B.Com(Hons.

) Semester-III Commerce

Skill Enhancement Course (SEC)

Personal Finance and Planning
Reference Material : Unit I

SCHOOL OF OPEN LEARNING

University of Delhi

Department of Commerce
-

,,
Unit I

TIME VALUE OF MONEY

II

To keep pace with the increasing COf!lpetition, companies have to go in for new ideas
implemented through new projects be it for expansion, diversification or modernization. A project is
an activity that involves investing a swn of money now in anticipation of benefits spread over a period of
time in the future. How do we detennine whether the project is financially viable or not? Our
immediate response to this question will be to sum up the benefits accruing over the future period and
compare the total value of the benefits 'with the initial investment. If the aggregate value of the benefits
exceeds the initial investment, the project is considere d to be financially viable. While this approach
prima facie appears to !JC satisfactory, w� must be aware of an important assump�on that underlies.
We have assumed that irrespective of the time when money is invested or received, the value of money
remains the same. Put differently, we have asswned that: value of one rupee now = value of one rupee at I'
the end of year 1 = value of one rupee at the end of year 2 and so on. We know intuitively that this
I
assumption is incorrect because money has time value. How d0 we define this time value of money
and build it into the cash flows of a project?

We intuitively know that Rs 1 000 in hand now is more valuable than Rs.1,000 receivable after
a year. In other words, we will not part with Rs.I, 000 now in return for a firm assurance that the same i
sum will be repaid after a year. But, we might part with Rs.I, 000 now if we are assured that something
more than Rs.1,000 will be IJaid at the end of the first year. This additional compensation required for
parting with Rs. l ,OQO now is called 'interest' or the time value of money. Normally, interest is
expressed in terms of percentage per annum.

Money has time value because of following reasons:

• lndividual generally prefer current consumption over future consumption of goods and ser­ I
vices though this preference may be subjective and differ from one person to another.
• Most individuals prefer present cash to future cash because of the available investment oppor­
tunities to whi�h they can put present cash to earn additional cash. This opportunity to get
return will not be available if the money is not invested now.
• The most important reason for time value of money is that future is not certain and therefore, he
prefers current cash than cash in future.
• ln inflationary conditions prices goes rise. As the price rise, the value of money goes down and
the purchasing power of rupee is also going down.

1
Valuation Techniques

There is a preference ofhaving money at present than at a future point oftime. This automatically
means that a person will have to pay in future more for a rupee received today and a person may accept
less for a rupee to be received in future.

The above statement relates to two different concepts:

1. Compound Value Concept
2. Present Value Concept

1. ComJ>Ound Value Concept: In case ofthis cno cept, the interest earned on the initial principal
becomes a part ofprincipal at the end ofthe compounding period. For example, ifRs. 100 is
invested at 100/o compound interest for two years, the return for first year will be Rs IO and for
the second year interest will be received on Rs. 110 (i.e. 100+10). The total amount due al
the end of second year will become Rs. 121 (i.e. 100 +10 + 11). This can be understood
better with the following illustration:

Exampl� : Rs. 1,000 is invested at I 0% compounded annually for three years. Calculate the
compounded value after three years.

Solution: Amount at the end of 1st year will be:

1,000 + (1,000 X 10) = Rs 1100

Amount at the end of2nd year will be:

1100+(1,IOOxlO ) =Rs 1210

Amount at the end of3rd year will be:

1,210+ (1, 210x 10) =Rs1331

The return from an investment is generally spread over a numbre ofyears. In the above illustration,
the interest has been compounded only for three years. However, ifinterest is calculated for five-six-years,
the method stated above would become tedious. The general equation used to calculate the compounded
value after 'n' years is given below:
A = P (l+ 1)''
where A = Amount at the end of period n
P =l>rincipal at the beginning ofthe period
i = Interest rate
n =Number ofyears.

The term (I +i)" is the compound value factor (CVF) ofa lump sum Re 1, and it always has a
value greater than 1 for positive i, indicating that CVF increases as i and n increase. The compound value
can he computed for any lump sum amount. Computation by this formula can also become very time
consuming if the number ofyears become large, say I 0, 15 or more. In such cases compound value tables
can be used.

2
 Compound Value of Rs. 1
. ·-
Peri<Jd I'¼. 15'¼ 3'¼ 4'¼ 5'¼ 6'¼ 7% 8% 9% 10% 11% 14% 15%
I 1.010 1.020 1 30 l.040 1.050 1.060 1.o70 1.080 1.090 1.100, 1.120 1.140 1.150
2 1.020 1.040 1.062 1.082 1.102 1.124 1.145 l.166 1.188 1210 1254 1.300 1.322
3 1.030 1.061 193 1.125 1.158 1.12] 1.225 1263 1.295 1331 1.404 1.482 1521
4 1.041 1.082 1.126 1.170 1.216 1262 1311 1360 1.412 l.464 1.574 1.689 1.749
5 I.OSI 1.104 1.159 1211 I21b 1338 1.403 1.469 1.530 1.611 1.762 1.925 2.01 I
6 1.062 1.126 1.194 1265 1340 1.419 l.501 1587 1.677 t.m 1.974 2.195 2.313
7 1.072 1.149 1.230 1316 1.407 1.504 1.606 l.71;4 1.828 1.949 2211 2.502 2.560
8 1.183 1.172 1267 .1.369 1.477 l.594 l.718 1.851 1.993 2.144 2.476 2.853 3.518
9 l.094 l.125 1.305 1.423 1.551 l.689 1.388 l.999 2.172 2358 2.773 3.252 3.518
10 1.105 1219 1.334 1.480 1.629 1.791 1.%7 2.159 2367 2.94 3.106 3.707 4 046
II· 1.116 1243 1.384 1539 1.710 1.898 2.105 2332 2.580 2.853 3.479 4.226 4.652
12 1.127 1268 1.426 1.601 1.7% 2.012 252 2.518 2.813 3.138 3.8% 4.818 5350
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452 3.363 4.492 6.153
14 1.149 1319 1.513 1.732 1.980 2261 2.579 2.937 3J42 3.797 4.887 6261 7.076
15 1'.61 1.346 1.558 J.801 2.079 2.397 2.759 3.172 3.642 4.177 5.474 7.138 8.137
16 1.173 1373 1.605 1.873 2183 2.540 2.952 3.426 3.970 4.595 6.130 8.137 9.358
17 1.184 1.400 1.653 1.948 2.92 2.693 3.159 3.700 4.328 5.054 6.866 9276 10.761
18 1.1% l.428 1.702 1..026 2.407 2.854 3.380 3.3% 4.717 5.560 7ff.1J 10.575 12375
19 1208 1.457 1.754 2.107 2527 3.026 3.617 4.316 5.142 6.116 8.613 12.056 14232
� 1.220 1.486 l.806 2.191 2653 3207 3.870 4.661 .604 6.728 9.646 13.743 16.637
25 1282 1.641 2.0974 2.666 3.386 4292 5247 6.848 8.623 .0.835 17.000 26.426 32.919
30 1.348 1.811 2.427 3243 4322 5.743 7.612 10.063 13268 17.449 29.960 50.960 66212

Using the above table, for example, we get the·same result.

A = P (1 + i)n
A = 1000(1 + .10)3
The compound value ofRs 1 at l 0% for 3 years period is 1.331.
A = 1000 x 1.331 -= 1331

Non annual compounding

Interest can be compounded more than once in a year. Saving institutions, particularly compound
the interest ·semi annually, quarterly and even monthly basis. When the interest is compounded semi annu­
ally, means interest is paid twice a year. The interest rate will be half. In other words, there are two periods
ofsix months. Similarly, in case ofquarterly cotnpounding interest rate will be ¼ di ofannual rate and there
are four quarters years. The formula for calculating the compound value is
A =P(l +i/m)"'"n
where A = Amount at the end ofperiod
P = Principal at the beginning ofthe period
i = Interest rate
n =Number ofyears
m = number oftimes per year compounding is made.

3
 &ample: A deposit ofRs. 10,000 is made in a bank.for a period of3 year. The bank offers to
receive interest 10% half-yearly. Calculate the compound value.

Solution: A = P(l + i/m)"'»'

A = 10000(1 + .10.'2)2x3
A = 10000(1 + .5)6
A = 10000 x 1.340
A= 11340.

The compound value ofRs. l at 5% interest for six years is 1.340 therefore, the compound v!llue
of10000 after 3 years at 10% is 11340.

Compound Value for series of cash flow

Usually an investor invest money in installments and wish to know the value ofhis saving after a
period oftime, then the compound value for series ofcash flow js calculated. For simplicity, we assume
that the compounding time period is one year and payment is made at the end ofeach year.

Example: Mr. X deposits each year Rs 500, Rs 1,000. Rs 1,5()9. Rs 2,000 and Rs 2,500 in his
saving bank account for 5 years. The interest rate is 5 per cent. He wishes to find the future value ofhis
deposits at the end ofthe 5th year.

Solution:
End of year Amount deposited Number of years Compounded Future value
compounded interest factor
I Rs. 500 4 1.216 Rs. 608.00
2 1,000 3 1.158 1,158.00
3 1,500 2 1.103 1,654.50
4 2,000 l 1.050 2,100.00
5 2,500 0 1.000 2,500.00
8,020.50

14'uture Value of an Annuity

Annuity is a fixed payment (or receipt) each year for a specified number ofyears. The formula for
this is
Sn =Ax (Vi, n)
where Sn = Compowid amount ofannuity
A = The value ofone payment
Vi, n = The table value of�uity corresponding to rate ofinterest
and number ofyears.

Let us illustrate the computation ofthe compound value ofan annuity.

4
 Example: A constant sum ofRs I 00 is deposited in a savings account at the end ofeach year for
four years at 5 per cent interest. Calculate the amount at the end offourth year.

Solution: This implies that Rs I 00 depositea at the end ofthe first year will grow for 3 years; Rs
I 00 at the end ofsecond year for 2 years, Rs 100 at the end ofthe third year for I year and Rs 100 at the
end ofthe fourth year will not yield an interest Using the concept ofthe annuity, the compound value is
Sn =Ax (Vi, n)
Sn = 100 x (5% for four years)
Sn = 100 x 4.3Jo·

• The value ofRs 1 as per the annuity table invested for four years at the rate of5%
Sn = 431.

Compound Value of Rs.1

Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
I 1.000 1.000 1.00 l.000 1.000 1.000 1.000 1.000 1.000 l.000
2 2.010 220 1.030 1.040 2.050 2.060 2.070 2.080 2.90 2.100
3 3.030 3.60 3.91 3.122 3.152 3.184 3215 3.246 3278 3.10
4 4.060 4.122 4.184 426 4.310 4.315 4.440 4.506 5.573 4.641
5 5.101 5.204 5.309 4.546 4526 5.637 5.751 5.867 5.958 6.I05
6 6.152 6308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716
7 7214 7.434 7.662 7.898 8.142 8394 8.654 8.923 9200 9.487
R 8286 853 8.892 9214 9549 9.897 10260 10.637 11.028 11.436
.9 9368 9.755 10.159 19.583 11.027 I 1.491 11.978 12.488 13.021 13.579
10 10.462 10.50 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.682 13.412 14.192 15.026 15.917 16:70 14.888 18.977 20.141 2IJ84
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24523
14 14.947 15974 17.086 18292 19598 2i.015 22.550 24.215 26.019 27.975
15 16.097 17293 18599 20.023 21.878 23276 25.129 27.152 29.361 31.m
16 17258 18.639 20.157 21.824 12.657 25372 27.8888 30.324 330.03 35949
17 18.430 20.012 21.761 23.697 25.840 28213 30.840 33.750 -36.793 40.544
18 19.614 21.412 23.414 25.645 28.132 30.90S 33.999 37.540 41.301 45599
19. 20.811 22.84 25.117 27.671 30.539 33.700 37.379 41.446 460.18 51.158
20 22.019 24297 26.870 29.778 33.066 36.785 40.995 45.762 51.169 57274
21 23239 25.783 28.676 31.969 35.719 39.992 44.865 50.422 56.764 64.022
22 24.471 27.299 30.536 ,34.248 38.505 43.392 49.005 55.456 62.872 71.402
23 25.716 28.845 32.452 36.618 41.430 46.995 43.435 00.893 69.531 79.542
24 26.973 30.421 34.426 39.082 44501 50815 258.176 66.764 76.789 88.496
\

25 28243 32.030 36.459 41.645 47.726 54.864 63.248 73.105 84.699 98.346
30 34.786 0567 47.575 56.084 66.438 79.057 94.459 113282 136.305 164.491

5
Present Value: Present Value or Discounting Technique

The concept of the present value is the exact opposite of that of compound value. While in the
latter approach money invested now appreciates in value because compound interest is added, in the
former approach (present value approach) money is received at-some future date and will be worth less
because the corresponding interest is lost during the period. In other words, the present value ofa rupee
that will be received in the future will be less than the value ofa rupee in hand today. Tus,
h
in contrast to the
compounding approach where we convert present swns into future swns, in present value approach future
sums are converted into present sums. Given a positive rate of interest, the present value of future rupees
will always be lower. It is for this reason therefore, that the procedure of finding present values is com­
monly called discounting. It is concerned with determining the present value ofa future amount, assuming
that the decision maker has an opportunity to earn a certain return on his money. 1bis return is designated
in financial literature as the discount rate, the cost of capital or an opportunity cost. Since finding present
value is simply the reverse of compounding, the formula for compounding of the sum can be readily
transformed into a present value formula.

where
p
- (I :i) " - A [ (I :i)" l
P = the present value for the future sum to be received or spent
A = the sum to be received or spent in future
i = interest rate
n = the number of years.

In order to simplify the present value calculations, tables are readily available fo. various ranges of
i and n.

This can be easily understood with this example.

Example : Mr. X has been given an opportunity to receive Rs 1,060 one year from now. He
knows that he can earn 6 per cent interest on his investments. What amount will he be prepared to invest
for this opportunity?

Solution:

A= 1060
i=6%
n = 1 year

p=
1060
(l+.0 6)

1060
P = 1 . 6 =Rs. 1000
0

6
 Example: Mr X wants to find the present value of Rs 2,000 to be received 5 years from now,
asswning l 0 per cent rate ofinterest.

Solution:
_ A = A[ 1 ]
p - (1+ i)" (1 + i)"

Or P =A (PV1F)

PVIF = Present value interest factor

•
PVIF as per Table for 5 years at 10% is 0.621.

Therefore, Present value = Rs 2.000 (0.621)

= Rs 1.242

Present Value of Re. 1

Ytars 5¾ 6" 8" 10¾ 12'¼ 1''¼ 15" 16'¼ 18'¼ 10¾ 11'¼ U¾ 15¾ 18'¼ JOU
I 0.952 0.943 0.926 0.909 0.893 0.877 0.870 0.862 0.847 0.833 0.820 0.806 0.800 0. 781 0.769
2 0.907 0.890 0.857 0.826 0.797 0.769 0.756 0.743 0 718 0.694 0.672 0.650 0.640 0.610 0.592
3 0.864 0.840 0.794 0.751 0.712 0.75 0.658 0.641 0.609 0.579 0.551 0.524 0.512 0.477 0.455
II 0.823 0.792 0.735 0.683 0.636 0.592 0.572 0.552 0.516 0:482 0.451 0.423 0.410 0.373 0 450
5 0.784 0.747 0.681 0.621 0.567 0.519 0.497 0.476 0.437 0.402 0.370 0.341 0.328 0.291 o.26<1
1
6 0.746 0.705 0.630 0.564 0.507 0.456 0.432 0.410 0.370 0.335 0.303 0.27� 0262 0.227 0.207
7 0.711 0.665 0.583 0.513 0.452 0.400 0.376 0.354 0.314 0.279 0.249 0.222 0.210 0.178 0.159
8 0.647 0.627 0.570 0.467 0.404 0.35 I 0.327 0.305 0.266 0.233 0.204 0.179 0.168 0 139 0 123
9 0.645 0.592 0.500 0.424 0.361 0.308 0.284 0.263 0.225 0.193 0.167 0.144 0 134 0 108 0 094
10 0.614 0.558 0.463 0.386 0.322 0.270 0.247 0.227 0.191 0.162 0.137 0.116 0.107 0 085 0 073
11 0.585 0.527 0.429 0.350 0.287 0.237 0.21S 0.195 0.162 0.135 0.112 0.094 0.087 006S 0 056
12 0.557 0.497 0.397 0.319 0.257 0.208 0.187 0.168 0.137 0.112 0.092 0.076 0.069 0 052 0 043
13 0.530 0.469 0.368 0.290 0.229 0.1112 0.163 0.145 0 I 16 0.093 0.075 0.061 0.055 0 040 0 033
14 0.505 0.442 0.340 0.263 0.205 0.160 0.141 0.125 0.099 0.078 0.062 0.049 0 044 () 012 0 02�
15 0.481 0.417 0.315 0.239 0.183 0.140 0.123 0.108 0.084 0.065 0.05 I 0.040 0.035 0 025 O 02i)
16 0.458 0.394 0.292 0.218 0.163 0.123 0.107 0.093 0.071 0.054 0.042 0.032 0 028 0 019 0 0 I,
17 0.436 0.371 0.270 0.198 0.147 0.108 0.093 0.080 0.060 0.045 0.034 0 026 0 023 o.o 15 0 f)l 2
18 0.416 0.350 0.250 0.180 0.130 0.095 0.081 0.069 0.051 0.038 0.028 0 021 0.018 0 012 0 009
19 0.396 0.33 I 0.232 0.164 0.0116 0.083 0.070 0.060 0 043 0.031 0.023 0.017 0.014 0 009 0 00.,
20 0.377 0.312 0.021' 0.149 0.104 0.073 0.061 0.051 O.OJ7 0.026 0.019 0.014 00 _
--
·-·-,, l').'i
Present Value of a Series of Cash Flows

In a business situation, it is ve1y natural that returns received by a firm are spread over a number of

7
years. An investment made now may fetch returns for a period after some time. Any businessman will like
to know whether it is worth to invest or forego a certain swn now, in anticipation ofretwns he will earn over
a number of year(s). In order to take this decision he will need to equate the total anticipated future returns
to the present sum he is going to sacrifice. To-estimate the resent value of future series of returns, the
present value of each expected inflows will be calculated. (In case of compounding, the expected future
value ofseries of cash flows was calculated).

The present value ofseries of cash flows can be represented by the following formula:
.A1 A2 A2 An
p = (l+i)1
+ 2 + (l+i)
(l+i) ···(l+it

p = f A-
+
,... 1 (1 i)

P = Sum of individual present values ofeach cash flow

A., A2 A3 = Cash flows after period 1, 2, 3, etc.
i = Discounting rate.

Example: Find out the present value of future cash inflows given the time value money as I 00/4
that will be received over next four years.

Year Cash flows (Rs)

I 1000
2 2000
3 3000
4 4000
Solution:

Year Cash flows (Rs.) Present Value Factor Present Value

1 1000 .909 909
2 2000 .826 1652
3 3000 .751 2253
4 4000 .683 2732
Present Value of series of cash flows Rs. 7546

Present Value of an Annuity

In the above case there was a mixed stream ofcash inflows. Annuity can be defined as a series of
equal cash flows ofan amount each time. Due to this nature ofan annuity, a short cut is possible.

8
 Ai A2 An n 1
PVAn = l 1 +
( +i) (l+i) 2 +...
(l+it
= [
(l+tttt
]

where PV A =Present value ofn annuity'

A = Value ofsingle instalment
i = Rate of interest.

However, as stated earlier a more practical method ofcomputing the present value would be to the
annual instalment with the present value factor. The fonnula wouid then be as follows:

PVA =A xADF

where ADF denotes Annuity Discount Factor.

Example: Mr. X wishes to detennine the present value ofthe annuity consisting ofcash inflows of
Rs 1,000 per year for 5 years. The rate ofinterest he can earn from hls investment is 10 per cent.

Solution:

Present Value of an Annuity of Rs 1000

Year end (1) Cash flows (2) PVF(J) Present Value (4)
(2) )( (J)
I •..
�
1000 .909 909
2 1000 .826 826
3 1000 .751 751
4 1000 .683 683
5 1000 .621 621
3790

The Present Value of an Annuity ofRs 1000 for 5 years is 3790.

However, calculations can be greatly cut short as the present value factor for each year is to be
multiplied by the annual amount ofRs 1,000. This method ofcalculating the present value ofthe annuity can
also be expressed as an equation:
P = Rs 1,000 (0.909)+ Rs 1,000 (0.826)+ Rs 1,000 (OTSl) + Rs 1,000 (0.683 + Rs
1 1,000 (0.621) = Rs 3.790.

Simplifying the equation by taking out 1,000 as common factor outside the equation.
P = Rs 1,000 (0.909 + 0.826 +0.751 +0.683 + 0.621) = Rs J : "'790) = Rs 3.790

9
 'Illus, the present value ofan annuity can be found by multiplying the annuity amount by the swn of
the present value factors for each year ofthe life ofthe annuity. Such ready-made calculations are available
in Table.

Present Value of Re. 1 Received Annually For NYears

Y�nrs s" 6¾ 8" 10¾ 12¾ U¾ IS" 16" 18¾ 20" 22¾ 2'" 25" 28" JO¾

I 0.952 0.943 0.926 0.909 0.893 0.877 0.870 0.862 0.847 0.833 0.820 0.806 0.800 0.781 0.769
2 l.859 0 1883 l 783 l.736 1.690 1.647 1.626 1.605 1.566 1.528 1.492 1.457 1.440 1.392 1.361
3 2.773 2.676 2.577 2.847 2.40! 2.322 2.283 2.246 2.174 Z0.16 2.042 1.981 1.952 1.868 1.8 I 6
4 3.546 3.465 3.312 3. I 70 3.037 2.914 2.855 2.798 2.690 2.589 2.494 2.404 2.362 2.241 2.166
5 4.330 4.212 3.993 3.791 3.605 3.433 3.352 3.274 3.127 2.991 2.864 2.745 2.689 2.532 2.346
6 S 076 4.917 4.623 4.335 4.111 3.889 3.784 3.685 3.498 3.326 3.167 3.020 2.951 2.1S9 2.643
7 5 786 S.582 5.206 4.868 4.564 4.288 4.160 4.039 3.812 3.605 3.416 3.242 3.161 2 937 2.802
8 6.463 6.210 5.747 5.335 4.968 4.639 4.487 4.344 4.078 3.837 3.619 3.421 3.329 3.076 2.925
9 7 109 6.802 6 247 5 759 5.328 4.946 4.772 4.607 4.303 4.031 3.786 3.566 3.463 3.184 3.019
10 7.722 7 360 6 710 6 145 S.650 S.216 S.019 0.833 4 494 4.192 3.923 3.682 3.571 3.269 3.092
11 8.306 7.787 7 139 6.495 5.937 5.453 S.234 S.029 4.656 4.237 4.35 3.776 3.656 3.335 3.147
12 8.863 8.384 7 536 6 814 6.194 5.660 5.421 5.197 4.793 4.439 4.127 3.851 3.72S 3.387 3.190
13 3 394 8 853 7 904 7 106 6.424 5.842 5.583 4.342 4.910 4.533 4 203 3.912 3.780 3.427 3.223
14 9 899 9.295 8.24� 7.367 6.628 6 002 5.724 5.468 5.008 4.611 4.26S 3.962 3.824 3.4S9 3.249
I� 10 380 9 712 8 559 7.606 6.81 I 6.142 5.847 5.515 5.092 4.67S 4.315 4.001 3.859 3.483 3.026E
16 10.3113 10 100 ll 851 7 824 6.974 6.265 5.954 5.669 5.162 4 730 4,357 4.033 3.887 3.503 3.28]
17 11.274 10 477 9 122 8.022 7 120 6 373 6.047 5.749 5.222 4.775 4.391 4.059 3.910 3.518 3.295
18 11 690 10 828 9 372 8.201 7.250 6.467 6.128 5.818 5.273 4.812 4 419 4.080 3.928 3.529 3.304
19 12 082 11 15� 9 614 8.365 7.366 6.5S0 6.188 5.877 5.316 4.844 4.442 4.097 3.942 3.539 3.311
°
20 12 462 11 470 9 818 S 514 7 469 6.623 6.25 5.929 5.3S5 4.870 4.460 4 110 3.954 3.546 3.316
.
Thus tabli.: presents the sum ofpresent values for an annuity discount factor (ADF) ofRs 1 for wide
ranges of interest rates, i, and number ofyears, n. From Table the sum ADF for five years at the rate ofl0
per cent is found lo be 3.791 Multiplying this factor by annuity amount (A) ofRs 1.000 in this example
gives Rs 3,791. This answer 1s the same as �e one obtained from the long method.

CONCEPT OF RISK AND RETURN

While making the decisions regarding investment and financing, the finance manager seeks to
ac.:hieve the right balance between risk and return, in order to optimize the value ofthe finn. Return and risk
go together in investments. Everything an investor (be it the finn or the investors in the firm) tloes is tied
directly or indirectly to re Lum and risk. Let us now examine these concepts of risk and return in greater
detail.

ar111rn

ThL HJJI.! •,, I.!it :my mvc:)tor i:s to maximize expected returns from his investments, subject to
.1rio11s con 1n.1111ts. pi ima111) risl<.:. R-:turn 1s the motivating force, inspiring the investor in the forin of

10
rewards, for undertaking the investment. The importance of returns in any investment decision can be
traced to the following factors
• It enables investors to compare alternative investments in terms of what they have to offer the
investor.
• Measurement of historical (past) ..�turns enables the investors to assess how well they have
done.
• Measurement of historical returns also helps in estimation of future returns.
This reveals that there are two types of returns-Realized or Historical Return and Expected Re­
turn.

Realized Return

This is ex-post (after the fact) return, or return that was or could have becm earned. For example,
a deposit of Rs.1,000 in a bank on January 1 , at a stated annual interest rate of 10% will be worth Rs.l,100
exactly a year later. The historical or realized return in this case is 10%

Expected Return

This is the return from an asset that investors anticipate or expect to earn over some future period.
The expected return is subject to uncertainty, or risk, and may or may not occur. The investor compensates
for the uncertainty in retums and the timing of those returns by requiring an expected return that is suffi-
ciently high to offset the risk or uncertainty.

The Components of Return

What constitutes the return on any investment? Return is basically made up of two components:
• The periodic cash receipts or income on the investment in the form of interest., dividends etc.
The term yield is often used in connection with this component of return. Yield refers to the
income derived from a security in relation to its price, usually its purchase price. For example,
the yield on a 10% bond at a purchase price of Rs.900 is 1 1.11 %.
• The appreciation (depreciation) in the price of the asset b referred to as capital gain (loss).
This is the difference between the purchase price and the price at which the asset can be, or is,
sold.

Many investors have capital gains as their primary objective and expect this component to be
larger than the income component.

Measuring the Rate of Return

The rate of return is the total return the investor receives during the holding period (the period
when the security is owned or held by the investor) stated as a percentage of the purchase price of the

11
investment at the beginning ofthe holding period In other words, it is the income from the security in the
fo1m ofcash flows and the difference in price ofthe security between the beginning and end of the holding
period expressed as a percentage of the purchase price of the security at the beginning of the holding
period

'The general equation for calculating the rate ofreturn is shown below:

k = Di +(P,-P,_1)
P,=I
where k = Rate ofretum
P, = Price ofthe security at time 't' i.e. at the end ofthe holding period. •
P, _, = Price of the security at time 't -l' i.e. at the beginning of the
holding period or purchase price.
D, = Income or cash flows receivable from the security �t time't'.

mare usually stated at an annual percentage rate to allow comparison of returns

betwe.en securities. Let us first look at the calculation ofthe rates ofreturn ofan equity stock and then a
bond.

A stock's rate of return

What are the two components ofreturn from shares? The first component 'Dt' is the income in
cash from dividends and the second component is the price change (appreciation and depreciation).

L!.xamplt; ·r a share of C Ltd is purchased for Rs.3,58 0 on February 8 oflast year, and sold for
Rs.3,&00 on Februacy 9 ofthis year and the company paid a dividend ofRs.3 5 forthe year, calculate the
rate ofreturn?

Solutio11 : k = Di+ (P,-P,_ 1) 35 +(3,8 00-3, 58 0) =?. l2%

P,.1 3,5 8 0

Rate of Return of a Bond (Debenture)

In the case ofbonds, instead ofdividends, the investor is entitled to payments ofinterest annually
or semi-annually, based on the coupon rate. The investor,also benefits ifthere is an appreciation in the price
of the bond.

Example: If a 14%, Rs I, 000 ICICI debentures was purchased for Rs.l, 3 50and the price ofthis
security rises to Rs. I, 500 by the end ofa year. Find the Rate of return for debenture.

14 +(1, 500-1,3 50)

Solution: k =
1,3 50
= 214 8%

12
Risk

Risk and return go hand in hand in investments and finance. Ont> c:a.T}Jlot talk about returns without
talking about risk, because, investment decisions always involve a trade-off between risk and return. Risk
can be defined as the chance that the actual outcome from an investment will differ from the expected
outcome. This means that, the more variable the possible outcomes tha1 can occur (i.e., the broader the
range of possible outcomes), the greater the risk.

Sources of Risk

Following are the some of the general sources of risk.

• Interest Rate Risk: Interest rate risk is the variability in a security's return resulting from
changes in the level of interest rates. Other things being equal, security prices move inversely to
interest rates. This risk affects bondholders more c!i.rectly than equity investors.
• Market Risk: Market risk refers to the variability ofretums due to fluctuations in the securi­
ties market. All securities are exposed to market risk but equity shares get the most affected.
lbis risk includes a wide range offactors exogenous to securities themselves like depressions,
wars, politics, etc.
• /1,jlation Risk: With rise in inflation there is reduction of purchasing power, hence this is alsq
referred to as purchasing power risk and affects all securities. This risk is also directly related
to interest rate risk, as interest rates go up with inflation.
• Business Risk: This refers to the risk of doing business in a particular industry or environ­
ment and it gets transferred to the investors who invest in the business or company.
• Financial Risk: Financial risk arises when companies resort to financial leverage or the use
of debt financing. The more the company resorts to debt financing, the greater is the financial
risk.
• Liquidity Risk : This risk is associated with the secondary market in which the particular
security is traded. A security which can be bought or sold quickly without significant price
concession is considered liquid. The greater the uncertainty about the time element and the
price concession, the greater the liquidity risk. Securities which have ready markets like trea­
sury bills have lesser liquidity risk.

Measurement of Risk

Risk is associated with the dispersion in the likely outcomes. Dispersion refers to variability. If an
asset's return has no variability, it has no risk. An investor analyzing a series of returns on an investment
over a period of years needs to know something about the variability of its returns or in other words the
asset's total risk. There are different ways to measure variability of returns. The range of the returns, i.e. the
difference oetween the highest possible rate of return andthe lowest possible rate of return is one measure,
but the range is based on only two, extreme values.

13
 '

The variance of an asset's rate of return can be found as the sum of the squared deviation of each
possible rate of return from the e�pected rate of return multiplied by the probability that the rate of return
occurs.

- 2
"""' l';(k; -K)
VAR(k) = .i..J
i=l

where VAR(k) = Variance ofreturns

P, = Probability asS09ated with the 1 possible outcome
kI = Rate of return from the th possible outcome
k = Expected rate of return
n = Number of years.

A third and most popular way of measuring variability ofreturns is standard deviation. The stan­
dard deviation denoted by is simply the square root of the variance of the rates of return explained above.

The star.dard deviation and variance are conceptually equivalent quantative measures of total risk.
Standard deviation is preferred to ran�e because of the following advantages:

• Unlike the range, standard dev:'.l1ion considers every possible event and assigns each event a
weight equal to its probability.
• Standard deviation is a very familiar concept and many calculators and computers are pro­
grammed to calculate it.
• Standard deviation is a measure of dispersion around the expected (or average) value. This is
in absolute consensus with the definition of risk as "variability ofreturns".
• Standard deviation is obtained as the square root of the s.um of squared differences multiplied
by their probabilities. This facilitates comparison ofrisk as measured by standard deviation and
expected returns as both are measured in the same costs. This is why standard deviation is
preferred to variance as a measure of risk.

14
 ELECTRONIC BANKING
Dr. Pooja Goel

OBJECTIVES

After going through this lesson you should be able to:

• Understand the Concept of E-Banking

• Describe the New Dimensions & Products of Banking
• Differentiate Between Debit and Credit Card
• Explain the Risks in E-banking

STRUCTURE

1. Meaning of E-banking
2. Automated Teller Machine
3. Internet Banking
4. Telephone Banking
5. Electronic Clearing Service
6. Electronic Funds Transfer (EFT)
7. Credit Cards
8. Smart cards
9. Electronic Cheques
10. Debit Card
11. Risks in E-banking
12. Conclusion
13. Test Questions
14. Further Readings
The banking industry is now a very mature one and banks are being forced to change rapidly as
a result of open market forces such as threat of competition, customer demand, and
technological innovations such as growth of internet banking. If banks have to retain their
competitiveness, they must focus on customer retention and relationship management, upgrade
and offer integration and value added services. With the increasing customer demands, banks
have to constantly think of innovative customized services to remain competitive. That’s why
internet banking is becoming a necessity today.

1. MEANING OF E-BANKING

Electronic banking (E-banking) is a generic term encompassing internet banking, telephone

banking, mobile banking etc. In other words, it is a process of delivery of banking services and
products through electronic channels such as telephone, internet, cell phone etc. The concept
and scope of E-banking is still evolving.
Electronic services allow a bank’s customers and other stakeholders to interact and transact
with the bank seamlessly through a variety of channels such as the internet, wireless devices,

15
ATMs, on-line banking, phone banking and telebanking. Other services offered under E-
banking include electronic fund transfer, electronic clearing service and electronic payment
media including the credit card, debit card and smart card. On-line banking helps consumers to
overcome the limitations of place and time as they can bank anywhere, anytime as these
services are available twenty four hours, 365 days a year without any physical limitations of
space like a specific bank branch, city or region. They also bypass the paper based aspect of
traditional banking.
As compared to other countries, e-banking growth and development is at a nascent stage in
India, yet the changing profile of customers and the resultant competition from establishment
of new private sector banks and foreign banks has provided a fillip to its growth. As a result,
India has emerged as one of the fastest growing markets in the world.
Several initiatives taken by the Government of India as well as the Reserve Bank of India
(RBI) have facilitated the development of E-banking in India. As a regulator and supervisor,
the RBI has made considerable progress in consolidating the existing payment and settlement
systems, and in upgrading technology with a view to establishing an efficient, integrated and
secure system functioning in a real-time environment, which has further helped the
development of E-banking in India. The Government of India enacted the IT Act, 2000 with
effect from October 17, 2000, which provides legal recognition to electronic transactions and
other means of electronic commerce.

2. AUTOMATED TELLER MACHINE

The Automated Teller Machine (ATM) is seen everywhere. This machine has brought
innovations in the Banking sector all over the world. The advent of the ATM has made the
concept of round the clock banking a reality. The ATM has been helpful to both the bankers
and the customers. The long crowd of customers in the banking hall of a branch waiting for
their turn to collect cash is disappearing. The branch business timings have lost significance to
the customers after the introduction of ATM.
The ATM is a device used by the bank customers to process account transactions. The
customer inserts into the ATM, a plastic card i.e. encoded with information on a magnetic strip.
The strip contains an identification code that is transmitted to the bank’s central computer by
modem. Every cardholder should be given a PIN (personal identification number) that he
should enter and after verifying the same with the records, ATM would allow operations.
Functions of ATM: The functions of ATM differ from bank to bank. The following features
are available in the ATM of all the banks.

• Fast Cash: When you want to do the only activity of drawing cash in pre-determined
amounts like Rs. 500, Rs. 1,000, Rs. 2,000, Rs. 5,000 etc. you can use this option.
• Normal Cash Withdrawal: Every bank has fixed a maximum limit of cash withdrawal
per account per day. It ranges between Rs. 10-15000. While in some banks the
maximum amount may be drawn in one shot (HDFC, ICICI) and in some other banks it
should be drawn in lots (Syndicate Bank, State Bank of India). All withdrawals shall be
in multiple of Rs. 100 only.
• Balance Enquiry

16
 • Mini statement of account: You get detail of last 5-10 transactions.
• Pin change:
• Cash Deposit: Varied procedures exist. Here special covers are available in the ATM
wherein the client has to fill up the challan, the denominations and key in these details.
Then, a window opens wherein the cover containing the cash has to be dropped. At the
end of the day, officials of the branch to which the ATM is attached, would open the
machine, take the cover and credit the account of the customer. If there is any cover, the
decision of the bank is final.
• Transfer transactions: If you want to transfer funds with in the bank i.e. from one
account to another at same branch or at different branch, you can use this option.
The ATMs are emerging as the most useful tool to ensure, “Any-Time Banking” and “Any-
where Banking” or “Any-Time Money”. While the benefits of ATM are immense, the cost of
ATM, though has come, down, it still prohibitive. An ATM costs between Rs. 8-10 lakh. If a
bank has to install 100 ATMs it should spend at least Rs. 8-10 crs. Added to this, is the
maintenance cost. Today any electronic device attracts and annual maintaing cost of Rs.8-12
per cent of capital cost. Besides this banks have to incur expenditure on the rent for retail
outlet, its ambience and on security personnel etc. While many public sector banks have gone
on a big way in opening ATMs there is a need for sufficient examination of their economic
viability. Already there is experience that the hits per ATM are less than 200 resulting in no big
gain for either the bank or customer. India with more population density should show a higher
average hit per day and this emerges as a critical factor in the overall ATM strategy towards
making the whole business idea profitable.
The rationale for banks introducing ATMs in 1970s, was to deliver their products more
cheaply than traditional branch networks which are loaded with expensive staff.

3. INTERNET BANKING

Internet banking is the latest and the cheapest technology introduced in the banking industry. I t
is acknowledged that the internet has already had a profound effect on delivery of financial
services and this likely to bring more radical changes. At the basic level, interknit banking can
mean the setting u of a web-page by a bank to give information about its products and services.
At an advance level, it involves provision of facilities such as accessing accounts, fund
transfer, and buying financial products or services online. This is called “Transactional Online
Banking”.
In general Internet Banking refers to the use if internet as a delivery channel for the banking
services, including traditional services, such as opening an account or transferring funds among
different accounts, as well as new banking services such as electronic bill presentation and
payment which allows the customers to pay and receive the bills on a bank’s website.
There are two ways to offer Internet Banking. First, an existing bank with physical offices
can establish a web-site and offer internet banking in addition to its traditional delivery
channel. Second, a bank may be established as a “branchless”, “Internet only”, or “Virtual
bank”. Further internet banking sites offer financial services products to customer in three
basic formats

17
 • Information Only: Informational only presents online information about the different
banks services and products to the customers as well as general public and may include
unsecured e-mail contract, with no customer identification or verification required.
• Information Exchange: Information Exchange Customer Information such as name,
address and account information may be collected or displayed, with possible secure e-
mail and/or data transfer, with verification of customer identification required. No
financial transactions are to be made.
• Transactional: Transactional customer account information enquiry, financial
transactions such as transfer of funds, payment of bill, application for loans and a
variety of other financial transactions, with strong customer authentication required.
When it was introduced for the first time, Internet Banking was used mainly as an
information presentation medium in which banks marketed their products and services on their
web sites with the development of asynchronous technologies; however more banks have come
forward to use internet banking both as a transactional as well as an informational medium.
A successful Internet Banking solution offers:

• Exceptional rate on savings CDs, and IRAS.

• Checking with no monthly fee, free bill payment and rebates on ATM surcharges.
• Credit card with low rates.
• Easy online applications for all accounts, including personal loans and mortgages.
• 24 hours account access.
• Quality customer service with personal attention.
Internet banking is a cost-effective delivery channel for financial institutions. All the
transactions are encrypted, using sophisticated multi-layer security architecture, including fire
walls and filters. Firewall is a protection device to shield a vulnerable area from some form of
danger. In Internet, a firewall system set up specifically, to shield a web from outside.
Typically, this allows insiders to have full access to services on the outside, while granting
access into the internal system, selectively based on log-in-name and password.
Internet banking is somewhat different from PC banking. PC banking is transactions
through PC at one’s office or home, which is connected to the branch through a modem. PC
banking is available only when branch is open and is available only through any PC. But,
internet banking enables to do the same through any PC connected to the internet, from
anywhere in the world.

Advantages of Internet Banking

• Anywhere and anytime banking as services are provided round the clock.
• Worldwide connectivity as it transcends geographical boundaries.
• Easy access to recent and historical data.
• Direct customer control of international movement of funds.
• Greater processing speed and accuracy.

18
4. TELEPHONE BANKING

The banks are aiming to make them more accessible by introducing telephone banking.
Telephone banking refers to dialing one telephone number using a telephone to access the
account, transfer funds, request statements or cheque book simply by following recorded
message and touching the keys on your phone. It allows the customers to check account at
convenient time and get simple things done without visiting bank premises. Telephone banking
aims at providing 24 hour service that is fast, convenient and secured for all customers. In the
modern society everyone has to access to telephone. Registering for telephone banking cost
nothing although there is a small transactions charge for making bill payment and frequent
usage charges.

5. ELECTRONIC CLEARING SERVICE

In 1994, RBI appointed a committee to review the mechanization in the banks and also t o
review the electronic clearing service. The committee recommended in its report that electronic
clearing service-credit clearing facility should be made available to all corporate
bodies/Government institutions for making repetitive low value payment like dividend,
interest, refund, salary, pension or commission. It was also recommended by the committee
Electronic Clearing Service- Debit clearing may be introduced for pre-authorized debits for
payments of utility bills, insurance premium and installments to leasing and financing
companies. RBI has been necessary step to introduce these schemes, initially in Chennai,
Mumbai, Calcutta and New Delhi.

6. ELECTRONIC FUNDS TRANSFER (EFT)

For making inter-city payments customer usually make payments through demand drafts, mail
transfers and telegraphic transfers. In 1996, RBI devised an electronic fund transfer (EFT)
system to facilitate fast transfer of funds electronically. The funds can be transferred between
any two bank accounts even if the sender and the receiver are located in different cities or deal
with different banks. EFT has accelerated the movement of funds across the globe. E-cash or
cyber cash plays a predominant role in world of commerce. Such electronic funds movements
amounting to a few trillion dollars are settled on a daily basis in major international financial
centers. Society for worldwide inter-bank financial telecommunication is a classic example of
EFT among banks with its own standards for messages, which ensures speed, reliability,
security and accuracy. SWIFT, as a co-operative society was formed in May 1973 with 239
participating banks from 15 countries with its headquarters at Brussels. It started functioning in
May 1977. Reserve Bank of India and 27 other public sector banks as well as 8 foreign banks
in India have obtained the membership of the SWIFT. SWIFT provides rapid, secure, reliable
and cost effective mode of transmitting the financial messages worldwide. At present more han
3000 banks are the members of the network. To cater to the growth in messages, SWIFT was
upgrade in the 80s and this version is called SWIFT-II. Banks in India are hooked to SWIFT-II
system.
SWIFT is a method of the sophisticated message transmission of international repute. This
is highly cost effective, reliable and safe means of fund transfer.

19
 • This network facilitate the transfer of messages relating to fixed deposit, interest
payment, debit-credit statements, foreign exchange etc.
• This service is available throughout the year, 24 hours a day.
• This system ensure against any loss of mutilation against transmission.
• It serves almost all financial institution and selected range of other users.
The objective of establishing an EFT system is to facilitate an efficient, secure, economical,
reliable and expeditious system of funds transfer and clearing in the banking sector throughout
India, and to relieve the stress on the existing paper based funds transfer and clearing system.
Advantages of EFT

• Funds can get transferred easily and conveniently without delays and paper work.
• Built-in security measures ensure safety of funds during transfer.
• Losses and frauds are minimized due to easy tracking of transactions/customers.

7. CREDIT CARDS

There are various ways of making payment through the banking system. These include
cheques, direct debits, bank drafts, electronic transfer, international money orders, letters of
credit, etc. Increasing affluence combined with increasing complexity of life has led to the
phenomenon of Credit Cards. They provide convenience and safety in the purchasing process.
It is generally known as plastic money. The credit card are made of plastic is widely used by
the consumers all around the globe. The changes in consumer behavior and tastes led to the
tremendous growth of credit cards. Credit card is a card which enables the consumers to
purchase products or services without paying immediately. This credit concept is based on the
principle of “Buy now pay later”. Credit card is a document that can be used for purchase of
goods and services all over the globe.
The world’s first credit card was issued by Mobil in 1940. This card was initially issued by
the Company to give specialized services to its regular customers. It helped to boost sales and
increase the customer base. After the tremendous success of Mobil card various organisations
began to think about the use of cards in different segments of the business. The Diners Club,
American Express and Carte Blanche Cards have emerged. The credit cards were popularly
known in USA. During the second World War US saw the growth of the credit cards. The first
bank card was issued by Fanklin National Bank, USA in the year 1952. In 1960, the credit
card operating system was developed by Bank of America, USA. An international bank card
system known as “VISA” International was established. Another international bank card
system called “Mastercard” was established. At present the market is dominated by the VISA
and Master Card. In the year 1988, the first woman card was launched “My Card” by
international bank of Asia in HongKong.
The credit cards are made of plastic. It is widely used by the consumers all around the globe
in the digital economy. The card identifies its owner. The owner of the card is entitled to
purchase the goods without cash. It provides purchase services without money and be eligible
to get credit from a number of merchant establishments. The issuer of the card issues credit
cards depending on the credibility of the customers. The card issuer enters into a tie up with
different merchant vendors located indifferent geographical places in various fields of business

20
activities. The card issuer will put up a credit limit for its card holders and a ceiling limit for
each vendor. The card offers the card holder an opportunity to buy air, rail tickets and stay at
hotels for payments. The card holder need only to present the card at the cash counter and has
to sign some firms. The credit cards can be considered as a substitute for cash and cheques.
The cards are not accepted by all the merchant vendors.
Process of Credit Card Business Cycle
Credit cards facilitate its holder to make purchases at various designated merchant
establishments. The establishments like travel agencies. Star hotels, Departmental stores will
accept all valid cards in lieu of cash payments. The card holder can avoid the risk of carrying
cash. The following steps are involved in the process of a transaction.
Step I: a card holder purchases goods and present the credit card to the designated merchant
establishment.
Step II: The retail vendor verifies the number on the card against the hot list provided to him
by the bank.
Step III: The card holder is required to sign on the voucher and the signature has to tally with
the one on the credit card.
Step IV: The Retailer has to present the sales vouchers to the bank for reimbursement for the
customers’ purchases. The bank also charges commission from the retailer.

Step V: The bank will make payment to the retailer on behalf of the card holder.
Step VI: After completion of the process. The bank sends the bill to the card holder and
received the money.
Benefits of the Credit Cards

The benefits of credit cards may be classified into two categories:

(A) Benefits to the Card Holders: There are so many benefits to the card holders for using the
cards:
• The card holder need not to carry cash at all times.
• The card holder will be covered by free insurance.
• The card can be used as identification card in some situations.
• The issuer of card offers rewards and gifts to the card holder.
• The card holders can avail special counters for Air and Travel reservations.
• The card holder can get complimentary magazines. For example, diners club
provide “signature” magazine to card holders.
• Family members of the card holder can avail this facility.
• The card holder can enjoy free credit uto 30 to 45 days.
• If the credit card is lost/stolen the liability is limited to a maximum of one
thousand rupees.
• Some credit holders will get free services such as confirmed ticket booking and
hotel reservations.

21
 • Some card holders will get benefit from the world wide network, for example,
Master card, Amex, Visa etc.
(B) Benefits to the Card Holders: There are also advantages to credit issuers. Such advantages
are such as:
• This business offers higher profits.
• The issuers can also improve their name and image by serving large number of credit
card holder base.
• This business is an additional activity in the banking sector to enhance their
profitability.

(c ) Additional Facilities: The credit cards besides providing credit facility, the issuer extend
some additional facilities to attract more customers. These facilities and services are presented
below
a) Incidental Expenses: The credit card holders can use their cards to pay for incidental
expenses. They have to do is to call the issuer bank and instruct it to make payment like
telephone bills, electricity bills, payment to mutual funds, public issues etc.
b) Instant cash Withdrawal: Some issuers allows their credit card holder to withdraw
instant cash up to 60 percent of his credit line from ATMs in all metros. The card
holders can also draw cash in case of medical emergencies for meeting expenses on
treatment at other than their home town. This emergency medical advance facility is
available with all Indian and foreign banks.
c) 24× 7×365 Customer Service: The technology adopted by the banking sector makes
comfortable life to the customers. The revolutionary phone banking service ensures that
the banks are just a phone call away to assist the card holders around the clock. Foreign
banks provide a world class service to card holders. A credit card holder can call
“Citiphone banking” and ask for temporary credit line any time.
d) Free insurance: Some of the issuers, insures the card holder at free of cost for a
particular sum. Citibank offer a complimentary personal accident insurance. The Bank
of Baroda card extends insurance protection to card holders spouse also.
e) Buy Anything on Credit Card: The credit cards are well accepted by the public. The
card can be used for all occasions and seasons. The card is also useful for purchasing
essential commodities like groceries, fuel, auto accessories and cosmetics. The cards
are useful even passing customs duties and hospital bills. We can purchase everything,
anywhere at any time under the sum at designated locations.
f) Joint Credit card and ATM Facility: Indian banks and foreign banks have introduced a
joint card. The joint card holder can access his accounts with the bank through ATMs.
g) Hotel Discount Facility: The credit holders are entitled to get discounts at all leading
hotels and clubs. The card holders are eligible to avail the facilities as per the schemes
which were offered by the hotels, travel agencies and on air ticket. Even the consumer
products are also available in this method.
h) Fuel Facility at Petrol Pumps: The BOB, Citibank, Standard Chartered cards are
accepted at all Bharat petroleum outlets. This is very convenient foe card holders at all
leading metro cities.
i) Purchase Protection: The credit card facility protects the purchases against damage or
loss due fire and theft. For compensation the card holder can claim the value of the
product damaged or lost from The New India Assurance Company. This protection is

22
 available for a limited period from the date of purchase of the product on the credit
card. Some of these facilities are exclusive offers, airport lounges, special hospital
facilities, special travel services.

Types of Credit Cards

The credit card system is becoming very popular in India and abroad. The system facilitates a
wide range of products and services. The growth of service sector depends on the pulse of the
customer. The needs of the customers are taken care off by different card issuers. The credit
cards can be classified into 4 basic types based on the issuers: Travel and entertainment card,
bank card, retail card, fuel card. There are many types of cards which are popular in India and
abroad. These cards can also be classified as follows:
a) Based on Geographical Territory: Under this category, the credit cards can be
categorised as Domestic cards and International cards. The domestic cards are
generally available from most of the banks. These cards will be valid in India and
Nepal only. All the transactions will be in rupees only. International cards will be
issued to persons who travel foreign countries frequently. These cards are subject to
the rules and regulations of the RBI. These cards will be honoured in throughout the
world except in India and Nepal.
b) Based on Franchise: The credit cards can be classified based on the tie-ups. They are
Visa card, Master card, Proprietary card and tie-up card. Visa card can be issued by
any bank which is having tie-up with VISA international USA. The card holder can
avail the facilities of Visa network for their transitions. Master card is a brand name
for another type of credit card. The issuer of the card has to obtain permission from the
master card corporation of USA. It will be honoured in the master card network
Proprietary card will be issued by the issuer bank on their own brand name. These
cards will be issued by banks in addition to their other tie-up cards. Tie-up cards are
issued by banks having a collaboration with domestic card brands.
c) Based on Status: This type of credit cards will be further classified as standard cards,
business cards and gold card. The standard card is a normal card generally issued by
all issuing banks. The card holder is offered limited privileges when compared to the
other cards. These cards are issued by some banks under the brand name of “classic”
card. Business card is meant for tax consultants, chartered accountants, small firms,
solicitors and executives etc. These cards are very useful for their business trips more
and more convenient. The business card facilitates more privileges than the standard
card. Some banks are issuing these cards in the brand name of “executive”.
d) Based on User: Under this category the credit cards are further classified as Individual
cards and corporate cards. The individual cards are issued to individual persons. All
the brands of cards will be given to individual corporate cards are issued to corporate
companies and business firms only. The corporate cards are issued on the name of the
company. The cards will be utilized by the executives and top officials the firms. The
bills will be paid by the company to the banks.
e) Based on Credit Recovery: These type of cards are again classified into two categories.
They are Revolving credit type card and charge card. The revolving credit card is
generally based on the revolving credit principle. According to this scheme, the card
holder has to pay a percentage of the outstanding credit for every month. The interest

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 is charged on the outstanding. The interest rate is charged on the outstanding amount.
The interest rate is more than 30 percent per annum charge card is a convenient
instrument. The issuer gives a consolidated bill for every month to the card holder.
The card holder shall pay the bills on presentation of the consolidation bills. Therefore,
there are no interest charges on this use of cards.

Credit Cards in India

The first credit card in India was Diners club card in the year 1964. Andhra Bank and Central
bank were the first to launch credit cards among the commercial banks. The Andhra bank
introduced the card in the year 1981 under the brand name of “Visa classic” followed by
Central bank of India in collaboration with Master Card Corporation in 1981. The other banks
Canara bank, bank of India and Bank of Baroda introduced credit cards in India. The foreign
banks such as Citi bank, Standard Chartered bank, Bank of America and American Express
bank have also introduced cards in India through their branches in India.

8. SMART CARDS

Smart card is a little plastic card. It is just like a credit card but it contains a micro-processor
and a storage unit. This card is developed with latest technology and it is an innovation that
overcomes all limitations. They are more expensive. The stored data is not exposed to physical
damage. These cards can store at least 100 times more data than magnetic strip cards. They are
more popular in Europe. They are categorized in two kinds; memory smart cards and
intelligent smart cards. Memory card contains less information and processing capabilities they
are used to record a monetary or unit value for a specific amount. Intelligent cards contain
more information and process a wider variety of information components than a memory smart
card. This card also has greater processing capabilities for programmed decision making for
various applications. The electronic purse is used to refer to monetary value, that is loaded on
to the smart cards microprocessor and that can be used by consumer for purchase. The
merchants, who are accepting the cards, must have a smart card reader. The smart card
technology may be used in either an online or offline mode as with magnetic strip cards.
Offline card technology can be used in underdeveloped countries. The functioning of offline
smart cards as presented below:
Step 1: Smart card holder inserts card into machine and downloads money from bank as to
microprocessor on the card.
Step 2: The consumer pays for merchandise/ service by inserting smart card into merchant’s
smart card reader.

Step 3: The merchant’s smart card reader records the transaction.

Step 4: At the end of the day, the merchant inserts a smart card to receive download of the
day’s sales.
Step 5: Take to bank for credit for day’s sale for cash.

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Smart cards used in place of cash have the advantage of providing an elect ronic record for
purchases and the ability to printout transaction data which can serve as receipts.
The smart card holder inserts his card into smart card reader enter a valid password and the
amount of the purchase is deducted from the balance from the balance on the card. The card
reader computes a running total of the sales amounts deducted from the customers. The smart
card can be taken to the bank for immediate cash payment. If the merchant has a networked
personal computer and banking software then it may insert the smart card and transfer the
amount on the smart card directly into a bank account. The telephone manufacturers are
introducing smart card phones that can be used for a variety of purposes. The phones can be
used to:
I. Pay for items purchased over the phone,
II. Download money from bank accounts to a smart card,
III. Transfer balances between accounts, and
IV. Check bank balances.

9. ELECTRONIC CHEQUES

Another mode for internet payments is the electronic cheques. In this method, the payor
instructs its bank to pay a specific amount to another party, the payee. The financial EDI
systems have performed this function for years using private communication circuits such as
value added network. The new generation of electronic cheques provides the following
functions:
I. Present the bill to the payor,
II. Allow the payer to initiate payment of the invoice,
III. Provide remittance information,
IV. Allow the payer to initiate automatic payment authorization,
V. Interface with financial management software, and
VI. Allow payments to be made at first time.
Electronic payment system involves two parties, payor and payee. An electronic bill contains
the same information as a hard copy bill transported to the payor through the postal system. An
electronic bill does not have to be received, a payor or can make payments for bills received
through the postal system.
Most electronic cheques can accommodate situations where the payee does not have account
at a financial institution; therefore many electronic cheque service providers will produce a
hard copy check for these types of payments. Electronic payment of bills is expected to
increase substantially over the forthcoming years.

10. DEBIT CARD

Debit Card is the innovative instrument in the financial services sector. It is the most
convenient method of payment to the merchant establishment. It needs involvement of many
banks. The card holder will present the card on completion of his purchases at the merchant
establishment on production of a debit card. The card details are fed through a terminal at the
merchant’s establishment. The card holder is immediately debited from the card holder’s

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 account and transferred to the account of merchant establishment. No overdrawing is allowed
in the case of debit card. A debit card is the variant of an ATM card. It has the following
features:
I. Whereas an ATM card can be used only where the ATM’s are provided by the banks,
and that too only for cash withdrawals, the debit card can be used in any merchant
outlet that is linked with the customer’s bank for making payment.
II. Credit card is issued to clients after a proper assessment of their credit standing. But for
a debit card holder there is no need to make such an assessment.
III. At the time of making payment through a debit card, the amount is instantly debited to
the customer’s account unlike payment made through the credit card where the account
of the customer is debited after a certain period.
IV. Debit card freeze the cardholder from carrying cash for his/her purchases.
V. Debit card is like a blank cheque, so it must be used carefully otherwise an
unscrupulous person can wipe the entire balance in the bank account of the holder.
VI. There are no chances of the debit card user to fall into the debt trap, since payment is
immediately debited to his account, as he can only use the money which is available in
his account.
VII. There are no transaction costs and no question of late fee payment in the use of debit
card.
VIII. Bankers also avoid the risk of bad debts.

11. RISKS IN E-BANKING

If internet banking has facilitated the banking service processes and made the customers life a
lot easier, it has also thrown new challenges in terms of various risks which may affect the
bank’s profitability, capital and reputation as well. Let us discuss some of the risk issues
related to the online banking.
1. Operational Risk: Operational risk is the price, which attaches to internet banking arising
from error, fraud and inability to provide services to customers or deliver products as per
the expectation, which may result in current and prospective loss to earnings of the bank.
Inaccurate processing of transactions, non privacy and confidentiality, attacks or
unauthorized access to banks systems and databases, weak technology adoption or
systems design or human factors like lack of awareness on the part of employees or
customers may lead to operational risk.
2. Credit Risk: Credit risk arises when a counter-party fails to settle an obligation when due
or any time henceforth for its full value. In internet banking scenario the credit worthiness
of the customer may not be properly evaluated. So any credit facilities provided to retail or
corporate customers requires proper evaluation and constant audit of lending as well as the
repayment progress at regular intervals to avoid such a risk.
3. Liquidity Risks: The bank may face liquidity crunch in short-term time horizon in internet
banking scenario as well. In this case, the outflow of fund may be sudden and hence the
banks, which are more exposed to internet banking, should ensure for sufficient liquidity
in case of redemption or settlement demands.
4. Foreign Exchange Risk: Due to the geographical and market extension of banks and
customers in internet banking scenario forex, legal and regulatory risk may arise. In cross

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 border transactions there would be difficulty in correctly assessing the counter parties
credentials and hence forex transaction against electronic money may lead to forex risk.
Different international cross-border jurisdiction can expose banks to legal and compliance
risks in view of different national rules, laws and regulations.
5. Security Risk: Security risk is one of very important issue in internet banking systems. In
internet banking information is considered as an asset and so worthy of protection.
Firewalls are frequently used on internet banking systems as security measure to protect
internal systems and should be considered for any system connected to an outside
network. Firewalls are a combination of hardware and software placed between two
networks through which all traffic must pass, regardless of direction flow. They provide
gateway to guard against unauthorized individuals gaining access to the bank’s `network.
Therefore, awareness among the internet banking customers as well as adoption of
security mechanism is essential.
6. Compliance Risk: The bank may face compliance and regulatory risk if it does not adhere
or follow the guidelines given by the supervisor or the regulator. Due to lack of awareness
and transparency the bank may fail in this matter and hence more care is required in this a.
7. Reputation Risk: A bank offering internet banking suffers reputation loss due to negative
opinion if the systems failed or discontinued for a considerable time or when the banking
products offered not found to their expectation or even the fraudulent activities by the
internal/external people or hackers using bona fide customer’s credentials. The bank-
customer relationship may suffer due to this and this may also affect bringing prospective
customers to its fold.
8. Legal Risk: Internet banking being a relatively a new phenomenon, the legal issues or
risks are usually less crystallized or ambiguous. They may arise from the violation of, or
non-conformance with laws, rules, and regulations or prescribed practices. A bank may
also face legal actions from the customers in case of hushing attacks or any other
fraudulent activities where the terms and conditions have not been framed adequately by
the bank.
9. Strategic Risk: Strategic risk may emanate from adverse business decisions due to wrong
implementation of unfavorable market conditions related to either the banking products
offered through electronic channel, or any technology or strategic decisions like
outsourcing policy, etc. Therefore, a proper market as well as technological survey is
essential in this regard before taking any final decision.
10. Money Laundering Risk: In view of the lack of personal interaction among the bank staff
and the customers in the internet banking scenario, the know your customers norms may
not be implemented effectively as fund transfer transactions of dubious nature may be
done by the offenders without much of hassles.
11. Interest Rate Risk: In case of electronic money becoming widely prevalent in the payment
system, the interest rate risk and market risk will have an impact on the value of the banks
assets against its electronic money liabilities.

12. CONCLUSION

Popularity which internet banking has won among customers, owing to its speed, convenience
and round-the-clock access they offer, is likely to increase in the future. That’s why internet
banking is a successful strategic weapon for banks to remain profitable in volatile and
competitive marketplace of today. Banks are in a position to lead consumer views, as well as to

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cater to existing demands. Clearly, despites of all the threats in banking industry, there is an
enormous opportunity for farsighted banks to reap the rewards available from internet banking.
Internet banking is going to develop much faster than most people imagine. With the
revolution, a new financial system will evolve that in many ways will be far more secure than
the one we have today.

13. TEST QUESTIONS

1. Discuss the various e-banking services offered by a bank.

2. ‘Plastic money has replaced paper money’. Critically analyze this statement. What are
the limitations of credit cards.
3. Write short notes on
a) Smart Card
b) ECS
c) Telebanking

14. FURTHER READINGS

“E-banking in India: Challenges and Opportunities” , Edited by R.K. Uppal and Rimpi jatana,
New Century Publications, New Delhi, India.
“Financial Services in India”, G.Ramesh Babu, Concept Publishing Company, New Delhi,
India.

“Financial Services”,Nalini Prava Tripathy, Prentice Hall of India, New Delhi.

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