Module 3

Merchant Banking

The word „merchant banking‟ was originated among the Dutch and Scottish traders. Later on it
was developed and professionalised in the UK and the USA. Now this has become popular
throughout the world.

Meaning and Definition of Merchant Banking

Merchant banking is non-banking financial activity. But it resembles banking function. It is a

financial service. It includes the entire range of financial services.

The term merchant banking is used differently in different countries. So there is no universal
definition for merchant banking. We can define merchant banking as a process of transferring
capital from those who own it to those who use it. According to Random House Dictionary,
“merchant bank is an organization that underwriters securities for corporations, advices such
clients on mergers and is involved in the ownership of commercial ventures. These organizations
are sometimes banks which are not merchants and sometimes merchants who are not bankers and
sometimes houses which neither merchants nor banks”. According to SEBI (Merchant Bankers)
Rules 1992, “A merchant banker has been defined as any person who is engaged in the business
of issue management either by making arrangements regarding selling, buying or subscribing to
securities or acting as manager, consultant advisor or rendering corporate advisory services in
relation to such issue management”. In short, “merchant bank refers to an organization that
underwrites securities and advises such clients on issues like corporate mergers, involving in the
ownership of commercial ventures”.

Thus merchant banking involves a wide range of activities such as management of customer
services, portfolio management, credit syndication, acceptance credit, counseling, insurance,
preparation of feasibility reports etc. It is not necessary for a merchant banker to carry out all the
above mentioned activities. A merchant banker may specialise in one activity, and take up other
activities, which may be complementary or supportive to the specialized activity.

In short, merchant banking involves servicing any financial need of the client.

Difference between Merchant Bank and Commercial Bank

Merchant banks are different from commercial banks. The following are the important
differences between merchant banks and commercial banks:

1. Commercial banks basically deal in debt and debt related finance. Their activities are clustered
around credit proposals, credit appraisal and loan sanctions. On the other hand, the area of
activity of merchant bankers is equity and equity related finance. They deal with mainly funds
raised through money market and capital market.
2. Commercial banks‟ lending decisions are based on detailed credit analysis of loan proposals
and the value of security offered. They generally avoid risks. They are asset oriented. But
merchant bankers are management oriented. They are willing to accept risks of business.

3. Commercial banks are merely financiers. They do not undertake project counseling, corporate
counseling, managing public issues, underwriting public issues, advising on portfolio
management etc. The main activity of merchant bankers is to render financial services for their
clients. They undertake project counseling, corporate counseling in areas of capital restructuring,
mergers, takeovers etc., discounting and rediscounting of short-term paper in money markets,
managing and underwriting public issues in new issue market and acting as brokers and advisors
on portfolio management.

Functions (Services) of Merchant Bankers (Scope of Merchant Banking)

Merchant banks have been playing an important role in procuring the funds for capital market for
the corporate sector for financing their operations. They perform some valuable functions. The
functions of merchant banks in India are as follows:

1. Corporate counseling: One of the important functions of a merchant banker is corporate

counseling. Corporate counseling refers to a set of activities undertaken to ensure efficient
functioning of a corporate enterprise through effective financial management. A merchant banker
guides the client on aspects of organizational goals, vocational factors, organization size, choice
of product, demand forecasting, cost analysis, allocation of resources, investment decisions,
capital and expenditure management, marketing strategy, pricing methods etc. The following
activities are included in corporate counseling:

(a) Providing guidance in areas of diversification based on the Government‟s economic and
licensing policies.
(b) Undertaking appraisal of product lines, analyzing their growth and profitability and
forecasting future trends.
(c) Rejuvenating old-line companies and ailing sick units by appraising their technology and
process, assessing their requirements and restructuring their capital base.
(d) Assessment of the revival prospects and planning for rehabilitation through modernization
and diversification and revamping of the financial and organizational structure.
(e) Arranging for the approval of the financial institutions/banks for schemes of rehabilitation
involving financial relief, etc.
(f) Monitoring of rehabilitation schemes.
(g) Exploring possibilities for takeover of sick units and providing assistance in making
consequential arrangements and negotiations with financial institutions/banks and other
interests/authorities involved.
2. Project counseling: Project counseling relates to project finance. This involves the study of
the project, offering advisory services on the viability and procedural steps for its
implementation. Project counseling involves the following activities:

(a) Undertaking the general review of the project ideas/project profile.

(b) Providing advice on procedural aspects of project implementation.
(c) Conducting review of technical feasibility of the project on the basis of the report prepared by
own experts or by outside consultants.
(d) Assisting in the preparation of project report from a financial angle, and advising and acting
on various procedural steps including obtaining government consents for implementation of the
project.
(e) Assisting in obtaining approvals/licenses/permissions/grants, etc from government agencies
in the form of letter of intent, industrial license, DGTD registration, and government approval for
foreign collaboration.
(f) Identification of potential investment avenues.
(g) Arranging and negotiating foreign collaborations, amalgamations, mergers, and takeovers.
(h) Undertaking financial study of the project and preparation of viability reports to advice on the
framework of institutional guidelines and laws governing corporate finance.
(i) Providing assistance in the preparation of project profiles and feasibility studies based on
preliminary project ideas, covering the technical, financial and economic aspects of the project
from the point of view of their acceptance by financial institutions and banks.
(j) Advising and assisting clients in preparing applications for financial assistance to various
national financial institutions, state level institutions, banks, etc.
3. Pre-investment studies: Another function of a merchant banker is to guide the entrepreneurs
in conducting pre-investment studies. It involves detailed feasibility study to evaluate investment
avenues to enable to decide whether to invest or not. The important activities involved in pre
investment studies are as follows:

(a) Carrying out an in-depth investigation of environment and regulatory factors, location of raw
material supplies, demand projections and financial requirements in order to assess the financial
and economic viability of a given project.
(b) Helping the client in identifying and short-listing those projects which are built upon the
client‟s inherent strength with a view to promote corporate profitability and growth in the long
run.
(c) Offering a package of services, including advice on the extent of participation, government
regulatory factors and an environmental scan of certain industries in India.
4. Loan syndication: A merchant banker may help to get term loans from banks and financial
institutions for projects. Such loans may be obtained from a single financial institution or a
syndicate or consortium. Merchant bankers help corporate clients to raise syndicated loans from
commercial banks. The following activities are undertaken by merchant bankers under loan
syndication:
(a) Estimating the total cost of the project to be undertaken.
(b) Drawing up a financing plan for the total project cost which conforms to the requirements of
the promoters and their collaborators, financial institutions and banks, government agencies and
underwriters.
(c) Preparing loan application for financial assistance from term lenders/financial
institutions/banks, and monitoring their progress, including pre-sanction negotiations.
(d) Selecting institutions and banks for participation in financing.
(e) Follow-up of term loan application with the financial institutions and banks, and obtaining
the approval for their respective share of participation.
(f) Arranging bridge finance.
(g) Assisting in completion of formalities for drawing of term finance sanctioned by institutions
by expediting legal documentation formalities, drawing up agreements etc. as prescribed by the
participating financial institutions and banks.
(h) Assessing working capital requirements.
5. Issue management: Issue management involves marketing or corporate securities by offering
them to the public. The corporate securities include equity shares, preference shares, bonds,
debentures etc. Merchant bankers act as financial intermediaries. They transfer capital from those
who own it to those who need it. The security issue function may be broadly classified into two –
pre-issue management and post-issue management. The pre-issue management involves the
following functions:

(a) Public issue through prospectus.

(b) Marketing and underwriting.
(c) Pricing of issues.
These may be briefly discussed as follows:

(a) Public issue through prospectus: To being out a public issue, merchant bankers have to
coordinate the activities relating to issue with different government and public bodies,
professionals and private agencies. First the prospectus should be drafter. The copies of consent
of experts, legal advisor, attorney, solicitor, bankers, and bankers to the issue, brokers and
underwriters are to be obtained from the company making the issue. These copies are to be filed
along with the prospectus to the Registrar Companies. After the prospectus is ready, it has to be
sent to the SEBI for clearance. It is only after clearance by SEBI, the prospectus can be filed with
the Registrar. The brokers to the issue, principal agent and bankers to issue are appointed by
merchant bankers.

(b) Marketing and underwriting: After sending prospectus to SEBI, the merchant bankers
arrange a meeting with company representatives and advertising agents to finalise arrangements
relating to date of opening and closing of issue, registration of prospectus, launching publicity
campaigns and fixing date of board meeting to approve and pass the necessary resolutions. The
role of merchant banker in publicity campaigns to help selecting the media, determining the size
and publications in which the advertisement should appear. The merchant bank shall decide the
number of copies to be printed, check accuracy of statements made and ensure that the size of the
application form and prospectus are as per stock exchange regulations. The merchant banker has
to ensure that he material is delivered to the stock exchange at least 21 days before the issue
opens and to the brokers to the issue, and underwriters in time.

(c) Pricing of issues: Pricing of issues is done by companies themselves in consultation with the
merchant bankers. An existing listed company and a new company set up by an existing
company with 5 year track record and existing private closely held company and existing
unlisted company going in for public issues for the first time with 2 ½ years track record of
constant profitability can freely price the issue. The premium can be determined after taking into
consideration net asset value, profit earning capacity and market price. The price and premium
has to be stated in the prospectus.

Post-issue management consists of collection of application forms and statement of amount

received from bankers, screening applications, deciding allotment procedures, mailing of
allotment letters, share certificates and refund orders. Merchant bankers help the company by
coordinating the above activities.

6. Underwriting of public issue: In underwriting of public issue the activities performed by

merchant bankers are as follows:

(a) Selection of institutional and broker underwriters for syndicating/ underwriting arrangements.
(b) Obtaining the approval of institutional underwriters and stock exchanges for publication of
the prospectus.
(c) Co-ordination with the underwriters, brokers and bankers to the issue, and the Stock
Exchanges.
7. Portfolio management: Merchant bankers provide portfolio management service to their
clients. Today every investor is interested in safety, liquidity and profitability of his investment.
But investors cannot study and choose the appropriate securities. Merchant bankers help the
investors in this regard. They study the monetary and fiscal policies of the government. They
study the financial statements of companies in which the investments have to be made by
investors. They also keep a close watch on the price movements in the stock market.

The merchant bankers render the following services in connection with portfolio management:

(a) Undertaking investment in securities.

(b) Collection of return on investment and re-investment of the same in profitable avenues,
investment advisory services to the investors and other related services.
(c) Providing advice on selection of investments.
(d) Carrying out a critical evaluation of investment portfolio.
(e) Securing approval from RBI for the purchase/sale of securities (for NRI clients).
(f) Collecting and remitting interest and dividend on investment.
(g) Providing tax counseling and filing tax returns through tax consultants.
8. Merger and acquisition: A merger is a combination of two or more companies into a single
company where one survives and others lose their corporate existence. A take over refers to the
purchase by one company acquiring controlling interest in the share capital of another existing
company. Merchant bankers are the middlemen in setting negotiation between the offeree and
offeror. Being a professional expert they are apt to safeguard the interest of the shareholders in
both the companies. Once the merger partner is proposed, the merchant banker appraises
merger/takeover proposal with respect to financial viability and technical feasibility. He
negotiates purchase consideration and mode of payment. He gets approval from the
government/RBI, drafts scheme of amalgamation and obtains approval from financial
institutions.

9. Foreign currency financing: The finance provided to fund foreign trade transactions is called
„Foreign Currency Finance‟. The provision of foreign currency finance takes the form of export
import trade finance, euro currency loans, Indian joint ventures abroad and foreign
collaborations. The main areas that are covered in this type of merchant activity are as follows:

(a) Providing assistance for carrying out the study of turnkey and construction contract projects.
(b) Arranging for the syndication of various types of guarantees, letters of credit, pre-shipment
credit, deferred post-shipment credit, bridge loans, and other credit facilities.
(c) Providing assistance in opening and operating bank accounts abroad. (d) Arranging foreign
currency loans under buyer‟s credit scheme for importing goods.
(e) Arranging deferred payment guarantees under suppliers credit scheme for importing capital
goods.
(f) Providing assistance in obtaining export credit facilities from the EXIM bank for export of
capital goods, and arranging for the necessary government approvals and clearance.
(g) Undertaking negotiations for deferred payment, export finance, buyers credits, documentary
credits, and other foreign exchange services like packing credit, etc.
10. Working capital finance: The finance required for meeting the day-to-day expenses of an
enterprise is known as „Working Capital Finance‟. Merchant bankers undertake the following
activities as part of providing this type of finance:

(a) Assessment of working capital requirements.

(b) Preparing the necessary application to negotiations for the sanction of appropriate credit
facilities.
11. Acceptance credit and bill discounting: Merchant banks accept and discount bills of
exchange on behalf of clients. Merchant bankers give loans to business enterprises on the
security of bill of exchange. For this purpose, merchant bankers collect credit information
relating to the clients and undertake rating their creditworthiness.

12. Venture financing: Another function of a merchant banker is to provide venture finance to
projects. It refers to provision of equity finance for funding high-risk and high-reward projects.
13. Lease financing: Leasing is another function of merchant bankers. It refers to providing
financial facilities to companies that undertake leasing. Leasing involves letting out assets on
lease for a particular period for use by the lessee. The following services are provided by
merchant bankers in connection with lease finance:

(a) Providing advice on the viability of leasing as an alternative source for financing capital
investment projects.
(b) Providing advice on the choice of a favourable rental structure.
(c) Providing assistance in establishing lines of lease for acquiring capital equipment, including
preparation of proposals, documentations, etc.
14. Relief to sick industries: Merchant bankers render valuable services as a part of providing
relief to sick industries.

15. Project appraisal: Project appraisal refers to evaluation of projects from various angles such
as technology, input, location, production, marketing etc. It involves financial appraisal,
marketing appraisal, technical appraisal, economic appraisal etc. Merchant bankers render
valuable services in the above areas.

Role of Merchant Bankers in Managing Public Issue

In issue management, the main role of merchant bankers is to help the company issuing
securities in raising funds for the purpose of financing new projects, expansion/ modernization/
diversification of existing units and augmenting long term resources for working capital
requirements.

The most important aspect of merchant banking business is to function as lead managers to the
issue management. The role of the merchant banker as an issue manager can be studied from the
following points:

1. Easy fund raising: An issue manager acts as an indispensable pilot facilitating a public/ rights
issue. This is made possible with the help of special skills possessed by him to execute the
management of issues.

2. Financial consultant: An issue manager essentially acts as a financial architect, by providing

advice relating to capital structuring, capital gearing and financial planning for the company.

3. Underwriting: An issue manager allows for underwriting the issues of securities made by
corporate enterprises. This ensures due subscription of the issue.

4. Due diligence: The issue manager has to comply with SEBI guidelines. The merchant banker
will carry out activities with due diligence and furnish a Due Diligence Certificate to SEBI. The
detailed diligence guidelines that are prescribed by the Association of Merchant Bankers of India
(AMBI) have to be strictly observed. SEBI has also prescribed a code of conduct for merchant
bankers.
5. Co-ordination: The issue manger is required to co-ordinate with a large number of
institutions and agencies while managing an issue in order to make it successful.

6. Liaison with SEBI: The issue manager, as a part of merchant banking activities, should
register with SEBI. While managing issues, constant interaction with the SEBI is required by
way of filing of offer documents, etc. In addition, they should file a number of reports relating to
the issues being managed.

Merchant Banking in India

Prior to the enactment of Indian Companies Act, 1956, managing agents acted as merchant
bankers. They acted as issue houses for securities, evaluated project reports, provided venture
capital for new firms etc. Few share broking firms also functioned as merchant bankers.

With the rapid growth in the number and size of the issues made in the primary market, the need
for specialized merchant banking service was felt. Grindlays Bank (foreign bank) opened its
merchant banking division in 1967, followed by Citibank in 1970. SBI started its merchant
banking division in 1972 and it followed up by setting up a fully owned subsidiary in 1980,
namely SBI Capital Markets Ltd. The other nationalized banks and financial institutions, like
IDBI, IFCI, ICICI, Securities and Finance Company Ltd., Canara Bank (Can Bank Financial
Services Ltd.), Bank of India (BOI Finance Ltd.) and private sector financial companies, like JM
Financial and Investment Consultancy Services Ltd., DSP Financial Consultancy Ltd. have also
set up their merchant banking divisions.

With over 1,100 merchant bankers operating in the country, the primary market activity is
picking up. Merchant banking services have assumed greater importance in the present capital
market scenario. With the investor becoming more cautious and discerning, the role of merchant
banker has gained more prominence.

In India, apart from the overall control by the RBI, merchant bankers‟ operations are closely
supervised by the SEBI for their proper functioning and investor protection.

Setting up and management of merchant banks in India

In India a common organizational set up of merchant bankers to operate is in the form of

divisions of Indian and Foreign banks and financial institutions, subsidiary companies
established by bankers like SBI, Canara Bank, Punjab National Bank, Bank of India, etc. some
firms are also organized by financial and technical consultants and professionals. Securities and
exchanges Board of India (SEBI) has divided the merchant bankers into four categories based on
their capital adequacy. Each category is authorized to perform certain functions. From the point
of Organizational set up India‟s merchant banking organizations can be categorized into 4 groups
on the basis of their linkage with parent activity. They are:
a) Institutional Base:

Merchant banks function as an independent wing or as subsidiary of various Private/ Central

Governments/ State Governments Financial institutions. Most of the financial institutions in
India are in public sector and therefore such set up plays a role on the lines of governmental
priorities and policies.

b) Banker Base:

These merchant bankers function as division/ subsidiary of banking organization. The parent
banks are either nationalized commercial banks or the foreign banks operating in India. These
organizations have brought professionalism in merchant banking sector and they help their
parent organization to make a presence in capital market.

c) Broker Base:

In the recent past there has been an inflow of Qualified and professionally skilled brokers in
various Stock Exchanges of India. These brokers undertake merchant banking related operating
also like providing investment and portfolio management services.

d) Private Base:

These merchant banking firms are originated in private sectors. These organizations are the
outcome of opportunities and scope in merchant banking business and they are providing skill
oriented specialized services to their clients. Some foreign merchant bankers are also entering
either independently or through some collaboration with their Indian counterparts. Private
Sectors merchant banking firms have come up either as sole proprietorship, partnership, private
limited or public limited companies. Many of these firms were in existence for quite some time
before they added a new activity in the form of merchant banking services by opening new
division on the lines of commercial banks and All India Financial Institution (AIFI).

Categories of Merchant Banks

Merchant bankers are classified into four categories according to the SEBI (Merchant Banking)
Regulations 1992. These are as follows:

(a) Category – I: To carry on any activity relating to issue management and act as adviser,
consultant manager, underwriter and portfolio manager for capital issues.

(b) Category – II: To act as adviser, consultant, co-manager, underwriter and portfolio manager
for capital issues.

(c) Category – III: To act as underwriter, adviser, and consultant to an issue.

(d) Category – IV: To act only as adviser or consultant to an issue.

Weakness of merchant banks / Problems of merchant banks

1. SEBI guidelines have authorised merchant bankers to undertake issue related activities only
with an exception of portfolio management. It restricts the scope of merchant bank activities.

2. SEBI guidelines stipulate a minimum net worth of Rs.1 crore for authorisation of merchant
bankers. Small but professional merchant bankers are facing difficulty for adhering such net
worth norms.

3. Non cooperation of the issuing companies in timely allotment of securities and refund
application money is another problem of merchant bankers.

4. Unhealthy competition among large number of merchant banks compels them to reduce their
profit margin, commission etc.

5. There is no exact regulatory framework for regulating and controlling the working of
merchant banks in India.

6. Fraudulent and fake issue of share capital by the companies are also posing problems for
merchant banks who act as lead manager or issue manager of such issues.

Credit Rating

Meaning and Definition

Credit rating is a financial service. Credit rating simply means rating of the credit worthiness of a
company by an independent agency. It is an assessment of the capacity of an issuer of debt
security, by an independent agency, to pay interest and repay the principal as per the terms of
issue of debt. A rating agency collects the qualitative as well as quantitative data relating to a
company (which has to be rated) and assesses the relative strength and capacity of company to
honour its obligations contained in the debt instrument. Credit rating is an opinion expressed by
an independent professional organisation after making a detailed study of all relevant factors.
Such an opinion will be of great help to investors in making investment decisions.

According to Moody‟s Investor Service, „Ratings are designed exclusively for the purpose of
grading bonds according to their investment qualities‟.

According to CRISIL, “Credit rating is an unbiased and independent opinion as to issuer‟s

capacity to meet its financial obligations. It does not constitute a recommendation to buy/ sell or
hold a particular security”.

Features of Credit Rating

The characteristic features of credit rating are as follows:

1. Credit rating is specific to a debt instrument and not for a company as whole. It is a process of
grading and analysis of the credit risk associated with that particular instrument.
2. The rating is based on the relative capacity and willingness of the issuer of the instrument to
service debt obligations (principal and interest), in accordance with the terms of the contract.
3. It is only guidance to the investors and not a recommendation to buy or sell a security.
4. The ratings are expressed in code number (symbols). These are easily understandable by
investors.
5. The rating process is based on information supplied by the issuer (of debt security) and also
the information collected from various other sources, including personal interactions with
various institutions.
6. It is an ongoing appraisal of a security i.e. for the entire life of the security.

Functions of Credit Rating Agencies

1. Providing an unbiased opinion regarding the capability of a company to service debt

obligation.
2. Providing quality information on credit risk.
3. Providing information to investors at a lower cost.
4. Providing true information to investors for taking correct investment decisions.
5. Inducing a healthy discipline on corporate borrowers.
Credit Rating Agencies in India

Some companies may have a good record, goodwill and reputation in the past, but their current
state of affairs may not be that bright. Investors in such circumstances felt the need for an
independent and credible agency which could judge the debt obligation of different companies
and assist investors in making decisions. This need paved the way for the birth of Credit Rating
Agencies in India. Presently, there are five leading Credit Rating Agencies (CRAs) approved by
the RBI – CRISIL, ICRA, CARE, Fitch Ratings India Private Ltd. and Brickwork Ratings India
Private Ltd. These are the five CR agencies registered with SEBI.

We discuss here the three important credit rating agencies in India.

I. Credit Rating Information Services of India Ltd. (CRISIL)

CRISIL is the first credit rating agency in India. It is a public limited company established in
1987 in the private sector. It is promoted jointly by ICICI and UTI. It started its operations on 1st
January 1988. Its objectives is to accord credit rating to public limited companies which desire to
float share capital, debentures, public deposits or commercial paper to raise finance from the
public.

II. Investment Information of Credit Rating Agency of India Ltd. (ICRA)

It is promoted by IFCI Ltd. It started operations in 1991. It offers credit rating services for rating
debentures or bonds, preference shares, medium term debts, including certificates of deposits as
well as short term instruments including commercial paper. It has entered into an area called
Earning Prospects and Risk Analysis. ICRA also provides credit assessment and general
assessment.

The primary objective of ICRA is to provide information and guidance to investors/creditors for
determining the credit risk associated with a debt instrument/credit obligation. ICRA Limited is
a Public Limited Company, with its shares listed on the Bombay Stock Exchange and the
national Stock Exchange. Today, ICRA and its subsidiaries together form the ICRA Group of
Companies (Group ICRA).

III. Credit Analysis and Research Ltd. (CARE)

It is promoted by the IDBI. It began its operations from October 1993. It offers a wide range of
services. Credit rating is conducted for debentures, fixed deposits, commercial papers etc.

CARE ratings are recognised by the Government of India and regulatory agencies in India. It is
registered with the Securities and Exchange Board of India (SEBI). The ratings are also
recognised by RBI, NABARD, NHB and NSIC. The three largest shareholders of CARE are
IDBI Bank, Canara Bank and State Bank of India. CARE s a full service rating company
offering a wide range of rating and grading services. These includes rating debt
instruments/enterprise ratings of corporates, banks, Financial Institutions (FIs), Public Sector
Undertakings (PSUs), state government bodies, municipal corporations, NBFCs, SMEs,
microfinance institutions, Structured finance and Securitisation transactions.

The other important credit rating agencies in India are:

a. Duff Phelps Credit Rating India Private Ltd. (DCR)

b. Onida Individual Credit Rating Agency Ltd. (ONICRA)
c. Fitch Rating India Pvt. Ltd., d. Brick Work Rating India Pvt. Ltd
Credit Rating Methods and Mode of Working of Credit Rating Agencies

Generally the following methodology is adopted for conducting credit rating analysis:

(a) Business analysis: In this analysis, industry risk, market share, overall efficiency and legal
aspects are all taken into consideration. In case of industry risk, the factors considered and
analysed are existing and future demand, number of competitors, expected level of competition
in the future cyclical as well as seasonal factors, etc. In the market share analysis, the existing
market share of the organization, expected changes in the market share in future, SWOT
(strengths, weaknesses, opportunities and threats) analysis of the product of the company, etc.,
are taken into consideration.
(b) Financial analysis: In this area, the overall accounting system, auditor‟s certificates, taxation
provisions, inventory valuation, depreciation policies, etc., are taken into consideration.
Similarly, existing and projected future profitability, cash inflows, ability of the company to
repay debt, obligations, cost structure are some of the areas which are analysed.

(c) Managerial evaluation: It another important area where the capabilities of management
team are analysed by applying various parameters. This analysis probes into the track record of
management, planning and control systems, depth of management talent, succession plans, goals,
philosophy and strategies.

Advantages (Importance) of Credit Rating

Credit rating offers advantages to investors, issuers, and to credit rating agencies.

A. Advantages to Investors

1. Low cost information: Credit rating provides relevant and reliable information to investors at
low cost.
2. Quick investment decision: Credit rating enables investors to take quick investment decision
on the basis of ratings.
3. Systematic risk evaluation: Rating helps the investors to undertake a detailed risk evaluation.
It helps the investors to arrive at a meaningful and consistent conclusion regarding the relative
credit quality of the security.
4. Independent investment decision: The rating symbols suggest the creditworthiness of the
instrument and indicate the degree of risk involved in the instrument. Hence the investors can
make direct investment decisions. They need not depend upon the advice of financial
intermediaries.
5. Protection: the creditable and objective rating agency can provide increased disclosure, better
accounting standard and improved investor protection.

B. Advantages to Issuers (Rated Companies)

1. Index of faith: Credit rating acts as an ideal index of faith placed by the market in the issuers.
2. Wider investor base: Rating increases the investor base. This enables the rated companies to
raise any amount required at lower cost without difficulty.
3. Warns risks: Credit rating acts as a guide to companies scoring lower rating. This enables the
management to take steps on their operating and marketing risks. This will change the perception
against the companies in the market.
4. Encourages financial discipline: Rating encourages discipline among corporate borrowers to
improve their financial structure and performance to get better rating.
5. Foreign collaboration: The foreign collaborators always ask for credit rating while
negotiating with an Indian company. Credit rating enables the foreign collaborators to identify
the relative credit standing of the company. Thus the foreign collaboration is made easy.
6. Benefits the industry as a whole: Relatively small and unknown companies use ratings to
instill confidence in investors. High rate companies get large amount of moneyat a lower cost.
Thus the industry as a whole can benefit from ratings.

C. Advantages to Intermediaries

1. Easy job: Merchant bankers and brokers will be relived of the responsibility of guiding
investors as to the risk of a particular investment. Their job is just to bring to the attention of
their clients the rating of debt securities.
2. Effective monitoring: The stock exchange intermediaries can use ratings as an input for
monitoring their risk exposure. Merchant bankers also use credit ratings for pre-packaging issues
through asset securitisation/structured obligations.

Limitations of Credit Rating

Credit rating has certain drawbacks. The drawbacks or shortcomings of credit rating are as
follows:

1. Only guidance: Rating provides only a guidance to investors in determining the level of risk
associated with the debt instrument. It does not recommended the investors/creditors to buy/sell
or hold securities.
2. Based on assumptions: Generally the rating is done on the basis of assumptions. In most of
the cases, the rating is done on the basis of the information supplied by the issuer themselves.
Hence there is a suspicion about the ratings.
3. Competitive ratings: Wherever a firm believes that it is not possible for it to obtain a
favourable rating grade; it may try for a much favourable rating. This is possible especially due
to competition between a relatively large number of players in the credit rating business.
4. Static study: Rating is a static study of present and past data of a company. A number of
factors have direct impact on the working of a company. This may lead to changes in the rating.
5. Difference in rating grades: Same instrument may be rated differently by the two rating
agencies. This may confuse the investors.
6. Inefficient staff: If the staffs of credit rating agency are inexperienced or less skilled, then the
rating may not be perfect.
Mutual Funds

Mutual funds represent one of the most important institutional forces in the market. They are
institutional investors. They play a major role in today‟s financial market. The first mutual fund
was established in Boston in 1924 (USA).

Meaning of Mutual Funds

Small investors generally do not have adequate time, knowledge, experience and resources for
directly entering the capital market. Hence they depend on an intermediary. This financial
intermediary is called mutual fund.

Mutual funds are corporations that accept money from savers and then use these funds to buy
stocks, long term funds or short term debt instruments issued by firms or governments. These are
financial intermediaries that collect the savings of investors and invest them in a large and well
diversified portfolio of securities such as money market instruments, corporate and government
bonds and equity shares of joint stock companies. They invest the funds collected from investors
in a wide variety of securities i.e. through diversification. In this way it reduces risk.

Mutual fund works on the principle of “small drops of water make a big ocean”. It is a form of
collective investment. To get the surplus funds from investors, it adopts a simple technique. Each
fund is divided into a small share called „units‟ of equal value. Each investor is allocated units in
promotion to the size of his investment.

Mutual fund is a trust that pools the savings of investors. The money collected is then invested in
financial market instruments such as shares, debentures and other securities. The income earned
through these investments and the capital appreciations realized are shared by its unit holders in
proportion to the number of units owned by them. Thus mutual fund invests in a variety of
securities (called diversification). This reduces risk. Diversification reduces the risk because all
stock and/ or debt instruments may not move in the same direction.

According to the Mutual Fund Fact Book (published by the Investment Company Institute of
USA), “a mutual fund is a financial service organization that receives money from shareholders,
invests it, earns return on it, attempts to make it grow and agrees to pay the shareholder cash
demand for the current value of his investment”.

SEBI (mutual funds) Regulations, 1993 defines a mutual fund as „a fund established in the form
of a trust by a sponsor, to raise monies by the trustees through the sale of units to the public,
under one or more schemes, for investing in securities in accordance with these regulations.
In short, a mutual fund collects the savings from small investors, invests them in government and
other corporate securities and earns income through interest and dividends, besides capital gains.

Features of Mutual Funds

Mutual fund possesses the following features:

1. Mutual fund mobilizes funds from small as well as large investors by selling units.
2. Mutual fund provides an ideal opportunity to small investors an ideal avenue for investment.
3. Mutual fund enables the investors to enjoy the benefit of professional and expert management
of their funds.
4. Mutual fund invests the savings collected in a wide portfolio of securities in order to maximize
return and minimize risk for the benefit of investors.
5. Mutual fund provides switching facilities to investors who can switch from one scheme to
another.
6. Various schemes offered by mutual funds provide tax benefits to the investors.
7. In India mutual funds are regulated by agencies like SEBI.
8. The cost of purchase and sale of mutual fund units is low.
9. Mutual funds contribute to the economic development of a country.
Types of Mutual Funds (Classification of Mutual Funds)

Mutual funds (or mutual fund schemes) can be classified into many types.

A. On the basis of Operation

1. Close ended funds: Under this type of fund, the size of the fund and its duration are fixed in
advance. Once the subscription reaches the predetermined level, the entry of investors will be
closed. After the expiry of the fixed period, the entire corpus is disinvested and the proceeds are
distributed to the unit holders in proportion to their holding.

Features of Close ended Funds

(a) The period and the target amount of the fund is fixed beforehand.
(b) Once the period is over and/ or the target is reached, the subscription will be closed (i.e.
investors cannot purchase any more units).
(c) The main objective is capital appreciation.
(d) At the time of redemption, the entire investment is liquidated and the proceeds are liquidated
and the proceeds are distributed among the unit holders.
(e) Units are listed and traded in stock exchanges.
(f) Generally the prices of units are quoted at a discount of up to 40% below their net asset value.
2. Open-ended funds: This is the just reverse of close-ended funds. Under this scheme the size
of the fund and / or the period of the fund is not fixed in advance. The investors are free to buy
and sell any number of units at any point of time.

Features of Open-ended Funds

(a) The investors are free to buy and sell units. There is no time limit.
(b) These are not trade in stock exchanges.
(c) Units can be sold at any time.
(d) The main motive income generation (dividend etc.)
(e) The prices are linked to the net asset value because units are not listed on the stock exchange.

Difference between Open-ended and Close-ended Schemes

1. The close-ended schemes are open to the public for a limited period, but the open-ended
schemes are always open to be subscribed all the time.
2. Close-ended schemes will have a definite period of life. But he open-ended schemes are
transacted in the company.
3. Close-ended schemes are transacted at stock exchanges, where as open-ended schemes are
transacted (bought and sold) in the company.
4. Close-ended schemes are terminated at the end of the specified period. Open-ended schemes
can be terminated only if the total number of units outstanding after repurchase fall below 50%
of the original number of units.
B. On the basis of return/ income

1. Income fund: This scheme aims at generating regular and periodical income to the members.
Such funds are offered in two forms. The first scheme earns a target constant income at relatively
low risk. The second scheme offers the maximum possible income.
Features of Income Funds

(a) The investors get a regular income at periodic intervals.

(b) The main objective is to declare dividend and not capital appreciation.
(c) The pattern of investment is oriented towards high and fixed income yielding securities like
bonds, debentures etc.
(d) It is best suited to the old and retired people.
(e) It focuses on short run gains only.

2. Growth fund: Growth fund offers the advantage of capital appreciation. It means growth fund
concentrates mainly on long run gains. It does not offers regular income. In short, growth funds
aim at capital appreciation in the long run. Hence they have been described as “Nest Eggs”
investments or long haul investments.

Features of Growth Funds

(a) It meets the investors‟ need for capital appreciation.

(b) Funds are invested in equities with high growth potentials in order to get capital appreciation.
(c) It tries to get capital appreciation by taking much risk.
(d) It may declare dividend. But the main objective is capital appreciation.
(e) This is best suited to salaried and business people.

3. Conservative fund: This aims at providing a reasonable rate of return, protecting the value of
the investment and getting capital appreciation. Hence the investment is made in growth oriented
securities that are capable of appreciating in the long run.

C. On the basis of Investment

1. Equity fund: it mainly consists of equity based investments. It carried a high degree of risk.
Such funds do well in periods of favourable capital market trends.

2. Bond fund: It mainly consists of fixed income securities like bonds, debentures etc. It
concentrates mostly on income rather than capital gains. It carries lower risk. It offers secure and
steady income. But there is no chance of capital appreciation.

3. Balanced fund: It has a mix of debt and equity in the portfolio of investments. It aims at
distributing regular income as well as capital appreciation. This is achieved by balancing the
investments between the high growth equity shares and also the fixed income earning securities.

4. Fund of fund scheme: In this case funds of one mutual fund are invested in the units of other
mutual funds.

5. Taxation fund: This is basically a growth oriented fund. It offers tax rebates to the investors.
It is suitable to salaried people.

6. Leverage fund: In this case the funds are invested from the amounts mobilized from small
investors as well as money borrowed from capital market. Thus it gives the benefit of leverage to
the mutual fund investors. The main aim is to increase the size of the value of portfolio. This
occurs when the gains from the borrowed funds are more than the cost of the borrowed funds.
The gains are distributed to unit holders.

7. Index bonds: These are linked to a specific index of share prices. This means that the funds
mobilized under such schemes are invested principally in the securities of companies whose
securities are included in the index concerned and in the same proportion. The value of these
index linked funds will automatically go up whenever the market index goes up and vice versa.

8. Money market mutual funds: These funds are basically open ended mutual funds. They have
all the features of open ended mutual funds. But the investment is made is highly liquid and safe
securities like commercial paper, certificates of deposits, treasury bills etc. These are money
market instruments.

9. Off shore mutual funds: The sources of investments for these funds are from abroad.

10. Guilt funds: This is a type of mutual fund in which the funds are invested in guilt edged
securities like government securities. It means funds are not invested in corporate securities like
shares, bonds etc.

Objectives of Mutual Funds

1. To mobilise savings of people.

2. To offer a convenient way for the small investors to enter the capital and the money market.
3. To tap domestic savings and channelize them for profitable investment.
4. To enable the investors to share the prosperity of the capital market.
5. To act as agents for growth and stability of the capital market.
6. To attract investments from the risk aversers.
7. To facilitate the orderly development of the capital market.

Advantages (Importance) of Mutual Funds

Mutual funds are growing all over the world. They are growing because of their importance to
investors and their contributions in the economy of a country. The following are the advantages
of mutual funds:

1. Mobilise small savings: Mutual funds mobilize small savings from the investors by offering
various schemes. These schemes meet the varied requirements of the people. The savings of the
people are channelized for the development of the economy. In the absence of mutual funds,
these savings would have remained idle.

2. Diversified investment: Small investors cannot afford to purchase the shares of the highly
established companies because of high market price. The mutual funds provide this opportunity
to small investors. Even a very small investor can afford to invest in mutual funds. The investors
can enjoy the wide portfolio of the investments held by the fund. It diversified its risks by
investing in a variety of securities (equity shares, bonds etc.) The small and medium investors
cannot do this.
3. Provide better returns: Mutual funds can pool funds from a large number of investors. In
this way huge funds can be mobilized. Because of the huge funds, the mutual funds are in a
position to buy securities at cheaper rates and sell securities at higher prices. This is not possible
for individual investors. In short, mutual funds are able to give good and regular returns to their
investors.

4. Better liquidity: At any time the units can be sold and converted into cash. Whenever
investors require cash, they can avail loans facilities from the sponsoring banks against the unit
certificates.

5. Low transaction costs: The cost of purchase and sale of mutual fund units is relatively less.
The brokerage fee or trading commission etc. are lower. This is due to the large volume of
money being handled by mutual funds in the capital market.

6. Reduce risk: There is only a minimum risk attached to the principal amount and return for the
investments made in mutual funds. This is due to expert supervision, diversification and liquidity
of units.

7. Professional management: Mutual funds are managed by professionals. They are well
trained. They have adequate experience in the field of investment. Thus investors get quality
services from the mutual funds. An individual investor would never get such a service from the
securities market.

8. Offer tax benefits: Mutual funds offer tax benefits to investors. For instance, under section 80
L of the Income Tax Act, a sum of Rs. 10,000 received as dividend from a mutual fund (in case
of UTI, it is Rs. 13,000) is deductible from the gross total income.

9. Support capital market: The savings of the people are directed towards investments in
capital markets through mutual funds. They also provide a valuable liquidity to the capital
market. In this way, the mutual funds make the capital market active and stable.

10. Promote industrial development: The economic development of any nation depends upon
its industrial advancement and agricultural development. Industrial units raise funds from capital
markets through the issue of shares and debentures. Mutual funds supply large funds to capital
markets. Besides, they create demand for capital market instruments (share, debentures etc.).
Thus mutual funds provide finance to industries and thereby contributing towards the economic
development of a country.

11. Keep the money market active: An individual investor cannot have any access to money
market instruments. Mutual funds invest money on the money market instruments. In this way,
they keep the money market active.

Mutual Fund Risks

In spite of the advantages offered by mutual funds, there are some risks also. This is so because
mutual funds invest their funds in the stock market on shares. These shares are subject to risks.
Hence, the following risks are inherent in the dealings of mutual funds:

1. Market risks: These risks are unavoidable. These arise due to fluctuations in share prices.

2. Investment risks: Generally mutual funds make investments on the advice sought from Asset
Management Company. If the advice goes wrong, the fund has to suffer a loss.

3. Business risk: Mutual funds invest mostly in equity shares of companies. If the business of
the companies suffers any set back, they cannot declare dividend. Ultimately, such companies
may be wound up. As a result, mutual funds will suffer.

4. Political risk: Change in government policies brings uncertainty in the economy. Every
player including mutual funds has to face this risk and uncertainty.

5. Scheme risks: There are certain risks in the schemes themselves. Risks are greater in certain
schemes, e.g., growth schemes.

Operation of Mutual Funds

A mutual fund invites the prospective investors to participate in the fund by offering various
schemes. It offers different schemes to suit the varied requirements of the investors. The small
and medium resources from the investors are pooled together. Then the pool of fund is divided
into a large number of equal shares called units. These are issued to investors. The amount so
collected is invested in capital market instruments like shares, debentures, government bonds etc.
Investment is also made in money market instruments like treasury bills, commercial papers etc.
Usually the money is invested in diversified securities so as to minimize the risk and maximize
return. The income earned on these securities (after meeting the fund expenses) is distributed to
unit holders (investors) in the form of interest as well as capital appreciation. The return on the
units depends upon the nature of the mutual fund schemes.

Mutual Funds in India

In India the first mutual fund was UTI. It was set up in 1964 under an Act of parliament. During
the year 1987-1992, seven new mutual funds were established in the public sector. In 1993, the
government changed its policy to allow the entry of private corporates and foreign institutional
investors into the mutual fund segment. Now the commercial banks like the SBI, Canara Bank,
Indian bank, Bank of India, Punjab National Bank etc. have entered into the field. LIC and GIC
have also entered into the market. By the end of March 2000, there was 36 mutual funds, 9 in the
public sector and 27 in the private sector. However UTI dominated the mutual fund sector. In
India mutual funds are being regulated by agencies like SEBI. Mutual funds play an important
role in promoting saving and investment within the country. There are around 196 mutual fund
schemes, and the amount of assets under their management was Rs. 47,000 crores in 1993, Rs.
80,590 crores in 2003 and it went up to Rs. 2, 17,707crores by 31.3.2006. Thus mutual funds are
growing in India. However, their growth rate is very slow.

Reasons for Slow Growth of Mutual Funds in India

1. There is no standard formula for calculating Net Asset Value. Different companies apply
different formulae. Thus there is no uniformity in the calculation of NAV.

2. Mutual funds in India are not providing adequate information and materials to the investors.
There is not good rapport between mutual funds and investors. In short, there is no transparency
in the dealings of mutual funds.

3. Mutual funds are rendering poor services to investors. Hence mutual funds fail to build up
investor confidence.

4. In India, most of the funds depend upon outside agencies for collecting data and conducting
research.

5. In India, professional experts in security analysis and portfolio management are rare.

6. Investors do not know that units are low-risk long term investment. They do not have the
patience to wait for long time to get good returns. They always want return in the short run.
Hence units are not much popular in India.