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FINANCIAL MANAGEMENT

Faculty: Dr. S K Chaudhuri

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Financial Management Course Outline

Instructor: Dr. S K Chaudhuri E-Mail: skchaudhuri@ipeglobal.com

Course Objectives

Financial Management course is designed to enable the students understand and learn tools and techniques of financial decision making. In particular, the course will focus on the following topics:

Finance functions and goals within the framework of overall business strategies and creating shareholder value

Working capital management and financing

DCF techniques and their applications in capital investment decisions

Various means of raising funds in domestic and international markets and the factors underlying the capital structure planning and dividend decision

Introduction to mergers & acquisitions and valuation

Pedagogy

The course will be delivered through lectures, exercises and case studies. Emphasis will be given on application of Excel in financial analysis.

Examination and Grading

Component Max. Duration Weight Three quizzes* 30 minutes each 30%

Assignments 20%

Term-End Examination 3 hours 50%

* There will be no make-up quiz.

Suggested Text Books

1. James C Van Horne : Financial Management and Policy, 12th Edition (VH) 2. Brealey & Myers : Principles of Corporate Finance 2. Prasanna Chandra : Financial Management: Theory and Practice, 6th Ed. (PC) 4. I. M. Pandey : Financial Management

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Course Outline (Duration of each session: 1 hour)

Session

Nos. Topics Handout/Exercise Cases/Assignments

1-10 Integrating business and finance goals – challenges of finance manager

Shareholder value creation Financial performance analysis

– EVA as performance indicator

Creating Shareholder Value

Balancing Score Card EVA as a Performance Measure

Deferred Tax Liabilities and Assets

Case studies 1. Financial

Performance Analysis - Ashok Leyland

Assignment Select a company and analyse the financial performance

11-14 Time value of money and DCF techniques

Risk and return concept

Formulae & exercises

15 - 19 Working capital management & financing

Money market instruments

Working Capital Management

Operating Statement Exercise Money Market Instruments

Case studies 2. ABC Watches Ltd 3. Jupiter Export

House

20-25 Capital budgeting – application of DCF techniques

Typical investment decisions (e.g., mutually exclusive projects; machine replacement decisions)

Financial appraisal of projects by financial institutions

Exercises on capital budgeting

Case studies 4. Joy Chemicals

26 - 29 Cost of capital CAPM and estimation of cost of

equity Adjusted present value

technique

CAPM and Estimation of Beta

Beta of Unquoted Stock

Exercise on WACC APV Calculation

Assignment Select a company and estimate share beta based on NSE/BSE data from website

30 - 34 Domestic capital market and instruments (right/bonus issues; buy-back of shares; various debt instruments)

Raising funds in international market (GDR/ADR; syndicated loans; export credit agencies; euro-bonds and foreign bonds)

Capital structure planning Credit rating (what is it? rating

methodology)

Types of Market Credit Rating: An Overview

Rating of a manufacturing & financing Company

Case studies 5. RIL issues of 100

Year Yankee Bond 6. GDR issue by

VSNL

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Session

Nos. Topics Handout/Exercise Cases/Assignments

35 Dividend policy (guiding factors; DDM models of share valuation)

Exercises

36-40 Mergers & acquisition Valuation (accounting & DCF

methods)

Case studies 7. Three Unilever tea

Companies to Merge

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CREATING SHARE HOLDER VALUE*

The corporate history is abound with cases to show how companies embark on rapid sales growth, report happy bottom line and earning per share, and then experience perils of growth. History also suggests that not all growth companies with long-term payoffs are rewarded in the stock market. Over the last one decade or so, academicians and professionals have therefore put more emphasis on value creation for shareholders in crafting the business strategies. No matter what growth strategies are pursued by the companies, they must pass through the benchmark of shareholder value creation.

It is a common practice to estimate shareholder value in terms of forecasted free cash flows, which are operating cash flows prior to finance-related cash flows like interest or dividend payments. When free cash flows are discounted by firm’s overall cost of capital, appropriate for the business and financial risks, we obtain what is knows a value of the firm. The shareholder value is determined by deducting market value of outstanding debt capital from the total value of the firm.

The case for why management should pursue the objective of shareholder value creation is comparatively straightforward. Management is often characterized as balancing the interests of various corporate constituencies such as employees, customers, suppliers, debt-holders, and stockholders. The company’s continued existence depends upon a financial relationship with each of these parties. Employees want competitive wages. Customers want high quality at a competitive price. Suppliers and debt-holders each have financial claims that must be satisfied with cash when they fall due. Stockholders as residual claimants of the firm look for cash dividends and the prospect of future dividends which is reflected in the market price of the stock.

If the company does not satisfy the financial claims of its constituents, it will cease to be a viable organization. Employees, customers and suppliers will simply withdraw their support. Thus, a going concern must strive to enhance its cash-generating ability. The ability of a company to distribute cash to its various constituencies depends on its ability to generate cash from operating its businesses and on its ability to obtain any additional funds needed form external sources.

Debt and equity financing are the two basic external sources. The company’s ability to borrow today is based on projections of how much cash will be generated in the future. Borrowing power and the market value of the shares both depend on a company’s cash-generating ability. The market value of the shares directly impacts the second source of financing, that is, equity financing. For a given level of funds required, the higher the share price, the less dilution will be borne by current shareholders. Therefore, management’s financial power to deal effectively with corporate claimants also comes form increasing the value of the shares.

In recent years, emphasis has also been put on value-based management. It is an approach to management that aligns a company’s overall aspirations, analytical techniques and management processes to focus management decision making on the key drivers of value. The appended exhibit illustrates the key drivers of shareholder value.

* Notes prepared by Dr. S K Chaudhuri, Professor, IMI

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Shareholder Value – Key Drivers

Strategy Development

Management Decisions Operating Investment Financing

Value Drivers • Sales Growth • Operating Profit

Margin • Income Tax Rate

• Value Growth Duration

• Working Capital Investment

• Fixed Capital

• Cost of Capital

Corporate Objective

Components of Value

Cash Flow from Operation

Discount Rate Debt

Creating Shareholder Value Shareholder Returns

• Dividends • Capital Gains

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BALANCING THE SCORE-CARD*

Despite the widespread adoption of total-quality programmes in recent years, far too many companies still measure performance exclusively or primarily by the latest financial results, isolating their senior managers from what is happening in the market-place.

“It is like steering a ship by its wake”. Confesses one senior executive describing how his business measured its performance. The management tended to concentrate on narrow financial measures that lagged rather than led the company’s underlying performance. The unfortunate result: Pressure to make the latest financial figures look good was leading to worse customer service with an adverse impact on the company’s future.

In contrast, many of the most advanced companies today seek a more long-range focus by measuring progress against key performance indicators in four main areas:

(1) Financial How well is the company creating shareholder value?

(2) Customer How well is the company serve its customers?

(3) Process How well is the company performing key internal business processes in terms of quality, speed and productivity?

(4) Learning What improvements and innovations is the company making in its services and products?

Taken together, these four categories provide a more complete and balanced picture of the business issues that determine long-term success.

A key task for the managers is the development of a vision and objectives for the organization, covering not only financial results but also other factors such as how the business will compete. Performance measures should play a pivotal role in implementing the business strategy by monitoring whether the full range of strategic objectives is being achieved.

Well-constructed performance measures also send signals to those whose performance is being measured. Competition to-day is not just about cost - it is increasingly about quality, speed and service to the customer. It is also about learning faster than the competition. Bottom- up and top-down analysis Designing such performance measures requires both bottom-up and top-down analysis. Without both, there is a risk that either the measurement is not grounded in the strategic objectives of the organization and therefore drives behaviour in the wrong direction, or that the strategic measurement bears no relation to the business activities of the organization and cannot be used to manage effectively.

For most managers, one of the most difficult challenges is leaning to measure customer service in a new way. Customer measures must be based on what the customer actually values as well as how the business appears to the customer. For

* Brian Taylor, C. Graham and C. Stafford, Cross border, Winter 1994.

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example, if on-time shipment is critical, then what ought to be measured is the time of arrival at the customer’s premises - not the time the lorry leaves the depot.

Measure results, not training

The same philosophy applies to measuring such areas as organizational learning. The key is not how many people are trained, but the results. In areas like quality, the rate of improvement is critical. For example, a high-tech company might measure how fast it can halve the number of rejects in new product lines. At the bank, the measure might be the speed at which it matches competitor’s products, thus reducing any potential advantage for competitors.

Care is essential when applying such measurements. The objective is not simply to maximize every score - the aim is to assess where the business is now and where it needs to be for each score. The focus must be on:

• Targets; • Trends; • Action; • Forecasting.

No more than 25 parameters should be measured. If too many measures are used, it is likely that balance will be lost and it will be impossible to focus on the most important ones. Care should be taken, however, not to reduce lower-level data into meaningless ratios. Word to the wise There are a number of pitfalls to avoid when developing a performance-measurement system:

• Don’t use new measures to reward or punish immediately - they take tine to become embedded in the corporate culture.

• Don’t ignore important areas because they are difficult to measure. • Don’t look for quick, standard solution • Don’t underestimate the cultural change needed.

Far-reaching impact

The successful redesign of a company’s performance measures can have substantial and far-reaching effects on how senior executives think about business performance and on the decisions they make. Take the case of one manufacturing company that had used earnings per share as its almost exclusive measure of performance. In its revised list of priorities, earnings per share dropped to last place, preceded by customer satisfaction, cash flow, manufacturing effectiveness and innovation. The reasoning: It is these measures, rather than earnings per share, that truly anticipate the trend in business.

Finally remember that measuring performance is an aid to management, not a substitute for it. The objective is to focus management attention on the key measures of business performance that provide a basis for judging the short-term and long-term health of the business.

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EVA AS A PERFORMANCE MEASURE*

A surge in shareholder activism has put increasing pressure on companies to consistently maximize shareholder value. However, this raises the important question of how senior executives should measure an organization’s progress in meeting this goal. In particular, the question concerns defining measures of corporate financial performance that correlates highly with shareholder wealth. This issue is also concerned with motivating managers to do what is best for shareholders. The central idea in most organizations is to tie managerial compensation to measures of financial performance that are linked closely to changes in shareholder wealth. In theory, this should motivate managers to maximize shareholder value.

The most direct financial performance measurement is the business’s stock price. However, stock prices can be limited in their usefulness. The litmus test for any performance measure is whether it accurately reflects the decisions taken by management. A good performance measure must, therefore, be responsive to a manager’s actions and decisions. In this sense, stock prices (or, for that matter, stock returns) are often ineffective in assessing past performance because they reflect the expectations of all future decisions. In fact, stock prices are not necessarily that responsive to the actions of even the most senior-executive in a company. As one goes further down the organization, the problem becomes even more severe as lower-level employees have even less impact on the stock price.

Economic Value Added (EVA), like other performance measures, attempts to resolve the tension between the need for a performance measure that is both highly correlated with shareholder wealth and responsive to the actions of a company’s managers. The term EVA is a registered trademark of a New York based consulting firm, Stern Stewart & Co.

If an enterprise’s objective is to maximize the value of the shareholders’ claim to the assets, then this is quite easily done. A company will meet this objective if it does two things: invest only in new projects that are expected to create value and retain only projects that create value on an on-going basis.

To this end, finance theory offers managers a simple guide to choosing capital investments through the net present value (NPV) rule. That is, by investing in projects that have positive NPVs, the company will create value. However, when managers seek such a well-defined rule for evaluating their ongoing investments, they are often met with frustration. In fact, most organizations are forced to rely on financial measures such as total sales, total earnings or even rates of return on their net assets as a means of differentiating between the ‘peaches’ and the ‘lemons’ in their business. However, assessing performance based on these measures can often distort the investment behaviour of management away from that of their shareholders’ wishes. Investment distortions typically arise because a manager is not ‘charged’ for the capital he or she uses, or even rewarded for the shareholder value created. This is where the fundamental contribution of EVA comes into play. It rewards managers for the earnings they generate net of the amount of capital employed to reap these earnings. In this vein, EVA is defined as:

EVA = NOPAT – (KW x Net Assets) Where, NOPAT = net operating profit after-tax KW = weighted average cost of capital and Net Assets = book value of assets, or net capital deployed

* (Adapted) Todd Milbourn, Mastering Finance, Financial Times, 1998.

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If managerial compensation is tied to EVA, then the manager’s inclination to consume capital is now tempered by the fact that he or she must pay a capital charge evaluated at the weighted average cost of capital on the net capital he or she uses.

The goal of a good financial performance measure is to ask how well a company has performed in terms of generating operating profits over a period, given the amount of capital tied up to generate those profits. EVA is novel in that it provides an answer to this question. The idea is that the business’s financiers could have liquidated their investment in the company and put the liberated capital to some other use. Thus, the financiers’ opportunity cost of capital must be subtracted from operating profits to gauge the organization’s financial performance. In this spirit EVA views NOPAT as a representation of operating profit and subtracts a capital charge that views the economic book value of assets in place as a measure of the capital provided to the company by its financiers.

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DEFFERED TAX LIABILITY AND ASSET

Dr. S K Chaudhuri

The need for deferred tax accounting arises because companies often postpone or pre-pay taxes on profits pertaining to a particular period. This is caused by the timing differences in booking some items of revenue and expenses in the profit and loss statement and in the tax-return1. The Accounting Standard 22 issued by the Institute of Chartered Accountants of India deals with the subject. In this appendix, we only explain them with numerical examples.

DEFERRED TAX LIABILITY

A common situation that creates deferred tax liability is when amount and timing of depreciation charges for accounting and tax purposes differ2. To appreciate the tax effect of timing difference in depreciation charges, consider a company which has purchased a machine at Rs. 150 million. Suppose the machine is eligible for 100 percent depreciation in the first year of operation for tax purpose, but the management decides to depreciate the machine on a straight-line basis over three years for accounting purpose. We further assume that the company will earn profit before depreciation and tax of Rs. 200 million each year and the corporate tax rate is 40 percent. Table 1 presents all the calculations.

As evident from the first-year calculations in Table 1, deferred tax liability occurs when higher tax expense is reported in the profit and loss statement than what is actually due. In our example, tax expense as per book profit is Rs. 60 million whereas as per tax-return the amount due is much less, Rs. 20 million only. This has lead to reporting of additional tax outgo of Rs. 40 million. To overcome this problem, a deferred tax account is created in the liability section of the balance sheet; this deferred tax account maintains a running total of differences between taxes reported and taxes actually due. Under the present system of presentation, taxes due are shown separately as current tax.

We may further note that when the company slows or ceases procuring new assets (as assumed in our example for the second and third years), there will eventually be a reversal, i.e. reported tax will be less than is actually due and deferred tax will become negative. In our example, reported tax in the second year is Rs. 60 million while actual amount to be paid in the same year stands at Rs. 80 million (see Table 1). The actual tax outgo in the second year is higher because the company has fully depreciated the machine in the previous year and it has not added any new asset. So, the company has no depreciation to be set off against taxable income in the second and third years. As a result, tax return shows higher tax amount and the deferred tax turns into negative in the second and third years. By the end of the third year, deferred tax account shows nil balance. In a different scenario, if the company continues to invest in depreciable assets, deferred tax reversal may be delayed indefinitely.

1 Deferred tax is not the same thing as taxes payable. While taxes payable are tax payments due within the year, deferred taxes are due for reversal at some indefinite future date. 2 Apart from depreciation, there are other examples of tax effect of timing differences leading to deferred tax liability. For example, tax law permits charging advertisement expenses in year it is incurred, but companies normally prefers to amortise the expenses over a couple of years. Similarly, pre-issue expenses, or expenses on research and development, or expenses incurred on mergers and acquisitions are allowed to be written off over a fixed period of years for tax purpose, but the company may decide to stretch the write off over a longer period.

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Table 1: Illustrative calculation of deferred tax liability

(Rs. Millions) Year 1

Year 2

Year 3

Accounting profit and taxation

Profit before depreciation and tax 200 200 200

Less: Depreciation @ 33.33% 50 50 50

Profit before tax 150 150 150

Less: Provision for taxation @ 40% 60 60 60

Profit after tax 90 90 90

Tax-return profit and taxation

Profit before depreciation and tax 200 200 200

Less: Depreciation @ 100% 150 0 0

Profit before tax 50 200 200

Less: Provision for taxation @ 40% 20 80 80

Profit after tax 30 120 120

Difference in taxation 40 (20) (20)

Presentation in Profit & Loss Account

Profit before depreciation and tax 200 200 200

Less: Depreciation @ 33.33% 50 50 50

Profit before tax 150 150 150

Less: Provision for taxation

Current tax (involves cash payment) 20 80 80

Deferred tax (non-cash charge) 40

Deferred tax reversal (20) (20)

Total 60 60 60

Profit after tax 90 90 90

In retrospect, deferred tax liability serves the purpose of a reserve, which will be draw down in the future years to meet the company’s higher tax liability in those years.

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DEFERRED TAX ASSET

When does a company create deferred tax asset? Deferred tax asset is created when a company is in effect pre-paying taxes. For instance, provisions made at the discretion of management, e.g., provision for bad debts, may not be fully allowed by the tax authorities. In this case, tax expense in the profit and loss account is less than the amount allowed for tax purpose. To reconcile the difference, the accountant is required to create deferred tax assets in the assets section of the balance sheet.

Another example is when a company may charge off taxes, duties, cess, fees, etc. against income during a year on accrual accounting basis but they are allowed for tax purpose in the subsequent year on payment basis. Such instances also lead to creation of deferred tax asset tax expense in the profit and loss statement happens to be more than the actual tax due.

Deferred tax assets should be recognised and carried forward only to the extent that there is a reasonable certainty that sufficient future taxable income will be available against which such deferred tax assets, i.e., pre-paid tax can be set off.

DEFERRED TAX LIABILITY - DEBT OR EQUITY?3

In terms of presentation, deferred tax liability (net of deferred tax asset) is placed on the liability side of the balance sheet below the loan funds. Though its position in the balance sheet gives an impression that deferred tax liability is a debt item, analysts are often confused whether to treat the deferred tax liability as debt or equity, or neither, in financial analysis.

There are different view points regarding how deferred tax liability is to be treated for financial analysis. One view point is that deferred tax liability must be added to equity since there is no definite time period for its reversal. In this sense, it is more like ‘equity’ than ‘debt’. But as mentioned earlier, when the company slows or ceases procuring new assets there will eventually be a reversal of deferred tax liability, i.e. reported tax will be less than is actually due and deferred tax will become negative. In that case, deferred tax liability is more akin to ‘debt’ than ‘equity’. Thus, analyst is required to take a view on whether reversal of deferred tax liability will eventually take place or it will be delayed for indefinite period.

Some analysts propose that the current period deferred tax (a non-cash charge) should be added back to profit; the argument is that profit is understated because of overstatement of taxes. Yet some others favour deducting deferred tax liability from net fixed assets. The logic here is that excess tax depreciation over book depreciation leads to decrease in assets valuation rather than creation of a liability.

3 For further discussion refer to James C Van Horne, Financial Management & Policy, 12th Edition, Pearson Education

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Balance SheetPage 1

(Rs. crores) 2005-06 2006-07 ChangeSources of FundsShare capital (face value of Re.1) 122.16 132.39 8.4%Reserves and surplus 1,290.29 1,762.18 36.6%Less : Revaluation reserve 23.95 22.96 -4.1%Less : Misc. expenditure not w/o 7.31 24.42Tangible networth 1,381.20 1,847.20 33.7%Deferred tax liability (net) 179.69 196.93 9.6%Equity capital 1,560.89 2,044.12 31.0%Secured loans 184.69 360.22 95.0%Unsecured loans 507.24 280.18 -44.8%Debt capital 691.93 640.40 -7.4%

Total 2,252.82 2,684.52 19.2%Linking Balance Sheet & Profit & Loss Account (2006-07) Application of Funds

Fixed assetsGross block (less revaluation reserve) 2,114.55 2,597.24 22.8%

(Rs. Crores) Less : Depreciation 1,195.23 1,313.16Net block 919.33 1,284.08 39.7%Add : Capital work-in-progress 141.42 237.49Net fixed assets 1,060.74 1,521.57 43.4%Investments 368.18 221.09 -39.9%Current assets, loans and advances

Raw materials 272.83 385.34 41.2%Stores, spares & tools 36.63 42.91 17.1%

Sub-total 309.46 428.24 38.4%Work-in-progress 143.73 109.51 -23.8%Finished goods 449.37 532.57 18.5%

Total inventories 902.56 1,070.32 18.6%Debtors more than six months 15.65 69.60 344.8%Other debtors 413.34 458.36 10.9%Less : Prov for doubtful debts (4.65) (5.09)

Sundry debtors 424.34 522.88 23.2%Cash and bank 602.88 434.94 -27.9%Loans and advances 302.64 669.58 121.2%

Total current assets 2,232.41 2,697.71 20.8%Less : Current liabilities and provisions

Creditors for goods 691.98 1013.71 46.5%Acceptances 353.97 419.98 18.6%Interest accrued but not due 5.83 5.21 -10.7%Other current liabilities 95.11 212.73 123.7%

Total current liabilities 1146.90 1651.63 44.0%Provisions 261.62 104.23 -60.2%

Total current liab & prov. 1408.52 1755.86 24.7%Net current assets 823.90 941.86 14.3%

Total 2252.82 2684.52 19.2%Contingent liabilities* 713.60 801.33 12.3%* Bulk of it represents contingent liabilities on account of bills discounted.

Equity1,829.27 + 214.85 = 2,044.12

+ =Debt

640.40

CapitalEmployed2,684.52

Net FixedAssets

1,521.57

Investment221.09

Net CurrentAssets941.86

Sales +other income

7,262.48

minusExpenditure

6,821.20

Profitafter tax441.28

Dividend &tax on dividend

226.43

Retainedprofit214.85

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Profit & Loss Statement Financial Analysis Unit 2005-06 2006-07Page 2

(Rs. In crores) 2005-06 2006-07 Change 1. Capital (or total assets) turnover = (net sales + other income) ÷ total assets times 2.355 2.705Net sales1 5,247.66 7,168.18 36.6% 2. Fixed assets turnover = net sales ÷ net fised assets times 4.947 4.711Materials consumed 4,133.62 5,493.78 32.9% 3. Working capital management:Stores and tools consumed 34.23 37.89 10.7% 3.1 Inventory turnover = net sales ÷ inventories (times) times 5.814 6.697Employee cost 403.89 480.70 19.0% Inventory holding in days = days in a year ÷ inventory turnover days 63 55Power & fuel cost 41.41 45.44 9.7% 3.2 Receivable turnover = net sales ÷ receivables (times) times 12.367 13.709Repairs and maintenance 45.38 54.85 20.9% Days sales ourstanding (DSO) = days in a year ÷ receivable turnover days 30 27Other expenses 35.55 2.39 -93.3% 3.3 Gross operating cycle in days = inventory holding days + DSO days 93 82Stock adjustments (300.60) (48.98) 3.4 Liquidity position:Cost of goods sold (excld depreciation) 4,393.47 6,066.06 38.1% 3.4.1 Current ratio = current assets ÷ current liabilities & provisions times 1.58 1.54Gross Profit 854.19 1,102.12 29.0% 3.4.2 Quick ratio = (current assets - inventories) ÷ current liabilities & provisions times 0.94 0.93Research and development 19.74 29.49 49.4% 3.4.3 Cash ratio = (cash & marketable securities) ÷ current liabilities & provisions times 0.69 0.37Selling, general & administrative expenses 294.39 369.95 25.7%EBITDA 540.07 702.69 30.1% 4. Sales per employee = gross sales ÷ number of employees Rs. m 5.21 6.99Add : Other income 57.17 94.31 65.0% 5. Value added per employee = (net sales - materials/stores/etc.) ÷ no. of employees Rs. m 0.91 1.35Less : Depreciation, amortization & impairment 126.01 150.57 19.5%EBIT 471.23 646.42 37.2% 6. Gross profit margin = gross profit ÷ net sales % 16.28 15.38Net interest2 40.65 28.84 -29.1% 7. Operating profit margin = EBITDA ÷ net sales % 10.29 9.80Profit before extraordinary items 430.59 617.58 43.4% 8. Net profit margin = PAT ÷ (net sales + other income) % 6.17 6.08Extraordinary items (21.72) 13.08 9. Return on capital (or assets) employed (ROCE) = PAT ÷ total assets % 14.53 16.44Profit before tax (PBT) 452.30 604.51 33.7% 10. Return on equity (ROE) = PAT ÷ equity capital (tangible networth + net deferred tax liability) % 20.97 21.59Taxation 124.98 163.22 30.6% Current tax (including fringe benefit tax) 117.75 140.2 19.1% 11. Materials cost-to-sales ratio = materials ÷ net sales % 78.77 76.64 Deferred tax 7.23 23.02 218.4% 12. Employee cost-to-sales ratio= employee cost ÷ net sales % 7.70 6.71Profit after tax (PAT) 327.32 441.29 34.8% 13. Power & fuel costs-to-sales ratio = power & fuel costs ÷ net sales % 0.79 0.63Dividend 159.79 198.58 24.3% 14. R & D expenses-to-sales ratio = R & D expenses ÷ net sales % 0.38 0.41Tax on dividend 22.41 27.85 15. SG&A expense-to-sales ratio = SG&A expenses ÷ net sales % 5.61 5.16Retained profit 145.12 214.85 48.0%

16. Business risk:1 Break-up of sales: 16.1 Sales variability (over trailing 10years) = standard deviation sales ÷ average sales % 40.79 53.58Vehicles-commercial 5,250.87 7,776.00 48.1% 16.2 Operating leverage = (net sales - variable costs) ÷ EBIT (excluding other income) times 2.61 2.96Engines 135.75 152.58 12.4% 17. Financial risk:Spare parts & others 783.78 546.84 -30.2% 17.1 Debt-equity ratio = debt capital ÷ equity capital (tangible net worth + net deferred tax liability) times 0.44 0.31Gross sales 6,170.41 8,475.42 37.4% 17.2 Debt-to-total assets = debt capital ÷ total assets % 30.71 23.86Less : Commission/rebate/discounts 117.30 170.70 45.5% 17.3 Inerest coverage ratio = EBIT ÷ gross interest expenses times 11.59 20.31

Sub-total 6,053.11 8,304.72 37.2%Less : Excise duty 805.45 1,136.54 41.1% 18. Sustainable growth rate = (year-end equity ÷ year-beginning equity) - 1 % 10.25 11.75Net sales 5,247.66 7,168.18 36.6%

19. Per share data :2 Gross interest 40.65 31.82 -21.7% 19.1 Earnings per share (EPS) = (PAT - dividend on preference shares) ÷ common shares outstanding Rs. 2.68 3.33Less : Interest capitalised 0.00 2.98 19.2 Cash flow per share (CFPS) = (PAT + depreciation + amortization) ÷ common shares outstanding Rs. 3.71 4.47

19.3 Dividend per share (DPS) = dividend ÷ common shares outstanding Rs. 1.31 1.50Memo item 19.4 Book value per share (BVPS) = equity capital ÷ common shares outstanding Rs. 12.78 15.44Number of employees 11,845 12,125 2.4% 20. Price-earning (P/E) ratio = market price ÷ EPS times 15.1 11.7Year-end market price (average of high & low) in 40.35 38.95 -3.5% 21. Price-to-cash flow ratio = market price ÷ CFPS times 10.9 8.7(Bombay Stock Exchange) 22. Market-to-book value ratio = market price ÷ BVPS times 3.2 2.5

E. Market Value

A1. Productivity (Assets management)

B1. Profitability

C. Risk Analysis

D. Growth Analysis

A2. Labour Productivity

B2. Key Elements of Expenditure

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Economic Value Addition (EVA)

Page 3(Amount in Rs. crores) 2005-06 2006-07

Year-beginning equity capital (E0) 1,415.77 1,829.27Year-end debt capital (E1) 1,560.89 2,044.12Average equity capital [E = (E0+E1)/2] 1,488.33 1,936.70Beginning debt capital (D0) 880.41 691.93End debt capital (D1) 691.93 640.40Average debt capital [D = (D0+D1)/2] 786.17 666.16Capital employed (K = E + D) 2,274.50 2,602.86Debt-to-total capital (D/K) 35% 26%Cost of equity (assumed) 15% 15%Interest rate (gross) 5% 5%Effective tax rate (t) 28% 27%After-tax cost of debt [Kd = i*(1 - t)] 4% 3%Cost of capital (WACC) 11% 12%EBIT 471.23 646.42NOPAT = EBIT x (1 - t) 341.02 471.88Capital charges = K x WACC 252.67 313.73EVA = NOPAT - K x WACC 88.36 158.15

Key Strategies to Enhance EVA

Operate : Set targets to improve ROCE

Build : Invest capital only when return exceeds cost of capital

Harvest : Divest capital when returns fall below the cost of capital

Optimize : Restructure capital to reduce cost of capital

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(Rs. In crores)Income Statement 2005-06 2006-07

Gross sales 6170.41 8475.42 Operating Cycle 2005-06 2006-07Less : Comm/rebate/discounts 117.30 170.70

Sub-total 6053.11 8304.72 Stock of materials/stores/ etc. (Rs. Crores) 309.46 428.24Less : Excise duty 805.45 1136.54 Consumption of materials/stores/etc. (Rs. Crores) 4,167.85 5,531.67Net sales 5247.66 7168.18 Stock as days' consumption (A) 27.10 28.26Materials consumed 4,133.62 5,493.78 Stock of WIP (Rs. Crores) 143.73 109.51Stores and tools consumed 34.23 37.89 Cost of production (Rs. Crores) 4,787.32 6,329.32Employee cost 403.89 480.70 Stock as days' cost of production (B) 10.96 6.32Power & fuel cost 41.41 45.44 Stock of finished goods (Rs. Crores) 449.37 532.57Repairs and maintenance 45.38 54.85 Cost of goods sold (Rs. Crores) 4,539.20 6,246.12Research and development 19.74 29.49 Stock as days' COGS (C) 36.13 31.12Depreciation, amortization & impairment 126.01 150.57 Inventory conversion period (A+B+C) 74.19 65.70Other expenses 35.55 2.39 Debtors (Rs. Crores) 424.34 522.88

Sub-total 4,839.81 6,295.10 Gross sales (Rs. Crores) 6,170.41 8,475.42Add : Opening stock of WIP 91.24 143.73 Debtors as days sales oustanding (D) 25.10 22.52Less : Closing stock of WIP 143.73 109.51 Gross operating cycle in days (E=A+B+C+D) 99.29 88.22Cost of production 4787.32 6329.32 Operating cyle in months 3.31 2.94Add : Opening stock of finished goods 201.25 449.37 Creditors & acceptances (Rs. Crores) 1,045.95 1,433.69Less : Closing stock of finished goods 449.37 532.57 Credit purchase in Rs. crores (materials/stores/etc.)1 4,209.74 5,650.45Cost of goods sold (COGS) 4539.20 6246.12 Credit period in months (F) 2.98 3.04Selling, general & administration (SG&A) 294.39 369.95 Net operating cycle in months(E-F) 0.33 (0.10)Cost of sales (COS) 4833.59 6616.07Operating income (net sales - COS) 414.07 552.11Add: Other income 57.17 94.31 1 Purchase of raw materials/stores/etc. (Rs. Crores) 2005-06 2006-07EBIT 471.24 646.42 Closing stock 309.46 428.24Interest 40.65 28.84 Add : Materials, stores & tools consumed 4,167.85 5,531.67Profit before extraordinary exp. 430.59 617.58 Less : Opening stock 267.57 309.46Extraordinary exp.(VRS comp.) (21.72) 13.08 Purchase of materials, stores & tools 4,209.74 5,650.45Profit Before Tax 452.30 604.51Taxation 124.98 163.22Profit after tax 327.32 441.29

12

TIME VALUE OF MONEY AND DCF TECHNIQUE

• Future value of money (discrete compounding): Cn = C0 (1 + k/m)mn • Future value of money (continuous compounding): Cn = C0 ekn

• Future value of ordinary amount: FV =

−+k

1)k1(An

• Future value of annuity due: FV =

−++

k1)k1()k1(A

n

• Time value of money : C0 = Ct / (1 + k)t

• Present value of a cash flow stream : ∑= +

=n

1tt

t

)k1(C(PV

• Present value of flat, perpetual cash flows : PV = C/k • Present value of a perpetual cash flows, growing at a constant growth rate (g) :

PV = C1 / (k - g), where C1 = C0 (1 + g) = cash flow at the end of period 1 and, k>g If g= -ve, then PV = C1 / (k+g)

• Present value of an annuity (A) : PV = A/(1+k)1 + A/(1 + k)2 + . . . + A / (1 + k)n

PV = k

])k1/(11[A n+− = A.a

where, a = annuity factor = k

])k1/(11[ n+−

A (annuity) = PV x 1/a = PV x CRF, where CRF = 1/a = capital recovery factor • Effective rate of interest : r = [1 + (k/m)]m - 1, where, k = annual rate of interest m= frequency with which compounding is done in a year • Yield-to-maturity of a fixed-income security P = C1/(1+k)1 + C2 /(1 + k)2 + . . . + Cn/ (1 + k)n + M/(1+k)n where P = current price of a bond Cn = coupon payment in period n M = maturity value k = internal rate of return (IRR) = yield-to-maturity • If P = face value of the bond, YTM = coupon rate

If P > face value , YTM < coupon rate If P < face value, YTM > coupon rate

• In case of periodic coupon payment (i.e., monthly, quarterly or say, half-yearly), annualised YTM would be greater than that of a similar bond with annual payment of coupon

13

EXERCISE ON PRESENT VALUE CONCEPT & DCF CALCULATIONS

1. As winner of a breakfast cereal competition, you can choose one of the following prizes:

a) $ 100,000 now

b) $ 180,000 at the end of 5 years

c) $ 11,400 a year forever

d) $ 19,000 for each of 10 years

e) $ 6500 next year and increasing thereafter by 5% a year forever

If the interest rate is 12 percent, which is the most valuable prize ? 2. Kangaroo Autos is offering free credit on a new $ 10,000 car. You pay $1000 down

and then $ 300 a month for the next 30 months. Turtle Motors next door does not offer free credit but will give you $ 1000 off the list price. If the rate of interest is 10 percent a year, which company is offering the better deal ?

3. You own an oil pipeline which will generate a $ 2 million cash return over the

coming year. The pipeline’s operating costs are negligible and it is expected to last for a very long time. Unfortunately, the volume of oil shipped is declining, and cash flows are expected to decline by 4 percent per year. The discount rate is 10 percent.

a) What is the present value of the pipeline’s cash flows if its cash flows are assumed to last forever?

b) What is the present value of the cash flows if the pipeline is scrapped after 20 years ?

4. For an investment of $ 1000 today, the Tiburon Finance Company is offering to pay

you $1600 at the end of 8 years. What is the annually compounded rate of interest ? What is the continuously compounded rate of interest?

5. You have just read an advertisement reading, “Pay us $ 100 a year for 10 years

and we will pay you $ 100 a year thereafter in perpetuity”. If this is a fair deal, what is the rate of interest?

6. Sanchez Hydraulics Company has outstanding a 14 percent coupon bond with three years to maturity. Interest payments are made semi-annually. Assume a face value of $ 100.

a) If the market price of the bond is $ 104, what is the yield to maturity? If it were $ 97, what would be the yield? If it were $100 what would be the yield?

b) If the bond’s yield were 12 percent, what would be its price? If it were 15 percent? 14 percent?

c) Instead of a coupon bond, suppose it were a zero coupon, pure discount instrument. If the yield were 14 percent, what would be the market price ? (Assume semiannual compounding)

7. Delphi Products Corporation currently pays a dividend of $2 per share and this

dividend is expected to grow at a 15 percent annual rate for 3 years, then at a 10

14

percent rate for the next 3 years, after which it is expected to grow at a 5 percent rate forever.

a) What value would you place on the stock if an 18 percent rate of return were required?

b) Would your valuation change if you expected to hold the stock only 3 years?

8. A company is considering two different makes of a machine. The projected cash

flows associated with each option are as given below. Which make (cheap or quality machine) should the company prefer? Assume that discount rate is 15 percent.

Cash Flows for the Cheap and Quality Machines

Year Cheap Machine Quality Machine 0 - $ 12,000 - $ 22,000 1 7,000 8,000 2 7,000 8,000 3 7,000 8,000 4 - 8,000 5 - 8,000

9. A private power producer has offered the following tariff (i.e., price of electricity)

schedule for the coming 5 years:

Year 2000 2001 2002 2003 2004

Tariff (Rs./Kwh) 3.25 3.50 3.60 3.75 4.00

Suppose you are interested to pay a constant (or flat, or levelized) price per kwh in

each year during the 5-year period under consideration. What price would you ask for? Assume that your opportunity cost of money is 16 percent.

10. An analyst intends to value a company in terms of the future cash generating capacity. He has projected the following after-tax cash flows:

Year 0 1 2 3 4 5 6 Cashflows (Rs. million)

867 1,379 -6054 -1068 3,258 5,716 11,193

It is further estimated that beyond 6th year, cash flows will perpetuate at a constant growth rate of 8% per annum.

(a) What is the value of the company in terms expected future cash flows? You

may assume a cost of capital of 15% for your calculation. (b) The company has outstanding debt of Rs.60,000 million and cash/bank

balance of Rs.5,000 million. Calculate shareholder value per share, if the number of outstanding shares is 850 million.

15

SOLUTION TO SELECT PROBLEMS

1. a) PV = $ 100,000

b) PV = 180,000 / 1.125 = $102,137 c) PV = 11,400 / 0.12 = $95,000 d) PV = 19,000 [Annuity factor, 12%, t = 10] PV = 19,000 [5.650] PV = $107,350 e) PV = 6,500 / (0.12 - 0.05) = $92,857

Prize (d) is the most valuable because it has the highest present value. 2. The fact that Kangaroo Autos is offering “free credit” tells us what the cash

payments are; it does not change the fact that money has time value. With compounding, a 10 percent annual rate of interest is equivalent to a monthly rate of 0.8 percent

(1 + rannual) = (1 + rmonthly)12

With rannual = 0.10 rmonthly = 0.008

The present value of the payments to Kangaroo Autos is: $1,000 + $300 [Annuity factor, 0.8%, t= 30]

The annuity factor is given by :

$1,000 + 300 {[1/0.008] - [1/0.008 (1.008)30]} = $8973

A car from Turtle Motors costs $9000 cash. Therefore Kangaroo Autos offers the better deal, i.e., the lower present value of cost.

3. a) This calls for the growing perpetuity formula with a negative growth rate, g = -

4% : PV = 2 / [0.10 - (-0.04)] = 2 / 0.14 = $14.29 million.

b) The pipeline’s value at year 20 (i.e., at t = 20), assuming its cash flows last forever, is :

PV20 = C21 / (r - g) = C1 (1+g)20 / (r - g) With C1 = 2, g = -0.4, and r = 0.10 PV20 = 2 (1 - 0.04)20 / (0.14) = 0.884 / 0.14 = $6.314 Next, we have to convert this amount to PV today, and subtract it from the

answer to part a: PV = 14.29 - 6.314 / (1.1)20 = $13.38

4. To find the annual rate (r), we solve the following future value equation :

16

1000 (1 + r)8 = 1600

Using trial and error, or logarithms, r = 0.0605 or 6.05%. This is equivalent to 5.87% continuously compounded (e0.0587 = 1.0605).

5. One way to approach this problem is to solve for the present value of (1) $100 a

year for 10 years and (2) $100 a year in perpetuity, with the first cash flow at year 11. If this is a fair deal, these present values must be equal, and thus we can solve for the interest rate, r.

The present value of $100 for 10 years is : PV = 100 {[1/r] - [1/r (1+r)10]} The present value, as of year 10, of $100 a year forever is : PV10 = 100 / r At t = 0, this present value is : PV = [1/(1+r)10] [100/r] Equating these two expressions for present value, we have : 100 { [1/r] - [1/r (1+r)10]} = [1/(1+r)10] [100/r] Using trial and error, we find that r = 7.18%. Notice that the interest rate is such

that your $100 payment doubles in 10 years. 6. a)

$104 = $7 /(1+r)1 + $7 /(1+r)2 + . . . + $7 /(1+r)6 +$100 /(1+r)6 r = semiannual yield = 6.18% R = annualised yield = 6.18 x 2 = 12.36% When, Price = $97, r = 7.64% R = 15.28% When, Price = $100, r = 7 % R = 14%

b) Price = Present value of semiannual cashflows, discounted at 6%

= $7 x 0.9434 + $7x 0.8900 + $7 x 0.8396 + $7 x 0.7921 + $7 x 0.7473 + $107 x 0.7050

= $104.92 When, Yield = 15%, Price = $ 97.65 When, Yield = 14%, Price = $100.00

c) Price = $100 / (1 + 0.07)6 = $100 x 0.6663 = $66.63

17

7. a)

END OF DIVIDEND PRESENT VALUE OF DIVIDENDS @18%

Year 1 $ 2.00 (1.15) = $ 2.30 x 0.84746 = $ 1.95 Year 2 2.00 (1.15)2 = 2.64 x 0.71818 = 1.90 Year 3 2.00 (1.15)3 = 3.04 x 0.60863 = 1.85 Year 4 3.04 (1.10) = 3.34 x 0.51579 = 1.73 Year 5 3.04 (1.10)2 = 3.68 x 0.43711 = 1.61 Year 6 3.04 (1.10)3 = 4.05 x 0.37043 = 1.50 Total = $10.53

Year 7 dividend = $ 4.05 (1.05) = $4.25 Present value of dividends, expected to grow at 5% forever, at the end of year

6 = 4.25 / (0.18 - 0.05) = $32.69 Present value at t = 0 of the perpetual stream of dividends = $32.69 x 0.37043 = $12.11 Market value of stock = $10.53 + $12.11 = $22.64 b) Present value of expected dividend to be received at end of year 1, 2, 3 = $1.95

+ $1.90 + $1.85 = $5.70 Expected market price of stock at the end of year 3 = $3.34 x 0.84746 + $ 3.68 x 0.71818 + $4.05 x 0.60863 +

$32.69 x 0.60863 = $2.83 + $2.64 + $2.46 + $19.90 = $27.83 Present value of expected market price (at t = 0) = $27.83 x 0.60863 = $ 16.94 Total value = $16.94 + $5.70 = $22.64. Thus, the value is the same for an

investor with a 3-year time horizon.

18

WORKING CAPITAL MANAGEMENT

The concept of working capital is used in two ways. Gross working capital refers to the firm’s investment in current assets. Net working capital means the difference between current assets and current liabilities, and therefore, represents that position of current assets, which the firm has to finance either from long-term funds and/or bank borrowings.

A firm is required to invest in current assets for a smooth, uninterrupted production and sale. How much a firm will invest in current assets will depend on its operating cycle. Operating cycle is defined as the time duration, which the firm requires to manufacture and sell the product and collect cash. (see the Exhibit). Thus operating cycle refers to the acquisition of resources, conversion of raw materials into work-in-process into finished goods, conversion of finished goods into sales and collection of sales. Larger the operating cycle, larger the investment in current assets. In practice, firms are allowed to acquire resources on credit. To that extent, firm’s need to raise working finance is reduced. The term net operating cycle is used for the difference between operating cycle (or gross operating cycle) and the payment deferral period (or the period for which creditors remain outstanding).

The manufacturing cycle (that is conversion of raw material into work-in-process into finished goods) is a component of operating cycle, and therefore, it is a major determinant of working capital requirement. Manufacturing cycle depends on the firm’s choice of technology and production policy. The firm’s credit policy is another factor, which influences the working capital requirement. It depends on the nature and norms of business, competition and the firm’s desire to use it as a marketing tool. The requirement for working capital finance will be reduced to the extent the firm is able to exploit the credit extended by suppliers. Depending on the possible availability of working capital finance and its own profitability, a firm may carry more or less investment in current assets than warranted by technical factors.

The firm’s decision about the level of investment in current assets involves a trade-off between risk and return. When the firm invests more in current assets it reduces the risk illiquidity but loses in terms of profitability since the opportunity of the earning from the excess investment in current assets is lost. The firm therefore is required to strike a right balance.

Typically, the current assets of a firm are supported by a combination of long-term and short-term sources of financing. The following sources of finance more or less exclusively support current assets: accruals, trade credit, and working capital advance by commercial banks, public deposits, and inter-corporate deposits, short-term loans from financial institutions, rights debentures for working capital, commercial paper and factoring.

19

Exhibit : Operating or Cash - To - Cash Cycle (Illustration)

Length of Operating Cycle = (2.7 + 2.5 + 0.4 + 2) – 3.8 = 3.8 months

2.0 months

Cash

3.8 months (Sales)

Creditors

&

Sales

Finished

G d W – I –

P

Raw Materi

l

2.7 months (Consumptio

2.5 months (Cost of

0.4 month (Cost of

Debtors

20

OPERATING STATEMENT (Rs. in lakhs)

Estimation for the year ended/ending

1 2 3 4

Last 2 years Actuals Current yr estimates

Following year projections

1 2 3 4

1. Gross Sales i) Domestic Sales ii) Export Sales Total 2. Less excise duty 3. Net Sales (1 - 2) 4. Expenditure i) Raw materials (including stores and

other items used in the process of manufacture)

ii) Other spares iii) Power and fuel iv) Direct labour (Factory wages and

salaries)

v) Other manufacturing expenses vi) Depreciation vii) Sub-Total (i to vi) viii) Add : Operating stocks in-process ix) Deduct : Closing stocks-in-process x) Cost of production xi) Add : Opening stock of finished

goods

xii) Deduct closing stock of finished goods

xiii) Cost of sales 5. Selling, general and admin expenses 6. Sub-Total 7. Operating profit before interest (3 - 6) 8. Interest 9. Operating profit after interest (7 - 8) 10. Add non-operating income/ sub-tract

net operating expense

11. Profit before tax/loss (9 + 10) 12. Provision for taxes 13. Net profit /loss (11 - 12)

21

ESTIMATION OF OPERATING CYCLE

(Rs. in million) Current Yr Projection1. Purchase of raw materials (credit) 4,653 6,0912. Opening stock of raw materials 523 8273. Closing stock of raw materials 827 9864. Raw materials consumed (1+2-3) 4,349 5,9325. Direct labour 368 4986. Depreciation 82 907. Other manufacturing expenses 553 7048. Total cost (4+5+6+7) 5,352 7,2249. Opening stock of WIP 185 32510. Closing stock of WIP 325 49811. Cost of production (8+9-10) 5,212 7,05112. Opening stock of finished goods 317 52613. Closing stock of finished goods 526 99514. Cost of goods sold (11+12-13) 5,003 6,58215. Selling, admn and general expenses 304 45716. Cost of sales (14+15) 5,307 7,039

(Rs. in million) Current Yr ProjectionSales 6,087 8,006Debtors 735 1,040Creditors 454 642

Operating Cycle Calculation(day) Current Yr Projection

69 612. WIP 23 263. Finished goods 38 554. Inventory conversion period (1+2+3) 130 1425. Debtors conversion period 44 476. Gross operating cycle (4+5) 174 1897. Credit purchase period 36 388. Net operating cycle (6-7) 138 1519. No. of cycles in a year 2.6 2.4

WORKING CAPITAL ESTIMATION ILLUSTRATIVE CALCULATIONS

22

ESTIMATION OF WORKING CAPITAL REQUIREMENT

1. Estimated level of activity: Production of completed units 104,000 Work-in-progress 4,0002. Unit cost (Rs./unit) Raw materials 80 Direct wages 30 Overheads 60 Total cost 170 Selling price 200

3. Stock of raw materials one week consumption4. Valuation of stock of WIP 50% completion stage in respect of conversion cost.5. Finished goods stock in units 8,0006. Credit period for debtors 8 week7. Credit period for purchase 4 week8. Lag in payment in wages 1.5 week9. Required cash at bank (Rs.) 25,000

Stock of raw materials [104000/52 x 80] 160000Work-in-progress [4000 x Rs. (80 + 30/2 + 60/2)] 500,000Stock of finished goods [8000 x Rs. 170] 1,360,000

Sub-Total 2,020,000Debtors [(104000 x 8/52) x Rs. 170] 2,720,000Cas 25,000

Total current assets 4,765,000Less:Creditors [(104000 x 4/52) x Rs. 80] (640,000)Liabilities on account of wages [(104000 x 1.5/52) x Rs. 30] (90,000)Net working capital requirement 4,035,000

23

ABC Watches Ltd. (Bank Financing of Working Capital)*

ABC Watches Ltd. currently enjoys fund based facilities to the tune of $ 6.8 million from its consortium of banks. The company has put up a proposal to enhance the funding limit to $ 9.4 million for the financial year 1998-99. In what follows is presented the assessment by one member bank of consortium of what funding facilities will be provided to the company. The summary of credit risk analysis done by same member bank of consortium is given in the Appendix. Bank Financing For the year ending March 1999, ABC has projected sales and net profit as follows:

Net Sales $ 34.91 million (FY 98: $ 28.46 million) Net Profit $ 2.79 million (FY 98: $ 1.83 million)

The increase in sales represents an increase of 22.66% as against a 41% increase in FY 98 and an increase of 53% in FY 97. Given the strengths of the brand name, selling and distribution network, past performance and the potential of the market, this is considered to be distinctly achievable. Based on the above projections and the data submitted by the company, the company’s Maximum Permissible Bank Finance for FY99 is determined as given under:

$ million 1. Total Current Assets 17.2 2. Total Current Liabilities (Other than Bank Borrowings)

2.9

3. Working Capital Gap 14.3 4. Minimum Stipulated Net Working Capital (25% of Working Capital Gap)

3.6

5. Actual/Projected Net Working Capital 4.9 6. Item 3-4 10.7 7. Item 3-5 9.4 8. Maximum Permissible Bank Finance (Lower of Items 6&7)

9.4

The requirement of current assets has been worked out on the basis of the following:

Current Assets Calculation Basis Actual FY 98 • Raw Materials (Imported) 3.31 months consumption 3.47 months consumption

• Raw Materials (Indigenous) 3.10 months consumption 2.90 months consumption

• Consumable Spares 9.44 months consumption 12.64 months consumption

• Stocks in process 0.83 months cost of production

0.65 months cost of production

• Finished Goods 3.03 months cost of sales 3.24 months cost of sales

• Debtors 35 days sales 51 days sales

* Prepared by Dr S K Chaudhuri for Class room discussion.

24

While inventory levels as on FY97 had increased substantially to 5 months, they were down to about 3.5 months in FY98 and although the company has forecast marginal improvement in inventory levels, the figure is expected to remain in the high range on account of vendor locations, transit time, customs clearance and other factors. Receivable days are forecast to be down to the 35 day range (FY98 / 51 days) as was the trend till FY97. This is expected to be achievable as the present high level is on account of a temporary “credit period” scheme that ABC has introduced for certain dealers. High finished goods inventories are required in view of the number of styles manufactured, the number of stock points where the stocks are based and the geographical distance which is covered by the sales network. However, ABC’s concentration on inventory management and control has led to a steady decline in holding levels from 4.56 months in FY97 to 3.24 months in FY 98, and projected at 3.03 months in the current year. This is considered to be achievable in line with the improvements made thus far. The Lead Bank of the consortium is also in the process of analysing the data and the same will be discussed in the consortium meeting, expected to be held very soon. Notes:

1. The lending method used in calculating MPBF is the first method of lending. 2. Banks are no longer bound to follow any of the methods of lending prescribed by

earlier RBI.

25

Appendix: Credit Risk Analysis ABC’s financials have been audited by A F Fergusson and Co. who has raised no qualifications to the report.

Profit & Loss Account FY 97 FY 98 ($ million) (Actuals) (Actuals) Net Sales 20.13 28.46 Depreciation 0.80 0.90 Operating profit before interest 1.73 3.16 Interest Expense 1.85 2.42 Operating profit after interest (0.12) 0.74 Net Profit 0.82 1.83

Sales For FY98, ABC achieved net sales of $ 28.46 million (2.03 million watches sold) as compared to sales in FY97 of $ 20.13 million (1.58 million watches sold). This growth of 41.40% was higher than the projected figure of $ 26.86 million. As a consequence of this, ABC has increased its market share in the organised quartz analog market segment to approximately 25%. The hold over the market has been achieved as a result of a clever marketing strategy in terms of pricing of products. With Titan gradually phasing out of the sub-$ 60 range and ABC concentrating its models in that range, any possible price overlap has been eliminated, while the companies have established a presence in all the existing price segments of the organised market. Further, new ranges such as the Digital range and the high end Vista/Indlo ranges of watches had been added to sales and increased per unit realisations from $ 12.73 to $ 14.02. In addition, strategic tie-ups with large corporate houses during the festive seasons facilitated bulk sales. Profitability Fuelled by the overall increase in sales for FY98, the company made an operating profit before interest of $ 3.16 million (PY $ 1.73 million). Although, Gross margin was virtually unchanged at 46.90% (PY 46.91%), control over Selling, General and Administrative expenses led to an increase in Operating Profit Margin to 11.12% (PY 8.58%). Interest Expense increased as a result of higher interest rates but the performance of the company was sufficient to offset these temporary phenomena as reflected in an increase in net profit to $ 1.83 million (PY $ 0.82 million). Net Marging increased to 6.42% (PY 4.06%). The performance was also a reflection of the ongoing benefits enjoyed by the industry in terms of reduction in import duties, whereby there was

- a reduction in movement part duties from 70% to 25%; - in cases/straps/dials & hands from 85% to 50%; - certain raw materials from 50% to 25%; - reduction in duties on certain specified capital goods imports from 35% to

35%.

26

Further reduction is expected by the industry in the ensuing budget as a part of GOI’s ongoing drive to assist the industry in phasing out the ‘grey’ market. Leverage / Cash Flow Despite the increase in Net Worth, leverage has increased marginally to 1.86 (PY 1.80) due to an increase in short term debt. The figure, however, remains at acceptable levels due to the company’s adequate Net Worth of $ 12.68 million (PY $ 10.86 million). The overall increase in sales and control of inventory levels was instrumental in generating Gross Cash profits of $ 12.94 million (PY $7.96 million) which were adequate to absorb the cash operating expenses of $ 9.23 million (PY $ 6.94 million). This resulted in cash after operations of $ 3.72 million (PY $ 1.05 million). Positive contribution of miscellaneous cash income of $ 0.64 million helped in absorbing the interest expense of $ 2.37 million (PY $ 1.77 million) resulting in Net Cash Income of $ 1.98 million (PY $ 0.31 million). This was, however, not enough to absorb the additional capital expenditure of $ 2.90 million and other long term investments (comprising deposits with customs /excise / landlords, etc.) of $ 1.19 million resulting in a financial requirement of $ 2.11 million (PY $ 0.64 million) which was supplemented by increase in short term debt.

Balance Sheet FY 96 FY 97 FY 98 Current Ratio 3.07 1.96 1.48 Leverage 1.58 1.80 1.86 Days Receivables 27 30 51 Days Payable 97 69 111 Days Inventory 408 297 225 Net Worth ($ million) $ 10.04 11.27 12.68

The current ratio has reduced from a high of 3.07 in FY 96 to the present 1.48 (FY 98). The ratio is now well within acceptable norms. Marketable securities increased from $ 2.31 million (PY) to $ 2.72 million (this comprises mainly $ 0.45 million worth equity shares and triple option convertible debentured of Reliance Petrochemicals Ltd. (PY $ 0.36 million) and $1.89 million worth units of the Unit Trust of India (PY $ 1.55 million). Receivables at 51 days have shown a considerable increase over the last year (30 days) and are a reflection of a credit scheme that ABC has introduced for select dealers whereby 30-45 days credit period is being offered to them. Payable days have also increased significantly to 111 days from 69 days (FY 97). ABC enjoys a 60-90 days interest free credit period from parent company. While the tenor of this interest free period used to be maximum of 60 days till last year, there has been a greater degree of credit from the parent company as the size of the business has grown and the increase in payables is testimony of the same. Days Inventory which was an area of concern in FY 96 (408 days) and had improved to 297 days in FY 97 has improved further to 225 days. Indigenisation of certain components has played a significant role in the improvement. Additionally, ABC has

27

strategic tie-ups with certain corporate houses during festive seasons and has been able to plan production schedules accordingly. The consolidation of the brand name has also resulted in consistent sales of certain models leading to lower inventory levels. The inventory figure, though reducing, is still high on account of :

- The wide range of models which are being assembled. - Large number of retail outlets to stock finished products. ABC has to keep

ready stock of all finished models at all the outlets as it is difficult to estimate demand of all the outlets.

Projections An analysis of the company’s projected performance for FY 99 vis-a-vis that of the previous year is as follows:

$ (million) FY ‘98 FY ‘99 Actuals Projections Net Sales 28.46 34.91 Depreciation 0.90 1.26 NPAT 1.83 2.79 Current Ratio 1.48 1.41 Leverage 1.86 1.52 Net worth 12.68 15.48

The company has projected an increase in sales of 23%. Given its performance in the previous year (sales up 41%), and the position that ABC enjoys in the market, this figure appears achievable. The position of strength has coupled with control over General and Admin. Expenses and phased indigenisation been responsible for improvements in margins. Additionally, the increase in sales have led to benefits in terms economies of scale which have manifested themselves in terms of better operating margins. With the company improving its liquidity position, the company has been in a position to switch its dependence of sources from long term to short term finances. ABC’s future appears bright in view of the backing of strong promoters, state of the art technology, excellent selling and distribution network, a wide product range well accepted in the market place and above all a healthy net worth.

28

Jupiter Export House§

Jupitar Export House (JEH), a partnership firm, was formed in June 1997 for manufacturing readymade garments. The firm did not do any business until October 2004 when it started negotiations with overseas buyers for regular export business. Over a short span of time, JEH could export garment to different countries namely Spain, England, Denmark, Norway, Canada, and USA.

The partners did not have any past experience in manufacturing or export of readymade garments. They established manufacturing facilities first using their own capital and thereafter taking a term loan (Rs.0.30 crores to be repaid in 36 monthly instalments starting from January 2006) from its bank. JEH approached bank for term loan only after getting good response from overseas buyers. The firm appointed professional/experienced personnel to run the business and meet commitments to the customers.

JEH achieved export sales of Rs.0.30 crores during 2004-05 against the target of Rs.0.75 crores on account of delay in start of manufacturing of garments (Table 1). During the current year (2005-06), the firm already achieved sales of Rs.2.29 crores up to October 2005 and it had confirmed orders of more than Rs.2.30 crores to be executed in the next three months. The sales for the entire current year were estimated to be Rs.6.00 crores and that for 2006-07 projected at Rs.10.00 crores. In terms of profit margin (PBT-to-sales ratio), JEH earned 2.50 percent in 2004-05. The margin was estimated to remain around the same level during 2005-06 but projected to increase along with business volumes to 3.13 percent over the next year, 2006-07.

In the past, the export of readymade garments from India had shown a consistent growth. Besides, with the end of the Agreement on Textiles and Clothing since 1st January 2005, which facilitated the existence of quotas on apparel and textile imports in the EU, US and Canada, the prospect for increased business volumes would go up for all garment exporters in India. According to the National Textiles Policy 2000, the garment export would be 50 billion US dollars by the year 2010.

In view of the growing business prospect, JEH had just submitted an application with its banker for extension of fund based working capital limit from Rs.1.00 crores to Rs.1.75 crores for the FY 2006-07 along with renewal of non-fund based limit (bank guarantee of Rs.0.05 crores). The firm also furnished necessary details including projected working capital position of the firm (Table 2). Incidentally, the main partner of JEH had been an old and valuable customer of the bank.

Questions for discussion 1. How would bank assess the permissible bank finance?

2. As a credit appraiser, would you recommend enhancement of credit limit?

§ Prepared by Dr. S K Chaudhuri (Professor, IMI, New Delhi) for class-room discussion.

29

Table 1: Financial Performance (Rs. Crores)

Particulars 2004-05 (Audited)

2005-06 (Estimated)

2006-07 (Projected)

Export sales 0.39 (1.75)

6.00

10.00

Other income 0.01 0.36 0.55

Profit before tax 0.01 (0.04)

0.16

0.33

PBT/sales (%) 2.50 (5.00)

2.52

3.13

Profit after tax 0.01

(0.03) 0.11 0.23

Cash accruals 0.04

(0.10) 0.22 0.32

Tangible net worth 0.71

(0.58) 0.90

1.19

Total outside lib/TNW 0.55

(1.85) 1.71 2.07

Current ratio 2.21

(1.33) 1.53 1.35

(Figures in brackets are estimates given at the time of last sanction)

Table 2: Working Capital Position

(Rs. Crores) Particulars 2004-05

(Audited) 2005-06

(Estimated) 2006-07

(Projected) Raw Materials 0.13

(1.86) 0.45

(1.00) 0.75

(1.03) Stock in Progress 0.06

(0.51) 0.25

(0.49) 0.43

(0.52) Finished Goods 0.07

(0.75) 0.26

(0.53) 0.45

(0.55) Receivables 0.35

(2.69) 0.55

(1.10) 0.80

(0.96) Other Current Assets 0.25 0.47 0.71 Total Current Assets 0.86 1.98 3.14 Creditors 0.02

(0.18) 0.20

(0.42) 0.40

(0.53)

(Figures in brackets represent months holding levels)

30

Jupiter Export House (Case Analysis) *

1. SWOT Analysis Strengths

− Long business experience of the promoter − Confirmed order received from buying houses with samples for further business

already approved − Incentives by the Govt. for exports like Duty Drawback, DEPG licence accrues to

the firm

Weaknesses

− The firm does not have any past background in manufacturing/export of Readymade Garments. However, they have employed professional staff for meeting the commitments to the customers. Besides employing trained staff, the firm has already negotiated with buying houses for orders after getting the samples approved.

Opportunities

− Entry of MNC’s as a result of increased globalisation, coupled with production facilities in India also offer a good opportunity.

− Readymade Garments and Textiles industry is very growth oriented and is a constantly expanding sector.

Threat

− Any adverse change in exchange fluctuation can adversely affect profitability of the firm.

2. Assessed Bank Finance Raw Materials : The present holding level of raw material at 1.83 months are very high as on March, 2005 and the same has been assessed at present holding level of 1.00 month which is enough to take care of the working cycle of the firm since all the raw materials are easily available.

Stock in Process / Finished Goods: The SIP/FG level has been estimated at present sanction norm of 0.50 month keeping in view the process time and delivery schedule of each export order.

Receivables: Keeping in view the time taken for shipment of goods, custom formalities and time taken in discounting a bill, a reasonable level of 0.90 – 1.00 month has been considered as level of receivables. The higher level is projected in view of bunching of orders and relative small period of execution of order.

Sundry Creditors: The level of Sundry Creditors has been assessed at a level of 0.40 – 0.50 months since no supplier would be extending credit on easy terms.

* Prepared by Dr. S K Chaudhuri (Professor, IMI, New Delhi) for class-room discussion.

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(Rs. Crores)Particulars 2004-05 2005-06 2006-07 Total current assets (TCA) 0.86 1.98 3.14 Other current liabilities (OCL) 0.04 0.29 0.57 Working capital gap 0.82 1.69 2.57 Net working capital 0.47 0.69 0.82 Assessed bank finance 0.35 1.00 1.75 NWC to TCA (%) 54.65 34.85 26.11 Bank finance to TCA (%) 40.70 50.51 55.73 OCL to TCA (%) 2.33 4.55 5.41 Sundry creditors to TCA (%) 2.33 4.55 5.41 Inventories to net sales (days) 59 55 56 Receivables to gross sales (days) 79 32 28 Sundry creditors to purchase (days) 9 14 17 Current Ratio 2.21 1.53 3.14

Permissible Bank Finance Based on Nayak Committee Recommendations

(Rs. Crores)

2005-06 2006-07 a) Sales projections 6.00 10.00 b) WC requirements (25% of sales) 1.50 2.50 c) Borrower’s margin (5% of sales) 0.30 0.50 d) Permissible bank finance 1.20 2.00 e) Limit requested for 1.00 1.75

Limits of Rs.1.00 crore and Rs.1.75 crores have been requested for by JEH for 2005-06 and 2006-07, which are in with the ABF method.

Keeping in view the peak level requirement of funds at any time with bunching of orders, a stand by line of credit of Rs.0.26 crores has been recommended by the bank.

3. Rating and Interest Rate Based on the existing guidelines for credit risk assessment, JEH is awarded rating CRA-2 (as on 31/3/2005). Interest will be charged taking into account CRA as well as RBI stipulated rates for export financing.

32

MONEY MARKET INSTRUMENTS∗

Treasury Bills (T-bills)

T-Bills are short term (upto one year) borrowing instruments of the Government of India. T-Bills are auctioned by Reserve Bank of India at regular intervals. They are issued at a discount to face value and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price is determined at each auction. Presently, RBI issues T-Bills for four different maturities: 14 days, 91 days, 182 days and 364 days. Since April 1, all Treasury Bills are issued with notified amounts fixed by RBI. Non-competitive bids are kept outside the notified amounts.

Investors with short term surpluses can buy these bills. Since these are the liabilities of GOI, they are zero risk short-term investments at market yields for a period of their choice. Further, two-way quotes are available in secondary market to enable anyone to invest and exit from such investment.

The salient features of the auctioned T-Bills are:

1. The 14/91/182/364-days bills are issued for a minimum value of Rs.25,000 and multiples thereof.

2. They are issued at a discount to face value.

3. Any person in India including individuals, firms, companies, corporate bodies, trusts ad institutions can purchase the bills.

4. Te bills are eligible securities for SLR purposes.

5. All bids above a cut-off price are accepted and bidders are permitted to place multiple bids quoting different prices at each auction. Till November 6, 1998, all types of T-Bills auctions were conducted by means of ‘Multiple Price Auction’. However, since November 6, 1998, auction of 91-days T-Bills are being conducted by means of ‘Uniform Price Auction’. In the case of ‘Multiple Price Auction’, method successful bidders pay their own bid prices, whereas under ‘Uniform Price Auction’ method, all successful bidders pay uniform price, i.e. the ct-off price emerged in the auction.

6. The bills are generally issued in the form of SGL - entries in the books of Reserve Bank of India. The SGL holdings can be transferred by issuing a SGL transfer form. For non-SGL account holders, RBI has been issuing the bills in scrip form.

Dated Government Securities

Governments (both central and the states) raise resources through issue of market loans regularly. As these are the liabilities of Government of India and the State Governments and because the repayment is made by RBI, investment in these securities is considered safe and risk free. These securities are eligible as SLR investments. Since the date of maturity is specified in the securities, these are known as dated Government securities. The dated Government securities market in India has two segments: (1) Primary Market and (2) Secondary Market. The Primary Market consists of the issuers of the securities, viz., Central and Sate Government. The secondary market includes commercial banks, financial institutions, insurance companies, Provident Funds, Trusts, individuals, Primary Dealers and Reserve Bank of India. Investment in government

∗ Source: Website (www.sbidfhi.com) of SBI DFHI Ltd.

33

securities is open to all types of investors including individuals and there is a very active secondary market.

During last few years, Government of India has issued new instruments such as Zero Coupon Bonds, Floating Rates Bonds, Partly-paid Stocks, Capital Index Bonds, Tap Stock, etc. The procedure for transactions in Dated Government Securities with DFHI has been outlined in Annexure I.

Ready Forward Contracts (Repos)

Ready forward or Repos or Buyback deal is a transaction in which two parties agree to sell and repurchase the same security. Under such an arrangement, the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a prefixed price. For the purchaser of the security, it becomes a Reverse Repo deal. In simple terms, it is recognized as a buy back arrangement. In a standard ready forward transaction when a bank sells its securities to a buyer it simultaneously enters into a contract with him (the buyer) to repurchase them on a predetermined date and price in the future. Both sale and repurchase prices of securities are determined prior to entering into the deal. In return for the securities, the bank receives cash from the buyer of the securities. As the inflow of cash from the ready forward transaction is used to meet temporary cash requirement, such a transaction in essence is a short term cash management technique.

The motivation for the banks and other organizations to enter into a ready forward transaction is that it can finance the purchase of securities or otherwise fund its requirements at relatively competitive rates. On account of this reason the ready forward transaction is purely a money lending operation. Under ready forward deal the seller of the security is the borrower and the buyer is the lender of funds. Such a transaction offers benefits both to the seller and the buyer. Seller gets the funds at a specified interest rate and thus hedges himself against volatile rates without parting with his security permanently (thereby avoiding any distressed sale) and the buyer gets the security to meet his SLR requirements. In addition to pure funding reasons, the ready forward transactions are often also resorted to manage short term SLR mismatches.

Internationally, Repos are versatile instruments and used extensively in money market operations. While inter-bank Repos were being allowed prior to 1992 subject to certain regulations, there were large scale violation of laid down guidelines leading to the ‘securities scam’ in 1992; this led Government and RBI to clamp down severe restrictions on the usage of this facility by the different market participants. With the plugging of loophole in the operation, the conditions have been relaxed gradually.

Apart from inter-bank repos, RBI has been using this instrument effectively for its liquidity management, both for absorbing liquidity and also for injecting funds into the system. Thus, Repos and Reverse Repo are resorted to by the RBI as a tool of liquidity control in the system. With a view to absorbing surplus liquidity from the system in a flexible way and to prevent interest rate arbitraging, RBI introduced a system of daily fixed rate repos from November 29, 1997.

Reserve Bank of India was earlier providing liquidity support to PDs through the reverse repo route. This procedure was also subsequently dispensed with and Reserve Bank of India began giving liquidity support to PDs through their holdings in SGL A/C. The liquidity support is presently given to the Primary Dealers for a fixed quantum and at the Bank Rate based on their bidding commitment and also on their past performance. For any additional liquidity requirements Primary Dealers are allowed to participate in the reverse repo auction under the Liquidity Adjustment Facility along with Banks, introduced by RBI in June 2000(Details given below).

34

The major players in the repo and reverse repurchase market tend to be banks that have substantially huge portfolios of government securities. Besides these players, primary dealers who often hold large inventories of tradable government securities are also active players in the repo and reverse repo market.

Scheme of Liquidity Adjustment Facility

Pursuant to the recommendations of the Narasimham Committee Report on Banking Reforms (Narasimham Committee II), it was decided in principle, to introduce a Liquidity Adjustment Facility (LAF) operated through repo and reverse repo since 5th June 2000.

Under this scheme, (i) Repo auctions (for absorption of liquidity) and (ii) reverse repo auctions (for injection of liquidity) will be conducted on a daily basis (except Saturdays). But for the intervening holidays and Fridays, the repo tenor will be one day. On Friday, the auctions will be held for three days maturity to cover the following Saturday and Sunday. With the introduction of the Scheme, the existing Fixed Rate Repo has been discontinued. The liquidity support extended to all scheduled commercial banks (excluding RRBs) and Primary Dealers through Additional Collateralized Lending Facility (ACLF) and refinance/reverse repos under Level II, have also been withdrawn. Export Refinance and Collateralized Lending Facility (CLF) at Bank Rate will continue as per the existing procedures. Like-wise, Primary Dealers will continue to avail of liquidity support at level I at Bank Rate. The funds from the Facility are expected to be used by the banks/pds for their day-to-day mismatches in liquidity.

Interest rates in respect of both repos and reverse repos will be decided through cut off rates emerging from auctions on "uniform price" basis conducted by the Reserve Bank of India, at Mumbai.

Certificate of Deposit

Certificates of Deposit (CDs) - introduced since June 1989 - are negotiable term deposit certificates issued by a commercial banks/Financial Institutions at discount to face value at market rates, with maturity ranging from 15 days to one year.

Being securities in the form of promissory notes, transfer of title is easy, by endorsement and delivery. Further, they are governed by the Negotiable Instruments Act. As these certificates are the liabilities of commercial banks/financial institutions, they make sound investments. The market for these instruments is not very deep, but quite often CDs are available in the secondary market.

The procedure for dealing with DFHI has been outlined in Annexure I. Important features of CDs are given in Annexure III

Salient features of CDs are as given under:

1. CDs can be issued to individuals, corporations, companies, trusts, funds, associates, etc.

2. NRIs can subscribe to CDs on non-repatriable basis.

3. CDs attract stamp duty as applicable to negotiable instruments.

4. Banks have to maintain SLR and CRR on the issue price of CDs. No ceiling on the amount to be issued.

5. The minimum issue size of CDs is Rs.5 lakhs and multiples thereof.

6. CDs are transferable by endorsement and delivery.

The minimum lock-in-period for CDs is 15 days

35

Commercial Paper

The introduction of Commercial Paper (CP) in January 1990 as an additional money market instrument was the first step towards securitisation of commercial bank’s advances into marketable instruments. The purpose of introduction of CP was to release the pressure on bank funds for small and medium sized borrowers and at the same time allowing highly rated companies to borrow directly from the market.

Commercial Papers are unsecured debts of the companies. They are issued in the form of promissory notes, redeemable at par to the holder at maturity. The market is generally segmented into the PSU CPs, i.e. those issued by public sector unit and the private sector CPs. Commercial papers issued by top rated companies are considered as sound investments. As in the case of CDs, the secondary market in CP has not developed to a large extent.

Salient features of CPs are:

1. CPs are issued by companies in the form of usance promissory note, redeemable at par to the holder on maturity.

2. The tangible net worth of the issuing company should be not less than Rs.4 crores.

3. Working capital (fund based) limit of the company should not be less than Rs.4 crores.

4. Credit rating should be at least equivalent of P2 or higher from any approved rating agencies and should not be more than 2 months old on the date of issue of CP.

5. Companies are allowed to issue CP up to 100% of their fund based working capital limits.

6. It is issued at a discount to face value.

7. CP attracts stamp duty.

8. CP can be issued for maturities between 15 days and less than one year from the date of issue.

• CP may be issued in the multiples of Rs.5 lakh.

• No prior approval of RBI is needed to issue CP and underwriting the issue is not mandatory.

• All expenses (such as dealers’ fees, rating agency fee and charges for provision of stand-by facilities) for issue of CP are to be borne by the issuing company,

Call/Notice Money

Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is "Call Money". When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No collateral security is required to cover these transactions.

The entry into this field is restricted by RBI. Commercial Banks, Co-operative Banks and Primary Dealers are allowed to borrow and lend in this market. Specified All-India Financial Institutions, Mutual Funds, and certain specified entities are allowed to access to Call/Notice money market only as lenders. Reserve Bank of India has recently taken

36

steps to make the call/notice money market completely inter-bank market. Hence the non-bank entities will not be allowed access to this market beyond December 31, 2000.

From May 1, 1989, the interest rates in the call and the notice money market are market determined. Interest rates in this market are highly sensitive to the demand - supply factors. Within one fortnight, rates are known to have moved from a low of 1 - 2 per cent to dizzy heights of over 140 per cent per annum. Large intra-day variations are also not uncommon. Hence there is a high degree of interest rate risk for participants. In view of the short tenure of such transactions, both the borrowers and the lenders are required to have current accounts with the Reserve Bank of India. This will facilitate quick and timely debit and credit operations. The call market enables the banks and institutions to even out their day to day deficits and surpluses of money. Banks especially access the call market to borrow/lend money for adjusting their cash reserve requirements (CRR). The lenders having steady inflow

Commercial Bills

Bills of exchange are negotiable instruments drawn by the seller (drawer) on the buyer (drawee) for the value of the goods delivered to him. Such bills are called trade bills. When trade bills are accepted by commercial banks, they are called commercial bills. If the seller wishes to give some period for payment, the bill would be payable at a future date (usance bill). During the currency of the bill, if the seller is in need of funds, he may approach his bank for discounting the bill. One of the methods of providing credit to customers by bank is by discounting commercial bills at a prescribed discount rate. The bank will receive the maturity proceeds (face value) of discounted bill from the drawee. In the meanwhile, if the bank is in need of funds, it can rediscount the bill already discounted by it in the commercial bill rediscount market at the market related rediscount rate. (The RBI introduced the Bill Market Scheme in 1952 and a new scheme called the Bill Rediscounting Scheme in November 1970).

With a view to eliminating movement of papers and facilitating multiple rediscounting, the RBI introduced an innovative instrument known as "Derivative Usance Promissory Notes" backed by such eligible commercial bills for required amounts and usance period (upto 90 days). Government has exempted stamp duty on derivative usance promissory notes. This has indeed simplified and streamlined the bill rediscounting by Institutions and made commercial bill an active instrument in the secondary money market. Rediscounting institutions have also advantages in that the derivative usance promissory note, being a negotiable instrument issued by a bank, is good security for investment. It is transferable by endorsement and delivery and hence is liquid. Thanks to the existence of a secondary market the rediscounting institution can further discount the bills anytime it wishes prior to the date of maturity. In the bill rediscounting market, it is possible to acquire bills having balance maturity period of different days up to 90 days. Bills thus provide a smooth glide from call/overnight lending to short term lending with security, liquidity and competitive return on investment. As some banks were using the facility of rediscounting commercial bills and derivative usance promissory notes for as short a period as one day merely a substitute for call money, RBI has since restricted such rediscounting for a minimum period of 15 days.

The eligibility criteria prescribed by the Reserve Bank of India for rediscounting commercial bill inte alia are that the bill should arise out of genuine commercial transaction evidencing sale of goods and the maturity date of the bill should not be more than 90 days from the date of rediscounting.

37

CASE STUDY: JOY CHEMICALS (P) LTD.*

The company being incorporated in early 1990, propose to manufacture “paracetamol” – a basic drug (analygesic and antipyretic), used for manufacturing of tablets, capsules, syrup, etc. The product is also used by pharmaceutical formulation manufacturers. There is sufficient demand for the product, and the company intends to sell the product directly to the pharmaceutical units as well as through the wholesale chemists/druggists.

Technical know-how for the manufacture of paracetamol is well established. The detailed know-how to the promoters will be provided by an experienced consultant. Plant and machinery and raw-material are indigenously available. The installed capacity of the units is estimated to be 180 MT per annum. The estimated cost of the project is Rs.63.59 lacs, and the promoters have approached the SFC for a term loan of Rs.45.60 lacs. The promoters themselves will bring in Rs.17.99 lacs by way of share capital. The further details of the project are summarized in Table 1.

Table 1: Cost of Project & Means of Finance (Rs. in lacs)

Cost of Project: Land 1.15 Building 7.51 Plant & Machinery 31.54 Misc. Fixed Assets 11.63 Furniture and Fixtures 0.30 Preliminary and Pre-Operative Exp. 3.70 Contingencies 1.90 Margin Money for Working Capital 5.86 Total 63.59 Means of Finance Share Capital 17.99 SFC Loan 45.60 Total 63.59

Note to Table 1: 1. Contingencies have been considered @5% on the estimated cost of building

construction. 2. The plant and machinery cost is estimated at Rs.30.33 lacs. Provision for taxes,

transportation, etc. and contingencies have been provided @4% and @5% of the cost respectively.

3. Preliminary and Pre-operative expenses include Rs.1.50 lacs being the interest paid during construction.

4. SFC loan is repayable in 7 years with a moratorium period of one year.

* Prepared by Dr. S K Chaudhuri for classroom discussion.

38

Table 2: Cost of Production and Profitability Statement (Rs. in lacs)

1 2 3 4 5 6 7 8 A. Installed Capacity (MT)

180 180 180 180 180 180 180 180

B. Capacity Utilization (%)

60 65 70 70 70 70 70 70

C. Cost of Production:

1. Raw Material

115.4 125.06 134.68 134.68 134.68 134.68 134.68 134.68

2. Packing Expenses

1.08 1.17 1.26 1.26 1.26 1.26 1.26 1.26

3. Consumables

0.50 0.54 0.58 0.58 0.58 0.58 0.58 0.58

4. Repair & Maintenance

1.59 1.67 1.75 1.83 1.92 2.02 2.12 2.23

5. Utilities (Power, Fuel, etc.)

13.15 14.25 15.34 15.34 15.34 15.34 15.34 15.34

6. Salary & Wages

4.09 4.29 4.50 4.73 4.97 5.22 5.48 5.75

7. Administrative Exp

1.09 1.14 1.20 1.26 1.32 1.39 1.46 1.53

8. Depreciation

5.67 5.67 5.67 5.67 5.67 5.67 5.67 5.67

9. Interest: SFC

5.70 5.29 4.48 3.66 2.85 2.04 1.22 0.41

Bank

2.81 3.05 3.28 3.28 3.28 3.28 3.28 3.28

10. Selling Expenses

3.20 3.46 3.73 3.73 3.73 3.73 3.73 3.73

Total Cost

154.32 165.59 176.47 176.02 175.60 175.21 174.82 174.46

D. Sales 159.84 173.16 186.48 186.48 186.48 186.48 186.48 186.48 E. Profit Before Tax

5.52 7.57 10.01 10.46 10.88 11.27 11.66 12.02

F. Taxation - - 2.22 3.81 4.48 4.97 5.41 5.63 G. Profit After Tax

5.52 7.57 7.79 6.65 6.40 6.30 6.25 6.39

H. Net Cash Accruals

11.19 13.24 13.46 12.32 12.07 11.97 11.92 12.06

39

Notes to Table-2:

1. Raw material comprises of para chloronitro benzene, caustic soda; sulphuric acid; iron powder; acetic anhydride; activated carbon; hydro; and hyflox.

2. Packing expenses @Rs.1 per kg. 3. Repairs and maintenance has been estimated @3% of building, plant and machinery,

and misc. fixed assets; the cost is assumed to increase by 5% each year. 4. Salaries and wages and administrative expenses are assumed to increase by 5% every

year. 5. Depreciation has been provided on a straight line basis (SLM) and at the following rates

buildings – 3.9%; plant and machinery – 12%, and misc. fixed assets – 12%. 6. Interest has been calculated @12.5% on SFC loan and @16.5% on bank borrowings for

working capital. 7. Selling expenses and commission are assumed @2% of sales revenue. 8. Sales realization has been estimated @Rs.1,48,000 per MT

Table 3: Working Capital Requirement (Rs. in lacs)

articulars Period (Norm)

Margin Amount Bank Loan

Raw Material 1 Month 25% 9.62 7.21 Work-in-Process 1 Week 25% 2.50 1.88 Finished Goods 1 Week 25% 2.63 1.97 Receivables ½ Month 10% 6.66 5.99 Working Expenses 1 Month 100% 1.50 1st Year 22.91 17.05 2nd Year 24.82 18.47 3rd Year 26.73 19.89

Notes to Table 3:

1. Work-in-process cost includes: raw material; packing expenses; consumables; repairs and maintenance; and utilities and fuel.

2. Finished goods are valued in term of the cost elements mentioned (1) above plus: salaries and wages; and administrative expenses.

3. Receivables are estimated in terms of half-a-month sales 4. Working expenses include: utilities; salary and wages; and administrative expenses.

40

Table 4: Cash Flow Statement

(Rs. in lacs) Const.

Period 1 2 3 4 5 6 7 8

A. Sources of Funds 1. Profit before tax but after dep.

- 5.52 7.57 10.01 10.46 10.88 11.27 11.66 12.02

2. Depreciation - 5.67 5.67 5.67 5.67 5.67 5.67 5.67 5.673. Increase in share capital

17.99 - - - - - - - -

4. Increase in Term Loan

45.6 - - - - - - -

5. Increase in Bank borrowing

- 17.05 1.42 1.42 - - - - -

Total – A 63.59 28.24 14.66 17.10 16.13 16.55 16.94 17.33 17.69B. Application of Funds:

1. Increase in Fixed Assets

54.03 - - - - - - - -

2. Preliminary & Pre-operative Exp.

3.70 - - - - - - - -

3. Repayment of Term Loan

- - 6.51 6.51 6.51 6.51 6.51 6.51 6.51

4. Increase in Current Assets

- 22.91 1.91 1.91 - - - - -

5. Taxation - - - 2.22 3.81 4.48 4.97 5.41 5.636. Dividend - - - 1.80 1.80 1.80 1.80 1.80 1.80Total – B 57.53 22.91 8.42 12.44 12.12 12.79 13.28 13.72 13.97

C. Surplus/ (Deficit) (A-B)

5.86 5.33 6.24 4.66 4.01 3.76 3.66 3.61 3.72

D. Opening Cash Balance

- 5.86 11.19 17.43 22.09 26.10 29.86 33.52 37.13

E. Closing Cash Balance

5.86 11.19 17.43 22.09 26.10 29.86 33.52 37.18 40.85

41

JOY CHEMICALS (P) LTD.

BREAK-EVEN SALES (1ST YEAR)

(Amount in Rs. Lacs) A. Variable Cost B. Semi Variable & Fixed Cost Material 115.44 Repairs and Maintenance 1.59

Packing Exp. 1.08 Salary & Wages 4.09

Consumables 0.50 Administrative Exp. 1.09

Utilities 13.15 Depreciation 5.67

Interest on Working Capital 2.81 Interest on Term Loan 5.70

Selling Exp. 3.20

Total-A 136.18 Total-B 18.14

Contribution Margin = Sales – Variable Cost = 159.84 – 136.18 = 23.66 Break-Even Sales

= Sales xonContributi

Cost Fixed&VariableSemi −

= (18.14x159.84)/23.66 = 122.55 Capacity Sales = (159.84x100)/60 = 266.40 Break-Even As % Capacity = (122.55x100)/266.4 =46%

42

JOY CHEMICALS (P) LTD. Calculation of IRR (Amount in Rs. Lacs)

YEAR 0 1 2 3 4 5 6 7 8

Capital Cost -56.23

Inc. in Working Cap. -22.91 -1.91 -1.91

Profit Before Tax 5.52 7.57 10.01 10.46 10.88 11.27 11.66 12.02

Depreciation 5.67 5.67 5.67 5.67 5.67 5.67 5.67 5.67

Interest 8.51 8.34 7.76 6.94 6.13 5.32 4.50 3.69

Salvage Value 31.96

NCF Before Tax -56.23 -3.21 19.67 21.53 23.07 22.68 22.26 21.83 53.34

Tax 2.22 3.81 4.48 4.97 5.41 5.63

NCF After Tax -56.23 -3.21 19.67 19.31 19.26 18.20 17.29 16.42 47.71

IRR Before Tax = 25.50% IRR After Tax = 21.75% Notes: 1. Capital Cost Project Cost 63.59 Less: Interest Paid during Construction

1.50

Less: Margin Money for Working Capital

5.86

Total 56.23

2. Salvage Value Land (100%) 1.15Building (1/3rd) 2.50Plant & Mach (5%) 1.58Working Capital (100%) 26.73

Total 31.96

43

123456789

101112131415161718192021222324252627

A B C D E F G H I J KSl. Month Log Return Log ReturnNo. Ending S&P CNX500 Wipro1 31-Jan-00 1.90% 34.72%2 29-Feb-00 10.74% 43.01%3 31-Mar-00 -16.71% -26.05%4 28-Apr-00 -18.77% -42.70%5 31-May-00 -2.78% -45.85%6 30-Jun-00 12.33% 50.16%7 31-Jul-00 -13.29% -25.28%8 31-Aug-00 7.53% 30.67%9 29-Sep-00 -12.79% -26.20%

10 31-Oct-00 -8.59% -10.69%11 30-Nov-00 6.09% 6.55%12 29-Dec-00 -2.53% -16.88%13 31-Jan-01 7.78% 16.03%14 28-Feb-01 -1.61% -7.44%15 30-Mar-01 -23.11% -59.56%16 30-Apr-01 0.89% 12.61%17 31-May-01 4.90% 12.30%18 29-Jun-01 -7.16% -17.43%19 31-Jul-01 -3.14% 7.60%20 31-Aug-01 -1.32% -0.60%21 28-Sep-01 -15.24% -29.18%22 31-Oct-01 7.11% 3.65%23 29-Nov-01 10.49% 30.55%24 31-Dec-01 -0.70% 4.43%25 31-Jan-02 2.21% 3.11%

Wipro

-80%

-50%

-20%

10%

40%

70%

-50% -20% 10% 40%

Market Return (rm)

Stoc

k R

etur

n (r

i)

Equation of Fitted Line:ri =0 .0347 +2.4975 * rm

Characteristic Line

CAPM & ESTIMATION OF BETA

The Capital Asset Pricing Model (CAPM) states that, under certain restrictive assumptions, the required return for a share of a company is given by

R = Rf + β (Rm - Rf)

Where,

Rf = risk-free rate of return Rm = return on market portfolio β = share beta

Higher the value of beta, greater is the risk and, hence, greater is expected return on the company’s share.

Beta is a measure of the responsiveness of the excess returns for a share (in excess of the risk-free rate) to those of the market, using some broad-based index (such as BSE 200) as a surrogate for the market portfolio. If the historical relationship between share returns and those for the market portfolio is believed to be a reasonable proxy for the future, one can use past returns to compute beta for a stock. In USA, firms like Value Line Investment Survey, Standard & Poor’s Stock Reports and Merril Lynch provide historical beta information on a large member of publicly traded stocks.

The risk-free rate can be approximated by the return on treasury (government) bonds. However, one needs to subtract the risk-premium of treasury bonds over treasury bills. (i.e. short-term government borrowing) to get a risk-free rate relevant for estimating cost of equity, which in turn determines the discount rate for long-term investment projects.

Exhibit A: Characteristic Line for Wipro

44

123456789

101112131415161718192021222324252627282930313233343536373839404142434445464748495051525354555657585960616263646566676869707172737475

A B C D E F G H I JMonth Log Return Log Return

Ending S&P CNX 500 Wipro31-Jan-00 1.90% 34.72%29-Feb-00 10.74% 43.01%31-Mar-00 -16.71% -26.05%28-Apr-00 -18.77% -42.70%

31-May-00 -2.78% -45.85%30-Jun-00 12.33% 50.16%31-Jul-00 -13.29% -25.28%

31-Aug-00 7.53% 30.67%29-Sep-00 -12.79% -26.20%31-Oct-00 -8.59% -10.69%30-Nov-00 6.09% 6.55%29-Dec-00 -2.53% -16.88%31-Jan-01 7.78% 16.03%28-Feb-01 -1.61% -7.44%30-Mar-01 -23.11% -59.56%30-Apr-01 0.89% 12.61%

31-May-01 4.90% 12.30%29-Jun-01 -7.16% -17.43%31-Jul-01 -3.14% 7.60%

31-Aug-01 -1.32% -0.60%28-Sep-01 -15.24% -29.18%31-Oct-01 7.11% 3.65%29-Nov-01 10.49% 30.55%31-Dec-01 -0.70% 4.43%31-Jan-02 2.21% 3.11%

SUMMARY OUTPUT

Regression StatisticsMultiple R 0.8814R Square 0.7768Adjusted R Square 0.7671

Standard Error 0.1363Observations 25

ANOVAdf SS MS F Significance F

Regression 1 1.4863 1.4863 80.0404 0.0000Residual 23 0.4271 0.0186Total 24 1.9133

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.0347 0.0280 1.2418 0.2268 -0.0231 0.0925 -0.0231 0.0925X Variable 1 2.4975 0.2792 8.9465 0.0000 1.9200 3.0750 1.9200 3.0750

RESIDUAL OUTPUT BetaSquare of

Observation Predicted Y Residuals Residuals Calculation of Residual Variance1 0.0821 0.2652 0.07032 0.3030 0.1271 0.0161 Sum of Square of Residuals ( ? ei

2 ) 0.42713 -0.3825 0.1220 0.0149 No. of Observations (n) 254 -0.4340 0.0070 0.0000 Residual Variance ( ? ei

2 / n) 0.01715 -0.0348 -0.4238 0.1796 Residual Standard Deviation 0.13076 0.3428 0.1589 0.02527 -0.2972 0.0444 0.00208 0.2229 0.0838 0.00709 -0.2847 0.0227 0.0005 Excel Functions for Regression Statistics

10 -0.1798 0.0729 0.005311 0.1868 -0.1214 0.0147 =INTERCEPT(C3:C27,B3:B27) 0.034712 -0.0285 -0.1402 0.0197 =SLOPE(C3:C27,B3:B27) 2.497513 0.2290 -0.0687 0.0047 =RSQ(C3:C27,B3:B27) 0.776814 -0.0055 -0.0689 0.004715 -0.5423 -0.0533 0.002816 0.0569 0.0691 0.004817 0.1570 -0.0340 0.001218 -0.1441 -0.0302 0.000919 -0.0437 0.1197 0.014320 0.0017 -0.0077 0.000121 -0.3458 0.0540 0.002922 0.2123 -0.1758 0.030923 0.2967 0.0088 0.000124 0.0172 0.0271 0.000725 0.0899 -0.0588 0.0035

A

B

C

D

(Std.Error)^2 x [(n - 2) / n]

Exhibit B: Regression Analysis to Estimate Wipro Beta

45

BETA OF UNQUOTED STOCK To adjust beta for difference in capital structure (i.e., leverage), we may follow the steps given below : Step 1 :

Unlever the levered beta using the following formula : βu = βL [1 + (1-T) x D/E) Where, βu = unlevered beta

βL = estimated levered beta D/E = debt-to-equity ratio T = corporate tax-rate

Step 2 :

Lever the unlevered beta (obtained in Step 2) taking into account D/E ratio of the proposed investment as well as tax-rate applicable to this new investment : βL = βu [1 + (1 - T) x D/E]

46

EXERCISE ON ESTIMATION OF WACC ABC Co. has two divisions - Health Foods and Specially Metals. Each of these divisions employs debt equal to 30% of its total capital requirements, with equity capital used for the balance. The current borrowing rate is 15% and the company’s tax rate is 40%. The Co. wishes to establish a hurdle rate (minimum required rate) of return for each division. The hurdle rates will be used to evaluate capital investment proposals of the respective divisions. The Co. has thought about using CAPM in estimating cost of equity. It has identified two proxy companies, with the following details: Proxy Co. for

Beta Debt-to-total Capital Tax Rate

Health Foods

0.90

0.50

0.40

Speciality Metals

1.25

0.30

0.40

The risk free rate presently is 12% and the expected return on the market portfolio is around 18%. You are required to calculate :

a) After-tax cost of borrowing b) Cost of equity for each division c) Minimum required rate of return (for screening investment proposals) for

each division.

47

Suggested Answer

a) After-tax cost of borrowing = 15*(1 - .40) = 9% b) Cost of equity for each division Beta calculation for Health Foods division Beta (unlevered) = .90/[1+(1 - .40)*1] Note D/E = 1 = .5625 Beta (levered) = .5625*[1+(1 - .40)*3/7] Note D/E = 3/7 = .7071 Beta calculation for Speciality Metals division Beta = 1.25 The proxy company's beta will be used since debt-equity ratio and tax rate of the proxy co. and the division are same. Cost of equity for Health Foods division Ke(HF) = 12 + .7071*(18 - 12) = 16.24% Cost of equity for Speciality Metals division Ke(SM) = 12 + 1.25*(18 - 12) = 19.50% c) Min. required rate of return for each division For Health Foods division = 9*.30 + 16.24*.70 = 14.07 For Speciality Metals division = 9*.30 + 19.50*.70 = 16.35

48

Adjusted Present Value (APV) - An Illustration

Cost of the Machine (Rs.) 2,000,000

After-Tax Cash Savings (Rs.)

400,000

per annum for 8 years All-Equity Financing Cost 13% Annuity Factor = -PV(.13,8,1) 4.7988 Un-livered NPV = -2,000,000+400,000*PV -80,480

Debt Financing 1,000,000

Cost of Borrowing 10% Repayment of Principal in 8 instalments 125,000 Tax Rate 40% Tax Savings on Interest Payment

Year

Outstanding Debt at Beginning of Yr.

Interest @10%

Tax Savings

PV Factor @10% PV

1 1,000,000

100,000

40,000

0.9091

36,364

2 875,000

87,500

35,000

0.8264

28,926

3 750,000

75,000

30,000

0.7513

22,539

4 625,000

62,500

25,000

0.6830

17,075

5 500,000

50,000

20,000

0.6209

12,418

6 375,000

37,500

15,000

0.5645

8,468

7 250,000

25,000

10,000

0.5132

5,132

8 125,000

12,500

5,000

0.4665

2,333

Total 133,254

APV = NPV + Tax Savings 52,774

49

Security markets

Primary market Secondary market

Public issue

Private placement

Exchange

Over-the-counter

Derivative market

Exchange Over-the-counter

Security markets

Money market Capital market

TYPES OF MARKETS

50

STRUCTURED OBLIGATION* (RIICO Bond Issue for RSEB)

The Instrument

Face Value - Rs. 5,00,000/- Coupon - 14.5% payable semi annually Issued and redeemed - at par Maturity - redemption in 5th, 6th and 7th years @ 30%, 30% and 40% respectively Rating - “LAA (SO)” by ICRA

Structure

Rajasthan State Industrial Development and Investment Corporation Ltd. (RIICO) issued bonds in January 1995 aggregating Rs. 2500 million to part finance a 1000 MW power plant being set-up by Rajasthan State Electricity Board (RSEB) at Suratgarh. The entire fund was then on-lent to RSEB by RIICO. The servicing of the bonds is covered by a back-to-back arrangement. RIICO was brought in as a vehicle for the fund raising because RSEB is restricted by the Electricity Act and also by poor investor perception of the SEBs. The bonds were issued in the nature of debentures. As the bonds were not secured by any tangible assets of RIICO, stamp duty was payable on the issue of the bonds. However, the stamp duty of 0.75 percent, was arranged to be remitted by the State Government of Rajasthan. The bonds were not issued as promissory notes like other central PSU bond offerings, as such an issue would attract a stamp duty of 1 percent, which can only be remitted by the Central Government. The arrangement worked out for RIICO carries the drawback of attracting stamp duty on transfer of bonds. The bonds were secured by a guarantee of the Government of Rajasthan and were backed by a pioneering and innovative payment mechanism to ensure timely and reliable servicing which is illustrated in the next page. An escrow account would be opened in State Bank of Bikaner and Jaipur. Electricity dues of certain large electricity consumers, previously identified and earmarked by RSEB, whose average billings exceed that of the interest/principal payment by adequate margin, would be collected and transferred by RIICO directly to the escrow account. The escrow account provides the first level of credit enhancement. The escrow account would be checked thirty days before the due date for payment of interest/principal to the investors and inform the Trustees. In the event of any shortfall of funds, the Trustees would call upon Rajasthan Government to transfer funds from either the RSEB account or out of the budgetary provision for RSEB and/or RIICO to replenish the escrow account. As a measure of further safety, the Bonds are covered by an unconditional and irrevocable guarantee of Rajasthan Government. If the above mentioned transfer of funds does not take place 20 days before the due date for payment of interest/principal, the Trustees shall invoke the State Government Guarantee and call upon Rajasthan Government to make up for the shortfall in the escrow account by 10 days before the

* Note prepared by Dr. S K Chadhuri, Professor, IMI.

51

due date for payment of interest/principal to the investors. The unconditional and irrevocable government guarantee provides the second level of credit enhancement. Payment Mechanism The above mechanism was developed in order to provide high safety to the investor as well as to achieve a lower cost of funds for the issuer. This is one of the first instances of a power project being financed through an open market borrowing. At an interest rate of 14.5%, this was one of the lowest cost debt financing for a power project.

Marketing

The primary objective of marketing was to keep the number of investors low. The target investors for these bonds were :

• Provident Funds, Gratuity Funds, Superannuation Funds, etc. • Banks: Nationalised and Co-operative • Mutual Funds • Other Financial Institutions like Insurance companies, UTI etc.

As the PFs can invest 30% of their investible funds in PSU bonds, they were the prime targets. The issue was timed to open in the first week of January, as the PFs receive

Select RSEB Consumers deposit their electricity dues in escrow A/c RIICO to check the Account

Funds Available ?

} T-30

No

} T-10

Trustees call upon GOR to transfer requisite amount

Interest/Principal payment cheques dispatched to investors

Trustees call upon GOR to bridge the gap through transfer from RSEB A/c with GOR and/or from budgetary provision for RSEB/RIICO } T-30 to T-20

No Yes

Timely Compliance ?

Yes } T-20

52

interest on special deposits from RBI (55% of the PF funds are mandatorily held in special deposits) during this period. Banks, Mutual Funds and other Financial Institutions were targeted to obtain large subscriptions to reduce the number of investors. Owing to the complex structure of the issue, one-to-one meetings with large investors were required to explain the payment mechanism of the bonds. However, the smaller (or less sophisticated) investors based their investment decision primarily on the “LAA (SO)” credit rating. As the State Government guarantee cover was available only for the target amount of Rs. 2500 million no amount of over-subscription could be retained. To avoid the unpleasant task of refunding over-subscription, it was decided to monitor the collections from all the centres simultaneously. Pre-marketing ensured a good response and it was more or less evident that the issue would collect the requisite amount in the first day itself. As soon as the total collection exceeded Rs. 2250 million, collections from centres other than Bombay (where the monitoring was done) were suspended. The subscription was closed as soon as the amount touched Rs. 2500 million.

Statistics

The following table gives the investor category-wise break-up of subscription. Investor Category Amount Subscribed (Rs. millions) Percentage Banks 1045 41.8% Mutual Funds 50 2.0% PFs etc. 1285 51.4 % Other Financial Institutions 120 4.8% Total 2500 100%

The majority of the total of 113 investors were from Bombay. Place Amount Subscribed (Rs. million) Percentage Bombay 1444.5 57.78 Calcutta 543.5 21.74% Delhi 201.0 8.04% Madras 82.5 3.30% Bangalore 137.5 5.50% Ahmedabad 91.0 3.64% Total 2500 100%

Investors who invested Rs. 100 million and above. Investors Amount invested (Rs. million) State Bank of India 500 Union Bank of India 200 MSRTC Contributory PF 116 Birla Industries PF 110 New India Assurance Co. Ltd. 100 State Bank of Mysore 100 United Bank of India 100 UCO Bank PF 100 UCO Bank * 100 Total 1426 **

* UCO Bank was the last investor and Rs. 15 million over-subscription was refunded. They were allotted only Rs. 85 million.

** This constitutes 57.04 percent of the targeted subscription.

53

GDR ISSUE BY VSNL * ♦ Offering of 32,130,000 GDRs

• Offered by the company : 24,330,000 GDRs • Offered by the Govt. : 7,800,000 GDRs

(Disinvestment)

• 1 GDR = one-half of one share of VSNL

• Offer price of GDR : US $ 13.93 per GDR

• Market price of VSNL share on 21 March 1997 was Rs. 985.25 per share, equivalent to US $ 27.46 based on market rate on such day

• Managers’ option : 5,670,000 additional GDRs

♦ Depositary - The Bank of New York

♦ Custodian - ICICI

♦ Joint global coordinators and bookrunners :

• Dresdner Kleinwort Benson

• Jardine Flemming

• Salomon Brothers International Ltd.

♦ Other details

• Listing London Stock Exchange; eligible for quotation through

⇒ Automated quotation system of LSE (“SEAQ International”)

⇒ National Association of Securities Dealers Inc.’s automated linkages (“PORTAL Market”)

• Underwritten (severally and not jointly) by 13 managers of the offering

• Combined management and under writing commission : US $ 0.1504 per GDR

• Selling concession : US $ 0.2257 per GDR

• GDRs are being offered and sold only outside India

• Offering is being made in the US only to qualified institutional buyers (QIBs) under Rule 144A of SEC

• Offered shares may not be withdrawn from the deposit facility pursuant to which the GDRs are issued until 60 days after the letter of the commencement of the offering and the last issue date of the GDR, subject to certain limited exceptions.

• Once withdrawn, shares cannot be redeposited under the Deposit Agreement

♦ Dividend: Cash dividends, if any, on the offered shares will be paid to the Depositary in rupees after deduction of applicable Indian withholding taxes and will be converted by the Depositary into dollars and paid to holders of GDRs (less the Depository’s fees and expenses).

* Prepared by Dr S K Chaudhuri, IMI, for class-room discussion.

54

♦ Voting rights: Holders of GDRs will have no voting rights with respect to offered shares while they are represented by such GDRs. The Depositary will, if permitted by law and subject to certain other conditions, exercise voting rights with respect to shares represented by GDRs in accordance with the direction of the Board of Directors of the company as conveyed by the Chairman thereof.

♦ Taxation: Dividends paid non-resident holders of GDRs will be subject to withholding tax at 10%; such tax is required to be withheld at source. Any gain realised on the sale of GDRs or shares by non-resident holder to another non-resident holder outside India is not subject to Indian capital gains tax. Subject to any relief provided pursuant to an applicable double taxation treaty, any gain realised on the sale of shares to an Indian resident or inside India generally will be subject to Indian capital gains tax.

Use of proceeds : VSNL intends to use its share of the net proceeds (the company will not receive any proceeds from the GDRs offered by the Govt.) from the offering to expand its international services and other telecommunications infrastructure and to make additional investments in telecommunications projects, principally under its Ninth Five Year Plan, as well as for general corporative purpose. VSNL has received permission from RBI to retain a substantial portion of its net proceeds from the offering in dollar or other currencies other than rupee, pending the use of its net proceeds, to deposit such proceeds outside India. The company intends to deposit such proceeds with financial institutions that are rated in the highest credit rating categories by internationally recognised rating agencies.

55

IPCL BOND PIERCED SOVEREIGN RATING*

All external debt rating is ‘restrained by the sovereign ceiling’, currently at, for India, BB plus (Standard & Poor) and Baa3 by Moodys. However, IPCL, a major player in the Indian . . . . . , has pierced the sovereign rating with its $175 million euro-convertible bond. This is the first time any Indian corporate has pierced the sovereign ceiling in any form of external borrowing. Possibly, this was also the first time that such a deal had been structured in the world. The deal was structured by investment banker Goldman Sachs and has Bank of America as the chief guarantor. BankAm will take the responsibility of meeting interest payments to investors. BankAm’s responsibility will end with the convertible bond’s conversion to equity. Since the US bank is shouldering this responsibility, the deal has been awarded BankAm’s credit rating of AA minus, much higher than the Inida rating. The deal was advised by Goldman Sachs’ Indian affiliate, Kotak Mahindra Capital Corporation. The $175 million convertible ($150 million offering with $25 million greenshoe) carries a coupon of 2.5 per cent and has a five-year tenor. The pricing has been done at a 21 per cent premium to current GDR prices and the conversion will take place at $13 per GDR, each GDR representing three underlying shares.

* Economic Times, 27 February 1997

56

RIL ISSUES 100 & 30-YEAR INTERNATIONAL BONDS *

Reliance Industries Ltd. (RIL) has managed to raise $314 million through an innovative combination of 100-year and 30-year Yankee bond issues in the international market. For its 100-year Yankee bond issue, the first by any company in Asia, RIL managed to raise $100 million at 355 basis points above the US treasury rate. The actual pricing of the 100-year debt, also described as perpetual equity, is 10.25 per cent, the US treasury rate being 6.7 per cent. Investment bankers (Morgan Stanley Japan and Merril Lynch) had managed a good price considering that China had made a 100-year sovereign debt issue at 350 basis points above the US treasury rate. The company’s offer of $100 million in unsecured notes has been over-subscribed seven times with subscriptions totalling over $700 million. The bond was sold to a large number of institutional investors in US. The first tranche of 100-year bullet bonds for $100 million will be due for redemption in 2097, while the second tranche debt of $214 millions will mature after 30 years, with a put option after 10 years. The 30-year debt of $214 million was priced at a coupon of 8.25 per cent, which works out to 175 basis points above the US treasury rate. Under the 10-year put option the buyer of the bonds has the option to sell the debt back to the company at the end of 10 years. Alternatively, the buyer could continue holding the bonds till maturity. According to investment bankers, only 22 issuers in the world have so far accessed the 100-year century bond. Some of the transnational corporations who have issued century bonds are IBM, Coca Cola, Walt Disney and so on. Why do companies issue century bonds? And what’s in it for the investor? The only benchmark that exists now to judge the efficacy of a century bond is British War Bond issued in 1916 at a coupon of 3.5 percent. The bond had no maturity date. Since it was issued at a low coupon and since the interest rates have moved after that, the bond now trades at a discount of 40 to 50 percent. Reliance has already had bond issues of 10, 12, 20, 30 and 50 year tenures in the international market. Most of those are quoting in the secondary market at 30 to 35 basis points lower than the coupon rate at which they were issued. This indicates that the bonds are going at a premium. As a group, the Reliance has raised $1.2 billion in debt from International markets.

* Source : Economic Times, 11 January & 19 February 1997.

57

CREDIT RATING: AN OVERVIEW* The rating of a debt instrument is taken up by a credit rating agency either on the receipt of a mandate or request from the issuer of the instrument or on its own, sometimes initiated by a group of investors. The emerging markets, is likely to face if it decided to carry out the rating as its own is considerable dependence on the secondary sources for information. As the issuer is not interested in getting the instrument rated voluntarily, under such circumstances, he may not interested in providing the necessary information and clarifications. The secondary sources of information in some countries are not reliable enough and too much dependence on them may lead to distortion and inaccurate ratings. A flow chart is reproduced to give an overview of the rating process followed by the ICRA. The rating process at ICRA usually takes about four weeks in case of an issuer whose instruments are being rated by the agency for the first time. When some other instrument of an issuer is rated earlier, the rating of a new instrument takes about two to three weeks. The time frame for an exercise is also a function of the complexity of an assessment, for instance, a multi-location, corporate entity would require greater time or effort than a single product single location entity. The rating exercise is taken up on receipt of basic information about the company’s business as well as the audited annual accounts of the company for the last three to five years. The team of rating analysts conducts preliminary research on the industry in which the company is operating and then carries out extensive meetings and visits. The data and information is collected from various sources and is then analyzed in a structured report. The visits include the visit of the location of manufacturing facilities of the site of a proposed plant, a new representative offices and the corporate office of the issuer. The team also interacts with the executives of the company at different levels including the chief executive to make the process more interactive.

Besides the visits and meetings within the organization of an issuer, the team of analysts also meets with external professionals like Bankers, Auditors, appraising institutions, suppliers, customers etc. whenever required while keeping the identity of the issuer confidential. ICRA required its analysts to follow certain rule due to diligence requirements and each of the analysts have to certify as a part of the report, the compliance of such requirements. The rating report is prepared after analyzing all the relevant facts and data collected by them from different sources. This report is circulated in advance to the members of the Rating Committee and is further discussed at a meeting of the Rating Committee. The critical issues are discussed and debated and finally the Rating Committee assigns the rating. The Rating Committee, comprising highly experienced and eminent members, is a permanent Committee with minimum possible change in its membership which ensures consistency in ratings assigned. Once the rating has been assigned, it is communicated to the issuer who is also advised the rationale for the rating assigned. If the issuer feels that there is a need for a review of the rating assigned, an opportunity is provided to the issuer to offer additional

* P K Choudhury, Managing Director, ICRA in Economic Times, 30 August 1994

58

information or clarifications. The Rating Committee takes up the review and its decision, thereafter, is final. As per the system prevailing in India, the issuer is given the option to accept or not to accept a given rating. If the rating is accepted, the same is published along with the rationale behind the rating. Such ratings, once accepted, are placed under continuous surveillance for the lifetime. Depending on the performance of the issuer in the future, the rating may be retained, placed under watch, upgraded or downgraded. Under these circumstances, ICRA reserves the right to disclose the rating or any change in the rating to the relevant regulatory bodies, in the public interest. The ratings given are symbolic and easy to understand, as is evident from the appended list of ICRA’s ratings. Rating Symbols Long-term debt-debentures, bond and preference shares LAAA : Highest safety. Indicates fundamentally strong position. Risk factors are negligible. There may be circumstances adversely affecting the degree of safety but such circumstances, as may be visualised, are not likely to affect the timely payment of principal and interest as per terms. LAA + / LAA/ LAA -: High safety. Risk factors are modest and may very slightly. The protective factors are strong and the prospect of timely payment of principal and interest as per terms under adverse circumstances, as may be visualised, differs from LAAA only marginally. LA+/LA/LA - : Adequate safety. Risk factors are more variable and greater in periods of economic stress. The proactive factors are average and any adverse change in circumstances, as may be visualised, may alter the fundamental strength and affect the timely payment of principal and interest as per terms. LBBB+/LBBB/LBBB - : Moderate safety. Considerable variability in risk factors. The protective factors are below average. Adverse changes in business economic circumstances are likely to affect the timely payment of principal and interest as per terms. LBB+LBB/LBB- : Inadequate safety. The timely payment of interest and principal are more likely to be affected by present or prospective changes in business/economic circumstances. The protective factors fluctuate in case of changes in economy/business conditions. LB+LB/LB- : Risk prone. Risk factors indicate that obligations may not be met when due. The protective factors are narrow. Adverse changes in business economic conditions could result in inability/unwillingness to service debts on time as per terms. LC+LC/LC - : Substantial risk. There are inherent elements of risk and timely servicing of debt obligations could be possible only in case of continued existence of favourable circumstances. LD : Default. Extremely speculative. Either already in default in payment of interest and/or principal as per terms or expected to default. Recovery likely only on liquidation or re-organisation. Medium - term debt - including fixed deposit programmes

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MAAA : Highest safety. The prospect of timely servicing of the interest and principal as per terms is the best. MAA +/MAA/MAA- : High safety. The prospect of timely servicing of the interest and principal as per terms is high, but not as high as in MAAA rating. MA+/MA/MA - : Adequate safety. The prospect of timely servicing of the interest and principal is adequate. However, debt servicing may be affected by adverse changes in the business/economic conditions. MB+/MB/MB- : /inadequate safety. The timely payment of interest and principal are more likely to be affected by future uncertainties. MC+/MC/MC -: Risk prone. Susceptibility to default high. Adverse changes in business/economic conditions could result in inability unwillingness to service debts on time as per terms. MD : Default. Either already in default or expected to default. Short-term - including commercial paper A1+/A1 : Highest safety. The prospect of timely payment of debt obligation is the best. A2+/A2 : High safety. The relative safety is marginally lower than in A1 rating. A3/+A3 : Adequate safety. The prospect of timely payment of interest and instalment is adequate, but any adverse change in business/economic conditions may affect the fundamental strength. A4+/A4 : Risk prone. The degree of safety is low. Likely to default in case of adverse changes in business/economic conditions. A5 : Default. Either already in default or expected to default. Note: The suffix of ‘+’ or ‘-’ may be used with the rating symbol to indicate the comparative position of the instrument within the group covered by the symbol. Thus, LAA+ lies one notch above LAA, and MAA+ lies one notch above MAA, while A1+ stands one notch above A1. The letter ‘P’ in parenthesis after the rating symbol indicates that the debt instrument is being issued to raise resources by a new entity for financing a new project and the rating assumes successful completion of the project.

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ICRA’s Rating Process - An Overview

Mandate

Assing rating team

Receive initial information Conduct basic research

Meetings and visits

Analysis and preparation of report

Rating meeting

Assign rating

Communicate the rating and rationale

Request for review

Surveillance Non acceptance

Acceptance

Fresh inputs/ clarifications

Initial stage

Fact finding and analysis

Preview meeting Rating finalisation

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Risk Profile: GEM CABLES AND CONDUCTORS LIMITED

Highly Favourable Favourable Average Unfavoured Risky

(5) (4) (3) (2) (1)

A. Industry Risk

i) Industry prospects for growth 5

ii) Market position of issuer 3

iii) Marketing arrangement 3+

iv) Market image 3+

B. Operating Efficiency

i) Level of technology 4-

ii) Inventory Management 3+

iii) Receivables management 3-

iv) Expense levels 3+

v) Profitability 4

vi) Performance in relation to industry benchmarks 4

vii) Earnings protection/ trend of margins

C. Management Evaluation

i) Competence 4+

ii) Track record 4

iii) Capabilities under stress 4

iv) Organisational structure 4

v) Personnel policies 4

vi) Industrial relations 4

vii) Level of priority for finance function 4

viii) Performance of group companies N. A

D. Accounting Policies

i) Deprecation policy 4

ii) Inventory valuation 3+

iii) Contingent liabilities 3+

iv) Income recognition 4

v) Provisioning/write off N. A

vi) Other items (if any) - N. A

E. Financial Risk

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Highly Favourable Favourable Average Unfavoured Risky

(5) (4) (3) (2) (1)

i) Existing financial position 4

ii) Financial flexibility 4

iii) Ability to access capital market 3+

iv) Liquidity/cashflow adequacy 3

v) Funding profile/leverage 4

F. General Economic Environment

i) Government policies 5

ii) Incremental competition 4

Summary

A. Industry Risk 4-

B. Operating Efficiency 4

C. Management Evaluation 4-

D. Accounting Policies 4-

E. Financial Risk 4+

F. General Economic Environment

Most critical parameters for B, C and E

assessing the repayment

capacity of proposed issue

Overall Rating CARE A for NCD of Rs.50 mn

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Risk Profile: CREDENTIAL FINANCE LIMITED

Highly

Favourable Favourable Average Unfavoured Risky

(5) (4) (3) (2) (1)

A. Industry Risk

i) Industry prospects for growth X

ii) Market position of issuer X

B. Operating Efficiency

i) Information Systems X

ii) Expense levels X

iii) Cost of Funds X

iv) Profitability X

C. Asset Quality

i) Overdues/Non Performing Assets X

ii) Credit appraisal systems X

iii) Recovery systems X

D. Management Evaluation

i) Competence X

ii) Track record X

iii) Organisational structure X

iv) Personnel policies X

E. Accounting Policies X

i) Deprecation policy X

ii) Contingent liabilities X

iii) Income recognition X

iv) Provisioning/write off -

v) Other items (if any) -

E. Financial Risk

i) Existing financial position X

ii) Financial flexibility X

iii) Ability to access capital market X

iv) Liquidity/cashflow adequacy X

v) Funding profile/leverage X

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Highly Favourable Favourable Average Unfavoured Risky

(5) (4) (3) (2) (1)

F. General Economic Environment

i) Government policies X

ii) Incremental competition X

H. Capital Adequacy

Summary

A. Industry Risk 3+

B. Operating Efficiency 3

C. Asset Quality 4-

D. Management Evaluation 4-

E. Accounting Policies 4-

F. Financial Risk 4-

G. General Economic Environment 3+

H. Capital Adequacy 4-

Most critical parameters for B, C, F

assessing the debt servicing

capacity of the proposed issue

FD (200 Mn) A-

Rating recommended ICD (300 mn) PR2

NCD (300 mn) A-

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PRINCIPLES OF MERGERS & ACQUISITIONS*

Mergers and acquisitions take place because of a variety of reasons. For an acquiring company, the reasons may be for obtaining profitable operations, for tax benefits, benefiting from managerial or technical expertise, product diversification etc. For a selling company, the rationale may be the need for additional finance, the prospects of marketing or technological changes, the desire for the majority of stockholders to dispose of their holdings, existence of an attractive purchase offer or simply as a means of survival. Another major consideration could be the strategic stance of a business unit in moving from the existing product line to an altogether new product line which is perceived to be more advantageous against the backdrop of the changing comparative and competitive global environment. However, M&A have raised important issues both for business decisions and for public policy formulation. M & A may be critical to the healthy expansion of business firms as they evolve through successive stages of growth and development. Thus, entry into new product markets and into new geographical markets by a firm may require mergers and acquisitions at some stage in the firm’s development. Sceptics of the efficiency argument hold that companies acquired are already efficient and that their performance after acquisition does not improve. Moreover, the gains to shareholders merely represent a redistribution of stakes among stakeholders. Another view is that M & A activities represent the machinations of speculators who reflect the frenzy of a “Casino Society”. Such speculative activities increase debt and erode equity, resulting in an economy slipping into a highly leveraged and vulnerable state of economic instability. Mergers are intended to benefit both companies – the acquirer and the acquired. If the products and markets are complementary, then M&A strengthen each other. They can be suppliers or end-users which can provide backward or forward integration. Mergers can also lead to elimination or reduction of competition if both companies are in the same line of production. Mergers can save taxes and depreciation or writing off losses. If the loss-making company is acquired by the profit-making companies. Takeovers can be friendly or hostile. Friendly takeovers are arranged between the companies through bargaining. Hostile takeovers are unfriendly acquisitions of shares in a way as to hold a controlling interest in the company. Mergers and acquisitions are expected to result in synergy. Operating synergy is mostly in the form of cost reductions which are the result of economies of scale or economies of scope. Economies of scale decrease the average cost through technological economies, which affect the minimum size of the plant in an industry, or managerial economies, which result in lower production and distribution costs. Economies of scope result from increase in the number of products offered. A company will be able to utilize one set of inputs to provide a broader range of products and services. Operating synergy is most likely to accrue from horizontal merger between two companies in the same line of business. In vertical merger (either backward with integration towards raw materials or forward with integration towards finished products), synergistic gains result when the merging firms are technologically or spatially proximate. Merging of group companies or acquiring those that were engaged in related business would enhance product scope/geographical reach.

* Source: RBI

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Financial synergy, on the other hand, is the impact of a merger on the cost of capital for the merging entities. One of the financial benefits of diversification is termed as the “coinsurance effect”. The acquisition of a company which is less responsive to fluctuations in the economy would give the acquiring company a steady stream of earnings. Another reason could be the acquiring company’s management belief that it can manage the target company’s resources better. Furthermore, a target company having transferable tax losses would be of interest to an acquiring company which could offset its income. M&A activities help to reduce the gestation period for launching new production facilities and promoting new brands, strengthen product portfolios, minimize duplication in basic research and development expenditure and expand marketing and distribution networks. In general, they enhance the shareholder value. Thus, M&A are perceived as prudent corporate strategy. It is necessary to recognise the importance of human resources too. Unless human resources are properly blended in the merged entity and organisational cross-cultures are properly acclimatized, many of the intended merger benefits will not accrue. Generally, mergers represent a resource allocation and reallocation process in the economy with firms responding to new investment and profit opportunities arising out of changes in economic conditions and technological innovations. Mergers rather than internal growth may sometimes be more efficient in terms of resource utilisation. One reason why merger activity is concentrated in periods of high business activity seems to be that firms are not motivated to make large investment outlays when business prospects are not favourable. Only when future benefits accruing to a business endeavour exceed its costs is the action warranted. M&A activities will be simulated when such favourable business prospects are combined with changes in competitive conditions directly motivating a new business strategy. There are certain pitfalls associated with M&A deals, such as insufficient investigation of the acquired company, overbidding to acquired control, too broad a diversification, acquisition of companies in unrelated fields, etc. These would pose a potential threat to effective implementation of such activities.

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THREE UNILEVER TEA COMPANIES TO MERGE* Following the liberalisation of FERA and MRTP rules, three Unilever group companies - Tea Estates India Ltd., Doom Dooma India Ltd. and Brooke Bond India Ltd. - are being merged, with effect from their next financial year beginning January 01, 1993. The merger proposal will be considered by the boards of the three companies on Thursday. The stock exchanges at Bombay, Bangalore, Calcutta and Madras were notified about this proposal by the three companies on Tuesday. The legal formalities such as shareholders’ and court approvals are likely to be completed by the middle of 1993. With the merger, the shareholding of Unilever Plc in the consolidated Brooke Bond will go up from 39.4 percent to 49.9 percent. At present, Unilever holds a 74 percent stake in each of the two plantation companies. These will now become divisions of the new, amalgamated Brooke Bond India Ltd. All the three companies earlier belonged to the former Brooke Bond group which was acquired by Unilever in 1984 through an overseas acquisition. The merger scheme envisages the issue of 12 shares of Brooke Bond for every 10 shares of Tea Estates and 11 for every 10 of Doom Dooma. Post-merger, the equity capital of Brooke Bond will increase from Rs. 58.87 crore to Rs. 84.56 crore. At the same time, its earnings per share (EPS) will improve from Rs. 5.90 (pre-merger) to Rs. 6.10 (post-merger) - for the year ended December 1991 - thanks to the much higher EPS of Tea Estates at Rs. 7.62 and Doom Dooma at Rs. 7.50. Lever group officials justify the lowering of the EPS of the plantation company shareholders consequent to the merger on the ground that they will be more than compensated by the much higher market capitalisation of Brooke Bond shares which enjoy a larger floating stock, better liquidity and high PE (price to earnings) multiples. At current market prices, 10 shares of Tea Estates would be worth Rs. 1,800 and of Doom Dooma, Rs. 1,780. These will now be equivalent to 12 shares and 11 shares of Brooke Bond worth Rs. 3,060 and Rs. 2,805 respectively on the market. The share exchange ratios have been worked out on the basis of internationally accepted valuation principles with the help of Mr Arun Gandhi, senior partner, N M Raiji & Co., chartered accountants. The valuation has been done on a ‘going concern’ basis with a 60-percent weightage assigned to capitalisation of earnings, 20 percent to net asset value (without any revaluation of tea estates) and 20 percent to market capitalisation. The Lever management views the proposed merger to be “synergistic” as it would complement the blended and packet tea business of Brookee Bond by providing a close, internal linkage with the tea gardens. Similarly, the plantations’ business would be protected from cyclical ups and downs in their earnings by their integration with a downstream blender like Brooke Bond. In fact, most tea plantation companies’ bottomlines are under severe pressure this year with the collapse of the Russian market.

* Economic Times Nov. 11, 1992

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Tea Estates and Doom Dooma together produce around 16.5 million kgs of tea every year or one-fifth of the 83.7 million kgs blended and packaged by Brooke Bond. Moreover, traditionally, Brooke Bond has been purchasing only around 30 percent of the produce of these two group plantations with the rest being bought from other companies. Even though this proportion may now go up, Brooke Bond will still continue to be a major purchaser of tea from auctions. What is more, it will also sell a part of its tea under its own banner.

Table 1

KEY FINANCIALS

Company Sales (1991)

Equity Capital

Net worth (as at Dec. 31, 92)

EPS (Rs) (1991)

Current market price

(Rs./share)

P/E (times)

Brooke Bond 700 58.87 118.4 5.90 255 43

Tea Estates 100 13.20 30.5 7.62 180 24

Doom Dooma 60 8.96 18.5 7.50 178 24

Total :

Pre-merger 860 81.03 167.4 6.36

Post- merger 860 84.56 167.4 6.10

Table 2

Company Capitalised EPS (1990,1991,1992) Weight : 60%

Net Asset Value * (as at Dec. 31, 92) Weight : 20%

Market ** capitalisation (Oct.91-Sept.92) Weight : 20%

Broke Bond 69 20 190

Tea Estates 92 23 192

Doom Dooma 83 21 177

* Estimated ** Excluding March to July 1992 which were considered to be abnormal months due to the securities scan.