ms 42 except ch 6

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UNIT 1 NATURE OF LONG TERMFINANCIAL DECISIONS

Objectives

The objectives of this unit are to :

� explain the basics of financial decisions and spell out the distinguishingfeatures and interlinkages between financing and investment decisions ofthe firm.

� describe and illustrate the primary objectives of financial decision making.

� discuss the cardinal principles of financial decisions.

� explain and illustrate the concepts of time value of money.

� explain and illustrate the computation of the implied rate of interest,implied principal amount and annuities in borrowing and lendingtransactions.

� narrates the basic factors influencing long term financial decisions.

Structure

1.1 Introduction

1.2 Nature of Financial Decisions

1.2.1 Investment Decisions

1.2.2 Financing Decisions

1.2.3 Dividend Policy Decisions

1.2.4 Inter-relationship amongst these Decisions

1.3 Wealth Maximisation Objective

1.3.1 Value Maximisation vs Wealth Maximization

1.3.2 Objective of Maximization of Profit Pool

1.3.3 Other objectives and Value Maximization Objective

1.3.4 Net present value rule

1.3.5 VMO and NPV rule

1.4 Cardinal principles of Financial Decision

1.5 Time value of Money

1.5.1 Compounded Value

1.5.2 Discounted Value

1.6 Determination of Implied interest Rates, Implied Principal Amount andAnnuities

1.6.1 Determination of Implied Interest Rate

1.6.2 Determination of the Implied Principal Amount

1.6.3 Determination of Annuities

1.7 Basic Factors Influencing Long term financial Decisions

1.8 Summary

1.9 Key Words

1.10 Self Assessment Questions

1.11 Further Readings

1.12 Answers

Overview of FinancialDecisions

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1.1 INTRODUCTION

Role and responsibilities of a finance manager have under gone a remarkabletransformation during the last four decades. Unlike the past, finance managerplays pivotal role in planning the quantum and pattern of fund requirements,procuring the desired amount of funds on reasonable terms, allocating funds sopooled among profitable outlets and controlling the uses of funds. Since allbusiness activities involve planning for and utilization of funds, finance managermust have clear conception of the financial objectives of his firm and cardinalprinciples of financial decisions. Against this back drop, we shall discuss thebasics of financial decisions; nature of long term financing and investmentdecisions; NPV Rule; time value of money; determination of implied interestrates, implied principal amount and annuities and basic factors influencing longterm financial decisions.

1.2 NATURE OF FINANCIAL DECISIONS

Financial decisions refer to decisions concerning financial matters of a businessconcern. Decisions regarding magnitude of funds to be invested to enable afirm to accomplish its ultimate goal, kind of assets to be acquired, pattern ofcapitalization, pattern of distribution of firm’s, income and similar other mattersare included in financial decisions. A few specific points in this regard are

(a) Financial decisions are taken by a finance manager alone or in conjunctionwith his other management colleagues of the enterprise.

(b) A finance manager is responsible to handle all such problems as involvefinancial matters.

(c) The entire gamut of financial decisions can be classified in three broadcategories: Investment Decisions, Financial Decisions and Dividend PolicyDecisions.

1.2.1 Investment Decisions

Investment decisions, the most important financial decision, is concerned withdetermining the total amount of assets to be held in the firm, the make-up ofthese assets and the business risk complexion of the firm as perceived by theinvestors. The salient features of investment decisions are as follows:

(i) The investment decision are of two types, viz, long term investmentdecisions and short term investment decisions.

(ii) Long term investment decision decides about the allocation of capital toinvestment projects whose benefits accrue in the long run. It is concernedwith deciding :

� What capital expenditure should the firm make?

� What volume of funds should be committed?

� How should funds be allocated as among different investmentopportunities?

(iii) Short terms investment decision decides about allocation of funds as amongcash and equivalents, receivables and inventories.

(iv) A firm may have a number of profitable investment proposals in hand. Butowing to paucity of funds, finance manager should be meticulous inchoosing the most profitable one.

(v) Thrust of financial decisions is on building suitable asset mix.

1.2.2 Financing Decision

In Financing decision, finance manager has to decide about the optimal

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financing mix. It is concerned with how to raise money for business so as tomaximize value of the firm. Highlights of financing decisions are as follows:

(i) Question of making financing decision arise as soon as decision regardinginvestment outlets is made. At times investment decision follows financingdecision.

(ii) A finance manager has to decide the appropriate mix of debt and equityin such a way that wealth of the shareholders is maximized.

(iii) A finance manager is supposed to delve into the following issues requiringfinancing decisions:

(a) From which sources are funds available?

(b) To what extent are funds available from these sources?

(c) What is the cost of funds presently used?

(d) What is the expected cost of future financing?

(e) What instruments should be employed to raise funds and at what time?

(f) Should firm approach financial institutions for securing funds?

(g) What will be the terms and conditions on which the funds will beraised from different sources?

(h) What will be the nature of underwriting arrangements?

(i) What innovations can be made in raising funds from wide variety ofsources?

(iv) A finance manager has to be in constant touch with financial markets.

(v) Financing decisions are primarily concerned with capital structure or debtequity compositions.

1.2.3 Dividend Policy Decision

Dividend policy decision decides about allocation of business earnings betweenpayment to shareholders and retained earnings. A part of the profits isdistributed amongst shareholders and other part is retained for growth of thecompany. A few specific points in this regard are as follows:

(i) Closely related to the issue of raising finance is the issue of distribution ofprofits, which is effectively a source of total fund requirements. Thisconstitutes the area of dividend decisions.

(ii) Although both growth and dividends are desirable, these two goals areconflicting: a higher dividend rate means less retained earnings andconsequently, a slower rate of growth in earnings and stock prices.

(iii) For maximizing the shareholder’s wealth, the finance manager has to strikea satisfactory compromise between the two.

(iv) Prudent finance manager takes dividend decision in the light of investor’spreferences, liquidity position of the firm, stability of earnings of thefirm, need to repay debt, restrictions in debt contracts, access to capitalmarkets etc.

(v) Dividend policy decision is integral part of financing decisions.

1.2.4 Inter-relationship Amongst these Decisions

The interrelationship between three types of financial decisions centres aroundthe following issues:

(a) Which decision comes first investment or financing?

One often wonders whether the financing decision comes first or theinvestment decision. The difficulty with such a question is that any answer infavour of the one or the other is bound to be wrong. For example, why would

Nature of Long TermFinancial Decision


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any management want to raise any capital unless it had some kind of projectalready in mind? Alternatively, how can a management consider undertaking anew project unless it already had some ideas as to how it is going to raise thenecessary finances? So how does one decide which comes first? Chicken orthe egg? The answer in our context is somewhat simpler than the mootquestion concerning the egg and its parent. The two decisions are in realitysimultaneous. In fact neither decision by itself makes sense without the other.There would be no financing decisions to make in the absence of investmentdecisions and vice versa.

(b) Investment Decision Vs Financing Decision- Fundamental Difference

This, however, is not to imply that the line dividing the two is fuzzy. In fact,conceptually the two kinds of decisions are quite different and it is important torecognize them as such. What is the fundamental difference between the two ?Evidently, both, financing as well as investment decisions involve a certainselection of cash flows. Typically, a financing decision involves accepting cashtoday (inflows) from the capital market and repaying the same together withinterest or dividend subsequently over a period of time (outflows). On theother hand, an investment decision involves investing the cash today in theproduct market (outflow) and receiving a stream of earnings (inflows)subsequently. Now, the cash invested in the product market is, in fact, the cashwhich is raised from the capital market.

(c) Relationship through NPV

If after paying all lenders their interest and shareholders their normally expecteddividends, some surplus is left, obviously, it will belong to the shareholdersthereby increasing their wealth. Usually, however, it is extremely cumbersome,though not impossible, to match the cash flows arising from the financingdecisions and the cash flows accruing from the investment decisions on aperiod basis on account of the possible mismatch between their timings. It istherefore far simpler to capture the financing cash flows through their cost (ofcapital and to use this rate for discounting the operating cash flows. Under thisframework, obtaining a positive net present value (NPV) implies the same thingas minimizing the cost of capital. The point becomes further clear if we takeanother look at the NPV formula i.e.

NPV=Co+C1/(1+r) where C

0 and C

1 are cash flows occuring at time 0 and 1

A close look into the formula would readily show that ‘r’ and NPV areinversely related. A higher ‘r’ would mean lower NPV and vice versa. The ‘r’being the rate of discount which normally represents cost of capital. It clearlyhighlights the interlinkage between the financing and the investment decisionsand provides an explicit justification of the NPV rule as the basic rule offinancial decision making.

Activity 1

(a) Identify forces than brought about fundamental change in role andresponsibilities of a finance manager in India.

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(b) Write down two sets of cash flows; one representing a financing schemeand the other an investment scheme.

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(c) Show the IRR of the Financing Scheme.

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(d) Discount the cash flows of the investment scheme using the above IRRas the discount rate.

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(e) ‘NPV formula captures the interlinkages between investment andfinancingdecision’. Explain, with examples.

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1.3 WEALTH MAXIMISATION AND MAXIMISATIONOF PROFIT POOL OBJECTIVES

In a highly competitive environment, financial objective of a firm should be setwithin the framework of corporate objective of sustainable competitive edge. Assuch Wealth maximization objective has come to be widely recognized criterionwith which the performance of a business enterprise is evaluated. The wordwealth refers to the net present worth of the firm. Net present worth is thedifference between gross present worth and the amount of capital investmentrequired to achieve the benefits. Gross present worth represents the presentvalue of expected cash flows discounted at a rate which reflects theircertainty or uncertainty. Thus, wealth maximization objective (WMO) asdecisional criterion suggests that any financial action giving positive NPVshould be accepted. Algebraically, net present value can be expressed asfollows:

Ck)(1

A

K)(1

A

k)(1

A

(W)

NPV

n

n

2

21 −+

++

++

=

whereW = net present worthA1,A2…An = the stream of benefits expected to occur over a period of time

K = appropriate discount rate to measure riskC = initial outlay required to acquire the assetn = time

The objective of wealth maximization removes the following limitations of profitmaximization objective (all such actions increasing income and cutting downcosts should be undertaken):



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(i) The term profit as used in the profit maximization goal is vague.

(ii) it ignores time value factor.

(iii) It ignores risk factor.

The wealth maximization objective has the advantage of exactness andunambiguity and also takes care of time value and risk factors.

1.3.1 Value Maximisation is Wealth Maximisation

The owner of the business employs a manager to look after his businessinterests. In case of a publicly held company, a manager is expected to act inthe best interest of the shareholders, who are the owners of the business. Now,what is in the best interest of the shareholders? This depends on what theshareholders want. Assuming the shareholders to be economically rationalbeings, it appears reasonable to assume that in general they want to get as richas possible through their stake in the business. In other words, they want tomaximize their wealth i.e. market value of shareholding. They are assumed totrade their wealth so as to obtain their desired consumption patterns. Further,they are assumed to choose the risks associated with the consumption patternchosen by them (for example, lending your money may give you a consumptionpattern which is less risky, whereas investing, your money in a security orshare may give you a consumption pattern with higher risk). In the finalanalysis, shareholders seek to maximize their return for a given level of risk orminimize their risk for a given level of return.

1.3.2 Objective of Maximization of Profit Pool:

In his endeavour to foster overall objective of sustainable competitive edge overthe rivals, finance manager has to focus on value maximization-not onlymaximization of shareholders’ value but also stakeholders’ value. Additionalvalue accrues only with efforts that maximize profit pool. A profit pool can bedefined as the total profits earned in an industry at all points along theindustry’s value chain. It includes disaggregation of processes, mapping of thevalue chain beyond the confines of legal entities, adoption of flexibleorganizational structures and creation of net-worked organisations. Mainhighlights of this objective are:

(i) Profit pool concept is based on the concept of looking beyond the corebusiness.

(ii) Shape of a profit pool reflects the competitive dynamics of a business.

(iii) Profit concentrations emanate from actions and interactions of companiesand customers.

(iv) A profit pool is not stagnant.

(v) A profit pool map answers the most pertinent question where and how ismoney being made.

(vi) Profit pool may prompts the management to examine how same profitsources exert influence over others and shape competition.

1.3.3 Other Objectives and Value Maximisation Objective

There are many other objectives which are assumed to compete with ValueMaximisation Objective (VMO). In fact there are a whole lot of researcherswho interview practicing managers and ‘show’ that the managers often have awhole lot of other ‘legitimate’ objectives other than the VMO. These are oftenenumerated as maximizing return on investment, maximizing profit after taxes,maximizing sales, maximizing the market share of their products and so on. It isoften held that very few managers in fact agree to pursue value maximisationof their firms as an explicit objective.

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A little reflection reveals the intrinsic weakness of such studies. For example,one researcher asked a manager who held maximization of market share as thecorporate objective, as to whether he would like his company to capture 100%market share by pricing below costs. Clearly if market share maximization isthe prime objective, he should have no objection to such a proposition. And yetit would be a poor manager indeed who goes for such an opinion. Clearly, hisdesire to maximize market share even at cost of profits in the short terms,must have been triggered off by the possibility of attaining a monopolisticposition so that profits in the long term can be maximized. Similarly, a managerwho maximizes sales may be operating under the assumption, that such acourse of action would eventually lead to enhanced profits in the long run, ifnot immediately. Other objectives such as maximization of return on investmentor profit before taxes etc. are at any rate linked to the wealth maximizationcriteria directly or indirectly. We can see that what are constructed asobjective as other than VMO are in fact merely short term operationalstrategies for maximizing wealth of the shareholders in the long run.

1.3.4 Net Present Value Rule

Wealth maximization objective gives Net Present Value (NPV) rule as the mostbasic rule of financial decision making. To make as investment decision, youcompare the returns on the investment with what the financial markets areoffering. The NPV rule really provides you with a simple way of making thatcomparison. By computing the present value of an investment you are findingout what the investment is worth today. On comparing the present value of aninvestment with its initial outlay, you arrive at the net present value which maybe positive or negative. The concept of NPV, in the form of a simplealgebraic formula, may be stated as follows:

NPV = C1/(1+r) - C

O

Where CO stands for initial cash outlay, C

1 for the cash that with be received

from the investment in one year’s time, r for is the discount rate. The discountrate r should include an appropriate premium for risk.

As a rule, an investment is worth making if it has a positive NPV. If aninvestment’s NPV is negative, it should be rejected.

Example:X invests Rs.70,000 in a piece of land. There are three proposals before himfor its sale:

A Rs.75,000B Rs.77,000C Rs.80,000

His expectation of income is 10%. When he should sell his price of land ? Byapplying NPV Rule, the results will be as follows:

NPV = C1/(1+r) –co

50.1817000,70)1.01(

000,75NPV1 −=−

+=

0000,70)1.01(

000,77NPV2 =−

+=

27.2727000,70)1.01(

000,80NPV3 =−

+=



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Applying the NPV rule, X will invest in land only where the land will sell forRs.80,000 next year and not where the land will sell for either Rs.75,000 orRs.77,000. positive NPV is the logic.

One might ask here: Is this NPV rule valid for firms also? The answer is‘yes’, as long as the objective of the firm is value maximization.

1.3.5 VMO and NPV Rule

It clearly emerges form the foregoing discussion that a manager can help theshareholders by making all business decisions in such a manner that theshareholders’ stake in the business is maximized. This would essentially meanthat the managers would invest in all such investment opportunities where thepresent value of the expected future cash inflows exceeds the current level ofinvestment, so that this excess of the present value of inflows over the initialinvestment enhances the total market value of the shares belonging to theshareholders.

It should be clear that if the New Present Value (NPV) of an investment wereto be negative, the investors would be better off by investing their fundselsewhere. Thus the manager must invest the shareholders’ funds only inventures which yield positive NPV such that the value of their shares ismaximized. Let us suppose that the market value of a firm’s share is Rs.100.Let us further assume that the shareholders of the firms expect to earn areturn of 20% per annum from their investment in the firm. If themanagement of the firm fails to earn Rs.20 per share, the market mechanismwould ensure that the price of the firm’s share drops. How much will the dropbe? It depends on the level of the firm’s earnings. If the earnings level falls tosay Rs.15 per share over a period of time, the price of the share would dropto Rs.75. why? This is because, given the earnings per share of Rs.15 of thefirm, the shareholders can continue to earn their expected level of 20% returnonly if the price of the share fell to Rs.75. this drop in the price of the sharewould however lower the wealth of the shareholders. Hence, the manager mustensure that the funds are invested in ventures which would be able to generateenough surplus to meet the expectations of the shareholders. thus, the principalobjective in business becomes the maximization of the shareholders wealth.

Activity 2

(a) Map out profit pool for a transport industry.

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(b) The market price of a company’s share falls. What could be the possiblereasons?

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(c) Investors in a capital market revise their expectation of return from aparticular company from 20% to 24% on account of that company havingundertaken some risky ventures recently. Would the market price of thatcompany’s share go up or go down ? why?

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(d) On account of certain government concessions to a particular company, itsfinancial performance is expected to improve in the future. Would themarket price of the company’s share go up or go down? Why?

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(e) A firm has decided to set up a steel plant. What sources of funds wouldyou suggest to the firm for funding the plant?

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1.4 CARDINAL PRINCIPLES OF FINANCIALDECISIONS:

A finance manager in his attempt to maximize corporate value of the firm mustkeep in view the following basic considerations while making financial decisions:

(i) Strategic Principle:

According to this principle, financial decisions of a firm should be tetheredto the overall corporate objectives and strategies.

(ii) Optimization Principle:

Thrust of financial decisions should be on intensive use of available fundsand for that purpose, proper balance between fixed and working capital shouldbe sought.

(iii) Risk – Return Principle

Maintaining suitable balance between risk and return is the crux of financialdecision making. Given the product-market strategy, return and risk are thefunction of decision relating to size of the firm, kinds of assets to be acquired,types of funds to be employed, extent of funds to be kept in liquid form, etc.

(iv) Marginal Principle:

According to this principle, a firm should continue to operate upto the pointwhere its marginal revenue is just equal to its marginal cost.

(v) Suitability Principle:

Focus of this principle is on creating an asset by a financial instrumentof the same approximate maturity.

(vi) Flexibility Principle:

According to this principle, financial plan of a firm should be capable tobeing changed in sync with changing environment.



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(vii) Timing Principle:

Timing should be crucial consideration in financial decisions. Investmentand financing decisions should be taken at a time that enable theorganisation to seize market opportunities and minimize cost of raising funds.

1.5 TIME VALUE OF MONEY

Suppose you are given an option to receive Rs.100 today or Rs.100 a yearfrom today, which option would you choose? Of course, Rs.100 today. Why?Could it be that Rs.100 today represents greater certainty than Rs.100 a yearfrom now? Possibly. But this element or risk associated with Rs.100 a yearfrom now could be eliminated or largely reduced through suitable promises,insurance against default and so on, so that you may disregard the possibility ofsuch default. So you are required to make your choice once again. Would youstill choose to receive Rs.100 today rather than a year form now? Why ?May be you are afraid that Rs.100 a year from now might be worth much lessthan Rs.100 today on account of inflation. Let us suppose, for the sake ofargument, that you are living in an economy which is free from inflation. Youmay be promised Rs.100 worth of goods today, instead of cash and the sameamount of goods a year from now, so that you are effectively protected againstinflation. What would your choice be ? Still Rs.100 today why ? A good reasoncan be that you could collect your Rs.100 today, put it in the fixed deposit inthe bank for a year, and collect Rs.110 a year from now, assuming that thebank gives you 10% interest on your deposit. Thus you would be better off byRs.10 than you would have been if you had received Rs.100 a year later.

The next question could be, why should the bank give you 10% interest onyour deposit? The obvious reason is that cash is a scarce resource and thebank is, therefore, prepared to give you a rental (Rs.10) in return for yourallowing them the use of your capital (Rs.100) for a year. Needless to say,the bank would not have agreed to give you Rs.10 for using your capital for ayear, if it did not expect to earn more than Rs.10 by investing Rs.100 elsewhereduring the year. Thus in this case, Rs.10 represents the time value of Rs.100for a period of one year, i.e. 10% per annum. Of course, the real time valueof money would depend on the total amount of money available in the economyand the investment opportunities available in the economy and so on.

Time value of money or time preference for money is one of the central ideasis finance. Money has a time value because of the following reasons:

(i) Individuals generally prefer current consumption.

(ii) An investor can profitably employ a rupee received today to give him ahigher value to be received tomorrow.

(iii) Future is uncertain.

(iv) Inflationary pressures make the money received in future of lesserpurchasing power.

Thus, there is preference of having money at present than at a future point oftime. This automatically means:

(i) That a person will have to pay in future more for a rupee received today.

(ii) A person may prefer to accept less today for a rupee to be received infuture.

They are called as compounded value and discounted value.

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1.5.1 Compounded Value

The process of finding the future value of a payment or receipt or series ofpayments or receipts when applying the concept of compound interest is knownas compounding. It is also called terminal value.

Present Cash to Future Cash

Let us now understand the concept of terminal value. Given that the time valueof money (say interest rate) is 10% per annum, what will be the value ofRs.100 one year from today? Obviously Rs.110. Thus the terminal (orcompounded) value of Rs.100 at the rate of 10% a year from now is equal toRs.110.

How did you arrive at the terminal value of Rs.110? whether you were awareof it or not, you multiplied Rs.100 by 0.10 (being 10%) and added the result toRs.100, to obtain Rs.110.

In mathematical terms:

Terminal value of Rs.100 @ 10% at the end of one year is equal to 100 +0.10 x 100 = 100 x 1.1 = Rs.110.

Similarly, can you now find out the terminal value of Rs.100 at the rate of 10%two years from today?

(Hint : First find out the terminal value of Rs.100 one year from now, whichwill be Rs.110. now find out the terminal value of Rs.110 a further one yearhence.)

In mathematical terms, this would be equal to 100 x 1.1 x 1.1 = 100 x 1.12 =Rs.121

In general then, the terminal value of an amount ‘p’, at a rate of ‘r’ per period,and for ‘n’ periods from today will be

p (1+r) (1+r) (1+r) …. n times = p (1+r)n

Note: (1+r)n is known as the Terminal Value factor n periods hence, at thecompound rate of r per period.

In case of multiple period compounding

nm

m

r1PA

×

+=

Where

A = Amount after n periodm = number of times per year compounding is madeP = Amount in the beginning of periodr = Interest raten = Number of years for which compounding is to be done

1.5.2 Discounted Value

“Deposit Rs.100 and take back Rs.110 after one year” stated in a numericalway means that Rs.100 is the present value of Rs.110 to be received a yearhence. In case of discounted value, we estimate the present worth of a futurepayment/instalment or series of payments adjusted for the time value of money.



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Future Cash to Present Cash

At the rate of 10% per annum, what will be the present (or discounted) valueof Rs.110 to be received one year from now? Clearly, this will be Rs.100. howwas this arrived at?

By dividing Rs.110 by 1.1 (Remember: Rs.110 was the terminal value ofRs.100 one year hence @ 10%).

Similarly, what will be the present value of Rs.100 to be received one yearhence, @ 10% per annum? This will be Rs.9.90909, arrived at by dividingRs.100 by by 1.1.

In mathematical terms:

Present value of Rs.100 to be received one year hence, @ 10% per annum =100/1.1=90.90909.

Similarly, the present value of rs. 100 to be received two years. Hence, @10% per annum = (100/1.1)/1.1=100(1.1)2 =82.64463.

In general then the present value of an amount ‘P’ to be received in ‘n’periods hence, at the rate or ‘r’ per period will be =P/(1+r)n.

Note: 1/(1+r)n is shown as the present value factor for an amount received ‘n’periods hence, at the discount rate of ‘r’ per period.

Activity 3

(a) A sum of Rs.1,000 is placed in the savings account of a bank at 5 percentinterest rate. Find the sum at the end of two years.

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(b) An investor has an Opportunity of receiving Rs.1,000, Rs.1,500, Rs.800,Rs.1,100 and Rs.400 respectively at the end of one through five year. Findthe present value of this stream of uneven cash flows, if the investor’sinterest rate is 8 present?

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(c) You can get an annual rate of interest of 13 percent on a public depositwith a company. What is the effective rate of interest if the compound isdone (a) half yearly (b) quarterly and (c) weekly.

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1.6 DETERMINATION OF IMPLIED INTERESTRATES, IMPLIED PRINCIPAL AMOUNT ANDANNUITIES

In this subsection, the process of determination of implied interest rates, impliedprincipal amount and annuities is explained.

1.6.1 Determination of Implied Interest Rates

Suppose you borrow Rs.100 for one year and the lender asks you to repayRs.120 one year later. What is the interest rate implied by your borrowing?Clearly 20%. This is because at the end of one year, you are required to repaythe principal of Rs.100 as well as the interest of Rs.20.

However, suppose the lender offers you any one of the following repaymentschedules for having borrowed Rs.100 now:

Repayment Schedule 1 2 3 4 5 6 7Repay at the end of 1st year = Rs. 20 20 45 70 95 95 20Repay at the end of 2nd year = Rs. 20 20 90 60 30 5 20Repay at the end of 3rd year = Rs. 120 20 — — — 5 20Repay at the end of 4th year = Rs. — 120 — — — 5 20Repay at the end of 5th year = Rs. — — — — — 30 20Repay at the end of 6th year = Rs. — — — — — — 20

(Repay in perpetuity) 20

What is the interest rate implied in each of the above repayment schedules? Isit 20% for all the schedules? At this stage you may find it more difficult toprovide an answer. It may, however, be relatively simpler to answer thequestion for schedules 1,2 and 7 intuitively.

In case of schedule 1, Rs.20 is paid towards interest at the end of first yearsince the loan is fully outstanding. Similarly Rs.20 is paid again at the end ofsecond and third years, at which time the principal of Rs.100 is also repaid.Similarly, in case of schedule 2, the principal amount is fully repaid only at theend of fourth year, till which time the interest of Rs.20 is being paid at theend of every year. In case of schedule 7, the principal is never repaid andhence the interest of Rs.20 is being paid at the end of every year for ever,thus, in all these cases the implied interest rate remains 20% per annum.

For repayment schedules from 3through 6, a similar interpretation is possible,through this would be somewhat more difficult. Consider, for example, schedule4. in this case, at the end of first year half of the principal is repaid. Howeversince the entire principal is outstanding for the whole of first year, the interestaccrued is Rs.20. this together with half the principal being repaid at the end ofthe first year amounts to Rs.70. Thus, only Rs.50 is outstanding as long for thesecond year so that the interest accrued on this amount at the rate of 20% inthe second year is only Rs.10. The outstanding loan of Rs.50 is fully paid theend of second year so that the total repayment at the end of second year isRs.60. Thus, the interest rate implied in this case is also 20%.

(Can you provide similar interpretations for schedules 3,5 and 6? You should beable to see that in all these cases the implied interest rate is 20% per annum).

It should be readily apparent that one may arrive at an infinite number of suchrepayment schedules all of which imply an interest rate of 20% per annum. Inthe absence of prior information on the interest rate, how can one determine



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what interest rate is implied in a given loan scheme? One must have a morestructured and systematic approach to determine the implied interest rate, givena loan amount and its repayment schedule.

Let us consider schedule 3. The Schedule represents a repayment of Rs.45 atthe end of first year and Rs.90 at the end of second year, against a loan ofRs.100 now. The interest rate may be defined as that rate at which the presentvalue of the repaid amounts exactly equal Rs.100 Let this rate be equal to ‘r’.Thus we must have:

100 = 45/(1 + r) + 90/(1 + r)2

(Note : 45/(1 + r) represents the present value of Rs.45 to be paid one yearlater and 90/(1 + r) represents the present value of Rs.90 to be paid twoyears later, at the rate of ‘r’ per annum).

The value of ‘r’ can be determined from the above equation using the hit andtrial method without much difficulty. In this case, it can be found that when r =0.20, the equation is exactly satisfied, so that the interest rate implied in thiscase is confirmed to be 20%.

You have studied that Internal Rate of Return (IRR) is the rate at which thepresent value of the inflows exactly equals the initial outflow. In the aboveexample, the initial borrowing (inflow) is 100 and the repayments (outflows) atthe end of the first and second years are Rs.45 and Rs.90, respectively. At therate of 20%, the present value of outflows exactly equals the initial inflow.Thus, for the set of cash flows represented by Rs. 100, in time zero, -45 at theend of the first year, and -90 at the end of second year respectively (plus signis for the inflow and minus sign is for the outflow), the implied rate of interestis equal to 20%. In other words, interest rate implied in a typical loan schemewhich involves an initial inflow (borrowing) followed by subsequent outflows(repayments) is just like the IRR of the cash flows associated with the loanscheme.

1.6.2 Determination of the Implied Principal Amount

Let us assume that a prospective borrower approaches you for a loan. He isconfident of being able to pay you Rs.193 for four years starting a year fromtoday. Assuming that your desired rate of interest is 20% per annum, howmuch amount would you be prepared to lend him today?

In the light of our discussion above, it should be clear that the amount youshould lend, should exactly equal the present value of the annual stream ofRs.193 for four years discounted at the rate of 20%. Let us assume that theamount you would be prepared to lend is P.

Mathematically, we must have:

P = 193/(1.2) + 193/(1.2)2 + 193/(1.2)3 +193/(1.2)4 = 500

Thus, you should be prepared to lend Rs.500 in the above case. The samelogic may be employed to determine what is called’ fair price of a share’ in themarket. Let us suppose you expect a company to pay you dividends worthRs.20, 30 and 40 at the end of one, two and three years from today,respectively. Further suppose you wish to hold the share for only three yearsand you expect to be able to sell the share at the end of the third year forRs.120 how much would you be prepared to pay for the share of such acompany today? “Clearly, we must employ the same technique as above and

15

find out the present value of the inflows, namely Rs.20 at the end of first year,Rs.30 at the end of second year and 160 at the end of third year (Rs.40 worthof dividends plus Rs.120 from the sale of the share) at a rate which youexpect to earn on your investment”. Let us assume that you wish to earn 25%on this investment as you consider the proposition somewhat risky (assumingthat higher the risk, higher the return expected). The present value of theabove inflows when discounted at 25% yields about Rs.117, which is theamount you should be willing to pay for a single share of the companymentioned above.

1.6.3 Determination of Annuities

Let us assume that you borrow Rs.100 at an interest of 20% per annum for aperiod of two years. However, you wish to repay the loan in two equal annualinstallments (also knows an annuities). What should be this installment?

(If your answer is Rs.50, it is obviously wrong. Guess why?).

Let us assume that each installment amount equals X. We have a cash flowpattern of the kind + 100 in time zero, X at the end of first year and x at theend of second year respectively.

According to the IRR rule, we must have:

100 = X/(1.2) + X/(1.2)2, or 100 = 0.833 X + 0.694 X or X = 100/1.527 = 65.49.

Activity 4

(a) In the above example, the repayments commenced one year later. Whatwould you do if annual repayments were to commence as soon as loanwas received, i.e. from time zero onwards, instead of from the end of firstyear onwards?

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(b) In the annuity example given above, can you find out the annuity paymentsif the repayment period were three years or four years or five years?What will be the annuities, if the payments were to commenceimmediately?

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(c) Given the cash flows + 500, -100, -200, -300, -400 in period 0,1,2,3 and 4,respectively. Calculate the Implied rate of interest.

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16

1.7 BASIC FACTORS INFLUENCING LONG TERMFINANCIAL DECISIONS

A finance manager has to exercise great skill and prudence while taking long-term financial decisions since they effect the financial health of the enterpriseover a long period of time. It would, therefore, be in fitness of things to takethe decisions in the light of external and internal factors as discussed below.

External factors

External factors refer to environmental factors that bear upon operations of abusiness enterprise. These factors are beyond the control and influence ofmanagement. The following external factors enter into long term financialdecision making process:

(i) State of economy-i.e. phase of trade cycle.

(ii) Institutional structures of capital markets (Developed or undeveloped).

(iii) State regulations in financing (Debt Equity Norms, Dividend PaymentRestrictions etc.

(iv) Taxation policy.

(v) Expectations of Investors in terms of safety, liquidity and profitability.

(vi) Lending policies of financial institutions.

Internal Factors

Internal factors comprise those factors which are related with internalconditions of the firm, as listed below:

(i) Nature of business

(ii) Size of Business

(iii) Age of the firm

(iv) Ownership structure

(v) Asset structure of the firm

(vi) Liquidity position of the firm

(vii) Expected return, cost and risk

(viii)Probabilities of regular and steady earnings

(ix) Attitude of management

It is practically inexpedient to consider all the factors at a time since they areantagonistic to each other. A prudent and skillful manager strives to strike aproper balance among these factors in the light of income, risk, control andflexibility factors.

1.8 SUMMARY

Investment decisions pertains to choice of outlets in which funds are to bedeployed so as to maximize value of the firm where as financing decisionsconcern with funding of the outlets and dividend policy decision shed light onallocation of net earnings between retention and distribution.

The objective of a firm is to maximize the wealth of its shareholders. Thewealth of the shareholders is measured through the market value of theirshares. The Market value of a firm’s share is nothing but the present value ofits future earnings, discounted at the rate of return expected by itsshareholders. In order to maximize the shareholders’ wealth, only thoseprojects which yield a positive NPV are accepted.

17

A rupee today is not equal to a rupee tomorrow. This is so because the rupeecan be put to some productive use during the intervening period and thus madeto earn. Like any limited resources, capital does not come free. It has a cost,which is termed as the time value of money. The mechanism by which weequate a rupee today with a rupee tomorrow is by bringing both the rupees ona common date, either today or tomorrow. Reducing them to today’s value iscalled their present value. Similarly, reducing them to tomorrow’s value isknown as terminal value. The former involves discounting the future rupee tothe present at the appropriate cost of money, while the letter involvescompounding the rupee today to a future date.

Finance manager has to exercise great skill and prudence to strike a properbalance amongst external and internal factors influencing financial decisions.

1.9 KEY WORDS

Annuity is an equalized stream of cash flows over a period of time.

Capital Market is where financial instruments are bought or sold.

Capital Structure is the composition of a firm’s capital in terms of debt andequity.

Cost of Capital is a term used to refer to the weighted average of the cost ofdebt and equity.

Equity represents the share of an investor in a business.

Internal Rate of Return (IRR) is the rate at which the present value of astream of cash inflows equals the initial outflow, so that the Net Present Value(NPV) of the set of given cash flows equals zero.

Net Present Value is the difference between the present values of cashinflows and cash outflows, when cash inflows are discounted at a suitable rate.

Present Value is value obtained when future cash flows are discounted to thepresent at a certain rate.

Terminal Value is the value obtained when current cash flows arecompounded to the future at a certain rate.

Time Value of Money refers to the instrinsic value of money on account ofits alternate use potential.

Financial Decisions refer to decisions concerning financial matters of abusiness concern.

Investment Decisions refer to assets mix or utilization of funds.

Financing Decisions refer to capital structure or optimal financing mix.

Dividend Policy Decisions decide about allocation of business earnings.

1.10 SELF-ASSESSMENT QUESTIONS

1) Why is Time Value of Money independent of inflation and risk?Differentiate Present Value and Terminal Value.



18

2) What is Net Present Value? How is the NPV rule related to the wealthmaximization objectives of a firm?

3) What is IRR ? How does it relate to financing decisions? Can you use itfor investment decisions of the accept/reject type?

4) What is Investment Decisions? How is it different from financingdecisions?

5) Bring out the factors influencing long-term financial decisions of the firm ?

6) ‘Obtaining Positive NPV implies the same thing as minimizing the cost ofcapital’ Explain with examples.

7) Project a and B require equal amount of investment. Project a will yieldRs.3,000. 4,000 and 5,000 in the first, second and third years, respectively,project B, however, will yield Rs.5,000, 4,000 and 3,000, respectively in thefirst, second and third years. Which project is superior? Why

8) What will be the monthly time adjusted interest rate which is equivalent toan annual interest rate of 15%?

Hint : if annual rate = R, and equivalent quarterly rate = r, We will have :(1 + R) = (1 + r) 4.

9) A client goes to the bank and borrows Rs.12,000. the Bank Managerrequires the client to repay Rs.6,000 at the end of every year for threeyears. What interest rate was the client charged? What would be theinterest rate if the Manager had instead asked the client to repay in fiveannual installments of Rs.4,000 at the beginning of every year starting fromthe date of borrowing?

10) Mr. X is considering to invest Rs.1 lakh in a project which is expected toresult in a net cash flow of Rs.20,000 at the end of each year for 8 years.Mr. X will have to borrow the amount required for investment at the rateof 12% per annum. Should he undertake the project ?

11) Suppose Govinda is currently earning Rs.50,000. Next year he will earnRs.60,000. Govinda is profligate and wants to consume Rs.75,000 this year.The current interest rate is 10%. What will be Govinda’s consumptionpotential by next year if he consumes according to his desires this year?

12) Amir is a miser. He currently earns Rs.50,000 and will earn Rs,40,000 nextyear. He plans to consume only Rs.20,000 this year. The current interestrate is 10%. What will be Amir’s consumption potential next year?

13) It is estimated that a firm has a pension liability of Rs.1 million to be paidin 24 years. To assess the value of the firm’s stock, financial analystwants to discount this liability back to the present. If the discount rate is16%, what is the present value of this liability?

14) Consider a firm with a contract to sell a capital asset for Rs.70,000.Payment is to be received at the end of 2 years. The asset costsRs.60,000 to produce. Given that the interest rate is 10%, did the firmmake a profit on this item? That is the interest rate at which the firmbreaks even?

15) You have won the Nagaland State Lottery. Lottery officials offer you thechoice of the following alternate payouts:Alternate 1 : Rs.10,000 1 year from nowAlternate 2 : Rs.20,000 5 years from nowWhich should you choose if the discount rate isa) 0% ?b) 10% ?c) 20% ?

16) You are considering to make an offer to buy some land for Rs.25,000 Youroffer will be to pay Rs.5,000 down and for the seller to carry a contract

19

for the remaining Rs.20,000. you would like to pay off the contract oversix years at an interest of 18 per cent per year. For the first year, youwish to pay interest only each month. For the remaining five years, youare willing to pay off the contract in equal monthly installments. What willbe your monthly payment for years 2 through 6 if the seller agrees to yourterms?

17) Sukhdev wants to save money to meet two objectives. First, he would liketo be able to retire twenty years from now and have a retirement incomeof Rs.30,000 per year for at least ten years. Second he would like topurchase a plot of land five years from now at an estimated cost ofRs.15,000. He can afford to save only Rs.5,000 per year for the first fiveyears. Shkhdev expects to earn 10 per cent per year on average frominvestments over the next thirty years. What must his minimum annualsavings be from years 6 through 20 to meet his objectives?

18) Deepak has asked your advice on the following problem. He has amortgage loan on the family home that was made several years ago wheninterest rates were lower. The loan has a current balance of Rs.30,000and will be paid off in twenty years by paying Rs.270 per month. He hasdiscussed paying off the loan ahead of schedule with an officer of thebank holding the mortgage. The bank is willing to accept Rs.27,000 rightnow to pay it off completely. What advice would you offer to Deepak?

19) Which decisions comes first-investment or financing?

20) Explain, briefly, the nature and types of financial decisions.

1.11 FURTHER READINGS

Ross, A. Stephen and Randolph W. Westerfield, 1988. Corporate finance,Times Mirror Missouri (Chapter 3).

Schall, Lawrence D. and Charles W. Haley, 1986. Introduction to FinancialManagement, McGraw Hill, New York (Chapters 1, 2, 4 & 5).

Van Horne, C. James, 1985. Financial Management and Policy, Prentice-Hallof India, New Delhi (Chapter 1).

Weston, J. Fred and Eugene F. Brigham, 1986. Managerial Finance, theDryden Press (Chapters 1,2,4 & 6).

Chandra, Prasanna, “Financial Management – Theory and practice”, TataMcGraw, New Delhi-1994 (Chapter 4).

Pandey, I.M., “Financial Management”, Vikas Publishing House, New Delhi –1993 (Chapter 1 & 8).

Srivastava, R.M., “Financial Management”’ Pragati Prakashan, Srivastava,R.M. Financial Management and policy Himalaya Publishing House, Mumbai– 2003 (Chapter 1)

Maheshwari, S.N., “Financial Management – Principles and Practice”,Sultan Chand & sons-1996 (chapter 1&2).

1.12 ANSWERS

Activity 3

(a) Rs.1102.50



20

(b) Rs.3921.60

(c) 13.42%, 13.65%, 13.86%

Activity 4

(b) First part –Rs.47.47, Rs.38.63 and Rs.33.44

Second part-Rs.39.56. Rs.32.19 and Rs.27.87

(c) Approximate -2)

Self assessment Questions/Exercises.

7. Prosecute B

8. 1.17.1.

9 first Part – 23.51. Second Part-20/.

10 No. Negative NpV – Rs.648

1

UNIT 2 COST OF CAPITALObjectives


� provide conceptual understanding of the cost of capital and its variants.

� illustrate the computation of cost of specific courses of long-term financeviz. long term debt and debentures, preference shares, equity shares, andretained earnings.

� discuss and illustrate the various weighting approaches and the WeightedAverage Cost of Capital (WACC).

� examine the utility of cost of capital

Structure

2.1 Introduction

2.2 Concept of Cost of Capital

2.2.1 Components of Cost of Capital

2.2.2 Classification of Cost of Capital

2.3 Computing Cost of Capital of Individual Components

2.3.1 Cost of Long-term Debt

2.3.2 Cost of Preference Capital

2.3.3 Cost of Equity Capital

2.3.4 Cost of Retained Earnings

2.4 Weighted Cost of Capital

2.5 Significance of Cost of Capital

2.6 Some misconceptions about the Cost of Capital

2.7 Summary

2.8 Keywords



2.11 Answers

Appendix 2.1: Share Valuation with Constant Growth in Dividends

2.1 INTRODUCTION

The Cost of Capital is an important financial concept. It links the company’slong-term financial decisions with the shareholders’ value as determined in themarket place. Two basic conditions must be fulfilled so that the company’s costof capital can be used to evaluate new investment:

1) The new investments being considered have the same risks as the typicalor average investment undertaken by the firm.

2) The financing policy of the firm remains unaffected by the investments thatare being made.

In this unit, we shall dilate upon the concept of the cost of capital and itsclassification, the process of computing cost of capital of individual components,weighted cost of capital, significance of cost of capital and a fewmisconceptions about the cost of capital.


2

2.2 CONCEPT OF COST OF CAPITAL

The term cost of capital refers to the minimum rate of return that a firm mustearn on its investments so as to keep the value of the enterprise infact. Itrepresents the rate of return which the firm must pay to the suppliers of capitalfor use of their funds.

The following are the basic characteristics of cost of capital :

i) Cost of Capital is really a rate of return, it is not a cost as such.

ii) A firm’s cost of capital represents minimum rate of return that will resultin at least maintaining (If not increasing) the value of its equity shares.

iii) Cost of Capital as a rate of return is calculated on the basis of actual costof different components of capital.

iv) It is usually related to long-term capital funds.

v) In operational terms, Cost of Capital in terms of rate, of return is used asdiscount rate, used to discount the future cash inflows so as to determinetheir present value and compare it with investment outlay.

vi) Cost of Capital has three components:

a) Return at Zero Risk Level.

b) Premium for Business Risk.

c) Premium for Financial Risk.

The cost of capital may be put in the form of the following equation:

K = ro + b + f

WhereK = Cost of Capitalro = Return at zero risk level (Risk free returns)b = Premium for business riskf = Premium for financial risk

Thus,

a) Cost of Capital with Business Risk > Cost of Capital with no risk; and

b) Cost of Capital with financial risk > Cost of Capital with Business Risk >Cost of Capital with no risk.

2.2.1 Components of Cost of Capital

A firm’s cost of capital comprises three components:

� Return at Zero Risk Level : This refers to the expected rate of returnwhen a project involves no risk whether business or financial.

� Purchasing power risk arises due to changes in purchasing power ofmoney.

� Money Rate Risk means the risk of an increase in future interest rates.

� Liquidity risk means the ability of a supplier of funds to sell his shares/debentures bonds quickly.

2.2.2 Classification of Cost of Capital

Cost of Capital can be classified as follows:

1) Explicit Cost and Implicit Cost : Explicit cost is the discount rate thatequate the present value of the expected incremental cash inflows with thepresent value of its incremental cash out flows. Thus, it is ‘the rate of

3

return of the cash flows of financing opportunity’. In contrast, implicit costis the rate of return associated with the best investment opportunity for thefirm and its shareholders that will be foregone if the project presentlyunder consideration by the firm were accepted. In a nutshell, explicit costsrelate to raising of funds while implicit costs relate to usage of funds.

2) Average Cost and Marginal Cost : The average cost is the weightedaverage of the costs of each components of funds. After ascertaining costsof each source of capital, appropriate weights are assigned to eachcomponent of capital. Marginal cost of capital is the weighted averagecost of new funds raised by the firm.

3) Future Cost of Capital : Future cost of capital refers to the expectedcost to be incurred in raising new funds while historical cost representscost of capital incurred in the past in procuring funds for the firms. Infinancial decision making future cost of capital is relatively more relevant.

4) Specific Cost and Combined Cost : The costs of individual componentsof capital are specific cost of capital. The combined cost of capital is theaverage cost of capital as it is inclusive of cost of capital from all sources.In capital budgeting decisions, combined cost of capital is used foraccepting /rejecting the investment proposals.

Activity I

1) Define the following :

i) Explicit Cost iii) Average Cost

ii) Cost of Capital iv) Marginal Cost

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2) Discuss various types of risks associated with the concept of Cost ofCapital.

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3) State how can Cost of Capital help a firm in converting its future cashinflows in its present value.

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2.3 COMPUTING COST OF CAPITAL OFINDIVIDUAL COMPONENTS

Computation of cost of capital from individual sources of funds helps indetermining the overall cost of capital for the firm. There are four basicsources of long-term funds for a business firm:

i) Long-term Debt and Debentures,

Cost of Capital


4

ii) Preference Share Capital,

iii) Equity Share Capital,

iv) Retained Earnings

Though all of these sources may not be tapped by the firm for funding itsactivities, each firm will have some of these sources in its capital structure.

The specific cost of each source of funds is the after-tax cost of financing.The procedure for determining the costs of debt, preference and equity capitalas well as retained earnings is discussed in the following sub-sections.

2.3.1 Cost of Long-Term Debt

Cost of long-term debt represents the minimum rate of return that must beearned on debt financed investments if the firm’s value is to remain intact.Long-term debt may be issued at par, at premium or discount. It may beperpetual or redeemable. The technique of computation of cost in each casehas been explained in the following paragraphs.

(a) The formula for computing the Cost of Long-term debt at par is

Kd = (1 – T) R

where

Kd = Cost of Long-Term Debt

T = Marginal Tax Rate

R = Debenture Interest Rate

Example, if a company has issued 10% debentures and the tax rate is 60%,the cost of debt will be

(1 - .6) 10 = 4%

(b) In case the debentures are issued at premium or discount, the cost of thedebt should be calculated on the basis of net proceeds realized. Theformula will be as follows.

Kd

T)(1Np

I−=

Where

Kd

= Cost of debt after tax

I = Annual Interest Payment

Np = Net Proceeds of Loans

T = Tax Rate

Example, a company issues 10% irredeemable debentures of Rs. 1,00,000. Thecompany is in 60% tax bracket.

Cost of debt at par = )60.1(0Rs.1,00,00

10,000 Rs.−×

= 4%

Cost of debt issued at = )60.1(90,000Rs.

10,000Rs.−×

10% discount= 4.44%

5

Cost of debt issued at = )60.1(0Rs.1,10,00

10,000 Rs.−×

10% Premium

= 3.63%

(c) For computing cost of redeemble debt, the period of redemption isconsidered. The cost of long-term debt is the investor’s yield to maturityadjusted by the firm’s tax rate plus distribution cost. The question of yieldto maturity arises only when the loan is taken either at discount or atpremium. The formula for cost of debt will be

where

mp = maturity period

p = nominal or par value

np = net proceeds i.e. (Par value - Discount + Premium)

Example, a firm issued 1,000, 10% debentures, each of Rs. 100 at 5%discount. The debentures are to be redeemed in the beginning of 11th year.The tax rate is 50%.

(d) In case of underwriting and other issuing costs, they are adjusted in thesame way as discount is being adjusted in net proceeds and othercalculations.

Example, A company raised loan by selling 2,500 debentures with 10% rate ofinterest at premium at Rs. 5 per debenture (Par value = Rs. 100), redeemablein the 11th year. Underwriting and other issuance costs amounted to 3% of theproceeds. The tax rate is 50%

Cost of Capital

I + Discountmp

In case ofpremium Premium

mp( )

3 (I – T) 3 100p + nP

2

10,000 +5,000

101,00,000 + 95,000

2

3 100 (1 – .5)

=10,50097,500

3 50 = 5.385%

10

875,7

10

500,12000,25 +−

225,54,2000,50,2 +

( )= 3 (1 – .5) 3 100

( )


6

1005.313,52,2

7881250000,25××

+−=

= 4.865%

(e) Yield to maturity method of computing cost of debt capital is anapproximation method. A better method is that which converts yield tomaturity into a discount rate. James C. Van Horne says “ the discountrate that equates the present value of the funds received by the firm, netof underwriting and other costs with the present value of expectedoutflows. These outflows may be interest payments, repayment ofprincipal or dividends”. It may symbolically be written as:

n (cash outflows)t

np = S ——————— t = 1 (1 + K)t

wherenp = net amount available for use

(Cash outflows) = amount of interest after tax + amount of repayment of principal

t = time periodK = discount rate

Example, A company has issued 11% debentures for Rs. 2,00,000. Theunderwriting, brokerage and other issuance costs amount to Rs. 10,000. Theterms of debenture issue provide for repayment of principal in 5 equalinstallments starting at the end of the first year. The tax rate is 60%.

Cash inflow = Rs. 2,00,000 - Rs. 10,000

= Rs. 1,90,000

Cash Outflows

Year Installment Interest Total Discount Present Discount PresentRs. Rs. Rs. Factor Value Factor Value

14% 12%

1 40,000 22,000 62,000 .877 54374 .893 55366

2 40,000 17,600 57,600 .769 44294 .797 37875

3 40,000 12,200 53,200 .675 35910 .712 30744

4 40,000 8,800 48,800 .592 28890 .630 25175

5 40,000 4,400 44,400 .519 23044 .576

186512 195067

)1214()186512195067(

)190000195067(%12 −

−−

+

%184.1328555

5067%12 =+

(f) Effective cost of debt is lower than the interest paid to the creditorsbecause the firm can deduct interest amount from its taxable income. Thehigher the tax rate, the lower the effective interest rate on debt and lowerthe cost of debt. Let us take an example.

7

There are two firms, A and B. The firm A has no debt and is totally financedby equity capital. The firm B has Rs. 200 lakhs outstanding debt and pays aninterest rate of 10 per cent. The firm’s net income after-taxes is calculatedusing three tax rates, 0, 25 and 50 per cent and the resulting values of netincomes are compared. Assume that the earnings before interest and taxes ofboth firms is Rs. 100 lakhs each.

Tax Rates and Effective Cost of DebtRs. in lakhs

0% tax rate 25% tax rate 50% tax rate

Firm A Firm B Firm A Firm B Firm A Firm B

1 Earnings before- 100 100 100 100 100 100interest and taxes

2 Interest 0 20 0 20 0 20

3 Taxable income 100 80 100 80 100 80

4 Taxes 0 0 25 20 50 40

5 Net income after 100 80 75 60 50 40taxes (NIAT)

(a) Difference 20 15 10

(b) Effective rate 10% 7.5% 5%

Notes :

a) NIAT of firm A - NIAT of firm B.

b) (a) ' Rs. 200 lakhs of outstanding debt of firm B.

If no taxes were paid, the only difference between the net incomes of the twofirms would be the interest expense incurred by the firm B. As the tax rateincreases, this difference diminishes. In the case of 0% tax rate, we can saythat the effective rate of debt is 10% (Rs. 20 / Rs. 200). In the case of 25%and 50% it is 7.5% and 5%, respectively.

A simple formula for computing the cost of debt may be stated as follows:

Effective cost of debt

= Interest rate x (1.0 - tax rates)

Substituting the data from the above example.1) Effective cost of debt at 0% tax rate

= 10% x (1.0 - 0.00)= 10%

2) Effective cost of debt at 25% tax rate= 10% x (1.0 - 0.25)= 7.5%

4) Effective cost of debt at 50% tax rate= 10% x (1.0 - 0.50)= 5%

A more generalised way of calculating the cost of debt capital is to find out thediscount rate which equates the present value of post tax interest and principalrepayments with the net proceeds of the debt issue i.e. (Par value x no. ofbonds – Issue floatation cost). Mathematically this relationship can be expressedas follows:

Cost of Capital


8

∑=

++

++

=n

1t k)(1

R

tK)(1

T)-(I I Np

n

Where : np = net amount realised on debt issueI = Annual interest paymentT = Tax rate applicableR = Redemption Valuen = Maturity period of debt.

In the above eq. solving for K would yield the cost of debt capital. For solvingthe above equation an approximation can be used which yield fairly close value.

2/NP)R(η

NP)-(R T)-(1 I

K+

+≅

Amortisation of the Cost of issue: Since the issue floation cost is tax deductiblecost and can be amortised evenly over the duration of debt finance, the cost ofdebt capital would be K in the following equation.

∑= +

++

=n

1t k)(1

R

K)(1

nNP)-(R - T)-(I I

Npnt

t

An approximation for K is as follows

P)/2(R

T)-(1 T)-(1 InP)(R-

K++

≅

Activity 2

1. A firm intends to issue 1,000, 10% debentures each of Rs. 100. What is thecost of debt if the firm desires to sell at 5% premium. The tax rate is 50%.

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2. A firm issues 1,000, 10% debentures of Rs. 100 each at a premium of 5%with a maturity period of 10 years. The tax rate is 50%. Find the costof capital.

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3. A company raises loan of Rs. 2,50,000 by 10% debentures at 5% discountfor a period of ten years, underwriting costs are 3% and tax rate is 50%.

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t

n

9

2.3.2 Cost of Preference Capital

Cost of preference share capital represents the rate of return that must beearned on preferred stocks financed investments to keep the earnings availableto residual stockholders unchanged. Cost of preference shares can beestimated by dividing the dividend stipulated per share by the current marketprice of the share.

DividendCost of Preference Capital = ——————————

Face Value - Issue Cost

Example, A Company is planning to issue 9% preference shares expected tosell at Rs. 85 par value. The costs of issuing and selling the shares areexpected to be Rs. 3 per share.

The first step in finding out the cost of the preference capital is to determinethe rupee amount of preference capital is to determine the rupee amount ofpreference dividends, which are stated as 9% of the share of Rs. 85 parvalue. Thus 9% of Rs. 85 is Rs. 7.65. After deducting the floatation costs,the net proceeds are Rs. 82 per share.

Thus, the cost of preference capital :

Dividend per share= ———————————

Net proceeds after selling

=82 Rs.

7.65 Rs. = 9.33%

Now, the companies can issue only redeemable preference shares. Cost ofcapital for such shares is that discount rate which equates the funds availablefrom the issue of preference shares with the present values of all dividendsand repayment of preference share capital. This present value method for costof preference share capital is similar to that used for cost of debt capital; theonly difference is that in place of ‘interest’, stated dividend on preferencesshare is used. The cost of preference capital which is redeemable is the valueof KP in the following equation

∑= +

++

=η

1tηt KP)(1

R

KP)(1

DNP

2 / NP)R(

N / NP)–(RDKP

++≅

2.3.3 Cost of Equity Capital

“Cost of equity capital is the cost of the estimated stream of net capital outlaysdesired from equity sources” E.W. Walker.

According to James C. Van Horne, cost of equity capital can be thought of asthe rate of discount that equates the present value of all expected futuredividends per share, as perceived by investors at the margin as in the currentmarket price per share.

Cost of Capital

n

n


10

In a nutshell, it is the discount rate which equates present value of all expecteddividends in future with net proceeds per share/current market price. Itrepresents the minimum rate of return that must be earned on new equity stockfinanced investment in order to keep the earnings available to the existingresidual owners of the firms unchanged.

Cost of equity capital is by for the most difficult to measure because of thefollowing reasons:

i) The cost of equity is not the out of pocket cost of using equity capital.

ii) The cost of equity is based upon the stream of future dividends asexpected by shareholders (very difficult to estimate).

iii) The relationship between market price with earnings is known. Dividendsalso affect the market value (which one is to be considered).

The following are the approaches to computation of cost of equity capital:

(a) E/P Ratio Method : Cost of equity capital is measured by earning priceratio. Symbolically,

Eo (current earnings per share)

——— x 100

Po (current market price per share)

The limitation of this method are:

� Earnings do not represent real expectations of shareholders.

� Earnings per share is not constant.

� Which earnings-current earnings or average earnings (Not clear).

The method is useful in the following circumstance:

� The firm does not have debt capital.

� All the earnings are paid to the shareholders.

� There is no growth in earnings.

(b) E/P Ratio + Growth Rate Method : This method considers growth inearnings. A period of 3 years is usually being taken into account forgrowth. The formula will be as follows.

Eo (1+b)3

————— Po

Where (1+b) 3 = Growth factor, where b is the growth rate as a percentageand estimated for a period of three years.

Example, A firm has Rs. 5 EPS with 10% growth rate of earnings over aperiod of 3 years. The current market price of equity share is Rs. 50.

100Rs.50

.10)(1 Rs.5 3

×+

10050

665.6100

)Rs.5(1.331

50×=×

= 13.31%

(c) D/P Ratio Method : Cost of equity capital is measured by dividendsprice ratio. Symbolically,

Do (Dividend per share)——— x 100 Po (Market price per share)

11

Example, the market price of equity share is Rs. 15 and dividend rate is 15%(Par value Rs. 10 per share)

Rs. 1.5———— x 100 = 10% Rs. 15

The following are the assumptions

i) The risk remains the unchanged.

ii) The investors give importance to dividend.

iii) The investors purchase the shares at par value.

Under this method, the future dividend streams of a firm, as expected by theinvestors, are estimated. The current price of the share is used to determineshareholder’s expected rate of return. Thus, if K is the risk-adjusted rate ofreturn expected by investors, the present value of future dividends, discountedby Ke would be equal to the price of the share. Thus,

D1 D2 D3 DnP = ———— + ——— + ——— + ———

(1+Ke) 1 (1+Ke) 2 (1+Ke) 3 (1+Ke) n

where,P = price of the share

D1…Dn = dividends in periods 1,2,3,…n,Ke = the risk adjusted rate of return expected by equity investors.

Given the current price P and values for future dividends ‘Dt’, one cancalculate Ke by using IRR procedure. If the firm has maintained some regularpattern of dividends in the past, it is not unreasonable to expect that the samepattern will prevail in future. If a firm is paying a dividend of 20% on a sharewith a par value of Rs. 10 as a level perpetual dividend, and its market price isRs. 20, then

P = Ke

D

20 = Ke

2

Ke = 20

2 = 10%

(d) D/P + Growth Rate Method : The method is comparatively morerealistic as

i) it considers future growth in dividends,

ii) it considers the capital appreciation.

This method is based on the assumption that the value of a share is the presentvalue of all anticipated dividends, which it will give over an infinite time horizon.The firm is here viewed as a going concern with an infinite life.

Thus,

Po = gKe

D1

− or Ke = OP

D1 + g

Where,Po = current price of the equity shareD1 = per share dividend expected at the end of year 1Ke = risk adjusted rate of return expected on equity shares. g = constant annual rate of growth in dividends and earnings.

Cost of Capital


12

The derivation of the formula has been given in Appendix 2.1.

The equation indicates that the cost of equity share can be found by dividingthe dividend expected at the end of the year 1 by the current price of theshare and adding the expected growth rate.

Example, Raj Textiles Ltd. Wishes to determine its cost of equity capital, Ke.The prevailing market price of the share is Rs. 50 per share. The firmexpects to pay a dividend of Rs. 4 at the end of the coming year 1998. Thedividends paid on the equity shares over the past six years are as follows:

Year Dividend (Rs.)1997 3.801996 3.621995 3.471994 3.331993 3.121992 2.97

The firm maintained a fixed dividend payout from 1986 onwards. The annualgrowth rate of dividends, g, is approximately 5 per cent. Substituting the datain the formula,

Rs. 50 = 0.05Ke

Rs.4

−

Ke = 50 Rs.

4Rs. + 0.05

= 0.80 + 0.05 = 13%

The 13% cost of equity share represents the return expected by existingshareholders on their investment so that they should not disinvest in the shareof Raj Textiles Ltd. And invest elsewhere.

(e) Realised Yield Method : One of the difficulties in using D/P Ratio andE/P Ratio for finding out Ke is to estimate the rate of expected return.Hence, this method depends on the rate of return actually earned by theshareholders. The most recent five to ten years are taken and the rate ofreturn is calculated for the investor who purchased the shares at thebeginning of the study period, held it to the present and sold it at thecurrent prices. This is also the realized yield by the investor. This yield issupposed to indicate the cost of equity share on the assumption that theinvestor earns what he expects to earn. The limiting factors to theusefulness of this method are the additional conditions that the investorsexpectation do not undergo change during the study period, no significantchange in the level of dividend rates occurs, and the attitudes of theinvestors towards the risk remain the same. As these conditions are rarelyfulfilled, the yield method has limited utility. In addition, the yield oftendiffers depending on the time period chosen.

(f) Security’s Beta Method : An investor is concerned with the risk of hisentire portfolio, and that the relevant risk of a particular security is theeffect that the security has on the entire portfolio. By “diversifiedportfolio” we mean that each investor’s portfolio is representative of themarket as a whole and that the portfolio Beta is 1.0. A security’s Betaindicates how closely the security’s returns move with from a diversifiedportfolio. A Beta of 1.0 for a given security means that, if the total valueof securities in the market moves up by 10 per cent, the stock’s price willalso move up, on the average by the 10 per cent. If security has a beta

13

of 2.0, its price will, on the whole, rise or fall by 20 per cent when themarket rises or falls by 10 per cent. A share with –0.5 beta will rise by10 per cent, when the market drops by 20 per cent.

A beta of any portfolio of securities is the weighted average of the betas ofthe securities, where the weights represent the proportions of investments ineach security. Adding a high beta (beta greater than 1.0) security to adiversified portfolio increases the portfolio’s risk, and adding a low beta (betaless than zero) security to a diversified security reduces the portfolio’s risk.

How is beta determined? the beta co-efficient for a security (or asset) can befound by examining security’s historical returns relative to the returns of themarket. Since, it is not feasible to take all securities, a sample of securities isused. In United States, such compilation of beta co-efficient is provided bycompanies, such as Value Line or Merill Lynch. The Capital Asset PricingModel (CAPM) uses these beta co-efficients to estimate the required rate ofreturns on the securities. The CAPM specifies that the required rate on theshare depends upon its beta. The relationship is:

Ke = riskless rate + risk premium x beta

Where, Ke = expected rate of return.

The current rate on government securities can be used as a riskless rate. Thedifference between the long-run average rate of returns between shares andgovernment securities may represent the risk premium. During 1926-1981, thiswas estimated in USA to be 6 per cent. Beta co-efficients are provided bypublished data or can be independently estimated.

The beta for Pan Am’s stock was estimated by Value Line to be 0.95 in 1984.Long-term government bond rates were about 12 per cent in November 1984.Thus the required rate of return on Pan Am’s stock in November 1984 was:

Required Rate = 12% + 6% x 0.95 = 17.7%

The use of beta to measure the cost of equity capital is definitely a betterapproach. The major reason is that the method incorporates risk analysis,which other methods do not. However, its application remains limited perhapsbecause it is tedious to calculate Beta value. Nevertheless, as the competitionintensifies and the availability of funds and their cost become a challenge,finance mangers will need this or similar approaches.

Activity 3

1. A firm has Rs. 3 EPS and 10% growth rate of earnings over a period of3 years. The current market price of equity share is Rs. 100. Compute thecost of equity capital.

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Cost of Capital


14

2. The current dividend paid by the company is Rs. 5 per share, the marketprice of the equity share is Rs. 100 and the growth rate of dividend isexpected to remain constant at 10%. Find out the cost of capital.

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3. A firm issues 8% non-redeemable preference shares of Rs. 10 each forRs. 1,00,000, underwriting costs are 6% of the sale price. Compute thecost of capital if shares are issued at discount of 2.5 percent and thepremium of 5%.

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2.3.4 Cost of Retained Earnings:

Corporate managers and some analysts normally consider the funds retained inthe firm as cost free funds because it does not cost anything to the firm tomake use of a part of its earnings not distributed to the shareholders.However, this is not true. It definitely cost the shareholders something and thisis an opportunity cost representing sacrifice of the dividend income which theshareholders would have otherwise received it and invested the same elsewhereto earn a return thereon. Thus, the minimum cost of retained earnings is thecost of equity capital (Ke).

Ezra Solomon suggested the concept of external yield to measure cost ofretained earnings.

Algebraically, the approach can be explained as:

B)(1TR)(1GP0

d1−−+

= Ke (1-TR) (1-B)

whereKe = Cost of equity capital based on dividend growth methodTR = Shareholders’ Tax RateB = Percentage Brokerage cost

ExampleA firm’s cost of equity capital is 12% and Tax rate of majority of shareholdersis 30%. Brokerage is 3%.

= 12% (1-0.30) (1-0.03)= 8.15%

2.4 WEIGHTED COST OF CAPITAL

Weighted cost of capital, also known as composite cost of capital, overall costof capital or weighted marginal cost of capital, is the average of the costs ofeach sources of funds employed by the firm, properly weighted by theproportion they hold in the capital structure of the firm.

15

2.4.1 Choice of Weights

The weights to be employed can be book values, market values, historic ortarget. Book value weights are based on the accounting values to assess theproportion of each type of fund in the firm’s capital structure. Market valueweights measure the proportion of each type of financing at its market value.Market value weights are preferred because they approximate the current valueof various instruments of raising funds employed by the company.

Historic weights can be book or market weights based on actual data. Suchweights, however, would represent actual rather than desired proportions ofvarious types of capital in the capital structure. Target weights, which can alsobe based on book or market values, reflect the desired capital structureproportions. In the firm’s historic capital structure is not much different from‘optimal’ or desired capital structure, the cost of capital is both the cases ismostly similar. However, from a strictly theoretical point of view, the targetmarket value weighting scheme should be preferred.

Marginal weights are determined on the basis of financing mix in additionalnew capital to raised for investments. The new capital raised will be themarginal capital. The propositions of new capital raised will be the marginalweights.

Activity 4

1) How is the cost of retained earnings computed?

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2) List out three types of weights which may be used for computing weightedaverage cost of capital of the firm.

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2.4.2 Computation of The Weighted Cost of Capital

Example

A firm has the following capital structure and after tax costs for the differentsources of funds used:

Source of Funds Amount Rs. Proportion % After tax cost %

Debt 20,00,000 20 4.50

Preference Shares 10,00,000 10 9.00

Equity Shares 30,00,000 30 11.00

Retained Earnings 40,00,000 40 10.00

1,00,00,000 100

Cost of Capital


16

On the basis of book value, the cost of equity capital will be calculated asfollows:

Method of Funds Proportion% Cost % Weighted cost %

Debt 20 4.50 0.90

Preference Shares 10 9.00 0.90

Equity Shares 30 11.00 3.30

Retained Earnings 40 10.00 4.00

9.10%

Example 2: Quality products is a consumer products company with well-established brand names. The cost of capital of quality products is estimatedat the end of 1996 for use in evaluating investment proposals in 1997. Thedata for Quality Products Ltd. are as follows:

Financial data for Quality Products Ltd.Rs. ‘0000

Source Book Value Rs. Market Value Rs. Current Interest rate %

Debentures (71/2%) 45 29 13.2

Debentures (91/2%) 50 42 13.2

Debentures (14%) 75 78 13.2

Other debt 210 192 13.2

Total debt 380 341 13.2

Preference shares (7%) 20 10 14.0

Equity shares 720 824

Equity Share Data Years

1991 1992 1993 1994 1995 1996

Dividend per share 1.45 1.60 1.77 2.05 2.28 2.48

Earnings per share 2.97 3.73 4.21 4.83 4.86 4.95

Price per share 24.00 50.000

Explanatory Notes

� Interest rates on the three debentures issues were set at the rate (13.2%)on the recently issued debentures of the firm which is selling close to par.This was considered to be the best estimate.

� Other debt includes different types of loans from financial institutions andother privately placed debentures.

� Market value is based on interest rates provided in the firm’s annualreport.

� Preference share is Rs. 100 par: current market price is Rs. 50 per share.

Since the firm’s dividend and earnings have been growing steadily since, 1991,the constant growth model can be used to estimate cost of equity. Thoughdividends have grown at a slightly higher rate than earnings, one may assumethat shareholders would expect them to grow at the same earnings (10.8%).Also assume, on the basis of the past record that the shareholders expect adividend of Rs. 2.60 in 1997. Thus:

17

DKe = —— + g

P

Rs. 2.60= ————— + 0.108 Rs. 50

= 16%

If the investors expect the dividends to grow at the higher rate (11.3%), thecost of equity capital works out to 16.5%.

Applying the beta method, we obtain a somewhat higher number. Beta forQuality Products is assumed to be 0.85. Interest rate on government bonds(riskless rate) in 1996 would be, say, 12 per cent. The market risk premiumis 6%.

ThusKe = Riskless rate + Risk premium x beta

= 12% + 6% x 0.85

= 17.1%

Thus, the cost of capital for Quality Products Ltd:

Amount Rs. Weight Cost Weight x Cost

Debt 341 0.29 7.1 2.1

Preference Shares 10 0.01 14.0 0.1

Equity Shares 824 0.70 17.0 11.9

Total 1175 1.00 17.0 14.9

Weighted Average Cost of Capital : 14.1%

Explanation

� Market values of debt, preference and equity shares are used.

� Current interest rate on debt is adjusted for tax rate of 46 per cent, whichis the firm’s effective rate 13.2% (1-0.46) = 7.1%

� Current preference dividend rate of 14% is used.

Activity 5

1) Compare Beta value of equity shares of any one company listed on Indianstock exchanges and list out the problems you faced in this regard.

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...................................................................................................................2) Compute overall cost of capital of an Indian company of your choice. List

out the steps you took for this purpose and the problems faced by you.

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Cost of Capital


18

3) Try to know from the Finance Manager of an Indian Company:

i) Do they compute the overall cost of capital of their company?

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ii) For what purpose?

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iii) If not, why not?

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2.5 SIGNIFICANCE OF COST OF CAPITAL

The determination of the firm’s cost of capital is important because

i) Cost of capital provides the very basis for financial appraisal of newcapital expenditure proposals and thus serves as acceptance criterion forcapital expenditure projects.

ii) Cost of capital helps the managers in determing the optimal capitalstructure of the firm.

iii) Cost of capital serves as the basis for evaluating the financial performanceof top management.

iv) Cost of capital also helps in formulating dividend policy and working capitalpolicy

v) Cost of capital can serve as capitalization rate which can be used todetermine capitalization of a new firm.

Activity 6

1) List three uses of Cost of Capital.

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2) What is Weighted Average Cost of Capital?

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19

3) The following details are available:Equity (Expected Dividend 12%) Rs. 10,00,000Tax Rate 50%10% Preference Rs. 5,00,0008% Loan Rs. 15,00,000

You are required to calculate Weighted Average Cost of Capital.

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2.6 SOME MISCONCEPTIONS ABOUT COST OFCAPITAL

The cost of capital is a central concept in financial management linking theinvestment and financing decisions. A few misconceptions in this regard are asfollows:

i) The concept of cost of capital is academic and impractical

ii) It is equal to the dividend rate.

iii) Retained earnings are either cost free or cost significantly less thanexternal equity.

iv) Depreciation has no cost.

v) The cost of capital can be defined in terms of an accounting basedmanner.

vi) If a project is heavily financed by debt, its weighted average cost ofcapital is low.

2.7 SUMMARY

The cost of capital of a firm is mainly used to evaluate investment projects. Itrepresents minimum acceptable rate of return on new investments. The basicfactors underlying the cost of capital for a firm are the degree of riskassociated with the firm, the taxes it must pay, and the supply of and demandof various types of financing.

In estimating the cost of capital, it is assumed that, (1) the firms are acquiringassets which do not change their business risk, and (2) these acquisions arefinanced in such a way as to leave the financial risk unchanged. In order toestimate the cost of capital, we must estimate rates of return requiredby investors in the firm’s securities, including borrowings, and average thoserates according to the market values of the various securities currentlyoutstanding.

While the cost of debt and preference capital is the contractual interest/dividendrate (adjusted for taxes), the cost of equity capital is difficult to estimate.Broadly, there are six approaches to estimate the cost of equity, namely, the E/P method, E/P + Growth method, D/P method, D/P + Growth method, Realisedyield method and using the Beta co-efficient of the share. Weighted cost ofcapital is computed by assigning book weights or market weight.

Cost of Capital


20

2.8 KEY WORDS

Cost of Capital is the minimum rate of return that must be earned oninvestment to maintain the value of firm.

Marginal Weights are determined on the basis of financing mix of additionalcapital.

Cost of Equity Capital is the discount rate which equates present value of allexpected dividends in future with net proceeds per share / current marketprice.

Business Risk is a possibility and the firm will not be able to operatesuccessfully in the market.

Financial Risk is the possibility that the firm will not earn sufficient profits tomake payment of interest on loans and/or to pay dividends.

2.9 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) Why is the cost of capital considered as the minimum acceptable rate ofreturn on an investment?

2) In using the cost of capital to evaluate investment projects, why is itnecessary to assume that the acceptance of projects and the financingstructure would not attract the business and financial risks?

3) How is the Cost of Debt Capital ascertained? Give examples.

4) You have just been communicated, “since we are going to finance thisproject with debt, its required rate of return should only be the cost ofdebt”. Do you agree or disagree? Explain.

5) How will you calculate the Cost of Preference Share Capital?

6) Which method of calculating the cost of equity shares would be mostappropriate for the following firms:

a) A profitable firm that has never paid a dividend, but has had steadygrowth in earnings.

b) An electricity company that has paid a dividend every year for thelast eighty years.

c) A firm that has grown very rapidly until two years ago, whencapacity problems in the industry produced severe price cutting in thefirm’s major product line. At the same time management decided toinvest heavily in facilities to manufacture a new product. So far, themanufacturing process has not worked properly. The firm lost Rs. 5crores last year, and the price of its equity share has dropped by 20per cent.

7) How would you find the cost of capital for proprietorship or partnershipfirm? Can you thing of any ways to do this? List them.

8) “Retained earnings are cost free” comment.

9) Discuss various uses of the concept of Cost of Capital.

10) Determine the cost of capital for the following securities. These areissued by different firms and the tax rate is 40 per cent.

21

a) A seven-year debenture with a coupon interest of 10 per cent. Thedebentures matures in five years and has a current market price ofRs. 90 as against its par value of Rs. 100.

b) A preference share pays 7 per cent dividend. Par value is Rs. 100per share and its current market price is Rs. 80.

c) The historical average rate of return earned by equity shareholders ofthe firm C has been about 17% per year until very recently. Thedividends of the firm have grown at an average rate of 13% per yearover the same period. The financial Express and another financialfortnightly have issued a report indicating the problems of the firmwith government’s regulatory agencies and forecasted that dividendsand earnings of the firm will grow at no more than the overall growthrate of the economy which is 5 per cent. The dividends are likely tobe Rs. per share. The price of the firm’s share adversely reacted tothe report dropping from Rs. 100 to Rs. 50.


Gitman, Lawrence J. 1985, Principles of Managerial Finance. Harper andRow Publishers, Singapore, Fourth Edition.

Schall, Lawrence D and Haley Charles W. 1986, Introduction to FinancialManagement, McGraw Hill Book Company, New York, London, New Delhi,Fourth (International Student’s) Edition.

Van Horne James W., Financial Management and Policy, Prentice Hall Inc.Englewood Cliffs, New Jersy.

Chandra, P. 1995, Fundamentals of Financial Management, Tata McGrawHill, New Delhi.

Maheshwari, S.N. 1996, Financial Management – Principles and Practices,Sultan Chan & Sons, New Delhi.

Srivastava, R.M. 2002, Financial Management, Pragati Prakashan, Meerut.(Chapter 17).

Srivastava, R.M. 2003, Financial Management and Policy, HimalayaPublishing House (Chapter 13)

2.11 ANSWERS

Activity 2

i) 4.76% ii) 4.64% iii) 5.62%

Activity 3

i) 3.99 ii) 15% iii) 8.11% and 8.73%

Activity 6

iii) 7.67%

Cost of Capital


22

Appendix 2.1: Share Valuation with Constant Growth in Dividends

Assuming so the most recent dividend, and that g is the growth rate in dividend

Do (1+g)1 Do (1+g)2 Do(1+g)a

Po = —————— + —————— + ————— …...........…. (1) (1+Ke)1 (1+Ke)2 (1+Ke) a

Multiplying each side of the equation by (1+Ke)/(1+g) and subtracting theresulting equation from (1),

Po (1+Ke) Do(1+g) a

——————— - Po = Do - —————— …………….(2) 1+g (1+Ke) a

As Ke is assumed to be greater than g, the second term on the right hand sideof (2) is zero, Thus

1+KePo (———— - 1) = Do ……………(3)

1 + g

Po (Ke – g) = Do (1 + g)

D1Po = ———— …………….(4) Ke-g

� Premium for Financial Risk : It refers to the risk arising out of patternof capitalization. In general, it may be said that a firm having a higher debtcontent in its capital structure is more risky as compared to a firm whichhas a comparatively low debt content.

Besides financial risk and business risk, the following risks also affect thecost of capital;

� Premium for Business Risk : Business risk is the possibility that thefirm will not be able to operate successfully in the market. Greater thebusiness risk, the higher will be the cost of capital. It is generallydetermined by the capital budgeting decisions.

1

UNIT 3 CAPITAL STRUCTURE DECISIONSObjectives

The objectives of this unit are to:

� define and distinguish capital structure

� explain briefly the important Characteristics of various long term sources offunds.

� dilate upon the criteria for determining pattern of capital structure.

� analyse EBIT-EPS and ROI-ROE relationship.

� examine critically theories of capital structure-decision

� identify the factors influencing capital structure decision

� evaluate the relevance of debt equity ratio in public enterprises.

Structure

3.1 Introduction

3.2 Conceptual Framework

3.3 Characteristics of Important long term sources of Funds

3.4 Criteria for determining pattern of Capital Structure

3.5 Risk and Capital Structure

3.5.1 EBIT – EPS Analysis

3.5.2 ROI – ROE Analysis

3.6 Theories of Capital Structure Decision3.6.1 Net Income Approach

3.6.2 Net Operating Income Approach

3.6.3 M-M Approach

3.6.4 Traditional Approach

3.7 Factors Influencing Pattern of Capital Structure

3.8 Relevance of Debt-equity ratio in Public enterprises

3.9 Summary

3.10 Key words

3.11 Self Assessment Questions/Exercises


3.1 INTRODUCTION

Planning the capital structure is one of the most complex areas of financialdecision making because of the inter-relationships among components of thecapital structure and also its relationship to risk, return and value of the firm.For a student of finance, the term capital usually denotes the long-term fundsof the firm. Debt capital and ownership capital are the two basic componentsof capital. Equity capital, as one of the components of capitalization, comprisesequity share capital and retained earnings. Preference share capital is anotherdistinguishing component of total capital. In this unit, characteristics of importantlong-term sources of funds, EBIT-EPS analysis, ROI-ROE analysis, factorsinfluencing capital structure, theories of capital structure decision, etc arenarrated briefly. In the end, relevance of debt-equity ratio in public enterprisesis also discussed.


2

3.2 CONCEPTUAL FRAMEWORK

According to Gerstenberg, “ capital structure refers to the make up of a firm’scapitalization”. In other words, it represents the mix of different sources oflong-term funds. E.F. Brigham defines the term as the percentage share ofeach type of capital used by the firm-Debt, preference share capital and equitycapital (equity share capital paid up plus retained earnings). According toE.W.Walker, concept of capital structure includes the following:

� The proportion of long-term loans;

� The proportion of equity capital and

� The proportion of short-term obligations

� In general, the experts in finance define the term capital structure toinclude only long-term debt and total Stockholders’ investment.

Financial structure means the composition of the entire left hand side (liabilitiesside) of the balance sheet. Financial structure refers to all the financialresources marshelled by the firm. It will include all forms of long as well asshort-term debts and equity.

Thus, practically speaking, there is no difference between the capital structure(as defined by walker) and financial structure.

In brief,

Capital structure = proportions of all types of Long-Term capitalFinancial structure = Proportions of all types of Long-Term and Short-Term capitalCapitalisation = Total Long-Term capital

3.3 CHARACTERISTICS OF IMPORTANTLONG-TERM SOURCES OF FUNDS

The four major sources of Long-Term funds in a firm are equity(or ordinary)shares preference shares, retained earnings and long term debt. Many financialanalysts and managers tend to think of preference shares as a substitute ofdebt, as the amount of dividend to be paid is fixed. The difference is that thepreference dividend, unlike debt interest, is not a tax- deductible expense. Itdoes not have a fixed maturity date. Preference shareholders have a priorclaim to receive income from the firm’s earning through dividends. Convertibledebentures have the features of both debt and equity capital.

The main focus in the discussion that follows is on deciding the mix of debtand equity which a firm should employ in order to maximize shareholderwealth. Because of the secondary position relative to debt, suppliers of equitycapital take greater risk and therefore, must be compensated with higherexpected returns. The distinguishing characteristics of debt, preference sharecapital, equity share capital and Retained Earnings are summarized in Table 3.1.

3.4 CRITERIA FOR DETERMINING PATTERN OFCAPITAL STRUCTURE

While choosing a suitable pattern of capital structure for the firm, financemanager should keep into consideration certain fundamental principles. Theseprinciples are militant to each other. A prudent finance manager strikes goldenmean among them by giving proper weightage to them.

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3.4.1 Cost Principle:

According to this principle, ideal pattern of capital structure is one that tends tominimize cost of financing and maximize the value per share. Cost of capital issubject to interest rate at which payments have to be made to suppliers offunds and tax status of such payments. Debt capital is cheaper than equitycapital from both the points of view. According to this, the use of debt capitalin the financing process is immensely helpful in raising income of the company.

3.4.2 Risk Principle:

This principle suggests that such a pattern of capital structure should be

Table 3.1: Characteritics of Long-Term Sources of Funds

Debt Preference Share Capitals Equity sharecapital

RetainedEarnings

1. Firm mustpay backmoney withinterest.

2. Interest rateis based onrisk ofPrincipal andinterestpayments asperceived bylenders

3. Amount ofmoney to berepaid isspecified bydebt contract.

4. Lenders cantake action toget theirmoney back

5. Lenders getpreferredtreatment inliquidation

6. Interestpayments aretax-deductable

1. Preference dividends are limitedin amount to rate specified inthe agreement.

2. Dividends are not legally requiredto be paid. But dividend onequity shares can not be paidunless preference shareholders arepaid dividend. Now payment ofdividend to preferenceshareholders for a number ofyears gives them the votingrights.

3. No maturity but usually callable

4. Usually no voting rights exceptas per (2) above.

5. Preference share-holders comenext, when lenders are paid inliquidation.

6. preference Dividends are not tax-deductable.

1. Money israised bysellingownershiprights.

2. Value of theshare isdeterminedby investors.

3. Dividends arenotcontractuallypayable. Nomaturity.

4. Voting rightscan createchange inownership.

5. Equityshareholdersget theresidualassetsprorata afterlenders &preferenceshareholdersclaims aremet inliquidation.

6. Equitydividends arenot tax-deductable,

1. Loweramount ofmoney forcurrentdividendsbut canincreasefuturedividends.

2. Shareholdersforgodividendincome butthey do notloseownershiprights, ifnew equityshares areissued.

3. Funds areinternal Noneed forexternalinvolvement.

4. Cost ofissuingsecurities isavoided.

5. It is relatedto dividendpolicydecisions.

Capital StructureDecisions


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designed so that the firm does not run the risk of bringing on a receivershipwith all its difficulties and losses. Risk principle places relatively greaterreliance on common stock for financing capital requirements of the corporationand forbids as far as possible the use of fixed income bearing securities.

3.4.3 Control Principle:

While designing sound capital structure for the firm and for that matterchoosing different types of securities, finance manager should also keep in mindthat controlling position of residual owners remains undisturbed. The use ofpreferred stock as also bonds offers a means of raising capital withoutjeopardizing control. Management desiring to retain control must raise fundsthrough bonds and preference capital.

3.4.4 Flexibility Principle:

According to flexibility principle, the management should strive for suchcombinations of securities that enable it to maneuver sources of funds inresponse to major changes in need for funds. Not only several alternatives areopen for assembling required funds but also bargaining position of thecorporation is strengthened while dealing with the suppliers of funds (throughbonds).

3.4.5 Timing Principle:

Timing is always important in financing more particularly in a growing concern.Maneuverability principle is sought to be adhered in choosing the types of fundsso as to enable the company to seize market opportunities and minimize cost ofraising capital and obtain substantial savings. Important point that is to be keptin mind is to make the public offering of such securities as are greatly indemand. Depending on business cycles, demand of different types of securitiesoscillates. Equity share during boom is always welcome.

Activity 1

1) What is capital structure? How is it different from financial structure?

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2) Bring out in brief, characteristics of equity share capital

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3) List out sources of long – term finance used by a company of India origin.

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4) Discuss the criteria for determining pattern of capital structure.

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3.5 RISK AND CAPITAL STRUCTURE:

A firm’s capital structure should be developed keeping in view risk focus becausethe risk affects the value of the firm. Risk can be considered in two ways:

a) The capital structure should be consistent with the business risk of thefirm, and

b) The capital structure results in a certain level of financial risk to the firm.

Business risk is the relationship between the firm’s sales and its earnings beforeinterest and taxes (EBIT). In general, the greater the firm’s operating leveragei.e. the use of fixed operating costs-the higher is the business risk. In additionto operating leverage, revenue stability and cost stability also affect the businessrisk of the firm. The revenue stability means the variability of the firm’s salesrevenues which depends on the demand and the price of the firm’s products.Cost stability refers to the relative predictability of input prices such as labourand material. The more predictable these prices are the less is the businessrisk. Business risk varies among firms. Whatever their lines of business, thebusiness risk is not affected by capital structure decisions. In fact, capitalstructure decisions are influenced by the business risk. Firms with highbusiness risks, tend to have less fixed operating costs. Let us take an exampleto illustrate the implications of business risk for capital structure decisions.

Example

Raj Cosmetics Ltd., engaged in the process of planning its capital structure, hasobtained estimates of sales and associated levels of EBIT. The salesforecasting group feels that there is a 25 percent chance that sales will be Rs.4,00,000 a 50 percent chance that sales will be Rs. 6,00,000 and 25 percentthe sales will total Rs. 8,00,000. These data are summarised Table 3.2.

Table 3.2: Estimated sales and Associated levels of EBIT

(000) .

Probability of Sales 0.25 0.50 0.25

Sales 400 600 800

-Variable operating costs (50% of Sales) 200 300 400

-Fixed Operating Costs 200 200 200

Earnings before interest and taxes (EBIT)—— —— ——

0 100 200—— —— ——

The EBIT data, i.e. Rs.0,100 or 200 thousands at probability levels of 25%,50% and 25% respectively reflect the business risk of the firm and has to betaken into consideration when designing a capital structure.

The firm’s capital structure affects the firm’s financial risk arising out of thefirm’s use of financial leverage which is reflected in the relationship betweenEBIT and EPS. The more fixed cost financing, i.e. debt and preference capitalin the firm’s capital structure, the greater is the financial risk. Suppliers offunds will raise the cost of funds if the financial risk increases . Let us takean example to illustrate this point.

Raj Cosmetics Let. Is now considering seven – alternative capital structure.Stated in terms of debt ratio) i.e. Percentage of debt in the total capital) theseare 0,10,20,30,40,50, and 60, per cent. Assume that (1) the firm has no current



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liabilities, (2) that its capital structure currently contains all equity (25,000 equityshares are outstanding at Rs. 20 par value), and (3) the total amount of capitalremains constant at Rs.5,00,000.

Table 3.3: Capital Structure Associated with Alternative Debt Ratios

Debt Ratio% Total Assests Debt (Rs. 000) Equity (Rs. 000) Equity Shares(Rs.000) 4 = 2 - 3 outstanding

(Numbers 000)1 2 3 4 = 2–3 5 = (4 4 Rs. 20)

0 500 0 500 25.00

10 500 50 450 22.50

20 500 100 400 20.00

30 500 150 350 17.50

As debt increases, the interest rate also increase with the increase in financialleverage (i.e. debt ratios). Hence the total interest on all debt also increase (assuccessive debenture issues carry higher interest rates) as shown in Table 3.4.

Table 3.4: Interest amount at Various levels of Debt

Capital Structure Debt (Rs.000) Interest Rate Interest amount% of Debt 1 (1) on all debt % (2) (Rs.000) (3 = 1*2)

0 0 0.0 0.00

10 50 9.0 4.50

20 100 9.5 9.50

30 150 10.0 15.00

40 200 11.0 22.00

50 250 13.5 33.75

60 300 15.5 49.50

3.5.1 EBIT-EPS Analysis for Capital Structure

Using the levels of EBIT in table 3.2, number of equity shares in the columns5 of table 3.3. and interest values calculated in table 3.4, the calculation ofEPS for debt ratios of 0,30, and 60 percent respectively is shown in Table 3.5.the effective tax rate is assumed to be 40 percent.

Table 3.5: Calculation of EPS for alternative Debt ratio

Probability 0.25 0.50 0.25

When Debt ration =Less Interest (Table 3.4) 0.00 100.00 200.00

0.00 0.00 0.00Earnings after taxes —— —— ——Less Taxes (0.40) 0.00 100.00 200.00

0.00 40.00 80.00Earnings after taxes —— —— ——EPS (25,000) shares (table 3.3) 0.00 60.00 120.00

0.00 2.40 4.80

When Debt ration = 30%EBIT 0.00 100.00 200.00Less Interest 15.00 15.00 15.00

—— —— ——Earnings before taxes (15.00) 85.00 185.00Less Taxes (0.40) (6.00) 34.00 74.00

—— —— ——Earnings after taxes (9.00) 51.00 111.00EPS (17,500 shares) (0.51) 2.91 6.34

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When Debt ratio = 60%EBIT 0.00 100.00 200.00Less Interest 49.50 49.50 49.0

—— —— ——Earnings before taxes (49.50) 50.50 150.50Less Taxes (0.40) (19.80) (a) 20.20 60.20

—— —— ——Earnings after taxes (29.70) 30.30 90.30EPS (10,000 Shares) 2.97 3.03 9.03

Notes: a ) It is assumed that the firm received the tax benefits from its loss inthe current period, as a result of carrying forward and setting off the lossagainst in the following periods.

Following the same procedure as in Table 3.5 we may obtain EPS for otherdebt ratios. Table 3.6 gives expected EPS at 50% probability level (to beviewed as typical level ) for seven alternative debt ratios along with theStandard deviation and co-efficient of variation of expected EPS.

Table 3.6: Expected EPS, Standard. Deviation and Co-efficient of variation of EPS at50% probability level for alternative debt ratios

Capital structure Expected EPS Standard deviation of Co-efficient ofdebt ratio (%) (Rs.) EPS (Rs.) variation

(1) (2) (2) + (1) = (3)

0 2.40 1.70 0.71

10 2.55 1.88 0.74

20 2.72 2.13 0.78

30 2.91 2.42 0.83

40 3.12 2.83 0.91

50 3.18 3.39 1.07

60 3.03 4.24 1.40

Notes: The standard deviation () represents the square root of the sum of theproduct of each deviation from the mean of expected value squared and theassociated probability of occurrence of each outcome. This is the most commonstatistical measure of assets risk.

The co-efficient of variation is calculated by dividing the standard deviation foran asset by its mean or expected value. The higher the co-efficient ofvariation, the risker is the asset.

Table 3.6 shows that as the firm’s financial leverage increases, its co-efficientof variation of EPS also increases, signifying that the higher level of risk isassociated with higher levels of financial leverage.

The relative risk of the two of the capital structures at debt ratio=0% and 60%respectively is illustrated in Figure 3.1 by showing the subjective probabilitydistribution of

EPS associated with each of them. As the expected level of EPS increase withincreasing financial leverage, the risk also increases which is reflected in therelative dispersion of each of the distributions. As the higher levels of financialEPS increase. There are chances that there will be negative EPS depending onthe probabilities of occurrence of the expected results.



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The EBIT –EPS analysis helps in choosing the capital structure whichmaximizes EPS over the expected range of EBIT. Since EBIT is one of themajor factors which affects the market value of the firm’s shares, EPS can aswell be used to measure the effect of various capital structure on shareholders’wealth. The relationship between EBIT and EPS of the firm to analyse theeffect of capital structure on results to the shareholders has been graphicallyshown in Figure 3.2 where data from Table 3.7 are used.

Table 3.7 : EBIT-EPS Coordinates (Selected Capital Structures)

Capital structure debt ratio (%) EBIT

Rs.1,00 000 Rs.2,00,000

Earnings per share

0 2.40 4.80

30 2.91 6.34

60 303 9.03

. . . . . . . . . . . . . .–5 –4 –3–2–1 0 1 2 3 4 5 6 7 8

Debt ratio

Debt ratio = 0%

Probability

Figure 3.1: A Graphic Presentation of Probability Distribution of EPS at Alternative DebtRatios.

Figures 3.2: A Graphic comparison of selected structures for Raj Cosmetics Ltd.

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. . . . . . . . . . . . . . . . . . . 0

1

2

3

4

5

6

7

8

9

10

50 100 150

EBIT (Rs. ‘000)

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Expected earnings before interest and taxes are assumed to be constantbecause only the effect of financing costs such as interest and preferencedividends on equity shareholders’ earnings is to be analysed. Thus, the businessrisk is assumed constant.

Graphically, the risk of each capital structure can be seen in the context of thefinancial break even point. (i.e. EBIT-axis intercept). Below the x-axis,negative EPS would result. The higher the financial break even point and thesteeper the slope of the capital structure line, the greater the financial risk.

The assessment of the capital structure can also be made by using ratios.With increased financial leverage, the ability of the firm to service its debtdecreases. Thus, the times Earned Interest Ratio (i.e. EBIT divided by interest)ratio also measures firm’s financial leverage and associated risk.

3.5.2 ROI-ROE Analysis

In the preceding section, we looked at the relationship between EBIT and EPS.Pursuing a similar type of analysis, we may look at the relationship betweenthe ROI and ROE for different levels of financial leverage.

Example:

Raj Ltd., which requires an investment outlay of Rs. 200 lakhs, is consideringtwo capital structures propositions:

Capital Structure X Capital Structure Y(Rs. in lakhs) (Rs. in lakhs)

Equity 200 Equity 100Debt 0 Debt 100

Tax rate = 50 percentCost of Debt = 12 percentBased on the above information, the relationship between ROI and ROE wouldbe as shown in Table 3.8.

Table 3.8: Relationship between ROI and ROE under capital structures X and Y

Particulars ROI EBIT Int. Profit Profit Tax Return onbefore tax after tax Equity

Capital Structure X 5% 10 0 10 5 5 2.5%10% 20 0 20 10 10 5.0%15% 30 0 30 15 15 7.5%20% 40 0 40 20 20 10.0%25% 50 0 50 25 25 12.5%

Capital Structure Y 5% 10 10 0 0 0 0.0%10% 20 10 10 5 5 5.0%15% 30 10 20 10 10 10.0%20% 40 10 30 15 15 15.0%25% 50 10 40 20 20 20.5%

Return on Equity is equity earnings divided by Net worth. Looking at therelationship between ROI and ROE, we find that

(1) The ROI under capital structure X is higher than the ROE under capitalstructure Y (ROI is less than the cost of Debt).

(2) The indifference value of ROI is equal to the cost of Debt.

(3) The ROE under capital structure X (ROI is more than the cost of Debt).



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Mathematically this relationship can be expressed as:ROE = [ROI + (ROI-r) D/E] (1-t)Where r = Cost of DebtD/E = Debt- Equity Ratiot = tax rate

Applying the above equation when D/E Ratio is 1, we may calculate the valueof ROE for two values of ROI namely, 15 percent and 20 percent.

ROI = 15% ROE = [15+(15-10) 1]0.5 = 10 %ROI = 20% ROE = [20+(220-10) 1]0.5 = 15%

The results are the same as we see in Table 3.8.

Activity 2

1. Leverage decision is the same as capital structure decision. Do you agree?Give one reason.

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2. Distinguish between EBIT and EPS.

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3. Collect the figures of any company and do the EBIT-EPS analysis bymaking necessary assumptions.

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4. With a real company example make ROI-ROE analysis.

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3.6 THEORIES OF CAPITAL STRUCTURE

A firm should try to maintain an optimum capital structure with a view tomaintaining financial stability. The optimum capital structure is obtained whenthe market value per equity share is the maximum. In order to achieve the goalof identifying an optimum debt-equity mix, it is necessary for the financemanager to be familiar with the basic theories underlying the capital structureof corporate enterprises.

1. N I Approach

2. NOI Approach

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3. MM Approach

4. Traditional Approach

Common assumptions of the theories of capital structure decision are asfollows:

(i) Preference share capital is merged with debt. The firm employs only debtand equity capital.

(ii) There are no corporate taxes.

(iii) EBIT is not expected to grow.

(iv) The firm’s total financing remains constant.

(v) The business risk does not change with the growth of business firm.

(vi) All investors have the same subjective probability distribution of the futureexpected earnings for a given firm.

3.6.1 Net Income (NI) Theory

According to this approach, capital structure decision is relevant to thevaluation of the firm in as much as change in the pattern of capitalizationbrings about corresponding change in the overall lost of capital and total valueof the firm. This theory, also known as fixed ke theory, was propounded byDavid Durand.

The critical assumptions of this theory are

(i) There are no corporate taxes.

(ii) The debt content does not change risk perception of the investors.

(iii) The cost of debt is less than the cost of equity.

The theory works like this.

“As the proposition of cheaper debt funds in the capital structure increases,the weighted average cost of capital decreases and approaches the cost ofdebt.

This theory recommends 100% debt financing is optimal capital structure.The following are the strengths of NoI approach:

(i) it tries to explain the effects of borrowings on overall cost of capital.

(ii) It explains and emphasizes on favourable financial leverage.

(iii) However, the theory ignores the risk consideration.

3.6.2 Net Operating Income (NoI) approach

This approach, also propounded by Durand, is just opposite of Net Income (NI)approach. According to this approach overall cost of capital and value of thefirm are independent of capital structure decision and change in degree offinancial leverage does not bring about and change in value of the firm andcost of capital.

The approach is based on the following assumptions:

(i) The overall cost of capital (kO) remains constant for all degrees of debt

equity mix or leverage.

(ii) There are no corporate taxes.

(iii) The market capitalizes the value of the firm as a whole.

(iv) The advantage of debt is set off exactly by increase in the equitycapitalization rate.



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According to the NOI Approach, the value of a firm can be determined bythe following equation;

OK

EBITV =

Where:V = Value of firm;K

O= Overall cost of capital

EBIT = Earnings before interest and tax.

Thus, according to Net Operating Income (NOI) Approach, any capitalstructure will be optimum.

The following are the strengths of NOI approach:

(i) it emphasizes on the role of NOI in the determination of total value of thefirm,

(ii) According to this theory, new investment proposals should be based onNOI approach

This theory seems to ignore the behavioral aspect of financing function ofmanagement.

3.6.3 Modigilian- Miller (MM) Theory

The Modigiliani-Miller (MM) approach is similar to the Net Operating Income(NOI) approach. It supports the NOI approach providing behaviouraljustification for the independence of the total valuation and the cost of capitalof the firm from its capital structure. In other worlds, MM approach maintainsthat the weighted average cost of capital does not change with change in thecapital structure of the firm.

The following are the three basic propositions of the MM approach:

(i) The overall cost of capital (KO) and the value of the firm (V) are

independent of the capital structure.

(ii) The cost of equity (KE) is equal to capitalization rate of a pure equitystream plus a premium for the financial risk.

(iii) The cut-off rate for investment purposes is completely independent of theway in which an investment is financed.

The MM approach is subject to the following assumptions:

1. Capital markets are perfect.

2. All firms within the same class will have the same degree of businessrisk.

3. All investors have the same expectation of a firm’s net operating income(EBIT).

4. The dividend pay-out ratio is 100%.

5. There are no corporate taxes. However, this assumption was removedlater.

The “arbitrage process” is the operational justification of MM hypothesis. Theterm ‘Arbitrage’ refers to an act of buying an asset or security in one markethaving lower price and selling it is another market at a higher price. Theconsequence of such action is that the market price of the securities of thetwo firms exactly similar in all respects except in their capital structures cannot for long remain different in different markets. Thus, arbitrage process

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restores equilibrium in value of securities. This is because in case the marketvalue of the two firms which are equal in all overvalued firm would sell theirshares, borrow additional funds on personal account and invest in theundervalued firm in order to obtain the same return on smaller investmentoutlay. The use of debt by the investor for arbitrage is termed as ‘home made’or ‘personal leverage’.

The following are limitations of MM’s theory-

(i) Rates of interest are not the same for the individuals and the firms.

(ii) Transactional costs are involved.

(iii) Home made leverage is not perfect substitute for corporate leverage.

(iv) The effectiveness of arbitrage process is limited.

Since corporate taxes do exist, MM agreed in 1963 that the value of the firmwill increase and overall cost of capital will deciline because of tax deductabilityof interest payments. A levered firm should have, therefore, a greater marketvalue as compared to an unlevered firm. The value of the levered firm wouldexceed that of the unlevered frim by an amount equal to the levered firm’sdebt multiplied by the tax rate. The formula is-

Vi = Vu + BtWhere :Vi = Value of levered firmVu = Value of an unlevered firmB = Amount of Debt andt = Tax rate

3.6.4 Traditional Approach

The traditional theory assumes changes in Ke at different levels of debt equityrate. It is the middle of the two extremes of NI and NOI.

Beyond a particular point of debt-equity mix, ke rises at an increasing rate.There are three stages:-

Stage I – Introduction of debt-Net Income rises; cost of equity capital risesbecause of risk but less than earnings rate leading to decline inoverall cost of capital and increase in Market value.

Stage II – Further Application of debt: cost of equity capital rises-net income– debt cost increases – value same.

Stage III – Further Application of debt – cost of equity capital is very high –value goes down.

Example

Raj Cosmetics Ltd. has estimated the following rates of return (Column (3) ofthe Table 3.9. Table 3.9 also gives the seven capital structures from thedebt ratios ranging from 0% to 60% and expected EPS in Rs. (from Table3.6).

From these data, it is possible to work out the expected share values in eachof the alternative capital structures. Calculations are set out in column 4 of theTable 3.9.



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Table 3.9: Calculation of Share Value Estimate Associated with Alternative CapitalStructures for Raj Cosmestics Ltd.

Capital structure Expected EPS Estimated required Estimated Sharedebt ratio (%) (Rs.) (From rate of return Esti. Value (Rs.)

Table 3.6) by the Co.)(1) (2) (3) (4)

0 2.40 0.115 20.8710 2.55 0.117 21.7920 2.72 0.121 22.4830 2.91 0.125 23.2840 3.12 0.140 22.2950 3.18 0.165 19.2760 3.03 0.190 15.95

Table 3.9 shows that the maximum share value occurs at the capital structureassociated with the debt ratio of 30%. This is the optimal capital structure. Itis noticeable that EPS is maximized at 50% debt ratio, while the share valueis maximized at 30% debt ratio. This discrepancy arises because EPSmaximization approach does not consider the risk as reflected in required ratesof return.

In addition to the analysis of the EBIT-EPS, required rates of returns and sharevalue, certain other factors are also taken into account in determining thecapital structure for the firm. These are listed below:

� Adequacy of cash flow to service debt and preference shares

� Having stable and predictable revenues

� Limitations imposed by previous contractual obligations

� Management Preference and attitudes towards risk

� Assessment of the firm’s risk by financial institutions and other agencies

� Capital market conditions and investor preferences

� Considerations of corporate control.

Activity 3

1) In what manner are the corporate taxes relevant to capital structuredecision?

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2) Contrast traditional and M-M position regarding optimal capital structure.

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3) Name of single most important factor which determines the capitalstructure of a company.

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4) Try to know from Finance Manager of any two companies:

i) What is their present capital structure?

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ii) What are the factors which determine their capital structure?

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iii) Do they intend to change their capital structure in the near future ?why?

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5) Show arbitrage process with an example.

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3.7 FACTORS INFLUENCING PATTERN OFCAPITAL STRUCTURE

Following are the major factors which should be kept in view while determiningthe capital structure of a company:

(1) Size of Business

Smaller firms confront tremendous problems in assembling funds because oftheir poor creditworthiness. Investors feel loath in investing their money insecurities of these firms. Lenders prescribe highly restrictive terms in lending.In view of this, special attention should be paid to maneuverability principle.This is why common stock represents major portion of this capital in smallerconcerns. Larger concerns have to employe different types of securities toprocure desired amount of funds of reasonable cost because they find it verydifficult to raise capital at reasonable cost of demand for funds is restricted toa single source.

(2) Form of Business Organisation

Control principle should be given higher weightage in private limited companieswhere ownership is closely held in a few hands. This may not be so imminentin the case of public limited commanies whose shareholders are large innumber. In proprietorship or partnership form of organisation, control isundoubtedly an important consideration because control is concentrated in aproprietor or a few partners.



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(3) Nature of Enterprise

Business enterprises which have stability in their earnings or which enjoymonopoly regarding their products may go for debentures or preference sharessince they will have adequate profits to meet the recurring cost of interest/fixeddividend. This is true in case of public utility concerns. On the other hand,companies which do not have this advantage should rely on equity share capitalto a greater extent for raising their funds. This is, particularly, true in case ofmanufacturing enterprises.

(4) Stability of earnings

With greater stability in sales and earnings a company can insist on the fixedobligation debt with less risk. But a company with irregular income will notchoose to burden itself with fixed charge. Such company should dependupon the sale of stock to raise capital.

(5) Age of Company

Younger companies generally find it difficult to raise capital in the initial yearsbecause of greater uncertainty involved in them and also because they are notknown to suppliers of funds. It would therefore, be worthwhile for suchcompanies accord to higher weightage to maneuverability factor. In a sharpercontrast to this, established companies with good earnings record are always incomfortable position to raise capital from whatever sources they like. Leverageprinciple should be insisted upon in such concerns.

(6) Purpose of Financing

In case funds are required for some directly productive purposes the companycan afford to raise the funds by issue of debentures. On the other hand, ifthe funds are required for non-productive purposes, providing more welfarefacilities to the employees the company should raise the funds by issue ofequity shares.

(7) Market Sentiments

Times of boom investors generally want to have absolute safety. In such cases,it will be appropriate to raise funds by issue of debentures. At other periods,people may be interested in earnings high speculative incomes; at such times, itwill be appropriate to raise funds by issue of equity shares.

(8) Credit Standing

A company with high credit standing has greater ability to adjust sources offunds upwards or downwards in response to major changes in need for fundsthan one with poor credit standing. In the former case the management shouldpay greater attention to maneuverability factor.

(9) Period of Finance

The period for which finance is required also affects the determination ofcapital structure of companies. In case, funds are required, say, for 5 to 10years, it will be appropriate to raise them by issue of debentures. However, ifthe funds are required more or less permanently, it will be appropriate to raisethem by issue of equity shares.

(10) Legal Requirements

Companies Act, Banking Co. Act etc. influence the capital structureconsiderations. The relative weightage assigned to each of these factors willvery widely from company to company depending upon the characteristics ofthe company, the general economic conditions and the circumstances under

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which the company is operating. Companies issue debentures and preferenceshares to enlarge the earnings on equity shares, while equity shares are issuedto serve as a cushion to absorb the shocks of business cycles and to affordflexibility. Of course, greater the operating risk, the less debt the firm can use,hence, in spite of the fact that the debt is cheaper the company should use itwith caution.

(11) Tax Considerations

The existing taxation provision makes debt more advantageous in relation tostock capital in as much as interest on bonds is a tax deductible expensewhereas dividend is subject to tax. In view of prevailing corporate tax rates inIndia, the management would wish to raise degree of financial leverage byplacing greater reliance on borrowing.

3.8 RELEVANCE OF DEBT – EQUITY RATIO INPUBLIC ENTERPRISES

It is generally argued that the practical significance of the debt-equity ratio islimited in the case of public enterprises in many countries because most of theloans are derived from the government itself or from public sector financialinstitutions. The government as the owner as well as the lender, has access toall the information it needs about the financial health of the enterprise and doesnot need to refer to any favourable ratio to derive confidence before makingloans to it. Even when the public enterprises are allowed to borrow fromprivate banks or from foreign financial institutions, there is a governmentguarantee in one from or another that the loans will be removed and lightenedby adoption of an appropriate policy measures.

Since all this has the effect of making institutional arrangements for sharing riskand thus reducing the disadvantages of debt, a case could be made forjustifying higher debt-equity ratios for public enterprises. A few observations inthis regard are made as under :

(a) Since not all of the public enterprise are wholly owned and financed(through loans) by government and there are many joint ventures, so thatinstitutional arrangements for diluting risks are not always available to theseenterprises, it has to be appreciated that in real life, public enterprises haveto face the bias of the lending agencies (local or foreign) towards thismeasure of the strength of their capital structure.

(b) In most of the countries public enterprises ministries e.g. planning andfinance, for a critical scrutiny and appraisal of their proposals. In anycase, the government owned financial institutions can be should beexpected to raise points also at the risk of further lending to an enterprise,the debt-equity ratio of whose capital structure is not in line with thenormal or which does not appear to be quite sound in context of itsfinancial prospects. Many of the worthwhile plans of investment in publicenterprises, whether for replacement and rehabilitation of existing assets orfor expansion and diversification, require significant amounts of foreignexchange. If these resources are arranged from foreign lending agencieslike the world Bank/IDA, the creditors make it a point to specifyadherence to a range of ‘healthy’ debt-equity ratios (and also to aconservative dividend disbursement policy) till their loans are repaid.

(c) It is also desirable from the enterprise’s own point of view to see that asufficiently high proportion of equity is maintained in its capital structurebecause it should enable it some freedom of action in the matter ofretaining its earnings for its “self-financed” projects or for financing a part



18

of its working capital, provided, of course, that it is in the happy position ofmaking profits. In the case of other enterprises which operate at a loss(whether because of government imposed pricing policies or because oftheir inefficiencies), there is usually a demand for concerting at least a partof their loan capital into equity capital. When such proposals are beingformulated and examined, the question of a reasonable or proper debt-equityratio for the type of enterprises under consideration is raised sooner or later.

(d) With an inappropriately high debt-equity ratio, the initial cost of a project/manufacturing facility put up by a public enterprise has the effect ofincreasing the fixed costs of operation through the capitalization of interestduring construction. This is likely to place the enterprise in adisadvantageous position vis-à-vis its competitions and can lead to a viciouscycle of accumulation of losses, under utilization of capacity, low morale ofworkers and management inefficiencies, short-term (and strategicallyunsuitable) solutions and further losses. Having once been trapped in thissituation, it is difficult indeed for the enterprise to extricate itself andrehabilitate its capital structure, particularly when the Governmentdepartments ministries are not very prompt in analyzing the causes of theseproblems and providing the requisite relief’s.

(e) There cannot be must argument with the proposition that, in long run, theequity portion of a public enterprise must not be regarded as a device ofcash convenience and as a no-cost input, because it certainly has anopportunity cost for the economy as a whole. Public enterprises have, as ageneral rule, to operate under pricing and operating policies dictated bytheir owner governments socio-economic (and political) objectives. Debt-equity ratio is one device by which the enterprise can be considered tohave been compensated for its expenses/losses on meeting these additionalobligations.

(f) If a certain range of debt-equity ratios is adopted for enterprise in aparticular sector of the economy, it can result in fixing a concessional rateof interest/return on the capital mix (loan at market rate plus equity at zeropercent).

It may, thus, be concluded that the view that the practical significance of thedebt-equity ratio is limited in the case of public enterprise is not based on acomplete appreciation of all the factors in which these enterprises have tooperate in many developing countries. While the private sector analogy in thisrespect may have to be qualified suitably when applied to the public enterprisesituation in a particular country, it will remain a useful indicator, both with theadministrative ministers and with the enterprise managements, to assess thestrength of their capital structures.

Activity 4

1) Bring out five factors that influence capital structure.

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2) “Debt Equity Ratio is not relevant for public enterprises” Comment.

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3.9 SUMMARY

A firm’s capital structure is determined by the mix of long-term debt and equityit uses in financing its operations. Financial structure means the composition ofthe entire left hand side of the balance sheet. The basic differences in debt(including preference shares) and equity capital are in respect of the votingrights, the claims on income and assets, and the tax treatment. Timing,flexibility, cost, risk and control principles are the criteria for determining patterof capital structure.

A firm’s capital structure should be consistent with its business risk and resultin an acceptable financial risk. The EBIT-EPS analysis can be used to evaluatevarious capital structure in the light of the degree of financial risk and thereturns to the equity shareholders. The EBIT-EPS analysis shows how thedesirable capital structure gives the maximum EPS.

The mathematical relationship between ROI is

[(ROE + ROI – r) D/E] (1-t)

NI and NOI theories of capital structures are extreme. The MM analysissuggests that the optimal capital structure does not matter and that as muchdebt as possible should be used because the interest is tax-deductible. The MMhypothesis is criticized because of its unreal assumptions. Tax adjustment makesit more realistic.

The traditional approach to capital structure indicates that the optimal capitalstructure for the firm is one in which the overall cost of capital is minimizedand the share value is maximized.

The cost of debt increases beyong a certain level of leverage.

Certain qualitative considerations such as cash flow, corporate control,contractual obligations, management’s risk tolerance, etc. are taken intoconsideration while determining the capital structure.

The practical significance of Debt-Equity ratio for public enterprises is limitedand has different perspectives.

3.10 KEYWORDS

Capital Structure is the proportions of all types of long-term capital. FinancialStructure is the proportions of all types of long-term and short-term capital.

EBIT = Earnings before Interest and taxes.EPS = Earnings per shareNI Approach says more usage of debt will enhance the value of the firm.

NOI Approach says that the total value of the firm remains constantirrespective of the debt-equity mix. Arbitrage refers to an act of buying asecurity in one market having lower price and selling it in another market at ahigher price. The consequence of such action is that the market price of thesecurities will become the same.



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3.11 SELF ASSESSMENT QUESTIONS/EXERCISES

1. What is a firm’s capital structure? How is it different from financialstructure?

2. Under the traditional approach to capital structure, what happens to thecost of debt and cost of equity as the firm’s financial leverage increases?

3. Explain ROI-ROE analysis.

4. Explain the EBIT-EPS approach to the capital structure. Are maximizingvalue and maximizing EPS the same?

5. Khosla Ltd. had made the following forecast of sales, with theassociated probability of occurrence.

Sales Rs. Probability2,00,000 0.203,00,000 0.604,00,000 0.20

The company has fixed operating costs of Rs.1,00,000 per year and variableoperating costs represent 40% of sales. The existing capital structure consistsof 25,000 equity shares of Rs. 10 each. The market place has assigned thefollowing discount rates to risky earnings per share.

Co-efficient of variation of EPS Estimated Required Returns %.43 15.47 16.51 17.56 18.60 22.64 24

The company is considering changing its capital structure by increasing debt inthe capital structure vis-à-vis capital. Different debt ratios are considered, givenhere with the estimate of the required interest rate on all debt.

Debt Ratio Interest on all debt20% 10%40% 12%60% 14%

The tax rate is 40% percent.

a) Calculate the expected earnings per share, the standard deviation ofEPS and the co-efficient of variation of EPS for the three proposedcapital structures.

b) Determine the optimal capital structure, assuming (i) maximization ofePS and (ii) maximization of share value.

c) Construct a graph showing relationship in (b).

6. Critically examine various theories of capital structure.

7. Narrate the factors influencing capital structure.

8. Explain the criteria for determining pattern of capital structure.

9. Discuss the relevance of debt-equity ratio for Indian Public Enterprises.

10. Assume the figures of an Indian company and examine the relevance ofMM’s theory of capital structure.

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Dani, Hemant R. 1973, Balance Sheets and How to Read Them. Hemant R.Dani, Bombay,

Gitman Lawerence J. 1985, Principles of Managerial Finance Fourth Edition.Haper & Row Publishers, Singapore, New York.

Schall Lawerence D & Haley Charles W. 1986, Introduction to FinancialManagement Fourth (International student) edition, Mc-Graw Hill Book Co.,New York.

Srivastava, R,M,, 2002 Financial Management, Pragati Prakash, Meerut.

Srivastava R.M. 2003 Financial Management and Pragati HimalayaPublishing Housing Mumbai.

Chandra, P., 1995 Fundamentals of Financial Management Tata McGraw,New delhi.

Maheshwari, S.N., 1993 Financial Management Sultan chand & Sons.

Upadhyaya, K.M., 1985 Financial Management Kalyani Publishers, Ludhiana.

Pendey, I.M., 1993 Financial Management.


1

UNIT 4 PROJECT PLANNINGObjectives

The objectives of this unit are:

� to provide an understanding of nature and types of projects,

� to throw light on project life cycle,

� to explain how project work is planned.

Structure

4.1 Introduction

4.2 Nature of a Project

4.3 Classification of Projects

4.4 The Project Life Cycle

4.5 Project Management Defined

4.6 Planning Project Work

4.6.1 Initial Project Coordination

4.6.2 System Integration

4.6.3 Sorting Out the Project

4.6.4 The Work Breakdown Structure and Linear Responsibility Charts

4.7 Summary

4.8 Self-Assessment Questions


4.1 INTRODUCTION

Effective management of projects is key to the progress of an economybecause development itself is the outcome of a series successfully managedprojects. This is why project management is receiving greater attention indeveloping countries like ours, so as to avoid project schedule slippages andcost overruns, a project needs to be meticulously planned, effectivelyimplemented and professionally managed in order to accomplish the objectivesof time, cost and performance. This demands fairly good understanding ofnature and types of projects, project life cycle and concept of projectmanagement.

4.2 NATURE OF A PROJECT

The term ‘project’ has a wider meaning to include a set of activities. Forexample, construction of a house is a project. It includes many activities likedigging of foundation pits, construction of foundations, construction of walls,construction of roof, fixing of doors and windows, fixing of sanitary fitting,wiring etc. Further, project is the non-routine nature of activities.

In fact, a project is an organized programme of pre-determined group ofactivities that are non-routine in nature and that must be completed within thegiven time limit. It is a non-routine, non-repetitive, one-off undertaking, normallywith discrete time, financial and technical performance goals.

The distinguishing features of a project are :

� Purpose: A project is usually a one-time activity with a well-defined set ofdesired end results. It can be divided into subtasks that must beaccomplished in order to achieve the project goals. The project is complex

Investment DecisionsUnder Certainty

2

enough that the subtasks require careful coordination and control in terms oftiming, precedence, cost, and performance. The project itself must often becoordinated with other projects being carried out by the same parentorganization.

� Life Cycle : Like organic entites, projects have a life cycle. From a slowbeginning they progress to a buildup of size, then peak, begin a decline, andfinally must be terminated. (Also like other organic entities, they often resisttermination.) Some projects end by being phased into the normal, ongoingoperations of the parent organization.

� Single Entity : A project is one entity and is normally entrusted in oneresponsibility centre while the participants in the project are many.

� Interdependencies : Projects often interact with other projects carried outsimultaneously by their parent organization; but projects always interact withthe parent’s standard, ongoing operations. While the functional departmentsof an organization (marketing, finance, manufacturing, and the like) interactwith one another in regular, patterned ways, the patterns of interactionbetween projects and these departments tend to be changing. Marketing maybe involved at the beginning and end of a project, but not in the middle.Manufacturing may have major involvement throughout. Finance is ofteninvolved at the beginning and accounting (the controller) at the end, as wellas at periodic reporting times. The project manager must keep all theseinteractions clear and maintain the appropriate interrelationships with allexternal groups.

� Uniqueness : Every project has some elements that are unique. No twoconstruction or R&D projects are precisely alike. Though it is clear thatconstruction projects are usually more routine than research and developmentprojects, some degree of customization is a distinct feature of a project. Inaddition to the presence of risk, as noted above, a project may be unique innature, which can not be completely reduced to routine. The projectmanager’s importance is emphasized because, as a devotee of managementby exception, the manager will find there are a great many exceptions tomanage by.

� Complexity : A rich project represents complex set of activities pertainingto diverse areas. Technology survey, choice of the appropriate technology,procuring the appropriate machinery and equipment, hiring the right kind ofpeople, arranging the financial resources, execution of the projects in time byproper scheduling of various activities contribute to the complexity of theproject.

� Team Work : Successful completion of a project calls for teamwork. Theteam is constituted of members who are specialists in relevant fields.

� Risk and Uncertainty : Risk and uncertainty are inherent in every project.However, degree of risk and uncertainty will depend on how a projectpasses through its various life cycle phases.

� Customer Specific : A project has always to be customer specific so as tocater to the needs of customers. As such, the organization should go forprojects that are suited to customers.

4.3 CLASSIFICATION OF PROJECTS

Much of what project will comprise and consequently its management dependsessentially on the category it belongs to. Projects can be categorized accordingto type of activity, location, time, ownership, size and need.

� According to Type of Activity : Under this category, projects can beclassified as industrial and non-industrial projects Industrial projects are setup for the production of some goods. Non-Industrial projects comprise

3

health care projects, educational projects, irrigation projects, soil conservationprojects, highway projects etc.

� According to Location : Location wise, projects can be categorized asnational and international projects. National projects are those set up in thenational boundaries of a country, while international projects are set up bythe government of private sector across the globe.

� According to Completion Time : Projects under this category can bedivided into two types, viz; normal and crash projects. In case of normalprojects there is no time constraint. Crash projects are those which are tobe completed within a stipulated time, even at the cost of ending up with ahigher project cost.

� According to Ownership : Projects under this category can be groupedinto public, private and joint sector projects. Public sector projects areowned by the Government. In private sector projects ownership is in thehands of the project promoters and investors. Joint sector projects arethose in which ownership is shared by the Government and privateentrepreneurs.

� According to Size : Based on size, there may be three categories ofprojects, viz; small, medium and large. As per the present guideline of theGovernment, projects with investment on plant and machinery upto Rs. 1crore are classified as small and those with investment in plant andmachinery above Rs. 100 crores are categorized as large scale projects.Those with investment limit between these groups are medium scale projects.

� According to Need : Based on the need for the project, projects can beclassified as new balancing, expansion, modernization, replacement,diversification, backward integration and forward integration projects.

4.4 THE PROJECT LIFE CYCLE

Most projects go through similar stages on the path from origin to completion.We define these stages, as shown in Figure 4.1, as the project’s life cycle. Theprojec is born (its start-up phase) and a manager is selected, the project teamand initial resources are assembled, and the work program is organized. Thework gets under way and momentum quickly builds. Progress is made. Thiscontinues until the end is in sight. But completing the final tasks seems to takean inordinate amount of time, partly because there are often a number of partsthat must come together and partly because team members “drag their feet”for various reasons and avoid the final steps.

Figure 4.1: The Project Cycle

100

0

Slow finish

Quick momentum

Slow start

Time

% P

roje

ct c

ompe

titi

on

Project Planning


4

The pattern of slow-rapid-slow progress toward the project goal is common.Anyone who has watched the construction of a home or building has observedthis phenomenon. For the most part, it is a result of the changing levels ofresources used during the successive stages of the life cycle. Figure 4.2 depictsproject effort, usually in terms of man-hours or resouces expended per unit oftime (or number of people working on the project) plotted against time, wheretime is broken up into the several phases of project life. Minimal effort isrequired at the beginning-when the project concept is being developed and isbeing subjected to project selection processes.

If this hurdle is passed, activity rate increases as planning is done, and the realwork of the project gets under way. This rises to a peak and then begins totaper off as the poject nears completion, finally ceasing when evaluation iscomplete and the project is terminated. In some cases, the effort may neverfall to zero because the project team, or at least a cadre group, may bemaintained for the next appropriate project that comes along. The new projectwill then emerge.

The ever-present goals of performance, time, and cost are the majorconsiderations throughout the project’s life cycle. Early in the life cycle,performance takes precedence. Team members focus on how to achieve theproject’s performance goals. We refer to the specific methods adopted to reachthese goals as the project’s technology because these methods require theapplication of a science or art.

When the major “how” problems are solved, project workers sometimes getpreoccupied with improving performance, often beyond the levels required bythe original specifications. This search for additional performance delays theschedule and pushes up the costs.

The middle stages of the life cycle are typified by a growing concern with costcontrol. During the latter stages of the life cycle, focus of attention is on time.With projects nearing completion, there tends to be more flexibility in cost andefforts are directed towards bringing things into conformity with the approvedschedule-as much as possible, even if it means cost penalties.

It would be a great source of comfort if one could predict with certainty, at thestart of a project, how the performance time, and cost goals would be met. In

Lev

el o

f ef

fort

Conception Selection

Planning, scheduling,Monitoring, control

Evaluation &termination

Time

Peak effort level

Figure 4.2: Time distribution of project effort

5

a few cases, for example routine construction projects, we can generatereasonably accurate predictions, but often we cannot. There may beconsiderable uncertainty about our ability to meet project goals. Thecrosshatched portion of Figure 4.2 illustrates this uncertainty.

Activity 1

a) Identify activities that constitute a project

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b) List out five national projects

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c) List out five international projects

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d) List out four stages of a national project.

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e) Identify four major elements that constitute an international project plan.

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4.5 PROJECT MANAGEMENT DEFINED

Project management is the process of identifying project opportunities,formulating profitable project profiles, procuring funds for project implementation,scheduling of project activities in such a way as to complete the project withinthe minimum possible time/cost, and monitoring of the project after itsimplementation.

Defining what is to be done and ensuring that it is done and performed asdesired within time and cost budgets fixed for it through a modular workapproach, using organizational and extra-organizational resources is what projectmanagement has to achieve.

Project Planning


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4.6 PLANNING PROJECT WORK

Project planning as represents a set of six planning sequences. First comespreliminary coordination where the various parties involved in the project gettogether and make preliminary decisions about what will be achieved (projectobjectives) and by whom. These preliminary plans serve as the basis for adetailed description of the various tasks that must be undertaken andaccomplished in order to acieve the objectives of the project. In addition, thevery act of engaging in the preliminary planning process increases themembers’ commitment to the project.

These work plans are used for the third and fourth sequences, deriving theproject budget and schedule. Both the budget and the schedule directly reflectthe detail (or lack of it) in the project work plan, the detail description ofprojects tasks. The fifth planning sequence is a precise-description of all projectstatus reports, when they are to be produced, what they must contain, and towhom they will be sent. Finally, plans must be developed that deal with projecttermination, explaining in advance how the project pieces will be redistributedonce its purpose has been completed.

But before we begin, we assume that the purpose of planning is to facilitateaccomplishment of its objectives. The world is full of plans that never becomedeeds. The planning techniques covered here are intended to smooth the pathfrom idea to accomplishment. It is a complicated process to manage a project,and plans act as a map of this process. The map must have sufficient detail todetermine what must be done next but be simple enough that workers are notlost in a welter of minutiae.

4.6.1 Initial Project Coordination

It is a crucial that the project’s objectives be clearly tied to the overall visionand mission of the firm. Senior management should define the firm’s intent inundertaking the project, outline the scope of the project, and describe theproject’s desired end results. Without a clear beginning, project planning caneasily go astray. It is also vital that a senior manager should call an initialcoordinating meeting and be present as a visible symbol of top management’scommitment to the project.

At the meeting, the project is discussed in sufficient detail the potentialcontributors develop a general understanding of what is needed. If the projectis one of many similar projects, the meeting will be quite short and routine, asort of “touching base” with other interested units. If the project is unqiue inmost of its aspects, extensive discussion may be required.

Whatever be the process, the outcome must be that : (1) technical objectivesare established (though perhaps not “cast in concrete”), (2) basic areas ofperformance responsibility are accepted by the participants, and (3) sometentative schedules and budgets are spelt out. Each individual/unit acceptingresponsibility for a portion of the project should agree to deliver; by the nextproject meeting a preliminary but detailed, plan about how that responsibility willbe accomplished. Such plans should contain descriptions of the required tasks,budgets, and schedules.

These plans are then reviewed by the group and combined into a compositeproject plan. The composite plan, still not completely firm, is approved by eachparticipating group, by the project manager, and then by senior organizationalmanagement. Each subsequent approval “hardens” the plan somewhat, andwhen senior management has endorsed it, any further changes must be made

7

by processing a formal change order. However, if the project is not large orcomplex, informal written memoranda can substitute for the change order. Themain point is that no significant changes in the project are made, withoutwritten notice, following top management’s approval. The definition of“significant” depends on the specific situation and the people involved.

Project Plan Elements

Given the project plan, approvals really amount to a series of authorizations.The project manager is authorized to direct activities, spend monies (usuallywithin preset limits), request resources and personnel, and start the project onits way to completion. Senior management’s approval not only signals itswillingness to fund and support the project, it also notifies sub-units in theorganization that they may commit resources to the project.

The process of developing the project plan varies from organization toorganization, but any project plan must contain the following elements:

Overview: This is a short summary of the objectives and scope of the project.It is directed to top management and contains a statement of the goals of theproject, a brief explanation of their relationship to the firm’s objectives, adescription of the managerial structure that will be used for the project, and alist of the major milestones in the project schedule.

Objectives: This contains a more detailed statement of the general goals notedin the overview section. The statement should include profit and competitiveaims as well as technical goals.

General Approach: This section describes both the managerial and thetechnical approaches to the work. The technical discussion describes therelationship of the project to available technologies. For example, it might notethat this project is an extension of work done by the company for an earlierproject. The subsection on the managerial approach takes note of any deviationfrom routine procedure, for instance, the use of subcontactors for some parts ofthe work.

Contractual Aspects: This critical section of the plan includes a complete listand description of all reporting requirements, customer-supplied resources, liaisonarrangements, advisory committees project review and cancellation procedures,proprietary requirements, any specific management agreements (eg., use ofsubcontractors), as well as the technical deliverables and their specifications anddelivery schedule. Completeness is a necessity in this section. If in doubt aboutwhether an item should be included or not, the wise planner will include it.

Schedules : This section outlines the various schedules and lists all milestoneevents. The estimated time for each task should be obtained from those whowill do the work. The project master schedule is constructed from these inputs.The responsible person or department head should sign off on the final, agreed-on schedule.

Resources: There are two primary aspects to this section. The first is thebudget. Both capital and expense requirements are detailed by task, whichmakes this a project budget. One-time costs are separated from recurringproject costs. Second, cost monitoring and control procedures should bedescribed. In addition to the usual routine cost elements, the monitoring andcontrol procedures must be designed to cover special resource requirements forthe project, such as special machines, test equipment, laboratory usage orconstruction, logistics, field facilities and special materials.

Project Planning


8

Personnel : This section lists the expected personnel requirements of theproject. Special skills, types of training needed, possible recruiting problems,legal or policy restrictions on work-force composition, and any other specialrequirements, such as security clearances, should be noted here. It is helpful toindex personnel needed for the project schedule. This makes clear when thevarious types of contributors are needed and in what numbers. Thesemanpower projections are important element of the budget, so the personnel,schedule, and resources sections can be cross-checked with one another toensure consistency.

Evaluation Methods : Every project should be evaluated against standardsand by methods established at the project’s inception. This section contains abrief description of the procedure to be followed in monitoring, collecting,storing, and evaluating the history of the project.

Potential Problems: Sometimes it is difficult to convince planners to make aserious attempt to anticipate potential difficulties. One or more such possibledisasters as subcontractor’s default, technical failure, strikes, bad weather,sudden required breakthroughs, critical sequences of tasks, tight deadlines,resource limitations, complex coordination requirements, insufficient authority insome areas, and new, complex, or unfamiliar tasks are certain to occur. Theonly uncertainties are which ones will occur and when. In fact, the timing ofthese disasters is not random. There are times, conditions, and events in the lifeof every project when progress depends on subcontractors, or the weather, orcoordination, or resource availability, and plans to deal with unfavourablecontingencies should be developed early in the project’s life cycle. SomeProject managers disdain this section of the plan on the grounds that crises cannot be predicted. Further, they claim to be very effective “fire fighters.” It isquite possible that when one finds such a Project manager, one has discoveredan “arsonist.” No amount of current planning can solve the current crisis, butpre planning may avert some.

These are the elements that constitute the project plan and are the basis for amore detailed planning of the budgets, schedules, work plan, and generalmanagement of the project. Once this basic plan is fully developed andapproved, it is disseminated to all interested parties.

4.6.2 Systems Integration

System integration (sometimes called systems engineering) plays a crucial rolein the performance aspect of the project. We are using this phrase to includeany technical specialist in the science or art of the project who is capable ofperforming the role of integrating the technical disciplines to achieve thecustomer’s objectives. As such, systems integration is concerned with threemajor objectives.

� Performance: Performance is what a system does. It includes systemdesign, reliability, maintainability, and reparability. Obviously, these are notseparate, independent elements of the system, but are highly interrelatedqualities. Any of these system performance characteristics is subject toover-design as well as undersign but must fall within the design parametersestablished by the client. If the client approves, we may give the clientmore than the specifications require simply because we have alreadydesigned to some capability, and giving the client an overdesigned system isfaster and less expensive than delivering precisely to specification. Attimes, the aesthetic qualities of a system may be specified, typicallythrough a requirement that the appearance of the system must beacceptable to the client.

9

� Effectiveness: The objective is to design the individual components of asystem to achieve the desired performance in a optimal manner. This isaccomplished throught the following guideline: Require no componentperformance specification unless necessary to meet one or more systemsrequirements. Every component requirement should be traceable to one ormore systems requirements. Design components to optimize systemperformance, not the performance of a subsystem.

� Cost: Systems integration considers cost to be a design parameter, andcosts can be accumulated in several areas. Added design cost may lead todecreased component cost, leaving performance and effectivenessotherwise unchanged. Added design cost may yield decreased productioncost, and production cost may be trade-off against unit cost for materials.Value engineering examines all these cost trade-offs and is an importantaspect of systems integration. It can be used in any project where therelevant cost trade-offs can be estimated. It is simply the consistent andthorough use of cost/effectiveness analysis. For an application of valueengineering techniques applied to disease control projects.

Systems integrations plays a major role in the success or failure of any project.If a risky approach is taken by system integration, it may delay the project. Ifthe approach is too conservative, we forego opportunities for enhanced projectcapabilities or advantageous project economics. A good design will take allthese trade-offs into account in the initial stages of the technical approach. Andit will avoid locking the project into a rigid solution with little flexibility oradaptability in case problems occur later on or changes in the environmentdemand changes in project performance or effectiveness.

4.6.3 Sorting Out the Project

In order to ensure a successful completion of a Project we need to knowexactly what is to be done, by whom, and when. All activities required tocomplete the project must be precisely delineated and coordinated. Thenecessary resources must be available when and where they are needed, andin the correct amounts. Some activities must be done sequentially, but somemay be done simultaneously. If a large project is to come in on time and withincost, a great many things must happen when and how they are supposed tohappen. In this section, we propose a simple method to assist in sorting out andplanning all this detail.

To accomplish any specified project, there are several major activities that mustbe completed. First, list them in the general order in which they would normallyoccur. A reasonable number of major activities might be anywhere betweentwo and twenty. Break each of these major activities into two to twentysubtasks. There is nothing sacred about the “two to twenty” limits. Two is theminimum possible breakdown and twenty is about the largest number ofinterelated items that can be comfortably sorted and scheduled at a given levelof task aggregation. Second, preparing a network from this information, is muchmore difficult if the number of activities is significantly greater than twenty.

Sometimes a problem arises because some managers tend to think of outcomes(events) when planning and other think of specific tasks (activities). Many mixthe two. The problem is to develop a list of both activities and outcomes thatrepresents an exhaustive, non redundant set of results to be accomplished(outcomes) and the work to be done (activities) in order to complete the project.

The procedure proposed here is a heirarchical planning system. First, the goalsmust be specified. This will aid the planner in identifying the set of requiredactivities for the goals to be met, the project Action Plan. Each activity has an

Project Planning


10

outcome (event) associated with it, and these activities and events can bedecomposed into sub-activities and sub-events, which may, in turn, besubdivided again. The Project Plan is the set of these Action Plans. Theadvantage of the Project Plan is that it contains all planning information in onedocument.

4.6.4 The Work Breakdown Structure and Linear Responsibility Charts

The Work Breakdown Structure (WBS) used in project management is a typeof Gozinto chart and is constructed directly from the project’s Action Plans.The WBS may also be perceived as an organization chart with taskssubstituted for people as shown in Figure 4.3. It pictures a project subdividedinto heirarchical units of tasks, work packages, and work units. The end resultsis a collection of work units each of which is relatively short in time span.Each has definite beginning and ending points along with specific criteria forevaluating performance. Each part of the project down to the smallest subtaskelements is budgetable in terms of money, man hours, and other requisiteresources. Each is a single, meaningful job for which individual responsibilitycan be assigned. Each can be scheduled as one of the many jobs that theorganization must undertake and complete.

In constructing the WBS, it is wise to contact the managers and workers whowill be directly responsible for each of the work packages. These people candevelop a hierarchical plan for the package delegated to them.

The WBS can be used to illustrate how each piece of the project is tied to thewhole in terms of performance, responsibility, budgeting, and scheduling. Thefollowing general steps explain the procedure for designing and using the WBS

Figure 4.3: Responsibility/WBS relationship

Organisation Responsibility

Defined byresponsibility structre

Organisation

Divisionalresponsibility centre

Departmentalresponsibility

centre

Engineering


centre

Construction


centre

Inspection

Work Breakdown Structure(WBS)

Facility

Location

Section 1

Location

Section 2

Material

Installation

Inspection

Responsibility

Responsibility

Responsibility

Source: Lavold, G.D., “Developing and Using the Work Breakdown Structure”, inCleland D.I., and W.R. King. Project Management Handbook, Van NostrandReinhold, 1983.

11

as it would be used on a large project. For small or moderate-size projects,some of the steps might be skipped, combined, or handled less formally thanour explanation indicates, particularly if the project is of a type familiar to theorganization.

1) Using information obtained from the people who will perform the work,break project tasks down into successively finer levels of detail. Continuethe decomposition of work until all meaningful tasks have been identifiedand each task can be individually planned, scheduled, budgeted, monitored,and controlled.

2) For each such work element:

Make up a work statement that includes the necessary inputs, thespecification reference, particular contractual stipulations, and specific endresults to be achieved. List any vendors, contract, and subcontractors whoare or may be involved. Identify detailed end item specifications for eachwork element regardless of the nature of the end item, whether hardware,software, test results, reports, etc.

Establish cost account numbers.

Identify the resource needs, such as manpower, equipment facilities,support, funds, and materials. Cost estimators can assist the ProjectManager in constructing a task budget composed of costs for materials,manufacturing operations, freight, engineering, contingency reserves, andother appropriate charges.

List the personnel and organizations responsible for each task. It is helpfulto construct a linear responsibility chart (sometimes called a responsibilitymatrix) to show who is responsible for what. This chart also shows criticalinterfaces between units that may require special managerial coordination.With it, the Project Manager can keep track of who must approve whatand who must report to whom.

3) The WBS, budget, and time estimates are reviewed with the people ororganizations who have responsibility for doing or supporting the work. Thepurpose of this review is to verify the WBS’s accuracy, budget, schedule,and to check interdependency of tasks, resources, and personnel. TheWBS may be revised as necessary, but the planner must be sure to checksignificant revisions with all individuals who have previously made inputs.When agreement is reached, individuals should sign off on their individualelements of the project plan.

4) Resource requirements, time schedules, and subtask relationships are nowintegrated to form the next higher level of the WBS; and so it continues ateach succeeding level of the WBS hierarchy. Thus, each succeeding levelof the WBS will contain the same kinds of information regarding resources,budgets, schedules, and responsibilities as the levels below it. The onlydifference is that the information is aggregated to one higher level.

5) At the uppermost level of the WBS, we have a summary of the projectbudget. For the purpose of pricing a proposal, or determining profit andloss, the total project budget should consist of four elements: direct budgetsfrom each task as described above; an indirect cost budget for the project,which includes general and administrative overhead costs (G&A), marketingcosts, potential penalty charges and other expenses not attributable toparticular tasks; a project “contigency” reserve for unexpectedemergencies; and any residual, which includes the profit derived from theproject, which may, on occasion, be intentionally negative.

6) Similarly, schedule information and milestone events can be aggregated intoa project master schedule. The master schedule integrates the manydifferent schedules relevant to the various parts of the project. It is

Project Planning


12

comprehensive and must include contractual commitments, key interfacesand sequencing, milestone events, and progress reports. In addition, a timecontingency reserve for unforeseeable delays should be included.

This series of steps complete the use of the WBS as a project planningdocument. The WBS is also a key document for implementing, monitoring,and controlling the project. The remaining steps concern its use for thesepurposes.

7) One can now compare required task performance and outputs specified inthe WBS with those specified in the basic project plan in order to identifypotential misunderstandings, problem, and schedule slippages, and thendesign corrective actions.

8) As the project is carried out, step by step, the Project Manager cancontinually examine actual resource use, by work element, work package,task, and so on up to the full project level. By comparing actual againstplanned resource usage to a given point in time, the Project Manager canidentify problems, harden the estimates of final cost, and make sure thatrelevant corrective actions have been designed and are ready to implementif needed. It is necessary to examine resource usage in relation to resultsachieved because, while the project may be over budget, the results maybe further along than expected. Similarly, the expenses may be exactly asplanned, or even lower, but actual progress may be much less thanplanned.

9) Finally, the project schedule must be subjected to the same comparisons asthe project budget. Actual progress is compared to scheduled progress, bywork element, package, task, and complete project, to identify problemsand take corrective action. Additional resources may be brought to thosetasks behind schedule so as to expedite them. These added funds maycome out of the budget reserve or from other tasks that are ahead ofschedule.

4.7 SUMMARY

For any developing economy new investments in greenfield projects, expansionof existing projects, diversification etc. is an integral part of the strategy tomove towards higher rate of growth. All this requires resources and strategy toallocate resources as resources are always in short supply. Apart fromallocating resources the various resources has to be coordinated. All thisrequires a specialized technique known as project management & planning. Inthis unit we have discussed about the unique features of the project, the projectlife cycle which represents the relationship between time and project completionand also depicts the rate of progress with respect to time. In the next sectionwe have discussed about the various elements which has to be kept inconsideration while planning the project work we had talked about workBreakdown Structure which shows how each piece of the project is tied to thewhole in terms of performance, responsibility, budgeting and scheduling.

4.8 SELF ASSESSMENT QUESTIONS

1) What are the six component planning sequences of project planning?

2) Any successful project plan must contain nine key elements. List theseitems and briefly describe the composition of each.

3) What are the basic guidelines for systems design that assure that individualcomponents of the system are designed in an optimal manner?

4) What are the general steps for managing each “work package” within aspecific project?

13

5) What percentage of the total project effort do you think should be devotedto planning? Why?

6) Why do you suppose that the coordination of the various elements of theproject is considered the most difficult aspect of project implementation?

7) What kinds of problem areas might be included in the project plan?

8) What is the role of systems integration in project management? What arethe three major objectives of systems integration?

9) In what ways may the WBS be used as a key document to monitor andcontrol a project?

10) Describe the process of subdivision of activities and events which composethe “tree” diagram known as the Work Breakdown Structure or Gozintochart. Why is the input of responsible managers and workers so importantan aspect of this process?


Goodman, L.J., “Project Planning and Management”, Pergamon Press, 1990.

Harrisons, F.L., “Advanced Project Management”, Gower Publicing, Hants,England, 1981.

Kerridge A.E. and Vervalin C.H., “Project Management”, Gulf PublishingCompany, Houston, 1986.

Machiraju, H.R., “Project Finance”, Vikas Publishing House Pvt. Ltd., NewDelhi 1996.

International Project Management Year Book, Butterworth, London, 1985.

Martin, CC, How to make it work, American Management Association, 1976.

Project Management Journal, Project Management Institute, USA, August, 1984.

Project Planning

1

UNIT 5 CAPITAL BUDGETING DECISIONSObjectives


� to explain nature and utility of Capital Budgeting,

� to provide an understanding of the process of evaluation of Investment proposals,

� to discuss various tools of ranking of Investment proposals.

Structure

5.1 Nature of Capital Budgeting

5.2 Utility of Capital Budgeting

5.3 Investment Proposals and Administrative Aspects

5.4 Choosing among Alternative Proposals

5.5 Estimating cash flows from Capital Budgeting

5.6 Evaluating Investment Proposals

5.6.1 Payback Method

5.6.2 Return on Asset Method (ROA)

5.6.3 Present Value Method

5.6.4 Internal Rate of Return Method

5.6.5 Profitability Index (PI)

5.7 Capital Budgeting Methods in Practice

5.8 Summary



5.1 NATURE OF CAPITAL BUDGETING

Capital budgeting is a managerial technique of planning capital expenditureswhose benefits are expected to extend beyond one year, such as expenditureon acquisition of new buildings, improvement of existing buildings, replacementof plant and machinery, acquisition of new facilities, new machines, etc.Permanent addition to working capital, R&D expenditure are also regarded ascapital expenditures.

Capital budgeting technique involves matching of expected net cash inflowsfrom the project with anticipated cost of the project these two components ofcapital budgeting technique are determinant of investment outlay.

5.2 UTILITY OF CAPITAL BUDGETING

Capital budgeting is the most potent technique employed in assessing financialviability of projects and for that matter, allocating prudently the funds amongthe projects by providing useful guidelines in identifying useful projects andranking them in terms of economic desirability to choose the most promisingone. Thus, it helps a firm in strenghthening its financial health and so also itscompetitive position.

Capital budgeting also acts as a planning and control device. As a planning tool,it helps the managements to determine long-term capital requirements andtimings of such requirements. It also serves as a control device when it isemployed to control expenditures.


2

However, capital budgeting as a technique of decision-making suffers from theproblems involved in predicting future cash benefits, cost of capital. Further, itfails to take cognizance of total consequences of the decision.

5.3 INVESTMENT PROPOSALS AND ADMINISTRATIVEASPECTS

Capital budgeting process involves several steps. The first step in the capitalbudgeting process is to assemble a list of proposed new investments, togetherwith the data necessary to appraise them. Although practices vary from firmto firm, proposals dealing with asset acquisitions are frequently groupedaccording to the following four categories:

1. Replacements of existing/old projects.

2. Expansion: additional capacity in existing product lines.

3. Growth: new product lines.

4. Other (for example, pollution control equipment)

Other important aspects of capital budgeting involve administrative matters.Approvals are typically required at higher levels within the organization as wemove away from replacement decisions and as the sums involved increase.One of the most important functions of the board of directors is to approve themajor outlays in a capital budgeting program as well as the total capital budgetfor each planning period. Such decisions are crucial for the future well-beingof the firm.

The planning horizon for capital budgeting programs varies with the nature ofthe industry. When sales can be forecast with a high degree of reliability for10 to 20 years, the planning period is likely to be correspondingly long; electricutilities are an example of such an industry. Also, when the product-technologydevelopments in the industry require an 8-to-10-year cycle to develop a newmajor product, as in certain segments of the aerospace industry, acorrespondingly long planning period is necessary.

After a capital budget has been adopted, funding must be scheduled.Characteristically, the finance department is responsible for scheduling andacquiring funds to meet scheduled requirements. The finance department isalso primarily responsible for cooperating with the operating divisions tocompile systematic records on the uses of funds and the installation ofequipment purchased. Effective capital budgeting programs require suchinformation as the basis for periodic review and evaluation of capitalexpenditure decisions - the feedback and control phase of capital budgeting,often called the post-audit review.

The foregoing represents a brief overview of the administrative aspects ofcapital budgeting; the analytical problems involved are considered in thefollowing paragraphs.

5.4 CHOOSING AMONG ALTERNATIVE PROPOSALS

In most firms, there are more proposals for projects than the firm is able orwilling to finance. Some proposals are good, others are poor, and methodsmust be developed for distinguishing between the good and the poor.Essentially, the end product is a ranking of the proposals and a cutoff point fordetermining how far down the ranked list to go.

Capital BudgetingDecisions

3

In part, proposals are eliminated because some are mutually exclusive.Mutually exclusive proposals are alternative methods of doing the same job. Ifone piece of equipment is chosen, other will not be required. Thus, if there isa need to improve the materials handling system in a chemical plant, the jobmay be done either by conveyer belts or by forklift trucks. The selection ofone method makes it unnecessary to use the others: They are mutuallyexclusive items.

Independent projects are those that are being considered for different kinds oftasks that need to be accomplished. For example, in addition to the materialshandling system, the chemical firm may need equipment to package the endproduct. The work would require a packaging machine, and the purchaseof equipment for this purpose would be independent of the equipmentpurchased for materials handling. The firm may undertake any or allindependent projects.

Finally, projects may be contingent. For example, there may be only one wayto build a football stadium but two ways of housing it (in a metal structure or ageodesic dome). Because the stadium and its housing are contingent, theanalysis requires that we consider them together. Hence, we would want tocompare the stadium within a metal structure with the alternative of thestadium within a geodesic dome.

To distinguish among the many proposals that compete for the allocation of thefirm’s capital funds, a ranking procedure must be developed. This procedurerequires calculating the estimated cash flows from the use of equipment andthen translating them into a measure of their effect on shareholders’ wealth.First, we turn our attention to the problem of estimating cash flows for capitalbudgeting purposes.

5.5 ESTIMATING CASH FLOWS FOR CAPITALBUDGETING

Cash flows for capital budgeting purposes are defined as the after-tax cashflows for an all-equity financed firm. Algebraically, this definition is equivalentto earnings before interest and taxes, EBIT, less the taxes the firm would payif it had no debt, T(EBIT), plus noncash depreciation charges, W dep.

W Cash flow = W EBIT - T (W EBIT) + W depreciation

Note that this definition of cash flows is unaffected by the firm’s financingdecision, for example the amount of debt which it uses. Consequently, theinvestment decision and the financing decision are kept separate when we usethis definition of cash flows for capital budgeting purposes.

We focus on how the firm’s cash flows will be changed. Table 5.1 providesan example of a pro-forma income statement which can be used to illustrate acash flow calculation.

To arrive at the change in after-tax cash flows created by the project, we startwith increased revenues, WR, then subtract out all items which are expensablefor tax purposes (WVC + WFCC + Wdep). The result is taxable income,assuming the firm has no debt. Next, we subtract the change in taxes and addback the change in depreciation because depreciation is not a cash outflow.The appropriate algebraic expression is:

WCash flow = (WR - WVC - WFCC - Wdep) - T(WR - WVC - WFCC -Wdep) + Wdep.


4

Table 5.1 Pro-forma Income Statement

Description Symbol Amount

Change in sales revenue W R Rs.145,000

Change in variable operating cost W VC -90,000

Change in fixed cash costs W FCC -10,000

Change in depreciation W dep -15,000

Change in earings before interest and taxes W EBIT 30,000

Change in interest expense W rD -5,000

Change in earings before tax W EBT 25,000

Change in taxes (@T=40%) W tax -10,000

Change in net income W NI 15,000

This equation can be simplified as follows:

WCash flow = (1–T) (WR – WVC – WFCC – WDep) + WDep

Note that the term in brackets is the same as the change in earings beforeinterest and taxes, WEBIT; hence, the equation becomes:

WCash flow = (1-T) WEBIT + Wdep.

Substituting in the numbers from Table 5.1, we have:WCash flow = (1 - .4)(Rs.145,000 - Rs.90,000 - Rs.10,000 - Rs.15,000) + Rs.15,000 = .6 (Rs.30,000) + Rs.15,000 = Rs.33,000

The procedure described above starts with revenues at the top of the incomestatement and then works down to obtain the definition of cash flows forcapital budgeting purposes. Alternately, one can start at the bottom of theincome statement, with changes in net income (WNI) and build upward toarrive at the same definition. Sometimes this approach is easier to use. Thealgebraic expression for the change in cash flows is

WCash flow-WNI+Wdep+(1 - T)W rD

Activity 1

a) Identify expenditures that are considered in Capital Budgeting technique.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

b) List out steps involved in evaluating investment proposals.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

c) Explain why net cash flows after tax is considered for decision making.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................


5

d) Explain how depreciation is treated while considering investment proposals.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

5.6 EVALUATING INVESTMENT PROPOSALS

The point of capital budgeting - indeed, the point of all financial analysis - is tomake decisions that will maximize the value of the firm. The capitalbudgeting process is designed to answer two questions: (1) Which of severalmutually exclusive investments should be selected? (2) How many projects, intotal, should be accepted?

Among the many methods used for evaluating investment proposals, five arediscussed here.

1. Payback method (or payback period): Number of years required toreturn the original investment.

2. Return on assets (ROA) or return on investment (ROI): Anaverage rate of return on assets employed.

3. Net present value (NPV) method: Present value of expected futurecash flows discounted at the appropriate cost of capital, minus the cost ofthe investment.

4. Internal rate of return (IRR) method: Interest rate which equates thepresent value of future cash flows to the investment outlay.

5. Profitability Index (PI): It shows the relative profitability of any project,or the present value of benefits per rupee of costs.

General Principles

When comparing various capital budgeting criteria, it is useful to establish someguidelines. What are the properties of an ideal criterion? The optimal decisionrule should have four characteristics:

1. It will select from a group of mutually exclusive projects the one whichmaximizes shareholders’ wealth.

2. It will appropriately consider all cash flows.

3. It will discount the cash flows at the appropriate market-determinedopportunity cost of capital.

4. It will allow managers to consider each project independently from allothers. This has come to be known as the value additivity principle.

The value additivity principle implies that if we know the value of separateprojects accepted by management, then simply adding their values, V

’ will give

us the value of the firm. If there are N projects, then the value of the firmwill be:

1,...Nj ,v

1j

n

V j ==∑=

This is a particularly important point because it means that projects can beconsidered on their own merit without the necessity of looking at them in aninfinite variety of combinations with other projects.

N


6

Table 5.2 gives the cash flows for four mutually exclusive projects. They allhave the same life, five years, and they all require the same investment outlay,Rs.1,500. Once accepted, no project can be abandoned without incurring theoutflows indicated. For example, Project A has negative cash flows during itsfourth and fifth years. Once the project is accepted these expected cashoutflows must be incurred. An example of a project of this type is a nuclearpower plant. Decommissioning costs at the end of the economic life of thefacility can be as large as the initial construction costs and they must be takeninto account.

Table 5.2: Cash Flows of Four Mutually Exclusive Projects

Cash Flows (Rs.)

Year A B C D PVIF@10%

0 -1,500 -1,500 -1,500 -1,500 1.000

1 150 0 150 300 .909

2 1,350 0 300 450 .826

3 150 450 450 750 .751

4 -150 1,050 600 750 .683

5 -600 1,950 1,875 900 .621

The last column of Table 5.2 shows the appropriate discount factor for thepresent value of cash flows, assuming that the appropriate opportunity cost ofcapital is 10 percent. Since all four projects are assumed to have the samerisk, they can be discounted at the same interest rate.

Now we turn our attention to the actual implementation of the five above-mentioned capital budgeting techniques (1) the payback method, (2) the returnon assets, (3) the net present value,(4) the internal rate of return, (5)Profitability Index. We shall see that only one technique - the net present valuemethod - satisfies all four of the desirable properties for capital budgetingcriteria.

5.6.1 Payback Method

The payback period is the number of years required to recover the initialcapital outlay on a project. The payback periods for the four projects in Table5.2 are given below.

Project A, 2-year payback

Project B, 4-year payback

Project C, 4-year payback

Project D, 3-year payback.

If management were adhering strictly to the payback method, then Project Awould be chosen as the best among the four mutually exclusive alternatives.Even a casual look at the numbers indicates that this would be a bad decision.The difficulty with the payback method is that it does not consider all cashflows and it fails to discount them. Failure to consider all cash flows results inignoring the large negative cash flows which occur in the last two years ofProject A. Failure to discount them means that management would beindifferent between the following two cash flow patterns:


7

Cash Flows

Year G G*

0 -1,000 -1,0001 100 9002 900 100

because they have the same payback period. Yet no one with a positiveopportunity cost of funds would choose Project G because Project G* returnscash much faster.

The payback method also violates the value additivity principle. Consider thefollowing example. Projects 1 and 2 are mutually exlusive but Project 3 isindependent. Hence, it is possible to undertake Projects 1 and 3 incombination, 2 and 3 in combination, or any of the projects in isolation.

The only arguments in favour of using the payback method is that it is easy touse, but with the advent of pocket calculators and computers, we feel thatother more correct capital budgeting techniques are just as easy to use.

5.6.2 Return on Assets (ROA)

The return on assets (ROA) which is also sometimes called the return oninvestment (ROI)is an average rate of return technique. It is computed byaveraging the expected cash flows over the life of a project and then dividingthe average annual cash flow by the initial investment outlay. For example, theROA for Project B in Table 5.2 is computed from the following definition:

Ioflow/ncash

0t

n

ROA ÷

=∑=

whereI

o = Initial cash outlay = Rs.1,500

n = Life of the project = 5 years.

Substituting in the correct numbers from Table 5.2, we have

5

1,950 Rs. 1,050 Rs. 450 Rs. 0 Rs. 0 Rs. 1,500- Rs.ROA ÷

+++++=

500,Rs.15

1,950 Rs.÷=

%261,500 Rs.

390 Rs.==

The ROA’s for the four projects are

Project A, - 8%

Project B, 26%

Project C, 25%

Project D, 22%

The ROA criterion chooses Project B as best. The major problem with ROAis that it does not take the time value of money into account. We would haveobtained exactly the same ROA for Project B, even if the order of cash flowshad been reversed with Rs.1,950 received now, Rs.1,050 at the end of Year 1,Rs.450 at the end of Year 2 and -Rs.1,500 at the end Year 5. But no one

–


8

with a positive opportunity cost of capital would be indifferent between thealternatives. The opposite ordering of cash flows would always be preferred.

5.6.3 Present value method

Another method based on discounted cash flow approach employed to evaluatefinancial viability of investment projects is the present value method, whichinvolves discounting of streams of future cash earnings to present value atrequired rate of return to the firm (cost of capital). For ranking projects underthis method, net present value is computed. Project with highest positive netpresent value is accorded the highest priority.

The equation for calculating the net present value of a project is :

IoK)(1

CF

1t

n

tt −

+=∑=

Here CF1,CF

2, and so forth represent the net cash flows; k is the firm’s cost

of capital;I0 is the initial cost of the project; and n is the project’s expected life.

The net present value of Project C in Table 5.2 is calculated below bymultiplying each cash flow by the appropriate discount factor (PVIF), assumingthat the cost of capital, k, is 10 per cent.

Year Cash Flow X PVIF = PV

0 -1,500 1.000 -1,500.00

1 150 .909 136.35

2 300 .826 247.80

3 450 .751 337.95

4 600 .683 409.80

5 1,875 .621 1,164.38

NPV = 796.28

The net present value of all four projects in Table 5.2 are:

Project A NPV = Rs. –610.95.

Project B NPV = Rs. 766.05.

Project C NPV = Rs. 796.28.

Project D NPV = Rs. 778.80

If these projects were independent instead of mutually exclusive, we wouldreject A and accept B,C, and D. Why? Since they are mutually exclusive, weselect the project with the greatest NPV, Project C. The NPV of the projectis exactly the same as the increase in shareholders’ wealth. This fact makes itthe correct decision rule for capital budgeting purposes. The NPV rule alsomeets the other three general principles required for an optimal capitalbudgeting criterion. It takes all cash flows into account. All cash flows arediscounted at the appropriate market-determined opportunity cost of capital inorder to determine their present values. Also, the NPV rule obeys the valueadditivity principle.

The net present value of a project is exactly the same as the increase inshareholders’ wealth. To see why, start by assuming a project has zero netpresent value. In this case, the project returns enough cash flow to do threethings:


9

1. To pay off all interest payments to creditors who have lent money tofinance the project.

2. To pay all expected returns (dividends and capital gains) to shareholderswho have put up equity for the project, and

3. To pay off the original principal, I0, which was invested in the project.

Thus, a zero net present value project is one which earns a fair return tocompensate both debt holders and equity holders, each according to the returnswhich they expect for the risk they take. A positive NPV project earns morethan the required rate of return, and equity holders receive all excess cashflows because debt holders have a fixed claim on the firm. Consequently,equity holders’ wealth increases by exactly the NPV of the project. It is thisdirect link between shareholders’ wealth and the NPV definition which makesthe net present value criterion so important in decision making.

5.6.4 Internal Rate of Return Method

The internal rate of return (IRR) is defined as the interest rate that equates thepresent value of the expected future cash flows, or receipts, to the initial costoutlay. The equation for calculating the internal rate of return is :

0IoIRR)(1

Cf...

IRR)(1

Cf

IRR)(1

Cfn

n2

21

1 =−+

+++

++

0IoIRR)(1

CF

1t

n

tt =−

+=∑

Here we know the value of Io and also the values of CF

1,CF

2,.....CF

n, but we

do not know the value of IRR. Thus, we have an equation with one unknown,and we can solve for the value of IRR. Some value of IRR will cause thesum of the discounted receipts to equal the initial cost of the project, makingthe equation equal to zero, and that value of IRR is defined as the internal rateof return.

The internal rate of return may be found by trial and error. First, compute thepresent value of the cash flows from an investment, using an arbitrarilyselected interest rate - for example, 10 percent. Then compare the presentvalue so obtained with the investment’s cost. If the present value is higherthan the cost figure, try a higher interest rate and go through the procedureagain. Conversely, if the present value is lower than the cost, lower the interestrate and repeat the process. Continue until the present value of the flowsfrom the investment is approximately equal to its cost. The interest rate thatbrings about this equality is defined as the internal rate of return.

Table 5.3 shows computation for the IRR for Project D in Table 5,2 and Figure5.1 graphs the relationship between the discount rate and the NPV of theproject.

Table 5.3: IRR for Project D

Year Cash Pv@10% PV@20% PV@25% [email protected]%Flow

0 -1,500 1.000 -1,500.00 1.000 -1,500.00 1.000 -1.500.00 1.000 -1,500.00

1 300 .909 272.70 .833 249.90 .800 240.00 .797 239.10

2 450 .826 371.70 .694 312.30 .640 288.00 .636 286.20

3 750 .751 563.25 .579 434.25 .512 384.00 .507 380.25

4 750 .683 512.25 .482 361.50 .410 307.50 .404 303.00

5 900 .621 558.90 .402 361.80 .328 295.20 .322 289.80

1650 778.80 219.75 14.70 -1.65


10

In Figure 5.1 the NPV of Project D’s cash flows decreases as the discountrate is increased. If the discount rate is zero, there is no time value of moneyand the NPV of a project is simply the sum of its cash flows. For Project D,the NPV equals Rs.1,650 when the discount rate is zero. At the oppositeextreme, if the discount rate is infinite, then the future cash flows are valuelessand the NPV of Project D is its current cash flow, –Rs.1,500. Somewherebetween these two extremes is a discount rate which makes the NPV equal tozero. In Figure 5.1, we see that the IRR for Project D is 25.4 per cent. TheIRR’s for each of the four projects in Table 1 are given below.

Project A IRR = - 200%

Project B IRR = 20.9%

Project C IRR = 22.8%

Project D IRR = 25.4%

If we use the IRR criterion and the projects are independent, we accept anyproject which has an IRR greater than the opportunity cost of capital, which is10 percent. Therefore, we would accept Projects B, C, and D. However,since these projects are mutually exclusive, the IRR rule leads us to acceptProject D as best.

Profitability Index (PI)

Another method that is used to evaluate projects is the profitability index (PI),or the benefit/cost ratio, as it is sometimes called:

Present value methods had the merit of simplicity in as much as it helps themanagement in choosing the most profitable proposal. Further, while evaluatingand ranking projects it focuses on one of the primary objectives of a firm, i.e.,increasing value of the firm.

However, main drawback of this approach is that it does not take intoconsideration size of investment outlay and net cash benefits together whileranking projects. This may at times lead to faulty decisions.

Profitability Index (PI) method has come to be employed to overcome the abovedrawback and to ensure rational investment decision by establishing relationshipbetween the present values of the net cash inflows and net investment outlay.

Figure 5.1: NPV of Project D at Different Discount Rates

Rs. 2,000

Rs. 1,00

0

Rs. -1,000

Rs. -2,000

IRR = 25.4%

10% 20% 30% 40% 50%

If K®¥, then NPV ® Rs. -1,500

NPV Capital BudgetingDecisions

11

The equation to compute ‘PI’ of a project is :

tt

tt

K)(I

COF

0t

n

K)(I

CIF

0t

n

CostsPV

benefits PVPI

+=∑

+=∑

==

Here CIFt represents the expected cash inflows, or benefits, and COF

t

represents the expected cash outflows, or costs. The PI shows the relativeprofitability of any project, or the present value of benefits per rupee costs.The PI for Project C, based on a 10 percent cost of capital is:

Similarly:Project A PI = 0.59Project B PI = 1.51Project D PI = 1.52

A project is acceptable if its PI is greater than 1.0, and the higher the PI, thehigher the project ranking. Mathematically, the NPV, the IRR, and the PImethods must always reach the same accept/reject decisions for independentprojects: If a project’s NPV is positive, its IRR must exceed k and its PI mustbe greater than 1.0. However, NPV, IRR, and PI can give different rankingsfor pairs of projects. This can lead to conflicts between the three methodswhen mutually exclusive projects are being compared.

Activity 2

a) Contact Finance Managers of five PSUs and five Indian Companies to findout the existing capital budgeting evaluation methods used by them.

...................................................................................................................

...................................................................................................................

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...................................................................................................................

b) Approach Finance Managers of three MNCs to ascertain what methodsare used to evaluate the projects.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

c) Explain why.

i) Future Net Cash flows are discounted

.............................................................................................................

.............................................................................................................

.............................................................................................................

.............................................................................................................

ii) Expected Investment outlay is not discounted

.............................................................................................................

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12

5.7 CAPITAL BUDGETING METHODS IN PRACTICE

The above discussion leads us to conclude that IRR, NPV and PI methods willresult in the same decision, except in certain cases involving mutually exclusiveprojects or non-normal cash flows. The question that arises which capitalbudgeting techniques do firm actually use in practice. Lawrence Gitman andJohn Forester conducted a survey to help answer this question.

Gitman and Forester received 103 usable responses from a survey sent to 268major companies known to make large capital expenditures. They found thatthe responsibility for capital budgeting analysis generally rests with the financedepartment. The respondents also stated that defining projects and estimatingtheir cash flows were the most difficult and the most critical steps in thecapital budgeting process.

Table – 5.4 summarizes the capital budgeting methods used by the respondentfirms. The results indicate a strong preference for discounted cash flow (DCF)capital budgeting techniques, that is, NPV, IRR, and PI, with the dominantmethod being IRR. However, the heavy use of ROA and payback as primaryranking techniques indicates that not all U.S. firms were technologically up topart in an economic sense.

Table 5.4: Capital Budgeting Methods Used

Primary SecondaryMethod Number Percent Number Percent

IRR 60 53.6% 13 14.0%

ROA 28 25.0 13 14.0

NPV 11 9.8 24 25.8

Payback period 10 8.9 41 44.0

PI 3 2.7 2 2.2

Total 112 100.0% 9 3 100.0%

It may also be noted that almost all the respondents used at least two methodsin their analysis, and as evidenced by the 112 primary methods from 103respondents, some firms use more than one primary method. Although thequestionnaire did not bring this point out, we suspect that many of the analystsof firms which use the IRR as the primary method recognize its drawbacks,yet use it anyway because it is easy to explain to non-financial executives butuse NPV as a check on IRR when evaluating mutually exclusive or non-normalprojects. It is also doubtful the payback method can be used as a liquidity and/or risk indicator, hence to help choose among competing projects whose NPVsand/or IRRs are close together. One interesting, and encouraging note is thatwhen compared with earlier surveys, Gitman and Forester found that thediscounted cash flow methods are gaining in usage.

As regards the use of assessment methods employed by Indian corporates,study of 100 medium and large scale companies conducted in 1994, reveals thatIndian Companies have started using discounting techniques more than non-discounting approaches. Although some companies are still using payback periodapproach, it is the net present value technique which is used quite widely,particularly by companies which have high sales volume and large-paid-upcapital. Small and new companies are still relying on traditional approach likepay-back period.


13

5.8 SUMMARY

For any economy/company there are many avenues of investments, but onecan’t go and invest in all of these avenues. This gives rise to problem ofselection of a particular project out of the many available. Here capitalbudgeting techniques play an important role in deciding which project to select& which to reject. Capital budgeting technique involves matching of expectednet cash inflows from the project with anticipated cost of the project. Capitalbudgeting techniques are broadly classified in two categories. Discounted andnon discounted the major difference between these two is that in former thefuture cash flows are discounted at appropriate discount rate (usually cost ofcapital) to get net present value of future cash flows.


1) Are there conditions under which a firm might be better off if it chose amachine with a rapid payback rather than one with the largest rate ofreturn?

2) Company X uses the payback method in evaluating investment proposalsand is considering new equipment whose additional net after-tax earningswill be Rs.150 a year. The equipment costs Rs.500, and its expected lifeis ten years (straight-line depreciation). The company uses a three-yearpayback as its criterion. Should the equipment be purchased under theabove assumptions?

3) What are the most critical problems that arise in calculating a rate ofreturn for a prospective investment?

4) What other factors in addition to rate of return analysis should beconsidered in determining capital expenditures?

5) A firm has an opportunity to invest in a machine at a cost of Rs.6,56,670.The net cash flows after taxes from the machine would be Rs.2,10,000 peryear and would continue for five years. The applicable cost of capital forthis project is 12 percent.

a) Calculate the net present value for the investment.

b) What is the internal rate of return for the investment?

c) Should the investment be made?


Besant C. Raj A, “Public Enterprises Investment Decisions in India: AManagerial Analysis.”, Macmillan Company of India Ltd., New Delhi, 1977.

Dhankar Raj S., “An Appraisal of Capital Budgeting Decision Mechanismin Indian Corporates” Management Review, NMIMS, Mumbai, July –December, 1995.

Murty, G.P., “Capital Investment decisions in Indian Industry”, HimalayaPublishing House, Bombay 1985.

Porwal, L.S., “Capital Budgeting in India”, Sultan Chand and Sons NewDelhi, 1976.

R.M. Srivastava, “Financial Management and Policy, Himalaya PublishingHouse, Mumbai,” 2003

1

UNIT 7 PROJECT MONITORING ANDCONTROL

Objectives


� to provide an understanding of how the monitoring system is designed,

� to explain concept of control and its various types,

� to focus on types of control Processes,

� to throw light on designing of control system.

Structure

7.1 Introduction

7.2 Designing of the Monitoring System

7.3 How to Collect Data

7.4 Information needs and the Reporting Process

7.5 Report Types

7.6 Project Control

7.7 Types of Control Processes

7.7.1 Cybernetic Control

7.7.2 Go/No-go Control

7.7.3 Post Control

7.8 Design of Control System

7.9 Control of creative Activities

7.10 Progress Review

7.11 Personnel Reassignment

7.12 Control of Input Resources

7.13 Summary



7.1 INTRODUCTION

Monitoring is collecting, recording, and reporting information concerning any andall aspects of project performance that the project manager or others in theorganization wish to know. In our discussion it is important to remember thatmonitoring, as an activity, should be kept quite distinct from controlling (whichuses the data supplied by monitoring to bring actual performance intoapproximate congruence with planned performance), as well as from evaluation(through which judgements are made about the quality and effectiveness ofproject performance).

7.2 DESIGNING OF THE MONITORING SYSTEM

The first step in setting up any monitoring system is to identify the key factorsto be controlled. Clearly, the project manager wants to monitor performance,cost, and time but must define precisely which specific characteristics ofperformance, cost, and times should be controlled and then establish exactboundaries within which control should be maintained. And there may also beother factors of importance worth noting, at least at certain points in the life ofthe project. for example, the number of labour hours used, the number or


2

extent of engineering changes, the level of customer satisfaction, and similaritems may be worthy of note on individual projects.

But the best source of items to be monitored is the project Action Plan -actually, the set of Action Plans that describe what is being done, when, andthe planned level of resource usage for each task, work package, and workunit in the project. The monitoring system is a direct connection betweenplanning and control. If it does not collect and report information on somesignificant element of the plan, control can be faulty or missing. The measuredand reported to the control system, but it is not sufficient. For example, theproject manager might want to know about changes in the client’s attitudestoward the project. Information on the morale of the project team might beuseful in preparing for organizational or personnel changes on the project.These two latter items may be quite important, but are not reflected in theproject’s action plan.

Unfortunately, it is common to focus monitoring activities on data that are easilygathered - rather than important - or to concentrate on “objective” measuresthat are easily defended at the expense of softer, more subjective data thatmay be more valuable for control. Above all, monitoring should concentrateprimarily on measuring various facets of output rather than activity. It is crucialto remember that effective project managers are not primarily interested in howhard their project teams work. They are interested in results.

Given all this, performance criteria, standards, and data collection proceduresmust be established for each of the factors to be measured. The criteria anddata collection procedures are usually set up for the life of the project. Thestandards themselves, however, may not be constant over the project’s life.They may change as a result of altered capabilities within the parentorganization or a technological breakthrough made by the project team; but,perhaps more often than not, standards and criteria change because of factorsthat are not under the control of the project manager.

Next, the information to be collected must be identified. This may consist ofaccounting data, operating data, engineering test data, customer reactions,specification changes, and the like. The fundamental problem in this regard is todetermine precisely which of all the available data should be collected. It isworth repeating that the typical determinant for collecting data too often seemsto be simply the ease with which it can be gathered. Of course, the nature ofthe required data is dictated by the project plan, as well as by the goals of theparent organization, and by the fact that it is desirable to improve the processof managing projects.

Therefore, the first task is to examine the project plans in order to extractperformance, time, and cost goals. These goals should relate to some fashion toeach of the different levels of detail; that is, some should relate to the project,some to its tasks, some to the work packages, and so on. Data must beidentified that measure achievement against the goals, and mechanisms designedfor gathering and storing such data. Similarly, the process of developing andmanaging projects should be considered and steps taken to ensure thatinformation relevant to the diagnosis and treatment of the project’sorganizational infirmities and procedural problems are gathered.

7.3 HOW TO COLLECT DATA

Given that we know what type of data we want to collect, the next question ishow to collect this information. At this point in the construction of a monitoringsystem, it is necessary to define precisely what pieces of information should begathered and when. In most cases, the project manager has options. questions

3

then arise. Should cost data be gathered before or after some specific event?Is it always mandatory to collect time and cost information at exactly the samepoint in the process? What do we do if a specific piece of desirable data isdifficult to collect because the data source (human) fears reporting anyinformation that might contribute to a negative performance evaluation? Whatdo we do about the fact that some use of time is reported as “hours charged”to our project, and we are quite aware that our project has been charged forwork done on another project that is over budget? Are special forms needed fordata collection? Should we set up quality control procedures to ensure the integrityof data transference from its source to the project information system? Suchquestions merely indicate the broad range of knotty issues that must be handled.

A large proportion of the data collected may take one of the following forms,each of which is suitable for some types of measures.

1. Frequency Counts : A simple tally of the occurrence of an event. Thistype of measure is often used for “complaints,” “number of times a projectreport is late,” “bugs in a computer program” and similar items. The dataare usually easy to collect and are often reported as events per unit timeor events as a percent of a standard number.

2. Raw Numbers : Dates, hours, physical amounts of resources used, andspecifications are usually reported in this way. These numbers are reportedin a wide variety of ways, but often as direct comparisons with anexpected or standard number. Also, “variances” are commonly reported asthe ratios of actual to standard. Comparisons on ratios can also be plottedas a time series to show changes in system performance.

3. Subjective Numeric Ratings : These number are subjective estimates,usually of a quality, made by knowledgeable individuals or groups. Theycan be reported in most of the same ways that objective raw numbers are,but care should be taken to make sure that the numbers are notmanipulated in ways only suitable for quantitative measures. Ordinalrankings of performance are included in this category.

4. Indicators: When the project manager cannot measure some aspect ofsystem performance directly, it may be possible to find an indirect measureon indicator. The speed with which change orders are processed andchanges are incorporated into the project is often a good measure of teamefficiency. Response to change may also be an indicator of the quality ofcommunications on the project team. When using indicators to measureperformance, the project manager make sure that the linkage between theindicator and the desired performance measure is as direct as possible.

5. Verbal Measures : Measures for such performance characteristics as“quality of team member cooperation,” “morale of team members,” or“quality of interaction with the client” frequently take the form of verbalcharacterization. As long as the set of characterizations is limited, and themeanings of the individual terms are consistently understood by all, thesedata serve their purposes reasonably well.

After data collection has been completed, reports on project progress should begenerated. These include project status reports, time/cost reports, and variancereports, among others. Causes and effects should be identified and trendsnoted. Plans, charts, and tables should be updated on a timely basis. Whereknown, “comparables” should be reported, as should statistical distributions ofprevious data if available. Both help the project manager (and others) tointerpret the data being monitored.

The purpose of the monitoring system is to gather and report data. The purposeof the control system is to act on the data. To aid the project controller, it is

Project Monitoring andControl


4

helpful for the monitor to carry out some data analysis. Significant variancesfrom plan should be highlighted or “flagged” so that they cannot be overlookedby the controller. The methods of statistical quality control are very useful fordetermining what size variances are “significant” and sometimes even help indetermining the probable cause(s) of variances. Where causation is known, itshould be noted. Where it is not known, an investigation may be in order. Thedecisions about when an investigation should be conducted, by whom, and bywhat methods are the prerogative of the project controller, although the actualinvestigation may be conducted by the group responsible for monitoring.

In creating the monitoring system, some care should be devoted to the issuesof honesty and bias. The former is dealt with by setting in place an internalaudit. The audit serves the purpose of ensuring that the information gathered ishonest. No audit, however, can prevent bias. All data are biased by those whoreport them, advertently or inadvertently. The controller must understand thisfact of life. The first issue is to determine whether or not the possibility of biasin the data matters significantly. If not, nothing need be done. Biased findings andcorrecting activities are worthwhile only if data with less or no bias are required.

There is some tendency for project monitoring systems to include an analysisdirected at the assignment of blame. This practice has doubtful value. Whilethe managerial dictum “rewards and punishments should be closely associatedwith performance” has the ring of good common sense, it is actually not goodadvice. Instead of motivating people to better performance, the practice is moreapt to result in lower expectations. If achievement of goals is directly measuredand directly rewarded, a tremendous pressure will be put on people tounderstate goals and to generate plans that can be met or exceeded withminimal risk and effort.

7.4 INFORMATION NEEDS AND THE REPORTINGPROCESS

Everyone concerned with the project should be tied into the project reportingsystem. The monitoring system ought to be so constructed that it addressesevery level of management, but reports need not be of the same depth or atthe same frequency for each level. Lower-level personnel have a need fordetailed information about individual tasks and the factors affecting such tasks.Report frequency is usually high. For the senior management levels, overviewreports describe progress in more aggregate terms with less individual taskdetail. Reports are issued less often. At times it may be necessary to moveinformation among organizations, as illustrated in Figure 7.1, as well as amongmanagerial levels.

Reports must contain data relevant to the control of specific tasks that arebeing carried out according to a specific schedule. The frequency of reportingshould be great enough to allow control to be exerted during or before theperiod in which the task is scheduled for completion.

In addition to the criterion that reports should be available in time to be usedfor project control, the timing of reports should generally correspond to thetiming of project milestones. This means that project reports may not be issuedperiodically-excepting progress reports for senior management. There seems tobe no logical reason, except for tradition, to issue weekly, monthly, quarterly,etc., reports. Few projects require attention so neatly consistent with thecalendar. This must not be taken as advice to issue reports “every once in awhile.” Reports should be scheduled in the project plan. They should be issuedon time. The report schedule, however, need not call for periodic reports.

5

Identification of project milestones depends on who is interested. For seniormanagement, there are only a few milestones even in large projects. For theproject manager, there may be many critical points in the project schedule atwhich major decisions must be made, large changes in the resource base mustbe initiated, or key technical results achieved. The milestones relevant to lowerlevels relate to finer detail and occur with higher frequency.

The nature of the monitoring reports should be consistent with the logic of theplanning, budgeting, and scheduling systems. The primary purpose is, of course,to ensue achievement of the project plan through control. There is, therefore,little reason to burden operating members of the project team with extensivereports on matters that are not subject to control - at least not by them. Thescheduling and resource usage columns of the project Action Plan will serve asthe key to the design of project reports.

There are many benefits of detailed reports delivered to the proper people on atimely basis. Among them are :

� Mutual understanding of the goals of the project.

� Awareness of the progress of parallel activities and of the problemsassociated with coordination among activities.

� More realistic planning for the needs of all groups and individuals workingon the project.

� Understanding the relationships of individual tasks to one another and to theoverall project.

� Early warning signals of potential problems and delays in the project.

� Minimizing the confusion associated with change by reducing delays incommunicating the change.

� Faster management action in response to unacceptable or inappropriatework.

� Higher visibility to top management, including attention directed to theimmediate needs of the project.

� Keeping the client and other interested outside parties up to date on projectstatus, particularly regarding project milestones and deliverables.

V.P.Ventures

Company Consultant

SteeringCommittee

Marketing

ProjectManager

TechnicalAssistant

ProjectManagerV

V

V VV

V

V

V

V

Denotes information flow

Figure 7.1: Reporting and information flows between organisations working on acommon project



6

7.5 REPORT TYPES

For the purposes of project management, we can consider three distinct typesof reports: routine, exception, and special analysis. The routine reports are thoseissued on a regular basis; but, as we noted above, regular does not necessarilyrefer to the calendar. For senior management, the reports will usually beperiodic, but for the project manager and lower-level project personnel,milestones may be used to trigger routine reports.

At times, it may be useful to issue routine reports on resource usageperiodically, occasionally on a weekly or even daily basis.

Exception reports are useful in two cases. First, they are directly oriented toproject management decision making and should be distributed to the teammembers who will have prime responsibility for decisions or who have a clear“need to know.” Second, they may be issued when a decision is made on anexception basis and it is desirable to inform other managers as well as todocument the decision - in other words, as part of a sensible procedure forprotecting oneself.

Special analysis reports are used to disseminate the results of special studiesconducted as part of the project or as a response to special problems that ariseduring the project. Usually they cover matters that may be of interest to otherproject manager, or make use of analytic methods that might be helpful onother projects. Studies on the use of substitute materials, evaluation ofalternative manufacturing processes, availability of external consultants,capabilities of new software, and descriptions of new governmental regulationsare all typical of the kind of subjects covered in special analysis reports.Distribution of these reports is usually made to anyone who might be interested.

The real message carried by project reports is in the comparison of activity toplan and of actual output to desired output. Variances are reported by themonitoring system, and responsibility for action rests with the controller.Because the project plan is described in terms of performance, time, and cost,variances are reported for those same variables. Project variance reportsusually follow the same format used by the accounting department, but at timesthey may be presented differently.

This variance report shows the ratio of the material estimated to the materialused in projects. As a result of this information, the program manager decidesthat it would be less expensive for the company to carry small inventories in afew of the commonly used high alloys, and to estimate (and price) material usecloser to actual expectations.

The Earned Value Chart

Thus far, we have covered monitoring for parts of projects. The monitoring ofperformance for the entire project is also crucial because performance is theraison d’etre of the project. Individual task performanxce must be monitoredcarefully because the timing and coordination between individual tasks isimportant. But overall project performance is the crux of the matter and mustnot be overlooked. One way of measuring overall performance is by using anaggregate performance measure called earned value.

A serious difficulty in comparing actual expenditures against budgeted orbaseline expenditures for any given time period is that the comparison fails totake into account the amount of work accomplished relative to the costincurred. The earned value of work performed for those tasks in progress isfound by multiplying the estimated percent completion for each task by the

7

planned cost for that task. The result is the amount that “should” have beenspent on the task thus far. This can then be compared with the actual amountspent. A graph such as that shown in Figure 7.2 can be constructed andprovides a basis for evaluating cost and performance to date. If the planned(baseline) total value of the work accomplished is in balance with the plannedcost (i.e., minimal scheduling variance), then top management has no particularneed for a detailed analysis of individual tasks. Thus the concept of earnedvalue combines cost reporting and aggregate performance reporting into onecomprehensive chart.

Three variances can be identified on the earned value chart. The spendingvariance is the actual cost less the value completed, the schedule variance isthe value completed less the baseline plan, and the total variance is the sum ofthe two: actual less planned cost. Top management, as mentioned above, isusually most concerned with the schedule (or time) variance, whereas theproject controller is probably concerned with the spending variance (costoverrun) and the controller of the parent will track the total variance. Theproject manager is concerned with all the three, of course.

If the earned value chart shows a cost overrun or performance under-run, theproject manager must figure out what to do to get the system back on target.Options include such things as borrowing resources for activities performingbetter than expected, or holding a meeting of project team members to see ifanyone can suggest solutions to the problems, or perhaps, notifying the clientthat the project may be late or over budget.

Activity 1

Managing Director of a Pharmaceutical of Company has approached you todesign the monitoring system for his organization.

a) List out the steps that you would take to design the monitoring system forthe organization.

......................................................................................................................

......................................................................................................................

Figure 7.2: Earned value Chart

Rup

ees

ActualCost

Time Varience(10 day delay)

TotalVariance

ScheduleVariance

Spending Varianceof Cost Overrun

(quantity and price)

Cost Schedule Plan(Baseline)

Value Completed

1 2 3



8

b) How would you collect the required data for monitoring purposes?

.....................................................................................................................

.....................................................................................................................

c) What information would you provide in your Report to the ManagingDirector?

.....................................................................................................................

.....................................................................................................................

7.6 PROJECT CONTROL

Nature of Control

Control is the act of comparing the planned performance with the actual andreducing the difference between the two. It is also the last element in theimplementation cycle of planning-monitoring-controlling. Information is collectedabout system performance, compared with the desired (or planned) level, andaction taken if actual and desired performance differ sufficiently that thecontroller (manager) wishes to decrease the difference. Note that reportingperformance, comparing the differences between desired and actualperformance levels, and accounting for why such differences exist are all partsof the control process.

Objectives of control are :

1. The regulation of results through the alteration of activities.

2. The stewardship of organizational assets.

Most discussions of the control function are firmly focused on regulation. Theproject manager needs to be equally attentive to both regulation andconservation. The Project Manager is shepherd of the organization’s resources.The project manager must guard the physical assets of the organization, itshuman resources, and its financial resources. The processes for conservingthese three different kinds of assets are different.

Types of Control

Physical Asset Control

Physical asset control requires of the use of these assets. It is concerned withthe asset maintenance, whether preventive or corrective. At issue also is thetiming of maintenance or replacement as well as the quality of maintenance.

If the project uses considerable amount of physical equipment, the projectmanager also has the problem of setting up maintenance schedules in such away as to minimize interference with the ongoing work of the project. It iscritical to accomplish preventive maintenance prior to the start of that finalsection of the project life cycle known as the Last Minute Panic (LMP).

Physical inventory, whether equipment or material, must also be controlled. Itmust be received, inspected (or certified), and possibly stored prior to use.Records of all incoming shipments must be carefully validated so that paymentto suppliers can be authorized. The same precautions applicable to goods fromexternal suppliers must also be applied to suppliers from inside the organization.Even such details as the project library, project coffee maker, project roomfurniture, and all the other minor bits and pieces should be accounted,maintained, and conserved.

9

Human Resource Control

Human resouces also need both regulation and conservation. Stewardship ofhuman resources requires controlling and maintaining the growth anddevelopment of people. Projects provide particularly fertile ground for cultivatingpeople. Because projects are unique, differing one from another in many ways,it is possible for people working on projects to gain a wide range of experiencein a reasonably short time.

Measurement of physical resource conservation is accomplished through thefamiliar audit procedures. The measurement of human resource conservation isfar more difficult. Such devices as employee appraisals, personnel performanceindices, and screening methods for appointment, promotion, and retention are notparticularly satisfactory devices for ensuring that the conservation function isbeing properly handled. The accounting profession has worked for some yearson the development of human resource account, and while their efforts haveproduced some interesting ideas, human resource accounting is not wellaccepted by the accounting profession.

Financial Resource Control

Though accountants have not succeeded in developing acceptable methods forhuman resource accounting, their work on techniques for the conservation (andregulation) of financial resources have most certainly resulted in excellent toolsfor financial control. This is the best developed of the basic area needingcontrol. It is difficult to separate those control mechanisms aimed atconservation of financial resources from those focused on regulating their use.Most financial controls do both. Capital investment, controls work toconserve the organization’s assets by insisting that certain conditions be metbefore capital can be expended, and those same conditions usually regulate theuse of capital to achieve the organization’s goals of a high return on itsinvestments.

The techniques of financial control, both conservation and regulation, are wellknown. They include current asset controls. These controls are exercisedthrough a series of analyses and audits, conducted by the accounting/controllerfunction for the most part. Representation of this function on the project teamis mandatory. The structure of the techniques applied to projects does not differappreciably from those applied to the general operation of the firm, but thecontext within which they are applied is quite different. One reason for thedifferences is that the project is accountable to an outsider - an external client,or another division of the parent firm, or both at the same time.

7.7 TYPES OF CONTROL PROCESSES

No matter what our purpose in controlling a project, there are three basic typesof control mechanisms that we can use: cybernetic control, go/no-go control,and post control. In this section we will describe these three types of controland briefly discuss the information requirements of each.

7.7.1 Cybernetic Control

Cybernetic, or steering control is by far the most common type of controlsystem. (Cyber is the Greek work from “helmsman.”) The key feature ofcybernetic control is its automatic operation.

Figure 7.3 shows that a system is operating with inputs being subjected to aprocess that transforms them into outputs. It is this system that we wish tocontrol. In order to do so, we must monitor the system output. This function is



10

performed by a sensor that measures one or more aspects of the output,presumably those aspects one wishes to control. Measurements taken by thesensor are transmitted to the comparator, which compares them with a set ofpredetermined standards. The difference between actual and standards. Thedifference between actual and standard is sent to the decision maker, whichdetermines whether or not the difference is of sufficient size to deservecorrection. If the difference is large enough to warrant action, a signal is sentto the effector, which acts on the process or on the inputs to produce outputthat conform more closely to the standard.

A cybernetic control system that acts to reduce deviations from standard iscalled a negative feedback loop. If the system output moves away fromstandard in one direction, the control mechanism acts to move it in the oppositedirection. The speed or force with which the control operates is, in general,proportional to the size of the deviation from standard. The precise way inwhich the deviation is corrected depends on the nature of the operating systemand the design of the controller.

7.7.2 Go/No-go Controls

Go/No-go controls take the form of testing to see if some specific preconditionhas been met. This type of control can be used on almost every aspect of aproject. For many facets of performance, it is difficult to know that thepredetermined specifications for project output have been met. The same isoften true of the cost and time elements of the project plan.

It is, of course, necessary to exercise judgement in the use of go/no-gocontrols. Certain characteristics of output may be required to fall withinprecisely determined limits if the output is to be accepted by the client. Othercharacteristics may be less precisely defined. In regard to time and cost, theremay be penalties associated with nonconformance with the approved plans.Penalty clauses that make late delivery costly for the producer are oftenincluded in the project contract. At times, early delivery can also carry apenalty. Cost overruns may be shared with the client or totally borne by theproject.

The project plan, budget, and schedule are all control documents, so the projectmanager has a predesigned control system complete with pre-specifiedmilestones as control checkpoints. Control can be exercised at any level ofdetail that is supported by detail in the plans, budgets, and schedules. The partsof a new jet engine, for instance, are individually checked for qualityconformance. These are go/no-go controls. The part passes or it does not, andevery part must pass its own go/no-go test before being used in an engine.

Processk

Effectorand

Decisionmaker

Comparator

Standards

Figure 7.3: A cybernetic control system

Inputsx

Outputsy

Sensor

V

V

V

V V

VV

VV

11

While cybernetic controls are automatic and will check the operating systemscontinuously or as often as designed to do so, go/no-go controls operate onlywhen the controller uses them. In many cases, go/no-go controls functionperiodically, at regular, preset intervals. The intervals are usually determined byclock, calendar, or the operating cycles of some machine system. Such periodicitymakes it easy to administer a control system, but it often allows errors to becompounded before they are detected. Things begin to go awry just after aquarterly progress check, for instance, and by the time the next quarterly checkis made, some items may be seriously out of control. Project milestones do notoccur at neat, periodic intervals; thus, controls should be linked to the actualplans and to the occurrence of real events, not simply to the calendar.

For an early warning system to work, it must be clearly understood that amessenger who brings bad news will not be shot, and that anyone caughtsweeping problems and mistakes under the rug will be. An important rule forany subordinate is the Prime Law of Life on a project : “Never let the boss besurprised!”

7.7.3 Post-control

Post-controls (also “post-performance controls” or “post-project controls”) areapplied after the fact. One might draw parallels between post-control and“locking the barn after the horse has been stolen,” but post-control is not a vainattempt to alter what has already occurred. Instead, it is a full recognition ofGeorge Santayana’s observation that “Those who cannot remember the past arecondemned to repeat it.” Cybernetic and go/no-go controls are directed towardaccomplishing the goals of an ongoing project. Post-control is directed towardimproving the chances for future projects to meet their goals.

Post-control is applied through a relatively formal document that is usuallyconstructed with four distinct sections.

a) The Project Objectives : The post-control will contain a description ofthe objectives of the project. Usually, this description is taken from theproject proposal, and the entire proposal often appears as an appendix tothe post-control report. As reported here, project objectives include theeffects of all change orders issued and approved during the project.

Because actual project performance depends in part of uncontrollableevents) strikes, weather, failure of trusted suppliers, sudden loss of keyemployees, and other acts of God), the key initial assumptions made duringthe preparation of the project budget and schedule should be noted in thissection. A certain amount of care must be taken in reporting theseassumptions. They should not be written with a tone that makes themappear to be execuses for poor performance. While it is clearly theprerogative, if not the duty, of every project manager to politically protecthimself, he or she should do so in moderation to be effective

b) Milestones, Checkpoints, and Budgets : This section starts with a fullreport of project performance against the planned schedule and budget.This can be prepared by combining and editing the various project statusreports made during the project’s life. Significant deviations of actualschedule and budget from planned schedule and budget should behighlighted. Explanations of why these, deviations occurred will be offeredin the next section of the post-control report. Each deviation can beidentified with a letter or number to index it to the explanations. Where thesame explanation is associated with both a schedule and budget deviation,as well often be the case, the same identifier can be used.

c) The Final Report on Project Results : Note that in the previoussection, when significant variations of actual from planned projectperformance were indicated, no distinction was made between favourable



12

and unfavourable variations. Like the tongue that invariably goes to thesore tooth, project managers focus their attention on trouble. While this isquite natural, it leads to complete documentation on why some things wentwrong and title or no documentation on why some things went particularlywell. Both sides, the good and the bad, should be chronicled here.

Not only do most projects result in outputs that are more or less satisfactory,most projects operate with a process that is more or less satisfactory. Theconcern here is not on what the project did but rather on how it did it.Basically descriptive, this part of the final report should cover projectorganization, an explanation of the methods used to plan and direct the project,and a review of the communication networks, monitoring systems, and controlmethods, as well as a discussion of intraproject interactions between the variousworking groups.

Recommendations for Performance and Process Improvement: Theculmination of the post-control report is a set of recommendations covering theways future projects for improving. Many of the explanations appearing in theprevious section are related to one-time happenings, sickness, weather, strikes,the appearance of a new technology, etc., that themselves are not apt to affectfuture project-although other different one-time events may effect them. Butsome of the deviations from plan were caused by happenings that are verylikely to recur. Provision for such things can be factored into future projectplans, thereby adding to predictability and control.

Just as important, the process of organizing and conducting projects can beimproved by recommending the continuation of managerial methods andorganizational systems that appear to effect, together with the alteration ofpractices and procedures that do not. In this way, the conduct of projects willbecome smoother, just as the likelihood of achieving good results, on time andon cost, is increased.

Activity 2

President of an MNC has asked you to develop control system for hisorganization:

a) List out the activities that you would cover while developing control systemfor the organization.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

b) List out the various assets of the organization that would require control.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

c) List out the three basic types of control mechanisms that you wouldemploy in the organization.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

13

7.8 DESIGN OF CONTROL SYSTEMS

Irrespective of the type of control used, there are some important questions tobe answered while designing any control system: who sets the standards? Howrealistic are the standards? How clear are they? Will they achieve the project’sgoals? What output, activities, behaviours should be monitored? Should wemonitor people? What kinds of sensors should be used? Where should they beplaced? How timely must be monitoring be? How rapidly must it be reported?How accurate must sensors be?

If the control system is to be acceptable to those who will use it and thosewho will be controlled by it, the system must be designed so that it appears tobe sensible. Standards must be achievable by the mechanical systems used.Control limits must be appropriate to the needs of the client, that is, not merelyset to show “how good we are.” Like punishment, rewards and penalties should“fit the crime.”

In addition to being sensible, a good control system should also possess someother characteristics as set out below :

� The system should be flexible. Where possible, it should be able to react toand report unforseen changes in system performance.

� The system should be cost-effective. The cost of control should neverexceed the value of control. As we noted above, control is not always lessexpensive than scrap.

� The control system must be truly useful. It must satisfy the real needs ofthe project, not the whims of the project manager.

� The system must operate in a timely manner. Problems must be reportedwhile there is still time to do something about them, and before theybecome large enough to destroy the project.

� Sensors and monitors should be sufficiently accurate and precise to controlthe project within limits that are truly functional for the client and theparent organization.

� The system should be as simple to operate as possible.

� The control system should be easy to maintain. Further, the control systemshould signal the overall controller if it goes out of order.

� The system should be capable of being extended or otherwise altered.

� Control systems should be fully documented when installed and thedocumentation should include a complete training program in systemoperation.

No matter how designed, all of the control systems described above usefeedback as a control process. Let us now consider some more specificaspects of control. To a large extent, the Project Manager is trying to anticipateproblems or catch them just as they begin to occur. The Project Managerwants to keep the project out of trouble because upper management oftenbases an incremental funding decision on a review of the project. This reviewtypically follows some particular milestone and, if acceptable, leads to a follow-on authorization to proceed to the next review point. If all is not going well,other technological alternatives may be recommended; or if things are goingbadly, the project may be terminated. Thus, the project manager must monitorand control the project quite closely.

The control of performance, cost, and time usually requires different input data.To control performance, the project manager may need such specificdocumentation as engineering change notices, test results, quality checks,



14

rework tickets, scrap rates, and maintenance activities. For cost control, themanager compares budgets to actual cash flows, purchase orders, labour hourcharges, amount of overtime worked, absenteeism, accounting variance reports,accounting projections, income reports, cost exception reports, and the like. Tocontrol the schedule, the project manager examines bench mark reports,periodic activity and status reports, exception reports, PERT/CPM networks,Gantt charts, the master project schedule, earned value graphs, and probablyreviews the Action Plans.

Some of the most important analytical tools available to the project manager touse in controlling the project are variance analysis and trend projection.

Earned value analysis was also described earlier. On occasion it may beworthwhile, particularly on large projects for the project manager to calculate aset of critical ratios for all project activities. The critical ratio is.

(Actual Progress/Scheduled Progress) x (Budgeted Cost/Actual Cost)

If this ratio is exactly one, then the activity is probably on target. If the ratiodiffers from one, then the activity may need to be investigated. The closer theratio is to one, the less important is the investigation. Consider Table 7.1 forexample.

We can see that the first task is being scheduled but below budget. If delay isno problem for this activity, the project manager need take no action. Thesecond task is on budget but its physical progress is lagging. Even if there isslackness in the activity, the budget will probably be overrun. The third task ison schedule but cost is running higher than budget, creating another probablecost overrun. The fourth task is on budget but ahead of schedule. A costsaving may result. Finally, the fifth task is on schedule and is running underbudget, another probable cost saving.

Task 4 and 5 have critical ratios greater than one and might not concern someproject manager but the thoughtful manager would like to know why they aredoing so well (and the project manager may also want to check the informationsystem to validate the unexpectedly favourable findings). The second and thirdactivities need attention, and the first task may need attention also. The projectmanager may set some critical-ratio control limits intuitively.

Table 7.1: (Actual Progress/Scheduled Progress) x (Budget Cost/Actual Cost)

Task Actual Scheduled Budgeted Actual CriticalNumber Progress Progress Cost Cost Ratio

1 (2 / 3) % (6 / 4) = 1.0

2 (2 / 3) % (6 / 4) = .67

3 (3 / 3) % (4 / 6) = .67

4 (3 / 2) % (6 / 6) = 1.5

5 (3 / 3) % (6 / 4) = 1.5

7.9 CONTROL OF CREATIVE ACTIVITIES

Some brief attention should be paid to the special case of controlling researchand development projects, design projects, and similar processes that dependintimately on the creativity of individuals and teams. First, the more creativityinvolved, the greater the degree of uncertainty surrounding outcomes. Second,

15

too much control tends to inhibit creativity. Control is not necessarily the enemyof creativity; nor, popular myth to the contrary, does creative activity implycomplete uncertainty. While the exact outcomes of creative activity may bemore or less uncertain, the process of getting the outcome is usually notuncertain.

In order to control creative projects, the project manager must adopt one orsome combination of three general approaches to the problem: (1) progressreview, (2) personnel reassignment, and (3) control of input resources.

7.10 PROGRESS REVIEW

The progress review focuses on the process of reaching outcomes rather thanon the outcomes per se. Because the outcomes are partially dependent on theprocess used to achieve them - uncertain though they may be - the process issubjected to control. For example, in the case of research projects theresearcher cannot be held responsible for the outcome of the research, but canmost certainly be held responsible for adherence to the research proposal, thebudget, and the schedule. The process is controllable even if the precise resultsare not.

7.11 PERSONNEL REASSIGNMENT

This type of control operates in a very straightforward way. Individuals whoare productive are retained. Those who are not to be retained are moved toother jobs or to other organizations. Problems with this technique can arisebecause it is easy to create an elite group. While the favoured few are highlymotivated to further achievement, everyone else tends to be demotivated. It isalso important not to apply control with too fine an edge. While it is notparticularly difficult to identify those who falls in the top and bottom quartiles ofproductivity, it is usually quite hard to make clear distinctions between people inthe middle quartiles.

7.12 CONTROL OF INPUT RESOURCES

In this case, the focus is of efficiency. The ability to manipulate input resourcescarries with it considerable control over output. Obviously, efficiency is notsynonymous with creativity, but the converse is equally untrue. Creativity is notsynonymous with extravagant use of resources.

The results flowing from creative activity tend to arrive in batches.Considerable resource expenditure may occur with no visible results, but then,seemingly all of a sudden, many outcomes may be delivered. The milestonesfor application of resource control must, therefore, be chosen with great care.The controller who decides to withhold resources just before the fruition of aresearch project is apt to become an ex-controller.

Sound judgement argues for some blend of these three approaches whencontrolling creative projects. The first and third approaches concentrate onprocess because process is observable and can be affected. But process is notthe matter of moment; results are. The second approach requires us tomeasure (or at least to recognize) output when it occurs. This is often quitedifficult. Thus, the wise project manager will use all three approaches: checkingprocess and method, manipulating resources, and culling those who cannot or donot produce.



16

7.13 SUMMARY

Project is a set of complex interelated activities. A bottleneck at any one of thestages has an impact on the completion schedule of other stages, therefore forany project a monitoring system is a must. The frequency and the type ofmonitoring as well as data collection for monitoring will vary from project toproject. Project monitoring reports are basically of three types 1) Routine, 2)Exception, 3) Special Analysis.

Project control is the act of comparing the planned performance with the actualand reducing the difference between the two. Project control has three domains1) Physical Asset Control, 2) Human Resource Control, 3) Financial ResourceControl.


1) What is the purpose of control? To what is it directed?

2) What are the three main types of control systems? What questions shoulda control system answer?

3) What tools are available to the project manager to use in controlling aproject? Identify some characteristics of a good control system.

4) What is the mathematical expression for the critical ratio? What does it tella manager?

5) How might the project manager integrate the various control tools into aproject control system?

6) How could a feedback control system be implemented in projectmanagement to anticipate client problems?

7) Define monitoring. Are there any additional activities that should be part ofthe monitoring function?

8) Calculate the critical ratios for the following activities and indicate whichactivities are probably on target and which need to be investigated.

Activity Actual Scheduled Budgeted Actual CostProgress Progress Cost

A 4 days 4 days Rs. 60 Rs. 40

B 3 days 2 days Rs. 50 Rs. 50

C 2 days 3 days Rs. 30 Rs. 20

D 1 day 1 day Rs. 20 Rs. 30

E 2 days 4 days Rs. 25 Rs. 25

9) Give the following information, which activities are on time, which areearly, and which are behind schedule?

Activity Budgeted Cost Actual Cost Critical Ration

A Rs. 60 Rs. 40 1.0

B Rs. 25 Rs. 50 0.5

C Rs. 45 Rs. 30 1.5

D Rs. 20 Rs. 20 1.5

E Rs. 50 Rs. 50 0.67

17


Cleland, D.I., and W.R. King, “Systems Analysis and Project management,”MC Graw Mill, 1983.

Kerridge, A.E. and vervalin C.H., “Project Management,” Gulf Publishing,London, 1986.

Wadsworth, M.D., “Project Management Controls,” Prentic Hall, 1982.


5

UNIT 8 CAPITAL BUDGETING DECISIONSAND THE CAPITAL ASSETPRICING MODEL

Objectives

Objectives of the Units are :

� to examine the relevance of risk in capital budgeting decisions,

� to understand the application and usefulness of capital asset pricing modelin capital budgeting decisions,

� to study the certainty equivalent and risk adjusted discounting rateapproaches.

Structure

8.1 Introduction

8.2 Capital Asset Pricing Model

8.3 Measuring Betas and Capital Asset

8.4 Stability of Betas over Time

8.5 Business and Financial Risk

8.6 What determines Asset Betas

8.7 Discounted Cash Flow Approach

8.8 Summary



8.1 INTRODUCTION

Long before the development of capital asset pricing theory1, which says thatthe equilibrium rates of return on all risky assets are a function of theircovariance with the market portfolio; smart financial managers adjusted for riskin capital budgeting. They realized intuitively that, if other things being equal,risky projects are less desirable than safe ones. Therefore, they demanded ahigher rate of return from risky projects or they based their decisions onconservative estimates of the cash flows.

Various rule of thumb are often used to make these risk adjustments. Forexample, many companies estimate the rate of return required by investors inits securities and use this required rate of return to discount the cash flows onall new projects. Since investors require a higher rate of return from a veryrisk company, such a firm will have a higher company cost of capital and willset a higher discount rate for its new investment opportunities.

You can use the capital asset pricing model as a rule of thumb for estimatingthe company’s cost of capital. For instance ABC Ltd. has a beta of 1.38, therisk free rate is 7.8 per cent and expected market risk premium 8.3 per centthen, the corresponding expected rate of return would be 203 or about 20 percent. Therefore, according to the company cost of capital rule, ABC shouldhave been using a 20 per cent discount rate to compute project net presentvalues2.

1 CAPM was first developed by William Sharpe in 1963, 64, and later on developed byJ.Mossin, 1963, J. Lintner, 1965, F. Black, 1972.

2 ABC did not use any significant amount of debt financing. Thus its cost of capital is therate of return investors except on its common stock.

Investment DecisionsUnder Uncertainty

6

This is a step in the right direction. Even though we can’t measure betas orthe market risk premium with absolute precision, it is still reasonable to assertthat ABC faced more risk than the average firm and, therefore, should havedemanded a higher rate of return from its capital investments.

But the company cost of capital rule can also get a firm into trouble if the newprojects are more or less risky than its existing business. Each project shouldbe evaluated at its own opportunity cost of capital. This is a clear implicationof the value-additivity principle. For a firm composed of assets A and B, firmvalue will be:

Firm’s value=PV(AB)=PV(A)+PV(B)= sum of separate asset values.

Here PV(A) and PV(B) are valued just as if they were mini-firms in whichstock-holders could invest directly. Note: Investors would value A by discountingits forecasted cash flows at a rate reflecting the risk of A. They would valueB by discounting at a rate relfecting the risk of B. The two discount rateswill, in general, be different.

Figure 8.1 exhibits a comparison between the company cost of capital rule andthe required return under the capital asset pricing model. ABC’s company costof capital is about 20 per cent. This is the correct discount rate only if theproject beta is 1.38. In general, the correct discount rate increases as projectbeta increases. ABC should accept projects with rates of return above thesecurity market line relating required return to beta.

If the firm considers investing in a third project C, it should also value C as ifit were a mini-firm. That is, it should discount the cash flows of C at theexpected rate of return investors would demand to make a separate investmentin C. The true cost of capital depends on the use to which the capital is put.

8.2 CAPITAL ASSET PRICING MODEL (CAPM)

CAPM approach is used to estimate risk adjusted discount rate for makinginvestment decisioins. It is a theory about how the prices of risky financialassets (securities) are determined in the capial market.

Capital asset pricing theory tells us to invest in any project offering a returnthat more than compensates for the project’s beta. This means that ABC

(required return)

Security market line showing

Required return on project

Company cost of capital

Project beta

20.3

7.8

Average beta of the firm’s assets = 1.38

Figure 8.1: Relationship between required return and Project Beta

7

should have accepted any project above the upward-sloping market line inFigure 8.1. If the project had a high beta ABC needed a higher prospectivereturn than if the project had a low beta. Now contrast this with the companycost of capital rule, which is to accept any project regardless of its beta aslong as it offers a higher return than the company’s cost of capital. In termsof Figure 8.1, it tells ABC to accept any project above the horizontal cost-of-capital line-that is, any project offering a return of more than 20 per cent.

It would be silly to suggest that ABC should demand the same rate of returnfrom a very safe project as from a very risky one. If ABC used the companycost of capital rule, it would reject many good low-risk projects and acceptmany poor high-risk projects. It is also fully to suggest that, just because XYZLtd. has a low company cost of capital, it is justified in accepting projects thatABC would reject. If you followed such a rule to its seemingly logicalconclusion, you would think it possible to enlarge the company’s opportunities byinvesting a large sum in risk free securities. That would make the commonstock safe and create a low company cost of capital.

The notion that each company has some individual discount rate or cost ofcapital is widespread, but far from universal. Many firms require differentreturns from different categories of investment. Discount rates might be setfor different investment purposes as given below :

Category Discount Rate Percent

Speculative ventures 30New product 20Expansion of existing business 15 (Company cost

of capital)Cost improvement, known technology. 10

In brief, the main insights of CAPM are :

� Investors need be rewarded for systematic risk only because insystematicrisk can be reduced to zero through diversification of investment profolio.

� A security’s systematic risk is measured by beta value.

� The required rate of return on a security depends on riskless rate ofinterest the market risk premium and the security’s beta value.

8.3 MEASURING BETAS AND CAPITAL ASSET

Now the question arises how to use beta pricing model to help cope with risk incapital budgeting situation the main problem in how to estimate the discount rate.

r = rf + ß

P (r

m - r

f)

r = Discounting rate

rf = Risk free rate

rm = Market rate of return

ßP = Project beta

And in order to do that you have to figure out the project beta. It is a difficultproblem so much so that many people hope it will go away if they ignore it.They may go away but unfortunately the problem won’t - any investmentdecision that is made contains an implicit assumption about project risk.

Capital Budgeting Decisionsand the Capital Asset

Pricing Model


8

We will start by reconsidering the problems you would encounter in using betato estimate a company’s cost of capital. It turns out that beta is difficult tomeasure accurately for an individual firm, much greater accuracy can beachieved by looking at an average of similar companies. But then we have todefine the ‘similar.’ Among other things we will find that a firm’s borrowingpolicy affects its stock’s beta. It would be incorrect, for example, to averagethe beta of a company which has borrowed heavily and the one which has not,although, they may have similarity otherwise.

The company’s cost of capital is the correct discount rate for projects thathave the same risk as the company’s existing business but not for those thatare safer or riskier than the company’s average. The problem is to judge therelative risk of the projects available to the firm. In order to handle thatproblem, we will need to dig a little deeper and look at what features makesome investments riskier than others.

There is still another complication: project betas can shift over time. Someprojects are safer in youth than in old age, others are riskier. In this case,what do we mean by the project beta? There may be a separate beta foreach year of the project’s life. To put it another way, can we jump from thecapital asset pricing model, which looks out one period into the future, to thediscounted-cash-flow formula for valuing long-lived assets? Most of the time itis safe to do so, but you should be able to recognize and deal with exceptions.

Capital asset pricing theory supplies no mechanical formula for measuring andadjusting for risk in capital budgeting. These tasks of financial management willbe among the last to be automated. The best a financial manager can do is tocombine an understanding of the theory with good judgement and a good nosefor hidden clues.

Suppose that you were considering an across-the-board expansion by your firm.Such an investment would have about the same degree of risk as the existingbusiness. Therefore, you should discount the projected flows at the companycost of capital. To estimate that, you could begin by estimating the beta of thecompany’s stock.

Table 8.1

Sharpe and Cooper divided stocks into risk classes according to their betas in one5-year period (class 10 contains high betas, class 1 contains low betas). They thenlooked at how many of these stocks were in the same risk class 5 years later.

Risk Percent in Same Risk Percent Within ClassClass 5 Years Later 5 Years Later

10 35 69

9 18 54

8 16 45

7 13 41

6 14 39

5 14 42

4 13 40

3 16 45

2 21 61

1 40 62

3 W.F. sharpe and G.M. Cooper, “Risk-Return Classes of New York Exchange CommonStocks, 1931-1967”, Financial Analysis Journal, 28:46-54, 81 (March-April 1972)

9

An obvious way to measure the beta of a stock is to look at how its price hasresponded in the past to market movements. We may plot monthly rates ofreturn of Company against market returns for the same months. We may fit aline through the points. Beta is the slope of the line (See Figure 8.2). It couldvary from one period to the other. If we use the past beta of a stock topredict its future beta, we would, in most cases, not have been too far off.

8.4 STABILITY OF BETAS OVER TIME

Of course, evidence from two (carefully selected) stocks is not worth much,but betas appear to be reasonably stable. An extensive study of stability wasprovided by Sharpe and Cooper3. They divided stocks into 10 classes accordingto the estimated beta in that period. Each class contained one-tenth of thestocks in the sample. The stocks with the lowest betas went into class1.Class 2 contained stocks with slightly higher betas, and so on. They thenlooked at the frequency with which stocks jumped from one class to another.The more jumps, the less stability. You can see from Table - 8.1 that there isa marked tendency for stocks with very high or very low betas to stay thatway. If you are willing to stretch the definition of stable to include a jump toan adjacent risk class, then from 40 to 70 percent of the betas were stableover the subsequent 5 years.

One reason that these estimates of beta are only imperfect guides to the futureis that the stocks may genuinely change their market risk. However, a moreimportant reason is that the betas in any one period are just estimates based ona limited number of observations. If good company news coincides by chancewith high market returns, the stock’s beta will appear higher than if the newscoincides with low market returns. We can twist this the other way around.If a stock appears to have a high beta, it may be because it genuinely doeshave a high beta, or it may be because we have over estimated it.

Figure 8.2: Estimating Beta

Market return

Company return

b


Pricing Model


10

This explains some of the fluctuation in betas observed by Sharpe and Cooper.Suppose a company’s true beta really is stable. Its apparent (estimated) betawill fluctuate from period to period due to random measurement errors. So thestability of true betas is probably better than Sharpe and Cooper’s results seemto imply.

Asset Betas and Equity Betas

Think again of what the company cost of capital is and what it is used for.We define it as the opportunity cost of capital for the firm’s existing assets;we use it to value new assets which have the same risk as the old ones. Theright beta for calculating the company cost of capital is the beta of the firm’sexisting assets, its asset beta.

Let us take a simple balance sheet with assets on the left and debt and equityon the right.

Asset value Debt Value (D)Equity value (E)

Asset value Firm value (V)

Note that the values of debt and equity add up to firm value (D + E = V), andthat firm value equals asset value.

Stockholders own the firm’s equity but they can’t claim all of the asset value;they have to share it with debt holders. The debt holders receive part of thecash flows generated by the firm’s assets, and they may bear part of theasset’s risks. (For example, if the assets turn out to be worthless, there will beno cash to pay stockholders or debt holders.) But debt holders of big firmssuch as TISCO bear much less risk than stockholders. Debt betas aretypically close to zero-close enough that for large blue-chip companies manyfinancial analyst just assume ß

debt=0. But we want the asset beta, ß

asset. How

do we get it?

Suppose you buy all the firm’s securities - 100 per cent of the debt and 100percent of the equity. You would own the assets lock, stock, and barrel. Youwouldn’t have to share the firm’s asset value with anyone; every rupee of cashthe firm pays out would be paid out to you. You wouldn’t share the risks withanyone else, either; you bear them all. Thus the beta of your debt plus equityportfolio would equal the firm’s asset beta.

The beta of this hypothetical portfolio is just a weighted average of the debtand equity betas4.

ßasset

= ßportfolio

= ßdebt

debt

debt equity+ + ßequity

equity

debt equity+

Calculating LMN Ltd. Asset Beta and Company’s Cost of Capital

Now that we know how to derive the beta of a firm’s assets from the beta ofits stock, we can return to the problem of figuring out company’s cost ofcapital. Say LMN Ltd. common stock ß is 0.36 and its common stockaccounted for 35 percent of its market value. The remaining 65 percentconsisted of debt and preferred stock. To keep matters simple we will just

4 Here we ignore certain tax complications. If debt interest generates valuable tax savings,then the formula for ß asset changes somewhat.

11

lump the preferred stock in with the debt and assume both are risk-free. Thisgives us the following estimates for the beta of LMN’s assets:

ßasset

= ßdebt

= ßdebt

debt

debt equity+ + ßequity

equity

debt equity+

= 0(.65) + .36(.35) = .13

Of course, this is a very low number. The reason for this is that LMM’s stockbeta is low (only 0.36) despite its heavy use of debt and correspondingly highfinancial risk. When the financial risk is removed, we find the remainingbusiness risk to be small.

With a risk-free rate of 7.8 per cent and an expected market risk premium of8.3 percent, LMN’s cost of capital is

r = rf+ß

asset (r

m-r

f)

= .078 + .13(.083) .089, or 8.9 per cent.

This estimate is probably low, because we arbitrarily assumed LMN’s debt wastotally risk-free. If we had used ß

debt = 0.15,

ßasset

= ßdebt

+ßequity

= .15(.65) + .36(.35)

= .22

r = rf+ß

asset(r

m–r

f)

=.078 + .22(.083) = .097, or 9.7%

8.5 BUSINESS AND FINANCIAL RISK

A firm’s asset beta reflects its business risk. The difference between its equityand asset beta reflects financial risk. More debt means more financial risk.

What would happen if LMN decided to use more debt and correspondingly lessequity? It would not affect the firm’s business risk. There would be nochange in the firm’s asset beta, and no change in the beta of a portfolio of allthe firm’s debt and equity security. The equity beta would change, however.

Let’s go back to the formula for ßasset

,

ßasset

= ßdebt

equitydebt

debt

+ + ßequity

equitydebt

equity

+

and solve the formula for ßequity

ßequity =

ßasset

+ (ßasset

– ßdebt

) equity

debt

If we assume LMN’s debt is risk-free, we have

ßequity

= .13 + (.13 – 0) = .36


Pricing Model


12

But if the company switched to 75 percent debt, ßequity

would go up to .52.On the other hand, if LMN paid off all its debt, we would expect to find:

ßequity

= ßasset

(ßasset

– ßdebt

) equity

debt

= .13 + (.13 - 0)

= .13

With no debt, the firm’s asset and equity betas would be exactly the same.

In general, the observed equity beta depends on the firm’s asset beta, ßasset

, thespread between the asset and debt betas, ß

asset - ß

debt, and the ratio of debt to

equity. Figure 8.3 plots the relationship assuming risk free debt (ßdebt

=0).

In many ways we have given an oversimplified version of how financialleverage affects equity risks and returns. We have said nothing about taxes,for example. The finer points can wait. For now, there are really just twopoints to remember. First, financial leverage creates financial risk. The beta ofthe firm’s stock increases in proportion to the amount borrowed. Second, assetbetas can always be calculated as a weighted average of the betas of thevarious debt and equity securities issued by the firm. Of course, it is the assetbeta that is relevant in capital-budgeting decisions, not the beta of the firm’s stock.

8.6 WHAT DETERMINES ASSET BETAS?

Stock or industry betas provide a rough guide to the risk typically encounteredin various lines of business. But an asset beta for, say, the steel industry cantake us only so far. Not all investments made in the steel industry are“typical.” What other kinds of evidence about business risk might a financialmanager examine?

In some cases the asset is publicly traded. If so, we can simply estimate itsbeta from past price data. For example, suppose a firm wants to analyze therisks of holding a large inventory of copper. Because copper is a standardized,widely traded commodity, it is possible to calculate rates of return from holdingcopper and to calculate a copper beta.

What should we do if our asset has no such convenient price record? Theadvice is to search for characteristics of the asset that are associated with highor low betas. We wish we had a more fundamental scientific understanding ofwhat these characteristics are. We see business risks surfacing in capitalmarkets, but as yet there is no completely satisfactory theory describing howthose risks are generated. Nevertheless, some things are known.

Figure 8.3: Effect of Financial Leverage on ß of equity

Effect of financial leverage onß

equity, the beta of the firm’s

common stock. The higherthe debt-equity ratio, thehigher ß

equity. When the firm

uses no debt (E=0), ßequity

=ß

asset; asset measures the

business risk of the firm’sassets. Note that this figureis drawn assuming risk-freedebt (ßdebt=0).

ß, Beta

ßequty

ßasset

0

D/E = 0D/E, Debt-equity ratio

13

Cyclicality

Many people intuitively associate risk with the variability of book or accountingearnings. But much of this variability reflects diversifiable or unique risk. Loneprospectors in search of gold look forward to extremely uncertain futureearnings, but whether or not they strike it rich is unlikely to depend on theperformance of the market portfolio. Even if they do find gold, they do notbear much market risk. Therefore an investment in gold has a high standarddeviation but a relatively low beta.

What really counts is the strength of the relationship between the firm’searnings and the aggregate earnings on all real assets. We can measure thiseither by the accounting beta or by the cash-flow beta. These are just like areal beta except that changes in book earnings or cash flow are used in placeof rates of return on securities. We would predict that firms with highaccounting or cash-flow betas should also have high stock betas - and theprediction is correct.

This means that cyclical firms - firms whose revenues and earnings arestrongly dependent on the state of business cycle - tend to be high-beta firms.Thus you should demand a higher rate of return from investments whoseperformance is strongly tied to the performance of the economy.

Operating Leverage

We have already seen that financial leverage - in other words, the commitmentto fixed debt charges - increases the beta of an investor’s portfolio. In just thesame way, operating leverage - in other words, the commitment to fixedproduction charges - must add to the beta of a capital project. Let’s see howthis works.

The cash flows generated by any productive asset can be broken down intorevenue, fixed costs, and variable cost.

Cash flow = revenue – fixed cost – variable cost.

Costs are variable if they depend on the rate of output. Examples are rawmaterials, sales commission, and some labor and maintenance costs. Fixedcosts are cash outflows that occur regardless of whether the asset is active oridle - property taxes, for example, or the wages of workers under contract.

We can break down the asset’s present value in the same way:

PV(asset)=PV(revenue)-PV(fixed cost) - PV (variable cost)

Or equivalently:

PV(revenue)=PV(Fixed Cost)+PV(variable cost)+PV(asset)

Those who receive the fixed costs are like debtholders in the project. Thosewho receive the net cash flows from the asset are like holders of leveredequity in PV(revenue).

We can now figure out how the asset’s beta is related to the betas of thevalues of revenue and costs. We just use our previous formula with the betasrelabeled:

ßrevenue

= ßfixed cost

)PV(revenue

t)PV (fixed cos + ß

variable cost )(revenuePV

ecost)PV(variabl + ß

asset )(

)(

revenuePV

assetPV


Pricing Model


14

In other words, the beta of the value of the revenues is simply a weightedaverage of the beta of its component parts. Now the fixed-cost beta is zero bydefinition: whoever receives the fixed costs holds a safe asset. The betas ofthe revenues and variable costs should be approximately the same, becausethey respond to the same underlying variable, the rate of output. Therefore, wecan substitute ß

revenue for ß

variable cost and solve for the asset beta. Remember

that ßfixed cost

= 0.

ßasset

= ßrevenue

PV(asset)

cost)ePV(variabl)PV(revenue −

= ßrevenue

+

PV(asset)

cost)PV(fixed1

Thus, given the cyclicality of revenue (reflected in ßrevenue

), asset beta isproportional to the ratio of the present value of fixed costs to the present valueof the project.

Now we have a rule of thumb for judging the relative risks of alternativedesigns or technologies for producing the same product. Other things beingequal, the alternative with the higher ratio of fixed costs to project value willhave the higher project beta.

Firms or assets whose costs are mostly fixed are said to have high operatingleverage. As we have seen, the analogy between financial and operatingleverage is almost exact. The beta of the stock increases in proportion to theratio of debt to equity, and the beta of the asset increases in proportion to theratio of the value of the fixed costs to the value of the asset. Empirical testsconfirm that companies with high operating leverage actually do have highbetas.

Searching for Clues

Recent research suggests a variety of other factors that affect an asset’s beta.But going through a long list of these possible determinants would take us toofar afield.

You cannot expect to estimate the relative risk of assets with any precision, butgood managers examine any project from a variety of angles and look for cluesas to its riskiness. They know that high market risk is a characteristic ofcyclical ventures and of projects with high fixed costs. They think about themajor uncertainties affecting the economy and consider how projects areaffected by these uncertainties.

8.7 DISCOUNTED CASH FLOW APPROACH

We have spent the bulk of this unit discussing how you might estimate the riskand required return on a project. We now have to worry a little about whathappens as risk changes over the life of a project.

We have implied that an expected rate of return calculated from the capitalasset pricing modelr = r

f + ß(r

m - r

f)

15

This could be plugged into the standard discounted cash flow formula as

tfmf

tt

t

)]r-(rr[1

C

1t

T

r)(1

C

1t

T

PVβ++=

=+=

=

You should not take step without thinking about it first. In capital budgeting wemust usually value cash flows extending over several future periods. Thediscounted cash flow formula does this is one step, but the capital asset pricingmodel looks at rates of return and prices over one period at a time.

One-period projects pose no problems.

)r-(rr1

C

r1

CPV

fmf

11

β++=

+=

Longer-lived assets likewise pose no problem if you have an estimate of PVt,

future value 1 period hence

)r-(rr1

PVC

r1

PV1C1PV

fmf

11

β+++

=+

+=

But suppose that your company is evaluating the construction of a nuclearpower station and asks your advice on how to calculate its present value.Would you tell it not to bother about anything other than the cash flow in thefirst period and the end-of-period value? Of course not. The end-of-periodvalue depends on the cash flow in later periods. You would want a formulathat explicitly took this into account. This is formally correct only if we knowthat the discount rates that will prevail in future periods will be the same asthis year’s. Among other things, this requires the asset’s beta to be constantover the asset’s entire future life. Only under that crucial assumption it isstrictly proper to write down the discounted cash flow formula with a singlediscount rate for all future cash flows.

What does that assumption mean in practical terms? In order to answer thatquestion we must develop alternative formulae for calculating present valuewhen beta and r do vary.

Certainty Equivalents

Let us start with a single future cash flow C1. If C

1 is certain, its present

value is found by discounting at the risk-free rate rf

f

1

r1

CPV

+=

If the cash flow is risky, the normal procedure is to discount its forecasted(expected) value at a risk-adjusted discount rate r which is greater than r

f.5

Another approach is to ask, “What is the smallest certain return for which Iwould exchange the risky cash flow C

1? This is called the certainty equivalent

of C1, denoted by CEQ

1

Suppose that the forecasted value of the risky cash flow is Rs.1000, but thatyou would be willing to trade it for a safe cash flow of as little as Rs.800.Then Rs.800 is the certainty equivalent of the risky cash flow. You areindifferent between an Rs.800 safe return and an expected but risky cash flowof Rs.1000.

5 The quantity r can be less than rf for assets with negative betas. But the betas of the

assets which corporations hold are almost always positive.


Pricing Model


16

What is the present value of Rs.1000 forecasted cash flow? It must be thesame as the present value of a certain Rs.800, because by definition you areindifferent between the two flows. Suppose the risk-free rate of interest isr

f = 0.08. Then

PV of forecasted Rs.1000 cash flow = f

1

r1

CEQ

+ = 08.1

800 = Rs. 740.74

We could have gotten the same answer by discounting Rs.1000 at a risk-adjusted rate. We can figure out what the proper discount rate is. If

PV = r1

1000

+ = Rs.740.74

then r = 0.35, or 35 per cent

Now we have two equivalent expression for PV.

PV =

As long as you look only one period into the future, the two formulas areexactly the same. But there are important differences when the concept ofcertainty equivalents is applied to cash flows generated by long-lived assets.

Relationship of Certainty Equivalent and Risk-Adjusted Discount RateFormulas for Long-Lived Assets

We can easily extend the concept of certainty equivalents to long-lived assets:

tf

ttt

f

t

)r(1

Ca

1t

T

)r(1

CEQ

1t

T

PV+=

=+=

=

where at is the ratio of the certainty equivalent of a cash flow to its expected

value (at = CEQ

t/C

t). Normally a

t will be positive, but less than 1.06.

Table 8.4Example showing certainty equivalents implied by use of constant risk-

adjusted discount rate

Period Expected Present Certainty at Ratio Present Value

Cash Value Using Equilvalent of CEQt

of CEQS at 4%Flow = C

t10% Risk- CEQ

t Implied TO C

tRisk-Free Rate

Discount Rate, By use ofPV = C

t/(1.10)t 10% Discount

CEQt = C

t

t

r1

rf1

++

0 -350 -350 -350 1.00 -3501 100 91 95 0.945 912 100 83 89 0.894 833 100 75 85 0.845 754 100 68 80 0.799 685 100 62 76 0.755 62

Net present value = 2 9 2 9

Note: By using a constant risk-adjusted discount rate of 10 per cent the financemanager is implicitly making larger deductions for risk from the later cash flows.Notice that discounting the cash flows at 10 per cent or the certainty equivalents at4 per cent would give NPV = 29.

6 The quantity at would be greater than 1.0 for negative-beta assets.

17

When we discount at a constant risk-adjusted rate rt we are implicitly making a

special assumption about the coefficients at. Consider an asset offering cash

flows in 2 periods. If the certainty equivalent and risk-adjusted discount rateformulas are really equivalent, they should give the same present value for eachcash flow:

2f

222

2

f

111

)r(1

Ca

r)(1

Cand

r1

Ca

r1

C

+=

=+=

+

But this implies that

21

2

2f

1 )(ar1

rf1aand

r 1

r1a =

=+

==+

In general, you are justified in using a constant risk-adjusted discount rate r tovalue the cash flow for each period only if the value of a

t decreases over time

at a constant rate. The formula is

t1

tf

t )(ar1

r1a =

++

=

Using Risk-Adjusted Discount Rates — An Example

Consider a project requiring Rs.350 today (t = 0) and offering expected cashflows of Rs.100 per year for 5 years. The risk-free rate is 4 percent, themarket risk premium is 9 percent, and the estimated beta is 0.67; therefore, thefinancial manager settles on a discount rate of

r = rt + ß(r

m-r

t)

= 0.04 + .67(0.09)= 0.10, or 10%

The project’s net present value is calculated as

Rs.29350)10.1(

100

2t

5

350-PVNPVt

=−= ==

What is the finance manager implicitly assuming about the values of at? The

answer is given by Table 8.4. By using a constant discount rate the financemanager is effectively making a much larger deduction for risk from the latercash flows. The larger deduction is reflected in lower values for a

t. Notice

also that at. decreases at a constant compound rate of about 5.5. per cent per

year.

It is usually reasonable to assume that risk increases at a constant rate. Forexample, if you are willing to assume that beta is constant in each futureperiod, then the risk borne per period will be constant but cumulative risk willgrow steadily as you look further into the future.

When You Cannot Use a Single Risk-Adjusted Discount Rate forLong-Lived Assets

The scientists at XYZ Ltd. have come up with an electric mop, and the firm isready to go ahead with pilot production and test marketing. The preliminaryphase will take a year and cost Rs.125,000. Management feels that there isonly a 50 percent chance that pilot production and market tests will besuccessful. If they are, then XYZ will build a Rs.1 million plant which wouldgenerate an expected annual cash flow in perpetuity of Rs.250,000 a year aftertaxes. If they are not successful, the project will have to be dropped.


Pricing Model


18

The expected cash flows (in thousands of Rupees) are

Co = – 125

C1 = 50% chance of - 1000 and 50% chance of 0

= .5 (–1000 + .5(0)= -500

Ct, for t = 2,3,...

= 50% chance of 250 and 50% chance of 0.= +.5(250) + .5(0) = 125

Management has little experience with consumer products and considers this aproject of extremely high risk. Therefore, they discount the cash flows at 25percent, rather than XYZ’s normal 10 percent standard:

Rs.125,00– or125t)25.1(

125

2t1.25

500––125NPV −

= ∞

+=

This seems to show that the project is not worthwhile.

Management’s analysis is open to criticism if the first year’s experimentresolves a high proportion of the risk. If the test phase is a failure, thenthere’s no risk at all - the project is certainly worthless. If it is a success,there could well be only normal risk from there on. That means there is a 50percent chance that in 1 year XYZ will have the opportunity to invest in aproject of normal risk, for which the normal discount rate of 10 per cent wouldbe appropriate. As such, they have a 50 percent chance to invest Rs.1 millionin a project with a net present value of Rs.1.5 million:

Success->NPV = –1000 + 0.10

250 = +1500 (50% chance)

Pilotproductionandmarkettests

Failure->NPV = 0(50% chance)

Thus, we could view the project as offering an expected payoff of.5(1500)+.5(0)=750 or Rs.750,000 at t = 1 on a Rs.125,000 investment at t = 0.Of course, the certainty equivalent of the payoff is less than Rs.750,000 but a

t

would have to be very small to justify rejecting the project. For example, if theCEQ is half the expected value (a

t=0.5), and the risk-free rate is 7 per cent,

the project is worth Rs.225,500;

f

11o r1

CaCNPV

++=

225,500 Rs.or,5.22507.1

0.5(750)–125 =+=

Not bad for a Rs.125,000 investment - and quite a change from thenegative NPV that management got by discounting all future cash flows at25 percent.

t

19

A Word of Caution

We sometimes hear people say that because distant cash flows are “riskier”,they should be discounted at a higher rate than earlier cash flows. That’s quitewrong: any risk-adjusted discount rate automatically recognizes the fact thatmore distant cash flows have more risk. The reason is that the discount ratecompensates for the risk borne per perid. The more distant the cash flows, thegreater the number of periods and the larger the total risk adjustment.

Activity I

a) Mention the most fundamental difference between Certainty Equivalent andthe Risk Adjusted Discount Rate approaches of incorporating risk in Projectevaluation.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

b) Given a choice between Certainty Equivalent and Probability Distributionapproach, to analyze risk, which one would you prefer? Why?

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

c) Identify two critical factors that affect asset betas.

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

d) Given a choice between Certainty Equivalent and Probability Distributionapproach, to analyze risk, which one would you prefer? Why?

...................................................................................................................

...................................................................................................................

...................................................................................................................

...................................................................................................................

8.8 SUMMARY

Capital Asset Pricing Model is used to estimate risk adjusted discount rate formaking investment decisions. In order to find an appropriate discount rate it isnecessary to find project beta which may be different from the firm’s betaexecuting that project. The beta of the assets is weighted average of debt andequity betas. A firm’s asset beta reflects it’s business risk, whereas thedifference between its equity and asset beta reflects financial risk.Certainly equivalent is the smallest certain return which one would exchangefor a risky cash flow. Emperically it has been found that the betas are stableover time.


Pricing Model


20


1. “For a high beta Project, you should use a high discount rate to valuepositive cash flows and a low discount rate to value negative cash flows.”Is this statement correct? Should the sign of the cash flow affect theappropriate discount rate?

2. “The errors in estimating beta are so great that you might just as wellassume that all betas are one.” Do you agree?

3. A Project has a forecasted cash flow of Rs.100,000 in year 1 andRs.120,000 in year 2. The risk free rate is 8 percent, the estimated riskpremium on the market is 10 per cent, and the project has a beta of 0.5If you use a constant risk adjusted discount rate, what would be:

(a) The present value of the project?

(b) The certainty-equivalent cash flows in year 1 and 2?

(c) The ratio (at) of the certainty - equivalent cash flows to the expected

cash flows in years 1 and 2?

4. (a) PQR Ltd has the following capital structure:

Security Beta Total marketvalue

Debt 0 100,000Preferred stock 0.20 40,000Common stock 1.20 200,000

What is the firm’s asset beta (that is, beta of its stock if it were all equityfinanced)?

(b) Assume the Capital Asset Pricing Model is correct. What discount rateshould PQR Ltd. set for investments that expand the scale of itsoperations without changing its asset beta? Assume any newinvestment is all-equity financed. Plug in numbers that are reasonabletoday. Specify two discount rates, one real and one nominal.


Brigham E.F., “Financial Management Theory and Practice”, Dryden Press,New York.

Levy H., Sarnat M., “Financial Decision Making under Uncertainty”.Academic Press, New York.

Sharpe W.F., Alexander G.J., Bailey J.V., “Investments,” Prentice Hall, NewDelhi.

1

UNIT 9 PROJECT EVALUATION UNDERRISK AND UNCERTAINTY

Objectives


� to provide conceptual understanding of state of certainty, risk and uncertainty,

� to explain various methods of measuring project risk.

Structure

9.1 Concept of Certainty, Risk and Uncertainty

9.2 Measurement of Project Risk :

9.2.1 Probability Distribution

9.2.2 Sensitivity Analysis

9.2.3 Scenario Analysis

9.2.4 Monte Carlo Simulation

9.2.5 Decision Tree Analysis

9.3 Summary



9.1 CONCEPT OF CERTAINTY, RISK ANDUNCERTAINTY

In the preceding chapters we considered investment decision without referringto the risk elements in projects. Rule for acceptance or rejection of projectswas that any project with positive net present value will be accepted and theone with the negative net present value would be rejected. However, the merefact that the finance manager does not know before he makes the investmentas to what would be the gains from the project indicates that uncertainty isattached to every investment project and different projects have varyingdegrees of risk. Since the valuation of the firm is very likely to be affected bythe amount of risks assumed by it in accepting a project, a finance managermust take cognizance of risk factor while taking investment decision andadditional adjustments must be made to cover risks.

Certainty is a state of nature which arises when outcomes in terms of cashflows are known and determinate. For example, if one invests Rs. 20,000 infive-yearly government bonds which is expected to yield 7% tax free returns,then the return on the investment @ 7% can be estimated quite precisely.Thus, the outcome is known to have probability of 1.

Risk involves situations in which the probabilities of cash flows occurring areknown and these probabilities are objectively or subjectively determinable. Themain attribute of risk situation is that the event is repetitive in nature andpossesses a frequency distribution. It is the inability to predict with perfectknowledge the course of future events that introduces risk.

In contrast, when an event is not repetitive and is unique in character and thefinance manager is not sure about probabilities of cash flows themselves,uncertainty is said to prevail. Uncertainty is subjective phenomenon. In such asituation no observation can be drawn from frequency distributions. Practicallyno generally accepted methods could so far be evolved to deal with situation of


2

uncertainty while there are a number of techniques to deal with risk. As such,the term risk and uncertainty will be used interchangeably in the followingparagraphs.

Measuring the Risk of a Project

Since prime objective of a finance manager is to maximize value of the firmand the degree of risk in a project affects the value, he must measure degreeof risk in different projects under consideration. The following paragraphs throwlight on this aspect.

9.2 MEASUREMENT OF PROJECT RISK

9.2.1 Probability Distribution

The Problem of Project Risk

As noted above, “riskiness” of an investment project is the variability of itscash flows from those that are expected. The greater the variability, the riskierproject is said to be. For each project under consideration, we can makeestimates of the future cash flows. Rather than estimate only the most likelycash-flow outcome for each year in the future, we estimate a number ofpossible outcomes. In this way we are able to consider the range of possiblecash flows for a particular future period rather than just the most likely cashflow.

An Illustration

To illustrate the formunation of multiple cash-flow forecasts for a future period,suppose that we had two investment proposals under consideration. Supposefurther that we were interested in making forecasts for the following alternativestates of the economy : deep recession, mild recession, normal, minor boom,and major boom. After assessing the future under each of these possible states,we estimate the followin net cash flows for the next year :

State of the Economy Annual Cash Flows Year1

Proposal A Proposal B(Rs.) (Rs.)

Deep recession 3,000 2,000Mild recession 3,500 3,000Normal 4,000 4,000Minor boom 4,500 5,000Major boom 5,000 6,000

We see that the dispersion of possible cash flows for proposal B is greaterthan that for proposal A. Therefore, we might say that it is relatively riskier. Toquantify our analysis of risk, however, we need additional information. Morespecifically, we need to know the likelihood of the occurrence of various statesof the economy. Assume that our estimate of the probability of a deeprecession occurring next year is 10 per cent, of a mild recession 20 per cent,of a normal economy 40 per cent, of a minor boom 20 per cent, and of amajor economic boom 10 per cent. Given this information, we are now able toformulate a probability distribution of possible cash flows for proposals A andB, as follows :

We can graphically depict the probability distributions, as shown in Figure 9.1.As we see, the dispersion of cash flows is greater for proposal B than it is forproposal A, despite the fact that the most likely outcome is the same for bothinvestment proposals - namely Rs. 4,000. The critical question is whether

3

dispersion of cash flows should be considered. If risk is associated with theprobability distribution of possible cash flows, such that the greater thedispersion, the greater the risk, proposal B would be the riskier investment. Ifmanagement, stockholders, and creditors are averse to risk, proposal A wouldthen be preferred to proposal B.

State of the Proposal A Proposal BEconomy Probability Cash Flow Probability Cash Flow

(Rs.) (Rs.)

Deep recession .10 3,000 .10 2,000

Mild recession .20 3,500 .10 3,000

Normal .40 4,000 .40 4,000

Minor boom .20 4,500 .20 5,000

Major boom .10 5,000 .10 6,000

Expectation and measurement of Dispersion: A Cash-Flow Example

The probability distributions shown in Figure 9.1 can be summarized in terms oftwo parameters of the distribution: (1) the expected value and (2) the standarddeviation.

1234567123456712345671234567123456712345671234567123456712345671234567

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.4

.3

.2

.1

0

Proposal A

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.4

.3

.2

.1

0

Proposal B

2000 3000 4000 5000 6000

Project Evaluation UnderRisk and Uncertainty

Figure 9.1: Comparison of two proposals using probability distributions ofpossible cash flows.


4

The expected value of a cash-flow probability distribution for time period t, CFt,

is defined as

)(P)(CF

1

n

CF ttt xx

x

==Σ=

where CFxt is the cash flow for the xth possibility at time period t, P

xt is the

probability of that cash flow occurring, and n is the total number of cash-flowpossibilities occurring at time period t. Thus, the expected value of cash flow issimply a weighted average of the possible cash flows, with the weights beingthe probabilities of occurrence.

The conventional measure of dispersion is the standard deviation whichcompletes our two-parameter description of a cash-flow distribution. The tighterthe distribution, the lower this measure will be; the wider the distribution, thegreater it will be. The cash-flow standard deviation at time period t, tσ , can beexpressed mathematically as where represents the square-root sign. Thesquare of the standard deviation, t

2σ , is known as the variance of the

distribution.

)(P )CF-CF(

1

n

σ t2

ttt xx

x =∑=

The standard deviation is simply a measure of the tightness of a probabilitydistribution. It is a statistical measure of the variability of a distribution aroundits mean. It is the square root of the variance. For a normal, bell-shapeddistribution, approximately 68 per cent of the total area of the distribution fallswithin one standard deviation on either side of the expected value. This meansthat there is only a 32 per cent chance that the actual outcome will be morethan one standard deviation from the mean. The probability that the actualoutcome will fall within two standard deviations of the expected value of thedistribution is approximately 95 per cent, and the probability that it will fallwithin three standard deviations is over 99 per cent.

An Illustration. To illustrate the derivation of the expected value and standarddeviation of a probability distribution of possible cash flows, consider again ourprevious two-proposal example.

Proposal A

Possible Cash Probability of (CFx1) (Pxt) (CFx1 ) – 1CF ) 2 (Px)

Flow, CFx1

Occurrence, Px1

(Rs.) (Rs)(Rs)

3,000 .10 300 (3,000 – 4,000)2 (.10)

3,500 .20 700 (3,500 – 4,000)2 (.20)

4,000 .40 1600 (4,000 – 4,000)2 (.40)

4,500 .20 900 (4,500 – 4,000)2 (.20)

5,000 .10 500 (5,000 – 4,000)2 (.10)

ª = 1.00 ª = 4,000 = 1CF ª = 300,000 = s21

= (300,000)-5 = 548 = s1

p

5

Proposal B

Possible Cash Probability of (CFx1) (Pxt

) (CFx1

) – CF1

) 2 (Px)

Flow, CFx1

Occurrence, Px1

(Rs.) (Rs)(Rs)

2,000 .10 200 (2,000 – 4,000)2 (.10)3,000 .20 600 (3,500 – 4,000)2 (.20)4,000 .40 1600 (4,000 – 4,000)2 (.40)5,000 .20 1000 (5,500 – 4,000)2 (.20)6,000 .10 600 (6,000 – 4,000)2 (.10)

ª = 1.00 ª = 4,000 = CF1

ª = 1,200,000 = s21

= (1,200,000)-5 = 1,095 = s1

The expected value of the cash-flow distribution for proposal A is Rs. 4000, thesame as for proposal B. However, the standard deviation for proposal A is Rs.548, Thus, proposal B has a higher standard deviation, indicating a greaterdispersion of possible outcomes – so we would say that it has greater risk.

Coefficient of Variation : A measure of the relative dispersion of a distributionis the coefficient of variation (CV). Mathematically, it is defined as the ratio ofthe standard deviation of a distribution to the expected value of the distribution.Thus, it is simply a measure of risk per unit of expected value. For proposal, A,the coefficient of variation is

CVA = Rs. 548/Rs. 4,000 = .14

While that for proposal B is

CVB = Rs. 1,095/Rs. 4,000 = .27

Because the coefficient of variation for proposal B exceeds that for proposal A,it has a greater degree of relative risk.

Total Project Risk

If investors and creditors are risk averse – and all available evidence suggeststhat they are - it is necessary for management to incorporate the risk of aninvestment proposal into its analysis of the proposal’s worth. Otherwise, capitalbudgeting decisions are unlikely to be in accord with the objective ofmaximizing share price. Having established the need for taking risk intoaccount, we proceed to measure it for individual investment proposal. Butremember that the riskiness of a stream of cash flows for a project can, andoften does, change with the length of time in the future that the flows occur. Inother words, the probability distributions are not necessarily the same from oneperiod to the next.

Activity 1

a) Define the following.

� Certain Projects

� Risky Projects

� Uncertain Projects

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b) Try to know from some finance managers the methods that they have usedto incorporate risk while evaluating investment Projects.

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9.2.2 Sensitivity Analysis

Intuitively, we know that most of the variables which determine a project’scash flows are based on some type of probability distribution. We also knowthat if a key input variable, such as units sold, changes, so will the project’sNPV. Sensitivity analysis indicates exactly how much NPV will change inresponse to a given change in an input variable, other things remainingconstant. Sometimes called “what if” analysis, sensitivity analysis answersquestions such as these: “What if sales are only 20,000 units rather than25,000? What then will happen to NPV?”

Sensitivity analysis begins with a base case situation based on expected inputvalues. To illustrate the procedure, let us consider the data given in Table 9.1,where projected income statements for ABC Ltd. project were shown. Thevalues for unit sales, sales price, fixed costs, and variable costs are theexpected, or base case, values, and the resulting Rs. 11,465,923 NPV shown inTable-9.2 is called the base case NPV. Now we ask a series of “what if”questions: “What if sales quantity is 20 per cent below the expected level?”“What if sales prices fall?” “What if variable costs are 70 per cent of totalsales rather than the expected 65 percent?” Sensitivity analysis is designed toprovide the decision maker with answers to questions such as these.

In a sensitivity analysis, we change each variable by specific percentagesabove and below the base case value, calculate new NPVs, holding otherthings constant, and then plot the derived NPVs against the variable inquestion. Figure 9.2 shows the ABC’s project sensitivity graphs for three of thekey input variables. The Table 9.3 gives the NPVs that were used to construct

7

the graphs. The slopes of the lines in the graphs show how sensitive NPV is tochanges in each of the inputs’ the steeper the slope, the more sensitive theNPV is to the change in the variable. Here we see that the project’s NPV isvery sensitive to changes in variable costs, fairly sensitive to changes in salesvolume, and relatively insensitive to changes in the cost of capital.

If we were comparing two projects, then, other things, held constant, the onewith the steeper sensitivity lines would be regarded as riskier-a relatively smallerror in estimating variables such as the variable cost per unit or demand forthe product would produce a large error in the project’s projected NPV. Thus,sensitivity analysis provides useful insights into the relative riskiness of differentprojects.

Table 9.1: ABC : Operating and Networking Capital Cash Flows, 1988-1993

1988 1989 1990 1991 1992 1993

Unit Sales 25000 25000 25000 25000 25000 25000

Sales Pricea 2000 2332 2472 2620 2777 2944

Net Salesa 55000000 58300000 61800000 65500000 69425000 73600000

Variable Costsb 35750000 37895000 40170000 42575000 45126250 47840000

Fixed Cost 8000000 8480000 8988800 9528128 10099816 10705805(Overhead)a

R&D expensesc 12500000 1250000 1250000 1250000 1250000 1250000

Depreciation 400000 800000 720000 640000 560000 560000(building)d

Depreciation 1425000 2090000 1995000 1995000 1995000 0(equipments)d

Earnings before 8175000 7785000 8676200 9511872 10393934 13244195taxes

Taxes (46%) 3760500 3581100 3991052 4375461 4781210 6092330

Project netincome 4414500 4203900 46855148 5136411 5612724 7151865

Noncash 3075000 4140000 3965000 3885000 3805000 1810000expensese

Cash flow from 7489500 8343900 8650148 9021411 9417724 8961865operationsf

Addition to (396000) (420000) (444000) (471000) (501000) (8832000)NWCg

NWC cash flows 7093500 7923900 8206148 8550411 8916724 17793865

a 1988 estimate increased by an assumed 6 per cent inflation rate.

b 65 per cent of net sales.

c If the project is accepted, ABC will amortize the Rs. 7.5 million of capitalized R&Dcost over 6 years, so it will have a noncash, deductible expenses for Rs. 7,500,000/6 =Rs. 1,25,000 per year.

d ACRS depreciation rates are follows

Year 1 2 3 4 5 6Building 5% 10% 9% 8% 7% 7%Equipment 15% 22% 21% 21% 21% -

e Sum of R&D expenses and depreciation on building and equipment.

f Net income plus noncash expenses.

g 12 per cent of next year’s increase in sales. For example, 1989 sales are estimated atRs. 3.3 million over 1988 sales, so the addition to NWC in 1988 to prepare for the1989 sales increase in 0.12 (3,300,000) = 396,000. The cumulative working capitalinvestment will be recovered in 1993.



8

Table 9.2: ABC : Time Line of Consolidated Cash FlowsEnd-of-year net Cash Flows

1985 1986 1988 1987 1989 1990 1991 1992 1993

4650000 4000000 19600000 7093500 7923900 8206148 8550411 8916724 22961065

Payback period : 5.6 years from first outflow.IRR : 20.4% versus a 10% cost of capital.NPV : 11,465,923PI : 1.5

Figure 9.2: Sensitivity Analysis for ABC (Thousands of Rupees)

Table 9.3

Net Present Value

Change from Units Sold (Rs.) Variable Cost per Unit (Rs.) Cost of Capital (Rs.)Base Value

-10% 7549 19416 13109

-5 9463 15442 12273

0 11468 11468 11468

+5 13472 7493 10692

+10 15476 3519 9946

9.2.3 Scenario Analysis

Although sensitivity analysis is widely used in industry, it does have limitations.Consider, for example, a proposed coal mine whose NPV is highy sensitive tochanges in both output and sales prices. However, if a utility company hascontracted to buy most of the mine’s output at a fixed price per ton, plusinflation adjustments, then the mining venture may not be very risky in spite ofthe steep sensitivity lines. In general, a project’s risk depends on both (1) itssensitivity to changes in key variables and (2) the range of likely values ofthese variables as reflected in their probability distributions. Because sensitivityanalysis considers only the first factor, it is incomplete.

A risk analysis technique which considers both the sensitivity of NPV tochanges in key variables and also the range of likely variable values isscenario analysis. Here, the operating executives pick a “bad” set ofcircumstances (low unit sales, low sales price, high variable cost per unit, highconstruction cost, and so on) and a “good” set. The NPV under the “bad” and“good” conditions would be calculated and compared to the exepcted, or basecase, NPV.

11468

a) Unit Sold NPV (Rs.)

b) Variable Cost Per Unit NPV (Rs.)

c) Cost of Capital NPV (Rs.)

-10% 25000 + 10%(Base)

11468

-10% 1.43 + 10%(Base)

11468

-10% 0.10 + 10%(Base)

9

Table 9.4: Scenario Analysis Results Summary

Sales Volume Sales NPVScenario (Units) Price (Rs.) (Thousands) (Rs.)

Worst case 5,000 1,700 22,421

Base case 25,000 2,200 11,468

Best case 40,000 2,700 50,093

As an example, let us return to the ABC project. Assume that ABC executivesare fairly confident in their estimates of all the project’s cash flow variablesexcept price and unit sales. Further, suppose they regard a drop in unit salesbelow 5,000, or a rise above 40,000 units, as being extremely unlikely. Similarly,they expect the sales price as set in the marketplace to fall within the range ofRs. 1,700 to Rs. 2,700. Thus, 5,000 units at a price of Rs. 1,700 defines thelower bound or the worst case scenario, while 40,000 units at a price of Rs.2,700 defines the upper bound or the best case scenario. Remember that theexpected, or base case, values are 25,000 units at a price of Rs. 2,200. Also,note that the indicated sales prices are for 1988, with future years’ pricesexpected to rise because of inflation.

To carry out the scenario analysis, we use the worst case variable values toobtain the worst case NPV and the best case variable values to obtain the bestcase NPV. Table 9.4 summarizes the results of the analysis. We see that thebase case forecasts a positive NPV; the worst case, a negative NPV; and thebest case, a very large positivie NPV. However, it is not easy to interpret thisscenario analysis, or to make a decision based on it. In our example, we cansay that there is a chance of losing on the project, but we cannot easily attacha specific probability to this loss. Clearly, what we need is some idea about theprobability of occurrence of the worst case, the best case, the most likely case,and all the other cases that might arise. This leads us directly to Monte Carlosimulatioin, which is described in the next section.

9.2.4 Monte Carlo Simulation

Monte Carlo simulation, so named because this type of analysis grew out ofwork on the mathematics of casino gambling, ties together sensitivities andinput variable probability distributions. However, simulation requires a relativelysophisticated computer, coupled with an efficient financial planning softwarepackage, while scenario analysis can be done using a hand-held calculator.

Table 9.5: Probability Distribution for ABC’s Project Sales Price

Sales Price Probability AssociatedRandom Numbers

(1) (2) (3)

Rs. 1,700 0.05 00-04

2,000 0.20 05-24

2,200 0.50 25-74

2,400 0.20 75-94

2,700 0.05 95-99

The first step in a computer simulation is to specify a probability distribution foreach of the key variables in the analysis. To illustrate, suppose we haveestimated the probability distribution of the ABC’s Project sales price asrepresented by Columns 1 and 2 of Table 9.5. The expected sales price is Rs.2,200, but the price can range from Rs. 1,700 to Rs. 2,700. The third columngives a set of random numbers associated with each price estimate. Notice that



10

in column 2, there is a 5 percent probability that sales price will be as low asRs. 1,700; therefore, 5 digits (0,1,2,3, and 4) are assigned to this price.Twenty digits are assigned to a price of Rs. 2,000 and so on for the otherpossible prices. Once the distributions and associated random numbershave been specified for all the key variables - in other words, once a tablesuch as 9.5 has been set up for sales quantity, unit variable costs, constructioncosts, and so on- the computer simulation can begin. These are the stepsinvolved:

1. Computers have stored in them, or they can generate random numbers.First, on Trial Run 1, the computer will select a different random numberfor each uncertain variable. For example, it might select 44 for units sold,17 for the sales price, and 16 for labour costs.

2. Depending on the random number selected, a value is determined for eachvariable. The 17 associated with the sales price indicates in Table 9.5 thatthe appropriate sales price for use in the firs turn Rs. 2,000. Values for allthe other variables are set in like manner.

3. Once a value has been established for each of the variables, the computergenerates a set of income statements and cash flows. These cash flowsare then discounted at the cost of capital (which may also be treated as arandom variable), and the result is the net present value of the project onthe computer’s first run.

4. The NPV generated on Run 1 is stored in memory, and the computer thengoes on to Run 2. Here a different set of random numbers, and hencecash flows, is used. The NPV generated in Run 2 is again stored, and themodel proceeds on for perhaps 500 runs. Modern computers can completethis operation almost instantaneously for a vary low cost.

5. The stored NPVs (all 500 of them) are then printed out in the form of afrequency distribution, together with the expected NPV and the standarddeviation of this NPV.

Using this procedure, we can perform a simulation analysis on ABC’s project.As in our scenario analysis, we have simplified the illustration by specifying thedistributions for only two key variables, sales quantity and sales price. For allthe other variables, we merely specify their expected values.

In our simulation analysis, we assume that sales prices can be represented by acontinuous normal distribution. Further, suppose that the expected value is Rs.2,200 and that the actual sales price is very unlikely to vary by more than Rs.500 from the expected value, i.e., fall below Rs. 1,700 or rise above Rs. 2,700.We know that in a normal distribution, the expected value plus or minus threestandard deviations will encompass virtually the entire distribution. Thus, forsales price, three standard deviations should equal Rs. 500, so as a reasonableapproximation, we assume that s

sales price = Rs. 500/3 = Rs. 166.67 = Rs. 167.

Therefore, we tell the computer that the sales price distribution is a normaldistribution with an expected value of Rs. 2,200 and a standard deviation ofRs. 167.

Next, we assume that the estimated distribution of unit sales is also symmetric.Further, the expected value is 25,000 units, but sales could be as high as 40,000units, given our production capacity, but if public acceptance is poor, sales couldbe as low as 10,000 units. We could have again specified a normal distribution,but in this case, management feels that a triangular distribution, with anexpected value of 25,000 a lower limit of 10,000, and an upper limit of 40,000is most appropriate.

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Table 9.6: Summary of Simulation Result

Probability of NPV or IRR being Greater than the Indicated Value(Thousands of Rupees)

0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10

NPV -1860 1825 5144 8397 11393 13683 16516 19639 25286

IRR 0.080 0.119 0.151 0.179 0.204 0.221 0.242 0.263 0.299

NPV Sample Statistics

Mean Standard Deviation Skewness

11228 10124 0.1

We used the Interactive Financial Planning System (IFPS) to conduct asimulation analysis of the project. Then the key results of our simulation arepresented in Table 9.6. The top line of the table shows the cumulativeprobability distribution. Suppose someone asks, “What is the probability that theproject will have an NPV greater than Rs. 5,000,000?” The answer is, “About70 per cent,” because NPV = 5,000,000 lies between 70 and 80 percent butmuch closer to 70 per cent.

The primary advantage of simulation is that it shows us the range of possibleoutcomes, with attached probabilities, not just a point estimate of the NPV. Theexpected NPV can be used as a measure of the projects profitability, while thevariability of this NPV as measured by s

NPV can be used to measure risk. To

illustrate, the ABC’s project’s expected NPV is Rs. 11,288,000 and the standarddeviation of this NPV, as calculated by the computer in the simulation, is s

NPV

= Rs. 10,124,000. If we assume that ABC’s average project has an expectedNPV of Rs. 975,000 and sNPV = Rs. 370,000, then we can calculate thecoefficient of variation (CV) for this project and compare it with the CV of theaverage project as follows:

NPV Expected

σ

valueExpected

deviation StandardCV variationoft Coefficien NPV==

0.90000Rs.11,228,

000Rs.10,124,CVProject ==

0.38Rs.975,000

Rs.370,000 CV Project Average ==

Since the coefficient of variation is a standardized risk measure, it can be usedto compare the relative riskiness of projects which differ in size. We see thatthe CV of this project is much larger than the CV of ABC average project. Toaccount for risk, ABC adds two percentage points to the cost of capital of suchhigh-risk projects as this particular project. Our analysis thus far was based onABC average cost of capital as 10 per cent. Therefore, we must nowreevaluate the project with a project cost of capital of 12 per cent. Whenevaluated at a cost of capital of 12 per cent, the NPV of the project, usingexpected values of all variables, is Rs. 8,533,722. Thus, even at the high-riskcost of capital, the office robot project has a large positive NPV. Thus, itappears to be acceptable.

Activity 2

A) Write two points of difference between Sensitivity Analysis and ScenarioAnalysis of determination degree of risk in investment projects.

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12

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B) List out the five steps involved in Monte Carlo Simulation of Analyzing riskin investment projects.

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9.2.5 Decision Tree Analysis

Many capital budgeting decisions are not made at a single point in time. Rather,they consist of two or more sequential decisions, which are made as theproject progresses through stages. For example, suppose ABC is consideringthe production of a product X for some other company. The capital budgetingdecision for this project will be broken down into three stages, as set forth inFigure 9.3.

Stage 1 : At t = 0, conduct a Rs. 500,000 study of the market potential forthis product X.

Stage 2 : If it appears that a sizable market for this product X does exist, thenat t = 1, spend Rs. 1,000,000 to design and fabricate several prototype ofProduct X.

Stage 3 : If reaction to the Prototype Product X is good, then at t = 2, build aproduction plant with a net cost of Rs. 10,000,000. If this stage were reached,the net payoff is expected to be either Rs. 13,000,000 or Rs. 16,000,000depending on the state of the economy, competition, and so forth.

Timet = 0 t = 1 t = 2 t = 3 Conditional NPV NPV Product

Probability(1) (2) (3) (4) (5) (6) (5) x (6) = (7)

(16000)

0.5 0.24 2347 563

(1000)

0.6 0.5 13000 0.24 94 23

(1000)

0.8 0.4 Stop 0.32 (1409) (450)

(500)

0.2 Stop 0.20 (500) (100)

1.00 Expected NPV = Rs. 36

Figure 9.3: ABC Decision Tree (Thousands of Rs.)

1

2

3

13

The diagram in Figure 9.3 is called a decision tree, a procedure often used toanalyze multi-stage, or sequential, decisions. A decision tree lays out theanalysis like the branches of a tree. In Figure 9.3, we assume that as on yeargoes by between decisions and that a single net cash inflow from the projectwould occur one year after the final decision to go into production. Each circlerepresents a decision points, or stage. The rupee value to the left of eachdecision point represents the investment required if the decision is “go” at thatpoint. Each diagonal line represents a branch of the decision tree, and eachbranch has an estimated probability. For example, if ABC decides to “go” withthe project at Decision Point 1, it will have to spend Rs. 500,000 on amarketing study. Management estimates that there is a probability of 0.8 thatthe study will produce favourable results, leading to the decision to move on toStage 2, and a 0.2 probability that the marketing study will produce negativeresults, indicating that the project should be cancelled after State 1. If theproject is stopped here, the cost of ABC will be Rs. 500,000 for the initialmarket study.

If the marketing study is undertaken, and if it does yield positive results, thenABC will go on to Decision Point 2 and spend Rs. 1,000,000 on the product.Managemetn estimates (before even making the initial Rs. 500,000 investment)that there is a 60 per cent probability that product will be useful and a 40 percent probability that it will not be useful. If the management accept the product,then company would spend the final Rs. 10,000,000 while if the management donot like it, the project would be dropped. Finally, if ABC does go intoproduction, the payoff is assmed to be either Rs. 16,000,000 or Rs. 13,000,000,with each outcome having a 50 per cent probability. (Although we used onlytwo production outcomes for simplicity, we could have used any number ofoutcomes or even a continuous distribution of outcomes.)

Column 5 of Figure 9.3 gives the conditional probability of occurrence of eachfinal outcome. Each conditional probability is obtained by multiplying together allprobabilities on a particular branch. For example, the probability the ABC will, ifStage 1 is undertaken, move through Stage 2 and 3, and that a strong economywill produce a Rs. 16,000,000 net cash inflow, is (0.8) (0.6) (0.5) = 0.24

Column 6 of Figure-9.3 gives the NPV of each final outcome. ABC has a costof capital of 10 per cent, and management assumes initially that all projectshave average risk. The NPV of the top (most favourable) outcome is aboutRs. 2,347,000:

500,00 Rs.)10.1(

1,000,000 Rs.

)10.1(

10,000,000 Rs.

)10.1(

16,000,000 Rs.NPV

123=−−=

Other NPVs were calculated similarly

Column 7 of Figure 9.3 gives the product of the NPVs in Column 6 times theprobabilities in Column 5. The sum of the NPV products is the expected NPVof the project. Based on the expectations set forth in Figure 9.3, and a cost ofcapital off 10 per cent, the expected NPV is approx. Rs. 36,000.

Since the expected NPV is positive, should ABC initiate Stage-1? Notnecessarily, since management only assumed that the project is of average risk,and hence used the unadjusted cost of capital to evaluate it. However, ABCmust now reconsider and decide whether this project is more, less, or as riskyas an average project. The decision tree provided a distribution of NPVs,similar to the one we obtained using simulation analysis for the single-stageproject. With this project, there is a probability of 0.52 of losing money and aprobability of 0.32 of losing almost Rs. 1.5 million. With those high loss



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probabilities, and the small NPV relative to the amount required to undertakethe project, chances are good that it would be rejected.

9.3 SUMMARY

Risk involves situations in which the probabilities of cash flow occuring areknown and are objectively or subjectively determinable. The event is repetitivein nature and the inability to accurately predict the future course of eventsintroduces risk. In contrast when an event is not repetitive in nature and theprobability of occurance is not determinable uncertainity is said to prevail.There are sevral techniques to measure project risk. The most basic and widelyused technique is Standard Deviation. Another technique is Sensitivity Analysiswhich measures the effect of change of variables on NPV of the project.

A risk analysis technique which considers both the sensitivity of NPV tochanges in key variables and also the range of likely variables value is ScenarioAnalysis. Monte Carlo Simulation ties together sensitivities and input variableprobability distribution. Another technique is that of Decision Tree Analysiswhich is used when Capital Budgeting Decisions are dependent on the outcomeof a precedent event.


1. Why should we be concerned with risk in capital budgeting? Is thestandard deviation an adequate measure of risk? Can you think of a bettermeasure?

2. If project A has an expected value of net present value of Rs. 20,000 and astandard deviation of Rs. 4000, is it more risky than project B, whoseexpected value is Rs. 14000 and standard deviation is Rs. 3000? Explain.

3. a) In a probability tree approach to project risk analysis, what are initial,conditional, and joint probabilities?

b) What are the benefits of using simulation to evaluate capital investmentprojects?

4. Naughty Pine Lumber Company is evaluating a new saw with a life of twoyears. The saw costs Rs. 3000, and future after-tax cash flows depend ondemand for the company’s products. The tabular illustration of a probabilitytree of possible future cash flows associated with the new saw is asfollows:

Year 1 Year 2

Initial Net Conditional NetProbability Cash Probability Cash

P (1) Flow P (2/1) Flow Branch(Rs.) (Rs.)

.30 1000 1.40 1500 .40 1500 2

.30 2000 3

1.00

.40 2000 4.60 2500 .40 2500 5

.20 3000 6

1.00 1.00

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a) What are the joint probabilities of occurrence of the various branches?

b) If the risk-free rate is 10 per cent, what is (i) the net present value ofeach of the six complete branches and (ii) the expected value and standarddeviation of the probability distribution of possible net present values?

c) Assuming a normal distribution, what is the probability that the actual netpersent value will be less than zero? What is the significance of thisprobability?

5. XYZ Inc., can invest in one of two mutually exclusive, one-year projectsrequiring equal initial outlays. The two proposals have the following discreteprobability distributions of net cash inflows for the first year :

Project A Project B

Probability Cash Flow Probability Cash Flow

.20 2000 .10 2000

.30 4000 .40 4000

.30 6000 .40 6000

.20 8000 .10 8000

1.00 1.00

a) Without calculating a mean and a coefficient of variation, can youselect the better proposal, assuming a risk-average management?

b) Verify your intuitive determination.


Brealy R., Myers, “Principles of Corporate Finance”, McGraw HillCompany.

VanHorne J.C., J.M. Wachowicz, “Fundamentals of Financial Management”,Prentice - Hall.

Stern J.M., D.H. Chew (Jr.), “The Revolution in Corporate Finance” BasilBlackwell.

Srivastava, R.M., Financial Management and Policy, Himalaya PublishingHouse, 2003, Chapter 12.


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UNIT 10 RISK ANALYSIS IN INVESTMENTDECISIONS

Objectives

The major objective of this unit is to discuss and show the application of someadvanced techniques of risk analysis in investment decisions.

Structure

10.1 Introduction

10.2 Stochastic Goal Programming Model

10.3 Game Theory

10.4 Expected Utility Approach

10.5 The Expected Utility Model

10.6 Summary



Appendix : A Goal Programming Model for Capital Budgeting

10.1 INTRODUCTION

Most of the literature on capital budgeting decisions has been woven aroundthe assumption of certainty and single goal. In unit two of this block, we havediscussed various techniques of risk analysis presuming that true certainty inexpected cash flow and the required rate of return do not exist in the realworld. However, we have continued to assume that a company has a singleobjective, i.e., higher rate of return. As we know, in real world not only weare faced with lot of uncertainty but companies tend to have multiple goals likerate of return, sales, employment, etc. The multi-objective criteria and theproblem of risk and uncertainty could be taken care of with the help of astochastic goal programming model by incorporating priority coefficients fordifferent objectives.

10.2 STOCHASTIC GOAL PROGRAMMING MODEL

Assumptions

1. Random variables ui are normally distributed with mean 0 and variance-covariance matrix S.

2. ‘a’ is a matrix of estimates of some unknown parameters, and it has rank >q.

3. The non-singular variance-covariance matrix S is known since only non-singular matrices have ordinary inverses.

Given the goals (x1,

x2,… , x

n)we analyse the goals such that

¦(x1,

x2,… , x

n) = bi (1)

where b represents given goals.

In order to convert into a real linear functional, this may be written as:¦(x

1, x

2,… , x

n)= a

1x

1 + a

2x

2 + ... + a

nx

n = bi (2)

where a1, a

2, ... , a

n are any real numbers such that ¦ is a real linear

functional.


2

In order to simplify the notation, we use the ideas of matrix algebra. Let x bea column vector with components x

1,x

2,..., x

n and let ‘a’ be a row vector with

components a1, a

2, ..., a

n then the (2) may be represented equivalently by

Axi = bi (3)

If a matrix A has an ordinary inverse A-1 then we have a unique solution x toAxi = bi which is given by xi = a-1bi. Geometrically, the transformation definedby A transforms xi into bi, whereas the transformation defined by A-1

transforms bi precisely back into xi. Therefore, if the matrix in our problem ofgoal analysis has its ordinary inverse, then the solution sub-goal which attainsthe given goal can be obtained by using the ordinary inverse of the matrix.When a matrix has the ordinary inverse, (i.e. when a matrix is non-singular), itis identical with generalized inverse of matrix.

By the generalized inverse matrix the possible solution to axi=bi is given byBi = axi (4)

In the presence of linear constraints on the variables, i.e.Bxi £ h, (4.1) xi ³ 0. (4.2)

The problem may be formulated in a linear programming format as follows:

Minimisez =(Pid+

t + Pid-

i) (5)

axi + d-t - d+

i = bi (5.1)

xi , d-2 – d+

i ³ 0 (5.2)

when the assumption of certainty is dropped, we formulate the problem into ageneralized inverse matrix form as follows:

bi = axi + ui (6)

in the presence of linear constraints on the variables, i.e.Bxi < h (6.1) xi > 0 (6.2)

where bi refers to a given set of goals and xi are linearly related to bivariables and ui are random variables.

The stochastic equation bi = axi + ui has the form of a linear model in reducedform if we consider the goals bi as endogenous and jointly determined andvariable ai as exogenous variables.

Therefore, it follows from the assumptions that bi is normally distributed withmeans (ax) and variance-covariance matrix S, i.e.

¦(b1, b

2, ... b

q) = 2II)q-/2 | S |-½ e-q/2 (7)

where the quadratic form Q is defined as

Q = (b-ax)’ S-1 (b-ax) (8)

A simple criterion function analogous to that used in the goal programmingmodel may be interpreted by analysing the statement b*

t = axi as follows:

Let B* be an appropriately defined region which covers the point b. Such thatb e B*. Then one chooses the goals xi for which the probability that therandom vector bi = axi + ui will lie inside the region B* is maximized.

Risk Analysis in InvestmentDecisions

3

Assumption I suggests that B* should be taken to be falling in defined regionand centred at b* of the form :

Q* £ c2 (9)

Where Q* is the quadratic formQ* = (b – b*)’ S-1 (b-b*) (10)

We know that if y is normally distributed and S is non-singular then quadraticform (10) has the chi-square distribution with q degrees of freedom. Thus B*can be interpreted as confidence region for b at level a because if we choosea set of goals x° such that E(b) = ax° = b* then the probability of b falling inthe region B* is given by a. Region B* may be restricted to be of the formQ* = c2.

Therefore, the stochastic goal programming model may be formulated asfollows:

MinimizeZ=(K+xAx’ + 2p’x) (11)

subject toBxi < h (11.1) Xi > 0 (11.2)

where K = b*’ S-1 b*, A = a’ S-1 a, p = a’ S-1 b* and A is (mxn) positivedefinite if q=n, and semi positive definite if q < n.

The above stochastic goal programming models equivalent to a quadraticprogramming problem in standard form since the constraints (11.1) and (11.2)are linear, and the problem can be solved by any of the existing algorithms.

The above stochastic goal programming (11) may be formulated into a linearprogramming format as follows:

Minimizez =(Pidi+

t +- Pid-

i) (12)

subject toaxi + uixi + d-

i -

d+

t = bi (12.1)

xi , d-i, d+

i > 0 (12.2)

where Pi refer to priority coefficients and d±i refer to positive and negative

devotional variables.

Using (12), Lorie and Savage modified problem may be formulated under theconditions of uncertainty as follows:1

Minimizez = p

1d-

1 + p

2d-

2 + p

3d-

3 + p

2d-

4 +4 p

2d-

5 +p

4d-

6

p4d-

7 + p

5d+

4 +

p

6d+

6 + p

6d+

7(13)

Subject to(A) Present value of investment goal14x

1 + 17x

2 + 17x

3 + 15x

4 + 40x

5 + 12x

6 + 12x

7 +

10x8 + 12x

9 + u

1x

1 + u

2x

2 + u

3x

3 + u

4x

4 + u

5x

5 +

u6x

6 + u

7x

7 + u

8x

8 + u

9x

9 + d-

1 = 32.4 (13.1)

1 See Appendix for detail of Lorie and savage problem.


4

(B) Budget ceiling goals12x

1 + 54x

2 + 6x

3 + 6x

4 + 30x

5 + 6x

6 + 48x

7 +

36x8 + 18x

9 + u

1x

1 + u

2x

2 + u

3x

3 + u

4x

4 + u

5x

5 +

u6x

6 + u

7x

7 + u

8x

8 + u

9x

9 + d-

2 = 50.0 (13.2)

3x1 + 7x

2 + 6x

3 + 12x

4 + 35x

5 + 6x

6 + 4x

7 +

3x8 + 3x

9 + u

1x

1 + u

2x

2 + u

3x

3 + u

4x

4 + u

5x

5 +

u6x

6 + u

7x

7 + u

8x

8 + u

9x

9 + d-

3 = 20.0 (13.3)

(C) Sales goals14x

1 + 30x

2 + 13x

3 + 11x

4 + 53x

5 + 10x

6 + 32x

7 +

21x8 + 12x

9 + u

1x

1 + u

2x

2 + u

3x

3 + u

4x

4 + u

5x

5 +

u6x

6 + u

7x

7 + u

8x

8 + u

9x

9 + d-

4 – d+

4 = 70.0 (13.4)

15x1 + 42x

2 + 16x

3 + 12x

4 + 52x

5 + 14x

6 + 34x

7 +

28x8 + 21x

9 + u

1x

1 + u

2x

2 + u

3x

3 + u

4x

4 + u

5x

5 +

u6x

6 + u

7x

7 + u

8x

8 + u

9x

9 + d-

5 = 84.0 (13.5)

(D) Employment goals10x

1 + 16x

2 + 13x

3 + 9x

4 + 19x

5 + 14x

6 + 7x

7 +

15x8 + 8x

9 + u

1x

1 + u

2x

2 + u

3x

3 + u

4x

4 + u

5x

5 +

u6x

6 + u

7x

7 + u

8x

8 + u

9x

9 + d-

6 – d+

6= 40.0 (13.6)

12x1 + 16x

2 + 13x

3 + 13x

4 + 16x

5 + 14x

6 + 9x

7 +

22x8 + 13x

9 + u

1x

1 + u

2x

2 + u

3x

3 + u

4x

4 + u

5x

5 +

u6x

6 + u

7x

7 + u

8x

8 + u

9x

9 + d-

7 – d+

7 = 40.0 (13.7)

x1, x

2, ..., x

9, d

1, d

2, ..., d

n ³ 0. (13.8)

When ui = 0), (where i = 1,2,..., N=9)

Computational Procedure

The Wolfe’s algorithm of a simplex type of a quadratic problem which apply tothe stochastic goal programming problem formulated for capital budgetingdecision under uncertainty is of the following form:

Let the variables of the problem constitute the n vector x = (x1, ... x

n)’ where

x is to be taken to be a column vector, with n x 1 matrix. If A be an m x nmatrix and b an m x 1 the linear constraints of the problem for l ³ 0.

Minimize f (l,x) = lpx

1/2x’ cx (14)May be specified as x ³ ), Ax = b

WhereXi ³ 0(j = 1, ..., n)

nS aij xj = bi(i = 1, ..., m).

j=1

The conditions that the n vector x solve the problem for l > 0 may be writtenas:

Ax=bCx – V + A’u+ p’u + p’l = 0 (15)x ³ 0, v ³ 0


5

or in the detached coefficient form as

x ³ 0 v ³ 0 l l (16)

A 0 0 0 = b

C -I A’ p’ = o

Constituting m x n equations in 2 n non-negative variables and m unrestrictedvariables and where l is not considered as a variable.

Let z1,and z2 and w be respectively n-, x- and m component vectors.

An initial basis for this system can be formed from the coefficients z1,z2 and wsince b ³ 0 by using the simplex method to minimize

Swt = 0.i

Keeping v and u zero, we would discard w and unused components z1, z2; letthe remaining n components be denoted by z and their coefficients by E. Thesolution of the system would be:

Ax = b

Cx - v + A’u + Ez = -p’ (17)

X, v,z ³ 0.

Given a basis and basic solution satisfying (17), v’x = 0 andnS Z

k > 0, make one change of basis in the simplex procedure

K=1minimizing the linear form

nS X

k(18)

K=1

under the side condition for k=1, ..., n, if xk is in the basis, we do not admitvk; and if vk is in the basis, we do not admit xk.

nIf S Z

k > 0, then we repeat the step (18) and the form will

K=1

vanish in subsequent iterations yielding z=0. The x part of the terminal basicsolution in a solution of the quadratic programming for l.

The computational procedure, when the number of constraints is larger may bepresented in the following manner alongwith line discussed above:

Let the constraints beA

11x

1 + A

12x

2= b

1

A21

x1 + A

22x

2 + y

2= b2 (20)

A31

x1 + A

32x

2 + y

3= b3

X1, y

2, y

3 > 0


6

the new system of linear constraints (corresponding to 16) will be:

x1 ³0 x

2y

2³0 y

3³0 v

1³0 u

1u

2³0 u

3³0 l

A11

A12

=b1

A21

A22 I

=b2

A31

A32 -I

=b3

C-I

A’11

A’21

A’31

p’1=0

A’12

A’22

A’32

p’2=0

The algorithm would proceed the same way as in (18) above. If (x1) k is in

the basis, we do not admit (v-1)k, and vice versa ; if (y-

2)k is in the basis we

do not admit (u3)k, and vice versa.

However, if number of variables involved or the number of iterations required islarge, computer package programme may be used to arrive at the solution.Our emphasis here has primarily been to suggest a model of stochastic goalprogramming for capital budgeting decision problem under risk and uncertaintyand the computational procedure for its solution.

10.3 GAME THEORY

Since game theory can be used as a technique for dealing with cases ofcomplete ignorance of the initial probabilities of possible outcomes, the readermight be inclined to pitch his hopes for useful guidance a little higher. Again,he is likely to be disappointed. But before pronouncing judgement we shallillustrate with one or two simple examples the relevant techniques known as the‘two-person zero-sum game’, so called for the rather obvious reason (1) thatthe game is played between two persons or groups, one of which may be‘nature’, and (2) that there are no mutual gains to be made; the gains to oneparty being exactly equal to the losses suffered by the other party.

Consider first a reservoir which is full at the beginning of the season and canbe used both for irrigation and for flood-control. Without any prior knowledgeof whether or not a flood will occur, a decision is required on the amount ofwater to be released. If a little water is released now it will be good for theharvest, but it will be ineffectual as a contribution to preventing future flooddamage. If, instead, a lot of water is released now it will make flood damagevirtually impossible, but it will damage the harvest to some extent.

Now the amount of water that can be released from the reservoir can range,in general, from nothing at all to the whole lot. As for the flood, if it occurs itcan be either negligible or highly destructive. In order to illustrate the principle,however, we can restrict ourselves to two possible outcomes, (b

1) full flood and

(b2) no flood. The options open to the decision-maker are also to be restricted

for simplicity of exposition : they will be (a1)release one-third of the water in

the reservoir, a2 release two-thirds of the water in the reservoir, and (a

3)

release all the water in the reservoir. In addition to the possible states ofnature, (b

1) and (b

2), and the options open to the decision maker, (a

1), (a

2), and

(a3), we are also assumed to have a clear idea of the quantitative result

corresponding to the particular outcome and the option adopted. If, forexample, a decision is taken to release two-thirds of the reservoir, which isoption (a

2), and a full flood, (b

1), happens to occur, the net benefit – that is the

value of the harvest less the value of the damage done by the flood — isassumed to be known. In this example we shall assume it is equal toRs.140,000. Again, if instead we choose the (a

3) option, that of releasing all

the water, the net benefit that arises if the full flood (b1) occurs is assumed

equal to Rs.80,000. Since there are three options, or strategies, and two


7

possible occurrences, or states of nature, there will be altogether six possibleoutcomes each identified by a net benefit figure. The scheme is depicted inTable 10.1 below.

Table 10.1: Net benefit figures for various options and various outcome

b1 b2Flood No Flood(Rs.) (Rs.)

a1

130,000 400,000a

2140,000 260,000

a3

80,000 90,000

A glance at the Table will convince the reader that, provided the six figuresabove are all accepted as correct estimates of net benefits, option a

3 –

requiring the release of all the water in the reservoir – will never be adopted.Whether b

1 or b

2 occurs the net benefits of adopting the a

3 option will be

lower than those of either a1 or a

2. In the Jargon, option a

3 is dominated by

the other options, a fact that is revealed by the figures in the a1 row

(Rs.130,000 and Rs.400,000) and those in the a2 row (Rs.140,000 and

Rs.260,000), both sets of figures being larger than the a3 row figures

(Rs.80,000 and Rs.90,000). We could then save some unnecessary calculationby eliminating the dominated option a

3, since there are no circumstances in

which it would pay to adopt it. Nevertheless we shall retain it in this simplifiedexample, as the additional exercise will be useful while the additional calculationwill be slight complex.

Given no information other than in Table 10.1 we could employ either of twostandard methods to produce a decision: a maximin procedure and a minimaxprocedure. We shall only illustrate the former for understanding the applicationof the game theory.

The maximum procedure : If he looks along the first row of Table 10.1showing the net revenues, Rs.130,000 and Rs.400,000, corresponding to each ofthe two possible alternative states of nature, b

1 and b

2, when the decision-

maker chooses option a1, it will be realized that the worst that can happen is

the occurrence of b1, yielding a revenue of only Rs.130,000. Assuming that the

decision-maker is a conservative person, he will want to compare this worstresult, or minimal net revenue, that he can obtain from choosing a

1 with those

minimal he might obtain if instead he adopts the a2 or a

3 option. Now the

choice of a2 or b

2 occurs respectively. He can then be sure of at least

Rs.140,000. Similarly if he chooses option a3 he can be sure of obtaining at

least Rs.80,000. These three row minima, Rs.130,000 for a1, Rs.140,000 for a

2,

and Rs.80,000 for a3 are all shown in the third column of Table 10.2 which is

the same as Table 10.1 except for the addition of two columns.

Table 10.2: The Maximum Procedure

b1

b2

Row minima Maximin(maximum ofrow minima)

Rs. Rs. Rs. Rs.a

1130,000 400,000 130,000

a2

140,000 260,000 140,000 140,000a

3 80,000 90,000 80,000

Down this third column he reads off the worst possible outcome correspondingto each option. If he chooses a

1, he can be sure of not getting less than


8

Rs.130,000. If he chooses a2, he can be sure of not getting less than

Rs.140,000. If he chooses a3, he can be sure of not getting less than

Rs.80,000. It will then occur to him that if he chooses any option other thana

2 he might get less than Rs.140,000; for example, if having chosen a

1, b

1

occurs, he will receive only Rs.130,000, whereas if he chooses a3 he will

receive only Rs.80,000 or Rs.90,000 according as event b1 or event b

2 occurs.

The largest net revenue he can be sure of obtaining is, then Rs.140,000. Themaximin principle, therefore, requires that he chooses option a

2 (releasing two-

thirds of the water in the reservoir), and assure himself of no less thanRs.140,000.

The guiding idea has been to pick out the maximum figure from column three,which column contains the minimum possible net revenues corresponding toeach option. Hence the figure chosen Rs.140,000 in column four of Table 10.2is spoken of as the Maximin.

One feature of the above example is that capital costs are taken to be constantfor each of the alternative options. This enables us to compare directly the netrevenues—annual revenues less annual loss in each of the first two columns.If we assume instead that revenues are fixed and that costs alone varyaccording to the decision made and the event which takes place, we can gothrough the same sort of exercise.

An example would be the installation of a boiler in a works. Again we cansuppose three options: a

1, installing a coal-fired boiler, a

2, installing an oil-fired

boiler, or a3, installing a dual boiler, one that could be switched from using coal

to using oil, and vice versa, at negligible cost. Three possible occurrences areto be considered: b

1, coal prices rise relative to oil prices over the next twenty

years by an average of 25 per cent; b2, the reverse of this; and b

3, the

relative prices of the two fuels remain on the average unchanged.

The outcomes of the relevant calculations are summarized in Table 10.3, thefigures being the present discounted values (in thousands of rupees) of thestreams of future costs associated with each option for each of the threepossible outcomes.

Table 10.3: Net benefit figures for various options and outcomes;the maximum procedure

b1

b2

b3

Row Maximum Maximin

a1

-13.0 -12.0 -12.0 -13.0a

2-11.3 -12.5 -11.3 -12.5 -12.5

a3

-12.8 -12.8 -12.8 -12.8

By convention costs are to be regarded as negative revenues, so the figures inTable 10.3 are all negative. Looking along the a

1 row the worst outcome is -

13.0. If a1 is chosen and b

1 should occur, the cost would be 13. (13 is the

highest absolute figure in the row but, seen as a negative revenue andconsidered algebraically, -13 is less than -12. Thus -13 is the lowest figure inthe row.) The largest costs, or the smallest gains, corresponding to options a

2

and a3 are, respectively, -12.5 and -12.8-, which figures are entered in the

fourth column. Of these row minima, the maximum (or least cost) is -12.5corresponding to option a

2 which, on the maximum principle, would be the one

to be chosen. Having chosen a2, we can be sure that the cost to which the

firm can be subjected cannot exceed 12.5, this cost would be incurred if eventb

2 took place. If, however, event b

1 or b

3 occurred the cost would be only

11.3.


9

10.4 THE EXPECTED UTILITY APPROACH

Here we will develop a model for consumption investment decisions byindividual under conditions of uncertainty. The general problem can bedescribed as follows:

Consider an individual who must make a consumption - investment decision ateach of r discrete points in his lifetime. At the first decision point he has aquantity of wealth W

1 that represents the maximum possible level of

consumption during time period 1. At the beginning of period 1, W1 must besplit between current consumption C

1 and investment h1=W

1-C

1.

At the beginning of period 2, the individual’s wealth level is_ _W

2 = h

1 (1 + R

2) = (W

1 - C

1) (1+R

2)

R2 is the % expected rate of return in period 2. R

2 is a random variable,

therefore, W2 is also a random variable.

At the beginning of period 2, W2 must in turn be allocated to consumption and

investment, and the consumption - investment decision problem is faced at thebeginning of each subsequent period until period r, the last period of theindividual’s life at which time the entire available wealth is consumed.

The individual is assumed to derive satisfaction only from consumption and hisproblems is to map out a consumption – investment strategy that maximizes thelevel of satisfaction provided by anticipated consumption over his lifetime.

Under uncertainty the decision problem is of course complicated by the factthat the actual lifetime consumption sequence is to some extent unpredictable,because as indicated above the wealth levels produced through time byany given investment strategy are usually random variables. Thus in order tosolve the individual’s sequential consumption - investment problem, we need atheory of choice under uncertainty that defines the criteria that the individualuses in choosing among different probability distributions of lifetimeconsumptions.

10.5 THE EXPECTED UTILITY MODEL

The theory of choice under uncertainty that we apply to the consumptioninvestment problem is the ‘Expected Utility hypothesis’.

In general terms, the expected utility hypothesis states that when faced with aset of mutually exclusive actions, each involving its own probability distributionsof ‘outcomes’ the individual behaves as if he attaches numbers called, purelyfor convenience, utilities to each outcome and then chooses that action whoseassociated probability distribution of outcomes provides maximum expectedutility.

In the r period consumption - investment problem, an outcome is a completesequence of lifetime consumption Cr = (C1,C2,...Cr), and an action is a rperiod consumption - investment strategy that produces a probability distributionfor different possible lifetime consumption sequences. But because theconsumption investment problem is just one possible application of the expectedutility model, first see the model in its most general form.


10

Since we are confronted here with how the individual ranks outcomes andprobability distribution of outcomes, just as behaviour in conformity with theordinary utility model. So we, have five axioms that can help produce a betterunderstanding of the model.

The Axiom System

The set of axioms we use is as follows:

Axiom 1 : (Comparability) The individual can define a complete preferenceordering over the set of prospects in S; that is, for only two prospects X and Yin S, he can say that X>Y and Y>X or X ~ Y.

Axiom 2 : (Transitivity) The ordering of prospective assumed in Axiom 1 isalso completely transitive. For example X>Y and Y>Z imply X>Z or X~Y andY~Z and so on.

Axiom 3 : (Strong Independence) The rankings of two prospects are notchanged when each is combined in the same way into a a gamble orprobability distribution involving a common third prospect.

If X~Y, then for any third prospect Z in S,G(X,Z:µ) ~ G(Y,Z:µ). HereG(X,Z:µ) represents a gamble, that is, a random prospects, in which theindividual gets either X, with probability X, or Z, with probability 1-µ, and G(Y,Z:µ) likewise represents a gamble that produces either Y or Z, with probabilitiesµ and 1-µ. We also assume that if X>Y, then G(X,Z: µ) > G(Y,Z:µ); or if X³ Y then G(X,Z:µ) ³ G(Y,Z:µ).

Axiom 4 : If the prospects X, Y and Z are such that either X>Y³Z orX³Y>Z, there is a unique µ such that Y~G(X,Z:µ).

Axiom 5 : If X³Y³Z and X³U³Z, and Y~G(X,Z:µ1) and U~G(X,Z:µ

2) then

µ1 > µ

2 implies Y>U and µ

1 = µ

2 implies Y~U.

Intuitively it is clear that ranking random prospects which are just probabilitydistributions of elementary prospectus, according to expected utility requires autility function in which the differences between the utility levels assigned todifferent elementary prospects have some meaning; that is, if the utility of arandom prospect is just the expected or average value of the separate utilitiesof each of its component then elementary prospects differences in utility levelsmust have meaning.

10.6 SUMMARY

As the number of variables and number of years in planning horizons increasesit becomes very tedious and cumbersome to evaluate risk in investmentdecisions. To cope with a problem of this kind it is helpful to resort tomathematical programming models which aids in determining the optimal solutionwithout explicitly evaluating each feasible combination. Stochastic GoalProgramming is one on them. Game theory is a technique for dealing withcases of complete ignorance of the initial probabilities of possible outcomes.The expected utility approach deals with consumption investment decisionsunder conditions of uncertainty.


11


1. Discuss the capital budgeting techniques without probabilities.

2. Describe the general formulation of a goal programming model.

3. What is meant by utility? Do you feel financial managers should be riskaverse? Why or why not?


Agarwal J.D., “Reading in Financial Management”, IIF, Delhi Publication,1994.

Hiller F.S., “The Evaluation of Risk Interrelated Investments”, North-HollandPub. Co., London.

Knight F.H., “Risk, Uncertainty and Profit”, University of Chicago Press,Chicago.


12

APPENDIXA Goal Programing Model for Capital Budgeting

Weingartner (1963) suggested a linear programming formulation taking up Lorieand Savage (1955) problem and suggested an optimal solution. Lorie andSavage problem specifies for consideration nine mutually exclusive projects withgiven present values of outlays for period I and II and given prsent values ofinvestments. The budget constraints for two periods were Rs.50 and Rs.20respectively. The problem may be specified as follows:

Exhibit - ILorie-Savage Problem of Investment Proposals

PV of outlays PV of InvestmentInvestment Period I Period II

Project (Rs.) (Rs.) (Rs.)

1 12 3 142 54 7 173 6 6 174 6 2 155 30 35 406 6 6 127 48 4 148 36 3 109 18 3 12

In order to examine the effect of priority coefficients on the CBD, the GPmodel (12) for the above problem is reformulated here below changing thepriority coefficients for the different objectives of the same objective set. Thedifferent priority coefficients assumed for the following reformulated GP model(13) are as follows:

Goals Priority Coefficient

Net present goal (over achievement) 1

Budget constraint goal I 7

Budget constraint goal II (under achievement not desired) 8

Sales goal I (under achievement not desired) 2

Sales goal II (under achievement not desired) 3

Employment goal I (under achievement not desired) 4

Employment goal II (under achievement not desired) 4

Sales goal I (over achievement undesirable) 5

Employment goal I (over achievement not desired) 6

Employment goal II (over achievement not desired) 6

The GP model for capital budgeting decisions with modified priority coefficientsmay be specified as follows:

Minimizez = p

1d-

1 + p

7d-

2 + p

8d-

3 + p

2d-

4 +4p

3d-

5 +p

4d-

6+

p4d-

7 + p

5d+

4 _ p

6d+

6 + p

6d+

7, (10)

Subject to(A) Present value of investment goal

14x1 + 17x

2 + 17x

3 + 15x

4 + 40x

5 + 12x

6 + 14x

7 +

10x8 + 12x

9 + d-

1 = 32.4 (10.1)


13

(B) Budget ceiling goals12x

1 + 54x

2 + 6x

3 + 6x

4 + 30x

5 + 6x

6 + 48x

7 +

36x8 + 18x

9 + d-

2 = 50.0 (10.2)

3x1 + 7x

2 + 6x

3 + 2x

4 + 35x

5 + 6x

6 + 4x

7 +

3x8 + 3x

9 + d-

3 = 20.0 (10.3)

(C) Sales goals14x

1 + 30x

2 + 13x

3 + 11x

4 + 53x

5 + 10x

6 + 32x

7 +

21x8 + 12x

9 + d-

4 – d+

4 = 70.0 (10.4)

15x1 + 42x

2 + 16x

3 + 12x

4 + 52x

5 + 14x

6 + 34x

7 +

28x8 + 21x

9 + d-

5 = 84.0 (10.5)

(D) Employment goals10x

1 + 16x

2 + 13x

3 + 9x

4 + 19x

5 + 14x

6 + 7x

7 +

15x8 + 8x

9 + d-

6 – d+

6= 40.0 (10.6)

12x1 + 16x

2 + 13x

3 + 13x

4 + 16x

5 + 14x

6 + 9x

7 +

20x8 + 13x

9 + d-

7 – d+

7 = 40.0 (10.7)

x1, x

2, ..., x

9, d-

1,... d

7,d+

4,d+

6,d+

7 ³ 0.

The optimal solution of (13) is presented in exhibit II.

Exhibit II reveals that to attain the optimal solutions for each of the sevenobjectives four projects, i.e., x

3, x

4, x

7 and x

9 should be selected. The

respective units of these projects to be chosen are x3

= 2.00933, x4

= 2.65466,x

7 = 0.53334. On comparison of the solutions presented in exhibit I and exhibit

II it may be observed that the basic difference which the modified prioritycoefficients made is the choice of the projects and their respective units. Theoptimal solutions under the two situations remained to be almost the samebecause the overall formulation with regard to different objectives and theirover achievement was the same. However, if the formulation with regard tothe under achievement and/or over achievement is also simultaneously changedthe optimal solution would also be different.

Thus, it may be concluded that a goal programing solution is certainly betterthan the linear programming solution since a GP model allows (i) asimultaneous solution of a system of complementary and conflicting objectivesrather than a single objective only, (ii) that more than any one period can beincluded in the final programme of choosing projects.


14

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1

UNIT 11 FINANCING THROUGH CAPITALMARKETS (DOMESTIC SOURCES)

Objectives


� provide an understanding of money market and capital market,

� highlight redeeming features of capital market,

� explain different methods of raising funds by corporates through capitalmarket.

Structure

11.1 Introduction

11.1.1 Money Market

11.1.2 Capital Market

11.2 Methods of Procuring Finance

11.2.1 Equity shares

11.2.2 Rights Issues

11.2.3 Private Placement

11.2.4 Non Voting Shares

11.2.5 Preference Shares

11.2.6 Cumulative Convertible Preference Shares (CCP)

11.2.7 Warrants

11.2.8 Debentures

11.2.9 Bonds

11.2.10 Secured Premium Notes

11.2.11 Public Deposits

11.2.12 Bank Credit

11.2.13 Venture Capital

11.3 Summary



11.1 INTRODUCTION

Economic growth implies a long-term rise in per capita national output. Thebasic conditions determining the rate of growth are effort, capital andknowledge. Among these, capital formation has been recognized as the mostcrucial factor in the economic growth of the developing countries. Capitalformation implies the diversion of the productive capacity of the economy to themaking of capital goods which increase future productivity capacity. Theprocess of capital formation, thus, involves transfer of savings from those whohave them in the hands of those who invest the same for productive purpose.Saving & investment activities are linked by finance. Finance providesmechanism through which savings of myriads of savers are pooled together andare put into the hands of those able and willing to invest. The mechanismincludes a wide variety of institutions which cater, on the other hand, to thesafety, liquidity and profitability notions of the savers; and on the other to thedifferent types of requirements for working and fixed capital of the investors.These insittutions are generally grouped into Money Market and Capital Market.

Financing Decisions

2

11.1.1 Money Market

Money market comprises those financial institutions which cater to the notionsof savers of high liquidity and safety along with profitability and which provideworking capital to trade and industries mainly in the form of loans andadvances. Thus, money market is reservoir of short-term funds. Money marketprovides a mechanism by which short-term funds are lent out and borrowed; itis through this market that a large part of the financial transactions of acountry are cleared. It is a place where a bid is made for short-term investiblefunds at the disposal of financial and other institutions, individuals and theGovernment itself.

11.1.2 Capital Market

Capital market is the place where the medium-term and long-term financialneeds of business and other sectors of the economy are met by financialinstitutions which supply medium and long-term funds to borrowers. The capitalmarket is composed of primary market and secondary market (also known asstock market).

While the primary market provides a mechanism through which the resourcesof the investing public are mobilized, the secondary market provides mechanismto facilitate an investor to buy and sell securities through dispensation ofbenefits of easy liquidity, transferability and continuous price formation ofsecurities. Thus, both the primary market and secondary market play animportant role in raising maximum resources for capital formation and balancedand diversified industrial growth in the country. However, metamorphicenvironmental developments in and outside the country following the policy ofliberalization, privatization and globalization with the walls cocooning theeconomy being torn and unprecedented technological advancements have led togeographical and functional integration of international financial markets andintensification of competition among various players both in banking and non-banking sectors, blurring of boundaries between money and capital markets andculminating in the emergence of more diversified multipurpose financialinstitutions and financial innovations of unprecendented dimensions.

11.2 METHODS OF PROCURING FINANCE

A company can raise funds through capital market by issuing the financialsecurities. A financial security is a legal document that represents a claim onthe issuer. The corporates securities are broadly classified into ownershipsecurities and creditorships securities. There are also securities known as hybridsecurities having the mix of the features of ownership securites as well ascreditorship securities. Further, company can also raise the funds through publicdeposits and borrowings from banking sector. Each method of financing has gotits distinctive features in terms of risk, return, control, repayment requirements,and security. Depending upon the market conditions and financing strategies, theissuers adopt different methods.

11.2.1 Equity Shares

According to the companies Act 1956, a share is a part of unit by which theshare capital of a company is divided. The Act makes a provision for only twoclasses of shares capital, Viz., equity share capital and preference share capital,Equity share capital refers to the share capital, which is not preference sharecapital. Equity share capital is also defined as the “amount of the value ofproperty over and above the total liens and charges. In other words, equityshare capital is what ever remains in the way of assets after all the debts andother charges have been paid or provided for. Thus equity share capital is alsoappropriately referred to as residual capital.

3

Equity shares represent the owner’s equity. Its holders are residual owners whohave unrestricted claim on income and assets and who enjoy all the votingpower in the company and thus can control the affairs of the company.Equity share capital is also known as risk capital as the equity shareholders areexposed to greater amounts of risk, but at the same time they have greateropportunities for getting higher returns. The equity shareholders also enjoygetting higher returns.

Another redeeming feature of equity shares is that its holders have pre-emptiveright, right to purchase additional issues of equity shares before the same isplaced in the market for public subscription. As a result, equity shareholdershave the power their proportionate interest in the assets, earnings and control ofthe company.

The following are the advantages and disadvantages of raising capital by issuingequity shares.

Advantages:

1) The equity shares are not repayable to the shareholders. So it is apermanent capital for the company, unless the company opts to return itthrough buying its own shares.

2) The debt capacity of a company depends on it’s equity including reserves.Raising capital through equity enhances the company’s debt capacity.

3) The company has no legal obligation to service the equity by paying acertain rate of dividend, unlike the debt for which interest is payable. So,the firm can conserve the cash when it faces the shortages, and pay whenit’s earnings are adequate to do so.

Disadvantages:

1) Among the alternative sources of capital the equity capital’s cost is high,because of various reasons like higher risk, flotation costs, non-deductibilityof dividend for tax purposes, etc;

2) Investor’s perceive the equity shares as highly risky due to last claim onassets, uncertainty of dividend and capital gains. Therefore, the companiesshould offer higher return to attract equity capital.

3) Addition to equity capital may not raise profits immediately, but will dilutethe earnings per shares, adversely affecting the value of the company.

4) Raising of capital by offering equity shares will reduce the controllingpower of promoters, unless they contribute proportionately, or opt for non-voting shares which are costlier than ordinary equity shares.

Companies can raise funds by issuing equity shares in five ways, Viz., throughpublic issue, rights issue, private placement, convertible debentures, andwarrants, while the first three are discussed here. The other two are explainedin the later part.

Public Issue:

To approach the public with a public issue to raise capital, the company shouldfollow various regulations and guidelines of the Companies Act, and Securitiesand exchanges Board of India (SEBI).

The important activities to public issue are:

1) Prepare a detailed project report, for which funds are intended.

2) Preparation of prospectus, and filing the same with SEBI.

3) Arrangements for listing the equity share in the stock exchanges.

Financing ThroughCapital Markets

(Domestic Sources)

Financing Decisions

4

4) Underwriting agreement with merchant bankers, brokers, etc.

5) Bridge loan arrangements to complete the project before equity sharecapital is raised.

6) Finalization of quotas to promoters, NRI’s employees, and firm allotments,and public.

7) If the public issue is not subscribed to the extent of atleast 90 percent ofthe equity issue, the money so colleted should be returned to the publicwithin 120 days of the last subscription date. In case of over subscription,proportional allotment has to be made as per SEBI guidelines.

11.2.2 Rights Issues

Under section 81 of the Companies Act, exiting shareholders of a companyhave a right to subscribe for news equity shares. If the company intends toraise additional equity capital in proportion to their share holding, these sharesare called rights shares. Instead of acquiring the rights shares the shareholderscan transfer the rights to others or can simply forego them. Those shares notsubscribed will be allotted to the other shareholders applying for more,proportionately.

If shares are left out even after giving additional allotment to the existingshareholders, those shares can be issued to the public. When rights are offeredin proportion to the existing shares of the shareholders, the rights pricing willnot influence the value of the company, when adjusted for the capital collectedtowards rights shares.

The right issue offers three main advantages. First the existing shareholdingpattern will remain constant. Therefore, the controlling power of theshareholders including promoter will not be disturbed the promoters mayenhance their controlling power, by allotting themselves additional shares to theextent of rights un-utilised by other share holders. Second, raising of capitalthrough rights issue instead of public issue leads to lower flotation, commission,and can reduce the publicity costs.

Even the over subscription will be limited, leading to lower costs of returningthe excess capital received. Third, the response to the rights issue is easy toguage, especially when the rights share price is set much below the prevailingprice of the share.

The wealth and controlling power of the shareholder will be reduced if he failsto subscrible to the rights issue. In India the financial institutions acquired largenumber of shares by using the loan conversion clause policy. The loan extendedcan be converted into equity shares at a pre-determined conversion price at theoption of the financial institution. In some profitable companies their shareholdings become more than that of the promoters making their controllingpower valuable. In such cases the promoters prefer public issue to rights issue.

11.2.3 Private Placement

In this method of raising capital, shares will be issued in bulk to issuing housesthrough financial intermediaries, investment companies, or other companies. Asper SEBI norms a company cannot issue shares to more than 99 persons underprivate placement. Often these institutions buy the shares through privateplacement, with an intention to make profit by selling them to the investors inthe secondary market through clients. The sale can take place in short-term orlong-term. While issuing bankers and brokers normally resell the sharesacquired through private placement in the short-term. This method has theadvantages of negligible floatation’s costs (if any) and better price for theshares.

5

11.2.4 Non-Voting Shares

The government came out with the proposal of non-voting shares to safeguardthe promoters from hostile takeovers. As per the Government proposal the non-voting share is similar to ordinary equity shares in all respects except in case ofvoting rights and dividend payment. The owners of non voting shares do notpossess voting right, and as a compensation for loosing the voting rights, theywill be paid a few percentage points of higher dividend than that was paid toordinary equity holders. If a company fails to pay dividend for more than astipulated period, the non-voting shares will automatically stand converted intoordinary equity shares with voting rights.

11.2.5 Preference Share

Preference shares are those which carry certain preferential rights as comparedto other securities. The preference shareholders have the right to get dividendat a fixed rate prior to any other class of shareholders. Similarly, the preferenceshareholders get repayment of capital before any other class of shareholdersget it when the company is liquidated. In other words, preference shares haveprior claims over equity shares on earnings and assets in the event ofliquidation, but rank below creditors. But unlike interest on bonds, dividenddeclaration by the company is not obligatory and may not be paid in a yearwhen profits are not enough. In other words, the preference shareholderscannot take legal action against the company for not declaring dividends.However, the preference shareholders have got the protection that no dividendcan be declared on the ordinary shares, unless dividend on preference shares isdeclared and paid. Further, if the preference shares are cumulative type,dividends not paid in any year will accumulate and must be paid at a later date,before paying dividend on ordinarily shares.

Preference shares are also of different kinds like redeemable preferenceshares, cumulative preference shares and convertible preference shares.Redeemable preference shares are those which will be redeemed in course oftime as per the terms and conditions as stated in the offer document.Cumulative preference shares carry accumulated unpaid dividends year to yeartill the company is in a position to pay all the dividends including the arrears ata stated rate. While the convertible preference shares get converted into equityshares as per the terms and conditions as stated into offer document, theinvestors who seek security and assured returns than in found in equity sharesgenerally subscribe preference shares. Companies generally issue preferenceshares in order to maintain the status quo in the control of the equity stock andalso to reduce the cost of capital as the preferred stock carries lower rates ofdividends as compared to other debt securities like debentures which usuallycarry higher rates of interest. At time, the preference shareholders may have aright to share the surplus profits by way of additional dividend and the right toshare in the surplus assets in the event of winding up after all kinds of capitalhave been repaid.

11.2.6 Cumulative Convertible Preference Shares (CCP)

Cumulative Convertible Preference (CCP) shares were introduced by thegovernment in 1985.

The features of CCP are:

1) The CCP’s can be issued by any public limited company to raise funds fornew projects, expansion and diversification etc.

2) The amount of funds raised can be to the extent of the equity shares tothe public for subscription.

3) The dividend payable is 10 per cent.


(Domestic Sources)

Financing Decisions

6

4) The entire amount of CCP would be convertible into equity shares betweenthree and five years.

This instrument is yet to become popular. Companies did not prefer it becausethe dividend on CCP’s is not tax deductible as in case of interest on debt. Atthe same time dividend of 10 percent is also not attractive to the invester.However dividends become tax free in the hands of shareholders from thefiscal 1998-99 and therefore CCP’s may become popular.

11.2.7 Warrants

Warrants is similar to call options. It is a right to buy a share of a companywhich issues them at a certain price during a specified period of time. When awarrant is exercised, the number of shares of the company increases, at thesame time resulting in cash flow for the company. Warrants may be issued inthe following circumstances.

i) Warrants may be attached to the sale of new equity shares assweetener.

ii) Through exchange as a result of reorganisation.

iii) Through separate sale, as issued to promoters of some Indian companiesto strengthen their controlling power. This is not a common practice.

Price of Shares Issued Through Warrants

The company will receive the consideration for shares issued through warrantsin three parts of (a) Cash received on sale of the warrants, (b) Cash receivedon exercise of warrants, and sale of the warrants, and (c) the consideration forthe earlier financing supplied to the company. The fair value of shares issuedon the exercise of warrants is the most reasonably determinable measure ofthe total consideration for the shares issued through warrants. The differencebetwen the total consideration for the cash received represents the cost ofcorporate financing. The following are the benefits to the company and investor,when warrants are issued.

Benefits to the Company

By issuing warrants the company will receive funds for its investment needs.However, it has no obligation to service those funds raised, in terms of payinginterest, and principal amount. The price of this privilege is the obligation todeliver the share wherever the warrant holder desires so during theprespecified time period. Normally, the exercise price will be more than thecurrent price of the share.

Benefits to the Investor

The investors seeking warrants advance funds to a company bearing the risk ofexpecting return based on future share price of that company. The investors donot get any interest, or dividends on their investment unless the warrants areconverted into shares. The possible gains to the investor are :

i) Instead of investing in the equity shares of a company at current price,the investor can opt for warrants with a right to buy the same numberof shares at a specified price in future paying a small amount for thewarrants. The funds, thus, saved can be used for other investmentavenues.

ii) The warrants are usually traded on the stock exchanges offeringliquidity. The Investor can book profits,or can en-cash the warrants, ifnecessary.

7

11.2.8 Debentures

Debentures are one of the principal sources of funds to meet long-termfinancial needs of companies. Though there is no specific definition ofdebenture, according to the Companies Act 1956, the word debenture includesdebenture stock, bonds and any other securities of a company. Thus, adebenture is widely understood as a document issued by a company asevidence of debt to the holder, usually arising out of loan and mostly securedby charge. The major differences between shares and debentures are asfollows;

i) The equity shareholders have proprietary interest in the company whereasthe debenture holders are only creditors of the company.

ii) The equity shareholders have voting rights whereas debenture holders donot enjoy such a right.

iii) Debenture holders are entitled to interest at a fixed rate whereas theequity Shareholders are entitled to dividends at varying rates.

iv) Debenture are usually redeemable and therefore have maturity periodwhereas the equity shares are not redeemable.

v) Debenture holders have priority over shareholders in the distribution ofassets on liquidation of the company.

Debenture holders can initiate legal proceedings against a company, if it defaultson its interest payment or principal repayment when these become due. Thecompany using debentures usually offers some sort of a security which is calledcharge. The charge may be fixed charge or floating charge.

Debenture are of various forms like: (i) secured and unsecured debentures,(ii) Fully convertible, partly convertible and non-convetible debentures,(iii) Redeemable and irredeemable debentures.

Of all the various kinds of debentures, convertible debentures, of late, havebecome more appealing to the investors. The investors may also have theoption of retaining the debentures without exercising the conversion option. Thepartly convertible debentures with buy back facility are also issued, wherein onepart of the debenture is converted into equity and non convertible part mayhave the facility of buy back either by the company or its associates. Theconvertible debentures can be exchanged for equity shares of the samecompany on the terms and conditions stipulated at the time of issue of thedebentures. Till conversion, these debentures are treated as debt instrumentsand enjoy the same priority in claims as those of ordinary debenture holders, onthe assets of the company. For the company, there is scope for reducing thecost of capital, since investors would be content with a lower return than thaton ordinary debentures, if there is a high likelihood of capital appreciation of thecompany’s shares in later years.

There are many advantages of debenture issues for the company. Moreparticularly, the debenture holders cannot interfere with the operation of thecompany as they do not have voting rights. The cost of debentures is usuallylow, as the interest payments on debentures are tax deductible expenses.

11.2.9 Bonds

A bond is a creditorship security whereby a company obtains money from thelenders for a promise to pay the stipulated rate of interest at specified intervalsand to repay the principal on maturity, and they get the principal sum onmaturity, which is also mentioned in the agreement. Bond holders have a priorclaim on the receipt of the interest and repayment of the principal over othercreditors of the company.


(Domestic Sources)

Financing Decisions

8

Bonds are of different types like secured and unsecured bonds, bearer bonds,perpetual bonds, sinking funds bonds, zero coupon bonds, convertible bonds,floating rate bonds, etc.

Zero coupon bonds have become very popular in recent years with theinvesting public. The zero coupon bondholders are not entitled to any interestand they get the principal sum on maturity. The zero coupon bonds are usuallysold at a hefty discount and the difference between the face value of thecertificate and the acquisition cost is the gain to the investors. There arecertain advantages to both the investors and issuers. As far as investors areconcerned, they need not bother about reinvestment of interest as there is noperiodical interest payment. Further, the difference between the acquisition costand maturity value of the bond is considered as capital gain and therefore, itattracts lower rate of tax as compared to the tax rates applicable to interestincomes. For the issuer, since there is no periodical payment of interest, thecompany may not have the cash flow problem in the initial years of theprojects whereafter the payment to the bondholders can be synchronized withcash flow pattern of the project.

Floating Rate Bonds (FRB) have also become popular in recent years. Thefirst floating rate bond in the Indian capital market was issued by the StateBank of India adopting a reference rate of one-year bank deposit rate plus300 basic points (BP). The bank also had the call option after 5 years toredeem the bonds earlier than the maturity period of 10 years at certainpremium. Later many corporate and development finance institutions came outwith floating rate bonds of different maturity periods. But most of them used364-days Treasury bill rate as the bench mark plus certain basis Points, whichagain varied from issue to issue. For example, ICICI issued floating rate Bondsadopting 364-days T-bill rate : 180 BP but Anvind Mills launched floating rateBonds adopting 364 days T Bill rate : 325 BP. Thus, the floating rate bondsprovide varying rates of return with a minimum assured return to the investors.The issuers may also have the benefits of making interest payments accordingto the current market.

11.2.10 Secured Premium Notes (SPN)

The Tata Iron and Steel company was the first corporate to issue SPN onrights basis. The main features of SPN, as issued by TISCO are as follows:

The face value of a SPN was Rs 300 and no interest will become due oraccrue during the first three years after allotment. Therefore, each SPN will berepaid in four equal annual instalments of Rs. 75 from the end of the fourthyear together with an equal amount of Rs. 75 with each installment, which willconsist of a mix of interest and premium on redemption. Further, each SPN willhave a warrant attached to it which will give the holder the right to apply foror seek allotment of one equity share for cash payment of Rs. 80 per share.Such rights are exercisable between first year and one and a half year afterallotment.

Thus, SPN can serve as long-term securities and given more flexibility to thecompanies as well as investors.

11.2.11 Public Deposits

According to the companies Act, 1956, all types of money received by acompany except the contribution to capital would fall in the category ofdeposits. Fixed deposits which are also known as public deposits have becomeattractive for companies as well as investors. For the companies, publicdeposits are easy form of fund mobilization without mortgaging assets. For theinvestors, public deposits provide a simple avenue for investment in good and

9

popular companies at a better rate of interest without many formalities asinvolved in the case of shares and debentures. However, the public depositsbeing unsecured, the repayment of deposits and regular payment of interest aresubject to a lot of uncertainty. That is, by presenting false information somecompanies manage to collect large deposits from the gullible public and fail tohonour commitments on payments, inspite of many regulatory provisions, ascontained in the Companies Act and Companies (Acceptance of Deposits)Rules, 1975.

11.2.12 Bank Credit

Banks including the development finance institutions have become chief sourceof funds to the corporate sector. In other words, the industrial credit is a majorrevenue earner to the banking sector as other types of credit like agriculturalcredit are subject to many restrictive conditions and regulations of RBI andtherefore, the margins on such credits are very thin. Banks extend credit toindustries and commercial establishments at varying rates of interest dependingupon the credit worthiness of the borrower as well as period of loan. Theproportion of bank credit in the total funds of the companies is very high inmany a case. The major advantage for the companies in that the bank credit isa flexible source of financing and it is relatively easy to mobilize funds throughthis source.


Governments around the world have been actively encouraging small andmedium business, especially feasible projects. The usual sources of capitalgenerally do not suit those promoters who are not in a position to put in enoughcontribution to satisfy the other investors and lending institutions. Even if otherinvestors are willing to chip in despite negligible promoter contributions, thepromoter cannot retain the control of the business after establishing andstabilizing in a profitable path, if the other investors chose to vote them out.The objective of the venture capital is to encourage those desiringentrepreneurs by providing long-term capital without the risk of losing control.By 1980’s, the U.S.A. had a well developed venture capital market. In Indiaventure capital market is emerging as a new source of funds.

Features:

It is defined as (similar to) equity investment in growth oriented small ormedium business to enable the investors to accomplish corporate objectives, inreturn for minority shareholding in the business or the irrevocable right toacquire it. Further, venture capital organization provides value addition in theform of management advice and contribution of overall strategy. The relativelyhigh risk will normally be compensated by the possibility of high return in theform of capital gains in the medium term. Venture capital is also called asprivate equity. The following are main features that distinguish the venturecapital from other sources of capital market.

i) Venture capital is a form of equity capital for relatively new companies,which find it too premature to approach the capital market to raise funds.It can also be in the form of loan or convertible debt. However, thebasic objective of a venture capital fund is to earn capital gain, whichusually will be higher than interest at the time of exit.

ii) It is long-term investment. The transfer of existing shares from othershareholders cannot be considered as venture capital investment. Thefunding should be for new project or for rapid growth of the business,with cash transferring from the fund to the company.

iii) The venture capital organization will actively participate with the topmanagement of the firm.


(Domestic Sources)

Financing Decisions

10

iv) All the projects financed by the venture capitalists will not be successful.However, some of the ventures yield very high return to more thancompensate for heavy losses on others.

Selection for Investment

The appraisal procedure for investment is similar to feasibility studies of thedevelopment finance institutions for grant of term loans and other financialassistance. In addition, the venture capital organization may persue track recordof enterpreneurs, threats from technological obsolescence and preliminary viewson preferred exits. The stages of financing and the mode of financing will alsobe finalized at this stage.

Stage of Financing: Generally, the stages of financing are (a) early stage and(b) later stage.

Early stage Financing: This stage is essentially an applied research phasewhere the concepts and ideas of the promoters are discussed and testedleading to a prototype. If the prototype is satisfactory, this stage moves towardsthe development phase leading to product testing and commercialization.Normally promoters complete this phase with their own resources, becausevery few venture capital funds finance this stage.

Start-up : This refers to the stage when commercial production is ready tobegin. At this stage product will be commercialized in association with theventure capital organization. In this stage some indication of the potentialmarket for the new product will be available. The risk perception is still high.The involvement of the venture capital organization at this stage also isrelatively less. Due to the unwillingness of the promoters to dilute theircontrolling stake, or too small amounts involved, or even unclear riskperceptions.

Later stage Financing : At this stage the investor firms require funds butcannot approach markets. This stage includes development capital, expansion,buy-outs and turn around.

Development Capital : It is for financing of established firms which haveovercome the high risk stage with a profit record for a few years, but can notraise funds in the capital market. The reasons for venture capital funds at thisstage are for purchase of new equipment/plant, expansion, improving marketingfacilities, refinancing of existing debt etc. In this stage the risk perception ismedium and venture capital funds involve actively.

Expansion and Buy-outs : In this stage the firms try to expand theirproductive assets and marketing facilities considerably either by procuring assetsor by acquiring controlling power of other similar firms through controllingstakes or other options.

Turn Around : This is an important segment of venture capitalists business.They require not only money but also management skills. Once the venturecapitalists identify the firms with good management skill, they come forward toprovide money. As the risk perception is high, skill is a focus area for manyventure capital funds.

Thus, the venture capital firms fund both early and later stage of requirementsof investor firms, balancing between risk and prifitability. This is an ideal sourceof capital for promotes having very good technical and management skills, withlimited financial resources.

11

11.3 SUMMARY

Capital market plays a very important role in the mobilization of funds forInvestment. Capital market can be classified as primary market and secondarymarket which are complimentary to each other. The capital market hasexperienced metamorphic changes over the last few years. The competition inthe market has become so intense necessitating the introduction of several kindsof securities. The corporates in India mostly raise their funds through capitalmarket by issuing equity shares, preference shares, debentures, bonds andsecured premium notes. They also raise their funds through public deposits andborrowings from banks. Technocrats and entrepreneurs with feasible project buthaving limited financial resources can approach venture capital organization.Each method has got its own distinctive features and depending upon themarket conditions and financing strategies the issuers adopt different methods.


1. What are the characteristics of capital market? How is it different frommoney market.

2. Explain the relationship between primary market and secondary market?

3. Assess utility of equity shares as source of corporate financing.

4. “Preference shares are known as ‘hybrid’ securities”. Comment.

5. What is creditorship security? How is it different from ownership security?

6. Examine potentiality bonds as source of corporate financing.


Jaimes C. Vanhorne, Financial Management and Policy, Prentice Hall ofIndia, New Delhi.

S.L.N. Sinha, D. Hemalatha and S. Balakrishan, Investment Management,IFMR, Chennai.

RM Srivastava, R. Divya Nigam, Management of Indian FinancingInstitutions, Himalaya Publishing House, Mumbai, 2001.

I.M. Pandey, Financial Mangement, Vikas Publishing House, Bombay.

M.Y. Khan, Indian Financial system, Vikas Publishing House, Bombay.

R.M. Srivastava, Financial Management and Policy, Himalaya PublishingHouse, Mumbai, 2003.


(Domestic Sources)

1

UNIT 12 GLOBALISATION OF FINANCIALSYSTEMS AND SOURCES OFFINANCING

Objectives


� explain the concept of globalisation,

� throw light on globalisation of world Financial systems,

� scan the Indian Scenario of globalisation,

� study the various global sources of financing.

Structure

12.1 Introduction

12.2 Deregulation in Financial Markets

12.3 Developments in the Banking Sector

12.4 Developments in the Foreign Exchange Markets

12.5 Special Financial Institutions

12.6 Indian Scenario

12.7 Global Sources of Financing

12.8 Summary



12.1 INTRODUCTION

In financial circles in recent years, the word ‘globalisation’ is often heard, mostcommonly with reference to the heightened internationalisation of financialtransactions. This catch word sums up the Phenomenon in which financialtransactions increasingly transcend the geographical and time limitations of localfinancial markets, giving rise to a single, uniform ‘global’ market. While thePhrase ‘internationalisation’ refers to cross border transactions among nationalmarkets, globalisation goes beyond national frontier to create a ‘borderless’market in which national borders gradually disappear.

The international financial system is characterised by the following types ofinstitutions:

a) Financial markets;

b) The banking sector;

c) Foreign exchange markets; and

d) Special financial institutions, such as the World Bank, IMF, etc.

Since the early eighties, there has been a virtual transformation of thesemarkets. Not only has there been a complete integration of these markets inany given country or economy, but the ties have been strengthened as to resultin a unified financial system on a world-wide scale. Not surprisingly, we hearof tendencies towards common transaction methods and common settlementperiods across the globe. A complete integration of the markets world-wide, nodoubt, requires swift communication between countries. The developments intechnology whereby information can be had within a matter of seconds from

Financing Decisions

2

any part of the globe have made the process of globalisation much easier andprofitable. Financial managers across the world are concerned with identifyingprofitable opportunities with associated minimum risk. The financial integrationof markets whereby funds can be easily transferred from one place to anotherhas certainly influenced the financing and investment decisions financialmanagers make on a day-to-day basis.

12.2 DEREGULATION IN FINANCIAL MARKETS

Many factors have helped the globalisation process in which no market,howsoever remote, remains isolated and insulated from developments takingplace world-wide. The October 1987 crash is much too recent to be forgottenand a telling evidence of the extent to which markets have been integrated.Popularly too, of American and Japanese markets, it is said that when Americacatches a cold, Japan sneezes. There have also been a number of studies onthe integration of European markets with the American market. In general, theshare prices move in tandem with each other.

The introduction of the floating exchange rate regime in 1973, interest ratederegulation and securitisation since the 1970s have been among the majorfactors behind the steady progress of financial globalisation. The OPECphenomenon of the 1970s and the debt crisis triggered by the developingcountries in the 1980s also significantly influenced the volume of internationalcapital flows and the restructuring of the financial system as a whole.Innovative financing techniques are constantly being designed to turn thefinancing game, instead of the zero-sum game that was witnessed in the 1980s.The innovativeness in finacing techniques and tools have also been accompaniedby the growing deregulation of the national financial markets, characterised byrelaxation of barriers separating the activities of different types of institutions,relaxation of interest rate ceiling, extension of the geographical domain ofexisting institutions, and reduction in barriers to entry into the domestic financialsystem by both foreign and non-banking institutions. The abolition or relaxationof exchange controls, elimination of quantitative credit ceilings, removal orreduction of withholding tax on interest earnings of non-residents and changesin regulations governing access of foreigners to domestic markets, and accessof residents to international markets has tremendously helped the nationalmarkets to forge a global financial market. The increasing competition amongbanks themselves on the one hand and between banks and non-banks on theother, for providing finance and financial services compelled banks to look intohitherto uncharted territories.

The deregulation of the London Stock Exchange that took effect from October27,1986, ecstatically referred to as the ‘Big Bang’, has been the mostmemorable one in the far-reaching changes that were introduced in thefinancing of the London financial market. The liberalisation, though initiallyintended to be limited to the abolition of the fixed commission on brokingbusiness and the separation of the functions of brokers and jobbers, nowencompasses a wide range of related aspects for facilitating competition andinternationalisation of the London Stock Exchange. The traditional distinctionbetween brokers (who buy and sell on behalf of investors) and jobbers (whomake the markets on the floor of the Stock Exchange) has been given a bodyblow in other financial centres also. The permitting of institutional membershipinto the stock market has meant the injection of new capital into the UK. Notto be left behind is the Bombay Stock Exchange in India, which besidespermitting institutional membership has also taken up computerization on a massscale.

Globalisation ofFinancial Systems

and Sources ofFinancing

3

The prominence of the Swiss market to its present status has been largely dueto its deregulated functioning. A significant portion of the Euro-deposits cameto be parked in the Swiss market because of the virtual absence ofGovernmental control as well as tax-free income from securities. Theemerging role of Tokyo as an important financial center has also been becauseof the easy access it provides to both domestic and overseas investors andfinancial intermediaries to a growing variety of instruments issued by or forJapanese entities. Foreign banks can now engage in trust business (althoughon a selected basis) and can join in the government bond underwritingsyndicate. Foreign securities houses can lead-manage Euro-yen bonds and canbe members of the Tokyo Stock Exchange. Amongst the great variety of debtinstruments and financial packages available in Japan are also the multi-currency bonds and the leasing bonds, where-in by providing funds to leasingcompanies to purchase high-valued items such as aircraft, cross-border financialleasing is facilitated.

The need for financial innovation to make large amounts of funds easilyaccessible has also been felt because of the growing trend towards privatisationof nationalised industries and increase in flexibility of operations leading to massrestructuring and consolidation of business entities. Competitive pressureshave led to a growing awakening towards maximising both economies of scaleand scope. The mass restructuring and consolidation of business entities haveresulted in more frequent breakups and dispositions, leveraged buyouts (LBOs)and management buyouts of units of companies that do not fit into coherentstrategic alliances, often with significant equity stakes, have also been enteredinto as alternatives to full mergers or acquisitions. Resources for financingmerger transactions have also been provided with bridge loans, ‘mezzaninefinancing’ synthetic securities, junk bonds, and other related techniques. While‘mezzanine financing’ refers to the issue of equity-related bonds, e.g., bondswith warrants, the term synthetic securities refers to a package of securitiessuch as a Eurobond and a currency swap arrangement that converts an originalsecurity into a security with different currency or other characteristics. Junkbonds are simply bonds rated below investment grade (BBB) by rating agenciesbut are popular because of the extremely high yields they promise. The junkbond market flourished initially by financing large volumes of LBO transactions.

12.3 DEVELOPMENTS IN THE BANKING SECTOR

The banking sector too, has gone through revolutionary changes. At least threetrends characterise the future of banking the world over:

i) The banks’ role as funding intermediaries is diminishing and instead banksare taking on the role of broker and/or underwriter for credittransactions;

ii) Banks’ formerly protected turf is being invaded by investment banks,thrifts, insurance companies, and even retail firms. In response, banks areexpanding their activities into the domain of investment banks andinsurance companies; and finally

iii) Banks are expanding geographically as they compete in inter-state andeven international markets.

However, although the role banks play as funding intermediaries is diminishing,it will not disappear entirely. Banks’ ability to fund loans will continue to beimportant in, at least, two ways.

First, banks will continue to make and hold loans that are not readilysecuritised. To make loan-backed securities marketable, securitisation requiresthe standardisation of loan terms and conditions. Similarly, it requires that

Financing Decisions

4

investors be able to evaluate the credit risk of the underlying pool of loans atrelatively little cost. Loans that require special knowledge of the expertise inlocal markets, therefore, are not easily standardised. To compensate lendersfor the higher costs associated with making these non-standardised loans, theiryields will rise relative to the yields on debt obligations that can be securitised.Consequently, banks will have incentives to continue to make and hold non-securitised loans. A second way in which banks will remain importantintermediaries is as backup sources of liquidity when borrowers find it difficultand/or costly to raise funds in capital markets. For this reason, even theborrowers that have ready access to commercial paper and other directsecurities markets still pay banks substantial fees to maintain lines of credit andloan commitments. Likewise in international capital markets, borrowers havebeen attracted to the note issuance facilities offered by banks. These facilitiesensure access to funds, should the borrowers be unable to sell their notesdirectly to investors.

The volume of newly arranged underwritten facilities reached their peak in1985 - about 18 per cent of total international financing. In 1986, theyaccounted for only 8 per cent of total international financing, due to theimposition of capital rations on banks’ off balance-sheet activities (OBSAs)since 1984. Nevertheless, bankers will continue to engage in these activities, ashistorical experience indicates that losses on such activities have been small.Other fee-generating activities include issuing stand-by letters of credit,commercial letters of credit, loan commitments and indulging in foreign-exchange obligations and interest rate swaps. Such business for major palyersrun into billions of dollars. Some idea of the globalization of banking can behad from the following table:

Table 12.1: The Growth of Bank Off Balance-Sheet Activities 1981-1987

Activity $ Billions 1986 Compound $ Billions Annual1980 Annual growth 1980-1986 growth

from1986

Letters of Credit 47 170 23.9% 168 -1.6%

Stand-by Commercial 20 28 5.8 30 9.6%Loan

Commitments 432 572 9.8% 595 5.4%

Foreign-exchange 177 893 31.0% 1558 110.0%transactions

Interest-rate swaps 186 367 97.3% 602 93.9%

Band Capital 108 183 9.2% 180 -2.2%

Source: Joseph F. Sinkey, Jr., Commercial Bank Financial Management in theFinancial Service Industry, Macmillan Publishing Co., 1989, p.578.

The table clearly shows that foreign exchange transactions and interest rateswaps are now the most important sources of revenues from OBSAs. Profitsin foreign-exchange trading come from two main sources:

i) trading profits generated by the bank trading for its own accounts; and

ii) fees generated by trading in currencies for its customers.

Multinational banks are very active in Euro-currency markets wherein theygather deposits and make loans, usually in Eurodollars. Interest-arbitragetransactions are frequently entered into, i.e., borrowing funds in one foreigncurrency and country and making loans in another currency and country, due to



5

substantially different interest rates across countries. The objective of thesearbitrage transactions is to maximise the interest-rate spreads, given the banks’risk preferences.

12.4 DEVELOPMENTS IN THE FOREIGN-EXCHANGE MARKETS

Foreign-exchange markets exist because of trade between countries withdifferent currencies. That is, exporters prefer not to hold foreign currencies;they want to be paid in their national currency. Foreign exchange transactionshave, thus, become an integral, even essential, part of international trade andfinance. In the immediate aftermath of World War II, foreign exchangetrading was relatively limited, as most major currencies were subject toextensive exchange controls, and the opportunities for the movement of fundsacross national boundaries were severely limited. The subsequent recovery andgrowth of the world economy brought a gradual relaxation of these controlsand as a result foreign exchange trading became more and more active. Thereally explosive growth of the exchange markets began, however, with theadvent of floating exchange rates following the collapse of the Bretton Woodssystem in the early 1970s. Since then, not only has world trade continued toexpand very rapidly, but international financial transactions have grownexponentially and with them, the foreign exchange markets. Moreover, not onlyhas the volume grown, but the markets have become increasingly volatile, andthat, in itself, has drawn in additional players to the market, both, for defensiveand aggressive trading.

The foreign exchange market is dominated by giant commercial banks. Toprovide foreign exchange services to customers, these banks take a position(i.e., hold inventories) in the major currencies of the world. Some banks dothis by keeping deposits with foreign banks. In addition to providing forcustomers’ foreign currency needs in either the spot or the forward markets,banks also trade on their own account in the foreign exchange market. Theimportance of foreign-exchange income to the major US banks is reflected bythe fact that it accounts for anywhere from 10 per cent to 60 per cent of theoverseas operating income of these banks.

This increased internationalisation has, nevertheless, meant increasedvulnerability of the players in these markets. Amongst the various risk-reductionmethods that have come to be employed, swaps, futures and options are themost conspicuous. These facilities enable banks and corporations to hedge theirexposure to financial risks arising from interest rate and exchange ratechanges. In the international markets, currency options are more predominantthan interest rate options. In currency options, standard period options (3months, 6 months, etc.) for major currencies against US dollars are beingincreasingly traded. In the options market, banks may act as agents for otherparties or as principals. Financial futures have registered significant expansionin recent years with the expansion of the business of existing futures marketsand also with the setting up of futures markets in other centres particularlyLondon, Singapore and Amsterdam. Interest and currency futures not onlyoffer actual hedging facilities but also speculative innovative techniques, which,though useful to transfer risks to counterparties has also called for appropriatemanagement control and monitoring systems. Capital adequacy norms for thebanking sector was one such step in the regulatory system. The need forregulation is heightened with fiascoes of massive proportions, such as thefailure of BCCI.

Financing Decisions

6

12.5 SPECIAL FINANCIAL INSTITUTIONS

The World Bank’s role as a catalyst in attracting development finance for high-priority programmes in the developing countries through co-financing hasincreased significantly in recent years. Co-financing has been a feature in about37 per cent of Bank/IDA operations and the volume of funds mobilised fromother sources external to borrowing countries has been equivalent to more than36 per cent of the total volume of banks group lending. Although historically,the major source of co-financing has been official bilateral and multilateral aidagencies, projects with private co-financing especially in the industrial andpower sectors are becoming more and more popular.

The Special Drawing Rights (SDRs) mechanism operated by the InternationalMonetary Fund whereby member countries bail each other out in times offoreign exchange crisis has provided a fair measure of stability to theinternational development agencies such as the export-import banks in variouscountries providing loans to domestic borrowers for export, import andoverseas projects, as well as technical service credits in such projects as theconstruction of factories, dams, etc., and direct loans to foreign governments,banks and corporations.

12.6 INDIAN SCENARIO

The Indian capital market had been insulated from changes in the internationaleconomy till 1991. It was due to high insulation of the Indian capital marketthat during the Gulf War when global capital markets were declining, the Indiancapital market was actually having a bullish run. However, since 1991 Indiancapital market has globalised so much so that now changes in any major capitalmarket or economy are reflected in the sensex. The Indian capital market hasnow become a major investment avenue for foreign investors. ForeignInstitutional Investors (FIIS) have invested over US $ 6 billion directly, whileIndian companies have raised over US $ 4 billion from the international marketthrough the global depository receipts route.

The last one and a half decades witnessed dramatic change in the pattern offinancing of corporate sector, with its increasing reliance on capital market. Till1980, funds raised from the capital market were less than Rs.200 crores and, infact, less than Rs.100 crores in several preceding years. Industry had todepend largely on financial institutions and its own surplus generation formeeting long-term investment needs and on banks for working capitalrequirements. Capital market emerged as a major source of funds to industryin 1980s. The equity culture which was lacking in its thrust earlier developedfast during this period.

Within a period of 10 years, the amount of capital raised from the market rose33 times from Rs.195.9 crores in 1980 to Rs.6473.1 crores in 1989-90. Thebuoyancy in the capital market gained further momentum right from thebeginning of 1990s with significant boost in the activities in the new issuesmarket. The amount raised from the capital market was of the order ofRs.22,480 crores in 1993-94 (11.4 per cent of the gross domestic savings) andRs.25,000 crores in 1994-95, however, in 1996-97 it slowed down.

The number of stock exchanges increased from 9 in the beginning of 1980s to23 now. Around 8000 companies are currently listed on the stock exchangesagainst only 2265 in 1980. The market capitalisation rose sharply from Rs.50billion to about Rs.4330 billion during this period. The number of shareholdersand investors in mutual funds increased from about 2 million in 1980 to over 40



7

million now. As a result, India ranks second in terms of investor population inthe world, next only to the U.S.

At the end of 1993, the International Finance Corporation ranked India 22nd interms of market capitalisation and 24th in terms of total value traded among 40countries with developed as well as developing markets. India is second onlyto the United States, at the end of 1993, in terms of the number of listedDomestic Companies with 8000 companies listed on Domestic StockExchanges. India has become today an important market in the emergingmarkets of the world, next only to Malaysia, South Africa, Mexico, Taiwan,Brazil, Korea and Thailand in terms of Market Capitalisation. With theexpected new offerings pouring in at the rate of about 10 per cent of themarket capitalisation, disinvestment of public sector undertakings taking place atthe rate of about 5 per cent of the market capitalisation and prices registeringall appreciation of about 20 per cent, market capitalisation of Indian StockMarkets can be estimated to rise by one-third every year which would meandoubling up the market capitalisation every two and a half years. In terms ofaverage company size (market capitalisation/listed domestic companies), India,however, did not figure in top 40 markets.

The market has been brought to a focal point by policy reforms initiated bygovernment since 1991. Pricing of equity is free and the Office of theController of Capital Issues (CCI) is abolished. Capital market has beenopened to foreign institutional investors and Indian companies have beenallowed to raise funds from abroad through Euro Issues. Private sector hasbeen permitted to set up mutual funds. Today it is possible to raise capital atlower cost, although there definitely continues to be a time lag between thegoing to the Securities and Exchange Board of India (SEBI), taking permissionwith regard to fixation of premia and clearance of prospectus and coming tothe market with their issues.

12.7 GLOBAL SOURCES OF FINANCING

Some of the major global sources of financing are;

1. Global Depository Receipts (GDR).

2. Euro Convertible Bonds (ECB).

3. Foreign Direct Investment (FDI).

4. Portfolio Funds (FII).

5. International Financial Institutions like World Bank, IMF, etc.

The Euro Currency Market:

The Euro Currency Market is outside the legal purview of the country inwhose currency the finances are raised. The term ‘Euro’ is affixed to an off-shore currency transaction. Capital raised in the Euro Currency Market can beclassified temporarily as under:

Eurocurrency Finance:

Short term Medium term Long term(upto 365 days) (2 to 10 years) (10 Yrs and above)

(a) Euroloans from (c) Syndicated (e) Eurobonds banks Loans(b) Eurocommercial (d) Revolving (f) Euroequities paper (ECP) Underwriting

Facilities (RUFs)

Financing Decisions

8

Euro-loans are essentially short term accommodations provided by bankers totheir clients. The interest charged is a mark up on the London Interbank OfferedRate (LIBOR), which varies according to the credit worthiness of the borrowingcompany.

Euro-commercial Papers are short term promissory (bearer) eurocurrencynotes. These are typically issued at a discount of their face value whichrepresent the yield to the investors.

Syndicated (Euro-currency) loans are given by syndicates of banks toborrowers at a variable rate of interest (e.g. Libor + 0.25%).

Revolving Underwriting Facility (RUF) involves sale of bearer notes toinvestors on a revolving basis. The investors under RUF undertake to makecertain amount of funds available to the borrower upto a certain date duringwhich the borrower is free to draw down, repay and redraw the funds aftergiving due notice.

Eurobonds are long term unsecured debt securities usually fixed rateinstruments, with bullet repayments. These are targeted at high net worthindividual and institutions and are listed on stock exchanges such asLuxembourg or London to provide liquidity.

Euroequities are company shares which could either be directly offered listingon the foreign stock exchanges or take the form of global depository receiptswith shares underlying such receipts.

Core Strategies for a successful Euro-Issue:

� Careful selection of a lead manager� Company Fundamentals� Timings of Issue� Careful Pricing� Good Marketing

� Innovative options in terms of financial instruments offered

Euro Issues ($ Million):

The Finance Ministry permitted Indian Companies to make Euro Issues ofGDRs and Euro convertible bonds in the Union Budget speech of 1991-92.Since May’92 when the first Euro Issue was made till December’96, Indiancompanies have raised $ 6.7 million through Euro Issues. ECB approval as onDecember 2002 were US $ 2788.94 million.

Table 12.2: Resources Raised

Year (Amount Rs)

1992-93 240

1993-94 2,493

1994-95 2,152

1995-96 627

1996-97 1,189

(Apr-Dec)

Total 8,701

Of the total inflows through Euro issues, $5.43 billion (or 81 per cent) havecome in the form of GDRs and the remaining $1.27 billion have been in theform of ECBS. The issuance of ECBs was discouraged by the governmentduring 1994-95 and 1995-96, since convertible bonds add to the external debt ofthe country till the time of conversion.



9

GDR Issues:

Inflow through the issuance of global depositor receipts (GDR) declinedsharply during 1995-96. During this year, Indian companies raised$0.63 billion as compared to $2.05 raised during 1994-95. During 1994-95,there were 29 GDR issues. This crowding of issues resulted in a clearoversupply of Indian paper in international markets, with the result prospectivecompanies either deferred or shelved their plans of making GDR issues,fearing the possibility of having to price their issue at a steep discountover the domestic price.

Table 12.3: GDRs/ADRs Issues ($ Million)

Year 94-95 95-96 96-97 97-98 98-99 99-00 00-01 01-02

Amount 2082 683 1366 645 270 768 831 477

Size of Indian GDR Issues:

GDR issues of Indian companies have, by and large, been small; in the regionof $50 million to $ 100 million. Out of the total 62 GDR issues made tillOctober 1996, the sizes of 22 issues were in this range.

Table 12.4: Size of Indian GDR Issues

Range ($ Million) No. of Issue

Below 50 17

50-100 22

100-150 16

150-200 5

Above 250 2

Total 6 2

Pricing of Indian GDRs:

Indian GDRs have generally been priced at a discount over the prevailingdomestic market price. Of the 62 GDR issues made, 34 were priced at adiscount over the domestic price at the time of pricing.

Euro Convertible Bonds:

Resources raised through Euro convertible bonds have been much lowerthan those raised through GDRS. This has been in view of the governmentguidelines issued in October 1994 which banned the issuance ofconvertible bonds. No ECB issue was floated during 1995-96.During 1994-95, $ 102 million were raised in the form of ECBs ascompared with $ 896 million raised in 1993-94. The coupon rates offered onthese bonds ranged from 2.5 per cent to 5.5 per cent for funds raised in dollarterms. Till the end of 1995-96, two companies issued ECBs designated inSwiss Bangs and one of these, Bharat Forge, placed convertible bonds with acoupon rate of just 1 per cent. The Finance Ministry permitted Indiancompanies to issue Euro convertible bonds during 1996-97. Till December 1996,three companies issued Euro convertible bonds for an aggregate amount of $273million.

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Table 12.5: ECB Issues ($ Million)

Year Amount

1992-93 01993-94 8961994-95 1021995-96 01996-97 273

(Apr-Dec)

Total 1,271

Although Indian corporates have raised resources through convertibles bonds atlow interest rates, they are now facing redemption pressure. Almost all thebond issues have a put option which enables the bondholder to convert orredeem the bond before the bond matures.

Foreign Direct Investment:

Foreign direct investment is very necesssary for any developing country as itbrings not only badly needed financial resources but new technology as well.Since 1991 India has made hectic efforts to attract FDI but the actual flow hasbeen much lower than the desired level. If we expect the Indian economy togrow at a rate of 7 per cent per annum, then we would need $ 10 billion of FDIannually. However, since 1991, we have not been able to cross the actual FDIlevel of $4 billion mark per annum, which is really peanuts in comparison to countrieslike china which is attracting anywhere between $30 to $50 billion per annum.Although most of the FDI has come in the area of infrastructure but the actualflow is only 25 per cent of the proposed FDI (Table 12.7) Although, scope isunlimited but somehow, 1 per cent of the total world foreign direct investment.

Table 12.6: Foreign Investment Inflows (US $ Million) in India

Year 1993-94 94-95 95-96 96-97 97-98 98-99 99-00 00-01 01-02

Direct 586 1314 2144 2821 3557 2462 2155 2339 3904Investment

Portfolio 3567 3824 2748 3312 1828 -61 3026 2760 2021Investment

Direct 14.11 25.57 43.82 45.99 66.05 102.54 41.59 45.87 65.89Investmentas percentageof totalinvestment

Table 12.7: Foreign Investment (US $ Millions)

Approvals Actuals

1991 207.63 141.12

1992 1315.41 242.28

1993 2822.23 568.79

1994 4519.00 946.37

1995 (Jan-April) 1783.58 709.41

Total 1067.85 2607.97

Actual Investment as a percentage of approved investment is 24.49 per cent.

Portfolio Funds:

Portfolio funds are basically brought in by foreign institutional investors. It islargely through pension funds, mutual funds, investment trust, asset managementcompanies, institutional Portfolio managers or their power of attorney holders in



11

securities traded in the primary and secondary capital markets. Currently about400 FIIs are registered with SEBI and about 100 are active players. FIIsinvestment in Indian capital markets has been hovering around $2 to $3 billionannually over the years (Table-12.6).

International Financial Institutions:

India has been financing its Public Sector as well as private sector industrial,social and economic projects from the funds available from internationalfinancial institutions like World Bank, IMF, Asian Development Bank, etc.,right from the inception of these institutions. India has figured amongst thetop ten borrowing nations of the world. Currently, about over $ 100 billionworth of funds are being made available by various international financialinstitutions.

The new financing instruments possess great potential to fund the requirementsof the Indian industry. Their imaginative use can provide finance in abundanceat a lower cost, making Indian industry competitive and enabling it to globaliseits operations. The current intensity of the Indian financial market reveals thatthere is a tremendous scope to deploy new financial instruments connected toequity, debentures/bonds, add-on products and derivatives. This may requireappropriate changes in certain legislations and the will on the part of the Indiancorporate enterprises to take risks and tune their decision making to theinvestor’s psychology and market preference.

The alternate sources of finance have to be increasingly tapped. This wouldnecessitate efforts on the part of the industry as well as necessary relaxationsin policy guidelines. In the new economic environment which stresses onopening and globalising the Indian economy, Indian industry will have to play amajor role to keep the economy on a high growth curve. Finance is a vitalinput for accelerating the pace of industrial progress. To ensure the timelyavailability of sufficient funds at reasonable cost, it would be important tostrengthen the existing sources of finance and simultaneously initiate measuresto tap alternate sources and new financial instruments.

12.8 SUMMARY

Globalisation has lead to increased degree of trade between various countriesand as a consequence of that the domestic financial systems are alligningthemselves to international financial systems. In this process the basic buildingblocks of financial system viz. the banking system, the foreign exchangemarkets and the capital markets are becoming more and more integrated withworld financial systems.

Recent years have witnessed a change of roles of the financial institutions i.e.banks moving into insurance and activities of non banking financial companies.

During the last decade the forex market has also witnessed quite a change,now forex rate are market determined with little or no intervention from thegovernment.

One of the major impact of globalisation on Indian companies is that now theycan raise low cost funds from abroad by ADRs, GDRs, ECBs etc. Apart fromthis due to the increased FII’s activities the shares of Indian companies arebeing quoted at fair value and there is less of information asymetry in thecapital markets.

Financing Decisions

12


1. What do you mean by globalisation? Comment on the level of globalisationof Indian capital market.

2. What are euro issues? Discuss some important instruments of euro currency.

3. Discuss some of the major types of institutions that constitute theinternational financial system.

4. What are the major global sources of financing? How far have IndianCorporates tapped these global sources?


Kim S.H. and S.H. Kim, “Global Corporate Finance - Text and Cases”Blackwell, Oxford, U.K.,1996.

Neelamegham S., “Competing Globally - Challenges and opportunities”,Allied Publishers, New Delhi, 1994.

Shapiro A.C., “Multinational Financial Management”, Prentice-Hall, NewDelhi, 1995.

Economic Survey, Government of India, New Delhi.

Management of Indian Financial Institutions, Himalaya Publishing House,Mumbai, 2001.



1

UNIT 13 FINANCING THROUGH FIsObjectives


� trace out the historical setting with respect to the role of FIs in financingindustrial units,

� analyse the trends in financing extended by FIs to different sectors,industries, etc.

� discuss the norms on the basis of which finance is extended,

� survey the reforms initiated by the government together with the actiontaken and the future agenda.

Structure

13.1 Historical Setting

13.2 Financing by All FIs

13.3 Role of Banks in Term Finance

13.4 Financing Norms

13.5 Share of FIs in the Company Financing

13.6 Reforms in the DFIs Sector

13.7 Summary



13.1 HISTORICAL SETTING

Financial Institutions (FIs) popularly known as Development Banks have startedengaging the attention of the people in the industry as early as in 1822, whenthe Societe Generale de Belgique was founded in Belguim. This was followedby the establishment of the French Credit Mobilier in 1852. By the turn of thecentury, there was great interest generated in this exercise and almost everycountry followed suit. In 1902, Japan founded the Industrial Bank of Japan.England started its effort with the setting up of “Carterhouse IndustrialDevelopment Company” in 1934 and Industrial and Commercial FinanceCorporation and Finance Corporation for Industry in 1945. Germany set up itsfirst development bank in 1949 for the purpose of supplying long term loans tothe industry. Encouraged by the success of ‘Credit Mobilier’, countries likeAustria, Netherlands, Italy, Switzerland and Spain have also floated financialinstitutions of the French kind. A review of the experiences of the variouscountries reveals the fact that almost all the countries realised the need forcreating a separate machinery for financing industrial development. As a matterof fact, though there were attempts at founding a congenial agency forfinancing industrial development, the real impetus for the development of FIstook place only after the Second World War. The economies in the westshattered by the war followed by the Depression found it a necessity toinnovate on the industrial front including the financing of it. This even led to thefounding of the International Bank for Reconstruction and Development[IBRD]. Though there is lot of diversity in the structure, objectives andmethods of financing across the globe, the core activity — financing industrialunits - however remained common to all FIs.

Developing economies, which happen to be the colonies of the West, alwayslooked to their rulers for innovation in forstering development. India, being no

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exception to this kind of a tendency, also emulated the experiments of the Westand founded its first financial institution - Industrial Finance Corporation of India[IFCI] in 1948 to cater to the medium and long-term credit needs of industrialunits. The constitution of IFCI was changed in 1993 from a statutorycorporation to a company under the Companies Act, 1956 to ensure greaterflexibility in the operations and to cope up with the changing financial system ofthe country. IFCI provides financial assistance by way of both rupee andforeign currency loans, underwriting, direct subscription to shares, debentures,guarantees, suppliers credit and equipment leasing. It provides a variety ofmerchant banking services which include project counselling, issue management,loan syndication, financial restructuring, mergers, acquisitions and debenturetrusteeship. The IFCI has now been merged with Punjab National Bank.TheIFCI followed by the setting up of the Industrial Credit and InvestmentCorporation of India [ICICI] Limited in 1955 as a public limited company. Theprimary objective of establishing ICICI was to promote industries in the privatesector and to meet their foreign currency requirements.

The next agency that was set up in this network for the provision of industrialfinance was the Refinance Corporation for Industry Limited (RCI) in 1958.This institution was promoted jointly by the RBI, LIC and some leadingcommercial banks. The RCI was intended primarily to provide refinancefacilities to commercial banks in respect of their medium term lending tomedium sized borrowers in the private sector. However, The RCI was mergedwith the Industrial Development Bank of India (IDBI) in September 1964.During the same time, several state governments have floated a variety ofFinancial Corporations and Industrial Development Corporations. Thus, theSFCs and SIDCs came into existence during 1950s. Further, in 1955 theGovernment of India set up an exclusive agency for the development of smallindustry in the name of National Small Industries Corporation Limited (NSIC).

Financing through FIs, however, took a sharp turn with the establishment of theIDBI in July, 1964 under an Act of Parliament as a principal financial institutionto provide credit and other facilities for the development of industry in thecountry. The main objective of IDBI was to provide term finance and financialservice for the establishment of new projects as well as for expansion,diversification, modernisation and technology upgradation of existing industrialprojects. As a premier organisation, IDBI was also vested with theresponsibility of coordinating the activities of the other financial institutionsengaged in the promotion and development of the industry.

The activity of establishing some more specialised agencies for taking care offinancial and non-financial needs of the industries is continuing till now. As atpresent, the structure of Financial Institutions catering to the needs of IndianIndustry comprises of 6 All-India level FIs, 4 specialised financial institutions, 3investment, 18 SFCs, 28 SIDCs, besides NABARD, Export Import Bank andmany other technical consultancy organisations.

13.2 FINANCING BY ALL FIs

Overall Position of Sanctions and Disbursements:

As indicated earlier, Financial institutions have been instrumental in providingterm finance to industry. Responding to the emerging needs of the industry,these institutions have developed and introduced a variety of products anddiversified into newer areas. Starting with the operations of IFCI, the FinancialInstitutions today have been advancing finance in sizeable amounts. Inretrospect, the sanctions and disbursements of IFCI during 1949-50 stood atonly Rs. 2.90 and Rs. 2.08 crore respectively. The network has spread now to

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13 institutions at the national level and 46 at the state level. All theseinstitutions could sanction and disburse an amount of Rs. 6181747 crore andRs. 4354065 crore respectively registering an annual growth rate of over 40per cent by the end of March 2000 (See Table 13.1). One particular problemwith the financial assistance sanctioned by these FIs is that it lacks consistency.This would be evident from the growth rates of sanctions and disbursements.These rates varied from the lowest of 2.6 per cent to the highest of 18.3 percent in case of sanctions and between 4.9 and 43.0 per cent in case ofsanctions during 1980-96. The individual record of the FIs during the sameperiod presents diversity of a still higher magnitude. In case of some of the FIsthere is even negative growth in the finance extended by them to the industrialunits.

Institution-wise Assistance:

Among the FIs, highest amounts were sanctioned by IDBI. It sanctioned anamount of Rs. 1,73,978 crore and disbursed Rs. 1,17,687 crores by the end ofMarch 2000. This was followed by the IFCI and UTI (See Table 13.2).Though IFCI was the first to be set up, it could not excel in sanctions for wantof limited funds available at its disposal, compared to the fund base of IDBI.While IDBI had Rs. 69849 crores at its disposal by the end of March 2000,IFCI had only Rs. 22,974 crore at its command. The differences that could benoticed in the figures (Table 13.2) mainly account for this reason.

Sector-wise Assistance:

To whom assistance should be sanctioned is always a matter of concern. SomeFIs concentrated in financing the public sector projects; while others wereengaged in the task of promoting the private sector. Similarly, the size andnature of activities also varied depending upon the peculiar conditions underwhich FIs were constituted and operated. As a matter of fact, developmentbanks established in the underdeveloped countries in the initial years wererequired to execute government investment projects. Some were evenauthorised to formulate plans for economic development.

But the objective of setting up FIs in India was stated to be the financing ofprivate sector enterprisese. While piloting the bill for the setting up of IFCI, thethen Finance Minister was reported to have observed that the IFCI was notintended to meet the financial requirements of nationalised industries; but onlyto provide finance for the needs of private industry. However, these restrictionsare not followed now and by following the rules and regulations any industrialenterprise can get sanction from the FIs; although private sector is the majorreceipient of their assistance. Of the cumulative sanctions made so far by allthe FIs in India, 84.2 per cent went to private sector, 9.4 per cent to publicsector and 6.4 per cent to joint sector.

Forms of Assistance:

These FIs are mainly set up to finance long-term operations of the industrialunits. This may be in the form of equity, loans and guarantees. To a greatextent, they sanction assistance in the form of loans at specified rates ofinterest. Their participation into the equity was once very limited. It is onlyafter the constitution of IDBI in 1964, FIs started providing direct finance inthe form of subscription to shares and debentures of industrial concerns.Altogether a new dimension is added after the establishment of UTI in 1964,since the very objective of this Trust was to channel household sector savingsfor investment in risk bearing industrial securities. Above all, underwriting ofnew issues of companies has been the continuous activity of FIs since theirinception. The intention of these institutions in extending underwriting supportwas not merely to ensure that the financing of the project was fully tied up,

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but also to indicate that the project was support-worthy and that investors couldtake the risk of investing in such securities.

Further, the form in which assistance in sanctioned by the FIs is also dependenton the specific provisions incorporated in their legislations, besides the financialstanding of the promoter, financing pattern, and the agreements already enteredinto by the promoter. For instance, under section 23 of the IFC Act, theCorporation was authorised to carry on and transact the following kinds ofbusiness:

i) guaranteeing loans raised by industrial concerns;

ii) underwriting the issue of stock, shares, bonds or debentures by industrialconcerns;

iii) granting loans or advances to or subscribing to debentures of industrialconcerns;

iv) acting as agent for the central government and/or with its approval, forthe IBRD in respect of loans sanctioned by them to industrial concerns;and

v) extending guarantee in respect of diferred payments by importes who areable to make such arrangements with foreign manufactures.

The powers given under section 23 of the Act were widened in 1960 throughan amendment to the Act to enable the Corporation to guarantee: (i) loansraised by industrial concerns from scheduled banks or state co-operative banks;(ii) deferred payments in connection with the purchase of capital goodsmanufactured in India; and (iii) with the prior approval of the centralgovernment, loans raised from or credit arrangement made by industrialconcerns with any bank or financial institution outside India in foreign currency.The Corporation was also empowered to subscribe directly to the stock orshares of any industrial concern.

In much the the same way, the SFCs were authorised to provide financialassistance of the following types to small scale and medium sized industries:

i) granting loans or advances or subscribing to debentures of industrialconcerns;

ii) guaranteeing loans raised by industrial concerns on such terms andconditions as may be mutually agreed upon; and

iii) underwriting the stock, shares, bonds and debentures.

These restrictions on the form of assistance have started losing theirsignificance after the setting up of IDBI in 1976 with a considerable measureof operational flexibility. The Bank has been empowered to finance all types ofindustrial concerns in whatever form it prefers to.

There are no restrictions as regards nature and type of security that may beaccepted from the industrial concerns. The financial sector liberalisation initiatedin early nineties has also led to a structural transformation in the business ofFIs. They are now expected to respond to the challenges imposed by the newcompetitive and deregulated financial environment. The FIs are now diversifyinginto both project and non-project lending and fee-based services.

Table 13.3 provides the details regarding the different forms of assistancesanctioned by diverse FIs by the end of March 2000. It is evident from thetable that loans forming part of the direct assistance are occupying the primeplace. Their significance seems to be more pronounced in case of SIDCs. Asindicated earlier, underwriting and direct subscription to the securities of


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industrial units is also a preferred activity of the FIs. Nearly, one-fifth of theirmoney is earmarked for this purpose.

Certain Special Schemes of FIs:

Yet another glaring feature of the assistance of FIs is that they have launcheddiverse schemes to cater to the special needs of the industrial units. As amatter of fact, the list of such schemes is quite exhaustive; however specificmention may be made of the following:

Development Assistance Fund of IDBI:

This fund was set up by the IDBI in 1965 with its own resources and fromthe resources of the central government. The fund is intended to provideassistance to those industries which, for various reasons like heavy investmentinvolved or low anticipated rate of return, may not be able to obtain funds inthe normal course. Assistance from the fund requires prior approval of thecentral government. The government, in turn, is to be satisfied that theproposed project is necessary in the interests of industrial development of thecountry. The IDBI is supposed to maintain separate accounts for this fund andalso to submit a report on the operations of the fund to the CentralGovernment.

Risk Capital Foundation Scheme of IFCI:

This scheme was started by IFCI in June 1976 with an initial money of Rs. 1crore. The objective of this scheme was to meet the seed capital requirementsof entrepreneurs who have other abilities but no finance to launch a project.This was meant to enable the new entrepreneurs to contribute their share ofpromoter’s equity. The loans from the foundation were granted on liberal termsuch as no interest, limited service charge and repayment in 15 years. Theseloans were to be repaid by the promoters out of their own income. Thisscheme was similar to the Seed Capital Scheme of IDBI. This scheme wasmerged with the Risk Capital and Technology Finance Corporation (RCTFC)from January 1988. The RCTFC Ltd., extended the operation of this scheme toinclude innovative technologies, products, processes, control of environmentalpollution, energy conservation and other venture capital schemes.

Soft Loan Scheme of IDBI:

This scheme is meant to finance traditional industries such as cotton, juste,textiles, cement, sugar and some engineering industries towards modernisation,replacement, renovation of their old and obsolete plant and machinery. Thoughthis scheme was originally introduced by IDBI in November 1976, the same isnow operated jointly by IDBI, IFCI and ICICI. The scheme is named as suchbecause of a number of concessions offered by the FIs to industrial units suchas low interest rates, less promoters contribution, high debt equity ratios, longrepayment periods, etc. Further, a liberal view is taken in respect of imposingmargins and security.

Seed Capital Assistance Scheme of IDBI:

In order ot encourage new enterpreneurs having technical and other skills,IDBI has introduced this scheme in 1976. Under this scheme, entrepreneursare provided with necessary finance upto Rs. 3 crore as seed money. Thismoney is granted free of charge. This scheme is intendedto induce andencourage the setting up of small and medium industrial units. The assistance isalso extended for the projects which have been appraised by the IDBI or anyother all India FI. The scheme is operated through the SFCs and SIDCs.These state level FIs are expected to make a thorough evaluation of theentrepreneur as to his capability to set up and run the project successfully;

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establish on the basis of appraisal, the technical, financial, economic andfeasibilities of the project and continously monitor the progress of the unit atvarious stages. This scheme has been liberalised to make it more worthwhileand effective. Now that not only technically qualified persons, but also any onewho has a worthy project can approach IDBI for this assistance. Similarly, thescheme is no longer restricted to projects in backward regions or prioritysectors.

Suppliers’ Line of Credit Scheme of ICICI:

This scheme was introduced by ICICI to help indigenous machinerymanufacturers to offer deferred payment facilities to the buyers so as toincrease the sales. Under this scheme, payment is made by ICICI directly tothe supplier of equipment without involving banks. The facility under thisscheme is available only to actual users of equipment. The supplier will getaround 80-90 per cent of the invoice value much early. The purchaser isprovided with a deferment period varying between 5 and 7 years.

Industry-wise Assistance:

Though there are some restrictions at least in the initial years, regarding thegrant of assistance to different sectors, and in different forms, the FIs arerelatively free to choose the industry of their choice. Perhaps, they are obligedto look into the priorities indicated in the Five-Year Plans regarding theencouragement to be given to a particular type of industry. As one can observefrom the operations of the FIs, there is a general preference towards thefunding of projects promoted by new entrepreneurs and technologists, thoselocated in backward areas, those having foreign exchange earning potential,those based on indigenous technoloy and those that are designed to fulfill theincreased demand for mass consumption goods like medicines, textiles, sugarand other food products and those engaged in the creation of necessaryinfrastructure for the development of Indian industry.

Table 13.4 provides the relevant statistics pertaining to the allocation of FIsassistance to different industrial sectors. It is clear from the table that theindustries such as textiles, chemicals, electricity generation and services havegot major share of the assistance from FIs. Each of them have got around 10per cent of the total assistance. Compared to over fifty categories of industriesconsidered by them for assistance, the above industries certainly had a betterpreference.

13.3 ROLE OF BANKS IN TERM FINANCE

Though the nexus between banks and industry is evident from the beginning ofthe growth of commercial banking during 19th century in India, banks havemainly concentrated on the financing of trade and commerce. Though theyhave opened their doors for industrial units, their financing is based on theBritish tradition with rule that banks provide only the working capitalrequirements of the industries. This was also because of the fact that theCentral Banking Enquiry Committee in 1931 and the A.D. Shroff Committee in1954 advised against the banks’ entry into the term finance. Further, with thegrowth of various merchant banking activities, banks realised the potentiality ofthe corporate sector in their exercises for deposit mobilisation. They felt thatthey could improve their deposits only with closer contact with the industrialunits. It is for this reason that banks have in recent years started exploringvarious possibilities and are participating in the ‘Consortia’ for meeting the termneeds of the industrial units. More so, banks had the facility now to get‘refinancing facility’ from IDBI and NABARD for the term loans extended bythem. Thus term lending by commercial banks is of a recent phenomenon.


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Initially, it was felt that the commercial banks could not afford to lock up largefunds in long-term assets because it would affect their liquidity and would makeit difficult for them to meet the working capital needs of trade and industry.However, since 1958, when Refinance Corporation was established by ReserveBank of India (RBI), the latter was eager to recommend a change in theattitude of commercial banks towards term lending because, on the one hand, itcould boost the profits of the lending banks and on the other hand, enable theborrowing units to enjoy certainty of having funds for a specified periodirrespective of any change in the monetary policy. As a result of this the,commercial banks started evincing interest in term-lending but on a verynominal scale. In may 1975, the RBI urged the commercial banks to step uptheir term-lending particularly in the following areas:

a) Deferred export payments.

b) Industries where a significant portion of the output is meant for exports.

c) Industries having short gestation period particularly in the core sector andespecially those producing mass consumption goods.

d) Agricultural sector.

e) Industries in the industrially backward areas.

f) Small scale industries involving investment and exceeding Rs. 25,000.

g) Capital good industries.

Quantitatively speaking, the share of term loans in total advances of scheduledcommercial banks grew from one-tenth in seventies to about one-fifth now.Further, commercial banks also take part in a limited way and subscribe directlyto theshares and debentures of the joint stock companies. Their holdings ofthese securities may be sometimes out of their underwriting commitments.Unfortunately, comprehensive data on investments in shares and debentures byCommercial Banks is not available. Available data reveal that the holdings ofbanks of shares and debentures aggregated to Rs. 12.7 crores; comprising of8.7 crores of shares and 4.0 crore of debentures by the end of 1951. This hasgone upto Rs. 92.7 crore by the end of March 1976; comprising of shares of27.3 crores and debentures of 65.4 crore. A remarkable feature of the banksinvestment in these securities is that their investment in debentures vis-a-visshares is increasing over time. Moreover, the holdings of banks of thesesecurities (both shares and debentures) constitutes only around 2 per cent ofthe aggregate investments of banks.

Activity 1

a) Establish the need for founding specialised financial institutions for financingindustrial units.

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b) Refer to the Memorandum of Association of any FI and list out theobjectives for which it is set up.

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c) Explain different Forms of Assistance.

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d) Collect the Annual Report of any FI and write a note on its operations.

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13.4 FINANCING NORMS

There are certain aspects which need to be known to fully appreciate theissues involved in financing through FIs. They include the following:

1. Project appraisal

2. Security of loans granted

3. Interest rate

4. Repayment schedule

5. Disbursal procedures

6. Conversion option

7. Post sanction monitoring

Project Appraisal:

While granting financial assistance to industrial units, FIs appraise the projectsof the latter from various feasibility points of view including economic, technical,financial and marketing. The economic feasibility may include the verification ofthe project’s suitability in terms of plan priorities, use of resources and importsubstitution, export promotion. If satisfied,then the FI may conduct otherfeasibility studies and satisfy itself about the worthiness of the project.

Under the technical feasibility, the FI may go into the aspects such as:

i) Location of the project,

ii) Appropriateness of the technology,

iii) Scale of operation,

iv) Suitability of plant and equipment

v) Collaboration Agreements

vi) Project implementation schedule.

Financial feasibility relates to the aspects like cost of the project, mode offinancing, capital structure, cash flow projections, rates of return and finally theviability of the project. Though FIs are often termed as Development Banks,they are more inclined to appraise the projects from the ‘Commercial’ point ofview rather than ‘development’ point of view. This is really a paradox. Perhapsthis is for this reason the word ‘Development’ has outlived its existence now.

Security of Loans Granted:

Security happens to be the basic tenet of lending. As many of us are aware, tillnationalisation in 1969, commercial banks followed only ‘security-based lending’instead of ‘need-based lending’. Same is true in case of FIs also. Security isconsidered a necessary adjunct to financial appraisal. This is considered all themore important due to non-availability of accurate information to probe into thecredit worthiness of the applicant in terms of his character. FIs accept manythings as security including the assets of the business, personal guarantees ofthe Directors and promoters. FIs also try to ensure security for their loans byincorporating certain conditions in the loan agreements; which may be of thenature of : priority for repayment, restrictions on the payment of dividends,commission, maintenance of minimum working capital, etc.


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Interest Rates:

What should be the rate of interest charged to industrial units on the financeextended by FIs is a matter of great concern. For, FIs should not charge toolow a rate to make loans to be a gift, nor they should put it high to drive awaythe business units. There is lot of focus on the interest rate policy of FIs.Apart from making available the needed finance, they should look into equityand their own cost of funds. No institution can lend at the rates lower than itsown cost of capital. Then, they must add some spread to continue in thebusiness.

The issue that engages the attention of many as for as interest rate policy ofFIs is concerned is that whether they should charge market rate or a lowerrate; since the FIs may secure funds from Government, Central Bank whosecost of funds is lower. Sometimes, FIs also receive grants from theGovernment having no interest element. When such is the case, whether FIsshould necessarily extend the same benefit to business units in the form oflower interest rates. This argument is not accepted by many. The reason beingthat FIs also undertake various kinds of financial and non-financial servicesinvolving financial commitment. As such, in majority of the cases, the FIs usedto charge a composite rate taking all its expenses into account.

In India, we have an administered interest rate system controlled by theReserve Bank. This has little to do with the rates determined by the marketforces. This is done as a matter of policy to maintain monetary stability in theeconomy. The RBI used to announce the changes in the interest rates (both fordeposits and loans) from time to time keeping in view of the money supply anddemand for credit. However, some relaxation is provided in this regime now.This process began in 1990 when the plethora of lending rates for differentslabs of borrowing were rationalised into six. A minimum lending rateprescription for large borrowers was introduced in 1988. After the recentchanges, there are only two rates of interest prescribed on the lending side andon the deposit side, there is only the prescription of a maximum rate. As far asFIs are concerned prime lending rate is decided and FIs can lend at varyingrates subject to this. Consequent upon the recent policy changes (October1997), there existed two prime lending rates, viz; one for the long-term loansand the other for the short-term and medium-term lending. As applicablefrom October 1997, the prime lending rate of IDBI, IFCI and ICICI is peggedat 13.5 per cent; whereas SBI could fix it at 12:75 per cent for long termloans.

Repayment Schedule:

In case of the financing through FIs, repayment is an important matter to bedecided. Usually, the repayment period is decided taking into account thegestation period, life of the project and cash flow generation. The repaymentperiod is also sometimes governed by the provisions in the respectivelegislations of the FIs. For example, under the provisions, IFCI is permitted toextend loans having a maximum of repayment period of 25 years. Similarly, therefinance facility extended by IDBI is subject to a specific maturity period.However, FIs are using their discretion subject to these limitations and the loansadvanced by FIs are usually repayable in annual or semi-annual installmentsspread over a period of 10 to 15 years.

Disbursal Procedures:

As can be seen from the data contained in Table 13.1, there is lot of gapbetween sanctions and disbursements. Sometimes, disbursements are just littleover half of the sanctions. As it is said in law that ‘Justice delayed is lawjustice denied’; we can say that ‘Disbursal delayed is assistance denied’. There

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is enormous delay in the disbursal of assistance. Perhaps, this is caused due tocumbersome loan procedures adopted by the FIs. The FIs may take appropriatemeasures to cut short these delays. On the other hand, borrowers also shouldhelp the FIs in completing their responsibilities in terms of providing theircontribution to the project, submitting the relevant information and othernecessary documents.

Conversion Option:

Convertability option refers to a provision in the loan agreement, whereby thelender will have an option to convert his loan into equity at his discretion. Thisclause came into the picture in the industrial financing on the recommendationsof the A.D. Shroff Committee. The objective of this provision was to check theuse of public money for private gain and to curb concentration of economicpower. The reasoning was that through convention, FIs would be able toparticipate in the management and control of industrial concerns and also in theprofits made by them. FIs have started invoking this clause almost from 1970 intheir loan agreements. Not only the stipulation, but the actual exercise of theoption by FIs is also significant.

Because of the above, there was lot of opposition from the industrial unitsregarding the convertibility clause. Realising this, the FIs have related this tothe magnitude of assistance. To start with convertibility clause was notintroduced into the agreements if the amount of loan is below Rs. 25 lakh. Itmay be introduced at the discretion of the institution, if the assistance isbetween Rs. 25 to 50 lakh; and the clause is compulsorily introduced, if theassistance is more than Rs. 50 lakh. Usually, the institutions are expected toexercise the option only after two or three years of the implementation of theproject. The government has relaxed these norms in June 1980. Thereafter,convertibility clause is introduced in the case of loans exceeding Rs.1 crore.Further, the FIs are forbidden to acquire more than 40 per cent of the totalshare capital of a company through loan conversions, excepting in the casesof persistent default by the company. In which case, the FIs can acquire upto51 per cent of the total share capital. In addition, conversion option is notnow applicable in case of loans sanctioned for the purpose of modernisationand rehabilitation.

Post-sanction Monitoring:

In view of the large stakes involved in the assistance sanctioned to differentindustrial units, there is a need to monitor the working of the assisted unitsclosely, not only to ensure safety of the funds invested; but also to ensureeffective utilisation of the funds and timely completion of the projects. In thisregard, FIs have to call for periodical reports about the operations of theprojects in terms of production, sales, cash flows, profitability, cost structure,etc. Depending on the necessity, FIs may hold discussions, consultations andconferences with the others interested in the project like bankers, stockbrokers and fellow FIs. It is also important for the company to ensure thatthe assisted units recruit qualified and experienced technical and managerialpersonnel.

In this regard, FIs like IFCI, ICICI and IDBI have adopted a rigorous follow-up procedure and have made a practice of carrying out regular inspection ofthe projects financed by them. As a matter of fact, ICICI is publishing areport entitled ‘Financial Performance of Companies: ICICI Portfolio” almostfrom the year 1971-72. This is a sample study of its assisted units (417)covering about 55 per cent of the paid-up capital of the non-governmentpublic limited companies at work in India by March 1981. Later, the coveragehas been increased to 675 companies with almost the same percentage in


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paid-up capital. In addition, ICICI has also initiated exclusive studies on thetopics like export performance and capacity utilisation. Similar to this exercise,IDBI has also started compiling and publishing data on the performance of itsassisted units.

Further, there is also the practice of nominating directors to the Boards of theassisted units. Where the assistence is large or where the project is complex,there is the practice of appointing nominee directors by the FIs. Nevertheless,there is lot of criticism on the role and function of these nominee directors. Itshould be constructive rather than destructive. Nominee directors are largelycriticised for their inaction and overaction. Instead of using their own discretion,they are guided by the dictates of the employer. This is naturally denounced. Itis felt that the role of the nominee directors should be an unmixed blessingrather than suspicious hindrance.

13.5 SHARE OF FIS IN THE COMPANY FINANCING

The foregoing analysis on the financing by FIs in terms of sanctions anddisbursements clearly reveals the fact that FIs played a useful role insupporting the rapid industrialisation of the country. It is no matter ofexxaggeration that these institutions have now assumed a position that withouttheir support, hardly any large project in the corporate sector can materialise.

The discussion on the Financing through FIs cannot be considered complete,unless we also account for the share of FIs in the total company financing. Forthis purpose, we have compiled data from the finances of Public LimitedCompanies published by RBI. The data of RBI covers a sample of 1720 non-government, non-financial public limited companies, accounting for 32.6 per centof such companies in terms of paid-up capital. The relevant data is presentedin Table 13.5.

It is evident from the table that FIs could provide about one-fifth of the totalexternal sources and around one-sixth in terms of the total sources in 1991-92.However, in the subsequent years, the relative contribution of FI’s hassignificantly declined mainly due to entry of commercial banks in term financingbusiness and growing financial disintermeditation resulting in greater reliance ofthe corporates on stock market.

Activity 2

a) Note down the salient features of Seed Capital Assistance Scheme ofIDBI.

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b) Comment on the Role of Banks in Term Finance.

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c) Elucidate the project appraisal procedure of any FI.

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d) Write a note on the Interest Rates in India.

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e) Examine the link between sanctions and disbursements.

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f) Role of External sources in Company Financing.

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g) Conversion option.

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13.6 REFORMS IN THE DFIS SECTOR

Consequent upon the poor performance of the economy, Government hasembarked upon initiating reforms from the beginning of nineties of the lastcentury. The sweep of the reform process extends logically to the FIs sectoralso. In an attempt to making a systematic effort in the direction of reforms,Government constituted a committee in 1991 under the chairmanship of M.Narasimham to suggest reforms in the financial sector.

Recommendations of Narasimham Committee Relating to DFIs:

The following are some of the important recommendations of the NarasimhamCommittee in respect of Development Financial Institutions.

1. In view of increasing competition in the financial sector, pressure on theavailability of concessional finance and progressive deregulation of interestrates, DFIs are required to become more and more competitive, efficientand profitable. They are also required to ensure operational flexibility andadequate internal autonomy in the matters of loan sanctioning and internaladministration.

2. The present system of consortium lending is operating like a cartel. Assuch, the consortium lending should be disposed with. In its place, a systemof syndication or participation in lending at the instance of lenders andborrowers should be introduced.

3. The present system of cross holding of equity and cross representation onthe boards of DFIs should be done away with.

4. As a measure of enhancing competition and ensuring a level playing field,the IDBI should retain only its apex and refinancing role and that its directlending function be transferred to a separate institution which could beincorporated as a company.

5. It is necessary to distance state level institutions from their respective stateGovernments to ensure that they function on business principles.

6. DFIs should seek to obtain their resources from the market on competitiveterms and their privileged access to concessional finance through SLR andother arrangements should gradually be phased out over a period of threeyears.


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7. The operations of the DFIs in respect of loan sanctions should be the soleresponsibility of the institutions themselves based on a professionalappraisal of the technical and economic aspects of the project, andevaluation of the promoter’s competence and integrity and the financingand other aspects of the proposal. There should be no room for behestlending of any kind.

8. DFIs should also be covered by the operations of the Asset ReconstructionFund (ARF), so that the contaminated portion of their portfolio is taken offthe books.

9. While the entry of commercial banks into the provision of term finance isthe first of necessary steps, it is also necessary to permit DFIs to enterthe area of working capital finance.

10. In respect of corporate take overs, DFIs should lend support to existingmanagement who have a record of conducting the affairs of the companyin a manner beneficial to all concerned including the shareholders, unless intheir opinion the prospective new management is likely to promote theinterest of the company better. In doing so, the FIs are expected toexercise their individual professional judgement, free of any extraneouspressures.

Action taken by the Government:

Based on the recommendations of the Committee, the Government has takenthe following measures:

1. IDBI, IFCI, ICICI, IRBI and Exim Bank were advised to achieve a capitaladequacy norm of 4 per cent by March 31, 1994. And those FIs havingdealings with agencies abroad were required to achieve a norm of 8 percent by March 31, 1995; while the rest were required to attain 8 per centnorm by March 31, 1996.

2. The Board for Financial Supervision (BFS) started supervising the DFIsw.e.f. April 1995.

3. Additional amounts have been sanctioned towards capitals of Certain DFIs.Further, they were permitted to approach capital market. During the lasttwo years alone viz., 1995-96 and 1996-97, the six All India FinancialInstitutions (Companies of IDBI, IFCI, ICICI, SIDBS, IRBI and SCICI)raised an amount of Rs. 19,579 crore from the capital market. It is logicalto assume that when the FIs raise such large amounts of funds from themarket, they also insist on the borrowers the same market discipline.

4. The prudential and capital adequacy norms, hitherto applied to thecommercial banks, are now made applicable to the FIs also. As per theseregulations, FIs are also required to maintain stipulated standards in respectof capital adequacy, income recognition, asset classification and provisioningrequirements.

5. There is reorganisation in some of the FIs intending to face emergingchallenges in the liberalized environment. SCICI Ltd. was merged with ICICILtd., on April 15, 1997 and similarly the IRBI was converted into a companyand was renamed as Industrial Investment Bank of India (IIBI) Ltd.

The Unfinished Agenda:

As it appears, there is lot of ground yet to be covered by the governmenttowards implementing the recommendations of Narasimham Committee toensure competition, operational flexibility and superior performance. Therecommendations of the committee regarding the creation of assetreconstruction fund, consortium lending, ensuring a level playing field, distancingDFIs from their sponsors are all to be implemented.

Financing Decisions

14

In a lecture arranged by the A.D. Shroff Memorial Trust, Bombay, Narasimhamremarked as follows (after two years of the submission of committee’s reporton ‘Financial Sector Reforms’):

“Since the submission of the report, the authorities have taken several steps ondifferent aspects of the recommendations. But essentially, the approach hasbeen somewhat ad hoc, piecemeal and at times even hesitant. The approach issuggestive of incrementalism rather than a sequencing of reform as part of anintegrated programme. It is pertinent to suggest that the committee’s variousrecommendations should be compared with a Jig-saw puzzle where the picturebecomes complete only when all the pieces are in place and until such time apiecemeal approach to the problem would not help us to obtain the full benefitsof the exercise.”

Even after a lapse of 5 years, the agenda is still unfinished, calling for a stillgreater attention by the Government.

Activity 3

a) Mention important Recommendations of Narasimham committee.

...................................................................................................................

...................................................................................................................

...................................................................................................................

b) What is the unfinished Agenda.

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13.7 SUMMARY

Attempt has been made in this unit to highlight the significance of financingextended to industrial units by Financial institutions. The discussion in this unitbegan with tracing out the historical setting leading to the founding of variousFIs in the country. The discussion underlined for financing its industrialdevelopment programmes. This was followed by the assessment of overallposition of sanctions and disbursements by the FIs as also according to sector,institution, form and industry. It was noted that the FIs in India tailored itsprocess of industrial finance to the needs of the corporate sector.

With the entry of commercial banks into the term finance area, the latterceased to be the prerogative of term-lending institutions. The increasingpresence of commercial banks in this area has further radicalised the scene ofindustrial finance. Aspects pertaining to the lending norms such as projectappraisal, security, interest rate, repayment schedule, disbursal procedures,conversion option and post sanction monitoring are also discussed in this unit.As a matter of fact, FIs are criticised by industrial units mainly because ofthese norms and the cumbersome procedures they are following in disbursingthe loan applications. Financing by FIs has also assumed significance in thetotal financing position of companies. Nearly one-fifth of the external resourcerequirements are being met now by the FIs. However, its importance hasdiminished remarkably in recent years. Nevertheless, there is lot ground yet tobe covered by our FIs. In view of increasing competition in the financial sector,pressure on the availability of concessional finance and progressive deregulationof interest rates, FIs are required to become more and more competitive,efficient, profitable and operationally flexible. The implementation of therecommendations of Narasimham Committee would go a long way in this regard.


15


1. Bring out the significance of term lending organisations in the financing of industries.

2. What are the recent trends in the financing of industrial units? Are theygoing in healthy direction?

3. Briefly highlight the procedures and norms followed by the FIs in extendingcredit. Can you suggest any modifications to the existing procedure?

4. What is post sanction monitoring? How is monitoring exercised by FIs in India?

5. Bring out the role of nominee-directors in the industrial units. Should wecontinue this practice?

6. “Convertibility clause is a drag on the Financing facility provided by IndianFinancial Institutions”. Comment.

7. Highlight the important recommendations of Narasimham Committeerelating to DFI sector. Are you satisfied with the way government isimplementing them?

8. In the present day scenario, should there be restrictions on the form andtype of assistance sanctioned by FIs in the country?

9. Briefly discuss the soft loan scheme of IDBI.

Table 13.1: Assistance Sanctioned and Disbursed by All FIs

(Rs. in crore)

Year Sanctions Growth Disbursements Growthrate % rate %

1964 - 65 118.1 — 90.5 —

1970 - 75 1916.7 — 1296.7 —

1975 - 80 7102.4 — 4623.4 —

1980 - 81 2934.0 — 1847.9 —

1981 - 82 3281.0 11.8 2352.0 27.3

1982 - 83 3366.9 2.6 2468.4 4.9

1983 - 84 4195.1 24.6 3138.4 27.1

1984 - 85 5578.7 33.0 3618.0 15.3

1985 - 86 6548.2 17.4 4937.7 36.5

1986 - 87 8138.9 24.3 5708.9 15.6

1987 - 88 9576.0 17.7 7061.3 23.7

1988 - 89 11386.6 18.9 7713.0 9.2

1989 - 90 14429.1 26.7 9640.4 25.0

1990 - 91 19254.7 33.4 12810.1 32.9

1991 - 92 22443.7 16.6 16259.9 26.9

1992 - 93 33282.0 48.3 23258.7 43.0

1993 - 94 41010.8 23.2 26629.3 14.5

1994 - 95 59663.1 45.5 33528.7 25.9

1995 - 96 67618.0 13.3 38442.6 14.7

1999 - 2000 1043407.6 15.5 684804.2 63.5

Cumulative 6181747.2 — 4354065.1 —upto end-

March 2000

Source : Report on Development Banking in India, 1999-2000 Mumbai, IDBI.

Financing Decisions

16

Table 13.2: Institution-Wise Assistance Sanctioned and Disbursed by All FIs

(Rs. in crore)

Institution Cumulative Cumulativesanctions Disbursements

upto March 2000 upto March 2000

All-India Development BanksIDBI 1988112.9 1348938.1IFCI 430141.9 390042.0ICICI 1914572.6 1141987.3SIDBI 554084.9 399505.1IIBI 100898.1 72525.6Sub-Total 4969637.3

Specialised Financial InstitutionsIVCF 1546.6 1474.3ICICI Venture 4710.2 4080.3TFCI 19435.4 11561.6Sub-Total 25692.2 17116.2

Investment InstitutionsLIC 330345.1 297323.3UTI 623900.1 476699.2GIC 109361.6 86695.4Sub-Total 1063606.8 860787.9

State-level InstitutionsSFCs 323282.1 265950.7SIDCs 207940.1 167998.2Sub-Total 531222.2 433948.9Grant-Total 6181747.2 4354065.1

* Including assistance to small scale sector upto end-March 1990.

Source: Report on Development Banking in India, 1999-2000. Mumbai, IDBI.

Table 13.3: Form-Wise Assistance (Cumulative) Sanctioned by FIsBy the end of March 2000

(Rs. in crore)

Form of Assistance All-India Dev. Banks State-Level InvestmentInstitutions

Rupee Loans 3531949.8 5046498 307723.5(71.1) (95.0) (38.9)

Foreignency Loans 616149.2(12.4)

Underwriting and direct 23309.3subscription (4.4)

506914.1 58746 755883.3(10.2) (18.4) (61.1)

Guarantees 314384.2 14339 3263.1(6.3) (4.5) (0.6)

Total 4969637.3 531222.2 1063506.8(100.0) (100.0) (100.0)

* Figures in the brackets indicate percentages to total assistance.

Source: Report on Development Banking in India, 1999-2000 Mumbai, IDBI.


17

Table 13.4: Industry-wise Cumulative Assistance Sanctioned byAll Financial Institutions by March end 2000

Industry Rs. in Crore

Textiles 541631.1Chemicals 676552.0Chemical Products 196127.6FertilizersRefineries or Oil Exploration 279291.1Basic Metals 524411.2Electrical & Electronic Equipment 299285.7Infrastructure 944851.9Services 715894.4

Total (Including Others) 5938759.8

Table 13.5: Share of 71s (Excluding Banks and Foreign 71s)in the company financing

Year Net Borrowings As % of As % offrom 71s External Total

(Rs. Crore) Services Services

1991-92 3594 19.8 14.3

1993-94 3689 18.6 13.8

1994-95 1584 4.8 3.4

1998-99 4115 2.6 1.1

1999-00 4322 2.6 1.1

2000-01 4642 2.7 1.0

Source: RBI Bulletins, January and October, 1997 and September, 2002


Sethuraman T.V., Institutional Financing of Economic Development in India,Delhi, Vikas Publications, 1970.

Basu, S.K., Theory and Practice of development Banking: A Study in theAsian Context, Bombay, Asia Publishing House, 1965.

Simha, S.L.N., Development Banking in India, Madras, Institute for FinancialManagement and Research, 1976.

Report on Development Banking in India, Mumbai, IDBI, 1997.

Vinod Batra, Development Banking in India, Jaipur, Printwell Publishers,1986.

Report on Trend and Progress of Banking in India, 1996-97, Mumbai, RBI,December 1997.

Prasad, G., Corporation Finance in India, Guntur, Sai Publications, 1987.

Report on Currency and Finance, 1995-96, Mumbai, Reserve Bank of India,1996.

Rao, K.V. and Venkataramaiah, B., Bank Finance to Industries, Jaipur,Printwell, 1991.

Report of the Narasimham Committee on The Financial System, 1991.

R.M. Srivastava, Management of Indian Financial Institutions, HimalayaPublishing House, Mumbai, 2001.

1

UNIT 14 OTHER MODES OF FINANCINGObjectives


� provide an understanding of non-traditional sources of long-term financing,

� focus on non-traditional sources of short-term financing.

Structure

14.1 Introduction

14.2 Non Traditional of Sources Long-term Financing

14.2.1 Leasing and Hire-Purchase

14.2.2 Suppliers’ Credit

14.2.3 Asset Securitization


14.3 Non Traditional Services of Short-term Financing

14.4 Summary



14.1 INTRODUCTION

Raising funds is an important activity of finance managers. Business unitsrequire funds for two reasons - to acquire fixed assets and to run theoperations of the units. Several factors influence the need for funds andtypically a growing firm needs more funds year after year. In the previousunits, we discussed how a firm can raise money from capital market andinstitutions. In this unit, we will look into other alternative sources of funds.Before we discuss these sources, let us quickly review the financing optionsavailable before a firm and what is the need for additional non-conventionalsources of finance.

It was noted earlier that firms typically raise money in the form of equity ordebt. Equity is risk capital and brought by owners, who want to take risk whileinvesting money. Debt holders are typically risk-averse investors, and hencewant safety but willing to provide funds at a lower rate of return. Debtholders are less interested on the future prospects of the company but they areinterested to know whether the company would be liquid enough to pay interestand principal on the due date. In between the equity and debt, firms also raisemoney through preference capital and convertible debt instruments. Also, firmsretain substantial part of the profit to meet their requirement. Fixing a broadmix and then choosing different sources of capital is an important job offinancial managers. You would by now know why financial managers spend lotof time on this issue particularly, when we also say finance mix is irrelevant invaluation of firm (Modigliani and Miller Theory).

While equity capital is raised not so frequently, firms take additional debt frominstitutions and other sources regularly. In fact, debt is found to be importantsource of capital next to retained earnings. While retained earning provideconvenience (easy to tap), debt is often believed cost effective particularly fortax reasons. In terms of convenience also, debt scores over fresh equity issuesince banks and financial institutions are easily approachable than approaching

Financing Decisions

2

capital market for equity issue. Equity issue involves considerable amount oflegal and other formalities and also there is no assurance that investors will beinterested in putting their money in the company. Finance managers choose aparticular source of capital after considering the following issues:

a) Whether the duration for funds required and funds available match?

b) What is the size of funds requirement?

c) What is the risk involved in the investments for which funds aredemanded?

d) Whether the funds are required urgently?

e) What is the current and future financial markets scenario?

Finance managers look for constantly alternative sources of funding anddepending on the demand and nature of funds, a particular source of funds istapped. Often, the finance managers tap non-conventional source of funds. Wewill discuss some of the non-conventional source of funds in this unit.

14.2 NON-TRADITIONAL SOURCES OF LONG-TERM FINANCING

Long-term finance is raised when the need for funds is for more than oneyear. Typically, long-term finance is required for acquisition of fixed assetshaving a life more than one year or investments, which have long-term impacton the earnings of the company. For instance, if a firm wants to buy a patentor brand, which in turn contributes to the sales of the firm for a long-term, itrequires long-term funds for such acquisition. While equity and debt areconventional source of finance, such source of finance is not available formany investments. Some time, the investment needs may not be large enoughfor the financial managers to approach banks or financial institutions. Theylook for alternative source of finance under these circumstances. In thefollowing sections, we will discuss four such sources of alternative long-termfinance available for the firms. They are (a) Leasing and Hire-purchase (b)Suppliers’ Credit (c) Asset Securitization and (d) Venture capital.

14.2.1 Leasing and Hire-Purchase

Firms need finance to acquire assets. Instead of borrowing and acquiringassets, it is possible for firms to acquire the assets on lease. There are twotypes of leasing - operational lease and financial lease. Operational lease isused when the assets are used for temporary period and the asset is returnedat the end of the short period. Suppose a firm gets an extra order for which itrequires some additional equipment. Such additional equipment can be taken onlease for few days, say three weeks and at the end of the three weeks, theequipment is returned to the owner. Some of the assets that are normallyacquired under operational lease arrangement are computers, vehicles,generators, small movable equipment, etc. While operational lease is notconsidered a source of finance, financial lease is used when the assets arerequired permanently or for a long period. Normally, the assets are ultimatelypurchased by the firm from the lessor at a nominal value. During the period oflease, the firm which acquired the assets on lease (called lessee) can use theassets but it is not the owner of the asset. The ownership rests with thecompany which provided the assets on lease. During the period of lease, thelessee has to pay lease rent to the lessor. Lessee is not entitled for anydepreciation whereas lessor can claim depreciation for the assets for taxpurpose. Hire-purchase is similar to financial lease. A hire-purchase transaction

3

is usually defined as one where the hirer (user) has, at the end of the fixedterm of hire, an option to buy the asset at a token value. In other words,financial leases with an option to buy the asset at the end of the lease termcan be called a hire-purchase transaction.

So the basic question is why firms acquire assets on financial lease and whysomeone wants to buy an asset and then lease the same to another firm. Thereare several reasons given below:

a) Easy Procedure: Acquiring an asset through a lease transaction is muchsimpler than borrowing money from a bank or financial institution foracquiring the same asset. Leasing companies have developed fairly simpleprocedure to process lease application. The level of legal documentation isalso fairly simple. In other words, you can acquire the asset in a very shortperiod of time through lease transaction. Suppose, a firm wants to buy 10lorries, it can be done with in two or three days through lease transaction.Acquisition of computers and other such electronics items like Air-conditioningcan be done within a day. Since the ownership of the asset rests with thelessor, the leasing companies are willing to take additional risk whileprocessing the lease application. If the assets leased are special type assets,whose re-sale value is low, leasing companies will take longer time to processsuch lease application since the risk involved in funding such assets is fairlyhigh. Typically, in borrowing the end use of the funds will not differentiate theloan application processing. Hence, firms use lease for acquiring certain typeof assets.

b) Size of Loan: Many banks and financial institutions fix certain minimumloan amount. If the need of firm is much lower, it doesn’t make sense toborrow more and keep the cash idle. Leasing company funds assets of anyvalue. If the requirement of funds is large, a consortium of leasing companiesfunds such acquisition.

c) Cost: It is difficult to say whether lease cost will be lower than borrowingcost but it is possible in certain cases due to tax impact. When a firm borrowsmoney and then acquires the assets, it pays interest and also claimsdepreciation. Both interest and depreciation can be claimed as deduction underincome tax. The net outflow will be thus much lower. On the other hand, whena firm acquires an asset on lease, it pays lease rent, which qualifies for incometax deduction but there is no depreciation benefit. However, depreciation benefitis claimed by the lessor and in all probability, the lessor will pass on the impactof the tax shield to the lessee by fixing lower lease rent. In other words, it ispossible to fix a lease rental such that it is equal to borrowing to both lessor(borrower) and lessee (lender). The following example explains the issuefurther.

Illustration: Suppose a firm requires an asset worth of Rs. 1,00,000 and it canraise the funds at 10% for five years from a bank. The bank requires the firmto repay the loan with interest in 60 equated monthly installment (EMI) at therate of Rs. 2124.70. Present value of annuity of Rs. 2174.20 at an interestrate of 0.83% per month for 60 months is equal to Rs. 1,00,000. It meansby paying Rs. 2174.20 every month for the next 60 months, you can wind upRs. 1 lakh loan you have taken today with an interest rate of 10%.Since each installment consists of interest as well as principal, the interestand principal paid over the five years are to be separated. While interest iseligible for tax deduction, the amount paid towards principal will not qualifyfor income tax deduction.

Other Modes ofFinancing

Financing Decisions

4

The values of interest and principal are as follows:

Year Interest Principal Total

1 9269.644 16226.76 25496.40

2 7570.491 17925.91 25496.40

3 5693.414 19802.99 25496.40

4 3619.782 21876.62 25496.40

5 1329.015 24167.39 25496.40

Total 27482.35 99999.65 127482.00

If the life of the asset is also 5 years and the asset qualifies a depreciationrate of 25%, the depreciation schedule is as follows:

Year Opening Balance Depreciation Closing Balance

1 100000 20000 80000

2 80000 16000 64000

3 64000 12800 51200

4 51200 10240 40960

5 40960 8192 32768

Let us assume that the asset is sold at the end of 5 years at Rs. 32768. Ifthe firm pays income tax at the rate of 35%, the after tax cost of the asset isas follows:

Year Interest Depreciation Total Tax Shield Cost net of@ 35% Tax Shield

1 9269.644 20000 29269.64 10244.38 19025.27

2 7570.491 16000 23570.49 8249.672 15320.82

3 5693.414 12800 18493.41 6472.695 12020.72

4 3619.782 10240 13859.78 4850.924 9008.859

5 1329.015 8192 9521.01 3332.355 6188.66

The present value of cost net of tax shield at a discount rate of 10% is equalto Rs. 48985. Suppose a leasing company is willing to provide the asset onlease at a lease rental of Rs. 7561 per month for five years and at the end iswilling to transfer the asset to you at a nominal cost of Re. 1, the presentvalue of lease rent net of tax is as follows:

Year Lease Rent Tax Shield Lease Rent Present value ofNet of Tax Lease Rent

1 90732 31756.2 58975.8 33486.91

2 90732 31756.2 58975.8 10669.96

3 90732 31756.2 58975.8 3399.77

4 90732 31756.2 58975.8 1083.27

5 90732 31756.2 58975.8 345.16

Total 453660 158781.0 294879.0 48985.09

In other words, both lease and borrowing leads to same effect. However, theactual lease rent may be higher or lower depending on the cost of funds to thelessor and tax shield the lessor get on leasing the asset. Further, if the lesseefirm is not tax paying entity, then there is no actual tax benefit from

5

depreciation and in that process, the cost of owning the asset will go up. Thus,in a situation where the tax rates of lessor and lessee are different and thecost of funds to lessor and lessee are different, then lease may be costeffective. Since lease transactions also attract some additional taxes like salestax, one has to consider such additional costs in evaluating lease vs. borrowdecision. Students desiring to know more on this may refer some specializedbook on Lease Finance (Vinod Kothari, Lease Financing and Hire Purchase,Wadhwa and Company, Nagpur).

Though leasing is not a major source of finance, Indian companies todayacquire assets through lease finance. The following table shows the value ofleased assets and lease rent (including operating lease rent) paid by BSE-100index companies during the last five years.

The table values show an increasing trend in the value of leased assets overthe years and also more than three time increase in the value of lease rent.Some of the prominent companies that use leasing extensively are ONGC,Shipping Corporation of India, IPCL, Larsen & Toubro, Reliance Industries, etc.Companies like ONGC hire most of the drilling equipment on lease and hencethe lease amount is significant. Transport companies like shipping companies,air-lines also acquire their assets through lease transactions. Companies thatprominently use leased assets, whose percentage on total assets is significantare Reliance Capital, Asian Paints, IPCL, Siemens, and BHEL. Today, thereare several types of leasing. There are also mega international leasetransactions called cross-broader leasing. Lease finance is likely to grow in thefuture due to its flexibility and convenience.

Table 14.1: Value of Lease Rent and Leased Assets of BSE-100 Index Companies(Rupees in Crores)

Year 1998-99 1999-00 2000-01 2001-02 2002-03

Lease Rent 593.52 778.72 798.31 1433.00 1950.99

Value of Leased Assets 5428.86 4819.34 5428.57 6940.09 7300.52

Activity 1

“Leasing is nothing but borrowing and acquiring the asset” - Do you agree withthis statement?

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Activity 2

Collect the details of lease/hire-purchase instalment per Rs. 1 lakh from alocal leasing company. Evaluate whether it is cheaper than borrowing Rs. 1lakh at an interest rate of 10% and buying the asset. Summarise your findingsbelow:

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Financing Decisions

6

14.2.2 Suppliers Credit

The concept of supplier credit is fairly simple and in existence for a long time.Under this, the equipment suppliers provide long-term credit and accept thepayment for the supply of equipment over a longer period of time say 5 to 8years. In that process, the company which acquires the assets neither takebank loan nor approach has leasing company for credit but directly takes thecredit from the supplier of the equipment. In other words, the supplier ofequipment acts as a lender or lessor. The question is how it is superior toother forms of acquiring the assets. First of all, the buyer need not approachany other agency for credit. Normally, suppliers provide short period of credit,and in this special case, the suppliers provide long-term credit. Since there is nointermediary to fund the acquisition between the seller and buyer, it reduces thecost. In addition, it is possible that the supplier may be a cash rich company ormay get funds at a much lower rate than the buyer. For instance, the creditrating of the supplier is far above than the credit rating of buyer or seller maybe in another country where the interest rates are low. There are specialisedgovernment agencies to provide funds to the suppliers in order to improve theexport sales or to help a particular sector. Though suppliers provide long-termcredit to the buyers, there is no need for the suppliers to stuck with such hugelong-term receivables because they can get finance under certain specificscheme against such receivables. They can also sell such receivables throughsecuritization.

14.2.3 Asset Securitization

Securitization is fairly a simple concept. It is the process through which anasset (fixed or current) is converted into financial claim. It other words, itbrings liquidity to an illiquid asset. The concept is very popular in housingfinance. Let us explain the concept with a simple example. Suppose a housingfinance company has Rs. 100 cr. During the first six months, it accepts theloan proposals and lent Rs. 100 cr. at an average interest rate of 10% and theduration of the loan is 15 years. Suppose the housing finance company getssome more loan applications say for Rs. 20 cr. in seventh month. Thecompany has to look for new source of finance to fund the new loan proposalssince it has already invested the entire capital and converted them into illiquidlong-term 15 years receivables. The growth of the housing finance company isthus restricted to its ability to raise additional funds. Securitization assumesimportance in this context. Suppose a group of pension companies is willing tobuy Rs. 100 cr. 15-years receivables from the housing finance companydiscounting the receivables at say 9%. With this new cash flow, the housingfinance company can finance new loans without making any fresh borrowing.In other words, the housing finance company has sold its 15-year illiquidreceivables and raised money against it. The process of selling makes theconcept slightly different from simple bill discounting concept. Undersecuritization, an intermediary agency is created, which initially buys the illiquidasset and against that it issues securities, which are tradeable in the marketthrough listing. Thus, it is also called asset-backed securities or mortgaged-backed securities. The value of the securities is improved by taking creditrating and often through insurance cover.

Securitization improves operating cycle of the capital in the sense the housingfinance company can recycle the capital several times and finance more houseswithout borrowing on its book. Every time when the cycle is completed, thefirm receives profit. You might wonder why pension funds or other companiesprefer to buy housing loans instead of investing or lending to housing financecompany. The logic is fairly simple. For instance, if the pension funds give loanto housing finance company, there is no guarantee that housing finance

7

company will lend money to quality loan proposals. The lender has no controlon the business of borrower. On the other hand, in buying the existing loan, thepension company can ask a credit rating agency to assess the quality of loans.In this process, the risk is reduced considerably. In addition, lending will blockthe funds of pension funds for a long-term whereas an investment in securitizedasset brings liquidity for the funds invested. So it is a rare case of win-winsituation for both the housing finance company and pension fund investors. Likepension fund, there are many investors who are looking for such investments,which essentially creates liquidity for these kinds of securities. Though thisconcept is yet to become popular in India, already several securitization dealshave taken place.

While securitization as a concept was developed to help finance companies tocovert their loans into liquid assets, it is now extensively used in several otherbusiness situations. It is possible for manufacturing or service firms to raiselong-term funds through securitization. For example, many electricity boards,whose balance sheet is very weak and no financial institutions would be willingto lend money to such companies, have raised long-term funds at a cheaperinterest rate by securitizing future receivables of some good clients. Bysecuritizing, the company actually sells the receivables to the intermediaryagency (called Special Purpose Vehicle or SPV), which collects the money anddistributes to the holders of such securities. Figure 14.1 shows the structure offuture flow securitization. There are several variation of this model but theessential principle is to protect the interest of investors. It is possible forcompanies producing commodities, where the demand is predictable, raise long-term resources by securitizing their future receivables. Companies like ReliancePetroleum have done such securitization. The amount thus raised can be usedto strengthen long-term or permanent working capital needs of the firms orinvest in fixed assets to expand the capacity.


Designated Customers(obligors)

Trust (collectionaccount/fiscal agent)

Special PurposeVehicle

Investor

Borrower in developingcountry (originator)

Productpayment

Futurereceivables

Excesscollections

Principal andinterestFuture

product

Proceeds Right tocollect futurereceivables

SecuritizedNotes

Offshore

Figure 14.1: Structure of Future Flow Securitization

Source: Suhas Ketkar and Dilip Ratha, “Securitization of Future Flow Receivables: AUseful Tool for Developing Countries”, Finance & Development, March 2001

Structure of a typical future flow securitization

Financing Decisions

8

Activity 3

Briefly discuss any one Securitization deal completed in India. You can get thedetails from business magazines and economic dailies which periodically reportsuch details.

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Activity 4

Why securitization is not popular in India? Find the details from some of yourfriends working for financial services company or bank.

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While leasing/hire-finance, suppliers’ credit or securitization are debt financing,venture capital is a equity finance. Venture capital is investment in early-stage,high-growth projects, which are high-risk with the potential to giveextraordinarily high returns over a period ranging from three to seven years.The risk factor being high, the probability of failure is also high. The returns tothe venture capitalist are from the handful of the projects, which succeed.Venture capital investment is generally in equity or quasi-equity instruments inunlisted companies, often set up to commercialise a novel idea. The venturecapitalist will, in the normal course of business, like to have a 20% to 50%stake in the company invested in. The returns to the venture capitalist are atthe time of disinvestment from the venture backed unit. This could be inseveral ways, such as buy-back of the stake of the venture capitalist by thepromoters, disinvestment of the investment at time of an IPO, or during amerger or acquisition transaction. Venture capital investment is “hands-on”investment, where the investor mentors and advises the promoters of thebusiness in which the investment has been made. The venture capitalist is aninvestor who guides the project through its different stages of growth byidentifying avoidable pitfalls and directs the business along possible avenues ofgrowth. The venture capitalist is, therefore, a partner who brings much morethan money to the project.

Venture capitalists receive several proposals for investment. Many projects,which find it difficult to raise funds from banks and other financial institutions,approach venture capitalists for assistance. Venture capitalists conduct apreliminary project appraisal. This includes verification of whether the project isin the area of their investment and a review of the promoters of the business.If the venture capitalists are interested in the project they offer a term sheet tothe promoters. The term sheet is a summary of the proposed principal termsand conditions of a venture capital investment. It sets out the broad terms andconditions of investment and is signed by both the venture capitalist and theproposed venture capital investee. Signing of a term sheet by both parties is astatement of good faith and is not an obligation until an agreement is signed bythe parties. It is normally subject to satisfactory completion of due diligencereview and signing of legal documents such as an equity subscriptionagreement.

9

A venture capitalist will look for a project that has potential for great returns.The project should be feasible and though it may be risky, there must be adefinite chance that it can be successful. The venture capitalist would like tomaximize the upside potential in any project, and would like to exit from aproject at a time when he can get a maximum return on his investment in theproject. The venture capitalist will look at different aspects of the projects.Some of these aspects are the integrity and ability of the promoters and keymanagement, the details of the project, the market potential and strategy forsale. A professional venture capitalist would validate all the data included inbusiness plans. A venture capitalist is most concerned about the ability of theentrepreneurs to adapt to different circumstances, good and bad. The promotersmust be committed and have a passion for their project. They must believe thatthey can do something different or differently. They must believe that they cansucceed. The venture capitalist backs the promoter first and then the project. Infact sometimes, the project may be excellent, but if the venture capitalist feelsthat the promoters lack the required skills, the project may get rejected. This isnot very surprising as venture investment is akin to a partnership, particularly inthe initial stages of the project. If the partners in the project are not inagreement or have different ways of functioning, the entire project can be injeopardy, despite having phenomenal potential.

A venture capitalist will also scan the project in great depth. The project musthave the potential to be commercially viable. Ultimately the investor wants afinancial return, so it is important that the investment makes commercialsense. It must have the potential for commercial success. The project mustbe feasible, it must be marketable, ie it must meet an existing requirement orfill a gap in the market or it must have the potential to create a market.Further, the venture capitalist would like to have higher than normal returnsas compared to other financial investors in a project. This is not surprising,since the venture capitalist does not expect all investments to do well, hewould like the few that do well to give above average returns. Professionalventure capitalists mentor projects they invest in. They are closely involved inthe operations of the investee. This does not stop at appointing a member tothe Board of Directors of the company and attending Board meetingsregularly. The venture capitalist often visits the project frequently. Someventure capitalists visit the projects every week, even spending half-a-day ineach visit. This is one of the reasons why most venture capitalists do notinvest in many projects at a time.

A venture capitalist does not take any collateral or guarantee (there have beencases of risk financiers who have asked for personal guarantees of thepromoters, but that is not typical of venture capital financing). If the projectdoes well, the venture capitalist would get good returns, if it fails, the entireinvestment would be written off. A venture capitalist looks for very greatreturns in say five years time. In many cases cash inflows in initial years areploughed back into the business.

Activity 5

Collect the details of any one projects funded by venture capital company,which run successfully today?

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Financing Decisions

10

Activity 6

Do you have any idea that fits venture capital funding? If yes, briefly discussthe idea here. Later on you can prepare a detailed business plan.

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14.3 NON-TRADITIONAL SERVICES OF SHORT-TERM FINANCING

As in the case of long-term finance, firms can raise short-term finance frombanks and other investors. However, in recent time, new methods of financingare also be used to raise funds for working capital. We will review brieflysome of these new methods in this section.

a) Commercial Paper:

Companies with good credit rating can raise money directly from the marketfor working capital purpose by issuing commercial papers. Commercial papersare unsecured notes but negotiable and hence liquid. Why firms issuecommercial paper and other invest in commercial paper? As discussed earlier,loan typically binds both lender and borrower for a period. The option for exitis difficult to exercise whereas instruments like commercial papers enable bothlenders and borrowers to move out of the relationship in a short period of time.Since lender and borrower meet directly, the cost of commercial paperborrowing will be lesser than working capital loan. Many banks and cash richcompanies participate in commercial papers, which are issued by high-qualitycompanies. Since they are liquid, even banks are willing to invest money incommercial papers.

b) Factoring Service:

Factoring is essentially a management (financial) service designed to help firmsbetter manage their receivables; it is, in fact, a way of off-loading a firm’sreceivables and credit management on to some one else - in this case, thefactoring agency or the factor. Factoring involves an outright sale of thereceivables of a firm by another firm specialising in the management of tradecredit, called the factor. Under a typical factoring arrangement a factor collectsthe accounts on the due dates, effects payments to its client firm on these days(irrespective of whether or not it has received payment or not) and alsoassumes the credit risks associated with the collection of the accounts. Forrendering these services, the factor charges a fee which is usually expressedas a percentage of the total value of the receivables factored. Factoring is,thus, an alternative to in-house management of receivables. The completepackage of factoring services includes (1) sales ledger administration; (2)finance; and (3) risks control. Depending upon the inherent requirements of theclients, the terms of factoring contract vary, but broadly speaking, factoringservice can be classified as (a) Non-recourse factoring; and (b) recoursefactoring. In non recourse factoring, the factor assumes the risk of the debtsgoing “bad”. The factor cannot call upon its client-firm whose debts it haspurchased to make good the loss in case of default in payment due to financialdistress. However, the factor can insist on payment from its client if a part ofthe receivables turns bad for any reason other than financial insolvency. Inrecourse factoring, the factoring firm can insist upon the firm whosereceivables were purchased to make good any of the receivables that prove to

11

be bad and unrealisable. However, the risk of bad debt is not transferred to thefactor. Canbank Factor and SBI Factor, the two factoring companies, havedone an annual turnover of nearly Rs. 2000 cr. and they are growing at anattractive rate. Many foreign and private banks have also started providing thefactoring services.

Activity 7

Visit the branch office of Canbank Factor or SBI Factor in your city or theirweb site. Collect the details of factoring service schemes they provide fordifferent types of companies.

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14.4 SUMMARY

Apart from traditional sources of finance like debt and equity from institutionsand others, finance managers today look into several non-traditional sources offinance. The reasons for raising finance from such non-traditional sources arecost advantage and flexibility. In this unit, we discussed three such sources oflong-term finance namely leasing/hire-purchase, asset securitization, and venturecapital. Leasing definitely scores over others in terms of flexibility and inspecial cases, it may also be cheaper. Asset Securitization is suitable when afirm wants to raise funds against future receivables or against some existingilliquid assets. Venture capital is most suitable for high risk venture whereventure capitalist is willing to put equity capital and assumes risk provided theproject has a scope for high return. Commercial paper and factoring are twoprominent sources through which firms can raise short-term funds in addition totraditional source of short-term finance like bank loan. While traditional sourceof finance contribute significant part of capital, these additional sources offinance are often used to leverage cost advantage and in some cases to gainflexibility. Finance managers have to bring innovative financial products thatsatisfy different segments of investors. The job is as challenging as sellingproducts to consumers.


1. How is lease finance different from that of equity or debt finance?

2. In evaluating funding options, when do you chose lease finance?

3. Is lease finance cheaper than other sources of finance? If so, under whatconditions will it be cheaper than other sources of finance?

4. Explain how Securitization is considered as a source of finance? Who arethe typical investors for such papers?:

5. Suppose you are working for a venture capital company. What are thethings you will look into a proposal that comes to you for venture capitalfunding?

6. Is it possible to get funds from venture capitalist for all kinds of projects?Explain.

7. How is factoring different from that of traditional bill discounting scheme?


Financing Decisions

12


Bygrave, Willam et. al. (Ed), Venture Capital Handbook, Financial Times/Pitman, London

Felix, Richard, Commercial Paper, Euromoney, London

Gupta, Naresh Kumar, Lease Financing: Concepts and Practice, Deep andDeep Publication, New Delhi

Lerner, Josh, Venture Capital and Private Equity, John Wiley & Sons, NewYork

Sengupta A K and Kaveri V S, International Factoring in India: Issues,Problems and Prospects, Macmillan India, New Delhi

Sriram K, Handbook of Leasing, Hire Purchase and Factoring, ICFAI,Hyderabad.

Vinod Kothari, Lease Financing and Hire Purchase, Wadhwa and Company,Nagpur.

Vinod Kothari, Securitisation: The Financial Instrument of the New Millennium,Academy of Financial Services, Calcutta.

R M Srivastava, Financial Management and Policy, Himalaya PublishingHouse, Mumbai, 2003.

1

UNIT 15 MANAGEMENT OF EARNINGSObjectives

Objectives of this Unit are to:

� discuss the dividend theories, their assumptions and criticism.

� throw light on practical issues of dividend policy.

Structure

15.1 Introduction

15.2 Dividend Theories

15.3 Walter’s Model

15.4 Gordon’s Model

15.5 Modigliani-Miller Hypothesis

15.6 Procedure of Paying Dividends

15.7 Types of Dividends

15.8 Factors Influencing the Dividend Policy

15.9 Dividend Stability

15.10 Deciding the Dividend Payout Ratio

15.11 Summary



15.1 INTRODUCTION

Success of an enterprise rests not only on optimal utilization of funds but alsoon efficient management of income produced by business operations.Distribution of fair amount of dividend to shareholders, provision for sufficientreserves to finance future expansion programmes of the enterprise and toabsorb the shock of business vicissitudes and provision of sufficient resourcesfor retiring old bonds and redeeming other debts call for effective managementof income. Efficacious management of income strengthens the financial positionof the enterprise and enables the firm to withstand seasonal fluctuation andbusiness oscillations, helps in enlisting the support of the shareholders in futureand finally facilitates in procuring resources from different avenues of capitalmarket.

As such dividend policy is the most important single area of decision making bythe management for a finance manager. Action taking in this area affectsgrowth rate of a firm and so also its value, nevertheless opinions of thefinancial wizards, as evidenced from their theories, are not unanimous in thisregard.

15.2 DIVIDEND THEORIES

Dividend theories can broadly be classified into two groups:

a) theories which consider divided policy as of no relevance, and

b) which consider divided policy as a relevant variable to enhanceshareholder’s wealth. They are briefly discussed below.

Strategic Financing Decisions

2

15.3 WALTERS MODEL

Professor James E. Walter emphasizes that dividend policy is a critical factoraffecting the firm’s value. According to him, dividend policy hinges on firm’sinternal rate of return (r) and the cost of capital (k). His model is based onthe following assumptions:

1. The firm finances new investments through retained earnings, without optingfor new debt or equity.

2. The firm’s internal rate of return, and cost of capital, are constant.

3. 100 per cent of earnings are either distributed as dividends or reinvestedinternally.

4. Initial earnings and dividends remain constant forever. The values ofearnings per share (EPS) and dividends per share (D) may be changed todetermine results, but any given values of EPS, and the D assumed toremain constant forever in determining a given value.

5. The firm has a very long infinite life.

The following is the Walter’s formula to determine the market price (P) pershare:

KKrD)–(EPS D�

The above formula can also be written as:

K

r/K D)–(EPS

K

D�

The above equation gives the sum of the present value of future stream ofdividends (D/K), and capital gains resulted by reinvestment of retained earnings(EPS-D) at the firm’s internal rate of return (r). The discount value is equalto the firm’s cost of capital (K) The effect of dividend policy on the firm’sshare value is explained in the following illustration 1 using Walter’s model.The basic data and computations are given in table 15.1 based on Walter’sformula:

Table 15.1: Dividend Policy and the Value of Share

BASIC DATA

Growth Firm Normal Firm Declining Firm(r > k) (r = k) (r < k)

R = 16% R = 10% R = 8%

K = 10% K = 10% K = 10%

EPS = Rs. 10 EPS = Rs. 10 EPS = Rs. 10

When pay out ratio = 0%

D = Rs. 0 D = Rs. 0 D = Rs. 0

.10(10.0) /.10)16.(0

P+=

.10(10.0) /.10)10(0+

.10(10.0) /.10)08(.0+

= Rs. 160 = Rs. 100 = Rs. 80

3


D = Rs. 3 D = Rs. 3 D = Rs. 3

.103)-(10 /.10)16(.3

P+=

.103)-(10 /.10)10(3+

.103)-(10 /.10)08(.3+

= Rs. 142 = Rs. 100 = Rs. 86


D = Rs. 5 D = Rs. 5 D = Rs. 5

.105)-(10 /.10)16(.5

P+=

.105)-(10 /.10)10(5+

.105)-(10 /.10)08(.5+

= Rs. 130 = Rs. 100 = Rs. 90


D = Rs. 8 D = Rs. 8 D = Rs. 8

.108)-(10 /.10)16(.8

P+=

.108)-(10 /.10)10(8+

.108)-(10 /.10)08(.8+

= Rs. 112 = Rs. 100 = Rs. 96


D = Rs. 10 D = Rs. 10 D = Rs. 10

.1010)-(10 /.10)16(.01

P+=

.1010)-(10 /.10)10(01 +

.1010)-(10 rs/.10)(01 +

= Rs. 100 = Rs. 100 = Rs. 100

Thus, Walter’s model brings out that dividend policy does help maximizeshareholder’s value, if used properly depending on its internal rate of return,and cost of capital. So the dividend policy differs depending on whether thefirm falls into the category of growth firm, normal firm, or declining firm. Theoptimum dividend policy for these firms is as follows.

Growth Firms: Growth firms have very good investment opportunities withreturns greater than their respective cost of capital. It can be observed fromthe table 15.1 that firm’s value will be maximized when then firms reinvest 100percent of earnings, choosing a zero dividend policy 1, to maximize the sharevalue.

Normal Firms: Over a period of time firms may not find unlimited investmentopportunities with returns higher than their cost of capital. They may haveinvestments with returns equal to cost of capital. As a result, it can be notefrom Table 15.1 that the share value remains constant, despite varying pay outratios. These firms can be indifferent to any dividend payout ratio, as there isno optimum policy.

Management of Earnings


4

Declining Firms: These firms may not have investment alternatives givingreturns atleast equal to the cost of capital. Such firms can at best declare 100dividend payout to enhance shareholders’ value, because they can reinvest themat a higher rate than the return available to the firm. The data in Table 15.1too supports this proposition.

Criticism of Walter’s Model: Though Walter’s model has been successful inhighlighting the role of firms return and cost of capital in determining thedividend policy, the model has been critisised for its following un-realisticassumptions.

No External Financing: Walter’s model is mixing both dividend policy andinvestment policy by assuming that investment opportunities will be financed onlywith retained earnings, without resorting to either debt or new equity. With theserestrictions the firm’s dividend policy, and investment policy will be sub optimal.

Constant Rate of Return: Walter’s Model assumes a constant rate of return,which is real life may not hold good. Because, firms choose from among themost profitable to less profitable projects, as long as their respective rate ofreturn is more than or equal to the firm’s cost of capital.

Constant Opportunity Cost of Capital: Another assumption of Walter’smodel, which may not hold good is constant opportunity cost of capital.However the firm’s cost of capital changes with its risk, the Macro EconomicChanges in the economy. Further, the present value of the firm’s incomechanges inversely with its cost of capital. By assuming the discount rate asconstant, Walter’s modal ignores the effect of risk on the firm’s value.

15.4 GORDON’S MODEL

Myron Gordon developed a popular Model relating dividend policy and thefirm’s value, based on the following assumptions:

� The firm has only equity capital, and no debt.

� Only retained earnings will be used for financing expansion. Thisassumption mixes dividend and investment policy, similar to Walter’s model.

� Firm’s internal rate of return is constant, which is not correct in practice.

� Firm’s discount rate is constant. Even this assumption is also incorrect, asis the case with Walter’s model.

� The firm and its stream of earnings are perpetual.

� The corporate taxes are nil.

� The retention ratio, once decided, remains constant, leading to a constantgrowth rate of earnings.

� The discount rate is higher than growth rate.

According to the Gordon’s model, the market value of a firm’s share willbe equal to the present value of future stream of dividends payable for thatshare. Accordingly, the value of share can be obtained by the followingequation:

g-K

D1 Po �

The above equation can also be expressed as:

br-Kb)–(I EPS

Po =

5

The second equation highlights the relationship of earnings, dividends policy,internal rate of return, and the firm cost of equity (which is also cost of capitalin the absence of debt) in deciding the value of the share.

The influence of dividend policy on the value of share and therefore on thefirm’s value can be understood by observing the following illustration, in whichthe implication of dividend policy for growth, normal, and declining firms, isexplained. The results in the illustration can be explained as: (a) If the firm’sinternal rate of returnis less than its discount rate, retaining earnings is notuseful for the shareholder’s value maximization. Because, by retaining earningsin the firm to invest at a lower rate of return, the shareholders are denied theopportunity to invest at higher or at least at rates equal to the discount rate. Insuch situation, the 100 percent pay out will maximize the share holder’s wealth.The promoters can even think of partial or full dis-investment, if the firm’sdiscount rate is less then to the prevailing rate of return in the market, to boostthe shareholder’s wealth. It can be seen that for normal firms whose discountrate is equal to their internal rates of return, the dividend policy is of nosignificance, as each firm’s value remains the same irrespective of any pay outratio adopted. The growth firms do well by retaining maximum portion of theirearnings to increase the shareholders’ value, because the opportunities availableto the shareholders are less attractive when compared to those available to thegrowth firm’s.

The conclusions drawn by Gordon’s Model are akin to those of Walter’s Model,essentially due to the similar asumptions made by both of then. However,Gordon adds that uncertainty increases with futurity. When dividend policy isconsidered in this context, the discount rate cannot be assumed to be constant.Due to uncertainty, the investors may be willing to pay higher price for theshare that pays higher early dividends, other things remaining constant.Therefore, Gordon concludes that dividend policy does effect the firm’s value.Then even those firms having the rate of return equal to their respectivediscount rates cannot be indifferent to the divident policy. The investors preferdividend to capital gains because dividends are easier to predict, less risky, anddo not involve timing decisions.

Illustration: In the following 15.2 the implications of dividend policy are shownunder Gordon’s Model for Growth, normal, and declining firms.

Table 15.2: Dividend Policy and the Value of Share

Growth Firm Normal Firm Deaclining Firm(r > k) (r = k) (r < k)

r = .16 r = .12 r = .09

k = .12 k = .12 k = .12

EPS = Rs.12 EPS = Rs.12 EPS = Rs.12

Pay-out ratio (1-b) = 30%, Retention Ratio, b=70%

G=br=(.7)(.16)=.112 G=br=(.7)(.12)=.084 G=br=(.7)(.09)=.063

.112–.12.7)–(1 12

Po =.084–.12

.7)–(1 12 Po =

.063–.12.7)–(1 12

Po =

= Rs. 450 = Rs. 100 = Rs. 63



6

Pay-out ratio = 60%, and Retention Ratio = 40%

G=br=(.4)(.16)=.064 G=br=(.4)(.12)=.012 G=br=(.4)(.12)=.036

.046–.12.4)–(1 12

Po =.048–.12

.4)–(1 12 Po =

.036–.12.4)–(1 12

Po =

= Rs. 129 = Rs. 100 = Rs. 86

Pay-out ratio = 90%, and Retention Ratio = 10%

G=br=(.1)(.16)=.016 G=br=(.1)(.12)=.012 G=br=(.1)(.09)=.009

.016–.12.1)–(1 12

Po =.012–.12

.1)–(1 12 Po =

.009–.12.1)–(1 12

Po =

= Rs. 104 = 10.8 = Rs. 100 = 10.8 = Rs. 97

15.5 MODIGLIANI – MILLER HYPOTHESIS

Modigliani and Miller (M–M) proposed an interesting model which concludesthat dividend policy does not affect the firm’s value. The firm’s value,according to them, hinges only on its earnings which result from its investmentpolicy. Given the investment policy, decision of retention and pay-out, they hold,will not affect the firm’s value M-M’s model is based on the followingassumption:

� The capital markets are perfect, investors behave rationally, information isavailable freely, and transaction and floatation costs do not exist.

� Either taxes do not exist, or they are same on both dividend income andcapital gains so that investors do not prefer one over other.

� The firm has a fixed investment policy.

� The risk, will not increase with futurity. The investors can forecast futureprices and dividends with certainty, and one discount rate is appropriate forall securities and all time periods.

When the above assumptions operate in capital market, the rate of return willbe equal to the discount rate which are same for all shares in the long term.Consequently, the price of each share must adjust so that the rate of return,based on dividends and capital gains, on each share will be equal to its discountrate, which have to be identical for all shares. M-M believed that the equalitywould take place through the process of switching from low yield shares tohigh yield shares. According to this model, the rate of return for one period canbe computed as follows:

PoPo)–D

R1P( 1+=

Similarly, the value of share can be calculated as:

R1P1 D1

Po++= =

K1P1 D1

++

7

The value of the firm can be obtained by multiplying both sides of the aboveequation with number of shares outstanding:

k)(1P1) (D1n

Npo V++==

M–M model does not make a restrictive assumption of financing newinvestments only with retained earnings like Walter’s and Gordon’s models forthe issuance of new shares. Firms can pay dividends and raise funds by issuingnew shares to take up investments, allowing the flexibility of financing newinvestments with retained earnings, or new equity capital, or both. Using thefollowing equation M–M show that the value of the firm will be unaffected byits dividend policy:

k1mP1–P1 m)(n D1n

Npo+++=

k1nD1)X1-(I1– P1 m)(n D1n

++++=

k1X2)I1– (P1 m)(n

+++=

Where: N = Number of shares outstanding M = Number of new shares to be sold by the firm at time 1 at price P1 I1 = Total amount of investment during time period 1. X1 = Total net profit of the firm during time period 1.

The M–M hypothesis is explained in the following illustration. It can beobserved that the firm has the flexibility of paying dividend and raising funds byisuing new equity shares. When the firm is paying dividend its share value willbe adjusted by the market to the extent of dividend amount, and the firm has toissue more number of shares to finance its investments. However the value ofthe firm remains same irrespective of the dividend policy.

Illustration 3: Vikas WSP LTD has 10 lakh outstanding shares, with themarket price of Rs. 50 each. The firm is planning to pay Rs. 4 or dividend pershare. The discount rate is 12 percent. What will be the price of its share atthe end of the year if(a) dividend is not paid and (b) dividend is paid as above?Vikas is expecting to earn a net profit Rs. 60,00,000 in the current year, andhas investment opportunities of Rs. 1,50,00,000 during the period. Decide howmany new shares should be issued. Also find out the value of the firm. Answerthe above question using M–M model.

Price of the share at the end of the current year can be determined withfollowing equation:

k1P1 D1

Po++=

² P1 = Po (1+K) – D1

The value of Vikas share when dividend is not paid.

= P1 = 50 (1+.12) – 0 = Rs.56



8

Vikas share value when dividend is paid:

= P1 = 50 (1+.12) – 4 = Rs. 52.

Number of new shares to be issued to finance new investments:

When dividend is not paid:

MP1 = I – (X–Nd1)Rs. 56 m = Rs. 1,50,000 – (60,00,000-00)Rs. 56 m = Rs. 90,00,000

M = 1,60,714

When dividend is paid:

Rs. 52 m = I – (X–nD1)Rs. 52 m = Rs. 1,50,00,000 – (60,00,000 – 40,00,000)Rs. 52 m = Rs. 1,30,00,000

M = 2,50,000

Value of the firm:

12.1)(56x160714– 56 16074) (10,00,000 0

Npo+

++=

12.15,60,000= = Rs. 5,00,00,000

When dividend is paid:

12.105,60,00,00= = Rs. 5,00,00,000

M–M further state that the firm need not have only equity capital to holdtheir model true. They conclude that their hypothesis of dividendirrelevance holds good even if the firm raises debt capital instead of equitycapital. For this, they put forth their indifference hypothesis with referenceto leverage.

The above conclusions are based on several restrictive assumptions ofM.M. model. The divided policy may effect the value of a share if thoseassumptions are relaxed and the market imperfections are considered, asdiscussed below:

Tax Differential: M–M made a simplistic assumption of no taxes or same rateon both dividends and capital gains but the reality is far from the assumption.In most of the countries both of them are taxed albeit at different rates.Normally dividends are clubbed with ordinary income for tax purpose which istaxed at a higher rate when compared to the capital gains. However, in Indiathe dividend income is tax free in the hands of investors from the financialyear 1998-1999. The companies pay a special tax of 10 percent of the profitsdistributed which is similar to tax deduction at source. The current long-termcapital gains tax rate is 20 percent. From the tax point of view theshareholders prefer the dividends. Therefore investors may prefer shares withhigh dividend pay out, to maximize their wealth.

9

Floatation Costs: M–M assume that the cost of retained earnings andexternal financing are same. But in reality, the process of raising fresh capitalfrom the capital market involves significant expenses in terms of floatation costswhich may be in the range of 6 to 10 percent of capital raised. Thus, thehigher cost of external financing, makes the retention of earnings a favourableoption. However, companies tend to maintain dividend payments, despitechanging earnings, as a policy, unless the earnings change by a significantproportion.

Transaction and Monitoring Costs: M–M model assume that transactioncosts do not exist. They also assume that the shareholders can sell a smallportion of their shares in lieu of dividend, when they are indifferent betweendividend and capital gains. But reality is for from that assumption. Theshareholders have to pay brokerage and often incidental costs to sell theirshares. As a percentage, the transaction costs vary inversely with the salevalue of shares i.e., higher the value of shares sold lower the percentage oftransaction costs and vice versa.

Existence of Perfect Capital Market: M–M assume that there exists aperfect capital market where information is freely available and future shareprices are known with certainty. In practice, companies do not share completeinformation with shareholders. The process of monitoring the company and themanager’s performance involves significant costs and also leads to uncertaintyin future share prices. Therefore, timing of selling the share to encash thecapital gains in lieu of dividend income becomes difficult. As a result,shareholders may prefer dividend income to capital gains.

To disseminate information to the share holders about the future earnings acompany can make statements to create a favourable impression. Thesestatements attract greater attention if they are accompanied by dividendannouncement. For example, if a firm’s earnings are expected to grow inthe future and if the firm does not announce increase in the dividendpayment, shareholders may not attach enough importance to such views ofgrowth in future earnings. Therefore, the share value may not reach realisticvalue.

Uncertainty And Preference for Dividend: M–M profess that the dividendpolicy continues to be irrelevant even under the conditions of uncertainly,because the share value of two firms with identical investment policies,business risk and future earrings cannot be different. These views are notconvincing to many researchers. According to them, investors try to reduceuncertainly to some extent through dividends. Their views are akin to the bird-in-hand argument of Gordon who argues that the discount rate increases withuncertainty, suggesting the preference of shareholders for higher dividendpayment. The preference for a steady stream of income in the form ofdividends by a section of investors also strengthen this argument.

Diversification: Even under the conditions of certainty, the argument of samediscount rate for all firms may not hold good because of investors’ preferencefor a diversified portfolio of securities. To fulfil their desire share holders likethe firm to distribute the earnings to invest in other firms. As such, theinvestors may use higher discount rate for firms with high retention ratioscompared to firms which pay high dividends by accessing external financing tomeet their requirements. Therefore, the value of the firm may increase if itpays higher dividends instead of retaining them.



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15.6 PROCEDURE OF PAYING DIVIDENDS

The dividends can be declared only by the board of directors, which issubject to the ratification by the shareholders in the annual general meeting.Once declared the dividends become a current liability of the firm. They canbe paid only out of profits (after providing depreciation) of the current or pastyears. The dividends are payable to those investors whose names appear inthe shareholders list of the firm, on a particular date announced in advancefor that purpose, which is normally called record date. The buyers can getthe shares transferred in their name before the record date. Buyers get thedividend from the seller if the shares are bought “cum dividends”. If theshares are bought on “ex dividend” basis, the buyers should return thedividend, if they receive.

15.7 TYPES OF DIVIDENDS

Several types of dividends exist in practice. Companies usually pay ‘Regularcash dividends’. These may be paid once a year or more times in a yearspllitting the amount. In some western countries, it is common to pay dividendsquarterly which is rare in India. Here the word regular does not convey anylegal obligation of the company to compulsorily pay dividends. It only connotesthat the companies can maintain similar payments in future also. For thatpurpose, dividends are set at such a level that a firm can pay even during theyears of poor performance. In a particular year, if a company pays a higherdividend and it believes that such payment is not possible in future, it willdeclare the extra dividend as special dividend indicating that they are not liableto be repeated.

For example, Lakme Ltd., and Max India Ltd are distributing around1000 percent as special dividends out of profits made by selling part oftheir businesses. Investors naturally, will not expect similar pay outs infuture.

Companies may also choose stock dividends instead of cash dividend. It isnot uncommon in West to popular the payment of regular stock dividends ofaround 5 percent. Such practice is not in India so far, though occasionalstock dividends of higher percentage in the name of bonus shares arepopular in India. Stock dividends are very similar to stock splits. Theyincrease the number of shares, but will not bring fresh funds to the firm,and will reduce values per share. But a stock dividend leads tocapitalization of reserves equal to the sum of new shares at par value. Incase of a stock split the face value (par value) will be reduced to increasethe number of shares. So, there will not be transfer of funds even in thebooks of accounts.

There are some other non cash dividends, corporate gifts, and discounts fall inthis category. For example, Reliance Industries Ltd., has been offering discountson its products, to the shareholders. In some countries companies encouragesshareholders to reinvest their dividends continuously, by allowing some discount,on prevailing market price. By offering reinvestment opportunity to theshareholders, the company can fulfil both payment of dividends and issuing ofnew share for additional capital simultaneously. In the process the company canalso save the floatation costs of issuing new shares.

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15.8 FACTORS INFLUENCING THE DIVIDENDPOLICY

A firm choosing a dividend policy will have to decide about the portion ofearning to be distributed as dividends, and the portion to be retained either forliquidity needs or for investments. Various factors should be considered whilefinalizing the dividend policy. They are firm’s expected rate of return on newinvestment opportunities, tax rates on dividends, and capital gains legalconsiderations, liquidity and debt servicing, control of management, shareholdersexpectations, access to the capital market, and the implications of following aparticular dividend policy.

New Investments: If new investments are not available to the firm withattractive rates of return and it is not willing to retire the debt, firm may usethe earnings to distribute as dividends. In a growing economy, if the firm findsgood investment opportunities, it may use major portion or all earnings tofinance the new projects. This can be found in case of new and fast growingcompanies with profitable ventures. They may do so after considering therelative costs and benefits of internal and external financing. At times, firmsmay retain earnings in liquid assets, even if profitable investments are notavailable currently, with the hope of investing in future. In real life, companiesneither follow 100 percent retention nor 100 percent distribution of theirearnings, whether projects with good returns are available or not.

Expectations of Shareholders: No doubt dividend decision is the prerogativeof the company directors. However, they only represent the shareholders, whoare the owners of the company, and they appoint the directors. Thus dueimportance will be given to the share holders’ expectations with regard todividends. Shareholders’ preference for dividend or capital gains hinges on theireconomic status and tax rates applicable to dividends and capital gains. Shareholders having sources of other regular income may not attach much weightageto regular dividend, compared to those who depdn on dividens as regularincome. Similarly, institutional investors who buy large blocks of stocks preferregular dividen to meet their own dividend obligations.

In case of closely-held companies, it is easy to ascertain the expectations ofthe shareholders to adopt a dividend policy of their choice. But, in case ofcompanies with large number of shareholders distributed across the country, it ishardly possible to gather their views on expected dividend policy. Under thecircumstances, the directors may tend to meet the expectations of thedominant groups of the shareholders. The minority groups may switch overto other companies which meet their expectations. So, at times companiesshould formulate its dividend policies keeping the target groups of shareholdersin mind.

Taxes: As explained in the dividend theories, the capital gains and dividendincome are not treated as same for tax purpose in most countries. In manycountries capital gains are treated favourable with a lower tax rate whencompared to dividends. However the situation is reverse in India, sincedividends are tax-free to the shareholders from 1998-99. Instead of theshareholders, the companies pay 10 percent tax on the distributed earnings,which is similar to uniform tax rate irrespective of the individual shareholder’stax slab. The current long-term capital gains tax rate is 20 percent. Therefore,investors may prefer shares with high dividend pay-out. Institutional investorsare exempt from both capital gains tax, and tax on dividends.



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Legal Restrictions on Paying Dividends: The companies have to followcertain legal norms while deciding the dividend payments. Some of therestrictions are: (a) The companies Act provides that dividend shall be paid onlyout of the current profits or past profits after providing for depreciation. But,the Central Government is empowered to allow any company to pay dividendfor any financial year out of the profits of the company without providing fordepreciation; (b) Lenders may put restrictions on dividend payment to protecttheir interests when the firm is experiencing liquidity or profitability problems.

Control: The existing management group normally tries to continue theircontrol on the company. When a company pays dividend and raises new equitycapital, the shareholding of the management group may come down as apercentage, unless they increase their share holding proportionately. If they areunwilling to increase their shareholding they may retain more earnings tofinance the projects. Thus, the control aspiration will affect the dividend policy.

Access to Capital Market: In spite of policy to distribute high dividends andraise new capital to finance the new investments, companies may fail to do so,when the capital markets are in a highly depressed state. The firms may prunethe dividend rate in such periods until they are able to access the capitalmarket as per their expectations.

15.9 DIVIDEND STABILITY

Companies normally dislike to change their dividend policies too often. Even theshare holders value stable dividends higher than fluctuating one. There arethree forms of stable dividends. They are:

� Stable dividend per share or rate

� Stable dividend pay-out ratio, and

� Stable dividend per share plus extra dividend.

Stable Dividend per Share: Most companies prefer to pay a fixed amountper share as dividend per share, regardless of fluctuations in the earnings. Thedividends follow a very slow but steady up ward or downward trend over aperiod of time. Relationship between earnings per share and dividend per shareis noticable in figure 15.1.

Figure 15.1: Relationship between EPS & DPS

EPS

DPS

Rs.

Year

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It is easy to follow this policy when the earnings are stable. If they changewildly, companies find it difficult to maintain stable dividends. To smoothen thedividend payments companies dig into their reserves to pay the constantdividend in years of low earnings. Research indicates that companies payingstable dividends will be preferred by the investors.

Stable Pay Out: Some companies may follow the policy of paying a fixedportion of earnings as dividends. Then the dividends entirely depend on thecurrent year earnings, and therefore dividend per share varies accordingly. Inthis policy internal financing is automatic and it removes the trouble of over orunder payment of dividends. As a result the share values may change wildly.Companies seldom follow this policy.

Stable Dividend per Share plus extra Dividend: In this method thecompany pays a stable regular dividend, and also pays an extra dividend inyears of high profits. Very few companies follow this method as policy.

Residual Dividend Policy: Comapnies can finance their investments throughfunds from debt market, retained earnings, and equity capital. Once thecompany finalizes the investment and the target debt equity ratio, it will securethe debt funds accordingly. The equity component will comprise of retainedearnings and new equity shares. In that components the management willdecide on how much to meet from retained earnings and capital market byselling new shares. The earnings left over in the process with be distributed asdividends.

15.10 DICIDING THE DIVIDEND PAY OUT RATIO

Based on a survey of corporate managers John Linter emphasized the followingpoints with reference to dividend policies:

� Firms pursue long-term target dividend pay out ratios.

� Managers do not attach much significance to dividend declarations, if theydo not represent any change from the current dividend policy of therespective firms.

� Dividend changes indicate significant changes in the long-term earnings.However, dividends will be smoothened over a period of time. Temporaryshifts in earning will not reflect in dividend payments.

� Managers dislike to reduce the dividends. So they tend to be overcautiousin recommending dividend hikes.

Considering the above facts, Linter developed a simple model to explain thedividend payments. According to the model, if a firm decides on a target payout ratio, the dividend in the next fiscal will be equal to a constant proportion ofearnings per share (EPS).

D1 = target dividend= target ratio x EPS1

then, the change in dividend will be equal to

= D1–Do = target change= target ratio X EPS1 – Do

Any firm following a constant pay out ratio will be paying different amounts ofdividends whenever earnings change. According to Linter, managers dislike



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changing dividends, preferring, smooth progression instead. Therefore, dividendchange as per Linter may conform to the following model:

(D1–Do = adjustment rate) (target change)= adjustment rate (target ratio X EPS1 – Do)

Through this model firms can slowly move towards their respective target payouts instead of repeatedly changing dividends. This model suggests that dividendhinges on both current earnings and dividend of the previous year. Some ofIndian studies also confirm the Linet’s hypothesis.

15.11 SUMMARY

The annual earnings of firm can be paid as dividend or retained for investmentsincrease the firm’s value. The Walter’s model suggests to take the dividenddecision based on firms rate of return and its discount factor, with severalrestrictive assumptions. Gordon expresses similar moves, but indicates that riskincreases with futurity, therefore giving more importance to dividends. M–Mhypothesis indicates the irrelevance of dividend policy to enhance the firm’svalue.

In practice, firms have been found pursuing are stable dividend policy and theyconsider several factors before deciding on dividend payout rate.


� What are the factors which influence management’s decision to paydividend of a certain amount?

� Discuss the implications of making dividends tax free.

� “If it is all very well saying that I can sell shares to cover cash needs, butthat may mean selling at the bottom of the market. If the company pays aregular dividend, investors can avoid that risk” discuss.

� “Risky companies tend to have lower target pay out ratios and moregradual adjustment rates” do you agree? Give reasons.

� What are the different pay out methods? How do shareholders react tothese methods?

� Distinguish between bonus shares and share split. What is their impact onearnings per share, dividends, and market price?

� Between 1971 and 1995 one could explain about two thirds of the variationin TEP Ltd’s dividend changes by the following equation:

DT – Dt–2 = –0.90 + .54 (–34 EPSt–Dt–1), Discuss.

� Do you agree with Walter’s dividend model ? Discuss its relevance andlimitations.

� Examine the M.M’s irrelevance hypothesis. Critically evaluate itsassumptions.

� What is the informational content of dividends? Discuss its its influence onshare value.

15


Van Hore, James W. Financial Management and Policy, Printice Hall Inc,New Jersey. Schall, L.D., and Halley C.W., Financial Management. Mc GrawHill Inc. New York.

Pandey I. M Financial Management. 7 ed, Vikas, New Delhi

Brealy R.A., and Stewart C. Myers. Principles of Corporate Finance, 4 ed,Tata Mc Graw Hill Ltd., New Delhi.

R M Srivastava, Financial Management and Policy, Himalaya PublishingHouse, Mumbai, 2003.


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UNIT 16 FINANCIAL ENGINEERINGObjectives


� provide an overview of financial engineering and the process involvedtherein

� focus on newly emerging fixed income products

� focus on newly emerging equity products

� explain derivative products developed by financial engineering

Structure

16.1 Introduction

16.2 Factors Contributing to Financial Engineering

16.3 Financial Engineering Process

16.4 Financial Engineering in Fixed Income Securities

16.5 Financial Engineering in Equity Products

16.6 Financial Engineering in Derivatives

16.7 Summary



16.1 INTRODUCTION

In general, engineering is the process through which some value is added to theraw material or semi-finished product so as to make it useful to the users orconsumers. Applying this general meaning of engineering, we can say financialengineering is the process through which finance managers or intermediaryinstitutions in financial markets add value to existing plain vanilla products thatsatisfy the users need. John Finnerty (1988) offers a comprehensive and luciddefinition of financial engineering as follows: "Financial engineering involves thedesign, the development, and the implementation of innovative financialinstruments and processes, and the formulation of creative solutions to problemsin finance". The users of financially engineered products include investorsincluding institutional investors like pension funds, banks and financial institutions,corporates, suppliers, consumers, employees and government.

We provide you a quick and intuitive understanding of financial engineeringconcept. The meaning and characteristics of debt and equity instruments arewell known. If you place these two instruments along risk-reward line, theycan be placed at two extreme points. Debt carries low risk and hence lowreturn. Equity carries high risk and hence high expected return. These two areplain vanilla products. Many financially engineered products are in betweenthese two products or decomposing the risk and return or changing them to thelevel users want. We can say preference shares is one of the earliestfinancially engineered product since it has higher risk compared to debt but alsocarries higher return. Compared to equity, it carries lower risk but also lowerreturn. So, an investor, who need moderate risk and return can choose'preference shares'. Is there any alternative to this financially engineeredproduct? Yes, it is possible that one can buy both equity and debt (ordebenture) of the same firm and synthetically create a product somewhat equalto preference shares. But it is something like mixing individual chemicals in


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your home to prepare cough syrup instead of buying formulated product. Inother words, preference share is equal to formulated product and ready for usewhereas buying both equity and debt in certain proportion to get the sameeffect is something similar to mixing chemicals by yourself to get the sameformulation.

Convertible debenture is another financially engineered product that is inexistence for a long time. Convertible debentures, which are optionallyconvertible, provide an opportunity to share the reward if the equity price goesup without risking your capital when the company is not doing well. In otherwords, here is a product, which decomposes the risk and return of the equityand passes on the return only to the investor. Of course, the convertibledebenture holder can't expect such product without incurring any cost andinterest rate for convertible debt will be lower than non-convertible debt. Whileconvertible debentures or bonds are financially engineered product by thecompany, the market has created similar product called option (call and putoption). It again decomposes risk and return and hand over return to one set ofinvestors and risk to another set of investors. The investors, who get return,agree to compensate the investors who take risk by paying premium. Optionsare again financially engineered product.

We can extend the concept to an extreme situation such that corporate form ofbusiness with limited liability itself is a financial engineered product in whichequity holders hold a call option on the value of the assets of the company.The plain vanilla product is sole proprietorship or partnership with unlimitedliability. Since the plain vanilla structure put a limitation on the growth of thecompany, we need a structure in which many investors can participate butmanagement is vested only with few. Since there is no guarantee thatmanagers will manage the business well, there is a need to restrict the liabilityof investors. Equity with a limited liability is financially engineered product.Though Finnerty definition requires 'innovation' as an essential characteristic offinancial engineering, not all engineered products are innovative. They are to bedifferent and add value to users. A financially engineered product may beinnovative today but it may eventually become a common product in the future.

16.2 FACTORS CONTRIBUTING TO FINANCIALENGINEERING

As stated above financial, engineering produces products or in some casessolutions that add value to the users. Why users of financial products orsolutions want some value-added products? An understanding of such needs willbe useful to appreciate the role of financial engineering and the products andsolutions that come out of financial engineering. John Finnerty (1988) identifiedeleven factors that are primarily responsible for financial innovation. Thesefactors are briefly discussed below:

(1) Tax Advantage: If there is a way to save tax or defer tax, every onewill exploit the opportunity. Often financial engineering helps to developsuch products. For instance, if you buy a zero coupon bond in thesecondary market, the difference between the redemption value and thepurchase price is treated as capital gains whereas interest received frominterest paying bonds are treated as regular income. Since the tax ratefor capital gains is substantially lower (it is 10% now for long-term capitalgains) than marginal tax rate of high net worth investors (it is 30% forindividuals and 35% for corporate entities), it make sense for companiesto issue zero-coupon bonds. Small investors wanting to show the incomeas regular income will buy the same in primary market whereas high net

Financial Engineering

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worth investors will buy from secondary market. Mutual funds is alsotax-efficient medium through which you can change the character of theincome from one to another. For instance, if you invest in bond marketfund, which in turn invest the money in bonds and receive interestincome, you can still show the income as capital gain by choosing certainschemes. You can convert capital gains into dividend and vice versa.Thus, mutual fund is a financially engineered structure to get taxadvantage and of course, it is also a vehicle through which investors canachieve diversification at low investment. There are several otherexamples. While operating leasing is a plain vanilla product, financialleasing is an engineered product, which often used to gain certain taxadvantage. Some years back, many companies have done 'sale and leaseback' transactions to exploit loopholes in tax laws, which was pluggedsubsequently. Similarly, a non-tax paying company and tax payinginvestors can save tax by investing in preference shares. It is possible fora company to issue 'convertible preference shares' such that the preferenceshares can be converted into non-convertible debenture on default ofdividend. Of course, many of the financially engineered product to exploittax law loopholes are effectively killed by the government by amendingthe tax laws and sometime with retrospective effect. The life ofsuch products or solutions is generally short but opportunities comeregularly.

(2) Reduced Transaction Cost: Financial products and solutions come withhigh transaction cost. For instance, if a firm issues debenture for 7-yearperiod, it has to repay at the end of seventh year but invariably it has toapproach the market again with another bond issue in the near futuresince growth demands fresh funds. An alternative is issue of fairly along-term bond, say 99-years with call and put options and in that processtremendous transaction cost is reduced. Add more features to take careof various concern like changes in credit rating, etc. and you will gettruly financially engineered product to handle transaction cost. Mutualfunds and several products of derivative markets are aimed to reduceeither transaction cost or at least recurring transaction cost to a largeextent.

(3) Reduced Agency Cost: Agency relationship between promoter/managersand other shareholders/stakeholders creates certain cost, which latterbear. Employee Stock Option (ESOP) is a financial innovative product,which swaps part of salary for equity such that the value of equityincreases only if mangers perform well. Leveraged Buyout (LBO)through issue of junk bonds is a financial process through whichinefficient management is replaced with efficient one and productivity ofthe assets is improved. Compare this with a situation where banks andfinancial institutions were not able to take action against defaultingcompanies except initiating time consuming court action and in meanwhileproductivity of assets are deteriorate further.

(4) Risk Reallocation: Financial engineering plays a major role in thisrespect too. We briefly discussed this point in introduction. Throughfinancial engineering, it is possible to reallocate the risk to differentparties and of course such reallocation comes with a price. For instance,fixed interest rate bond is plain instrument in which both investors andissuer are exposed to interest rate risk. A floating rate bond takes awaythe risk. However floating rate brings new problem and issuers areexposed to higher cost of borrowing. A swap transaction can shift suchrisk from company to counter party. Like this, you can create anenvironment in which you can trade 'risk'!! We will see more examples insubsequent sections.


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(5) Increased Liquidity: Liquidity reduces the cost and improves efficiencyof pricing. Liquidity is affected due to rigidity and inability to assess therisk level. For instance, real assets in general are less liquid compared tofinancial assets. Land is not as liquid as bonds issued by a companydealing in buying and selling of land. Equity and bonds of leasingcompanies are more liquid than assets funded by leasing companies. Loanportfolio is less liquid if some banks want to sell the loan portfoliocompared to stocks and bonds of the bank. Through securitization,financial engineering can improve the liquidity. Another example, is open-end mutual funds, which give option to enter and exit at anytime and ofcourse with certain cost (entry and exit load).

(6) Regulatory or Legislative Factors: Regulation or deregulation, bothmake life complex. A regular public issue in the US market is highlycostly for an Indian company since the regulations are very high and thecost of compliance of such regulations is high. ADR and GDR arefinancially engineered products, which allow companies to issue shares inUS and other markets without attracting such high level of regulations.Depository and electronic-trading are positive side of regulations, whichreduces level of risk and also transaction cost. Mutual funds areintroducing several new products within regulation to attract investors andtap new sources of funds. Insurance is another highly regulated industrybut you can witness so many products offered by them. If regulationputs certain restrictions, you have to be more innovative to keep theinterests of investors. If regulation removes certain restrictions and allowscompetition, you have to be equally innovative to compete and retain yourinvestors. For instance, RBI puts lot of restrictions on companies raisingdeposits from public.

(7) Level and Volatility of Interest Rates: Interest rate influences theprice of almost all products of the economy and of course interest rate inturn is influenced by several factors. Volatility in interest rate createsproblem for several players in the market but there are people who likevolatility of interest rates and hence want to assume additional risk.Financial engineering can help these two parties to swap their riskappetite on interest rate volatility. All interest rate derivatives are outcomeof such volatile behaviour of interest rates.

(8) Level and Volatility of Prices: Producers and users of products (realas well as financial) and services are exposed to high level of price risk.Bonds linked to commodity prices shift such price risk from those risk-averse players to those who are willing to take up such risk.

(9) Academic Work: Sometime new and value added products aredeveloped as a matter of academic exercise and subsequently someonefinds it useful.

(10) Accounting Benefits: Accounting regulation requires certain items to betreated in a particular way. Earlier when there were no regulation ontreatment of stock option, many companies have reduced salary byconverting a part of salary into stock option (ESOP) but not recognizedas expense. In that process, profit and profitability increase. Zero-coupon convertible bonds are beneficial if there is no regulation on howto treat the discount in stock price that is going to be offered in thefuture;

(11) Technological Developments and other Factors: A complex exoticderivative structure was neither in demand nor life was as complicated astoday requiring such products. Technological development in computationalfinance today makes it possible to develop such products and allow usersto trade risk and return.


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Activity 1

Visit the web site of few large Indian and US companies and see their annualreport. Examine whether they have issued any security other than plain equityand bonds.

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16.3 FINANCIAL ENGINEERING PROCESS

Financial engineering process is no different from the process that any firmfollows in developing new value added products or services. The process startswith identification or realization of some needs. Sometime such needs areknown but many times, you have to identify the needs of the market and bringout products or services or solution to the users without expecting them toformally communicate such needs. Like car manufacturers, mutual fundsmanagers have to constantly look for ways to innovate new products that areappealing to investors and at the same time achieves certain additionalobjectives. It is quiet possible that you may add one more feature to theexisting products, which increase its value to users. For example, an open-endfund gives liquidity compared to close-end funds but still investors have to fulfilso many formalities to get the money. Cheque book facility to mutual fundsholder takes away so many formalities relating to redemption and provideinstance liquidity. Corporate finance managers have to look for ways to reducecost of capital or reduce the risk arising out of operating activities. Treasurymanagers of banks while talking to clients can get ideas for new product orsolutions. Once the need is identified, an initial sketch of the product isdeveloped. At this stage, depending on the product requirement, complex modelbuilding exercise is used. For instance, a structured derivative product requireshigh level of mathematical modeling. The next stage is testing of the product socheck whether the desired result is achieved. Sometime it involves simpleverification with the users or some senior managers' assessment. Sometime,you may have to run some simulation exercise to verify how the product willproduce results under various simulated future scenario. Once the product isperfected, the next stage is pricing of the product. At the stage of pricing, it isquiet possible that the price paid by the customer may be more than the benefitderived out of the product. So, the product may be restructured again so as tomake it attractive to the users. Finally, the product is launched or solutions areprovided either directly or after some test marketing.

Activity 2

Suppose you are in a large bank specialising consumer loans. You are asked todevelop a new product to achieve 20% growth in consumer loans. Examine theexisting products available and then develop a new product. List down theprocess you have applied in developing new product.

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16.4 FINANCIAL ENGINEERING IN FIXED INCOMESECURITIES

Fixed income securities have seen large-scale innovation and new products. Aswas mentioned in the introduction of the Unit, zero-coupon bond and convertiblebonds are some of the early part of new products. A zero-coupon bond enablesthe borrowers to defer interest payment whereas it gives an option for theinvestors to show the appreciation either income or capital gain depending ontax preference. An optionally convertible bond reduces interest cost toborrowers whereas investors get an option for converting the same into equitydepending on the performance of the company, which may not be assessable atthe time of investment. Another major innovation in bonds was floating ratebond, which takes away the interest rate risk. A number of subsequentinnovations on floating rate bond aim to deal with different types of risk. Atypical floating rate bond contains a float part and fixed part. For example, itcan be bank rate or LIBOR + fixed premium say 4% or 2%. When theinterest rate moves upward in the market, the bank rate or LIBOR also movesup and hence investors get higher interest rate. When the rate declines,borrowers are not stuck with higher interest liability. Thus, float part effectivelyhandles the interest rate risk. Here interest rate risk means additional interestliability on account of fixed interest commitment that the borrower has to bearwhen the interest rates are moving down in the market. Similarly, when theinterest rate moving upward, the investors of fixed interest rate bonds loosemoney as the prices of bonds decline. In other words, the market prices ofbonds move up and down based on changes in the market interest rates.

Instead of fixing the float to Bank Rate or LIBOR, if the issuer and investorfix the float to some other value, they can tackle different types of risk. Forinstance, a commodity producer or oil company is exposed to considerableamount of commodity or oil price risk. Prices of commodities, oil, metal, etc.,are highly volatile and producers of these products are exposed to high level ofrisk. In other words, in a balance sheet context, the asset side risk (also calledbusiness or operating risk) is very high. Naturally, for these companies, a purefixed interest paying debt will add more problems. For some reasons, if theprices of the products crash, it may hurt the business considerably. While debtcreates such adverse effect in a falling prices, it creates value when pricemoves upward. The issue before the finance managers of these companies ishow to resolve the negative effect of the debt in a falling market price whileretaining profit opportunity when the prices move up. It is resolved by linkingfloating rate with the commodity price index. That is, the investors will gethigher interest rate when the market price of the commodity moves up andgets lower return when the prices fall. For instance, if the interest rate ofsuch floating bond is 4%+changes in oil price or price index, the bond holderswill get a return of 4% only if the price remains same. If the price increasesby 3%, then bond holders will get 7%. Normally, there will be a floor rate andcap rate for such issues. In the above case if the floor is 4% and cap is 10%,the interest rate will be minimum of 4% (even in cases when the oil pricedeclines by 10%) and maximum of 10% (even when the oil price increases by20%). So, the instrument, by and large, retains, the characteristics of debt butit brings some equity flavour into the instrument.

What about the users of such commodities, metals and oils? They are alsoexposed to price risk. When the prices of input moves up, it may not bealways possible for the company to adjust the end product price. This will hurtthe profitability of the company particularly cause distress if the company alsohas fixed interest rate debt. Inverse floating rate bonds, where interest is linkedto commodity price changes but in a inverse direction. That is, interest liabilitywill be lower when the price of input moves upward. Similarly, when the price


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of input moves downward, then interest liability will be more. The borrowerwould be happy to share part of the profit caused by lower input price with thelender provided the lender agrees to share the loss when the input priceincreases. You may be wondering why no one bothers to develop suchinstruments for consumers, who are ultimately affected by the prices. They caninvest in the bonds and shares of those companies until financial engineerscome out with a product.

As was discussed earlier, financial engineering developed several innovativeproducts in debt instrument. We mentioned earlier that zero-coupon bond is oneof the earliest innovations. But the problem is, investors who are looking forregular investments that will avoid such instrument. To overcome this and alsoto create some additional liquidity, issuers of such zero-coupon bonds havestarted issuing baby bonds, which are also zero-coupon bonds. Those who arelooking for regular income can sell the baby bonds while retaining the motherbond. Of course, tax treatment for such baby bonds was also one of thereasons for such innovations.

Can you create Zero-coupon bond (ZCB) from an interest-paying bond? Thereis nothing impossible before financial engineer. It works like this. If youcarefully look into interest-paying bond, it is a structure in which you investtoday some amount and borrower will pay you regularly interest at the end ofevery period (say six months) and principal on maturity (say 10 years). Thusyou will be getting 20 cash inflows. Investment bankers issued 20 differentseries securities backed by investments in such interest paying securities andthe 20 such securities are zero coupon bonds with different maturity. That is,series 1 will mature at the end of 6 months and the face value of the same isequal to first interest payment. Series 2 will mature at the end of 12 monthsand the face value is equal to second interest payment. Such that series 20 willmature at the end of 10 years and the face value is equal to principal and lastinstalment interest. All these zero-coupon bonds are discounted and issued todaysuch that investment banker collects the face value of the interest paying bondplus a small commission. Those investors, who have surplus for 6 months, willinvest in series 1, those who have surplus for 12 months will invest in series 2,etc. Interestingly, all investors of ZCB get benefit more than what they wouldget otherwise for investing money for such term.

Innovation in debt instruments in general (a) aims to remove interest rate risk(b) bring a bit of equity flavour into the instrument and (c) improve taxefficiency of the product. Suppose a firm borrows money in dollar but does notwant to take the risk of foreign exchange rate fluctuations. It is possible toissue a bond in one currency, pay interest in another currency and repay in adifferent currency. Alternatively, you can peg the interest rate to the changes inforeign exchange rate fluctuations. In essence, foreign exchange risk istransferred from the company to others. In other words, any risk can behandled, restructured and transferred from a person who is not willing to takesuch risk to a person who is willing to assume such risk.

Activity 3

Reliance Industries has successfully leveraged convertible debentures forexpansion. Examine convertible debentures issues of Reliance and figure outhow it helped them to achieve high growth without diluting their stake. Also,figure out why other companies like Essar Oil failed to replicate such innovation.

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16.5 FINANCIAL ENGINEERING IN EQUITYPRODUCTS

Equity product witnessed limited innovations since by definition, these productsare designed to carry high risk. Nevertheless, a few attempts have been madeto reduce the risk or share the risk and change some of the basiccharacteristics of the instruments. One of the basic characteristics of commonstock is voting rights that it gets for the holders. Unlike co-operative form oforganization in which each shareholder gets only one vote irrespective of sharethat the shareholder contributes, common stocks holders' votes equal to numberof shares that the shareholder possess. For instance if you have 1000 sharesand your friend has 100 shares, you get 1000 votes and your friend gets 100shares. Voting rights give the shareholders to participate in key decisions to theextent of their stake in the company. Such voting right has a value. This basiccharacteristic of the equity has been changed and voting rights value isswapped for additional dividend by issuing different classes of shares. Forinstance, under Indian law, it is now possible for the public limited company inIndia to issue non-voting shares. Subscribers of such shares have no votingrights and in this process it is almost like preference shares but without anyright on even dividend. However, when companies issue such non-voting shares,a suitable compensation either in the form of discount in offer price oradditional dividend is offered to the subscribers. Though so far no company hasissued such shares, some companies may issue such shares in the future. Thebenefits that non-voting shares offer are (a) it enables key promoters to retaintheir voting rights while issuing additional shares and (b) many small investorsand mutual funds are not interested in voting rights of good companies and theyare happy with additional dividend to exchange the voting rights. Empiricalstudies have shown that there is no significant difference in market pricebetween the shares of different classes except in period of takeover contestwhere voting rights assume importance.

A more common form of this kind of shares is 'differential voting rights' sharesin which all classes of shares have voting rights but in a disproportionate form.For instance, Class A shares will have voting right of one vote for one sharewhereas Class B shares will have a voting right of 100 votes for one share.Sometime, the arrangement will be such that Class B shareholder will not getany dividend from the company or get only one-tenth of dividend of Class Ashareholders. Typically, promoters would subscribe Class B shares whereasmost small investors would prefer Class A shares. Initially, companies will issueClass A shares to all investors and subsequently will announce for exchangingClass A shares with Class B shares on certain terms (eg. For every 10 sharesof Class A surrendered, the shareholder will get one Class B shares, which has100 voting rights per share and no dividend). Naturally, those who areinterested in control stake would go for exchange. Sometime, companies mayissue non-voting or low-voting shares for ESOP. While the uses of suchinstruments could be many, it is generally considered that non-voting or low-voting shares increase the agency cost since promoters are trying to retain theircontrol without investing an equal amount.

Some companies in the US and West have issued puttable common shares inwhich the holders of the equity shares have right to surrender the equity sharesat a pre-determined price on a pre-determined date. If you closely observe thebasic characteristics of the instruments, it is somewhat equal to buyback ofshares or selling puts. In other words, the risk associated with equity shares isconsiderably reduced by issuing such shares. You might wonder that why Indianregulators have not insisted such instruments from companies since many Indiancompanies during the period of 1994-96 and recently in 2000-01 have been


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promoted by fly-by-night operators. Good companies gain by charging morepremium for such shares because of less risk associated with such shares.There is no loss to the company since the shareholders will not exercise theirright if the company performs well. Companies like Intel have issued 'putoption' instead of puttable common shares.

Yet another innovation from mutual funds and investment bankers is splitting thetotal return of equity into two components and trade them separately. Forexample, SBI Mutual fund could invest 100000 shares in Infosys and create100000 Class A and 100000 Class B stripes against the investment in Infosys.SBI defines that those who purchase Class A shares will get only dividend (ordividend plus 20% capital appreciation) and Class B shares will get no dividendbut entire capital appreciation (or 80% capital appreciation). The Class A iscalled PRIME and Class B is called SCORE. While small investors preferClass A or PRIME, speculators will prefer Class B or SCORE component.

16.6 FINANCIAL ENGINEERING IN DERIVATIVES

The contribution of financial engineering on derivatives is substantial. In fact,every derivative instrument is the outcome of financial engineering. Toappreciate the contribution of financial engineering on managing risk throughderivatives, let us go back to the origin of such developments. Market is aplace where goods, products or services are exchanged. Normally, suchexchanges take place when the parties transact and such trades are calledcash market trades. However, cash market transaction creates certainproblems. For example, a food processing company may not be in a position tobuy its entire one-year requirement of wheat and wheat producer may not bein a position to supply entire quantity of wheat. Both parties are exposed toprice risk if they decide to transact periodically, say once in a month - that is,producer will supply one month wheat every month based on the priceprevailing in the market. To manage the price risk, producers and consumershave started transacting in forward market. Forward is an agreement betweenthe two parties entered today with all terms of contracts agreed today butsettled at a future period. Forward is a plain vanilla instrument that gives birthto derivatives through financial engineering. Forward performs almost allrequirements of both parties of transactions but there are certain limitations. Forinstance, if one of the parties wants to get out of the contract before thesettlement date, both parties have to negotiate for the reversal of the contract,which often will be expensive. In other words, there is no easy way for gettingin and getting out of the forward contract. However, futures (both commodityand financial futures), which are a derivative instrument, offer this facility.Future is a standardized forward contract entered between two parties andtraded in the exchange. Because of standardization, it is possible to trade inorganized exchanges and because it is traded in exchanges, it is easy to get inand get out of the contract. Today, futures are highly liquid and available onlarge number of financial products like stocks, bonds, currencies andcommodities like coffee, cotton, plantation, etc. They are also available onmetals and energy products.

While futures resolve basic problem of liquidity while allowing parties to 'lock-in' the price today so that there is no price risk, the parties forgo theopportunity to exploit the price advantage. For instance, the buyer will continueto pay higher price even the current market price is much lower. Of course,the producers gain in such situation. On the hand, if the prices move up, theproducers continue to sell at lower price while buyers' gain in such a situation.Hence when the prices move up or down, one of the parties gain and otherincur loss. Financial engineers designed options contract which allows buyer of


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the option to retain the benefit of price movement while avoiding loss.Consumers buy call option, which gives them a right to buy at a predeterminedprice. They exercise the right only when the price is more than thepredetermined price. Producers buy put option, which gives them a right to sellat a predetermined price and producers exercise their right when the pricemoves downward. Option contracts split the risk into positive and negative andallow parties to take whatever they like. Buyers of option, who take positiveside of the risk, are expected to pay a price or premium to sellers of option,who take negative side of the risk.

Swaps are similar to futures but the difference is it is a series of futures.Swaps are normally entered into exchange fixed rate borrowing/lending withfloating rate borrowing/lending or to exchange one currency borrowing/lendingwith another currency borrowing/lending. Suppose your company has borrowedmoney in the US but your exports are primarily to Europe. It is possible thatyou can swap dollar loan with Euro currency loan so that your foreignexchange risk is reduced. Swaption is another variation of swaps contract andit brings option element into swaps. Financial engineers have developed severalsuch variations and you will have an opportunity to learn them in derivativecourses.

Activity 4

Visit internet and find out the details of some exotic derivatives like weatherderivative and write a brief report on the same.

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16.7 SUMMARY

Financial engineering like any other engineering has brought several newproducts and solutions to the market. It has completely changed the financialmarket today. Its main contribution is to split the risk and return into severalcomponents and allow investors of financial markets to decide the combinationthat is most suitable to them. Such innovations are seen in bonds, equity,derivatives, and also in other fields like merger, acquisition and corporaterestructuring. It also provides mechanism to price such combinations bydeveloping various pricing models for futures and options. Some of the modelsare cost-of-carry model, binominal model, Black-Scholes Option Pricing Model,etc. Today, it is possible to quantify risk and return of any new products andalso price them with the help of these models. Financial engineering is anexciting field, which attracts some of the best human resources. The professionis also highly rewarding.


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1. What is financial engineering? Do you feel financial engineers play aneconomic role in the society?

2. Briefly discuss the financial engineering process that you will follow whiledeveloping new products or solutions.

3. List down with examples any five variables that contribute new productsdevelopment.

4. Explain how fixed income securities are used to manage product price risk.

5. Discuss innovation that took place in equity products and explain what theyachieved.

6. What is non-voting share? How is it useful to the company and investors?

7. What is the use of derivatives? Is it an instrument designed for speculatorsor useful to others too?

8. Explain any two derivative products and show the value addition in them.


Finnerty, J. D., Financial Engineering in Corporate Finance: An Overview,Financial Management, Winter 1988, Pp. 14-33.

Marshall, John.F and Bansal, Vipul K, Financial Engineering: A CompleteGuide to Financial Innovoation, Printice-Hall of India,New Delhi, 1996.

Mason, S P., Merton, R.C., Perold A. F., and Tufano P., Cases in FinancialEngineering: Applied Studies of Financial Innovation, Prentice Hall, EnglewoodCliffs, New Jersey, 1995.

Miller, M H. Finanical Innovation: The Last Twenty Years and the Next,Journal of Financial and Quantitative Analysis, December 1986, Pp. 459-71.

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UNIT 17 INVESTORS RELATIONSObjectives


� explain the corporate form of business organization and the need formaintaining investor relations

� highlight the importance of investor relationship for the corporate form ofbusiness organization.

� pinpoint the different forces that demand for information from thecompanies and varying purposes for which it is demanded by thestakeholders

� bring out the rationale for corporate governance in building by good investorrelations

� explain the advantages achieved from being a good governance company

Structure

17.1 Introduction

17.2 Corporate form of Business Organization

17.3 Demand for Information

17.4 Transparency and Disclosure

17.5 Corporate Governance

17.6 Investor Service

17.7 Summary



Appendix : Corporate Governance Report of Infosys Technologies Ltd.

17.1 INTRODUCTION

Savings and investment determine the growth, be it the economy or thecompany. Business units require funds for acquiring assets for manufacturingand investing in good projects and thereby achieving economies of scale. Thecompany form of business organization facilitates the creation of such largefirms with large capital base. This is made possible by collecting money frommillions of investors. Investors provide capital at the time of starting theventure as well as for the growth of the firm. While the funds provided by theequity holders make them the owners of the company, the funds provided bythe debt holders make them the lenders.

Hence, the company form of business mostly has a financial structure with amix of debt and equity. Generally the equity holders are the promoters, thedirectors and their relatives, Government, sometimes the institutional investors,the banks and the general public (or small investors) and they all jointly ownthe company. The debt holders are basically financial institutions, banks andgeneral public who lend money against a mortgage or by getting bonds or debenturesissued from the company. In some cases, the debt holders are issued convertiblebonds, as per which they can submit their bonds and get them converted toequity at later stage. So in this case they become owners from lenders.

Table 17.1 furnishes the details of the equity share capital and the number ofequity shares held by the investors of large Indian companies forming part ofNSE 50 index. The table shows that the paid up share capital of these firms


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range from Rs. 30 crores to 4000 crores. The number of equity shares issuedrun into millions and in some cases in billions. To get better understanding ofwho actually controls the company, we need to look into the shareholdingpattern data of these companies. Table 17.2 presents the percentage of equityholding by different categories of equity shareholders of these nifty companies.The promoters holding represent the equity holding of those who had promotedthe company and they basically control the management. The foreignpromoters' holding arises if there is joint venture between an Indian companyand a foreign company. Such investment can also arise if the foreign firm setsup its own company in India, which are often called as multinationals. Hencepromoters could comprise of either Indian or foreign based on how theyoriginated. The institutional investors' holding represents the equity holding ofthe financial institutions, the banks and mutual funds. The other privatecorporate body equity holding implies the holdings of other companies. Forinstance if Britannia industries invests in the shares of the ABB Ltd, it wouldbe classified into other company holdings. Companies at times do this form ofinvesting, when excess cash is available and it lies idle in the company. Theothers equity shareholding represent the holdings of small investors, who arealso owners of the company. But these small investors mostly invest for thesake of investment or speculation. They sell their shares if they feel that thecompany's share is performing badly in the capital market.

These two tables thus highlight the fact that number of investors are largetypically in large companies and also the categories of the investors are ofdifferent kinds. While the average promoters' holding of these companies isaround 43%, non-promoters contribution is 57%. In such a scenario a formalinvestor relationship arrangement assumes importance. Many companies todayhave a full fledged investor relations department headed by an investorrelationship officer. The present unit is dedicated to discuss why thecompanies need to have a good relationship with investors and what exactlyshould the companies do to maintain such good relationships.

17.2 CORPORATE FORM OF BUSINESSORGANIZATION

The company form of organization is governed by the Companies Act. In India,the Companies Act was passed during 1956. The Companies Act of mostcountries allow a group of people to start a company and approach public toraise large capital in the form of debt or equity. Generally, the small investorsbuy the shares and become the owners of the company. Institutional investors,as explained earlier, not only buy the shares, they also lend money to thesecompanies against bonds or mortgage. Hence it can be found that the ownersof a company could be any number of small investors. The investor rangeincreases with the size of the company. So the ownership is spread across theworld or countries. Figure 17.1 provides an overview of the links between thecompany, the shareholders, the institutions and the market.

While ownership is widely spread, the control is retained by a few. In thesense that the management of the company is handed over to few Board ofDirectors elected by the shareholders. This is because not all owners canmanage the company with a very small stake. This separation of ownershipand control leads to agency problem. Since agents behave with self-interest, itmight harm other investors who are not directly involved in management of thecompany. For instance, managers may invest the capital in not so good projects,and the result being the shareholders bear the loss of such bad investment. Themanagers may also use the shareholders money in different possible ways toserve their own interest.

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Table 17.1: Equity shares and capital of NSE 50 companies

Company Name Eq. Capital (Rs. Crores) No. of Shares

A B B Ltd. 42.38 42381675

Associated Cement Cos. Ltd. 171.13 170929944

B S E S Ltd. 137.83 137725666

Bajaj Auto Ltd. 101.19 101183510

Bharat Heavy Electricals Ltd. 244.76 244760000

Bharat Petroleum Corpn. Ltd. 300 300000000

Britannia Industries Ltd. 25.9 25904276

Cipla Ltd. 59.97 59972349

Colgate-Palmolive (India) Ltd. 135.99 135992817

Dabur India Ltd. 28.58 285749934

Digital Globalsoft Ltd. 32.98 32980532

Dr. Reddy'S Laboratories Ltd. 38.26 76515948

G A I L (India) Ltd. 845.65 845651600

Glaxosmithkline Con.Healthcare Ltd. 45.38 45380621

Glaxosmithkline Pharmaceuticals Ltd. 74.48 74475000

Grasim Industries Ltd. 91.69 91669685

Gujarat Ambuja Cements Ltd. 155.27 155189921

H C L Technologies Ltd. 57.58 287884290

H D F C Bank Ltd. 282.05 282045713

Hero Honda Motors Ltd. 39.94 199687500

Hindalco Industries Ltd. 92.46 92481325

Hindustan Lever Ltd. 220.12 2201243793

Hindustan Petroleum Corpn. Ltd. 338.83 339330000

HDFC 244.41 244414492

I C I C I Bank Ltd. 612.66 613034404

I T C Ltd. 247.51 247511886

Indian Hotels Co. Ltd. 45.12 45114695

Indian Petrochemicals Corpn. Ltd. 249.05 248225622

Infosys Technologies Ltd. 33.12 66243078

Larsen & Toubro Ltd. 248.67 248668756

Mahanagar Telephone Nigam Ltd. 630 630000000

Mahindra & Mahindra Ltd. 116.01 116008599

N I I T Ltd. 38.65 38649279

National Aluminium Co. Ltd. 644.31 644309628

Oriental Bank Of Commerce 192.54 192539700

Ranbaxy Laboratories Ltd. 196.72 185452098

Reliance Industries Ltd. 1395.92 1396377536

Satyam Computer Services Ltd. 62.91 314542800

Shipping Corpn. Of India Ltd. 282.3 282302420

State Bank Of India 526.3 526298878

Steel Authority Of India Ltd. 4130.4 4130400545

Sun Pharmaceutical Inds. Ltd. 46.52 93048478

Tata Chemicals Ltd. 180.7 180638651

Tata Iron & Steel Co. Ltd. 369.18 367771901

Tata Motors Ltd. 319.83 319784387

Tata Power Co. Ltd. 197.91 197897864

Tata Tea Ltd. 56.22 56219857

Videsh Sanchar Nigam Ltd. 285 285000000

Wipro Ltd. 46.51 232563992

Zee Telefilms Ltd. 41.25 412505012

Investors Relations


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Table 17.2: Shareholding pattern of Nifty companies (in %), March 2003

Company Name Promoters Institutions Cor. Bodies Others

A B B 52.11 30.47 1.10 17.42

ACC 0.00 45.48 18.26 54.52

B S E S 58.22 28.13 0.48 13.65

Bajaj Auto 29.17 21.07 13.52 49.76

BHEL 67.72 29.83 0.52 2.44

BPCL 66.20 27.72 1.39 6.08

Britannia Industries 47.00 28.37 1.98 24.63

Cipla 39.94 24.85 2.22 35.21

Colgate-Palmolive (India) 51.00 11.93 1.01 37.07

Dabur India 78.34 11.61 1.09 10.04

Digital Globalsoft 50.61 33.85 1.37 15.54

Dr. Reddy'S Laboratories 26.02 35.20 1.90 38.77

G A I L (India) 67.34 9.42 0.36 23.23

Glaxosmithkline Con. Health 40.00 34.19 3.54 25.81

Glaxosmithkline Pharma 48.83 26.56 1.50 24.61

Grasim Industries 20.42 38.23 5.80 41.36

Gujarat Ambuja Cements 27.51 38.45 3.55 34.04

H C L Technologies 77.04 10.55 4.12 12.41

H D F C Bank 24.41 30.49 1.16 45.09

Hero Honda Motors 52.00 31.05 2.01 16.95

Hindalco Industries 24.37 38.15 3.19 37.48

Hindustan Lever 51.56 26.03 0.84 22.42

HPCL 51.01 37.01 3.14 11.98

HDFC 0.00 59.70 2.37 40.30

I C I C I Bank 0.00 59.74 4.93 40.26

I T C 0.00 48.00 0.85 52.00

Indian Hotels Co. 37.38 27.24 2.33 35.37

Indian Petrochemicals Corpn. 79.98 8.38 2.11 11.64

Infosys Technologies 28.42 48.44 1.01 23.14

Larsen & Toubro 0.00 44.09 20.04 55.91

Mahanagar Telephone Nigam 56.25 31.29 0.74 12.46

Mahindra & Mahindra 26.26 43.79 5.61 29.94

N I I T 31.25 41.97 7.42 26.78

National Aluminium Co. 87.15 7.47 3.59 5.38

Oriental Bank Of Commerce 66.48 16.67 1.71 16.85

Ranbaxy Laboratories 32.05 35.85 1.00 32.10

Reliance Industries 46.52 27.76 1.67 25.72

Satyam Computer Services 20.74 56.27 2.34 22.99

Shipping Corpn. Of India 80.12 11.17 2.90 8.71

State Bank Of India 0.00 82.40 1.79 17.60

Steel Authority Of India 85.82 9.73 0.69 4.45

Sun Pharmaceutical Inds. 71.75 17.37 2.69 10.88

Tata Chemicals 30.56 26.39 5.03 43.05

Tata Iron & Steel Co. 26.41 34.34 6.78 39.25

Tata Motors 32.21 35.03 9.87 32.76

Tata Power Co. 32.54 33.95 2.35 33.51

Tata Tea 29.48 34.03 3.21 36.49

Videsh Sanchar Nigam 71.12 9.36 2.80 19.52

Wipro 83.90 4.40 1.78 11.70

Zee Telefilms 51.77 33.53 3.28 14.70

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These managers may also get involved with creative accounting, with the helpof the auditors. We have seen many instances of scams of this nature. In allthese cases, every stakeholder is affected. The equity holders, on learningsuch frauds, start selling the shares and this pulls down the prices of the stockin the market. Not only will the small investors do such act, this could happenwith the institutional investors as well. The matter is even worse with theinstitutional investors. This is because the institutional investors are both lendersas well owners in many companies. They not only cause damage by sellingthe shares, they will avoid lending to these companies in future. So the growthof the firm gets affected and finally the company might get liquidated.

There are several ways in which the management or promoters can assure themanagers manage the firm efficiently. Investor relationship in a broader senseincludes all such efforts taken by the agents to ensure that investors are notaffected by the agency problem. Investors expect management to run the firmefficiently in a most transparent manner and take all decisions that maximizethe investors return. The next section would explain in detail the expectations ofthe investors from the management of the company. If these expectations arenot met, then the company would be heading towards serious trouble.

17.3 DEMAND FOR INFORMATION

Basically, the demand for corporate information comes from the shareholdersand investors, managers, employees, customers, lenders and other suppliers,security analysts, policy makers, regulators and government. Purpose ofsoliciting information by different stakeholders of the organization varies to agreat extent. For instance, the Government seeks financial information of thecompany mainly to check if it pays the right amount of taxes as also to checkif it does not violate licenses granted, export-import policies etc.

The suppliers would be demanding the financial information basically to ensurethat the company would be in business for sufficiently long period of time andit would be worth while to have business with them. They would like to knowif the company would be able to pay their dues. Likewise, the lenders woulduse information to verify the creatibility of the company.

The managers call upon information of various types for planning and controlpurposes. Of course, the information supplied to the managers within the firmmay be much more in detail and confidential compared to the informationprovided to the outsiders. The customers, particularly the consumers of durablegoods or vehicles or IT products, would be interested in knowing whether the

Primary / Secondary Institu

SFinance Function Managers

Functional Managers

Capital Market

Corporate

Figure 17.1: The Functioning of Corporate Form of Business

Investors Relations


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company would exist in near future to provide them the service for the productthey purchased. So they would be constantly watching the company’sperformance for the same. The employees would be interested in the companyinformation because they would want to know if they would get better wagesor salaries for the coming years. Because if the firm is not doing well, thechances are that they might lose their jobs and also lose wages. So they keepa watch on the performance of the company.

The analyst demand information to publish reports on the performance of thecompany and to rate its debt payment capacity. He continuously tracks thecompany for information and analyzes the company accordingly and informs thepublic on buy and hold strategies. On the other hand, the demand forinformation by small and retail investors differs from that of the experiencedanalysts. The small investors simply do not have the time to keep track of thecompanies latest information. This is because small investors invest in a numberof companies and it is difficult for them to keep track of the information of allthese companies. Moreover they would not be able to analyze the informationas usefully as the experienced analysts do. Hence, they require much moredetailed information and mainly in a processed format so that they can evaluatethe risk and return characteristic of the company. This is for the fact that therisk and return of a firm are dependent on the following:

(i) the social, political and macroeconomic factors which are common tobelonging to differents all companies industries, such as social harmony,relations with other countries, political stability, growth rate of grossdomestic product (GDP), inflation rate, money supply, and policies of thegovernment;

(ii) the industry factors which are common to all companies in a particularindustry, such as labour conditions in the industry, policies of governmentwhich have influence on the industry, and demand and supply factors and;

(iii) company-specific factors which are important to any company, such asfinancial performance, changes in the top management, decisions relatingto financing, investment and dividend. With the knowledge of thesefactors, investors would be able to calculate the expected returns ofsecurities of different firms, the risk associated with their returns andaccordingly take their investment or portfolio decision.

Once the investment decision is made, shareholders and investors demandinformation for the purpose of safeguarding their interest in the corporate firm.This involves control of managerial behaviour so as to guide managerialactivities towards the maximisation of shareholders' wealth. Thus, shareholdersand potential investors require information so as to help them to make theinvestment decision, as also to design contracts and mechanisms for controllingthe behaviour of managers, and orient the managerial behaviour towardsrealising the objectives of a firm. Accordingly, they demand all information thatis non-proprietary, i.e. information whose disclosure does not affect the firm'sfuture cash flows.

We know that the objective of existing shareholders is to maximise theirexpected utility or wealth, even if it is at the expense of other parties involvedin the activities of a concern. First, they wish to safeguard their interest andwant to limit the possibilities for expropriation by all other parties. Second, theywill try to achieve the goal of maximisation of the wealth of the firm oralternatively the expected utility or wealth of shareholders by expropriating theother parties involved. Towards this end, they would like the management totake decisions which would increase their wealth either through achievinghigher sales, higher incomes and higher profits or through transfer of wealthfrom other parties involved in the corporate activity such as creditors, managers,

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employees, customers and government. They also demand the management ofthe company to disclose information that maximises the value of the firm.

However, we should also note that the demand for disclosure of corporateinformation of prospective shareholders differs from that of existing investors.Whereas the former wants the firm to reveal both value enhancing as well asvalue diminishing information, the latter, expects the firm to reveal only thevalue enhancing information and not to reveal the value diminishing information.Such conflicts can be seen as amount existing groups of promoters, institutionalshareholders and public shareholders.

There are several agencies engaged in protecting the interest of small investorsand other stakeholders. The requirement that the company form of organizationhas to be registered under the companies Act, 1956 is the first protection toinvestors and others. The Registrar of companies makes sure that the companythat is formed is genuine and has been formed for the purpose of being in thebusiness. The investors' interests are protected by the Securities Exchange andBoard of India (SEBI). SEBI had laid down some listing requirements for thecompanies seeking to raise money from the small investors or public. Once thecompany accepts the listing agreements, the company's shares get listed in thestock exchange. SEBI has also brought several regulations and guidelines formarket participants and intermediaries to protect the interest of investors. TheInstitute of Chartered Accountants of India lays down the necessary accountingstandards based on which the companies need to prepare the financialstatements and get it audited by the chartered accountants. This is done toensure that the financial statements represent true and fair view of the financialposition of the company.

Basically the investor demands can be classified into three basic categories.

1) Transparency and Disclosure

2) Good corporate governance

3) Investors Service

Each of these are discussed in detail in the following sections.

Activity 1

Check with some of your friends who invest in stocks on the information thatthey require/use while selecting the stocks for investments. Identify whethercompanies disclose such information in the annual report.

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Activity 2

Check with your friend whether he/she is happy with the information suppliedby the company in disclosing such information. Also, find out whether they aresatisfied with the role of SEBI and Stock Exchanges in improving disclosurestandards.

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17.4 TRANSPARENCY AND DISCLOSURE

Companies typically do not make available information on a day to day basisbecause of strategic reasons, and huge costs involved in collection anddissemination of such information to all the users. At the same time, thecompanies disclose summary of information periodically for various purposes.Corporate disclosure of information is determined by the market forces, costsassociated with corporate disclosures and the regulatory forces (Refer Figure 17.2)

Market forces which influence the decision of corporate firms may relate tothe capital, labour and corporate control market. Corporate firms compete witheach other in the capital market for resources. They may issue differentinstruments which meet the requirements of investors. The various forms ofraising finance have been discussed in the earlier sections. Under thesecircumstances, capital market forces exert pressure on firms to provideinformation relating to the instruments offered, terms of instruments, thedistribution of expected returns and importantly, on the projects for which thecapital is being raised. This is necessary because the investors have noforesight about returns and the quality of the product. And firms may beapprehensive, that in the absence of the authentic information, they may beperceived by investors as 'lemon'. In the instance of non-disclosure bycorporate firms, the investors may not be able to assess the risk and returns onthe projects undertaken by the firms, as they would have no idea as to whichfirm's projects are good or bad. Investors, under such circumstances, requireon average a high return. This higher required return may force the issuers ofcapital to withdraw from the market as the net present value of the projectwould be negative, if the projects are implemented with resources mobilised ata higher cost. When 'good' issues are withdrawn from the market, investorsrevise their required return upwards, which force some firms to withdraw fromthe market. In this process, the capital market ends up in a situation wherethere are only high risk offers, and there would be no investors ready to supplythe resources. Given the uncertainty about the product quality, success of theprojects and the cost of being perceived as a 'lemon', corporate firms have anincentive to supply the information that they believe will enable them to raisecapital on the best available terms.

Some firms may make overly optimistic forecasts about the future cash flowsassociated with a project. However, checks such as (i) reputation of the firm,(ii) reputation of the management, (iii) third-party assessment and clarification,and (iv) legal penalties, act as deterrents for firms to make these overlyoptimistic forecasts.

The labour market forces also exert pressure on the management to discloseinformation to the public. This can be due to either external or internal forces.For example, reputation of a management plays a vital role in determining themanagers' prospects of promotion and other incentives structure within the firmas well as outside the firm. Hence, managers would not be willing to takesteps that damage their reputation of competence. Further, professionalmanagers are governed by a set of standards of behaviour or a code ofconduct which are determined by professional bodies, and non-adherence tostandards may lead to disciplinary action against them by the professionalbodies. Thus, forces in the labour market prompt the managers to discloseinformation which improves their prospects, as well as their reputation.

The corporate control market forces also influence the firms' decision ofdisclosure, and the timing of information release to the public. The efficientworking of a concern depends on the soundness of the policies determined bythe board of directors, and their effective implementation by the managingdirector and his team of managers. If investors perceive that a company is not

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run efficiently and identify ways in which its functioning can be improved, theymay attempt to take over the controlling stake of the company. This perceptionof non-controlling stakeholders is influenced by their private information. Suchprivate information gives them an advantage, as they can acquire the stocks ofthe company at the existing prices. Under such circumstances, managers areforced to improve not only their working but also the level of informationdisclosure. At times, even when the investors do not have information about itsgood future prospects, the prices of a company's securities may be underpriced. However, the corporate predators and raiders, under suchcircumstances, make attempts to take over the company by actively buying thesecurities of the company in the secondary market. This forces the managersto reveal the information about the prospects of the company to the outsiders.Thus, the market forces influence the supply of information in two ways: firstby prompting the existing management of firms to disclose information to thepublic and secondly, through the threat of actions of corporate predators andraiders, who continuously explore the opportunities for takeovers.

The costs associated with corporate disclosures also influence the time andextent of disclosure of information. These costs include: (i) collection andprocessing costs, (ii) litigation costs, (iii) political costs, (iv) competitivedisadvantage costs, and (v) additional constraints on management decisions.

Collection and processing costs include the costs borne by both the suppliersand users of financial information. Corporate firms as well as users ofinformation incur the costs of collection of information. The corporatemanagement has to make decisions on what information is to be collected andat what frequency. It is not possible for firms to collect all the information on acontinuous basis, as it involves unlimited resources, both human and financial.The decision on information collection is often based on the assessment ofcosts and benefits associated with such information. Firms, while computingthe costs of collecting and processing information, have to bear in mind thecosts incurred by the firm as well as the costs borne by investors in performingsuch task. Similarly, while computing the benefits of information production andprocessing, firms have to take into view the benefits that accrue to all theusers of corporate information who have a stake in the corporate firm.

Litigation costs arise when the corporate has to face a dispute in a legal forum.The prompt public release of information as well as corrective information, ifany, can reduce the potential losses to shareholders and the potential exposureof the firm and its management in subsequent litigations.

Decision by Firms

Market Forces

Regulatory Forces

Information Availableto External Parties

Decision by non firm InformationSources, for example, brokerage

houses, and industry trade associations

Fig. 17.2: Factors Influencing the Information Set Available to External Parties

Source: Foster, George, Financial Statement Information, p.24, Prentice-Hall International,Englewoodcliffs, New Jersey, 1986.

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Political costs arise in situations where the perception of government andpolicies of government are influenced by the disclosure of corporate informationwhich influences the government to take actions which transfer resources fromthe corporate to the other constituents of society through fiscal and othermeasures. In these circumstances, firms may choose accounting methods thatthey perceive will reduce the likelihood of large profit increase being reportedin any one year.

Competitive disadvantage costs arise when firms choose to reveal a portion ofproprietary information. Typically, firms choose to keep strategic informationsuch as information on research and development, new products, advertisingexpenditure, break down of major customers and forecasts of gross margin,income or sales by individual lines of business, when they perceive that theyhave an advantage over competitors in these areas. However, they face adifficult situation when they want to raise new capital. In such a situation,irrespective of whether the firms disclose the information or not, the firmstands to experience a reduction in its value. For instance, unless firms providesome information pertaining to their research and development activities or newproducts, the capital market is not likely to support a new share offering, andyet, if they do provide detailed information, they may reduce the lead time withwhich competitors learn about developments within the company.

Disclosure of certain types of information by managers imposes constraints ontheir behaviour and may lead to a conflict between their efficiency andreputation. For example, earnings forecasts and their disclosure to the publicput pressure on managers to implement policies that result in the actualearnings converging towards the forecast values.

Regulatory forces also influence the disclosure and timing of release ofinformation by firms. A number of regulatory agencies govern the functioningof corporate and regulate their information disclosure. Such agencies can bebroadly discussed under four levels: (i) level one consists of the executive,legislative, and judicial branches of the government. The legislative makes lawswhich are enforced by the executive. The legislative and executive define themanner in which the corporate has to disclose information. The judiciaryexerts influence on the disclosure practices by its rulings; (ii) level two includesgovernment regulatory bodies. As discussed briefly in the earlier sections, inIndia, this level includes the Securities and Exchange Board of India (SEBI),the Company Law Board, and the Department of Company Affairs under theMinistry of Finance. These agencies are often delegated with the authority ofoverseeing the adherence of rules and procedures by corporate firms; (iii) levelthree includes private sector regulatory bodies such as Accounting StandardBoard, the Institute of Chartered Accountants of India, and Stock Exchanges.Professional bodies, through conducting seminars and publication of discussionpapers and in-depth analysis, from time to time, recommend standard practicesto be followed in the preparation of balance sheets, cash flow statements andprofit and loss accounts; (iv) level four includes lobbying groups that attempt toinfluence the decisions made by the parties in the above three levels. Theseprofessional bodies include industrial and trade associations, investor associationsand other interest groups.

The market forces and regulatory forces, described above, influence thedecisions of both the corporate firms and non-firm information sources such asbrokerage houses, and industry and trade associations as to what to discloseand when to disclose. The decisions of corporate firms and decisions ofsources other than corporate firms influence each other.

However, not all information disclosed by the companies are mandated byregulation. Companies also choose to disclose voluntarily information like the

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social services performed by them, the company philosophy, objective, businessthey are operating, the market share of the business, etc. However, as satedearlier, companies would be hesitating to provide information, which wouldreveal their competitive advantage to the competitors. For instance, the ICAIintroduced a new accounting standard on Segment Reporting (AS-17) witheffect from 2001. However, most companies still do not provide this informationdespite being made mandatory by claiming that they are single segmentcompany. This is because as per this standard, companies are supposed todisclose their financial information based on the different segments. Prior to2001, investors did not know whether companies were performing good in allthe segments in which they were operating. For instance, prior to 2001 investorsdid not know whether L&T was performing well in their cement or constructionsegment. Only the performance of L&T was made known to the companies.

There has been tremendous improvement in the last few years in the disclosurelevel of the Indian companies. This is mainly due to the new accountingstandards introduced by the ICAI like consolidation of accounts, segmentreporting, revealing the related party transactions, revealing the intangible assetvaluation etc. Apart from this the listing requirement had also been tightened.And listing requirements demanded more information from the companies. Onesuch latest requirement is the introduction of the Clause 49 on corporategovernance code. Accordingly, every company wanting to get listed in the stockexchange will have to disclose the corporate governance systems andprocedures existing within the company. Detailed aspect discussion on this madehad been made in the next section.

Activity 3

Compare for any one company, the annual reports of the year ending March2000 and March 2003. Identify major changes that you have seen on the itemsdisclosed by the company.

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17.5 CORPORATE GOVERNANCE

Corporate governance plays an important role in building a good relationshipwith the investors. This is because when companies are able to keep theirinvestor well informed about the way the business is done in a transparentmanner, this would definitely present a positive image. No investor would wantto do away his investment from such a company. McKinney in one of theirsurveys (2000) reported that investors are willing to pay more for companieswith good governance. And the premium the investors would be willing to payfor well-governed companies, they reported, differed by country. As reported,the investors were willing to pay 18 percent more for the shares of a well-governed UK or US company, for example, than for the shares of a companywith similar financial performance but poorer governance practices. But theywould be willing to pay a 22 percent premium for a well-governed Italiancompany and a 27 percent premium for a well-governed company in Indonesia.A well governed company is defined as having a majority of outside directorson board with no management ties; holding formal evaluation of directors; andbeing responsive to investor's requests for information on governance issues. Inaddition, directors hold significant stockholdings in the company, and a largeproportion of director's pay in the form of stock options. (Monks, 2001).

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However, the existence of corporate governance by itself does not become asufficient condition for the better performance of a firm. It can, however,become a necessary condition in the highly competitive world, particularly whenthe market has become global. But why does it become a necessary condition?Corporate governance can do a lot of things for the better performance of thecompany:

1. Good corporate governance helps the company to evaluate the betterinvestment decisions.

2. It would help resolve the agency cost of debt and equity.

3. It can help retain the existing investors.

4. It can attract more and more investors, implying raising capital would be easier.

5. Suppliers would be willing to deal with such companies.

6. Lenders would not be hesitating to lend to such companies, as the systemsare transparent and the performance of the company is well revealed.

Companies like Infosys could be shown as a good example for maintaininggood corporate governance. The corporate governance report of the InfosysTechnologies Ltd., for the year 2003 as required under clause 49 is given inAppendix to this Unit.

Activity 4

Find and write a brief report on events that lead to appointment of CadburyCommittee on Corporate Governance in the UK.

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Activity 5

Find from your stock market investor friend whether he or she is happy withthe corporate governance set up of Indian companies.

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17.6 INVESTOR SERVICE

In the earlier sections we had discussed about the importance of companiesmaintaining a good relation with the investors. We had seen that companiesgain a substantial advantage by transparent policies and disclosure practices.However, in order to sustain the good relationship earned, the companies needto provide the right information at the right time at the right place. Further theymust also attend to the queries of the investors promptly and provide them abetter service.

Though most of the information discussed above is filed with the stockexchanges, information in the annual report are sent to the shareholders bypost. Some information are sent to the interested parties on demand. The betterpractice has been that companies these days provide almost all information intheir websites. In fact, this is also mandatory by regulation. The quarterlyreturns filed with the stock exchange have to be made available in theirwebsite as well.

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Some good governance companies provide a lot of these information in asystematic manner in their websites; for instance the website of Infosystechnologies covers almost all information filed with the regulatory agencies.

As part of the annual reports, companies furnish the following details which areuseful to investors.

1. Financial calendar specifying the dates of holding the annual general meeting

2. Dates on which the quarterly returns are to be released

3. Dates of book closure for different purposes like share transfer anddividend payment

4. The addresses of the companies and the head office

5. Listing in stock exchanges

6. Information on dividend payment

7. Details about the investor grievances committee

8. Method of voting by proxy

9. Shareholding pattern of the company

10. The number of shareholders present in the company supplying the differentrange of shares held.

11. Market price data of the shares traded in the listed stock exchanges and acomparison of the share performance with the indices are also given.

12. Share transfer procedures. Though all the share trading is performed thesedays in the demat mode, the details of the same are also given.

13. Plant locations

Investors are comfortable dealing with companies that furnish the maximuminformation for the shareholders and also provide them good service.

Activity 6

List down the procedure to be followed when a shareholder has grievanceagainst the company. What are the alternative avenues available to investorsand what is the role of SEBI in handling investors grievances?

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Activity 7

Visit SEBI's web site (www.sebi.gov.in) and visit EDIFAR link and write abrief note on EDIFAR and its usefulness to investors.

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17.7 SUMMARY

Mr. Narayanamurthy of Infosys stated that "The primary purpose of corporateleadership is to create wealth legally and ethically. This translates to bringing ahigh level of satisfaction to five constituencies -- customers, employees,investors, vendors and the society-at-large. The raison d'être of every corporatebody is to ensure predictability, sustainability and profitability of revenues yearafter year." Some companies not only state their philosophies in just letter butthey act on it as well. Having a mission statement, underlying principles forachieving the mission and delivering value to the owners and the otherstakeholders enables the companies to have a long-term good relationship withits investors. If the companies do not sustain such long-term good relationship,we have seen that most companies get liquidated in the process of cheating theinvestors. Hence, maintaining a good relationship with the investors andperforming the operations in the most transparent manner helps the companiesin the long term.


1. Who are the stakeholders of a company?

2. Why is that the investor relationship gains more importance in corporateform of business organization rather than the other forms of businessstructures. Does it really matter or apply for other forms of businessorganizations? If so, how?

3. What are the forces that drive for information from the company?

4. What type of information is demanded by the different type of stakeholdersincluding the shareholders?

5. Do you think corporate governance matter in investor relationship?

6. Find out about 5 companies who have been rated as 'Good CorporateGovernance' company and examine their investor relationship. Are theinformation provided by these companies to the investors differ to a greatextent? If so, list down in what aspects they differ.

7. What are the regulatory agencies that govern the disclosure of informationby companies. List them and their roles.

8. How does the information demanded by the inside shareholders differ fromthe retail or external investors?


Bhabatosh Banerjee and Arun Kumar Basu (2001), Corporate FinancialReporting (Eds.), University of Calcutta, Calcutta.

Bhabatosh Banerjee (2002), Regulation of Corporate Accounting andReporting in India, World Press, Calcutta.

Birgul Caramanolis-coteli, Lucien Gardiol, Rajna Gibson Asner Nils S.Tuchschmid (1999), "Are Investors Sensitive to the Quality and theDisclosure of Financial Statements?" European Financial Review 3, 131-159.Monks, Robert A. G. (2001), "Redesigning Corporate GovernanceStructures and Systems for the Twenty First Century" Corporate GovernanceJournal 9(3), July: pp. 142-147.

John E. Core (2001), "A review of the empirical disclosure literature:discussion" Journal of Accounting and Economics 31, 441-456.

Paul Coombes and Mark Watson (2000), "Three Surveys on CorporateGovernance" Mckinsey Quarterly, No. 4.

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Paul M. Healy, Krishna G. Palepu (2001), "Information asymmetry, corporatedisclosure, and the capital markets: A review of the empirical disclosureliterature" Journal of Accounting and Economics 31, 405-440.

Stenberg, Elaine, (1999), "The Stakeholder Concept: A Mistaken Doctrine"Working Paper, Centre for Business and Professional Ethics, University ofLeeds.

Ubha D.S. (2002), Corporate Disclosure Practices, Deep & Deep Publications.

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Appendix: Corporate Governance Report of Infosys Technologies Ltd.

Infosys Technologies Limited

Corporate Governance report for the year ending March 2003

'1 hope to challenge corporate America to Look beyond rules, regulationsand laws, and Look to the principles upon which sound business is

based."William H. Donaldson, Chairman, Securities and Exchange Commission, USA

(Remarks at the practicing law institute - SEC speaks)

Corporate governance is about commitment to values and about ethical businessconduct. It is about how an organization is managed. This includes its corporateand other structures, its culture, its policies and the manner in which it dealswith various stakeholders. Accordingly, timely and accurate disclosure ofinformation regarding the financial situation, performance, ownership andgovernance of the company is an important part of corporate governance. Thisimproves pubic understanding of the structure, activities and policies of theorganization. Consequently, the organization is able to attract investors, and toenhance the trust and confidence of the stakeholders.

Corporate governance guidelines and best practices have evolved over a periodof time. The Cadbury Report on the financial aspects of corporate governance,published in the UK in 1992, was a landmark. This led to the publication of theVi Report in France in 1995. This report boldly advocated the removal ofcross-shareholdings that had formed the bedrock of French capitalism fordecades. Further, The General Motors Board of Directors Guidelines in the USand the Dey Report in Canada proved to be influential in the evolution of otherguidelines and codes, across the world. Dyer the past decade, various countrieshave issued recommendations for corporate governance. Compliance with theseis generally not mandated by law, although codes that are linked to stockexchanges sometimes have a mandatory content.

The Sarbanes-Oxley Act, which was signed by the US President George WBush into law last July has brought about sweeping changes in financialreporting. This is perceived to be the most significant change to the federalsecurities law since the 1930s. Besides directors and auditors, it has also laiddown new accountability standards for security analysts and legal counsels.

The Higgs report on non-executive directors and the Smith report on auditcommittees, both published in January 2003, form part of the systematic reviewof corporate governance being undertaken in UK and Europe. This is in light ofrecent corporate failures. The recommendations of these two reports are aimedat strengthening the existing framework for corporate governance in the UK.Enhancing the effectiveness of the non-executive directors and switching thekey audit relationship from executive directors to an independent auditcommittee are part of this. These recommendations are intended to take effectas revisions to the Combined Code on Corporate Governance.

In India, the Confederation of Indian Industry (CII) took the lead in framing adesirable code of corporate governance in April 1998. This was followed by therecommendations of the Kumar Mangalam Birla Committee on CorporateGovernance. This committee was appointed by the Securities and ExchangeBoard of India (SEBI). The recommendations were accepted by SEBI inDecember 1999, and are now enshrined in Clause 49 of the Listing Agreementof every Indian stock exchange. Infosys' compliance with these requirements ispresented in this chapter. Your company fully complies with, and indeed goesbeyond all these recommendations on corporate governance.

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Investors RelationsIn addition, the Department of Company Affairs, Government of India,constituted a nine-member committee under the chairmanship of Naresh Chandra,former Indian ambassador to the US, to examine various corporate governanceissues. The committee has submitted its report to the government. Thegovernment has not made it mandatory yet for Indian companies. Your company'scompliance with these recommendations is listed in the course of this chapter

We believe that sound corporate governance is critical to enhance and retaininvestor trust. Accordingly we always seek to attain our performance rules withintegrity The Board extends its fiduciary responsibilities in the widest sense ofthe term. Our disclosures always seek to attain the best practices ininternational corporate governance. We also endeavour to enhance long termshareholder value and respect minority rights in all our business decisions.

Our corporate governance philosophy is based on the following principles:

1. Satisfy the spirit of the law and not just the letter of the law. Corporategovernance standards should go beyond the law.

2. Be transparent and maintain high degree of disclosure levels. When indoubt, disclose.

3. Make a clear distinction between personal conveniences and corporate resources.

4. Communicate externally in a truthful manner, about how we run ourcompany internally

5. Comply with the laws in all the countries in which we operate.

6. Have a simple and transparent corporate structure driven solely by thebusiness needs.

7. Management is the trustee of the shareholders' capital and not the owner.

At the core of our corporate governance practice is the board, which overseashow the management serves and protects the long-term interests of all thestakeholders of the company We believe that an active, well-informed andindependent board is necessary to ensure the highest standards of corporategovernance. Majority of our board - 8 out of 15 - are independent members.Further, we have a compensation, a nomination and an audit committee, whichare fully comprised of independent directors.

As a part of Infosys' commitment to follow global best practices, we complywith the Euro shareholders Corporate Governance Guidelines 2000, and therecommendations of the Conference Board Commission on Public Trusts andPrivate Enterprises in the US. Your company also adheres to the UN GlobalCompact Programme. Further, a note on Infosys' compliance with the corporategovernance guidelines of six countries - in their national languages - ispresented in the chapter entitled Financial statements prepared in substantialcompliance with GAAP requirements of Australia, Canada, Prance, Germany,Japan and the United Kingdom, and reports of compliance with the respectivecorporate governance standards.

Corporate Governance Guidelines

Over the course of many years, the board has developed corporate governanceguidelines to help fulfill its corporate responsibility to various stakeholders. Thisensures that the board will have the necessary authority and practices in placeto review and evaluate the company operations as and when needed. Further, itallows the hoard to make decisions that are independent of the companymanagement. These guidelines are intended to align the interests of thedirectors and the management with those of the company shareholders.These guidelines may be changed from time to time by the board in order toeffectively achieve its stated objectives.


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A) BOARD COMPOSITION

1. Size and Composition of the Board

The current policy is to have an appropriate mix of executive and independentdirectors to maintain the independence of the board, and to separate the boardfunctions of governance and management. The board consists of fifteenmembers, seven of whom are executive or whole-time directors, and eight areindependent directors. Five of the executive directors are founders of thecompany The board believes that the current size is appropriate based on thecompany present circumstances. The board periodically evaluates the need forincreasing or decreasing its size.

Table 1 gives the composition of Infosys' board, and the number of outsidedirectorships held by each of the directors.

Table 1: Composition of the board, and external directorships held during FY 2003

2. Responsibilities of the Chairman, CEO and the COO

The current policy of the company is to have a chairman and chief Mentor -Mr. N. R. Narayana Murthy; a chief Executive Officer (CEO), President andManaging Director - Mr. Nandan M. Nilekani; and a Chief Operating Officer(COO) and Deputy Managing Director - Mr. S. Gopalakrishnan. There areclear demarcations of responsibility and authority between the three.

� The Chairman and Chief Mentor is responsible for mentoring Infosys' coremanagement team in transforming the company into a world-class, next-generation organization that provides state-of-the-art technology-leveragedbusiness solutions to corporations across the world. He also interacts withglobal thought-leaders to enhance the leadership position of Infosys. Inaddition, he continues to interact with various institutions to highlight and tohelp bring about the benefits of IT to every section of society As chairmanof the board, he is also responsible for all board matters.

� The CEO, President and Managing Director is responsible for corporatestrategy, brand equity, planning, external contacts and other managementmatters. He is also responsible for achieving the annual business plan.

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Investors Relations� The COO and Deputy Managing Director is responsible for all customerservice operations. He is also responsible for technology; new initiatives,acquisitions and investments.

The Chairman, CEO, COO, the other executive directors and the seniormanagement make periodic presentations to the board on their responsibilities,performance and targets.

3. Broad Definition of Independent Directors

According to Clause 49 of the Listing Agreement with Indian stock exchanges,an independent director means a person other than an officer or employee ofthe company or its subsidiaries or any other individual having a materialpecuniary relationship or transactions with the company which, in the opinion ofthe company's board of directors, would interfere with the exercise ofindependent judgment in carrying Out the responsibilities of a director.

Infosys adopted a much stricter definition of independence as required by theNASDAQ listing rules and the Sarbanes-Oxley Act, US. The same is providedin the Audit charter section of this Annual Report.

4. Board Membership Criteria

The nominations committee works with the entire board to determine theappropriate characteristics, skills and experience for the board as a whole aswell as its individual members. Board members are expected to possess theexpertise, skills and experience required to manage and guide a high-growth, hi-tech, software company deriving revenue primarily from G-7 countless.Expertise in strategy, technology, finance, quality and human resources isessential. Generally, they will be between 40 and 60 years of age. They willnot be relatives of an executive director or of an independent director. Theyare generally not expected to serve in any executive or independent position inany company that is in direct competition with Infosys. Board members areexpected to rigorously prepare for, attend, and participate in all board andapplicable committee meetings. Each board member is expected to ensure thattheir other current and planned future commitments do not materially interferewith the member responsibility as a director of Infosys.

5. Selection of New Directors

The board is responsible for the selection of any new director. The boarddelegates the screening and selection process involved in selecting the newdirectors to the nominations committee, which consists exclusively ofindependent directors. The nominations committee makes recommendations tothe board on the induction of any new member.

6. Membership Term

The board constantly evaluates the contribution of its members, andrecommends to shareholders their re-appointment periodically as per statute.The current law in India mandates the retirement of one-third of the boardmembers (who are liable to retire by rotation) every year, and qualifies theretiring members for re-appointment. Executive directors are appointed by theshareholders for a maximum period of five years at a time, but are eligible forre-appointment upon completion of their term. Non-executive directors do nothave a specified term, but retire by rotation as per law. The nominationscommittee of the board recommends such appointments and / or re-appointments. However, the membership term is limited by the retirement agefor the members.


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7. Retirement Policy

Under this policy, the maximum age of retirement of all executive directors is60 years, which is the age of superannuation for the employees of thecompany. Their continuation as members of the board upon superannuation /retirement is determined by the nominations committee. The age limit forserving on the board is 65 years.

8. Succession Planning

The nominations committee constantly works with the board to evolvesuccession planning for the positions of the Chairman, CEO and COO, as wellas to develop plans for interim succession for any of them, in case of anunexpected occurrence. The board, as required, may more frequently reviewsuccession planning.

9. Board Compensation Review

The compensation committee determines and recommends to the board thecompensation payable to the directors. All board-level compensation is approvedby shareholders, and separately disclosed in the financial statements.

Remuneration of the executive directors consists of a fixed component and aperformance incentive. The compensation committee makes a quarterlyappraisal of the performance of the executive directors based on a detailedperformance-related matrix. The annual compensation of the executive directorsis approved by the compensation committee, within the parameters set by theshareholders at the shareholders meetings.

Compensation payable to each of the independent directors is limited to a fixedamount per year as determined and approved by the board - the sum of whichis within the limit of 0.5% of the net profits of the company for the year,calculated as per the provisions of the Companies Act, 1956. The compensationpayable to independent directors and the method of calculation are disclosedseparately in the financial statements.

Those executive directors who are founders of the company have voluntarilyexcluded themselves from the 1994 Stock Offer Plan, the 1998 Stock OptionPlan and the 1999 Stock Option Plan. Independent directors are also not eligiblefor stock options under these plans, except for the latest 1999 Stock OptionPlan. Table 2a gives the compensation of each director; and Table 2b gives thegrant of stock options to directors.

10. Memberships of other Boards

Executive directors are excluded from serving on the board of any other entity,unless these are corporate or government bodies whose interests are germaneto the future of the software business, or are key economic institutions of thenation, or whose prime objective is that of benefiting society Independentdirectors are not expected to serve on the boards of competing companies.Other than this, there are no limitations on them save those imposed by lawand good corporate governance practices. The number of outside directorshipsheld by each director of Infosys is given in Table 1 above.

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Investors RelationsTable 2a: Cash compensation to the directors for FY 2003in Rs. crore

Table 2b: Grant of stock options to directors during FY 2003

Name of directors Salary Performance Commission Sitting fees Total Notice periodincentive/bonus payable (in months) (in months)

N.R. Narayana Murthy 0.19 – – – 0.19 6Nandan M. Nilekani 0.19 – – – 0.19 6S. Gopalakrishnan 0.19 – – – 0.19 6Deepak M. Satwalekar – – 0.12 0.01 0.13 NAProf. Marti G. Subrahmanyam – – 0.12 0.01 0.13 NAPhilip Yeo – – 0.12 NA 0.12 NAProf. Jitendra Vir Singh ** – – 0.28 0.01 0.30 NADr. Omkar Goswami – – 0.12 0.01 0.13 NASen. Larry Pressler – – 0.12 0.01 0.13 NARama Bijapurkar – – 0.12 0.01 0.13 NAClaude Smadja – – 0.12 0.01 0.13 NAK. Dinesh 0.19 – – – 0.19 6S. D. Shibulal 1.25 – – – 1.25 6T. V. Mohandas Pai 0.18 – – – 0.18 6Phaneesh Murthy • 3.73 – – – 3.73 NASrinath Batni 0.17 – – – 0.17 6

* Resigned on July 23, 2002** Resigned effective April 12, 2003None of the above is eligible for any severance pay.

Name of director Number of options Grant price Expiry date(1999 ESOP) (in Indian Rs.)

Claude Smadja 2,000 3,333.65 July 09, 2012

The above options were issued at fair market value. The options granted will vest over a period of four yearsfrom the date of grant.


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B) BOARD MEETINGS

1. Scheduling and Selection of Agenda Items for Board Meetings

Dates for the board meetings in the ensuing year are decided in advance andpublished as part of the Annual Report. Most board meetings are held at thecompany registered office at Electronics City, Bangalore, India. The Chairmanof the board and the company secretary draft the agenda for each meeting,along with explanatory notes, and distribute these in advance to the directors.Every board member is free to suggest the inclusion of items on the agenda.The board meets at least once a quarter to review the quarterly results andother items on the agenda, and also on the occasion of the annual shareholders'meeting. When necessary, additional meetings are held. Independent directorsare expected to attend at least four board meetings in a year. Committees ofthe board usually meet the day before the formal board meeting, or whenrequired for transacting business.

There were six board meetings held during the year ended March 31, 2002.These were on April 10, 2002, June 8, 2002 (coinciding with last year AnnualGeneral Meeting of the shareholders), July 10, 2002, October 10, 2002,December 8, 2002 and January 10, 2003.

2. Availability of Information to the Members of the Board

The board has unfettered and complete access to any information within thecompany, and to any employee of the company. At meetings of the board, itwelcomes the presence of managers who can provide additional insights intothe items being discussed.

The information regularly supplied to the board includes:

� annual operating plans and budgets, capital budgets, updates;

� quarterly results of the company and its operating divisions or businesssegments;

� minutes of meetings of audit, compensation, nomination, investors grievance andinvestment committees, as well as abstracts of circular resolutions passed;

� general notices of interest;

� declaration of dividend;

Table 3: Number of board meetings and the attendance of directors during FY 2003

Name of directors Number of board Number of board Whether attendedmeetings held meetings attended last AGM

N. R. Nasrayana Murthy 6 6 YesNandan M. Nilekani 6 6 YesS. Gopalakrishnan 6 6 YesDeepak M. Satwalekar 6 6 YesProf. Marti G. Subrahmanyam 6 5 YesPhilip Yeo 6 3 NoProf. Jitendra Vir Singh ** 6 5 YesDr. Omkar Goswami 6 5 YesSen. Larry Pressler 6 5 YesRama Bijapurkar 6 5 YesClaude Smadja 6 4 NoK. Dinesh 6 6 YesS. D. Shibulal 6 5 YesT. V. Mohandas Pai 6 6 YesPhaneesh Murthy * 3 3 YesSrinath Batni 6 5 Yes

* Resigned on July 23, 2002** Resigned effective April 12, 2003

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� information on recruitment and remuneration of senior officers just belowthe board level including appointment or removal of CFO and companysecretary;

� materially important litigations, show cause, demand, prosecution and penaltynotices;

� fatal or serious accidents or dangerous occurrences, any material effluent orpollution problems;

� any materially relevant default in financial obligations to and by thecompany or substantial non-payment for goods sold by the company;

� any issue which involves possible public or product liability claims of asubstantial nature;

� details of any joint venture or collaboration agreement;

� transactions that involve substantial payment towards goodwill, brand equityor intellectual property;

� significant development on the human resources front;

� sale of material nature, of investments, subsidiaries, assets, which is not inthe normal course of business;

� details of foreign exchange exposure and the steps taken by management tolimit the risks of adverse exchange rate movement; and

� non-compliance of any regulatory statutory nature or listing requirements aswell as shareholder services such as non-payment of dividend and delays inshare transfer.

3. Independent Directors' Discussion

The board's policy is to regularly have separate meetings with independentdirectors to update them on all business-related issues and new initiatives. Insuch meetings, the executive directors and other senior management personnelmake presentations on relevant issues.In addition, the independent directors of the company will meet periodically inexecutive session i.e. without the chairman, any of the executive directors orthe management being present.

4. Materially Significant Related Party Transactions

There have been no materially significant related party transactions, pecuniarytransactions or relationships between Infosys and its directors, management,subsidiary or relatives except for those disclosed in the financial statements forthe year ended March 31, 2003.

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C) BOARD COMMITTEES

Currently, the board has six committees - the audit committee, thecompensation committee, the nominations committee, the investors grievancecommittee, the investment committee and the share transfer committee. Thefirst three consist entirely of independent directors. The investors grievancecommittee is composed of an independent, non-executive chairman and someexecutive and non-executive directors. The investment committee and the sharetransfer committee consist of all executive directors.

The board is responsible for the constituting, assigning, co-opting and fixing ofterms of service for committee members to various committees, and itdelegates these powers to the nominations committee.

The chairman of the board, in consultation with the company secretary of thecompany and the committee chairman, determines the frequency and durationof the committee meetings. Normally all the committees meet four times a yearexcept the investment committee and the share transfer committee, which meetas and when the need arises. Typically the meetings of the audit, compensationand nominations committees last for the better part of a working dayRecommendations of the committee are submitted to the full board forapproval.

The quorum for meetings is either two members or one-third of the membersof the committees, whichever is higher.

1. Audit Committee

In India, Infosys is listed on the stock Exchange, Mumbai (or the BSE), theNational Stock Exchange (N5E) and the Bangalore Stock Exchange (BgSE). Inthe US, it is listed on the NASDAQ. In India, Clause 49 of the ListingAgreement makes it mandatory for listed companies to adopt an appropriateaudit committee charter. The Blue Ribbon Committee set up by the USSecurities and Exchange Commission (SEC) recommended that every listedcompany adopt an audit committee charter, which has been adopted byNA5DAQ.

In its meeting on May 27, 2000, Infosys' audit committee adopted a charterwhich meets the requirements of Clause 49 of the Listing Agreement withIndian stock exchanges and the SEC. It is given below.

The audit committee of Infosys comprises six independent directors. They are:

Mr. Deepak M. Satwalekar, Choirmon

Ms. Rams Bijapurkar

Dr. Omkar Goswami

Sen. Larry Pressler

Mr. Claude Smadja

Prof. Marti G. Subrahmanysm

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1.1 Audit Committee Charter

1. Primary Objectives of the Audit Committee

The primary objective of the audit committee (the "committee") of InfosysTechnologies Limited (the "Company") is to monitor and provide effectivesupervision of the management's financial reporting process with a view toensure accurate, timely and proper disclosures and the transparency integrityand quality of financial reporting.

The committee oversees the work carried out in the financial reporting process- by the management, including the internal auditors and the independent auditor- and notes the processes and safeguards employed by each.

2. Responsibilities of the Audit Committee

2.1 Provide an open avenue of communication between the independentauditor, internal auditor, and the board of directors

2.2 Meet four times every year or more frequently as circumstances require.The audit committee may ask members of the management or others toattend meetings and provide pertinent information as necessary

2.3 Confirm and assure the independence of the external auditor andobjectivity of the internal auditor.

2.4 Appoint, compensate and oversee the work of the independent auditor(including resolving disagreements between management and theindependent auditors regarding financial reporting) for the purpose ofpreparing or issuing an audit report or related work.

2.5 Review and pre-approve all related party transactions in the Company forthis purpose, the committee may designate one member who shall beresponsible for pre-approving related party transactions.

2.6 Review with the independent auditor the co-ordination of audit efforts toassure completeness of coverage, reduction of redundant efforts, and theeffective use of all audit resources.

2.7 Consider and review with the independent auditor and the management:

(a) The adequacy of internal controls including computerized informationsystem controls and security; and

(b) Related findings and recommendations of the independent auditor andinternal auditor together with the management's responses.

2.8 Consider and if deemed fit, pre-approve all non-auditing services to beprovided by the independent auditor to the Company For the purpose ofthis clause, "non-auditing services" shall mean any professional servicesprovided to the Company by the independent auditor, other than thoseprovided to the company in connection with an audit or a review of thefinancial statements of the Company and includes (but is not limited to):

– Bookkeeping or other services related to the accounting records offinancial statements of the Company;

– Financial information system design and implementation;

– Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;

– Actuarial services;

– Internal audit outsourcing services;

– Management functions or human resources;

– Broker or dealer, investment advisor, or investment banking services;

– Legal services and expert services unrelated to the audit; and

– Any other service that the BoD determines is impermissible.

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2.9 Review and discuss with the management and the independent auditors,the annual audited financial statements and quarterly unaudited financialstatements, including the Company's disclosures under "ManagementDiscussion and Analysis of Financial Condition and Results of Operations"prior to filing the Company Annual Report on Form 20-F and QuarterlyResults on Form 6-K, respectively with the SEC.

2.10 Direct the Company independent auditors to review before filing with theSEC the Company interim financial statements included in QuarterlyReports on Form 6-K, using professional standards and procedures forconducting such reviews.

2.11 Conduct a post-audit review of the financial statements and audit findings,including any significant suggestions for improvements provided tomanagement by the independent auditors.

2.12 Review before release, the unedited quarterly operating results in theCompany quarterly earnings release.

2.13 Oversee compliance with the requirements of the SEC and SEBI, as thecase maybe, for disclosure of auditor's services and audit committeemembers, member qualifications and activities.

2.14 Review, approve and monitor the code of ethics that the Company plansfor its senior financial officers.

2.15 Review management monitoring of compliance with the Companystandards of business conduct and with the Foreign Corrupt Practices Act.

2.16 Review, in conjunction with counsel, any legal matters that could have asignificant impact on the Company financial statements.

2.17 Provide oversight and review at least annually of the Company riskmanagement policies, including its investment policies.

2.18 Review the Company compliance with employee benefit plans.

2.19 Oversee and review the Company policies regarding informationtechnology and management information systems.

2.20 If necessary, institute special investigations with full access to all books,records, faculties and personnel of the Company

2.21 As appropriate, obtain advice and assistance from outside legal,accounting or other advisors.

2.22 Review its own charter, structure, processes and membership requirements.

2.23 Provide a report in the Company proxy statement in accordance with therules and regulations of the SEC.

2.24 Establish procedures for receiving, retaining and treating complaintsreceived by the Company regarding accounting, internal accountingcontrols or auditing matters and procedures for the confidential,anonymous submission by employees of concerns regarding questionableaccounting or auditing matters.

2.25 Consider and review with the management, internal auditor and theindependent auditor:

(a) Significant findings during the year, including the status of previousaudit recommendations;

(b) Any difficulties encountered in the course of audit work including anyrestrictions on the scope of activities or access to requiredinformation;

(c) Any changes required in the planned scope of the internal audit plan.

2.26 Report periodically to the BoD on significant results of the foregoingactivities.

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3. Composition of the Audit Committee

3.1 The committee shall consist solely of 'independent' directors (as defined in(i) NASOAQ Rule 4200 and (ii) the rules of the Securities and ExchangeCommission) of the Company and shall be comprised of a minimum of threedirectors. Each member will be able to read and understand fundamentalfinancial statements, in accordance with the NASOAQ National Market AuditCommittee requirements. They should be diligent, knowledgeable, dedicated,interested in the job and willing to devote a substantial amount of time andenergy to the responsibilities of the committee, in addition to BoDresponsibilities. At least one of the members shall be a "Financial Expert" asdefined in Section 407 of the Sarbanes-Oxley Act. The members of thecommittee shall be elected by the BoD and shall continue until their successorsare duly elected. The duties and responsibilities of a member are in addition tothose applicable to a member of the BoD. In recognition of the time burdenassociated with the service and, with a view to bringing in fresh insight, thecommittee may consider limiting the term of the audit committee service, byautomatic rotation or by other means. One of the members shall be elected asthe chairman, either by the full BoD or by the members themselves, bymajority vote.

4. Relationship with Independent and Internal Auditors

4.1 The committee has the ultimate authority and responsibility to select,evaluate, and, where appropriate, replace the independent auditors inaccordance with law. All possible measures must be taken by the committee toensure the objectivity and independence of the independent auditors. Theseinclude:

– reviewing the independent auditors' proposed audit scope, approach andindependence;

– obtaining from the independent auditors periodic formal written statementsdelineating all relationships between the auditors and the company consistentwith applicable regulatory requirements and presenting this statement to the BoD;

– actively engaging in dialogues with the auditors with respect to anydisclosed relationships or services that may impact their objectivity andindependence and I or recommend that the full BoD take appropriate actionto ensure their independence;

– encouraging the independent auditors to open and frank discussions on theirjudgments shout the quality, not just the acceptability of the companyaccounting principles as applied in its financial reporting. This includes suchissues as the clarity of the company's financial disclosures, and degree ofaggressiveness or conservatism of the company accounting principles andunderlying estimates, and other significant decisions made by themanagement in preparing the financial disclosure and audited by them;

– carrying out the attest function in conformity with US GAAS, to performan interim financial review as required under Statement of AuditingStandards 71 of the American Institute of Certified Public Accountants andalso discuss with the committee or its chairman, and an appropriaterepresentative of Financial Management and Accounting, in person or bytelephone conference call, the matters described in SAS 61,Communications with the Committee, as amended by SAS 90 AuditCommittee Communication prior to the company filing of its Form 6-K (andpreferably prior to any public announcement of financial results), includingsignificant adjustments, management judgment and accounting estimates,significant new accounting policies, and disagreements with management; and

– reviewing reports submitted to the audit committee by the independentauditors in accordance with the applicable SEC requirements.

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4.2 The internal auditors of the company are in the best position to evaluateand report on the adequacy and effectiveness of the internal controls. Keepingin view the need for the internal auditors' independence from management inorder to remain objective, a formal mechanism should be created to facilitateconfidential exchanges between the internal auditors and the committee,regardless of irregularities or problems. The work carried out by each of theseauditors needs to be assessed and reviewed with the independent auditors andappropriate recommendations made to the BoD.

5. Disclosure Requirements

5.1 The committee charter should be published in the annual report once everythree years and also whenever any significant amendment is made to thecharter.

5.2 The committee shall disclose in the company Annual Report whether or not,with respect to the concerned fiscal year:

– the management has reviewed the audited financial statements with thecommittee, including a discussion of the quality of the accountingprinciples as applied and significant judgments affecting the companyfinancial statements;

– the independent auditors have discussed with the committee theirjudgments of the quality of those principles as applied and judgmentsreferred to the above under the circumstances;

– the members of the committee have discussed among themselves,without the management or the independent auditors being present, theinformation disclosed to the committee as described above;

– with the committee, in reliance on the review and discussions conductedwith management and the independent auditors pursuant to therequirements above, believes that the company's financial statementsare fairly presented in conformity with Generally Accepted AccountingPrinciples ("GAAP") in all material respects; and

– the committee has satisfied its responsibilities in compliance with its charter

5.3 The committee shall secure compliance that the BoD has affirmed to theNASD / Amex Stock Exchange on the following matters, as required interms of the relevant NASD I Amex rules:

– Composition of the committee and independence of committee members;

– Disclosures relating to non-independent members;

– Financial literacy and financial expertise of members; and

– Review of the committee charter.

5.4 The committee shall report to shareholders as required by the relevant rulesof the Securities and Exchange Commission ("SEC") of the United States.

6. Meetings and Reports

6.1 The Committee shall meet at least four rimes a year

6.2 The Committee will meet separately with the CEO and separately with theCEO of the Company at such times as are appropriate to review thefinancial affairs of the Company The audit committee will meet separatelywith the independent auditors and internal auditors of the Company at suchtimes as it deems appropriate (but not less than quarterly) to fulfill theresponsibilities of the Audit Committee under this Charter

6.3 In addition to preparing the report in the Company proxy statement inaccordance with the rules and regulations of the SEC, the committee willsummarize its examinations and recommendations to the Board of Directorsas may be appropriate, consistent with the committee's charter.

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7. Delegation of Authority

7.1 The committee may delegate to one or more designated members of thecommittee the authority to pre-approve audit and permissible non-auditservices, provided such pre-approval decision is presented to the full auditcommittee at its scheduled meetings.

8. Definitions

8.1 Independent MemberIn order to be 'independent', members should have no relationship with thecompany that may interfere with the exercise of their independence from themanagement and the company The following persons are not consideredindependent:

– a director who is employed by the company or any of its affiliates for thecurrent year or any of the past five years;

– a director who has been a former partner or employee of the independentauditor who worked on the company audit engagement in the current yearor any of the past five years;

– a director who accepts any compensation from the company or any of itsaffiliates in excess of $60,000 during the previous fiscal year, other thancompensation for board service, benefits under a tax-qualified retirementplan, or non-discretionary compensation in the current year or any of thepast five years;

– a director who is a member of the immediate family of an individual whois, or has been, in any of the past three years, employed by the corporationor any of its affiliates as an executive officer. "Immediate family" includesa person's spouse, parents, children, siblings, mother-in-law; father-in-law,brother-in-law, sister-in-law, son-in-law, daughter-in-law, and anyone whoresides in such person home;

– a director who is a partner in, or a controlling shareholder or an executiveofficer of, any for-profit business organization to which the companymade, or from which the company received, payments (other than thosearising solely from investments in the company securities) that exceed5% of the company or business organization's consolidated grossrevenues for that year, or $200,000, whichever is more, in any of the pastfive years;

– a director who is employed as an executive of another entity where any ofthe company's executives serve on that entity compensation committee forthe current year or any of the past five years; and

– a shareholder owning or controlling 20% or more of the company votingsecurities.

8.2 Financial Expert'Financial Expert' means one, who has through education and experience as apublic accountant or auditor or a principal financial officer, comptroller or

Investors Relations

1.2 Table 4: Audit Committee Attendance during FY 2003

Name of audit committee member No. of meetings held No. of meetings attended

Deepak M. Satwalekar 4 4Prof. Marti G. Subrahmanyam 4 4Dr. Omkar Goswami 4 4Sen. Larry Pressler 4 4Rama Bijapurkar 4 4Claude Smadja 4 4

Four audit committee meetings were held during the year. These were held on April 9, 2002, July 9,2002, October 9, 2002 and January 9, 2003.


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principal accounting officer of a company (or from a position involving similarfunctions), an understanding of generally accepted accounting principles andfinancial statements, experience in preparing or auditing financial statement ofcomparable companies and in applying generally accepted accounting principlesin connection with the accounting for estimates, accruals and reserves,experience with internal accounting controls, and an understanding of auditcommittee functions.

1.3 Audit Committee Report for the year ended March 31, 2003

Each member of the committee is an independent director, according to thedefinition laid down in the audit committee charter given above, and Clause 49of the Listing Agreement with the relevant Indian stock exchanges.

Management is responsible for the company internal controls and the financialreporting process. The independent auditors are responsible for performing anindependent audit of the company financial statements in accordance with thegenerally accepted auditing standards, and for issuing a report thereon. Thecommittee's responsibility is to monitor these processes. The committee is alsoresponsible to oversee the processes related to the financial reporting andinformation dissemination, in order to ensure that the financial statements aretrue, correct, sufficient and credible. In addition, the committee recommends tothe board the appointment of the company internal and statutory auditors.

In this context, the committee discussed with the company auditors the overallscope and plans for the independent audit. Management represented to thecommittee that the company financial statements were prepared in accordancewith Generally Accepted Accounting Principles. The committee discussed withthe auditors, in the absence of the management (whenever necessary), thecompany's audited financial statements including the auditor's judgments aboutthe quality, not just the applicability, of the accounting principles, thereasonableness of significant judgments and the clarity of disclosures in thefinancial statements.

The committee also discussed with the auditors other matters required by theStatement on Auditing Standards No.6 1 (SAS 61)- Communication with auditcommittees, as amended by SAS 90 - Audit committee communication.

Relying on the review and discussions conducted with the management and theindependent auditors, the audit committee believes that the company financialstatements are fairly presented in conformity with Generally AcceptedAccounting Principles in all material aspects.

The committee also reviewed the internal controls put in place to ensure thatthe accounts of the company are properly maintained and that the accountingtransactions are in accordance with prevailing laws and regulations. Inconducting such reviews, the committee found no material discrepancy orweakness in the internal control systems of the company

The committee also reviewed the financial and risk management policies of thecompany and expressed its satisfaction with the same.

The company auditors provided to the committee the written disclosuresrequired by Independence Standards Board Standard No. 1 - 'Independencediscussions with audit committees', based on which the committee discussed theauditors' independence with both the management and the auditors. Afterreview, the committee expressed its satisfaction on the independence of boththe internal and the statutory auditors.

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Moreover, the committee considered whether any non-audit consulting servicesprovided by the auditor's firm could impair the auditor's independence, andconcluded that there was no such materially significant service provided.

The committee secured compliance that the board of directors has affirmed tothe NASOAQ stock exchange, under the relevant rules of the exchange oncomposition of the committee and independence of the committee members,disclosures relating to non-independent members, financial literacy and financialexpertise of members, and a review of the audit charter.

Based on the committee discussion with management and the auditors and thecommittee's review of the representations of management and the report of theauditors to the committee, the committee has recommended to the board ofdirectors that:

1. The audited financial statements prepared as per Indian GAAP for the yearended March 31, 2003 be accepted by the board as a true and fairstatement of the financial health of the company; and

2. The audited financial statements prepared as per US GAAP and to beincluded in the company Annual Report on Form-20F for the fiscal yearended March 31, 2003 be filed with the Securities and ExchangeCommission.

The committee has recommended to the board the appointment of Bharat S.Raut & Co., Chartered Accountants, as the statutory and independent auditorsof the company for the fiscal year ending March 31, 2004, and that that thenecessary resolutions for appointing them as auditors be placed before theshareholders. The committee has also recommended to the board theappointment of KPMG as independent auditors of the company for the USGAAP financial statements, for the financial year ending March 31, 2004.

The committee recommended the appointment of internal auditors to reviewvarious operations of the company, and determined and approved the feespayable to them.

The committee has also issued a letter in line with recommendation No. 9 ofthe Blue Ribbon Committee on audit committee effectiveness, which has beenprovided in the Financial statements prepared in accordance with US GAAFsection of this Annual Report.

In conclusion, the committee is sufficiently satisfied that it has complied with itsresponsibilities as outlined in the Audit committee charter.

Sd/-Bangalore Deepak M. SatwalekarApril 9, 2003 Chairman, Audit committee

2. Compensation Committee

The compensation committee of Infosys consists entirely of non-executive,independent directors:Prof. Marti C. Subrahmanyam, ChairmanDr. Omkar GoswamiMr. Deepak M. SatwalekarProf. Jitendra Vir Singh (resigned effective April 12, 2003)Mr. Philip Yea

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2.1 Compensation Committee Charter

Purpose

The purpose of the compensation committee of the board of directors (the"Board") of Infosys Technologies Limited (the "Company") shall be to dischargethe Board responsibilities relating to compensation of the Company executivedirectors and senior management. The committee has overall responsibility forapproving and evaluating the executive directors and senior managementcompensation plans, policies and programs of the Company

The compensation committee is also responsible for producing an annualreport on executive compensation for inclusion in the Company proxystatement.

Committee membership and organization

The compensation committee will be appointed by and will serve at thediscretion of the Board. The compensation committee shall consist of no fewerthan three members. The members of the compensation committee shall meetthe (i) independence requirements of the listing standards of the NASDAQ, (ii)non-employee director definition of Rule 16b-3 promulgated under Section 16 ofthe Securities Exchange Act of 1934, as amended, and (iii) the outside directordefinition of Section 162(m) of the Internal Revenue Code of 19B6, asamended.

The members of the compensation committee will be appointed by the Boardon the recommendation of the nomination committee. Compensation committeemembers will serve at the discretion of the Board.

Committee responsibilities and authority

The compensation committee shall annually review and approve for the CEOand the executive directors and senior management of the Company (a) theannual base salary, (b) the annual incentive bonus, including the specific goalsand amount, (c) equity compensation, (d) employment agreements, severancearrangements, and change in control agreements I provisions, and (e) any otherbenefits, compensation or arrangements.

The compensation committee in consultation with the CEO, shall review theperformance of all the executive directors each quarter basis on the basis ofdetailed performance parameters set for each of the executive directors at thebeginning of the year. The compensation committee may, from time to time,also evaluate the usefulness of such performance parameters, and makenecessary amendments.

The compensation committee is responsible far administering the Companystock option plans, including the review and grant of eligible employees underthe plans.

The compensation committee may also make recommendations to the boardwith respect to incentive compensation plans. The compensation committee mayform subcommittees and delegate authority to when appropriate.

The compensation committee shall make regular reports to the Board.

The compensation committee shall review and reassess the adequacy of thischarter annually and recommend any proposed changes to the Board forapproval.

The compensation committee shall annually review its own performance.

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The compensation committee shall have the sole authority to retain andterminate any compensation consultant to be used by the Company to assist inthe evaluation of CEO, executive directors or senior management compensationand shall have the sole authority to approve the consultant's fees and otherretention terms. The compensation committee shall also have the authority toobtain advice and assistance from internal or external legal, accounting or otheradvisors.

2.3 Compensation Committee Report for the year ended March 31, 2003

The committee reviewed the performance of all executive directors andapproved the compensation payable to them for fiscal 2004, within the overalllimits approved by the shareholders. The committee also reviewed and approvedthe compensation proposed for all the management council members for fiscal2004. The committee also reviewed the grant of stock options on a sign-on andregular basis to various employees of the company during the year.

The committee believes that the proposed compensation and benefits, along withstock options, are adequate to motivate and retain the senior officers of thecompany

The committee took on record the compensation committee charter in itsmeeting held on October 9, 2002.

Save as disclosed, none of the directors had a material beneficial interest in anycontract of significance to which the company or any of its subsidiaryundertakings was a party, during the financial year.

Sd/–Bangalore Prof. Math G. SubrahmanyamApril 9, 2003 Chairman, compensation committee

3. Nominations Committee

The nominations committee of the board consists exclusively of the followingnon-executive, independent directors:Mr. Claude Smadja, ChairmanSen. Larry PresslerProf. Jitendra Vir Singh (resigned effective April 12, 2003)Mr. Philip Yeo

3.1 Nominations Committee Charter Purpose

The purpose of the nominations committee is to ensure that the board ofdirectors is properly constituted to meet its fiduciary obligations to shareholdersand the Company To carry Out this purpose, the nominations committee shall:(1) assist the board by identifying prospective director nominees and to select /recommend to the board the director nominees for the next annual meeting ofshareholders; (2) oversee the evaluation of the board and management; and (3)recommend to the board, director nominees for each committee.

Investors Relations2.2 Table 5: Compensation committee attendance during FY 2003

Name of audit committee member No. of meetings held No. of meetings attended

Prof. Marti G. Subrahmanyam 4 4Deepak M. Satwalekar 4 4Philip Yeo 4 3Prof. Jitendra Vir Singh 4 4Dr. Omkar Goswami 4 4

Four compensation committee meetings were held during the year ended March 31, 2003: on April9, 2002, July 9, 2002, October 9, 2002 and January 9, 2003.


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Committee Membership and Organization

� The nominations committee shall be comprised of no fewer than two (2)members.

� The members of the nominations committee shall meet the independencerequirements of the NASDAQ.

� The members of the nominations committee shall be appointed and replacedby the board.

Committee Responsibilities and Authority

� Evaluate the current composition, organization and governance of the boardand its committees as well as determine future requirements and makerecommendations to the board for approval.

� Determine on an annual basis, desired board qualifications, expertise andcharacteristics. and conduct searches for potential board members withcorresponding attributes. Evaluate and propose nominees for election to theboard. In performing these tasks, the Committee shall have the soleauthority to retain and terminate any search firm to be used to identifydirector candidates.

� Oversee the board performance evaluation process including conductingsurveys of director observations, suggestions and preferences.

� Form and delegate authority to subcommittees when appropriate.

� Evaluate and make recommendations to the board concerning theappointment of directors to board committees, the selection of boardcommittee chairs, and proposal of the board slate for election.

� Evaluate and recommend termination of membership of individual directorsin accordance with the board governance principles, for cause or for otherappropriate reasons.

� Conduct an annual review on succession planning, report its findings andrecommendations to the board, and work with the board in evaluatingpotential successors to executive management positions.

� Coordinate and approve board and committee meeting schedules.

� Make regular reports to the board.

� Review and re-examine this charter annually and make recommendations tothe board for any proposed changes.

� Annually review and evaluate its own performance.

� In performing its responsibilities, the Committee shall have the authority toobtain advice, reports or opinions from internal or external counsel andexpert advisors.

3.2 Table 6: Nominations committee attendance during FY 2003

Name of compensation committee Number of meetings Number of meetingsmembers held attended

Claude Smadja 4 4Philip Yeo 4 3Prof. Jitendra Vir Singh 4 4Sen. Larry Pressler 4 4

Four nominations committee meetings were held during the year on April 9, 2002, July 9, 2002,October 9, 2002 and January 9, 2003.

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3.3 Nominations Committee Report for the year ended March 31, 2003

During the year, Mr. Phaneesh Murthy resigned from the directorship of thecompany and the same was taken on record. Also the comittee took on recordthe resignation of Prof. Jitendra Vir Singh effective April 12, 2003.

The committee approved the induction of Mr. Sridar Iyengar as an additionaldirector of the company and also recommended his induction into audit committee.

The committee discussed the issue of the retirement of members of the boardas per statutory requirements. As a third of the members have to retire everyyear based on their date of appointment, Messrs. Srinath Batni, Sen. LarryPressler, Omkar Goswami and Rama Bijapurkar will retire in the ensuingAnnual General Meeting. The committee has recommended the resolution forre-appointment of the retiring directors by the shareholders.

Sd/-Bangalore Claude SmadjaApril 9, 2003 Chairman, nominations committee

4. Investors Grievance Committee

The investors grievance committee is headed by an independent director, andconsists of the following directors:Mr. Philip leo, ChairmanMs. Rama BijapurkarMr. K. DineshMr. Nandan M. NilekaniMr. S. 0. Shibulal

4.2 Investors Grievance Committee Report for the year ended March31, 2003

The committee expresses satisfaction with the company performance in dealingwith investors grievance and its share transfer system. It has also noted theshareholding in dematerialised mode as on March 31, 2003 as being 99.18%.

Sd/-Bangalore Rama BijapurkarApril 9, 2003 Member, investors grievance committee

Investors Relations

4.1 Table 7: Investors grievance committee attendance during FY 2003

Name of compensation committee Number of meetings Number of meetingsmembers held attended

Philip Yeo 4 3Rama Bijapurkar 4 3Nandan M. Nilekani 4 4K. Dinesh 4 4S. D. Shibulal 4 4

Four nominations committee meetings were held during the year on April 9, 2002, July 9, 2002,October 9, 2002 and January 9, 2003.


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5. Investment Committee

The investment committee consists exclusively of executive directors:

Mr. N. R. Narayana Murthy, Chairman

Mr. Nandan M. Nilekani

Mr. S. Gopalakrishnan

Mr. K. Dinesh

Mr. S. D. Shibulal

Mr. T. V Mohandas Pai

Mr. Phaneesh Murthy (resigned on July 23, 2002)

Mr. Srinath Batni

Investment Committee Report for the year ended March 31, 2003

The committee has the mandate to approve investments in various corporatebodies within statutory limits and the powers delegated by the hoard. Duringthe year, the committee approved an investment of USS 2.5 million (Rs. 12.25crore) in Progeon Limited, majority owned subsidiary of Infosys.

Sd/-Bangalore N. R. Narayana MurthyApril 9, 2003 Chairman, investment committee

6. Share Transfer Committee

The share transfer committee consists exclusively of executive directors:Mr. Nandan M. Nilekani, ChairmanMr. K. DineshMr. S. 0. Shibulal

Share transfer committee report for the year ended March 31, 2003

The committee has the mandate to approve all share transfers. During the year,the committee approved transposition with respect to 200 shares andtransmissions with respect to 4,800 shares.

Sd/-Bangalore Nandan M. NilekaniApril 9, 2003 Chairman, share transfer committee

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D) MANAGEMENT REVIEW AND RESPONSIBILITY

1. Formal Evaluation of Officers

The compensation committee of the board approves the compensation andbenefits for all executive board members, as well as members of themanagement council. Another committee headed by the CEO reviews, evaluatesand decides the annual compensation for officers of the company from thelevel of associate vice president, but excluding members of the managementcouncil. The compensation committee of the board administers the 1998 and the1999 Stock Option Plans.

2. Board interaction with Clients, Employees, Institutional Investors,the Government and the Press

The chairman, the CEO and the COO, in consultation with the CPO, handle allinteractions with investors, media, and various governments. The CEO and theCOO manage all interaction with clients and employees.

3. Risk Management

The company has an integrated approach to managing the risks inherent invarious aspects of its business. As part of this approach, the board of directorsis responsible for monitoring risk levels according to various parameters, and themanagement council is responsible for ensuring implementation of mitigationmeasures, if required. The audit committee provides the overall direction on therisk management policies.

4. Management’s Discussion and Analysis

This is given as separate chapters in this Annual Report, according to IndianGAAP and US GAAP financials, respectively

Investors Relations


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E) SHAREHOLDERS

1. Disclosures Regarding Appointment or Re-appointment of Directors

According to the Articles of Association, one-third of the directors retire byRotarian and, if eligible, offer themselves for re-election at the Annual GeneralMeeting of shareholders. As per Article 122 of the Articles of Association,Messrs. Srinath Batni, Sen. Larry Pressler, Omkar Goswami and RamaBijapurkar will retire in the ensuing Annual General Meeting. The board hasrecommended the re-election of all the retiring directors.

In addition, Mr. Sridar Iyengar, who was appointed as an additional directorwith effect from April 10, 2003, is eligible and is offering himself forappointment as independent director of the company

The detailed resumes of all these directors are provided in the notice to theAnnual General Meeting.

2. Communication to Shareholders

Since June 1997, Infosys has been sending to each shareholder, quarterlyreports which contain audited financial statements under Indian GAAP andunaudited financial statements under US GAAP, along with additionalinformation. Moreover, the quarterly and annual results are generally publishedin The Economic Times, The Times of India, Business Standard, Business Line,Financial Express and the Udayavani (a regional body of Bangalore). Quarterlyand annual financial statements, along with segmental information, are pasted onthe company website (w Earnings calls with analysts and investors arebroadcast live on the website, and their transcripts are pasted an the websitesoon thereafter. Any specific presentations made to analysts and others are alsoposted an the company website.

The proceedings of the Annual General Meeting is web-cast live an theInternet to enable shareholders across the world to view the proceedings. Thearchives of the video are also available an the company home page far futurereference to all the shareholders.

3. Investors’ Grievances and Share Transfer

As mentioned earlier, the company has a board-level investors grievancecommittee to examine and redress shareholders' and investors' complaints. Thestatus an complaints and share transfers is reported to the full board. Thedetails of shares transferred and nature of complaints are provided in thefollowing chapter an Additional information to shareholders.

For matters regarding shares transferred in physical form, share certificates,dividends, change of address, etc. shareholders should communicate with KarvyConsultants Limited, the company's registrar and share transfer agent. Theiraddress is given in the section on Shareholder information.

4. Details of Non-compliance

There has been no non-compliance of any legal requirements by the companynor has there been any strictures imposed by any stock exchange, SEBI orSEC, on any matters relating to the capital market over the last three years.

5. General Body Meetings

Details of the last three Annual General Meetings are given in Table 8.

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6. Postal Ballots

For the year ended March 31, 2003, there have been no ordinary or specialresolutions passed by the company's shareholders that require a postal ballot.However, the company has voluntarily decided to comply with the provisions ofpostal ballot for all the resolutions placed before the shareholders in the AGMto be held on June 14, 2003. The detailed instructions are provided in the noticeto the Annual General Meeting.

7. Auditor’s Certificate on Corporate Governance

As required by Clause 49 of the Listing Agreement, the auditor's certificate isgiven as an annexure to the Directors' report.

Investors RelationsTable 8: Date, time and venue of the last three AGMs

Financial year (ended) Date Time Venue

March 31, 2000 May 27, 2000 1500 hrs Taj Residency Hotel, 41/3 M.G.Road, Bangalore, India

March 31, 2001 June 2, 2001 1500 hrs J. N. Tata Auditorium, NationalScience Seminar Complex, IndianInstitute of Science, Bangalore,India

March 31, 2002 June 8, 2002 1500 hrs J. N. Tata Auditorium, NationalScience Seminar Complex, IndianInstitute of Science, Bangalore,India

Date, time and venue of the last EGM

Date Time Venue

February 22, 2003 1500 hrs Taj Residency Hotel, 41/3 M.G. Goad,Bangalore, India


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F) COMPLIANCE WITH THE RECOMMENDATIONS OF THEREPORT OF THE COMMITTEE ON CORPORATE AUDIT ANDGOVERNANCE (NARESH CHANDRA COMMITTEE)

The Government of India by an order dated the 21st August 2002 constituted ahigh level committee under the Chairmanship of Mr. Naresh Chandra toexamine the auditor-company relationship. The committee had since submittedits report to the government. The Government of India has not yet made itmandatory for the Indian companies.

The report contains five chapters. Chapters 2, 3 and 4 which deal with auditor-company relationship, auditing the auditors and independent directors - role,remuneration and training is relevant to your company The chapter one is anintroductory section and chapter 5 relates to regulatory changes. Your companyhas substantially complied with most of these recommendations.

The auditor-company relationship

Recommendation 2.1 – Disqualifications for audit assignments – In line with theinternational best practices, the committee recommends an abbreviated list ofdisqualifications for auditing assignments which includes:

� Prohibition of any direct financial interest in the audit client – Complied with.� Prohibition of receiving any loans and I or guarantees – Complied with.� Prohibition of any business relationship – Complied with.� Prohibition of personal relationships – complied with.� Prohibition of service or cooling off period – Complied with.� Prohibition of undue dependence on an audit client – Not applicable

Recommendation 2.2 – List of prohibited non-audit services – Complied with.

Recommendation 2.3 – Independence standards for consulting andother entities are affiliated to audit firms – Complied with.

Recommendation 2.4 – Compulsory audit partner rotation – Complied with.

Recommendation 2.5 – Auditor’s disclosure of contingent liabilities – Complied with.

Recommendation 2.6 – Auditor’s disclosure of qualifications andconsequent action – Complied with.

Recommendation 2.7 – Management’s certification in the event ofauditor’s replacement – Complied with.

Not applicable, as we do not have any proposal to replace the auditors. TheCompany’s Act is yet to be amended by the government to seek special resolution ofthe shareholders in case of a replacement of an auditor. The audit committee consistingfully of independent directors recommends the appointment of replacement of auditors.

Recommendation 2.8 – Auditor’s annual certification of independence

The audit committee receives the certification of independence from both the internaland statutory auditors every year.

Recommendation 2.9 – Appointment of auditors – Complied with.

Recommendation 2.10 – CEO and CFO certification of annual audited accounts – Complied with.

Auditing the auditors

Recommendation 3.1 – Setting-up of independence quality reviewboard – Not applicable

Recommendation 3.2 – Proposed disciplinary mechanism for auditors – Not applicable

Independent directors: Role, remuneration and training

Recommendation 4.1 – Definition of an independent director – Complied with.

Recommendation 4.2 – Percentage of independent directors – Complied with.

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Investors RelationsRecommendation 4.3 – Minimum board size of listed companies – Complied with.

Recommendation 4.4 – Disclosure on duration of board meetings /committee meetings – Is being

complied withfrom January2003 meetings.

Recommendation 4.5 – Tele-conferencing and video conferencing – At present,the law doesnot permitthis.

Recommendation 4.6 – Additional disclosure to directors

At present, we submit a summary of all the press releases issued during a quarter, toall the external board members, during the board meetings. The presentations made atvarious investors conferences are available on the web. Going forward, the companywould send a compy of all press releases as well as the investor presentations to allthe directors.

Recommendation 4.7 – Independent directors on audit committee oflisted companies – Complied with.

Recommendation 4.8 – Audit committee charter – Complied with.

Recommendation 4.9 – Remuneration of non-executive director – Not applicable

Recommendation 4.10 – Exempting non-executive directors from certain liabilities – Not applicable

Recommendation 4.11 – Training of independent directors – Not applicable

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UNIT 18 FINANCIAL RESTRUCTURINGObjectives


� provide an understanding of concept, motives and dimensions of corporaterestructuring;

� explain concept, forms and motives of mergers;

� assess merger as a source of value addition;

� provide an understanding of criteria for determining exchanges rate;

� explain process entailed in formulating merger and acquisition strategy;

� throw light on divestiture and its financial assessment;

� explain leveraged buyout, leveraged recapitalization, spin-offs, carve-outs,reorganization of capital and financial reconstruction.

Structure

18.1 Introduction

18.2 Corporate Restructuring

18.3 Financial Restructuring

18.4 Assessing Merger as a Source of a Value Addition

18.5 Formulating Merger and Acquisition Strategy

18.6 Regulation of Mergers and Takeovers in India

18.7 Takeover Strategies – Indian Experience

18.8 Divestitures

18.9 Characteristics of and Pre-requisities to Leveraged Buyout Success

18.10 Leveraged Recapitalization

18.11 Reorganization of Capital

18.12 Financial Reconstruction

18.13 Summary

18.14 Key Words



18.1 INTRODUCTION

The world has witnessed tectonic and tumultuous changes during the last twodecades in terms of unification of Germany, rising economic power of Japanand NICs in the world market, dismantling of the erstwhile USSR, emergenceof new trade blocks, realignment of economic forces such as the unification ofthe European Community, the North American Market, ASEAN, etc; formationof WTO and far reaching changes in global trading regulations prescribed by it,growing economic inter dependencies and globalization of markets, free flow ofcapital and knowledge, following economic liberalization, greater interactionsamong different financial systems of different countries, faster growth in worldtrade, integration of world financial markets at unprecedented reforms acrossthe East European and South Asian Countries, and path breaking proliferationand convergence of technologies. These changes along with fast changingdemographies of work force, cataclysmic change in personal, social, familial andcultural values of people and rapidly moving customers tastes have not only


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increased business complexities but also rendered global business scenario muchmore volatile and fairly competitive. To cope with the incredible opportunitiesand enhance share owners’ wealth, business enterprises across the globeembarked on programmes of restructuring and alliance spree Global dealvolume during the historic mergers and alliance wave of 1995 to 2000 totalledmore than $12trillion.

To meet competitive challenges from the foray of multinationals followingliberalization, privatization and globalization and to ensure their survival Indiancorporate giants such as Tatas, A V Birlas, Reliance, HLL, SBI have, of late,pursued, the strategy of restructuring their assets, products, technologies, marketand manpower resulting in spate of mergers and acquisitions in recent years(Table 18.1). Indeed, 2003 has seen the biggest ever rush of Indian corporatesacquiring foreign firms. A V Birla group acquired four companies. Wiproacquired Nerve Wire, Essar group acquired a 3 MT Steel Plant in Thailand,Dabur India having acquired three comanies in the UAE and Bangladesh andMahindra & Mahindra is scouting for a tractor plant in Europe.

Table 18.1: Mergers & Acquisitions

Year No.

1991 285

1992 842

1993 858

1994 872

1995 1208

1996 524

2000 447

2001 395

2002 290

18.2 CORPORATE RESTRUCTURING

A. Concept of Restructuring

Corporate Structuring is a process of redefining the basic line of business anddiscovering a common thread for the firm’s existence and consolidation. Thus,restructuring is a process by which a corporate enterprise seeks to alter what itowes, refocus itself to specific tasks performance. This it does after making adetailed analysis of itself at a point of time. At times restructuring wouldradically alter a firm’s product market mix, capital structure, asset mix andorganization so as to enhance the value of the firm and attain competitive edgeon sustainable basis. While planning for restructuring, the management shouldspecify what type of business the firm can do most effectively. Those business/market areas which offer little or no potential should be removed from thebasic business structure. Others having unsatisfactory earnings, poor competitiveposition or management incapability should also be discontinued.

B. Motives for Restructuring

Corporate enterprises are motivated to restructure themselves in view of thefollowing forces:

� The Government policy of liberalization, privatization and globalizationspurred many Indian organizations to restructure their product mix, market,

Financial Restructuring

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technologies etc. so as to meet the competitive challenges in terms of cost,quality and delivery. Many organizations pursued the strategy of accessingnew market and customer segment. Convertibility of rupee has encouragedmany medium – sized companies to operate in the global market.

� Revolution in information technology facilitated companies to adopt newchanges in the field of communication for improving corporate performance.

� Wrong diversification and divisionalization strategy has led manyorganizations to revamp themselves. New business embraced by companiesin the past had to be dropped because of their irrelevance in the changedenvironment. Product divisions which do not fit into company’s carebusiness are being divested.

� Improved productivity and cost reduction have necessitated downsizing ofthe workforce.

� Another plausible reason for restructuring is improved management. Somecompanies are suffering because of inefficient management. Suchcompanies opted for change in top management.

� At times, organizations are motivated to reorganize their financial structurefor improving the financial strength and improving operating performance.

C. Dimension of Restructuring

Corporate restructuring is a broad umbrella that covers the following:

� Financial Restructuring: This involves decisions pertaining to acquisition,mergers, divestitures, leveraged buyout, leveraged recapitalization,reorganization of capital, etc.

� Technological Restructuring: This involves decisions pertaining toredesigning the business process through revamping existing technologies.

� Market Restructuring: This involves decisions regarding product –market positioning to suit the changed situations.

� Organizational Restructuring: During the post liberalization period manyIndian firms embarked on organizational restructuring programme throughregrouping the existing businesses into a few compact business units,decentralization and delayering, downsizing, outsourcing non-value addingactivities and subcontracting.

You may please note that a good restructuring exercise consists of a mixture ofall these. These alterations have a significant impact on the firm’s balancesheet or by exploiting unused financial capacity.

Activity 1

a) List out the five primary forces that forced Indian corporates to engage inrestructuring exercises.

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b) Name three top business groups in India which embarked on restructuringprogrammes.

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18.3 FINANCIAL RESTRUCTURING

A. Concept of Financial Restructuring

Financial restructuring is the process of reorganizing the company by affectingmajor changes in ownership pattern, asset mix, operations which are outside theordinary course of business. Thus, financial restructuring covers many thingssuch as the mergers and takeovers, divestitures, leveraged, recapitalization, spin-offs, curve-outs, reorganization of capital and financial re-construction. Let usdilate upon each of these aspects.

B. Mergers and Takeovers

Concept

A company intending to acquire another company may buy the assets or stockor may combine with the latter. Thus, acquisition of an organization isaccomplished either through the process of merger or through the takeoverroute.

Merger is combination of two or more companies into a single company whereone survives and the others lose their identity or a new company is formed.The survivor acquires the assets as well as liabilities of the merged company.As a result of a merger, if one company survives and others lose theirindependent entity, it is a case of ‘Absorption’. But if a new company comesinto existence because of merger, it is a process of ‘Amalgamation’.

Takeover is the purchase by one company of a controlling interest in the sharecapital of another existing company. In takeover, both the companies retain theirseparate legal entity. A takeover is resorted to gain control over a companywhile companies are amalgamated to derive advantage of scale of operations,achieve rapid growth and expansion and build strong managerial andtechnological competence so as to ensure higher value to shareowners. Indiantakeover kings are R P Goenka, Chabria, Khaitan, Kumar Mangalam Birla andLondon based Swaraj Paul.

Forms

Horizontal Merger

A horizontal merger is one that takes place between two firms in the same lineof business. Merger of Hindustan Lever with TOMCO and Global TelecomServices Ltd. with Atlas Telecom, GEC with EEC are examples of HorizontalMerger.

Vertical Merger

Vertical Merger takes place when firms in successive stages of the sameindustry are integrated. Vertical Merger may be backward, forward or bothways. Backward merger refers moving closer to the source of raw materials intheir beginning form. Merger of Renusagar Power Supply and Hindalco is acase in point. Forward merger refers to moving closer to the ultimatecustomer. DU Pont acquired a chain of stores that sold chemical products atthe retail level for increased control and influence of its distribution.

Conglomerate Merger

Conglomerate Merger is a fusion in unrelated lines of business. The mainreason for this type of merger is to seek diversification for the survivingcompany. A case in point is the merger of Brooke Bond Lipton with HindustanLever. While the former was mostly into foods, the latter was into detergentsand personal care.


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Reverse Merger

It occurs when firms want to take advantage of tax savings under the IncomeTax Act (Section 72A) so that a healthy and profitable company is allowed thebenefit of carry forward losses when merged with a sick company. Godrejsoaps, which merged with the loss-making Godrej Innovative Chemicals is anexample of reverse merger.

Reverse merger can also occur when regulatory requirements need one tobecome one kind of company or another. For example, the reverse merger ofICICI into ICICI Bank.

Motives for Mergers

� To Avail Operating Economics

Firms are merged to derive operating economies in terms of elimination ofduplicate facilities, reduction of cost, increased efficiency, better utilizationof capacities and adoption of latest technology. Operating economies at thestaff level can be achieved through centralization or combination of suchdepartmental as personnel accounting, advertising and finance which arecommon to both organizations. Merger of Reliance Petrochemicals withReliance Industries was aimed at enhancing shareholders’ value by realizingsignificant synergies of both the companies. Similarly, amalgamation of AseaLtd with Asea Browns Bover (ABB) was intended to avail of the benefitsof rationalization and synergy effects.

� To Achieve Accelerated Growth

Both horizontal and vertical combination take place to achieve growth athigher rate than the one accomplished through its normal process of internalexpansion. In fact, mergers and takeovers have played pivotal role in thegrowth of most of the leading corporations of the world. Nearly two-thirdsof the giant public corporations in the USA are the outcome of mergersand acquisitions.

� To Take Advantage of Complementary Resources

It is in the vital interest of two firms to merge if they have complementaryresources each has each other needs. The two firms are worth moretogether than apart because each acquires something it does not have andgets it cheaper than it would by acting on its own. Also the merger mayopen up opportunities that neither firm would pursue otherwise.

� To Speed Up Diversification

Many companies join together to reduce business risk through diversificationof their operations. By merging with relatively more stable enterprise, acompany prone to wide cyclical swings may be able to minimize the degreeof instability in its earnings and improve its performance. Similarly, a smallcompany may be hesitant to launch a new product with a high potentialmarket because of high risk exposure to the projects, the potential loss willnot be as significant to the surviving company as to the small one. Recentalliances of Jenson and Nicholson India Ltd. with Carl Scheneek A G, andJ K Corporation with Mitel of Canada are examples of acquisition based ondiversification motive.

� To Combat Competitive Threats

Majority of the recent mergers struck in India were motivated to thwartcompetitive challenges both from domestic as well as multinationalcomapnies and achieve competitive edge over the rivals. The fear ofincreasing competitive resulting from the tie up between Procter andGamble and Godrej Soaps forced Hindustan Lever to merge with TOMCO.Recent alliance between Max India and GIST–Brocades has made tocovert potential competitor into a partner.


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� To Access to Latest Technology

Many organizations have, of late, forged alliances with foreign firms so asto gain access to latest product technology cheaply. Tata Telecom tie upwith AT&T, Maruti-Suzuki alliance, Caltex alliance with IBP were madeessentially to secure latest technology.

� To Widen Market Base

In recent few years large number of firms forged alliances with specificpurpose of globalising the firm’s products. Tie-ups between HCL and HPLtd, Tata-IBM, Ranbaxy Laboratories and Eli Lilly, Parle and Coco-Cola,Hindustan Motors and General Motors, DCM Data and Control Data ofUSA, Tata Tea and Tetelay of USA and Onida and JVC have been madeto exploit tremendous market opportunities of foreign countries.

� To Strengthen Financial Position

Another cogent motive for the merger may be to mitigate the financialproblem. A company embarking on the expansion programme may find itsdifficult to satisfy its requirements owing to temporary imbalance in its cashflows, capital structure or working capital position. By joining with a stable,unlevered cash rich company a firm may present a consolidated picture ofthe financial position that will be more appealing to potential investors.Merger of Renu Sagar Power Supply and Hindal Co and ICICI with ICICIBank are cases in point.

� To Avail Tax Shields

A firm with accumulated losses and/or unabsorbed depreciation would liketo merge with a profit making company to utilize tax advantages better fora long time.

� To Utilize Surplus Funds

At times, a firm in a mature industry having generated a substantial amountof cash may not find adequate profitable investment opportunities.Management of such firms may be tempted to acquire another companyshares. Such firms often turn to mergers financed by cash as a way ofredeploying their capital.

� To Acquire Competent Management

When a firm finds that it is not a position to hire top quality managementand that it has none to come up through the ranks, it may seek mergerwith a firm endowed with sapient and savvy management.

� To Strengthen Controlling Power

Acquisition of profit making companies by Indian businessmen like KumarMangalam Birla, Ratan Tata, Mukesh Ambani, R P Goenka, G P Goenka,Piramals, Modis, Ruias, Khaitan, etc. took place to get hold of thecontrolling interest through open offer of market prices.

18.4 ASSESSING MERGER AS A SOURCE OFVALUE ADDITION

While taking decision whether to acquire a firm, finance manager of a firmmust ensure that this step would add value to the firm. For this purpose hehas to follow the procedure laid down below:

(i) Determine if there is an economic gain from the merger. There is aneconomic gain only if the two firms are worth more together thanapart. Thus, economic gain of the merger is the difference betweenthe present value (PV) of the combined entity (Pvxy) and the presentvalue of the two entities if they remain separate (Pvx + pvy). Hence,

Gain = Pvxy – (Pvx+Pvy)


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(ii) Determine the cost of acquiring firm Y. If payment is made in cash,the cost of acquiring Y is equal to the cash payment minus Y’s valueas a separate entity. Thus,

Cost = Cash paid – Pvy

(iii) Determine the net present value to X of a merger with Y. It ismeasured by the difference between the gain and cost. Thus,

NPV = gain – cost

= W Pvxy – (Cash–Pvy)

If the difference is positive, it would be advisable to go ahead with the merger.

Example 1

Firm X has a value of Rs. 400 crore, and Y has a value of Rs. 100 crore.Merging the two would allow cost savings with a present value of Rs. 50crore. This is the gain from the merger. Thus,

Pvx = Rs. 400 crorePvy = Rs. 100 crore

Gain = W Pvxy = Rs. 50 crorePvxy = Rs. 550 crore

Suppose that Firm Y is bought for cash, say for Rs. 130 crore. The cost ofmerger is:

Cost = Cash paid – Pvy= Rs. 130 crore – Rs. 100 crore = Rs. 30 crore

Note that the owners of firm Y are ahead by Rs. 30 crore. Y’s gain will beX’s cost. Y has captured Rs. 30 crore of Rs. 50 crore merger gain. Firm X’sgain will, therefore, be:

NPV = Rs. 50 crore – Rs. 30 crore = Rs. 20 crore

In other words, firm’s X’s worth in the beginning is Pv = Rs. 400 crore. Itsworth after the merger comes to Pv = Rs. 400 crore and then it has to payout Rs. 130 crore to Y’s stockholders. Net gain of X’s owners is

NPV = Wealth with merger – Wealth without merger= (Pvxy–cash) – Pvx

= (Rs. 550 crore – Rs.30 crore) – Rs. 400 crore = Rs. 20 crore

In the above procedure, the target firm’s market value (Pvy) is taken intoconsideration along with the changes in cash flow that would result from themerger. It should be noted that it would be incorrect to undertak emergeranalysis on the basis of forecast of the target firm’s furture cash flows interms of incremental revenue or cost reductions attributable to the merger andthen discount them back to the present and compare with the purchase price.This is for the fact that there are chances of large errors in valuing a business.The estimated net gain may come up positive not because the merger makessense but simply because the analyst’s cash flow forecasts are too optimistic.

Estimating Cost When the Merger is financed by Stock

In the preceding discussion our assumption was that the acquiring firm payscash compensation to the acquired firm. In real life, compensation is usuallypaid in stock. In such a situation, cost depends on the value of the shares innew company received by the shareholders of the selling company. If thesellers receive N shares, each worth Pxy, the cost is:

Cost = NX Pxy – Pvy


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Let us consider an example:

Example 2

Firm X is planning to acquire firm Y, the relevant financial details of the twofirms prior to the merger announcement are:

X Y

Market Price per share Rs. 100 Rs. 40

Number of shares Rs. 50,000 Rs. 2,50,000

Market value of the firm Rs. 50 lakh Rs. 10 lakh

The merger deal is expected to bring gains which have a present value of Rs.10 lakh. Firm X offers 125,000 shares in exchange for 250,000 shares to theshareholders of firm Y.

The apparent cost of acquiring firm Y is:

125,000 X 100 – 10,000,000 = Rs. 25,00,000

However, the apparent cost may not be the true cost. X’ stock price in Rs.100 before the merger announcement. At the announcement it ought to go up.

The true cost, when Y’s shareholders get a fraction of the share capital of thecombined firm, is equal to:

Cost = aPvxy – Pvy

In the above example, the share of Y in the combined entity will be:

a = 12,50,000/5,00,000 + 1,25,000 = 0.2

Terms of Merger

While designing the terms of merger management of both the firms would insiston the exchange ratio that preserves the wealth of their shareholders. Theacquired firm (Firm X) would, therefore, like that the price per share of thecombined firm is atleast equal to the price per share of the firm X.

Pxy = Px ...................................... (1)

The market price per share of the combined firm (XY) is denoted as theproduct of price earnings ratio and earnings per share:

Pxy = (PExy) (EPSxy) = Px ........ (2)

The earnings per share of the combined firm is denoted as:

EPSxy = Ex+Ey/Sx+Sy(Erx) ......... (3)

Here Erx represents the number of shares of firm X given in lieu of one shareof firm Y. Accordingly, Eq. 2 may be restated as:

Px = (Pexy)(Ex+Ey)/Sx+Sy(Erx) ... (4)

Solving Eq. 4 for Erx yields:

Erx = –Sx/Sy + (Ex+Ey) (Pexy)/PxSy

Let us explain the process of determination of exchange rate with the help ofan example:


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Example 3

X corporation is contemplating to acquire Y corporation. Financial informationabout the firms are setout below:

X Y

Total current earnings, E Rs. 10 lakh Rs. 4 lakh

Number of outstanding shares, S Rs. 5 lakh Rs. 2 lakh

Market price per share, P Rs. 6 Rs. 4

Determine the maximum exchange ratio acceptable to the shareholders of Xcorporation if the P/E ratio of the combined entity is 3 and there is no synergy.What is the minimum exchange ratio acceptable to the shareholders of Ycorporation if the P/E ratio of the combined entity is 2 and there is synergybenefit of 5%?

Solution:

(a) Maximum exchange ratio from the Point of the shareholders of X corporation

ERx = –Sx/Sy + PExy (Exy)/PxSy= –5 lakh/2 lakh + 3X 14lakh/6X2lakh

= 1.0

(b) Minimum exchange ratio from the point of view of the Y shareholders:

ERy = PySx / (Pxy) Exy – PySy= 4X5lakh/2X (14lakhX1.05) – 4X2lakh

= 20 lakh/14.70 lakh – 8 lakh= 0.3

Criteria for Determining Exchange Ratio

Commonly used criteria for establishing exchange ratio are earnings per share(EPS), market price per share and book value per share.

Earnings per share reflect, the earning power of a firm. However, it does nottake into consideration the difference in the growth rate of earnings of the twofirms, gains stemming out of merger and the differential risks associated withthe earnings of the two firms. Further, EPS cannot be the basis if it isnegative.

Market price per share can also be the basis for determining exchange ratio.This measure is very useful where the shares of the firms are actively traded.Otherwise, market prices may not be very reliable. There is also possibility ofmanipulation of market process by those having a vested interest.

As regards utility of book value per share as the basis for determiningexchange ratio, it may be noted that book values do not reflect changes inpurchasing power of money as also true economic values.

Takeovers

Financial restructuring via takeover generally implies the acquisition of a certainblock of equity share capital of a firm which enables the acquirer to exercisecontrol over the affairs of the company. It is not always necessary to buymore than 50% of the equity share capital to enjoy control since effectivecontrol can be exercised with a remaining portion is widely diffused among theshareholders who are scattered and ill-organized.


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Some of the recent major takeovers in the Indian Corporate world are:

HLL : Modern Foods

HINDALCO : INDAL

Sterlite Industries : Hindustan Zinc

Chhabrias : Shaw Wallace

Tatas : CMC

Hindujas : Ashok Leyland

Goenkas : Calcutta Electric Supply Company

Wipro : Ner Ve Wire

Satyam : India World

Gujarat Ambuja : DLF Cement

18.5 FORMULATING MERGER AND ACQUISITIONSTRATEGY

Mergers and acquisition should be planned carefully since they may not alwaysbe helpful to the organizations seeking expansion and consolidation andstrengthening of financial position. Studies made by Mc Kinsey & Co. showthat during a given 10-year period, only 23 percent of the mergers ended uprecovering the costs incurred in the deal, much less shimmering synergisticheights of glory. The American Management Association examined 54 bigmergers in the late 1980s and found that about half of them lead straight downhill in productivity and profits or both.

Broadly speaking, acquisition strategy should be developed along the followinglines:

� Laying down Objectives and Criteria

A firm embarking upon a strategy of expansion through acquisition must laydown acquisition objectives and criteria. These criteria sum up the acquisitionrequirements including the type of organization to be acquired and the type ofefforts required in the process. Laying down the corporate objectives and theacquisition criteria ensures that resources are not dissipated on an acquisitionwhen these might more profitably be used to expand existing business activities.

� Assessing Corporate Competence

A detailed and dispassionate study of the firm’s own capabilities should form anintegral part of acquisition planning. Such a study is done to make sure that thefirm possesses the necessary competence to carry out the acquisitionprogramme successfully. Once the corporate strengths have been formulatedthe management should appoint an adhoc task force with a member of the topmanagement team to head this body and functional executives on its membersto carry out the pre-acquisition analysis, negotiate with the prospective firm andintegrate the firm, perform post-acquisition tasks and monitor acquisition results.

� Locating Companies to Acquire

Before undertaking search process the central management should consider anumber of factors which have their significant bearing on the aquisition. Someof these factors are listed below:


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1. Choice of Company: A firm keen to takeover another companyshould look for companies with high growth potential and shortlist firmswith large assets, low capital bases with fully depreciated assets orwith large tracts of real estate or securities.

2. Type of Diversification: Success of acquisition also depends on formof diversification. Success has been reported mostly in horizontalacquisitions, where the company purchased belonged to the sameproduct-market as the acquirer. Success rate in the case of verticalintegrations has been relatively lower. Further, marketing-inspireddiversifications appeared to offer the lowest risk, but acquisitionsmotivated by the desire to take advantage of a common technologyhad the highest failure rate of all. Pure conglomerate acquisitions, whichtend to be in low technology industries, had a lower overall failure ratethan all forms of acquisition except horizontal purchases.

3. Market Share: Another variable influencing acquisition success is themarket share. Higher the market share, greater the success ofacquisition move. Kitching’s study reveals that acquisition with marketshares of less than 5 percent for diversification moves had failure ratesof over 50 percent.

4. Size of Purchase: The size of an acquired firm in relation to theacquirer is an important determinant of acquisition success. Thepossibility of success increases with increase in size of theacquisitionbecause acquisition of a large firm is likely to bring aboutmaterial change in corporate performance. For large purchases,management makes a determined effort to ensure that the newacquisition achieves the results expected of it quickly.

5. Profitability of Acquisitions: Success of acquisition also dependsupon profitability of the firm being acquired. Acquiring a loss makingfirm may not ensure success unless the acquiring firm is equipped witha skilled management, capable of handling such situations. It may,therefore, be in firms are not available for sale or require the paymentof such a premium as to make their acquisitions unattractive.Acquisition of highly promising organizations may be resisted by thehost country governments. The firm may go for low profit organizationsif they are at the bottom of their business cycle or when theunprofitable assets are broken up and disposed off to return more thanthe purchase price or where there are tax shields of losses to becarry forward or other similar financial advantages.

Keeping in view the above factors, the acquiring firm should ascertainwhat the potential firm can be for the organization which it cannot doon its own, what the organization can do for the potential firm, what itcannot do itself, what direct and tangible benefits or improvementsresults from acquiring the potential firm and what is the intangiblevalue of these saving to the organization. In the same way, legalprocedures involved in acquisition must begin through in detail.

An enormous amount of information pertaining to the above aspectsgathered over a period of time is indispensable to a firm with an activecontinuous acquisition programme. Commercial data are not readilyavailable everywhere. Financial data in particular is not reliable in somecountries due to varying accounting conventions and standards, localtax patterns and financial market requirements. However, this shouldnot deter management from going ahead with its plan of acquiringoverseas firms. The desired information can be gathered particularlythrough information service organizations such as Business Internationaland Economic Intelligence Unit, non-competing firms and from variousinternational publications like International Yellow Pages, the Exporter’s


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Encyclopaedia and Directories of manufacturers, importers and otherkinds of business in world markets.

� Evaluating the Prospective Candidtates for Acquisition

After identifying firms according to the specification, the task force shouldevaluate each of the prospective candidates to pick out the one that suits mostof the needs of the acquiring company. The following aspects should receiveattention of the evaluator:

� General Background of the Potential Candidates

The background information of each of the identified companies about thenature of business, past year business performance, product range, fixed assets,sales policy, capital base, ownership, management structure, directors andprincipal officers and the recent changes in regard to the above should becollected and sifted in terms of the interests of the acquiring company.

It will also be useful to scan the current organizational structure and climate ofthe perspective firms. The focus of the study should be on strength of labour,their skills, labour unions and their relations with management. Departmentationof the firms, extent of delegation of authority, communication channels, wageand incentive structure, job evaluation etc.

� Appraisal of Operation of the Potential Candidates

The task force should scan the location of the plants of the company, itsmachines and equipments and their productivity, replacement needs, operatingcapacity and actual capacity being used, critical bottlenecks, volume ofproduction by product line, production costs in relation to sale price, quality,stage in life cycle, production control, inventory management policies, storesprocedures, and plant management competence. It may be helpful to appraiseresearch and development capability of managing production lines andcompetence in distributing products.

It will also be useful to undertake detailed appraisal of the product purchasingorganization and its competence, major suppliers and materials supplied by them,prices being charged and alternative sources. It should also be found out ifthere have been instances of bad buying, overstocking, large stock write offs,slow ‘moving stock.’

Evaluator should assess the operations of the firm from marketing point ofview. Thus, current policies of the firm pertaining to product, pricing, packaging,promotion and distribution and recent changes therein, channels of distribution,sales force and its composition, markets served in terms of the share held,nature of consumers, consumer loyalty, geographical distribution of consumersshould be kept in view. Identification of major competitors and their marketshare are source of the critical aspects the must receive attention of theevaluator.

18.6 REGULATION OF MERGERS AND TAKEOVERS IN INDIA

Mergers and acquisition may lead to exploitation of minority share holders, mayalso stifle competition and encourage monopoly and monopolist corporatebehavior. Therefore, most of the countries have their own legal frame work toregulate the merger and acquisition activities. In India, merger and acquisitionare regulated through the provision of companies Act 1956, the monopolies andrestrictive trade practices (MRTP) Act 1969, the Foreign exchange regulation


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Act (FERA) 1973, the income tax Act 1961, and the securities and exchangeboard of India (SEBI) also regulates mergers and acquisition (take over).

Legal Measures Against Takeover:

The company’s act restricts an individual or a group of people or a company inacquiring shares in public limited company to 25 percent (including the shareheld earlier) of the total paid up capital. However, the control group needs tobe informed when ever such holding exceeds 10 percent. When ever thecompany, or group of individuals or individuals acquires the share of anothercompany in excess of the limits should take the approval of the share holdersand the Government.

In case of a hostile takeover bid companies have been given power to refuseto register the transfer of shares and the company should inform the transfereand transfer within 60 days. Hostile take over is said to have taken place incase if

� legal requirements relating to the transfer of share have not be compliedwith or

� the transfer is in contravention of law or

� the transfer is prohibited by Court order

� the transfer is not in the interests of the company and the public Protectionof minority shareholders interests

The interest of all the shareholders should be protected by offering the samehigh price that is offered to the large share holders. Financial Institutions, banksand few individuals may get most of the benefits because of their accessibilityto the process of the take-over deal market. It may be too late for smallinvestor before he knows about the proposal. The company act provides that apurchaser can force the minority shareholders to sell their shares if.

1. The offer has been made to the shareholders of the company.

2. The offer has been approved by at least 90 percent of the shareholderswhen transfer is involved within four months of making the offer.

� Guidelines for Takeovers:

A listing agreement of the stock exchange contains the guidelines of takeovers.The salient features of the guildelines are:

1. Notification to the Stock Exchange: If an individual or a companyacquires 5 percent or more of the voting capital of a company the stockexchange shall be notified within 2 days of such acquisition.

2. Limit to Share Acquisition: An individual or a company which continuesacquiring the shares of another company without making any offer to shareholders until the individual or the company acquires 10 percent of the votingcapital.

3. Public Offer: If this limit is exceeded a public offer to purchase aminimum of 20 percent of the shares shall be made to the remainingshareholders.

4. Offer Price: The offer price should not be less than the highest price paidin the paid in the past 6 months or the negotiated price.

Disclosure: The offer should disclose the detailed terms of offer in details ofexisting holding.

Offer Document: The offer document should contains the offer and financialinformation. The companies act guidelines for take over are to ensure fulldisclosure about the merger and take over and to protect the interests of theshare holders.


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Legal Procedures: The following in the legal procedure for merger oracquisitions laid out in the Companies Act 1956.

Permission for Merger: Two or more companies can amalgamate only whenamalgamation is permitted under their memorandum of association. If thememorandum of association does not contain this clause it is necessary to seekthe permission of the share holders board of directors and the company lawboard before affecting the merger.

Information to the Stock Exchange: The acquiring and acquired companiesshould inform the stock exchange where they are listed about the merger.

Approval of Board of Directors: The Board of Directors of the individualcompanies should approve the draft proposal for merger and authorize themanagement to further to pursue the proposal.

Application in the High Court: An application for approving the draftamalgamation proposal duly approved by the board of directors of the individualcompanies should be made to the high court. The high court would convene themeeting of the shareholders and creditors to approve the amalgamationproposal. The notice of meeting should be sent to them at least 21 days inadvance.

Shareholders and Creditors Meetings: The individual companies should holdcorporate meetings of their shareholders and creditors for approving the mergerscheme. A minimum of 75 percent of share holders and creditors in separatemeetings by voting in person or by proxy must accord approval to the scheme.

Sanction by the High Court: After the approval of shareholders and creditorson the petitions of the companies the high court will pass order sanctioning theamalgamation scheme after it is satisfied that the scheme is fair andreasonable. It can modify the scheme if it deems fit so.

Filling of the Court Order: After the court order its certified true copies willhave to be filled with the Registrar of companies.

Transfer of Assets and Liabilities: The assets and liabilities of the acquiredcompany will exchange shares and debentures of the acquired company ofaccordance with the approved scheme.

Payment by Cash or Securities: As per the proposal the acquiring companywill exchange shares and debentures and or pay cash for the shares anddebentures of the acquired company. These securities will be listed on the stockexchange.

18.7 TAKE OVER STRATEGIES: INDIANEXPERIENCE

The take over strategies involve successful identification and takeover ofanother corporation. However, it entails complex legal and financial action onthe part of the acquiring firm when a firm’s strategy is to seek external growththrough acquisition. This is generally done by the firm’s top management, legalstaff, bankers and even outside consultants who specialise in recommendingworkable corporate unions.


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As financial analyst, we must have a way to evaluate mergers and acquisitions.The evaluator of acquisition should analyse the price paid for acquisition and itsimpact on the share holders wealth. The shareholders’ wealth is interpreted bydifferent people in different ways. There are several methods of wealthmaximisation of share holders. The tools and techniques for the evaluation ofmergers are also used in support of the executive judgement and politicalprocess in corporations.

When a company wants to acquire another company, its share holders have topay considerations to the shareholders of the company under acquisition. Thisconsideration is the value of the shares or assets of the company underacquisition. The right kind of consideration to be paid its current market valueof the firm under acquisition. However, it is found in many of the acquisitionsthat the current market value is minimum consideration to be offered, if theconsideration price to be paid is more than the current market price is atpremium. The premium may be paid because of the under valuation of theshares or as an incentive to the share holders of the company underacquisition. This would enable the acquiring company to have the controllingright of the acquired company.

In 1932 the Lever Brothers (INDIA) began its manufacturing activity in India(now Hindustan Lever Ltd) taking over North West South Co with a capacityof 2,250 tones. Over the years and till the mid fifties Lever similarly acquiredsick factories at various other sites. The govt. got tough in 1969 with theMRTP Legislation making takeover virtually impossible.

In the early eighties the Government accorded high priority to the revival ofsick units and enacted laws like the Industrial Reconstruction Bank of India Actand other Sick Industrial Legislation.

Lever quickly saw an opportunity in taking over and reviving a sick companyviz. Stepehn Chemicals a Punjab based soaps and detergents firm. Thecompany was not in attractive shape, its outstanding debts stood at Rs. 6 croreand its Rs. 3 crore capital had been wiped out by losses. But that did not deterLever from 10,000 tones of detergents and 7,200 tones of soaps that Stephenhad capacities for when lever started the lease. The Rs. 200 crore companytoday rolls out more than 50,000 tonnes of soaps and detergents. The high pointof stephen’s success game four years ago is in the forefront of Lever waragainst Nirma, “Wheel” washing power. Lever’s successful answer to Nirmachallenge was produced by Stephen.

The Stephen acquisition was followed by a chain of other sick units whichLever snapped up and quickly revived.

Detergent Bar Manufacturer jon. Home products and Sunrise Chemicals, asoap company in Rajakot. There is also a unique case of Shivalik cellulose aGujarat based paper plant which was set up in seventies, but turned sickthough it was a paper plant. Lever was interested. Taking Shivalik on a 24years lease with an option to buy after five years; Lever turned the paper plantinto a 30,000 tones soap plant has kicked of production recently.

In the afternoon of 9th March 1993 Tata Oil Mill company Ltd (TOMCO)informed the Bombay stock exchange about its intention to merge with theHindustan Lever Ltd. The Board of Directors of the two companies approvedthe merger on 19th March, 1993, TOMCO is Rs. 4,460 million turn over (1992)company and Lever’s Rs. 20,000 million.

Lever would control one-third of three million tonnes soaps and detergentsmarkets by this merger. Some competitors of Lever think that it will eliminate


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competition. The management of Lever, however, felt that the merger wouldresult into a strategic fit in many areas such as brand positioning, manufacturinglocations, geographical reach and distribution network. Tomco has fourmanufacturing plants and large distributive network covering 2,400 stockists andnine million outlets. It is strong in South.

Merger would have many benefits for Tomco which is reported to haveincurred a loss of Rs. 66 million for the first six months of 1992-1993. It wasLever’s nearest rival but lagged much beind in the eighties. A number ofattempts by management to revive Tomco through diversification did notsucceed. The acquisition of Tomco by the Lever to gain market leadership anddominance is seen strategically important in view of the intensifying competitionfollowing strategic alliance between Godrej soaps and the Americanmultinational, Procter and Gamble.

Already most of Tomco’s brands Hamam, Moti, the 501 range of laundry soapsrange have been re-launched. Tomco take over has helped on capitalizing onnew brand like Tomco hair Oil, Nihar and Tomco’s eau de cologne.

With the new take over code, the Indian corporates are experiencing the waveof merger and acquisitions. The new legal frame work govering the merger andtake over opened the doors to hostile take over. The market for corporatecontrol has exploded, with merger and acquisitions being accepted as means ofcorporate restructuring and redirecting capital towards efficient management.The political uncertainty and the slow down of industrial production havedepressed the share prices to levels where acquisition have become viable. Thisis an ideal opportunity to take over without the government intervention. Nowthe financial institutions are also ready to sell their stock at good prices. Theyare no more interested in protecting the existing promoters, in the recent half adozen mergers and acquisitions. The Rs. 8,342/- crore Hindustan Leverresurfaced with the negotiated acquisition of the Rs. 59,11 crore LAKME fromthe Rs. 35,000 crore TATA GROUP the Rs. 1,162 crore Indian Aluminum wastargeted by Rs. 1,146 Sterlite Industries by targeting 20 percent stock in theformer one. Imeediately alarmed by this, Indian Aluminum targeted the Rs. 162crore Pennar Aluminum. In Pharmaceuticals, the Rs. 400 crore wockhardtargeted Rs. 200 crore Merind. The cement Industry saw a major restructuringbid as the Rs. 832 crore India Cements managed to take over the Rs. 349crore Raasi Cements.

Indian Cements Ltd.

The Chennai based cements major India Cements Ltd. (ICL) has pulled off aquite coup in its bid to acquire Raasi Cement Ltd by winning over the fightingmain promoter and chairman Dr. B.V. Raju ICL originally held 9.75 percentstake in RCL. Later it acquired 8.28 percent from Mr. M.K.P. Raju, 2.23percent from APIDC and 1.14 percent from a Chennai based shar broking


Financials 1996-97 (Rs. Crores)

India Cements Raasi Cements

Sales 632.50 410.19

Gross Profit 126.65 42.20

Net Profit 82.58 22.83

Equity 64.34 16.31

EPS (Rs) 12.83 13.99

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firm. The promoters of RCL sold their 32 percent equity to ICL. ICL and itsassociates on the verge of picking up 8 percent from a transport contractorwho is also an the board of Raasi. ICL now plan to go ahead with an openoffer to mop up 20 percent at the earlier offered price of Rs. 300. This willincrease the total Stake in Raasi to nearly 78 percent. Dr. B. v Raju, managingDirector of Raasi said the “The present take over regulation do not giveprotection to technocrat promoter who cannot have large stake in companies.The regulations should be modified to protect the technocrat entrepreneurs andthe government should seriously consider of introducing the buy back ofshares.”

While the merger and acquisition may become direction less and corporateconglomerates may end up with unanticipated added costs instead of anticipatedeconomies of scale, the benefits of a successful acquisition are powerful,offering dominant market share, the strength of sheer size and uniquecompetitive advantage. But how does the bidder for takeover know beforehand whether the acquisition he is targeting will be worth the price he has topay?

Corporate India is in the grip of a new wave of mergers. It is take over timeagain if you read the pink papers. The take over bazaar is brimming over withcompanies waiting to be picked up. The volume of mergers & acquisitions dealin the country is no match for similar deals currently struck abroad. OneInternational Mega deal the recently aborted one is between Glaxo andSmithkilne Beecham will dwarf the total value of deal (roughly estimated at Rs.2000 crore by market source) struck here over past few months.

Activity 1

Bharat Chemicals Ltd. is planning to merge Modern Fertilizers Ltd. BharatChemicals has approached you to advise in this regard. Putting yourself in theposition of a financial consultant:

a) What information would you like to collect from the firms?

b) How would you evaluate feasibility of the proposal?

c) What important criteria would you take into account to determine exchangerate between the two firms?

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18.8 DIVESTITURES

While mergers and acquisitions lead to expansion of business in some way orthe other, divestiture move involves some sort of contraction of business.Divestiture as form of corporate restructuring signifies the transfer ofownership of a unit, division or a plant to someone else. Sale of its cementdivision by Coromandel Fertilizers Ltd. to India Cements Ltd. is an example ofdivestiture.

Divestiture strategy is pursued generally by highly diversified firms who havehad difficulty in managing broad diversification and have elected to divestcertain of their businesses to focus their total attention and resources on alesser number of core businesses. Divesting such businesses frees resourcesthat can be used to reduce debt, to support expansion of the remaining busines,or to make acquisitions that materially strengthen the company’s competitiveposition in one or more of the remaining core business. For instance, A V Birlagroup divested a publicly announced paper and chemicals project and a seawater magnesia unit in Visakapatnam and MRPL a petrochemicals JointVenture with HPCL, so as to strengthen its core business.

Before taking a final decision, finance manager should assess if its is in theinterest of the firm to do so.

Financial Assessment of a Divestiture

Financial assessment of divestiture proposition involved the following steps:

� Estimate the post-tax cash flow of the selling firm with and withoutdivestiture of the unit in question.

� Establish the discount rate for the unit on the basis of cost of capital ofsome firms engaged in the same line of business.

� Compute the unit’s present value, using the discount rate, as determined above.

� Find the market value of the unit’s specific liabilities in terms of presentvalue of the obligations arising from the liabilities of the unit.

� Determine the value of the selling firm’s ownership position in the unit bydeducting market value of the unit’s liabilities from the present value of itscash flow.

� Compare the value of ownership position (VOP) with the proceeds fromthe divestiture (PD). PD represents compensation received by the sellingfirm for giving up its ownership in the unit. Hence, the decision rule will be:

PD > VOP = Sell the unit

PD = VOP = Be indifferent

PD < VOP = Retain the unit

18.9 CHARACTERISTICS OF AND PRE-REQUISITIESTO LEVERAGED BUYOUT SUCCESS

Leveraged buyout (LBO) is an important form of financial restructuring whichrepresents transfer of an ownership consummated heavily with debt. LBOinvolves an acquisition of a division of a company or sometime other sub unit.At times, it entails the acquisition of an entire company.

� Characteristics of LBO

1. A large proposition of the purchase price in debt financed.

2. The debt is secured by the assets of the enterprise involved.


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3. The debt is not intended to be permanent. It is designed to be paid down.

4. The sale is to the management of the division being sold.

5. Leveraged buyouts are cash purchases, as opposed to stock purchases.

6. The business unit involved invariably becomes a privately held company.

� Pre-requisites to Success of LBO

1. The company must have a several year window of opportunity wheremajor expenditures can be deferred. Often it is a company having gonethrough a heavy capital expenditure programme and whose plant is modern.

2. For the first several years, cash flows must be dedicated to debt service. Ifthe company has subsidiary assets that can be sold without adverselyimpacting the core business, this may be attractive because sale of suchassets provides cash for debt service in the initial years.

3. The company must have stable, predictable operating cash flows.

4. The company should have adequate physical assets and/or brand nameswhich in times of need may lead to cash flows.

5. Highly competent and experienced management is critical to the success of LBO.

Example 5

Modern Manufacturing Ltd. (MML) has four divisions, viz; Chemical, Cement,Fertilizers and Food. The Company desires to divest the Food Division. Theassets of this division have a book value of Rs. 240 lakh. The replacementvalue of the assets is Rs. 340 lakh. If the division is liquidated, the assetswould fetch only Rs. 190 lakh. MML has decided to sell the division if it getsRs. 220 lakh in cash. The four top divisional executives are willing to acquirethe division through a leveraged buyout. They are able to come up with onlyRs. 6 lakh in personal capital among them. They approach a finance consultantfor financial assistance for the project.

The Finance Consultant prepares projections for the Food division on theassumption that it will be run independently by the Four executives. Theconsultant works out that cash flows of the division can support debt of Rs.200 lakh it finds a finance company that is willing to lend Rs. 170 lakh for theproject. It has also located a private investor who is ready to invest Rs. 24lakh in the equity if this project. Thus, the Food division of MML is acquired byan independent company run by the four key executives, which is funded throughdebt to the tune of Rs. 170 lakh and equity participation of Rs. 30 lakh.

In the above case, two forms of funds are employed:

Debt (Rs. 170 lakh) and equity (Rs. 30 lakh). Thus, LBO permits going privatewith only moderate equity. The assets of the acquired division are used tosecure a large amount of debt. The equity holders are, of course, residualowners. If things move as per plans and the debt is serviced according toschedule, after 5 years they will own a healthy company with a moderate debt.In any LBO, the first several years are key. If the company can repay debtregularly, the interest burden declines resulting in improved operating earnings.

Two types of risks involved in LBO are: business risk – arising out ofunsatisfactory performance of the company and the consequent failure toservice the debt – and interest rate risk arising out of changing interest rateswhich may, in case of sharp rise, involve increased financial burden.

Thus, the equity owners are playing a high-risk game and the principle ofleverage being a double-edged weapon becomes evident. Another potential


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problem with the need to service debt is the focus on short-run profitability.This may have telling effect on the long-term survival and success of theorganization.

18.10 LEVERAGED RECAPITALIZATION

Another kind of financial restructuring is leveraged recapitalization (LR). LR isa process of raising funds through increased leverage and using the cash soraised to distribute to equity owners, often by means of dividedn. In thistransaction, management and other insiders do not participate in the payout buttake additional shares instead. As a result, their proportional ownership of thecompany increases sharply.

LR is similar to LBO in as much as high degree of leverage is incorporated inthe company and the managers are given a greater stake in the business viastock options or direct ownership of shares. However, LR allows company toremain public unlike LBO which converts public traded company into private one.

As for the potentiality of LR as a means of value addition to the company, LRhas been found to have a salutary effect on management efficiency due to highleverage and a greater equity stake. Under the discipline of debt, internalorganization changes may take place which may lead to improvements inoperating performance.

Spin-Offs

A spin-off, as a form of restructuring, involves creation of a new, independentcompany by detaching part of a parent company’s assets and operations. Sharesin the new company are distributed to the parent company’s stockholders.

Spin-offs widen investors’ choices by allowing them to invest in just one part ofthe business. More important, spin-offs can motivate managers to performbetter. By spinning-off those businesses which do not fit the company’s corecompetence, the management of the parent company can concentrate on itsmain business. If the businesses are independent, it is easier to see the valueand performance of each and reward managers accordingly. Investors feelrelieved from the worry that funds will be siphoned from one business tosupport unprofitable capital investment another.

Announcement of a spin-off is generally greeted as good news by investorswho reward the focus and penalize scope, scale and diversification. Spin-off isconsidered as a way of protecting the Crown Jewel from a predator. Inincreases the competence of core business and keeps away the unwantedactivities resulting in improved profitability of the parent company.

Carve-Outs

Carve-outs are similar to spin-off with one exception that shares in the newcompany are sold in public instead of distributing them among existing equityowners. Carve outs result in new cash flows.

Although carve-outs share many of the virtues of spin-offs, the same dependson whether a majority stake is sold so that the new company operatesindependently. Sale of a minority stake leaves the parent company is controland may not reassure without the investors who worry about lack of focus orpoor fit.

But at times a minority carve-out can create a market for the subsidiary sharesand allows compensation schemes based on management ownership of sharesor stock options.


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18.11 REORGANIZATION OF CAPITAL

Reorganization of Capital refers to the restructuring of company by affectingchange in the capital structure of the company with a view to improving itsfinancial strength. It is an adjustment of gearing i.e. debt-equity ratio of thecompany so as to maximize the wealth of the share owners.

Despite careful financial planning, a firm may be constrained to bring aboutcertain adjustments in its capital structure because of changes in business climate,fluctuation of interest rates need to avoid unwanted leverage or to eliminate abond issue carrying prohibitively restrictive features and similar other situations.

In reorganization of capital a firm attempts to reduce total debt by reducingfixed charges through raising fresh equity share capital. But when the equity ishigher, the cost of serving also tends to be higher which can be reduced byrelying more on debt for financing further expansion programmes. Firm may,therefore, think of reducing fixed burden of debt financing through voluntaryextinction of bonds, extinction through refunding, extinction through redemptionand extinction through conversion.

� Extinction Through Refunding

Refunding means substituting old bonds by new bond issue. The managementuses this method to take advantage of cheaper sources of financing. Wheninterest rate in the market drops and the management believes that the firmcan sell new bonds at a lower rate of interest than that being paid onoutstanding debts. Sometimes, to avoid bonds carrying unfavourable terms, themanagement may be tempted to substitute old bonds by new ones. Also, a firmwhich borrowed funds in its initial years at higher cost because of its weakfinancial position may find subsequently when it gains strength that it canprocure loans at cheaper cost and at convenient terms.

Accordingly, the firm may take recourse to refunding as a means of reducingits cost of capital. The management may also use refunding to consolidateseveral existing bond issues to simplify their management. Among thesereasons, however, refunding is generally resorted to reduce cost of servicingdebt and to improve earning per share of the firm.

Before refunding an outstanding bond the finance manager must determinewhether or not refunding is profitable. Accordingly he must, as in capitalbudgeting decision, match the costs of refunding against receipts as a result ofthe refunding operation. It is only when receipts exceed costs, the managementshould proceed ahead with refunding operation otherwise the idea of refundingmust be dropped.

� Extinction Through Redemption

Redemption is the actual paying of the debt. Through redemption, the firmextinguishes the bonded debt absolutely. this is possible only when bond issuescontain call privilege giving the firm the option to buy back the bonds at astated price before their maturity. The bond indenture provides the prices whichthe firm pay the bondholder for a bond called for redemption before theirmaturity. Generally, this redemption price is greater than the par value of thebond. The actual price is fixed taking into account par value of the bond plus areasonable premium. This bonus is provided to enable the bondholder whosebond has been called for redemption to take time to find another profitableinvestment for his money without suffering any loss of interest.

When bonds are redeemed, the firm needs cash to take them up. There aretwo methods of providing the cash, viz; (i) voluntary setting aside of moneys


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received from earnings in such amounts as make it possible to meet the bondswhen they are to be paid and (ii) putting aside of a sinking fund to pay off thebonds. While the former is done by the management as a matter of businessand financial policy and not because of any agreement with bondholders, thelatter is made obligatory by the terms of the bond indenture.

� Extinction Through Conversion

Management may sometimes convert bonds into stocks in order to simplifycapital structure and also to get rid of bonded indebtedness and the fixedinterest charges associated with it. When a firm converts its bonds, it does notrequire cash to pay to the bondholders. When bonds are converted into stock,bondholders become owner of the firm and bonded indebtedness is wiped out.

This is possible only when bond issue is convertible. The conversion privillege isexercised almost without exception wholly at the option of the bondholders.However, the company may force conversion at a time when it is moreprofitable for the bondholders to convert rather than surrender the bonds andreceive cash. Before deciding about conversion finance manager must examinethe impact of the transaction on the market value of the stock as the decisioncriterion. Rate of conversion is provided in debt indenture. For example, oneRs. 1000 par value bond may be exchanged for 10 shares of the stock.Sometimes the conversion basis is expressed by stating that the bonds areconvertible into stock at some specified figure, say Rs. 100 which means thatthe stock is being valued for conversion purposes at Rs. 100 a share.

18.12 FINANCIAL RECONSTRUCTION

Financial reconstruction is the recasting of firm’s capital structure to reduce theamount of fixed burden of leverage. Where firm has been suffering operatinglosses for several years but has potential to recover in future and its economicworth as an operating entity is greater than its liquidation value, managementmay think of keeping the firm alive by changing its capital structure.

The major difference between reorganization of capital and financialreconstruction is that the former is resorted to for further improving financialhealth of the firm but the latter is taken up when the firm is continuouslysuffering losses and is heading towards liquidation.

Formulation of reconstruction plan involves three steps:

(i) Determine total valuation of the company by capitalization of prospectiveearnings. For example, if future earnings of a company are expected tobe Rs. 4 lakh, and the overall capitalization rate of similar companiesaverage 10 percent, total value of Rs. 40 lakh would be set for the company.

(ii) Determine new capital structure for the company to reduce fixed chargesso that there will be an adequate coverage margin. To reduce these fixedcharges, the total debt of the firm is reduced by shifting to income, bonds,preferred stock and common stock. In addition, terms of the debt may bechanged. If it appears that the reconstructed company will need newfinancing in the future, a more conservative ratio of debt to equity maybe thought of so as to provide for future financial flexibility.

(iii) Valuation of the old securities and their exchange for new securities. Ingeneral, all senior claims on assets must be settled in full before a juniorclaim can be settled. In the exchange process, bondholders must receivethe par value of their bonds in another security before there can be anydistribution to preferred stockholders. The total valuation figure arrived atin step 1 sets an upper limit on the amount of securities that can be issued.


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The existing capital structure of a company undergoing reconstruction is givenas under:

Rs. in lakhsDebentures 18Subordinated debentures 6Preferred stock 12Common stock equity (book value) 20

Total Rs. 56

If the total valuation of the company is to be Rs. 40 lakh, the following couldbe the new capital structure:

Rs. in lakhsDebentures 6Income bonds 12Preferred stock 6Common stock 16

Total Rs. 40

After deciding about the ‘appropriate’ capital structure for the company, thenew securities have got to be allocated. Thus, the debentureholders exchangetheir Rs. 18 lakh in debentures for Rs. 6 lakh in new debentures and Rs. 12lakh in income bonds, that the subordinated debentureholders exchange theirRs.6 lakh in securities for preferred stock, and that preferred stock holdersexchange their securities for Rs. 12 lakh of common stockholders would thenbe entitled to Rs. 4 lakh in stock in the reconstructed company, or 25 percentof the total common stock of the reconstructed company.

Thus, exchange claim is settled in full before a junior claim is settled. In a harshreconstruction, debt instruments may be exchanged for common stock in thenewly reconstructed company and the old common stock may be eliminatedcompletely. Much depends on negotiation between the management and claimholders.

18.13 SUMMARY

In recent years majority of the Corporate Organizations across the globeincluding India engaged in restructuring exercises so as to cope with increasedbusiness complexities and uncertainties and improve their competitive strength.Corporate restructuring exercises were financial, technological and organizationalin nature.

Mergers, acquisitions, takeovers, divestitures, spin-offs, leveraged buyouts,leveraged recapitalization and financial reconstruction, as significant forms offinancial restructuring, have become a major force in the economic andfinancial milieu all over the world.

Mergers, which subsume both absorption and consolidation, may take the formof horizontal, vertical, conglomerate and reverse. The principle economic rulefor a merger is that value of the combined entity should be greater than thesum of the independent values of the merging entities. The most cogentreasons for merger are economies of scale, higher growth, advantage ofcomplementary resources, speedy diversification, access to latest technology,larger market base, strong financial position and so on. The net economicbenefit of a merger is the difference between the present value of the combinedunit and the present value of the combining entities if they remain independent.

A divestiture represents sale of division or plant or unit of one firm to another.Divestiture decisions are driven by a variety of motives such as raising capital,


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curtailment of losses, strategic realignment and efficiency gain. Sincedivestitures have become common, management should scan their financialdesirability systematically and rationally.

LBO as a form of restructuring represents transfer of an ownershipconsummated heavily with debt. It is a cash purchase as opposed to stockpurchase. The firm going for LBO must have stable, predictable operating cashflows and should have adequate physical assets and/or brand names.

LR is a process of raising funds through increased leverage and using the cashso raised to distribute to equity owners. It is similar to LBO in as much as highdegree of leverage is incorporated in the company. However, LR allows thecompany to remain public unlike LBO which converts public traded Companyinto private one.

At times, a company suffering from operating losses and financial problem maygo for financial reconstruction to recast its capital structure to reduce theamount of fixed burden of leverage. Financial reconstruction process involvesthree main steps, viz; determination of total valuation of the company,determination of new capital structure for the company to reduce fixed chargesand finally valuation of the old securities and their exchange for new structures.

18.14 KEY WORDS

Absorption: refers to a situation where a company survives and others losetheir identity.

Amalgamation: refers to a situation where a new company comes intoexistence because of merger.

Take over: is the purchase by one company of a controlling interest in theshare capital of another existing company.

Divestiture: signifies the transfer of ownership of a unit, division or a plant tosome one else.

Leveraged buyout: represents transfer of an ownership consummated heavilywith debt.

Leveraged Recapitalization: is a process of raising funds through increasedleverage and using the cash so raised to distribute to equity owners.

Spin-offs: involve creation of a new, independent company by detaching part ofa parent company’s assets and operations.


1. What is corporate restructuring? What motivates an enterprise to engagein restructuring exercise?

2. Discuss various forms of mergers. What are the driving forces formergers & acquisitions?

3. Discuss various steps involved in a merger.

4. What are the regulatory provisions in India regarding mergers and acquisitions?

5. How would you assess merger as a source of value addition?

6. What is the cost of a merger from the point of the acquiring company?

7. How would you determine the present value of a merger from the pointof view of the acquiring company?


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8. What are the important bases for determining the exchange ratio?

9. What are the salient features of divestitures? How would you assessdivestiture programme of a company?

10. What is leveraged buy out? How is it different from leveragedrecapitalization?

11. Distinguish between spin-offs and carve-outs.

12. Under what circumstances does a firm reorganize its capital? What arethe various techniques of reorganization of capital?

13. Divya Sugar Mills plans to acquire Shubhra Sugar Mills. The relevantfinancial information are:

Divya Sugar Mills Shubhra Sugar Mills

Market Price per share Rs. 140 Rs. 64

Number of outstanding shares 40 lakh 30 lakh

The merger is expected to generate gains which have a present value of Rs.400 lakh. The exchange rate agreed to is 0.5.

Compute the true cost of the merger from the view point of Divya Sugar Mills.

14. Dolly Electronics is contemplating to merge Smriti Electronics. Thefollowing data are available:

Dolly Electronics Smriti Electronics

Total Current Earnings, E Rs. 100 lakh Rs. 40 lakh

Number of outstanding shares, S 40 lakh 20 lakh

Market Price per share, P Rs. 30 Rs. 20

(i) What is the maximum exchange ratio acceptable to the owners of DollyElectronics if the P/E ratio of the combined entity is 12 and there is nosynergy gain?

(ii) What is the minimum exchange ratio acceptable to the shareholders ofSmriti Electronics if the P/E of the combined entity is 11 and there is asynergy benefit of 5 percent?


James C. Van Horne, Financial Management Policy, Prentice Hall of IndiaPvt. Ltd., New Delhi, 2002

Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance,Tata Mc Graw Hill Public Company Ltd., New Delhi, 2000

J.F. Weston, K.S. Chung and J.A. Siu, Takeovers, Restructuring andCorporate Finance, Prentice-Hall, upper saddle River, N.J. 1998

John J. Hompton, Financial Decision Making, Prentice Hall PublishingCompany, Virginia, 1978

J. Fred Weston, Eugene F. Brigham, Managerial Fiannce, Dryden Press,Hinsdace, Illinois, 1978

Prasanna Chandra, Financial Management, Tata Mc Graw Hill PublicCompany Ltd., New Delhi, 2001

R.M. Srivastava, Financial Management and Policy, Himalaya PublishingHouse, Mumbai, 2003.

ms 42 except ch 6

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