Page 15 - DCOM304_INDIAN_FINANCIAL_SYSTEM

Indian Financial System

Notes Besides, long-term financial instruments are employed to procure funds for longer period of
time. Among various instruments, equity shares and bonds are the most popular.
Equity Shares represent the owner's equity. The holders of equity shares are residual owners
who have unrestricted claim on income and assets of the firm and who possess the voting power
in the firm.

Bonds are a long-term promissory notes with maturities ranging from 5 to 30 years. Holders of
bonds have priority of claim to income over equity shareholders and have legal recourse for
enforcing their rights. Further, the bondholders' claim to income is fixed and certain and the
borrowing firm is under a legal obligation to pay it in cash regardless of the level of earnings of
the firm. They have also priority over shareholders in respect of their claim on assets. Bonds
may be secured by mortgages and other assets of the firm or they may be unsecured. Unsecured
bonds are also known as debentures and are generally issued by firms of the highest credit
quality. Corporate bonds are usually bought by institutions not requiring high liquidity of
their financial assets.
Broadly speaking, financial assets perform two principal economic functions. One such function
is to funnel funds from those who have surplus of income over expenditures to those who need
funds to invest in tangible assets. Another function is reallocation of risk. Financial assets seek
to transfer funds in such a manner as to redistribute the unavoidable risk associated with the
cash flow generated by tangible assets among those seeking and those supplying the funds. The
following illustration will explain these functions.

Example:
1. A, a retired executive, has got a license to manufacture TV sets. He estimated that ` 5 crores
will be required to set up the plant and install machinery for the purpose.
2. A has lifetime savings of ` 1 crore. He does not want to invest it in plant and machinery.
3. B has recently inherited ` 3.5 crores. He plans to use ` 50 lakhs on some jewellery and
invest the remaining ` 3 crores.
4. C, a chartered accountant, has savings after taxes of ` 2.5 crores. He desires to spend ` 50
lakhs to install a computer system and invest the balance ` 2 crores.
These persons met at a social gathering. In course of their meeting, they discussed their future
plans and arrived at a deal. A agrees to invest ` 50 lakhs of his savings in the business and sells
a 50% interest to B for ` 3.5 crore. C agrees to lend A ` 1 crore for 5 years at an interest rate of 15%
p.a. A will be responsible for operating the business without the assistance of B and C. A now has
` 5 crores to manufacture TV sets.
In the above meeting, two distinct financial claims came out. The first is an equity instrument
issued by A to B for ` 3.5 crore. The other is debt instrument issued by A and purchased by C for
` 1 crore. Thus, the two financial assets allowed funds to invest to A, who needed funds to invest
in tangible assets. This transfer of funds is the first economic function of financial assets.
In this process of transfer of funds, it was noted that A was loath to invest his life savings of `1
crore in the venture and wanted to transfer part of that risk which he did by selling a financial
asset to B giving him a financial claim equal to one-half of the cash flow from the business. He
further managed to procure an additional fund from C, who is not keen to share the risk of the
business, by way of an obligation requiring payment of a fixed cash flow, irrespective of the
outcome of the venture. Thus, this shifting of risk is the second economic function of financial
assets.

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