Question Paper

Investment Banking and Financial Services –I (261) : Oct 2002

Part A : Basic Concepts (30 Points)
• This part consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one point.
• Maximum time for answering Part A is 30 Minutes.

1. Which of the following statements is/are true regarding auction of Treasury Bills in India?
I. Non-competitive bids are accepted at the weighted average of the successful bids
if the notified amount is not fully subscribed to
II. Auction of T-Bills is an example of Dutch auction
III. In auction of T-Bills there is always a possibility of winner’s curse.
a. Only (I) above
b. Only (II) above
c. Both (I) and (II) above
d. Both (I) and (III) above
e. All (I), (II) and (III) above.
2. Currently, the settlement in the Indian stock exchanges is done on a
a. T + 3 system
b. T + 5 system
c. 7-day settlement cycle
d. 14-day settlement cycle
e. 30-day settlement cycle.
3. According to the capital adequacy norms applicable to NBFCs, which of the following off-
balance sheet exposures carry a credit conversion factor of 50% ?
a. Underwriting obligations with respect to shares and debentures
b. Lease contracts entered into but yet to be executed
c. Bills discounted/rediscounted with banks
d. Both (a) and (b) of the above
e. Both (b) and (c) of the above.
4. Which of the following is/are true regarding cross border factoring?
I. The client assigns the export receivables to the export factor who in turn assigns to
the import factor.
II. The import factor carries out the tasks of credit checking, sales ledgering and collection.
III. The client is required to deal with both the import factor and export factor.

a. Only (II) above

b. Only (III) above
c. Both (I) and (II) above
d. Both (II) and (III) above
e. All (I), (II) and (III) above.
5. ASMA Ltd., a manufacturing company has a paid up capital of Rs.24 crore and free reserves
of Rs.16 crore. The maximum amount of public deposits that ASMA can raise from the
public (excluding its shareholders) is
a. Rs. 6.0 crore
b. Rs. 8.4 crore
c. Rs.10.0 crore
d. Rs.14.0 crore
e. Rs.16.0 crore.

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6. Which of the following is true regarding cumulative convertible preference shares (CCPS)?
I. CCPS helps companies to maintain EPS and increase the leveraging capacity of
the company
II. CCPS can be considered as a part of the net worth of the company even before its
conversion
III. CCPS cannot be issued with warrants.
a. Only (I) above
b. Only (II) above
c. Both (I) and (II) above
d. Both (II) and (III) above
e. All (I), (II) and (III) above.
7. The minimum denomination and maturity of the American CDs is _______ and _______
days respectively.
a. $50000, 15
b. $50000, 30
c. $100000, 10
d. $100000, 15
e. $100000, 30.
8. Niagara Distilled Water Ltd. issues 9 months CPs of face value of Rs.1000000 at Rs.956555.
The stamp duty payable on each CP is
a. Rs.2391.40 by the issuer
b. Rs.2500.00 by the investor
c. Rs.3587.08 by the issuer
d. Rs.3587.08 by the investor
e. Rs.3750.00 by the issuer.
9. For an underwritten issue, the minimum underwriting that has to be committed by the Lead
Manager to the issue is
a. Rs.20 lakhs
b. Rs.25 lakhs
c. 5% of the issue size
d. 5% of the issue size or Rs.25 lakhs, whichever is less
e. Underwriting by Lead Manager is not mandatory.
10. Divine Divas Ltd. comes up with an IPO of Rs.1000 crore. The registration fee payable to
SEBI is _______.
a. Rs. 25,000
b. Rs. 50,000
c. Rs.1,00,000
d. Rs.2,50,000
e. Rs.5,00,000.
11. Exotic Resorts Ltd. is coming up with an issue of Rs.200 crore of 8000000 equity shares of
face value Rs.5 at a premium of Rs.245. The market lot of the issue would be
a. 10 shares
b. 25 shares
c. 40 shares
d. 50 shares
e. 100 shares.
12. An instrument is rated MA from ICRA. The instrument rated is a/an
a. Bond
b. Commercial paper
c. Equity
d. Fixed deposit
e. Preference share.

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13. In which of the following stages, sales tax affects a lease transaction?
I. When the asset is purchased by the lessor for the purpose of leasing
II. When the right to use the asset is transferred to the lessee for a valuable consideration
III. When the asset is sold by the lessor at the end of the lease period.
a. Only (I) above
b. Only (II) above
c. Both (I) and (II) above
d. Both (I) and (III) above
e. All (I), (II) and (III) above.
14. While evaluating a hire purchase proposal, under which of the following situations,
replacement cost is the appropriate measure of valuation?
I. Realisation value > Economic value > Replacement cost
II. Economic value > Replacement cost > Realisation value
III. Economic value > Realisation value > Replacement cost
a. Only (I) above
b. Only (II) above
c. Both (II) and (III) above
d. Both (I) and (III) above
e. All (I), (II) and (III) above.
15. In a hire purchase agreement the borrower is to pay 48 installments of Rs.1,000 each for an
asset costing Rs.46,750. Immediately after paying the 30th installment, he wishes to repay the
outstanding loan and purchase the equipment. The interest rebate as per Rule of 78 Method is
a. Rs. 84.44
b. Rs.162.63
c. Rs.169.55
d. Rs.181.76
e. Rs.189.49.
16. The equated monthly installment (EMI) for a consumer loan of Rs.25000 is Rs.2400 for 12
months. The annual effective rate of interest (by trial and error method) charged by the
finance company is
a. 15.00%
b. 15.20%
c. 15.82%
d. 26.04%
e. 30.67%.
17. Under which of the following aspects, factoring differs from bills discounting?
I. In a bill discounting arrangement, the financial intermediary does not assume the
responsibilities of sales ledger administration and collection of debts, which the
factor does under the factoring arrangement
II. Unlike bill discounting, no notice of assignment is provided to the customers of
the client under the factoring arrangement
III. The bill discounting arrangement is recourse to the client whereas a factoring
arrangement can be with or without recourse.
a. Only (I) above
b. Both (I) and (II) above
c. Both (I) and (III) above
d. All of the above
e. None of the above.

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18. Which of the following is true regarding charge cards?
a. The payment period is revolving credit payment period – normally within 45 days of
purchase
b. 2.5% to 3% interest is charged on the outstanding balance
c. Only annual payment is charged
d. Amount of payment to be made is atleast 5% of the purchase
e. There is no preset spending limit.
19. Consider the following data of a company:
EBIT Rs.2,50,000
Lease payments per period Rs.50,000
Depreciation Rs.25,000
Interest charges Rs.30,000
Loan repayment per period Rs. 5,000
Marginal tax rate 30%
The cash flow coverage ratio of the company is
a. 2.00
b. 2.15
c. 2.48
d. 3.73
e. 4.00.
20. Before roll over of NCDs or the non convertible portion of PCDs, fresh credit rating shall be
obtained within a period of ______ months prior to the date of redemption and
communicated to debenture holders before roll over.
a. 2
b. 3
c. 6
d. 9
e. 12.
21. In case of mortgages, while assessing the credit worthiness of a borrower which of the
following is/are true regarding Loan-To-Value ratio (LTV)?
I. It indicates the percentage of down payment required by lenders
II. It will increase as the mortgage balance decreases
III. It will be quoted high in times of lower interest rates.
a. Only (I) above
b. Only (II) above
c. Both (I) and (II) above
d. Both (I) and (III) above
e. All (I), (II) and (III) above.
22. Which of the following forms of loan will hedge against interest rate risk?
a. Bow ties
b. Gap loans
c. Mini-perms
d. Buy down loans
e. Both (a) and (b) of the above.
23. Which of the following is/are true with regard to the call money market?
I. The call rates are calculated on a weekly basis
II. The call rates are highly volatile
III. Low call rates indicate lack of liquidity in the financial system
a. Only (II) above
b. Only (III) above
c. Both (I) and (II) above
d. Both (I) and (III) above
e. Both (II) and (III) above.

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24. Which of the following is not true with regard to repo transactions?
I. These involve borrowings of unsecured nature
II. State government securities are not eligible for repo transactions
III. The interest rate on the borrowing is negotiated between the borrower and the lender.
a. Only (I) above
b. Only (II) above
c. Both (I) and (II) above
d. Both (I) and (III) above
e. None of the above.
25. Which of the following is not true with regard to depositories?
a. The securities are held in an electronic form
b. Securities are transferred by book entries
c. Stamp duty is payable on transfer of securities, though at a lesser rate than physical
transfer of securities
d. There is no risk of bad deliveries
e. All corporate actions are handled by depositories.
26. Allease Ltd. leases an equipment costing Rs.10 lakhs to Best Ltd. for a period of 3 years. The
lease rentals are payable yearly in advance at the rate of Rs.110 ptpq. If the lease rentals
attract a sales tax of 4% and marginal cost of debt of Best Ltd. is 14%, the present value of
lease payments for Best Ltd. is
a. Rs.12.11 lakhs
b. Rs.11.65 lakhs
c. Rs.11.20 lakhs
d. Rs.10.63 lakhs
e. Rs.10.22 lakhs
27. Which of the following statements is/are true about Real Estate Investment Trusts (REITs)?
I. REITs can be viewed as mutual funds that invest in real estate properties and/or
mortgages.
II. REITs are permitted to issue only shares of beneficial interest and cannot raise
funds by way of bank borrowings.
III. Many REITs list their shares on the stock exchanges or their shares are traded in
the OTC markets.
a. Only (I) above
b. Both (I) and (II) above
c. Both (I) and (III) above
d. Both (II) and (III) above
e. All (I), (II) and (III) above.
28. Vijay Limited is planning a rights issue of equity shares in the ratio of 1 right share for every
5 shares held. If the current market price of the share is Rs.45 and ex-rights price should not
fall below Rs.43, subscription price should be more than or equal to
a. Rs.10
b. Rs.30
c. Rs.33
d. Rs.42
e. Rs.44.
29. The required amount of successful bids by a primary dealer who participated in the bidding
of treasury bills is Rs.400 crores. The commitment to aggregate bidding would have been
a. Rs.1,000 crores
b. Rs.1,200 crores
c. Rs.1,400 crores
d. Rs.1,600 crores
e. Rs.2,000 crores.

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30. Not more than ____% of the Foreign Currency Convertible Bonds raised by an Indian
company should be used for general corporate restructuring including working capital
requirements.
a. 10
b. 15
c. 20
d. 25
e. 30.

END OF PART A

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 Part B : Problems (50 Points)
• This part consists of questions with serial number 1 – 5.
• Answer all questions.
• Points are indicated against each question.
• Detailed workings should form part of your answer.
• Do not spend more than 110 - 120 minutes on Part B.

1. I@Dreams Entertainment Ltd. is a leading producer of entertainment software. I@Dreams intend to expand
its production expertise to meet the growing demand in the domestic and the international entertainment
market. For this it wants to finance its expansion mainly through the ECB route. The company has received
the following offer from the Bank of Tokyo. AMEX has agreed to provide guarantee cover on this loan.
The terms and conditions of the loan are as follows:
Amount 40 billion Yen
Maturity 8 years
Draw down 20 billion Yen on January 01, 2003
20 billion Yen on January 01, 2004
Interest 125 BP over Yen LIMEAN, payable annually
Management fee 20 BP
Underwriting fee 30 BP
Commitment fee 15 BP (payable at the beginning of the year)
Agency fee 30 million Yen per annum (payable at the beginning of the year)
Guarantee fee 60 BP (payable at the end of the year)
Amortization 4 equal installments at the end of 5th, 6th, 7th and 8th year

The expected Yen LIBOR and LIBID, as per a survey conducted by Japanese Bond Research Institute
(JBRI), are as follows:

Year LIBOR (%) LIBID (%)

2003 1.50 1.40
2004 2.00 1.85
2005 3.00 2.75
2006 2.75 2.55
2007 2.85 2.50
2008 2.10 2.00
2009 2.05 1.85
2010 2.00 1.75
2011 1.80 1.50
You are required to
a. Compute the effective cost of the loan to I@Dreams Entertainment Ltd.
b. State the provisions regarding the end use of ECBs as per the Guidelines on Policies & Procedures for
External Commercial Borrowings for 1999-2000.
(7 + 2 = 9 points)

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2. Best Financial Services Ltd. (BFSL) is a financial service company offering leasing, hire purchase and
other financial services to its customers. Recently, Fitwell Fabrics Ltd. (FFL) has approached BFSL for
funding its investment in a machinery costing Rs.100 lakhs for its expansion program. The machinery is
estimated to have a life of 5 years and a salvage value of Rs.10 lakhs at the end of 5 years. The tax relevant
rate of depreciation is 30%.
FFL expects to generate cash flow from the second year and requests BFSL to structure the lease rentals in
such a way that the lease rentals payments match the cash flow of FFL. After careful analysis, FFL and
BFSL agreed for the following pattern of lease payments over the lease period of 5 years:
Year Lease Rentals
1 Nil
2 Nil
3–5 Rs.120 ptpq payable quarterly in advance
BFSL has suggested the alternate mode of financing i.e. hire purchase. Under hire purchase BFSL requires
20% of the cost of asset as down payment and payment to be made quarterly in arrears over a period of 5
years. BFSL allocates interest on SOYD basis.
BFSL falls in the tax bracket of 30%. Ignore interest tax.
Your are required to:
a. Determine the flat rate of interest under hire purchase facility so that BFSL is indifferent between
leasing and hire purchase.
b. Show the accounting treatment of the hire purchase transaction in the books of BFSL for the first two
years.
(13 + 4 = 17 points)
3. Mr. S plans to purchase a vehicle worth Rs.75,000. He approaches Citywide Financial Services to finance
the purchase of vehicle under its Express Cash Personal Loans Scheme.
The following details are provided by the finance company:
Monthly outgoings are:
Loan Amount Monthly Installment (Rs.)
(Rs.) 12 months 24 months 36 months
25,000 2,417 1,375 1,033
50,000 4,833 2,750 2,066
75,000 7,250 4,125 3,099
• 2% processing fee (minimum Rs.300) to be paid upfront.
• No prepayment charges.
• On the day of prepayment the borrower has to pay only the balance of capital. Interest is allocated
to the installments on a straight line basis.
You are required to:
a. Calculate the flat rate and effective rate of interest that would be charged on the loan granted to Mr. S
by the finance company for a loan period of 36 months.
b. Calculate the effective rate of interest assuming Mr. S prepays the loan at the end of the 30th month
under the finance scheme.
(3 + 3 = 6 points)

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4. First Finance Corporation, a leading US private equity fund has recently started its operations in the Indian
market by way of providing equity and mezzanine finance to corporates desiring public offering of their equity.
Sri Sai Balaji Food Processing Pvt. Ltd. is a fast growing Hyderabad based food processing company. It
intends to acquire some advanced food processing machines from Germany. The Managing Director of Sri
Sai Balaji approaches First Finance Corporation Ltd. to make an equity investment of Rs.15 crore.
The current EPS of Sri Sai Balaji is Rs.9 and the expected growth rate of EPS as estimated by the company
for the coming year is as follows:
Growth rate in EPS (%) Probability (%)
10 20
20 50
30 30
The forecast of the Financial Analyst of First Finance regarding the P/E ratio for the Indian Food
Processing industry is as follows:
P/E ratio Probability (%)
15 30
22 45
30 25
The salient features of investment policies of First Finance Corporation Ltd. are as follows:
• The time horizon of all investments made is 1 year
• The target return should be 40%
• The probability of achieving the target return should be at least 72%
• Divestment is priced at industry P/E ratio.
You are required to use the normal distribution table and compute the price per share at which First
Finance Corporation Ltd. should invest in Sri Sai Balaji Food Processing Pvt. Ltd.
(10 points)
5. Paribus Factors, a subsidiary of BNP Paribus offers recourse factoring on the following terms:
Facility Recourse Factoring
I. Discount charge (payable up-front) 18% p.a.
II. Reserve 21%
III. Commission 2.5%
The Finance Manager of Fabulous Furnishings Ltd, a dealer in home furnishings has approached Paribus
Factors to factor its receivables. After intricate analysis of the sales documents of Fabulous Furnishings
Ltd, Paribus Factors offered a guaranteed payment period of 45 days.
The following information about the credit policy and trends of Fabulous Furnishings Ltd is available:
Fabulous Furnishings sells on terms 2/10 net 45. On an average 50% of the customers pay on the 10th day
and avail the discount. Again on an average the remaining customers pay 80 days after the invoice date
The bad debts and losses amount to 1% of the sales invoices
The sales personnel are responsible for following up collections and by and large the Fabulous Furnishings
can increase its annual sales by Rs.25 lakhs if the sales people are relieved from collection jobs. The gross
margin on sales is 28% and the estimated sales turnover for the following year without considering the
increase in sales is Rs.300 lakhs
By offloading sales ledger administration and credit monitoring, Fabulous Furnishings can save overheads
to the extent of Rs.1.50 lakhs per annum
Currently, Fabulous Furnishings is financing its investments through a mix of bank finance and long-term
funds in the ratio of 3:2. The effective rate on bank finance is 17% and the pre-tax cost of long-term funds
is 21%.
Your are required to:
a. Perform cost-benefit analysis of recourse factoring and advise Fabulous Furnishings whether to accept
the factoring proposal or not.
b. Find out the maximum rate of factoring commission Fabulous Furnishings can pay if it wishes to
relieve the cost of bad debts and be indifferent between recourse and non-recourse factoring.
(6 + 2 = 8 points)
END OF PART B

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 Part C : Applied Theory (20 Points)
• This part consists of questions with serial number 6 - 7.
• Answer all questions.
• Points are indicated against each question.
• Do not spend more than 25 -30 minutes on Part C.

6. The National Housing and Habitat Policy outlined the urgency of development of mortgage market in the
country. In this context, discuss four different forms of non-traditional mortgages.
(10 points)
7. Credit rating has emerged as one of the very important financial services. Discuss the various steps in credit
rating. How does a shadow rating vary from a formal rating?
(10 points)

END OF PART C

END OF QUESTION PAPER

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 Suggested Answers
Investment Banking and Financial Services –I (261) : Oct 2002
Part A : Basic Concepts
1. Answer : (d)
Reason : In the auction of T-Bills in India, successful competitive bids will be accepted upto the minimum
discounted price called ‘cut-off’ price determined at the auction. The bids above the cut-off
price are accepted completely and bids at offer prices below cut-off price are rejected. If the
notified amount is not fully subscribed to, the non-competitive bids are accepted at the weighted
average of the successful bids. Hence (I) is true. Dutch auction is an auction in which all the
successful bidders pay the price of the lowest accepted bid. English auction is an auction where
the successful bidders pay the price at which they have bided. As all the successful bidders will
be allotted the T-Bills at the respective prices at which the bids have been made, it is an example
of English auction. Hence, (II) is not true. Winner’s curse is a situation where the bids are
accepted but the bidder may make a loss. As in auction of T-Bills, all the successful bidders pay
the price at which they have bided there is always a chance of the bidder bidding too high. Hence
winner’s curse can happen in a T-Bills auction. Hence (III) is true. Hence, (d) is correct answer.
2. Answer : (a)
Reason : Currently the settlement in the Indian stock exchanges is done on a T+3 system. Hence (a) is the
correct answer.
3. Answer : (a)
Reason : According to capital adequacy norms applicable to NBFCs, underwriting obligations with
respect to shares and debentures carry a credit conversion factor of 50%.
4. Answer : (a)
Reason : Cross border factoring also referred to as an international factoring is similar to domestic
factoring except that there are usually four parties to the transaction – exporter, importer, export
factor and import factor. Under this system, the exporter enters into a factoring agreement with
the export factor who in turn enters into an arrangement with a factor based in the country where
the importer resides and contracts out the tasks of credit checking etc. Hence, (II) is true and the
answer is (a).
In this factoring arrangement, the client assigns the export receivables to the export factor but the
export factor does not assign the same to the import factor. Hence, (I) is incorrect. Although
cross border factoring employs the two factor system, the exporter is required to deal with only
one factor residing in his country. Hence, (III) is also incorrect.
5. Answer : (c)
Reason : The total amount of public deposits (other than that from the share holders) that can be
outstanding at any point of time cannot exceed 25% of the aggregate of paid-up capital and free
reserves. Hence the maximum amount of public deposit that ASMA can raise from the public
(except its shareholders) = 25% of aggregate of paid-up capital and free reserves = 25% of (24 +
16) = 25% of Rs.40 crores = Rs.10 crores. Hence (c) is the correct answer.
6. Answer : (c)
Reason : CCPS are similar to convertible bonds i.e. they are eventually converted to equity. CCPS pays
fixed dividend. CCPS helps companies to maintain EPS and increase the leveraging capacity of
the company as they are considered as part of owner’s capital. Hence, (I) is true. CCPS can be
considered as a part of the net worth of the company even before its conversion. Hence, (II) is
also true. CCPS can be issued with warrants. Hence (III) is incorrect.
7. Answer : (e)
Reason : The minimum denomination and maturity of the American CDs is $100000 and 30 days
respectively. Hence (e) is the correct answer.

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8. Answer : (e)
Reason : The stamp duty payable on a 9 months CP is 0.375% on the face value. And stamp duty is
always payable by the issuer. Hence stamp duty payable on a 9 months CP of Rs.1000000 is
0.375% of Rs.1000000 = Rs.3750, and this is payable by the issuer. Hence (e) is the correct
answer.
9. Answer : (d)
Reason : For an underwritten issue, the minimum underwriting that has to be committed by the Lead
Manager to the issue is 5% of the issue size or Rs.25 lakhs, whichever is less. Hence (d) is the
correct answer.
10. Answer : (e)
Reason : The registration fee payable to SEBI for an issue of size above Rs.500 crore is Rs.5,00,000.
Hence the registration fee payable to SEBI by Divine Divas for an IPO of Rs.1,000 crore is
Rs.5,00,000. Hence (e) is the correct answer.
11. Answer : (d)
Reason : For an issue price of Rs.100 to Rs.400, the market lot is 50 shares. Thus for an issue price of
Rs.250 (5 + 245), the market lot would be 50 shares. Hence (d) is the correct answer.
12. Answer : (d)
Reason : An instrument, which is rated MA from ICRA is a Fixed Deposit. Hence (d) is the correct
answer.
13. Answer : (e)
Reason : In all of the following stages, sales tax affects a lease transaction:
• When the asset is purchased by the lessor for the purpose of leasing
• When the right to use the asset is transferred to the lessee for a valuable consideration
• When the asset is sold by the lessor at the end of the lease period
Hence (e) is the correct answer.
14. Answer : (e)
Reason : In (I), as the realization value exceeds economic value, it appears that the firm should disinvest
and therefore RV is the most appropriate measure. But applying the criterion of “loss suffered on
deprivation”, it is clear that the replacement cost is the most appropriate measure. In (II) and
(III), the loss suffered by the firm on deprivation is the replacement cost. Hence replacement cost
is the most appropriate measure under all the situations. Hence (e) is the correct answer.
15. Answer : (d)
Reason : Interest rebate, R = [t(t + 1)/n(n + 1)] x D,
Where, t = number of level installments that are not due and outstanding = 48 – 30 = 18.
And n = total number of level installments = 48
D = total charge of credit = Rs.48 × 1,000 – 46,750 = Rs.1,250
18 ×19
Hence R = × Rs.1,250 = Rs.181.76
48 × 49
Hence (d) is the correct answer.
16. Answer : (e)
Reason : Effective rate of interest is value of ‘r’ in the following:
2,400 PVIFAr,12 = 25,000
PVIFAr,12 = 10.417
Looking at the interest tables and by interpolation r = 30.67%.

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17. Answer : (c)
Reason : Factoring differs from bills discounting in the following respects
• In a bill discounting arrangement, the financial intermediary does not assume the
responsibilities of sales ledger administration and collection of debts, which the factor does
under the factoring arrangement. Hence, I is true.
• The bill discounting arrangement is recourse to the client whereas a factoring arrangement
can be with or without recourse. Hence, III is true.
• Unlike factoring, no notice of assignment is provided to the customers of the client under
the bill discounting arrangement. Hence, II is not true.
Hence (c) is the correct answer.
18. Answer : (e)
Reason : Charge cards, is a variation of plastic money where the entire payment is normally paid within
30 days of purchase. Hence (a) is not true.
Interest is not charged as there is no extension of payment period. Hence (b) is not true.
Both annual payment and commission is charged in case of charge card. Hence, (c) is not true.
Amount of payment to be made is 100% of the purchase. Hence, (d) is also not true.
Unlike credit cards, as the entire payment is made there is no present spending limit. Hence, (e)
is true.
19. Answer : (d)
Reason : Cash flow coverage ratio = [EBILT + D]/[I + L + {LR/(1 – t)}]
= [250000 + 50000 + 25000]/[30000 + 50000 + {5000 / (1 – 0.3)}] = 3.73.
Hence (d) is the correct answer.
20. Answer : (c)
Reason : Before roll over of NCDs or the non convertible portion of PCDs, fresh credit rating shall be
obtained within a period of 6 months prior to the date of redemption and communicated to
debenture holders before roll over. Hence (c) is the correct answer.
21. Answer : (d)
Reason : LTV is used by the lenders to indicate the percentage of down payment required by them. High
LTVs are quoted only for newer, readily marketable properties and in times of lower interest
rates. Hence (I) and (III) are true and (d) is the correct answer. However, as the mortgage
balance declines, LTV also declines. Hence, (II) is not true.
22. Answer : (a)
Reason : A bow tie protects both the lender and the borrower against the volatility in the interest rates. If
the market rates of interest exceed the ceiling rate agreed upon the documentation, an additional
amount may have to be added as a balloon payment to the principal at maturity. Hence (a) is the
correct answer.
Mini-Perm is a short-term loan extended at the time of completion of the project to provide bridge
finance until the developer can obtain financing of a more permanent nature. It has no relevance to the
interest rate risk. Gap loan are extended to the developer to cover the difference or gap between the
bank construction loan and the total cost of the project. Gap loans also have no relevance to the
interest rate risk. Buy down loans are similar to pledged a/c mortgages where the seller of the property
places cash in a segregated account in order that additional amounts required may be drawn and paid
along with the mortgage payments done by the borrower. Interest rate risk has no relevance in case of
buy down loans. Hence, (b), (c), (d) and (e) are not true.
23. Answer : (a)
Reason : Call money market is a part of the money markets, where, day-to-day surplus funds, mostly of
banks are traded. The interest paid on call loans are known as the call rates. Call rates are
expected to freely reflect the day-to-day market scarcities or lack of funds. These rates vary very
often and are considered as very volatile. Hence, (II) is true & (a) is the answer. Call rates are
calculated on a daily basis. Hence, (I) is incorrect. High rates indicate a tightness of liquidity
while low rates indicate an easy liquidity position in the market. Hence, (III) is also incorrect.

13
24. Answer : (c)
Reason : Repo (Ready Forward Deal) is an agreement, which involves a sale of a security with an
undertaking to buy-back the same security at a predetermined price at a future date. If a bank
borrows amount through a repo, the lender will receive a security duly transferred which will be
held in his name till the reversal of the transaction takes place. Though very unlikely, in the
event of the reversal not taking place, the lender does not suffer any loss since the transaction
tantamounts to an outright purchase of a security. Hence, the borrowing under Repo is a secured
borrowing. Hence, (I) is not true. RBI announces the nature of securities eligible for Repo
transactions as a part of development of the repo market. Even State Government Securities have
been made eligible for undertaking repos. Hence, (II) is also not true and statement is the answer.
The interest rate on the borrowing will be mutually negotiated depending on the term, amount
and the prevailing call money and term money rates. Hence, (III) is true.
25. Answer : statement
Reason : A depository is an entity which holds the securities in electronic form on behalf of the investor.
Dematerialization is a process by which physical certificates of the investor are destroyed and an
equivalent number of securities are credited to the account of the investor. This also enables
transfer of securities by book entries. The risk of bad deliveries is also eliminated. Further the
depository also handles all the corporate actions like exercising for rights, collection of
dividends, credit for bonus, exercising of warrants, conversion option, etc. on behalf of the
investor. Transfer of securities through depository does not attract stamp duty. Hence, statement
is the answer.
26. Answer : (a)
Reason : Present value of lease payments to Best Ltd. at the marginal cost of debt of 14% is
0.11 × 10 × 4 PVIFA14%,3 × 1.04 × 1.14 = Statement12.11 lakhs.
27. Answer : statement
Reason : The indirect real estate equity investment is done predominantly through equity real estate
investment trusts (REITs). In a loose sense, REITs can be viewed as mutual funds that invest in
real estate properties and/or mortgages instead of securities such as bonds and shares. Hence, (I)
is true. REITs list their shares on the stock exchanges or their shares are traded in the over-the-
counter markets. Hence, (III) is true and statement is the answer. REITs raise the funds required
for investment in properties through issue of shares of beneficial interest (analogous to equity
shares), borrowings from institutions such as banks and insurance companies and issue of a
variety of debt instruments. Hence, (II) is not true.
28. Answer : statement
Reason : Ex-rights price ≥ Statement43
NPO + S
≥ 43
N +1
Where N is the number of share required for 1 right share = 5
P0 is the current market price = 45
S is the subscription price
5× 45 + S
Therefore, ≥ 43
5+1
S ≥ 43 × 6 – 5 × 45
≥ Statement33.
29. Answer : (a)
Reason : The minimum success ratio for primary dealers is 33.33% for government securities and 40% for
treasury bills. If the required amount of successful bids in the bidding of treasury bills is
400
Statement400 crores, commitment to aggregate bidding is = Statement1,000 crores.
0.4
30. Answer : (d)
Reason : According to the guidelines issued for FCCBs and Euro issue, not more than 25% of the FCCB
issue proceeds may be used for general corporate restructuring including working capital
requirements. Hence, (d) is the answer.

14
 (261)
Part B : Problems
1. a.
Year LIBOR LIBID LIMEAN Interest rate
2003 1.50% 1.40% 1.45% 2.70%
2004 2.00% 1.85% 1.93% 3.18%
2005 3.00% 2.75% 2.88% 4.13%
2006 2.75% 2.55% 2.65% 3.90%
2007 2.85% 2.50% 2.68% 3.93%
2008 2.10% 2.00% 2.05% 3.30%
2009 2.05% 1.85% 1.95% 3.20%
2010 2.00% 1.75% 1.88% 3.13%
2011 1.80% 1.50% 1.65% 2.90%

(Amount in billion Yens)

Upfront 31.12.03 31.12.04 31.12.05 31.12.06 31.12.07 31.12.08 31.12.09 31.12.10

Drawdown 20.0000 20.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Amortization 0.0000 0.0000 0.0000 0.0000 0.0000 10.0000 10.0000 10.0000 10.0000

Interest 0.0000 0.5400 1.2720 1.6520 1.5600 1.5720 0.9900 0.6400 0.3130

Management fee 0.0800 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Underwriting fee 0.1200 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Commitment fee 0.0300 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
Agency fee 0.0300 0.0300 0.0300 0.0300 0.0300 0.0300 0.0300 0.0300 0.0000

Guarantee fee 0.0000 0.1200 0.2400 0.2400 0.2400 0.2400 0.1800 0.1200 0.0600
Net Cash Flow 19.7400 19.3100 -1.5420 -1.9220 -1.8300 -11.8420 -11.2000 -10.7900 -10.3730

Effective cost of borrowing to Entertainment Ltd. is the IRR of the above cash flow = 4.3773%
b. A. External commercial loans are to be utilized for import of capital goods and services (on FOB or
CIF basis) and for project related expenditure in all sectors subject to following conditions:
a. ECB raised for project-related rupee expenditure must be brought into the country
immediately.
b. ECB raised for import of capital goods and services should be utilized at the earliest and
corporates should strictly comply with RBI’s extant guidelines on parking ECBs outside till
actual imports. RBI would be monitoring ECB proceeds parked outside.
c. ECB raised is not permitted for investment in stock market or in real estate.
B. Corporate borrowers will be permitted to raise ECB to acquire ships/vessels from Indian
shipyards.
C. Under no circumstances, ECB proceeds will be tilized for
i. Investment in stock market; and
ii. Speculation in real estate.

15
2. If BFSL has to be indifferent between leasing and hire purchase, the IRR on both the transactions should be
same.
IRR on the lease transaction is the discounting rate in the following:
– Investment cost + PV of lease rentals – PV of tax on lease rentals + PV of DTS + PV of salvage value
=0
a. Investment cost = Statement100 lakh
r r
b. PV of lease rentals = 0.12 x 100 x 4 4 x PVIFAr,3 PVIFr,2 = Statement48 4 PVIFAr,3 PVIFr,2
d d
lakhs
c. PV of tax on lease rentals = 0.120 x 100 x 4 x PVIFAr,3 PVIFr,2 x 0.3
= Statement14.4 PVIFAr,3 PVIFr,2 lakhs
d. Depreciation tax shield: (Statement lakhs)
Year Depreciation Depreciation Tax Shield
1 30.000 9.000
2 21.000 6.300
3 14.700 4.410
4 10.290 3.087
5 7.203 2.161
PV of DTS = (Statement9PVIFr,1 + 6.3 PVIFr,2 + 4.41PVIFr,3 + 3.087 PVIFr,4 + 2.161PVIFr,5)
e. PV of salvage value = Statement10PVIFr,5 lakhs
IRR is the value of r in the following
r
–100 + 48 4 PVIFAr,3 PVIFr,2 – 14.4PVIFAr,3 PVIFr,2 + 9PVIFr,1 + 6.3PVIFr,2 + 4.41PVIFr,3
d
+ 3.087 PVIFr,4 + 2.161PVIFr,5 + 10PVIFr,5 = 0
At r = 12%
– 100 + 48 × 1.0739 × 2.402 × 0.797 – 14.4 × 2.402 × 0.797 + 9 × 0.893 + 6.3 × 0.797 + 4.41 × 0.712
+ 3.087 × 0.636 + 2.161 × 0.567 + 10 × 0.567
= –100 + 98.682 – 27.567 +8.037 + 5.02 +3.140 + 1.963 + 1.225 + 5.67 = Statement–3.829.
At r = 10%
– 100 + 48 × 1.0618 × 2.487 × 0.826 – 14.4 × 2.487 × 0.826 + 9 × 0.909 + 6.3 × 0.826 + 4.41 × 0.751
+ 3.087 × 0.683 + 2.161 × 0.621 + 10 × 0.621
= – 100 + 104.698 – 29.581 + 8.181 + 5.204 + 3.312 + 2.108 + 1.342 + 6.21 = Statement1,474.
By interpolation
1.474
r = 10 + x2
1.474 + 3.829
= 10.56% = 11% (approx)
HP Transaction:
Let the value of hire payments be Statement H lakhs per quarter.
A. Loan amount = 100 x 0.8 = Statement80 lakhs.
i
B. PV of hire payments = 4H PVIFA11%,5 x 4 = 4H × 3.696 × 1.0404
i
= Statement15.381H lakhs.
C. PV of the tax on finance changes:
Total charge for credit = 4H × 5 – 80
= 20 H – 80
= Statement20 (H – 4) lakhs

16
 (Statement in lakhs)
Year S0YD factor Interest PVIF at 11% PV
20 + 19 + 18 + 17 74
1 = 7.048 (H– 4) 0.901 6.350 (H – 4)
20 + ......... + 1 210
16 +15 + 14 +13 58
2 = 5.524 (H– 4) 0.812 4.485 (H – 4)
20 + .........+ 1 210
12 + 11 + 10 + 9 42
3 = 4 (H– 4) 0.731 2.924 (H – 4)
20 + .........+ 1 210
8+7+ 6+5 26
4 = 2.476 (H– 4) 0.659 1.632 (H – 4)
20 + .........+ 1 210
4 + 3 + 2 +1 10
5 = 0.952 (H– 4) 0.593 0.565 (H – 4)
20 + .........+ 1 210
15.956 (H – 4)
PV of tax on finance charges = 15.956 (H – 4) x 0.3
= Statement4.787 (H – 4) lakhs
Hire payments is the value of H in the following:
– A + B – C =0
– 80 + 15.381 H – 4.787 (H – 4) = 0
10.594H = 60.852
H = 5.744 lakhs.
5.744 × 4 × 5 − 80
Flat rate = ×100 = 8.72%
80 × 5
b. Accounting treatment:
Annual hire payment = 5.744 x 4 = Statement22.976 lakhs
Allocation of total charge for credit
Statement lakhs
Year Interest Capital content
1 12.292 10.684
2 9.634 13.342
3 6.976 16.000
4 4.318 18.658
5 1.660 21.316

Income Statement
(Rs. in lakhs)
Year 1 Year 2 Year 1 Year 2
Hire Finance income 12.292 9.634
Balance Sheet
Year 1 Year 2 Year 1 Year 2
Current liabilities: Stock on Hire 91.904 68.928
Unmatured Finance Income 22.588 12.954

17
3. a. Loan = Rs.75,000
EMI = Rs.3,099
3099 × 36 − 75,000
Flat rate of interest = = 16.25%
3 × 75,000
Effective rate of interest is ‘i’ in the following:
3099 PVIFAi,36 + 1500 – 75,000 = 0
‘i’ is approximately 2.456% p.m. = 33.8% p.a.
75,000 × 0.1625
b. Interest per month on straight line basis = = Rs.1015.63
12
As interest is charged on straight-line basis each EMI has an interest portion of Rs.1016 and a
principal portion of Rs.2083.37.
∴ Capital repaid upto 30th installment = Rs.62,501
Balance principal to be repaid = Rs.12,499.
Effective rate of interest is ‘i’ in the following:
3099 PVIFAi,30 + 1500 + 12499PVIFi,30 – 75,000 = 0
‘i’ is approximately 2.25% p.m. = 30.6% p.a.

4.
Growth Expected (Expected price –
P/E Exp. Joint (Expected price –
rate in Exp. EPS price – 2 Average Price)2 ×
ratio Price Prob. Average Price)
EPS Average price Prob.
(Rs.) (Rs.) %
(1) (2) (3) (4) (5) (6) 7 = (6)2 8 = (5) x (7)
0.10 15 9.9 148.5 0.06 – 89.99 8098.20 485.89
0.20 15 10.8 162.0 0.15 – 76.49 5850.72 877.61
0.30 15 11.7 175.5 0.09 – 62.99 3967.74 357.10
0.10 22 9.9 217.8 0.09 – 20.69 428.08 38.53
0.20 22 10.8 237.6 0.225 – 0.89 0.7921 0.18
0.30 22 11.7 257.4 0.135 18.91 357.59 48.27
0.10 30 9.9 297.0 0.05 58.51 3423.42 171.17
0.20 30 10.8 324.0 0.125 85.51 7311.96 914.00
0.30 30 11.7 351.0 0.075 112.51 12658.5 949.39
Average
238.49 3842.14
Price
ó P = 3842.14
= 61.98
Probability of divestment price should be more than 72%
Let x be the divestment price
∴ Value of Z should be – 0.58
x -ì
Z = = − 0.58
ó
x − 238.49
= − 0.58
61.98
x = Rs.202.54.
Target return = 40%

18
 202.54 − P
i.e. = 0.4
P
202.54
P= = Rs.144.67
1.4
Hence, First Finance should invest at Rs.144.67/share.

5. a. The relevant costs associated with in-house management of receivables and recourse factoring are
listed below:
Relevant costs of in-house management of receivables
A. Cash discount = 300 × 0.02 × 0.50 = Rs. 3.0000 Lakhs
Average collection period = (10 × 0.50) + (80 × 0.50) = 45 days
Cost of bank finance = (300 × 3/5) × (45/360) × 0.17 = Rs.3.8250 lakhs
Cost of long-term funds = (300 × 2/5) × (45/360) × 0.21 = Rs. 3.1500 lakhs
B. Cost of funds invested in receivables = Rs.6.9750 lakhs
C. Bad debt losses = 300 × 0.01 = Rs.3 lakhs
D. Contribution lost on foregone sales = 25 × 0.28 = Rs.7.0000 lakhs
E. Avoidable cost of sales ledger administration & credit monitoring = Rs.1.5000 lakhs
Relevant costs of recourse factoring
F. Factoring commission = 325 × 0.025 = Rs.8.1250 lakhs
G. Discount charge = 325 × 0.79 × 0.18 × (45/360) = Rs.5.7769 lakhs
H. Cost of long term funds invested in receivables = 325 × 0.21 × 0.21 × (45/360) = Rs.1.7916 lakhs
Cost-benefit analysis of recourse factoring
I. Benefit associated with recourse factoring = A + B + D + E = Rs.18.4750 lakhs
J. Cost associated with recourse factoring = F + G + H = Rs.15.6935 lakhs
K. Net benefit = I – J = Rs.2.7816 lakhs
As the net benefit associated with recourse factoring, is positive Fabulous Furnishings is advised to
opt for recourse factoring.
b. As the net benefit should be same and as benefit of non-recourse factoring is increased by the amount
of bad debt losses i.e. Rs.3 lakhs, non-recourse factoring commission can be higher than recourse
factoring by Rs.3 lakhs.
∴ Non-recourse factoring commission = 8.125 + 3 = Rs.11.125 lakhs.
11.125
Rate = = 3.42%
325

19
 Part C: Applied Theory
6. The features of some of the popular forms of non-traditional mortgages are discussed below
Graduated-Payment Mortgages (GPMs)
The payments on GPMs unlike the payments on traditional mortgages are not equal. The payments under
GPMs start at a relatively low level and rise for a specified number of years and then become equal after
the specified number of years. The level of steps of increase and the specified number of years after which
the payments become equal depend upon the plan indicated in the mortgage agreement.
The terms of five popular plans are given in the table below:
Graduated-Payment Mortgages
Plan Term to Maturity (in years) Years that Payments Rise Percentage Increase per year
I 30 5 2.5%
II 30 5 5.0%
III 30 5 7.5%
IV 30 10 2.0%
V 30 10 3.0%
The comparison between monthly payments under a GPM based on Plan III and those under a traditional
mortgage for a loan of $100,000 at 10% interest is given below:
Year(s) Monthly Payment under GPM Monthly Payments under Traditional
$ Mortgage $
1 667.04 877.58
2 717.06 877.58
3 770.84 877.58
4 828.66 877.58
5 890.80 877.58
6-30 957.62 877.58
GPMs are preferred by young first-home buyers whose current income is not sufficient to take on a large
loan, but whose income is expected to increase rapidly in the near future.
As GPMs have smaller initial payments than the traditional mortgages, they do not pay down their
mortgage balances as quickly. Another feature of GPMs is that the mortgage balance increases for a short
period of time because smaller payments in the initial years do not even cover the interest and the short fall
is added back to the mortgage balance. However, with the increase in the monthly payments gradually
mortgage balance decreases and eventually reaches zero by the end of the term.
Figure 1 shows the mortgage balance for a traditional and a plan III GPM. Under plan III GPM mortgage
balances increase for a period of about 4 years and starts declining from then.

Figure 1: Comparison between Plan III GPM and a Traditional Mortgage

Pledged-Account Mortgages (PAMs)
PAMs are so structured that the repayments resemble traditional mortgages from the lender’s point of view
and the repayments resemble GPMs from the borrower’s point of view. This is achieved as follows:
Under PAMs some portion of the down payment as required under a traditional mortgage is deposited in a
savings account.

20
The borrower then pays installments which are lower than those under traditional mortgage. These
installments are increased at a specified percentage for a definite number of years and thereafter the
borrower pays equal installments. Thus, for the borrower the payments resemble a GPM.
The lender is however, paid equated monthly installments by drawing the difference between the
installment paid by the borrower and the installment due from the pledged savings account.
Buy Down Loans
The buy down loan is similar to the PAM; however, it is the seller of the property and not the
buyer/borrower who places cash in a segregated account in order that additional amounts required may be
drawn and paid along with the mortgage payments done by the borrower. The pledged account is created by
the seller out of his profits as in the absence of such pledged account, the borrower may not be eligible for
any kind of loan. The amount that the seller pledges is a direct reduction of the sale proceeds for him and
the borrower uses the seller’s money without himself having to repay this amount to the seller. Though,
theoretically this cost incurred by the seller may be inbuilt in the price by increasing it, the mortgage lender
may not allow it. Buy down loans are arranged by sellers who are anxious to sell their property.
Adjustable-Rate Mortgages (ARMs)
Many different kinds of ARMs have originated with their own features with the result that not all ARMs
are even referred to as ARMs. Terms such as VRM (variable-rate mortgage), ROM (roll over mortgage),
RRM (renegotiated-rate mortgage) and the like are used to refer to ARMs.
ARMs have a number of complex features:
• ARMs can have maturities that vary as well as interest rates. It is impossible to calculate in advance
the exact amortization schedule for an ARM.
• ARMs can have a provision that in any period, the interest cannot change beyond a specified basis
points is referred to as a `periodic cap’. It can also have a provision that the mortgage interest rate may
not rise above 2.5 percent (250 basis points) during the term of the maturity and is referred to as life
time cap.
• Another provision found on many ARMs is negative amortization. The borrower may be allowed to
maintain a constant monthly payment after an interest rate increase by opting to add any interest
shortfall to the outstanding mortgage balance. This process is allowed to continue until the mortgage
balance reaches a maximum amount at which time payments must rise.
With all these complexities, the ARM became popular due to the following reasons:
i. ARM reduces interest rate risk for the lender. Hence, for thrift institutions such as the S & Ls, ARMs,
in spite of the life time caps, offer obvious advantages.
ii. Borrowers accept ARMs because the lenders by offering lower initial rates express their preference
for ARMs. Depending on the competition and aggressiveness of the lender the initial interest rate on
ARM could be 1/2 percent to 2 percentage points or more below the rates being quoted for fixed-rate
mortgages. ARMs tend to be most popular when interest rates are highest and buyers are hunting for
arrangements that could lower initial outflows.
The disadvantage of ARMs is that they are difficult to be sold in pooled or security form as there are no
standard clauses. It is difficult to find large quantities of any one kind of ARM, as there are diversities in
initial interest rates, index, interest rate reset frequency, periodic or life time caps and so on.
Share-Appreciation Mortgages (SAMs)
High interest rates in the early 1980s brought about this innovative mortgage arrangement. SAMs use
inflation as a way of paying for the property. The lender agrees to charge a very low level of interest on the
funds and in turn, the borrower agrees to share part of the increase in the property value with the lender
when the loan matures, or when the property is sold or at some other specified time.
When SAMs came into existence, a one-third participation was popular; the lender would agree to decrease
the interest charged by about a third of the prevailing rate in return for one third of the appreciation in the
property value.
For the borrower SAMs are attractive as he can purchase an otherwise unaffordable home. The lender has
the potentially lucrative equity kicker, depending on the rate of inflation. However, the disadvantage with
SAMs is that they are not standardized and hence cannot be pooled, packaged into units and sold as securities.
Mortgage Pass Through Securities
When mortgages are pooled together and undivided interests in the pool are sold, pass-through securities
are created. The term `undivided’ in the context of pass-through securities means that each holder of the
security has a proportionate interest in each cash flow generated in the pool. When a pass-through security
21
 is sold, it is to be construed as a sale of assets and not as an issuance of debt obligations of the originator of
the mortgages. That is, the obligation to pay continues to be that of the borrowers collectively and the
originator has no obligation to pay. The pass-through securities promise that the cash flow from the
underlying mortgages would be `passed through’ to the holders of the securities in the form of monthly
payments of interest, principal and prepayments. When the holder of an individual mortgage prepays the
whole or part of the principal before the scheduled date, prepayments are said to occur.
Mortgage-backed Bonds
The mortgage-backed bonds, another form of asset securitization, were evolved to address a weakness
inherent in a mortgage pass-through security, namely, lack of call protection and poor predictability of cash
flow.
A mortgage-backed bond is a collateralized term-debt offering. It is secured by mortgages which have a
market value of 110 to 200 percent of the principal amount of the bond. Unlike the pass-through
certificates, the mortgages are not sold to the holder of the security, but are used only as collaterals for the
bonds which are issued to raise finance. The terms of these bonds are like the bonds floated in the capital
market – semi-annual or quarterly payments of interest at a fixed rate or floating rate and final bullet
payment of principal.
Collateralized Mortgage Obligations (CMOs)
CMOs retain many of the yield and credit quality advantages of passthroughs, while eliminating some of
the less desirable elements of the traditional mortgage-backed security. CMOs are bonds or debt obligations
issued by mortgage originators by offering whole loan mortgages or mortgage passthrough securities as
collateral. The cash flows generated by the assets in the collateral pool are first used to pay interest and then
pay principal to the CMO bondholders.
The major difference between traditional passthroughs and CMOs lies in the principal payment process. In
the case of passthrough securities, each investor receives a pro rata distribution of any principal and interest
payments (net of servicing fees) made by the homeowner. Since mortgages are self-liquidating assets, the
holder of a passthrough receives some return of principal each month. Until all the mortgages in the pool
are finally retired, complete return of principal and the final maturity of the passthrough does not occur.
Thus, a large difference between average life and final maturity is created and there is a great deal of
uncertainty with regard to timing of principal return under a passthrough security.

7. The various steps in credit rating:

1. The rating process commences when a client approaches the credit rating agency to analyze and
provide a rating symbol/report to a security/individual/borrower, etc.
2. The rating agency then assimilates all the necessary information required for this by meeting the
management of the company/borrower. The information provided for rating process will be highly
confidential and will not be used for any other purpose.
3. Based on the analyses of the report, the rating will be decided.
4. The rating will then be communicated to the client along with the reasons supporting the rating. If this
rating is not agreeable, the client may appeal for reviewing the rating for which additional/new
information will have to be provided.
5. If the rating is accepted by the client it will then be declared to the public by the credit rating agency.
6. Since rating is not a one time process, there will be a continuous monitoring of the client’s
performance and its operational environment. Based on this information the rating may be affirmed,
upgraded or downgraded. Any changes will, however, be informed to the public.
Types of Ratings
The rating services in the international markets can be classified into Shadow Rating and Formal Rating.
The basic distinction between these two types of ratings is that the shadow rating is an indicative rating and
will give the issuer an idea of its formal rating and suggests if it would be beneficial to go for a formal
rating.
Shadow Rating: The issuer will not have to disclose the rating to the public.
The firm can, either independently or with the help of its investment banker, assess its shadow rating by
proceeding in the following manner:
1. After collecting the relevant information, various financial ratios used by rating agencies can be computed.
2. Identify companies with similar projects having published ratings. The financial ratios of these
companies can be used for comparison.
22
3. Apart from these financial ratios, assess the management quality, performance of parent/group
companies.
4. Give more weightage to those factors/ information that have a major impact on the performance of
the company. Based on this also identify the strengths and limitations of the firm.
5. Use the ratings of the industry averages, other companies with similar projects and assign an
indicative rating.
6. To this indicative rating apply the sovereign limitations to get the final indicative rating. This rating
should preferably be in the form of a range and not as a specific rating.
Formal Rating: The issuer will have to announce the rating assigned in Formal Rating to the public.
The process involved in formal rating will be more detailed than the shadow rating process, since there will
be a need for more disclosures, and sometimes even plant visits may be involved in it. Further, the shadow
rating will not require any annual fee and meetings. While on the other hand, since formal rating will
involve monitoring, there will be an annual fee for such ratings. In addition to this there will also be annual
meetings.

23