Year: 2020

Debt to equity ratio (also termed as debt equity ratio) is a long term solvency ratio that indicates the soundness of long-term financial policies of a company. It shows the relation between the portion of assets financed by creditors and the portion of assets financed by stockholders. As the debt to equity ratio expresses the relationship between external equity (liabilities) and internal equity (stockholder’s equity), it is also known as “external-internal equity ratio”.

Formula:

Debt to equity ratio is calculated by dividing total liabilities by stockholder’s equity.

The numerator consists of the total of current and long term liabilities and the denominator consists of the total stockholders’ equity including preferred stock. Both the elements of the formula are obtained from company’s balance sheet.

Significance and interpretation:

A ratio of 1 (or 1 : 1) means that creditors and stockholders equally contribute to the assets of the business.

A less than 1 ratio indicates that the portion of assets provided by stockholders is greater than the portion of assets provided by creditors and a greater than 1 ratio indicates that the portion of assets provided by creditors is greater than the portion of assets provided by stockholders.

Creditors usually like a low debt to equity ratio because a low ratio (less than 1) is the indication of greater protection to their money. But stockholders like to get benefit from the funds provided by the creditors therefore they would like a high debt to equity ratio.

Debt equity ratio vary from industry to industry. Different norms have been developed for different industries. A ratio that is ideal for one industry may be worrisome for another industry. A ratio of 1 : 1 is normally considered satisfactory for most of the companies.

Foreign direct investment in India is the most influential financial resource, especially for the emerging sectors. Foreign direct investment helps in exploiting a wide range of opportunities and utilizing the same to attain the desired level of development in the nation (Gola, Dharwal, & Agarwal, 2013). The world economy including both the developed countries and other emerging countries are facing some varying trends of foreign direct investment in recent years.

The major player that is coming into view of late in India. Analyzing the trend of foreign direct investment in India shows that it is rising and the main reasons for such an increase are due to new government policies and various initiatives such as Make in India. The country has faced elevated trends of the foreign direct investment due to building investor-friendly climate in the country, thereby enabling the ease of doing business. India has been able to climb up to 10^th position in 2015 from 15^th position in 2014 as a trusted nation for Foreign direct investment. As a result, India has attracted foreign direct investments worth of $40 billion for the financial year 2015- 16, which was  29.2% higher than the last year (UNCTAD, 2016).

Sources of foreign direct investment in India

By catching the attention of the economies worldwide, India has been able to gain a huge sum by the way of equity inflows. Singapore has become the largest investor with a total investment of $13.69 billion during the financial year 2015-16. Followed by Singapore are the economies including Mauritius and USA investing $8.35 and $4.19 billion respectively. The aggregate Merger and Acquisition (M&A) deals as well as the private equity deals, which are the methods of foreign direct investment inflow, have grown up 2 times from the last year of 2015 (IBEF, 2016a).

Foreign direct investment in India has shot up 318.2 times starting from the year 1991 to 2005, from $129 million in 1991-92 to $41050 million (Dutta & Sarma, 2008). Before the year 2015-16, Mauritius was the topmost investor in the country as succeeded by Singapore. Still, the country is the major investor with its cumulative percentage share to total inflows being 34% more than double the percentage of Singapore.

The report of the department of industrial policy and promotion has shown that India has been able to gain value in various sectors including the service sector, information technology (IT) sector, automobile industry, pharmaceutical sector, power industry and construction business from the period of 2000 until 2015.

Trends of foreign direct investment in the service sector

The service sector has been able to draw the highest amount of foreign direct investment equity in the country, totalling up to $240.57 billion during 2000-2015. In 2015 the total amount of foreign direct investment in this sector amounted to $27.63 billion (DIPP, 2015). From 1991-2000, the share of service sector in the foreign direct investment in India was 15.2% as compared to the share in 2000-2011 is 19.9%.

The notable increase in the foreign investments in the service sector from the year 2014 was due to the current government coming in power and introducing a more investor-friendly climate. The major reason for such a rise in foreign direct investment in this respective sector includes the various initiatives taken by the government. The investment cap has risen in various sectors including the insurance sector from 26% to 49% and others including defence and railways. Changes in the timelines of the approval of foreign direct investment projects have also contributed to such growth of investment in this sector (IBEF, 2016).

Trends of foreign direct investment in the information technology sector

The information technology sector is the second most attractive industry for foreign investments in India. The total inflows in this sector have reached the mark of $108.13 billion in 2015 since 2000 and in the year 2015, it amounted to $34.3 billion (DIPP, 2015). Some notable motivation in this regard is that the IT industry in the country is rapidly growing and the availability of cheap labour that is highly attracting the companies from the overseas market. Again the turning year in this regard is the year 2014.

Trends of foreign direct investment in the construction industry

The construction business is again a major sector attracting foreign direct investment in the country from the past 15 years. The industries draw $113.8 billion foreign direct investment starting from the year 2000 till 2015. Various initiatives introduced by the Indian government such as Make in India helps to attract a large amount of foreign direct investment in this sector. However, the influx of foreign direct investment in the year 2015 dipped to $0.67 billion (DIPP, 2015). It is observed that even though the amount of investment is decreasing from the year 2011 itself, but its cumulative inflows from the year 2000 have been the second highest, only after service sector. The rise of foreign direct investment in such sector owes it to the rising opportunities in the power sector including power generation, distribution, transmission and equipment. Besides, the infrastructure sector has also gained momentum on an average from the year 2000. Foreign direct investment in the construction sector contributes 9% to the total foreign direct investment inflows in the country (IBEF, 2016b).

Government’s Policy in Regard to Foreign Capital:

After India became independent in August 1947, Jawaharlal Nehru, the then Prime Minister of India, made a statement in April 1949 giving the following assurances to foreign capital:

1. There would be no discrimination between foreign companies and purely Indian companies which meant that foreign capital would get the same treatment as indigenous capital.
2. Foreign investors would be permitted to remit profits and repatriate capital, taking into consideration India’s position in regard to availability of foreign exchange.
3. In case a foreign company was nationalised, fair and equitable compensation will be given to foreign investors.

The above policy was based on several considerations. There was a shortage of indigenous capital and that needed supplementing by foreign capital, if rapid industrial and economic development were to be brought about. Also, there was need of capital goods and equipment and technical know-how from abroad as India then lacked these essential requisites of growth and development.

Tax Concessions:

In the initial stages, with a view to attract foreign capital (that is, foreign companies) to India, Government offered various tax concessions and to avoid delays in finalising foreign collaboration agreements, streamlined its licensing policy of procedures to quickly approve foreign collaboration agreements.

In 1961 the Indian Investment Centre was opened, the objective being to bring together Indian and foreign businessmen and appraise foreign investors of the vast business opportunities in India.

In 1972 the Government of India took another major step to attract foreign capital into the country. It permitted wholly-owned subsidiaries in India of foreign companies, provided they undertook to export 100 per cent of their production.

Export Liability:

If the export liability was less than 100 per cent of its output, the extent of permissible foreign capital was to be decided by negotiations between the foreign companies and the Government of India.

Thus, the Government of India had to choose between the Indianisation of foreign subsidiary companies in India or boosting up export through their help. Government preferred the second of the above two possible courses. But Government’s choice of the second policy was beset with many difficulties.

A country needs natural resources, adequate levels of savings, latest technical know how, skilled human resources etc. for economic development.  Compared to developed countries, developing countries are deficit of  these resources. Lack of resources and skilled labor forces may prompt them to seek assistance from economically well developed countries. Assistance may be in the form of either technical knowledge or investments and very often, both. It may be through collaborations with foreign countries or private companies.  In India, such collaborations have always been predominant from the time of independence itself. Government has always welcomed such foreign investments with some restrictions giving new paths of co-operation. Also, its policy has undergone several changes since independence. Foreign investment policy has a direct impact on inflow of foreign money, skills and knowledge.

What are the merits of foreign capital?

No doubt, a developing country like India has many reasons to welcome fund inflows that can play an important role in the economic development of our nation.

1. Some natural resources may go unnoticed or unexploited in the absence of technology. So, welcoming new ideas can help in the effective use of resources and prevent them from going to the waste.
2. Also, new technologies can help in upgrading present techniques giving more result thus saving man power, money and time.
3. When new technologies are welcomed, employment opportunities also are created. So, it gives many employment opportunities, particularly to new professionals with new ideas. So, skilled labor force can be used in a better way.
4. They can supply domestic savings and capital formation thereby accelerating the investment rate for the economic development of the country.
5. New technologies can bring new markets and marketing experts too, thus helping to sell Indian goods in international markets for good prices.
6. Backbone of development of a country, of course, is agriculture and industry. Foreign capital can provide infrastructure for both. 

Foreign investment policy in India

Investment policy of India can be broadly classified into two periods – 1948-1990 and 1991 onward. Till 1990, there were only restricted policies and regulated inflows. But from 1991 onward, India witnessed liberalization of foreign investment laws.

The restrictive period – 1948-1990

At First, the policy of independent India was reflected in Industrial Policy Resolution (IPR) which fully accepted the participation of foreign capital, particularly with new technology ideas to promote industrialization in our country. But certain regulations were also attached which required ownership and control in Indian hands. In 1949, the then Prime Minister of India, Pt. Jawahar Lal Nehru made a statement in constituent assembly bringing three major issues namely, no discrimination between foreign and Indian enterprises, fair compensation to foreign investors if need arises for the nationalization of a foreign enterprise and also allowed them to remit profits if foreign exchange position allowed. Also, foreign collaborations were encouraged in those industries which required large capital investments, production skills and processes, export industries and those which were needed for country’s development as a whole. Also, foreign collaborations with equity participation were appreciated which led to the sharp increase in its number. Thus, country witnessed outflow of profits, dividends, and royalties which led to foreign exchange crisis in the late sixties.

Foreign Exchange Regulation Act (FERA) of 1973 is an act to consolidate and amend laws regulating transactions indirectly affecting foreign exchange payments, currency exchange and conservation and utilization of foreign exchange resources of the country. It included all non-banking companies and branches with more than 40% foreign participation. During late seventies, India realized its poor technology and products as compared with other nations. This was partially due to a highly protected local markets and MNCs. However, Industrial Policy Statements of 1980 and 1982 gave a liberalization of licensing rules and some exemptions under FERA.

Liberalization period- 1991 onwards

Introduction of new industrial policy in 1991 led to many radical changes in foreign investment policy. To promote foreign funds and investments, many restrictions were removed and encouragement like tax exemptions also given. It virtually welcomed foreign investors to almost every sector of India, even renting foreign participation with advanced technologies and adding new skills. Unlike in the past, our country is promoting international business and investments even through Government delegations visiting other countries. They are trying to attract foreign investors to invest, seeing it as a part of industrialization and exchange of new ideas, skills and better use of resources, both human and non-human.

India’s foreign investment policy has come a long way since 1947. Though they were warmly welcomed at first to promote rapid industrialization and foreign fund, certain restrictions and selections were made later. But, since India’s technology did not improve as years passed by and conditions only worsened more, further liberalization of foreign policy became necessary to attract more investors to India. But often a question is raised as to whether foreign technology and investments help India in long run or adversely affect our economy.  But everyone agrees that India is far behind in the proper utilization of resources and skilled people purely depending on foreign technology a lot. While many developing countries like Japan and China are coming forward with many innovative ideas, we are just depending on them, thinking how can we import their commodities at cheap rates and market it here, fooling ordinary man. Disputes won’t send by adding a single point or two. 

Need for Foreign Collaboration:

Lack of capital is a serious handicap in the way of economic development of underdeveloped countries. The internal resources are not sufficient, so they have to rely on foreign capital in the initial stages of their development. The pace of economic development primarily depends upon the rate of capital formation. But in the underdeveloped countries the per capita real income being very low, the rate of saving investment is very low.

Therefore, these countries are obliged to depend upon external sources of capital for initiating them process of economic development.

External capital cards in the form of (i) direct business investment commonly called, private foreign capital and (ii) international loans and grants more commonly known as foreign aid or external assistance.

Contribution of Foreign Capital:

The underdeveloped countries are always capital scarce countries and that is a perpetual need of capital for economic development projects. The degree of dependence on foreign capital depends on the extent to which domestic resources could be mentioned. India has required foreign capital to speed up economic growth.

There was considerable opposition to the use of foreign capital in India. This was mainly due to the political role it played in the past. The colonial empires of the 19th and 20th centuries were built by European countries on the basis of trade and identity. The Government of India at one time was subjected to the pressure of foreign companies and foreign government.

Arguments in Favour of Foreign Capital:

India is a developing country, and has adopted the path of economic planning for growth. Her natural resources and labour force are in abundance but there is lack of capital. Our technological knowledge is outdated and industrial productivity is very low under these circumstances, the importance of foreign capital increases.

This can be explained as under:

1. Encouragement to Domestic Savings:

In a developing country like India the level of domestic savings is low because of low income of the people. Naturally it suffers from scarcity of investment and in this way is caught in the vicious circle of poverty. With the help of foreign capital, the savings and investments can be pushed up.

2. Proper Exploitation of Natural Resources:

India possesses abundant natural resources but due to lack of technological knowhow and capital, the natural resources cannot be properly exploited. Thus it is necessary that the help of foreign capital is sought in order to accelerate the pace of economic development.

3. Availability of Foreign Technology and Managerial Techniques:

Developing countries also lack new technology and modern scientific managerial techniques. With the help of foreign capital these can also be gained. This process is essential for the economic development of the country.

Establishment of Basic and Key Industries:

Basic and capital intensive industries cannot be set up for want of sufficient capital. The domestic capital is shy and does not come forward. Thus foreign capital can easily contribute to the development of such industries. Economic history of India is an evidence that foreign capital has played a vital role in the establishment of basic and key industries.

Helpful in Accelerating the Pace of Economic Development:

To accelerate the pace of economic development the policy of comprehensive economic planning has to be followed. Its need cannot be met with domestic reasons. Thus foreign capital becomes essential in boosting the level of capital formation.

Arguments against Foreign Capital:

1. Obsolete Machines of Technology:

Foreign capital is responsible for obsolete machines and technology being passed on to Indian partners by the foreign collaborations.

2. Dependence on Foreign Countries:

Foreign collaboration has made Indian industries dependent to a considerable extent on imports and intermediate goods and parts of machinery. It has destroyed self-reliance.

3. Foreign capital offer Prize Posts and superior jobs to their own nationals. They disregard the claims of highly qualified Indians and thus follow the policy of discrimination.
4. Foreign capital derives the industrial profits out of the country. This may lead to the exhaustion of country’s valuable resources and the progressive impoverishment of the country.
5. Foreign capital and enterprise brings about economic development by the foreigners. Economic domination may entail political domination in some form. Foreign capital may thus give rise to vested interests which may oppose the political and economic advancement of the country.
6. Foreign capital bound to beat to great dependence on foreign countries. This may, it is apprehended, impede the attainment of socialist pattern of society.
7. Foreign capital can prove highly prejudicial to national defence if have and key industries are monopolized by the foreigners.

These are the disadvantages that accrue to the country from the use of foreign capital. But in spite of strong reaction in the country against the import of foreign capital we have to consider our need to foreign capital in the light of requirements of a backward country like India.

Dangers of Private Foreign Capital:

From the Indian experience since her independence, the following dangers of private foreign capital operating in India (through their Indian collaborators) have come to be noticed:

1. Foreign companies from the West European countries and from the United States are generally reluctant to enter into collaboration with public sector companies (i.e. Government companies) in India, mostly on ideological grounds. If insisted to do so, they would rather not come to India than offer their participation with the Public Sector Indian companies.
2. In certain areas of industrial production, Indian technology is fairly well developed. Collaboration with foreign companies in low priority areas like cosmetics and luxury goods has only meant duplication of technology which is unnecessary and often costly. Indian companies or entrepreneurs have the necessary technology in such low priority industries which means any collaboration in such areas is superfluous.
3. The rate of return on initial foreign investments in India is very high, making it possible to return the entire amount of foreign investment within 2 to 4 years. It is, therefore, argued that unless foreign collaboration agreements help to increase India’s exports and result in decrease in dependence on foreign countries for imports, outflow of foreign exchange might far outweigh initial gain from foreign collaboration agreements.
4. Often technology that is passed on by private foreign collaborators of Indian partners is obsolete on not appropriate to Indian conditions; often import of capital equipment was far in excess of India’s requirements. Thus, technology appropriate to Indian conditions or development of such technology in Indian itself through collaboration with foreign companies has not become possible to any very great extent.
5. It is noted that royalty payments and fees for technical services rendered by foreigners all result in increasing claims on India’s foreign exchange earnings and reserves which are relatively small in relation to the country’s requirements. One estimate is that total outgoings due to private foreign collaboration agreements were more than the inflow of foreign capital. For example, Coca Cola with a small investment of foreign currency used to send abroad many times that amount annually by way of profit until permission to continue its activities was refused to the country.

The same is true of the US oil companies like of ESSO and Caltex. For example, the ESSO with an investment of Rs. 30 crore (with Indian holdings of only Rs. 57 lakh) took away from India profit (in foreign currency) of Rs. 83 crore during 1968 to 1970 only.

6. On the whole, the impact of foreign private collaboration on India’s balance of payments has not been favourable. The main reason for his has been the substantially high level of imports consequent on foreign collaboration agreements as compared to the low level of exports, such foreign collaborations hardly adding to India’s export earnings.

For long under the private foreign collaboration agreements, as excessive number of technicians, often not suitable to Indian conditions were sent to India and designs and machines were not suitable to Indian conditions; but under the agreements, they were imposed on India.

7. There is also the myth of the policy of Indianisation. Under Section 29(1) of the Foreign Exchange Regulation Act, all foreign companies are required to dilute their ownership to 74 per cent and under Section 29(2) of the FERA, the Indian branches of foreign companies are to be converted into Indian companies with non­resident share in equity capital not exceeding 40 per cent.

It is observed that the dilution of equity form 100 per cent to 74 per cent (or from 100 per cent to 40 per cent) has hardly made any difference to the drain of foreign exchange from India to foreign countries in which the head offices of foreign collaborations are situated.

It is observed, for example, that Ponds and Warren Tea were able to send home net worth of their company’s investment every two years. In the case of Colgate-Palmolive, the highest limit of profit was 89 per cent which meant that the entire net worth of assets invested in India was repatriated within less than 14 months.

The new issues of such companies are excessively oversubscribed on the pretext of broadening the Indian of these companies are able to raise plenty of local capital and the Indian Shareholders with their personal interest only in view and in dividend, provided support to the functioning of multinational companies whenever the bogey of expropriation was raised in Indian Parliament.

It was not the existing equity capital that was shared with India national, but the new equity that was issued to Indians. The Indian shareholders were scattered all over India and even if they wanted, they could not take any concerted action against the policies of the company. In fact, Indian shareholders were only interested in dividend and hardly took any interest in the functioning of the company. Thus, the domination of foreign collaborators continued unabated in India.

The myth of Indianisation can be exposed by the fact that foreign partners or the parent companies in their collaboration agreement retained the absolute power of appointing chairman and managing directors of their Indian subsidiaries even when the dilution of shareholdings was brought down to 25 per cent.

It is also observed that by adopting the practice of wide dispersal of equity holdings and ownership rights, the foreign collaborators have also significantly blunted Indian people’s opposition to multinational foreign companies with subsidiaries in India while repaying very high returns on their investments.

It may be said that garb or covering of Indianisation is being cleverly exploited by many foreign multinational companies to convert the business environment in India in their favour and thus continue to make and transfer home enormous profits made in India annually.

Michael Kidron has estimated that during 1948 to 1961, foreign companies as a whole had taken out of India total funds worth three times their investments in India. It may be said that the situation did not change much during the 1970s.

8. Instead of allowing foreign private capital and its participation on a selective basis and only in the case of essential capital equipment and other essential inputs, foreign collaboration agreements were permitted out of overenthusiasm to bring foreign capital into India into lines of production of commodities such as chewing gum, cosmetics, boot-polish, cigarettes, hotels and so on.

Though government assumed powers under the FERA, no concrete results have followed and foreign companies continue to make enormous profit in India and remit them to their mother countries as before.

Global Depository Receipt (GDR) is an instrument in which a company located in domestic country issues one or more of its shares or convertibles bonds outside the domestic country. In GDR, an overseas depository bank i.e. bank outside the domestic territory of a company, issues shares of the company to residents outside the domestic territory. Such shares are in the form of depository receipt or certificate created by overseas the depository bank.

Issue of Global Depository Receipt is one of the most popular ways to tap the global equity markets. A company can raise foreign currency funds by issuing equity shares in a foreign country.

Global Depository Receipt Example

A company based in USA, willing to get its stock listed on German stock exchange can do so with the help of GDR. The US based company shall enter into an agreement with the German depository bank, who shall issue shares to residents based in Germany after getting instructions from the domestic custodian of the company. The shares are issued after compliance of law in both the countries.

Global Depository Receipt Mechanism

• The domestic company enters into an agreement with the overseas depository bank for the purpose of issue of GDR.
• The overseas depository bank then enters into a custodian agreement with the domestic custodian of such company.
• The domestic custodian holds the equity shares of the company.
• On the instruction of domestic custodian, the overseas depository bank issues shares to foreign investors.
• The whole process is carried out under strict guidelines.
• GDRs are usually denominated in U.S. dollars

Let’s now look at the advantages and disadvantages of Global Depository Receipt.

Advantages of GDR

The following are the advantages of Global Depository Receipts:

• GDR provides access to foreign capital markets.
• A company can get itself registered on an overseas stock exchange or over the counter and its shares can be traded in more than one currency.
• GDR expands the global presence of the company which helps in getting international attention and coverage.
• GDR are liquid in nature as they are based on demand and supply which can be regulated.
• The valuation of shares in the domestic market increase, on listing in the international market.
• With GDR, the non-residents can invest in shares of the foreign company.
• GDR can be freely transferred.
• Foreign Institutional investors can buy the shares of company issuing GDR in their country even if they are restricted to buy shares of foreign company.
• GDR increases the shareholders base of the company.
• GDR saves the taxes of an investor. An investor would need to pay tax if he purchases shares in the foreign company, whereas in GDR same is not the case.

 Disadvantages

 The following are the disadvantages of Global Depository Receipts:

• Violating any regulation can lead to serious consequences against the company.
• Dividends are paid in domestic country’s currency which is subject to volatility in the forex market.
• It is mostly beneficial to High Net-Worth Individual (HNI) investors due to their capacity to invest high amount in GDR.
• GDR is one of the expensive sources of finance.

Deposit Insurance and Credit Guarantee Corporation (DICGC) is a wholly owned subsidiary of Reserve Bank of India. It was established on 15 July 1978 under the Deposit Insurance and Credit Guarantee Corporation Act, 1961 for the purpose of providing insurance of deposits and guaranteeing of credit facilities.

DICGC insures all bank deposits, such as saving, fixed, current, recurring deposit for up to the limit of Rs. 500,000 of each deposits in a bank.

Legal Framework/Objective

The functions of the subsidiary are governed by the provisions of ‘The Deposit Insurance and Credit Guarantee Corporation Act, 1961’ (DICGC Act) and ‘The Deposit Insurance and Credit Guarantee Corporation General Regulations, 1961’ framed by the Reserve Bank of India in exercise of the powers conferred by sub-section (3) of Section 50 of the Act.

A maximum of ₹5,00,000 (after the budget of 2020-21) is insured for each user for both principal and interest amount. If the customer has accounts in different banks, all of those accounts are insured to a maximum of ₹5,00,000 each.

However, if there are more accounts in same bank, all of those are treated as a single account. The insurance premium is paid by the insured banks itself. This means that the benefit of deposit insurance protection is made available to the depositors or customers of banks free of cost.

The Corporation has the power to cancel the registration of an insured bank if it fails to pay the premium for three consecutive half-year periods. The Corporation may restore the registration of the bank if the bank makes a request and pays all the amounts due by way of premium from the date of default together with interest.

Reforms

The Financial Sector Legislative Reforms Commission (FSLRC) was a body set up by the Government of India, Ministry of Finance, on 24 March 2011, to review and rewrite the legal-institutional architecture of the Indian financial sector. In its report the FSLRC recommended a regulatory structure consisting of seven agencies including a deposit insurance-cum regulatory agency (which was named as Resolution Corporation). The present DICGC will be subsumed into the Resolution Corporation (RC) which will work across the financial system.

Drawing on the best international practice, the FSLRC proposal involved a unified resolution corporation that will deal with an array of financial firms such as banks and insurance companies; it will not just be a bank deposit insurance corporation. It will concern itself with all financial firms which make highly intense promises to consumers, such as banks, insurance companies, defined benefit pension funds, and payment systems.

It will also take responsibility for the graceful resolution of systemically important financial firms, even if they have no direct links to consumers.

The Government of India introduced the Financial Resolution and Deposit Insurance bill, 2017 (FRDI bill) in Lok Sabha in the Monsoon session of 2017 to bring forth these reforms. There have been many concerns with regards to the new bill such as:

1. Presently the banks have to pay a sum to the DICGC as insurance premium which insures all kinds of bank deposits up to a limit of ₹5,00,000. In case a stressed bank had to be liquidated, the depositors would be paid through DICGC. Though the bill proposes the banks to pay a sum to the Resolution Corporation, it neither specifies the insured amount nor the amount a depositor would be paid. It is thus unclear how much a depositor would be paid in case of liquidation.
2. The bail in clause which largely worked against the interests of the depositors (as in Cyprus).

Bank overdraft

Bank overdraft is a temporary arrangement with the bank that allows the organization to overdraw from its current deposit account with the bank up to a certain limit. The overdraft facility is granted against securities, such as promissory notes, goods in stock, or marketable securities. The rate of interest charged on overdraft and cash credit is comparatively much higher than the rate of interest on bank deposits.

Commercial Paper:

Commercial paper is a form of financing which consists of short-term promissory notes which are unsecured and are sold in the money market. They are issued by large companies and pri­marily sold to other business firms, insurance companies, pension funds, and banks. Because they are unsecured and are sold in the money market, they are restricted in use to the most credit-worthy of the large companies.

Though the commercial paper market has a long history, much of its tremendous growth has occurred in recent years with increases in the installment financing of automo­biles and other consumer durable goods.

As credit tightens in terms of the banks’ ability to make loans, the commercial paper market increases. Many of the companies that issue these notes now look at this market as an alternative source of financing.

The Commercial Paper Market:

The commercial paper market includes a dealer distribution system and a system of direct placement. Most industrial firms, utilities, and medium-size finance companies utilize the dealer market to place their commercial paper.

Five major dealers com­prise the market, which purchases the paper from firms and then sells it to investors. Denominations of commercial paper range from Rs.25,000 to several rupees, and maturity runs from about two to six months, with an average of five months.

The cost of this paper is from 0.5 to 1 per cent below the prime lending rate. Considering that there are no compensating balance require­ments, the rate differential is still more significant. The commis­sion on the sale of paper runs from 0.125 of 1 per cent. Many firms are looking at this source of financing more in terms of a perma­nent source than as the traditional seasonal instrument.

Appraisal of the Commercial Paper Market:

Commercial paper is a much cheaper source of financing than short-term bank financing, as we have noted. Many companies are considering commercial paper as a supplement to bank credit. A company could make use of the paper market when the interest rate differential was large and borrow from the bank when the gap narrowed. This would result in the lowest borrowing cost to the firm in the short term.

Evidence has indicated that it is imperative for a firm not to impair its relations with a bank by using its services only during periods of extremely tight money, however. It is often suggested that a firm should have a backup line of credit with a bank to cover its borrowing position in the commercial paper market.

One factor which has helped the growth of the commercial paper market is a regulation that the maximum loan a national bank can make to a single borrower is 10 per cent of the bank’s capital and surplus. It is the perpetual need of short-term capital that has helped the commercial paper market to boom.

Factoring Accounts Receivable:

When a firm factors its account receivable, it actually sells them to a factor who actually buys the receivables. This may be done with or without recourse. With recourse, the factor can look to the seller of receivables for payment if there is a default on the pay­ment of the receivable. Without recourse, the factor cannot look to the seller of the receivables for collection in case of default.

The factor maintains a credit department which can undertake a credit check of a customer. If a firm sells without recourse, utilization of this service can allow it to forego the cost of main­taining a credit department of its own.

In this case, the factor assumes risk and bad-debt losses and all expenses associated with collecting slow accounts. The customer of the firm who is factor­ing the receivables may or may not be told of the factor agreement; this decision is made between the lender and the seller of the receivables.

Associated with the assumption of risk and servicing of the receivables is an added cost to the seller. Usually a fee is attached which runs from 1 to 3 per cent of the face value of the receivables. In addition, there will be interest charges for funds that are advanced before collection by the factor.

The cost of using a factor can be illustrated with the following example. A firm factors on the average Rs.100,000 per month for a year. The factor will lend 80 per cent of the face value of the receivables and will charge a factoring fee of 1 per cent of that face value.

In addition, the factor charges 1 per cent interest per month on the amount borrowed. The interest cost and the factoring fee are taken out in advance of all funds given to the firm. Assume that the firm borrows the full amount each month.

We can calcu­late the annual cost to the firm of utilizing the factoring service as shown in following equation:

Inventory Financing:

Inventory is another asset that has considerable merit as collat­eral for short-term financing. The lender usually will advance only a specified percentage against the face value of the inventory. This loanable value is based on the type of inventory being consid­ered and the ability of the lender to dispose of it in case of default.

The more specialized the inventory and the market for the prod­uct, the more unwilling is the lender to advance a large percentage of the face value.

The more standard and salable the inventory, the higher the loan percentage. Frequently lenders will loan 90 per cent of the face value when they feel the inventory is standard and has a ready market, apart from the marketing organization of the borrower.

Lenders usually consider such items as marketability, perish­ability, market price stability, and difficulty in liquidating the inventory in determining the percentage value that they are will­ing to advance on an inventory loan.

The most important aspect of a lender’s analysis is to substantiate that there is enough liquidat­ing value in the inventory to cover the loan and accrued interest in case of default on the part of the borrower.

In addition, the lender must determine the ability of the borrower to service the debt by examining the cash flow structure of the firm. There are several ways in which inventory can be collateralized.

These methods are discussed below:

1. Floating Lien:

A feature of the Uniform Commercial Code permits a borrower to pledge inventory “in general” as collateral against a loan, with­out specifying the inventory involved. This allows the lender to obtain a floating lien or claim against all of the borrower’s inven­tory. This type of arrangement is very difficult to police, and in general it is made only to provide extra security for a loan.

A floating lien can cover both receivables and inventory; thus it allows a lender to obtain a lien on the major part of the current assets of a firm. The floating lien also can cover both present and future inventory.

2. Chattel Mortgage:

A chattel mortgage provides for the borrower’s inventory to be identified specifically by a serial number or some other means. The borrower still holds title to the goods, but the lender has a lien or claim on the inventory. Under this arrangement, the lender has to give his consent before the inventory can be sold.

Any inven­tory that has a rapid turnover or is not readily identifiable would not be suited for this type of lien arrangement. Capital asset items such as machine tools and other heavy equipment are well suited for a chattel mortgage.

3. Trust Receptions:

With a trust receipt loan, the borrower holds both the inventory and the proceeds from the sale of inventory in trust for the lender. Consumer durable goods, automobiles, and equipment are good examples of the types of inventory that are well suited to serve as this form of collateral.

The automobile dealership system is an excellent example of how a trust receipt collateral system works. When automobiles are shipped to the dealer from the manufacturer, the lending institu­tion will pay the manufacturer under an arrangement made with the dealer. The dealer in turn signs a trust receipt agreement which specifies the handling of the inventory.

The dealer is allowed to sell the cars and must turn the proceeds over to the lender. Under the trust receipt arrangement, the inventory is serialized and is periodically audited by the lender. The purpose of the audit is to determine if any cars have been sold without the proceeds of the sale being remitted to the lender.

Each time a new batch of cars is acquired from the manufac­turer, a new trust receipt agreement is signed to take account of the new inventory. Though this method provides a wider margin of safety than a floating lien arrangement, there is always the possibility that a dealer will sell cars and not remit the proceeds to the lender in payment of the funds advanced.

4. Terminal Warehouse Receipt Loans:

Under another arrangement for using inventory as collateral for a loan, the borrower’s inventory is housed in a public, or terminal, Warehouse Company. A warehouse receipt which speci­fies the inventory located there provides the lender with a security interest in the inventory.

Because the goods in inventory can only be released on authorization by the lender, it can maintain strict control over the inflow and outflow of inventory. In addition, an insurance policy is usually issued which contains a loss-payable clause for the benefit of the lender.

The warehouse receipt can be in a negotiable or nonnegotiable form. If it is negotiable, the receipt can be transferred from one party to another by endorsement, but before the goods can be released the receipt must be presented to the warehouse man.

A nonnegotiable warehouse receipt is issued in favour of the lender, which has title to the goods and is the only one that can release them. The nonnegotiable receipt arrangement provides that the release of goods must be authorized in writing. Most arrange­ments are of the nonnegotiable form.

5. Field Warehouse Receipt Loans:

With the form of collateralization known as the field warehouse receipt loan, the inventory remains on the property of the bor­rower. A field warehouse company sets off a specific part of the borrower’s storage area in which to locate the inventory being used as collateral. Often this area is physically fenced off and only the field warehouse company has access to it.

Once the collateral value of the inventory is verified by the field warehouse company, the lender advances the funds. This arrangement is desirable when there is great expense involved in locating the inventory elsewhere, especially true when the borrower has a high inventory turnover ratio.

There is no question that the cost of this form of collateral financing is very high. This is primarily due to the cost of the warehouse company which acts as a third party in this arrange­ment.

The evidence of collateral is only as good as the warehouse company issuing the receipt. Historically there has been evidence indicating fraud in terms of the validity of the inventory actually being stored in a particular spot.