Detailed, Step-by-Step NCERT Solutions for 11 Business Studies Chapter 8 Sources of Business Finance Questions and Answers were solved by Expert Teachers as per NCERT (CBSE) Book guidelines covering each topic in chapter to ensure complete preparation.
Sources of Business Finance NCERT Solutions for Class 11 Business Studies Chapter 8
Sources of Business Finance Questions and Answers Class 11 Business Studies Chapter 8
Tick (✓) the correct answer out of the given alternatives :
Equity shareholders are called :
(a) Owners of the company
(b) Partners of the company
(c) Executives of the Company
(d) Guardian of the company
(a) Owners of the company
The terin ‘redeemable’ is used for :
(a) Preference Shares
(b) Commercial Paper
(c) Equity Shares
(d) Public Deposits
(a) Preference Shares
Funds required for purchasing current assets is an example of:
(a) Fixed capital requirement
(b) Ploughing back of profits
(c) Working capital requirement
(d) Lease financing
(c) Working capital requirement
ADR’s are issued in:
Public deposits are the deposits that are raised directly from:
(a) The Public
(b) The Directors
(c) The Auditors
(d) The Owners
(a) The Public
Under the lease agreement, the lessee gets to right to:
(a) Share profits earned by the lessor
(b) Participate in the management of the organization
(c) Use the assist for a specified period
(d) Sell the assets
(c) Use the assist for a specified period
(a) Fixed capital of the company
(b) Permanent capital of company
(c) Fluctuating capital of the company
(d) Loan capital of the company.
(d) Loan capital of the company.
Under the factoring arrangement, the factor:
(a) Produces and distributes the goods or services
(b) Makes the payment on behalf of the client
(c) Collects the client’s debt or account receivables
(d) Transfer the goods from one place to another.
(b) Makes the payment on behalf of the client
The maturity period of a commercial paper usually ranges from:
(a) 20 to 40 days
(b) 60 to 90 days
(c) 120 to 365 days
(d) 90 to 364 days
(d) 90 to 364 days
Internal sources of capital are those that are:
(a) generated through outsiders such as suppliers.
(b) generated through loans from commercial banks.
(c) generated through issue of shares.
(d) generated within the business.
(d) generated within the business.
Short Answer Questions
What is business finance? Why do businesses need funds? Explain.
Business is an economic activity directed towards producing, acquiring wealth through buying and selling of goods. It is a very wide term. Finance is the lifeblood of the business. Funds are required to commence and carry on business. All business activities such as planning, organizing, managing, controlling, purchasing, selling, directing, marketing, etc cannot take place without finance.
Thus, we can say the requirements of funds by a business to carry out its various activities is called business finance. When an entrepreneur takes a decision to start a business the need for funds arises in order to meet the expenses of the establishment of the business, finance is required for purchasing fixed and current assets, for day-to-day operations, purchase of raw material, to pay salaries, etc. Smooth functioning, expansion, and growth of the business are possible when it has sufficient funds.
List sources of raising long-term, and short-term finance.
Types of Business Finance – On the basis-of nature and purpose served finance used in business is of the following types:
(i) Long-term finance
(ii) Medium-term finance.
(iii) Short-term finance.
Types of Business Finance
(i) Long-term Finance – Long-term finance is used for meeting the permanent needs of business. It is required for investment in fixed assets like, building, plant and machinery and for financing expansion programmes. Long-term funds are raised for a long period, say, more than five years. They are generally invested in fixed assets.
The sources of long-term financing are :
- financial institutions and
- retained earnings.
The amount of long-term finance required depends bn the type of business and the fixed assets required. For instance, a big steel, Cement or chemicals factory involves heavy investment on building, machinery and equipments.
A small factory producing garments or a small workship repairing electrical goods will require a small investment in fixed assets. Traders generally require lesser amounts for long-term investment as compared with the requirements of manufactures.
(ii) Medium-term finance – It is required for upgrading of technology, introduction of a new product, investment in working capital and for repayment of debts. It is raised for a period ranging from more than one year to less than five years. It is needed for modernization and expansion.
The sources of medium-term financing include :
- financial institutions
- public deposits and
- commercial banks.
The need for medium-term funds arises because of changing technology, introduction of a new product or necessity to invest on advertisement and sales promotion. The extra income generated out of his investment is used to pay back the medium-term capital. Medium-term finance is raised from debenture holders, financial institutions and banks.
(iii) Short-term Finance – it is required for meeting the short term needs of working capital. Its period is one year or less than one year and it can be raised from the following sources:
- public deposits
- trade credits
- commercial banks
- customer advance.
Short-term funds are required for purchase of raw materials, payment of wages and salaries and meeting other day-to-day expenses. They are raised through short-term loans or trade credits. As soon as goods are sold and funds are recovered, the amounts may be used for current operations or for paying back the loans.Generally, production processes are completed within a year and goods are ready for sale. Hence, short term funds can be used over and over again from year to year.
What is the difference between internal and external sources of raising funds? Explain.
Sources of Company Finance – A business firm can raise funds from two main sources:
(a) owned funds (internal sources)
(b) borrowed funds (external sources)
Owned funds refer to the funds provided by the owners. Insole proprietorship, the proprietor himself provides the owned fund from his personal property. In a partnership firm, the funds contributed by partners as capital are called owned funds. In a joint-stock company, funds raised through the issue of shares and reinvestment of earnings are the owned funds.
Borrowed funds are raised by way of issue of debentures. Raising loans from financial institutions, public deposits and commercial banks. Thus, the various sources of finance may be divided as follows :
Sources of Finance
Difference between owner’s fund and borrowed fund (internal and external source of raising loans):
(i) Owner’s funds are contributed by the owners and the reinvestment of profits in the business. It is a source of permanent capital of the business while borrowed funds are a source of temporary capital to the business.
(ii) Internal source of capital attaches risk to the business while borrowed funds have to be paid back regularly depending upon the time period of the loan, as long term, medium-term or short term.
(iii) owners have control over the management of the business regarding the follow on to the policies laid down, while the lenders do not have any right of control over management of the business.
(iv) Owners are entitled for dividends in case of sufficient profits while interest on borrowed capital is to be paid at regular intervals.
What preferential rights are enjoyed by preference shareholders? Explain.
The following preferential rights are enjoyed by preference shareholders
- Receiving a fixed rate of dividend, out of the net profits of the company, before the dividend is declared for equity shareholders.
- Preference over equity shareholders in receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation.
- In case of dissolution of the company, preference share capital is refunded prior to the refund of equity share capital.
Name any three special financial institutions and state their objectives.
The government has established a number of financial institutions all over the country to provide finance to business organizations. These institutions are established by the Central or State, Governments. They provide both owned capital and borrowed capital : for long and medium-term requirements and supplement the traditional financial agencies like commercial banks.
In addition to providing financial assistance, these institutions also conduct market surveys and provide technical assistance and managerial services to people who run the enterprises. This source of financing is considered suitable when large funds for longer duration are required for expansion, reorganization and modernization of an enterprise.
Major Special Financial Institutions and their Objectives :
(1) Industrial Finance Corporation of India (IFCI) – It was established in July 1948 as a statutory corporation under the Industrial Finance Corporation Act 1948. Its objectives include assistance towards balanced regional development and encouraging new entrepreneurs to enter into the priority sectors of the economy. It has also contributed to the development of management education in the country.
(2) State Financial Corporations (SFC) – The State Financial Corporations Act 1951 empowered the State Government to establish State Financial Corporations in their respective regions for providing medium and short-term finance to industries which are outside the scope of the IFCI.
(3) Industrial Credit and Investment Corporation of India (ICICI) – This was established in 1955 as a public limited company under the Companies Act. ICICI assists the creation, expansion and modemalization of industrial enterprises exclusively in the private sector. The corporation has also encouraged the participation of foreign capital in the country.
(4) Industrial Development Bank of India (IDBI) – This was established in 1964 under the Industrial Development Bank of India Act 1964 with an objective to coordinate the activities of other financial institutions including commercial banks. It performs the different types of functions such as assistance to other financial institutions, direct assistance to industrial concerns and promotion of financial technical services.
What is the difference between GDR and ADR? Explain.
Global Depository Receipts (GDR):
The depository receipts denominated in US dollars issued by depository bank to which the ” local currency shares of a company are delivered. GDR is a negotiable instrument and can be traded freely like any other security. In the Indian context, a GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange.
American Depository Receipts (ADR):
The depository receipts issued b a company in the USA are known as American Depository Receipts ADRs are bought and sold in American markets like regular stocks. ADR is similar to a GDR except that it can be issued only to American citizens and can be listed and traded on a stock exchange of the USA.
Long Answer Questions
Explain trade credit and bank credit as sources of short¬term finance for business enterprises.
Short-term funds are required for trading purposes like purchase of raw materials, payment of wages and salaries and meeting other day-to-day expenses. They are raised through short-term loans or trade credits. As soon as goods are sold and funds are recovered, the amounts may be used for current operations or for paying back the loans.
Often all, production cycle is completed within a year and goods are sold during that period, the short-term funds can be used over and over again from year to year.
Bank credit for short-term needs of working capital reign on the business. Its period is 12 months or less than 12 months and it can be raised by the sources of public deposits, trade credits, commercial banks and customer advances. It is used for meeting the short-term needs of the business.
It is known as working capital requirements. Working capital is the capital required for meeting the day-to-day needs of the business i.e. purchase of materials and payment of wages, salaries, rent, taxes, freight charges etc. The firm can carry on its business smoothly and without any interruptions with the help of short¬term loans and finances.
Short-term financing is most common for financing of current assets such as accounts receivables and inventories. Seasonal businesses that must build inventories in anticipation of selling requirements often need – short-term financing for the interim period between seasons. Wholesalers and manufactures with a major portion of their assets tied up in inventories or receivable also require large amount of funds for a short period.
Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion.
Financial institutions established by the central as well as State Governments all over the country to provide finance to business organizations are considered the most suitable source of financing when large funds for longer duration are required for expansion, reorganization, and modernization of an enterprise.
This institution provides both owned capital and loan capital for long and medium-term requirements and supplements the traditional financial agencies like commercial banks. In addition to providing financial assistance, these institutions also conduct market surveys and provide technical assistance and managerial services to people who run the enterprises.
The various Special Financial Institutions in India are as under:
1. Industrial Finance Corporation of India (IFCI):
It was established in July 1948 as a statutory corporation under the Industrial Finance Corporation Act, 1948. Its objectives Include assistance towards balanced regional development and encouraging new entrepreneurs to enter into the priority sectors of the economy. IFCI has also contributed to the development of management education in the country.
2. State Financial Corporations (SFC):
The State Financial Corporations Act, 1951 empowered the State Governments to establish State Financial Corporations in their respective regions for providing medium and short-term finance to industries which are outside the scope of the IFCI. Its scope is wider than IFCI since the former covers not only public limited companies but also private limited companies, partnership firms, and proprietary concerns.
3. Industrial Credit and Investment Corporation of India (ICICI):
This was established in 1955 as a public limited company under the Companies Act. ICICI assists the creation, expansion, and modernization of industrial enterprises exclusively in the private sector. The corporation has also encouraged the participation of foreign capital in the country.
4. Industrial Development Bank of India (IDBI):
It was established in 1964 under the Industrial Development Bank of India Act, 1964 with an objective to coordinate the activities of other financial institutions including commercial banks. The bank performs three types of functions, namely, assistance to other financial institutions, direct assistance to industrial concerns, and promotion and coordination of financial-technical services.
5. State Industrial Development Corporations (SIDC):
Many state governments have set up State Industrial Development Corporations for the purpose of promoting industrial development in their respective states. The objectives of the SIDCs differ from one state to another.
6. Unit Trust of India (UTI):
It was established by the Government of India in 1964 under the Unit Trust of India Act, 1963. The basic objective of UTI is to mobilize the community’s savings and channelize them into productive ventures. For this purpose, it sanctions direct assistance to industrial concerns, invests in their shares and debentures, and participates with other financial institutions.
7. Industrial Investment Bank of India Ltd:
It was initially set up as a primary agency for the rehabilitation of sick units and was known as the Industrial Reconstruction Corporation of India. It was reconstituted and renamed as the Industrial Reconstruction Bank of India in 1985 and again in 1997, its name was changed to Industrial Investment Bank of India. The Bank assists sick units in the reorganization of their share capital, improvement in the management system, and provision of finance at liberal terms.
8. Life Insurance Corporation of India (LIC):
LIC was set up in 1956 under the LIC Act, 1956 after nationalizing 245 existing insurance companies. It mobilises the community’s savings in the form of insurance premia and makes it available to industrial concerns, both public as well as private, in the form of direct loans and underwriting of and subscription to shares and debentures.
What advantages does issue of debentures provide over the issue of equity shares?
Debentures are an important instrument for raising long-term debt capital. The debenture issued by the company is an acknowledgment that the company has borrowed a certain amount of money.
Merits of Debentures: Debentures are an important source of raising long-term finance. The main advantages of debentures are as follows:
(1) Appeal to Cautious Investors – Large amount of finance can be raised by issue of debentures from cautious and orthodox investors who prefer safety of investment and a fixed return at lesser risk. In tight money conditions, debentures are the best source of finance. Debentures are liked by the investors who give weightage to safety of principal and a continuous income on their money.
(2) Regular Return – Debentureholders are paid interest at a fixed rate and at periodical intervals, irrespective of profits. Therefore, debenture holders are free from risk of fluctuations in the company’s earnings. A continuous return in the shape of interest on debentures attract the investor for regular return on their principal amount.
(3) Safety of Investment – Debentures are usually secured by a charge on the company’s assets. Therefore, their repayment is assured.
(4) Economical Source – A company can raise funds through debentures at a relatively low cost. This is because investors consider debentures a safe investment. Debentures can be sold more easily than shares. Underwriting commission, brokerage and other expenses of issue are lesser.
(5) Freedom of Management – Debentures do not carry voting rights. Therefore, a company can raise funds without diluting or weakening the control of the existing members. The management retains its independence as there is no interference from debenture holders.
(6) Trading on Equity – Interest on debentures is paid at a fixed rate. After payment of interest, the remaining profits are available to shareholders. When the earnings of the company increase, the rate of dividend on equity shares can be increased. This is known as trading on equity! Debenture offer an opportunity to the company to trade on equity and thereby increase the return of equity shareholders.
(7) Flexibility – A company can repay the funds raised through debentures when it does not require the funds any more. The facility of redemption avoids the danger of over capitalisation and keeps the financial structure flexible. Funds are available for a fairly long period and can be repaid out of earnings. Debentures provide financial flexibility as they can be redeemed when the company has surplus funds.
(8) Tax Relief – Interest paid on debentures is allowed a deduction while calculating taxable income. It results in saving in income tax liability. Thus, the company enjoys tax benefit by issuing debentures.
Popularity of Debentures – Despite their limitations, issue of debentures as a method of raising long-term finance has gained popularity these days. The response of the investors has been encouraging because of the following factors:
(i) Debentures with more attractive terms, particularly having a convertible clause have been issued. The conversion of debentures into equity shares encourages the investors to invest in debentures.
(ii) Statutory restrictions on the institutional investors like Life Insurance Corporation and Unit Trust of India have been relaxed. They can have more debentures in their investment portfolio.
(iii) Debentures are issued by the flourishing companies also to have the benefit of trading on equity. This has changed the attitude of banks and other institutions towards the companies having issued the debentures. Formerly, the companies having issued debentures were considered to be less credit-worthy concerns.
(iv) Companies prefer to issue debentures because of low cost of financing through debentures. Less formalities have to be observed while issuing debentures. Moreover, the interest paid on debentures is allowed as a deductible expenditure against the profit of the company.
(v) Companies can raise funds through debentures considering it as safe investment. Debentures can be sold more easily than shares. The facility of redemption of debentures avoids the danger of overcapitalization and keeps the financial position of the company strong and stable.
State the merits and demerits of public deposits and retained earnings as methods of business finance.
The deposits that are raised by organizations directly from the public are known as public deposits. Rates of interest offered on public deoosits are usually higher than those offered on bank deposits. Any person who is interested in depositing money in an organization can do so by filling up a prescribed form.
The organization in return issues a deposit receipt as an acknowledgment of the debt. Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organisation.
While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from banks. Companies generally invite public deposits for a period upto three years. The acceptance of public deposits is regu¬lated by the Reserve Bank of India.
Merits: The merits of public deposits are,
- The procedure of obtaining deposits is simple and does not contain restrictive conditions as are generally there in a loan agreement.
- Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions.
- Public deposits do not usually create any charge on the assets of the company. The assets can be used as security for raising loans from other sources.
- As the depositors do not have voting rights, the control of the company is not diluted.
Limitations: The major limitation of public deposits are as follows.
- New companies generally find it difficult to raise funds through public deposits;
- It is an unreliable source of finance as the public may not respond when the company needs money;
- Collection of public deposits may prove difficult, particularly when the size of deposits required is large.
A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings maybe retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or selffinancing or ‘ploughing back of profits’. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation.
Merits: The merits of retained earning as a source of finance are as follows.
- Retained earnings is a permanent source of funds available to an organisation.
- It does not involve any explicit cost in the form of interest, dividend or floatation cost.
- As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
- It enhances the capacity of the business to absorb unexpected losses.
- It may lead to increase in the market price of the equity shares of a company.
Limitations: Retained earning as a source of funds has the following limitations.
- Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends;
- It is an uncertain source of funds as the profits of business are fluctuating;
- The opportunity cost associated with these funds is not recognized by many firms. This may lead to sub-optimal use of the funds.
Discuss the financial instruments used in international financing.
With globalization and liberalization of the economy, Indian companies, have started generating funds from international markets. The international sources from where the funds can be procured include foreign currency loans from commercial bank, financial assistance provided by international agencies and development banks and issue of financial instruments like GDRs and ADRs in capital markets. The prominent sources of international finance may be discussed as follows.
International Sources of Finance:
Euro Issue – The euro issue is an international source of finance for Indian companies. Under such an issue, securities are issued in some foreign currency and are offered for sale internationally.
That means private and corporate investors in different countries can purchase securities put for sale under a Euro issue by an Indian company. An Euro issue is different from a foreign issue under which securities are denominated in Rupee (i.e., the currency of the country of issue) and are aimed at the investors in the country where the issue is made.
The term “Euro market/issue” is not confined to the European countries only, rather it has got an international character now. The two major instruments which are floated in the Euro-capital markets are bonds and equity shares.
As a part of the globalisation of the Indian economy after 1991, the Government of India allowed Indian companies to float their securities in the Euro markets to raise funds in foreign currencies. Over the years, several Indian companies have raised capital from the Euro markets by issuing Global Depository Receipts (GDRs) and Foreign Currency Convertible Bonds (FCCBs). These to instruments are commonly referred to as Euro issues.
Euro issues are treated as foreign direct investments (FDIs) in the issuing company and are subject to the Government policy concerning FDIs. In some cases, the issuing company has to obtain prior clearance of the Euro-issue from the Foreign Investment Promotion Board (FIPB). Each Euro-issue must be approved by the Ministry of Finance, Government of India.
Global Depository Receipts (GDRs) – A GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. For instance, GDRs issued by Reliance Industries were listed in the New York Stock Exchange in 1992.
A GDR represents a number of shares of the issuing company registered in India. A holder of GDR can at any time convert it into the number of shares that it represents. Once conversion takes place, the underlying shares are listed and traded on some Indian stock exchanges. Many companies such as Infosys, Reliance groups, Wipro and ICICI have raised money through the issue of GDRs.
GDRs do not carry any voting rights unless they are converted into shares (in Indian Rupees). However, dividend on GDRs is to be paid in Rupees only as in case of equity shares. Thus, there is no risk of fluctuation in the rates of foreign exchange. Moreover, on conversion of GDRs into equity shares, no remittance is to be made by the company as in the case of redemption of bonds. GDR is a negotiable instrument and can be traded freely like any other security.
A global Depository Receipt (GDR) is issued in the form of a depository receipt/certificate created by the Overseas Depository Bank (ODB) outside India and issued to non-resident investors against the issue of ordinary shares or foreign currency convertible debentures (FCCDs) of the issuing company.
The ODB is the bank authorized by the issuing company to issue GDRs against its issue of ordinary shares or FCCDs. The issued shares or debentures are delivered by the issuing company to a Domestic Custodian Bank (DCB) who would request the ODB to issue GDRs (or ADRs) to the foreign investors.
American Depository Receipts (ADRs) – The depository receipts issued by a company in the USA are known as American Depository Receipts. An ADR is just like a GDR except that it can be issued to the USA citizens only and can be listed and traded on a stock exchange of the USA.
Thus, ADRs are issued on behalf of an Indian company for raising funds from the investors of the USA. Like GDRs, ADRs are also treated as a foreign direct investment (FDI) in the issuing company.
ADRs are issued by an American Depository Bank certifying that shares of some non-USA based company (say Indian company) are held by some custodian bank in the home country. These may be listed on New York Stock Exchange, American Stock Exchange or Nasdaq. ADRs are bought and sold in American markets like regular shows.
An ADR represents a specified number of shares of the issuing company. It does not carry voting rights. A holder of ADRs can at any time convert them into the number of shares they represent. After conversion, shares are listed and traded on the domestic (i.e. Indian) stock exchanges.
The dividend on ADRs is payable in the Indian currency, i.e., Rupees. That means there is no outflow of any foreign exchange. Like GDRs, ADRs can also.be issued with the framework of the guidelines issued by the Ministry of Finance (Government of India) from time to time. The procedure for the issue of ADRs is quite similar to the issue of GDRs.
Foreign Currency Convertible Bonds (FCCBs) – An FCCB is a bond issued by an Indian company subscribed by non-resident in foreign currency and convertible into equity shares of issuing company. FCCBs are basically equity-linked debt securities, to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCBs has the option of either converting them into equity shares, normally at a predetermined price and even at a predetermined exchange rate, or retaining the bond.
The FCCBs carry a fixed rate of interest which is lower than the rate of any other similar non-convertible debt instrument. They can be traded conveniently and at the same time the issuing company can avoid any dilution in earnings per share. Also, they can still be traded on the basis of underlying equity value. The FCCBs are issued in foreign currency.
FCCBs can be freely traded and the issuing company has no control over the transfer mechanism and is not even aware of the ultimate beneficiary. The convertible bonds provide an opportunity to the holders to participate in the capital growth of a company. Till the time a bondholder holds the bonds, he gets a fixed return and in case he chooses to convert them into equity, he will earn a capital gain.
Thus, the convertible bonds offer a mixture of the characteristics of the fixed interest and equity shares. Another advantage accruing to the investor is that the bonds can be issued in a currency different from the currency in which the shares of the company are denominated. This feature enables the option of diversifying currency risks.
FCCBs are very much like the Convertible Debentures (CDs) issued in India. FCCBs are issued in a foreign currency and carry a fixed interest or coupon rate. They are convertible into equity shares at the prefixed price. FCCBs are listed and traded in foreign stock exchanges.
Companies prefer FCCBs as a dilution of equity is delayed. It allows the company to avoid any current dilution in earnings per share that a further issue of equity shares would cause. There are some drawbacks also. FCCBs involve the creation of more debt and Forex outgo in the form of interests.
If the investors do not convert the bonds into equity shares there is burden of repayment. Foreign Direct Investment (FDI) – It refers to the investment – made by a company in manufacturing and/or marketing facilities in a foreign country. Foreign Direct Investment (FDI) connects direct investment in the equity shares, debentures or bonds of Indian companies by the foreign investors.
FDI is channelised in the form of direct foreign contribution to the equity capital of the company and is akin to domestic equity invested by the Indian shareholders of the companies. The New Industrial Policy, 1991 envisaged a significant inflow of FDI into the country.
The Government has set up a high-powered Foreign. Investment Promotion Board (FIPB) to provide for single-window approval channel for the inflow of FDI. Many restrictions on the inflow of foreign capital have been withdrawn over recent years. Enron the power plant in India is an example of investment made in foreign direct investment.
Prior to July 1991, FDI was allowed only on a case-to-case basis, with a normal ceiling of 40 percent of the total equity capital of the company registered in India. A higher percentage of FDI was permitted in certain country or.if the venture was mainly export-oriented.
Under the New Industrial Policy, 1991, foreign equity has been delinked from the technology transfer. As of now, FDI is being sought actively in a wide range of high priority, export-oriented, and critical infrastructure industries. With this purpose in view, the Central Government has liberalized rules for FDI over the years.
- investment in setting up a new subsidiary or branch in a foreign country
- expansion of overseas subsidiary or branch; and
- acquisition of an overseas enterprise.
The main features of the latest policy of the Government as regards FDI are as under :
(1) Automatic approval permitting 100 per cent foreign equity is allowed in respect of generation/transmission of electric energy, construction and maintenance of roads, highways, vehicular bridges, toll bridges/roads, ports and harbours, manufacture of pollution control devices, infrastructure and service sectors etc.
(2) During 2000-2001, FDI upto 100 percent of equity was permitted under the automatic route for:
- Business to Business e-commerce.
- Oil refining.
- All manufacturing activities in Special Economic Zones (SEZs) or Export Processing Zones (EPZs).
- Specified activities in the Telecom sector.
(3) Offshore Venture Capital Funds/Companies are allowed to invest in Indian Venture Capital Funds as well as other companies through the automatic route, subject to SEBI regulations.
(4) Existing companies with FDI are eligible for automatic route to undertake additional activities covered under the automatic route.
(5) FDI upto 26 percent is eligible under the automatic route in the insurance sector. However, a license from the Insurance Regulatory and Development Authority (IRDA) is essential.
(6) FDI is permitted upto 20 percent in the banking sector subject to the guidelines issued by the Reserve Bank of India. FDI through automatic route is not allowed in the following cases:
- Where industrial licence under the Industries Development and Regulation Act (IDRA) Is required, eg., alcohol, cigarette, defence related equipments.
- Industries reserved exclusively for the small-scale sector.
- Proposals in which a foreign collaborator has a joint venture.
Foreign investment proposals in the above areas require prior approval by the Foreign Investment Promotion Board (FIPB) or the Secretariat for Industrial Approval (SIA). After this approval, the Reserve Bank of India’s approval under Foreign Exchange Management Act is also required.
Thus, FDI is seen as a means to supplement domestic investment for achieving a higher level of economic growth and development. FDI benefits domestic industry as well as the Indian consumers by providing opportunities for technological upgradation, access to global managerial skills and practices, utilization of human and natural resources, making Indian industry internationally competitive, opening up export markets, providing backward and forward linkages and access to international quality goods and services.
What is commercial paper? What are its advantages and limitations?
Commercial Paper emerged as a source of short-term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds, and banks.
The amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good credit ratings can issue the CP. Its regulation comes under the purview of the Reserve Bank of India.
The merits and limitations of a Commercial Paper are as follows:
- A commercial paper is sold on an unsecured basis and does not contain any restrictive conditions.
- As it is a freely transferable instrument, it has high liquidity.
- It provides more funds compared to other sources. Generally, the cost of CP to the issuing firm is lower than the cost of commercial bank loans.
- A commercial paper provides a continuous source of funds. This is because their maturity can be tailored to suit the requirements of the issuing firm Further, maturing commercial paper can be repaid by selling new commercial paper.
- Companies can park their excess funds in commercial paper thereby earning some good return on the same.
- Only financially sound and highly rated firms can raise money through commercial papers. New and moderately rated firms are not in a position to raise funds by this method.
- The size of money that can be raised through the commercial paper is limited to the excess liquidity available with the suppliers of funds at a particular time.
- Commercial paper is an impersonal method of financing. As such if the firm is not in a position to redeem its paper due to financial difficulties, extending the maturity of a CP is not possible.