Types of Financing – CA Inter FM Study Material

Types of Financing – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.

Types of Financing – CA Inter FM Study Material

Theory Questions

Question 1.
What is debt securitization? Explain the basic debt securitization process. (4 Marks May 2011)
Answer:
Debt Securitisation:
It is a process of conversion of existing loans of financial institutions into securities. Existing car loans, credit card etc. are transferred to special purpose vehicle (SVP), who convert these loans into securities and sold these securities to pension fund, provident fund etc. It is a process of recycling of funds. It supports to financial intermediaries to support the lending volumes.

Assets generating steady cash flows are packaged together and against this asset pool, market securities can be issued, e.g. housing finance, auto loans, and credit card receivables. These assets are generally secured by personal or real property such as automobiles, real estate, or equipment loans but in some cases are unsecured.

Process of Debt Securitisation
1. The origination function. First a borrower apply for a loan with a finance company, bank, HDFC. The creditworthiness of borrower is evaluated and contract is entered into with repayment schedule structured over the life of the loan.

2. The pooling function: An underlying pool of assets is created by clubbing of similar loans on receivables together. The pool is transferred in favour of Special purpose Vehicle (SPV), which acts as a trustee for investors.

3. The securitisation function: SPV creates structure and issue securities against asset pool. The securities carry a coupon and expected maturity which can be asset based mortgage based. These are generally sold to investors through merchant bankers. Investors are: pension funds, mutual funds, insurance funds.

Question 2.
Distinguish between Operating lease and financial lease. (4 Marks Nov. 2011, Nov. 2014, May 2016)
Answer:
Difference between Operating lease and Financial lease

Sl. No.	Operating Lease	Financial Lease
1	The lessee is only provided the use of the asset for a certain time. Risk incident to ownership belongs only to the lessor.	The risk and reward incident to ownership are passed on the lessee. The lessor only remains the legal owner of the asset.
2	The lessor bears the risk of obsoles­cence.	The lessee bears the risk of obsoles­cence.
3	The lease is kept cancellable by the lessor.	The lease is non-cancellable by either party under it.
4	Usually, the lessor bears the cost of repairs, maintenance or operations.	The lessor does not bear the cost of repairs, maintenance or operations.
5	The lease is usually non-payout.	The lease is usually full payout

Question 3.
Explain Bridge finance. (2 Marks Nov. 2011, Nov. 2016)
Answer:
Under bridge finance bank provides short term loan to a company (which has pre-approved term loan) to fulfil requirements of funds upto date of sanction of term loan. Flowever, once the loans are approved in principle, firms in order not to lose further time in starting their projects arrange for bridge finance.

Such temporary loan is normally repaid out of the proceeds of the principal term loans. It is secured by hypothecation of movable assets, personal guarantees and demand promissory notes. Generally rate of interest on bridge finance is higher as compared with that on term loans.

Question 4.
What is venture capital financing? Discuss factors that a venture capitalist should consider before financing any risky project. (4 Marks May 2012, May 2013)
Answer:
Venture capital financing:Fmancing of new high risky startups by talented and qualified entrepreneurs who lack experience and funds to shape their ideas into a successful business. In broad sense, under venture capital financing, venture capitalist make investment to purchase equity or debt securities from inexperienced entrepreneurs who undertake highly risky ventures with potential to succeed in future.

Factors to be considered by a venture capitalist before financing any risky project are:

1. Management team should be efficient. They are required to show a high level of commitment to the project.
2. Technical team should be able to develop and produce a new product or service.
3. Technical feasibility of the new product or service should be considered.
4. Venture capitalists should be ensured that the prospects for future profits compensate for the risk.
5. Venture capitalists should be ensured that there is a market for the new product. A research must be carried out to ensure.
6. The venture capitalist himself should have the capacity to bear risk or loss, if the project fails.
7. There should be exit routes for venture capitalist.
8. Venture capitalist should have a place on the Board of Directors.

Question 5.
Write short note on Deep Discount Bonds. (2 Marks May 2012)
Answer:
Deep Discount Bonds (DDBs) are in the form of zero interest bonds. These bonds are sold at a discounted value and on maturity face value is paid to the investors. In such bonds, there is no interest payout during lock-in period. IDBI was first to issue a Deep Discount Bonds (DDBs) in India in January 1992. The bond of a face value of ₹ 1 lakh was sold for ₹ 2,700 with a maturity period of 25 years.

Question 6.
“Financing a business through borrowing is cheaper than using equity.” Briefly explain. (4 Marks Nov. 2012)
Answer:
Debt capital is cheaper than equity capital from the point of its cost and interest being deductible for income tax purpose, whereas no such deduction is allowed for dividends. Issue of new equity dilutes existing control pattern while borrowing does not result in dilution of control. In a period of rising prices, borrowing is advantageous. The fixed monetary outgo decreases in real terms as the price level increases.

Question 7.
What is debt securitization? And also state its advantages. (4 Marks May 2013, Nov. 2016)
Answer
Debt Securitisation:
It is a process of conversion of existing loans of financial institutions into securities. Existing car loans, credit card etc. are transferred to special purpose vehicle (SVP), who convert these loans into securities and sold these securities to pension fund, provident fund etc. It is a process of recycling of funds. It supports to financial intermediaries to support the lending volumes.

Assets generating steady cash flows are packaged together and against this asset pool, market securities can be issued, e.g. housing finance, auto loans, and credit card receivables. These assets are generally secured by personal or real property such as automobiles, real estate, or equipment loans but in some cases are unsecured.

Advantages:
The asset is shifted off the Balance Sheet, thus giving the originator recourse to off balance sheet funding. It facilitates better balance sheet management; assets are transferred off balance sheet facilitating satisfaction of capital adequacy norms. It converts illiquid assets to liquid portfolio.

The originator’s credit rating enhances. These funds also help the company disburse further loans. Similarly, the process is beneficial to the investors also as it creates a liquid investment in a diversified pool of assets, which may be an attractive option to other fixed income instruments.

Question 8.
State the main elements of leveraged lease. (2 Marks Nov. 2013, May 2016)
Answer:
Under this lease, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party ie., lender. The asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor is entitled to claim depreciation allowance.

Question 9.
State the main features of Global Depository Receipts (GDRs) and American Depository Receipts (ADRs). (4 Marks May 2014, May 2017)
Answer:
Global Depository Receipts (GDRs):
When a company wants to issue its shares in foreign country then it can be done by issuing GDR. One unit of GDR represents a certain number of a company’s regular shares. Company who wants to issue its shares has to deposits its original shares with custodian bank of foreign country and against these deposited shares GDR will be issued.

American Depository Receipts (ADRs):
If any non-US company wants to sell its securities on New York Stock Exchange then it can be done by issuing ADR. One unit of ADR represents a certain number of a company’s regular shares. Non-US Company has to deposits its original shares with custodian bank of US and against these deposited shares ADR will be issued.

The Indian companies have preferred the GDRs to ADRs because the US market exposes them to a higher level or responsibility than a European listing in the areas of disclosure, costs, liabilities and timing.

Question 10.
Name any four financial instruments, which are related to international financial market. (2 Marks May 2014)
Answer:
Some of the various financial instruments dealt with in the international market are Euro Bonds, Foreign Bonds, Fully Hedged Bonds, Medium Term Notes, Floating Rate Notes, External Commercial Borrowings, Foreign Currency Futures, Foreign Currency Option, Euro Commercial Papers.

Question 11.
State the different types of Packing credit. (4 Marks Nov, 2014)
Answer:
Types of Packing Credit:

1. Clean packing credit: Under this type of credit exporter gets credit by just showing confirm export order or letter of credit. There is no charge or control of bank over raw material or finished goods.
2. Packing credit against hypothecation of goods: Under this type of credit goods are hypothecated.
3. Packing credit against pledge of goods: Under this type of credit the possession of the goods lies with the bank.

Question 12.
Explain ‘Sales and Lease Back’. (4 Marks May 2015)
Answer:
Sale and Lease Back: Legal owner of asset sells asset to second party after this transfer second party leases back it to first party. Under this arrangement, the asset is not physically exchanged but it all happen in records only. The main advantage of this method is that the lessee can satisfy himself completely regarding the quality of an asset and after possession of the asset convert the sale into a lease agreement.

Under this transaction, the seller assumes the role of lessee (as the same asset which he has sold came back to him in the form of lease) and the buyer assumes the role of a lessor (as asset purchased by him was leased back to the seller). So, the seller gets the agreed selling price and the buyer gets the lease rentals.

Question 13.
What is meant by venture capital financing? State its various methods. (4 Marks Nov. 2015, Nov, 2020)
Answer:
Venture capital financing:Financing of new high risky startups by talented and qualified entrepreneurs who lack experience and funds to shape their ideas into a successful business. In broad sense, under venture capital financing, venture capitalist make investment to purchase equity or debt securities from inexperienced entrepreneurs who undertake highly risky ventures with potential to succeed in future.

Methods of Venture Capital Financing:

1. Equity Financing:Financial institute purchase equity of business but not more than 49% of the total equity capital of venture capital undertakings.
2. Conditional Loan: In case of conditional loan 2-15 per cent royalty is payable instead of interest.
3. Income Note: It is a combination of normal loan and conditional loan.
4. Participating Debenture: During first phase no interest is charged, during second phase a low rate of interest is charged and in last phase a high rate of interest is charged.

Question 14.
Distinguish between the Preference Shares and Debentures. (2 Marks Nov. 2015)
Answer:
Difference between Preference Shares and Debentures

Sl. No.	Preference Shares	Debentures
1	Preference Share Capital is a special kind of share, preference shareholders are the partial owners of the company.	Debenture holders are creditors of the company.
2	Preference shareholders receive fixed payment of dividend.	Debenture holders receive fixed payment of interest.
3	Preference shares are a hybrid form of financing with some characteristic of equity shares and some attributes of debt capital.	Debentures are instrument for raising long term capital with a fixed period of maturity, it is pure debt fund.
4	Preference shares are the source of long term financial requirements.	Debentures are the sources of short to medium term finance.
5	Preference shares are unsecured or not backed up by any collateral.	Debentures are issued by creating a charge on the company’s assets, hence secured.

Question 15.
Explain Operating Lease. (2 Marks Nov. 2017)
Answer:
Operating Lease:
An operating lease is a form of lease in which the right to use the asset is given by the lessor to the lessee. However, the ownership right of the asset remains with the lessor. The lessee gives a fixed amount of periodic lease rentals to the lessor for using the asset.

Further, the lessor also bears the insurance, maintenance and repair costs etc. of the asset. In operating lease, the lease period is short. So, the lessor may not be able to recover the cost of the asset during the initial lease period and tend to lease the asset to more than one lessee. Normally, these are callable lease and are cancellable with proper notice.

The term of this type of lease is shorter than the asset’s economic life. The lessee is obliged to make payment until the lease expiration, which approaches useful life of the asset.

An operating lease is particularly attractive to companies that continually update or replace equipment and want to use equipment without ownership, but also want to return equipment at lease end and avoid technological obsolescence.

Question 16.
What are Masala Bonds? (2 Marks May 2018)
Answer:
Masala (means spice) bond is an Indian name used for Rupee denominated bond that Indian corporate borrowers can sell to investors in overseas markets. These bonds are issued outside India but denominated in Indian Rupees. NTPC raised ₹ 2,000 crores via masala bonds for its capital expenditure in the year 2016.

Question 17.
Explain in brief following financial instruments:
(1) Euro Bonds
(2) Floating Rate Notes
(3) Euro Commercial Paper
(4) Fully Hedged Bond (4 Marks Nov. 2018)
Answer:
(1) Euro Bonds:
Euro bonds are debt instruments which are not denominated in the currency of the country in which they are issued e.g. a Yen note floated in Germany. Such bonds are generally issued in a bearer form rather than as registered bonds and in such cases they do not contain the investor’s names or the country of their origin. These bonds are an attractive proposition to investors seeking privacy.

(2) Floating Rate Notes (FRN):
These are issued up to seven years maturity. Interest rates are adjusted to reflect the prevailing exchange rates. They provide cheaper money than foreign loans.

(3) Euro Commercial Papers (ECP):
ECPs are short term money market instruments. They have maturity period of less than one year. They are usually designated in US Dollars.

(4) Fully Hedged Bonds:
As mentioned above, in foreign bonds, the risk of currency fluctuations exists. Fully hedged bonds eliminate the risk by selling in forward markets the entire stream of principal and interest payments.

Question 18.
Explain in brief the following bonds: (2 Marks Jan. 2021)

1. Callable Bonds
2. Puttable Bonds

Answer:

1. Callable bonds: A callable bond has a call option which gives the issuer the right to redeem the bond before maturity at a predetermined price known as the call price (Generally at a premium).
2. Puttable bonds: Puttable bonds give the investor a put option (ie. the right to sell the bond) back to the company before maturity.