Merchant Bankers Functions

MERCHANT BANKERS FUNCTIONS

The different functions of merchant bankers towards the capital issues management are 1. Designing Capital Structures. 2. Capital Market Instruments. 3. Preparation of prospectus. 4. Selection of bankers. 5. Advertising Consultants. 6. Choice regarding registrar to the issue. 7. Arranging for underwriting the proposed issue. 8. Choice for the bankers to the issue. 9. Choice for the brokers.

1. DESIGNING CAPITAL STRUCTURE DECISIONS The term capital structure refers to the proportionate claims of debt and equity in the total long-term capitalization of a company.

According to Weston and Brigham, ―Capital structure is the per represented primarily by long-term-debt, preferred stock and common equity, but excluding all short-term credit. Common equity includes common stock, capital surplus and accumulated retained earnings.

Optimal Capital Structure An ideal mix of various sources of long-term funds that aims at minimizing the overall cost of capital of the firm, and maximizes the market value of shares of a firm is known as ‘Optimal capital structure’. An optimal capital structure should possess the following characteristics:

a. Simplicity An optimal capital structure must be simple to formulate and implement by the financial executives. For simplicity, it is imperative that the number of securities is limited to debt and equity.

b. Low Cost A sound capital structure must aim at obtaining the capital required for he firm at the lowest possible cost. For this purpose, financial executives must pay attention to keep the expenses of issue and fixed annual payments at a minimum. This would help maximize the shareholders‘value.

c. Maximum Return and Minimum Risks An ideal capital structure must have a combination of debt and equity in such a manner as to maximize the firm's profits.

Similarly, the firm must be guarded against risks such as taxes, interest rates, costs, etc. with the aim of either reducing them or removing them.

d. Maximum Control The capital structure must aim at retaining maximum control with the existing shareholders. The issue of securities should be based on the pattern of voting rights. It must affect favorably the voting structure of the existing shareholders, and increase their control on the company’s affairs.

e. Liquidity In order to have a sound capital structure, it is important that the various components help provide the firm greater solvency through higher liquidity. To attain a high order of liquidity, all such debts that threaten the company’s solvency must be avoided.

f. Flexibility The capital structure should be so constructed that it is possible for the company to carry out any required change in the capitalization in tune with the changing conditions. Accordingly, the firm must be able to either raise a new level of capital, or reduce the existing level of capital.

g.   Equitable Capitalization An ideal capital structure must be neither over capitalized nor under-capitalized. Capitalization must be based purely on the financial needs of the enterprise. An equitable capitalization would help make full utilization of the available capital at minimum cost.

h. Optimum Leverage The firm must attempt to secure a balanced leverage by issuing both debt and equity at certain ideal proportions. It is best for the firm to issue debt when the rate of interest is low. Conversely, equity is suitable where the rate of capitalization is high.

Factors Affecting Capital Structure Decisions The following factors significantly influence the capital structure decision of a firm: Economy Characteristics The major developments taking place in the economy affect the capital structure of firms. In order words, the way the  economy of a country is managed determines the way the capital structure of a firm will be determined. Factors that are active in the economy are:

1. Business activity: The quality of business activity prevailing in the economy determines the capital structure pattern of a firm. Under conditions of expanding business activities, the firm must have several alternatives to source the required capital in order to undertake profitable investment activities. Under these circumstances, it is advisable for a firm to undertake equity funding rather than debt funding.

2. Stock market: The buoyancy, or otherwise, of the capital market greatly influences capital structure decisions. A study of the capital market trends would greatly help a firms decision on the quantum and cost of issue. Accordingly, if the stock market is expected to witness bullish trends, the interest rates will go up and debt will become costlier.

3. Taxation: The rates and rules of taxation prevalent in an economy also affect capital structure decisions. For instance, higher rates of taxation will be advantageous due to the tax deductibility benefit of debt funding. Similarly, the taxes on dividend income, if any, would adversely affect the ability of firms to raise equity capital.

4.  Regulations: The regulations imposed by the state on the quantum, pricing etc. of capital funds to be raised also influences the capital raised by a firm. For instance, restrictions have been imposed by SEBI on the issue and allotment of shares and bonds to different type of investors. A finance manager should take this factor into consideration while designing the capital structure.

5.  Credit Policy: The credit policy pronouncements made by the central monetary authority, such as the RBI, affects the way capital is raised in the market. For instance, the interest rate liberalization announced by RBI has been dominating the lending policies of financial institutions. This affects the ability of finance managers to raise the required funds.

6.  Financial Institutions: The credit policy followed by financial institutions determines the capital structure decisions of firms. For instance, restrictive lending terms by financial institutions may deter firms from raising long-term funds at reasonable rates of interest. Easy terms, on the other hand, may encourage firms to obtain a higher quantum of loans.

2. CAPITAL MARKET INSTRUMENTS Financial instruments that are used for raising capital resources in the capital market are known as Capital Market Instruments. The changes that are sweeping across the Indian capital market especially in the recent past are something phenomenal. It has been experiencing metamorphic in the last decade, thanks to a host of measures of liberalization, globalization, and privatization that have been initiated by the Government. Pronounced changes have occurred in the realm of industrial policy. Licensing policy, financial services industry, interest rates, etc. The competition has become very intense and real in both industrial sector and financial services industry. As a result of these changes, the financial services industry has come to introduce a number of instruments with a view to facilitate borrowing and lending of money in the capital market by the participants.

Types of Capital Market Instruments The various capital market instruments used by corporate entities for raising resources are as follows: 1. Preference shares 2. Equity shares 3. Non-voting equity shares 4. Cumulative convertible preference shares 5. Company fixed deposits 6. Warrants 7. Debentures and Bonds

1. PREFERENCE SHARES: Shares that carry preferential rights in comparison with ordinary shares are called ‘Preference Shares’ardingpayment. of The pr dividend and the distribution of the assets of the company in the event of its winding up, in preference to equity shares.

Types of Preference Shares

1. Cumulative preference shares: Shares where the arrears of dividends in times of no and/or lean profits can be accumulated and paid in the year in which the company earns good profits.

2.   Non-cumulative preference shares: Shares where the carry forward of the arrears of dividends is not possible.

3. Participating preference shares: Shares that enjoy the right to participate in surplus profits or surplus assets on the liquidation of a company or in both, if the Articles of Association provides for it.

4. Redeemable preference shares: Shares that are to be repaid at the end of the term of issue, the maximum period of a redemption being 20 years with effect from 1.3.1997 under the Companies amendment Act 1996. Since they are repayable, they are similar to debentures. Only fully paid shares are redeemed. Where redemption is made out of profits, a Capital Redemption Reserve Account is opened to which a sum equal to the nominal value of the shares redeemed is transferred. It is treated as paid-up share capital of the company.

Fully convertible cumulative preference shares: Shares comprise two parts viz., Part A and B. Part A is convertible into equity shares automatically and compulsorily on the date of allotment. Part B will be redeemed at par/converted into equity shares after a lock-in period at the option of the investor, conversion into equity shares taking place after the lock-in period, at a price, which would be 30 percent lower than the average market price. The average market price shall be the average of the monthly high and low price of the shares in a stock exchange over a period of 6 months including the month in which the conversion takes place.

6. Preference shares with warrants attached: The attached warrants entitle the holder to apply

for equity shares for cash, at a ‘premium’, at any time, i and fifth year from the date of allotment. If the warrant holder fails to exercise his option, the unsubscribed portion will lapse. The holders of warrants would be entitled to all rights/bonus shares that may be issued by the company. The preference shares with warrants attached would not be transferred/sold for a period of 3 years from the date of allotment.

2. EQUITY SHARES:

Equity shares, also known as „ordinary shares are the shares held by the owners of a corporate entity. Since equity shareholders face greater risks and have no specified preferential rights,  they are  given  larger  share  in  profits  through  higher  dividends  than  those  given  to preference shareholders, provided the company’s performance is ex dividends in case there are no profits or the profits do not justify dividend for previous years even when the company makes substantial profits in subsequent years. Equity shareholders also enjoy the benefit of ploughing back of undistributed profits kept as reserves and surplus for the purposes of business expansion. Often, part of these is distributed to them, as bonus shares. Such bonus shares are entitled to a proportionate or full dividend in the succeeding year. A strikingly noteworthy feature of equity shares is that holders of these shares enjoy substantial rights in the corporate democracy, namely the rights to app of dividend, enhancement of managerial remuneration in excess of specified limits and fixing the terms of appointment and election of directors, appointment of auditors and fixing of their remuneration, amendments to the Articles and Memorandum of Association, increase of share capital and issue of further shares or debentures, proposals for mergers and reconstruction and any other important proposal on which member’s approval is required under the Companies Act. Equity shares in the hands of shareholders are mainly reckoned for determining the management’s control over the company. Where for the management to retain the control, as it is not possible for all the shareholders to attend the company's meeting in full strength. Furthermore, the management group can bolster its controlling power by acquiring further shares in the open market or otherwise. Equity shares may also be offered to financial institutions as part of the private placement exercise. Such a method, however, is brought with the danger of takeover attempt by financial institutions. Equity shareholders represent proportionate ownership in a company. They have residual claims on the assets and profits of the company. They have unlimited potential for dividend payments and price appreciation in comparison to these owners of debentures and preference shares who enjoy just a fixed assured return in the form of interest and dividend. Higher the risk, higher the return and vice-versa. Share certificates either in physical form or in the demat (with the introduction of depository system in 1999) form are issued as a proof of ownership of the shares in a company. Fully paid equity shares with detachable warrants entitle the warrant holder to apply for a specified number of shares at a determined price. Detachable warrants are separately registered with stock exchange and traded separately. The company would determine the terms and conditions relating to the issue of equity against warrants. Voting rights are granted under the Companies Act (Sections 87 to 89) wherein each shareholder is eligible for votes proportionate to the number of shares held or the amount of stock owned. A company cannot issue shares carrying disproportionate voting rights. Similarly, voting right cannot be exercised in respect of shares on which the shareholder owes some money to the company.

Capital Equity shares are of different types. The maximum value of shares as specified in the Memorandum of Association of the company is called the authorized or registered or nominal capital. Issued capital is the nominal value of shares offered for public subscription. In case shares offered for public subscription are not taken up, the portion of capital subscribed is called subscribed capital. This is less than the issued capital Paid-up capital is the share capital paid-up by shareowners which is credited as paid-up on the shares.

Par Value and Book Value

The face value of a share is called its Par value. Although shares can be sold below the par value, it is possible that shares can be issued below the par value. The financial institutions that convert their unpaid principal and interest into equity in sick companies are compelled to do if at a minimum of Rs.10 because of the par value concept even though the market price might be much less than Rs.10. Par value can also lead to unhealthy practices like price rigging by promoters of sick companies to take market prices above Rs.10 to get their new offers subscribed. Par value is of use to the regulatory agency and the stock exchange. It can be used to control the number of shares that can be issued by the company. The par value of Rs.10 per share serves as a floor price for issue of shares. Book value is the intrinsic value of a share that is calculated to reflect the net worth of the shareholders of a corporate entity. Cash Dividends These are dividends paid in cash. A stable payment of cash dividend is the hallmark of stability of share prices.

Stock Dividends These are the dividends distributed as shares and issued by capitalizing reserves. While net worth remains the same in the balance sheet, its distribution between shares and surplus is altered.

3. NON-VOTING EQUITY SHARES

Consequent to the recommendations of the Abi amendment to the Companies Act, corporate managements are permitted to mobilize additional capital without diluting the interest of existing shareholders with the help of a new instrument called non-voting equity shares’. Such shares will be entitled to all the benefits except the right to vote in general meetings. Such non-voting equity share is being considered as a possible  addition to the two classes of share capital currently in vogue. This class of shares has been included by an amendment to the Companies Act as a third category of shares. Corporates will be permitted to issue such share up to a certain percentage of the total share capital. Non-voting equity shares will be entitled to rights and bonus issues and preferential offer of shares on the same lines as that of ordinary shares. The objective will be to compensate the sacrifice made for the voting rights. For this purpose, these shares will carry higher dividend rate than that of voting shares. If a company fails to pay dividend, non-voting shareholders will automatically be entitled to voting rights on a prorate basis until the company resumes paying dividend. The mechanism of issue of non-voting shares is expected to overcome such problems as are associated with the voting shares as that the ordinary investors are more inclined towards high return on capital through sizeable dividends and capital appreciation through the issue of bonus shares and the inability of corporate to respond to the investors just aspiration for reasonable dividends. Moreover, there is every need for corporate to spend huge sums of money on a variety of not-souseful items including colorful and costly annual reports. For all these above-mentioned reasons, non-voting equity shares are expected to have a ready and popular marker. In effect, this kind of share is similar to preference shares with regard to non-voting right but may get the advantage of higher dividends as well as appreciation in share values through entitlement to bonus shares which is not available to preference shares.

4. CONVERTIBLE CUMULATIVE PREFERENCE SHARES (CCPS)

These are the shares that have the twin advantage of accumulation of arrears of dividends and the conversion into equity shares. Such shares would have to be the face value of Rs.100 each. The shares have to be listed on one or more stock exchanges in the country. The object of the issue of CCP shares is to allow for the setting up of new projects, expansion or diversification of existing projects,  normal  capital  expenditure  for  modernization  and  for  meeting  working  capital

requirements. Following are some of the terms and conditions of the issue of CCP shares :

1.  Debt-equity ratio: For the purpose of calculation of debt-equity ratio as may be applicable CCPS is be deemed to be an equity issue.

2.  Compulsory conversion: The conversion into equity shares must be for the entire issue of CCP shares and shall be done between the periods at the end of three years and five years as may be decided by the company. This implies that the conversion of the CCP into equity shares would be compulsory at the end of five years and the aforesaid preference shares would not be redeemable at any stage.

3.   Fresh issue: The conversion of CCP shares into equity would be deemed as being one resulting from the process of redemption of the preference shares out of the proceeds of a fresh issue of shares made for the purposes of redemption.

4.  Preference dividend: The rate of preference dividend payable on CCP shares would be 10 percent.

5.  Guideline ratio: The guideline ratio of 1:3 as between preference shares and equity shares would not be applicable to these shares.

6. Arrears of dividend: The right to receive arrears of dividend up to the date of conversion, if any, shall devolve on the holder of the equity shares on such conversion. The holder of the equity shares shall be entitled to receive the arrears of dividend as and when the company makes profit and is able to declare such dividend.

7.  Voting right: CCPS would have voting rights as applicable to preference shares under the companies Act, 1956.

8. Quantum: The amount of the issue of CCP shares would be to the extent the company would be offering equity shares to the public for subscription.

5. COMPANY FIXED DEPOSITS:

Fixed deposits are the attractive source of short-term capital both for the companies and investors as well. Corporates favor fixed deposits as an ideal form of working capital mobilization without going through the process of mortgaging assets. Investors find fixed deposits a simple avenue for investment in popular companies at attractively reasonable and safe interest rates. Moreover, investors are relieved of the problem of the hassles of market value fluctuation to which instruments such as shares and debentures are exposed. There are no transfer formalities either. In addition, it is quite possible for investors to have the option of premature repayment after 6 months, although such an option entails some interest loss.

Regulations Since these instruments are unsecured; there is a lot of uncertainty about the repayment of deposits and regular payment of interest. The issue of fixed deposits is subject to the provisions of the Companies Act and the Companies (Acceptance of Deposits) Rules introduced in February 1975. Some of the important regulations are:

1.  Advertisement: Issue of an advertisement as approved by the Board of Directors in dailies circulating in the state of incorporation.

2.  Liquid assets : Maintenance of liquid assets equal to 15 percent (substituted for 10% by Amendment Rules, 1992) of deposits (maturing during the year ending March 31) in the form of bank deposits, unencumbered securities of State and Central Governments or unencumbered approved securities.

3.  Disclosure: Disclosure in the newspaper advertisement the quantum of deposits remaining unpaid after maturity. This would help highlight the defaults, if any, by the company and caution the depositors.

4. Deemed public Company : Private company would become a deemed public company (from June 1998, Section 43A of the Act) where such a private company, after inviting public deposits through a statutory advertisement, accepts or renews deposits from the public other than its members, directors or their relatives. This provision, to a certain extent, enjoins better accountability on the part of the management and auditors.

5.  Default: Penalty under the law for default by companies in repaying deposits as and when they mature for payment where deposits were accepted in accordance with the Reserve Bank directions.

6.  CLB : Empowerment to the Company Law Board to direct companies to repay deposits, which have not been repaid as per the terms and conditions governing such deposits, within a time frame and according to the terms and conditions of the order.

6. WARRANTS

An option issued by a company whereby the buyer is granted the right to purchase a number of shares of its equity share capital at a given exercise price during a given period is called a ‘warrant’. Although tradingockmarketsfor morein warra than 6 to 7 decades, they are being issued to meet a range of financial requirements by the Indian corporate. A security issued by a company, granting its holder the right to purchase a specified the Indian context are called ‘sweeteners’and were issued by a few Indian companies since 1993. Both warrants and rights entitle a buyer to acquire equity shares of the issuing company. However, they are different in the sense that warrants have a life span of three to five years whereas; rights have a life span of only four to twelve weeks (duration between the opening and closing date of subscription list). Moreover, rights are normally issued to effect current financing, and warrants are sold to facilitate future financing. Similarly, the exercise price of warrant, i.e. The price at which it can be exchanged for share, is usually above the market price of the share so as to encourage existing shareholders to purchase it. On the other hand, one warrant buys one equity share generally, whereas more than one rights may be needed to buy one share. The detachable warrant attached to each share provides a right to the warrant holder to apply for additional equity share against each warrant.

7. DEBENTURES AND BONDS

A document that either creates a debt or acknowledges it is known as a debenture. Accordingly, any document that fulfills either of these conditions is a debenture. A debenture, issued under the common seal of the company, usually takes the form of a certificate that acknowledges indebtedness of the company. A document that shows on the face of it that a company has borrowed a sum of money from the holder thereof upon certain terms and conditions is called a debenture. Debentures may be secured by way of fixed or floating charges on the assets of the company. These are the instruments that are generally used for raising long-term debt capital.