preference shareholders get the dividend first at a fixed rate. ii) Fixed Economic Burden: Company has to incur fixed economic burden because in the case of no profit, the company have to pay the dividend. iii) High Cost of Capital: Dividend paid to preference shareholders is not free from tax. So it is costly to raise the capital from preference shares than debentures. iv) Difficult to Receive Additional Capital: It is the provision in company law that the company want to issue new shares or debentures they have to take the permission from preference shareholders. So it becomes difficult to raise additional capital.

7.2.2.

Equity Shares

Ordinary shares, also known as equity shares or common shares represent the owners’ capital in a company. The holders of these shares are the real owners of the company. They have a control over the working of the company. Equity shareholders are paid dividend after paying it to the preference shareholders. The rate of dividend on these shares depends upon the profits of the company. They may be paid a higher rate of dividend or they may not get anything.

7.2.2.1.

Features of Equity Shares

1) Maturity: Equity shares provide permanent capital to the company and cannot be redeemed during the life time of the company. Under the Companies Act, 1956, a company cannot purchase its own shares. Equity shareholders can demand refund of their capital only at the time of liquidation of a company. Even at the time of liquidation, equity capital is paid back after meeting all other prior claims including that of preference shareholders.
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2) Claim/Right to Income: Equity shareholders have a residual claim on the income of a company. They have a claim on income left after paying dividend to preference shareholders. The rate of dividend on these shares is not fixed; it depends upon the earnings available after paying dividends on preference shareholders. In many cases, they may not get anything if profits are insufficient; or may get even a higher rate of dividend. That is why, equity shares are also known as ‘variable income security’. 3) Claim on Assets: Equity shareholders have a residual claim on ownership of company’s assets. In the event of liquidation of a company, the assets are utilized first to meet the claims of creditors and preference shareholders but everything left, thereafter, belongs to the equity shareholders. 4) Right to Control or Voting Rights: Equity shareholders are the real owners of the company. They have voting rights in the meetings of the company and have a control over the working of the company. 5) Pre-emptive Right: to safeguard the interests of equity shareholders and enable them maintain their proportional ownership, section 81 of the Companies Act, 1956 provides that whenever a public limited company proposes to increase its subscribed capital by the allotment of further shares, after the expiry of two years from the formation of the company or the expiry of one year from the first allotment of shares in the company, whichever is earlier, such shares must be offered to holders of existing equity shares in proportion, as circumstances admit, to the capital paid up on these shares. 6) Limited Liability: Another distinct feature of equity shares is unlimited liability. Thus, although, equity shareholders are the real owners of the company, their liability is limited to the value of shares they have purchased.

7.2.2.2.

Advantages of Equity Shares

1) Equity shares do not create any obligation to pay a fixed rate of dividend. 2) Equity share can be issued without creating any charge over the assets of the company. 3) It is a permanent source of capital and the company has not to repay it except under liquidation. 4) Equity shareholders are the real owners of the company who have the voting rights. 5) In case of profits, equity shareholders are the real gainers by way of increased dividends and appreciation in the value of shares.

7.2.2.3.

Disadvantages of Equity Shares

1) If only equity shares are issued, the company cannot take the advantage of trading on equity. 2) As equity capital cannot be redeemed, there is a danger of over capitalization. 3) Equity shareholder can put obstacles in management by manipulation and organizing themselves.
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4) During prosperous periods higher dividends have to be paid leading to increase in the value of shares in the market and speculation. 5) Investors who desire to invest in safe securities with a fixed income have no attraction for such shares.

7.2.3.

Debentures

A company may raise long-term finance through public borrowings. These loans are raise by the issue of debentures. “A debenture is a document under the company’s seal which provides for the payment of principal sum and interest thereon at regular intervals, which is usually secured by a fixed or floating charge on the company’s property or undertaking and which acknowledges a loan to the company”. A debenture holder is a creditor of the company. A fixed rate of interest is paid on debentures. The interest on debentures is a charge on the profit and loss account of the company. The debentures are generally given a floating charge over the assets of the company. When the debentures are secured, they are paid on priority in comparison to all other creditors.

7.2.3.1.

Features of Debentures

1) Maturity: Although debentures provide long-term funds to a company, they mature after a specific period. Generally, the debentures are to be repaid at a definite time as stipulate in the issue. The company must pay back the principal amount on these debentures on the given date otherwise the debenture holders may force winding up of the company as creditors. 2) Claims on Income: A fixed rate of interest is payable on debentures. Unlike shares, a company has a legal obligation to pay the interest on due dates irrespective of its level of earnings. Even if a company makes no earnings or incurs loss, it is under an obligation to pay interest to its debenture holders. The default in payment of interest may cause winding up of the company. 3) Claims on Assets: Even in respect of claim on assets, debenture holders have priority of claim on assets of the company. They have to be paid first before making any payment to the preference or equity shareholders in the event of liquidation of the company. However, they have a claim for the principal amount and interest due only and do not have any share in the surplus assets of the company, if any. 4) Control: Since debenture holders are creditors of the company and not its owners, they do not have any control over the management of the company. 5) Call Feature: Issue of debentures sometimes provide a call feature which entitles the company to redeem its debentures at a certain price before the maturity date. Since the call feature provides advantage to the company at
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the expense of its debenture holders, the call price is usually more than the issue price.

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7.2.3.2.

Advantages of Debentures

The advantages of debentures to the company and to the investor are as follows: 1) Advantages to the Company: They are as follows, i) Long-term Finance: Debentures provide long-term funds to a company. ii) Low Cost of Capital: The rate of interest payable on debentures is, usually, lower than the rate of dividend paid on share. iii) Interest-tax Shield: The interest on debentures is a tax-deductible expense and hence the effective cost of debentures (debt-capital) is lower as compare to ownership securities where dividend is not a taxdeductible expense. iv) Ownership Control: Debt financing does not result into dilution of control because debentureholders do not have any voting rights. v) Increase Shareholders Wealth: A company can trade on equity by mixing debentures in its capital structure and thereby increase its earnings per share. vi) Fixed Outflow of Cash: Many companies prefer issued of debentures because of the fixed rate of interest attached to them irrespective of the changes in price levels. vii) Flexible Capital Structure: Debentures provide flexibility in the capital structure of a company as the same can be redeemed as and when the company has surplus funds and desires to do so. viii) Easy Availability: Even during depression, when the stock market sentiment is very low, a company may be able to raise funds through issued of debentures or bonds because of certainty of income and low risk to investors. 2) Advantages to the Investors: They are as follows, i) Fixed Income: Debentures provide a fixed, regular and stable source of income to its investors. ii) Floating Right: It is comparatively a safer investment because debentureholders have either a specific or a floating charge on all the assets of the company and enjoy the status of a superior creditor in the event of liquidation of the company. iii) Maturity Period: Many companies prefer issue of debentures because of a definite maturity period. iv) Marketability: A debenture is usually a more liquid investment and an investor can sell or mortgage his instrument to obtain loans from financial institutions v) Low Risk of Default: The interest of debenture holders is protected by various provisions of the debenture trust deed and the guidelines issued by the Securities and Exchange board of India in this regard.
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7.2.3.3.

Disadvantages of Debentures

1) Disadvantages to the Company: They are as follows: i) Legal Obligations: The fixed interest charges and repayment of principal amount on maturity are legal obligations of the company. These have to be paid even when there are no profits. Hence, it is a permanent burden on the company. ii) Restriction on Raising Further Loan: Charge on the assets of the company and other protective measures provide to investors by the issue of debentures usually restrict a company form using this source of finance. A company cannot raise further loans against the security of assets already mortgaged to debenture holders. iii) Increase Financial Risk: The use of debt financing usually increases the risk perception of investors in the firm. This enhanced financial risk increases the cost of equity capital. iv) High Transaction Cost: Cost of rising finance through debenture is also high because of high stamp duty. v) Floating Charge: A company who’s expected future earnings are not stable or who deals in products with highly elastic demand or who does not have sufficient fixed assets to offer as security to debenture holders cannot use this source of raising funds to its benefit. 2) Disadvantages to the Investors: They are as follows, i) No Voting Rights: Debentures do not carry any voting rights and hence its holders do not have any controlling power over the management of the company. ii) No Participation in Profit: Debenture holders are merely creditors and not the owners of the company. They do not have any claim on the surplus assets and profits of the company beyond the fixed interest and their principal amount. iii) Tax on Interest Received: Interest on debentures is fully taxable while shareholders may avoid tax by way of stock dividend (bonus shares) in place of cash dividend. iv) Fluctuation of Interest Rate: The prices of debentures in the market fluctuate with the changes in the interest rates. v) Insecurity: Uncertainty about redemption also restricts certain investors from investing in such securities.

7.2.4.

Bond

A bond is a debt security, in which the authorized issuer owes the holder a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. A bond is simply a loan in the form of a security with different terminology; The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds.
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Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and resell them to investors. The security firm takes the risk of issue not being sold to investors. Government bonds are typically auctioned.

7.2.4.1.

Features of Bond

The most important features of a bond are: 1) Nominal, Principal or Face Amount: The amount on which the issuer pays interest, and which has to be repaid at the end. 2) Issue Price: The price at which investors buy the bonds when they are first issued, typically ` 1,000. The net proceeds that the issuer receives are calculated as the issue price, less issuance fees, times the nominal amount. 3) Maturity Date: The date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenure or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of upto thirty years. Some bonds have been issued with maturities of upto one hundred years, and some even do not mature at all. In the market for U.S. Treasury securities, there are three groups of bond maturities: i) Short-Term (Bills): Maturities up to one year; ii) Medium-Term (Notes): Maturities between one and ten years; iii) Long-Term (Bonds): Maturities greater than ten years. 4) Coupon: The interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which coupons had attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment. 5) Coupon Dates: The dates on which the issuer pays the coupon to the bond holders. In the U.S., most bonds are semi-annual, which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only one coupon a year. 6) Indentures and Covenants: An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of bond holders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing.
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7) Optionality: A bond may contain an embedded option; i.e., it grants option-like features to the holder or the issuer: i) Callability: Some bonds give the issuer the right to repay the bond before the maturity date or the call dates. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called Call Premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost. ii) Putability: Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates. iii) Call Dates and Put Dates: The dates on which callable and putable bonds can be redeemed yearly. 8) Convertible Bond: Convertible bond lets a bond holder exchange a bond to a number of shares of the issuer’s common stock. 9) Exchangeable Bond: Exchangeable bond allows for exchange to shares of a corporation other than the issuer.

7.2.4.2.

Advantages of Bond

1) Advantages to the Company i) Interest is tax-deductible, while dividends paid to stockholders are not. ii) Bondholders do not participate in earnings growth of the company. iii) Debt is repaid in cheaper rupees during inflationary periods. iv) Company control remains undiluted. v) Financing flexibility can be achieved by including a call provision allowing the company to pay the debt before the expiration date of the bond in the bond indenture. However, the issuer pays a price for this advantage in the form of the higher interest rates that callable bonds require. vi) It may safeguard the company’s future financial stability if used in times of tight money markets when short-term loans are not available. 2) Advantages to the Investors For investors, bonds have the following advantages: i) They pay a fixed interest payment each year. ii) They are safer than equity securities.

7.2.4.3.

Disadvantages of Bond

1) Disadvantages to the Company i) Interest charges must be met regardless of the company’s earnings. ii) Debt must be repaid at maturity. iii) Higher debt implies greater financial risk, which may increase the cost of financing. iv) Indenture provisions may place stringent restrictions on the company.
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v) Over commitments may arise from errors in forecasting future cash flow.

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2) Disadvantages to the Investors i) Bonds carry interest rate risk, the chance that principal will be lost if interest rates rise and the bond drops in value. ii) Bonds do not participate in corporate profitability. iii) Bond holders have no voting rights and therefore no say in how the company is run.

7.2.5.

Term Loans

The term ‘Term loan’ denotes long-term loans offered for project financing. The period of principal repayment of such long-term loans vary from 5 to 10 years depending upon the nature of the project (it will be more for infrastructure projects, say in the order of 20 to 25 years). Initial moratorium (holiday period) for the repayment of principal of one to two years is normally provided. The length of the moratorium period depends upon the period of implementation of the project. Term loans are offered by All India Financial Institutions (like IDBI, SIDBI, ICICI, IFCI, LIC, UTI, GIC) State Financial Corporations (SFCs), State Industrial Development Corporations (SIDCs), State Industrial and Investment Corporations (SIICs) and Commercial Banks. The term lending institutions (institutions that offer term loans) stipulate a certain minimum contribution to be brought-in by the project promoters towards meeting the project cost. The promoter’s contribution is fixed by the institutions keeping in view the nature of the project, its location, its repaying capacity, etc. No project is extended 100% assistance by the lending institutions, even if the project is highly profitable, since the institutions expect a minimum promoter’s stake in the project so that they get involved in the project.

7.2.5.1.

Features of Term Loans

The features of term loans are: 1) Maturity: The maturity period of term loans is typically longer in case of sanctions by financial institutions and is in the range of 6-10 years in comparison to 3-5 years of bank advances. However, they are re-scheduled to enable corporates/borrowers tide over temporary financial exigencies. 2) Negotiated: Term loans are negotiated between borrowers and lenders. They are akin to private placement of debentures in contrast to their public offering to investors. 3) Security: All term loans are secured. While the assets financed by term loans serve as primary security, all the other present and future assets of the company provide collateral/secondary security for the term loan. Generally, all the present as well as the future immovable properties of the borrower constitute a general mortgage/first equitable mortgage/floating charge for the entire institutional loan, including commitment charges, interest, liquidated damages and so on. They are additionally secured by
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hypothetication of all movable properties subject to prior charge in favor of banks, with respect to working capital finance/advance.

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4) Covenants (Negative): To protect their interests, financial institutions reinforce the asset security stipulation with a number of restrictive terms and conditions. These are known as covenants. They are both positive/affirmative and negative in the sense of what the borrower should and should not do in the conduct of his operations, and fall broadly into four sets as respectively related to assets, liabilities, cashflows and control.

7.2.5.2.

Advantages of Term Loans

1) The cost of term loan < cost of equity or preference capital (as interest on term loans is tax deductible). 2) Term loans do not result in dilution of control. 3) Leverage advantage.

7.2.5.3.

Disadvantages of Term Loans

1) The interest and principal payments are obligatory payments. Failure to meet these may threaten the solvency of the firm. 2) Restrictive covenant may reduce managerial freedom. 3) Term loan increases the financial risk of the firm which may raise the cost of equity capital.

7.2.5.4.

Term Loans Procedure

Term loans are also known as term-project finance. The procedure associated with a term loan involves the following principal steps: 1) Submission of Loan Application: The borrower submits an application form that seeks comprehensive information about the project. The application form covers the following aspects: i) Promoter’s Background: The promoters of the company must give their detailed bio-data. ii) Particulars of the Industrial Concern: The products to be manufactured and the market that need to be penetrated must be stated. Also the forecast for growth in that industry as well as their opportunities (export potential…) must be mentioned. iii) Particulars of the Project: Capacity, process, technical arrangements, management, location, land and buildings, plant and machinery, raw materials, effluents, labor, housing, and schedule of implementation. iv) Cost of the Project: The cost taking all factoring to account must be arrived at. v) Means of Financing: There should be details of the debt equity ratio, the level of gearing, the capital structure, and the source of financing. vi) Marketing and Selling Arrangement: The project report must state if the company has appointed any wholesalers or distributors for its goods services or if it has tied-up with another company for marketing its product. vii) Economic Considerations: The project must be economically feasible (i.e., demand exceeds supply).
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viii) Government Consents: The promoters should certify that they have obtained the necessary government approvals for the project. 2) Initial Processing of Loan Application: When the application is received, an officer of the financial institution reviews it to ascertain whether it is complete for processing. If it is incomplete the borrower is asked to provide the required additional information. When the application is considered complete, the financial institution prepares a ‘flash report’ which is essentially a summarization of the loan application. On the basis of the ‘Flash Report’, it is decided whether the project justifies a detailed appraisal or not. 3) Detailed Appraisal of the Proposed Project: The detailed appraisal of the project covers the financial, technical, economic and managerial aspects. The appraisal memorandum is normally prepared application after marketing project appraisal. Based on that a decision is taken whether the project application will be accepted or not. 4) Issue of the Letter of Sanction: If the project is accepted, a financial letter of sanction is issued to the borrower. This communicates to the borrower the assistance sanctioned and the terms and conditions relating thereto. It includes: i) Loan period, ii) Security both primary and secondary, iii) Restrictive covenants, and iv) Repayment schedule. 5) Acceptance of the Terms and Conditions by the Borrowing Unit: On receiving the letter of sanction from the financial institution, the borrowing unit convenes its board meeting at which the terms and conditions associated with the letter of sanction are accepted and an appropriate resolution is passed to that effect. The acceptance of the terms and conditions has to be conveyed to the financial institution within a stipulated period. 6) Execution of Loan Agreement: The financial institution, after receiving the letter of acceptance from the borrower, sends the draft of the agreement to the borrower to be executed by the authorized persons and properly stamped as per the Indian Stamp Act, 1899. The agreement, properly executed and stamped, alongwith other documents as required by the financial institution must be returned to it. Once the financial institution also signs the agreement, it becomes effective. 7) Disbursement of Loans: Periodically, the borrower is required to submit information on the physical progress of the projects, financial status of the project, arrangements made for financing the project, contributions made by the promoters, projected funds-flow statement, compliance with various statutory requirements, and fulfillment of the pre-disbursement conditions. Based on the information provided by the borrower, the FI will determine
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the amount of term loan to be disbursed from time-to-time. Before the entire term loan is disbursed, the borrower must fully comply with all the terms and conditions of the loan agreement. 8) Creation of Security: The term loans (both rupee and foreign currency) and the deferred payment guarantee assistance provided by the financial institutions are secured through the first mortgage, by way of deposit of title deeds, of immovable properties and hypothecation of movable properties (in the form of guarantees by the promoters). 9) Monitoring: Monitoring of the project is done at the implementation stage as well as at the operational stage. During the implementation stage, the project is monitored through the following: i) Regular reports, furnished by the promoters, which provide information about placement of orders, construction of buildings, procurement of plant, installation of plant and machinery, trial production, etc. ii) Periodic site visits. iii) Discussion with promoters, bankers, suppliers, creditors, and other connected with the project. iv) Progress reports submitted by the nominee directors. v) Audited accounts of the company. During the operational stage, the project is monitored with the help of: i) Quarterly progress report on the project, ii) Site inspection, iii) Reports of nominee directors, and iv) Comparison of performance versus promise. The most important aspect of monitoring, of course, is the recovery of dues represented by interest and principal repayment. Continuous monitoring helps in improving receivable management, etc.

7.2.6.

Internal Accruals

Internal accruals form part of the means-of-finance in respect of expansion projects. As existing company that goes for an expansion (or diversification or modernization) project may opt to finance a portion of the capital investment out of internal cash accruals. Depreciation which is not cash expenditure and profits retained after payment of dividends are the main sources of internally generated funds. Apart from the internal funds that have already been generated, the likely internal generation during the course of project implementation can also be used as a source for funding expansion projects.

7.2.6.1.

Advantages of Internal Accruals

Internal accruals are viewed very favorably by most corporate managements for the following reasons:
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1) Internal accruals are readily available. Management does not have to talk to outsiders (shareholders or lenders).

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2) Use of internal accruals, in contrast to external equity, eliminates issue costs and losses on account of under-pricing. 3) There is no dilution of control when a firm relies on internal accruals. 4) The stock market generally views an equity issue with skepticism. Internal accruals, however, do not carry any negative connotation.

7.2.6.2.

Disadvantages of Internal Accruals

The disadvantages of internal accruals include the following: 1) The amount that may be available by way of internal accruals may be limited. 2) The opportunity cost of retained earnings is quite high as it is equal to the cost of equity – remember that retained earnings, in essence, represent dividends foregone by equity shareholders. 3) The opportunity cost of depreciation-generated funds is equal to the weighted average cost of capital of the firm. 4) Many firms do not fully appreciate the opportunity costs of retained earnings and depreciation-generated funds. They tend to impute a low cost to internal accruals. Comforted by the easy availability of internal accruals and the notion that they have a low cost, managements may invest in submarginal projects that have a negative impact.

7.2.7.

Unsecured Loans

If there is some shortfall in the means-of-finance, the promoters/directors can mobilize funds from their friends, relatives and well wishers in the form of loan to make good the shortfall. Such loans are always unsecured, i.e., the lenders cannot have any charge over the assets of the company. Unsecured loans can be mobilized only based on the rapport that the project promoters have with their friends and relatives. Banks and financial institutions view unsecured loans with an eye of caution. They normally stipulate the following conditions if unsecured loan is to form part of the means-of-finance: 1) The promoters shall not repay the unsecured loan till the term loan persists. 2) Interest, if any payable on unsecured loan shall be paid only after meeting the term loan repayment commitments (both repayment of principal and interest). 3) The rate of interest payable on unsecured loan shall not be higher than the rate of interest applicable for term loan. Banks/financial institutions also stipulate the maximum limit for unsecured loan. Normally, unsecured loan component is expected not to exceed 50% of the equity capital.

7.2.7.1.

Advantages of Unsecured Loan

1) Unsecured personal loans do not require collateral security so there is no risk of loosing personal property if there is default on the loan.
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2) Unsecured personal loans also give full freedom over the usage of the funds because lenders do not impose any restrictions on them like other types of loans. 3) Unsecured personal loans can help to establish a good payment history and positive credit history. 4) They also have faster approval times over loans that require collateral.

7.2.7.2.

Disadvantages of Unsecured Loan

1) High Interest Rates: Because unsecured loans are backed only by trust, they are more of a risk for the lender, the higher the risk the higher it costs to borrow; borrowers with bad credit will face high interest rates. 2) Limited Loan Amounts: If we need to borrow a substantial sum of money, an unsecured loan is not the solution for us; unsecured loans are given in small amount, usually we can only borrow upto ` 25,000. 3) Lack of Flexibility: When we take-out an unsecured loan usually agree to pay it back in installments over a given period of time, e.g., ` 3,000 per month for 5 years, we will not be able to adjust to a lower payment, also if we wish to pay-off the loan sooner, we will face an early repayment fine.

7.2.8.

Public Deposits

Public deposits are the fixed deposits accepted by a business enterprise directly from the public. This source of raising finance was very popular in the absence of banking facilities. Many firms, large and small, have solicited unsecured deposits from the public in recent years, mainly to finance their working capital requirements.

7.2.8.1.

Advantages of Public Deposits

Following are the advantages of public deposits: 1) Simple and Easy: The method of borrowing money through public deposit is very simple. It does not require many legal formalities. It has to be advertised in the newspapers and a receipt is to be issued. 2) No Charge on Assets: Public deposits are not secured. They do not have any charge on the fixed assets of the company. 3) Economical: Expenses incurred on borrowing through public deposits is much less than expenses of other sources like shares and debentures. 4) Flexibility: Public deposits bring flexibility in the structure of the capital of the company. These can be raised when needed and refunded when not required.

7.2.8.2.

Disadvantages of Public Deposits

Following are the disadvantages of public deposits: 1) Uncertainty: A concern should be of high repute and have a high credit rating to attract public to deposit their savings. There may be sudden withdrawals of deposits which may create financial problems.
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2) Insecurity: Public deposits do not have any charge on the assets of the concern. It may not always be safe to deposit savings with companies particularly those which are not very sound. 3) Lack of Attraction for Professional Investors: As the rate of return is low and there is no capital appreciation, the professional investors do not appreciate this mode of investment. 4) Uneconomical: The rate of interest paid on public deposits may be low but then there are other expenses like commission and brokerage which make it uneconomical. 5) Hindrance to Growth of Capital-Market: If more and more money is deposited with the companies in this form there will be less investment in securities. Hence the capital market will not grow. This will deprive both the companies and the investors of the benefits of good securities. 6) Over-Capitalization: As it is an easy, convenient and cheaper source of raising money, companies may raise more money than is required. In that case it may not be able to make the best use of the funds or may indulge in speculative activities.

7.2.9.

Lease Financing

Lease is a contract whereby the lessor (the owner of an asset) gives to the lessee (the user of the asset) the right to use the asset, usually for an agreed period of time, in return for the consideration of periodical payments by the lessee to the lessor called, lease rentals. Lease, as a source of project finance is mainly suitable for expansion projects. This is because of the reason that repayment of lease rental starts immediately after acquisition of the leased asset by the lessee. New projects will take time for generating cash for repayment whereas existing projects that go for expansion can start repaying immediately out of their cash generation from their existing facilities.

7.2.9.1.

Features of Lease Structure

The salient features of the lease structures in India are as detailed below: 1) The lease agreements do not provide for transfer of ownership to the lessee as such transactions are classified as hire-purchase from the tax angle. 2) The lease rentals are structured so as to recover the entire investment cost during the primary period. They are quite nominal during the secondary period. The lease rates are determined by a number of factors including the relevant tax, depreciation, and so on. 3) The lease rentals are payable generally in equated/level monthly installments at the beginning of every month. A number of rental structures are used, related to the lessees requirements and projected cash flow pattern.
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7.2.9.2.

Advantages of Leasing

The advantages of leasing to the lessee and to the lessor are as follows: 1) To the Lessee i) Financing of Capital Goods: Lease financing enables the lessee to have finance for huge investments in land, building, plant, machinery, heavy equipments, and so on, up to 100 percent, without requiring any immediate down payment. Thus, the lessee is able to commence his business virtually without making any initial investment (of course, he may have to invest the minimal sum of working capital needs). ii) Additional Source of Finance: Leasing facilitates the acquisition of equipment, plant and machinery, without the necessary capital outlay, and, thus, has a competitive advantage of mobilizing the scarce financial resources of the business enterprise. It enhances the working capital position and makes available the internal accruals for business operations. iii) Less Costly: Leasing, as a method of financing, is less costly than other alternatives available. iv) Ownership Preserved: Leasing provides finance without diluting the ownership or control of the promoters. As against it, other modes of long-term finance, for example, equity or debentures normally dilute the ownership of the promoters. v) Avoids Conditionalities: Lease finance is considered preferable to institutional finance, as in the former case, there are no strings attached. Lease financing is beneficial, since it is free from restrictive covenants and conditionalities, such as, representations on the Board, conversion of debt into equity, payment of dividend, and so on, which usually accompany institutional finance and term loans from banks. vi) Flexibility in Structuring of Rentals: The lease rentals can be structured to accommodate the cash flow position of the lessee, making the payment of rentals convenient to him. The lease rentals are so tailor-made that the lessee is able to pay the rentals from the funds generated from operations. The lease period is also chosen so as to suit the lessee’s capacity to pay rentals and considering the operating lifespan of the asset. vii) Simplicity: A lease finance arrangement is simple to negotiate and free from cumbersome procedures with faster and simple documentation. As against it, institutional finance and term loans require compliance of covenants, formalities and bulk of documentation, causing procedural delays. viii) Tax Benefits: By suitable structuring of lease rentals, a lot of tax advantage can be derived. If the lessee is in a tax paying position, the rental may be increased to lower his taxable income. The cost of asset is thus amortized more rapidly than in a case where the asset is owned by the lessee, since depreciation is allowable at the prescribed rates. If
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the lessor is in tax paying position, the rentals may be lowered to pass on a part of the tax benefit to the lessee. Thus, the rentals can be adjusted suitably for postponement of taxes. ix) Obsolescence Risk is Averted: In a lease arrangement, the lessor, being the owner, bears the risk of obsolescence and the lessee is always free to replace the asset with latest technology. 2) To the Lessor i) Full Security: The lessor’s interest is fully secured since he is always the owner of the leased asset and can take repossession of the asset if the lessee defaults. As against it, realizing an asset secured against a loan is more difficult and cumbersome. ii) Tax Benefit: The greatest advantage for the lessor is the tax relief by way of depreciation. If the lessor is in high tax bracket, he can lease out assets with high depreciation rates and, thus, reduce his tax liability substantially. Besides, the rentals can be suitably structured, to pass on some tax benefit to the assessee. iii) High Profitability: The leasing business is highly profitable, since the rate of return is more than what the lessor pays on his borrowings. Also the rate of return is more than in case of lending finance directly. iv) Trading on Equity: Lessors usually carry out their operations with greater financial leverage. That is, they have a very low equity capital and use a substantial amount of borrowed funds and deposits. Thus, the ultimate return on equity is very high. v) High Growth Potential: The leasing industry has a high growth potential. Lease financing enables the lessees to acquire equipment and machinery even during a period of depression, since they do not have to invest any capital. Leasing, thus, maintains the economic growth even during recessionary period.

7.2.9.3.

Disadvantages of Leasing

The disadvantages of the lease to the lessee and to the lessor are as follows: 1) To the Lessee i) High Cost: The lease rentals include a margin for the lessor as also the cost of risk of obsolescence. It is, thus, regarded as a form of financing at higher cost. ii) Loss of Moratorium Period: The lease rentals do not take care of the gestation period. It usually takes a long time before the asset generates funds to pay it back. The term loan provides certain suspension period in repayments for that reason. But no such moratorium is permitted under lease arrangements.

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iii) Risk of being Deprived of the Use of Asset: The lessee may be deprived of the use of the asset due to the deterioration in the financial position of the lessor or winding up of the leasing company.

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iv) No Alteration or Change in Asset: As the lessee is not the owner of the asset, he cannot make any substantial changes in the asset. Contrary to it, in case of outright purchase, the buyer can modify or alter the asset to increase its utility. v) Loss of Ownership Incentives: There are certain advantages of owning the assets, such as depreciation and investment allowance. Incase of lease, the lessee is not entitled to such benefits. vi) Penalties on Termination of Lease: The lessee is usually required to pay certain penalties if he terminates the lease before the expiry of the lease period. vii) Loss of Salvage Value of the Asset: An asset generally has certain salvage value at the expiry of the useful life. As the lessee does not become the owner of the asset, he cannot realize the salvage value at the expiry of the lease rather he has to return the asset to the lessor. 2) To the Lessor i) High Risk of Obsolescence: The lessor has to bear the risk of obsolescence especially in the present era of rapid technology developments. ii) Competitive Market: As a number of leasing companies have emerged in recent years in India, the lessor has to face a tough competition from Indian as well as foreign companies. Due to this competition, the lessor may not be able to obtain sufficient lease rentals to recover the cost of the asset and his expected profit on investment as well as taking the risk. iii) Price-Level Changes: In spite of the increase in prices of assets due to inflation, the lessor gets only fixed rentals based on previous costs. iv) Management of Cash Flows: The success of a leasing business depends to a large extent upon efficient use of cash flows which are very difficult to manage because of unexpected market fluctuations. v) Increased Cost due to Loss of User Benefits: The lessor is not entitled to certain benefits available to buyers who are actual users of the assets such as concession in sales tax, duties, etc. This increases the cost of the asset and compels the lessor to charge higher lease rentals. vi) Long-term Investment: It usually takes a long time to recover the cost of the lessor in the capital outlays through lease rentals. Thus, lease rentals received may not represent actual realized profits because of inherent risks involved. Payment of dividends out of present earnings may ultimately result into payment out of capital.

7.2.10. Deferred Credits
Some machinery suppliers provide the facility of deferred credit, provided the credit-taker offers a bank guarantee. A project promoter who wants to avail the deferred credit facilities offered by a machinery supplier should approach a
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bank for offering guarantee for the repayment of deferred installments to the machinery supplier. Banks examine the viability of the project proposal before giving their guarantee. Normally, banks obtain mortgage of additional securities from the credit-takers to ensure that the bank does not stand to lose in the event of the guarantee being invoked by the machinery supplier due to nonrepayment of deferred installments.

7.2.11. Capital Investment Subsidy
Government provides subsidy for the setting-up of industries. The subsidy offered is two types, viz.: 1) Area Subsidy: Area subsidy is available for projects (both new and expansion projects) set-up in notified backward areas. Government notifies backward areas from time to time based on the industrial activity prevailing in different parts of the country. The objective of notifying certain areas as backward/most backward is to promote industrial development in those area (with a view to bring about balanced industrial growth) by offering certain incentives to projects coming-up in these areas. Any industry that is set-up in such notified areas is eligible for capital investment subsidy. (The term capital investment subsidy means that the quantum of subsidy eligible depends upon the investment on fixed assets). The quantum of capital investment subsidy is in the range of 15% to 20% on the investment on fixed assets. It must be verified whether the area wherein the project is proposed to be located finds place in the current list of notified backward area for ensuring availability of subsidy. Apart from notified backward areas, Government also extends subsidy to projects coming-up in industrial estates developed by Government Sponsored Development Organizations, though such industrial estates do not come within notified backward areas. 2) Product Subsidy: Product subsidy is available for projects that manufacture specified products. These products that are eligible for subsidy are identified by the Government by keeping in view the potential for the economic development of the country in such sectors of industries and notified by the Government. Projects that are set-up for the manufacture of products that find place in the list of eligible products, can avail product subsidy, irrespective of the location of the project, i.e., the project can avail subsidy irrespective of whether the unit is set-up in a notified backward area or not. The quantum of product subsidy is also fixed at a certain percentage on the investment on fixed assets (in the range of 10% to 20% for different types of notified products).

7.3. FINANCIAL INSTITUTIONS
The term financial institutions include all kinds of organizations which intermediate and facilitate financial transactions of both individuals and corporate customers. Thus, it refers to all kinds of FIs and investing institutions
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which facilitate financial transactions in financial markets. They may be in the organized sector or in the unorganized sector.

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7.3.1.

Norms and Policies of Financial Institutions

The Development Financial Institutions constitute an important segment of the Indian Financial System. They provide long-term funds for the development of industries, infrastructure projects and other major activities and thus, help in the growth of the economy. They are basically governed by their own statues and charters – Industrial Development Bank of India by the provisions of IDBI Act, 1964; and the Industrial Finance Corporation of India Ltd. (IFCI), the Industrial Credit and Investment Corporation Ltd. (ICICI) and the Industrial Investment Bank of India (IIBI) by their respective Memorandum of Association and Articles of Association, besides the Companies Act, 1956. Moreover, these financial institutions are also controlled by the regulations made by both the regulators of the Indian Financial System, namely the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). Section 45L of the Reserve Bank of India Act, 1934, extends the supervisory authority of the Reserve Bank over the financial institutions. This section empowers the Reserve Bank of India to: 1) Require the financial institutions to furnish to the Bank information and particulars relating to their business, and 2) Give these institutions directions relating to the conduct of their business as financial institutions. Norms and policies can be explained as follows: 1) Raising of Resources: In the matter of raising of resources, financial institutions have to comply with the direction of the Reserve Bank of India, and the Securities and Exchange Board of India (SEBI). Till 1991, these institutions had access to cheap sources of funds – IDBI, alongwith ExportImport Bank of India and Industrial Investment Bank of India (IIBI) used to receive loans and advances out of the National Industrial Credit (LongTerm Operations) Fund of the Reserve Bank of India. The bonds issued by them carried Government guarantee, making them eligible of being subscribed to by commercial banks to meet their statutory liquidity requirement. Both of these sources of raising financing at cheaper cost have been withdrawn since 1991. They are now allowed to raise resource from the capital market through bonds on market-determined terms and conditions without the patronage of government guarantee. For raising the funds in the capital market through bonds, the financial institutions are required to seek the approval of the Reserve Bank of India. In addition, they have to comply with “Guidelines to Development Financial Institutions for Disclosure and Investor Protections” issued by SEBI in September 1992. In May 1997, Reserve Bank of India replaced instrument-wise limits fixed for each financial institution with an umbrella limit (i.e., overall limit) for mobilization of resource by way of term money borrowings, certificates of
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deposits, fixed deposits, Commercial Paper and inter-corporate deposits. The overall ceiling for the umbrella limit has been fixed at 100% of the net owned funds for each financial institution. Financial institutions are also permitted to accept fixed deposits for 1 to 5 years and issue certificates of deposits for a minimum amount of `10 lac. Rating for the term deposits accepted by financial institutions has been made mandatory effective from November 1st, 2000. During 1997-78, Reserve Bank of India permitted these institutions to issue bonds with maturity of 5 years and above without its prior approval, but with simple registration with the Reserve Bank, provided the bonds are without options, etc., and carry interest rate not more than 200 basis points (one hundred basic points equal one per cent) above the yield on Government of India securities of equal residual maturity at the time of their issue. All other bond issues are required to be referred to the Reserve Bank for approval. In April 2000, Reserve Bank of India has decided to provide more freedom and flexibility to financial institutions in raising resources through bonds subject to overall limits fixed in terms of net owned funds. At present their total borrowings can be within the ceiling of 10 times of their net owned funds. A copy of the offer document is to be submitted to SEBI. Lead Manager has to certify that this document is in conformity with the SEBI Guidelines. 2) Exposure Norms: To minimize the risks in term lending, Reserve Bank of India has prescribed the exposure limits for term lending institutions (i.e., IDBI, ICICI, IIBI, Exim Bank and TFCI) and the refinancing institutions (i.e., SIDBI, NHB, and NABARD). Exposure ceiling has been linked to the institution’s capital funds. Earlier it was not to exceed 25% of the paid up capital and free reserves in case of individual borrowers 50% in case of group borrowers. Exposure includes funded and non-funded credit limits, underwriting and other commitments. With effect from September 1997, the group exposure limit was raised to 60% provided that the additional exposure related to infrastructure projects only. Moreover, exposure to any single industry has been prescribed at 15% of institution’s loan portfolio. These exposure limits are applicable to Infrastructure Development Finance Company (IDFC) also. With effect from March 2002, the maximum exposure has been reduced to 15% for individual borrowers, 40% for group borrowers and additional 10% for financing infrastructure projects. 3) Lending Operations: Though, the financial institutions enjoy autonomy as regards their lending operations, the Reserve Bank of India has intervened in the matter on a few occasions. It imposed a ban on financial institution on granting bridge loans against expected equity flows/issues, which was subsequently lifted on 23 rd January, 1998. Recently, the
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development financial institutions have been permitted by the Reserve Bank of India to grant short-term loans to the corporates for working capital purposes. Reserve Bank of India has also permitted these institutions to fix their prime lending rates separately for short-term loans. 4) Prudential and Capital Adequacy Guidelines: In March 1994, Reserve Bank of India prescribed prudential guidelines regarding capital adequacy, income recognition, asset classification and provisioning of the term lending institutions. Subsequently these guidelines were extended to SIDBI, NABARD and National Housing Bank also. These guidelines are similar to those issued to the commercial banks, except for minor changes. i) Capital Adequacy Norm: All India Financial Institutions were required to achieve capital adequacy norm of 8% by March 31, 1996. Capital adequacy norm has been expressed as a percentage of risk weighted assets. In December 1998, the minimum Capital Adequacy Norm for financial institutions, was enhanced to 9% to be effective from March 31, 2000. All the financial institutions except IFCI Ltd., have achieved this norm at the end of March, 2001. Capital funds are divided into two categories, i.e., tier I and tier II capital on the pattern of norms for commercial banks. ii) Income Recognition: Financial institutions are allowed to treat an asset as Non-Performing Asset (NPA) if interest/principal is overdue for more than 180 days with effect from March 31, 2002. In respect of NPAs the financial institutions should not take interest income, fees or any other charge, unless actually received. iii) Asset Classification and Provisioning: The basis of assets classification and provisioning for financial institutions is almost on the same lines, as prescribed for commercial banks.

7.3.2.

SEBI Guidelines

SEBI guidelines for financing the project consider: 1) SEBI Guidelines for Merchant Banking 2) SEBI Guidelines for Mutual Funds

7.3.2.1.

SEBI Guidelines for Merchant Banking

Following are the SEBI regulations on merchant banking: 1) Categories of Merchant Banker’s i) Category I a) To carry on any activity of the issue management, which will inter alia consist of preparation of prospectus and other information relating to the issue, determining financial structure, tie-up of financiers and final allotment and refund of the subscription; and b) To act as adviser, consultant, manager, underwriter, portfolio manager.
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ii) Category II: To act as adviser, consultant, co-manager, underwriter, portfolio manager.

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iii) Category III: To act as underwriter, adviser, and consultant to an issue. iv) Category IV: To act only as adviser or consultant to an issue. 2) Requirements for Granting of Certificate: The applicant is: i) Shall be a body corporate other than an NBFC. ii) Has the necessary infrastructure to effectively discharge his activities. iii) Should have minimum two experienced employees to conduct the business of the merchant banker. iv) Should fulfill the capital adequacy requirement as specified. v) His partner, director or principal officer should not be involved in any litigation connected with the securities market which has an adverse bearing on the business of the applicant. vi) His partner, director or principal officer has not, at any time, been convicted for any offence involving moral turpitude or has been found guilty of any economic offence. vii) Should have the professional qualification from an institution recognized by the government in finance, law or business management. viii) Should be a fit and proper person. 3) Capital Adequacy Requirements i) The Capital Adequacy Requirement (CAR) shall not be less than the net worth of the person making the application for grant of registration. ii) The net worth shall be as follows, namely:
i) ii) iii) iv) Category Category I Category II Category III Category IV Minimum Amount ` 5,00,00,000 ` 50,00,000 ` 20,00,000 Nil

iii) For the purposes of this regulation “net worth” means in the case of an applicant which is a partnership firm or a body corporate, the value of the capital contributed to the business of such firm or the paid up capital of such body corporate plus free reserves as the case may be at the time of making application. 4) Code of Conduct i) Every merchant banker shall abide by the code of conduct as specified in Schedule III. ii) No merchant banker, other than a bank or a public financial institution, who has been granted a certificate of registration under these regulations, shall after June 30th 1998 carry on any business other than that in the securities market. iii) A merchant banker, who has been granted certificate of registration to act as primary dealer by Reserve Bank of India, may carry on such business as may be permitted by Reserve Bank of India.
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5) Appointment of Lead Merchant Bankers i) All issues should be managed by atleast one merchant banker functioning as the lead merchant banker. ii) Every lead merchant banker shall before taking up the assignment relating to an issue, enter into an agreement with such bodycorporate setting out their mutual rights, liabilities and obligations relating to such issue and in particular to disclosures, allotment and refund. 6) Restriction on Appointment of Lead Merchant Bankers: The number of lead merchant bankers may not, exceed in case of any issue of Size of Issue No. of merchant bankers. i) Less than rupees fifty crore – Two (2), ii) Rupees fifty crore but less than rupees one hundred crore – Three (3), iii) Rupees one hundred crore but less than rupees two hundred crore – Four (4), iv) Rupees two hundred crore but less than rupees four hundred crore – Five (5), v) Above Rupees four hundred crore – five or more as may be agreed by the SEBI. 7) Responsibilities of Lead Merchant Bankers i) No lead manager shall agree to manage or be associated with any issue unless his responsibilities relating to the issue mainly, those of disclosures, allotment and refund are clearly defined, allocated and determined and a statement specifying such responsibilities is furnished to the SEBI atleast one month before the opening of the issue for subscription. ii) In case there is more than one lead merchant banker, the responsibilities should be clearly demarcated. iii) No lead merchant banker shall agree to manage the issue made by any body-corporate, if such body corporate is an associate of the lead merchant banker. 8) Maintenance of Books of Accounts, Records, etc. i) Every merchant banker shall keep and maintain the following books of accounts, records and documents namely: a) A copy of balance sheet and P&L account as at the end of each accounting period; b) A copy of the auditor’s report on the accounts for that period; and c) A statement of financial position. ii) Every merchant banker shall intimate to the SEBI the place where the books of accounts, records and documents are maintained. iii) Every merchant banker shall, after the end of each accounting period furnish to the SEBI copies of the balance sheet, profit and loss account and such other documents for any other preceding five accounting years when required by the SEBI.
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9) Submission of Half Yearly Results: Every merchant banker shall furnish to the SEBI, half yearly unaudited financial results when required by the SEBI with a view to monitor the capital adequacy of the merchant banker. 10) Amendments to SEBI (Merchant Bankers) Regulations, 1992: Merchant bankers have been barred from undertaking activities other than related to the securities market. The SEBI (Merchant Bankers) Regulations, 1992 have been amended on December 9, 1997 to provide that: i) The applicant should be a fit and proper person; ii) A merchant banker has to seek separate registration for its underwriting or portfolio management activities; iii) The categorization of merchant bankers I, II, III and IV has been dispensed with; iv) A merchant banker, other than a bank or a public financial institution, has been prohibited from carrying any activities not pertaining to the securities market; and v) The applicant should be a corporate body other than non-banking finance company. The Merchant Bankers Regulations were amended on January 21, 1998 to provide time upto June 30, 1998 to sever their activities or hive-off their activities not pertaining to the securities market. The Reserve Bank of India has exempted merchant banking companies from the provisions of Reserve Bank of India Act, 1934 relating to compulsory registration (Section 451A), maintenance of liquid assets (Section 451B), creation of reserve fund (Section 451C) and all the provisions of the recent directions relating to deposit acceptance and prudential norms. Merchant banking companies, to be eligible for the above exemption, are required to satisfy the following conditions: i) Such companies are registered with the SEBI under Section 12 of the SEBI Act, 1992 and are carrying-on the business of merchant banker in accordance with the rules/regulations framed by the SEBI. ii) They acquire securities only as part of their merchant banking business. iii) They do not carry-on any other financial activities as mentioned in Section 451 (c) of the RBI Act, 1934. iv) They do not accept/hold public deposits.

7.3.2.2.

SEBI Guidelines for Mutual Funds

The SEBI regulations for the establishment and issue of schemes by mutual funds are as follows: 1) Mutual fund shall be established in the form of trusts under the Indian Trust Act and managed by separately formed asset management company.
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2) Money market mutual fund would be regulated by the RBI and other mutual funds would be regulated by SEBI. 3) Fifty per cent members of the board of AMC must be independent directors and must have no connection with sponsoring organization. 4) The directors should have at least 10 years experience in the field of portfolio management, financial administration, etc. 5) The AMC should have a minimum net worth of ` 10 crore. 6) The SEBI has the authority to withdraw the authorization of AMC if they fail to work for the interest of investors. This stipulation is not applicable to banks sponsoring mutual funds. 7) An AMC cannot act as the AMC for another mutual fund. 8) AMCs are also allowed to do other fund based businesses such as providing investment management services to offshore funds, other mutual funds, venture capital funds, and insurance companies. 9) The minimum amount to be raised with each closed-end scheme should be ` 20 crore and for the open-ended scheme ` 50 crore. 10) Each scheme of the mutual fund is registered with SEBI before it is floated in the market. 11) Closed-end schemes should not be kept open for subscription for more than 45 days. For open-ended schemes, the first 45 days should be considered for determining the target figure. 12) If the minimum amount or 60% of the target amount is not raised, the entire subscription has to be returned to the investors. 13) For each scheme, there should be a separate and responsible fund manager. 14) The SEBI guidelines (1999) restrict MFs to invest not more than 10% of NAV of a scheme in shares or share related instruments of a single company. 15) SEBI increased the maximum investment limit for MFs in listed companies from 5 to 10% of NAV in respect of the open-ended funds. 16) The initial issue expenses should not exceed 6% of the funds raised under each scheme. 17) All mutual funds must distribute a minimum of 90% of their profits in any given year. 18) Every mutual fund is required to send the audited annual statements of accounts and six months unaudited accounts of net assets for each of its schemes to the SEBI. 19) The SEBI shall lay down a common advertising code for all mutual funds to comply with. 20) The SEBI after due investigation may impose penalty on mutual funds for violating the guidelines.
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7.3.3.

Sample Financing Plans

1) Project Cost: Present a table detailing each component of the project cost by category (hard and soft costs, fees by type, pre-opening expenses, permanent working capital). Discuss contingencies and the timing of cash payments. 2) Financial Plan: Explain the financial plan, noting each category of financing being sought and different capitalization scenarios, if applicable. Note how much funding has been raised so far and on what terms and conditions, and how much is expected to be raised from whom, on what terms and conditions, and in what timeframe. Note how much has been spent and for what purposes. Discuss cashflow estimates and potential changes and issues. 3) Operational and Financial Projections: i) Present a summary of financial projections. ii) Explain details of assumptions used to project the levels of operation of each department or service unit, as well as details of projected revenues and expenses. iii) Present projected financial statements, i.e., income statement, cashflow statement, and balance sheet, in detail, with monthly projections for the first two years of operations and quarterly projections for years three and four (and annual projections from year five on). 4) Summary of Financial Viability and Sensitivity Scenarios: i) Present the internal rate of return on total investment. ii) Present the base case financial projections and various sensitivity scenarios based on revisions to key assumptions, particularly in relation to risks that are identified as beyond the control of the project’s sponsors and the hospital’s management. iii) Explain changes in the assumptions used for the sensitivity cases, the implications of each sensitivity scenario, the likelihood of each scenario becoming a reality, and actions that can be prepared to manage the situation in the event it occurs. iv) Presented selected financial ratios such as the current ratio, asset turnover ratio, debt-to-asset ratio, and debt-to-equity ratio, as well as profitability measures (cash margins at different levels, return on assets, return on equity, and so forth) for base case and sensitivity cases.

7.4. STRUCTURE OF FINANCIAL INSTITUTIONS
They may be classified into four types: 1) Regulatory Bodies 2) Banking Financial Institutions 3) Non-Banking Financial Institutions 4) Non-Banking Financial Companies
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Regulatory Bodies SEBI IRDA RBI

Banking Financial Institution Commercial Bank Cooperative Bank

Non-Banking Financial Institution LIC GIC UTI IFCI ICICI IDBI EXIM Bank NABARD SIDBI SFCs

Non-Banking Financial Companies Hire Purchase Leasing Housing Finance Service AMC Venture Capital Companies

7.4.1.

Regulatory Bodies

Regulatory bodies of financial institution are: 1) Securities and Exchange Board of India (SEBI): The establishment of the Securities and Exchange Board of India (SEBI) was a land mark government measure to monitor and regulate capital market activities and to promote healthy development of the market. The SEBI was constituted in 1988 by a resolution of Government of India and it was made a statutory body by the Securities and Exchange Board of India Act.1992. Powers and Functions of SEBI [Section 11] The Board is expected to protect the interest of investors in securities and to promote the development of, and to regulate the securities market, by such measures as it thinks fit. To fulfill these objectives, the following are the powers and functions of the board, granted under section 11(i) of the Act: i) Regulating the business in stock exchanges and any other securities markets; ii) Registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisors and such other intermediaries who may be associated with securities markets in any manner; iii) Registering and regulating the working of collective investment schemes, including mutual funds; iv) Promoting and regulating self-regulatory organizations. v) Prohibiting fraudulent and unfair trade practices relating to securities markets. vi) Promoting investors education and teaching of intermediaries of securities markets;
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vii) Prohibiting inside trading in securities; viii) Regulating substantial acquisition of shares and take-over of companies; ix) Calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges and intermediaries and self-regulatory organizations in the stock market; x) Performing such function and exercising such powers under the provisions of the Capital Issues (Control) Act, 1947 and The Securities Contracts (Regulation) Act, 1956 as may be delegated to it by the Central Government; xi) Levying fees or other charges for carrying out the purposes of this section; xii) Conducting research for the above purposes; xiii) Performing such other functions as may be prescribed. 2) Insurance Regulatory and Development Authority (IRDA): The Insurance Regulatory and Development Authority Act, 1999 provides for the establishment of an Authority to protect the interests of insurance policy holders, to regulate, promote and ensure orderly growth of the insurance industry and for matters connected therewith or incidental thereto. It also aims to amend the Insurance Act, 1938, the Life Insurance Corporation Act, 1956 and the General Insurance Business (Nationalization) Act, 1972 in order to end the monopoly of the Life Insurance Corporation of India (for life insurance business) and General Insurance Corporation and its subsidiaries (for general insurance business). Duties/Powers/Functions of IRDA Under Section 14 of the IRDA Act, the Authority’s duty is to regulate, promote and to ensure an orderly growth of the insurance and the reinsurance business. Under sub-Section 1 of Section 14 of the IRDA Act, the Authority has the following powers and functions: i) Registration: Issuance of certificate of registration, or to renew, modify, withdraw, suspend or cancel such registration. ii) Protection: Protection of the interests of policy holders in matters concerning assigning of policy, nomination by policy holders, insurable interest, settlement of insurance claim, surrender value of policy and other terms and conditions in contracts of insurance. iii) Qualification: Specifying the requisite qualifications, code of conduct and practical training for insurance intermediaries and agents. iv) Fees etc.: Levying fees and other charges for carrying out the objectives of this Act. v) Funds Investment: Regulating investment of funds by insurance
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companies.

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vi) Margin of Solvency: Regulating the maintenance of margin of solvency. vii) Premium Income: Specifying the percentage of the premium income going into finance schemes for promoting and regulating professional organizations pursuing assurance business. viii) Rural Insurance etc.: Specifying the percentage of life insurance business and general insurance business to be undertaken by the insurer in the rural or social sector. 3) Reserve Bank of India (RBI): The Reserve Bank of India (RBI) is the Central Bank of the country. It has been established as a body corporate under the Reserve Bank of India Act, which came into effect from 1 st April, 1935. The Reserve Bank was started as share-holders bank with a paid-up capital of `5 crores. On establishment it took over the function of management of currency from the Government of India and power of credit control from the then Imperial Bank of India. Powers of Reserve Bank of India The Reserve Bank Act, 1934, and Banking Regulation Act, 1949 have given the RBI wide powers of: i) Supervision and control over commercial and cooperative banks, relating to licensing and establishments. ii) Branch expansion. iii) Liquidity of their assets. iv) Management and methods of working, amalgamation reconstruction and liquidations; v) The RBI is authorized to carry out periodical inspections of the banks and to call for returns and necessary information from them.

7.4.2.

Banking Financial Intermediaries

Intermediaries supply only short term funds to individuals and corporate customers. They consist of 1) Commercial Banks: Commercial banks comprising public sector banks, foreign banks and private sector banks represent the most important financial intermediary in the Indian financial system. The largest commercial Bank in India, the State Bank of India (SBI), was set up in 1955 when the Imperial Bank was nationalized and merged with some banks of the princely states. SBI associate banks were nationalized in 1959. In 1969, in one fell swoop, the fourteen largest privately-owned commercial banks were nationalized. Subsequently, six other privatelyowned commercial banks with the capital of more than ` 200 crore were nationalized in 1980. As a result of these actions, public sector commercial banks dominate the commercial banking scene in the country.
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Structure of Commercial Banks The commercial bank includes: i) Public Sector Banks: Public sector banks are banks in which the government has a major holding. These can be classified into three groups: a) State Bank of India: The State Bank of India was initially known as Imperial Bank. b) Nationalizated Banks: The nationalization of banks in India took place in 1969 by Mrs. Indira Gandhi the Prime Minister. It nationalized 14 banks then. c) Regional Rural Banks: The idea of establishing Regional Rural Banks in order, to provide employment to the rural educated youth; and to bring down the cost of rural banks by recruiting their staff on the same scale of pay and allowances as for the employees of State Government/local bodies. It was on the recommendations that the first five RRBs were set up on 2 October 1975 under an ordinance promulgated on 26 September 1975 which was replaced by the Regional Rural Banks Act of 1976. ii) Private Sector Banks: After the nationalization of 14 larger banks in 1969, no banks were allowed to be set up in the private sector. In the pre-reforms period, there were only 24 banks in the private sector. Today, there are 31 private sector banks in the banking sector; 23 old private sector banks and 8 new private sector banks. These new banks have brought in state-of-the art technology and aggressively marketed their products. These banks reported profits in the very first year of their existence. The public sector banks are facing a stiff competition from the new private sector banks. The guidelines for entry of new banks in the private sector were revised in January 2001. The guidelines prescribed an increase in initial minimum paid-up capital from ` 100 crore to ` 200 crore. Moreover, the initial minimum paid-up capital shall be increased to ` 300 crore in subsequent three years after commencement of business. The guidelines also enable a Non-Banking Finance Company (NBFC) to convert into a commercial bank, if it satisfies the prescribed criteria of: a) Minimum net worth of ` 200 crore, b) A credit rating of not less than AAA (or its equivalent) in the previous year, c) Capital adequacy of not less than 12 per cent, and d) Net NPAs not more than 5 per cent. 2) Co-Operative Banks: Co-operative Banks came into existence with the enactment of the Co-operative Credit Societies Act of 1904 which provided for the formation of Co-operative Credit Societies.
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Co-operative Banks fill in the gaps of banking needs of small and medium income groups not adequately met through by the public and private sector banks. The Co-operative Banking system supplements the efforts of the commercial banks in mobilizing savings and meeting the credit needs of the local population. Their exposure to corporate (wholesale) banking is also limited due to factors such as small size of their balance sheet and inadequate expertise. Co-operative Banks came under the purview of the Banking Regulations Act only in 1966. Urban Co-operative Banks are supervised by the Reserve Bank, while rural Co-operative Credit Societies are supervised by the NABARD.

7.4.3.

Non-Banking Financial Intermediaries

Non-banking Financial Institutions carry out financing activities but their resources are not directly obtained from the savers as debt. Instead, these Institutions mobilise the public savings for rendering other financial services including investment. All such Institutions are financial intermediaries and when they lend, they are known as Non-Banking Financial Intermediaries (NBFIs) or Investment Institutions. Following are the Non-Banking Financial Intermediaries explained below: 1) Life Insurance Corporation of India: There has been life insurance business in India since 1818. Till 1956, the insurance business was mixed and decentralized. There were a large number of companies (245 on the eve of nationalization) of different ages, sizes, and patterns of organization, which conducted only life insurance business, and there were some companies whose main business was general insurance but which did life assurance also. In addition, there were a number of Provident Societies. In 1956, the life insurance business of all companies as mentioned was nationalized and a single monolithic organization, the Life Insurance Corporation of India (LIC), was set up. Today, life insurance is almost entirely in the hands of the LIC. The Post and Telegraph Department conducts some business in this area for its employees, but the volume of that business in relation to that of LIC, is negligible and declining. 2) General Insurance Corporation of India: The government nationalized the general insurance business in 1972. One hundred and seven insurers, including branches of foreign companies operating in India, were amalgamated and grouped into four companies, namely, The National Insurance Company Limited, The New India Assurance Company Limited, The Oriental Insurance Company Limited, and The United India Assurance
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Company Limited with head offices at Kolkata, Mumbai, Delhi and Chennai.

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The General Insurance Corporation (GIC) was incorporated as a holding company of these four general insurance companies in November 1972. The Government of India subscribed to the capital of GIC which, in turn, subscribed to the capital of the four companies. All the four companies are government companies registered under the Companies Act. The General Insurance Corporation commenced business on January 1, 1973. The GIC was expected to generate competition among the four subsidiary companies. GIC was also entrusted to write directly the Aviation (Hull and Liability) insurance of the national carriers (Indian Airlines and Air India), Hindustan Aeronautics Limited, and the International Airport Authority of India. The main objectives of GIC were superintending, controlling, and carrying on the business of general insurance. 3) Unit Trust of India: The unit trusts provide an opportunity to small and medium investors to make investments indirectly in those stocks in which they could not have otherwise done. The small investors purchase units of the trusts which are of small denominations. The trusts on the other hand invest this money in purchasing shares of good companies. The income and capital gains from these investments are shared with the unit holders. Unit trusts help investors to obtain high return, low-risk combination from their indirect holding of equities and other assets. The Government of India was thinking of establishing an investment trust to extend facilities of investment in equity capital of companies by large and growing number of small and medium investors. The Unit Trust of India was established by Government of India under the Unit Trust of India Act, 1963. The Trust was accordingly set up in February 1964. 4) Industrial Finance Corporation of India (IFCI): The Industrial Finance Corporation of India was established in 1948 under the IFC Act, 1948. The main objectives of the corporation have been to provide medium and longterm credit to industrial concerns in India. The Financial assistance of the corporation is available to limited companies or co-operative societies registered in India and engaged or proposing to engage in (a) manufacture, preservation or processing of goods (b) the mining industry; (c) the shipping business; (d) the hotel industry; and (e) the generation or distribution of electricity or any other form of power. 5) Industrial Credit and Investment Corporation of India (ICICI): The World Bank was helping the setting up of development banks in underdeveloped countries. ICICI was one of such banks which were set up in India in January, 1955, the ownership of the corporation was entirely in private hands but certain safeguards were contemplated against the acquisition of control by vested interests.
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ICICI provides funds of various kinds. The primary purpose for which funds are made available by the corporation is the purchase of capital assets such as land, building and machinery. 6) Industrial Development Bank of India (IDBI): The Industrial development Bank of India was established under the Industrial Development Bank of India Act., 1964, as a wholly owned subsidiary of the Reserve Bank of India. The ownership of IDBI has since been transferred to Central Government from February 16, 1976. 7) Export Import Bank of India (EXIM Bank): It is an apex institution for coordinating the working of institutions in India engaged in financing exports and import of goods and services. With initial authorized capital of ` 200 crore (increased to ` 500 and then to ` 2,000 crore) Exim Bank was established on January 01, 1982 (and started functioning w.e.f. March 01, 1982) under Export Import Bank of India Act 1982, which took over the export finance activities of IDBI. It raises funds by way of bonds and debentures, borrowing from RBI or other institutions, raising foreign deposits. 8) National Bank For Agriculture & Rural Development (NABARD): RBI constituted a Committee to Review Arrangements for Institutional Credit for Agriculture and Rural Development (CRAFICARD) in 1979. Set up at the instance of Government of India (GOI), the committee undertook the task of reviewing the need of integrating short-term, medium-term and long-term agriculture credit structure. The committee ultimately recommended the establishment of National Bank for Agriculture and Rural Development (NABARD). NABARD is an apex institution, accredited with all matters concerning policy, planning and operations in the field of credit for agriculture and other economic activities in rural areas in India. NABARD was established as a development bank for providing and regulating credit, and other facilities for the promotion and development of agriculture, small scale industries, cottage and village industries, handicrafts and other rural crafts, and other allied economic activities in rural areas with a view to promoting integrated rural development and securing prosperity of rural areas and for matters connected therewith or incidental thereto. 9) Small Industries Development Bank of India (SIDBI): The SIDBI was set up in October 1989 under the Act of Parliament as a wholly-owned subsidiary of the IDBI. Its authorized capital is ` 250 crore with an enabling provision to increase it to ` 1,000 crore. It is the central or apex or principal institution which oversees co-ordinates and further strengthens various arrangements for providing financial and non-financial assistance to small-scale, tiny, and cottage industries. In pursuance of the SIDBI (Amendment) Act, 2000, 51.1 per cent of the shares of the SIDBI held by IDBI have been transferred to selected public sector banks, LIC, GIC, and other institutions owned and controlled by the Central Government.
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10) State Financial Corporations (SFCs): The State Financial Corporation Act was passed by the Government of India in 1951 with a view to provide financial assistance to small and medium scale industries which were beyond the scope of IFCI. According to this Act, a State Government is empowered to establish a financial corporation to operate within the State.

7.4.4.

Non-Banking Financial Companies (NBFCS)

The financial institutions which provide the various banking facilities but are not termed as banks because they do not hold the banking license are known as the Non-Banking Financial Institution. It is a company registered under the Companies Act, 1956. Non-banking finance companies are governed by the directions issued by Reserve Bank of India. Non-banking finance companies consist mainly of finance companies which carry on hire purchase finance, housing finance, investment, loan, equipment leasing or mutual benefit financial companies but do not include insurance or stock exchanges or stock-broking companies. According to the Reserve Bank (Amendment Act) 1997, “A Non-banking Finance Company (NBFC) means: 1) A financial institution which is a company; 2) A non-banking institution which is a company and which has as its principal business the receiving of deposits under any scheme or arrangement or in any other manner or lending in any manner; 3) Such other non-banking institution or class of such institutions, as the Bank may with the previous approval of the Central Government specify.

7.4.5.

Schemes of Assistance

AIDFIs also offer different specific schemes of assistance to cater to the needs of the industry. While some of the schemes offered by different AIDFIs are parallel, some others have different terms and conditions to suit the kind of assistance offered. It may be mentioned here that the schemes discussed below are in addition to the normal project finance scheme available with AIDFIs. The schemes narrated hereunder are only illustrative and not exhaustive:

7.4.5.1.

Specific Schemes of IDBI

Specific schemes of IDBI are as follows: 1) Scheme for Foreign Currency Assistance i) The scheme is available to industrial concerns intending to import capital goods/technology for setting-up new projects or undertaking expansion/diversification/modernization/balancing schemes of existing projects. There is no ceiling on the quantum of the loan. Terms and conditions of a foreign currency loan depend upon the source of foreign currency funds to be allocated to the industrial
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concern by IDBI. The risk arising out of exchange fluctuation is to be borne by the borrower. IDBI has also introduced Foreign Currency Refinance (FCR) Scheme for providing refinance assistance to SIDCs and SIICs to enable them to meet the foreign currency requirements of small and medium scale units. All the projects which are eligible for financial assistance from state level institutions under IDBI’s normal Refinance Scheme are eligible under FCR Scheme. ii) IDBI has obtained permission from Reserve Bank of India to book forward contracts on behalf of its borrowers on a roll-over basis in order to enable them to obtain forward cover against exchange risk on their debt servicing liabilities. IDBI also does hedging operations on behalf of the borrowers in respect of loans availed of by them in foreign currencies. iii) IDBI also offers foreign currency loans on self-liquidation basis to export-oriented units. The minimum maturity period for the selfliquidating loan has been relaxed by RBI from two years to 180 days. All 100% Export-Oriented Units (EOUs) including the newly set-up ones are eligible to avail of this loan. However, green-field projects or new units other than 100% EOUs will have to establish clear track record in order to qualify for foreign currency loans under this scheme. IDBI will be charging a reasonable spread over quarter/halfyearly rate of interest on London Inter Bank Offered Rate (LIBOR) for U.S. dollars. The loans can be utilized to finance import of capital goods, raw materials, components or technology payment or local rupee cost of projects. 2) Equipment Finance Scheme for Import of Capital Goods: With a view to make available foreign currency loans to industrial concerns for import of capital goods and equipment not related to any specific project, a simplified procedure is framed by IDBI known as Equipment Finance Scheme. Assistance under this scheme is available to existing industrial concerns having good record of performance and sound financial position which have been in operation for a period of five years and consistently making profit for last three years. Import of capital goods, inspection equipment and tools, balancing equipment, dies, tools and components (provided these are of capital nature) are eligible for financial assistance under this scheme. Import of second-hand capital goods/equipment will not be eligible for assistance under this scheme. A separate form of application has been prescribed under the scheme. 3) Bills Re-Discounting Scheme: The scheme is intended to help the manufacturers of indigenous machinery to augment sale of their product and provide quick and simple means of financial assistance to industrial concerns for purchasing equipment. The manufacturers of indigenous machinery/capital equipment can push-up the sales of their products by offering deferred payment facilities to the prospective purchaser-users. The purchaser-user is enabled to utilize the machinery acquired and repay its
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cost over a number of years. The manufacturer gets the value of machinery within a few days of the delivery of machinery by discounting with his banker the bills/promissory notes arising out of the sale of machinery. Facilities under the scheme are available to all manufacturing industries including manufacturers of automobiles, agricultural machinery and equipment, renewable energy equipment, and effluent disposal/treatment equipment. Under this scheme, the intending purchaser-user of indigenous/imported machinery, who is not in a position to offer immediately full cash payment for the required machinery approaches the manufacturer, sole selling agent, importer of capital goods or design engineering concern seeking deferred payment facility. A separate bill/promissory note is drawn/made for each installment together with interest payable on the deferred installments. The bills or promissory notes are accepted/guaranteed on behalf of the purchaser-user and delivered to the manufacturer-seller who gets them discounted with his banker. The banker in turn gets them re-discounted by IDBI. The discounting bank takes the bill against payment to IDBI three working days in advance of the due dates and obtains payment thereof from the acceptor/guarantor of the bills/promissory notes on due dates. 4) Bills Discounting Scheme or Director Discounting Scheme: Concurrently with the existing Bills Rediscounting Scheme, IDBI has been operating a scheme where IDBI directly discounts the bills/promissory notes arising out of sale of machinery accepted/guaranteed by the purchaser’s bank or seller’s bank (a scheduled commercial bank). Under this Scheme, the seller should satisfy the following requirements: i) It should be a manufacturer of machinery/equipment, ii) It should have been in production for atleast five years with good record of performance and financial position, and iii) It should not be in arrears to its term lenders. 5) Venture Capital Fund Scheme: Under this scheme, IDBI provides financial assistance in the form of loan carrying concessional rate of interest during the development period for financing cost of fixed assets (land, building, plant, and machinery) as well as operating expenditure (including cost of raw materials, utilities, and market development expenses). The assistance under the scheme is available for: i) Setting-up pilot plant based on laboratory process developed, ii) Technological innovations leading to substantial quality upgrading, reduced material consumption, reduced energy consumption, cost reduction and improved competitiveness, iii) Adaptations/modifications to process/product which has been imported so as to make it suitable for Indian conditions, and iv) Cost of studies, surveys, market promotion programs and training in relation to the above. The maximum project cost shall not ordinarily exceed `500 lac.
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This scheme is designed to provide Venture Capital Fund Assistance to new or existing industrial concerns for: i) Encouraging commercial application of indigenously developed technology, ii) Adopting imported technology to wider domestic applications, and iii) High risk-High return ventures. 6) Asset Credit Scheme: IDBI has introduced a scheme known as Asset Credit Scheme for acquiring (and/or fabricating) equipment/machinery by financially sound companies as part of their capital expenditure program. Assistance under the scheme will be available to industrial concerns having good record of performance and sound financial position. The companies should have been in operation for a minimum period of five years, consistently profit making for the last three years. The scheme envisages sanction of line of credit which would be valid normally for a period of one year towards purchase of assets (including those fabricated in-house) and will not be available for acquiring second hand assets. 7) Equipment Lease Scheme: Equipment Lease Scheme has been launched for lease of equipment/machinery to existing companies having a track record of good operational performance and sound financial position as part of their asset acquisition program. There is a fundamental difference between the relationship of IDBI with its constituents under the existing loan scheme and leasing. While the normal relationship is one of the lender and borrower, under the Equipment Lease Scheme, it is in the nature of lessor and lessee. IDBI offers assistance in the nature of full payment of financial lease wherein the cost of assets will be recovered during a single lease period. Under the scheme, equipment lease limit would be offered to the industrial concern, which would be valid normally for a period of one year. The transaction would cover lease of equipment/machinery including mining, construction equipment, computers, office equipment, earthmovers, etc. The cost of equipment would normally include taxes, duties, freight, transportation, and other costs incurred/paid by IDBI towards the purchase of equipment. 8) Corporate Loan Scheme: The scheme is designed for financially sound companies having been in commercial operation for five years and making profit consistently for the last three years to make available finance for capital expenditure and long-term working capital. The assistance is available both in the form of rupee loan and foreign currency loan. The minimum assistance provided under the scheme is `5 crore and the maximum limit shall not exceed 70% of the cost of capital goods or raw materials or components, etc., to be purchased or imported. The debtequity ratio shall be 1.5:1. The loan is repayable in 1 to 3 years in quarterly installments.
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9) Assistance for Pollution Control: With a view to controlling, monitoring and abatement of industrial pollution, IDBI has been granting rupee designated loans for part-financing sub-project proposals aiming at waste minimization, resource recovery and pollution abatement in new or existing industrial concerns and sub-grant to the extent of 25% of the project cost subject to a ceiling of `50 lac for part financing Common Effluent Treatment Plants (CETPs) at industrial estates/cluster for treatment and disposal of liquid and solid wastes. While loans/funds for individual sub-projects will be approved by IDBI as part of normal sanctioning projects, loan/grant funds to CETPs will be approved by IDBI in consultation with National Steering Committee. 10) Merchant Banking Services: IDBI provides services relating to issue management, mergers and amalgamations, loan syndications, private placements with Foreign Institutional Investors (FIIs) and mutual funds and corporate advisory services. IDBI has been acting as debenture trustees in respect of debenture issues by public companies, where the minimum issue size is `50 lac.

7.4.5.2.

Specific Schemes of SIDBI

With a view to give impetus for establishment of small scale and tiny industries which provide employment potential and earn much needed foreign exchange, SIDBI was established as an apex financial institution. Its entire share capital is held by IDBI. It is a statutory corporation formed under the Small Industries Development Bank of India Act, 1989. SIDBI started its working primarily as a refinancing institution. But, it has since diversified its activities and introduced several new schemes to meet the pressing needs of small-scale sector. The diverse schemes under which financial assistance is made available by SIDBI are briefly discussed as under: 1) Scheme for Assistance to Marketing Agencies: Specialized agencies in the corporate/cooperative sector, well-established voluntary groups and marketing agencies would be eligible to get assistance from SIDBI for setting-up of new sales outlets or renovation/expansion of existing show-rooms for marketing the products of small scale sector, cottage, and village industries. 2) Scheme for Women Entrepreneurs: The scheme has twin objectives, viz.: i) Providing training and extension of services to support women entrepreneurs, and ii) Extending financial assistance to set-up industrial units in small scale sector. Scheme for Refinance Assistance to Women Entrepreneurs The projects in SSI sector (including cottage, village, and tiny industries) promoted and managed by women entrepreneurs will be eligible for refinance from SIDBI. The loan will be repayable over a period not
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exceeding 10 years including a moratorium of 2 years. The loans will be refinanced by SIDBI to the extent of 100% in the case of SFCs and SIDCs, if covered under Automatic Refinance Scheme and 85% if the proposals come under Normal Refinance Scheme. In case of banks, the extent of refinance will be 75% of the loan amount, both under ARS and NRS. 3) National Equity Fund Scheme: In order to provide equity type of support to small entrepreneurs for establishing new projects in the tiny and small scale sector and for rehabilitation of viable sick units in SSI Sector, National Equity Fund has been set-up in participation with Government of India. Assistance out of the fund will be channelized through private and public sector banks, SFCs and selected urban cooperative banks. The unit in order to become eligible for assistance out of the fund should be located in a village/town having population not exceeding 5 lac. The project cost of a new unit or the total outlay on rehabilitation should not exceed `10 lac. The assistance in the form of soft loan carrying service charge @ 1% p.a. is provided to meet the gap in equity as per prescribed debt-equity norm, after taking into account the promotors’ contribution, subject to a maximum of 15% of the project cost within a ceiling of `1.50 lac per project. 4) Scheme for Direct Assistance to Ancillary and Sub-Contracting Units: To encourage ancillary/sub-contracting units to adopt improved/updated technology, improve their product quality, diversify product range and improve marketing and export as per the requirements/plans of their mother unit, SIDBI is operating a scheme for direct assistance to ancillary and sub-contracting units. 5) Scheme for Direct Discounting of Short-Term Bills: The scheme for direct discount of short-term bills arising from sale of parts, components, sub-assembles, accessories, etc., to intermediate manufacturer of small scale industries has been introduced by SIDBI. The scheme is intended to improve the liquidity of small scale units and provide medium and large scale units with access to small scale units on credit terms on an increasing scale for their mutual advantage. Under the scheme, the purchasers satisfying criteria stipulated by SIDBI will be sanctioned annual limits. Suppliers of components should draw usance bills on the purchasers for goods supplied which are duly accepted by the purchaser for payment at the designated office of SIDBI. The purchasers should retire the bills on due dates. The period of unexpired usance of the bill shall not exceed 90 days, while tenure of the bill shall not exceed 120 days. 6) Bills Rediscounting Scheme: To help manufacturers in the small scale sector to maximize their sales by offering deferred payment credit facilities at concessional terms to the prospective purchaser-users, SIDBI has devised Bills Rediscounting Scheme.
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7) Equipment Finance Scheme: The scheme is intended to assist the existing small scale industrial units for acquisition of machinery/equipment, both indigenous and imported, which are not related to any specific project. The minimum amount of loan should not be less than `25 lac per unit; no upper ceiling has been prescribed and SIDBI adopts a need based approach regarding the maximum amount of assistance under this scheme.

7.4.5.3.

Specific Schemes of IClCI

Specific schemes of ICICI are as follows: 1) Project Finance: Project financing has been ICICIs principal line of business. For project financing, ICICI endeavors to evolve products tailored to meet the requirements of different industries. Besides this, ICICI provides assistance in the form of: i) Margin money for working capital, ii) Direct subscription to and underwriting of shares and debentures, iii) Guarantee for payment to suppliers of equipment, iv) Funding of exports, and v) Infrastructure projects support. 2) Financial Services: Through the leasing division, ICICI provides: i) Lease finance for domestic and imported equipment, ii) Lease syndication services, iii) Installment sale facility, and iv) Asset credit. ICICI has also been providing lines of credit for manufacturers of capital equipment to sell on deferred payment terms and also to companies for meeting capital expenditure on deferred payment. 3) Technology Finance: ICICI finances the varying needs of Indian industry covering the entire spectrum of R&D activities from pre-feasibility and laboratory studies to pilot plant and scale-up operations leading to eventual commercialization. 4) Merchant Banking: These activities include offering advisory services with respect to capital issues, loan syndications, corporate advisory services, etc. ICICI has diversified its activities. It also provides home loans and credit card facilities. Note: Various parameters of these Schemes are undergoing frequent changes. It is, hence, desirable to obtain necessary information from the concerned institutions after taking a preliminary view about the type of assistance to be availed of.
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7.5. PROJECT APPRAISAL FINANCIAL INSTITUTIONS
7.5.1. Introduction

BY

Project appraisal or feasibility study is an important stage in the evolution of a project. It is necessary to consider alternatives, identify and assess risks, at a time when data is uncertain or unavailable. Project appraisal is a process whereby a lending financial institution makes an independent and objective assessment of various aspects of an investment proposal for arriving at a financing decision. Appraisal exercises are basically aimed at determining the viability of a project and sometimes also help in reshaping the project so as to upgrade its viability. Appraisal is likely to be a cyclic process repeated as new ideas are developed, additional information received and uncertainty reduced, until the client is able to make the critical decision to sanction implementation of the project and commit the investment in anticipation of the predicted return.

7.5.2.

Aspects of Project Appraisal

The factors generally considered by institutions while appraising a project include the following: 1) Technical Aspects: Technical appraisal of a project broadly involve a critical study of the following: i) Appropriateness of the technology, the suitability of selected technical process under Indian conditions and arrangements made or proposed to be made therefore. ii) Scale of operations and whether the size of the unit would be adequate for economic and financial viability of the project. iii) Selection of the plant site in relation to load bearing capacity, flood and earthquake hazards, free access from public roads, satisfactory sources of raw materials, water, power and fuel as also transport facilities, availability of skilled labor, nearness to the market for finished products, etc. iv) Adequacy and suitability of the plant and equipment and their specifications, plant layout, reputation of machinery suppliers, balancing of different sections of the plant, proposed arrangements for procurement of plant and equipment, technical engineering services, etc. v) Technical and executive management available during the implementation period and for operation of the project.

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vi) Arrangements for the disposal of factory effluents, prevention and control of pollution, maintenance of environmental and ecological balances, and utilization of by-products, if any.

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vii) Project Implementation Schedule – PERT or CPM Chart, if any, and monitoring arrangements for implementation of the project. viii) Technical collaboration arrangements, if any, terms of technology transfer, etc. 2) Financial Aspects: Scrutiny of financial aspects involves an analysis of working results, balance sheets and cashflow for the past few years in the case of an existing concern as also an examination of the following aspects in existing as well as new projects: i) Basis and reasonableness of estimated cost of the project. ii) Financial collaboration arrangements and terms thereof. iii) Financing plan with reference to capital structure, promoters’ contribution to the total project cost, debt-equity ratio, and availability of the anticipated resources. iv) Critical examination of applicant’s existing investments, if any, in other concerns or any trading activities other than normal industrial activities. v) Assessment of requirement of working capital. vi) Projections of future profitability. vii) Projections of cashflow. viii) Assessment of financial rate of returns, financial ratios, cost-benefit analysis, etc. ix) Break-even and sensitivity analysis of the project. 3) Commercial Aspects: One of the crucial factors that determine the commercial viability of an industrial project is the market for the products proposed to be manufactured by a new or existing unit. In the present economy, factors like sluggish trading conditions, sickness in the industry, gradual switch-over from a sellers’ to a buyers’ market, etc., make it all the more imperative that a detailed market survey and a thorough appraisal thereof are carried out before launching a project. For this purpose, it is necessary that study of the product and product-mix, analysis of the demand and supply position of the product(s) concerned, their cost and price structure, demand patterns, trends in capacity utilization and prices, demand growth rate and forecasts made thereof, marketing and sales strategies, sales organization and selling arrangements, and other relevant factors are looked into very carefully. 4) Economic Aspects: As a part of economic appraisal, AIDFIs endeavor to assess the Internal Exchange Rate (IER) in projects involving considerable capital or current expenditure in foreign exchange and more particularly in projects which aims at import substitution or export promotion. Besides, ‘Social Cost Benefit Analysis’ is also made while appraising a project for which purpose Economic Rate of Return (ERR), based on accepted principles, is determined. Inter-firm comparison of the project with similar projects financed earlier is also made with a view to assess the project cost and its profitability in as realistic a manner as possible.
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5) Energy Management and Ecological Aspects: Alongwith the economic appraisal, sociological, and ecological considerations are also kept in view and given due weightage. It is ensured that the applicant concern has made adequate provision for treatment of effluents so that environment remains pollution-free. In all cases, clearance from pollution control authorities is insisted as a pre-condition for sanction of assistances. In the context of high priority and significant importance being given to the energy conservation and use of alternate sources of energy, AIDFIs have been attaching considerable importance to the ‘energy management’ while financing industrial projects. For this purpose, steps proposed to be taken for the conservation of energy or use of alternate sources of energy are now examined in greater depth, while appraising a project. 6) Social and other Related Aspects: It has been observed that most of the new industrial projects set up in backward areas suffer because of the absence of adequate infrastructure facilities. Assistance for ‘projectspecific infrastructure’ is also now available for new projects coming up in Category “A” districts/areas. Further, with a view to ensure that there is a ‘spread’ effect of industrialization, the prospects of ancillarization and use of appropriate technology or technology transfer into the country in proper direction are given due weightage, while making an evaluation of projects for the purpose of financing.

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