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What is a project?
A project is a specific, finite task to be accomplished in order to generate cash flows. It is a proposal for capital investment to develop facilities to provide goods and services. The proposal may be for setting up a new unit, for expansion or improvement of existing facilities. The project however has to be amenable for analysis and evaluation as an independent unit.
The stages of project selection
The identification of project ideas is followed by a preliminary selection stage on the basis of their technical, economic and financial soundness. The objective at this stage is to decide whether a project idea should be studied in detail and to determine the scope of further studies. The findings at this stage are embodied in a prefeasibility study or opportunity study. For the purpose of screening and priority fixation, project ideas are developed into prefeasibility studies. Prefeasibility studies give output of plant of economic size, raw material requirement, sales realisation, total cost of production, capital input/ output ratio, labour requirement, power and other infrastructure facilities.
After ensuring that a project idea is suitable for implementation, a detailed feasibility study giving additional information on financing, breakdown of cost of capital and cash flow is prepared. The feasibility study should contain all technical and economic data that are essential for the evaluation of the project.
1. Before dealing with any specific aspect, feasibility study should public policy with respect to the industry. For example, to evaluate the prospects for investing in the telecom market, a firm should consider the following aspects of the New Telecom Policy: • • • Cable networks will be allowed to provide data and voice services subject to licensing. Inter connectivity between cable and basic service provider allowed. Domestic monopoly of DoT for long distance calls will end by January 1, 2000. For giving the licenses, almost 72 % weightage will be given to license fees, 15 % for rural development, 10% for network rollout and 3% for indigenisation. 2. It should specify output and alternative techniques of production in terms of process choice and ecology friendliness, choice of raw material and choice of plant size.
3. 4. 5. 6.
The feasibility study, after listing and describing alternative locations, should specify a site after necessary investigation. The study should include a layout plan along with a list of buildings, structures and yard facilities by type, size and cost. Major and auxiliary equipment by type, size and cost along with specification of sources of supply for equipment and process know-how has to be listed. The study has to identify supply sources and present estimates, costs for transportation, services, water supply and power. The quality and dependence of raw materials and their source of supply have to be investigated and presented in the feasibility study.
The feasibility study should include financial data. It should cover preliminary estimates of sales revenue, capital costs and operating costs for different alternatives along with their profitability. Feasibility study should present estimates of working capital requirement to operate the unit at a viable level.
An essential part of the feasibility study is the schedule of implementation and estimates of expenditure during construction.
The feasibility study is followed by project report firming up all the technical aspects such as location, factory lay-out specifications and process techniques design. In a way, project report is a detailed plan of follow-up of project through various stages of implementation.
Chapter 2 - Market Appraisal
Analysis of demand for the product proposed to be manufactured requires collection of data and preparation of estimates. Market appraisal involves:
Preparing a description of the product, its major uses, scope of the market, possible competition from
substitutes, special features of the product proposed to be manufactured in regard to quality and price which would result in consumer preference for the product in relation to competitive products • • Estimating existing and future demand and supply of the products proposed to be manufactured Assessing likely competition in future and special features of the product which may enable it to meet
competition. Identifying export possibilities and compiling comparative data on manufacturing costs. The CIF and FOB prices and landed cost of the proposed product have to stated. It is also necessary to identify principal customers and state particulars of any firm arrangements entered into with them. Selling arrangements contemplated in terms of direct sales or through distributors or dealers have to be classified. After collection of the data, the existing position has to be assessed to ascertain whether unsatisfied demand exists. Since cash projections are to be made, possible future changes in the volume and pattern of supply and demand have to be estimated. This would help in assessing the long term prospects of the unit. Estimation of demand requires the determination of the total demand for a product and the share that can be captured by the unit through appropriate marketing strategies.
Methods of demand forecasting
The commonly used methods of demand forecasting are trend, regression and end-use method. Trend Method
The trend method assumes that the behaviour of the variable would continue in the same direction and magnitude as in the past. In this method, it is useful first to draw a graph to ascertain whether a linear or an exponential trend is appropriate for projection. The assumption under linear trend is that the variable would increase by a constant amount, whereas in exponential it will change by a constant percentage amount. Graphing the data will help to decide which period to choose and what type of form be used for forecasting. Only after analysis of past data the trend line should be fitted.
In regression approach the factors influencing the variables that are to be forecast have to be identified. In this method we have the dependent variable and the explanatory or independent variable. The dependent variable is the one subject to forecasting. The explanatory variables are those which cause changes in the dependent variable. If rate of inflation is to be forecast, the independent variables may be money supply, per capita availability of food grains and rate of monetisation of the economy. Specification or identification of factors is crucial in forecasting by regression approach. In multiple regression we have more than one explanatory variable.
The end use approach enables customer industry-wise demand forecasts and it is easy to evaluate any discrepancy in the forecasts with the actual value. The main advantage of regression method is that it enables the estimation of turning points. provision should be made for changes in the norms as a result of technological change or emergence of substitute products. End-Use Method In this method the users of the product proposed to be manufactured. In trend method the need for independently forecasting the explanatory variable does not arise. the National Small Industries Corporation and the Small Industries Services Institute provide valuable market information about projects and products. the Directorate General of Technical Development and the Planning Commission may be mentioned. In regard to small scale sector. Regression method is more accurate than the trend method because it takes into account causal factors. Several associations of manufacturers make estimates.The regression coefficients should have the right sign arid be statistically significant. . It takes into account the impact of all variables influencing the dependent variable. whereas the trend method cannot predict the turning points. An intensive study of the past and present situation and a thorough assessment of the future prospects of the various end user industries is made to determine the expected levels of production for the various end user industries. are identified. This is reflected in the value of R . Among the government agencies. In the case of regression the explanatory variables have to be forecast independently. Demand projections and estimates are made by agencies of government as well as industry associations. Several private consultants undertake market surveys for a fee. A study of the consumption norms for each end user industry in respect of the product for which forecasts are needed is also made. the Development Commissioner for Small Scale Industries. In actual practice forecasts by both methods may be attempted. However. the square of the multiple correlation coefficient 2 Limitations and Advantages of Trend and Regression Methods The trend is a catch all approach. The method is appropriate for intermediate industrial products such as steel and caustic soda. The actual value of dependent variable and the estimated value should be close to each other for the sample period. as the values of 't' at a future period are known.
However. recovery of chlorine and hydrogen no doubt requires additional investment but improves profitability as compared to a plant producing just caustic soda. variations in price have to be checked. products and equipment design. especially. and annual production on the length of the crushing season. Sometimes additional investment would improve the profitability enormously. design. Capacity of Plant . the project should be able to deliver marketable product from the resources deployed. of production capacity. of raw materials to be used. In a caustic soda plant. If there are seasonal variations. For example. Basically. It is on record that a public sector textile process plant was set up without checking the quality of water. the availability of soft water is essential for a textile processing plant. at a cost which would leave a margin adequate to service the investment and plough-back a reasonable amount to enable the enterprise to consolidate its position. capacity varies with the composition of yarn of different counts.Chapter 3 . The daily production in a sugar mill depends on sugar content of the cane. engineering design and plant and machinery are established facts and can be checked from published information on the process or from prospective collaborators/ consultants and on the basis of similar plants in operation elsewhere. . An integrated textile mill with cotton as a starting material would require larger investment and is more profitable than an un-integrated mill of the same capacity producing fabric from grey cloth.Technical Appraisal Objectives of technical appraisal Technical appraisal is primarily concerned with the project concept covering technology. The extent and degree of integration and facilities for by-product recovery also affect size of project investment and profitability. in technical appraisal one should be alert and apply trained and informed skills. The result was a large additional investrnent to cure water. Technical appraisal has a bearing on the financial viability of the project as reflected by its ability to earn satisfactory return on the investment made and to service equity and debt. Evaluation of Technology . scope and content of the plant as well as inputs and infrastructure facilities envisaged for the project.Project concept comprises various important aspects such as plant capacity. should the need arise. product mix and raw material composition. The design and layout of the plant in technical appraisal should ensure ease of operation and convenience of maintenance and uncomplicated expansion of the stream capacity. Accurate assessment of plant capacity on a sustained basis is of crucial importance. Project Concept .In technical appraisal. degree of integration. Above all. facilities for by-product recovery and flexibility of the plant. It is indeed difficult to assess capacity. in the case of agricultural inputs. For instance paper plant capacity varies with grammage. inputs are scrutinised for availability and quality dependability. In a textile mill. considerable skill is required in evaluating the claims of emergent technology. Inputs . Evaluation of industrial projects is undertaken to compare and evaluate alternative variants of technology.Capacity of a plant depends on several factors such as product specification.Outstanding features of technology process. of location and of local production versus import.
General functional layout should facilitate smooth and economical movement of raw materials. Material flow diagram presents flow of materials. obtaining Government approvals. plant size. The ideal factors are. delivery period of equipment. A small integrated paper plant using bagasse. plant layout identifies the exact location of each piece of equipment determined by proper utilisation of space leaving scope for expansion. procurement of equipment. Antipollution regulations may also force the choice of large size plants to curtail noise pollution or to install anti. need for power and utilities and distance from the next section. building construction. land acquisition. which helps in the installation of utility supply. Project Charts and Layouts . Pollution control restricts the use of steam boilers while power scarcity restricts the installation of induction furnaces. water and effluent disposal system. work-inprocess and finished goods. Several mini steel plants set up in a big way in '7Os were out of business as a result of lack of steel scrap from imports. production line diagram. Production line diagram establishes the progress of production from one machine to another with description. there must be realistic time schedules and a coherent arrangement. its erection and testing to final commissioning.up financial arrangements. the technical appraisal of the individual project may be supplemented by a supplementary review of the project in terms of interdependence of the basic parameters of the project which are.While it is easy to enumerate desirable factors to be taken into account while determining location. as well as the efficiency of the management to tie up various ends in a coordinated and speedy manner. Since an overrun In the pre-commissioning time invariably leads to overrun in cost and consequential problems. it is important that timing of construction is realistically planned. For all main physical elements of the projects. These are general functional layout. which leads to the completion of the project on most economical basis. proximity to the market and inputs. The scheduling of construction and the identification of potential causes of delay form an important part of the technical aspects of the project appraisal. material flow diagram. paddy husk or straw without need to recover process chemicals may be more viable than large integrated paper mill requiring forest based raw material. scrap and emissions. location and technology. from project concept. Sometimes undependable supply of basic inputs could spell disaster. smooth flow of goods to minimise production cost and safety of workers. final products. of course. Use of scheduling techniques like PERT and CPM and proper adherence to them is an essential aspect to be insisted upon in technical appraisal. In some industries effluent disposal facility is necessary. Finally. intermediate products. tying. utility layout and plant layout. water and compressed air. Finally. engineering design. which are environment friendly. Interdependence or the Parameters or Project . space required. utilities.Finally. in practice various constraints dictate location away from the ideal one.Project charts and layouts have to be prepared to define the scope of the project and provide the basis for detailed project engineering. Utility layout shows the principal consumption points of power. the quality and availability of water which shows seasonal trends especially in case of a project requiring water as an input should be checked. preferably where well developed infrastructure exists. location. Location . which was due to foreign exchange crisis. . The implementation of the project has cost and time over-run implications. The schedule of construction depends mainly on the speed of civil construction works.vibration equipment with adverse impact on costs.Similarly power quality has to be checked in terms of variation in supply voltage and in-line current frequency and duration of blackouts.
penetration price for a new producer will have to be lower than the current price of an established manufacturer. comparison with similar projects is useful. selling expenses (including product promotion) and interest on borrowings. repairs and maintenance. .Estimates of production costs and projection of profitability is the concluding part of the technical appraisal. marketing strategy. inadequate operating skills. prices. The profitability estimates should be on a realistic selling price. too.products. In a competitive market. shortage of power and lack of demand. administrative overheads. In practice capacity utilisation may fall short of estimated levels on account of defective plant and machinery. their costs. Adequate provision is made for higher expenses in the initial years for technical troubles. lower operating efficiency and higher selling costs. power and fuel requirement. consumption norms for various inputs and yields and recovery of by. salaries and wages. Here. inadequacy of raw materials. technical constraints relating to process and plant facilities. norms of raw material consumption (including provision for wastage).Cost of Production . and operators' efficiency). The cost of production and profitability estimates take into account the level of production in different years and product-mix (which are dependent on market potential. Cost of production is worked out taking into account the build up of capacity utilisation. higher wastages and lower yields. a general build-up starting with 40 percent and reaching a normal level of 80 percent in three to four year’s time is provided. In estimating production.
Financial projections for a ten-year period have also to be made. prospective liquidity and financial returns in the operating phase. whether there is any inter-locking of funds with associate companies and whether the concern has been ploughing back profits into the business and building up reserves. a proforma balance sheet and profit and loss statement certified by the management may be examined. it is desirable to make an assessment of its latest financial position. For this purpose. cost of the project and means of financing. In case an audited balance sheet as on a fairly recent date is not available. In appraising a project. the project's direct benefits and costs are estimated at the prevailing market prices. Working Results of Existing Units In the case of an existing unit. whether the gross block has been properly depreciated and has not been shown at an inflated value. For the purpose of appraisal it is necessary to make estimates relating to working results in case of existing concerns. how the current liabilities stand in relation to current assets. .Chapter 4 . whether the concern is under/over capitalised. It may be noted that financial appraisal is concerned with the measurement of profitability of resources invested in the project without reference to their source. The latest balance sheet and profit and loss account may be analysed with a view to ascertaining. whether the borrowings raised are not out of proportion to its paid up capital and reserves. This analysis is used to appraise the viability of a project as well as to rank projects on the basis of their profitability.Financial Appraisal Introduction Financial appraisal is concerned with assessing the feasibility of a new proposal for investment for setting up a new project or expansion of existing productive facilities. This involves an assessment of funds required to implement the project and the sources of the same. its latest audited balance sheet and profit and loss statement as well as the balance sheets for the last five years have to be analysed. The other aspect of financial appraisal relates to estimation of operating costs and revenues.
a first legal charge on fixed assets of the company ranking pari passu with the charge if any. These are inter related and are prepared on the basis of the estimated cost of the project. availability of inputs and their price trends and selling price. in favour of other financing institutions. a) c) Land and site developments. While the emphasis of financial institution is on the viability of the project they generally stipulate by way of security. it is desirable to compare the cost of the project with the cost of a similar project or by the information about cost that may be gathered in respect of other units in the same industry with comparable installed capacity and other common technical features. estimate of wages and salaries. Further relaxation in debt equity is made in the case of capital intensive projects. Equity is arrived after deducting carried forward losses in the case of an existing unit. unsecured loans from promoters and internal accruals in the case of an existing unit. Financial projections For the purpose of determining the profitability of the project and the ability of the company to service its loans and give a reasonable return on the equity capital. Sources of Finance The usual sources of finance for a project are: Equity capital. b) Buildings. As a part of the process of an appraisal of the capital cost of the project. It is important that no gap is left in financing patterns. e) f) Expenses on foreign technicians and training of Indian technicians abroad. cost of utilities. term loan. All long-term loans/deferred credit are treated as debt while equity includes free reserves. cash flow and projected balance sheets have to be prepared in the proforma given in Annexure 1 for ten years. estimate of administrative expense.Cost of the Project The capital cost of the project whether it pertains to expansion or a new project should be shown under. The important assumption that should be scrutinised carefully before making estimates are capacity build up. A balance has to be struck between debt and equity. Otherwise it will result in delays in implementation of the project. Plant and machinery. sources of finance envisaged and various assumptions regarding capacity utilisation. A condition is stipulated by financial institutions that the promoters shall arrange for funds to meet any over run in the cost of the project. estimates of cost of the project. d) Technical know-how fees. selling price assumed and provisions made for depreciation and statutory taxes. profitability. Miscellaneous fixed assets. A debt equity ratio of 1:1 is considered ideal but it is relaxed upto 2:1 in suitable cases. The entrepreneur may be . g) Preliminary and pre-operative expenses. Verification of profitability is the core of proper appraisal of the project. raw material cost. It has to be ensured that all these items are covered in the cost and the expenditure under each item is reasonable. deferred payment. h) Provision for contingencies and i) Margin money for working capital.
It is to be ensured that the profits projected are realistic. The profitability projections are closely linked to the schedule of implementation.naturally tempted to present a bright picture but it is the task of financial appraisal to verify the estimates. In case of multiproduct firms. The quantum of raw materials and utilities estimated to be consumed to obtain a particular quality/quantum of end product is the core of cost of manufacture estimates and should tally with the performance guarantees furnished by the collaborators/machinery suppliers. cash flow and projected balance . In case of new units. the product mix is decided on the basis of contribution of each product. Annual increases in wages and salaries should be about five percent. The selling price should be fixed keeping in view the present domestic price of the product. utilisation of plant capacity as well as market. Depreciation of fixed assets should be provided as per income tax rules. Repairs and maintenance will have to be provided keeping in view the type of industry and the number of shifts to be worked. On the basis of profitability projections. any sharp build up of capacity within a year or two will be unwarranted especially if the product is new.
00. The simple rate of return helps in making a quick assessment of profitability.00. R = (F + Y)/ I = Re =F/Q where R = Simple rate of return on total investment Re = Simple rate of return on equity capital F = Net profit in a normal year after depreciation. For evaluation.Evaluation of Cash Flow and Profitability Financial appraisal uses two popular methods and two discounted cash flow techniques to evaluate the cash flows and profitability of investment. Normal year is a representative year in which capacity utilisation is at technically maximum feasible level and debt repayment is still under way. the pay-back period is given by. 1. The two popular methods are the simple rate of return and pay back period. accurate data is required. it should take into account the time value of money and finally it should help to choose a project from among mutually exclusive projects. The simple rate of return could be presented as. interest and taxes Y = Annual interest charges I = Total investment comprising of equity and debt. particularly of projects with short life.000 and an expected cash flow of Rs. The methods should have three properties to lead to consistently correct decisions. They employ annual data at their nominal value. Payback Period = Initial Investment Outlay / Annual Cash Flow .000 per year for 10 years. In its absence simple rate of return may be incorrect Simple rate of return method is more suitable for financial analysis of existing units. Its shortcoming is that it leaves out the magnitude and timing of cash flows for the rest of the years of a project's life. which maximise the value of the firm’s stock. and Q = Equity capital invested. It is the expected number of years required to recover the original investment If we consider a project with an investment of Rs. The discounted cash flow techniques take into consideration the project's entire life and the time factor by discounting the future inflows and outflows to their present value. First. They do not take into account the life span of the project but rely on one year. secondly. 5. It is not suitable for optimising investment Pay-Back Period Pay-back period for a project. If one is interested in equity alone the profitability of equity can be calculated. it should consider all cash flows over the entire life of a project. measures the number of years required to recover a project's total investment from the cash flows it generates. Simple Rate or Return Method Simple rate of return is the ratio of net profit in a normal year to the initial investment in terms of fixed and working capital.
= 5.00. 5. IRR is represented by that rate. such that n T= 0 ∑ [At/ (1 + r)t] = 0 where At is the cash flow for period t (net inflow or outflow) and n is the last period in which cash flow is expected.000/ (1+r) + 5. Actually.70.000/1. In the IRR method the discount rate is unknown.000 = 5. If investment occurs at time 0. It leaves out the cash flows after the pay back period.7 lakhs. There is a value of IRR. Internal Rate of Return (IRR) IRR for an investment proposal is the discount rate that equates the present value of future cash inflows to the initial cost of the project. A0. If initial investment is Rs. the above equation can be expressed as The future cash flows Al through An are discounted by r to equal the initial investment at time 0. the payback period can be calculated easily by adding together cash flows until the investment is recovered.00. it is biased against project which yield higher returns in later years. The two methods are the internal rate of return and the present value method. annual cash flows are Rs.000/ (1+r) . The IRR method finds the specific discount rate that equates the present value of the expected cash flows to the initial cost of the project.70.70. the problem can be expressed as: A0 = A1/ (1+r) + A2/ (1+r) + … An/ (1+r) 2 n 2 3 4 5 18. 18 lakhs. The method is easy to calculate and emphasises the liquidity aspect of investment. which will cause the sum of discounted cash flows to equal the initial cost of the project making the NPV equal to zero. They take into account both the magnitude and timing of expected cash flows in each period of a project's life.000/ (1+r) + 5. r.000/ (1+r) + 5.000 = 5 years The pay-back period shows that the project's initial investment is recovered in five years. The payback period method is not suitable for evaluation of alternatives and to make systematic comparison. for five years.000/ (1+r) + 5. The shorter the pay-back period the quicker is the recovery of initial investment But it leaves out the time pattern of the cash flows within the pay-back period. They take into account time value of money and a rupee today is more valuable than a rupee tomorrow.70.00. By definition. DCF Techniques The discounted cash flow (DCF) methods provide a more objective basis for evaluating investment proposals.70. IRR is the rate of discount that reduces net present value of a project to zero. This value is defined as IRR. Even if cash flows are not uniform.
If a project's NPV is zero or positive the project is acceptable and if the NPV is negative. All future cash flows from the project are discounted to present value using the required rate of return.70.12) 5.12) + = -18.700 When the NPV is zero. IRR is estimated by an iterative process.The internal rate of return. The two DCF techniques.12) 5 2 3 4 + 5.00.000/ (1. Estimating Cost of Capital with Capital Asset Pricing Model . The present value of cash inflows should exceed the present value of cash outflows. If IRR is greater than the minimum acceptable rate of return. n NPV = ∑ 0 At/ (1 + k)t T= where k is the required rate of return. r is 17. the project is deemed to be profitable. The project is accepted only if it exceeds the required rate of return.12) + 5. and subtract from it the initial cost of the project. NPV = -18. the project is unacceptable. a rate of return is calculated which balances the cash inflows over time with the cash outflows overtime. An investment proposal is accepted if the sum of discounted cash flows is zero or more.000 + 5. When the firm chooses a zero NPV project. If IRR is less than the cost of capital. The net present value (NPV) of an investment proposal is. the project will impose a cost and results in reduction of the value of the stock. To calculate the net present value find the present value of expected net cash flows of an investment discounted at an appropriate interest rate. When IRR is employed.70. This surplus will accrue to the firms shareholders by increasing the value of the company's stock.70. the project would cover all required operating and financial costs but it has no excess returns. IRR method is similar to the NPV method. Instead of a minimum acceptable rate of return being defined as an input.000/ (1.70. the IRR and NPV lead to the same acceptance or rejection decisions. the net present value with an assumed required rate of return of 12 per cent would be. leaving a surplus after paying for the capital. If we use the IRR example.000/ (1. discounted at the appropriate cost of capital.12) + 5. minus the cost of investment. Net Present Value (NPV) Method This is the present value of future cash flows.000 + 20.54.700 = 2. the selection of a project is decided by comparing it with a required rate of return or cut-off or hurdle rate. it is rejected.70. If not.000/ (1. the firm becomes larger but its value does not change.000/ (1.54.00.57 percent.
fudge factors to discount rates to offset bad outcomes of a project should be avoided. The higher the beta risk associated with an investment the higher the expected rate of return must be to compensate investors for assuming risk. The capital asset pricing model can be used for estimating the company's cost of capital. Each project should be evaluated at its own opportunity cost of capital. rf interest rate on risk free asset like treasury bill. The beta has to be adjusted to remove the effect of financial risk since borrowing increases the beta (and expected return) of its stock.In the analysis so far. While estimating project betas. To calculate the company's cost of capital the beta of its assets has to be ascertained. Finally. If the project risk differs from the risk on existing assets. A more reliable estimate is an average of estimated betas for a group of companies in the same industry. n n t t/ (1 + r) PV 0 C ∑ T= = T=∑ Ct/ [1 + rf + β ( rm . Since investors require a higher rate of return from a very risky company. The company's cost of capital is the correct discount rate for projects that have the same risk as the company's existing business. However. plus a premium for all non-diversifiable risks associated with investment Projects should be evaluated as portfolios and there is a reduction of risk when they are so combined. firms require different rates of return from different categories of investment. Towards this purpose the company's cost of capital is used to discount cash flows in all new projects. such a company will have a higher cost of capital and will set a higher discount rate for its new investment opportunities. The expected rate of return calculated from the capital asset pricing model r = rf + β (rm .rf) (Where r is discount rate. identification of the characteristics of high and low beta assets (for instance cyclical investments are high beta investment) would help to figure out effect on cash flows. operating leverage should be assessed since high fixed production charges are like fixed financial charges resulting in an increase in beta. In cases where project beta cannot be calculated directly.rf )]t 0 . The cost of capital or required rate of return on the project would be the same as the one on company's existing assets if the risk is the same. This is not an accurate method since the risk of existing assets of a company may differ from the risk of new project assets. the project has to be evaluated at its own opportunity cost of capital. But the beta cannot be plugged into the capital asset pricing model to find the company's cost of capital because the stock's beta reflects both business and financial risk. The discount rate increases as project beta increases. Many companies estimate the rate of return required by investors in their securities. Capital asset pricing theory tells us to invest in any project offering a return that more than compensates for the project's beta which measures the amount that investors expect the stock price to change for each one percent additional change in the market risk. The true cost of capital depends on the use to which it is put. the company's cost of capital was used to discount the forecasted cash flows of the new project. r m expected return) can be plugged into standard discounted cash flow formula). The CAPM provides a framework for analysing the relationship between risk and return. The CAPM holds that there is a minimum required rate of return even if there are no risks.
which measures the proportion of the firm's assets financed by debt relative to the proportion financed by equity. accounts receivable (sundry debtors) and inventories] divided by current liabilities [accounts payable (sundry creditors). If the risk adjusted rate r is used to discount the cash flow. Quick Ratio = (Current Assets . For this purpose ratios are employed which reveal existing strengths and weaknesses of the project Liquidity Ratios Liquidity ratios or solvency ratios measure a project's ability to meet its short-term obligations. Current ratio = Current Assets/ Current Liabilities The current ratio measures the assets closest to being cash over those liabilities closest to being payable. the greater the cushion against . Debt Utilisation Ratio: Debt utilisation ratio measures a firm's degree of indebtedness. Acid Test or Quick Ratio: Since inventories among current assets are not quite liquid. It is computed by. the current ratio and quick ratio. The quick ratio includes only assets which can be readily converted into cash and constitutes a better test of liquidity.The capital asset pricing model values only the cash flow for the first period C 1. Two ratios are calculated to measure liquidity. which must be honoured. especially source of finance. The two long-term solvency ratios are debt utilisation ratio and coverage ratio. which takes into account the financial features of a project. Projects. Creditors prefer low debt ratios because the lower the ratio. Financial Analysis An integral aspect of financial appraisal is financial analysis. Debt includes current liabilities and long term debt. investment in securities. A current ratio 1. Legal action may be initiated to enforce the fulfilment of the claims. creditors and advances from customers]. Current Ratio: The current ratio is defined as current assets [cash. the quick ratio excludes it. yield cash flows for several years. Capital Structure Analysis Long-term solvency ratios measure the project's ability to meet long term commitments to creditors. It is an indicator of the extent to which short term creditors are covered by assets that are expected to be converted to cash in a period corresponding to the maturity of claims. The larger the amount of these claims the higher the chances of their not being met. 'Creditors' claims on a firm's income arise from contractual obligations.Inventories)/ Current Liabilities A quick ratio of 1:1 is considered good from the viewpoint of liquidity.0 is considered acceptable. short term loans from banks. we assume that cumulative risk increases at a constant rate. however. bank balances. The assumption will hold when the project's beta is constant or risk per period is constant.5 to 1. Financial analysis helps to determine smooth operation of the project over its entire life cycle. The two major aspects of financial analysis are liquidity analysis and capital structure analysis.
Interest Coverage Ratio = (Net Profit before taxes + interest)/ Interest Market Value Ratios: Market value ratios relate the company's share price to its earnings and book value per share. Price Earnings Ratio: P/E ratio relates the per share earnings to price of the share. In calculation of debt. (nonoperating expenses). Interest Coverage Ratio: The interest coverage ratio measures the number of times interest expenses are earned or covered by profits. The above formula takes into account the effect of taxes on the profits expected. Debt Ratio = Total Debt/ Total Assets Debt Equity Ratio: Debt equity ratio is the value of total debt divided by the book value of equity. DSCR = (PAT + Depreciation + other non-cash charges + interest on term loan )/ (Interest on term loan + repayment of term loan).creditor's losses in the event of liquidation. The owners prefer higher levels either to magnify earnings or to retain control. short-term obligations of less than one-year duration are excluded. The ratio emphasis the ability of the project to generate adequate cash flow to service its financial charges. Debt Equity Ratio = Long Term Liabilities/ Shareholders Equity Sometimes debt equity ratio is referred to as debt capitalisation ratio. Debt coverage ratio measures the number of times earnings cover the payment of interest and repayment of principal. These ratios are a performance index of the company and indicate the investor’s perception of the company's performance and future prospects. . A debt coverage ratio of 2 is considered good. The fixed assets coverage ratio shows the number of times fixed assets cover loan. P I E Ratio = Market Price Per Share /Earning Per Share P/E ratios are computed for firms as well as for the market. Hence it gives a realistic picture of the ability to meet obligations. Fixed Assets Coverage Ratio = Net Fixed Assets/ Term Loan Debt Coverage Ratio: The debt coverage ratio measures the degree to which fixed payments are covered by operating profits. Fixed Assets Coverage Ratio: Two other ratios relating to long term stability used by development finance institutions (DFIs) in appraisal of projects are fixed assets coverage ratio and debt coverage ratio. P/E ratios are higher for companies with high growth prospects and lower for riskier companies.
BEP occurs at that production level at which net operating income (sales-operating cost) is zero. . Break Even Point (BEP): An essential aspect of financial appraisal is the determination of BEP. Break-even is that level of production and sales at which total revenues are exactly equal to operating costs. An example of conventional income statement is presented in Table 2. To calculate and project cash flows it is important to assess the BEP . which is classified into fixed and variable expenses. Book value per share is the sum of net worth (paid up capital plus reserves) divided by number of shares outstanding. In summary. Generally if the returns on assets are high. If BEP is too high. of shares outstanding Market/Book Ratio (M/B Ratio): If the market price per share is divided by book value. other measures make no sense. the viability of a project can be assessed with the help of break-even analysis.Market/Book Value Ratio: The ratio of market price of the share of the company to its book value per share gives an indication of how investors regard the company. the conventional income statement has to be classified into fixed and variable costs. Book value per share = Total Net Worth/ No. Unless it is determined. It indicates the volume necessary for profitable operation of the project. we get the market book (M/B) ratio. For the purpose of break even analysis. these shares sell at higher multiples of book value than those with low return. the price assumed for the output may have to be reviewed. With the help of break-even analysis the quantity required to be produced at a given sales price per unit to cover total fixed cost and variable cost can be found.
000 90.000 5.000 Table 3:1 Derivation of BEP from Income Statement For deriving BEP .000 * 100)/ 40 = Rs. 3.000 1.80.00.000 Net profit Total Sales Fixed ----------Variable 1.80. 6. Sales Less: Variable costs(60% on sales) Margin available for fixed expenses Rs.000 . Sales required to meet fixed cost = (1. 6.000 6.000 60.000 8.000 54. 4. Items of cost Materials Labour Manufacturing expenses Selling expenses Administrative expenses Miscellaneous expenses 1.000 95. 60 paisa is spent on variable costs and the balance of 40 paisa (40% ) is left to meet the fixed cost. The profit status at this level is.68.20..65..000 2. it is necessary to recast the income statement in Table3:1 into fixed and variable costs.68.000 60.00. 1.95.000 The volume of Rs.4.000 36.Table 2: Illustrative Conventional Income Statement Net Sales Less: Cost of goods sold: Materials Labour Rs.20.e.000 1.000 tile total fixed cost is divided by 40 per cent.000 3.35.52.000 16.000 Manufacturing exp.000 4. To find the total sales required to meet the fixed cost of Rs.000 Less: Operating expenses Selling expenses Less: Miscellaneous expenses Profit 54.000 1.000 46.000 1.000 60.68.000 is known as the break-even sales volume which must be achieved if loss is to be avoided.000 3.20.000 Total 1.60. 1.000 3. 60 per cent of sales.000 36.68.000 Rs.000 1.000 i.000 2. 1.95. It means that on every rupee of sales.000 It may be seen from the above statement that for a sale of Rs.000 75.000 the variable cost is Rs.000 20.28.00.00. 4.60.000 72.000 72.80.
4.000/ (3.000 = 70% At capacities lower than 70 percent.000 *100/ 6.000 If Rs.60.4 = Rs.60) = 1.000 sales can be regarded as normal for a month. The normal rate for capacity utilisation is about 50 percent. Breakeven Sales Volume = 1.Profit The computation of break-even sales volume can be summarised as.. it will make profits at levels above the 70 per capacity utilisation. Substituting the figures mentioned above. On the other hand. 6.000) = 1. project is bound to incur losses.00.00.20.20.68.68. Nil Break -even sales volume = Total Fixed Cost/ (1 – Total Variable Cost/ Total Sales Volume) BEP = F/ (1 – V/S) where F is fixed cost V is variable cost S is sales volume. .68.000/ 6. This will be Breakeven Sales Volume * 100/ Standard Sales Volume = 4.even' capacity represents the capacity utilisation rate to be achieved to make the project viable.000/ .000/(1 . (standard sales volume) capacity utilisation rate at which the project must operate in order to 'break-even' can be calculated.20. The 'break.
The first deals with the effect of the project on employment and foreign exchange and second deals with the impact of the project on net social benefits or welfare. Since indirect employment is to be counted. In such cases an analysis of the effects of the project on balance of payments and import substitution is necessary. Total employment effect (direct and indirect) is. The proforma enables the analysis of liquidity of a project in terms of foreign exchange. Not only direct employment. Net foreign exchange effect of the project includes the net foreign exchange flow in Statement 3 and the import substitution effect. For this purpose. the impact on unskilled and skilled labour has to be taken into account. ZTe = JOT / I t where ZTe = total employment effect JOT = total number of new job opportunities I = total investment (direct and indirect) t Net foreign exchange effect A project may be export oriented or reduce reliance on imports. We may classify these under two broad categories. net foreign exchange flows are calculated as per the proforma in Annexure 2.Chapter 5 . additional investment needed in projects with forward and backward linkage effects also should be counted.Economic Appraisal Economic appraisal of a project deals with the impact of the project on economic aggregates. . The import substitution effect of a project measures the estimated savings in foreign exchange owing to the curtailment of imports of the items of production of which has been taken up by the project. Employment effect While assessing the impact of a project on employment. CIF values are used in calculation of import substitution effect. balance of payments effects of the project and second. import substitution effect of a project. but also indirect employment should be considered. The assessment of project on the country's foreign exchange is done in two stages. The annual net flows as well as the net impact over the economic life of the project have to be found. Direct employment refers to the new employment opportunities created within the project and first round of indirect employment concerns job opportunities created in projects related on both input and output sides of the project under appraisal. first.
Cost benefit analysis is concerned with the examination of a project from the view point of maximisation of net social benefit. Net social benefits are found by deducting from WTP the compensation required (the cost). The economist uses as a measure of this preference. In many cases the prices are not observable or are distorted. While cost benefit analysis originated to evaluate public investment.The analysis of net foreign exchange effect may be done for the entire life of the project or on the basis of a normal year. Social cost benefit analysis Another aspect of economic appraisal is social cost benefit analysis. In these circumstances cost benefit analysis must seek surrogate prices or shadow prices to measure what the society will be willing to pay if there is a market. If two or more projects are compared on the basis of their net foreign exchange effect. . the annual figure should be discounted to their present value. Maximisation of net benefit should be finally equivalent to the maximisation of social utility or social welfare. Cost benefit appraisal of a project proposes to describe and quantify the social advantages and disadvantages of a policy in terms of a common monetary unit An enterprise or project adopting cost benefit analysis approach has. The unit should reflect society's strength of preference for each outcome. net benefits to society whereas the objective function of a private project is net private benefit or profit. Net social benefit entails that gains and 1osses be valued in a common unit. it is also used in project appraisal. as its objective function. This will be partly reflected in the price he pays for the goods. the consumer’s willingness to pay (WTP) for a good.
Debentures may.Chapter 6 .1992. Unsecured or Naked Debentures Debentures. which either creates a debt or acknowledges it. however. A debenture is issued by a company and is usually in the form of a certificate. Debenture is a document. which are issued without any charge on assets. Debenture holders have no right to vote in the meetings of the company. Kinds of Debentures Bearer Debentures: They are registered and are payable to its bearer. Issue of capital which was regulated by the Capital Issues (Control) Act. be issued without any such charge. Registered debentures are not negotiable instruments. Secured Debentures Debentures. A registered debenture contains a commitment to pay the principal sum and interest. Debentures are debt securities and there is a wide range of them. 1947 was repealed on May 29. The holders are like unsecured creditors and may sue the company for recovery of debt. Debentures Definition and Nature The issue of debentures by public limited companies is regulated by Companies Act 1956. Debentures are issued through a prospectus. Preference share is a hybrid security that entails a mixture of both ownership and creditorship privileges. Registered debentures can be transferred but have to be registered again. Securities represent claims on a stream of income and/or particular assets. Registered Debentures: They are payable to the registered holder whose name appears both on debenture and in the register of debenture holders maintained by the company. It also has a description of the charge and a statement that it is issued subject to the conditions endorsed therein. are known as secured debentures. Redeemable Debentures . They are negotiable instruments and are transferable by delivery. The issue of capital and pricing of issue have become free of prior approval.Choice of Securities Introduction To meet 1ong-term requirements for funds. which create a charge on the assets of the company. which may be fixed or floating. They are issued under the company's seal. Debentures are one of a series issued to a number of lenders. Equity shares in corporate sector or privatised public sector undertakings are ownership securities. are unsecured or naked debentures. securities are issued to public (issue of capital) by firms in the corporate sector and public sector. The date of repayment is invariably specified in the debenture. which is an acknowledgement of indebtedness. Generally debentures are issued against a charge on the assets of the company.
third party convertible debentures. In our country the convertible debentures are very popular. They are basically similar to convertible debentures but embody less risk. The instrument is quite risky for the investor because the anticipated capital appreciation may not materialise. The coupon rate is specified at the time of issue. providing flexibility to the issuer as well as the investor to exit from the terms of the issue. convertible debentures with options. Third Party Convertible Debentures They are debt with a warrant allowing the investor to subscribe to the equity of a third firm at a preferential price vis-a-vis the market price. Deep Discount Bonds They are designed to meet the long term funds requirement of the issuer and investors who are not looking for immediate return and can be sold with a long maturity of 25-30 years at a deep discount of the face value . They can. the holders cease to be lenders and become owners.Normally debentures are issued on the condition that they shall be redeemed after a certain period. convertible debentures redeemable at premium. They might find investors if issued by existing dividend paying companies. however. Debentures are usually issued in a series with a pari passu (at the same rate) clause which entitles them to be discharged rateably though issued at different times. Convertible Debentures with Options They are a derivative of convertible debentures with an embedded option. New debt instruments issued by public limited companies are participating debentures. which participate in the profits of a company. Perpetual Debentures When debentures are irredeemable they are called perpetual. be reissued after redemption under Section 121 of Companies Act 1956. Debt-equity Swaps Debt-equity swaps are an offer from an issuer of debt to swap it for equity. Convertible Debentures If an option is given to convert debentures into equity shares at stated rate of exchange after a specified period. Interest rate on third party convertible debentures is lower than pure debt on account of the conversion option. they are called convertible debentures. debt equity swaps and zero coupon convertible notes. New series of debentures cannot rank pari passu with old series unless the old series provides so. On conversion. Convertible Debentures Redeemable at a Premium Convertible debentures are issued at face value with a put op entitling investors to later sell the bond to the issuer at a premium. Participating Debentures They are unsecured corporate debt securities.
yet above those prevailing at issue time. The exercise price is 10 to 30 percent above the prevailing market price. They are also issued in mergers and acquisitions. is redeemable after a notified period. Debentures issued with warrants. Warrants A warrant is a security issued by a company granting the holder of the warrant the right to purchase a specified number of shares at a specified price any time prior to an expirable date. If the holder exercises this option. Interest rates linked to the benchmark ensure that neither the borrower nor the lender suffers from the changes in interest rates. and the same bonds are likely to be inequitable to the lender when interest rates rise subsequently. Yield means the return on investment at current market price. The minimum value of a warrant represents the exchange value between current price of the share and the shares purchased at the exercise price. the holder will be repaid the principal amount along with additional amount of interest/ premium on redemption in instalments. The zero coupon convertible notes are quite sensitive to changes in interest rates. which was 10 percent. If the investor knows the price of a debenture and its characteristics. like convertible debentures carry lower coupon rates. If choice is exercised investors forego all accrued and unpaid interest. IDBI deep discount bonds for Rs. as decided by the company. The State Bank of India's floating rate bond issue was linked to maximum interest on term deposits. interest payments and repayment of principal at maturity have to be made to debenture holders. Warrants have no floatation costs and when they are exercised the firm receives additional funds at a price lower than the current market. 2. Floating rate is quoted in terms of a margin above or below the benchmark rate. It is expressed as (Rate of return * Face value)/ Current Market Price = Yield percent . Secured Premium Notes (SPN) with Detachable Warrants SPN. Warrants may be issued with debentures or equity shares. Zero Coupon Convertible Note A zero coupon convertible note can be converted into shares. 1 lakh repayable after 25 years were sold at a discount price of Rs. expiration date. The warrants attached to it ensure the holder the right to apply and get allotted equity shares. Warrants have a secondary market. The conversion of detachable warrant into equity shares will have to be done within the time limit notified by the company. When rates are fixed. But they would be irrational if they ignore alternative investments that bring in a higher return. say four to seven years. Interest and Yield on Debentures No matter what happens. The main features of a warrant are number of shares entitled. be can infer a rate of return called Yield to Maturity (YTM). they are likely to be inequitable to the borrower when interest rates fall subsequently. Floating Rate Bonds The yield on the floating rate bond is linked to a benchmark interest rate like the prime rate in USA or LIBOR in Eurocurrency market. provided SPN is fully paid. In case the SPN holder holds it further. The specific rights are set out in the warrant. no interest/premium will be paid on redemption. There is a lock-in period for SPN during which no interest will be paid for the invested amount The SPN holder has an option to sell back he SPN to the company at par value after the lock-in period.700/-. which is issued along with a detachable warrant.of debentures. and stated price/exercise price. New or growing firms and venture capitalists issue warrants. The floor rate in SBI case was 12 percent.
2. Debenture financing increases the financial risk associated with the firm. They earn a stable rate of return They enjoy priority in the event of liquidation They generally enjoy a fixed maturity period Disadvantages of debentures From the company’s point of view 1. From the investor’s point of view: 1. The cost of debentures is lower than that of equity or preference capital because the interest on debentures is tax deductible. Hence the effective post tax cost of debentures is lower. To the extent the equity is higher the . and less than the rate of interest when the market price is higher than par value. This would be attractive to a company which expects its income level to go up substantially in the future. From the investor’s point of view 1. Risky debentures have to pay higher yields to maturity to attract investors. 2. Yield to maturity and average rate of return compounded annually to maturity refer to effective rate of return if held to maturity. the market price is above its face value and the coupon rate is higher than yield to maturity. If it is selling at a premium. debentures carry a fixed financial burden. The firm has no fixed obligation to pay periodic dividends. If the debenture is selling at a discount. They also provide cushion against losses from the pointof view iof the creditors. This may increase the cost of equity t the company. The debenture interest and capital repayment are obligatory payments. Debenture financing does not lead to dilution of control since debentures do not carry voting rights. Advantages of debentures From the company point of view: 1. 2. The interest on debentures is taxable Debentures do not carry voting rights Equity Shares Equity shares represent proportionate ownership of a company.The yield works out more than the rate of interest if market price is below par value. A company may pay dividend if if it generates earnings and has no pressing internal needs for them. Its yield to maturity exceeds coupon rate. 2. Irrespective of the price level. 3. Shares have unlimited potential for dividend payments and share appreciation. Yield to maturity is more significant than the coupon rate to debenture investors. its market price is below its face value. This right is expressed in the form of participating in the profits of a going company and sharing the assets of a wound up company. Equity shares have the lowest priority claim on earnings and assets of all securities issued.
Book Value is determined by deducting total liabilities including preference shares from total assets and the difference. The portion subscribed. The voting rights are proportional to the share owners share of paid-up capital of the company. Nominal or Authorised Capital is the maximum capital the Memorandum envisages for the company unless it is changed. While net worth remains the same in the balance sheet its distribution between shares and surplus is altered. Paid-up Capital is the share capital paid-up by shareowners or which is credited as paid-up on the shares. owners of debentures and preference shares enjoy an assured return in the form of interest and dividend. Voting rights The Companies’ Act deals with the voting rights of a shareowner. An equity shareowner has a right to vote on every resolution placed before the company.credit worthiness of the firm is higher. Capital appreciation rather than dividends is what an investor has to look for in their case. authorised or issued or paidup capital. however. is subscribed capital that is less than issued capital. Voting rights cannot. Cash Dividends A stable cash dividend payment was believed to be the basis for the increase in company's share prices. No Company can issue shares that carry voting rights disproportionate to the rights attached to the holders of other issues. In case all shares offered for public subscription are not taken up. As a result of this risk. be exercised in respect of shares on which a call or any other sum due to the company has not been paid. The Memorandum also specifies the division of authorised capital into shares of fixed amount. Alteration or Share Capital . Equity Shares with Detachable Warrants Detachable warrants are issued along with fully paid equity shares. All shares carry proportionate rights. This should have a favourable effect on the rating of its debentures. It does not tell anything about the value of shares. lower its cost of debt and increase its future ability to raise debt. Bonus shares are issued by capitalising reserves. Detachable warrants are separately listed with the stock exchanges and traded separately. A growth-oriented firm retains as much capital as possible for internal financing. which will entitle the warrant holder to apply for a specified number of shares at a determined price. The terms and conditions relating to issue of equity shares against warrants are determined by the company. In contrast. investors are unwilling to invest in equity shares unless they offer a rate of return sufficiently high to induce investors to assume the possible loss. Maintaininig a reserve borrowing capacity is essential to overcome operating problems. which is equal to shareholder equity with the number of equity shares outstanding. Bonus Shares (or stock dividends) Bonus shares are dividends paid on shares instead of cash. Issued capital is the nominal value of shares offered for public subscription. It may be noted that the word 'capital' in share capital is used to mean nominal. Old established firms tend to pay out large proportion of their earnings as dividend. Par Value is the face value of a share.
Though the equity shareholders have voting power. (2) consolidate and divide all or any part of its share capital into shares of larger amount. Equity prices fluctuate wildly. It represents permanent capital. 2. Equity shareholders have voting rights that enable them to have controlling power in the company. 2. Income from equity is exempt from tax. It results in dilution of control over the company.If the Articles of Association authorise limited company can (I) increase share capital by issue of new shares. From the investor’s point of view Preference shares . 2. the higher is the ability to obtain credit. Advantages of equity From the company’s point of view 1. Under Section 95. 4. There is no obligation for repayment. From the investor’s point of view 1. Equity dividends are not tax deductible The cost of issuing equity is higher than the cost of issuing other types of securities due to expenses like brokerage. It increases the creditworthiness of the company. They enjoy the lowest priority in the payment of dividend and the repayment of capital. Disadvantages of equity From the company’s point of view 1. Equity usually earns a higher rate of interest than other instruments. the larger the equity base of the company. The SEBI guidelines provide for issues to public by existing companies being tI priced differentially as compared to rights share holders. etc. underwriting commission. The cost of equity capital is usually the highest. 3. Equity shareholders cannot insist on the payment dividend. Increase in subscribed capital by issue of new shares should be offered in proportion to existing shares held by shareholders. 3. advertisement. 1. (4) subdivide shares into shares of smaller amount and (5) cancel shares which have not been subscribed (does not constitute reduction of share capital). Composite Issues Composite issues consist of rights and public issues. notice of alteration of capital should be sent to Registrar of Companies (ROC) within 30 days. 3. 3. There is no fixed obligation for payment of dividends. 4. 2. In general. Increase in Subscribed Capital Increase in the subscribed capital of a company may occur by allotment of further shares and by conversion of debentures or loans into shares. making equity investment risky. the real control exercised by them is often weak because they are disorganised. (3) convert fully paid-up shares into stock or vice versa.
such preference share holders would be called participating preference shareholders. It should be noted that redeemable preference shares are not shares in the strict sense of the term. As a rule. cumulative and non. if there is no profit in any year. preference shareholders enjoy a preferential right to dividend. Since they are repayable. The shares have to state clearly that they are redeemable. Cumulative and Non-cumulative Preference shares are of two types. If the warrant holder fails to exercise his option.cumulative. Transfer of Shares . Part B will be redeemed at par/converted into equity shares after a lock-in period at the option of the investors. A and B.cumulative preference shares. the face value of it will stand reduced proportionately and the equipref shares are deemed to have been redeemed to the extent of each part on the respective dates of conversion. a Capital Redemption Reserve Account is opened to which a sum equal to the nominal amount of the shares redeemed is transferred. From the date of allotment. it carries on the winding up of a company a preferential right to be repaid the amount of capital paid. Where redemption is made out of profits.up on such shares. Upon conversion of each part of the equipref shares. Part A is convertible into equity shares automatically and compulsorily on the date of allotment. Participating Preference Shares If the articles of association provide that a preference share holder will also have the right to participate in surplus profits or surplus assets on the liquidation of a company or in both. Redeemable preference shares Redeemable preference shares are paid back to the shareholder out of the profits or out of the proceeds of new issue of shares. the arrears of dividend are carried forward and paid in the following years out of profits. Only fully paid shares are redeemed. It is treated as paid-up share capital of the company.Nature Preference shares carry preferential rights in comparison with ordinary shares. No such carry forward provision exists for non. The dividend on fully convertible cumulative preference share is fixed and paid on the Part B of the share. before any dividend is paid on ordinary shares. they are similar to debentures. Conversion into equity shares after the lock-in period will take place at a price which would be 30 percent lower than the average market price calculated on the basis of monthly high and low price of the share in the preceding six months including the month of conversion. The holders of warrants will be entitled to all rights/bonus shares that may be issued by the company. the unsubscribed portion will lapse. Fully Convertible Cumulative Preference Share (Equipref) Equipref is a very recent introduction (1993) into the market It consists of two parts. But in the case of irredeemable preference shares the amount that is fully paid is never returned. the preference shares with warrants attached would not be transferred/sold for a period of three years. In the case of cumulative preference share. As regards capital. Preference Shares with Warrants Attached Each preference share carries a certain number of warrants entitling the holder to apply for equity shares for cash at 'premium' at any time in one or more stages between the third and fifth year from the date of allotment.
skipping them may seriously affect the image of the firm. From the investor’s point of view 1. The rate on preference dividend is usually not very high. They cannot enforce the right to dividend. Another form of transfer of shares is blank transfer. 1. The procedure on transfer of share or debenture has been laid down in Sections 108. 2. Hence it increases the creditworthiness of the firm. They do not usually carry voting rights. because the dividend paid to preference shareholders is not tax deductible. 2. Preference dividend has been exempted from income tax. There is no redemption liability in case of perpetual preference shares. Advantages of preference shares From the company’s point of view 1. it is more expensive.A transfer of shares is complete as soon as the name of the transferee is substituted in place of transferor in the register of members. Though it is not obligatory to pay preference dividends. 3. It earns a stable dividend rate. There are two kinds of transfer: (a) a transfer under a proper instrument of transfer duly stamped and executed by the transferor and transferee and (b) transmission by operation of law. From the investor’s point of view Disadvantages of Preference Capital From the company’s point of view 1. Transfer means a transaction by the act of the parties whereas transmission means a transaction by operation of law. There is no obligation to pay preference dividend. Hence they do not lead to dilution of control from the promoters. Preference capital is generally regarded as a [art of net worth. 2. 110 and 111 of the Companies Act. Transmission occurs on death or bankruptcy of owner. It must be made in prescribed form and delivered to the company for registration within the prescribed time. 2. As compared to debt capital. 4. .
State Financial Corporations have been set-up under State Financial Corporations Act 1951. represent a source of debt finance which is usually payable in more than a year but less than ten years. Industrial Finance Corporation of India (IFCI) The Industrial Finance Corporation of India (IFCI) was set up under a statute in 1948 but has been converted into a public limited company to give flexibility to its operations. financial services and promotional services. IDBI has been providing direct financial assistance to large and medium industrial units and also helping small and medium industrial concerns through banks and state level financial institutions. SFCs also provide equity type assistance under the special capital and seed capital schemes to entrepreneurs having viable projects but lacking adequate funds of their own. SIDBI will also participate with selected commercial banks in financing small-scale projects . debentures. They provide financial assistance to small and medium enterprises by term loan. 50 lakhs is given on a selective basis. financing and developing industrial concerns in small scale sector. they form an integral part of the development financing institutions in the country. financing and development of industrial concerns in small scale sector and also coordinates functions of institutions engaged in promotion. IFCI provides to industrial units. and assisting development of such institutions. also referred to as term finance. Small Industries Development Bank or India (SIDBI) Small Industries Development Bank of India has been established in 1989 to function as an apex bank for tiny and small scale industries. project finance.It provides term loans in Indian and foreign currencies.Term Loans Term loans. They are employed to finance acquisition of fixed assets and working capital margin. direct subscription to equity/debentures. expansion. Industrial Credit and Investment Corporation of India (ICICI) Industrial Credit and Investment Corporation of India (ICICI) was established in 1955 as a public limited company to encourage and assist industrial units in the country . Along with the all India financial institutions. State Finance Corporations (SFCs) At the state level. discounting of bills of exchange and guarantees.It also promotes or develops industrial units. guarantees for deferred payments and foreign currency loans. underwriting and direct subscription to shares. It functions as the principal financial institution for promotion. Such assistance of above Rs. From 1993 SIDBI is extending direct assistance to small-scale units. There are 18 SFCs in the country.Chapter 7 . makes direct subscription to the issues and guarantees payment for credit made by others. financial assistance is available to units in the corporate and cooperative sectors for new units. underwrites issues of shares and debentures. diversification and modernisation programme in the form of rupee loans and foreign currency loans. is the principal financial institution for providing credit and other facilities for development of industry . co-ordinates working of institutions engaged in financing. Under its project finance. Sources of term loans: Development Finance Institutions Industrial Development Bank of India (IDBI) The Industrial Development Bank of India (IDBI) which was established in 1964 under an Act of Parliament.
If the DFI agrees to consider the proposal. Techniques described in the earlier chapters have to be applied. 10. Out of equity of Rs. The land for the project. has to be obtained. 2:1 is to be applied That would give debt of Rs. LIC and GIC and its subsidiaries also provide term loans. The choice of debt and equity has to be made on the basis of the cost of capital and the ability of the unit to yield a required rate of return. TFCI has to be approached. Capital Incentives They are part of equity. financial and economic appraisal are covered. 33 lakhs. 22. the financial institutions provide the necessary foreign exchange loan after assessing the viability of the project The foreign currency loans are part of various lines of credit for financing projects based on imported plant and equipment.so that working capital will be fully tied up in the case of jointly financed projects. 1 crore and promoters contribution is at 22. Foreign Currency Loans from Financial Institutions Wherever imported machinery and equipment is necessary. Interest rate depends on the rate applicable to the foreign currency funds utilised by the financial institution. IFCI. be judged independent of the quantum and availability of capital incentives. Apart from the conventional tourism projects in the hospitality segments. for projects in tourism. Cash flow statement for a seven to ten year period is required. the approximate amount of term loan has to be determined. Aspects on technical. The viability of the project should however. The loan covers CIF value of the capital goods and the know-how fees.5 percent The debt equity ratio.5 lakhs should be deducted. car rental services and air taxi passenger facilities. After verification that the project would be eligible for term loan. assistance sanctioned by TFCI has enabled non conventional tourism projects like amusement parks.5 percent of project cost or Rs. The loan application requires details of promoters. Equipment finance targeted at well run existing units will be extended to take up modernisation and technology upgradation. For example. background. The merchant banker has also to ensure that the project adheres to the guidelines for financing of industrial projects. The promoters or merchant bankers retained by them should make an appraisal of the project to satisfy that it is viable. of let us say. The decision as to which financial institution should be approached depends on industry. 66 lakhs and equity of 33 lakhs. Investment Institutions Institutions like UTI. Application for Term Loans Having determined the promoters' contribution. Tourism Finance Corporation of India Ltd (TFCI) TFCI was sponsored by IFCI which commenced operations in 1989 to sanction project loans. location of the unit and size of project cost. relevant experience and financial soundness. lease assistance and direct subscription to shares. 66 lakhs. Before weighing how much of debt and equity.5 lakhs and loan to be raised at Rs. a preliminary meeting should be fixed with the financial institution. That would leave equity to be raised at Rs. Borrowing From Financial Institutions Term loans can be raised from financial institutions. The market research study for the project has to establish the contribution of the project to existing and estimated demand. Commercial Banks Apart from these financial institutions. the application for term loan along with the check list of information to be supplied. Assume that the project cost is Rs. promoters' contribution has to be taken into account. plans for building and . The next step would be design of capital structure. promoters' contribution of 22. commercial banks also can sanction term loans. IDBI and ICICI grant foreign currency loans. technical skills.
Clean title to land as security. 2. The. 3. The debt equity ratio is 3: 1 for Small industrial units and 2: 1 for medium and large units. articles of association. Details of plot of land for project 4. The final structure of financing emerges after taking into account debt-equity ratio. 1. 9. Similarly. Some preliminary understanding with the bank would be necessary before going ahead with the application for term loan. latest annual report and statement of accounts if any. building and machinery separately. the term loan is 75 percent of the value of fixed assets. memorandum. have to be filed. 10. Search report and title deeds for the land . Lien on all fixed assets. Undertaking for non-disposal of promoters' shareholding for a period of 3 years. Further capital expenditure only on the approval of DFI. Normally. Scrutiny of Articles of Association to ensure that it does not contain any restrictive clause against covenants of the financial institutions. The security margin is 25 percent. Undertaking from promoters to finance shortfalls in funds/cost over-run.quotations for the machinery from two manufacturers have to be obtained. Insurance of assets. 7. unsecured loans from friends and relatives and capital incentives are considered a part of equity. The actual production process has to be depicted. After the loan is sanctioned the requirements to be met are. Along with the loan application. Finally. working capital requirements have to be estimated and a commercial bank should be approached. Payment of dividend and issue of bonus shares subject to the approval of financial institution. 8. the ability of the project to service debt in reasonable time and the priority of the industry in government policy into which the project falls. 5. The gross cash accruals should normally be 1. 2. 1. Security Margin The term loan is sanctioned against the security of fixed assets. documents are to be enclosed for the guarantor company if the loan is guaranteed. Acceptance of terms and conditions of loans Deposit of legal charges 3. debt service coverage ratio and security margin. 4. While computing debt equity ratio. The financial institution determines the proportion of debt in capital structure on the basis of the nature of the project (capital intensive or otherwise). Gross cash accruals are related to project liability in respect of interest and payment of installment towards principal. Debt equity ratio by and large constitutes an upper limit. Personal and corporate guarantees of major shareholders and associates concerns.6 to 2 times to assure that the project has inherent strength and potential to service debt. Term loans are granted subject to the following terms and conditions. certificate of incorporation. Debt Service Coverage Ratio (DSCR) The payment of interest and repayment of principal within the stipulated time is measured by DSCR. Security margin represents the excess value of fixed assets over the term loan. 6. Approval of appointment of managerial personnel by DFI. merchant banker's involvement would also enable him to state that he has exercised due diligence in the exercise of his obligation under various regulations.
In some cases after the term loan is sanctioned. promoters have to bring in their entire contribution first. a bridge loan is granted against a bank guarantee. which require time. Legal documents to create a charge on proposed assets 8. in turn. Personal guarantees and undertakings along with income tax and wealth tax clearance of the prompters and directors 9. As machines arrive term loan is disbursed at 75 percent of their value. In such cases. 6. pollution clearance 7. General body resolutions for creation of charge over assets.5. disburses the loan in parts ensuring that machines or assets are on site. Stamp duty and registration fees have to be paid. . disbursements are need-based. disbursements are made on the basis of assets created at site. In the case of large projects. Balance after security margin is paid by the DFI. The bank. documents have to be executed and submitted. pollution clearance. the cheque being made in the name of the supplier. Before the loan is disbursed. This is done in special cases where it is physically not possible to inspect each machine as it arrives because of locational factors or to overcome procedural problems such as establishing clean title. After these requirements are complied with. There has to be a security matching every disbursement starting with land and buildings. subscribed and paid-up capital to be brought in by the promoters as required by the DFI and creation and registration of charge on the present and future assets of the company. Architect and auditor's certificate for civil construction.
In post tax terms. (They need to be securitised.) . The interest and principal repayment are obligatory. 2. Term loans increase the financial risk of the firm. the cost of term loans is less than that of equity or preference capital. 2.Advantages of Term Loans From the Company point of view: 1. 2. as the lenders do not have voting rights. Further. From the lender’s point of view: 1. they entitle the lenders to put their nominees on the board of the borrowing company. 3. 3. Their non payment may threaten the existence of the firm. Term loans do not carry voting rights. This in turn raises the cost of equity to the company. Term loans carry fixed rate of interest and have a definite maturity period. 1. Term loans represent secured lending Term loans carry several restrictive covenants to protect the interest of the lender. to overcome this limitation. Term loans do not lead to dilution of control. Term loan contracts carry restrictive covenants that restrict the managerial freedom. Disadvantages of Term Loans From the company point of view: 1. From the lender’s point of view: Term loans are not represented by negotiable securities.
held on deposit. For those companies who are truly global. The following are a few Indian companies whose ADRs are being traded on the American Exchanges. It gives more US exposure and allows them to tap into the rich North American equity markets. For this reason US banks simply purchase a large lot of shares from the company. Companies may have capital demands that outstrip the availability of financing at home. ADRs were introduced as a result of the difficulty buying shares in other countries. bundles the shares into groups and reissues them on the NYSE. The foreign issuer does . ADRs are bought and sold on American markets a just like regular stocks.Issue of ADRs and GDRs American Depository Receipts Definition: An ADR is a certificate issued by an American bank. 2. Ltd. The depository bank sets the ratio of US ADRs per home country share. Bajaj Auto Limited Dr. Since the bank holds the stock.Chapter 8 . then each ADR would represent several real shares. which trade at different prices and currency values. Why do companies use ADRs? 1. These are becoming less common. This ratio can be anything less than or greater than 1. 2. and are issued/sponsored in the US by a bank or brokerage. Videsh Sanchar Nigam Ltd (VSNL) Types of ADRs 1. or NASDAQ. AMEX. which trades in the United States but represents a specified number of shares in a foreign corporation. in the home country. Reddy's Laboratories Ltd Finolex Cables Limited Great Eastern Shipping Co. Sponsored: These ADRs are issued by a depository appointed by the foreign issuer under a Deposit Agreement. Level I: They trade on the U. 3. There are three levels of sponsored ADRs: a. OTC market but cannot be used to raise capital. it is equivalent to trading the foreign stock. A majority of ADRs range between $10 and $100 per share. Origin and Nature: Introduced to the financial markets in 1927. Unsponsored: These are issued by one or more depositories in response to market demand but without a formal agreement with the foreign issuer. Ltd. Increasing the size of the market for its shares that may increase or stabilise the share price. 4. Tata Engineering and Locomotive Co. it allows buyers of the company's products and services to also invest in the company. which represents a foreign stock share. the shares are worth considerably less. They also enhance the image of the company's products or services. an American Depository Receipt (ADR) is a stock.S. The reason they do this is because they wish to price the ADR at a value that can be easily purchased by individual investors yet convey substantial value to the stock. If.
Entitled to the same information disclosure as holders of the underlying security . Level II and III: These are for foreign issuers who want a listing on a recognised exchange and the ability to raise capital in the U. dollars .Easier than buying foreign shares .All issuers must report by U.U.S.Liquidity .Abundant Selection .Denominated in U.S. Private Placement Depository Receipt: These allow foreign companies to have easy access to the U.Safety . Benefits of ADRs to investors: .S.S. c. research is available . private placement market with Qualified Institutional Buyers.Simplicity .not have to comply with SEC disclosure.S.All notices and reports are issued in English . b. standards .
For all good purposes.) "In Principle Approval" by DEA for issue of GDR/FCCB. capital expenditure including domestic purchase/installation of plant. There are however. GDRs can be treated as direct investment in the issuing companies. Cabinet approval etc. ports. Clearance Requirements a. ceilings on foreign equity participation. e. investment in stock markets and real estate will not be permitted. Restrictions However.) "Final Approval" by DEA for issue parameters where other mandatory approvals are involved. This condition would be relaxed for infrastructure projects such as power generation. airports and roads. DEA's final approval will be granted only after other approvals are obtained by the GDR issuing company. but London is also used. equipment and building and investment in software development.Global Depository Receipts Nature and Definition: Global depository receipts (GDRs) are essentially instruments created by overseas depository banks which are authorised by issuing companies in India to issue outside the country. if any. b. GDRs simplify cross-border trading and settlement. like IMC approval for joint venture. Permission for Issue: An applicant company seeking Government's approval in this regard should have consistent track record for good performance (financial or otherwise) for a minimum period of 3 years.) Approval from Department of Company Affairs under the provisions of Companies Act. c. Companies may retain the proceeds abroad or may remit funds into India in anticipation of the use of funds for approved end uses. Use of GDRs The proceeds of the GDRs can be used for financing capital goods imports. Any investment from a foreign firm into India requires the prior approval of the Government of India. Each depository receipt represents a multiple number or fraction of the underlying share or alternatively the shares correspond to the GDR in a fixed ratio say of 1 GDR = 10 shares. minimise transaction costs. and equity investment in JVs in India. d. accommodate legal restrictions or direct ownership of shares. The price of GDRs reflects the price performance of the underlying shares. if necessary. realise tax advantages and broaden investor base.) Approval by FIPB in the case of Industries/activity that is outside the purview of Annex III items or cases involving foreign equity beyond 51% foreign equity after the proposed GDR issue. They are listed on a European Stock Exchange-often Luxembourg. GDRs are issued to non-resident investors against the shares of the issuing companies held with the nominated domestic custodian banks. GDRs can be redeemed at the price of the corresponding shares of the issuing company ruling on the date of redemption.) Any other mandatory approval under Government Laws. They are negotiable certificates that usually represent a company's publicly traded equity and are denominated in US dollars. telecommunication. enhance liquidity. petroleum exploration and refining. prepayment or scheduled repayment of earlier external borrowings. .
Companies making Euro issues may have understanding with depository bank resulting in certain voting pattern. On the other hand. GDR transactions do not involve the foreign investor in SEBI approval as a foreign investor. they enjoy the benefits of international diversification while avoiding long delays in settlement and transfer of shares. Finally. the custodian depository bank. confusing trade and tax practices. . free of foreign exchange risk. The image of the issuer is also enhanced in the global market. Advantages to the Investor: In regard to the investors. They enable the foreign investor to avoid restriction on purchase and holding of individual company's shares. GDRs are attractive to foreign investors because the returns are large.Advantages of GDR for the Issuer: The share price of the company may stabilise because of the widening of the market. GDRs are quite as liquid as the underlying shares and they can be exchanged for shares. The Indian Company does not bear any foreign exchange risk since the securities are denominated in rupees. GDRs are quoted in dollars and dividends are paid in dollar. Euro-issues are easier to administer since dealings are with a single shareholder. it receives the proceeds of Euro-issue in foreign currency. Euro issues cost less than domestic rights issue.
firms obtained use of assets by buying them. the lessee has to reimburse the lessor for any losses occasioned by the cancellation. The lease . Several banks have added leasing activity to their business. It receives the purchase price put by the buyer or the lessor. The user of the asset is the lessee who makes periodic payments to the owner of the asset who is called the lessor. The sale and lease back instrument is an alternative to mortgage. Definition and Nature Lease is a rental agreement that extends for a year or more and involves a series of fixed payments. For instance. operating leases are short-term leases and can be terminated at the lessee's option prior to the end of the contract period. There are two parties to a lease. The firn which sells the assets is the lessee. Lease agreements contain an option to the lessee to purchase the asset at fair market value at the end of the lease period. While the investor or lender in conventional financing looks to the cash flow from the issuers' overall business to provide the return on investment or loan. Actually. an alternative is to lease equipment. the investor or lender looks principally to the cash flow from the specific assets or collection of assets in which their funds are invested. in lease finance.Lease Finance Introduction Lease finance has emerged as a source of financing project cost over the last few years. firms own fixed assets and report them in their balance sheet. However. Lease finance is a cheap and flexible means of financing as compared to term loans from financial institutions. Among long term leases are financial or capital leases which extend over the estimated useful economic life of the asset and cannot be cancelled by the lessee before the expiry of the lease. anything can be had on lease and in advanced countries 25 percent of all new capital equipment acquired by business is at lease. the access or use of equipment and building is important than their ownership. Where they are cancellable. The burden of costs the lessee or lessor have to bear differ according to the type of lease. The lessor is responsible for maintenance. Finance companies undertake leasing as one of their activities. Types of Leases There are four kinds of leases: Sale and Lease Back Under this lease a firm that owns the asset (building. Generally. The lessee is responsible for these costs under a net lease.Chapter 9 . Leasing achieves the separation of ownership from economic use. insurance and payment of property taxes in the case of a full service lease. Leasing industry consists mainly of finance and leasing companies who are lessors. Traditionally. land and equipment) sells the asset and simultaneously executes an agreement to lease the asset back for a specified period on specific terms. The seller-lessee retains the use of the assets. for these returns. For carrying on economic activity or organising production. The terms of the lease as well as the rights of the lessee vary from lease to lease.
The equipment is leased for relatively short periods of around six months to a year or two years. In view of these factors. Operating leases frequently contain a cancellation clause which gives the lessee the right to cancel the lease. The equipment may be given on lease to a succession of lessors over the economic life of the equipment The lessor may also sell the equipment in second hand market. lower maintenance cost and expertise in the range of equipment he specialises. . Operating leases are frequently not fully amortised. leases or sale of leased equipment.payments under sale and lease back are set so as to return the full purchase price to the investor-lessor while providing a specified rate of return on the lessor's outstanding investment. in cases where the lessor activities are restricted to a given range of equipment. Structuring of the Operating Lease The equipment leased under an operational lease has an established use or an active second hand market. he may be able to offer attractive lease terms reflecting his purchase discounts. Longer duration is adopted for ships and aircraft. the cost of equipment is not sought to be fully recovered by the lessor through rental from a single lessee. The lessor expects to recover the full investment costs through subsequent rental payments. Finally. Operating Lease They are also called service leases and provide for the lessor to maintain and service the leased asset and the cost of such maintenance is built into the lease payment.
Financial Lease A financial lease is a long term agreement. the cost of the leased asset is financed by issuing debt and equity claims against the asset and the future lease payments. a) c) The existence of a large value equipment providing for substantial depreciation. Leveraged lease A leveraged lease is arranged when the equipment is very costly. there are three parties in the leveraged lease. the lessee and the lender of funds. using lease contract as the security of the loan. Leveraged leases are financial leases in which the lessor borrows a part of the purchase price of the leased asset. Generally.Financial or Capital Lease Financial or capital lease involves a long term commitment between lessor and lessee. however. the lessor agrees to finance the use of the equipment by the lessee over a time period and is generally not subject to cancellation by the lessee before the end of the base lease period. The equipment is selected by the firm that uses it (lessee) and negotiates the price and delivery terms with the manufacturer. Signing a financial lease contract is like borrowing money. Advantages of Leasing: . But financial lease differs from operating lease in three respects: • • • They do not provide for maintenance service They can not be cancelled They are fully amortised. The lessor obtains maximum tax shelter under the leveraged lease such as complete tax benefits of depreciation as owner of the equipment despite limited equity participation. generally extending over the estimated economic life of the asset. The cost of the lease depends upon the weighted cost of the capital. While the lessee pays rentals without much difference of the nature of the lease. the debt is secured by a first charge on the equipment or lien on lease rentals beyond which the lessor is not liable for the debt obligation.e. create a lien on other assets for realisation of debt from the lessor. which include the lessor. In the leveraged lease. Under the agreement. The leveraged lease has a longer maturity owing to its high value. The agreement may. The lease duration is generally equal to half of the expected life of the asset. Requirements for a leveraged lease are. Financial lease is a source of finance for the acquisition of the equipment. The lessor provides equity funds and is generally termed as equity participant and the lender is called the debt participant. the lessor receives leveraged lease rentals after debt service. The funds borrowed to finance the cost of the assets are of nonrecourse nature i. The user firm negotiates with the leasing unit to buy the equipment from the manufacturer or distributor and after purchase the lease agreement is executed by the user. The availability of a lender willing to extend funds to the user on the strength of user's credit rating b) The inability of either the lessee or a single lessor to utilise depreciation in good time. taxes and other expenses. leaves a return to the lessor. d) The existence of equity investors (lessors) with potentially large tax outflow. Financial leases are also called full payout leases as they enable a lessor to recover his investment in the lease and make a profit. The lease payment is a fixed obligation of the lessee and apart from amortising the cost of asset.
Transaction costs are also lower for lessors of readily saleable assets. These expenses are generally not financed under a term loan. Finally. Dilution of Equity: Dilution of equity by the issuance of equity or convertible term finance can be avoided in lease financing. interest on advance payments. The documentation is quicker as compared to 'security tied' credits such as term loans. Further. lease funding may work out cheaper than a term loan. A large leasing company may be able to borrow more cheaply than a smaller operating company. The procedure for lease financing is much simpler than any other form of asset-backed financing. Lease financing is more comprehensive. Reduced cost of borrowing: Lease finance is highly cost effective source of funds for smaller companies. in several states of the Indian Union. They also relieve the lessee of product obsolescence. the lessee may have to accept some restrictions. the lessor can pass on a part of the benefit to the lessee through a lowering of the lease rental. Simplicity: A leasing agreement is simple to negotiate and administer. As a result. In view of the accelerated amortisation of equipment. Full Funding: Leasing provides 100 percent of equipment finance. Leasing can also be used in project financing with the rentals structured so as to defer lessee's payment obligation till the asset is in commercial operation. taxes and installment payments. cost ineffective. . Expenses: Most of the expenses associated with the leased equipment can be built into the lease and amortised over the lease period. Restrictive Covenants: Lease agreements are free of restrictive covenants and conditionalities as compared to term-loan agreements.Short Term: Operating leases are short term which constitute a convenient means of obtaining the use of an asset for a relatively short period of time. the risk of obsolescence is minimised under a lease. These expenses include delivery charges. The lessee also assumes a higher financial obligation in the event of equipment being found operationally unsuitable or if lessee opts for an early termination of the lease agreement Incentives and grants available to owners of assets who are also end users are lost in the case of a lease by both lessor and lessee. Swapping Tax Shields: In situations where the lessor is in tax paying position vis-a-vis the lessee. Lease Rentals: Lease rental can be structured to accommodate the operational cash-flow pattern of the lessee and aid tax planning of the lease rental. In opting for a lease. lease rentals can be structured to get maximum tax benefit. New Source or Funds: Lease financing may permit a lessee to tap a new source of funds such as finance companies. sales tax is applicable on lease rentals rendering lease finance. Disadvantages or Leasing The principal disadvantages are lessee's forfeiture of the tax benefits of ownership and loss of residual value.
short term securities. which deals with financing of fixed assets. It is necessary that the investment in the current assets should be neither excessive nor inadequate. it is not a part of Project Finance. Strictly.e. The time required to complete the following sequences of events in case of a manufacturing firm is called the operating cycle. Gross working capital refers to the firm’s investment in the current assets and includes cash. it is seen that many a unit flounders because of inadequate working capital. To earn sufficient profits they need to do enough sales. Current liabilities are those claims of outsiders. Promoters have to ensure adequate working capital to reach breakeven point and step up capacity utilisation. if available. the margin money for working capital has to be financed by long term sources and. bills payable. WC requirement of a firm keeps changing with the change in the business activity and hence the firm must be in a position to strike a balance between them. The Net WC being the difference between the current assets and current liabilities is a qualitative concept.Chapter 10 . Concepts of working capital Working capital is the capital you require for the working i. in case the need arises and whereto invest in case of excess funds. which further necessitates investment in current assets like raw materiel etc. bank overdraft and outstanding expenses. debtors. It is essential that such estimates are available and resources are tied up to meet the working capital requirements of the project. Conversion of cash into raw material Conversion of raw material into WIP . bills receivables and stock (inventories). functioning of your business in the short run. secondly. When current assets exceed current liabilities it is called Positive WC and when current liabilities exceed current assets it is called Negative WC. which are expected to mature for payment within an accounting year and include creditors. 2. 1. The financial manager should know where to source the funds from. It indicates: The liquidity position of the firm Suggests the extent to which the WC needs maybe financed by permanent sources of funds Operating Cycle and Cash Cycle All business firms aim at maximising the wealth of the shareholder for which they need to earn sufficient return on their operations. But working capital has to be dealt with under project finance for two reasons: first. Net working capital refers to the difference between the current assets and the current liabilities.Working Capital Financing Introduction Working capital refers to current assets and liabilities. There is always an operating cycle involved in the conversion of sales into cash.
. if you pay dividends or increase drawings.. Also the operating cycle of financial and service firms involves conversion of cash into debtors and debtors into cash. these are cash outflows remove liquidity from the business.loans. If you . Time Is Money... Thus we can say that the time that elapses between the purchase of raw material and collection of cash for sales is called operating cycle whereas time length between the payment for raw material purchases and the collection of cash for sales is referred to as cash cycle. 4. When it comes to managing working capital. 5. receivables and payables) has two dimensions -time and money. Conversion of WIP into FG Conversion of FG into debtors and bills receivable through sales Conversion of debtors and bills receivable into cash Each component of working capital (namely inventory.. leasing etc.. if cash is tight.3... The operating cycle is the sum of the inventory period and the accounts receivables period.. Similarly. equity. whereas the cash cycle is equal to the operating cycle less the accounts payable period. stock of finished goods into debtors and debtors into cash.. You release cash from the cycle Your receivables soak up cash increase your cash resources Get better credit (in terms of duration or You amount) from suppliers Shift inventory (stocks) faster Move inventory (stocks) slower You free up cash You consume more cash Operating Cycle Of Non Manufacturing Firms / Operating Cycle Of Service And Financial Firms DEBTORS CASH CASH DEBTORS STOCK OF FINISHED GOODS Operating cycle of non-manufacturing firm like the wholesaler and retail includes conversion of cash into stock of finished goods.. • • • • • Collect receivables (debtors) faster Collect receivables (debtors) slower Then . . Therefore. one should consider other ways of financing capital investment .
PERIOD A/C’S Pay.ORDER PLACED STOCK ARRIVES STOCK GOES CASH RECD. Period FIRM REC. INVOICE CASH PAID FOR MATERIALS OPERATING CYCLE CASH CYCLE . PERIOD A/C’S REC. INV.
Also a firm with a large scale of operations will obviously require more WC than the smaller firm. Fixed assets (%) 80-90 70-80 60-70 50-60 40-30 30-40 20-30 10-20 Industries Hotel and restaurants Electricity generation and Distribution Aluminum. 3. Since the cost and risk of maintaining a constant production is high during the slack season some firm’s may resort to producing various products to solve their capital problems. this is seen mostly in the industrial products. Firm’s Credit Policy: If the firm has a liberal credit policy its funds will remain blocked for a long time in form of debtors and vice-versa. We can say that trading and financial firms have very less investment in fixed assets but require a large sum of money to be invested in WC. On the other hand Retail stores. then they require high WC. Nature and size of business: The WC requirement of a firm is closely related to the nature of the business. If they do not.The following are the factors that affect the WC needs: 1. Construction Manufacturing cycle: It starts with the purchase and use of raw materials and completes with the production of finished goods. Business fluctuation: When there is an upward swing in the economy. thus it will increase the WC requirement of the firm and vice-versa. for example. hence provisions should be made accordingly.Operating Cycle and Cash Cycle Factors influencing the working capital requirement All firms do not have the same WC needs . . Shipping Iron and Steel. Production policy: To maintain an efficient level of production the firm’s may resort to normal production even during the slack season. basic industrial chemical Tea plantation Cotton textiles and Sugar Edible oils. Tobacco Trading. sales will increase also the firm’s investment in inventories and book debts will also increase. This will lead to excess production and hence the funds will be blocked in form of inventories for a long time. have to carry large stock of variety of goods little investment in the fixed assets. 4. Normally industrial goods manufacturing will have a liberal credit policy. Longer the manufacturing cycle larger will be the WC requirement. The following table shows the relative proportion of investment in current assets and fixed assets for certain industries: Current assets (%) 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 2. whereas dealers of consumer goods will a tight credit policy. 5.
variable working capital is required to meet the liquidity. which is temporary. a portion of working capital. and if they decide to pay their dividends it will weaken their WC position. borrowing from banks. through its effect on tax liability and retained earning. In the case of a new unit. The core current assets represent the absolute minimum stock of raw materials. This will help the firm to maintain a good image and also not part with the money immediately. Profit Margin and Profit Appropriation: A high net profit margin contributes towards the WC pool. The choice of sources for financing working capital has to be made on the basis of their suitability for fixed and variable components. as the cash will flow out. and shareholders and trade credit. tax liability is unavoidable and hence provision for its payment must be made in the WC plan. it needs to plan its WC requirements during the growth period. Financing Working Capital Sources Working capital may be obtained from different sources such as raising from funds from capital market through issue of shares and debentures. Sources of Working Capital .6. directors. otherwise it may impose a strain on the WC. Conditions of Supply of Raw Material: If the supply of RM is scarce the firm may need to stock it in advance and hence need more WC and vice-versa. Also. However this can be avoided by declaring bonus shares out of past profits. which will reduce the tax payable and also retain more cash. 8. Depreciation policy of the firm. Internal sources such as retained earnings and depreciation may be good for an established unit. Thus depreciation is an indirect way of retaining profits and preserving the firms WC position. if the firm is planning to increase its business activities. While fixed and variable components are required to facilitate production and sale through operating cycle. Also if the firm’s policy is to retain the profits it will increase their WC. Availability of Credit: If the firm gets credit on liberal terms it will require less WC since it can always pay its creditors later and vice-versa. The need for WC does not follow the growth but precedes it. Usually. If the dividend policy is linked with net profits. margin. banks insist that the permanent portion of the working capital requirement be brought by the promoters from long term sources – either equity or debt. Growth and Expansion Activities: It is difficult precisely to determine the relationship between volume of sales and need for WC. as the cash does not flow out. Hence. The firm may charge a high rate of depreciation. 9. the firm can pay fewer dividends by providing more depreciation. 7. But a minimum level is required to ensure continuous production. goods in process and finished goods and stores. has an influence on the WC. Core current assets To maintain the operating cycle. excess balance of current assets is required to support varying levels of production and sales caused by seasonal factors. current assets are required which vary over time. Variable working capital On the other hand. which is known as fixed or permanent working capital or core current assets. which are in pipeline to ensure continuity of production. may be financed by equity. thus not affecting the WC position.
any deposit unless – It is in accordance with the prescribed rules. Pursuant to the provisions of the Act. Accruals: This includes what the firm owes to the employees. An advertisement is issued showing the financial position of the company and The company is not in default in the repayment of any deposit or interest. Purchase/Discount of Bills: A bill may be discounted with the bank and when it matures on a future date the bank collects the amount from the party who had accepted the bill. 2. Public Deposits: There are certain provisions under the Companies Act. Obtaining trade credit depends on: a) c) 3. Since they are payable at a future date. Earnings record over a period of time Record of payment. They are a source of spontaneous financing. the company cannot invite. However. which constitutes 25 to 50 % of short term financing. Since the firm pays no interest. 1998’ which have to be complied with along with the provisions of Section 58A of the Act. the Central Government has issued `Companies (Acceptance of Deposits) Rules. bill discounting is an expensive source of short-term funds. Trade Credit: It is a spontaneous source of financing. they have been accrued but not shown as paid in the balance sheet. 4. Letter Of Credit: When an L/C is opened by the bank in favour of the customer it takes the responsibility of honoring the obligation in case the customer fails to do so. Section 58A of the Act deals with the acceptance of deposits. 1975’ and in case of non banking financial companies. A fixed rate of interest is charged and the loan amount is repayable on demand or in periodical installments. Current assets are normally financed by the short-term sources.A combination of short and long term finances is used to finance to WC requirements. 1956 (the Act) under which a company may accept fixed deposits from public/shareholders to meet its short term requirements. When a bank is short of funds it can sell or rediscount the bill on the other hand the bank with surplus funds would invest in bills. Loans: They are either credited to the current account of the borrower or given to him in cash. Forms Of Bank Finance: Banks are the most important source of Working Capital Finance. with discount rates at 13-14 per cent for 90-day paper. they are regarded as a ‘free’ source of finance. or allow any other person to invite or cause to be invited on its behalf. the Reserve Bank of India has issued `Non Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions. Till that time they serve as source of finance. Its main components are wages and taxes. In case of non banking and non financial companies. which include the following: 1. A minimal chare is payable for availing this facility. In this case though the customer provides the credit the risk is borne by the bank. Interest is charged only on the running balance and not on the sanctioned amount. . They give working capital advances in the following ways: b) Liquidity position of a firm over a period of time d) The confidence of the suppliers Cash Credits / Overdrafts: Under this arrangement the borrower can borrow upto a fixed limit and repay it as and when he desires.
maximum deposit a company can accept from public/shareholders is 35% of its paid up capital and free reserves as mentioned above. then it can accept or renew deposits from public upto 35% of its paid up capital and free reserves. Limits for accepting deposits A Company can borrow deposits upto the extent given below: upto 25% of the paid-up capital and free reserves of the company from the public and Upto 10% of its paid-up capital and free reserves from its shareholders. a company may accept deposits upto 10% of its paid up capital and free reserves which are repayable after three months. the funds have to repaid faster Higher rate of interest Short period of maturity. Therefore. and (ii) by the revaluation of any assets of the company. companies normally prefers to accept fixed deposits instead of taking loans from banks as the rate of interest for deposits is generally less as compared to interest charged by banks. a company can accept/invite deposits for a period between 6-36 months. However. Advantages of Public Deposits from the Company’s point of view: Simple procedure for obtaining deposits No restrictive covenants are involved No security needs to be offered The post tax cost is fairly simple Only limited amount of funds can be raised The maturity period being short. Normally. Period of accepting deposits A Company can invite/accept deposits for a period not less than 6 months and not more than 36 months from the date of acceptance of such deposits or from the date of its renewal. from the date of such deposits or renewal thereof to meet any of its short term requirements.For its short term requirements. Therefore. normally 1 to 3 years Disadvantages of Public Deposits from the Company’s point of view: Advantages of Public Deposits from the investor point of view: Disadvantages of Public Deposits from the investor point of view: No security offered by the company The interest on public deposits is not exempt from tax . listed companies come out with the schemes of fixed deposits. Response to such listed companies from public is better as compared to unlisted companies. capital and debenture redemption reserves and any other reserves shown in the balance-sheet of the company and created by appropriation out of the profits of the company. "Free Reserves" mean the balance in the share premium account. If the company is a `Government Company’. but does not include (i) the balance in any reserve created for repayment of any future liability or for depreciation in assets or for bad debts.
5. Inter-Corporate Deposits: They are defined as deposits made by one Company in another company for a period upto 6 months. They are divided into the following types:
Call deposits: They are withdrawable by the lender after giving a day’s notice, however in real life it takes about three days. The interest on such deposits is around 16 % p. a Three-months deposit: they are taken to overcome the shortage resulting out of disruption in production, excessive imports of raw material, tax payment, delay in collection, etc. The interest in this case is normally around 18 % p.a. Six-months deposits: They are normally made with good borrowers and the interest rate in this case is around 20 % p.a.
Important characteristics of the inters-corporate deposits market include:
Lack of regulation: It has helped to make inter-corporate deposits hassles free and hence very convenient Secrecy: The brokers do not reveal the names of their borrowers and lenders, which would other wise lead to unwanted competition and underwriting of rates Importance of personal contacts: The lending decisions in these markets are often based on personal contacts rather than reliable market information
Although deposits can be of varying maturity structures, they work best as short-term bridging instruments and not as a regular funding source.
6. Short-Term Loans From Financial Institutions: The LIC, GIC and UTI provide short-term loans to manufacturing companies that have a good track record. The following are the eligibility conditions if obtaining the loans:
Declared an annual dividend of 6 % for the past 5 years, in some cases it is 10 % over last 3 years The debt equity ratio should not exceed 2:1 The current ratio should be at least 1:1 The average of the interest cover ratios for the past three years should be at least 2:1
The important features of the short-term loans provided by the financial institutions include:
They are unsecured and given on the basis of a demand promissory note The loan is given for a period of 1 year and can be renewed for two consecutive conditions are satisfied years if the eligibility
The company has to wait for at least 6 months after its repayment in order to avail of a fresh loan
7. Rights Debentures For Working Capital: In order to get long term resources for working capital, the public limited companies can issue ‘rights’ debentures to their shareholders. The key guidelines to be followed include:
The amount of debenture issue should not exceed 20 % of the gross current assets, loans and advances minus the long term loans presently available for financing working capital OR 20 % of paid up share capital, including preference capital and free reserves, whichever is the lower of the two The debt - equity ratio including the proposed dividend issue should not exceed 1:1
They shall be first offered to Indian resident shareholders of the company on a pro rata basis
8. Commercial Paper: Large firms who are financially strong issue commercial paper .It represents a shortterm unsecured promissory note issued by firms of high credit rating. Its important feature include:
Maturity ranges from 60-180 days It is sold at a discount from its face value and redeemed at its face value. Thus the implicit interest rate is a function of size of the discount and the period of maturity Either directly placed with investors or sold through dealers Usually bought by investors who keep it till the maturity and hence no well developed secondary market
Who can issue CP? Highly rated Corporate Bodies, primary dealers, satellite dealers and All-India financial institutions have been permitted to raise short-term resources. Eligibility of issuing CP
Minimum tangible net worth as per the latest audited balance sheet is Rs. 4 crore. Company has been sanctioned working capital limit by bank(s) or all-India financial Institution(s) and Borrowal account of the company is classified as a Standard Asset by the financing bank(s)/institution(s). Minimum Credit Rating required from recognised credit rating agencies.
Minimum credit rating required to issue CP Specified credit rating of P2 is obtained from Credit Rating Information Services of India Ltd. (CRISIL), A2 in the case of Investment Information and Credit Rating Agency of India Limited (ICRA) and PR2 in the case of Credit Analysis and Research Limited (CARE), Maturity period of CP The CP can be issued for maturities between 15 days to 1 year from the date of its issue. Minimum amount of investment and denomination of CP The minimum amount required to be invested by a single investor is atleast Rs. 5 lakhs. It can be issued in denominations of Rs. 5 lakh or multiples thereof. Who can act as Issuing and Paying Agent (IPA)? Only a scheduled bank can act as an IPA for issuance of CP. Who can invest in CP? CP may be issued, to and, held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the limits set for their investments by Securities and Exchange Board of India (SEBI). Mode of issuance of CP
CP can be issued either in the form of a promissory note or in a dematerialised form through any of the depositories approved by and registered with SEBI. As regards the existing stock of CP, the same can continue to be held either in physical form or can be dematerialised, if both the issuer and the investor agree for the same.
Procedure of issuing CP Every issuer must appoint an IPA for issuance of CP. The issuer should disclose to the potential investors its financial position as per the standard market practice. After the exchange of deal confirmation between the
investor and the issuer, issuing company shall issue physical certificates to the investor or arrange for crediting the CP to the investor’s account with a depository. Investors shall be given a copy of IPA certificate to the effect that the issuer has a valid agreement with the IPA and documents are in order 9. Factoring: A factor is a financial institution set up to provide services related to management and financing of debt arising from credit sales. The important features of factoring services include:
The factors selects the account of the clients, and establishes credit limits applicable to the selected accounts It takes the responsibility for collecting the debt of accounts handled by it. For each account the factor pays to the client at the end of the credit period or when the account is collected, whichever comes earlier The factor advances the money to the client against not yet collected and not yet due debts. Normally the amount received is 70-80 % of the face value of the debt and carries an interest rate which is equal or a little higher than the lending rate of the commercial banks
The credit risk could be borne by the client or the factor. In India it is mostly on the recourse basis, i.e. the risk is borne by the client. The factor charges a commission which may be 1-2 % of the face value of the debt factored. Advantages of factoring:
Ensures definite pattern of cash inflows from credit sales Continuous factoring may virtually eliminate the need for the credit and the collection department Comparatively an expensive form of financing The factoring debt may be perceived as a sign of financial weakness
Disadvantages of Factoring
10. Loan Syndication
Borrowing for working capital from a single commercial bank or a consortium has restricted fund flows to corporates. Loan syndication, a method used in Euro-dollar market is an alternative to consortium lending. The major benefits reaped by corporates, in syndication, are amount, tenor and price. The syndication method reverses the current practice where the corporate borrower faces rigid terms in a take it or leave it situation. The cost of syndication is likely to vary with credit risk. Borrowers of high credit standing are likely to get best terms. Syndications make for efficient pricing and are administratively easier. In loan syndication, the borrower approaches several banks, which might be willing to syndicate a loan, specifying the amount and tenor for which the loan is to be syndicated. The syndicated loans are being discussed as an alternative for consortium loans for working capital. But they can be used for project financing, as is the practice in the Euro- dollar market. On receiving a query, the syndicator or the lead bank scouts for banks that may be willing to participate in the syndicate. The lead bank/syndicator assembles a management group of other banks to underwrite the loan and to market shares in it to other participating banks.
the lead bank/syndicator prepares a common document to be signed by all the members of the syndicate and the borrowing company. On the basis of data in the placement memorandum. A syndicated loan would have a funded component or core component on which interest will be charged on the loan being sanctioned and a standby line of credit which would meet the adhoc increases in credit needs of borrower. a placement memorandum is prepared by the lead bank and the loan is marketed to other banks who may be interested in taking up shares. a five-year period. While the borrower signs only one document. The placement memorandum helps the banks to understand the transaction and provides information about the borrower. Once the syndicator/ lead bank receives the mandate from the borrower. warranties and agency. However. security. loan pre-payment. say. Interest on the standby portion will be charged only on the amount withdrawn. The loan could dispense with the restrictions or norms of the working capital assessment. interest. Agent's fees is a yearly charge.The lead bank or syndicator can underscore his willingness to syndicate the loan on a firm commitment basis or on a best efforts basis. banks make a reasonable appraisal of the credit before deciding about the participation in the loan. . a commitment fee is charged on unutilised portion. The former is akin to underwriting and will attract capital adequacy norms reducing the bank's flexibility. The document usually lists out details of the agreement with regard to tenor. Based on the information received from all participating banks. Once the bank decides to become a member of the syndicate. The agent to the loan who is normally the lead bank/ syndicator attends to all administrative work such as collection of interest and amortisation of the loan. it indicates the amount and the price it is likely to charge on the loan. The total syndicated loan could take care of the requirement for project finance and working capital. he shares separate contractual relationship with each syndicate member. The interest charge can either be floating or fixed. may be on a floating rate basis pegged to minimum lending rate. Actually working capital requirements for.
RK Sinha. • • A rough estimate of the returns from the project was made. The largest railway project in this part of the world in the last five decades threw up a whole range of difficulties technical. That is. The rocky Sahyadris had to be bored through. Finance. A Detailed Project Report was prepared. . a railway line had to be built out of nowhere. financial. the following two factors were kept in mind: 1) The land acquisition had to be minimum. Goa and Karnataka . The Appraisal Before the project was handed over to the KRC. Director. The project was expected to generate an internal rate of return (IRR)of 14 percent. at least in this part of the world. Mumbai and Mangalore. It aimed at improving access to the fertile areas of Konkan and thus ensure economic development of the region. The various problems. With a total number of 2. had been carried out efficiently and in a very short time. poisonous snakes and tigers had to be faced.500 rivers had to be forded. This report consisted of two parts: Detailed Engineering Survey Detailed Traffic survey The Engineering Survey aimed at studying the land terrain to arrive at the optimum alignment between the starting and the end points of the rail network. 2.Case Study 1 . it was being handled by the Southern Railway. emotional and psychological.Konkan Railway Corporation (KRC) Methodology: Interview with Mr. And sometimes. Findings: The project: The Konkan Railway is the missing link between India's commercial capital. line now connects Maharashtra. Objective of the project The project intended to provide alternate. emphasis was laid on laying the track from around the inhabited areas. Konkan Railway Corporation. A two level appraisal was followed: 1. Hence. The 760 Km. the project is the biggest and perhaps most difficult railway undertaking during this century. 1.000 bridges and 92 tunnels to be built through this mountainous terrain containing many rivers.a region of criss-crossing rivers. not too many inhabited areas were to be affected by the project. permanent and shorter transport facilities to this part of the country. For this. plunging valleys and mountains that soar into the clouds.
but the securities scam of 1992 depressed the primary market for bonds too. To level the land for laying the track. however that would essentially mean the privatisation of railways. 1043 crore from Rs. There was a need for further funds. 750 crore.5% by the Ministry of Finance in 1992. The central government roped in four state governments to subscribe to the equity. KRC resorted to External Commercial Borrowings of $115 million (Rs. which were tax free.861 Crore. was fixed at 9%. Providing for the inflation for two years @10%. the project cost went up to Rs. the KRC took the project over from the Southern Railway. Usha Ispat. It is essentially the ‘end use’ method of demand forecasting. Hence the need was felt to separate the project from the government. The debt equity ratio for the project was fixed at 3:1. which was not acceptable to the government. three things could be done: Building bridges Boring tunnels through the mountain Earthwork. Estimated cost of the project: The project. Hence the idea of Konkan railway bonds took birth.2) Arriving at the optimum path to minimise the cost of levelling the land. In 1991.e. cement plants were expected to be established at Saurashtra and hence increase the flow of traffic. Similarly. This was raised to 10. It sold off the already constructed railway tracks to Infrastructure Leasing and Financial Services (IL & FS) and raised Rs. 861 crore earlier. i. through the questionnaire method. The equity was fixed at Rs.. It aimed at finding out the movement of raw materials and finished goods into and through the project area. This would enable access to the capital market. was expected to cost Rs. either ‘cutting’ the land or ‘filling’ the land The Traffic Survey consisted of Origin-Destination Study (OD). Accordingly. The project had not taken off for two years. 250 crore and the debt (only bonds) at Rs. This was on a BOT basis. . the government did not have the funds to meet the cost of the project. Thus the cost of the project rose to Rs 1600 crore. as estimated by the Southern Railway Corporation in 1989-90. The OD consisted of studying the industries in the catchment area. the ownership pattern of the KRC was now as follows: Ministry of Railways : 51% Maharashtra: 22% Karnataka: 15% Goa: 6% Kerala: 6% The interest rate on the bonds. Sale and Lease Back was another source of finance that KRC resorted to. etc. Hence. However. Estimates were also made regarding future bulk traffic on account of the establishment of Essar Steel in Ratnagiri. The interest was payable even during the construction period. 409 crores). 100 crore.
The final financing structure stood as follows: Equity: Rs. 2750 crore The debt was made up of the following components: Bonds: Rs. Infact. 2. This is highly unfavourable. 325 crore. mostly the interest on bonds. 100 crore Breakeven Point KRC expects to breakeven in the next 20 years. 4.409 crore Sale and lease back: Rs. as it increased the interest burden. which proved very costly in a falling rupee scenario. 520 crore (it was swapped at this point). 5. This delayed the project by 7 to 8 months. This delayed the project by two years. cement. Hence the expected traffic did not materialise. 2520 crore. Time overruns due to opposition from the environment groups proved very costly. 2250 crores ECB: Rs. This increased the cost of finance as well as increased the principal substantially. Analysis of the Konkan Project: 1. as seen in the P&L Account of 2000-01 is the financing charges. . The demand being derived demand. But the bulk traffic in the form of transport of coal. The cement units expected to start at Saurashtra did not start their operations. it turned out to be fractured rock. 1030 crore. The falling rupee market increased the value of the ECB from Rs. 800 crore Debt: Rs. The fall in the bond markets due to the Harshad Mehta scam of 1992 forced KRC to avail itself of ECBs. 3. as the high cost bonds entail a permanent burden even during the construction period. It stands at Rs. This led to major expenses by way of interest. The major item of expense. More equity should have been raised from the state governments as the centre did not have the funds. 3550 crore. it is very sensitive to the state of the economy and the rate of growth in basic industries. etc is not coming as expected. 2) Unexpected terrain: The soil structure turned out to be much more difficult than expected. This was over and above the interest burden of Rs. 409 crore to Rs. Highly unfavourable debt equity ratio: The debt equity ratio of KRC stood at about 5:1. The reason for such a long gestation is the nature of the demand for railways. now the cement is milled and packed at different locations. Infact it has reduced due to an overall slowdown in the economy.Time and Cost overruns Two important factors led to time and thus cost overruns for the project: 1) Objection from environmental groups in Goa: The Prime Minister ordered stoppage of work till the enquiry by the Justice Ojha Committee was completed. which is 60% of the total expenses incurred in the year. Thus the total cost of the project worked out to Rs. Instead of the laterite soil that was expected. By now the estimated project cost had gone up to Rs. steel.
3. 2. A company that is directly benefiting from the project can be approached to subscribe to the equity. 4. KRC should use the expertise it has developed in commissioning such infrastructure projects to augment its income. though KRC is making losses. . Augmenting income from other sources: This is necessary so that KRC can repay its debt early and hence bring down its cost of finance. ensuring that it recovers atleast its variable costs. i.e. Roping in a private company as a minority stakeholder should not be ruled out.. Ensuring that the operating income is positive.Steps that can be taken now: 1. It should undertake more construction projects like the Skybus project it has undertaken for Iraq.
. This is applicable to term loans and more so to the capital markets. Sometimes delays may make a project completely unviable to undertake. delays may occur primarily due to the failure to get the legal approvals in time. an ongoing project needing more funds will find it extremely tough to raise equity in the dried up market. 1. For example. Background of the promoters: This factor plays a very important role in the ability of a project to raise finance for its project. For example. the current recession in the global economy has made it difficult for any company to come out with a public issue. Market Dynamics: The ability of a firm and the ease with which it can raise funds depends on the market sentiments. The project managers thus have to ensure that a healthy relationship is maintained with the policy makers and the ruling parties. 3. Thus. the strong image of Reliance Industries as being excellent at project implementing and getting it off the ground would help them get access to funds much more readily than to another company. The recent terrorist attacks on World Trade Center have depressed market sentiments worldwide. A firm proposing to raise equity capital has to trade off between time and cost overruns (of waiting for the markets to revive) and the decision to raise finance from other sources. These problems need to be given due consideration when anyone is undertaking any project. The financial structure has to be adjusted suitably to minimise such costs. Hence Konkan Railway Corporation had to resort to External Commercial Borrowings at a high cost. This was amply evident in the recent controversy involving Enron Corp with regard to the Dabhol Power Company. The Harshad Mehta scam in 1992 scared away investors from the market for some time. Time and cost overruns: This problem may be faced by any project manager. Uncertainty of political environment: The political environment and consequently the public policy with regard to sector or a project may undergo serious and adverse change. In such an environment. The failure to get the project off the ground in time or delays due to external factors push the cost of a project upwards significantly.Observations and conclusions: There are certain very important practical and unexpected problems that a project manager may face. 2. a two year delay in getting the project off the ground cost Konkan Railway Rs. In the Indian context. 4.
5. Development of innovative means of finance: The market sentiment and legal requirements may force you to look beyond the traditional means of finance. Such problems should be avoided by devising appropriate financial structures. Tatas had issued Secured Premium Notes in 1992. The Globalisation of Project Financing: Project financing has become truly global. For example. The entry of credit rating: Credit rating has entered the Project Finance arena. The issue of ADRs and GDRs makes it possible for companies to access global markets for their funds requirement. Firms like Moody's help a project get a rating based on its viability and expected profitability. 7. . Companies should make full use of the leeway that is allowed to them by law in designing financial instruments. the Japanese Leveraged Lease used by Air India to finance its aircraft purchases is an excellent innovation. A new project should make full use of such ratings to convince the FIs. Similarly. This also means that project appraisal and management techniques will have to be tuned to meet global standards. its financial structure was such that it entailed a high fixed interest burden on the project even during the construction period. Similarly.182 crores in terms of inflation. This calls for creative solutions to enable the project to get funds. 6. Banks and the retail investors of its viability and thus make it easier to raise finance.
The bids are invited from international banks / financial institutions for a suitable financing package including any innovative financing proposals for acquisition of aircraft. An aircraft-financing package can either be a conventional ‘Vanilla Loan’ or ‘ Structured Financing’. (b) Air India can avail of export credit guarantees given by ‘Export Credit Agencies’ in the countries of aircraft manufacture. this tranche is also available for financing the cost of acquisition of spares. A conventional ‘Vanilla Loan’ package for aircraft financing normally consist of two tranches: An export credit agency guaranteed tranche upto 85% of the aircraft cost. 7. workshop equipment and ramp equipment included in the aircraft project cost. 10. The spread over LIBOR of this tranche is comparatively higher than the export credit agencies guaranteed tranche at (a) above. Dy. and 9. Before delivery of aircraft. 6. The reasons for borrowing in foreign currency are as follows: (a) Air India earns a large proportion of its revenues in foreign currencies. 2. Air India has financed its aircraft acquisition programmes in the past through External Commercial Borrowings instead of borrowings in the domestic market. Pradnya Oraskar. The mandate is then awarded to the bank / financial institution offering the cheapest package as per the approval of the Ministry of Finance. Air India approaches the Ministry of Finance through the Ministry of Civil Aviation for their approval in principle to invite bids and contract foreign currency loans for aircraft purchase. Air India’s low cost borrowings in the international market are protected in this manner from the impact of the virtually continuous depreciation of the Indian Rupee. A Commercial Loan tranche for the remaining 15% of the aircraft cost. The lending banks accept a lower spread over LIBOR under this tranche since there is no risk exposure to either Air India or to the Government of India defaulting in the transaction. Air India initiates the process of contracting foreign currency loans to finance the acquisition of the aircraft after signing a purchase agreement with the aircraft manufacturer. Projects Division. 5. General Manager.Aircraft Financing At Air India Methodology: Interview with Mrs. The repayment of the loan . Air India then evaluates the underwritten offers received in order to determine the most economic package. 8. which could otherwise offset the low cost of borrowing in the international market. In addition. Air India Findings: 1. The tenure of both the tranches is normally for a period of 10/12 years and in any case not exceeding 12 years. Both tranches together comprise the total aircraft financing package. This tranche normally carries a lower spread over LIBOR (London Interbank Offered Rate) since this tranche is guaranteed by the ’Export Credit Agencies’ of the country of the aircraft manufacturer. The revised offers are again evaluated and the recommendations submitted to the Ministry of Finance through the Ministry of Civil Aviation in order to obtain Government of India’s approval to arrange the financing package. 3. It has therefore a natural hedge against adverse currency fluctuations. 4. The parties are requested to resubmit their best possible offers. thereby achieving a more competitive cost of financing as export credit guarantees have even lower spreads than foreign currency commercial loans. The term sheet submitted by the banks / financial institutions are scrutinised and detailed discussions are held with the shortlisted banks/ financial institutions wherein clarifications on their term sheets are sought.Case Study 2 .
principal is in semi-annual installments. Japanese Leverage Lease (Jll) Air India had also financed three aircraft (one B747-300 Combi in 1988 and two A310-300s in 1990) through Japanese Leverage Lease (JLL). This mode of financing gained popularity in the mid 1980’s and early 1990’s and was a much favoured form of financing employed by various airlines for their aircraft purchases. . recent accounting guidelines in India and abroad make it mandatory to disclose JLLs in the Balance Sheet (g) As the airline does not have to borrow 100% of the aircraft cost upfront to pay the aircraft manufacturer. Some additional features of a Japanese Leverage Lease are as follows: (a) The equity subscribers to the SPC are mainly Japanese corporations desirous of taking advantage of the Japanese tax laws which allow depreciation benefit on the aircraft under JLL (b) A part of the tax benefit is passed on to the airline through the mechanism of lower lease rentals. However. the agent bank forms a Special Purpose Company (SPC) in Japan with an equity participation from a group of Japanese investors. Under the JLL financing. the Government has informed Air India that no guarantee can be given for financing aircraft acquisitions in future from January 1995 even if the airline were prepared to pay a guarantee as in the past. The aircraft is then leased to the airline by a separate agreement for a maximum period of 12 years. there is a substantial Net Present Value (NPV) benefit in such a structure. Other Finance Structures A. the ownership of the aircraft passes to the airline after the payment of a Purchase Option of approximately 45% of the original aircraft cost. the airline pays interest only on the loan amount and the equity providers mainly get their returns by claiming the depreciation in their books in addition to a marginal return from the airline. in the case of two A310-300s financed under JLL in 1990. which is passed on to the lending banks through the SPC. However. A part of this payment is covered by an initial yen deposit placed with the bank structuring the deal (e) The entire payment profile is structured to minimise the cost to the airline and thus make the structure attractive (f) This structure enables the airline to keep the debt (balance lease obligations) off its balance sheet thus allowing it to show a better debt: equity position. For example. The SPC borrows money from the lending banks and makes the payment to the aircraft manufacturer and thereby owns the aircraft. In the past the entire financing package was guaranteed by the Government of India. Technically. Air India was required only to borrow 91% of the cost to service the debt and the equity holders thus resulting in an upfront 9% NPV benefit. The Japanese equity investors are required to contribute around 15% to 25% of the aircraft cost and the balance is arranged through loans. The airline makes regular lease payments comprising of principal and interest. thus making the JLL very attractive as compared to traditional loans (c) The Japanese equity providers require an indication of comfort that their contributions will be repaid and hence the Airline has to keep a deposit (in Yen) in a bank in Japan to secure this obligation (d) At the end of the lease term of 12 years.
Accounting Treatment for Asset Based Financing . Unlike a Japanese Leveraged Lease structure. The interest rate on the US Exim tranche of this financing was very attractive (three-month LIBOR in US dollars plus a spread of 0. This enabled Air India to arrange loans at competitive rates. France and Germany. Air India. However as the Government of India was firm in its decision of not providing a guarantee. there is no equity contribution from the lessor as owner of the aircraft and therefore Air India could not derive any upfront benefit. The Government of India had at that time categorically stated that no guarantee would be forthcoming for the financing package for these aircraft. As this structure was asset based. Under this structure a Special Purpose Company (SPC) was set up in a tax-free haven (Bermuda) to own the aircraft and subsequently lease the aircraft to Air India. therefore. Asset Based Financing 1. arranged asset based financing with a US Eximbank’s guarantee. The US Eximbank insisted on a Letter of “Comfort” from the Government of India. 4. The Company will capitalise these values at the end of lease period if the option to purchase is exercised. 2. the Lessor) as the shares of this SPC were pledged to US Eximbank. the Company has an option to purchase these aircraft at 45% of the original cost or terminate the lease as per the agreement. the aircraft acquired under this financing structure together with two additional B747-400 aircraft acquired earlier were required to be mortgaged to the US Eximbank as security for their guarantee.e. the US Eximbank agreed to do an asset based financing structured as a Finance Lease. At the end of the lease period. Normally the US Eximbank does not allow government owned airlines to undertake asset based financing.Accounting Treatment for Japanese Leverage Lease (JLL) The Japanese Leverage Leases are off Balance Sheet. i. The title to the aircraft will pass on to Air India on expiry of the lease term of 12 years without payment of any purchase price. This enabled the US Eximbank to control directly the SPC (i. Air India acquired two B747-400 aircraft in Oct/Nov 1996. neither the aircraft nor the balance lease obligations of the Corporation are shown in the Balance Sheet. In view of a 100% Government ownership. Air India had not faced any problem in getting guarantees from the US Eximbank and the export credit agencies of the UK.e. This letter was provided after protracted negotiations with the Ministry of Finance. 5.08%). 9. 10. 3. All payments against the lease are debited to Profit and Loss Account and no depreciation is claimed on these aircraft. 8. The US Exim guaranteed lenders provided the funds to the SPC to enable the SPC to purchase the aircraft from the manufacturer. B. The outgo to Air India under this finance lease structure was exactly the same as under a vanilla loan. 7. the Ministry of Civil Aviation and the Ministry of Law. 6.
loan taken for lease financing. Keeping with International Accounting Standards the two aircraft acquired during the year 1996-97 have been brought into the books of accounts.e. . Only the interest charges of the lease rent is debited to Profit and Loss Account and the principal amount of the lease rent is reduced from the balance lease obligation i.Air India had structured the loan taken for acquisition of these aircraft as Finance Lease in order to give US Exim Bank control over the mortgaged aircraft. Air India claims depreciation on these aircraft as per the standard depreciation policy adopted for all aircraft. The new aircraft form a part of the Fixed Assets of the Company and the balance lease obligations are shown under Long Term Debt.
Working capital Year 0 1 2 3 4 5 .. Administration expenses 5.10 Annexure 2: Proforma for Estimate of Foreign-Exchange Flows or a Project (In foreign exchange) Item 0 I.. Salaries & wages 3. Direct inflow . Sales tax @ x% Earnings before depreciation.. Sales Revenues B.Annexure 1 Project Cost Financing and Cash Flow Proforma for Appraisal (Rs.. Foreign-exchange inflows (FI) 1 2 Year 3 4 5 A. Lakhs) Outflows 1. lakhs) Total Projected figures 0 A. interest and income tax(A-B) Less: interest Profit before depreciation and income tax Less: depreciation Profit before income tax Less: Income tax Net profit Add: Depreciation Working capital Cash inflows Less: Cash outflows Net cash flow 1 Year 2 3 4 5 . Manufacturing expenses 4. Raw materials 2. Equity capital (2) (DE Ratio 1:2) Cash flow projections (Rs.10 Total outlay Sources of finance 1. Term loans (1) 2. Land and building 2. Less Operating Costs: 1. Plant and machinery 3.
technical consultancy. Exports of goods or Services 6. Import of raw materials. Export of goods or services 11. machinery. Import of capital goods. engineering fees 13. know-how and patent rights 21. intermediates and replacements 25. 2. Survey. Imported goods purchased on domestic market 26. Foreign equity capital Term loan 3. Foreign aid or grant 10. Repayment of term loans 20. Capital 8. components. and machinery 24. Foreign aid or grant 4. Goods or equipment on deferred payment 5. Others B. negative -) . replacements. Others II Foreign exchange Outflows (FO) A. Royalty. Direct outflow 12. Construction and installation charges 17. Term loans in cash and in kind 9. Indirect outflow (for linked projects) 23. equipment. Import of capital goods.1. Salaries payable in foreign exchange 19. Others B. Others III Net foreign-exchange flow (I -II) (positive +. equipment. 14. Direct charges on imports of raw materials. Imported goods purchased from domestic market 16. Import of raw materials. Repatriation of profits and capital 22. parts and semi-finished goods 15. intermediates and replacements (Payable in foreign currency) 18. Indirect inflow (For linked projects) 7.
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