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Prashant Kulkarni Asst.

Professor, Economics and Public Policy, Indus Business Academy, Bangalore

IBA Campus Lakshmipura, Thataguni Post, Kanakapura Main Road Bangalore 560062. India

Published By: IBA, Publications IBA, Bangalore 2012 Diagrams & Illustrations as credited.

Cover Design & Edited By: Sanjog Behera and Durvankur Suhas Sheth ISBN No. 978-81-920996-7-5

All rights reserved. No part of this publication may be reproduced, or transmitted in any form or by any means, electronic or mechanical, including copying, or by any information storage and retrieval system, without permission in writing from IBA, Bangalore. Enquiries concerning reproduction outside the scope of the above should be sent to the address mentioned below.

Citation: The papers part of this edited book may be cited as: Name: Case Studies in Managment

Case learning has been the staple diet for B-Schools for ages. I was lucky to get into case writing at the start of my career and my employers tolerated all my experiments into case writing on exotic topics. Over a period of time Ive written exhaustive case studies, study notes and also situation analysis/ caselets suiting to the needs of the course. This is an occasion for compiling all the case studies that I have prepared over the years into a single edition so that it can be used by other teachers. Further I have experiment with varying assignments being given to students. Some of these assignments really turned to be interesting explanations for real life phenomenon a few which I have been able to include here. The idea for documentation of these papers arose in the discussion with Prof. Subhash Sharma, our Director quite some time ago. The idea was dormant was quite long time but found its awakening a few months when I finally decided to put that effort to document the papers presented all these years. I thank our Chairman Sri B.M.L. Jain and our CEO Sri Manish Jain for their support and encouragement all these years. Further without the constant coaxing of Prof. Subhash Sharma, these papers would have been dormant in one corner of my system than being collated as a compilation for future researchers to work. I thank IBA publications for bringing this volume. Id like to thank each and everyone who have supported me during building up these cases and also the students on whose throats some of these were pushed through and made to sit and solve. Further, all those students who were forced to put up with my quixotic and exotic assignments and the endless torture they went through the rewards of which are being visualized in this edition. Id like to acknowledge the efforts of Durvankur and Sanjog who have painstakingly helped me in formatting this edition apart from their involvement in cover design I dont want to have too detailed a preface and would let the readers judge themselves the case studies which are presented here

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. Analyzing mergers and takeovers using game theory: the case of TATA-CORUS deal .. 2 The Economics of Exchange Rates: Revaluing Yuan ..................................................... 12 SAFTA: Issues and prospects.......................................................................................... 19 Issues in disinvestment: The IPCL case .......................................................................... 27 Innovative approaches in public services delivery: Case study of Bangalore................. 36 Managing the Public Services in London: Challenges and Opportunities ...................... 54 iGoli 2002- Making Johannesburg a World City ............................................................ 59 Revenue creation in Urban Local Bodies: A Case on Bangalore Mahanagar Palika ...... 65 Information systems in urban governance: Bangalores tryst with MIS as strategic tool 69 Subex Systems Limited: A Case on Financing Decision ............................................ 72 Managing earnings in firms......................................................................................... 84 EVA: A Primer............................................................................................................ 91 To Swim or to Sink: Kingfisher Airlines in 2012 ....................................................... 99 Caselets in Macroeconomics ..................................................................................... 101

Contemporary Subjects Through Students Eyes.................................................................. 105

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1. Analyzing mergers and takeovers using game theory: the case of TATA-CORUS deal
Ms. Surabhi Agarwal 2 Prof. Prashant Kulkarni.3 Prof Anantha Murthy N.K.4 The recent spurt in cross border mergers and acquisitions by Indian companies in the last few years seems to suggest the arrival of India Inc. on the global stage. While acquisitions were earlier happening in the IT industry, the phenomenon has spread to other sectors too. Arcelor-Mittal (though Mittal is UK based company run by an NRI), Tatas victory over CSN to take over Corus, Hindalcos acquisition of Novelis, Tatas acquiring Jaguar all reflect these indicators. These acquisitions have been two ways both Indian companies acquiring abroad and overseas companies hunting for Indian firms. Daichiistake over of Ranbaxy is an illustration of the latter. Analysis of these events is done through valuations of the respective firms. We believe that merger and acquisition is a game and should be viewed in that perspective. Surprisingly, we find little evidence of substantiate literature on this subject. This becomes more evident in the case of Indian firms. We hope to fill this gap by introducing game theory models and use it to study the Tata-Corus deal. Mergers and Acquisitions have fascinated academicians, practitioners and laymen alike. With many Indian companies on the shopping spree in the market of takeovers, hardly a day passes without news of some merger or takeover happening in some part of the globe. Mergers mean a common means of restructuring the assets. Cross-border mergers and acquisitions (M&As) have increased dramatically over the last two decades. But little justice has been done in trying to fully understand the drivers of this activity and the consequent implications. This makes it the top of the discussion table for both policy makers as well as academics. This background becomes a natural corollary for us to frame the objectives for the present study

1 The paper is a version of the paper same titled same presented at national conference of management science organized by Chennai 2 Product manager at a leading research firm in Noida 3 Asst. Professor, economics & public policy, IBA Bangalore 4 Faculty , quantitative methods & operations research

ORSI & IIT Chennai at IIT

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Objectives Mergers, while traditional literature view it as an outcome of rational decisions, we view it as a game. Thus our objective becomes an application of how Game Theory is applied in Mergers and Acquisitions. (ii) Addition to the literature on mergers and acquisitions. Methodology We do an extensive literature survey on mergers and game theory. Based on this secondary data collection we adopt the case study approach to present our point. With an eye on the contemporary happenings the corporate world we take the example of the TATA CORUS deal, TATA outbidding CSN. The analysis proceeds with the use of dominance principle as an initial step followed by the use of auction theory to analyze the bidding procedures. With a lot of debate ranging on the strategy of Tatas in paying a premium, some of whom feel is unjustified, we adopt the Winners Curse approach to find whether the critics are really justified. To arrive at the conclusion, we go for traditional valuation models in finance besides bringing in the existing literature treatment for mergers. Literature survey Existing literature on mergers tends to focus on the fact the mergers represent an outcome of firms decisions taken in a rational manner. The rational manner is assumed to comprise of a process that is exhaustive and incorporates all available information implying no information asymmetry (Steiner, 1975, Chaterjee 1986, Jensen 1984 and Srivastva 1994). Economic theory of mergers shows that merger can be welfare enhancing instead of welfare reduction (Roller 2001). Further empirical studies have attempted to approach mergers as outcome of IO theory and thus a function of firm specific attributes. In IO literature, mergers are often discussed using the game theory approach. The seminal contribution has been of Horn and Perrson (2001) who develop an endogenous market model. The pioneering work however was by Manne (1965). He proposed that the corporates are best run by efficient and competent managers. He advocated a market for corporate control as best way of achieving this in a free market mechanism. The market would comprise of tender offers, mergers and proxy fights. Traditional financial theories focused on the presence of frictionless capital markets with complete information. This however had its critics and limitations in the fight for corporate control. The large premiums over initial stock market valuations paid for targets appeared to be at variance with market efficiency. This anomaly remained a puzzle for many academicians until the introduction of game theory concepts and techniques. Grossman and Hart (1980) pointed out that the tender offer mechanism involved a free rider problem. The introduction of this new problem aroused considerable interest. They argued that a firm makes a bid for a target in order to replace its management and run it more efficiently would provide an incentive for each of the targets shareholders to reject the bid. The new price would reflect their perception of the likely value addition to the firm by the new management. This free rider problem would then exclude the possibility of takeovers. Grossman and Harts Cases In Management Page 3 (i)

solution to this dilemma was to enable the acquirors to obtain benefits unavailable to other shareholders after the acquisition through the process of dilution which could be incorporated in the corporate charter. Shleiferand Vishny (1986a), favor toeholds by the bidders in the target before making any formal tender thus benefiting from the price appreciation in the toehold of shares. They already own. However Bradley, Desai and Kim (1988) find that the majority of bidders own no shares prior to the tender offer making this empirically limited. Contrary to theory of auctions, bidding in takeover contests occurs through several large jumps rather than many small ones. This was supported by the study of Jennings and Mazzeo (1993) who found that the majority of the initial bid premiums were over 20% of the market value of the target 10 days before the offer. Fishman (1988) argument rests on the foundation that the large initial premium deters potential competitors and reduces the likelihood of competition. He argues that a second bidder will find it worthwhile to spend the cost to investigate the target of if the initial bidders price was low. Shleifer and Vishny (1986b) develop a model where the payment of greenmail to a bidder, signals to other interested parties that no white knight is waiting to buy the firm. This puts the firm in play and can lead to a higher price being paid for it than initially would have been the case. Gort (1969) and Mitchell and Mulherin (1996) find that M&A activity is significantly correlated with technological shocks and generally with disturbance to the economy or a specific industry. This line is also followed by Jovanovic and Rousseau (2002). In this view, a merger wave is the effect of inefficiencies caused by exogenous shifts in the economic environment. Other contribution include Faria (2002) stating mergers serve as a vehicle for the transfer of managerial skills (intangible assets), and Lambrecht (2001) and Morellec and Zhdanov (2003) emphasizing non-strategic real options aspects of the merger decision. Last, Rhodes-Kropf and Viswanathan (2003) show that in situations with economy-wide misvaluations, targets may have a larger propensity to accept takeover offers. Horn and Persson (2001), Bjorvatn (2004) and Norbck and Persson (2004) provide theoretical models where foreign firms may acquire domestic acquisition targets, with the acquisition price being determined endogenously in a bargaining process. In these models, contrary to the tariff-jumping argument, high trade costs do not necessarily induce crossborder M&As. High trade costs not only encourage tariff-jumping mergers, but also increase the incentives for domestic mergers as they reduce the degree of competition in the domestic market thereby increasing the acquisition price domestic acquirers are prepared to pay for domestic targets (pre-emptive domestic mergers) Hietala, Kaplan, and Robinson (2004) present a framework for determining the information that can be extracted from stock prices around takeover contests. They use this framework to infer synergies and overpricing in the takeover contests. They use the takeover contest for Paramount in 1994 in which Viacom overpaid by more than $2 billion. Our findings are consistent with theories of managerial overconfidence Cases In Management Page 4

Bhagat and Hirshleifer (1997) estimate overpayments and synergies using movements in the bidders and targets stock prices around an intervening offer from another firm. They identify their empirical analysis by using ex post data (the sample average) to estimate the exante probabilities of success for initial and subsequent bidders and the expected price that a winning bidder will have to pay. Fuller et al. (2002) estimate bidder returns for frequent or serial acquirers. Schurman (1999) uses a related intervention technique to estimate proposed overpayments in acquisitions that were rejected by anti-trust authorities.

The Tata Corus Deal

Corus, the Anglo Dutch Company was acquired by the Indian Company TATA steel after outbidding its Brazilian rival CompanhiaSiderurgicaNacional (CSN) by paying Corus $12.1 billion. The London-based Corus Group is one of the world's largest producers of steel and aluminum. Corus itself was formed in 1999 as a result of the merger of Dutch group KoninklijkeHoogovens N.V. with the UK's British Steel Plc on October 6, 1999. Employing 47,300 people worldwide and 24,000 people in the United Kingdom, Corus makes nearly 4 times more steel than TATA steel and has an annual turnover of $ 18 billion. It is listed on the London Stock Exchange, Euronext Amsterdam and the New York Stock Exchange. Corus has four divisions: strip products division, long products division, distribution and building systems division, and aluminum division. The newly merged company will become the 5th largest producer in the world and the 2 in Europe. Tatas justified the deal with the intention of exploiting the low cost advantage of its Indian production coupled with the breaking up of supply chain to suit its needs. Tata Steel would now start producing the semi-finished goods at locations where it has raw material support and cost efficiencies and then making the finished good in the market where it gets the value, i.e. China, South East Asia and European countries.

Critics opine that Tatas have overpaid for the Corus deal. The final bid was nearly 455pence which rose to the final offer of 608 pence was nearly 33% of the initial bid amount. The Tata Steel stock shed over 10 per cent since the acquisition. This was a continuation of its sharp under-performance relative to the broad market and its sectoral peers since it announced its intention of taking over Corus. Financing the deal will come from the debt markets, with the borrowings secured against the cash flows of both Corus and Tata. An implication could be that Corus may have to struggle to service its debts and may even go Tata also has to manage several variables including steel prices, raw material supplies, and interest costs on the $8 billion debt that is being raised to fund the deal. Besides it also has to deal with sensitive issues of possible retrenchment and layoffs in Coruss manufacturing plant.

Tata Steel made a friendly takeover offer for Corus for 7.6 billion dollar at 455 pence a share in cash on October 17, 2006. This was culmination of the sequence starting a week earlier when Tata Steel evinced its interest in Corus. Three days later, the bid offer got the nod from the Board of Directors of Corus. Things seemed to be moving towards logical end Cases In Management Page 5

for Tatas when CSN entered in to the fray. The CSN board made an indicative bid of 475 pence per share on November 20, 2006. In early December the Corus board postponed its meeting to consider the offer of CSN. Tata Steel made its counter move on December 10th offering 500 pence per share. The total bid amount was $9.2 billion. This evoked a prompt response from CSN which upped its price to 515 pence per share amounting to $9.6 billion. Corus board accepted this offer but the matter went up to the UK regulators. In its judgment, on December 19, 2006 the UK Takeover Panel watchdog set a January 30 deadline for Tata Steel and CSN to make revised offers. On Dec 22, Tata Steel won t the approval from the European Commission to buy Corus. The stage was set for the final auction on January 26, 2007 when the Takeover Panel says it will launch an auction on January 30. Meanwhile CSN got the EU nod for its bid on January 29, 2007, leading to the auction on January 30. On Jan 31, the Tatas outbid CSN with 608 pence a share offer. The above bid actions and transactions can be presented as a payoff matrix as
Bidding 1


3 455 , 603 500 , 603 608 , 603


1 2 3

455 , 475 500 , 475 608 , 475

455 , 515 500 , 515 608 , 515

According to this pay off matrix prepared by the above given data, there are two players TATA and CSN, where TATA is the main player and CSN is the secondary player. The player on the vertical axis is the main player. The columns and rows numbered 1, 2, 3 are the number of the biddings of both the players in the CORUS game and the two numbers in every row and column are the pay offs which indicate the value of the bidding. The first value in every cell is the bidding value of TATA and the second value in each cell is the counter bidding of CSN against TATA. For obtaining solution we can reduce the above pay off matrix which shows the difference between values in each cell of the above pay off matrix as:

Bidding 1 1 - 20 25 133 2 - 60 -15 93 3 - 148 -103 5


2 3

The values in each cell in the above pay off matrix are the difference between the values of the biddings made by the two players i.e. TATA and CSN. The negative values indicate that TATA has lost the bidding and the positive values indicate that TATA has won the bidding. Cases In Management Page 6

Now, this pay off matrix can be used to calculate the saddle point by the application of the Dominance Principle. In the Dominance Principle, the row having the highest values dominates the row having the lowest values and the row with the lowest row is eliminated. Similarly, the column having the lowest values dominates the column having the highest values and the column with the highest values is eliminated. While doing this either row or column is taken into consideration. The process continues till we are left with one cell, the value in that cell is called the Game Value and the intersection of that point is called the Saddle Point. Thus, using Dominance Principle in the above pay off matrix, we get 5 as the Game Value and its intersection i.e. (3, 3) is the Saddle Point. When we get a Saddle Point then the strategy adopted by the two players is called the PURE STRATEGY as it gives a unique solution. Thus, we arrived to the conclusion derived from the Dominance Principle is that Overvaluation = 5 pence TATA and CSN both adopt the 3rd strategy The strategy adopted is a Pure Strategy TATA is the winner by 5 pence and CSN is the loser

Do Tatas suffer from Winners Curse?

See, I dont consider that I have overbid for Corus. We have paid more than what we had initially wanted to pay; that we offered in October. And that would have been the price at which we took Corus. Then we had a competitor who came in and between him and the hedge funds, the price of Corus went up. It never reached a level where we would have thought it would be jeopardy to our shareholders to take it. And if we had reached such limit, we would not have taken. -Ratan Tata, on CNN-IBN, Feb 27, 2007 Tatas defense has not convinced many. Critics do feel that Tatas overpaid for the deal. We take a look at the market prices of the Tatas during this period. We believe that market estimations are best way of judging whether it is overpaid or not. Corus has been alternating between bankruptcy and peak over its existence. Its P/E ratio is quite less compared to the S&P500. In 2004 and 2005, its P/E ratio was less than one third of that of S&P 500. Even in 2006 the P/E ratio of 13.6 is less than S&P 500s figure of over 20. The Price to Book ratio also compares unfavorably with the industry average and S&P 500.

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Current Valuation of Corus

Stock Price/Earnings Price/Book Price/Sales Price/Cash Flow Dividend Yield % 13.3 1.8 0.6 8.8 1.2 Industry 15 5.6 3.1 14.6 1.1 S&P 500 20.9 4.2 3 15.2 1.7 Stock's 5Yr Average* --0.8 0.3 6.3 ---

* Price/Cash Flow uses 3-year average.

Source: The forward valuations too reflect the same

Forward Valuations
Stock Forward Price/Earnings PEG Ratio PEG Payback (Yrs) 15.3 --NMF Industry Average 11.8 3 9 S&P 500 Average 17.5 1.6 9.1

Source: The yield curve is shown below

Yield on Corus Stock

Source: In this scenario Tatas paying a hefty premium has led to question marks. If we were to compare the Tatas performance over the past few months, it has been underperforming relatively to the industry and the BSE Sensex. The trend line is shown below. Cases In Management Page 8

Market perception of TATA on bidding dates

560 540 520 500 480 460 440 420
O ct (1 17 ) th (2 ) 20 17 th(3 ) th No v( 11 4) th De c( 5) 22 nd 29 ( th 6) Ja n( 7 31 ) st (8 )

Price of stock

Price of the stock Trend values

5t h

Bidding dates

Looking at the graph it seems that particularly when CSN entered the fray, the market did not approve Tatas decision to raise the price. The market prices of Tatas have been going down. In the end the victory also doesnt get reflected in the enthusiasm of the market. While the prices are slightly above the trend line the narrow margin seems that that market is wary about the deal. This again reflects a case of overvaluation likely to have happened.

Based on our analysis we draw the following conclusions 1. The trend of the events does follow the theoretical underpinnings. While the initial offer of a high premium was intended to minimize the possibility of a competitor entering, Tatas could not prevent it. 2. The next theory that psychology plays a role in bidding did seem to have happened with Tatas increasing their bid to more than 25% of the initial offer to outbid Corus. 3. While initially it does seem that there is some overvaluation, Tatas feel that their management would add value to Corus. In other words Corus was sharply undervalued. 4. If this were to be the case we feel that we need to wait and watch the prices over the next year before arriving at any definitive conclusion. 5. The market reaction however shows it is not exactly buoyant about the deal. The frequent underperformance of Tata Steel stock during the run up to the deal and the lukewarm reaction by the market on Tata Steels victory is pointers to this. 6. Our analysis too points out to a similar conclusion that Tatas did overvalue Corus.

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1. Betton, S and Eckbo, B E (2000) Toeholds, Bid-Jumps and Expected Payoffs in Takeovers, Review of Financial Studies, 13, pp841-882. 2. Berkovitch, E and Narayanan, M P (1993) Motives for Takeovers: An Empirical Investigation, Journal of Financial and Quantitative Analysis, 28, pp347-362. 3. Bradley, M, Desai, A and Kim, E H (1988) Synergistic Gains from Corporate Acquisitions and Their Division Between the Stockholders of Target and Acquiring Firms, Journal of Financial Economics, 21, pp3-40. 4. Bulow, J, Huang, M and Klemperer, P (1999) Toeholds and Takeovers, Journal of Political Economy, 107, pp427-454. 5. Burkart, M (1995) Initial Shareholding and Overbidding in Takeover Contests, Journal of Finance, 50, pp1491-1515. 6. Chowdhry, B and Jegadeesh, N (1994) Pre-Tender Offer Share Acquisition Strategy in Takeovers, Journal of Financial and Quantitative Analysis, 29, pp117-129. 7. Eckbo, B.E., 1985, Mergers and the Market Concentration Doctrine: Evidence from the Capital Market, Journal of Business 58, 325-349. 8. Eckbo, B E and Langohr, H (1989) Information Disclosure, Method of Payment and Takeover Premiums: Public and Private Tender Offers in France, Journal of Financial Economics, 24, pp363-403. 9. Engelbrecht-Wiggans, Richard (1994) Auctions with Price-Proportional Benefits to Bidders, Games and Economic Behavior, 6, pp339-346. 10. Ettinger, D (2002) Auctions and shareholdings, working papers Ceras. 11. Franks, J R and Harris, R S (1989) Shareholder Wealth Effects of Corporate Takeovers, Journal of Financial Economics, 23, pp225-249. 12. Goergen, MandReneboog, L (2002) Shareholder Wealth Effects of European 13. Domestic and Cross-border Takeover Bids, Working paper 2002-50, Center, Tilburg University. 14. Grossman S J and Hart, O D (1980) Takeover Bids, the Free-Rider Problem and the Theory of Corporation, Bell J. of Econ., 11, pp42-64. 15. Gupta, A, LeCompte, R and Misra, L (1997) Acquisitions of Solvent Thrifts: Wealth Effects and Managerial Motivations, Journal of Banking and Finance, 21, pp14311450. 16. Hirshleifer, D (1995) Mergers and Acquisitions: Strategic and Informational 17. Issues in Finance, edited by R A Jarrow, V Maksimovic and W T Ziemba. 3d ed Handbook in Operations Research and Management Science, vol 9, Amsterdam, North-Holland. 18. Hirshleifer, D and Titman, S (1990) Share Tendering Strategies and the Success of Hostile Takeover Bids, Journal of Political Economy, 98, pp295-324. 19. Jarrell, G A and Poulsen, A B (1989) Stock Trading before the Announcement of Tender Offers: Insider Trading or Market Manipulation?, Journal of Law, Economics and Organization, 5, pp225-248 20. Kaplan, S.N., 1994a, Paramount 1993, Case, University of Chicago Graduate School of Business. 21. Kaplan, S.N., 1994b, Paramount 1994, Case, University of Chicago Graduate School of Business. Cases In Management Page 10

22. Maasland, E and Onderstal, S (2002) Auctions with Financial Externalities, Working paper 2002-22, Center, Tilburg University. 23. Roll, R., 1986, The Hubris Hypothesis of Corporate Takeovers, Journal of Business 59, 97-216. 24. Shleifer, A and Vishny, R W (1986) Large Shareholders and Corporate Control, Journal of Political Economy, 94, pp223-249. 25. Singh, R (1998) Takeover Bidding with Toeholds: the Case of the Owners Curse, Review of Financial Studies, 11, pp679-704. 26. Stulz, R M (1988) Managerial Control of Voting Rights: Financing policies and the Market for Corporate Control, J. of Financial Econ., 20, pp25-54. 27. Stulz, R M, Walkling, R A and Song, M H (1990) The Distribution of Target Ownership and the Division of Gains in Successful Takeovers, Journal of Finance, 45, pp817-833. 28. Walkling, R A (1985) Predicting Tender Offer Success: A Logistic Analysis, Journal of Finance and Quantitative Analysis, 20, pp461-478. 29. Walker, M.M., 2000, Corporate Takeovers, Strategic Objectives, and AcquiringFirm Shareholder Wealth, Financial Management 29, 53-66.

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2. The Economics of Exchange Rates: Revaluing Yuan

Prashant Kulkarni5 In May 2005, a buzz seemed to have set in among speculators, investment managers, policy makers and economists alike. They seemed to be convinced that China was set to revalue its currency, Yuan, against the dollar. A news report on the website of government run Peoples Daily in the same month predicting revaluation seemed to have added further fuel. Though the report was found to be erroneous and the newspaper withdrew the story, not many were convinced. China had been facing pressure in recent times from the US, Europe and IMF to revalue its currency.

Background Note
The Yuan had been pegged to the dollar at 8.28 since 1995. The strong economic growth which China had been experiencing since the mid-1990s was attributed to large scale foreign investments flowing into the country. These investments were, in turn, facilitated by the dollar Yuan exchange rate. China was also able to come out of the currency crisis that shook South East Asia during the late 1990s, relatively unscathed. But, with the passage of time, many analysts began to see the fixed exchange regime as a liability for China. By early 2005, Chinas forex reserves were growing at around $17 billion per month6. In contrast, India, the country often compared with China, was receiving just a quarter of this amount. Chinese central bank was facing problems in utilizing these reserves. Most of it was going towards keeping Yuan pegged at 8.28. The surplus on the current account had touched more than 4% of the GDP. Besides, the policy makers in the US and Europe, who saw a weak Yuan as a threat to their domestic industry and economy, too started pressurizing China to allow its currency to float. In early 2005, the US threatened to take retaliatory measures in the form of tariffs, if China did not let Yuan appreciate. There were, however, equally vociferous voices opposing any change in the currency peg. Domestic pressure was mounting on Chinese authorities not to take any action under external pressure. Various reasons including cheaper exports by China rising US Trade deficit, need for a strong monetary policy by China, overheated Chinese economy, etc. were cited by both the parties to advance their arguments.

5 Asst. Professor, Economics & Public Policy, IBA Bangalore 6 Whats it Worth?, The Economist, May 21, 2005

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Exhibit I Exchange Rates Exchange rates were defined as the price of one countrys currency relative to another countrys currency. Exchange rates were classified into two types, viz. Fixed Exchange rates and Floating Exchange rates. In the case of fixed exchange rates, the central bank of the country, in concurrence with the government, fixed the rate for exchange of the domestic currency with the external currency. The currencies were generally tied to the dollar. In some cases, the rates were tied to basket of currencies. While the basket was supposed to be a secret, in general it was tied to the leading currencies. The rate remained stable and the central banks intervened by selling or buying foreign currencies to keep the rate fixed. In the case of floating exchange rates, the domestic currency was allowed to float freely in the market against external currencies. In some cases, the central bank enforced some restrictions on the movement of the currency. The currency could be traded within the fixed band. Sometimes, this practice was termed as managed float or even dirty float. Source: Compiled from various sources by Research Team, ICBR

Issues Cheaper Exports

Chinas policy of keeping Yuan weak was aimed towards making exports competitive. Critics felt that cheaper exports hurt other countries and resulted in an unfair advantage to China. Authorities, however, feared that any move to appreciate the Yuan would hurt Chinas export sector. Appreciation of the Yuan would weaken the exports, resulting in the fall of revenues to the companies. This in turn would impact profitability. Since many enterprises employed surplus workers, they might have to retrench the workers to absorb the rise in the cost of labor. With unemployment on the rise, this was expected to add to its woes. Agriculture sector was heavily subsidized. With nearly a quarter of the food sold in the market being imported, the percentage might go up once import prices got cheaper. This was likely to hit the farmers hard particularly when nearly two thirds of the Chinese population was agrarian. These led to apprehensions about the possibilities of social unrest, particularly in the interior of the country. On the other hand, imports into China had become expensive. China was facing rising demand for machinery, metals and petroleum which it imported from other countries. With rising prices in oil, steel and copper, there were concerns about the negatively impact this might have the trade balance. A stronger Yuan had the potential to offset the rising import prices. The benefits could be passed on to the consumers, leading to lower prices. Cases In Management Page 13

Chinas Monetary Policy

China feared massive capital losses if it were to go in for sharp appreciation of currency. Estimates suggested the losses to the extent of around $100 billion (7% of Chinas GDP as per 2004 figures) if Yuan were to appreciate around 20%7. While this might deter China from revaluation, or at best induce her to opt for revaluation on lesser scale, a section of analysts opined that carrying costs might be higher if China were to delay the revaluation. Some even suggested the costs could be as high as 30% of the GDP. To many, Chinas monetary policy seemed to be ignoring these carrying costs. They felt that the interest income earned on these reserves did not compensate for the costs incurred. According to some estimates, the costs might eat up the foreign exchange reserves upto the extent of 50% of the total reserves (more than 10% of the GDP). On the other hand, the Chinese economy was believed to be overheated. There was a feeling that there was excess liquidity in the market. Current account surplus, which was around 1% of the GDP in 2001, had jumped up to nearly 4.5% by 2004. This created distortions in macroeconomic management. Resources were being diverted to promote exports at the cost of the rising domestic demand. A stronger exchange rate was likely to result in greater purchasing power to the consumers. The Chinese Central Bank had issued domestic currency bonds (nearly 1 trillion Yuan outstanding by early 2005) to counter this excess liquidity. With local banks reluctant to buy these bonds any further, revaluation was thought to make things worse.

Financial System
Analysts felt that Chinas financial system was still fragile and underdeveloped as compared to that of the Western countries. Many firms had little experience in hedging and remained financially backward. The presence of foreign banks was limited. Managing currency risk was yet to take off. Securities and futures markets were a recent phenomenon. Observers feared that speculators might take advantage of this to book profits and then exit the market. A small revaluation might be taken by speculators as a hint of further revaluation. This in turn, might lead to inflow of more speculative capital causing greater volatility in the financial markets. As a result of these factors the markets may not be able to withstand the revaluation of the currency. Chinese banks on the other hand also feared of the possible increase in loan defaults. The system was already troubled by the large percentage of Non-Performing Loans (NPLs) (about 40% in 2002-03). These NPLs were securitized and traded with US investors being the dominant players in the market. Revaluing Yuan would increase the value of these NPLs while the dollar assets held by central banks to keep Yuan pegged would lose its value. Worst case scenarios drawn by economists pointed out the danger of even the Chinese Central bank going insolvent.

7Nouriel Roubini, Ten Reasons why China should move its peg and pull the plug on the US reckless policies, May 11, 2005,

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Inflationary pressures
Though inflation had come down to around 3% in mid-2005, from about 5% the year before, some studies predicted that China could experience a high inflation in the forthcoming years. Prices were controlled and there were discrepancies in measuring the price indices. China was in the midst of real estate investment boom. The low interest rates on deposits seemed to have made investors turn towards real estate where returns were far higher. Investment to GDP ratio was around 45% by early 20058. The fall in prices of agricultural commodities was being seen as a temporary phenomenon. Given the widespread perception that the Yuan was undervalued (some figures quote to the extent of 60%), experts warned about the possibility of a further rise in inflation.

US Trade Deficit
By 2004, the US economy was facing the prospect of a trade deficit crisis. By May 2005, the deficit had touched nearly $60 billion. The administration believed that the undervalued Yuan was largely responsible for this crisis. They argued that low cost Chinese exports flooding into the US markets were hurting local producers and causing unemployment. Euro zone countries which were bearing the effects of the falling dollar were also keen on appreciation of the Yuan and other Asian currencies. A section of analysts, however, argued that trade with China accounted just about 10% of the total. Revaluation of Yuan even by 20% would still fall well short of the target required to peg the deficit levels at 2-3%, levels considered manageable by most. Moreover, Chinese exports were found to have high import content, thus considerably reducing the impact of any revaluation. Moreover, Chinese Central Bank was one of the leading buyers of the dollar. If the Asian Central Banks were to diversify their foreign exchange reserves, dollar could experience a steeper fall. Some analysts went to the extent of claiming that but for China buying the dollars to shore up its reserves; the dollar would have experienced a further fall. Others attributed the rising deficit to high consumption rates in the US. The US was believed to have one of the lowest savings rates in the world at around 1% of the GDP.

The Road Ahead

By early 2005, the Bush administration seemed to be growing vociferous in voicing its demands for the revaluation of the currency. The US Treasury Secretary John Snow, while conceding that China had done some ground work, demanded that it speed up its process. Congressmen in the US were calling for legislations that would enforce tariffs on Chinese goods. They believed that this would make China come around to the US viewpoint. Critics however called it a protectionist measure which could rebound on US. Meanwhile, debate was getting around in understanding the options before China as it proceeds to take the next step. While China might go in for revaluation of the Yuan as demanded by the US, there seemed to be no consensus on what might be the right value for

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revaluation. If China were to go in for small correction, it might lead to expectation of further revaluation coming about. Speculators might exploit this sentiment. Reports from China were already discussing about the rise in the inflows of hot money into the country. Other Central Banks in Asia too limited the appreciation of their respective currencies to maintain competitiveness with Yuan. Any possible Chinese move was likely to have a chain reaction with these currencies too getting appreciated. Some expected a possible diversification of forex reserves by central banks in Asia which had been leading buyers of gold. This school of thought believed that this would lead to upward pressure on US interest rates besides rise in import prices. With foreign banks generally sensitive to prices of financial assets and a good percentage of US imports coming from the Asia Pacific Rim, the belief seemed to have found some credence. However, others argued that though the central bank purchase of US treasury bills had slowed down, demand from private investors remained strong. Moreover, it seemed extremely unlikely that the central banks would stop purchasing dollars altogether. Further, even a slight rise in interest rates would curb American consumption, which some felt, was the cause of American economic woes. Moreover, critics of US administration felt that China should call US bluff by letting Yuan appreciate. They pointed out that with other central banks going in for diversification of reserves, it might be China that would ultimately have to take up the burden of financing the US deficits. Meanwhile, large multinationals, which had a strong presence in China (either they had production units there or sourced raw materials from China), were calling for status quo in the price of Yuan. They feared that a stronger Yuan would result in rise in prices hurting their bottom line. Some experts reckoned that China would have to let its currency appreciate sooner or later. According to them, the least China could do was to widen the peg against the dollar or go in for a gradual shift from the dollar peg to one based on a weighted basket of currencies. The advantage was likely to stem from the fact China would have the advantage of adjusting its movement in relation to multiple currencies unlike now where its fortunes were completely dependent on the fortunes of the dollar. The second option for China seemed to widen the band within which Yuan was trading. The band could be a range of 1-1.5% on either side of the central value. Some analysts however argued that China would have to go in for one time revaluation of 10-15% to be followed by managed float. Given the rising prices in real estate, revaluation was likely to ease the pressure on inflation apart from giving Chinese central bank more flexibility in framing its monetary policy. Besides, Chinas external debt had crossed $200 billion by late 2004. With a large percentage of the debt denominated in dollars, appreciation of the Yuan was likely to reduce its debt value in dollar terms. While Chinese policy makers seemed to be thinking on the possible revaluation, they seemed determined not to do it under pressure. Any sign of revaluing Chinese currency was being seen in the domestic quarters as surrender to the international pressure. Besides, it was being equated to surrendering of national respect.

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There was also a feeling that the economic overheating was confined to a few sectors. Moreover, with China in the process of undertaking structural reforms in its banking and financial sector, they were concerned with the systems ability to bear the likely impact. They cited the experiences of Hong Kong and Japan when they went in for revaluation (Exhibit II). They further warned of likely repeat by China of these instances.

Exhibit II Revaluation: Other Experiences In November 1974, Hong Kong floated its dollar after abandoning its fixed rate mechanism. This action resulted in volatility in the financial markets. By 1983, the volatile markets had taken their toll resulting in a sharp fall of the Hong Kong dollar. People had even resorted to hoarding toilet paper, rice and cooking oil to protect themselves from rising prices. Hong Kong had to abandon the floating rate mechanism and switch back to fixed rate system. Japan floated its yen in 1971 following the collapse of the Bretton Woods system. The banking system had collapsed consequent to the rise in NPLs in the economy. Strong Yen was often seen as the cause for recessions in Japan. In 1989, Japan witnessed a peak in property and share market. During this bubble, a single square mile of Tokyo was worth more than many other countries in the world. Even by 2005, Japan had not been able to recover completely from that crisis. Source: Compiled from various sources by Research team, ICBR While the debate raged on the probable course of actions and counter actions, what China might exactly do continued to remain anybodys guess.

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References 1. Chinas Currency Impact, Textile World, December 2004 2. Yuan Step at a time, Economist, January 22, 2005 3. Paul Freedenberg, Balancing Economic Opportunity and Strategic Risk in China, American Machinist, February 2005. 4. Cock-a-doodle-doo, Economist, February 5, 2005 5. James Haughey, Fair Exchange?, Electronic Business, March 2005 6. Nouriel Roubini, Ten reasons why China should remove its peg and pull its plug on the US reckless policies,, March 11,2005 7. Nouriel Roubini, Is the US Really Serious or Masochist About Demanding a Revaluation of the Chinese Currency? Playing with Fire and the Risk of a Market Crash,, April, 2005 8. Ted H. Chu, The Chinese RMB: its Peg, its Value and its Future, Business Economics, April 2005 9. Yuan Revaluation: Pros and Cons,, April 2005 10. Softly, Softly , Economist, April 2, 2005 11. Chinas Central Bank says no plan for imminent revaluation- says report,, April 24, 2005. 12. Global Impact of Yuan Revaluation, www.emerging-markets-online-com, April 25, 2005 13. Revaluing the Yuan: Where Politics and Economics Collide, Knowledge@Wharton, May 2005 14. Prospects and Implications on Chinese Yuan Revaluation, Report by Economic Research Department, Northern Trust Company, May 6, 2005, 15. Pressure on Chinas Revaluation wont work,, May 12, 2005 16. Paul Krugman, The Chinese Connection, New York Times, May 20, 2005

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3. SAFTA: Issues and prospects

Prof. Prashant Kulkarni9 With the economic integration at a global level fraught with hurdles owing to issues like inequality and structural asymmetries between economies, the focus is now shifting to more on integration at regional levels. The shining examples of this trend were the European Union which has moved from a stage of an economic community to the one involving political union and that has provided for a common currency. NAFTA involving USA, Canada and Mexico and ASEAN involving South East Asian nations were seen as other examples of how regional integration can step up economic progress. But South Asia has lagged behind. Comprising seven countries Viz. India, Pakistan, Bangladesh, Nepal, Sri Lanka, Maldives and Bhutan the region is host to about 1.2 billion people of whom over 425 million account for the middle class10. The GDP based on Purchasing Power Parity is $3.7 trillion and the economy is growing at combined growth rate of 7%.But it only captures just 2% of worlds GDP and commands just 1% of share in global trade. In contrast, the European Union which represents 6.3 percent of the worlds population accounts for 20 percent of global GDP, and over 40 percent of world exports. The story of SAFTA is the one of the countless opportunities lost, of gains being withered away, of trade being held hostage to politics, of fears of a single country dominating the rest of leaders not being able to rise above their narrow short term considerations and of bitter squabbles between the member nations. But at the SAARC summit in Islamabad in Jan 2004, the leaders of the seven nations agreed to move ahead with the formation a South Asian Free Trade Area (SAFTA) which comes into effect on 1st Jan. 2006. Beginning from 2006 over the period of 10 years the duties will be reduced to 20% in India, Pakistan and Sri Lanka while the less developed ones like Nepal, Bangladesh, Maldives and Bhutan would reduce their duties to 30%11. South Asian Association for Regional Co-operation (SAARC) was formed in 1985 at a summit of leaders of South Asia held at Dhaka. While the initial focus was on enhanced cooperation in various spheres the movement had been held hostage to the continuing hot and cold relationship between India and Pakistan. This baggage which SAARC had carried ever since its inception ensured that the organization remained in limbo while feigning life on paper. The impressive achievement it sought to portray in South Asian Preferential Trade Agreement (SAPTA) did not take off. The ground towards the next logical step of Free Trade Area (SAFTA) therefore had to be dragged off for nearly six years. The crunch of the problem was the never ending disputes between India and Pakistan. This had lead to a situation of Pakistan importing tea from Kenya even though neighboring India was the largest producer. While the first years the organization was trying to get its feet going the first real movement came in Dec.1995 with the formalization of the South Asian Preferential Trading Arrangement (SAPTA). The aim of this agreement was to provide preferential concessions to member countries on a host of items with special provisions made for the Lesser Developed

9Asst. Professor Economics & Public Policy, IBA Bangalore 10Dr.KhwajaAmjadSaeed, South Asian Economic Union by 2010, 11M.Aftab, Can SAFTA lead to a South Asian Economic Union, Dawn Jan 19th 2004,

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Countries. But post 1998 onwards with the deteriorating situation between India and Pakistan cast its shadow over SAPTA and delayed the introduction of SAFTA.

Proposals of SAFTA
It aims to move to a higher level of trade and economic co-operation by eliminating the restrictions that have hampered intra-region trade. It classifies the countries into two categories. The first was Least Developed Countries (LDCs) which comprised Bangladesh, Sri Lanka, Nepal, Maldives and Bhutan. India and Pakistan were categorized as Non Least Developed Countries (NLDCs). While affirming the existing rights of Marrakesh agreement on WTO, the framework provided for the free movement of goods in the region by seeking to eliminate tariffs and para-tariffs and non-tariff restrictions on movement of goods within the region12. The member countries would harmonize their legislations so as to facilitate trade and commerce among the member countries. The NLDCs were also needed to accommodate the LDCs by offering concessions on a non reciprocal basis. The arrangement would come into effect on January 1st 2006. The framework talked about India and Pakistan undertaking the reduction in tariffs from the existing rates to 20% within a two year period while the corresponding rate for the other countries will be 30%. While the NLDCs will have to bring down their tariffs in the range 0-5% in a five year period starting from Jan.1st 2008 Sri Lanka would get six years and the other countries 8 years. There is also the provision for unilateral accelerated reduction of tariffs. The provision of Sensitive Lists was provided for to protect domestic industry subject to Ministerial Review after every four years. The LDCs however would receive special considerations and flexibilities in regard to anti-dumping measures and quantitative restrictions and also a suitable mechanism for loss of revenue on account of elimination of trade barriers. The framework also provides for safeguards on Balance of Payments, dispute settlements, and harmonization of standards, custom clearance and documentation issues. The framework works for the promotion of investments within the region and also development of transport and communication faculties which would enhance the development in the region.

Issues in SAFTA Trade Effects

The theoretical underpinnings for these regions lie in the theory of Trade effects propounded by Jacob Viner in the 1940s. The economic area is held viable from the static point of view if the Trade Creation outweighs Trade Diversion. However in a dynamic setting the issue can be approached in terms of positive benefits accrued on account economies of scale, access to improved technology, increased investments in infrastructure and services and enhanced bargaining power accrued on the emergence of the larger group.
12M.Aftab, Can SAFTA lead to a South Asian Economic Union, op.cit

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The negative impact would be due to flight of capital from the less developed countries to the more developed ones. This could result in adjustment problems for the less developed countries. There is also the distinct possibility of giant firms emerging taking advantage of mergers and acquisitions and this could result monopolist or oligopolistic tendencies in the market. In the case of South Asia, the presence of high barriers on account of non economic considerations the trade between member regions is minimal. India and Pakistan do not even accord Most Favored Nation (MFN) status to each other though they are obliged to do so by the provisions of WTO. The intra-SAARC trade is at a very low 3.8% of the total trade in the region with comparative figures for ASEAN and NAFTA being 40% and 37% respectively. The intra-European Union (EU) trade is at a high figure of 65%. Indias imports from SAARC countries account for 0.11%, 0.9% and 2.7% of the total imports under SAPTA1, 2 and 3 respectively implying India imports from outside the region.13.

Trade Flows
To understand how SAFTA is likely to change the trade patterns it will pertinent to see the changes witnessed in the trade patterns between India and Sri Lanka following the Free Trade Agreement between the two countries. The Agreement was signed in Dec.1998. Indo Sri Lankan trade was hampered by historical reasons and the mindset of the people. The fruits which were imported at expensive rates from outside the region now are imported from India. In case of coconut oil, there was widespread smuggling when the industry was protected. The FTA formalized these channels enabling the bilateral trade to cross $1billion mark by the June 200214. UNCTAD reports that Sri Lanka's exports to India increased from $71 million in 2001 to $168 millions in 2002 while India's exports to that country went up to $ 831 million in 2002 from $604 million in 200115. The free trade agreement apart from imparting dynamism in the trade between the two countries also helped in reducing trade surplus of India with Sri Lanka from 8.6:1 to 4.9:1 within two years16. The scope of FTA is being expanded to the Services sector also. A closer scrutiny of the trade flows between the member countries revealed that the exports from India in the informal sector comprise to a large extent the locally produced goods. On the other hand the third country goods account for a lions share in the goods being imported by India. Therefore analysts feel that the rules of origin (ROO) should be built into the framework of SAFTA so that no country takes undue advantage of dumping third country goods into the other member countries. This would ensure the survival of the domestic industry.

Synergies and Complementarities among Member Countries

The experience of Regional Trading Arrangements (RTA) had shown that there is considerable benefit through utilization of synergies among the member countries. In Europe
13 Dr. K.R.G.Nair ,, India and Regional Economic Groupings in Asia op cit 14V.S.Sambandan, Growing Economic Links, Frontline Nov.8-21 2003 15 The Hindu Sep 8 2003 16Nagesh Kumar, SAFTA: Trade or Development, The Hindu Jan 5 2004

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the formation of the European common market led to a substantial restructuring in the industry taking full advantage of pan regional set up. This enabled the industry to reap fully the economies of scale and focus on scope and specialization leading to greater efficiency and increased welfare. RTAs thus become a matter of investments and industrial restructuring as much as they are a matter of trade. The evolution of SAFTA may help in horizontal specialization across the region. This would help in optimal utilizations of the synergies of various member countries for mutual advantage. The major areas are likely to be Sri Lanka for rubber based industries, Bangladesh for energy based industries owing to the high unexploited reserves of natural gas it sits on and Bhutan for forest based products. However it should also be noted except in case of Bangladesh, the other specializations are in case of commodities that fall in the lower end of the value chain and therefore may not really help in kick starting the economic growth. The measure of success of any regional trading arrangement depends to a great extent on the complementarities it generates among three member countries. Textiles are the major export item among the SAARC countries particularly India, Sri Lanka and Bangladesh17. The major items of import are POL products, machinery and industrial raw material. Except India the trade complementary index falls very low. This is due to the narrow trade base for those countries whereas India with its diversified base commands a significant share in global market in sectors like engineering goods, pharmaceuticals and information technology. However with the changing focus on vertical specializations as opposed to the traditional viewpoint of horizontal one, there appeared to be tremendous potential for the SAARC countries to take advantage of.

India as a Big Brother

India with it huge population and industrial base is far ahead in relative economic terms compared with its neighbors. The Indian industry is likely to be the biggest beneficiary by the emergence of the free trade zone. While the Indian trade is likely to touch $ 6.2 billion by March 2004 the next competitor {Pakistan is expected to account only for $ 510 million by the same period). This reflects the huge inequality that exists between India on one hand and the other nations on the other. This asymmetry presents itself as a major challenge to the policy makers in SAARC in general and India in particular. India showed its sensitiveness when it drew up a FTA with Sri Lanka by allowing greater access to Sri Lankan products into the Indian market did not insist in reciprocity. The new regime would witness the lowering of tariffs. This had resulted in the fear by smaller countries like Nepal and Bhutan of the Indian products flooding the market. While Sri Lanka benefited in reducing its deficit with India as shown above after the FTA, it needs to be seen whether the same could be said of other SAARC countries. To assuage these fears India has proposed some unilateral initiatives. These include the reopening of road, rail and ferry links with Pakistan, the open skies arrangement and ferry links with Sri Lanka, optical fiber backbone project, rail agreement and hydroelectric projects

17Dr.AkhtarHasan Khan, SAARC: Chances missed so far, Dawn January 5 2004

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undertaken in Nepal, hydroelectric projects in Bhutan and the Dhaka-Agartala bus service in Bangladesh.

Conflict of Interests: Indias Attempts for Trade Arrangements with Other Countries
Indias size and population despite making it an ideal candidate for an important role in the global economic set up has been bogged down by the relationship with the neighborhood particularly Pakistan. These conflicts affecting the progress of SAARC made India think about other avenues to fulfill its aspirations. This lead to the formulation of Look East policy, focusing on enhancing relationship with ASEAN as Full Dialogue Partner and concluding FTA with Thailand and Singapore. BIMSTEC initiative to promote co-operation in tourism, education, culture, transport and communication is also an integral part of this approach. McKinsey reported that the Indian trade with ASEAN would reach $24-30 billion by the year 2007 from $9 billion in the year 2000. However experts felt that India had woken up too late and it will be difficult catch up with China which has already signed a FTA with ASEAN resulting in creation of the largest FTA in the region with the likely trade generation of $ 1.2 trillion. However there is ample scope for expansion in trade with ASEAN given the fact while Indias trade with it accounts for about 7% of its world trade, ASEANs is less than 1% of its global trade. With Bangladesh also part of these economic forays and Sri Lanka and Nepal likely to join suit the danger is present of the derailing SAFTA due to shift in focus. However analysts also believe that while to an extent this diversion could hamper SAFTA, it will lead to formation of new opportunities for the Indian business in South Asia the access to which had been hitherto hampered by extraneous factors and pave way for emergence of a new regional identity.

Indo-Pakistan Relations and SAFTA

India and Pakistan command a dominant position in the region naturally because of their size and population. Economically too they are relatively better off than their neighbors like Bangladesh and Nepal. Therefore any success of the FTA will hinge upon the enthusiasm and willingness to co-operate between these two players. But as history shows the two countries have done exactly the opposite resulting in the entire process of regional integration being held hostage to hot and cold relationship between these two countries. The situation after having hit low in Dec. 01 saw a movement towards normalization in 2003 and this cautious optimism paved the way for the summit. This struggle between the two leading players of the region had put a question mark on whether SAFTA would ever be a reality or would remain a mirage. The trade between two countries was estimated to be around $ 700million through official channels18. As of Sep. 2003 the Indian exports to Pakistan was about $ 68 million while the imports $32 million19. The paradox of the trade between the two countries was best highlighted by the lack of trade in tea. Pakistan is the third largest importer of tea with the value hovering around 150 million kg per year. India on the other hand is the worlds biggest producer. But less than 3% of
18 Pakistan ready to discus MFN status, The Hindu Jan 8 2004 19

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Pakistans imports come from India. Conversely in cotton while Pakistan is one of the largest growers, India is a traditional importer to feed its textile industry. The current trade between the two to the tune of $2 billion which takes place through third country channels like Hong Kong and Singapore was expected to reach $10 billion if the bottlenecks like lack of communication and transport linkages eased. India is one of the largest consumers of energy and therefore a potential market for energy producer in Central Asia. The development of SAFTA was being seen by analysts as a positive measure for Turkmenistan Afghanistan Pakistan (TAP) pipeline which could benefit India through cheaper imports from the region and also the Central Asian economies by giving them easier access to a large market. Though there is a question mark among the experts on the nature of stabilization of the Indo Pak relationship there is optimism that given the economic gains likely to accrue, the treaty will take off.

Prospects for the Indian Industry

Statistics show while Indias global trade increased from $24 billion to $94 billion in the period 1995-2000, the trade with the SAARC region went up $2.36 billion in 2000 from $1.71 billion in the year 199520. While Indias exports to SAARC countries shot up considerably the imports showed a very marginal increase. In case of Bangladesh while the Indian exports shot up to $ 1 billion by 2002 from $180 million in 1991, the increase in imports was marginal in real terms going up to $ 150 million up from $ 30 million in the corresponding period21. Indias trade surplus with SAARC countries are also at a high figure of $2.2 billion. India which accounts for nearly $500 billion of the total trade in SAARC would naturally benefit in absolute terms by the formation of SAFTA. With the coming of the FTA, the Indian tea industry would get a boost as mentioned above. The Indian automobile industry was also expected to benefit since Suzuki Meheran, the Pakistans equivalent of Maruti 800 was available at double the Indian price. The Indian pharmaceutical industry, the most established and diversified in the region would be boosted by the fact that the member countries could possibly import pharmaceutical products particularly generics from India. The high levels of informal trade between the member countries which would now into come into formal channels would give a tremendous boost to the industry and trade between India and Pakistan alone is expected to jump around 5-fold. The intra-regional trade was also expected to double every five years. The lowering of the import duties to the level of 0-5% would go a long way in making the area competitive vis-a- vis ASEAN in the growing competition in the international market. The agro based industries and commodities like wheat and tea which were the most affected by the informal trade would also benefit. The industry was looking forward to advantage of the complementarities that exist between the member countries like the one in auto component industry. There is strong demand for chemicals, medicines, videotapes, cosmetics, tires spices and viscose fiber in Pakistan and similarly for textiles in India and these are the products that garner a strong share in the informal market. If these
20Nadeem Malik, New Dawn for South Asian Trade, Jan 13th 2004, Asia Times Online, 21 ibid

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could be formalized it would come as shot in the arm for these industries. The industry expected that it can look towards Pakistan as a bridge for trading with Central Asian countries. The energy pipeline which was expected to get a fresh lease of life would solve Indias energy problems to a great extent and act as an aid to growth. However the industry was also expected to face stiff competition from other member countries. The very threat of Indian industry garnering lions share among the region had put a question mark on the future of SAARC which the industry has to address. But with SAARC seemingly stuck in limbo, India has gone ahead with enhancing economic ties through other avenues. Apart from the FTA with Sri Lanka, India is looking towards the East Asian countries by entering into FTAs with Thailand and Singapore. It also went ahead with a new concept BIMSTEC (Bangladesh India Myanmar Singapore Thailand Economic Co-operation).

Some issues left out of SAFTA

Analysts feel that the deficiencies in SAFTA arose due to the inability of the member countries to come to concretize agreements on the issues of revenue compensation, rules of origin, sensitive lists and technical assistance for LDCs. The rules and regulations required for the effective implementation of the treaty were also not drawn up. The agreement made no mention of the deadlines on negotiating issues like harmonization of legislations, identifying the special needs of LDCs, issues of technical assistance, rules of origin. The treaty also was unable to make any concrete provisions on crucial issues which can become a bone of contention, like anti-dumping measures, subsidies, countervailing duties, technical barriers and sanitary and phyto-sanitary measures. Also the services sector which is seen as a step further in the value chain has not found favor. There are still barriers on the movement of people. There was no investment protection treaty which was essential to boost investments in the region. The lengthy timeframe set for the implementation has also created a sense of skepticism among the analysts who feat that this could render the treaty redundant.

Gazing the Future

The community has been virtually divided into two parts SAARC-5(Bangladesh, Sri Lanka, Nepal, Bhutan and Maldives) who have been victims of the inability of the SAARC-2 (India and Pakistan) to work together in the larger interests of the region. Naturally there is skepticism among analysts over the direction which SAFTA is likely to take. The progress of course lies in the willingness of the partners to effectively implement the proposals of SAFTA. Analysts feel that movement on conversion to Customs Union and extending the Free Trade concept to the services sector should be the logical priorities. The strong similarity among the international trade basket among the member countries could effectively lead up to a situation wherein the member nations would act as competitors to each other. It is also to be understood that trade follows investment and there was a significant need not to only to promote investment but also for investment protection. Experts felt of a need to conduct an empirical study to understand the pros and cons of the implementations so that the shortcomings could be identified thus enabling the policy makers to rectify them.

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The success of SAFTA would determine on how far the regional business communities exhibit their dynamism and how best they institute the economic measures to strengthen the complementarities. As the history has shown more often the countries have fallen into the cobweb of politics and other extraneous issues hampering the progress of SAARC and unless they come out of this mindset skepticism was bound to remain among the industry watchers. However they felt that this was a significant positive step which would benefit the smaller countries facilitating the stabilization of political environment in the region.

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4. Issues in disinvestment: The IPCL case

Prof. Prashant Kulkarni

The scene
On May 19th 2002 Reliance won the battle against the other competitors in the global competitive bidding for the 26% stake in the Indian Petrochemicals Corporation Ltd.(IPCL) held by the Government of India. It was a culmination of a long saga. IPCL had been put on the chopping block by the government as part of it ambitious programme to exit from the business of running the industry. It was a hard battle for all the parties concerned. It seemed to cross a maze of numerous legal intricacies. Besides, critics had questioned the very process of disinvesting the petrochemical sectors which was seen by them as a strategic sector. Reliances acquisition of 26% stake valued at Rs. 1491 crores (US$ 303 mm) worked out to Rs. 231 per share (US$ 4.7 / share), 74 % premium to IPCLs last traded share price. The transaction value of Rs 1491 crores was the highest public sector unit disinvestment proceeds received by the Government in a single transaction exceeding Rs.1153.68 crores from IBP and Rs.1439 crores from VSNL22 till then. Under the law Reliance would have to make another 20% open offer at the same price. Reliance was expected to incur Rs.2638 Crores (US $ 536mm) for this acquisition. Reliance was expected to command in excess of 70% share of the market in most product categories of the petrochemicals industry in the country. With the per capita consumption of polymers in India one of the lowest in the world the prospects seemed to very bright. But the victory was not an easy one. The sale of government stake not just in IPCL but also in other sectors had long been embroiled in controversies. It was marked by political battles, legal battles and questions were often raised on issues of transparency. The critics questioned the very need of disinvestment of the public sector and argued that the public sector should be recapitalized and not sold out. Also there has been the issue of what is the preferred mode of disinvestment whether should it be a strategic sale or would the open offering in the domestic market be the better way? To understand this whole gambit of disinvestment and why these questions are being raised it is necessary to go into the background of the whole set-up. It means the need to know why the public sector was set up in the first place, how the experiment worked and now why the question of government exiting from this sector.

When India achieved freedom from the yokes of British colonialism, the state of Indian industry was pathetic. The economy had been ruined and had become a sourcing base for cheap raw materials for the British industry and also a market for the British finished products. This had totally destroyed the industry. Even before the British colonial rule industrial set up in India was mainly restricted to the small scale cottage industry. India had been traditionally dependent on cotton, spices, silk and other agro based industries. The
22 Business Line May20th 2002, Reliance Makes it Big With IPCL.

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Industrial Revolution which kick stated the European economy was wholly absent in the India. There were a few attempts by visionaries like J.N.Tata, G.D.Birla and others to set up infrastructure and develop an industrial base but the amount required for that was huge. The problem of non-accessibility to capital resources hindered the progress of these enterprising entrepreneurs. It was in this scenario that the government had to step in to develop the industrial base and establish India as one of the leading industrialized countries in the world. Prime Minister Nehru was a believer in Socialist Model of Economy wherein a dominant role was given to the government in the economic sector. Under his vision, the public sector was expected to reach the commanding heights of the economy. However as the time progressed, flaws crept into the experiment. There was over transgression the and the Public Sector Undertakings(PSUs) as they came to be known became too many to be handled .Added to it the autonomy provide to the PSUs was encroached upon. There was lot interference in their functioning, the efficiency took a back seat and they became a source of patronage for those in power. The bogey of nationalization became to be used as a tool of populism and also as a stick for the private industries that refused to fall in line with the establishment. In spite of this several PSUs flourished and made it to the Big League. Indian Oil Corporation (IOC) was the first Indian company to make it to the Fortune 500. In 1991 with the winds of change began to appear and the business environment started to ease out. Liberalization, Privatization and Globalization became the buzz words and in these change settings the debate arose on the very question of whether the government has any right to be in business. The changed contours of the policy parameters made the government to set up the Disinvestment Commission head by Mr. G.V. Ramakrishna to examine how the Public Sector Companies could be liberalized and made free from government encroachments on their powers. The government though broadly accepted its recommendations however did not proceed entirely in tune with it. The push for disinvestment was achieved by the Vajpayee government when it disinvested Modern Foods. The company was sold off to Hindustan Lever for an amount of Rs.125.5 crores at an average cost of Rs.11490 per share. The big ticket disinvestments were however the ones of Tatas capturing Videsh Sanchar Nigam Limited (VSNL) and Computers Maintenance Corporation (CMC), IOC taking over Indo Burma Petroleum(IBP) and Reliances acquisition of IPCL. Ceding control to Suzuki in Maruti Udyog Limited (MUL) was a slightly different one since the company was formed as a joint venture of 50-50 between the government and Suzuki of Japan in the first place. The reasons for the slack and sometimes fits and starts approach in the process of disinvestment are many. They are examined below using the disinvestment of IPCL case as an illustration.

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Issues in the case: Can Public Wealth be sold?

The public sector companies have been built in many a case from the scratch by the government using public money. This in turn implies that they belong to the people at large and are national assets. Can Governments which come and go sell these assets off to the private parties? Is it possible to sell only those companies which are loss making? Experts feel that it is neither desirable nor feasible to sell only loss making units as there is a possibility of no buyer being interested. While an effort can be made to privatize such units, if unsuccessful they should be closed by offering suitable compensation to the workers. According to the Business Standard Survey of Public Sector companies for the year 2002-03 the top 10 PSUs account for 98% of the total profits of all PSUs23. IPCL was started in 1969 to provide vital raw materials in chemicals sector to the Indian industry. It was converted into a public limited company in 1986. Till Reliance entered the scene IPCL was virtually the sole supplier of raw materials to the Indian industry. Its product range ranged included synthetic organic chemicals, plastics, fiber and fiber intermediates from petroleum feedstock. It was also the first petrochemical complex in India in the public sector24. Its market share in 2002 was 89% in Id PE, 100% in BR, 100% in acrylates and 100% in acrylonitrile25. By the year 2002 IPCL had become the 2nd largest company in India in the petrochemical industry in terms of sales, assets, net worth and profits and 19th largest company in India in terms of sales It earned a Net Profit of Rs.1019 crores in the financial year ending 2002. However it was a decline by more than Rs. 1300 crores from the net profit of 2000-01. but when the process of disinvestment was started in 2001 the company had actually posted a profit of nearly Rs. 2500 crores in 2000-01 up from nearly 1900 crores in the year 19992000. The companys Net Assets in the year ending 2001-02 was a healthy Rs. 57,000 million. The financial details are displayed under the exhibits 1 and 2. Therefore the critics questioned the need for privatizing such a profit making company The proponents on the other hand argued that the only by privatizing the company would it be able to leverage its resources more effectively. The major arguments of critics was that the process of privatization or undertaking a strategic sale would transfer the public money and assets into private hands. IPCL which has been the bulwark in its segment was built by using the taxpayers money that is through budgetary allocations. Now after it has reached a position of eminence does it make sense to divest it to a private owner? There is a strong line of argument on the need to keep the company in public hands. This implies that the company instead of being sold off to a private investor should instead be made to offer the shares to the public at large through domestic

23 24 25

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offerings. This raises the point on the effective mode of selling i.e. if we are top sell then how to sell?

Strategic Sale vs. Domestic Offering

One of the strongest criticisms of the disinvestment programme has been on the issue of modalities of sale. There are two approaches to sale. The first is the strategic sale which involves selling of a chunk of government shares to the private investor ceding the management control to the successful bidder. The public offering would involve the offloading the government shares in the capital market while retaining the control of the government of the management. The government would continue to manage the company even if its share-holding falls well below 51%. This approach has been advocated particularly in the so-called strategic sector like oil. This issue which has attracted the focus of attention in the oil sector naturally cast its shadow on the IPCL disinvestment saga. Reliances acquisition of 26% stake in IPCL was done at 74% premium compared to the last trade price. This implied that the minority shareholders got a fir deal since Reliance had to make an open offer at the same price. The strategic sale also helped in boosting the market capitalization of IPCL. However this argument is often counteracted by the argument of loss of control. But the possibility of government raising the same amount of Rs 1491 crores through public offering was unlikely owing to the probability of the public being unenthusiastic about the offering since there is little likelihood of change in management control. The very fact that Reliance paid a premium of 74% reflects the fact that the strategic sale could become a cash earner for the government over the domestic offering. Also since the sale involved open international bidding the dominant position which was enjoyed by IPCL came in handy to attract hefty premium. There is also the question mark over whether the definition of strategic sector being applied to IPCL. The two largest companies in the oil sector Indian Oil Corporation (IOC) and Oil and Natural Gas Commission (ONGC) both remain in government hands and there is little likelihood of them being privatized in the near future. Incidentally IPCL is engaged in production of petrochemicals which is a downstream operation and not an operation which could threaten the security interests of the country in case of national emergency However when juxtaposed with the earlier question of hiving off public assets created by the public money to benefit the general public cannot be overlooked. Moreover there is also the task of determining what the right price is? The price depends upon the valuation of the company.

Valuation of the company in case of strategic sale is done by the bidders during the process of due diligence. The government would fix the reserve price. For IPCL the reserve price was fixed at Rs131 per share, the figure being arrived at using the Discounted Cash Cases In Management Page 30

Flow (DCF) method. This price of chosen by the evaluation committee form a set of four alternative valuations offered by UBS Warburg which functioned as the advisor to the deal26. IOC pitched its bid at Rs128 per share while Nirma was even lower at Rs.110 per share However critics alleged that considering the assets and equity base of IPCL the price should be much higher,. Based on the working committees report of disinvestment which placed the price at Rs.265 per share (arrived at using Replacement costs method), they contended that Reliances price of Rs.231 per share represent a loss to the government. They further contend that the acquisition would also result in the monopolization of the market which implies that the price should even be higher. Reliance justified the price it bid for by claiming thats its valuation rested on the premise of EBITDA. This approach meant assessing the overall earnings of IPCL without factoring the interest costs, depreciation and taxes. Reliance believed that with the recovery phase on in the Petrochemical industry the net value of equity of IPCL would go up to Rs.240 per share. Along with this quantitative assessment the Reliances bid was also based on the opportunities the acquisition would provide. Reliance-IPCL would become a monopoly in the Indian market. With the market for polymers expected to grow by 15-20% the value would go even more higher27. Interestingly this was also the pint the critics had been raising. They argued that it is just not just one approach should be taken into account but also the qualitative aspects like the possible emergence of the monopoly the industry growth prospects and demand for the polymers in India which was expected to become the third largest in the world after US and China. This issue of valuations had always been thorny. There are different approaches to valuations and it is possible to arrive at different prices based on different methods used to evaluate the companies. The issue had been dragged many a time before the Supreme Court. The Apex Court has held that the valuations are a matter of technical expertise and it cannot go into its merits or demerits unless it is established that the process is vitiated by fraud and mala fide. In the Hindustan Lever case the court held that the court would not interfere merely because the determination by different methods has resulted in arriving at slightly different conclusions28. Irrespective of what is the right valuation method to be used to arrive at the price, Reliances acquisition of the stake at a premium of 74% over the market traded price was in recognition of the fact that the position of Reliance would be considerably strengthened in the market post acquisition of the stake. This brings to the question of whether monopolies are desirable, can the process of disinvestment be conducted so as to avoid formation of monopolies and the perceived double standards of the government in regard to different cases as will be discussed below.

26V.Sridahar and AnupamaKatakam, Birth of a Monopoly, Frontline June 8-21 2002 27 Ibid 28 pg 44

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Reliance-IPCL combine will garner at least 70% share and in some even 100% share in the Indian market in most product segments. The capacity share in the new scenario is displayed under the exhibit 3. The aim of the government is to prevent the emergence of monopolies. This was exactly the reason why the government prevented IOC a public sector company form biding for Bharat Petroleum and Hindustan Petroleum (both since aborted). Now in this case Reliance a private sector firm which already was the dominant player in the market was allowed bidding for IPCL which too commanded a major presence in the Indian market. The next rung players like Haldia Petro are nowhere even in the picture. If the purpose of the government was to encourage competition and discourage monopolies this would serve exactly the opposite. There was considerable opposition even within the ruling alliance over the possible of Reliance acquiring the stake. The then Finance Minister Mr. Yashwant Sinha and Mr.Arun Jaitley were among those who expressed of replacing a public sector monopoly with a private sector one29. The supporters contend that the products being produced by PICL fall in the Open General License OCGL) which implies that they can freely imported. Moreover in the post WTO it is very difficult to charge exorbitant prices. Bu the fears still persist. Incidentally the government had made it clear it would allow the formation of a monopoly in the services sector. However it feels in the production sector with foreign competition in the fears of monopolization may be unfounded.

Autonomy to IPCL
In 1997 as part of the new policy the government had decided Navaratna status to the major companies of which IPCL was one. The aim of this policy was to ensure that these Navaratna companies would be given functional autonomy and encourage them to emerge as global players. However IPCL was left headless for a long period of time and this had an impact on its bottom-line. Analysts opined that there was hardly any attempt made to understand the changing competitive scenario or in trying to chalk out a new strategy. The low prices prevailing in the international market added to the woes. This created a suspicion that the IPCL was being deliberately let down to lower its market value and became a strong weapon at the hands of the critics.

Concessions to Bidders
The government in the bidding process offered three concessions to the bidders, the advantage of which would be fully taken by Reliance. The Central Excise had duty claim of Rs.600 crores on IPCL. The government withdrew it justifying on the grounds that contingent
29Ravi Kapoor , DoD to finalize IPCL shareholders' agreement soon , Financial Express dt: Sep 4th 2000

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liability would depressed the quoted prices. The government also sorted out the issues relating to IPCLs long term contract for supply of gas and its pricing with ONGC and Gas Authority of India Limited (GAIL). The critics felt that this was secured by pressuring the two PSUs in agreeing to a favorable deal. While on one hand the government claimed to be dismantling the Administered Pricing Mechanism (APM) in the industry, on the other it was forcing ONGC and GAIL to enter into a long term kerb-side transaction30. The issue could also be seen in the light that the prospective bidder would be constrained in his source for raw materials by this agreement instead of leaving it to the new management to negotiate on what it considers the favorable terms. The third sop was the decision of the Finance Ministry to extend Sovereign guarantee to IPCL which was negotiation with the World Bank for a loan of about $100 million31. It needs to be seen whether the government would extend the sovereign backing to the loans being acquired by the private sector.

Rosy for reliance but..

Reliance Industries Limited was expected to yield many advantages by acquiring IPCL. Apart from acquiring its closest competitor which would give a total control on the market there were other synergies too. The complexes of both Reliance and IPCL were situated in the same region. The synergies in feedback outsourcing and transportation are immense. There would not be a need of high investment in logistics and some improvements in pipelines would enable Reliance to move feed stock to the complexes. With the new pipelines coming up and existing pipelines also close by there was tremendous scope for Reliance to synergize the feed stock process. With the two largest competitors coming together it was expected to take advantage operations of scale thereby reducing marketing and operating costs thus providing increased margins for the two companies. More importantly there was also the strategic space in the petrochemicals sectors that was sought to be occupied by Reliance. Indian Oil Corporation was also looking for a foothold in the petrochemical industry. It would have made sound sense for it to explore into the other segments of the petroleum industry. Reliance buy this acquisition preempted IOCs bid and this probably explains why reliance was ready to pay such a high premium. The shareholders of IPCL would also benefit by the premium Reliance offered. The IPCL stock had plummeted to Rs.33 per share just six months before. With the open offer which Reliance would have to undertake as per the law, the shareholders would also become the beneficiaries of this deal. However the questions about the process remain. Firstly is about the company. The company which was a pioneer in the industry and enjoyed as strong reputation should be allowed to go into the hands of its major competitor in the private sector had to be answered. There was also the question whether the sale through a public offer would have commanded the same premium. Also there was a need to examine the different approaches to valuations. It was to be considered whether more premiums are to be extracted for the intangible benefits the company derives by acquiring the stake. In this case Reliance stood to gain not just on the operational front but also on the strategic front. .
30 Frontline op.cit. 31 ibid

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The government further downloaded 5% of its residual stake in the company. Reliance which had 46% stake and had the first right of refusal in any further downloading by the government politely declined to exercise of the option of buying 5% stake. If it had Reliance would have got majority stake in IPCL. Analysts feel that Reliance may go in for purchases form the market. However the price of offer for this residual issue was fixed at Rs.170 per share. The issue got oversubscribed by about 10% on the first day itself. Though the acquisition went off well unlike the problems faced by the Tata-VSNL deal it is imperative for the government to formulates appropriate strategies so as to avoid controversies. While there is no one formula for the disinvestment process

Exhibit 1: Annual results of IPCL

0303-3(12) 0203-3(12) 0103-3(12) 0003-3(12) 9903-3(12)

Sales Stock Adjustment Raw Material Consumed Power And Fuel Employee Expenses Excise Admin And Selling Expenses Research And Development Expenses Other Expenses Total Expenses Operating Profit Other income Total interest Net depreciation Tax Net Profit/Loss Extra-ordinary item Prior Year Adjustments Adjusted Net Profit/Loss Equity capital EPS(Rupees) Equity Dividend Rate (%) OPM (%) NPM (%)

57,980.0 0 -2,810.00 20,500.0 0 0.00 4,170.00 7,690.00 0.00 0.00 18,050.0 0 47,600.0 0 10,380.0 0 1,050.00 3,690.00 4,550.00 590.00 2,600.00 0.00 -560.00 2,040.00 2,490.00 8.19 0.00 17.90

47,398.9 0 1,928.20 18,681.5 0 0.00 4,014.20 0.00 0.00 0.00 15,329.1 0 39,953.0 0 7,445.90 1,641.90 3,736.70 4,244.10 87.90 1,019.10 0.00 55.60 1,074.70 2,490.50 4.32 20.00 15.70

50,059.7 0 -760.30 18,898.8 0 0.00 4,390.60 0.00 0.00 0.00 17,429.0 0 39,958.1 0 10,101.6 0 1,677.20 4,909.50 4,149.00 231.30 2,489.00 0.00 0.00 2,489.00 2,490.50 9.99 0.00 20.17

40,600.4 0 0.00 0.00 0.00 0.00 0.00 0.00 0.00 32,684.5 0 32,684.5 0 7,915.90 1,121.00 3,875.50 3,189.80 83.10 1,888.50 0.00 0.00 1,888.50 2,490.50 7.58 19.49

31,148.1 0 0.00 0.00 0.00 0.00 0.00 0.00 0.00 26,291.7 0 26,291.7 0 4,856.40 794.90 2,618.70 2,703.80 35.20 293.60 0.00 0.00 293.60 2,490.50 1.18 15.59


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Exhibit 2: Balance sheet of IPCL

0303-(12) 0203-(12) 0103-(12) SOURCES OF FUNDS Owner's Fund 2,490.50 2,490.50 2,490.53 0.00 0.00 0.00 0.00 0.00 0.00 20,360.70 25,782.40 29,461.26 17,201.30 19,848.40 16,071.30 17,314.50 56,123.80 65,435.80 USES OF FUNDS 96,382.80 0.00 35,776.70 60,606.10 426.20 885.10 23,268.90 29,278.60 -6,009.70 216.10 56,123.80 885.10 0.00 3,692.00 248,225,62 2.00 89,094.80 0.00 31,261.70 57,833.10 5,838.80 1,121.30 18,406.40 18,111.90 294.50 348.10 65,435.80 1,121.30 0.00 4,269.40 248,225,62 2.00 9,940.85 32,816.65 74,709.29 0003-(12) 9903-(12)

Equity Share Capital Share Application Money Preference Share Capital Reserves & Surplus Loan Funds Secured Loans Unsecured Loans Total Fixed Assets Gross Block Less : Revaluation Reserve Less : Accumulated Depreciation Net Block Capital Work-in-progress Investments Net Current Assets Current Assets, Loans & Advances Less : Current Liabilities & Provisions Total Net Current Assets Miscellaneous expenses not written Total Book Value of Unquoted Investments Market Value of Quoted Investments Contingent liabilities Number of Equity shares outstanding

2,490.53 0.00 0.00 27,835.39 14,482.58 32,978.18 77,786.68

2,490.52 0.00 0.00 27,812.75 16,791.79 29,725.68 76,820.74

87,566.90 0.00 26,982.73 60,584.17 859.08 1,091.04 25,321.33 13,714.64 11,606.69 568.31 74,709.29 1,091.04 0.00 4,147.89 248,225,52 2.00

85,833.80 0.00 22,852.40 62,981.40 1,304.89 741.03 27,178.32 15,134.62 12,043.70 715.64 77,786.66 741.03 0.00 7,576.88 248,224,89 2.00

60,548.04 0.00 19,746.72 40,801.32 20,505.50 696.63 27,508.95 13,364.44 14,144.51 672.76 76,820.72 696.63 0.00 8,529.30 248,223,79 2.00


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5. Innovative approaches in public services delivery: Case study of Bangalore

Prof. Prashant Kulkarni32 It is natural to associate cities with modernization, development, prosperity and innovation. This image has however come under set of challenges in recent years. The cities are increasingly facing problems in regard to shelter, water supply, electricity, public transport, sewage and sanitation, solid waste, pollution etc. Migration from rural areas is on the rise. Experts attribute it largely on account of the lowering wages in the villages, and attractiveness of the city riches. This has created pressure on urban lands as they find it difficult to cope up with these people. Shelter becomes a problem leading to proliferation of slums Added to these problems are the issues of clean and regular water supply, electricity, public health, education etc. The management and governance of cities and other urban areas are in the hands of urban local bodies (ULBs) in India. These were granted statutory status under the 74th Amendment. The Amendment also provides for a list of functions that could be undertaken by the ULB. However unlike the delineation of Central and State List there is no clear division of powers .It is left to the discretion of the State Governments to devolve the powers to the local bodies. This has lead to constraints in the functioning of the Corporation. Their functions can be classified into obligatory functions and discretionary functions. It is being increasingly observed that there is a growing gap between the nature of functions to be undertaken by the local body and the resources it commands to undertake these functions .with the traditional sources like octroi by and large abolished, newer sources of revenue have not been explored. This leads to dependence on State Governments for grants. The autonomy of the body starts eroding. In some cases, the extent of dependence is nearly 40%. There is also positive side to it. Few local bodies are trying out innovative measures to increase the coffers. Apart from reducing the dependence on the state government, these measures are also likely to help decide on the tax base of the corporation. An interesting experiment in this regard is the case of Bangalore Mahanagar Palike (BMP). When BMP released their annual report for the year 2001-02, they became the first city in India to do so. This had become essential by the introduction of the Fund Based Accounting System in the city corporation. The statements had been modeled on the guidelines developed by the Government Accounting Standard Board (GASB), USA. This move was a departure from the traditional cash based accounting that had been followed till then. The new modeled was based on accrual system of accounting. BMP also is undertaking innovative measures like creating an effective Management Information System (MIS) framework that provides for activity based information unlike the event based MIS in the past. Revenues are being streamlined and market mechanisms are being implemented in discharge of the functions. These involve user charges for the services provided and the charges are linked to the quality of the service.

32 Asst. Professor Economics & Public Policy, IBA Bangalore

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These moves were seen as helping various stakeholders like the elected representatives, corporation officials, citizens, stat government, media etc. by giving them access to timely, structured and accurate information.

Need for Reforms

The urban population in India has seen rapid growth with almost an increase of 400% in the last four decades. In 1951, the first census after independence reported the urban population at 62 million which was about 17% of the total population. In 2001 the total urban population has increased 285 million which amounts to under 30% of the total population. It is expected to increase to more than 500 million by the year 2021. There were 35 metropolitan cities in India in 2001 and more than 3000 Urban Local Bodies (ULBs) functioned in the country in 2001. Though 90% of the urban population has access to safe drinking water only 63% has access to potable water within their premises. Less than two thirds of population has access to basic sanitation facilities. Only about 60% of the solid waste generated is being collected every day. Environmental degradation is emerging as a major area of concern in the urban societies. Though ULBs are responsible for providing services like drinking water, sanitation, primary health, most are found wanting on these issues. In fact many observers feel the quality of services has deteriorated over the years. The lack of employment opportunities in rural areas has seen a migration of rural families towards the cities. Most cities are overwhelmed with migration and are unable to cope up with this. This has led to problem of lack of infrastructure, and unemployment. The rising unemployment, more people fighting for the land and other services is seen to increase crime rates within the city. While poverty rate has declined over the last 50 years, urban poverty remains a major problem area. Analysts hold that these issues stem from the inability of the policy makers to draw up a long term strategy to handle the growth in these cities. Scarcity of resources and weak managerial and operation capabilities has made things worse. Most urban bodies are under fiscal stress and unable to meet the requirements for maintaining the services in the city. They are forced to depend on the higher bodies to meet their financing needs and this has been seen as reducing autonomy for the local authorities. According to India Infrastructure Report published in 1996, urban bodies required and annual investment about Rs.22, 000 crores on water and sanitation alone as against the expected fund flow of about Rs. 5000 crores. It is beyond the limits of ULBs to raise the resources of this nature. This has led to a call for strong revamp of the financing patterns of the urban bodies. They have to be given powers to raise funds. In the US most municipal bodies tap the market. To maintain the market ratings they are compelled to maintain transparency and accountability in their system.

Functions of the ULBs

Under the 74th Amendment, the ULBs were given statutory status. It removed the threat of supersession from them. The new Act provided for regularity in elections, representation and reservation with elections to be held after every five years. The states were however free to Cases In Management Page 37

enact laws suiting the local conditions. The devolution of powers and functions to the ULBs was left to the discretion of the State governments. Comprising of City Corporations, Municipalities and Town Panchayats, these ULBs numbered nearly 3500 including 101 Corporations. The Twelfth Schedule provides for 18 items and also gives an illustrative list of functions that could be delegated to the municipal bodies. Article 243W read with the Twelfth Schedule is the basis for the delegation of powers to the local bodies but it is left to the discretion of the State Government to decide which functions are to be handed over and to what extent they are to be handed over. However, very few states devolve all or even substantial powers in practice. The functions of the bodies can also be classified based on the nature of the functions.33. They are 1. 2. 3. 4. 5. Essential Municipal Function Environmental Management Functions Planning Functions Agency Type Functions Functions Relating to Governance

The City
By late 2004, Bangalore was being described as the IT Capital and the most happening place in the country. Bangalore had recorded phenomenal growth over the last few decades and was widely acclaimed as the IT capital of India. The software industry in Bangalore was expected to be worth $1.75 billion growing at Compounded Annual Growth Rate of 52% over the period over the previous five years. Apart from this, biotechnology and IT Enabled Services (ITES) industries maintained a strong presence in the city. The city was the home to a number of public sector units in the strategic sector like BHEL, HAL, BEML, HMT, BEL etc. With prestigious institutes like Indian Institute of Management and the Indian Institute of Science making their base in Bangalore, it is also one of the leading academic centers in India. The Bangalore Mahanagar Palike (BMP) founded in 1949 was spread over 100 wards comprising an area of 225 sq. kms. It had a population of nearly 5.5 million and an equally large floating population. As per the BMP Act 1976, there were thirty functions that were classified as obligatory functions while another 23 were grouped as discretionary functions. Bangalore Agenda Task Force was set up in 1999 to suggest and undertake reforms in the city. The council of BMP adopted the BMP (Accounts) Regulation in 2001 containing the prescribed formats and statements needed to conform to the FASB requirements.

33Kulwant Singh Trends and Issues in Decentralization and Urban Governance in India

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Functions of BMP
The functions of Urban Local Bodies (ULBs) including BMP were classified into obligatory functions and discretionary functions. It was incumbent of the local body to perform the functions assigned to it by the State Act under the obligatory functions. The discretionary functions, as the name suggested, were left to the City Government on whether to undertake those functions or not. Based on the nature of the work, the functions of the BMP were classified into five categories. Essential management functions constituted the first charge on the Municipalities. They included functions such as erection of boundary marks, construction and maintenance of roads and streets, provision of public amenities like gardens, parks and playgrounds, maintaining schools, maintaining of vital statistics like births and deaths, provision for collection, disposal, and treatment of garbage and solid waste, water supply and sanitation, maintenance of street lights etc. Environmental management functions included protection of environment, promotion of urban forestry etc. and were undertaken usually in co-ordination with the State Government. The Planning functions were usually taken up at the State level but implementation had to be done at the local level. These functions included slum upgradation and improvement, rehabilitation of the mentally and physically handicapped, protection and welfare of weaker sections of society etc. Agency functions like firefighting services, public transport, and electricity supply were undertaken by the ULB as an agent of the State Government. The Governance functions were the ones mandated under law as the representative government of the city. According to experts there was broad similarity in the nature of functions undertaken by the local bodies across the country. To undertake these functions the local bodies needed financial resources. The abolition of octroi had starved the local bodies of a good source of funds. The had to depend on advertising tax, property tax and the grants by the State Government to meet their financing needs. BMP relied to the extent of nearly 20% on the Government grants to meet its requirements. However it was becoming clear to many city managers that the cities should raise resources on their own and undertake a better management of those resources in order to fulfill their functions. There was a view that the Fund Based Management Accounting System (FBAS) would provide a better solution to the city managers.

Fund Based Accounting System

Finance Management Begins.. .Where Accounting Ends.. Accounting Begins With Objective Orientation and Operational Utility
The working of FBAS was described as an interaction of various departments with each other and the amount would be disbursed based on the requirements and linked to the revenue generation potential of that project. (Exhibits I and II)

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Financial management in a corporate set up required information to facilitate decision making and also in understanding the financial health of that set up. This principle was sought to be adopted in the setup of the urban local bodies. Using FBAS was thought to help in identifying the different sources that could be used to tap the financial resources and then identifying the uses these could be used best. It also would help in assessing and analyzing the financial health of the local body. The system was expected to provide information about compliance with legal and statutory requirements. This information could be handy not only for elected representatives and the local body officials but also the citizens who would be the ultimate beneficiaries of the various projects undertaken by the ULB. This information could be used by the ULB in tapping the financial markets since the lenders would get an accurate of what is happening inside the Corporation. FBAS envisaged the creation of funds each having a set of self-balancing accounts and key financial statements, a balance sheet and revenue and expenditure account. These funds were to be of three types. The first was the government type. The second was known as proprietary type and the third category of funds created was known as Agency & Trust Type Fund. (Exhibit I).

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Exhibit I Types of Funds Government funds These comprised the accounts in use for the normal operation of the local bodies. The focus here was on spending and implementation of the program. Cash based accounting was the norm and capital items too were accounted under revenue/expenditure. Tracking of fixed assets and long term debts were done by a Special method. Fixed assets and long term liabilities were left out of the purview of the balance sheet with the result only the current assets and liabilities were included in the statement. Depreciation was not done on infrastructure assets. These funds were further classified into general, capital projects, special revenue and debt service. Proprietary Funds These funds were envisaged for the discharge of commercial function of the corporation. These included activities like construction of market complexes, provision of urban amenities etc. the ULB collected user charges to fund these activities. Accrual system of accounting with depreciation was the norm while accounting for these activities. This was used for helping the management to revise the user charges and also in maintaining and up gradation of assets. These funds were further classified into external or internal funds. Fiduciary Funds These known as Agency and Trust Type was essentially funded by an outside agency but the ULBs was held accountable for the activity. The outside agencies, could be the World Bank funded projects or a philanthropists coming forward to construct a project. Assets would be created by the external parties; they would operate them for a few years and later transfer those assets to the BMP. It would be put under Governmental or Proprietary based on the nature of the activity though there were suggestions that this could remain as fiduciary fund since BMP had invested any amount in creating the assets. Fiduciary funds were classified further into agency and trust type.

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Implementing FBAS: The BMP Story

BMPs budget had tripled from Rs.200 crores in 1995-96 to Rs.600 crores in 199899. There was greater pressure on infrastructure. The needs for infrastructure had resulted in excess demand of more than Rs. 200 crores by 1998-99. The authorities did not have the exact position of both sources and uses of funds. The asset liability position of BMP was not available. There were no reliable measures to measure the service costs. The accounts were processed manually. Information required for accurate and timely decision making was not available for the ULB. The financial statement comprised only the receipts and payments. Cash based accounting did not provided for information on receivables and payables. There was neither a clear picture on the asset owned nor liabilities owed by the BMP. There was no clear picture about the financial health of the BMP neither a performance appraisal could be made for the ULB. As a result of these factors it led to creation of problems in planning control and implementation of various operations of BMP. Analysts felt that the BMP needed a strong restructuring of its accounting activities. From being a terminal activity it transformed the accounting exercise into a core activity of the Corporation. It was given a technological push by computerizing the accounting procedures and better reporting systems were introduced. There was a movement towards integrating the various functional streams like Human Resource Development, Legal, Management Information Systems (MIS), and Technology, Banking Relationships etc. the solution required was to create a modern computerized accounting system handled by trained people and involved citizens in the programmes.

The challenge is to implement the right sequence to extract genuine value

The first step towards introduction of FBAS was taken when the BMP (Accounts) Regulations 2001 was passed. The adoption of FBAS was to come into effect on April 1, 2001. A Memorandum of Understanding (MoU) was signed with the Government of Karnataka (GoK) in July 2001. A MoU was signed with HUDCO in November 2002. Online accounting entries were introduced in January 2003 and the opening balance sheet was prepared in the same month. On May 17, 2003, the BMP published the financial statements for the financial year (FY) 2002-03. This was the first instance in the country of such publication by any City government. By the end of the year the system was fully computerized to provide timely information. The financial statements were also published in leading newspapers in the city as part to inform the citizens about the financial health of the Corporation. MIS requirements had to be understood. Effective functioning of MIS needed the providing of timely, structured and accurate information. Timely information was provided by computerizing the system. Departmental heads were trained in the usefulness of the new system. The reporting system was designed so as to customize it to each department. The Cases In Management Page 42

finance related MIS information was transmitted to the finance department to draw up the budgetary plans. This was to be the core of the finance department. The rest of the data generated was to be in the departmental records which would be available for the Finance officials when needed. The departments also had to undertake verification of records to ensure that the records were accurate. It took nearly 30 months for the BMP to impellent the system. A team of officials at all levels worked to create the groundwork for implementation. Bangalore Agenda Task Force (BATF) also put in lot of efforts and was assisted by NCRCL in creating the system.

Impact of FBAS
It helped in reducing the time of information flow cycle. This meant that the flow of information was fast and timely. It became a better measure for performance appraisal. Under the previous system, it was difficult to appraise the performance of both departments and employees in the absence of any reliable indicators. It brought greater transparency and credibility in the financial functioning of the body. It was felt that this increased the confidence of the people in the activities of the Corporation. It enabled a better enforcement of accountability among the officials. It served to bring the ULB in line with international standards. These standards were to be maintained to secure acceptance from international agencies like World Bank, IDA, ADB and national bodies like ICAI, CAG etc. While the citizens got a greater scope in participating in the activities of the BMP, there was better understanding among the corporators about the activities. The impact on the finance department was felt in the reduced time for information flow. The flow time which was 48 days prior to the introduction of the system got reduced to 48 hours. Work was decentralized. Daily Reports (TL-2) were possible. Review of the activities could be undertaken more easily with the publishing of Budget Variance Report (BV1). Liability position of each project and asset position vis a vis the target for collection was possible. Classification of entries under accounts was made more scientific. Real time knowledge of revenue position helped the officials compare the collection vs. target position easy. Revenue analysis could now be done even at ward level. A single data source of information was created. It streamlined the works in the engineering department. It had the largest allocation among all departments. The infrastructure projects of the BMP were undertaken through this department. The system made a provision for a report on Works Liability Registers vs. Bill Registers. Real time liability position was available with the top official and this helped them decide on the future allocations. The system introduced a coding system for tracking the works. Payments to the contractors were made only on the production of the work code. This gave the department complete control over the works being executed. Payroll was computerized leading to creation of an electronic database that carried the information about all employees. Employee related reports could be generated easily. It provided for the timely and hassle free payment of salaries.

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BMP signed a MoU with the banks that enabled BMP to get reports from the banks as per requirements. BMP specific daily and weekly reports were generated to bring about greater clarity in the works. The classification was also done as per the requirements of BMP and not under the heads specified by the banks. This made reconciliation of accounts easy. The MoU also had provisions for offering of different value added services by banks to meet BMP needs.

The information regarding the position of assets and liabilities was more structured and easy to interpret. There was better verification process Tracing of assets and liabilities became streamlined and effective. This reduced the risk of corruption and brought in transparency. The MoU with the GoK had provided for specific performance indicators in finance and accounting streams. BMP was able to report these measures to the government. 24 of the 33 indicators listed under the MoU had been complied with the by the BMP by the end of 2004. Citizens were involved for the first time in budget related activities. Presentations were made at quarterly public meetings organized by Public Record of Operational Finance (PROOF) for dissemination of data at wider level. The use of technology provided the basis for scientific methods of budgeting and accounting. Bringing out balance sheets and other financial statements helped the Corporation in bringing out transparency. The effectiveness of the system could be judged by understanding the financial performance of the Corporation. The financial year 2003-04 began with an opening balance of Rs. 41.69 crore and ended with a closing balance of Rs. 36.58 crore. Property tax collection rose to Rs. 198 crores from Rs. 113 crores in 1999-00. Revenues under Building License fees showed an increase of nearly 135% as compared to the previous year. However the collections under stamp duty reduced and were attributed to the amendment passed in the Stamp Paper Act on levy of surcharge. Rents from shops and markets improved marginally and the overall receipts increased by nearly Rs. 25 crores to close the year 2003-04 at Rs. 648 crores. Though expenditures on salary and garbage outsourcing showed an increase they were within the budgetary estimates. Cost of interest payments was sought to be kept low by enforcing a policy of drawing of loans strictly based on physical progress of the work Exhibits II, III and IV show annual reports for the three years 2002-03, 2003-04, 2004-05 (half yearly). As the year 2004-05 was to close officials were optimistic of surpassing the performance of the previous year.

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Exhibit II-A Balance Sheet as 31/03/03

Source: BMP Annual Report

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Exhibit II-B Balance Sheet as 31/03/03

Source: BMP Annual Report

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Exhibit III-A Balance Sheet as 31/03/04

Source: BMP Annual Reports

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Exhibit III-B Balance Sheet as 31/03/04

Source: BMP Annual Report

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Exhibit IV BALANCE SHEET as on 30/09/2004 As on 30-09-2004 Funds Accounting Group Long Term Debt Memor andum Total As on 30/09/2003

Govern mental

Enter prise

Fidu ciary


Fixed Assets


LIABILITIES 1,490.8 3 245,1 35.05 279. 69 246,9 05.58 246,90 5.58 251,4 25.70

Fund Balance

Long Term Liabilities

35,1 63.4 3

35,16 3.43

35,163. 43

26,40 9.25

Current Liabilities and Provisions 5,524.5 9 2,442.9 8 13,091. 37 21,058. 95 Cases In Management 5,551 .80 2,529 .91 13,09 1.37 21,17 3.09 5,551.8 0 2,529.9 1 13,091. 37 21,173. 09 4,752 .76 1,978 .83 8,616 .98 15,34 8.57 Page 49

Current Liabilities





114.1 4

Inter Fund Balances





Sources of Funds for Fixed Assets

70,170 .42

70,17 0.42

70,170. 42

40,23 9.96


22,549. 78

245,3 20.51

279. 69

268,1 49.98

70,170 .42

35,1 63.4 3

105,3 33.85

373,48 3.84

333,4 27.02

ASSETS Fixed Assets 68,46 0.82 267. 71 68,72 8.54 5,944. 18 53,296 .87 8,294. 45 2,483. 05 5,944 .18 53,29 6.87 8,294 .45 2,483 .05 151.8 7 70,17 0.42 74,672. 72 53,296. 87 183,81 6.09 2,489.4 4 72,29 2.56 30,78 7.36 180,0 79.68 1,056 .65


Infrastructure Assets


175,5 21.64

175,5 21.64

Other Assets







243,9 88.85

267. 71

244,2 56.57

70,170 .42

314,42 6.99

284,2 93.13

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Long Term Investments




105.0 0

Current Assets 178.8 6 7,969 .65 1,033 .10 1,462 .71 10,64 4.31 358.8 6 8,615 .15 3,514 .30 1,510 .80 13,99 9.12





7,558.2 0

411.4 5 920.2 1

7,969.6 5 1,033.1 0 1,462.7 1 10,644. 31

Cash & Bank Balances Loans and Advances


11.9 8

1,462.7 1 9,300.6 8

1,331 .66

11.9 8

Inter Fund Balances Application of Long Term Liabilities





35,1 63.4 3

35,16 3.43

35,163. 43

26,40 9.25

Work in Progress

13,091. 37

13,09 1.37

13,091. 37

8,616 .98


22,549. 78

245,3 20.51

279. 69

268,1 49.98

70,170 .42

35,1 63.4 3

105,3 33.85

373,48 3.84

333,4 27.02

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Annexure I Approaches to Public Finance - an Enterprise Approach

State Govt.


Horticulture Health Markets


Finance and Administration


SWM Engineering



Elected Rep

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Annexure II Stakeholders and FBAS


BMP Employee

BMP Admin




State Government

Advocacy Gaps

Elected Reps

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6. Managing the Public Services in London: Challenges and Opportunities

Prof. Prashant Kulkarni34 London, one of the largest and most affluent cities in the world was for long considered the financial and economic capital of the world. Comprising an area of 174 sq.kms, it was the home to more than 7 million people belonging to more than 90 nationalities. With nearly a quarter of Londoners born overseas, more than 300 languages were spoken in the city. Governing such a large and diverse population seemed to be tough task to the Greater London Authority that constituted the City Government for London. It was constituted under the Greater London Authority Act 1999. It comprised of the London Assembly (25 members) and the Mayor of London. The Mayor acted as the spokesman for London. He was responsible for developing strategies relating to economic development, transportation and environment. Apart from it he also is responsible for preparing budgets for different agencies like Metropolitan police, London Transport Authority (LTA) and city Fire Services. The role of the Assembly was to scrutinize the proposals of the Mayor, investigate the problems of the city and publish its findings and recommendations.

History of London City Government

The Corporation of London functioned as the city government for most of the capital till 1889. The rest of the areas and suburbs were governed by local parishes and other boards. In 1889, London County Council (LCC) was created to govern the inner city though the powers and functions of the London Corporation remained unaffected. LCC was formed to replace its predecessor Metropolitan Board of Works (MBW). The parishes and vestries were abolished in 1899 to make way for 28 metropolitan boroughs that would come under LCC. In 1964 the Greater London Council (GLC) was created which further redefined the boundaries of London. The boundaries were extended to cover Outer London. LCC was abolished and both the boroughs and LCC were replaced by 32 London boroughs. These new boroughs came to be collectively known as Inner London. However the London Corporation was untouched. From 1964 till 1985 greater London was ruled by a two tiered government. The responsibilities were divided between the GLC and the boroughs and sometimes even shared. GLC had the responsibility of transport, fire services, flood prevention etc, the boroughs controlled consumer services, libraries and swimming pools etc. Roads and housing remained the collective responsibility of both. The Conservatives that ran the general elections in 1983 on the agenda of abolishing GLC did it in 1986. The powers and responsibilities were carved between Central Government, boroughs and a new set of bodies that came into being for handling various functions. No single democratic body remained to tackle issues like transport, environment, planning and development. A host of advisory bodies and groups stemmed up to govern and implement these issues. In 1997, the Labor Government came to power. It promised to restore the democratically elected authority for London. A referendum was held in 1998 and it approved the setting up of Greater London Authority. Many bodies that had sprung up after GLC now came under the purview of GLA. Some others got merged into Association of London Government (ALG). The Mayor was to
34 Asst. Professor Economics & Public Policy, IBA Bangalore

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be elected by a direct election. However the boundaries of the cities remained the same as demarcated under the GLC. The 32 boroughs of London and the London City Corporation form a regional tier of Corporation and they are responsible for services like education, solid waste management, housing and local planning. The boroughs are effectively independent of the GLA.

Londons Economy
Londons economy was worth more than $160 billion. It was higher than counties like Finland and Portugal. It accounted for nearly a fifth of the total GDP of UK. The extent of Londons contribution could be gauged that its per capita GDP was nearly 25% higher than the per capita GDP for the rest of UK. For almost fifty years since 1945, the growth rates in rest of UK have been higher than London. But over the last decade or so, the growth rate in London has been exceeding the growth rate in the rest of UK. Analysts felt that this growth was not in expense of the rest of UK but was complementing and supporting growth in the rest of country. Interestingly this pattern has been witnessed even in New York. London also served as a source of demand for goods and services produced in the rest of the country. In 2003, goods and services worth more than $100 billion were imported into London from the rest of the country. Nearly 40% of these were financial and business services products while manufacturing products constituted nearly a third of imports. On the other hand, London also exported goods and services worth nearly $125 billion to the rest of the country. It accounted for nearly 10% of the total manufacturing output of Great Britain. London also provided jobs to nearly 70-80,000 people migrating from rest of the country every year. Nearly 750,000 people commute to London every day for jobs while another 250,000 commute from London to outer areas for work. London was the home to many key activities like media and entertainment, capital and financial markets, publishing, property management, telecommunications and a host of professional services. London was also the nerve center for financial activities not only in UK but across Europe. Nearly 30% of the people engaged in financial services industry worked in London. Nearly For a long time it had held the position of the financial capital of the world till it got replaced by New York. Even now the London foreign exchange market had a turnover that exceeded New York and Tokyo combined. Nearly a third of the Fortune-500 companies had their base in London to co-ordinate European operations. This was way ahead of both Paris and Frankfurt. The city was home to one of the largest bus networks in the world. The city comprised of nearly 14,000 kms of roads and more than 300 kms of underground railway lines. Heathrow Airport in London was considered to be one of the busiest while the Port of London was believed to be the largest in Europe.

Public Services in London

Public Services comprise of activities like law and order, health services, transportation, solid waste management, electricity, water supply etc. Though it doesnt mean that public sector is involved in providing these services, it has been found that generally public sector is involved in some form or the other in provision of these services. While in some countries some of these activities do not fall Cases In Management Page 55

under the purview of the local bodies, the GLA Act mandates the GLA to be responsible for almost all these activities in London. Surveys have shown that performance of London schools was on average higher than the rest of the country. The health services were found to be on par with cities in the other developed countries. Crime rate was low though it was slightly higher than prevalent rate in the rest of the urban areas in UK. However the access to health care is one of the poorest in UK. The emergency services were overstretched and the response was not quick. The private healthcare force attracted top professional talent. This however created an inequality since most wealthy and middle income groups shifted to private care. The lack of incentives in the government sector caused a brain drain towards private facilities affecting the performance in the government health care sector. In some public services the presence of high performance groups created in improved services. The level of services was higher in spite of the challenging circumstances in which the workers performed their duties. These poor conditions often acted as a deterrent to the workforce performance. It also resulted in high turnover rates many a times. The delivery systems of public services was often complex. They had to cater to varying segments of society which of which had their own distinct features. There were also complaints of services being misused by sections of the population. In spite of these circumstances analysts have opined that London was much better prepared in handling emergency crises than many other cities across Europe. Studies have also found that there were linkages between the deprivation of service, income levels, and poverty and crime rates. The diversity which London was known for was believed to act as a hindrance at times for delivery of services. It created communication barriers between the providers and the recipients owing to language problem. Lack of awareness of services provided also acted as a barrier. The diversity of the workforce while creating a potential for high performance in some segments also created conditions for lack of cohesion. This lack of cohesion across communities resulted in lower productivity. The differences in lifestyles attitudes and the culture and faith also played a role in shaping the responses of the citizens to various services being provided by the city. These often resulted in difficulties in policing as intelligence and data gathering became difficult and also the historical prejudices that were known to affect the British society at large. Some of the communities remained backward owing to lack of access to education facilities. It also resulted in higher costs in provision of services by catering to these diverse segments. Generic campaigns were found to be somewhat ineffective and customized campaigns provided logistical problems. Few experts believe that different ethnic groups are prone to certain diseases. Drug usage is also high an adds to the problem. In the education sector, people of certain ethnic groups perform better than certain other groups. This has resulted in imbalance among the educational qualifications among different sections of the society. Ethnic groups also have a fear of insecurity. They have to be provided effective protection. This adds pressure on the local police force. The diverse population of London seems to have made the task of the police force more difficult. Certain groups like asylum Cases In Management Page 56

seekers and migrants are more vulnerable to crime and they are also being increasingly drawn in the criminal networks. London, as seen above, witness a large number of commuters who visit the city daily for work. Even many local residents have to commute from one part to another. This places a burden on the transport services. Apart from the labor force, students commute around the city to attend schools and colleges. Migrants who seek temporary accommodation in London also use the London transport system to commute to their places to work and for other essential needs. There are also fears about the impact the mobility would have on the performance of the students. Most of the time is spent in commuting and this deprives valuable time that could be used for studies. Mobility also seemed to have made community-police relations difficult since the authorities find it tough to build a long relationship with the communities. There also internal problems for the public services. Though the public sector attracts good and highly skilled talent, the lure of the private sector causes retention problems. Public services account for high turnover and vacancies are higher compared to the private sector in similar activities. Turnover rate in nurses was around 20%, in police force it was around 10%. Nearly 10% of the teachers were not qualified to required need. There was also pay disparity among the workforce in the public services. While the private sector employees earned an average gross weekly pay of around 700 pounds, the corresponding average in the public sector was only 500 pounds. However for the female workforce the disparity was much less and the public services maintained gender equity as far as pay was concerned. The bureaucracy, working conditions particularly in deprived areas, low wages, language barriers in attending to various ethnic communities, fear of crime, seemed to be acting as a deterrent to work force in Londons public services.

Responding to Challenges
The Mayor of London Ken Livingston introduced the scheme of congestion tax. The aim of the tax was to reduce congestion in the city. The scheme came into effect in February 2003. Vehicles entering the central part of London on weekdays were required to pay a tax of $5 per day. Bicycles, mopeds and motorbikes were exempted. Some other vehicles were eligible for discount. The discount and exemptions were provided on the basis of their meeting strict environmental criteria. More than 150 check points were set up to monitor the vehicles that entered and left the congestion zone. Penalties were imposed on evaders. Traffic congestion and journey times reduced significantly both inside and outside the zone. While the average speed in the zone was around 8 miles per hour in 2002, it had increased to nearly 11 miles per hour by 2005. Traffic congestion fell by 40% against targeted 25%. Journey times fell more than 10%. The revenues surpassed the targets every year. The congestion tax became the focal point of the transport strategy for London. Londons bus transport system was dominated by private players who were unregulated. Fares were high. The city government regulated the private operators. Prices fell down and passenger growth picked up by 7% in 2003 within the year of regulation. London operated highest passenger mileage in almost 40 years. The revenues in 2003 were also the highest in more than 40 years. The city managers felt that the presence of policeman itself can often deter crime. It found that people were ready to pay for having more policemen on the streets. It was also felt that this would Cases In Management Page 57

act to strengthen the relationship between police officers and the communities. London increased its police force to nearly 30,000 by 2004 and expected to increase it further.

Scope for the Future

Studies found that more than the fares, Londoners believed that the frequency of the bus services should be increased. Reliability of service was found to be the most important factor considered by commuters while using the transport system. More than half the car trips and more than three quarters of the bus trips were less than five miles. This had to be reduced. Usage of cars was found to harm the environment and increase the pollution. London was also in the process of developing new rail systems to supplement the tube rail and the bus system. This had to be quickened to ease the strain on the existing transport system. However the cross rail project was expected to cost 10-15 billion pounds for its completion. The growing population will put on more pressure on the services. Moreover London faces a problem of complex funding system. The flows from taxes imposed by the borough councils and City corporations and the GLA and its bodies constitute the major revenue source for the city. The local bodies also receive grants from the central government. Experts believe that the funding criterion has shortcomings that aggravate the situation. Each funding agency has its own formula and there is no consistency among the different agencies. They vary sharply. Most of them do not take into account the diversity and transience that seemed to have made Londons problems unique in the country. 90% of the expenditure incurred on public services in London comes directly or indirectly from the central government. This has resulted in a situation where in London has limited autonomy in responding to its problems. This is ironical due to the fact that London has the highest tax base and also equally high needs. These needs are best responded by the local bodies than from central control. Unlike other cities like New York and Tokyo which have considerable financial autonomy, in case of London, most of the taxes are set nationally and expenditure too follows the same curve. The government office of London coordinates between the local governments and the central government. However most of this co-ordination is on smaller works. On broader issues like police forces, transport, education etc, analysts have often commented on the lack of co-ordination between the two partners. The issues of London would be best handled when there is devolution of financial powers and better co-ordination between the various agencies.

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7. iGoli 2002- Making Johannesburg a World City

Prof. Prashant Kulkarni35 Johannesburg was the second largest city in South Africa after Durban. It was also the richest urban area in South Africa. It was known as City of Gold for the gold mines that flourished in the region. The city was home to nearly two thirds of the countrys corporates and contributed nearly one sixth of the countrys Gross Domestic Product (GDP). It further contributed to more than 10% of countrys employment. Like in other cities, it too had a dominant black presence that traditionally supported African National Congress (ANC). By 1998, the city was on the verge of a severe fiscal crisis. Income had declined whereas expenditure was on the rise. The crisis threatened to engulf the city in a state of bankruptcy. To solve this crisis, consultants were hired to prepare a report. This led to Igoli 2002 the report that called for restructuring of Johannesburg. The report aimed to make Johannesburg World City. The plan revolved around introducing principles of business in the management of the city. It called for the local body to enter into a series of contractual agreements with the private partners who were to offer public services to the residents.

The City
South Africa underwent a transition from apartheid regime to democracy in the early 1990s. Led by Nelson Mandela was considered an idol, ANC started its programmes that aimed at uplifting the nations black majority. The community had been impoverished and suffered during the apartheid regime that had lasted for more than 100 years. Johannesburg was home to various races, ethnicities and nationalities. It was believed that distribution of income was highly uneven across the different communities in the city. Crime rates were high and experts warned that this conflict could lead to undermining of local democracy and peace. There were multiple sources of authority in the city of Johannesburg. Till 1995, the city was ruled by 13 different authorities with differing capacities and often overlapping powers and functions. The system resulted in imbalances in allocation and delivery of services to the residents accentuated by rapid urbanization. In 1995, the system was overhauled to make it a two tier structure. It was to comprise GJMC and four local metropolitan councils (MLCs). This authority was to be replaced by a unicity authority by the end of 2001. ANC which was the ruling party supported this initiative to meet it objective of one city, one tax base. Though was ANC was reelected in the Presidency, the priorities seemed to undergo a change with a greater focus on delivery. The changes in the functioning of the government were thought to contribute to the problem. Though each MLC and GJMC had its own budget and was responsible for its implementation, it was felt that it was as good as having one budget. However each council had its own tax structure and tax base. It seemed too many that it was an attempt to slowly integrate different races and ethnicities into an unified structure. However the political contest between the councils over tax allocation and collection caused divisions among the local councils. There was also lack of clarity among the roles responsibility and accountability of the different bodies. In late 1997, the city officials appointed a team of consultants to study the problem and suggest the remedies. The primary focus of the team was to review the process of urbanization and the
35 Asst. Professor Economics & Public Policy, IBA Bangalore

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accompanying problems like housing, public transport, environment, infrastructure development activities etc. It studied the functions of the various different departments including the Mayors office. The report criticized the structure of the local body, the mode of operation and concentration on non core activities as the core problems facing the city. It reported extensive duplication and lack of prioritization among the city officials. It classified the functions into asset based, agency based and others. Asset based functions included local public transport, gas, electricity, water supply, sanitation and sewerage, fresh produce markets, cemeteries, beer halls, sports facilities, parking lots etc. Agency functions comprised of housing social welfare and ambulance services. The rest of the functions included museums, maintaining zoological and botanical gardens etc. Even though the review was on it was becoming evident that the city was coming under financial strain. By early 1998, it owed 3 months of dues to the local power company. It recorded a deficit of R338 million. In what was seen as an insult to injury, it had to use an overdraft of R400 million to pay punitive interest rates on overdrafts and call bonds. The city administration had to take some steps to control the situation. The urgency to solve the crisis became more apparent due to the fact that Johannesburg was the richest local body in the country. The central government also saw it as an opportunity to reform the local bodies across the country.

The Crisis: Why it Happened?

Analysts attributed the strain to multiplicity of causes rather than pointing out to a single source. There was an increased spending and no controls were set. Most of the spending was directing at providing facilities to a small proportion of population. With the dismantling of apartheid, the city had to manage additional responsibilities. These new areas had been severely affected by lack of infrastructure. The extra burden of providing adequate infrastructure facilities was a strain on the local body. The city budgets were expenditure driven. By all accounts there seemed to be no thought given on the resources needed to be generated to drive this expenditure. Neither there seemed to be any thought on the beneficial effects of the expenditure incurred. In the post apartheid regime this was coupled with the rise in demand from black dominated areas which remained grossly underdeveloped. The accounting system was found to be deficient in understanding the fiscal situation. It was based on revenue collection and often presented a misleading picture to the city managers. The financial system tended to emphasize more on the regulatory aspects rather than focusing on the principles of financial management. Experts opined that the city government went in for high levels of borrowing at times going in for expensive call bonds that added to the interest burden of the body. On the other hand revenue generation showed a decline causing the increasing deficit. The former black areas contributed very low levels of revenues attributed mainly to lower incomes among the population there. It was felt that the government did very little to increase the productivity of the workers. Though there was overstaffing, the powerful trade unions ensured that there was no retrenchment of the excess staff.

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The central government also reduced its grants to the local bodies which seemed to make things worse.

Steps to Solve the Crisis

As a first step to solve the crisis, the government appointed a committee of 10 councilors to govern the GJMC. This came to be popularly known as C10. The mandate before it was to revise the budgets of GJMC for 1998-99 to provide for financial depth even in case of possible shortfall of tax revenues. It was also asked to create a mechanism that would lead to more effective utilization of the existing staff and also suggest ways to improve the credit quality of the city. The information systems in the councils were seen to be outdated and C10 was asked to suggest measures to improve the information systems. It also went into the activities of the corporation and examined the surplus generating activities and also the functions that could be outsourced to the third parties. However C10 failed because of it slack of expertise. The fiscal problems showed no signs of abatement and led to its dissolution. It was replaced by an expanded team of fifteen councilors which came to be known as C15. C15 was asked to design and implement the policies on municipal services. It was also given the mandate to negotiate with private players on outsourcing and hiving off the different municipal services in the city of Johannesburg. It was also asked to identify areas of co-operation with the private sector and new areas and functions that could be outsourced or corporatized. A subcommittee was also formed to facilitate easy implementation of Public Private Partnerships (PPP). This was needed since only the Metro Gas the utility that supplied gas to the city was in a stage wherein it could be privatized. Two types of activities were further identified. The non-core activities like airports, Metro Gas, power plants water were to be disposed while in other activities like information technology, public transport, fleet management were to be run like corporates. But these would not be privatized though the principles of corporate world would be the guiding points of managing these functions. The city also appointed project managers to look after each of these functions. Terms of reference and approval for each project manager we also drafted. External consultants were also brought in to help in transition. Feasibility studies were to be conducted to ascertain the health of the utilities and the desirability of having and alternative and effectiveness of that alternative. To further quicken the process of transition, a City Manager was appointed for Johannesburg in early 1999. His term was to run for two years. He was to be assisted by Chief Transformation Officer (CTO), Chief Financial Officer (CFO) and Chief Labor Relations Officer (CLRO). Ketso Gordhan was the first City Manager and it was his recommendations on the revitalizing the city that came to be known as iGoli 2002.

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iGoli 2002 It was a three year plan which thought as a solution to address the institutional, financial and service delivery problems affecting the city. It called for creation of a unicity structure. As a consultancy report put it36: It introduces the unicity concept by transforming local government through changed governance, financial viability, institutional transformation, sustainable development and enhanced delivery iGoli 2002 had acquired deep significance in the debate over the future of Johannesburg both within the ANC and outside. According to the City Mayor37: iGoli 2002 is an innovative transformation and development plan with primary goal of effective, efficient and sustainable democratic governance ensuring stimulation of socio-economic investment opportunities which have local provincial, national and international significance But it resulted in a strong debate across the city and the country. The left wing which was dominant and felt threatened argued that it resulted in bowing before the market forces. They further questioned the need for privatizing the services. Most experts felt that the debate was more on the nature of proposals formulated by iGoli 2002 rather than the need for the restructuring the city. What iGoli 2002 Proposes? The first step in the process was the proposal to create a unicity structure. The proposal envisaged creation of a political body with functional and management independence. The utilities and corporatized entities were to be delinked from the centralized administrative processes. The creation of the new body involved notification of the council, demarcation of wards, elections to the council followed by the constitution of the metropolitan Council which would ten constitute, sub committees, ward committees etc. It envisaged creation of 10 companies that would run Johannesburgs utilities autonomously. The units would be run on business lines rather than the government lines. The councilors would not constitute more than 20% of the board that would be formed to run the companies. It also sought to keep the role of trade unions minimum. The plan identified half the functions of the new structure as utilities of agencies. Nearly 20% of those functions were to be corporatized and the balance to be run as under the existing arrangements. Proponents of the plan stressed this fact the only 10% of the functions were to be corporatized and these mostly comprised the non-core functions of the body. The administration was also to be divided into eleven regional administrations with one core. Public utilities were to be created to manage the water supply and sanitation, electricity and solid waste management. It further proposed to create separate agencies for constructing and maintaining roads, storm water drains parks and cemeteries. These agencies were to be arm length agencies and the aim of the council was to create conditions for entry of private sector into these
36Prem Govender and James Aiello Johannesburgs Strategic Plan for Municipal Services Partnerships, Development South Africa, Summer 1999 37Mogase, I, Message from the City Mayor in GJMC 1999, iGoli 2002: Making the City Work, 1999

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activities. All these utilities and agencies would be corporatized and run as companies. However they would remain the ownership of the Metropolitan Council. The corporatized units would enjoy autonomy in their functions. They had to raise revenues to meet their costs. In case of shortfall there was a provision of the government stepping in and providing the grants. This was however to be in exceptional circumstances. The city council would normally act as a client to these utilities. The other entities that were to be corporatized included the city zoos and the Civic Theatre. Functions like managing Metro gas, Rand Airport, fresh produce market and the Sports Stadium were to be sold off the private parties. Supporters of privatization argued these activities constituted only 3% of total activities undertaken by the Metropolitan Council. They argued further that the money raised by selling off these units could be utilized to develop and strengthen the other units that were being corporatized. Critics however argued that the process was largely driven by the City Manager and his team advised by the donor agencies. Consultations outside this group seemed minimal. The information technology division had been outsourced in the past but experts felt that it had not yielded desired results. The new plan was to keep the core with the administration while the ancillary activities

Stakeholders, Critics and Pitfalls

In August 1999, the city held a conference among various stakeholders to debate the plan,. It received widespread support from all the political parties including Confederation of South African Trade Unions (COASTU). It also support from the international donor agencies. Local media and businesses also came out in support out of the plan However it faced several hurdles. Analysts opined that the sharp differences in which the different stakeholders viewed their interests posed the biggest challenge to the implementation of the plan. The two dominant unions in GJMC were South African Municipal Workers Union (SAWMU) and Independent Municipal and Allied Trade Union (IMATU). The trade unions for long had dominated the public sector and utilities in the city and through the country. It felt that its role was threatened. Fearing the loss of clout, it launched agitations through the city. Strikes were held and the unions threatened to disrupt the privatization and corporatization plan. While IMATU abandoned the path of disruption in her initial stages and tried to work out a deal with the policy makers to secure the best possible terms, SAWMU remained adamant. Efforts were made to involve it in the implementation of the plan but it went in vain. In an interesting development, COASTU of which SAWMU was a member signed an agreement with the South African Local Government Association (SALGA) on the reforms in municipal services. The agreement provided for co-operation between the local unions affiliated to COASTU. It was followed by lengthy negotiations. Added to this the South African Communist Party (SACP) also joined the protests. The students and the church also opposed the plan strongly. The city was witness to clashes between supporters and opponents of the plan and security forces had to be called in. In 2000, the ruling ANC contested the strike by SAWMU. City watchers attributed it to the determination of ANC governed council to move with the reforms. This was in contrast with the conciliatory moves undertaken by the ANC till then. Opponents got a boost when an independent survey conducted in early 2000 showed that most workers were skeptical about the retaining the jobs. This was in spite of commitment by iGoli 2002 planners to retain the existing employees for at least three years. The fear of insecurity was thought by many as fostering the discontent against the plan. The union leaders backed their claims with research reports from Bolivia, Argentina and Canada that showed the disadvantages of privatization plan in municipal services. Cases In Management Page 63

Though the administrators could not secure a total support on the iGoli 2002, SAWMU did give tacit support on some of the issues. Observers believed that the dues owned by the users of the utilities to the government were the primary factor that led to the crisis. According to estimates, by 1999, nearly R2.1 billion was owed by the consumers to the government. The basic premise of the new plan was the restructuring of the utilities and the pricing mechanisms would make consumers pay their dues in a prompt manner. However a section of citizens particularly the affluent classes were believed to be unhappy at the cross subsidization proposed in the pricing structure. This section believed that the utility providers lacked in accountability and transparency. They held that the quality of service provided did not measure upto the tariffs charged. The poorer sections could not afford to pay even the subsidized rates in some cases. Another problem that was haunting the service providers was the nature of logistics involved in providing services to a large scale of population. By the late 1990s, more than 150,000 households did not have a metered connection for water supply. This was causing a great loss to the council. Political constraints were believed to be a difficulty in regularizing the connections. Analysts however suggested the adoption of innovative measures like staggered payment of dues to solve the problem. The plan also came in for some criticism from the environmentalists. Supporters however argued that the plan advocated the efficient and balanced use of resources and took care of environmental concerns. The termination of illegal water and electricity connections was thought to help saving of water and electricity. The plan also called for stricter environmental supervision and stringent measures. Critics believed that the major aim of the plan was to please the financial community and the international agencies on which the city depended for its finances. Though few supported the criticism, they felt that it helped identification of revenues streams and the utilization of the revenues. There had been no linkage between the revenue and the expenditure. This plan was thought to bring about the linkages between the two. The staff and officials of the city government had to trained and motivated. It was felt there was lack of trained staff and often their responsibilities overlapped. It was felt that demarcation of responsibilities and prioritization of functions had to be taken up for smoother implementation.

Performance and Outlook

The city had recovered from the crisis by mid-2001. The city recorded a surplus of R71 million for the financial year ending June 2001. It improved further the next year generating a surplus of R83 million. Analyst opined that despite the hurdles, iGoli 2002 could be called a success. It was to be succeeded by a longer plan called iGoli 2010. This plan with a vision was to make Johannesburg a World Class City. iGoli 2010 aimed for an integration of service delivery, human development and economic growth. The plan was to involve UN Habitat for implementation of the plans. The elections to the council were held in While the results certainly generated optimism among the city watchers and residents alike, experts were cautious about the future.

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8. Revenue creation in Urban Local Bodies: A Case on Bangalore Mahanagar Palika

Mr. Prashant Kulkarni38 The passing of the 74th Amendment Act was seen as a landmark in the history of Urban Local Bodies in India (ULBs). The Act conferred on them a statutory status and the threat of supersession that was hanging around their heads was eliminated. The Act provided for regular elections to the local bodies and delegated powers to the ULBS for their effective functioning. It also provided for setting up for a Finance Commission in the States that would periodically examine the allocation of funds to the local bodies. Though the local bodies could raise resources through taxes, it was left to the state government to decide on what taxes could be collected by the ULBs and also the quantum of collection. In many states the local bodies were largely dependent on the State Governments for grants to manage their functions. Many felt that this dependence on State Governments was hindering the functioning of the ULBs. This resulted in the need for the ULBs to look for raising resources on their own that would reduce their dependence on State grants. This could be in form of new taxes or else rationalizing their functions or even it could designing a pricing mechanism for the functions undertaken by the Corporation. The last mechanism was considered as a better option as it would provide for the local body to raise resources for the services it provides to its residents and also raise resources. The actual users would be paying for the services unlike taxes which were an indirect form of raising revenue.

Functions of ULBs
The functions of the corporation can be classified into core functions, environment management function, planning functions, agency functions and governance functions (Kulwant Singh, Issues and Trends in Decentralization) The core functions constituted the first charge on the city corporation and these included basic amenities like providing of water supply and sewerage, solid waste management, construction and maintenance of roads and streetlights, recording and maintaining of vital statistics like births and deaths etc, providing of urban amenities like schools, playgrounds, parks, gardens, libraries etc. The environment management functions included promotion of urban forestry and environmental measures in the city. Agency functions were undertaken as an agent of the state and included firefighting services etc. The planning functions included slum development, rehabilitation, providing shelter etc. it also involved functions relation to protection of weaker sections of society.Governance functions involved the discharge of functions as the statutory body of the government. The functions are statutorily classified as Obligatory functions and discretionary functions. While the bodies are obliged to discharge functions listed under obligatory list, they are within their discretion to undertake the functions under discretionary category. Generally the core functions come under the purview of obligatory functions. The planning functions fall usually under discretionary mechanism. The functions relating to environmental
38 Asst. Professor Economics & Public Policy, IBA Bangalore

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management fall under discretionary category. Most of the planning functions are under discretionary list while the agency functions by its name suggest it is discretionary. Local bodies need resources to manage these functions. While in many cases it has been an indirect form, experts have felt that market mechanism could be introduced while discharging the functions that fall under the ambit of discretionary functions.

The Case of Bangalore

By the start of the 21st century, Bangalore had turned into the fifth largest city in India. It had become the preferred location for many companies particularly in the IT and biotech sector. Apart from being host to numerous MNCs like GE, Oracle, IBM, Cisco etc. it also served as the base for many Indian giants like Infosys, Wipro, and Biocon. The city was also known for its high standards in education and a number of premier educational institutes like Indian Institute of Management (IIM), Indian Institute of Science (IISc) and a host of engineering, medical and business schools were located in the city. Consequent to this spurt in economic activities the city was witnessing a strong growth in its population. Added to the resident population of nearly five million, it boasted of an equally large floating population. This was putting severe pressure on the city managers. The city was being governed by the Bangalore Mahanagar Palike (BMP) under the Karnataka Municipalities Act (1976). It was established in 1949 and was spread over an area of 225 sq. kms. The Corporation was responsible for maintaining the City services. These functions were usually classified into core functions, agency functions, environmental functions and governance functions. Bangalore was one of the cities that were in the forefront of accounting reforms and was process of rationalizing and improving the revenue streams.

Revenue Management in Bangalore

The City Corporation depended on two primary sources of revenue. One was revenue receipts and the second was the capital receipts. For a long time octroi used to be the primary revenue earner for the local bodies. Property taxes, advertisement taxes and surcharges on stamp duties were the primary tax sources. With the abolition of octroi, tax revenues of the corporation took a hit and they had to rely on state grants for boosting their finances. This eroded the autonomy of the corporations to some extent. These factors made it incumbent on the local body to rely on tax sources to increase their coffers. These sources comprised apart from grants, service charges, fees and fines and receipts from Corporation Properties. Capital Receipts on the other hand comprised of loans from HUDCO and KUIDFC and income from sale of commercial complexes etc. Revenue Receipts generally make up from nearly half of the total income for the corporation. Capital receipts account for more than 40% while the rest is usually the statutory deposits, cess on property taxes etc. Revenue receipts have shown an increase in the annual budgets from 4Rs.47, 000 lakhs in 2002-03 to nearly Rs 67,000 lakhs in s 2004-05. This could be attributed to the sharp increase in collection of fees and fines particularly building deviation charges which constitute Rs 15,000 lakhs for the year 2004-05. Tax revenues have registered an increase of around 40% from Rs 22,000 lakhs to Rs 31,000 lakhs. While earlier these could be considered a significant jump but now the real measurements are undertaken by comparing with the target revenue. Grants from SFCs and other sources have shown a decline. Cases In Management Page 66

A cause of concern is the decline of service charges levied for providing various services like infrastructure and parking lots, storm water drains etc. these have fallen by Rs 1000 lakhs between 2002-03 and 2004-05. The mechanism is moving towards loans from bodies like HUDCO and KUIDFC which have nearly doubled.

Revenues from Public Services

The management of public services constitutes a major charge on BMP. It is responsible for construction and maintaining roads, streetlights, provision of amenities like schools, playgrounds, gardens parks, and libraries, constructing and maintaining storm water drains (SWDs), construction and maintaining commercial complexes, parking lots, bus shelters etc. Some of these functions are discretionary in nature. It is being increasingly felt that these services could be provided by levying user charges. They are mostly financed indirectly through taxes. Many times the actual users do not pay and others end up paying for them. It has to be ensured the consumers will have to pay for the services they consume. Hence a market mechanism has to be worked out. Solid waste management: The contractors collect the garbage and send to processing plant where the waste is recycled. The contractors get assured payment from the corporation irrespective of their performance. This had to be now linked to performance. The contractors would be allotted areas and they were to collect garbage from those areas. They could levy user charges from the residents which would have to be approved by BMP. This would ensure the performance on the part of contractors engaged in collecting this waste. In addition they can sell of the waste to the recycling plants which would recycle and sell the recycled products to external users. Bus Shelters: It is the responsibility of the BMP to construct bus shelters. The user charges are difficult to levy in this case. So a new experiment was thought about. Private parties were asked to construct and maintain bus shelters. They were provided space on those shelters to advertise their wares. They in turn have to pay tax on advertising and also on the land used. The bus shelters were converted into advertising boards and a service that was 100% expenditure oriented with no direct income now became the source of income while causing zero expenditure. Commercial Complexes: These were to be handed out to the private parties for construction and they could rent it out to different business like shops, hotels etc. the parties that constructed and owned the complexes would have to pay taxes to the local body. This practice was extended to parking complexes also. Bottom line: There had been no linkage between the revenues earned and the expenditure incurred on creating the asset for all these years. There is now a need to bring in market intervention in many of the functions. This envisages the creation of a direct link between the expenditure incurred on the creation of the asset and the revenues it generates for the corporation. While in some cases particularly in core function it may be difficult for the corporation to price its products and services to recover costs, it is well within its reach of using market based approaches to recover the costs incurred Cases In Management Page 67

and in some cases to generate a surplus. This would be beneficial because if the corporation could generate surplus in these activities it could reduce taxes. Taxes are involuntary and are independent of the services used, these new measure would bring make the revenues earned directly dependent on services offered.

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9. Information systems in urban governance: Bangalores tryst with MIS as strategic tool
Mr. Prashant Kulkarni39 By the early years of the 21st century, Bangalore had turned into the fifth largest city in India. It had become the preferred location for many companies particularly in the IT and biotech sector. Many MNCs had located their offices in Bangalore and they included GE, Oracle, IBM, Cisco etc. Many Indian stars like Infosys, Wipro, and Biocon had their base in Bangalore. The city was also known for its high standards in education and a number of premier educational institutes like Indian Institute of Management (IIM), Indian Institute of Science (IISc) and a host of engineering, medical and business schools were located in the city. Consequent to this spurt in economic activities the city was witnessing a strong growth in its population. Added to the resident population of nearly five million, it boasted of an equally large floating population. This was putting severe pressure on the city managers. The city was being governed by the Bangalore Mahanagar Palike (BMP) under the Karnataka Municipalities Act (1976). It was established in 1949 and was spread over an area of 225 sq. kms. The Corporation was responsible for maintaining the City services. These functions were usually classified into core functions, agency functions, environmental functions and governance functions. Essential management functions constituted the first charge on the Municipalities. They included functions such as erection of boundary marks, construction and maintenance of roads and streets, provision of public amenities like gardens, parks and playgrounds, maintaining schools, maintaining of vital statistics like births and deaths, provision for collection, disposal, and treatment of garbage and solid waste, water supply and sanitation, maintenance of street lights etc. Environmental management functions included protection of environment, promotion of urban forestry etc. and were undertaken usually in co-ordination with the State Government. The Planning functions were usually taken up at the State level but implementation was done at the local level. These functions included slum upgradation and improvement, rehabilitation of the mentally and physically handicapped, protection and welfare of weaker sections of society etc. Agency functions like firefighting services, public transport, and electricity supply were undertaken by the ULB as an agent of the State Government. BMP however did not undertake any of these agency functions. The governance functions were the ones mandated under law as the representative government of the city.

Rationale for modern MIS

By 19998-99, BMPs budget had triple to nearly Rs 600 crores in just three years. The body had to allocate higher amounts on infrastructure every passing year. There were no reliable measures to assess the performance of the projects. Most of the projects were facing cost and time over-runs. The financials of the Corporation comprised only of receipts and payments. There was no holistic measure like the financial statements in businesses to understand the financial health of the Corporation. Many experts and corporation officials were coming around to the view of a need to restructure the activities of the Corporation. The first major overhaul had to be done in case of accounting activities. These activities would be the basis for creation of financial statements and thus
39 Asst. Professor Economics & Public Policy, IBA Bangalore

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provide information to various stakeholders like corporators, corporation officials, state governments, media, citizens etc. This needed there should be classification of essentials and non essentials. Certain activities were confined only to the respective departments and would not have an impact on other activities. These non finance activities had to be left out of the core budget making and preparation of financial statements. Integrating the different departments was undertaken. The functions of the corporation were being undertaken manually. The growing size and the functions created a necessity of having an advanced information mechanism. There was a delay in the conversion of data into information and then in using that information in planning for the future. This necessitated the need to modernize the Management Information System (MIS). It was not as if MIS did not exist previously. What was done was to improvise the existing MIS and bring it on par with the modern technological changes.

Elements of MIS
The earlier system of MIS was event based. The transactions were recorded based on the event. An instance could be given of the tax collection. Previously, tax collection was viewed in comparison to the past year. If suppose Rs. 10 lakhs were collected in the previous year and this year the tax collection was Rs 15 lakhs it would record that tax collection had increased by 50% which would claim to represent a healthy achievement. But it would not be the case if looked from the point of demand vs. collection. This necessitated the transition to the activity based system. In the new system, tax collection would be viewed as percentage of demand. If the tax base was Rs 50 lakhs and Rs 10 lakhs was collected, it was seen as 20% collection. If the tax collection was Rs 15 lakhs the next year in comparison to demand of Rs 100 lakhs, it amounted to collection of 15% down by 5% from last time. Earlier this would have been projected as an increase of 50%. This made the comparison of revenues and expenditure more reliable. Effective functioning of MIS required providing of timely, structures and accurate information. People had to be trained to use these systems. The first component in the MIS element was providing timely information. This was done by computerizing the whole set up. This facilitated access of records easily and the records could be stored more efficiently than the cumbersome storage in files. But this was only part of the story. These records would be redundant if there was no mechanism to separate the chaff from the grain. It called for creating structure for storage of information. The information may be available timely but would be rendered useless if it cannot be retrieved. This led to the development of a structure that provided for easy retrieval of information. The software was customized to suit each department. Only the information pertaining to financials was transmitted to the financial department for further action .the rest of the information was maintained in the respective department. This information could be however be sought by the financial department as supplementing of the financial information. These records would have to be verified and only the verified data was accepted by the financial department. This verification ensured in accuracy of data. The information thus generated was integrated with both event and activity creating a holistic picture of financial health of the urban body.

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The system helped in setting up more efficient indicators for measuring the performance of various departments, projects and personnel. It sought to create a system that helped in bringing greater transparency in the system. It was in line with alignment with the international standards. Prior to the introduction of the system, the information flow time to the finance department was 48 days. Work was decentralized. Daily Reports (TL-2) were possible. Review of the activities could be undertaken more easily with the publishing of Budget Variance Report (BV1). Liability position of each project and asset position vis a vis the target for collection was possible. Classification of entries under accounts was made more scientific. More importantly it also facilitated easier verification of records. Real time knowledge of revenue position helped the officials compare the collection vs. target position easy. Revenue analysis could now be done even at ward level. A single data source of information was created. It streamlined the works in the engineering department. It had the largest allocation among all departments. The infrastructure projects of the BMP were undertaken through this department. The system made a provision for a report on Works Liability Registers vs. Bill Registers. Real time liability position was available to the top officials and this helped them decide on the future allocations. The system introduced a coding system for tracking the works. Payments to the contractors were made only on the production of the work code. This gave the department complete control over the works being executed. While in the previous system, the disbursement occurred based on the cost of the project without assessing the actual need of the project, the new system provided for reviewing the past performance while allocating fresh amount. If there underutilization in the earlier years, the allocation would be cut down accordingly and the project managers had to spend the unutilized amount before they get fresh allocations. This allocation based on activity rather than a pure statistical event created a potential for savings and helped in better planning for expenditure and revenue for the next year. The proper interpretation of the indicators was also handy in deciding the tax base. If the ULB finds that is can raise revenues or undertake savings in expenditure it could even result in lower tax rates thus benefiting the common man. This also introduces scientific methods of determining the tax rates for the future years.

Lessons for Other Cities

Transparency was ensured and the possibility of leakages and over-runs minimized. The future allocation was based on the real time reports of existing utilization of budgets. The publishing of financial statements by the BMP which was the first in the annals of Urban Local Bodies (ULBs) in India would not have been possible without existence of MIS. It also facilitated more efficient involvement and integration of the different stakeholders in the activities of the Corporation.

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10. Subex Systems Limited: A Case on Financing Decision

Sandeep Revankar40 Prashant Kulkarni41 On May 14, 2004, Subex Systems Ltd a Bangalore based software Product Company which addressed fraud management and revenue maximization solutions for telecom companies announced that it was planning to raise $15 million during the next 2-3 months to fund its future growth. Also the company stated that an approval to raise this amount would be sought in the extraordinary general meeting (EGM) scheduled for May31, 2004. The company was likely to use this cash to fund its acquisitions, which was likely to happen during that fiscal. While there were various options ahead of the company to raise this amount the company was yet to decide on the choice of the instrument.

Company background
Two first generation entrepreneurs, Subash Menon and Alex J Puthenchira founded the Subex group in 1992. Headquartered in Bangalore, the company had about 150 employees and had branches in US, Canada and Cyprus. The company started as a systems integrator in the areas of coverage for wireless networks and test and measurement for voice and data. Gaining substantial domain expertise in the telecom space over a span of six years and identifying the huge growth opportunity presented by telecom software applications business, the company entered this lucrative field in 1998. By mid2000, it transitioned fully into a telecom software solutions player. The company provided telecom companies with tools to maximize revenues and software consultancy. It had a revenue maximization suite called Rev Max that comprised of two productsRanger, which was a telecom fraud management system, and INcharge, which was a revenue assurance system (See Exhibit 1). In January 2000, the company acquired IV Generation, Inc. of New Jersey, USA and converted the same into a wholly owned subsidiary called Subex Technologies Inc. In May 2001, Subex acquired the product line of Magardi Inc. of Canada. The products include OUTsmart (was later merged with Ranger) and INcharge. AT&T was the biggest international client, while others included France Telecom, Vodafone, and Connex etc. In the domestic market, they served almost all players including Hutch, Reliance, and Bharti etc. Revenue had touched Rs89.13crores for 2003-04, up 27 percent on the previous year and net profit stood at Rs17.75crores, up 78 percent over the previous year. The products business grew sharply by 60 percent thereby accounting for nearly 45 percent of the revenues. Product revenue as a percentage of the total revenue was 45 percent during the fiscal year 2003-04, compared to 36 percent in 2002-03 and 30 percent in 2001-02. See Exhibit 2 for segmental reporting for 2003-04. Subex went public in 1999 and by 2004 shares was listed in Mumbai, Hyderabad, Bangalore and the National Stock Exchanges.

40 Program head Manipal Universal learning, Bangalore 41 Asst. Professor Economics & Public Policy, IBA Bangalore

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Industry structure and outlook and concerns

Telecom companies faced the problem of revenue leakage due to various reasons like telecom fraud, incorrect billing, interconnect disputes, network errors, switching errors etc. According to industry estimates in 2004, the top 20-telecom companies in the world having combined revenue of US$1 trillion faced a telecom fraud leakage of 4 percent or US$40 billion42. Revenue maximization solutions helped these companies to plug revenue leakage due to fraud and incorrect billing. However, only 28 percent of the telecom companies used any revenue maximization solutions of which around 60 percent used in-house solutions. Observers felt that telecom companies had not paid much attention to leakage so far, as they were concentrating on increasing their subscriber base. The revenue maximization space had the presence of major telecom original equipment manufacturers (OEMs) like HP, Ericsson, Alcatel, Nortel etc. Though this had not been the focus area, the downturn which the companies faced in the early part of the decade was expected to force these companies to look into this space actively. It was felt that this would give these companies the marketing edge due to their ability to bundle revenue maximization solutions along with the telecom products. The telecom industry went into a recession in 1999 but by late 2003 observers had become optimistic of a recovery being underway. The industry was moving towards stability and a strong upward trend was being predicted by 2005-06. For Subex, 90% of the revenues came through the international market. The domestic market contributed only 10% of the revenues. The margins were thin and there was a spread of nearly 25% in margins between the international and the domestic market.

Companys past performance, investments and financing

The company grew rapidly from sales of Rs8.1crores in the year 1998 to Rs89.36crores in the year 2004 recording a compounded annual growth rate of 49 percent over the six year period. The profits during the same period moved from Rs0.59crores to Rs17.75crores and return on equity from 23 percent to 15 percent. However, the growth rate year on year had been highly fluctuating with the worst performance coming in the year 2002 due to melt down in the telecom spend globally. See Exhibit II, III & IV for the three financial statements viz. Income Statement, Sources and Uses Statement and the Cash Flow Statement.

Telecom products took about 15-18 months for the launch of commercial version from the time the product was conceptualized in the board rooms. After the launch, it took another 8 to 10 months before the company could bag a commercial contract. This required investments to be made in development, sales and marketing over a span of two years. About 20 percent of the costs in the product development stage were associated with development and the balance 80 percent in sales and marketing costs. Apart from creating software products like RevMax, the company also went in for acquisitions. The two main acquisitions were:


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a. In January 2000, the Company acquired IVth Generation, Inc. New Jersey, USA, which used to provide turnkey project development, services to American telecom companies for Rs33.6crores. Roughly Rs19.79crores was paid in the year of acquisition and the balance was paid in next three years, as per the terms of the agreement. The balance amount was reported as Deferred Consideration payable under unsecured loans. b. In May 2001, the Company acquired the intellectual property rights (IPR) comprising software codes and licenses of OUTsmart, a Wireline Fraud Management System and INcharge an intercarrier billing verification system from Marardi, Inc. of Canada for Rs15.89crores. Nearly Rs11.56crores was paid in 2001 and the remaining was paid in the next two years and was reported as Deferred Consideration payable under unsecured loans. The debtors collection period stood at 210 days as on March 31, 2003 which was much higher than the industry average of 120-150 days. As on 31st March 2003 the net working capital stood at Rs50.4crores much larger than the investment in strategic investments and fixed assets.

Financing needs
The company had been raising capital in various form equity, debt and hybrid instruments to meet its growing capital requirements. The company raised Rs32.10crores in 1999, Rs7.281crores through initial public offerings (IPO) when it issued 9,71,000 equity shares at premium of Rs65 per share and Rs24.81crores by issuing 3,30,800 equity shares at a premium of Rs740 per share to Mutual funds and Bodies Corporate on a preferential basis. During 2002-03, the company, in order to raise money for its product development efforts and repayment of deferred payments on acquisitions, had placed Redeemable Optionally Convertible Cumulative Preference Shares (ROCCPS), 15.71lakh preference shares with strategic investors Intel Capital and UTI Venture Funds at Rs88 premium per share. The preference shares carried dividend of 12.5 percent payable semiannually with an option to convert their preference shares into equity shares of the company at 1:1 ratio during six month period of April 1, 2004 to September30, 2004. In case of preference shareholders not opting for the option of conversion during the stipulated period, preference shares were to be redeemed in three years period. With the same above terms 2.13 lakh preference shares were also issued to Toronto Dominion Bank but with a premium of Rs90 per share. The total amount raised was Rs17.52crores. Upon conversion the shareholding pattern for the company is shown in Exhibit VI. The Capital History of the Company is displayed under Exhibit VII The debt to equity (defined as Total liabilities/Equity) had been fluctuating as shown in Table 1 Table 1 1998 1999 2000 2001 2002 2003 2004 Year Debt to Equity 1.96 2.14 0.57 0.38 0.70 0.58

Future outlook
According to SubashMenon, president and chief executive officer: We now have two promising products-one of which is expected to attain the largest installed base globally during financial year 2005 while the other is gathering momentum in its march towards a similar position Cases In Management Page 74

within the next 2 to 3 years. The company has set a target of becoming a $50 million company by 2007. The company expects revenue from products to grow by about 30-35 percent, while the services business is tipped to grow by 7-10 percent, leading to the overall top line growth of 15-20 percent. Profits after tax are expected to grow by 25-30 percent. The software telecom products would contribute around 70-80 percent of total revenues in the next three years43. Exhibit VIII-A to VIII-D show the graphical representation of performance of key indicators of Subex Systems Ltd. Select Financial Data under Stock and Debt Financing (2004)(in Rs. Millions) Stock Shareholder Equity Debt Capital Interest Payments Principal Payments No. of outstanding shares (million) Dividend payments (in Rs.) Debt

1475 800 168 843 14.30 68.3 56 140.4 32.12 25.17 33.12 25.17

Only two types of financing available- Debt and Equity to raise $ 15 million (15*45 Rs/$=Rs.675 m) Equity to be raised @ Rs.100 per share Tax rate applicable for firm is 25%. All ROCCP to be converted into equity. Cost of debt is 8% for period of 8 years. Existing debt to be repaid in 3 years time. The company wants to maintain dividend ratio of Re 1 per share

Questions for Discussion

1. Evaluate the tax benefits for debt financing and financial distress costs (Hint: Operating leverage, Nature of assets and business, Coverage Ratios under both financing schemes) 2. Calculate Earnings Per Share (EPS), Return on Equity (ROE) and Return on Invested Capital (ROIC) under both schemes and comment on their behavior assuming following scenarios (2005) EBIT Level BOOM 400 million BUST 100 million EXPECTED 300 million Perform EPS/EBIT Analysis and calculate the indifference point. 3. Suppose the company needs $5-10 million in the next five years for future investment needs, how wills this impact todays financing decisions?
43 Subex may go for Buyout this Year, Business Standard, May 1, 2004

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4. Discuss how the stock price of the company would react on announcement of raising debt and equity. ( Hint: Market Signaling, Timing of Issue, Asymmetric Information) 5. The cost of debt Kd =8.5%, cost of equity Ke=17% (Risk free return Rf =7%, Beta b= 1.54, Market risk premium 6.5%). Cost of debt is much lower compared to cost of equity, hence it makes sense to raise capital through debt Comment. 6. Discuss the issue of control (ownership) and agency problems associated with capital structure decisions. Exhibit I Product Range of Subex The product range comprised of three products 1. Ranger - Fraud Management System 2. INcharge - Revenue Assurance Solution 3. The RevMax suite- combination of the above two The RevMax suite Ranger - Fraud Management System Ranger is an end-to-end Fraud Management System (FMS) for wireless and wireline networks that has been designed specifically to address fraud in roaming, pre-paid and post-paid environments. Ranger accepts input from data sources like IPDR, CDR, subscriber information, information from the IN platform etc, thus enabling it to address fraud detection in the emerging areas like GPRS and other 3G technologies. More on Ranger INcharge - Revenue Assurance Solution Subex'sINcharge is a Revenue Assurance solution that enables the revenue assurance department to fully support the carriers expanding product portfolio, subscribers, interconnect partners and traffic volumes. The flexible modules are designed to identify and address issues such as unbilled subscriber usage, overpayment of interconnect charges and discrepancies between multiple OSS in order to provide the carrier with an overall view into the revenue leaks that are occurring within the network.


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Exhibit II Segment Reporting of Subex Systems Ltd. Particulars of Segment Assets And Liabilities (in Rs. Million)
Products 2003-04 Segment Assets 421,052, 294 2002-03 272,541, 563 Services 2003-04 175,186, 913 2002-03 127,336, 266 Unallocable 2003-04 151,669, 562 76,628,4 61 2002-03 260,532, 032 66,552,2 95 Consolidated 2003-04 747,908, 769 76,628,4 71 2002-03 660,409, 861 66,552,2 95

Segment Liabilities UnallocableAssets include Investments Advance taxes income

326,902, 626 10,690,3 98 256,942

326,686, 613 4,795,74 5 1,731,66 6 2,050,00 0

Miscellaneous expenditure Deferred Tax Asset

337,849, 666 Unallocable Liabilities Include Loans Secured 147,203, 061 1,748,50 8 18,883,6 19 40,077,1 36 Tax 1,570,00 0 209,482, 324

337,264, 024

156,020, 508 43,078,5 00 84,220,9 55 17,222,7 55

Loans- Unsecured Deferred Consideration Provisions Deferred Liability

300,542, 718

Source: Annual Report of Subex Systems Ltd. 2003-04

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Exhibit III Income Statement Subex Systems Ltd. (in Rs. Million) 0403-(12) 0303-(12) 0203-(12) 0103-(12) 0003-(12) Income Operating Income 879.25 700.10 591.83 552.38 312.14 Expenses Material Consumed Manufacturing Expenses Personnel Expenses Selling Expenses Administrative Expenses Expenses Capitalized Cost Of Sales Operating Profit Other Recurring Income Adjusted PBDIT Financial Expenses Depreciation Other Write offs Adjusted PBT Tax Charges Adjusted PAT Non Recurring Items Other Non Cash adjustments Reported Net Profit

15.64 2.38 522.86 13.60 64.52 0.00 618.99 260.26 9.15 269.41 14.30 41.20 1.47 212.43 14.67 197.76 -26.92 6.66 177.50

2.65 2.10 473.42 7.19 49.55 0.00 534.91 165.19 4.10 169.29 22.46 36.50 1.47 108.85 5.31 103.53 -9.31 1.90 96.44

1.34 6.39 417.51 6.07 64.54 0.00 495.85 95.98 0.64 96.61 12.08 34.20 1.47 48.86 3.20 45.66 -0.95 -2.87 44.72

53.01 1.39 338.89 3.40 32.08 0.00 428.77 123.61 4.98 128.59 3.72 19.33 1.47 104.07 0.06 104.01 -0.12 -1.11 103.88 109.41 14.25 0.00 93.70

126.70 1.16 97.70 1.62 22.78 0.00 249.96 62.18 3.64 65.82 5.60 2.54 1.23 56.45 6.00 50.45 -0.19 0.00 50.26 59.54 11.48 0.00 46.63

Earnings Before Appropriation 315.20 148.04 60.54 Equity Dividend 14.71 7.34 7.13 Preference Dividend 22.65 0.05 0.00 Retained Earnings 273.05 139.69 53.42

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Balance Sheet of Subex Systems Ltd. (Rs. Millions) 0403-(12) 0303-(12) 0203-(12) 0103-(12) 0003-(12) SOURCES OF FUNDS Owner's Fund Equity Share Capital 73.54 73.44 71.26 71.26 35.62 Share Application Money 0.24 0.00 0.00 0.00 0.00 Preference Share Capital 184.93 153.88 0.00 0.00 0.00 Reserves & Surplus 403.26 458.01 421.82 369.05 540.94 Loan Funds Secured Loans Unsecured Loans Total USES OF FUNDS Fixed Assets Gross Block Less : Revaluation Reserve Less : Accumulated Depreciation Net Block Capital Work-in-progress Investments Net Current Assets Current Assets, Loans & Advances Less : Current Liabilities & Provisions Total Net Current Assets Miscellaneous expenses not written Total Book Value of Unquoted Investments Market Value of Quoted Investments Contingent liabilities Number of Equity shares outstanding 166.09 1.75 967.49 240.24 43.08 913.90 269.16 35.48 833.91 130.09 0.00 623.17 128.52 0.00 533.19

209.17 0.00 119.95 89.22 0.44 326.90 670.99 120.33 550.67 0.26 967.49 326.90 0.00

161.56 0.00 83.72 77.84 0.00 328.69 589.42 83.78 505.64 1.73 913.90 328.69 0.00

163.77 0.00 54.28 109.50 0.03 330.18 294.29 62.26 232.03 162.16 833.90 330.18 0.00

109.76 0.00 24.32 85.44 0.06 326.22 262.98 56.21 206.76 4.68 623.16 326.22 0.00 0.30 7,125,680. 00

46.55 0.00 5.73 40.82 4.19 337.20 257.91 111.79 146.11 4.87 533.19 337.20 0.00 2.24 3,562,840. 00

0.00 0.08 6.16 7,353,811. 7,343,825. 7,125,680. 00 00 00 Source:

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Profit Before Tax Depreciation P and L On Sale Of Assets Interest Income Interest Paid Net Interest Net Assets Written Off Provision And WO Net Provisions For Bad Debts NPA Trade And Other Receivables Inventories Trade Payables Direct Taxes Paid Loan And Advances Other Operating Activity Net Cash Flow-Operating Activity Purchase Of Fixed Assets Sale Of Fixed Assets Sale Of Investments Acquisition Of Companies Interest Received Dividend Received Inves Activity Others From Investment Activity Net Cash Used In Investing Activity Proceeds From Issue Of Equity Capital Proceed From Issue Of Cap. Incl. Sh. Prem. Proceed from bank Borrowings -50.15 31.82 Proceed from other. L Term 0.00 0.00 Borrowing Repayment Of Borrowings 0.00 0.00 Dividend Paid -21.05 -7.00 Interest Paid -12.63 -22.16 Others From Fin Activity 0.00 0.00 Of Short Term Borrowings 0.00 0.00 Net Cash Used in Fin. Activity -51.69 175.36 Net Inc/Dec In Cash And Equivalent -128.75 143.53 Cash And Equivalent Begin of Year 162.36 18.83 Cash And Equivalent End Of Year 33.61 162.36

0403(12) 189.05 42.68 -0.20 -1.68 14.30 0.00 1.27 0.00 0.00 -196.39 0.06 10.05 -12.03 -8.10 1.58 40.58 -55.39 1.31 0.00 -65.34 0.00 0.00 1.78 -117.64 32.14 0.00

0303(12) 101.75 37.98 -0.51 -0.30 22.46 0.00 1.10 0.00 3.47 -166.15 2.63 20.81 -1.80 3.97 -0.20 25.21 -8.96 3.56 0.00 -53.14 0.00 0.00 1.50 -57.04 172.69 0.00

0203(12) 47.92 35.68 -0.12 -0.51 12.08 0.00 0.99 0.00 20.57 -78.13 0.88 -18.73 -6.07 5.98 1.08 21.61 -59.84 0.74 0.00 -115.65 0.00 0.00 -3.96 -178.71 0.00 0.00 165.61 0.00 -5.30 -15.70 -11.56 0.00 0.00 133.04 -24.06 42.89 18.83

0103(12) 103.94 20.80 0.00 -4.98 2.16 0.00 0.65 0.00 0.00 -10.09 11.65 -49.32 -1.14 -18.77 1.30 56.21 -62.85 2.39 1.40 7.97 0.00 0.14 0.00 -50.95 0.03 0.00 -3.79 0.00 0.00 -12.90 2.68 -1.28 0.00 -15.27 -10.01 52.90 42.89

0003(12) 56.30 2.50 0.30 0.00 -5.40 1.80 0.00 1.20 0.00 -117.30 -2.10 50.30 -7.80 -6.50 0.00 -26.70 -27.10 0.20 0.00 -197.90 3.60 0.00 0.00 -221.20 0.00 322.10 0.00 2.70 0.00 -3.50 0.00 -6.10 -21.30 293.90 46.00 6.90 52.90

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Exhibit VI Shareholding Pattern of Subex Systems Ltd. Holding Pattern as on : Face Value (in Rs.) Share Holder 30/09/2004 10.00 % No. Of Holding Shares 30/06/2004 10.00 % No. Of Holding Shares 0.00 47.59 0.00 47.59 0 4021600 0 4021600 31/03/2004 10.00 % Holding 0.00 54.69 0.00 54.69

No. Of Shares

PROMOTER'S HOLDING Foreign Promoters 0 0.00 0 Indian Promoters 4020480 43.45 4021600 Person Acting in 0 0.00 0 Concert Sub Total 4020480 43.45 4021600 NON PROMOTER'S HOLDING Institutional Investors Mutual Funds and UTI 1024677 11.07 946340 Banks Fin. Inst. and 0 0.00 0 Insurance FII's 1344038 14.53 1103279 Sub Total 2368715 25.60 2049619 Other Investors Private Corporate 219862 2.38 228744 Bodies NRI's/OCB's/Foreign 1004896 10.86 524469 Others GDR/ADR 0 0.00 0 Directors/Employees 113419 1.23 113810 Government 0 0.00 0 Others 87260 0.94 87240 Sub Total 1425437 15.41 954263 General Public 1438060 15.54 1424858 GRAND TOTAL 9252692 100.00 8450340 Source:

11.20 0.00 13.06 24.25 2.71 6.21 0.00 1.35 0.00 1.03 11.29 16.86 100.00

302552 0 1097048 1399600 294533 34902 0 70780 0 113842 514057 1418554 7353811

4.11 0.00 14.92 19.03 4.01 0.47 0.00 0.96 0.00 1.55 6.99 19.29 100.00

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Exhibit VII Capital history summary

Subex Systems Ltd. Issue month Issue Security type type value amount PUC PUC Face Security Additional Increased

(Rs.) Jul-99 Jun-00 Mar-03 Apr-03 PUBLIC Equity BONUS PPL PPL Equity Equity Cumulative Convertible Pref. Shares Equity Equity 10 10 10 100 10 10 7.28 0 0.01 18.87 0.02 0.02

(Rs. Crore) 0.97 3.56 0 0 0 0 1.06 7.13 7.34 7.34 7.34 7.35

Aug-03 PPL Dec-03 PPL

Source: Subex Annual Report

Source: Annual report Subex Systems Ltd

Source: Annual Report Subex Systems Source: Annual Report Subex Systems Ltd

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References 1. 2. 3. 4. 5. 6. Subex may go for Buyout this Year, Business Standard, May 1, 2004 Annual Reports, Subex Systems Ltd. 2000-2004, CMIE-Prowess Database

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11. Managing earnings in firms

Prof. Prashant Kulkarni44 Earnings Management acquired a greater focus after the scandals that hit US over the last few years. While the GAAP permits discretion in accounting it has been seen as being misused by many companies. They are dictated by the tendency to cater to the market whims and thus present their statements in such a way so as to please the market. This article tends to concentrate on the ways and means companies to manage their reported earnings In his famous The Numbers Game speech in 1998 delivered at New York Center for Law and Business, SEC Chairman Arthur Levitt brought to focus the problems in accounting practices of companies that could undermine the US capital markets. One of the processes he touched upon was the issue of Earnings Management. The accounting literature defines Earnings Management as the distorting of Generally Accepting Accounting Principles. It refers to all those actions that leave no impact on either cash flows or the economic earnings. It encompasses a wide range and spectrum of activities and actions beginning from legally permissible actions to creative interpretations within the boundaries of accounting and reporting standards to outright fraud. Companies face pressure to manage earnings for a number of reasons. The earnings pressures constitute the most important factor in earnings management. James Duncan lists out External Factors like Analyst Forecasts, Company Culture and Personal Factors as constituting major factors managing earnings. Companies indulge in earnings management by either overstating or understating the actuals so as to present a picture which the company considers beneficial to it at that point of time. The market is generally obsessed with stable earnings and an apparent dislike for fluctuating incomes. This tendency of the market and the companys desire to oblige the market is also responsible for managing earnings to ensure smoothening of income. This is done by postponing any unsustainable gains to the quarter where there is likely to be shortfall and hiding the shortfalls which they feel can be offset by future gains. This article highlights the ways in which companies manage their earnings to achieve the desired results.

Flexibility in GAAP
The flexibility in GAAP offers considerable latitude for companies to manipulate their earnings. There are areas in GAAP which call for discretionary accruals. These relate to events and transactions which call for judgments, estimates and projections on the part of management. The fact that a number of accounting maneuvers require the exercise of judgments make it difficult, if not impossible, to judge whether the company is presenting its earnings prudently or is indulging in some manipulation. The accounting procedures being nebulous add to the freedom that companies get in presenting their accounting statements. This is often done legally and the reported earnings though different from actual earnings do not change the underlying cash flows. This subjectivity in accounting practices which has resulted in the growth of manipulation and managing of earnings has made few analysts call for a need to have more comprehensive accounting rules and procedures. This is often referred to as cookbook accounting. William Parfet, a well-known financial analyst, however

44Asst. Professor Economics & Public Policy, IBA Bangalore

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argues against this. He feels that trying to write rules that cover every eventuality and possible circumstances is bound to end as a futile exercise.

Accelerating Revenue
GAAP allows the flexibility to record higher revenues in the current quarter while allowing for certain expenses to be delayed. Richard Wayman gives the example of Global Crossing to highlight this problem. Global Crossing is a telecom company that sold long term contracts that allows other telecom companies to use its fiber routes. The payment it received for providing these services was booked as revenue in a single quarter though the service to be provided was to spread over a period of several years. On the other hand, the company also entered into contract with other telecom firms to buy capacity on their fiber routes. But this facility was spread over a period of several years thus creating small quarterly expenses over the period of contract. In short, what Global was doing was recording the revenues it earned in a single quarter while the expenses were spread out over the period of contract thus resulting in a misrepresentation of facts in the financial statement.

Delayed Expenses
GAAP provides the companies the flexibility to match the expenses with the benefits they accrue. In case of investment in machinery or a plant the company may incur expenses today whereas the benefit will be realized in the future. To match these benefits accruing in the future, companies can match the expenses incurred on these plants and equipments to the benefit accruing over the useful period of the asset. However, companies misuse this principle of delaying expenses to manage their earnings. The example one can quote is of AOL. AOL got around the rules by capitalizing on the expenses. It had produced millions of CDs and it capitalized on the expenses for producing these CDs. Though the increasing trade brought in revenue the cost of making and distributing the CDs was spread over a longer period of time. However, the regulators were successful in making AOL restate its earnings and expense the capitalization of producing the CDs over a shorter period of time.

Accelerating Expenses
Companies can boost their earnings in the markets at times by showing off miraculous recoveries from what had appeared to be in dire straights. The companies usually take a hit in a quarter by usually writing off a huge charge. Though the company may suffer in that quarter, the charge being written off at one go will enable it to show increased profits in the succeeding quarters even though the cash flows remain the same and the expenses occur. This is done broadly by writing off charge on R&D, goodwill, and the non recurring expenses.

Writing off In-house R&D

Charging off on R& D expenses stem from the following fact. During acquisitions the acquired company may have developed technologies which may not be commercially viable yet. It is imminently possible that the technology so developed may find use in the future. However, the company decides to write off the expenses incurred on the development of that technology. In the future if the technology comes into prominence the company can show increased revenues without showing off the expenses incurred on development of such technologies.

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Goodwill Charges
Another manifestation of accelerating expenses emerges in the writing off goodwill costs. This too is prevalent in mergers and acquisitions. Goodwill is paying above the book value of the asset to buy owing to the perception of the buyer that there is something extra to the asset which he intends to buy. When the company pays more than book value to buy another company they record it as goodwill in their balance sheets. They may pay more than the value for the acquisition since they may perceive value in the brand or technology they are acquiring. The accounting procedure required the companies to amortize the goodwill costs over a period of years. But the new amendment made it necessary for the companies to write off the goodwill costs at one go if the current value of the company is less than the book value of goodwill. This is known as goodwill impaired.

Big Bath Charge

There is a tendency in the market to ignore one off expenses. The company may not be able to keep up the earning targets owing to certain factors which may be beyond its control and these usually do not have an adverse impact on the share prices. This is due to the fact that the event occurred just once and was unlikely to recur. The companies take advantage of this and attribute certain losses to onetime events and overload expenses to that event. This heavy charge which companies take so as to boost the earnings in the next quarter and attribute factors which may not be concerned with the event and take the charge is known as Big Bath Charge and can be seen as an aggressive mode of earnings manipulation. Inventory write-off remains another popular technique. This is used by the companies when there is a likelihood of a downturn. The companies write off inventory charges on the supposed grounds of obsolescence whereas the inventory remains in place and are sold in the next quarter adding to the profits. This obviously will reflect a healthy position on the balance sheet and boost EPS.

Charging Restructuring Costs

This was one of the major concerns expressed by Arthur Levitt in his speech. The legendary investor Warren Buffet feels that while the restructuring charge as an accounting entry is legitimate, it is a device that is too often a tool for manipulation of accounts. The charges which should amortize over a period of years are written off at a single go. This is done at times to cover up earlier misrepresentations and at certain times to prepare for future misrepresentations. The companies go by the assumption that it will not have an impact on the Wall Street as long as the future earnings consistently exceed earnings expectations. Two examples can be quoted. Lucent Technologies announced losses of $7 billion for the quarter ending Sep. 2001. The losses were the result of the massive restructuring the company undertook. Kelloggs & Co. is one of the most popular cereal makers. It took a massive after tax charge of $126 million to streamline its European initiatives and also in the other parts of the world. There was nothing unusual in it except the fact that it was the ninth time in the previous eleven quarters that company had taken a charge on streamlining operations.

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Non Recurring Charge

The game of non recurring charge is also employed by the companies by recognizing a charge as contingency reserve. This reserve is expected to take care of future losses which the company anticipates. In reality, however, it may happen that the company may add its reserve in the future quarters boosting its earnings by drawing from these reserves and reducing the estimated earnings.

Cookie Jar Reserves

Cookie jar reserves are also very popular among the companies. This technique is used by the companies in times of strong growth. During the period of strong growth, expense accruals are created so as to set aside a percentage of profits which can be used during times of downturn when the profits may turn to be lower than anticipated. These reserves are used as a sort of Cookie Jar which the companies can dip into and use it to meet the expectations of the Wall Street. The best example is that of the Microsoft. The software giant deferred a share of revenue from every sale into a line item unearned revenue. These deferrals were attributed to those charges that customers pay for maintenance or software updates. Though Microsoft settled allegations with the SEC of moving $900 million into the accounts for unanticipated expenses into reserves it did not admit guilt or any wrongdoing. These reserves, however, stated to decline following a downturn in 2000 with earnings growing at a much lower pace. These confirmed fears being expressed of these reserves being used for rainy days.

Intermediate Parking
The process works in the following manner. The companies, to show a much better picture of their sales or to meet their sales projections, shift their inventory from the factory to the distributors or other intermediaries. While the distributors may not be able to make a sale of those products the company can always show it as a sale since there had been physical movement of the goods. However, no economic value would have been added to the inventory. The methods used are deferred deliveries and intermediate parking. The example can be quoted of Sunbeam. In 1997 Sunbeam realized that it would fall short of the projected expectations. To overcome that it sold spare parts to a company called EPI Printers. The sale which fetched it $11 million enabled it to record a profit of $8 million. After the close of the income statement of the calendar year 1997 EPI Printers was allowed to cancel the contract. The method basically followed was intermediary parking by which the goods were shown as been sold to EPI Printers whereas in reality it was just a parking slot.

Off Balance Sheet Financing

It has achieved prominence in recent years and encompasses the methods used by the companies to shift their assets and liabilities and also incomes and expenses from their balance sheets and income statements. While the primary aim is to protect the investors and shareholders from business risks by transferring such risky assets to the subsidiaries or special entities, the practice has acquired notoriety of being misused so as to be used to benefit the companys bottom line. The methods which the companies use are discussed below:

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Special Purpose Entities

In high risky industries like oil, to minimize risk to the shareholders of the parent company, the law allows the companies to float special purpose entities (SPEs) to which these risky assets can be transferred. The law however requires the consolidation of statements of SPEs into the balance sheet of the parent companies if the parent company controls more than 50% of the shareholding in the SPE. However, the companies manage to evade it by holding 50% stake in the SPE and the balance is held by supposedly independent investors. This floating of off balance sheet companies to finance risky business is legitimate under law. Enron, the classic example of such misuse, made the mistake of transferring the losses incurred to these SPEs which resulted in non disclosure in its balance sheet. The example of Enron brought the practice of floating of SPEs into considerable notoriety as that allowed the companies maximum leeway to transfer their assets and liabilities off their balance sheets.

The companies can spin off a subsidiary into a separate public traded entity. The major difference between a SPE and a spin-off is that the spin-off must publicly disclose its financial statements just as its parent. The example of spin-off is Dell Financial Services (DFS) entering into joint venture with Tyco to create DFS. According to the Dell Balance Sheet, DFS generated business of $2.5 billion. But since Dell, even though it owns 70% shares in DFS, claims it doesnt control it, it has managed to keep its debts off the parents balance sheet.

Securitization Transactions
Some assets like loans, credit card balances can be transferred by securitizing them. This process is known as securitization. Financial companies including banks, insurance companies, and loan associations undertake securitization of their assets as a means of risk management. These transactions are recorded as a sale in the companys financial statements and the risks associated with the transferor even after the sale are omitted from mention.

Leasing Transaction
Companies own assets to run their operations and they finance it with debt. They have to record both the asset and the debt (liability) that is associated with it. However if the company structures the same asset as a lease and records as an operating lease, then it need not report either the asset or the liability. The most interesting example here would be of an airline which used leased aircraft to report that it doesnt have any aircraft!!

Synthetic Leasing
Synthetic leasing is a method by which companies finance their acquisitions of a new plant or build a new facility and also boost their financial ratios. If the companies were to go for financing in the existing mode the cost of financing would be higher and would also affect the bottom line since it is reflected in the balance sheet. To overcome this hassle the companies go in for SPEs. Synthetic leases allow 97% financing for the new plants or facilities but allow the companies to keep it off their financial statements. The company sets up an SPE which borrows money to build the facility and then leases it out to the parent company. It is recorded as operating and hence out of purview of the balance sheet. The rent is the interest payable for financing the acquisition. The company acts as Cases In Management Page 88

owner and manager of the property assuming all risks and benefits. However, the law does state that the synthetic lease should not exceed more than seven years and at the end of the lease the company must acquire the ownership of the asset and refinance the debt.

Employee Stock Options

Stock options, though a useful tool for aligning the interest of both managers and shareholders, have been subject to abuse in the absence of proper control. The deluge of accounting scandals in recent years has shifted the focus back onto these options which are used to manipulate the earnings. Simply put these stock options or ESOPs as they are known, are incentives conferred by the companies on certain employees to purchase company stock at predetermined price. The options will be exercised if the fair market value exceeds the grant price of the option. They have become the most popular form of long term compensation incentives for executives not only among US companies but among companies in many parts of the world. But the problem with ESOPs arises in their creative use to suit the companys needs and thus distorting their effects on the balance sheet. The options provide the CEOs to receive huge incentives when the companys stock price goes up reflecting the companys good performance. The awarding of stock incentives to the companys top brass also raises the question of insider trading. The companys management knows about the internal situation of the company and they can encash these options when they feel the time is ripe. In the case of Computer Associates, the top executives reaped $1 billion in stock after the companys share closed above $ 53.33 for 60 days in May1999. Soon after this the company started showing lower revenue growth due to lowering demand and reclassified its revenue figures even though the earnings were unaffected due to the matching reduction in expenses. Cisco is another example of how companies can make creative use of the liberty to offer stock options. Cisco paid employee compensation in the form of non-qualified stock options thus reducing the employee compensation in the financial statement. This helped in overstating of earnings. The cost of exercising those options is not included in the financial statements. By minimizing the payment of cash the company was able to reap the full advantages of maximizing its resources in the areas it requires without unduly affecting the bottom line.

Pro Forma EPS

In simple terms the word pro forma indicates that certain assumptions were made to arrive at the number being discussed at. If a company undertakes an acquisition it would be unfair for the combined results of the new company to the historical results of the old company. The investors would be benefited if they would know what was the organic growth (the growth of the core business) and the growth of the acquired the company. Similarly in the case of hiving of the divisions this becomes necessary. Therefore, in these cases companies use the pro forma sales and earnings to avoid distortions. But the fancy to please the Wall Street has made companies divert from real earning to pro forma earnings which they arrive at by deducting certain expenses which should have used to calculate EPS. reported the pro forma earnings of $0.09 as compared to $0.01 which it reported in the GAAP for the Q4 2001 results. It had tried to focus its attention to derived earnings by excluding certain expenses which were necessary to arrive at the real EPS45. In 2001, VerticalNet Inc. stated that it had lost 30 cents per share in the first quarter of 2001 even though the SEC filing stated that the figure was as high as 99 cents per share. This difference involved a charge of $443 million on various acquisitions. By eliminating this huge charge from the pro forma earnings
45Wayman, Richard J. op.cit

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the company was able to provide analyst and investor a deceptively positive picture of its performance. Since the charge was non-recurring the company was very much within the letter of law even though against the spirit by ignoring this charge.

From the discussion above, it emerges that while companies are well within the rights to use the discretion provided under GAAP while preparing financial statements, there is no license to misuse either the letter or the spirit of law. While in most cases the misuse is not against the letter of law per se it nevertheless affects the investors by hiding from them the real facts and providing a deceptive picture of the company than what the actual position is.

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12. EVA: A Primer

Prashant Kulkarni46 The financial theory has long suggested that companys ultimate aim is to maximize shareholders wealth. That should be natural since shareholders own the company and as rational investors expect good long term yield on their investment. Metrics like Return on Investment (ROI) and Earnings per Share (EPS) have and are being used as the important indicators and measures of performance of the company. They are even used as a bonus base in a large number of companies. It is in this context that the so-called Value Measures have received a lot of attention in the recent years. These measures are being claimed by their proponents as a panacea for the shortcomings of the existing measures of performance. Currently the most popular Value Based Measure is the Economic Value Added (EVA) on which there has been a vivid debate for and against EVA in academic and management literature. The concept has now caught fancy in the developing countries including India. These new performance metrics seek to measure the periodic performance in terms of change in Value. EVA was developed by Stern Stewart a consulting firm in US. As defined by Stern Stewart, EVA is the difference between companys net operating income after taxes and its cost of capital of both equity and debt (Stern Stewart, 93)

Objectives and motivation of the study

The Consultants, popular business press and investment analysts have hailed EVA as a new financial metric that seeks to be the missing link to the three corporate returns i.e. Shareholder returns, Accounting Returns and Economic Returns. It is being described as the hottest financial idea by Fortune. On the other hand there has been strong debate against the efficiency of EVA as a performance measure and its effectiveness as compared with the traditional measures such as ROI and ROCA. The primary motivation of the study is to understand o the implications of using EVA as a performance metric with specific reference to the developing economies. The objectives of the study can be summarized as follows. It seeks to understand the effectiveness of EVA as a performance metric particularly in the context of Indian companies. The Stern Stewart has been a conducting a yearly study with Business Today, an Indian Business magazine measuring the EVA of Indian companies and ranking them. This paper proposes to have a critical look on this ranking system. Profitability and Growth though both viewed as desirable are difficult to simultaneously attain and choice between the two constitutes a difficult trade off. The study proposes to look at this conflict of interests and the way EVA affects the choices. EVA depends on the cost of capital which itself depends upon the perception of investors which in turn implies the measure of EVA is determined by the very body of persons whose wealth is sought to be maximized. The calculation of cost of equity depends only upon the systematic risk which implies that managers should ignore non equilibrium risks or they will be punished by the market. The

46Asst. Professor Economics & Public Policy, IBA Bangalore

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study will try to highlight this contradiction and understand how the unsystematic risk and not systematic risk is the primary concern of the managers. Most importantly the very definition of EVA has been questioned both in theory and practice. There is no statutory or widely accepted definition for EVA. The study will also highlight this factor and show how variances occur due to this lack of definition.

Scope and methodology

The authors undertook a wide ranging survey of academic and management literature on this subject. It included books, journals, newspapers and Internet. The data was collected through these sources examined in details and the findings presented. The study also examined the BT-Stern Stewart survey on the measure.

ECONOMIC VALUE ADDED (EVA) It is measured as Net operating Profit after Tax less Capital Charge (Cost of Capital * Invested Capital) Equals Economic Value Added (EVA) . NET OPERATING PROFIT AFTER TAX (NOPLAT) It is the operating profit (EBIT) minus the taxes. Another name for NOPLAT is PAT (Profit after Tax) MARKET VALUE ADDED (MVA)47 It measures the value added by the management over and above the capital invested by the investors MVA=Market Value of the firm minus Economic Capital.

Literature survey
EVA has been described by Fortune in its cover story in Sep.1993 as the hottest thing in the financial world and getting hotter. Prof. V. Raghunathan of IIM-A explains EVA is one measure that can practically assess the economic contribution of a company short of accounting anomalies. It is a relevant management tool since it unifies the concepts of Net Present Value (NPV), market price and book value48. Bennet Stewart in his Quest for Value (91) describes EVA as 1. 2. 3. 4. Operating profits less the cost of capital employed to produce those earnings. One and the same thing (as NPV) The only measure to tie directly to intrinsic market value and The fuel that fires up the premium in the stock market value

47Business Today Feb 22nd 2000 48 Quoted in Business Today Feb 22nd , 2000 pg 82-83

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As Stewart(94) himself notes As a concept EVA starts simple in practice can be made as comprehensive as needed to accommodate managements needs and preferences. 49 While the term EVA appeared as early as 1989 it received little attention until Fortune in its article in Sep 93 provided a detailed description of the concept, Stern Stewarts practice and successful adoptions by major US Corporations led to a flurry of papers being published primarily in the popular press and practitioner journals to promote EVA. Although anecdotal stories may differ in detail among EVA users, a common claim seems to be that EVA adoption leads to dramatic improvement in stock performance. According to an advertisement of Stern Stewart in 1995 Forget EPS, ROE and ROI. EVA is what drives stock prices50. While successful EVA stories are quite encouraging there is another side of the story. The research which exists in support of the EVA claim of supremacy is primarily anecdotal with insufficient empirical research. Moreover most of the research has been conducted by consultants who stand to gain financially and independent research is limited. In countries like India empirical evidence is very insufficient. EVA is measured by the difference of the net operating profit after deducting taxes and the cost of capital multiplied by capital employed. This implies the marriage of two concepts one the NOPLAT which is an accounting concept to be derived from the companys account books the second being the cost of capital which is an economic concept based on perception of investors. This gives rise to two issues one computational issue and secondly systematic issues. While the calculation of NOPLAT relates to computational problems, the problems in calculating cost of capital results in systematic issues. We will deal these issues one by one. The shortcomings in acceptance of EVA as a performance measure lie in two aspects. One is computational and the other is systemic. EVA is measured as the excess of NOPLAT over the cost of capital. However the calculation of NOPLAT itself is subjective. It has become a source of manipulation. While NOPLAT is an accounting concept the introduction of cost of capital leads to introduction of the market concept. So the measurement of EVA becomes a combination of accounting and market based concepts. Since both NOPLAT and Capital Employed are derived for accounting figures they require to be converted to economic profit from accounting profit and this is subject to be manipulated. According to Weaver Due to measurement differences, Economic Value Added is a limited tool that cannot be used for competitive analysis. In practice there is no consistent definition of EVA and numerous fundamental differences exist with regard to NOPLAT51. Weaver brilliantly analyses the difficulties in computation in arriving at these figures and show how they could be a very wide variation. He argues that the measurement practices vary widely and in some cases significantly52. He finds of all the 28 companies which responded to his questionnaire, none of the companies made the same combination of adjustments to NOPLAT. He goes on to argue that the measurement practices the companies are using for NOPLAT are inconsistent applications of EVA theory.
49Weaver, Samuel.C, Measuring Economic Value Added:A Survey of the Practices of EVA proponents, Journal of Applied Finance, 50 quoted in Pablo Fernandes, EVA, Economic Profit and Cash Value Added Do not measure Shareholder Value Creation ICFAI Journal of Applied Finance Vol 9, No.3 May 2003 51 quoted in Measuring Economic Value Added: A Survey of Practices of EVA Properties, Samuel Weaver, Professor of Finance, Leigth University, Bethlem PA 18015 , Journal of Applied Finance 2001. 52 ibid Summary and Conclusions

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Further his findings about the calculation of net assets also bring about interesting revelations. The EVA theory led to a Net Asset Value of $810 using a hypothetical data. Applying the respondents approaches to that same data produces 15 different net asset values ranging from $560 to $100053. In his analysis he takes the example of food processing industry. Of the three companies he surveyed in that industry he found that while company 1 makes 16 adjustments, company 2 and 3 make 24 and 31 adjustments respectively. He goes on to show how NOPLAT and Invested Capital can arrived using different approaches even when the same industry economics and dynamics are in place.

Computational issues
The computational problems have their root in the fact that there seems to be no statutory definition for EVA nor there seems to be any broad based acceptance for the definition. The concept developed by a consultant Stern Stewart makes it open for manipulation. In fact many companies have made selective adjustments and developed their own versions of EVA. E.g. AMP uses their version called AMP Value Added (AVA) which is measured as NOPLAT divided by Invested Capital54. Interestingly Business Today in its survey on EVA acknowledges.... since the cost of capital is determined by the prevailing interest rate in the country, the ranking of each company on the cost of capital and percentage growth is a purely mathematical exercise and not indicator of efficiency55. The computational problems stem from the fact that Stern Stewart advocates as many as 164 adjustments to the accounting items for arriving at NOPLAT and cost of capital which become a tool for manipulation. But the companies have been selective in their adjustments. As Biddle points out (97) for their publicly database... Stern Stewart makes a handful of standard adjustments. For their corporate clients, Stern Stewart makes additional custom adjustments not available to public56. The lack of universally acceptable definition for NOPLAT could result in the manipulation of figures and the different methods could even lead to different figures. This is evident when we compare Stern Stewart-BT survey with the annual reports of companies. Comparing the BT-Stern Stewart survey with the annual reports of companies brings this picture vividly. For the year 2002 there is a wide difference between NOPLAT calculations of Hindustan Lever Ltd in their annual report and in the survey. While Hindustan Lever Ltd in their annual report a NOPLAT of Rs.1722 crores the survey puts the figure at Rs.1535crores57. But more importantly while NOPLAT calculations can be explained because of the different methods used the fact that the EVA itself is different draws home the deficiency of EVA. Take the example of Hindustan Lever Ltd. The following table illustrates it.

53 ibid 54 quoted in Measuring Economic Value Added: A Survey of Practices of EVA Properties, Samuel Weaver, Professor of Finance, Leigth University, Bethlem PA 18015

55 Business Today Feb 22nd 2000 op.cit. 56 Does EVA Beat Earnings? Evidence on Associations with Stock Returns and Firm Values ,Gary.C.Biddle, Robert Bowen,, James Wallace ; 57 BT-Stern Stewart survey of India Incs Biggest Wealth Creators Apr.13-2003 and Hind Lever Report and Accounts 2002 pg.F33

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2000(Rs.Crores) 2001(Rs.Crores) 2002(Rs.Crores) Annual Report BT-Stern Stewart 858 570 1080 765 1236 1003

Let us look at the example of Infosys. In the year 2002 while Infosys projects a figure of Rs. 510 crores, BT-Stern Stewart arrive at a figure of Rs. 242 crores58. The difference in EVA cannot be explained easily when the gap is so huge. As analyzed by Weaver, if there is a difference between two reports then the implication some other calculation may result in another figure being floated. If the purpose of EVA is to be an indicator of efficiency and result in reward system for the managers then the different figures being floated would result in the whole exercise becoming a mockery.

Systemic issues
The other half in measuring EVA is calculating the cost of capital. The cost of capital as shown above is measured as the product of weighted average cost of capital (WACC) expressed as percentage and the total capital employed. The cost of capital depends on the perception of the investors or the shareholders. Therefore it implies that the persons whose wealth is sought to be maximized themselves decide the cost of capital. When this becomes the case the manager develops strategies catering to market fads which are prone to change quite rapidly. The market is driven by herding momentum which creates volatility in the market. In handling these situations the manager loses sight of the long term objectives of the company. This obviously results in company loosing the value in the long run and the investors who maximize their wealth anyhow may ditch it when the going becomes tough. Hence this strategy is a Loss-Loss strategy for the firm. The cost of capital depends on cost of two components i.e. debt and equity. The cost of equity is calculated using the CAPM model. The cost is measured by Re=Rf+ b (MR-Rf) Where, Re - Expected Rate of Return Rf - Risk-free rate of return (usually the return on government bonds) MR - Market rate of return b - Beta which measures market risk

The calculation of cost of capital leads us to the systemic problems. The cost of capital is subjective and depends on the perception of investors. This implies that the beneficiaries themselves decide the measure of EVA. The cost of capital is calculated by the weighted average of cost of equity (key) and cost of debt (kid). The cost of equity is calculated by the CAPM model. CAPM model incorporates only systematic risk and totally ignores unsystemic risk. This leads to conclusion
58 Sources: Annual report of Infosys 2002, the EVA statement and BT-Stern Stewart Survey of Wealth Creators April 13-2003

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that the managers are being encouraged to ignore unsystematic risk. But the management of the unsystematic distinguishes one company form another and thus lies at the heart of the strategy team. The expected rate of return depends on the perception of the investors. Beta measures the market risk. But the CAPM model takes into account only the systematic risk. According CAPM, the unsystematic risk is eliminating by holding a wide portfolio which will cancel out unsystematic risks. But this is not the case. The manager is differentiated by the way he handles the unsystematic risk. It is in this management where the heart of strategy lies. CAPM ignores this unsystematic risk and thus there is danger of the manager being encouraged to unsystematic risk and being actually rewarded for that. Therefore EVAs ignorance of unsystematic risk is one of its major drawbacks. Beta is itself subjective and prone to manipulations. The beta measures the market risk and is concerned only about the systematic component. Each company has its own beta based on the risk perception of the market about the company. The industry beta gives the average systematic risk associated with the industry as a whole. This cannot be taken as representative for any individual company. This is what Infosys has actually done. Till 2002 they have adopted the software industry beta of the US market as their beta. This can lead to erroneous conclusions since the beta represents only the average of the industry and within the industry there could be wide gap for betas of different individual companies. Interestingly Infosys uses the Indian GAAP procedures for arriving at EVA while using the beta for the US market. Then last year for 2003 they have used the beta of the company in the Indian market. This change in beta also has an impact. This usage of different betas by different sources for arriving at EVA and the mixtures highlights another aspect of the drawbacks associated with EVA calculation and thus the possibility of erroneous conclusions. The risk free rate of return (Rf) itself is not constant. It is subject to changes and is not entirely risk free though usually it is measured based on the return of government bonds. CAPM owes its existence from the Efficient Market Hypothesis (EMH). In the EMH world the asset prices are plotted on the Securities Market Line (SML) where Asset prices (market prices) correspond to Asset Values (book prices). On the SML, Expected Rate of Return (ERR) will always be equal to Required Rate of Return (RRR). In such a case the EVA which measures the difference between these two values will be zero. The EVA therefore becomes a quantum whose existence itself cannot be defined. Even if there is a difference between ERR and RRR it will be statistically insignificant to worth such a value. In reality however EMH world doesnt exist which leads to the possibility of arbitrage and thus the CAPMs effectiveness is open to question. The primary drivers in stock market are the effects of volatility, momentum and herding. The concept of EVA ignores this vital fact. These are the computational and systematic issues that are raised by the adoption of EVA. Based on the above findings the next section will draw the conclusions and ascertain whether EVA is and effective measure in the context of Indian conditions.

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As one journeys through the maze of the above findings one cannot help but comment that the measure of EVA seems more like a fad oriented one than anything concrete or substantial measure to measure companys productivity. The measure of the efficiency and productivity has been traditionally measured by the metrics like ROI and ROA. EVA gives the same result as these traditional metrics. Therefore there seems to be no reason why one should use EVA instead of these relatively cheaper and easier modes of measurement. As seen above the lack of statutory definition for EVA acts as a biggest inhibitor for its effectiveness since this lack of suitable definition gives ample scope for manipulation and arbitrariness. There are many companies e.g. AMP which have developed their own measures and this defeats the very purpose of EVA. The very complexity of this model which deters the companies from proceeding with EVA and now the added possibility of manipulation is a great handicap and works against the concept. Traditionally the managers in the company are concerned with achieving two objectives one is the profitability and the second growth. These act in conflict with each other and though desirable to have both are very difficult to achieve simultaneously. The concept of EVA leads the managers to look at short term goals which is rather dangerous and detrimental to companys long term interests. Stock markets always tend to be driven by factors like volatility and momentum rather than companys prospects over the long term but as research as shown the association between stock market performance and key financial indicators have reduced over the period of time. In fact only a quarter of financial and other economic announcements have any effect on the stock markets and this has been investigated extensively by Cutler et al.(1989), Haughen (1991) etc. The question of transmission of EVA into MVA is an area that requires additional research and thus one cannot conclusively say about the positive co-relation between EVA and MVA. In fact in the BT-Stern Stewart survey on Wealth Creation 42 companies have positive MVA and negative EVA (among the top 100 performers). At this moment it is worthwhile to have a look at the BT-Stern Stewart survey on Wealth Creation which they have been coming off with for the last few years. While the survey talks about the wealth creation of the Indian companies in terms of Economic Value Added it ranks the companies in terms of Market Value Added. In case of Banking and Financial services companies (BFS Companies) the cost of equity is taking as cost of capital which leads to the conclusion that the BFS companies might have be overvalued. In fact after considering the fact that they have been overvalued most of the BFS companies have negative EVAs. The survey leads us to believe that the companies with higher MVA are wealth creators while those with negative values are wealth destroyers. In fact as shown above very little empirical evidence is available on the transmission of EVA into MVA. The survey itself acknowledges the fact that the negative EVA of ICICI Bank is mainly due to the reverse merger of ICICI with ICICI Bank. Interestingly the survey leads us to come to another important conclusion that the concept of EVA ignores the possibility of future returns. If future returns are ignored then it is unreliable to use EVA in measuring the performance of the company. In fact the stock market depends on the investors perception about the future returns of the company as demonstrated by the CAPM model which exists on the Expected Rate of return which in turn depends on how the investor perceives the company is going to perform in the future. The companys performance depends mainly on the management of the unsystematic risk which is ignored by the EVA. Ignorance of this key differential factor leads us to arbitrary and erroneous conclusions. Since the measure of EVA is determined by the perception of investors who are more concerned about their wealth maximization the managers may be forced to cater to their Cases In Management Page 97

needs rather than the firms which in the long run destroys value than create it. This conflict of interest between shareholders and the managers is detrimental and leads to the situation wherein the managers are performing to the tunes of the market than the other way round. In countries like India where growth is more important and the markets have just opened up there is always the possibility of the Value Addition being negative in the initial stages. The addiction to the concept of Value Based Measures like EVA is going to shift the focus to the short run and will at to detriment to the companys long term interest and divert funds from projects which create wealth in the long run towards those projects which add to the EVA though not necessarily in the companys interests. Therefore the practice of EVA should not be encouraged in the emerging markets like India. One of the majors claims by the proponents of the EVA is that is helps in assessing performance at divisional level. The very complexity of the model makes it rather difficult if not impossible to disaggregate the metric at divisional levels. Moreover the term being an absolute figure it is very difficult even to assess the competitor strength. In all one can say that since there is little difference between the traditional metrics like ROI, ROA etc and the EVA it makes little sense to depart from the easier and relatively cheaper metrics to shift to the new metric like EVA which is more complex, more costly, more time consuming and ultimately prone to arbitrariness and manipulation which will defeat the very purpose for what it has been claimed to have been created for. Ultimately one can say EVA can only be one of the metrics used in performance measurement and assessment but cannot be the only metric or even the superior metric.

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13.To Swim or to Sink: Kingfisher Airlines in 2012

Prof. Prashant Kulkarni June 2012 brought new worries for Vijay Mallya (Mallya), the owner of Kingfisher Airlines (Kingfisher). The airline which once had 20% of the total market share, now commanded a mere 5%.59. Kingfisher returned 32 aircraft taken on lease since it could not pay the dues. Inspite of claims of voluntarily returning these aircraft many remained unconvinced. A number of engineers and pilots had quit Kingfisher in the previous months owing to nonpayment of salaries. Kingfishers efforts to raise funds both domestically and from abroad reportedly did not meet with success. Fuel suppliers were reluctant to supply fuel on credit. The bank accounts were frozen affecting Kingfishers ability to clear of its dues and payment of salaries. Its debt exceeded $1 billion60. British Airlines among others terminated their code-sharing agreement with Kingfisher. Cancelled flights and repeated flight delays became routine embarrassing the management. In February 2012, the Director General of Civil Aviation (DGCA) ordered a special audit of Kingfisher operation to ensure the financial preoccupations did not hinder customer safety. Mallya had been arguing of capital infusion in the firm to keep the airline afloat for what he termed as in national interest. The jury remained divided whether to allow Kingfisher to sink or bail it out in the present crisis.

Opposition to Bail Out

The Hindu, in its editorial, laid the blame on the business model and lack of financial management and operational efficiency for the crisis. It sought to counter Kingfishers claims of high taxes, high fuel prices and falling Rupee as the causes of the crisis61. Internet was abuzz with criticism about possible bail out plans. Blogs suggested that Mallya, being well aware of the ground realities of the aviation sector, should accept failure of not incorporating the same in his business plan. Moreover, airlines have closed down in the past62. Further, it was opined that commercial ventures like Kingfisher should be allowed to fail in case of improper management. Drawing parallels to General Motors (GM) bailout, GM was declared bankrupt, existing shareholders lost the money and the firm started afresh with new shareholders. The concern was saving jobs and capital and not the individual shareholders or management. Further, importance of GM or Ford to US economy was different as opposed to Kingfisher. Similar comparisons were drawn to Air India, another company that seemed to be in perpetual crisis. Analysts felt that Air India bailout set a wrong example though few suggested that Air India, being a government owned airline, be treated differently. To some analysts, Kingfisher bailout could happen only after the wiping out the existing shareholder base and possible evidence suggesting the continued existence of airliner in national interest or of societal value. Few argued that Kingfisher was deliberately overplaying the crisis pressurizing the government to allow higher limits on Foreign Direct Investment (FDI) limits in the aviation sector. These limits prevented a possible buyout of Kingfisher by a foreign airliner63.

595 biggest worries for Kingfisher Airlines,, June 26, 2012, Accessed on June 26, 2012 60 Nathalie Thomas, Crisis deepens at Kingfisher Airlines, March 12, 2012,, Accessed on June 24, 2012. 61 Dont Bail Out, The Hindu, November 13, 2011 62 The Ethics of Bailing Kingfisher Out,, Accessed June 26, 2012 63Rumi DattaHardasmalani, Is Kingfisher Airlines Really in Trouble?, Business Standard, June 28, 2012.

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For Bailing In
With many airliners operating on high cost platforms and below cost airfares, the crisis seemed imminent. A view was for the government to take pragmatic approach and offer a onetime bailout to ensure the sector remained afloat. Relaxing limits on FDI or allowing direct imports of jet fuels did not seem to impress analysts. Fuel costs comprised 40-50% of total airline costs. The logistics associated with setting up the infrastructure for direct imports seemed to deter the airliners64. To some, it appeared nave to suggest bailing out Kingfisher would equate with bailing out Mallyas lavish lifestyle. Mallya would lose only to the extent of his shareholding (58.6% in December 2011) apart from the prestige. In contrast the loss experienced by others was likely to be higher. Other shareholders would lose money. SBI and other banks which had lent a large amount of money would lose causing a loss to its shareholders and depositors alike. With Kingfisher opting for leasing aircraft left these lenders with little choice in case of default. Estimates suggested Kingfisher owing nearly Rs. 1000 crore of credit to state-run oil companies like HPCL, BPCL etc. There were defaults on provident fund dues direct tax payments and service tax which would remain unrecovered. Further, their employees would be rendered jobless.

Future outlook
While several methods were being discussed in the media and the policy circles, the million dollar question on a win-win solution to Kingfishers woes continued to elude the key participants.

Question: Should Kingfisher be allowed to Survive or Fail? Present your take on the caselet.

64ShailendraTyagi, Open Sky Policy: Act IV, Scene I, February 25, 2012, Accessed on June 23, 2012

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14. Caselets in Macroeconomics

Prof. Prashant Kulkarni65

Caselet I- Rupee depreciation and textile industry

The recent rupee depreciation has enabled the Indian textile industry to hold yarn prices and also increase yarn exports. Though Indian industry demonstrates stronger backward linkages, low labour costs have enabled countries like Bangladesh, Pakistan and Vietnam to overtake India in terms of capturing textile export markets. With Chinese Yuan appreciating, Indian exports have become more competitive. Indian textile export share is marginal ( 5% as compared to Chinas 30%). Many analysts advocate leveraging the current scenario to capture the global market at the expense of China. As a CEO of leading textile manufacturer, you are planning to go in for capacity expansion. Capacity expansion necessitates funding and thus you approach a consortium of banks. Prepare the detailed projections convincing the bankers how the global economic trends portray well for Indian textile exporters. (Note: Use financial statements showing the projected increase in exports and also how rupee depreciation results in increased profits to convince the bankers)

Caselet II- Government policy and Aluminum industry

India is fifth largest alumina producer in the world and accounts for 5% of the worlds aluminum production. Moreover, Indian bauxite reserves, account for 7.5% of total bauxite reserves. In India, the industries that require aluminum mostly include power (44%), consumer durables, transportation (10-12%), construction and packaging (17%). Yet, the per- capita consumption is low compared other major economies and usage patterns also differs from major economies. In the leading economies, aluminum is used in transportation particularly building aircrafts. Rising costs (power costs) and uncertainty in global demand has resulted in lower prices ($2300-$2400 per tone) in 2011. Domestic demand has slowed down to around 9% in the last five years and will hover around 8-9% in the next five years. Production however has increased by 11% CAGR. Though prices are likely to recover, the increasing prices of raw materials and power are likely to keep the pressures subdued. As a representative of the aluminum industry, make a representation to the government about the budgetary expectations in FY2012-13. Build scenarios on tax proposals and their impact on domestic industry profitability. (Note: Use financial statements to build scenarios on tax rate changes impacting profitability. Tax changes for end users can also impact your industry)

Caselet III- Inflation and retail industry

As the festive season approached, retail industry CFOs and CEOs were keeping their fingers crossed. High inflation combined with high interest rates seemed to have dampened the enthusiasm of the consumers to spend. Traditionally the period starting from Dusherra to Diwali was considered auspicious in India and consumer spending usually grew at 20-25% during this period. However, in 2011, the spending was projected to be less than 10%. As a CFO of leading retail chain, analyze the

65Asst. Professor Economics & Public Policy, IBA Bangalore

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impact of inflationary pressures in the economy on the retail industry in terms of its sales and profitability. (Note: Need to build a financial statement for the industry showing the projected figures in the normal and the projected figures in the current period. Reasons for variations have to be clearly explained)

Caselet IV- Interest rates and automobile industry

Automobile industry usually moves along with a business cycle. In the US for examples, the average period for holding a car is 6.5 years. An increase in the average period by one year leads to a drop of 15% in terms of car sales. In India, automobile purchases are financed by interest rates. Interest rates increase the cost of borrowing and households postpone the purchase of cars. Sales growth in 2011 slowed to just 4.3%, compared with a stellar 31% in the previous 12 months. Further the overall growth through to March 2012 is projected to be 2-4% only. However, in positive feelers, with RBI likely to cut rates or at least unlikely to increase, car sales may show up. As a automobile analyst, prepare the projections for the auto industry in 2012-13 based on the likely interest rate scenarios. (Note: Need to build a financial statement for the industry showing the projected figures using interest rate changes and consequent impact on the industry. Reasons for variations have to be clearly explained)

Caselet V- US fiscal policy and Indian ITES industry

Recently, President Obama proposed the withdrawal of tax breaks for industries that ship jobs abroad. Implied in the proposal was a coaxed warning to US industry not to outsource to countries like India. This has the potential for upsetting over $60 billion IT export industry in India. However, leading research firms like Gartner and key analysts have ruled out any impact on the Indian IT industry. You have approached a venture capitalist for financing an opening of KPO. He is reluctant given the Obama proposals. Convince him your financials would see minimal impact of the US fiscal proposals. (Note: Use financial statements to back up your claim. Show the impact scenarios both when tax breaks do not get withdrawn and when tax breaks get withdrawn)

Caselet VI- Consumer durable industry and IIP trends

Index of Industrial Production (IIP) has seen negative growth (-5.1%) in October 2011. Capital goods and manufacturing sector were the worst affected. But home appliances industry is made of many small-ticket items (kitchen appliances, low-end models in washing machines, aircoolers, and so on) too, where financing doesn't play a major role in a consumer's purchase decision. To analysts, less than 10 per cent of the home appliance industry's sales happen via the financing route. The Board of Directors of a lead home appliances manufacturer, however, were concerned about the downtrend impacting the firm. Add to it is high interest rate regime. As a Chief Economist of the firm you have to make a presentation before the BoD about the implications of this fall in IIP. Convince them about how consumer durable industry starts recovering before the other sectors do and how the worst is over. Use financial statements to prove your point that their fears are unfounded.

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(Note: Financial statements to reflect to projected sales and profits and the reasons for this upturn to happen before other industries start to recover)

Caselet VII- Subsidies and fertilizer industry

An analysis of the recent budget 2011-2012 suggests that the India's subsidy bill will jump by more than 100 per cent during the four-year period ending 2011-12 to Rs 1.43 lakh crore. This is being attributed to the rising outgo towards petroleum and food items. Interestingly the non-plan expenditure on subsidies for the fiscal 2011-12 is at Rs 1,43,570 crore, which is over 102 per cent more than the actual expenditure of Rs 70,926 crore during 2007-08. There is a proposal to shift to a direct transfer of cash subsidy to people living below the poverty line in a phased manner. This is likely to ensure greater efficiency, cost effectiveness and better delivery for both kerosene and fertilizers. The greatest share of subsidy allocation is for the three segments -- food, fertilizer and petroleum. The projected subsidy for food in 2011-12 is Rs 60,573 crore, for fertilizer and petroleum it is Rs 49,998 crore and Rs 23,640 crore, respectively. As an economic analyst using financial statements, prove the relative effectiveness of direct subsidies vs cash transfers in terms of sales and profitability of fertilizer industry (Note: Financial statements to reflect profitability projections under both scenarios: direct subsidies or cash transfers. Cash transfers represent redistribution of money from the government to the farmers to enable to buy fertilizers from the markets. Direct Subsidies on the hand represent the selling of fertilizers at lower than market prices to the farmers, with the government paying the balance to the firm)

Caselet VIII- Repo and reverse repo rates and housing industry
RBIs ambitious policy of inflation targeting through interest rate hikes has seen rate hikes in the last year and a half. With the increase in repo and reverse repo rates, the cost of funds for banks has increased. Implied is a shifting of this burden to the consumers particularly in the housing sector. The loan amounts available has reduced by 25% besides the EMIs have increased by one and half times for an average buyers. All these factors spell a negative sentiment in the housing market and thus adds to troubled bottom lines of the housing sector firms. As a CFO of the leading housing sector company, present your projections to your shareholders on the impact of repo and reverse repo rate hikes by RBI in terms of profitability of the firm. Also present your future anticipation of interest rates and its impact on your company (Note: Build the financial statements incorporating the sensitivity of the housing sector industry to the changes in repo and reverse repo rates )

Caselet IX- Government expenditure and Infrastructure industry

India's spending on infrastructure has been in the region of about 3% to 4% of the GDP, which the government now plans to take to 9% by the year 2012. Yet compared to other countries it is quite small. Investment opportunities abound in roads, bridges, ports, power, railways, airports, urban infrastructure, water, irrigation or gas transport. Since most of these are public goods, it is felt the government has to take the initiative for the increased expenditure. The beneficiaries of the increased government expenditure are the infrastructure and ancillary infrastructure companies. A leading Cases In Management Page 103

domestic infrastructure company wants to take advantage of the proposed expenditure but is short of funds. Hence it is looking at a collaborator from abroad. Apart from the FDI inflows, the overseas collaborator will bring in its technical expertise. As the financial consultant for the domestic firm, prepare financial projections to convince overseas collaborator the benefits of investing in India. (Note: Financial statements will have to be prepared showing the projected and sales and profit trends and how sensitive the industry is to increase in government expenditure. For every Rupee increase in expenditure, there is a multiplier effect in firms profitability)

Caselet X- GDP growth rates and Hotel industry

Indian GDP growth rates have been by CRISIL to grow at around 7% for FY 2011-12. The downtrend in growth projections is being attributed to uncertainty in global demand accentuated by European crisis, oil price rise owing to developments in the Arab world, slackening investment climate in India and lack of fiscal space in Indian economy. Industries which are closely linked to GDP growth rates are affected. Hotel industry grows at a multiple of about 2.5 of the GDP growth rate. Linked to rising incomes, hotel industry sees uptrend when GDP shows an increase. In current revised scenario, the hotel industry is likely to face downward projections. As an stock market analyst, show the financial projections for the profitability of the hotel industry in the revised scenario. (Note: Prepare financial projections for the hotel industry profit rates based on the current trends in GDP and also how it is going to change following increase or decrease of GDP growth rate)

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Contemporary Subjects Through Students Eyes

Essentially, the bottom line of teaching revolves around the ability of the students to ingrain the essence of the faculty discourse. Often, passionate the teacher, higher is the possibility of getting the students ingrained in the direction a teacher originally wants them to be. It is long process but certainly rewards are reaped in the form of student contributions. While few papers in this collection were student collaborated papers, what I present in this section are student contributions during the course. This is done with minimal editions so as to capture the essence of the students. Contribution I- Cultural Exports (Ms. Aarti Behera)

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Contribution II- Determinants of Market Access (Ms. Pranjalee Jaiswal)

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Contribution III- Virtual Cultures and Social Movements (Mr. Vishnu U.)

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Contribution IV- Discontents of Globalization (Ms. Brinda D)

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Contribution V-SEZs and National Soverignity(Ms. Sonali Jagdev)

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Contribution VI- Sweatshops (Ms. Swapna A)

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Contribution VII- Sports Power (Mr. Srinivas R)

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Contribution VIII- User Driven Innovation (Mr. Viplav Chaubey)

Developed by Viplav Chaubey

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Contribution IX- Slums in the Global Economy (Mr. Soumya Ranjan Panda)

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Contribution X-MNCs and Growth (Ms. Preeti Morla)

Contribution XI-Food Security (Ms. Haindavi K.)


Exporting their manufactured goods and importing food RUSSIA Provide opportunity for employment Provide food

Feed the future initiative by US Govt Transferring their technology to other countries UNITED STATES OF AMERICA Micro finance, Improving distribution channels Good refrigeration during storage INDIA HIGH

Food accessibility



Food availability

Ive tried to capture some original contributions which reflect the ability of students to inherenty absorb the prinicples of the subject being taught.

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