Module-3

Types of Financial Services

•Meaning,
•Types, fund based, fee based financial services,
•Project finance, Credit rating,
•Leasing and hire purchasing, types of lease, financial evaluation

of a lease, cross border leasing, contents of a lease agreement,

•Bills discounting,
•Factoring and forfeiting,
•Securitization.
•(Theory and Problems-on lease and hire purchasing)

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 1
Financial services

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 2
Financial Services
 Financial services includes all activities
involved in the transformation of savings
into investment.

  It is 'financial inter mediation‘, a process by

which funds are mobilizing from a large
number of savers and make them available
to all those who are in need of it and
particularly to, corporate customers.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 3
Financial services-Cont
 Financial services refer to economic services
provided by various financial institutions that
deal with the management of money.
 It is an intangible product of financial

markets like loans, insurance, stocks, credit

card, etc.
 Financial services are products of institutions

such as banking firms, insurance companies,

investment funds, credit unions, brokerage
firms, and consumer finance companies.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 4
Prof. Sainath, Ph.D, Dept of
Management Studies, NHCE 5
Nature of financial services
 1.Customer Oriented: Financial services are customer-
focused services that are offered as per the requirements
of customers. Financial institutions properly study
customer needs before designing and offering such
services. They are meant to fulfill the specific needs of a
customer which differs from person to person.

 2.Intangibility: These services are intangible which makes

their marketing a challenging task for financial
institutions. Such institutions need to focus on building
their brand image by providing innovative and quality
products to customers. Firms enjoying better credibility
in market are easily able to sell off their products. 

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Management Studies, NHCE 6
Nature of financial services
 3.Inseparable: Financial services are produced and
delivered at the same time simultaneously. These
services are inseparable and can’t be stored in
advance. Here production and supply function both
occurs at the same time.

 4.Manages Fund: Financial services are specialized at

managing funds of people. These services enable
peoples in allocating their idle lying funds into
useful means for earning revenues. Financial
services provide various means to people for
converting their savings into investment.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 7
Nature of financial services
 5.Financial Intermediation: These services does the work of financial
intermediation as it brings together the lender and borrower. Financial
services mobilize the funds of people who are having enough of it and
made it available to the one who are in need of it. 

 6.Market Based: Financial services are market based which changes as

per the changing conditions. It is a dynamic activity which varies as per
the variations in socio-economic environment and varying needs of
customers.

 7.Distributes Risk: Risk distribution is the key feature offered by

financial services. These services transfer the risk of an individual not
willing to take among different persons who all are willing to bear it.
Financial institutions diversify the risk and secure people against
damages by providing them various insurance policies.
 

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 8
Classificaion Financial Services

 I. Traditional services:

 A. Fund/Asset based: the financial services will revolve

around the fund.

 B. Non- Fund/Fee based: The services wherein financial

institutions operate in specialized fields to earn a
substantial income in the form of fees or dividends or
brokerage on operations.

 II. Modern services: The services rendered to meet the

modern day challenges of business.

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Management Studies, NHCE 9
A. Fund based Services

 The financial services will revolve around the

fund.

 Following are the examples of fund based

activities;

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Management Studies, NHCE 10
A. Fund based Services
 1.Underwriting: An agreement under which
financial institutions take the risk of selling of the
securities of the issuing firm for a commission.

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Management Studies, NHCE 11
A. Fund based Services
 2.Dealing in secondary market activities:
Acting as a stock broker and buying/selling
the securities on behalf of the client.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
A. Fund based Services

 3.Participating in money market instruments:

Assisting the clients in money market
operations

 4.Equipment leasing: A lease is an agreement

under which a firm acquires a right to make
use of a capital asset like machinery on
payment of lease rentals.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 13
A. Fund based Services
 5.Hire purchase: Hire purchase is a
transaction where goods are purchased and
sold on the condition that payment is made
in installments. The buyer gets only
possession of goods. He gets the ownership
after paying all the installments.

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Management Studies, NHCE 14
A. Fund based Services
 6.Seed capital: Financial services that assist in
getting the initial investment required for a
business

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Management Studies, NHCE 15
A. Fund based Services
 7. Dealings in foreign exchange market
activities: This includes hedging contracts like
Forward contract, Options, Futures, Swaps
etc

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Management Studies, NHCE 16
A. Fund based Services
 8.Bill discounting: The holder need not wait
till maturity or due date. He can discount the
bill with his banker.

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Management Studies, NHCE 17
B. Non- Fund/Fee based Services:

 It includes those financial services wherein

financial institutions operate in specialized
fields to earn a substantial income in the
form of fees or dividends or brokerage on
operations.
 Examples of non-fund/fee based financial

services include the following:

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 18
B. Non- Fund/Fee based Services:
 1.Managing the capital issue : Acting as Lead
managers, Underwriters, Bankers to an issue –
Registrars and Share Transfer Agents, Brokers to
the issue – Debenture Trustees etc

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 19
B. Non- Fund/Fee based Services:

 2. Arrangements for the placement of capital

and debt: Assisting in fulfilling in various
legal formalities for raising capital/debt

 3. Arrangement of funds for clients:

Negotiating with the bank on behalf of its
clients and fulfilling other formalities.

 4.Assisting in getting Government/other

clearances: Licenses, permissions etc.,

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 20
II. Modern services

 The financial services rendered to meet the

modern day challenges of business comes
under the modern services.

 1.Rendering project advisory services:

preparing project repots, estimating financial
requirements, suggesting sources of finance
etc.

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Management Studies, NHCE 21
II. Modern services

2.Planning for Mergers and Acquisitions:

Assisting the clients in mergers and
acquisitions including negotiations etc.,

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Management Studies, NHCE 22
II. Modern services

 3. Guiding in capital restructuring: Altering the

debt, equity mix to optimize wealth.

 4. Acting as trustees to the debenture holders: A

debenture trustee is a person or entity that serves
as the holder of debenture stock for the benefit of
another party. As per the SEBI, a Debenture Trustee
can be a scheduled bank, an insurance company, a
body corporate or a public financial institution.

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Management Studies, NHCE 23
II. Modern services

 5. Guiding in management structure and

management style: Helping in development
that management structure /style which
assists in achieving organizational objectives
most efficiently.

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Management Studies, NHCE 24
II. Modern services

 6.Structuring the financial collaborations / joint

ventures: Helping clients to negotiate at the
time of financial collaborations/joint ventures.

 7.Rehabilitating and restructuring sick

companies: Assisting in the total revamping of
assets and liabilities, incomes and expenses of
businesses to make them financially viable.

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Management Studies, NHCE 25
II. Modern services

 8. Hedging of risks: Assisting in entering

hedging contracts like the forwards, futures,
swaps etc., to mitigate the risk

 9. Managing portfolio of large Public Sector

Corporations: Assist in construction of a
portfolio by which the returns are maximized
with minimum risk.

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Management Studies, NHCE 26
II. Modern services
 10.Insurance services: The financial
institution that is the insurer undertakes to
compensate the insured for the loss arising
from the risk insured

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Management Studies, NHCE 27
II. Modern services

 11.Housing finance: Providing finance for

housing purposes. Institutions providing
housing finance include HDFC, LIC Housing
Finance, Citi Home, Ind Bank Housing etc

 12. Assisting in selecting sources of funds:

Assisting in developing a proper debt equity
mix that results in reduced weighted average
cost of capital.

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Management Studies, NHCE 28
II. Modern services

 13. Guiding in the minimization of the cost of

debt and optimum debt-equity mix: Assisting
in developing a proper debt equity mix that
results in maximizing equity share holders
wealth.

 14. Undertaking services relating to the

capital market: Assisting both in the primary
and secondary markets.

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Management Studies, NHCE 29
II. Modern services
15. Promoting credit rating agencies: Credit
rating is judging the creditworthiness of a
company by an independent organization like
CRISIL, ICRA, CARE

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Management Studies, NHCE 30
II. Modern services

 16.Merchant Banking: SEBI (Merchant Bankers) Rule, 1992 has

defined a merchant banker as, “any person who is engaged in the
business of issue management either by making arrangements
regarding selling, buying or subscribing to securities or acting as
manager, consultant, advisor, or rendering corporate advisory
services in relation to such issue management”.

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Management Studies, NHCE 31
II. Modern services

 17.Loan Syndication: An arrangement where a

group of banks participate to provide funds
for a single loan particularly, when the loan
amount is huge.

 18. Leasing: A lease is an agreement under

which a firm acquires a right to make use of a
capital asset like machinery etc. on payment
of an agreed fee called lease rentals.

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Management Studies, NHCE 32
II. Modern services
 19.Mutual Funds: Are financial intermediaries which mobilize
savings from the people and invest them in a mix of
corporate and government securities.

SIP=Systematic Investment Plan, SWP=Systematic Withdrawal

Plan, STP=Systematic Transfer Plan
Prof. Sainath, Ph.D, Dept of
Management Studies, NHCE 33
Types of Mutual funds
1. Based on Asset Class
◦ Equity Funds
◦ Debt Funds
◦ Money Market Funds
◦ Hybrid Funds
2. Based on Structure
◦ Open-ended Funds
◦ Closed-ended Funds
◦ Interval Funds
3.Based on Investment Goals
◦ Growth Funds
◦ Income Funds
◦ Liquid Funds
◦ Tax-Saving Funds
4.Based on Risk
◦ Very Low-Risk Funds
◦ Low-Risk Funds
◦ Medium Risk Funds
◦ High-Risk Funds
5.Specialized Mutual Funds

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Management Studies, NHCE 34
1. Mutual Fund Types Based on Asset Class

 a. Equity Funds
 Primarily investing in stocks, they also go by the name stock funds. They invest the money amassed
from investors from diverse backgrounds into shares of different companies. The returns or losses are
determined by how these shares perform (price-hikes or price-drops) in the stock market. As equity
funds come with a quick growth, the risk of losing money is comparatively higher.
 b. Debt Funds

 Debt funds invest in fixed-income securities like bonds, securities and treasury bills – Fixed Maturity

Plans (FMPs), Gilt Fund, Liquid Funds, Short Term Plans, Long Term Bonds and Monthly Income Plans
among others – with fixed interest rate and maturity date. Go for it, only if you are a passive investor
looking for a small but regular income (interest and capital appreciation) with minimal risks.
 c. Money Market Funds

 Just as some investors trade stocks in the stock market, some trade money in the money market, also

known as capital market or cash market. It is usually run by the government, banks or corporations by
issuing money market securities like bonds, T-bills, dated securities and certificate of deposits among
others. The fund manager invests your money and disburses regular dividends to you in return. If you
opt for a short-term plan (13 months max), the risk is relatively less.
 d. Hybrid Funds

 As the name implies, Hybrid Funds (also go by the name Balanced Funds) is an optimum mix of bonds

and stocks, thereby bridging the gap between equity funds and debt funds. The ratio can be variable or
fixed. In short, it takes the best of two mutual funds by distributing, say, 60% of assets in stocks and
the rest in bonds or vice versa. This is suitable for investors willing to take more risks for ‘debt plus
returns’ benefit rather than sticking to lower but steady income schemes.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 35
2. Mutual Fund Types Based On Structure

 a. Open-Ended Funds
 These funds don’t have any constraints in a time period or number of units – an
investor can trade funds at their convenience and exit when they like at the current
NAV (Net Asset Value). This is why its unit capital changes constantly with new
entries and exits. An open-ended fund may also decide to stop taking in new
investors if they do not want to (or cannot manage large funds).
 b. Closed-Ended Funds
 Here, the unit capital to invest is fixed beforehand, and hence they cannot sell a
more than a pre-agreed number of units. Some funds also come with an NFO period,
wherein there is a deadline to buy units. It has a specific maturity tenure and fund
managers are open to any fund size, however large. SEBI mandates investors to be
given either repurchase option or listing on stock exchanges to exit the scheme.
 c. Interval Funds
 This has traits of both open-ended and closed-ended funds. Interval funds can be
purchased or exited only at specific intervals (decided by the fund house) and are
closed the rest of the time. No transactions will be permitted for at least 2 years.
This is suitable for those who want to save a lump sum for an immediate goal (3-12
months).

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 36
3. Mutual Fund Types Based on Investment Goals

 a. Growth Funds
 Growth funds usually put a huge portion in shares and growth sectors, suitable for
investors (mostly Millennials) who have a surplus of idle money to be distributed in
riskier plans (albeit with possibly high returns) or are positive about the scheme. 
 b. Income Funds
 This belongs to the family of debt mutual funds that distribute their money in a mix of
bonds, certificate of deposits and securities among others. Helmed by skilled fund
managers who keep the portfolio in tandem with the rate fluctuations without
compromising on the portfolio’s creditworthiness, Income Funds have historically
earned investors better returns than deposits and are best suited for risk-averse
individuals from a 2-3 years perspective. 
   c. Liquid Funds
 Like Income Funds, this too belongs to the debt fund category as they invest in debt
instruments and money market with a tenure of up to 91.
 d. Tax-Saving Funds
 ELSS or Equity Linked Saving Scheme is gaining popularity as it serves investors the
double benefit of building wealth as well as save on taxes – all in the lowest lock-in
period of only 3 years. Investing predominantly in equity (and related products)

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 37
3. Mutual Fund Types Based on
Investment Goals
 e. Aggressive Growth Funds
 Slightly on the riskier side when choosing where to invest in, Aggressive Growth Fund is designed to
make steep monetary gains. Though susceptible to market volatility, you may choose one as per the
beta (the tool to gauge the fund’s movement in comparison with the market). Example, if the market
shows a beta of 1, an aggressive growth fund will reflect a higher beta, say, 1.10 or above.
 f. Capital Protection Funds

 If protecting your principal is your priority, Capital Protection Funds can serve the purpose while

earning relatively smaller returns (12% at best). The fund manager invests a portion of your money in
bonds or CDs and the rest in equities. You will not incur any loss. However, you need a least 3 years
(closed-ended) to safeguard your money and the returns are taxable.
 g. Fixed Maturity Funds

 Investors choose as the FY ends to take advantage of triple indexation, thereby bringing down tax

burden. If uncomfortable with the debt market trends and related risks, Fixed Maturity Plans (FMP) –
investing in bonds, securities, money market etc. – present a great opportunity. As a close-ended plan,
FMP functions on a fixed maturity period, which could range from 1 month to 5 years (like FDs). The
Fund Manager makes sure to put the money in an investment with the same tenure, to reap accrual
interest at the time of FMP maturity.
 h. Pension Funds

 Putting away a portion of your income in a chosen Pension Fund to accrue over a long period to secure

you and your family’s financial future after retiring from regular employment – it can take care of most
contingencies (like a medical emergency or children’s wedding). Relying solely on savings to get
through your golden years is not recommended as savings (no matter how big) get used up. EPF is an
example, but there are many lucrative schemes offered by banks, insurance firms etc.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 38
4. Mutual Fund Types Based on Risks

 a. Very Low-Risk Funds

 Liquid Funds and Ultra Short-term Funds (1 month to 1 year) are not risky at all, and
understandably their returns are low (6% at best). Investors choose this to fulfill their
short-term financial goals and to keep their money safe until then.
 b. Low-Risk Funds
 In the event of rupee depreciation or unexpected national crisis, investors are unsure
about investing in riskier funds. In such cases, fund managers recommend putting money
in either one or a combination of liquid, ultra short-term or arbitrage funds. Returns
could be 6-8%, but the investors are free to switch when valuations become more stable.
 c. Medium-risk Funds
 Here, the risk factor is of medium level as the fund manager invests a portion in debt and
the rest in equity funds. The NAV is not that volatile, and the average returns could be 9-
12%.
 d. High-risk Funds
 Suitable for investors with no risk aversion and aiming for huge returns in the form of
interest and dividends, High-risk Mutual Funds need active fund management. Regular
performance reviews are mandatory as they are susceptible market volatility. You can
expect 15% returns, though most high-risk funds generally provide 20% returns (and up
to 30% at best).

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 39
5. Specialized Mutual Fund Types

 a. Sector Funds
 Investing solely in one specific sector, theme-based mutual funds. As these funds invest
only in specific sectors with only a few stocks, the risk factor is on the higher side. One
must be constantly aware of the various sector-related trends, and in case of any decline,
just exit immediately. However, sector funds also deliver great returns. Some areas of
banking, IT and pharma have witnessed huge and consistent growth in recent past and
are predicted to be promising in future as well.
 b. Index Funds
 Suited best for passive investors, index funds put money in an index. It is not managed by
a fund manager. An index fund simply identifies stocks and their corresponding ratio in
the market index and put the money in similar proportion in similar stocks. Even if they
cannot outdo the market (which is the reason why they are not popular in India), they play
it safe by mimicking the index performance.
 c. Funds of Funds
 A diversified mutual fund investment portfolio offers a slew of benefits, and ‘
Funds of Funds’ aka multi-manager mutual funds are made to exploit this to the tilt – by
putting their money in diverse fund categories. In short, buying one fund that invests in
many funds rather than investing in several achieves diversification as well as saves on
costs.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 40
5. Specialized Mutual Fund Types

 d. Emerging market Funds

 To invest in developing markets is considered a steep bet and it has undergone
negative returns too. India itself a dynamic and emerging market and investors to earn
high returns from the domestic stock market, they are prone to fall prey to market
volatilities. However, in a longer-term perspective, it is evident that emerging
economies will contribute to the majority of global growth in the coming decade as
their economic growth rate is way superior to that of the US or the UK.
 e. International/ Foreign Funds
 Favored by investors looking to spread their investment to other countries, Foreign
Mutual Funds can get investors good returns even when the Indian Stock Markets do
fare well. An investor can employ a hybrid approach (say, 60% in domestic equities and
the rest in overseas funds) or a feeder approach (getting local funds to place them in
foreign stocks) or a theme-based allocation (eg, Gold Mining).
 f. Global Funds
 Aside from the same lexical meaning, Global Funds are quite different from
International Funds. While a global fund chiefly invests in markets worldwide, it also
includes investment in your home country. The International Funds concentrate solely
on foreign markets. Diverse and universal in approach, Global Funds can be quite risky
to owing to different policies, market and currency variations, though it does work as a
break against inflation and long-term returns have been historically high.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 41
5. Specialized Mutual Fund Types
 g. Real Estate Funds
 In spite of the real estate boom in India, many are wary about investing in such projects due to
multiple risks. Real Estate Fund can be a perfect alternative as the investor is only an indirect
participant by putting their money in established real estate companies/trusts rather than projects.
A long-term investment, it negates risks and legal hassles when it comes to purchasing a property
as well as provide liquidity to some extent.
 h. Commodity-focused Stock Funds
 Ideal for investors with sufficient risk-appetite and looking to diversify their portfolio, commodity-

focused stock funds give a chance to dabble in multiple and diverse trades. Returns are not periodic
and are either based on the performance of the stock company or the commodity itself. Gold is the
only commodity in which mutual funds can invest directly in India. The rest purchase fund units or
shares from commodity businesses.
 i. Market Neutral Funds
 For investors seeking protection from unfavorable market tendencies while sustaining good returns,

Market-neutral Funds meet the purpose (like a hedge fund). With better risk-adaptability, these funds
give high returns and even small investors can outstrip the market without stretching the portfolio
limits.
 j. Inverse/leveraged Funds
 While a regular index fund moves in tandem with the benchmark index, the returns of an inverse index

fund shift in the opposite direction. Simply put, it is nothing but selling your shares when the stock
goes down, only to buy them back at an even lesser cost (to hold until the price goes up again).

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 42
5. Specialized Mutual Fund Types
 k. Asset Allocation Funds
 Combining debt, equity and even gold in an optimum ratio, this is a greatly
flexible fund. Based on a pre-set formula or fund manager’s inferences on
the basis of the current market trends, Asset Allocation Funds can regulate
the equity-debt distribution. It is almost like Hybrid Funds but requires
great expertise in choosing and allocation of the bonds and stocks from the
fund manager.
 l. Gift Funds
 Yes, you can gift a mutual fund or a SIP to your loved ones to secure their
financial future.
 m. Exchange-traded Funds
 It belongs to the Index Funds family and is bought and sold on exchanges.
Exchange-traded Funds have unlocked a world of investment prospects,
enabling investors to gain comprehensive exposure to stock markets
abroad as well as specialized sectors. An ETF is like a Mutual Fund that can
be traded in real-time at a price that may rise or fall many times in a day.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 43
II. Modern services
 20.Factoring: Factoring is the outsourcing of
the credit control department to a third party.
 The debts of the company are effectively sold

to a factor (normally owned by a bank).

 The factor takes on the responsibility of

collecting the debt for a fee.

 Factoring is primarily designed to allow

companies to accelerate cash flow, providing

finance against outstanding trade receivables.
This improves cash flow and liquidity.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 44
II. Modern services
21.Forfaiting: Type of export financing (practiced largely
in Europe) in which a forfeiter (usually a bank or a finance
company) purchases freely-negotiable instruments (such
as unconditionally-guaranteed letters of credit, export
invoice, bills of exchange) at a discount from an exporter.
This arrangement is without recourse to the exporter who

is relieved of all (commercial, political, exchange rate, and

interest rate) risks, but is liable for the payment's legal
validity and any defect resulting from the underlying
transaction.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 45
II. Modern services
Unlikefactoring, forfeiting is available for 100 percent of
the payment amount, but only for relatively larger sums
(usually not less than $100,000) and for longer maturity
dates (usually one to five years) although periods as short
as 180 days and as long as ten years may also be
considered.

22.Venture Capital: The capital which is available for

financing risky project with the objective of earning a high
rate of returns.

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Management Studies, NHCE 46
II. Modern services

 23. Custodial Services: are the service of keeping the

securities safe for and on behalf of somebody else for a
remuneration called custodial charges.

 Examples of Registered Custodian of Securities with SEBI

 The Royal Bank Of Scotland N.V. (Formerly ABN Amro

Bank N.V.)
 Axis Bank Limited,
 BNP Paribas,
 Citibank

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 47
II. Modern services

 24.Corporate advisory services: extending advisory

services in the areas of corporate administration
including managerial, legal, procedural etc.

 25.Securitization: It is a mortgage-backed
security. It is a technique whereby ill-liquid, non-
negotiable and high value financial assets converts
into securities of small value which are made
tradable and transferable.

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Management Studies, NHCE 48
II. Modern services
 26.Derivative Security:
 A derivative is a security with a price that is dependent

upon or derived from one or more underlying assets.

 The derivative itself is a contract between two or more

parties based upon the asset or assets. Its value is

determined by fluctuations in the underlying asset.
Examples of derivative contracts include the futures,
forwards, swaps, options
 The most common underlying assets include stocks,

bonds, commodities, currencies, interest rates and

market indexes.
 

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Management Studies, NHCE 49
II. Modern services

 27.New products in Forex Markets: Examples,

Forward contract, Options, Futures , Swaps

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Management Studies, NHCE 50
II. Modern services

 28.Lines of Credit: an arrangement of a

financing institution of one country with
another to support the export of goods and
services so as to enable the importer to
import on deferred payment terms.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 51
Project Finance
People involved in projects find financing deals for
projects such as mining, transportation and public
utility industries Challenging.
 Risks, compensations, repayment of loan, insurance

and assets in process needs to be considered.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 52
Project Finance
 Understanding project finance is important in order
to manage project cash flow for ensuring profits
which can be distributed among multiple parties,
such as investors, lenders and others

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 53
What is a project?
A Project is normally a long-term infrastructure,
industrial or public services scheme, development
or undertaking having:
 large size
 Intensive capital requirement – Capital Intensive.
 Finite and long Life.

 Few diversification opportunities i.e. assets

specific.
 Stand alone entity.

 High operating margins.

 Significant free cash flows.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 54
Types of Projects
• Motorway and expressways
• Metro, subway and other mass transit systems.
• Dams
• Railway network and service – both passenger and
cargo
• Power plants and other charged utilities
• Port and terminals
• Airports and terminals
• Mines and natural resource explorations.
• Large new industrial undertakings – [no expansion and
extensions
• Large residential and commercial buildings.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 55
Project Financing
 International Project Finance Association (IPFA) defined
project financing as:

“The financing of long-term infrastructure, industrial

projects and public services based upon a non-recourse
or limited recourse financial structure where project
debt and equity used to finance the project are paid
back from the cash flows generated by the project.”

Project finance is especially attractive to the private

sector because they can fund major projects off balance
sheet.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 56
Key characteristics of Project
Financing:
 Financing of long term infrastructure and/or industrial
projects using debt and equity.
 Debt is typically repaid using cash flows generated from
the operations of the project.
 Limited recourse to project sponsors.
 Debt is typically secured by project’s assets, including
revenue producing contracts.
 First priority on project cash flows is given to the Lender.
 Consent of the Lender is required to disburse any surplus
cash flows to project sponsors
 Higher risk projects may require the surety/guarantees
of the project sponsors.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 57
Credit Rating
 A Borrowing is essentially a promise, and a credit
rating determines the likelihood that the borrower will
pay back a loan within the confines of the loan
agreement, without defaulting.

 A high credit rating indicates a high possibility of

paying back the loan in its entirety without any
issues; a poor credit rating suggests that the
borrower has had trouble paying back loans in the
past, and might follow the same pattern in the future.
Credit Rating

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 59
Meaning of Credit Rating
 Credit Rating is an assessment of the creditworthiness
of a borrower in general terms or with respect to a
particular debt or financial obligation.
 A credit rating can be assigned to any entity that
seeks to borrow money – an individual, corporation,
state or provincial authority, or sovereign government.
 Credit assessment and evaluation for companies and
governments is generally done by a credit rating
agency such as Standard & Poor’s,  Moody’s or Fitch.
 These rating agencies are paid by the entity that is
seeking a credit rating for itself or for one of its debt
issues.
Meaning of Credit Rating
 Credit scores apply to individuals (An
individual's credit score is reported as a
number, generally ranging from 300 to 900)
For ex: CIBIL Score (CIBIL=Credit Information
Bureau (India) Limited)
 Sovereign credit ratings apply to national

governments, and 
 Corporate credit ratings apply solely to
corporations.
Credit rating Process of Financial
Instruments:
 The rating process typically takes six to eight
weeks, and the steps involved are:

 Step – 1 – Initiate Rating Process

 Step – 2 – Collect publicly available

information
 Step – 3 – Perform pre-analysis & request

non-public information, if appropriate

 Step – 4 – Prepare detailed questionnaire
Credit rating Process of Financial
Instruments:
 Step – 5 – Hold meetings with entity
management and other Stakeholders
 Step – 6 – Perform in-depth analysis
 Step – 7 – Draft report
 Step – 8 – Hold ratings Committee
 Step – 9 – Assign ratings, write & publish

commentary
 Step – 10 – Conduct ongoing surveillance
Factors considered for Rating
1.Operative Environment:
 Issuer ratings depend not only on the company itself, but

also on the environment in which the issuer operates.

Each rating analysis will therefore begin with a qualitative
assessment of the company’s business environment in
order to determine any operating risks faced by the
issuer, before subsequently evaluating financial risks in a
quantitative analysis.
2.Industry risk
 Outside factors are able to impact on a company’s

success and therefore credit rating agencies will

determine an issuer rating within the context of the
industry in which the issuer is active.
Factors considered for Rating
3.Market position:
Significant factors in this evaluation will be:
◦ Market share.
◦ Competitiveness.
◦ Diversification in terms of products and key
customers.
◦ The ability to maintain or dictate prices in the
market.
Factors considered for Rating
4.Management:

Significant factors in this evaluation will be:

◦ Management strategy.
◦ Risk tolerance.
◦ Organizational considerations.
◦ Company policies.
Factors considered for Rating
5.Corporate governance:
 corporate governance is another area that

may have an impact on ratings. The

framework in which management operates
may influence the effectiveness and control of
senior managers.

◦ Board effectiveness.
◦ Board independence.
Factors considered for Rating
6.Accounting:
 The quality of financial reporting gives a good

indication of the solidity of the governance

framework. Both equity and credit investors will
rely on the accuracy and transparency of the
issuer’s accounting statements in their
investment decisions. Analysts will review the
audit process to ascertain whether it is
objective and removed from management
interference, and also based on solid internal
controls.
Factors considered for Rating
7.Quantitative analysis:
 The main focus of the quantitative analysis is the issuer’s

ability to generate cash. The financial position is also

measured in profitability and debt coverage ratios, which
are tested with regard to their long-term sustainability.
8.Profitability:
 Analysts will consider a wide range of financial ratios. The

issuer’s ability to generate profit is a major factor in

determining the degree of credit protection and level of
credit risk for investors. The higher a company’s operating
margins and return on capital, the greater the potential to
generate capital internally and to gain access to external
capital sources.
Factors considered for Rating
 9.Cash flow:
 Although there tends to be a close connection between cash flow and
profitability, it is important to bear in mind that any payments of
interest or principal are not made from earnings, which may be subject
to a specific accounting treatment. Payments must be made from cash
flow. Only if the operating cash flow is sustainable will the company be
in a position to both service the debt and fund its operations and
growth. Cash flow patterns typically indicate a more realistic debt-
servicing capability than earnings figures.
 10.Capital structure:
 A company’s relative dependency on external funding may have an
effect on its debt servicing ability. The credit effect that financial
leverage might have is therefore monitored in light of the nature of
business operations and operational cash flow. As different industries
have varying capital requirements, an issuer’s capital structure is always
compared to that of peers and the average within the industry.
Factors considered for Rating
 11.Financial flexibility:
 Financial flexibility concerns the evaluation of

how a company will be able to react under

stress. This means, in particular, how an
issuer will service debt obligations during
spells of volatility and what kinds of
additional funding are at the company’s
disposal.
Top Indian Credit Rating Agencies

CARE

ICRA

ONICRA

SMERA

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 72
Top US Credit Rating Agencies

Standard & Poor's

(S&P),

Moody's

Fitch Group

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 73
Rating Agencies

CRISIL:

 CRISIL (formerly Credit Rating Information

Services of India Limited) is the largest credit
rating agency in India. It was established in
1987. The world’s largest rating agency
Standard & Poor's now holds majority stake in
CRISIL. Till date it has rated more than 5178
SMEs across India and has issued more than
10,000 SME ratings.
Rating Agencies

CARE Ratings:

 Incorporated in 1993, Credit Analysis and

Research Limited (CARE) is a credit rating,
research and advisory committee promoted
by Industrial Development Bank of India
(IDBI), Canara Bank, Unit Trust of India (UTI)
and other financial and lending institutions.
CARE has completed over 7,564 rating
assignments since its inception in 1993.
Rating Agencies

 ICRA
 Investment Information and Credit Rating

Agency of India (IICRA India) is an

independent and professional investment
information and credit rating agency in India.
ICRA was established in 1991 by leading
Indian financial institutions and commercial
banks.
 International credit rating agency, Moodys, is

the largest shareholder.

Rating Agencies

 ONICRA Credit Rating Agency (Onida Individual

Credit Rating Agency) was established in 1993
as a rating agency. It analyzes data and
provides rating solutions for Individuals and
Small and Medium Enterprises(SMEs).
 ONICRA has an extensive experience in
operating a wide range of business processes in
areas such as Finance, Accounting, Back-end
Management, Application Processing, Analytics,
and Customer Relations. It has rated more than
2500 SMEs.
Rating Agencies

 SMERA (Small and Medium Enterprises Rating

Agency) is a joint initiative by SIDBI, Dun &
Bradstreet Information Services India Private
Limited (D&B) and several leading banks in
the country.

 SMERA is the country's first Rating agency

that focuses primarily on the Indian MSME
segment. SMERA has completed 7000 ratings.
US Credit Rating Agencies
 The Big Three credit rating agencies of the US are
 1.Standard & Poor's (S&P),
 2.Moody's, and
 3.Fitch .
 S&P and Moody's are based in the US, while Fitch
is dual-headquartered in New York City and
London, and is controlled by Hearst.
 They hold a collective global market share of
"roughly 95 percent“ with Moody's and Standard &
Poor's having approximately 40% each, and Fitch
around 15%.
Rating symbols of different
companies
 The Securities and Exchange Board of India (SEBI)
circular dated June 15, 2011, standardized the
rating symbols and their definitions for all credit
rating agencies in India.
 Pursuant to the said circular, Ind-Ra has revised
its rating symbols and their definitions, which
will be used for all outstanding issuer default
ratings (IDR) and outstanding instruments
rated/assigned.
 The revised rating symbols and their definitions
are as follows:
 India Rating Scale for Long Term Debt Instruments
[the instruments with original maturity exceeding one year]

IND AAA Instruments have highest degree of safety regarding timely servicing of
financial obligations. Such instruments carry lowest credit risk.

IND AA Instruments have high degree of safety regarding timely servicing of financial
obligations. Such instruments carry very low credit risk.

IND A Instruments have adequate degree of safety regarding timely servicing of

financial obligations. Such instruments carry low credit risk.

IND BBB Instruments have moderate degree of safety regarding timely servicing of
financial obligations. Such instruments carry moderate credit risk.

IND BB Instruments have moderate risk of default regarding timely servicing of

financial obligations.

IND B Instruments have high risk of default regarding timely servicing of financial
obligations.

IND C Instruments have very high risk of default regarding timely servicing of
financial obligations.

IND D Instruments are in default or are expected to be in default soon.

Note: Modifiers {"+" (plus) / "-"(minus)} can be used with the rating
Sovereign credit ratings
 A sovereign credit rating is the credit rating
of a sovereign entity, such as a national
government.
 The sovereign credit rating indicates the risk

level of the investing environment of a

country and is used by investors when
looking to invest in particular jurisdictions,
and also takes into account political risk.
Sovereign credit ratings-Cont

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 83
Sovereign credit ratings

Country risk rankings (Q1 2016)

Overall
Rank Country
Score
1 Norway 88.59
2 Switzerland 87.95
3 Singapore 86.49
4 Luxembourg 85.14
5 Netherlands 84.49
6 Denmark 83.87
7 Sweden 83.49
8 Germany 82.49
9 Canada 82.04
Leasing 
 It is a process by which a firm can obtain the use of
a certain fixed assets for which it has to pay a series
of contractual, periodic, and other payments.
 The parties involved in a lease agreement

1. Lessee: the receiver of the asset

2. Lessor: the owner of the assets.

 The consideration  for the lease is called rent.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 85
Lease
 Is a legal document outlining the terms and
conditions of leasing.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 86
Lease
 A lease guarantees the lessee the use of an
asset and guarantees the lessor regular
payments for a specified number of months
or years.
 Under common law, a lease should have three

essential characteristics:
1. A definite term
2. Rent
3. Possession

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 87
Advantages of Leasing:
 Leasing is less capital intensive than purchasing assets

 Leasing safeguard cash flow

 Leasing protects the lessee from the risk of fluctuation in the market value of
assets.

 Lease payments (Rent, repairs and maintenance etc.,) are considered as

expenses which can be set off against revenues when calculating taxable profit.

 In some cases a lease may be the only practical option; for example, a small
business may wish to open a location in a large office building within tight
locational parameters. (Ex banks, Jewelery shops)

 Leasing may provide more flexibility to a business which expects to grow or

move in the relatively short term, because a lessee is not usually obliged to
renew a lease at the end of its term.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 88
Disadvantages

 A lease may shift maintenance costs to the

lessee (tenant).
 It is Very difficult to terminate a lease before

the end of the term.

 Lessor may demand higher rental payments

when lessee come up for renewal.

 If the value of the business is tied to the use

of a asset, the lessee will be in a

disadvantageous position in negotiations.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 89
Types of Lease:
Finance Lease  & Operating Lease.
 1.Finance Lease: or a capital lease is a commercial
arrangement where:
 the lessee (customer or borrower) will select an asset
 the lessor (finance company) will purchase the asset;
 the lessee will use that asset during the lease;
 the lessee will pay a series of rentals or installments for
the use of that asset;
 the lessor will recover a large part or all of the cost of
the asset plus earn interest from the rentals paid by the
lessee;
 the lessee has the option to acquire ownership of the
asset

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 90
2.Operating Lease
 Cancelable short-term lease (a period shorter
than the economic life of the leased asset)
where property owners expect to take back
the leased asset after the lease term and re-
lease it to other users.
 The lessor gives the lessee the
exclusive right to possess and use the leased
asset for a specific period and under
specified conditions, but retains almost all
risks and rewards of the ownership. 

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 91
Financial evaluation of leasing:

 Leasing can be evaluated in two ways. One is

1. from the Lessor’s point of view and
 2. from the Lessee’s point of view .

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 92
1.From the lessors point of view
 The present value method can be used to
evaluate the lease.
 The cash outflows by deducting tax advantage of
owing an asset and cash inflow after the tax is
calculated.
 The present value of the cash outflows after the
tax is discounted at weighted average cost of
capital of the lessor.
 PV. of cash inflows exceeds the PV of cash
outflows i.e. if the NPV is positive. Leasing
decision is done otherwise not.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 93
2.From the Lessee’s point of view
 also, the present value method can be used to evaluate
the lease.
 The present value of net-cash flow of the buying
option-NPV(B) and the present value of net cash flow of
the leasing option-NPV(L) has to be calculated.
 Decision whether to buy or lease the asset or reject the
proposal should be based on the net present value.
 If NPV from Leasing is positive and greater than the
NPV of Buying, leasing the asset should be
considered and if the NPV of buying as well as NPV of
Leasing are both negative, the proposal should be
rejected.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 94
Cross-border leasing
 is a leasing arrangement where lessor and
lessee are situated in different countries.
 widely used in some European countries,
to arbitrage the difference in the tax laws of
different jurisdictions, usually between a
European country and the United States.
 Typically, this rests on the fact that, for tax
purposes, some jurisdictions assign ownership
and the attendant depreciation allowances to
the entity that has legal title to an asset.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 95
Contents of a lease agreement:

 Details of the lessor and lessee, and their addresses

 Details of property leased - its location and
identification
 Declaration by the lessor that he is either the owner of
the property or is duly authorized by the owner to give
the property on lease
 Date of commencement of the lease agreement.
 Term of the lease
 The lease rent and the mode of payment
 Security deposit amount paid, whether it is interest-
free or not, and the circumstances when it is
refundable

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 96
Contents of a lease agreement-Cont
 Advance rent payable, if any, and the mode of its
adjustment
 Rent escalation clause - when can the rent be increased
and at what rates• Facilities to be included in the rent
 Who pays the municipal dues, property tax
 Who bears the maintenance charges
 Who will bear the routine repair and maintenance
expenses.
 Grounds for termination of the agreement•
 Who will bear the registration expenses of the lease
deed
 Renewable clauses.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 97
Hire purchase (HP)
  HP is the legal term for a contract, in which a purchaser agrees to
pay for goods in parts over a number of months.
 Ownership of the good remains with the seller until the last
payment is made.
 The hire purchase agreement was developed in the United
Kingdom in the 19th century to allow customers with cash
shortage to make an expensive purchase they otherwise would
have to delay.
 For example in cases where a buyer cannot afford to pay the price
for a property in a lump sum but can afford to pay a parts over a
period of time, a hire-purchase contract allows the buyer to hire
the goods for a monthly rent. When a sum equal to the original
full price plus interest has been paid in installments, the buyer
may then exercise an option either to buy the goods at a
predetermined price or return the goods to the owner.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 98
Hire purchase (HP)
  

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 99
Hire Purchase-Cont
 If the buyer defaults in paying the installments, the
owner may repossess the goods.
 HP is frequently advantageous to consumers because
it spreads the cost of expensive items over an
extended time period.
 Business consumers may find the different balance
sheet and taxation treatment of hire-purchased
goods beneficial to their taxable income.
 These contracts are most commonly used for items
such as cars and high value electrical goods,
machineries etc., where the purchasers are unable to
pay for the goods in one lump sum.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 10
0
Hire Purchase-Cont
 To be valid, HP agreements must be in writing and signed by
both the parties.

 They must clearly lay out the following information in writing:

◦ A clear description of the goods
◦ The cash price for the goods
◦ The HP price, i.e., the total sum that must be paid to hire and then
purchase the goods
◦ The deposit
◦ The monthly installments
◦ A reasonably comprehensive statement of the parties'
◦ The right of the hirer to terminate the contract when he feels like doing
so with a valid reason.
 

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 10
1
Implied warranties and conditions to
protect the hirer
 
 Enjoy quiet possession of the goods
 Receive the ownership as per agreement.

(Generally after the payment of last

installment.)
 Goods received are of merchantable quality

and fit for their purpose

 Receive goods as per the description given

before.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 10
2
The Hirers rights (The person who
takes the property by Hire)

 To buy the goods as per agreement.

 To return the goods to the owner as per

agreement.
 With the consent of the owner, to assign both

the benefit and the burden of the contract to

a third person.(Finance company)
 To recover the goods, if the owner wrongfully

repossesses the goods

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 10
3
The Owners rights:

 Right to terminate the agreement where the hirer defaults

in paying the installments or breaches any of the other
terms in the agreement. This entitles the owner:
◦to forfeit the deposit
◦to retain the installments already paid and recover the
balance due
◦to repossess the goods (which may have to be by
application to a Court depending on the nature of the goods
and the percentage of the total price paid)
◦to claim damages for any loss suffered.
 
 
 
 

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 10
4
The hirers obligations: The Buyers
obligation
 To pay the hire installments
 To take reasonable care of the goods
 To inform the owner about the place at which

the property is stationed.

 Not to sell unless he has purchased the

goods.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 10
5
Difference between Lease and Hire Purchase:

Lease Hire-Purchase
1.Ownership Ownership lies with the Owner ship is transferred to
lessor. the hirer after the payment
of last installment
2.Depreciation  Depreciation is claimed Depreciation is claimed by
by the lessor. (Owner) the hirer (Buyer)
3.Rental Rent is the cost of an installment amount includes
Payments asset over is life. principal and interest
4.Duration long duration and for Short duration and for
bigger assets like land, cheaper assets like hiring a
property etc. car, furniture, machinery etc.
5.Repairs and Lies with lessee Lies with the hirer.
Maintenance:  (financial lease) with
lessor (operating lease).
Prof. Sainath, Ph.D, Dept of
Management Studies, NHCE 10
6
Problem-1
A limited company is interested in acquiring the use of an asset costing Rs.
5,00,000. It has two options:

(i) To borrow the amount at 18% p.a. repayable in 5 equal installments or

(ii) To take on lease the asset for a period of 5 years at the year end rentals of
Rs. 1,20,000.
The corporate tax is 50% and the depreciation is allowed on
w.d.v. at 20%. The asset will have a salvage of Rs. 1,80,000 at the end of the
5th year.
You are required to advise the company about lease or buy decision.

Note:
(1) The present value of Re. 1 at 18% discount factor is:1st year – .847, 2nd
year – .718, 3rd year – .609, 4th year – .516, 5th year – .437

(2) The present value of an annuity (PVIFA)of Re. 1 at 18% p.a. is Rs. 3.127.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 10
7
Solution
Lease option
Lease Tax savings on Lease rent PVIF Present Value
Rent lease rent after tax At 18% of outflow
(50%)

1,20,000 60,000 60,000 .847 50,820

1,20,000 60,000 60,000 .718 43,080

1,20,000 60,000 60,000 .609 36,540

1,20,000 60,000 60,000 .516 30,960

1,20,000 60,000 60,000 .437

Prof. Sainath, Ph.D, Dept of 26,220 10
Management Studies, NHCE
8
Solution
Buying/loan option
*Loan **Tax ***Tax Total Net cash PVIF PV of out
installmen savings savings savings outflows At flows
t on on (4) (1-4)=5 18%
(1) Interest Deprecia
(50%) tion
(2) (50%)
(3)
1,59,898 45,000 50,000 95,000 64,898 .847 54,969
1,59,898 38,709 40,000 78,709 81,189 .718 58,294
1,59,898 31,280 32,000 63,280 96,618 .609 58,840
1,59,898 22,526 25,600 48,126 1,11,772 .516 57,674
1,59,898 12,191 20,480 32,671 1,27,227
Prof. Sainath, Ph.D, Dept of .437 55,598
Management Studies, NHCE 10
9
Suggestion/advice
I. Total PV of outflows with lease option 1,87,620
II. Total Present value of outflows in 2,06,715
case of buying/loan option

Lease option is advised as it results in

less PV of outflows

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 11
0
Calculations
*Loan installment= Amount of the loan/PVIFA
PVIFA=Present value interest factor of annuity
5,00,000/3.127(Given)=1,59,898

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 11
1
 Calculations
**
Interest
Year Opening Loan Loan Interest Principal Closing loan
balance installment Component component balance
(1) (2) (3) (18%) (4) (3-4)=5 (2-5)=6
1 5,00,000 1,59,898 90,000 69,898 4,30,102
2 4,30,102 1,59,898 77,418 82,480 3,47,622

3 3,47,622 1,59,898 62,572 97,326 2,50,296

4 2,50,296 1,59,898 45,053 1,14,845 1,35,453

5 1,35,453 1,59,898 24,382(Bal) 1,35,453

Prof. Sainath, Ph.D, Dept of Nil 11
Management Studies, NHCE
2
Calculations
**Tax savings on Interest
(50%)
90,000X50/100=45,000
77,418X50/100=38,709
62,572X50/100=31,280
45,053X50/100=22,526
24,382X50/100=12,191

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 11
3
Calculations
***
Tax savings on Depreciation
Year Depreciation Tax savings
on
depreciation
(50%)
1 5,00,000x20/100 =1,00,000 50,000
2 4,00,000x20/100 =80,000 40,000
3 3,20,000x20/100 =64,000 32,000
4 2,56,000x20/100 =51,200 25,600
5 2,04,800x20/100 =40,960 20,480

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 11
4
Problem-2
 XYZ Ltd is in the business of manufacturing steel utensils. The firm
is planning to diversity and add a new product line. The firm can
either buy the required machinery or get it on lease.

 The machine can be purchased for Rs 15,00,000 with a useful life

of 5 years and a salvage of Rs 1,00,000 after the expiry of 5 years.
 The purchase can be financed by 13% loan repayable in 5 equal
installments at the end of each year.
 Alternatively the machine can be taken on year end lease rentals of
Rs 4,50,000 for 5 years. Advice the company which option it
should choose. Assume the following:

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 11
5
Problem:2
 1.The machine will constitute a separate block for
depreciation purposes. The company follows WDV
method of depreciation, the rate of depreciation
being 25%.
 2. The tax rate is 35% and the cost of capital is 13%
 3. Lease rents are to be paid at the end of the year.
 4. PVIF at 13% at the end of 1 year is 0.885, 2 nd
year 0.783, 3rd year 0.693, 4th year 0.613 and 5th
year 0.543.
 5. PVIFA for 5 years and 13% is 3.517

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 11
6
Solution:
Lease option
Lease Rent Tax savings Lease rent PVIF Present
on lease rent after tax At 13% Value of
(35%) outflow
4,50,000 1,57,500 2,92,500 0.885 2,58,863
4,50,000 1,57,500 2,92,500 0.783 2,29,027

4,50,000 1,57,500 2,92,500 0.693 2,02,702

4,50,000 1,57,500 2,92,500 0.613 1,79,302

4,50,000 1,57,500 2,92,500 0.543 1,58,827

Prof. Sainath, Ph.D, Dept of
Management Studies, NHCE 11
7
Solution
Buying/loan option
*Loan **Tax ***Tax Total Net cash PVIF PV of out
install savings savings savings outflow At flows
ment on on Dep (4) (1-4) 13%
(1) Interest (35%) 5
(35%) (3)
(2)
4,26,500 68,250 1,31,250 1,99,500 2,27,000 0.885 2,00,895
4,26,500 57,717 98,437 1,56,154 2,70,346 0.783 2,11,680
4,26,500 45,814 73,828 1,19,642 3,06,858 0.693 2,12,653
4,26,500 32,364 55,371 87,735 3,38,765 0.613 2,07,663
4,26,500 17,230 41,528 58,758 3,67,742 0.543 1,99,684
Prof. Sainath, Ph.D, Dept of
Management Studies, NHCE 10,32,575
11
8
Suggestion/advice
I. Total PV of outflows with lease option 10,28,723
II. Total Present value of outflows in 9,78,275
case of buying/loan option

HP option is better as it results in less

outflow of Rs 9,78,275 when compared
to lease option which has a outflow of
10,28,723

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 11
9
Calculations
*Loan installment= Amount of the loan/PVIFA
PVIFA=Present value interest factor of annuity
15,00,000/3.517(Given)=4,26,500

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
0
 Calculations
**
Interest
Year Opening Loan Loan Interest Principal Closing loan
balance installment Component component balance
(1) (2) (3) (13%) (4) (3-4)=5 (2-5)=6
1 15,00,000 4,26,500 1,95,000 2,31,500 12,68,500
2 12,68,500 4,26,500 1,64,905 2,61,595 10,06,905

3 10,06,905 4,26,500 1,30,898 2,95,602 7,11,303

4 7,11,303 4,26,500 92,469 3,34,031 3,77,272

5 3,77,272 4,26,500 49,228(Bal) 3,77,272 Nil

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
1
Calculations
**Tax savings on Interest
(35%)
1,95,000x35/100=68,250
1,64,905x35/100=57,717
1,30,898x35/100=45,814
92,469x35/100=32,364
49,228x35/100=17,230

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
2
Calculations
***
Tax savings on Depreciation
Year Depreciation Tax savings
on
depreciation
(35%)
1 15,00,000x25/100 3,75,000 1,31,250
2 11,25,000x25/100 2,81,250 98,437
3 8,43,750x25/100 2,10,937 73,828
4 6,32,813x25/100 1,58,203 55,371
5 4,74,610x25/100 1,18,652 41,528

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
3
Problem-3
 From the information given below, you are required to advise about
leasing out of the asset or not.(From the lessor point of view)

 The Present Value of Rs 1 at 12% discount factor for 5 years is: .

893, .797, .712, .636,.567

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
4
Calculations
Cash inflows after Tax (CFAT)
Y Lease rent -Depre =Earnings -Tax + Cash flow PVIF PV of
e ciation before tax (50%) Deprecia after tax inflows
ar (EAT) tion (CFAT)

1 1,50,000 80,000 70,000 35,000 80,000 1,15,000 .893 1,02,695

2 1,50,000 80,000 70,000 35,000 80,000 1,15,000 .797 91,655

3 1,50,000 80,000 70,000 35,000 80,000 1,15,000 .712 81,880

4 1,50,000 80,000 70,000 35,000 80,000 1,15,000 .636 73,140

5 1,50,000 80,000 70,000 35,000 80,000 1,15,000 .567 65,205

Total Present value of inflows 4,14,575

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
5
Solution
 Present value of cash inflows=4,14,575(Calculated)
 -Present value of cash outflows=4,00,000 (given)
 =Net Present Value=+14,575
 As the NPV is positive leasing out is advised

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
6
Poblem:4
 XYZ company is analyzing its policy regarding
computers which are being leased on a rent
amounting to Rs 1,00,000 per year. The same
computers can be bought for Rs 5,00,000,
financed by 16% loan repayable in 4 equal
installments.
 It is suggested that the economic life of the
computers should be 4 years and the computers
would be sold for Rs 2,00,000 after 4 years.
The company uses straight line method of
depreciation and the corporate tax is 50%.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
7
Cont
 A.Comment on whether the equipment
should be bought or leased?
 B.Analyze the financial viability from the view

point of the lessor, assuming 14% cost of

capital
 C.Determine the minimum lease rent at which

the lessor would break even.

 D.Determine the lease rent which will yield an

IRR of 16% to the lessor

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
8
 Lease option
Lease Rent Tax savings Lease rent PVIF Present
on lease rent after tax At 16% Value of
(50%) outflow
1,00,000 50,000 50,000 0.8621 43,105
1,00,000 50,000 50,000 0.7432 37,160
1,00,000 50,000 50,000 0.6407 32,035
1,00,000 50,000 50,000 0.5523 27,615

Total present value of Outflows: 1,39,915

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 12
9
 Buying/loan option
*Loan **Tax ***Tax Total Net cash PVIF PV of out
install savings savings savings outflow At 16% flows
ment on on Dep (4) (1-4)
(1) Interest (50%) 5
(50%) (3)
(2)
1,78,699 40,000 37,500 77,500 1,01,199 0.8621 87,244

1,78,699 32,104 37,500 69,604 1,09,095 0.7432 81,079

1,78,699 22,945 37,500 60,445 1,18,254 0.6407 75,765

1,78,699 12,349 37,500 49,849 1,28,850 0.5523 71,164

Less Salvage value at the end of the 4th year : 2,00,000 0.5523 Less
Prof. Sainath, Ph.D, Dept of
1,10,460
Management Studies, NHCE 13
0
 Interest
Yea Opening Loan Interest Principal Closing
r Loan installment Component component loan
balance (3) (16%) (4) (3-4)=5 balance
(1) (2) (2-5)=6
1 5,00,000 *1,78,699 80,000 98,699 4,01,301
2 4,01,301 1,78,699 64,208 1,14,491 2,86,810
3 2,86,810 1,78,699 45,890 1,32,809 1,54,001
4 1,54,001 1,78,699 24,698 1,54,001 Nil
*Loan installment=
Amount of the loan/PVIFA
PVIFA=Present value interest factor of annuity
5,00,000/2.798(Table value for 4 years at Ph.D,
Prof. Sainath, 16%)=1,78,699
Dept of
13
Management Studies, NHCE
1
 Tax savings on Depreciation
Year Depreciation Tax savings on
depreciation
(50%)
1 75,000 37,500
2 75,000 37,500
3 75,000 37,500
4 75,000 37,500
Depreciation Straight line method
5,00,000-2,00,000=3,00,000/4 years=75,000 PA

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 13
2
**Tax savings on Interest 50%

 1 Year:80,000=40,000
 2 Year: 64,208=32,104
 3 Year: 45,890=22,945
 4 Year:24,698=12,349

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 13
3
A. Comment on whether the equipment should be bought or leased?

I. Total PV of outflows with lease option 1,39,915

II. Total Present value of outflows in 2,04,795
case of buying/loan option

Lease option is better as it results in

less outflow of Rs 1,39,915 when
compared to Buying option which has a
outflow of Rs 2,04,795

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 13
4
B.Analyze the financial viability from the view point of the lessor, assuming 14% cost of
capital

Cash inflows after Tax (CFAT)

Ye Lease rent -Depre =Earnings -Tax + Cash flow PVIF at PV of
ar ciation before tax (50%) Deprecia after tax 14% inflows
(EAT) tion (CFAT)

1 1,00,000 75,000 25,000 12,500 75,000 87,500 0.877 76,738

2 1,00,000 75,000 25,000 12,500 75,000 87,500 0.769 67,288

3 1,00,000 75,000 25,000 12,500 75,000 87,500 0.675 59,062

4 1,00,000 75,000 25,000 12,500 75,000 87,500 0.592 51,800

Add Salvage value at the end of the 4th year : 2,00,000 0.592 +1,18,400

Total Present value of inflows 3,73,288

Less outflows 5,00,000

NPV Prof. Sainath, Ph.D, Dept of -1,26,712

Management Studies, NHCE 13
5
D.Determine the lease rent which will yield an IRR of 16% to the lessor

Cost of the computers 5,00,000

-PV of salvage at 16% -1,10,400
2,00,000x0.552
Net cost to be recovered =3,89,600
PVIFA at 16% at the end of 4th year 2.798
CFAT Desired 3,89,600/2.798=1,39,242
Less depreciation 75,000
EAT =64,242
Add Taxes +64,242
EBT =1,28,484
+ Depreciation =75,000
=Rentals which yield IRR of 16% Prof. Sainath, Ph.D, Dept of 2,03,484 13
Management Studies, NHCE
6
C.Determine the minimum lease rent at which the lessor would break
even.

Cost of the computers 5,00,000

-PV of salvage at 14% -1,18,400
2,00,000x0.592
Net cost to be recovered =3,81,600
PVIFA at 14% at the end of 4th year 2.914
CFAT Desired 381,600/2.914=1.30,954
Less depreciation 75,000
EAT =55,954
Add Taxes 55,954
EBT 1,11,908
+ Depreciation 75,000
=Rentals desired to Break even Prof. Sainath, Ph.D, Dept of 1,86,908 13
Management Studies, NHCE
7
Bill Discounting

 Discounting a bill means that the Bank buys

the bill (i.e. Bill of Exchange or Promissory
Note) before it is due and credits the value of
the bill after a discount charge to the
customer's account.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 13
8
Bill Discounting
 The transaction is practically an advance against
the security of the bill and the discount represents
the interest on the advance from the date of
purchase of the bill until it is due for payment.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 13
9
Bill Discounting-Cont
 Under certain circumstances, the Bank may
discount a bill of exchange instead of
negotiating them.
 The amount the Bank advances depends on

the customers past record and reputation of

the drawee.
 

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 14
0
conditions to be fulfilled to discount a bill:

 A bill must be a usance bill

 It must have been accepted and bear at least

two good signatures (eg. of reputable

individuals, companies or banks etc.)
 The Bank will normally only discount trade

bills
 Where a usance bill is drawn at a fixed period

after sight, the bill must be accepted to

establish the maturity.

Prof. Sainath, Ph.D, Dept of

Management Studies, NHCE 14
1