November 29, 2012

MA0036 [Financial Systems and Commercial Banking] Set1 Q2

Q2. What are the financial services provided by a Merchant banker?

Ans:

The financial services provided by a merchant banker are:

Corporate finance services
The most visible function of a merchant banker is the function of mobilizing funds for the companies. Starting from public issue of securities, it extends to private placements, brought – out – deals, euro – issues and corporate valuation. Managerial or corporate finance is the task of providing the funds for a corporation's activities (for small business, this is referred to as SME finance). Corporate finance generally involves balancing risk and profitability, while attempting to maximize an entity's wealth and the value of its stock, and generically entails three interrelated decisions. In the first, "the investment decision", management must decide which "projects" (if any) to undertake. The discipline of capital budgeting is devoted to this question, and may employ standard business valuation techniques or even extend to real options valuation; see Financial modeling. The second, "the financing decision" relates to how these investments are to be funded: capital here is provided by shareholders, in the form of equity (privately or via an initial public offering), creditors, often in the form of bonds, and the firm's operations (cash flow). Short-term funding or working capital is mostly provided by banks extending a line of credit.

The balance between these elements forms the company's capital structure. The third, "the dividend decision", requires management to determine whether any inappropriate profit is to be retained for future investment / operational requirements, or instead to be distributed to shareholders, and if so in what form. Short term financial management is often termed "working capital management", and relates to cash inventory and debtors management. These areas often overlap with the firm's accounting function, however, financial accounting is more concerned with the reporting of historical financial information, while these financial decisions are directed toward the future of the firm.

Project finance services: 
Merchant banker should carry out an independent appraisal of a project. Besides advising clients on project feasibility, they also find the best package of financing mix necessary for such project. If there is foreign currency element in the project finance, the role of a merchant banker’s advice on the financing package becomes very important due to the financial risk arising from exchange rate fluctuations. Project finance is the long term financing of infrastructure and industrial projects based upon the projected cash flows of the project rather than the balance sheets of the project sponsors. Usually, a project financing structure involves a number of equity investors, known as sponsors, as well as a syndicate of banks or other lending institutions that provide loans to the operation. The loans are most commonly non-recourse loans, which are secured by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modeling. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets, and are able to assume control of a project if the project company has difficulties complying with the loan terms.

Generally, a special purpose entity is created for each project, thereby shielding other assets owned by a project sponsor from the detrimental effects of a project failure. As a special purpose entity, the project company has no assets other than the project. Capital contribution commitments by the owners of the project company are sometimes necessary to ensure that the project is financially sound, or to assure the lenders of the sponsors' commitment. Project finance is often more complicated than alternative financing methods. Traditionally, project financing has been most commonly used in the extractive (mining), transportation, telecommunications and energy industries. More recently, particularly in Europe, project financing principles have been applied to other types of public infrastructure under public private partnerships (PPP) or, in the UK, Private Finance Initiative (PFI) transactions (e.g. school facilities) as well as sports and entertainment venues.

International finance services:
Companies have gone to overseas capital markets to raise capital. GDRs, American Depository Receipts (ADRs) and FCCBs are issued foreign investors. In this, the domestic merchant bankers and foreign investment banks play a major role. Large merchant banking outfits have entered strategic alliances with international investment bankers and tapped the international markets for resources. Merchant banks play a role in arranging External Commercial Borrowings (ECBs). ECB (External Commercial Borrowings) is an instrument used in India to facilitate the access to foreign money by Indian corporations and PSUs (Public Sector Undertakings). External Commercial Borrowings (ECB) basically refer to commercial loans in the form of bank loans, buyers’ credit, suppliers’ credit, securitized instruments (e.g. floating rate notes and fixed rate bonds) availed of from non-resident lenders with minimum average maturity of 3 years. ECBs include commercial bank loans, buyers' credit, suppliers' credit, securitized instruments such as Floating Rate Notes and Fixed Rate Bonds etc., credit from official export credit agencies and commercial borrowings from the private sector window of Multilateral Financial Institutions such as International Finance Corporation (Washington), ADB, AFIC, CDC, etc. ECBs cannot be used for investment in stock market or speculation in real estate. The DEA (Department of Economic Affairs), Ministry of Finance, Government of India along with Reserve Bank of India, monitors and regulates ECB guidelines and policies. For infrastructure and green field projects, funding up to 50% (through ECB) is allowed. In telecom sector too, up to 50% funding through ECBs is allowed. 

External Commercial Borrowings and Trade Credits availed of by residents are governed by clause (d) of sub-section 3 of section 6 of the Foreign Exchange Management Act, 1999 read with Notification No. FEMA 3 / 2000-RB,viz., Foreign Exchange Management (Borrowing or Lending in Foreign Exchange) Regulations 2000, dated May 3, 2000, as amended from time to time.

Miscellaneous services: 
The miscellaneous functions are
1. Stock broking, for both institutional and retail investors.
2. Distribution of financial products.
3. Dealing in currency derivatives.
4. Insurance broking
5. Asset management
6. Underwriting
7. Investment research
8. Portfolio management services
9. Commodities broking
10. Forex advisory services
11. Advisory services for joint ventures
12. Strategic services related to M & As

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